David R. Henderson  

My Reviews of Rajan and Kotlikoff

The Psychology of People Again... A Challenge to Libertarians...

The latest issue of Regulation magazine carries my joint review of Fault Lines by Raghuram Rajan and Jimmy Stewart is Dead by Larry Kotlikoff.

Excerpts from the section on Rajan's Fault Lines:

When he sticks to what he knows best--international financial markets--he is usually clear and often insightful. When he ventures beyond his expertise--in discussing such topics as income inequality, education, and health care--he fails to go back to basics and thus repeats many of the myths that have been propagated by "progressives."
. . .
To buttress his income inequality concerns, Rajan throws in the emotion of envy. Even if the apparently immobile are buying more and better items, they compare themselves negatively with those who have even more and better items. "[M]y Chevrolet becomes much less pleasurable when my neighbor upgrades from a Honda to a Maserati," he writes. I think that is Rajan's problem. If the apparently immobile are getting nicer and nicer cars--yes, even Chevrolets are getting better--then it is up to them to control their own green-eyed monster. It is hardly an indictment of the system if wealthier people can afford Maseratis.

And on Jimmy Stewart is Dead:
Laurence Kotlikoff's book Jimmy Stewart Is Dead gives an excellent, dramatic play-by-play on many of the policies that led to the financial crisis of 2007-2008 --or should I say, 2007-201?--and on many of the participants. You will not read this book and come away feeling secure about our financial future.

Later, Kotlikoff advocates a huge regulatory agency that forbids financial firms from being anything other than middlemen:
When the potential borrower applies for the loan, the bank sends the paperwork on to the FFA, which would use private rating agencies to assess the loan's risk. Then the FFA would reveal this information online (hiding the borrower's identity) and open it up for bids on the mortgage.
Do you see the problem here? The same government that failed to catch Bernie Madoff and that takes months to get back to people about their applications for Social Security Disability Income is suddenly competent and able to get information about a specific person quickly to a bank. I think this makes Kotlikoff's proposal a non-starter, and I have not even discussed the fact that various financial firms will try to find ways around his proposed draconian restrictions on corporate risk-taking.

Comments and Sharing


COMMENTS (9 to date)
Kurbla writes:

David vrote:

    "To buttress his income inequality concerns, Rajan throws in the emotion of envy... then it is up to them to control their own green-eyed monster"

Why do you think that selfish motives should be satisfied through economic system and envious motives should be controlled? Why shouldn't we use similar approach for both?

Mike writes:


I read Kotlikoff and had much the same take as you regarding his over reliance on the capability of the government to take on such an important role as his FFA. I thought his proposal had more merit than you perhaps would give. You seem to give his FFA a central role in what is basically a 100% reserve system similar to what was advocated by Friedman and many of his followers back in the 1950s and 60s. I don't see the central importance of his FFA to his proposal. I do however have some other questions he nor you addressed. Maybe you can speak to some of these questions here.

I would summarize his proposal as eliminating the Federal Reserve as we know it by eliminating fractional reserve banking and turning banks into public utilities in managing demand deposits and then using their monopoly over demand deposit management as a marketing tool to draw customers to their financial store to sell them customized mutual fund products which would replace what they formally did for themselves in lending (along with having to bear the risk and reap the higher, leveraged return) by making loans to homeowners and businesses. They would still act as the originator of these loans but under his system would only sell interests to investment customers in the bundled loan portfolios. To the extent these mutual fund shares met investor needs the banks would succeed.

Under such a system there would be no reason for the Fed or the FDIC as we know it to exist as fractional reserve banking would no longer exist. Under his 100% reserve system there would no longer be any reserves for the Fed to manage. Furthermore, if the reserves were held in treasuries the government would be the ultimate backstop through the 100% treasuries in reserve so what need would there be for an FDIC.

