Mythology of Market Discipline Unraveled by Market Crash

A New Philosophy of Governance

March 11, 2010

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development

March 7, 2010

To:       Honorable President Barack Obama

Cc:       Honorable House Speaker Nancy Pelosi

Honorable Senators Harry Reid and Richard J. Durbin

Honorable Chairman, House Oversight and Government Affairs Committee

Honorable Chairman, Financial Crisis Enquiry Commission

Sub:     Mythology of Market Discipline Unraveled by Market Crash

and a New Philosophy of Governance to Guide a Great Nation[1]

Dear President Obama,

Your overriding goal seems to be equal economic opportunity and liberty for all.  This goal is lofty and democratic.  It represents your party’s ideals.  The principle of equality has inspired prominent republicans like Abraham Lincoln.  America has become powerful and rich due to an adherence to the principle of equality.  This principle attracted talents and capitals to America, unlike any other nation, to make the country nonpareil on earth.  But the principle of equal economic opportunity can be easily misunderstood as socialism in the current trying times, especially when you present a legislative agenda that imputes higher taxes and higher health insurance premiums. 

What should be the overriding theme or philosophy of governance to achieve your goal while making Americans prosperous? The philosophy of governance must resonate with the constitution, so that even the opponents cannot reject it publicly.  The constitution is considered sacred by all. Martin Luther King could achieve political equality by invoking the constitution. 

Unequal economic opportunity due to lopsided rules of law leads to financial bondage that transcends race, color, creed, religion and national origin. This must be articulated through a coherent philosophy of constitutional governance, as presented below, to achieve your goal.  This philosophy must expose the opponents’ principled stand as specious and unconstitutional. It needs to be articulated in the language of the opposition to endear the independents siding with them.

Constitutional Governance

Free trading means that the government does not intervene, for example, to bail out failing firms, to force mergers among firms, to inject new taxpayer funds to firms or to buy "illiquid" assets of firms. Free trading subsumes arbitrage trading of securities including derivatives and hedging of risk associated with such trading. The principle of free trading imposes no restriction on any enterprise including hedge funds, insurance companies, commercial banks and investment banks. Free trading leads to arbitrage pricing of assets which is the prevailing wisdom. Free trading, for example, lets private agents bid for assets of failed banks.  So, the free trading principle should be adopted by the government of “We the people.”  Free trading is scripted in the constitution. 

Failure of Unconstitutional Governance

A government that runs with only policies that maximize firm profits does not necessarily reduce the cost to the taxpayers or allow free trading. This government is unconstitutional.  It will inject new taxpayer funds to failing firms that have luxuriously paid off their profits as executive bonuses and made generous political contributions to tinker policies to privatize profits and socialize losses.  This government is unconstitutional because it abandons the constitutional provision of free trading in a market economy.

An unconstitutional government will be neither small nor smart. It will eventually fail. How? Each group of firms will lobby with this government to adopt those policies that maximize their profits. This would imply larger product prices and smaller wages for people, who support the firms and government. Short-run profits of firms will rise as a result, netting higher tax revenues and enlarging the government. The short-run policies are, however, myopic because they gradually pressure the households to accept lower wages and to support higher prices. Eventually many households will fail to afford the rising prices with their shrinking incomes. This will lead to a failure of many firms, loss of jobs for people and shrinking tax revenues for the government. The economy will then nosedive. The surviving firms with the amassed wealth will gain the power to dictate policies, which will allow less freedom to people and lead to a repetition of the same game.

A government thus run by policies which maximize firm profits will eventually collapse. This is the danger faced during the depressions and now.  

Unconstitutional governance with profit maximizing firms constitutes laissez faire capitalism that prevailed and collapsed during the Great Depression.

Mythology of Market Dogma

My undergraduate students easily follow the above logic of failure of an unconstitutionally running government.  But prominent economists, their prestigious journals and their leading followers running Wall Street and government agencies have spectacularly missed the current financial meltdown, let alone devising preemptive policies to avert the crisis.  Admission of failure of the genius is clear in a column written in a prestigious newspaper by a prominent economist and in a research paper by another top economist claiming that the recent financial meltdown was an act of the invisible hand (god).    

