Begetting First-best Status for Principals

Based on First-Best Policy Research
Economically Efficient Constitutional Governance
Governance Needed to Attain the Most Efficiently Competitive Economy

Dr. Sankarshan Acharya
University of Illinois (U.S.A.)
and Research Center for Finance and Governance (India)

October 17, 2011

To:       Honorable President Barack Obama

Cc:       Honorable House Speaker John Boehner
Honorable Minority Leader Nancy Pelosi
Honorable Senators Harry Reid, Richard J. Durbin, John McCain, and Jim DeMint

Sub:     Begetting first-best status for principals (citizens)

Dear President and Congressional Leaders,

The Congress is supposed to represent the collective wisdom of We the People.  But pundits have often portrayed how the Congress has pandered to the vested interests for quid-pro-pro political contributions and, as a result, caused the economic mess. 

My experience is profoundly different.  I have observed that the Congress has really proved to be the Paramatama (the paramount soul of all souls of people), though not perfect yet, but still willing to establish governance based on truth and may thus be able to save the economy.  This memo is on four issues:

  • How the prevailing system of financial moral hazard has been established?
  • How the Congress has already discovered a new path of governance based on truth after the finance catastrophe of 2008?
  • How the Congress can now gear the economy for first-best level of prosperity of the principals (not necessarily measured by economic growth) by treading on the same path it has already discovered?
  • What exact Congressional acts are needed to be adopted immediately to beget first-best prosperity amid stability?

1. Prevailing Financial System

Let’s delve into the principal-agent analysis to see how the current system of finance has been established and perpetuated.   The principals are the households and firms who produce and serve the nation.  They elect individuals to represent their best interests.  The agents include (i) financial guardians (executives of financial firms who are custodians of the savings of principals), (ii) regulators like the Treasury, Fed, SEC, CFTC and FDIC who monitor the financial guardians, and (iii) the experts in the finance-economics academy and think tanks who research on the best viable system needed to keep everyone engaged in production and mutual service. 

A common goal of the principals and agents, as citizens of the same country, is to achieve their first-best level of prosperity amid stability. 

The principals are somewhat disadvantaged because the agents have deeper insights about the economy and thus use their insights to lobby for policies.  Academically, the agents control the economy and the principals face moral hazard due to asymmetry of information.  The journals, publishers and media have been under the control of a group of very powerful and rich agents.  They have promoted feasibility of only second-best policies written by the experts. 

Many principals and elected officials have been trained by the same experts in prestigious universities and colleges.  They have been ingrained with a belief that only second-best policies are feasible. The elected representatives have thus accepted second-best policies as laws.  These laws have shaped the prevailing system of financial moral hazard.  The agents who have promoted second-best policies have so far ensured first-best existence for themselves by subjecting the principals to second-best status.

In the prevailing system of financial moral hazard, the agents make some political contributions to the elected representatives of the principals, fund the experts to continue their research on only second-best policies, rob the principals of their savings through second-best laws, and suppress and purge from the academy anyone who dares to prove the existence of first-best policies to resolve financial moral hazard even in a more rigorous, general model of equilibrium than the myopic models used in second-best policy research by the experts financed by the usurped wealth. 

The irony is that the political contributions and funding of experts add up to a tiny fraction of the wealth usurped from the principals.  Even the usurped wealth is a small part of the gargantuan amount of destroyed wealth of principals due to financial moral hazard.  The system of financial moral hazard is, thus, economically inefficient.  It is also unconstitutional.  It has caused continual depressions in the U.S.  This has been formally proved by first-best policy research since 1991.  The agents promoting second-best policies have suppressed publication of the first-best policy research in their controlled journals, publishers and media.

The first-best policy research being pursued since 1991 includes Economically Efficient Constitutional Governance and Optimal Holding Company Organization and Capital Structure for Constitutional Governance. These and other related first-best policy research papers have illustrated how a financial catastrophe had been brewing and would be unavoidable if the first-best general economic equilibrium policies were not preemptively adopted.  The first-best policy research papers have proved that the prevailing system of money and finance is unconstitutional and economically inefficient.  

