Allowing banks to gamble on borrowed money when they know that the Federal Government will bail them out if they fail creates a moral hazard and has contributed to the banking crises we now face. So what is the solution? J. Kotlikoff, a professor of economics at Boston University thinks he has a better way.

            He calls it “limited-purpose-banking”.  Instead of owning assets, banks should act as facilitators between borrowers and lenders. Professor Kotlikoff calls it “financial intermediation”.

            According to Professor Kotlikoff, the FDIC has reported reserves of $19 billion. A bank run would require $4.8 trillion to cover all the indebtedness created by the present banking system. Evidence of the failure of the banking system is clear.  The treasury has spent $173 billion on AIG, but that sum only represents the tip of a gigantic pile of debt that totals $1.6 trillion in credit default swaps. AIG has more exposure than most taxpayers realize. The banking industry is in debt for $3 trillion, which is the cash surrender value. If we add in government guarantees of private-pension funds, we would need to add another $100 billion.

            In the limited banking plan all financial institutions would function as they are suppose to, as disinterested intermediaries. We would never have a situation where the government has to make promises it can’t keep. The economy is on life support. The government is running out of money, and the Obama Administration wants to incur the additional costs of a government health insurance plan.

            Government stimulus, bank bailouts, taking over private corporations that are too big to fail, turning management over to the union is like turning the prison administration over to the inmates, none of these policies create purchasing power. None of these would have occurred if the banking industry were already limited.

            The limited banking concept allows private parties to gamble their assets, but the bank does not gamble. There can be no systemic collapse of the banking institutions. In a limited banking system, for example, investors who wanted to invest in mortgages would invest in mutual funds that lend to homeowners. Instead of banks borrowing from the Federal Reserve and lending the money out, all such transactions would be handled through mutual funds created by the financial industry.

            Although the structure is new, there is actually nothing novel about the limited banking concept,. Before fractional reserves were conceived, banks lent only the money it had on hand. Depositors took the risk of loss, not the government and taxpayers. Clearly the present system has failed. The limited banking plan can fail only to the extent that individuals who took the risk fail. There would be no transferring losses to the taxpayer.

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