So, a richly endowed academy of finance and economics misses to foresee the major financial crisis brewing within the industry (transparently observable to yours truly), let alone devise preemptive policies to avert it.  It then broadcasts the Great Recession as an unforeseeable act of god in its controlled media.  It continues to propagate its dogma that the market will discipline itself hereafter if the government does not intervene at least until the next act of god.  The dogmatists pretend that people would not worry about transfers of taxpayer funds and guarantees to firms that gambled away the federally insured bank deposits and debts to wangle the hard earned savings of households before scaring the Congress to make such transfers. 

The prevailing market dogma is schizophrenic because on one hand it does not want government intervention in firms, while on the other hand it seeks government bailout of failing firms.  Is this schizophrenia also an act of god?  Who then are the gods?  Are we witnessing a modern mythology of the market dogma scripted by these gods?  These questions are paramount for the U.S. at this juncture because an elected president’s agenda is being blocked by a principled opposition based on this schizophrenic dogma. 

The market dogmatists believe that government intervention is detrimental to the economy.  They justify government intervention, only in the form of bailout of financial institutions bankrupted by the market players, by arguing that such bankruptcies are acts of god (invisible hands) beyond the comprehension of humans.  They propagate a belief that depressions and recessions are natural cycles (acts of god) which people must solve without asking any questions and by simply printing money for the institutions that were bankrupted by the market players (the executors of the dogma). 

The phoenix like market dogma is thus perpetuated by the plenipotentiary modern gods-the journal editors and their bands of referees and authors.  These gods are not within the purview of the people or their elected representatives.  They are mostly motivated by the largesse received from the preachers and practitioners of their dogma.  The mythology of market dogma thus continues to expand as long as the market players are able to scare the people and their representatives to have new money printed, at least to get past the god-created depressions.  They keep their zombie firms alive with vociferous opposition to government interference.

The British coined the term “mythology” by mixing an Indian word “myth,” which stands for lies, and an English suffix “ology,” which connotes science.  So, “mythology” stands for science of lies.  The British described Indian epics as mythology.  Now, the British must have discovered a modern mythology of market dogma propagated by a richly endowed academy of finance and economics.  One can infer this from the outburst of British Prime Minister Gordon Brown in his 2008 Washington Post column about the irresponsible and undisclosed lending by banks.

Center of Market Dogma

The main center that propagates the mythology of market dogma is the Federal Reserve Board.  Top economists at the Federal Reserve frequently questioned me, during my tenure there as an economist, how I was sure of the existence of moral hazard in banking.  The market dogma and its execution in the real world is the riskiest moral hazard that I felt caused the 1987 market crash.  Then on, I have struggled to eliminate moral hazard through research based public policies.  I could not prove then that moral hazard was indeed being practiced.  I did not then know that it was unconstitutional.  But that moral hazard posed potentially grave risk to the taxpayers was obvious to me. 

My policy proposals articulated in plain English and submitted to the Congress in 2003 could have been considered to preempt the financial meltdown due to moral hazard.  Sound public policy cannot be based on wishes that people are ignorant about the rampant game of moral hazard in banking and capital markets.  But the Fed presumed innocence about any existence or practice of moral hazard.  It actively nurtured an antithesis (market discipline) to suppress any theory on efficient resolution of moral hazard.  The Fed rewarded handsomely those economists who were willing and able to concoct and publish papers on an ordained market discipline area to form a redoubtable team of gods to propagate an unconstitutional mythology of market dogma to guide the destiny of a great innovating nation.  These papers published in prestigious academic journals are concoctions because it is really oxymoronic to use data generated by an industry roiled by moral hazard to prove empirically the absence of moral hazard. 