2. Discovery of Truth by Congress

The second-best policy promoting agents have succeeded, till the financial catastrophe erupted in 2008, in convincing the Congress to not consider any first-best policy research, howsoever robust it may be, if it is not published by the top journals and publishers controlled by the agents.  During their testimonies before the Congress-appointed Financial Inquiry Commission, the second-best policy promoting financial guardians in the industry and regulatory agencies simply feigned innocence by claiming that no one in the academy, industry or government saw the crisis coming.  Even the academic experts flaunted their wisdom authored in a book, promoted by a renowned academic publisher, to assert that the financial catastrophe of 2008 was a Slap by the Invisible Hand.  

It must have befuddled the second-best policy promoting guardians, regulators and experts how the Congress rejected their testimonies by remaining oblivious of all the political contributions.  The FCIC found out the truth that the financial catastrophe was caused by the failure of the second-best policy experts, guardians and regulators. 

The Congress must have discovered the epistemic truth that the failure of second-best policy agents caused the catastrophe as a result of the following factual events: 

  1. The Congress has received first-best policy research-which has been rejected by the second-best policy promoting agents’ controlled journals and publishers and which has been published elsewhere-since March 2003 from an author of the optimal bank foreclosure rule.
  2. The Congress has adopted the optimal bank foreclosure rule, soon after it was published , as new law (FDICIA-1991) to foreclose a bank, whenever the bank’s capital-to-assets ratios falls below a minimum required threshold. 
  3. The first-best policy memos and research papers, which the Congress directly received from an author of the optimal bank foreclosure rule since 2003, show how the bank holding companies have transgressed this rule via a manmade multi-tier leveraging of bank holding companies.  Such leveraging can raise return on equity of a BHC by 1000% by decimating the BHC’s consolidated capital-to-assets ratio to one-tenth of the minimum required under the law, as illustrated in the first-best policy research paper received by the Congress in 2003.  These first-best policy memos and research papers received by Congress since 2003 show how such transgression of the bank foreclosure law by bank holding companies was piling up enormous risk on the public exchequer.
  4. After receiving the first-best policy research paper in March 2003, the Congress did in fact seek testimonies from the Federal Reserve Board on safety and soundness of the US banking system in October 2003.  The Congress perhaps even instructed the Fed to convene a conference (which was actually held in November 2003) among agents (experts, regulators and guardians) on the issue.  The author of first-best policy research was also invited to the conference held in November 2003.  One can verify the government and Fed records to validate the facts about these events.
  5. During their testimonies before Congress and conference in 2003, the second-best policy promoting agents have assured that any deviation from the bank foreclosure law at the BHC level (as warned in first-best policy papers and memos received by Congress since 2003) would not jeopardize the safety and soundness of banks because of the firewalls and self-discipline of BHCs. 
  6. The second-best policy promoting agents effectively dominated the thinking of Congress until 2008 that (i) the moral hazard-plagued financial system (second-best policies) was safe and sound because it was supported by eminent research (including the Nobel variety) published by top journals and publishers vetted by eminent finance-economics experts and (ii) no first-best policy research paper which is unpublished by these journals and publishers or published elsewhere merits consideration by Congress–even if the such first-best policy research is based on a more general and realistic economic environment than ever modeled by the second-best policy experts to prove how the prevailing second-best policies have piled enormous risk on the public exchequer. In other words, the second-best policy agents have portrayed themselves as the almighty god before the Congress.  Their controlled journals and books promoting second-best policy papers were presented as scripts from god.  By offering liberal political contributions to both parties and by flaunting vast accumulated wealth, the second-best policy promoting agents virtually crowned themselves with the halo of god.  This may have influenced the Congress to second-guess even pioneering first-best policy research , which has been rejected by the journals controlled by the second-best policy promoting agents or published in second-tier journals not controlled by these agents. 
  7. The second-best policy experts never disclosed to the Congress that (i) their research could be influenced by the lucrative chairs and grants gifted by the financial guardians, (ii) the unconstitutional and economically inefficient second-best rules they have crafted (manmade) and published in top journals controlled by the agents facilitated usurpation of the public exchequer and of the public’s pension plans and mutual funds, (iii) the second-best policies advocated by the experts (based on their myopic and irrelevant research) will ultimately drain out the savings of the American principals, and (iv) the principals, so deprived, could occupy everywhere in protest.
  8. The second-best policy experts never disclosed to the Congress until 2008 that the top journals and publishers they control have been baselessly rejecting publication of robust and rigorous first-best policy research papers which accurately (i) proved unconstitutionality and inefficiency of the current (manmade) system of financial moral hazard, (ii) showed how the current (manmade) system was waiting to explode , and (iii)  obtained an efficient and constitutional (manmade) system, which resulted in first-best equilibrium within a general economic model and which was needed to be adopted to avert a looming crisis to beget first-best status for the American principals. 

