Under LPB, people, not companies, bear risk as their mutual funds do well or poorly

TO BE NOTED: From Big Greg Mankiw:

"The Ideal Financial System

As seen by economists Larry Kotlikoff and Ed Leamer. Their suggestions remind me of narrow banking proposals."

And Forbes:

"A Banking System We Can Trust
Laurence J. Kotlikoff and Edward Leamer 04.23.09, 12:00 AM ET

Before throwing more money at Wall Street, let's understand what our financial system was supposed to deliver, what it did deliver and what price it charged.

The system was supposed to channel our hard-earned savings into the best real investments: new homes, offices, factories, equipment and research. And it was supposed to correctly price our assets.

It did neither. Instead, Wall Street morphed into a vast gambling enterprise, generating massive trades of existing securities without, in fact, raising the investment rate or growing the economy.

During the dot-com bubble, Wall Street funded all manner of silly businesses, and during the housing bubble, it put millions of people in homes they couldn't afford. This "expertise," which cost one-tenth of our output, was delivered by the best and brightest, with half of Harvard's graduating classes becoming high-class croupiers.

As for pricing assets, the stock market's been on a five-decade roller coaster, notwithstanding a relatively stable real economy. The market rose dramatically from 1950 through the mid-1960s. It then spent the next decade and a half falling through the floor. Then it rose like crazy in the late '90s, crashed, soared and crashed again.

We need a financial sector but not one like this. Nor do we need Wall Street hitting us up for its gambling debts. What we need is Limited Purpose Banking (LPB), which would transform all financial corporations, including insurance companies and hedge funds, into mutual funds. They would, henceforth, be called banks.

Under this system, banks would never fail for a simple reason. They'd never hold any financial assets and they'd never borrow except to finance their mutual fund operations. Instead, they'd be limited to their legitimate purpose--financial intermediation. Under LPB, people, not companies, bear risk as their mutual funds do well or poorly.

A new Federal Financial Authority (FFA)--would rate, verify, supervise custody, disclose and clear all securities purchased, held and sold by LPB mutual funds. Private rating companies could stay in business, but no one would need to trust them ever again.

Banks would initiate personal and business loans (including mortgages), send them to the FFA for processing and then sell them to mutual funds, including their own. Loans would activate when sold, so no bank would ever have an open position.

All mutual funds would break the buck with one exception: cash mutual funds. These funds would strictly hold cash and be valued at $1 per share. Owners of these funds would write checks against their balances and never have to worry about a bank run. Fractional reserve banking and the FDIC would be history.

LPB would include insurance mutual funds. These funds would pay off based on the losses experienced by contributors. If losses are larger than expected, less is paid out per loss. Hence, LPB prevents insurance companies from insuring the uninsurable, e.g., claiming they'll pay the same life insurance claims even if there's a plague.

All risk allocation arrangements can be run through mutual funds, including credit default swaps. Take a bank that markets the GE-Defaults-On-Its-Bonds-In-2010 fund. Under this closed-end fund, shareholders specify in advance if they want to get paid off if GE does default on its bonds in 2010 or paid off if GE doesn't default. All money put into the fund, less the mutual fund's fee, would be held in one-year Treasuries and paid out at the end of the year to the winning shareholders in proportion to their holdings.

Hence, Limited Purpose Banking can accommodate credit default swaps (CDS) as well as any other risk product. But what Limited Purpose Banking won't do is leave any bank exposed to CDS risk since people, not banks, would own the CDS mutual funds.

If such mutual funds sound revolutionary, they're not. Funds of this kind have been around for centuries. They go by the name "tontines," or systems of "pari-mutuel betting."

Limited Purpose Banking would enhance liquidity, since all funds would trade in the market even if their underlying assets are illiquid. It would permit the extension of as much credit as the public--which is the ultimate source of credit--wishes to provide by buying mutual funds that purchase household and business loans. And it would force banks to charge fees and pay their employees based on their mutual fund performances as determined by the market.

What LPB will eliminate is insider rating, freeriding on FDIC insurance, self-custody arrangements, no-doc loans, institutionalized gambling, me-now compensation plans, financial malfeasance and the possibility of future financial collapse. In other words, it would be a system we can trust.

Laurence J. Kotlikoff and Edward Leamer are professors of economics at Boston University and UCLA."

adopt the stock-buying plan comes in spite of considerable opposition to government intervention in the market

TO BE NOTED: From the FT:

"Japan plans emergency share purchases

By Michiyo Nakamoto in Tokyo

Published: April 17 2009 05:41 | Last updated: April 17 2009 18:12

Japan’s ruling Liberal Democratic Party on Friday unveiled details of its proposed Y50,000bn scheme to allow the government to buy shares from the market if share prices fall to an extent that is seen as an economic emergency.

LDP lawmakers said the proposals would be submitted to parliament on April 27, the same day a supplementary budget to fund a record Y15,400bn ($155bn) stimulus package is put ­forward.