The concocted academic publications on market discipline were obviously designed to bulldoze my Safe Banking policy proposal submitted to the US Congress in March 2003 for an efficient resolution of moral hazard.  Indeed, the Fed’s testimony to the US Congress in the wake of submission of my policy proposal emphasized how market discipline was making banks safe and sound.  The system wide conference organized by the Fed that year also was on how market discipline was making the banks safe and sound. 

My memo of February 27, 2010 outlines how a deliberately orchestrated game of moral hazard decimated the trust in American banking, bank regulators and government, and how it caused the Great Recession which may lead to Great Depression II because of the continuing game of moral hazard in banking and capital markets. This memo narrates how (a) banks could convert to holding companies, (b) existing bank holding companies could open new subsidiaries (off-balance sheet) to highly leverage their scarce capitals, and (c) how private equity funds and hedge funds operated by bank executives and their cronies could use taxpayer insured deposits for private gains, while piling the latent losses on taxpayers.  This was the true game of moral hazard that I tracked to prove the necessity of resolving moral hazard efficiently to avert depressions, to maintain trust in banking and capital markets, and to enhance national competitiveness.  The ever expanding volume of concocted literature on market discipline could not simply suppress the truth that moral hazard causes depressions.  The modern mythology of market dogma and the mighty gods propagating such dogma could not suppress the truth.  A test of profound truth is that it cannot be suppressed by even the mightiest forces because such forces are ultimately propped by people who love the truth.

 

Market dogmatists have argued endlessly in empirical papers published in their controlled journals that bankers are able to discipline themselves.  Is self-discipline possible despite the severe dilution of a bank’s consolidated capital to a small fraction of the FDICIA-1991 minimum via off-balance sheet subsidiaries and bank holding company structures, permitted openly by the center of propagation of market dogma, the Federal Reserve, and its sister regulatory agencies?  They must have responded “yes,” in their testimonies to the Congress in 2003 when they declared that banks were safe and sound.  The Congress indeed sought the testimonies on safety and soundness of banks after I challenged the market dogma through a published paper, submitted to the Congress in March 2003.  My paper pleads for enactment of a Safe Banking policy to resolve moral hazard efficiently and to avert an impending meltdown in the banking and financial markets. In a Federal Reserve sponsored conference held in 2003, the gods reinforced their mythology of market dogma to proclaim that the banks were safe and sound.  This conclusion must have conveyed to the Congress that my Safe Banking policy was not worthwhile.

Establish the Truth about Constitutional Governance

Now the U.S. Congress needs to formally investigate and establish if my Safe Banking policy–that would leave the banking sector almost free according to the constitutional tenet of free market economy while obviating the unconstitutional moral hazard of socializing losses and privatizing profits–would have prevented the crisis from happening.  The investigation should publicly establish the truth and exhibit no vindictiveness towards anyone.  People love the truth and the members of Congress relying on the support of people should establish the truth publicly. This is paramount because efficient resolution by you of the unconstitutionally practiced moral hazard in banking and capital markets must have been the single most important hope of the people when they voted you resoundingly in response to the precipitously fall in stock markets in late 2008. 

The people’s support for you and for the Democrats is waning because you did not accord priority to the resolution of the unconstitutionally practiced moral hazard in banking and financial markets in your legislative agenda.  This practice amounts to financial subjugation of the vast majority of people your party represents.  This is the single most source of economic inequality experienced by the vast majority that you want to redress. The only way you can redress the damage is by establishing the truth publicly about the current schizophrenic, unconstitutional philosophy of governance that has decimated the destiny of this great nation.  This will automatically pave the way to establish the truth about a non-schizophrenic, constitutional philosophy of governance to advance America.  You have no other path to convince the people to accept your costly legislative agenda. 

A non-schizophrenic philosophy of constitutional governance will resonate with every American to enhance your popularity to facilitate a passage of even a costly legislative agenda that is consistent with the new philosophy.  A public search for the truth by the Congress will scare even the Republicans to accept the new philosophy of governance, grudgingly.  It will discipline the gods of market dogma and undo their motivation of concocting and preaching a mythology, which is at best schizophrenic and at worst seriously detrimental for the future of a great nation. 

