Efficient Resolution of Moral Hazard is Necessary for Individual Liberty

February 17, 2010

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development


                                                                                               

February 17, 2010

To:       Honorable President Barack Obama

Cc:       Honorable House Speaker Nancy Pelosi

Honorable Senators Harry Reid, Richard J. Durbin and John McCain

Honorable Chairman, House Oversight and Government Affairs Committee

Honorable Chairman, Financial Crisis Enquiry Commission

Sub:     Efficient Resolution of Moral Hazard is Necessary for Liberty

Dear President Obama,

By electing a Republican senator in a predominantly Democratic constituency in Massachusetts, the “Left Movement” has turned Right to convey that Washington cannot change.  What drives the Right (Tea Party) Movement, like the “Change you Believe in” of the Left Movement? 

The Left and the Right Movements are both angry.  But are they driven by the same cause? 

The economy is growing and jobs aren’t being lost.  What could then be driving the grassroots Movements and their supporters?  Is the economic growth camouflaging some latent common source of frustration? 

Since 2003, I have openly argued that national economic growth is not an indicator of prosperity of the vast majority.  I have presented a numerical example to illustrate that the vast majority can face deteriorating incomes and declining net assets even when the economy is growing and unemployment is zero.[1] 

Declining prosperity, measured by deteriorating net worth, can frustrate people, especially when they observe a growing economy.  The government is not collecting data on net worth of individual households to gauze if, say, the bottom 90% is facing a decline in net household assets.  The aggregate data collated by the Federal Reserve is incapable of depicting individual household experience. 

People with declining prosperity also see their government printing money on their back to enrich those who have inflicted losses to their net household assets, incomes, and jobs. 

People see moral hazard, which literally means that the appointed agents (elected representatives) are not serving the best interests of the principals (voters).  People from the Left and Right are forging to form grassroots movements to convey that such moral hazard thrust on them must be efficiently resolved. 

Let’s talk in plain English the “complicated” moral hazard problem that I formulated and efficiently resolved in a paper written in 1991 and revised lately in 2007.[2]  The foundation of this paper comprises three elements:

1.      A market environment that allows free trading.  This prevents the government from deciding whether or not a failing bank or non-bank will operate based on largesse in form of new money printed on the back of the vast majority of people.  This free market environment is scripted in the Constitution of the U.S. Everyone including CEOs of banks and non-banks, the President and Members of Congress has sworn to uphold the Constitution.

2.      Firms with goals to maximize their profits.

3.      A not-for-profit government that upholds the Constitution and serves the best interests of the vast majority of households, at least those who innovate and produce globally competitive goods and services.  The assumption is that the prosperity, stability and security of a nation depend on these households and that they have a proclivity for charity to support the non-producers. 

The equilibrium in this model is Safe Banking Policy with no government guarantee of bank deposits and no regulation.[3]  My paper portrays this as the efficient (first-best) resolution of moral hazard.  If I artificially restrict the environment within my model to only maximization of profits by firms, then I obtain a second-best equilibrium.  In the first-best equilibrium, the government does not bailout firms, but maintains equilibrium as per constitution.  The second-best equilibrium is obviously not stable in a democracy in which people do not want to be restricted by a lack of trading (being able to trade failing firms at market prices) or by a government bailout of failing firms with new money printed on their back.

Nobel Memorial Prizes in Economics have been awarded to papers that present second-best equilibriums in theoretically restricted environments.  My paper has been rejected by journals edited and reviewed by the Nobel Prize Winners.  The only explanation given for the rejection is that my model is too complicated.  Yes, it is somewhat complicated as it involves dynamic decision making in a game theoretic framework with arbitrage trading and optimization by all players like the firms and government policymakers. 

Is it credible that the Academy of Finance and Economics–with rocket scientists and mathematicians–would reject a paper because it is complicated?  No.  The truth is that the Academy of Finance and Economics has been broadcasting a mythic gospel of second-best equilibrium through Chaired, Distinguished Professors and Nobel Memorial Prizes administered by the finance industry.  The second-best equilibrium literally means that the real innovators and producers of globally competitive goods, services and ideas live a second-class life with unemployment or underemployment and with their hard-earned savings literally looted by the bankers who have established prestigious prizes in economics and chairs in banking and finance. 

If the “esteemed” professors and their “prestigious” journals were as great as touted, they could have foreseen the crisis and presented preemptive policy solutions.  The unpleasant truth is that they did not even want to see the Truth presented to them by yours truly.  In fact, they did everything within their command to suppress the Truth and shoot the messenger of Truth. 

