11/09/2010 08:43 pm ET | Updated May 25, 2011

Mervyn King Has It Right -- Our Financial System Is the Worst

In its October 30 article, "King Plays God," the Economist denigrates Bank of England Governor Mervyn King for telling the truth about our current banking system. The article is a pity. King has it completely right. We do have the worst possible banking system because it is built on two pillars of straw--proprietary information and leverage.

The banks are here to intermediate--to connect lenders to borrowers and savers to investors. They are not here to borrow on their own account, make risky investments, hide the details of those investments, and then arrange for taxpayers to cover their losses when their gambles turn sour.

This system is not only a foundation for systemic fraud, it's a prescription for financial collapse. Since those who lend to the banks, via deposits or the purchase of bank paper, aren't privy to what is being done with their money, the strong whiff of fraud, whether actual or not, can provoke massive bank runs. What we saw in 2008 was precisely this--a fraud run. It was not a liquidity run, but a run on one major financial institution after another because the creditors to those institutions suspected that they were being taken or that other creditors had reached this conclusion and were going to get their money out first.

To prevent this run from taking down every major financial intermediary on the planet, the large central banks rode to the rescue with massive guarantees that tempered the crisis. But, truth be told, those guarantees are themselves subject to a massive run for the simple reason that they are nominal, not real (purchasing power) guarantees. If bank depositors and other creditors of the surviving banks suspect that inflation is taking off or may take off, they will first walk, then trot, and then run to withdraw their funds and buy something real, like canned goods or cars or furniture, before prices rise. Such a run would entail, in the case of the US, the Fed's printing over $10 trillion to cover its explicit and implicit FDIC, money market, and other guarantees. This money creation would produce precisely what was originally feared--hyperinflation--and thereby make the run in everyone's narrow self interest.

Instead of thoughtfully discussing these fundamental issues, the Economist refers to King's interest in moving the world off this precipice as "radical." But what's radical is not the truth. What's radical is maintaining the current financial status quo, which, globally speaking, put tens of millions of people out of work and has damaged or destroyed tens of millions of retirements.

The Economist also repeatedly suggests that King's goal is to break up the big banks and that doing so is the only alternative to what we now have. This too is off base. In his Buttonwood Conference speech in New York, Governor King mentioned a number of reform proposals, none of which would entail breaking up big banks. Instead they would change how banks, large and small, function. For example, under Limited Purpose Banking, a plan that I have put forward and one referenced by the governor in his speech, all incorporated banks as well as other financial corporations (e.g., hedge funds and insurance companies) would be reorganized as mutual fund companies with no limit on their size.

Individual mutual funds marketed by mutual fund companies are, effectively, small banks with zero leverage. Hence, individual mutual funds and the potentially very large limited purpose banks that sponsor them would never fail. This would put a definitive end to financial collapse, which has been at the heart of so many terrible economic downturns over the centuries.

The other critical aspect of Limited Purpose Banking is having a single regulatory body with a very narrow charter, namely to hire non-conflicted companies to verify, appraise, rate, and disclose in real time on the web all securities held by the mutual funds. Thus Limited Purpose Banking doesn't break up large banks. It limits them to their legitimate purpose, namely intermediation as opposed to gambling. And it forces them to do turn on the lights and operate with full disclosure and complete transparency.

The Economist's article got one thing right--its title. When it comes to fixing the banks, Mervyn King is playing God and thank God for that.