The Congress represents the collective will of people, who financially support even the gods of market dogma.  Indians often describe god as Paramatma, which means the soul of all souls of people.  They conferred a lesser title of Mahatma (great soul), not Paratmatma, to Gandhi, perhaps because he did not represent the soul of all souls.  Whether Paramatma should be the notion of god is incidental.  The main point here is that Congress in the U.S. or the Parliament in another nation should be the Paramatma to probe even the gods preaching an ever expanding modern mythology of market dogma. 

This modern mythology of market dogma is yet to conjure a credible theory to claim that the bankers will remain self-disciplined even when their own survival is endangered by simultaneous, program-driven, mutually annihilating short selling among themselves.  The gods now have the plenipotentiary power of rejecting research that does not dovetail their philosophy.  The rejections are designed to kill livelihoods of authors of philosophies of constitutional governance.  The gods of market dogma thus want to perpetuate unconstitutional governance to continue economic inequality artificially. 

The Congress should ask the market dogmatists why it is so difficult for them to generate a plausible non-schizophrenic economic theory of how depressions occur and how to prevent such depressions, beyond ex post suggestions to remedy the malaise by printing enough money for the failing firms. 

The society ultimately bears the sustenance of even the gods of market dogma, but cannot question their schizophrenic, unconstitutional philosophy even when financial catastrophes hit everyone.  The gods keep buttressing their philosophy by publishing new articles about invisible hands slapping the markets and about how such market failures are indeed designed (by gods) to punish those market participants who were not disciplined enough to cause the crisis.  The gods of market discipline thus close the chapters on the Great Recessions and Great Depressions without being noticed by people or their representatives. 

The gods of market discipline go scot-free.  Their disciples run the banks, capital markets, clearing houses, security and commodity exchanges, government regulatory agencies and even the Administrations and Congress.  The spectacular failure of their disciples does not even dent the gods of market discipline or their philosophy.  It is because their disciples still operate and control the coffers (hard-earned savings) of people and can scare the Congress to print more money for them.  The Congress needs to investigate this to establish the truth without being vindictive towards anyone and without painting everyone in the profession in the same brush.  I have offered the Congress to pillory me for my lapses long before the Great Recession unfolded.     

Wisdom in Governance

The spectacular failure of markets bares the mythology of market dogma and their latent gods.  It also brings forth wisdom based on truth discovered through selfless research: efficient resolution of moral hazard through a unique Safe Banking policy to restore the trust in American financial institutions needed to enhance national competitiveness and individual prosperity.  This wisdom is the only unique path available for a wider acceptance of your costly legislations by the people, despite the opponents’ propaganda to the contrary.  I will bow with deference to anyone who has a different path to restore the needed trust in American banking, capital markets, governance and currency.

Even a principled, well-funded opposition will peter out if you can articulate the Safe Banking philosophy to credibly fulfill the common longing of people.  I was startled one day when an undergraduate student asked me why Mr. Obama did not accord priority to reform banking and capital markets that caused the financial crisis, and jumped to health care insurance reform.  I was surprised about her ingenuity because that was what I had inferred independently as the common longing of people, at least the rich and middle class, who see how the moral hazard game that at the end enriches only a few top bankers, after laying swathes of financial ruin for the rest. 

The common longing of the vast majority is to stop the lopsided policies that enrich a few by causing financial destruction to the rest.  Many hedge funds and their principals and retail investors have lost massively in the lopsided game.  Even the largest investment banks like Goldman Sachs and Morgan Stanley had fallen. 

Will the survivors win when their wealth is nothing but the credit propped by the indebted households and institutions?  This is the source of their fear towards reform.  It is in their best interest to lobby with accentuated broadcasts of the mythology of market dogma. 