I have sacrificed enormously to present the Truth in plain English: the only first-best equilibrium to resolve moral hazard is Safe Banking.  It is constitutional.  It is efficient.  The second-best equilibrium is transient (unstable in long-run), unconstitutional and inefficient. 

The Constitution was scripted to provide first-best living for the hard working men and women who fought for their liberty.  What are we doing now?  We are printing trillions of dollars primarily for those who do not produce but wangle away hard-earned savings of the producers, who thereby remain subjugated with underemployment or unemployment.

A well-known professor for whom I have deep regards once admitted that his theory, now published in a prestigious journal, tacitly presumes irrationality or stupidity of the vast majority of people. If policies are based on such theories, we will of course be doomed as a society.  

My previous memo, dated January 30, 2010, argues that the “Volcker Rule” will solve little.  It is indeed based on a paper I wrote and circulated since late 2007 on sub-optimality of lending taxpayer insured bank funds to private hedge funds operated by bank executives.  This paper is available at my website Pro-Prosperity.Com.  Yes, it too was rejected by a journal edited by a Nobel Memorial Prize winner because it was not suitable to the journal.  So, a “prestigious” economics journal edited by a “renowned” professor does not find this paper suitable!  Why?  Is this an irrelevant economic idea that the President of a great country would like to wager his political capital on?  That is incredible. 

A few days after faxing my January 30 memo, a “prestigious” publisher approached me to write a book.  This may be coincidental.  I sent him a book proposal on efficient resolution of moral hazard and liberty.  This book could be sold in millions of copies at least to the people participating in the grassroots movements because it is about fulfilling a common longing for liberty through efficient resolution of moral hazard.  The publisher could reap millions of dollars in profit by selling a book like this.  But the senior editor of the publishing house declined to publish it!  Wow!  He obviously does not want to propagate the truth about “efficient resolution of moral hazard” as necessary for liberty. Can the Truth be suppressed forever by the “renowned” keepers of “prestigious” media, journals and publishing houses? 

We are now facing Great Depression II and a new World Order.  This would not have happened if the Truth were not suppressed but publicized.  The custodians would have lost some ground by publicizing the truth.  But they are now poised to lose significantly more ground.  The grassroots movements will ensure that the Truth prevails and liberty is restored for the real innovators and producers of globally competitive goods, services and ideas.

With profound regards,

Humbly and sincerely,

Sankarshan Acharya



PS: Mahatma Gandhi has once described a test of the Truth (and I paraphrase): If and when the Truth is presented, "they" will first ignore it.  Then "they" will say, maybe there is something in it.  At the end, "they" will concede by proclaiming that "they" knew it all along.  By "they," he meant the beneficiaries who served their self interests by subjugating the vast majority through suppression of the truth.  



[2] http://pro-prosperity.com/Citizens%20Publishing/TableOfContents.pdf

[4] To the best of my knowledge, there is no publication after the Glass-Steagall Act was repealed in 1999 to advocate banning the usage of the federally insured bank funds in private hedge funds managed by the same banks, until I widely distributed my paper in November 2007.  In fact most pundits in academia as well as Wall Street argued how safe and self-disciplined the capital markets had become to pave the repeal of the Glass-Steagall Act.. 

[5]I have not proposed this element of the “Volcker Rule.”

                                                                                                January 17, 2010

To:       Honorable President Barack Obama

Cc:       Honorable House Speaker Nancy Pelosi

Honorable Senators Harry Reid, Richard J. Durbin and John McCain

Honorable Chairman, House Oversight and Government Affairs Committee

Honorable Chairman, Financial Crisis Enquiry Commission

Sub:     Reforming the Financial System to protect Taxpayers and Productive Households

Dear Honorable President and Members of Congress,

Under the current financial system, in every five to seven years, (a) the capital market custodians (top bankers) scare the households (through short-selling strategies) to sell the risky assets and then to transfer the atrophied household savings to “riskless” bank deposits or money market funds, (b) the economy shrinks, and (c) the Federal Reserve responds by lowering the interest rate on the decimated household savings. 

In this system, households are flogged by both the capital market honchos and the Federal Reserve.  The result is enervated savings, destruction of earned capital, severe underemployment and rising unemployment, which pave the way for yet another Great Depression. 