The stock-buying facility, which would run only until March 2012, highlights concerns about the impact of the sharp fall in Japanese share prices, which hit a 26-year low last month. The LDP’s plan is in addition to the stimulus package

Masaaki Shirakawa, the Bank of Japan governor, on Friday warned that fears about the fall in stock prices or a worsening economy could damage the ability of financial institutions to perform their role in financial intermediation.

“Commercial paper and corporate bond issuance is improving. But Japan’s financial environment remains severe as a whole with more companies, regardless of their size, saying funding conditions and banks’ lending attitudes are severe,” Mr Shirakawa told BoJ regional branch managers on Friday.

Since Japanese banks count a substantial level of stock holdings as part of their capital, a sharp decline in share prices hurts their ability to increase assets.

Under the LDP’s proposal, a new public body would be set up to buy the shares with funds raised from the Bank of Japan as well as private banks and guaranteed by the government.

Strict criteria would have to be met to trigger the buying of shares, and the prime minister would head a financial crisis committee responsible for giving the go-ahead.

For example, action could be triggered by the market’s price-formation function being seriously damaged or the price earnings ratio of companies dropping to below “normal” levels for an extended period. Panic selling could also trigger buying by the public body.

The decision to adopt the stock-buying plan comes in spite of considerable opposition to government intervention in the market.

Some sceptics see it as an election ploy by the LDP. “It appears to be a political gambit to make sure that the stock market doesn’t collapse during the election campaign,” said an equity salesperson at a western investment bank."

"Consumers should not be regarded as Pavlov’s dogs, automatically responding to stimuli offered by politicians"

Here's an interesting post on the FT:

"The fiscal cure may make the patient worse

By Leszek Balcerowicz and Andrzej Rzonca

Published: December 10 2008 19:56 | Last updated: December 10 2008 19:56

As the financial crisis attacks the economy, there is growing pressure on governments around the world to introduce fiscal stimulus programmes. This follows big interventions in the financial sector, massive easing of monetary policy, especially in the US, and substantial loosening of fiscal policy. The fact that there are time lags between these interventions and their effects seems to have been ignored."

I don't think anyone's ignoring them mates.

"The assumption appears to be that fiscal stimulus will automatically revive private spending. But this belief contrasts with data that show there is considerable uncertainty about the size and nature of the stimulus required to cause spending to increase."

I don't make such a Mechanistic assumption at all. It's a gamble.

"Some say that financial crisis in the developed economies creates favourable conditions for a strong Keynesian stimulus. This would, the theory goes, boost the confidence of consumers and increase their readiness to spend the extra money. The larger the stimulus, the stronger its impact on consumer confidence and the greater the multiplier effect. How this effect would be produced is not explained. Instead we are given mechanical metaphors, such as “jump-starting” the economy."

I too am worried about the size of the stimulus. The focus on a number bothers me as too mechanistic. We should be focusing on what we should spend the money on that makes sense on its own terms. I call it "Cowen's Creed".

It's not fair to say that there are no explanations of how it might work, but they're controversial. That's why I fall back on Cowen's Creed.

"Consumers should not be regarded as Pavlov’s dogs, automatically responding to stimuli offered by politicians. Consumers are guided by expectations. They take a longer term view in making their spending and saving decisions. This limits the stimulating effect of most temporary tax cuts relative to permanent ones. Consumers also have concerns about the fiscal sustainability of their governments in assessing their long-term disposable income. Research suggests that when the ratio of public debt to gross domestic product is already high, the multiplier effect of fiscal stimulus is low. In extreme cases, fiscal expansion may even be contractionary. This fact should reduce the number of countries that undertake fiscal stimulus, especially if one considers their unfunded liabilities and the fiscal consequences of the public interventions undertaken so far."

This I completely agree with. Incentives of any kind are not automatic as to their results. Also, the WSJ/NBC Poll showed that people are far more aware of our current fiscal situation than many believe. The stimulus is a risk.

"Not only is there a danger that the high initial level of public debt relative to GDP will limit the impact of any fiscal stimulus. In addition, the sheer size of a stimulus package, which would lead to a deterioration of a country’s fiscal position, may have a negative effect on consumer confidence. "

This seems possible.

"Consider Sweden’s banking crisis in the early 1990s. Discretionary fiscal stimulus was immense, but counter-productive. With public debt growing fast, households and entrepreneurs became pessimistic about the future of the country. This pulled private spending down. Besides, risk premiums rose to the same level as in Italy, which had a tradition of excessively loose fiscal policy. This is a warning that cheap financing of radically increased budget deficits should not be taken for granted. The current crisis has taught consumers in many countries that there are limits to their debt. Do we want to learn this lesson in relation to the public debt as well?"

There are differences in the two types of debt, but, going forward, it would be nice if people got behind the idea of drastically lowering the debt.