Will the gods propagating their mythology of market dogma win eventually?  Their mythology must have already lost ground significantly, with Congressional outbursts like “uselessness” of economists.  Again, vindictiveness and painting of everyone by the same brush should be avoided.   

The modern mythology of market dogma is quite sly.  It preaches freedom of the markets, so does my philosophy of optimal (small but smart) governance.  It wants no government intervention in business enterprises, so does my philosophy. 

So what is the difference in my model that yields an efficient resolution of moral hazard, namely, a Safe Banking Policy in equilibrium that the market dogmatists seem to abhor?  The difference is the role in my model of a not-for-profit government that minimizes the cost to taxpayers and enforces debt and arbitrage pricing contracts.  In my model, the government does not intervene ex ante or ex post.  The mythology of market dogma seeks no ex ante intervention while the firms keep privatizing their profits.  But it invokes government intervention, ex post, to bailout failing firms. 

The mythology of market dogma does not entertain government in its paradigm, only ex ante, but begs the government to bail out failing firms, ex post.  This schizophrenic paradigm can survive only if it conjures the financial depressions wrought by mass failures of firms as acts of god.  Only then can it hope to induce “We the People” to print new money for their survival.  But “We the People” have recognized the game. 

In my paradigm, a smart government plays a non-interventionist role ex ante as well as ex post.   There is no schizophrenia in this paradigm.  This paradigm is thus robust.  What it yields is thus seriously important: a free market resolution of failing firms without any injection of taxpayer funds.  Injection of taxpayer funds to bail out zombie firms is the unconstitutionally practiced moral hazard that can be obviated only by discontinuing the legislated guarantee of bank debt and by stopping the tacitly practiced protection of too big to fail firms. 

Adopting New Wisdom of Governance

A smart government will obviate panic prone bank runs by legislatively chartering Safe Banks that invest only in government securities.  The smart government will monitor the Safe Banks for adequate capital to ensure that the executives do not make huge bonus payments to deplete the assets.  The rest of the banks will be Universal Banks that will be free to offer banking services to anyone, will face no government regulation, and will have no protection by taxpayers.  There will be no guarantee of bank deposits in either the Safe Banks or the Universal banks.  This will lead to a closure of the FDIC, that has willy-nilly created the too-big-to fail banks, for example, in a weekend seizure a large bank, Washington Mutual, and handing it over to JP Morgan that needs additional taxpayer-insured deposits to stay as the largest infallible bank.   

What will a Safe Banking policy entail?[2] 

1.      If the Safe Banking policy is implemented, the too-big-to fail bankers and their cronies will no longer be able to play moral hazard unconstitutionally for self-aggrandizement at huge cost to taxpayers and households. 

2.      The Glass-Steagall Act, repealed in 1999, will not need reinstatement. 

3.      Safe Banking will impose no new regulation on trading within banking firms or hedge funds as long as they follow other laws meant to ensure free trading for all in the capital markets.

4.      Safe Banking policy is constitutional. 

5.      Safe Banking will result in heavily capitalized and unregulated Universal Banks because investors will no longer trust thinly capitalized unprotected banks.  Taxpayers will not protect any Universal Bank and so thinly capitalized Universal Banks will not survive to create havoc to the economy.    

6.      Safe Banking will at once stop the ability of bankers to use taxpayer-insured deposits for unconstitutional moral hazard gambling which costs taxpayers enormously, hurts the economy badly and erodes the national competitiveness irreparably.[3] Recall that the banking panics of 1907 led to runs on banks.  People thereafter did not trust banks.  Their savings could not be channeled to businesses to create jobs in the economy.  This led to the Great Depression.  Bankers then drafted legislation for the Congress to have the government insure bank deposits.  This legislation allowed a formal, sly institution of the unconstitutional game of moral hazard with tacit collusion of the Federal Reserve. 