Such discovery of epistemic truth has reinforced my belief that the Congress represents, though not perfectly yet, the real-world Paramatma (soul of all souls) of the principals.

I have concrete evidence to establish how the same failed second-best policy peddling agents continue to reject first-best policy research which has discovered an implementable (manmade) system of money and finance to beget first-best status for the American principals.  The failed second-best policy experts, still ruling the roost, have recently rejected publication of first-best policy research with virtually no review by a top-tier journal, which has already published multiple major papers written by the same first-best policy author on different topics.  Continued rejection of first-best policy research proves that the failed second-best policy agents are hell-bent to suppress the publicity any rigorous research designed (manmade) to beget the first-best status for the American principals. The failed experts have promoted only second-best research through their myopic models to suit their sponsoring financial guardians.  They abhor the prospect of being debased from their statuses in the academy, industry and government! 

To discover the truth about the financial catastrophe, the Congress was rightly not swayed by fame of the finance-economics experts or by the prestigious institutional affiliations of these experts.  The Congress was not moved by the expertise of the finance economics experts in the academy or regulatory agencies.  Neither was the Congress influenced by the ability of the Masters of Universe bankers to be wealthy and to make generous political contributions.  The Congress was nonchalant about the fame of the institutions that housed the second-best policy experts in the academy, industry and regulatory agencies.  The Congress squarely rejected the second-best expert-wisdom of portraying the catastrophe as an act of god in papers and books printed in journals and media controlled by the same agents.
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The FCIC unanimously found the truth that the crisis was manmade (avoidable), due to a failure of the second-best policy promoting agents, including those at the helms of the Federal Reserve Board and top banks. The minority FCIC view presents, in addition, the root causes of the crisis as reckless lending and borrowing.  The FCIC report (released to public in January 2011) does not, however, show how the system generated excessive credits to be lent recklessly to borrowers, or why the regulators permitted acceptance of inflowing credits as bank debts without requiring the latter to raise sufficient capital according to the bank foreclosure law.  The FCIC has kept many documents and testimonies beyond the purview of the public, and so may have answers somewhere.     

The constitutional and economically first-best model (written since 1991), which has been rejected by the second-best policy experts, (i) shows how the prevailing financial moral hazard system that crashed in 2008 is, in fact, manmade and (ii) obtains an alternative manmade system, which is economically first-best efficient and constitutional.

The failed second-best policy promoting agents and their controlled journals and publishers have thus proved to be schizophrenic:  they have painted themselves until 2008 as the almighty god, but when the real world including the Congress discovered their failure due to their clueless testimonies, they attributed the financial catastrophe to some other god.  Their rejection of profoundly important first-best policy research designed (manmade) to beget first-best status for the American principals is truly dangerous to the prosperity amid stability and security of the nation.

The failed second-best policy promoting agents need to be replaced, urgently, to attain first-best level of prosperity amid stability for American principals.  The University of Illinois produces every year more than one hundred advanced undergraduates who take my courses on futures and options markets and fixed income securities and their derivatives.  They are groomed in the nitty-gritty of financial valuation and trading strategies.  Some of these graduates have later completed MBA programs in schools like the University of Chicago and Carnegie-Mellon.  They have written to me how easy it was for them to simply repeat and walk over the courses at those programs due to the material they learnt in my classes.   The University of Illinois’ advanced undergraduates learn about models on valuation of total risk (as opposed to just the extant wisdom based on valuation of partial risks rejected by data) and about first-best governance of banks and capital markets to ensure that the fair valuation models of finance do not go haywire by confounding professionals trained via books and papers that publish the extant wisdom based on unconstitutional and economically inefficient rules of governance designed (manmade) by the second-best policy peddling agents who are deemed (truly) by the Congress to have failed.

