Book review: Econned, by Yves Smith; and Jimmy Stewart is Dead, by Laurence J Kotlikoff

Whose fault was the crash? Two splendidly splenetic writers name the guilty parties - but don't agree.

by Shamik Dhar
Last Updated: 25 Oct 2010

Larry Kotlikoff and Yves Smith are both angry. And so will you be when you read about the jaw-dropping arrogance, incompetence, fraudulence and criminal duplicity that preceded the Great Crunch of 2007. Neither author pulls punches: they name names and forensically document events. They take on the establishment, political, financial and academic.

Kotlikoff takes aim at the bankers. These people, he says, are not like Jimmy Stewart in It's a Wonderful Life. Instead, many of his modern-day counterparts are rapacious crooks who have socialised risk and privatised exorbitant profits in 'the big con'. They couldn't understand the risks they took, yet claimed astronomical rewards even as they made colossal mistakes for which the world paid the price.

The writer lashes the regulatory authorities for letting it happen, and says the response to this financial crisis was misguided. Bailouts sow the seeds for the next disaster. The long-term solution must be more radical: no less than the abolition of banks as we know them.

A flaw in the current system renders it prone to systematic fraud and periodic collapses: a government cannot credibly offer depositors perfect insurance. It can only guarantee deposits by printing vast amounts of money, so the real value of deposits can never be protected; when depositors realise this, a bank run is triggered.

The only solution is to return to 'narrow' or what Kotlikoff calls 'limited purpose' banking. In this world, banks convert their instant-access deposits into 'cash mutual funds' backed 100% by currency, eliminating the possibility of runs.

Banks would be allowed to offer riskier mutual fund investments but these would be 'plain vanilla', regulated by a single Federal Financial Authority (FFA), whose job would be to oversee, regulate and ratify in the interest of the public at large. Banks would be restricted to connecting savers with borrowers, and would be barred from speculating with investors' money.

Kotlikoff's plan might involve a huge increase in bureaucracy - imagine the FFA monitoring every mortgage application or overdraft request - the long-term costs of which could approach that of large but infrequent crises.

Forcing banks to hold more assets in safe, liquid form makes much sense, but the idea that the optimal ratio is 100% depends on a rationality assumption of an increasingly unfashionable kind. Most dangerous of all, a badly handled transition to narrow banking could start another credit crunch.

Still, Kotlikoff's radical ideas are gaining traction, particularly in central banking circles. Mervyn King, governor of the Bank of England, mentioned them approvingly in recent testimony to the Treasury Select Committee, and the dust jacket sports an impressive cast of A-list academics in praise.

Mind you, that would be enough to condemn it for Smith. The anger of this creator of a popular blog is as palpable as Kotlikoff's, and her dissection as devastatingly forensic. But, for her, the economists are to blame for the crisis.

According to her, we economists have fallen prey to the ideology of free markets, idealised and fetishised in the form of equilibrium theory. Neo-liberal ideology inspired the rush to deregulate in the 1980s and created the conditions for the looting that triggered the crunch. But, she says, equilibrium analysis rests on weak intellectual foundations, its shortcomings hidden in a fog of mathematical formalism.

Smith has a problem with 'the math'. Like her confrere Nassim Nicholas Taleb, she scorns the pretensions of economists, lambasting them for sticking to absurd assumptions about human behaviour.

Well, yes and no. Academic economics has been too intolerant of heterodox thought, and key policy-makers put too much faith in the 'efficient markets' hypothesis. But the idea that all economists are in thrall to one mode of thought and that this caused the crisis is ludicrous. Smith herself quotes many highly respected economists in support of her views. From now on, models will often incorporate multiple equilibria - good and bad. The math, applied wisely, is useful.

Both books bristle with righteous fury but start from different ideological positions. Kotlikoff is inside the tent shouting out, whereas Smith wants to set fire to it. Kotlikoff believes in individual rationality - indeed, rationality renders the current system vulnerable - and he believes in the math too. Smith thinks the opposite.

Kotlikoff's anger is bolstered by fear of the instability his models predict; Smith's by what she sees as a dangerously influential and smug profession, slave to 'groupthink'.

The trick is to find a balance between free markets and regulation, and to break the 'bubble psychology' that infected so many - not just bankers. Neither of these splendidly splenetic books ultimately convinces that is has the answer.

Jimmy Stewart is Dead: Ending the world's ongoing financial plague with limited purpose banking
Laurence J Kotlikoff
John Wiley ú18.99
John Wiley ú18.99

Econned: How the myth of free markets wrecked our economy
Yves Smith
Palgrave Macmillan ú20.00
Shamik Dhar is chief Asia economist at Aviva Investors

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