7.      Elimination of deposit insurance under Safe Banking Policy will cease the virtual control that a few bankers have wielded over the Congress and people.  Bankers will have to establish their trustworthiness and creditworthiness by investing sufficiently their own equity capitals to attract depositors to their Universal Banks.  In the current system of federal deposit insurance and debt guarantees, bankers are eager to siphon off bank earnings directly as bonuses and underhandedly through unconstitutional moral hazard lending to private equity and hedge funds run by them.  This system has enervated banks as shells.  The Safe Banks will cater the savers who may not still trust the highly capitalized Universal Banks.

Safe Banking is really difficult to implement now, even if all the opponents with vested interests agree to go along.  Why? 

The banks do not now have the taxpayer insured deposits in their chests to transfer to the newly chartered Safe Banks if many depositors want to switch.  Banks have deployed, in their risky bets, all the insured deposits and other debt freshly insured by the FDIC and taxpayers during the meltdown in 2008.  The nation has plunged even deeper into the unconstitutional moral hazard ditch in 2008 as a result of forcing the taxpayers to guarantee all the banking gambles.  The taxpayers have been forced to grant such guarantee, unwittingly and unknowingly. 

The question is how to get out of the above described quick sand?  To discover a path from the ditch to the shores of normalcy, one needs all the facts.  But the Congress will first need to investigate the modern mythology of market dogma and determine if Safe Banking is indeed the truth (wisdom) to which the path must lead.  My prognosis is that it will cost taxpayers even greater (leading to a crisis for the dollar) if the Congress delays the process of seeking new wisdom for the nation.

Moral of the longest mythology

The longest and perhaps oldest epic of mankind is Ramayana, which was neither scripted nor directed by the hero of the epic, Rama.  The epic portrays Rama as a principled, powerful man.  He has been scripted as the reincarnation of god because he vanquishes all the evil forces to establish fair rules of governance.  He even banishes his chaste wife to an ashram after hearing rumors against her.  He once appears in disguise before a robber who has been looting people to enrich his family and friends.  Rama asks the robber if his family and friends thriving on his loot will share the sins of robbing people.  The puzzled robber rushes to the beneficiaries of his loot to enquire if they will join him in the hell for the sin committed.  The beneficiaries express surprise about the wealth being looted, refuse to accept it again and decline to join the robber in hell.  The worried robber runs back to the disguised Rama to seek a path to salvation.  Rama advises the robber to meditate until the flesh accreted by the loot sheds.  The robber follows suit, loses his earlier macho self, and becomes a saint with a name, Balmiki to write the largest epic about Rama.  NASA has recently discovered the path under the water connecting India to Sri Lanka that Rama, as per the epic, had used to travel to defeat the most powerful evil force.  The epic may thus have some truth, though it is perhaps highly exaggerated by a devotee turned scripter.    

The moral of the epic: The Congress should refuse contributions from the bankers after finding the truth about how they generate such largesse unconstitutionally and refuse to seek advice from the market dogmatists after seeking the truth about the motivation that underlie their schizophrenic unconstitutional mythology. 

With profound regards,

Sankarshan Acharya



[1]This memo is based on a paper, entitled, “An Economic Theory of Constitutional Governance,” which originated in 1990 as efficient resolution of moral hazard due to free trading.  This paper is available on the internet, http://pro-prosperity.com/Research/MoralHazardLiberty.pdf

[3] http://pro-prosperity.com/Research/Sub-optimality%20of%20Lending%20Taxpayer%20Funds%20to%20Hedge%20Funds.pdf

                                                                                               

February 27, 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

            Honorable Prime Minister of India

Sub:     Small and Smart Government

Dear President Obama,

Every political leader now despises the rising cost of governance.  They are correct.  The matter is serious.  A dispassionate analysis will show, however, that the administrative cost of services in the private sectors like higher education and healthcare must be mindboggling. 

Rising administrative costs in relation to the value of service rendered to customers results in a failure of corporations.  Will it lead to a failure of the private and public service sectors?  What is the preemptive policy to prevent any impending failure?