3. Grumbling principals

People should salute the Congress for finding and establishing the truth

The truth, effectively, is that the second-best policy promoting agents manipulated the system and camouflaged the reality by (a) training the finance and economics students and politicians about feasibility of only second-best policies, (b) rejecting the first-best policy research by their controlled journals and publishers and (c) persuading the Congress to not use first-best policy research because it has not been accepted by famed journals and publishers controlled by the same agents.  The agents’ political contributions, fame, wealth and manipulating skills did not sway the Congress in proclamation of the truth.  The Congress declared that the agents’ failure caused the crisis.  The Congress has also adopted many of the first-best policies: safe central banking to insure money market funds and bank debt and to require bank holding companies to have minimum capital on a consolidated basis.

Why are the principals then grumbling or protesting, first through the Tea Party Movement and now the Occupy Everywhere Movement?  These movements have the same common theme: “banks got bailed out, principals got sold out.”

  1. The street protest we are witnessing is simply a microcosm of the pent-up frustration due to the wealth lost by the vast majority including billionaires, millionaires, small, medium and large businesses, and small local and community banks.
  2. The total wealth lost is far greater than the wealth usurped by the rich who got richer. 
  3. Those who got richer may play innocence by telling that they did not get as much as the vast destruction of accumulated capital.  It is like a few robbers destroying the houses of a community to cherry-pick the valuables like gold and diamond.  They then tell the police that what they got is miniscule, compared to the vast accumulated wealth lost by the community.  The robbers are thus telling the truth.  But is their wealth accumulation shenanigan constitutional and economically efficient?  No.  It is dangerous, ex post, even for the robbers. 
  4. What has been happening in the capital markets is quite like the above example of robbers destroying a community, based on unconstitutional and economically inefficient rules of governance of banks and financial institutions.  For example, a bank holding company short-sells 10% of a pool of mortgage securities.  It then uses its power of credit (federally insured deposits and temporarily borrowed from Fed) to depress the value these securities by 10%.  Then the small banks having long positions in the same pool of mortgage securities lose 10% of their asset value and become instantly insolvent.  The FDIC then forecloses the small banks to hand them over to the short-selling robber-baron, BHC.  This wipes out the wealth of the small banks’ stakeholders.  If this process is repeated often, the vast majority of households including small and medium sized businesses lose their wherewithal to survive financially.  Principals then panic and withdraw from their investments which have propped jobs in society and deposit their remaining funds at near-zero interest rates decreed by the Fed on the government-guaranteed deposit schemes.  This is the exact predicament facing the economy.  This predicament was presaged by the first-best policy researcher, who had made since 2003 proposals to enact first-best policies to avert the looming catastrophe preemptively. Going with the second-best policy research is sub-optimal, even for the agents (the guardians, experts and regulators), when the principals’ objective is first-best status.  The first-best policy researcher had warned in a memo submitted to the US President and Congress in January 2005 that the agents would eventually realize sub-optimality of their strategy when the principals discover the truth about the existence of first-best policy research by a principal that the second-best policy promoting agents rejected through the journals and publishers they controlled.
  5. The printing of money by the Fed for the robber barons, BHCs, amounts to short-selling the dollar to support the agents who have destroyed the economy.  Such printing of money is not first-best policy, but it has been supported by journals, books and popular media, controlled by the second-best policy promoting failed agents.  
  6. The stakeholders of short-sold and depressed non-banking companies emigrate abroad with their ideas and technologies to start their businesses outside the U.S.  They are not even willing to repatriate their profits, lest the robber barons aided by the Fed will usurp it.  The profits stashed abroad earn much higher interest rates than the near-zero rate set by the Fed.  The near-zero rate Fed policy has effectively allowed the robber barons to swallow cheaply the hard-earned savings of American principals including non-banks to generate lavish executive compensation and bonuses. 
  7. The 2008 catastrophic panic and run, spread among American principals including the non-banks will not evanesce as long as the robber barons are in-charge to dictate second-best policies by funding second-best policy research of the failed experts and by surreptitiously rejecting the first-best policy research that serves the best interest of principals.  The principals fear about losing their profits and even businesses again. 
  8. The wealth generated by short-selling robber-barons, BHCs, maybe merely 10% of the value of the mortgage pool short-sold.  But the loss to the economy in terms of wealth lost by American principals is enormously larger.  I have sent you other examples of how short-selling destroys capital, hard-earned with mental and physical labor.  
  9. The prevailing financial moral hazard system continues to permit the robber barons governed by the Federal Reserve Act of 1913 (which was implanted by the barons) to short-sell the American principals with impunity. 
  10. The street protests are simply the tips of the iceberg. 
  11. The mega problem facing the US economy is the fear of non-banks to invest in the prevailing second-best financial moral hazard system which has already bared its latent devilish designs during the financial catastrophe of 2008.  Please make a survey among the non-banking firm executives.  It is not surprising, now, to these nonbanking firms that that the first-best policy research-which proves that the prevailing system is unconstitutional and economically inefficient-is being rejected by the journals and publishers which are controlled by the second-best policy promoters (the failed experts and their financial sponsors).  
  12. American principals, including small local banks and non-banking firms, are now seeking to dissociate their elected representatives from these failed agents who are hell-bent on perpetuating second-best status for the American principals by suppressing first-best policy research.  But the principals are shouting for first-best research policies.  They do not want any second-best policy, which is tailored to usurp their hard-earned capitals, the stored values of their labor. 

