Professor Larry Kotlikoff: hailed as Mervyn King's 'obscure guru'

The phone line was crackling when I spoke to Professor Larry Kotlikoff in Amsterdam recently but his message was clear: the west can only fix its economies by fundamental reform of its banking systems, and, if it doesn't, we will soon be plunged into a financial crisis even bigger than the present one.

The Boston economist went further, telling me that the US bailout and the Obama administration's latest proposals are tinkering with the disease rather than treating it.

As he says: "All they've done is stick a Band Aid on the cancer." And the cancer is a system which is designed for hucksters and snake-oil salesmen; one that allows financial companies to gamble with our money, secure in the knowledge that Uncle Sam – or another government – will bail them out. What's worse, the more governments do bail them out, the more they will gamble at the public's expense.

Kotlikoff is unusual among economists; he doesn't just criticise but has a plan for change, one which would stop future financial crises, restart investment in the economy, and restore trust in banking.

To understand his solution, you have to know what Kotlikoff believes caused the crash: not low interest rates, toxic debt and leverage, or trade imbalances; these are symptoms, not causes. In his words, fraud, greed, malfeasance, Ponzi schemes, corrupt bankers and regulators, kickback accounting, fractional reserves, insider-rating, top Harvard students who in effect became croupiers, and director sweetheart deals are responsible.

Kotlikoff calls his new regime Limited Purpose Banking because it does what it says; it limits banks to their legitimate purpose – connecting and intermediating between borrowers and lenders, savers and investors. He wants banks banned from lending money that is not matched in cash reserves. And, under LPB, all corporations engaged in any financial intermediation – banks, hedge funds, insurers – would act as middlemen. They would create mutual funds, sell shares in the funds to the public and use the proceeds to buy assets, not unlike a unit trust. But they would never own any financial assets, so could never fail due to bad risk, thus making banks the "disinterested intermediaries they pretend to be". Banks, then, would let people gamble, but the banks themselves would not. "If Dick Fuld or Nick Leeson wish to gamble, let them do it with their own money. We don't have enough babysitters to protect us from these people," he says.

He's not against bankers per se, but says there are enough "fast-talking con artists, riverboat gamblers and highwaymen" to ruin the system. Nor is he against gambling, depending on whose money is used. Mutual funds have been around for centuries – the US has 8,000, holding over $12 trillion of assets, and they have not been hit by the crash. They also allow for risk, known as "parimutuel" betting. Nor will there be a lack of credit – mortgages can be lent on the same basis and there's no reason why the system shouldn't allow maximum liquidity.

Kotlikoff says LPB should be policed by a new government body which would clear all securities sold by its funds, giving maximum transparency, and allowing people to see what risk they are taking. There's another plus – LPB can be put into effect easily and at little cost.

It's no wonder Kotlikoff's big ideas have caught the fancy of Mervyn King, the governor of the Bank of England; so much so that the relatively unknown economist was thrust into the spotlight after King namechecked him at the recent UK treasury select committee, saying his proposals deserve further study. Hailed as King's "obscure guru", Kotlikoff, who first met King while working at the Bank in 1998, assures me it's the other way round: "It's Mervyn who is my guru; there's no doubt his views on this crisis are responsible for pushing serious reform to the top of the agenda in the US as well as the UK."

Nor is Kotlikoff obscure; he's written extensively in the US criticising President Obama's bailout, but it's only now his work is filtering through to this side of the Atlantic.

But, as one economist says of Kotlikoff's book: "It's scarier than anything Stephen King ever wrote." We have been warned.