Averting the Next Looming Disaster: Busting of Dollar

September 20, 2008

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development

September 20, 2008

Written to U.S. Senators

Sub:    Policies on Market Making and Greed

1.      Ban Short-Selling in Market Making to save the MMs and contain systemic risk

Market makers (MMs) provide a very useful service if they simply balance the buy and sell orders of a day and receive a commission for the service.   If, however, MMs (their proxy hedge funds and investment banks) are allowed to sell securities short, they will be vulnerable to their own failure causing systemic risk to society.  Vulnerability induces MMs to rig the market, even by unscrupulous means.  Rigging causes cycles of euphoria (boom) and panics (bust) which lead to continual depression in the capital markets. 

How can unrestricted short-selling cause systemic risk?  In euphoric times, punctuated by good news (real or fictitiously spread), investors buy securities from offers made by the MMs.  This makes MMs sell the security short and build up large short positions.  The MMs must cover their short positions, especially after their account values drop.  Under financial pressure, MMs often resort to unscrupulous practices to orchestrate price drop: spread bad news, negative investor sentiments or downgrades through complying analysts.  Then the short-term investors and traders, who often borrow margin debt to buy the securities while the price rises, suddenly dump their holdings. The MMs use the dumping to trigger a sell off and price compression.  Unrestricted short-selling in market making thus abruptly depresses a euphoric state and precipitates a fall in prices.    

MMs flush in capital and unfettered credit lines use market-making with unrestricted short-selling to generate ample profits, taxes and political contributions.  The lawmakers, regulators and tax collectors then remain oblivious of the robbery of the retirement savings or fruits of labor of the vast majority.  When the vast majority loses everything or stays away from the conning games or plays it safe, the MMs begin to rob each other.  They land in a classic prisoners’ dilemma, remaining mutually locked up due to massive short and long positions.  Some event like falling values of mortgage backed securities squeezes the MMs, causing widespread panic and crunch.   

Optimal Policy: The only optimal policy option to contain mass failure of MMs and to prevent systemic risk being faced now is to disallow MMs (including their proxy hedge funds and investment banks) from taking and maintaining short positions. 

Many bankrupt MMs (independent or units within universal banks and brokerages) will now face extinction and they should be allowed to let go just like the liquidation of the vast majority of margin traders.  The markets have the ability to absorb failures of the once largest investment bank, Drexel Burnham Lambert, largest hedge fund, LCTM, and now Bear Stearns and Lehman Brothers. 

If some investment bank or hedge fund made a lot of money in its heydays, but is incapable of standing on its own due to market forces, the government should not interfere in its fall except to ensure that the fall is orderly under the law.  If this policy is transparently followed, new strong MMs will emerge to execute their function transparently under new optimal policies. 

Long-run optimal policies should be quickly adopted to prevent recurrence of such mass failures and systemic risks to economy.  Suspension of the mark-to-market accounting will really help some of the strong financial companies survive as they can hold their non-performing assets until the housing sector recovers.  Equity investments in banks like Citigroup will help.  But systemic purchase of toxic assets should be avoided, as argued in my memo dated September 28, 2008.

2.      Policies on Containing Greed

Both the honorable presidential candidates, who represent the aspirations of the vast majority of Americans, have expressed that greed is the principal driving cause of the current financial crisis. 

One may claim that greed caused the financial crisis despite good policies.  Or, greed is behind the bad policies that led to the catastrophe.  In either case, it behooves us to probe for the root cause of pervasive greed. 

Legislation against greed per se is not enforceable.  We must, nevertheless, ensure that our academic programs are not willy-nilly instilling the greedy creed in the minds of the youth.  Economic programs around the world, for example, promote that it is rational for individuals to maximize utilities of their wealth to choose their behavior.  Such curricula may be emboldening individuals to presume that they need to enhance only their own wealth or net worth to maximize their utilities.[1]

Individuals maximize their utilities of wealth to make decisions, subject to constraints imposed by public policies promulgated by the government. A government representing the interests of such individuals chooses optimal public policies by maximizing the aggregate utilities of individuals. This paradigm for public policies may seem rational, at first blush, for individuals with finite lives. But this paradigm may eventually hurt the collective human welfare and cause social instability due to sporadic riots, global depression, global warming, nuclear proliferation, depletion of ground water, pollution of surface water and environmental degradation.

The current government policy tends to ignore how individual utility maximizing actions can undermine collective human welfare in future, if not immediately. It can also degrade utilities of individuals in future, if not now. Government policies should not be, therefore, predicated only on individual utility maximizing efforts.

A truly rational public policy paradigm should maximize aggregate individual utilities of wealth while minimizing the cost to humanity of individual utility maximizing actions. The current economic paradigm, maximizing individual utilities of wealth, propagates a myth about what the humans should consider as rational. It panders to and promotes the baser temptation of humans to focus on individual utilities of wealth.

To enhance long run welfare of humanity, democratic governments must be responsible to design laws based on the truly rational paradigm and tell the truth about the long-run adverse effect of pandering only to immediate human desires.

Long run human welfare can be promoted only through worldwide awareness – with efforts of governments, media and academia – about how the individual utility maximization paradigm may unduly accentuate self-serving behavior and undermine collective welfare. We should formalize the current election slogan of helping neighbors and communities.  

With profound regards,

Sankarshan Acharya

[1] See “Utility of Wealth, Policy and Governance,” available here http://www.pro-prosperity.com/Research/UtilityWelfareDemocracy.pdf