The households comprise innovators, scientists and producers of globally competitive goods and services.  They produce food, technology and engineering goods.  They serve and secure the nation.  They protect what America stands for: individual liberty.  Yet, their retirement savings are wangled away by indolent, unproductive bank traders.  Wangling such savings (repertoires of hard work), even surreptitiously, amounts to subjugation of the true innovators and producers – who keep the nation strong and secure - by those who do not produce anything but weaken the nation willy-nilly. 

A preemptive policy needed now (and should have been adopted in 2008) to avert another Great Depression was already communicated by yours truly:

 

1.      Use Fannie Mae and Freddie Mac to refinance at 2.25% all the good loans held in the portfolios of commercial banks.  This home mortgage rate is simply the Federal Funds rate (0.25%) plus a premium of about 2% that is sufficient to fetch a decent return on banking service of loans. 

This policy will impose no risk to either the GSEs or the taxpayers because the loans are good.  It will induce the commercial banks to compete with Fannie and Freddie to refinance the good loans at lower rates.  Such competition will lower the mortgage rates dramatically for most borrowers.  Falling mortgage rates will eventually raise the home prices.  Rising home prices will engender pervasive optimism.  More tangibly, it will lower mortgage payments and generate fresh household savings which will stimulate the economy as optimistic households begin to spend again.  Rising home prices will lower loan losses for banks and thus reduce the future bailout risk to taxpayers. 

2.      Ban short-selling to forever close the path to another Great Depression.[1]

Currently, bank traders – who do not produce globally competitive good and services – have two potently destructive instruments at their disposal: (a) short-selling and (b) massive taxpayer-insured bank funds.  They use these instruments to make capital markets highly volatile in order to nibble away the hard-earned savings of the innovators and producers of globally competitive goods and services. 

The bank traders are induced by trading-based bonus schemes to wangle and ultimately destroy the wealth created by the productive households.  They do not seem to worry a bit about ruining the very financial institutions which provide them the berth for such trading or the very taxpayers who have unknowingly and naively underwritten such financially suicidal instruments for the traders.   It is as if to add salt to the injury of the taxpayers and productive households, the Federal Reserve and the US Treasury provide the ultimate security to the bank traders by transferring taxpayer funds to the ruined financial institutions. 

Short selling is the most potent instrument available to bank traders.  Individual households can also sell securities short, but they invariably lose when massive taxpayer-insured bank funds are available to bank traders.  When top institutional traders lose (as they did during 2007-08), their patrons (the banks) lobby for bailout funds created-borrowed by the government.  So, the current financial system does not serve the taxpayers or the productive households who indeed prop the government and the nation.  The current system is designed to cause Great Depressions by gradually weakening the economy and the nation. 

Banning short-selling will help serve the taxpayers, producers, government and country.  A nation should not predicate its policies on thoughts or advices of self-serving bank traders that short-selling is necessary to hedge risk.  Sure it hedges the risk of the nonproductive bank traders and rewards them handsomely, while ruining the hard-earned savings of the real producers who prop the nation and the economy.

3.      Ban bonus schemes tied to trading profits in directly insured and tacitly protected (too-big-to-fail) financial institutions.[2]

These policies will also obviate the vindictive knee-jerk actions like taxing bank executive bonuses or levying bank liabilities.  Seeking retribution from bankers, who act optimally from the point of view of their businesses, is not sanguine for a nation.  If anyone is to blame for the disaster, it should be the Congress and successive Administrations for not adopting policies which are optimal for taxpayers.   

Aren’t these policies necessary for a nation to compete and stay innovative, creative and productive?  Why are we then scared to adopt policies that are necessary and good for the country?  

 

Top bankers have succeeded in keeping the current financial system intact to continue the unfettered wangling of savings of the producers of globally competitive goods and services.   They have succeeded in scaring the lawmakers to not change the system. 

The households are, however, not scared of reforming the system.  They are angry with the Congress and rightly so.  They are longing for a reformed system that rewards innovation and that bans indolent schemes (like short-selling) and back-door protection of bank traders designed to surreptitiously wangle the savings of the true innovators and producers.  They are longing for a reformed financial system that will make the nation stronger and resilient, consistent with their nonpareil achievements like septa bites of broadband transmission per second and the cheap super computers on household desktops.  Such longing is consistent with the dream of the founding fathers and the constitution. 

With profound regards,

Sankarshan Acharya



[1]“Sub-optimality of short-selling,” http://www.pro-prosperity.com/Research/Sub-Optimality%20of%20Short%20Selling.pdf

[2]“Optimal CEO compensation in best national interest” http://www.pro-prosperity.com/Research/OptimalCEOCompensation.pdf