"A large fiscal stimulus may also turn out to have a negative impact on financial intermediation. Financial turbulence generates the risk of a credit crunch. How to mitigate this danger is a major worry of many governments. One of the reasons banks are reluctant to lend is they have insufficient capital. According to the International Monetary Fund’s recent “Global Financial Stability Report,” banks need globally almost $700bn (€540bn, £474bn) of additional capital. A simultaneous large borrowing by governments to finance their fiscal stimulus could make it more difficult for banks to gain access to global capital markets and possibly limit any increases in their capital and lending. The ability of the emerging economies to finance their growth will also be affected. Large fiscal stimulus by developed economies could deepen a credit crunch in the less developed one."

These are possible problems.

"One thing is sure: a large fiscal stimulus would increase public indebtedness and impose a burden on future growth. Big increases in public investments are likely to be wasteful, as it is not possible to have a long backlog of well-prepared projects. In addition, political pressures might dominate considerations. A large increase in spending may also raise the possibility of corruption. A fiscal stimulus that temporarily lowers indirect taxes at the cost of future increases in marginal income taxes (for example, in the UK) does not improve incentives to work, invest and innovate."

All of these are possible problems.

"The effects of large fiscal stimulus in most countries are likely to be disappointing, while the longer time impact would be negative. The financial crisis is blamed on, among other things, deficient risk management. The proposals for a large fiscal stimulus suffer from the same weakness."

No one's omniscient. Look, the stimulus, printing money, propping up mortgages, bailing people out, are all risky and possible failures. But deflation and a downward spiral of confidence in markets and governments is also a terrible risk.

I think that this is a good post in that it reminds us to be very prudent in the amount of money we spend on a stimulus and what we spend it on. This is not a cavalier decision. Obviously some people see the stimulus as the road to a greater role for government in the future. I do not.

This is an Existential Choice. Kantian Moral Theory gives the impression that there is always a clear and principled way to make a decision. Existentialism understands that sometimes there are only bad choices, and no clear and principled way to make a decision. We're currently engaging in a series of decisions that defy easy answers. Risk is inherent in every decision we are going to make.

"Natural and understandable, certainly. But also most unwise and dangerous. This is how we got into this mess in the first place."

Willem Buiter with an interesting post on FT about moral hazard, which I hold to be the main problem in this whole crisis:

"Not quite. Sure, the boom looks like the right time to worry about moral hazard and to create the right legal and regulatory incentives to encourage appropriate risk taking. The problem with this recommendation is that it ignores the reality of the political economy of legal and regulatory reform of the financial sector. During financial boom years, the financial sector is rolling in resources and flush with influence. It can buy off, stop or sabotage all attempts at serious reform. The only time the authorities have both the means and the incentives to pursue far-reaching reform of the financial sector is when the financial sector is on its uppers - down and all but out. That means now, when the furies of financial crisis are howling around us.

As regards the two central objectives of establishing the correct incentives for appropriate risk taking (moral hazard, in the loose way in which this phrase is used in the debate) and mitigating the immediate recession, it makes no sense to have a lexicographic preference ordering. Houses on fire provide cute images, but they don’t capture the reality of the choices that have to be made. So the preference ordering between addressing the immediate crisis and moral hazard should not be lexicographic, with the immediate crisis in pole position. A little deeper or longer crisis can be acceptable in exchange for a material improvement in moral hazard.

In addition, Charles Goodhart, Martin Wolf and countless others overstate the extent to which the two objectives of immediate crisis mitigation and addressing moral hazard are in conflict with each other in practice. Often the same quantum of solace can be given to the crisis-hit economy in a number of different ways, some of which are vastly superior as regards their impact on long-term incentives. I will illustrate this with ten examples of what to do and what not to do."

Read the whole post, as he's infinitely more knowledgeable than me. But here's my intrepid comment:

“I hope these ten examples make it clear that we can fight moral hazard and the creation of bad incentives for future excessive risk taking by financial institutions and by all participants in the financial intermediation process, without undermining the effectiveness of efforts to prevent the recurrence of the Great Depression of the 1930s. A crisis is the best time, indeed the only time, to address moral hazard and other perverse incentives in the financial intermediation system.

The time to deal with moral hazard is now, in every action, every policy measure and every initiative taken to address the immediate crisis.”

Your one of my favorite commentators,and you can hope all you want.But with 1,3,4,5,8,9, and 10, you’ve shown that the moral hazard was ignored in practice. At this point, moral hazard means nothing. If the moral hazard were upheld, no one would think it was because of moral hazard. They would simply think that the government had made a fickle and stupid decision to draw the line here and now. Besides, actions matter, and people are now making decisions on those actions, so that moral hazard will be seen not as principled, but arbitrary.

For moral hazard to work, you need to nip the problem in the bud, otherwise it gains its own momentum. It’s too late this time, and stemming government intervention in a crisis is nearly impossible. That’s when voters demand action.

The time to deal with moral hazard is during calmer times, by putting out a clear set of tripwires and actually fulfilling them.

Again, it’s like value investing. The place that you should really be scared and focus on regulations and moral hazard is during the good times. It must work for some, because value investing has worked well for a lot of serious investors who manage to survive crises and even make money during them.

Posted by: Don the libertarian Democrat | November 3rd, 2008 at 3:11 am