US Debt Crisis: How to Avert the Next Financial CollapsePublished: June 21, 2011 in Knowledge@Australian School of Business
The US is in the throes of a debt crisis. Congress must raise the statutory debt limit by early August so the world's largest economy can repay its loans. Economist Larry Kotlikoff, the William Fairfield Warren Professor at Boston University, is not surprised. National debt levels in the US have become a game of semantics, he says. The real debt figure is a whopping US$200 trillion, according to Kotlikoff who's predicting an imminent meltdown in the US bond market. He says the US economic future looks bleak without reforms to the tax, healthcare and social security systems – and that's just for starters. In his latest book, Jimmy Stewart is Dead, Kotlikoff suggests a way to avoid future financial crises through the introduction of Limited Purpose Banking. He outlines to Julian Lorkin of Knowledge@Australian School of Business, why banks should become fully transparent mutual fund holding companies.
An edited transcript of the interview follows.
Knowledge@Australian School of Business: Back in 2004, you predicted there would be a financial crisis – a meltdown in the US. Is it fair to say that you forecast the global financial crisis?
Larry Kotlikoff: I was thinking more about the fiscal problems leading to a collapse in the US bond market, which I think is still going to come. I wasn't really thinking of the financial industry systematically producing toxic assets. That's certainly compounded our fiscal problems.
The US is essentially bankrupt. People don't seem to understand exactly how bad the fiscal picture is because they look at the official debt numbers. However, the unofficial obligations to pay pension benefits and healthcare benefits to 78 million baby boomers are just massive and will make our official debt explode relative to GDP – that is starting to dawn on the American public. That's why you have this big fight in the US between the Republicans and the Democrats over how to fix things.
We have to fix our tax system, our pension system and our financial system. On the healthcare side, you could achieve the solution pretty easily by starting from scratch. That means getting rid of the employer-based healthcare and our healthcare system for the elderly, which we call Medicare, along with Medicaid, our health insurance for the very poor. I propose the government gives everybody a voucher to buy a basic plan from a health insurance company. That voucher is going to have a different number on it, depending on your pre-existing conditions. If sick, you're going to have a big voucher. If healthy, you'll have a small voucher.
I like to call the health reform for the uninsured ObamaCares, because I think he does care and he should care because we have 50 million uninsured people. Everybody needs health insurance. There's a consensus. So the President put in place a system for the uninsured that's very similar to what I just proposed. We're having big arguments in the US over the Democrats' plan for healthcare. We have a bunch of children arguing while the house is burning down. This is Nero fiddling as Rome burns.
Knowledge@Australian School of Business: You're saying the economy's bankrupt. The published accounts from the US show it's not great, but suggest the government can muddle through.
Larry Kotlikoff: At the government level, our accounting is worse than Enron accounting. When a government – any government – takes in money from the public, it has the option to call that borrowing or call it taxes. The money it hands out can be called a transfer payment or return on principal plus interest on some prior borrowing, so the measurement of debt is up for grabs. Borrowing is a matter of the government's choice of language.
How it's labelled will determine the fiscal gap, that's the difference between all the spending and all the taxes. The true national debt number that we want to look at here is US$200 trillion. But how much of that fiscal gap shows up as official debt versus how much is unofficial debt or obligations? In the case of the US, the unofficial debts are needed to pay for healthcare, social security benefits and defence spending.
The fiscal gap combines unofficial debts and official debts. The amount of the debt is a matter of a choice of words. There are no economic rules that determine whether a government should take somebody's contributions for retirement and call that a tax or whether it should call it a borrowing and say that the benefits in retirement correspond to return of principal plus interest on that borrowing.
No economic theory will tell you whether to use one set of words or another. It won't change what the equations are saying. A well-conceived model can tell you a story about the economy and how it moves through time. For decades, the US has used words to disguise what's happening to keep the official debt really small, but the unofficial debt is massive.