How to measure the value of government service to customers, “We the People”?  There are two objective measures: (1) the international value of national currency and reserve status of that currency, and (2) trade balance.  Dollar has so far retained its premier reserve currency status.  Euro has not yet succeeded in challenging the dollar.  This has afforded the vital private and government sectors to swell their administrative costs in relation to the service they render to producing households who are critical for exports and substitution of imports needed for a balance in trade.  But the swelling costs (or waste) of administering the essential public and private services has enormously eroded the national competitiveness.

The current financial meltdown is not the first alarm for the dollar.  Alarm bells were ringing equally loudly during 1987-89, when I was at NYU, across a beaten down Wall Street.  The researcher in me chose to uncover the truth about the continual market breakdowns, bank failures and governance.  I co-authored a paper with a colleague at NYU on “optimal” bank reorganization policies.  The paper was promptly accepted within the Academy and was discussed at the Board of Governors of the Federal Reserve System.  I was invited by the Fed for a presentation and then offered a job.  I went to the Fed on a two-year leave of absence from NYU but stayed on at the Fed for more than five years.  I was surprised that the consummate Fed economists never missed an opportunity to deride the word “optimal” in my research. 

I must narrate the genesis of scorn towards “optimal” in bank regulation because it is at the epicenter of the current financial meltdown (which is hardly over) and potential failure of governance.  This is important to a great nation in which the opposition is now pining for a small government to pull you down. 

We are now facing the specter of a failure of governance of the essential public and private sectors.  The important sectors will, of course, function.  The threat is to the credit amassed through usurious prices of such service that is piled as debt on the producers of globally competitive goods and services.  As the debt holders default, the credit will shrink to the lower level of debt the producers can afford.  The gravity towards a lower level of credit will be very painful and chaotic as the creditors seek to block reform in governance while the debtors demand the opposite.  This can result in a failure of governance, unless preemptive optimal policies are followed.  This may also lead the nation to a formal dictatorship and consummated financial slavery through a further dilution of democracy. 

This memo will concentrate on avoiding the failure of the public sector governance through “optimal governance” of a constitutionally mandated democracy and free market economy. 

I specify optimal governance as a not-for-profit government that runs efficiently at the minimum possible cost to taxpayers.  Every political leader now publicly pines for optimal governance.  So, the scorn for optimal governance is thoroughly misguided.  An academic model of optimal governance in late 1980’s was unprecedented.  It was daunting too because one had to structure the long-run dynamic decision making process of all the players including profit maximizing firms and a not-for-profit government running at lowest cost to taxpayers in a constitutionally mandated free market economy.  The result of the academic exercise then was nevertheless astoundingly simple and equally unprecedented: to foreclose banks with significantly positive capital levels, whenever their capital-to-assets ratios fell below a minimum threshold.  The US Congress quickly enacted this result into FDICIA 1991 and then the BIS Basle Accords followed suit.  A stable banking industry in USA and Europe thereafter attracted capital from all over the world leading to unprecedented prosperity and tripling of stock market indexes. 

I know first-hand how the banking industry subverted the spirit of FDICIA 1991 with the permission of bank regulators for multi-tier leveraging of equity capital in banks.  Bank holding companies must have proliferated and the layers of leveraging expanded within the existing banks soon after 1991. 

The FDICIA 1991 was subverted to pave the way for highly leveraged bets for enormous profits to bankers at growing risk and cost to taxpayers.  This is presented as a Case Study below and described in greater detail in my book and Safe Banking paper in 2003:[1]

Case Study:    

I had a meeting with the top management in Citicorp in 1994, when I pointed out the increased risk due to effective dilution of the minimum capital requirements though multi-leveraging.  The Citicorp management then was very furious and my Fed colleagues present in the meeting patched up by suggesting that my point should not be taken seriously. 

The scorn among the bank regulators for “optimal governance” thus stemmed from the shockwaves in the banking industry due to the optimal rules enacted by the Congress in FDICIA 1991.  Active suppression of my research started in 1994 and accentuated with my completion of a paper on efficient resolution of moral hazard in banking. 