The principals are perhaps angry because they still observe the following facts:

  1. The Congress seems helpless because it has not brought appropriate legislation to beget a first-best economy by removing the failed second-best policy promoting agents (experts, guardians and regulators).  The same failed second-best policy experts-who helped plant and perpetuate second-best status for the principals and caused the financial catastrophe-are still ruling the roost everywhere including the academy. 
  2. Many demands raised by the protesters are, eerily, the same constitutional and economically efficient rules of governance as discovered through decades of selfless first-best policy research by a principal relegated by the second-best policy peddling agents.  For example, people are demanding to end the Fed, seeking a public bank, and ending the financial shenanigans (academically, moral hazard).  The first-best policy research finds within a general equilibrium model that the Federal Reserve Act of 1913 is unconstitutional and economically inefficient and obtains a safe central bank open to every household and firm (not just banks).  It shows that the established structures causing the moral hazard problem (due to the FDIC and holding company structures in the banking and mutual fund companies) are unconstitutional and inefficient.  The first-best policy research obtains a first-best efficient resolution of this problem by dismantling the FDIC, by disallowing discriminatory trading rules and by instituting a safe central bank. 
  3. The Congress indeed averted the cascading domino of financial moral hazard in 2008 by offering (as per first-best policy research) a safe central banking facility (via Fed and Treasury guarantees) to guarantee the $3.5 trillions of money market funds and trillions of dollars of previously uninsured bank debt.  The financial catastrophe of 2008 could have been avoided if the first-best policy research were adopted preemptively: safe central banking facility open to every household and firm (not just banks), elimination of discriminatory trading practices, and dismantling of the FDIC.  The Congress could have more completely used the first-best policy research (freely disseminated at pro-prosperity.com) from an author of bank foreclosure rule.  The failed promoters of second-best policy research, still ruling the roost, are in public denial about even the existence of first-best research, while tracking it by continually visiting pro-prosperity.com and while rejecting it when submitted to the journals they control. They are (like everyone else), however, welcome to visit pro-prosperity.com because the first-best research serves the best long-run interests of the principals and agents. The agents need to recognize, though, that the principals cannot be fooled forever and that the ex post cost of promoting second-best policies by suppressing first-best research policies can be much larger than the ex ante gains of agents. 
  4. Principals are grumbling perhaps because the Congress has not repealed the discriminatory Federal Reserve Act of 1913, which is unconstitutional and economically inefficient according to first-best policy research.  This Act continues to transfer hundreds of billions of dollars every year from the public exchequer to bankers, as the Fed creates money at near-zero percent for banks to lend the same to the government at 5% with no risk.  It is efficient for the government to create the money it needs without the Fed sending it via banks at 5%. It is inefficient for the taxpayers to bear this 5% interest given away to banks, who have caused second-best status for the principals though unconstitutional and economically inefficient trading shenanigans punctuated by failed second-best policy experts.  The American principals see this dichotomy between their first-best goal vis-à-vis what their elected representatives could do but have not done.  
  5. The Congress has not repealed the second-best moral-hazard causing trading shenanigans, which are discriminatory towards passive investors whose main job is to produce globally competitive goods, services and ideas that prop the nation.  This is a source of second-best status of the principals.  The holding company structure of BHCs and their governance can be drastically simplified with much less regulation to make it economically efficient and constitutional and to create the first-best status for those who prop the nation.  But as long as the Congress depends on the same failed second-best policy promoting agents, it cannot accomplish such a monumentally important task needed to revive the economy with nonpareil inventions and discoveries made by American principals.  The principals are perhaps angry when they see that their leaders are dependent on the same failed second-best policy promoting agents, who have openly admitted before the Congress that they did not have a clue about the crisis coming.   
  6. It befuddles the principals how they could see everything brewing under the veneer of hooted economic growth (concocted through CDO, CDS and other financially engineered products) which has basically passed on to the same group of agents, who have been deemed by the Congress as having failed.