Huge resources have been taken from young people and given to old people. We've been running this massive Ponzi scheme for six decades now, starting really with (President) Eisenhower, who doubled the size of the social security system and other Republican and Democratic presidents who have taken from young and given to the old. They use words that don't show big official debts, while accumulating huge implicit unofficial debts. Now we're at the end of this Ponzi scheme where we don't have enough young people coming along, earning enough money to pay for all these promises that have been made.
The US could have a rational healthcare system that wouldn't work much differently from the Australian, Dutch or German systems. But we're not doing that. We're having fights in Washington, so I do expect there to be a massive collapse of the US bond market and skyrocketing interest rates. I expect to see huge financial fallout from all of this.
Knowledge@Australian School of Business: Can you put a timescale on this?
Larry Kotlikoff: I think it could happen very soon – in the next few months. It really depends on a lot of people's sense that the game is up. Bankruptcy is in the eyes of the creditor. If enough creditors say, "We don't trust the US Government to repay", then everyone might jump on the bandwagon and the market for the US Treasury bonds would collapse.
(Bond market authority) Bill Gross, who runs the largest mutual fund in the world for (global investment company) PIMCO, has just said he's not going to hold any long- or medium-term US government bonds because the concern is the government is going to print money to pay its bills. The US has been printing money like crazy since 2008. By the end of this year, the basic money supply will have quadrupled. The banks are now being bribed not to lend out this money. The Federal Reserve is paying interest on the excess reserves the banks are holding. But, if this extra money that the government – the Federal Reserve – has printed gets into the bloodstream by being lent out, then we could have a quadrupling of prices. If inflation takes off, interest rates will take off, bond markets will crash.
Bill Gross has just pulled out of the market and maybe George Soros will start selling Treasury bonds short. If enough big players start doing this, things will happen. Ratings agency Standard and Poor's has put out a warning on the US fiscal situation. I think it's desperately grave.
If everybody believes the US government can't pay its bills and they think it will start printing money, then money will become a hot potato. Even with the same supply, if money starts circulating more rapidly because people don't want to hold money if they think prices are going to go up, so they start trying to unload it very quickly – that effectively ends up being like more money. It's called the velocity of money rising. By itself, that can lead to inflation, if not hyper-inflation. In the great hyper-inflations, the growth rate of prices has been much greater than the growth rate of the money supply because money starts circulating much more rapidly.
If people start to expect inflation, they will make it happen. The bond market will crash and interest rates will rise. The first thing Ben Bernanke (chairman of the Federal Reserve) will have to do is print money to try and lower interest rates. As a result, exactly what people fear happening will happen – it can be a self-fulfilling prophecy.
Knowledge@Australian School of Business: But we've seen collapses in other bond markets overseas in Argentina, for example, and now in Greece. A Greek bond is very different to a US Treasury bond which is seen as a gold standard. Would a meltdown in US Treasury bonds leave a financial wasteland that would take decades to recover from?
Larry Kotlikoff: The US fiscal situation is worse than Greece, but the bond market doesn't really understand that. Greece's fiscal gap is about 11 times GDP, whereas in the US it's about 14 times GDP. In terms of unofficial debts, the US is in worse shape than Greece. But when looking at official debts, it appears we're in better shape. Even on an official debt basis, in a decade the US will be at the debt-to-GDP ratio of Greece. On the current trajectory (as a share of GDP), official debt in the US will far exceed the Greek value over 15 to 20 years.
Knowledge@Australian School of Business: In your latest book, Jimmy Stewart is Dead, you've been looking at ways to avoid a further financial meltdown. Can you explain Limited Purpose Banking for me?
Larry Kotlikoff: At the end of the book I wrote about how to fix the healthcare system, social security system – that's the government pension system – and also the tax system, and there are very simple solutions for those problems. But, we also have a financial system that's fundamentally fragile because it's subject to fraud. There's no transparency coming from Wall Street.
Every major bank and insurance company is saying: "You can't see what I'm doing with your money because I have the Midas touch. I can't tell you what I'm doing with it, just trust me. I'm going to make you a fortune." In some instances, they've invested in fraudulent securities or, in the case of (jailed operator of the world's largest Ponzi scheme) Bernie Madoff, he just pocketed the money.
