Root Cause of Financial Meltdown

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

April 18, 2011. Updated November 2, 2011. Updated September 30, 2012

One needs to first rule out the misconceptions about the root causes of the 2008 financial market meltdown:

1. The 1999 repeal of the Glass-Stegall Act of 1933 which separated investment banking from commercial banking could not have caused the meltdown because commercial banks were already engaged in investment banking since about 1988. See the statements of prominent people in finance on this issue in the Bloomberg article, dated September 30, 2012.

2. Recklessness of borrowers and lenders could not have caused the crisis if lenders did not have credits to lend.

3. Suggesting that the crisis was a slap of the invisible hand (god) is as good as making sun spots responsible for what humans do.

As I have written to ex-President Clinton, yesterday, an estimated $20 trillion of hard-earned wealth has been wiped out in the
financial catastrophe of 2008. No one has been prosecuted under the current laws.

My research shows that first-best economic efficiency [necessary for national competitiveness, growth and prosperity] is one-to-one with a crucial principle of governance - that no one be allowed to usurp public wealth and others' private wealth, even surreptitiously. This principle of governance has been universally adopted in the constitutions around the world.

The financial catastrophe of 2008 was due to a failure of the established second-best system of governance, which I had proved/presaged since 1991 within a general equilibrium model as economically inefficient, unconstitutional and unstable.

As the public now knows, the US Congress found in its financial crisis inquiry commission report released in 2011 that the cause of the 2008 financial catastrophe was due to a failure of the promoters of the second-best system (the academic experts including Nobel Laureates, industry honchos and government regulators).

The second-best policy promoters testified before the Congress that the crisis was an act of god (using a book authored by a Yale U professor and published by Oxford U Press), and that no one saw it coming.

But the US Congress had since 2003 received my memos and published papers about the instability of the prevailing second-best system, about an impending catastrophe and about my first-best policies to preemptively avert the crisis.

To stem the domino of crashing markets in 2008, the US Congress was indeed forced to adopt the same first-best policies (like capital requirements on a consolidated basis for bank holding companies and safe central banking facility to guarantee $3.5 trillion in money markets and $7.8 trillion of bank debt) which I had proposed since 2003.

The US Congress was, therefore, forced to 'find' that the financial catastrophe was manmade (because of failure of the second-best policy promoters) and avoidable because my first-best policies could have been adopted earlier (not after the crisis which wiped out $20 trillion of hard-earned wealth).  The US Congress rejected the second-best policy promoters' testimonies.

Conclusions:

1. If no one who caused the manmade crisis (which could have been avoided) could be prosecuted under the laws existing prior to 2008, these laws were obviously designed to save those who would make such catastrophic losses to American Households. Shouldn't those pre-2008 laws/rules be repealed first?

2. At the time of passage of each of those pre-2008 laws, the Presidents and Congress made the same kind of assurances to people, as they made during the passage of yet another (Dodd-Frank) law in 2010, that there would be no crisis in future. But according to recent analysis, the rich have gotten richer and the poor have gotten poorer, employment is not improving, and the underemployment is spreading rampantly since the passage of the new laws.

3. The pre-2008 and post-2008 laws are, therefore, not alleviating, rather exacerbating the deepening malaise to the economy. These laws are making the current economic system of governance still more unstable.  My research has shown and post-2008 the public would agree with my findings that these laws (i) are economically inefficient and (ii) transgress the fundamental principle of governance which has been widely adopted in the constitutions around the world. The economies around the world need first best governance and a first-best system of money and finance.

The root cause of the financial meltdown is perpetuation of the prevailing financial system, based on second-best (inefficient) policies, by deliberately suppressing truths about the existence of first-best (efficient) policies.

The promoters of the prevailing system have drawn support from second-best policy research (published in top journals and won Nobel Prizes) to claim falsely that first-best policies are not feasible. The promoters of the prevailing system and the experts fave failed and caused a manmade financial crisis, according to the Financial Crisis Inquiry Commission Report released in January 2011.

That first-best policies, presented to the Federal Reserve since 1991 and to the Congress since 2003, are designed to beget first-best status for principals (citizens).

Mr. E. J. Dionne, Jr of Washington Post says eloquoently:

"A ruling class closed to new talent doesn’t remain a ruling class for long." 

This is pertinent in the context of the email conversation I had today with the American Enterprise Institute Fellow who was a dissenter in the U.S. Financial Crisis Inquiry Commission about the root cause of the crisis.

The elite tells that the financial crisis is due to irresponsibility of borrowers, without bothering that at any point in time, factually, total credit equals total debt.

How were the lenders suffused with an abundance of credit to lend?

The elite is grumbling about government housing policy forcing banks to lend frivolously.  It is not addressing the root causes of the crisis: (i) how the expanded credit was created, globally, for the US Banks to lend it to American Businesses and Households frivolously and (ii) whether the lending rates were indeed artificially exorbitant (usurious) considering (a) the subsequent precipitous fall in the rates and (b) massive supply of credit in relation to the demand for it.

Frivolous lending standards and on fudging of records by many borrowers are true.  But these are symptoms of the true underlying malaise, global expansion of credits.

My analysis during the pre-crisis period showed that the rates of interest at which the American households and businesses were locked up were significantly higher than that could be possible if the macro data fed into the Federal Reserve were not based on manipulated markets.

When the Fed funds rate was hovering at around 6%, I had challenged in memos to the President and Congress (i) that the Federal Reserve model for setting interest rate was feeding market-manipulated data, (ii) that the true interest rate should be near zero percent because of a looming depression lurking under the veneer of government-hooted economic growth and (iii) that the Fed would be forced to reduce the rate to near zero percent.  The Fed actually reduced the rate to near zero percent within a few months after it understood from my memo the underlying mechanics of market manipulation and how the market data so produced and fed into Fed's decision making was useless.

So, if the equilibrium rate was near zero percent, why should businesses and households be locked up at 6+ percents (had it not been for market manipulation)?

The economy is locked up in those high rates of interest and the Federal Reserve has no tools to get it out of the ditch, while the fiscal imbalance looms large.

To continue discussion further, you need to first read all my research and research-based memos available at pro-prosperity.com

Why is the ruling class (media included) blocking publicity of truths discovered through research based on a general equilibrium model of economics, which is more general than any other model ever scripted in the literature?  Why?  Will a ruling class closed to new talent cease to be the ruling class for long, as Mr. Dionne says?

Dr. Sankarshan Acharya
Director, Center for Constitutional Capitalism
Founder, Pro-Prosperity.Com and Citizens for Development