How does multi-leveraging work for a bank to profit enormously by burdening the taxpayers and leading to a failure of governance?  The following example from my book and a paper forwarded to Congress in March 2003 illustrates the serious matter:

Example:

A bank is formed with $8 of equity capital and $92 of insured deposits and debts.  This makes $100 for investment in assets like mortgage loans, business loans, stocks, bonds and derivatives.  This bank meets the criteria for minimum capital of 8% under the FDICIA 1991. 

If the return on this bank’s investment is 6% and the cost of funds is 4%, the bank earns a net $2 or 2% on assets and 25% on equity per year.  The owner gets his equity back in 4 years and continues to own his bank freely by meeting the FDICIA 1991 minimum capital requirements. 

But the owner is not satiated with a mere 25% return on equity investment.  He then forms a one-bank bank holding company (BHC) comprising a parent company (PC) and a subsidiary bank (SB).  The SB is legally firewalled from the PC so that the SB can fail but not the PC.  The previous bank is now restructured with the $8 of equity and $92 of debt held by the PC.  This makes the total PC assets of $100.  The PC assets are now injected as equity to the SB.  The SB then raises $900 in additional debt and insured deposits.  The PC now has 8% capital-to-assets ratio and the SB has 10% capital-to-assets ratio.  Both the PC and SB are permitted under FDICIA 1991 because each entity meets the minimum capital requirement of 8%.  The BHC now has $1000 in total assets with a net income of 2% or $20, which makes 20/8 = 250% return per year on the equity investment of $8.  This is a highly profitable real strategy for the owner of a bank. 

The same bank, after becoming a BHC, now has the same $8 in equity, but $992 in debt and insured deposits.  This works out to a mere 0.8% (8/1000) of capital-to-assets ratio on a consolidated basis.  Multi-leveraging thus undermines the FDICIA 1991 badly. 

This is the true episode of Moral Hazard by the banks and their regulators.  Banks reap enormous wealth through transfers from taxpayers, global depositors and the effective producers of globally competitive goods, services and ideas.  They thus have sufficient resources to make hefty political contributions to tinker policies in their favor for continued self-aggrandizement and to offer lucrative positions to bank regulators and academics who succeed in blocking selfless research from individuals like yours truly.  Individuals like yours truly remain permanently oppressed or extinguished into oblivion as the media controlled by the same custodians joins the party. 

After writing the truth in simple English in many different ways, notwithstanding the heavy odds, I noticed that the Congress ultimately acted to set executive orders to ensure that bank holdings companies meet the FDICIA 1991 capital standards on a consolidated basis.  The Treasury Department vocally and publicly pressured the banks to raise capitals.  The highly leveraged banks that could not raise sufficient capitals fell in 2008.

The above case illustrates that Moral Hazard enormously raises the costs to taxpayers.  Moral Hazard, if not thwarted, can lead to a thorough failure of governance.  A complete failure of the U.S. government can happen if the dollar loses its reserve currency status, i.e., when the rest of the world curtails trading in dollar.  But policies to eliminate Moral Hazard efficiently can prevent this from happening, especially when the rest of the world does not want a demise of the dollar.

Optimal governance means enactment of only those policies which resolve moral hazard efficiently in banking, capital markets, health insurance and every other sector.[2]  There is no other option for the United States or for the rest of the world, notwithstanding the high powered lobbying and suppression of selfless research on such policies.      

It is heartening that political leaders across the aisle are publicly embracing the philosophy of optimal governance to pave the way for a small but smart government.  I beseech that you and the Congress publicly chastise those who deride the philosophy of optimal governance for continuance of their game of moral hazard for self-aggrandizement.  The philosophy of optimal governance is vital to preserve the primacy of dollar in a constitutionally democratic free market economy. 

With profound regards,

Sankarshan Acharya

PS: I have marked a copy of this letter to the Prime Minister of the largest constitutional democracy facing the same types of moral hazard problems, though in different forms.