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The Congress can do much more than just addressing any street protest by following its own path of discovering the truth about the financial catastrophe of 2008: that it was caused by a failure of agents who promoted second-best policies for American principals.  This Congress’ path, consistent with its discovery of truth, is to not depend on the same second-best wisdom (even through different individuals) that led to the financial catastrophe due to a failure of the second-best policy promoting agents.  The 2008 catastrophe is an alarm bell for a bigger disaster, which in my earnest analysis should not happen given the enormous advances made by the principals

Why should a principal-who has not only pursued for seminal first-best policy research to design policies to further the best interests of principals, but also selflessly lobbied with the Congress to adopt only first-best policies since 2003 by developing a more general equilibrium model than any other in the extant literature-be financially oppressed by the second-best policy experts and guardians, who have been deemed by the Congress to have failed?  It is happening because of the rejection of first-best policy research by the journals and publishers controlled by the same failed second-best policy agents.  This needs not and should not happen if the goal of the Congress is to establish a first-best society for American principals. 

The Congress should fund a center of constitutional-efficient finance and a rigorous Journal of Constitutional-Efficient Finance founded on seminal first-best policy research designed to beget a first-best status for the American principals consistent with the dream of the founding fathers and with the truth discovered by the Congress.  Why should the first-best policy researcher’s pay be less than 20% of the failed second-best policy experts in the academy and less than 1% of the failed second-best policy guardians of finance?

The real problem is not whether enough taxes are raised from some income group or the other.  It is how some of the large incomes are being generated by recklessly destroying the ingeniously developed capital or labor due to a system of moral hazard championed by the second-best policy experts and guardians, who have admitted their failure and which the Congress has also determined as the cause of the financial catastrophe of 2008.

 

4. First-Best Policy Path

Please recall that after the bank foreclosure rule, authored by the first-best policy researcher, was implemented in 1991 by Congress the economy zoomed forward with stock market indexes tripling.  It happened because investors all over the world regained their confidence in a decidedly stable US banking system, which has been now decimated by the second-best policy agents. 

Please also recall that the first-best policy researcher (as a Fed financial economist) had complained about the surreptitious transgression of the bank foreclosure rule through the bank holding company structure in 1994, and had written then a series of first-best policy research papers to avoid the transgression though new first-best policy.  But the Fed has been a part of the second-best policy agents due to the Federal Reserve Act of 1913.  So, it was not hard to see that the Fed would not support first-best policy for principals.  I did not read the Federal Reserve Act before I was lured to leave NYU.  I learned at the Fed that only the Congress could represent the principals.  So, I came to the University of Illinois in 1995 to communicate my first-best policy research directly with the Congress. 

I had requested you a few months ago to ask the failed second-best policy agents–who are still ruling the roost–to devise a path to extricate the economy from the rut that they have pushed the principals to fall into.  They have failed to find a way, except for grumbling about raising taxes or cutting government spending to balance the budget

In this section, I propose how to implement the first-best policies practically without raising taxes or printing money to enhance prosperity amid stability of American principals.  I see this as the unique path (consistent with first-best policy research) to get out of the rut and to advance prosperity of American principals, which is not necessarily the same as the economic growth pursued by the second-best policy agents.  

The Congress has discovered the truth that a first-best system exists and is being rejected by journals and publishers controlled by the agents willing to perpetuate the first-best status only for themselves by subjecting the rest to second-best existence.  The Congress has found that the current agents have failed.  The failed agents or others ingrained in the second-best policy wisdom cannot foster first-best status for American principals. The only way to implement or adopt first-best policies is to have an irrevocable rule of promptly replacing the agents (guardians, regulators and experts) who have failed, at least after the Congress has determined that such failure has imploded the established second-best system of financial moral hazard.   A society can preemptively replace such failing agents only by public funding and promoting first-best research policies to serve the best interests of the principals.  This is the only reason for my proposal, made since 2005, to establish a national or global center for research on constitutional-efficient finance.  

