Bailout is Suboptimal But Safe Banking is Optimal for Taxpayers

September 24, 2008

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development

To U.S. Congress

Sub:    The bailout proposal is sub-optimal for taxpayers

It is very remarkable that the market forces are imposing a “safe banking” policy that I had proposed in 2003: we now have $3 trillion money market funds (“safe banks”) insured by the federal government and other banks operating as “universal banks.”[1]  To consummate this policy, we just need to deregulate the “universal banks” and not federally insure their deposits or monitor them.  This will make banking safe and sound, with (a) the safe-banks catering to panic-prone depositors, (b) the universal banks serving the rest, and (c) the taxpayers losing little due to moral hazard. 

Safe banking will obviate the continual gargantuan burdens on taxpayers due to moral hazard in banking.[2]  I had predicted in my book and paper in 2003 that the loss to taxpayers would be at least a trillion dollars.  That this prediction has come true is less important than the reasons for failure of the industry vividly outlined in my book that the Congress has now conceded as per press reports.

Safe banking is optimal for taxpayers, though annulling the federal insurance of deposits in the universal banks at this juncture may seem outlandish.     

As someone who has researched for more than twenty years on devising bank regulatory policies that are optimal for taxpayers and who had warned in 1994 while at the Federal Reserve about bank holding companies subverting regulatory capital requirements predicated on such research and had sent such warnings to the U.S. Congress in the form of memos and papers in 2003, I should humbly state that the $700 billion price for bailing out the distressed financials is not optimal for taxpayers.  My arguments for this statement and for safe banking follow.

The Americans have virtually imposed on policymakers and Wall Street bankers a “safe banking” system that I have argued to be optimal for taxpayers.  They have been pulling out their deposits even from money market funds and from Goldman Sachs and Morgan Stanley.  They thus forced the government to insure the money market funds, thus creating safe banks needed in equilibrium.  Taxpayers have made emotional pleas to Congress to not bailout the Wall Street bankers.  This should leave no ambiguity about what the taxpayers consider as optimal.  The Treasury and the Federal Reserve are obviously proposing policies contrary to what is optimal for taxpayers.

To be optimal, regulatory policies must (a) not choke the economy, which is sum total of the private legitimate activities of persevering individuals, and (b) be consistent with equilibrium among the private agents if they were allowed to work freely within a hypothetically deregulated economy.  The government has an important role to ensure that private agents pursue legitimate activities freely without being choked by a few.  Optimal regulation ensures that a few do not choke the vast majority, especially, through panics.  Only then will the economy grow. Is the $700 billion giveaway to a few Wall Street bankers optimal for the vast majority as claimed by the Treasury and Federal Reserve?

To answer the above question, let’s see who has been choking the vast majority.  The highly levered hedge funds (HLHFs) include investment banks and firewalled subsidiaries of universal banks.  The HLHFs borrow massively from the federally insured deposit base and money markets to take huge bets on securities to distort the prices, temporarily, and thereby create euphoria or panic to induce others to buy such securities at outrageously high prices or to sell at insanely low prices.  The issue of HLHFs’ wangling $80 billion annually from the vast majority is incidental.  The vexing issue is the huge market distortions HLHFs cause that erode trillions from retirement savings and impose systemic panics and potential recurrence of the Great Depression on the globe. 

The vast majority of taxpayers store a part of their earnings from labor for retirement.  A few HLHFs borrow from banks insured by taxpayers to wangle such fruits of labor by distorting the markets through massive leverage.  The taxpayers have to be constantly vigilant about the few HLHFs, lest the fruits of their labor will be robbed.  The vast majority is thus hobbled by a few HLHFs.  The U.S. output has suffered and may go down as a result. 

The vast majority has succeeded, however, in taming the HLHFs.  Two HLHFs have perished, one was merged with a major bank, and the other two are tottering.  What is optimal for the vast majority has been thus achieved in equilibrium. 

Transferring $700 billion from the vast majority of taxpayers to the few HLHFs will distort the equilibrium and choke, once again, the legitimate activities of the vast majority.  Policymakers and lawmakers are supposed to act in the best interest of the vast majority of taxpayers.  They should, therefore, desist from adopting any policy that is clearly suboptimal. 

I agree with the Treasury Secretary that the financial system is locked in knots that cannot be easily untangled.  I have been discussing such locking since 2001 in my finance classes.  The locking is due to short and long positions of the HLHFs to remain hedged, while distorting market prices to make trading gains.  That no more trading gains can be made and the HLHF hedging has gone haywire is obvious from the current situation in the capital markets.  But the vast majority of taxpayers have immensely succeeded in unlocking the knots by sending the HLHFs packing.  The HLHFs and their patrons have obviously failed to “solve” the problem in their way.  But that is moot.  The reality is that the market forces comprising the formidable vast majority of households have resolved the problem imposed by the HLHFs and their patrons on the economy.  The $700 billion giveaway to the HLHFs will only distort, once again, what is right for the economy and has been achieved by market forces.  The dollar will likely crash if the giveaway plan is adopted.  This will almost surely beget unforeseen miseries to Main Street and the economy.

We should congratulate the Federal Reserve and the Treasury for taking over the top mortgage banks (GSEs) and for helping the top insurer (AIG) to operate.  Main Street depends on these entities.  These entities must have suffered from the shenanigans of the HLHFs.  The HLHFs should not and must not, therefore, be bailed out by taxpayers’ funds.  They should indeed be prevented from borrowing federally insured deposits from banks and money markets.  Deposit insurance should be gradually be withdrawn from bank holding companies that choose to operate as universal banks.  Without federal insurance, these BHCs will be scared to lend to HLHFs for unproductive activities that decimate the prosperity of Main Street and endanger the survival of BHCs.  Once federal insurance is withdrawn from the BHC-universal banks, the government should stop regulating these uninsured financial institutions.       

Simply put, the usurious profits generated by the HLHFs over the years have been lent to Main Street.  Some residents of Main Street, who have lost jobs or are earning meager incomes, are unable to repay their loans.  The HLHFs have to forfeit the non-repayable loans, and not ask for bailing out by the vast majority of creditworthy taxpayers.  The vast majority will optimally not grant this request.  This is the equilibrium that everyone should welcome.   Artificially distorting this equilibrium via government intervention will likely bust the dollar to wreck unforeseen miseries on Main Street, the economy, and even the few who are pleading for a bailout.

With profound regards,

Sankarshan Acharya