Financial Crisis: Lessons Learned

The federal government responded aggressively -- at a huge cost -- to the financial crisis that began in the fall of 2008, says Laurence J. Kotlikoff, a professor of economics at Boston University and a senior fellow with the National Center for Policy Analysis. But nearly two years later little progress has been seen in the country's economic health.

In his forthcoming book, "Jimmy Stewart Is Dead: Ending the World's Ongoing Financial Plague with Limited Purpose Banking," Kotlikoff discusses the problems with the explicit and implicit guarantees the federal government has made:

· Around $12.5 trillion has been pledged by the federal government ($2.5 trillion in direct expenditures and roughly $10 trillion in contingent commitments) to keep the financial sector afloat.
· The fiscal gap in the United States (the difference between the government's official debt plus its discretionary spending and the amount of taxes current and future citizens will pay) is currently estimated by Jagadeesh Gokhale of the Cato Institute and Kent Smetters of the University of Pennsylvania at $77 trillion.
· This is more than five times the United States' present gross domestic product.

However, the U.S. economy is still in trouble and people are still losing jobs. There is increasing concern that the Bush-Obama economic rescue effort has failed and will instead spell massive tax hikes, hyperinflation and high interest rates.

The U.S. economy is down because distrust is high, says Kotlikoff. The underlying cause of crises in our financial system is not people taking risks. It is people risking other people's money without their knowledge, understanding and consent -- in investments that are backed by implicit government guarantees. In the latest crisis, bankers invested depositors' and other creditors' money in risky instruments, including collateralised debt obligations, many of which were, themselves, invested in fundamentally fraudulent securities. When the investments failed, financial institutions and corporations that were too large to fail were propped up, bailed out or bought out by the federal government.

The way to avoid these recurring crises and restore trust is to return the financial system to its principal function: bringing together suppliers and demanders of funds. This could be done by requiring all financial corporations, including insurance companies, to adopt the pass-through model of asset ownership used by mutual funds.

This would eliminate the need for government guarantees and a host of regulatory agencies. The federal government would create transparency by certifying and disclosing all the financial statements in all financial securities purchased by the mutual funds and also by arranging for independent ratings and appraisals of these securities. It would not tell anyone how much they could borrow or how much risk they could take. Individuals would decide what mutual funds to buy, but they would do so knowing, to the maximum extent possible, what it is they are buying.

Source: Laurence J. Kotlikoff, "Financial Crisis: Lessons Learned," National Center for Policy Analysis, Brief Analysis No. 693, February 22, 2010.

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First published by the National Center for Policy Analysis, Dallas & Washington, USA

FMF Policy Bulletin, 23 February 2010

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