Let’s come to the nitty-gritty of immediate policy reforms as per findings of first-best research.  The principals have a right to demand efficient (cheap and effective) governance.  But finding policies consistent with such governance has not been easy.  In 1989, J. F. Dreyfus and I first used a policy goal to attain efficiency in governance and proved that banks should be foreclosed whenever their capitals fell below a minimum threshold by assuming that the federal guarantee of bank deposits is necessary and priced fairly.  The Congress enacted this finding as law in FDICIA-1991.  Dreyfus and I have not proved then, though, that the federal deposit guarantee itself is efficient.  My subsequent research, first mimeographed at the Federal Reserve in 1991, shows that the federal guarantee of bank deposits is inefficient and explicitly proves in a published paper in 2003 that a safe central banking facility open to every firm and household (not just banking firms) will make the inefficient federal deposit guarantee unnecessary to avert potential panics and runs due do rare random shocks in the economy.  

So, Congress should move forward to enact these first-best research findings:

  1. Fund first-best policy research by establishing a center with a rigorous journal on governance through first-best research.
  2. Close the FDIC.
  3. Repeal the Federal Reserve Act of 1913.
  4. Introduce a new act for opening safe central-government banking to all firms and households.
  5. Eliminate the federal guarantee of bank deposits
  6. Foreclose all the effectively insolvent mega banks through some kind of conservatorship

Most major banks (the BHCs) are now operating as shells:  with negative equity after accounting for the reality of a huge shortfall due mortgage loans being much larger than home values.  An optimal government policy, thus, is to foreclose to reorganize these major banks including the investment banks, by leaving behind the solvent local and community banks.  This is optimal as per research on bank foreclosure rule that has already become law and is consistent with first-best policies presented earlier. 

Without prompt foreclosure of the effectively insolvent mega banks and investment banks, the executives and their private hedge funds will drain out whatever assets are left under their control, ruin whatever is left in the economy due to their financially explosive trading games they are imbued with, and push the economy to uncontrollable (but unwarranted) pessimism and financial depression. 

The new safe central bank will comprise two parts: a safe bank open to all firms and households and a risky bank based on a merger of the foreclosed mega banks.  This will be equivalent to what the government (Treasury and Fed) is already having due to guarantees of money market funds, bank debts and deposits, except a transfer control of the mega bank to the new safe central bank by a new act of Congress. 

The new risky bank will drastically reduce expenses on executives, completely eliminate the capital-destructive mutually annihilating trading strategies among mega banks, and suddenly transform the pervasive gloom and doom among American principals to budding optimism and hard work.  The fear and uncertainty will be supplanted by the dawn of prosperity in the horizon.  

The risky bank will continue to pay dividends and interests to the stakeholders of the mega banks merged with the new safe central bank as soon as it becomes solvent.  The safe central bank can eventually spin off the risky banks after they become stable to new managements imbued with first-best policy wisdom.

The subsidy currently flowing to the mega bankers due to lending the government at much higher rates the same money taken from the Fed and government guaranteed deposits at near-zero rate of interest will stop.

  1. Convert all mutual fund holding company structures to the regular mutual funds.  This is necessary to dissociate trading between private hedge funds owned by holding company executives and fund managers.
  2. Discontinue the capital-destructive, economically inefficient and unconstitutional practice of short-selling of financial securities all firms.  The slogan of protesters “banks got bailout, we were sold out” is actually rooted in the very structure of the prevailing financial moral hazard: the Fed itself short-sells dollars when it prints money and rescues the mega short-sellers at a huge cost to the principals and their enterprises who hold long positions, positive stakes in companies and societies.

 

5. Conclusion

I look forward to having your response, seriously.  This is important because you have determined that the agents (experts, regulators and financial guardians) on whom the society has depended so far have caused the financial catastrophe of 2008 by promoting second-best policy research and by suppressing first-best policy research.  After the catastrophe of 2008, three years have lapsed.  Yet, the failed second-best policy promoting agents have been unable to come up with policies to lift the economy from the rut they have dumped the principals in, despite early warnings from first-best policy research. The principals can now hope to gain their freedom from their second-best existence to enjoy first-best living if you continue to move forward on your discovered path of governance by truth.  The truth is that first-best policies exist and can be practically implemented.   

