Limited Purpose Banking?

In April, I reviewed Jimmy Stewart is Dead by Laurence Kotlikoff.

Yesterday, Jerry O’Driscoll posted a review of his own:

Chapter 1 of the book is titled “It’s a Horrible Mess,” and in it Laurence Kotlikoff, a professor of economics at Boston University, reminds the reader of the breadth, depth, and horror of the global financial crisis. It is a cure for the dispassionate observer of events, an indictment that would send all but those with ice water in their veins to sign up for the Tea Party Express. The book is a particularly well-written account of the crisis that begins in housing finance, spreads throughout the financial system, and then throughout the real economy. The crisis hit in tsunami-like waves beginning in 2007 and continued into 2009.

In Kotlikoff’s words, “We thought we had well-functioning banking and insurance companies with competent directors, world-class managers, responsible regulators, and incorruptible rating companies. But overnight, we it learned it was a sham.”

O’Driscoll thinks the Achilles heel of Kotlikoff’s proposals is their reliance on a financial regulator:

Kotlikoff excels at detailing the failings of the existing regulatory structure, but does not explain why his proposed system would work any better. If the regulators at the FFA face the same incentives as do those at the SEC (and the rest of Washington’s alphabet soup panoply of regulators), then we should expect the same outcome.

Government regulation, no matter the industry, typically fails for two reasons. First, there is the Hayekian knowledge problem. The information needed for effective regulation is dispersed across firms, the industry, and even the economy. There is no effective means for marshaling and centralizing the information within the agency.

Second, regulators are routinely captured by the industry they regulate. Through frequent interaction with members of the industry, regulators come to identify with the industry’s interests over the public’s. The revolving door between industry and government exacerbates that problem.

Even so, he concludes:

There is a great deal to recommend this book. First, there is Kotlikoff’s recounting of the crisis itself. Second, there is sense of the manifest injustice of a system in which bad actors get to gamble with other people’s money. Third, there is the challenge to do something radical to reform a system that is radically dysfunctional.

Read the whole review.