"Trust-me" banking has to be transformed to "show-me" banking. We need full transparency so we don't see trust-runs on financial institutions, when people are concerned about fraud. In 2008, they ran on Bear Stearns due to mistrust of the person at the top, CEO Jimmy Cayne. He was purported to be playing bridge while his two big hedge funds collapsed - when he was supposed to be managing the risk of a portfolio the size of a New York telephone book.
Everybody ran because they thought maybe others didn't trust Cayne. Those at the very top of these institutions are the only ones who actually have the ability to find out what's really going on, so trust in the CEO is critical. Individual traders in those companies don't even have access to all the positions.
But the "trust-me" banking system is extremely fragile because all the trust resides with the very top person, whether it's Dick Fuld from Lehman Brothers or Jimmy Cayne or the head of Citigroup. It makes the system open to runs. We need to have transparency with all the positions made available to investors on the web in real time. We have to give up proprietary information and make it clear what people are investing in.
That's one key feature of Limited Purpose Banking. The way it works is there's going to be a Federal Financial Authority that would fully disclose the securities that the financial intermediaries are holding. Now the financial intermediaries – banks and insurance companies – would become mutual fund holding companies.
Now, a mutual fund holding company is engaged in issuing and marketing mutual funds. A mutual fund itself is a bank that doesn't borrow – a non-leveraged bank. It takes in money on an equity basis and sells shares. The investors hand it the money and then the mutual fund buys the securities that it says it's investing in. In the US, we have 8,000 mutual funds and some invest in treasury bonds or stocks. Others invest in foreign stocks and mortgages.
The idea is to tell the banks and insurance companies that they have to operate in just one way, as a mutual fund, and therefore take money in on a non-leverage basis. The mutual funds then will invest – and guess what? – the mutual funds, as the financial intermediaries, can never go broke because there's no borrowing (debt). The mutual fund holding company, that may be marketing 50 mutual funds, can't go broke either because its individual components can't be broke.
That's a financial system that can never collapse. If one mutual fund invests in things that lose all their value, it doesn't affect any other mutual fund. There are natural firewalls. Under the current system, streams of gasoline connect the different financial institutions. If one lights up, it quickly spreads from one to the next so the whole thing can burn down.
We need a financial system that is safe, particularly in a context of a fiscal policy that's completely unsafe. What happens tomorrow if there is a collapse in the US bond market? Interest rates are going to shoot up, the Fed is going to print more money, people are going to get nervous about inflation and, if I've got assets in a bank, I'm going to want to get that money out and buy something real before prices go up.
A fear of inflation could prompt runs on the banks in the US and then we'd have a fiscal crisis and a financial crisis at the same time.
So let's use Limited Purpose Banking to keep the financial system safe, and then let's reform our fiscal institutions. Right now, the entire US economy lies under a kind of a sword of Damocles. In 2008, we barely averted a complete financial meltdown. When there's a financial system in which promises have been made that can't be kept – and everybody can then run – it can melt down.
Deposit insurance – or bank guarantees – don't solve the problem because the government is guaranteeing to pay back dollars, not purchasing power. If inflation takes off, purchasing power becomes the emphasis. People want to use their money to buy something real before it's worthless. So they start withdrawing money from the banks. The FDIC, the Federal Deposit Insurance Company, comes in and has to print literally six trillion bucks to cover these withdrawals. They also have to print another three trillion to cover the withdrawals from the money market accounts that would occur right away. Then the life insurance companies have about three trillion in cash surrender value policies. The Federal Reserve may have to print about US$12 trillion overnight. Wall Street was engaged in making promises it couldn't keep, but the US Government says: "Don't worry, public. Wall Street has made these fraudulent promises but we're going to guarantee them." And that itself is a fraudulent promise because they can't guarantee, in real terms, US$12 trillion – that's almost the size of our GDP. So Uncle Sam has made promises it can't keep in real terms, and it's conveyed these promises in a way that people think they're real.