With profound regards,

SankarshanAcharya  


The common notions of truth, soul, Paramatma, god, religions, beliefs and modern science can be rationally reconciled with modern concepts on (probability) beliefs used in science, mathematics, engineering, and economics as well as spiritualism.  See Acharya, S. (1995-2011), “A Unifying Philosophy of Governance,” available at http://www.pro-prosperity.com/A-Unifying-Philosophy-of-Governance.html

See Acharya, S. (2009), “Optimal Governance for Prosperity amid Stability: A New Economic Philosophy for Democratic Capitalism, Realizing a Common Dream…” for measurement of prosperity, http://www.pro-prosperity.com/Research/Prosperity%20Amid%20Stability%20-%20A%20New%20Economic%20Paradigm.pdf.

See Acharya, S. (2010), “Economically Efficient Constitutional Governance,” at http://www.pro-prosperity.com/Research/moralhazardliberty.pdf and Optimal Holding Company Organization and Capital Structure at http://www.pro-prosperity.com/Research/OptimalHoldingCompanyOrganizationCapitalStructure.pdf

See, Acharya, S. (March 2003), “Warning to Congress on Current Home Mortgage Debt Debacle,” at http://www.pro-prosperity.com/Global%20Economy%20Chatterbox/Warning-USCongress-In-2003-On-Home-Mortgage-Debacle.html See also Acharya, S. (August 2003), “Safe Banking,” published in the Journal of American Academy of Business,  available at http://www.pro-prosperity.com/usa/safe%20Banking.pdf This safe central banking paper has many references, especially, the paper on optimal bank foreclosure rule, Acharya, S. and J.F.Dreyfus (1989), Optimal Bank Reorganization Policies and Pricing of Federal Deposit Insurance, Journal of Finance, XLIV, 1313-1333

Acharya, S. and J.F.Dreyfus (1989), Optimal Bank Reorganization Policies and Pricing of Federal Deposit Insurance, Journal of Finance, XLIV, 1313-1333

Public exchequer is defined by the pool of tax funds and money created by the Federal Reserve or borrowed by the government.  For numerical examples, See Acharya, S. (August 2003), “Safe Banking,” published in the Journal of American Academy of Business,  available at http://www.pro-prosperity.com/usa/safe%20Banking.pdf

See Safe Bank Central (January 21, 2009), “Safe Banking, an early thought leader’s view” reproduced at  http://www.pro-prosperity.com/Research/Safe%20Banking%20-%20An%20Excellent,%20early,%20thought%20leader's%20view.pdf  I know nothing about Safe Banking Central or how they got hold of my paper on Safe Banking.  Internet browsing led me to Safe Banking Central’s comments on my paper.

See Acharya, S. (January 31, 2005), “Enhancing American Competitiveness,” sent to the then US President and Congress including the then Senator Barack Obama of Illinois.

For a rational rendition of epistemic truth, soul and Paramatma, see Acharya, S. (1995, revised 2011), A Unifying Philosophy of Governance, http://www.pro-prosperity.com/Research/A%20Unifying%20Philosophy%20of%20Governance.pdf

See a few attached feedbacks from UIC advanced undergraduate students in finance.

See, Acharya, S. (January 31, 2005), Enhancing American Competitiveness at http://www.pro-prosperity.com/USPresident013105.html

See Acharya, S. (October 10, 2011), No-subsidy Mantra of Governance needed to Attain the Most Efficiently Competitive Economy, at http://www.pro-prosperity.com/Research/Governance-and-Most-Efficient-Competitive-Economy.pdf

See Acharya, S. (2009), Optimal Governance for Prosperity amid Stability, at http://www.pro-prosperity.com/Research/Prosperity%20Amid%20Stability%20-%20A%20New%20Economic%20Paradigm.pdf

The original research of 1991 has expanded to obtain first-best general equilibrium policy results in Economically Efficient Constitutional Governance, available at http://www.pro-prosperity.com/Research/Prosperity%20Amid%20Stability%20-%20A%20New%20Economic%20Paradigm.pdf