1) You seem to feel that if the government cannot be trusted with the FFA then Kotlikoff's system falls like a house of cards. Is that necessarily the case? He seems to place great importance in his market clearing function facilitated by the independent vetting role provided by the FFA. I don't see why a free market, spontaneous order could not emerge without an FFA.

2) How would monetary policy be administered and what would be the Fed's new role under this system?

I thought Kotlikoff might be onto something with his proposal but I have been surprised at how little interest it has attracted from the establishment economics community. I have been concerned that maybe I was missing something that was so obvious that everyone else was dismissive of his proposal. On the other hand maybe it is just too radical of a proposal and could never be viable due to the elimination of so many powerful interest groups (bankers, etc.).

Kotlikoff is definitely on to something, and he's not the only one.

You can't borrow what hasn't already been produced and saved. That truism is completely obvious in both a barter economy and a 100% reserve banking system.

Fractional reserve banking makes it seem possible to borrow beyond that part of output that is saved. This particular form of money illusion lies at the very center of why we're still in the grips of financial crisis around the world. The EU is a bit ahead of America in the crisis, but we are close on their heels.

100% reserve banking would greatly reduce the power of the few over the many. It's easy to understand why the politically powerful oppose the idea. Your question about why economists oppose the idea is much more difficult to answer without resorting to uncharitable statements about motives.

John Goodman writes:

I worked with Larry on an earlier version of the proposal and we wrote about it in the New Republic:


I do not regard the regulatory functions David describes as very important or necessary. The important part of the propsal is 100% reserve banking. Financial intermediaries should not be able to put other people's money at risk without their knowledge or consent.

So if you are a financial intemediary and you claim the protection of limited liability (which I assume all libertarians agree is not yours by right), you cannot gamble. You have to perform purely intermediary functions.

David R. Henderson writes:

I think we should use a similar approach for both greed and envy. I don't want people making policy based on their envy. I don't want people making policy based on their greed, e.g., the ethanol subsidy, the quotas on sugar, preferential hiring, subsidies to college students, or any of literally thousands of programs.
@John Goodman,
As my economist friend Jeff Hummel has pointed out, we have fractional reserve parking and fractional reserve airline ticketing. Airlines will often sell many more seats than are available because they have good data on the probability that x people will not show. As anyone can vouch who's traveled a lot, it works out pretty well. Banking is not unique. Indeed, historically fractional reserve competed out full reserves, well before government was involved, because people who stored gold for others and gave them a certificate of ownership found that they could lend out some of the gold.

Alex J. writes:

David, thank you for bringing envy into the discussion about inequality.

Blackadder writes:

You can't borrow what hasn't already been produced and saved.

If something can't happen then it doesn't happen. Therefore, if you can't borrow what hasn't already been produced and saved, then under fractional reserve banking no one does borrow what hasn't already been produced and saved.

On the other hand, it is possible to borrow *against* what hasn't already been produced and saved. And indeed it's hard to see why anyone would ever borrow money if you couldn't do this.

John Goodman writes:

David, the difference between money and credit and parking and airline tickets is that the fromer has potentially huge social externalities and the latter does not.

It is in our individual self interest to create a separation between risk taking and the institutions that make borrowing and lending possible and determine the money supply.

Kurbla writes:

OK, so, you believe that economic system should satisfy selfish i.e. but not greedy (by def. excessively selfish) motives. But, still, you believe that system should satisfy some selfishness (as moderate version of greed) and not some envy. Why, what is the difference?

Libertarians are usually proud to accept selfishness. Many probably do not think that selfishness is virtue, but that it is reality that should be taken into account. If society denies selfishness, the results will be bad.

However, we are born not only predominately selfish, but also predominately envious. If some high school boy is significantly poorer than others, he'll certainly suffer. It is not his guilt, and it is not the shame, that's how we, humans, are constructed. Why not accept envy on the same way selfishness is accepted, i.e. not necessarily as a virtue, but as reality that should be taken into account?

Comments for this entry have been closed
Return to top