Safety-net and Budget through First-best Policy

April 13, 2013

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development

To:       Honorable President Barack Obama

Date:   April 13, 2013

Sub:     Safety-net and budget through first-best policy

[Please feel free to circulate.]
           
Dear President Obama,

One of my students last semester proposed to “End the Fed,” in his Term Project on the financial crises.  He was disappointed about my disagreement with his prescription, not with the “A” grade he got in the course.  His grade reflected the coherence of presentation.  He nevertheless challenged that I was biased by my safe central banking research.  My response (which he did not challenge) was that he did not show how a policy to “End the Fed” attained in equilibrium, whereas my safe central bank obtained in general equilibrium of an economy.  I asked him to develop a more general model than mine to prove whether not having a central bank keeps the economy in equilibrium (stability).

The above conversation is important for your administration and budget and for continuance of the safety-net for Americans.  This is also important because ex-Treasury Secretary Hank Paulson talked about ending the Fed and Fed Chairman Ben Bernanke opposed it, while members of Congress did not want to take a risk.  A prominent guru of finance and ex-partner of Goldman Sachs, Fisher Black, now deceased, openly expressed in a Fed board meeting (when I was a Fed economist) that the Fed should shut its doors to serve the best interests of people.  Ending the Fed is a refrain among many prominent lawmakers. 

By abstracting away from a dynamic math model of microeconomics, the general equilibrium among economic agents (citizens) can be presented in plain English as follows:[1] each agent prefers to hold some of his/her hard-earned savings safely (with guaranteed returns) and invest the rest in risky assets (with uncertain returns).  Only a safe central bank with government mandate can provide safety.  This is equilibrium because there is no alternative (like not having a central bank) which can be agreeable to all.  This equilibrium is consistent with the reality of government mandated central banks worldwide.  Even China created a central bank (Peoples Bank of China) in 1994.    

Research on first-best efficient governance proves that the current Federal Reserve (guided by the Federal Reserve Act of 1913), as well as its counterparts elsewhere, is not my safe central bank, because it creates money by fiat and dilutes the real value of deposits presumed to be safe.  The Fed cannot synchronize the true inflation rate with the official inflation rate or interest rate on deposits presumed to be safe. The Fed is forced to create fiat money because government policies have caused unsustainable fiscal deficits. Policies are dictated by mega creditors through funding of elections of lawmakers.  Mega creditors have emerged and reigned supreme due to the very policies they have helped establish.  Mega creditors have thus caused paralysis in governance, failure of central banks, and dysfunction of academies conducting research to prop such policies.  How to pull out of this problem?

1. Officially recognize that the government cannot continue policies to facilitate usurpation of public and private wealth: like insuring deposits and keeping it under the control of mega creditors to bet against public’s investments and paying meager rates on these deposits and on Fed funds while lending such borrowed funds at rigged up interest to students, households and credit card holders.  The FCIC has done its part in its 2011 report by stating that the 2008 crisis was caused by a failure of policies promoted by experts in behalf of mega creditors.

2. Follow first-best policies already proposed for government sponsored enterprises (GSEs) like Fannie and Freddie.[2]  The mega creditors, who sold their GSE stock and bond holdings and went short, are free to reverse their path by covering back their short positions and going long on Fannie and Freddie securities by purchasing them in the open market at throw-away prices wrought due to their short-selling and media-expert promotion to dismantle the GSEs.  The only expert argument for elimination of the GSEs, permeating through the media, is that the current form of GSEs restricts credit markets via government meddling.  This argument is specious.  GSEs in their current form constitute general equilibrium with free markets:

  • Firstly, free markets result in a safe central bank in which the households and businesses hold the part of their savings safe, as argued earlier in the memo. 
  • To earn the highest return at the lowest risk, the safe central bank lends the deposits under its custody as home and business mortgage loans and government through an intermediary (call it GSE).  The earned return less the cost of GSE and safe central bank is paid as interest to lenders.  If there is a loss in such lending (because the GSE underpriced the risk and the safe central bank promised a higher safe rate of interest on deposits), the safe central bank creates new money to make up for the shortfall.     
  • Free markets permit any coalition of agents including mega and small creditors to form their private banks (and the government should neither restrict nor regulate them) for taking deposits at higher rates than the safe central banking rate but without any government guarantee and to lend at lower rate than the GSE’s lending rate.  The private banks may freely choose to have investment banking and commercial banking under a holding company structure.        
  • The safety net so created for the part of the hard-earned deposits that the savers want to keep safe averts any panic and obviates any government deposit guarantee in private banks since the safe central bank operates with government mandate.
  • The above system constitutes general equilibrium among all agents of an economy including creditors, debtors, investors and consumers, businesses, regulators, lawmakers and even economists because there is no other system they will ever agree on.  Any other system (like the current one or another without a central bank or GSE) will subsidize one group of agents (like mega creditors) by burdening the others.

3. Crete a health insurance GSE to bring down the cost of health insurance under the current system of private insurance companies.  The current private insurers have squeezed both the medical service providers (by cutting their fees) and patients (by reducing their treatments) and bankrupted Medicate and Medicaid.  A government-sponsored public insurance company should provide a minimum standardized health insurance plan (like the one available to Congress).  All private health insurers should be required to provide the minimum standard public insurance option along with any other deluxe plans they may offer.  This is just like the public option you prescribed in your 2008 campaign, but could not adopt as president.  Following the steps in point 2, we can prove that the health insurance GSE will emerge in general equilibrium.  

4. The Social Security Administration is already a GSE.  But it needs to operate actuarially fairly by giving an option for either an actuarially fair pension based on contributions (SS tax plus employer matching contribution) or a lump sum withdrawal equal to all the deposits and the going Federal Reserve interest rates, like the IRS calculates interest on unpaid taxes.

5. Establish a GSE Clearing House to disallow anyone’s access to private holdings of financial securities of others.  There is no other market clearing house system (including the one now controlled by the Clearing House LLC) that will be agreeable to all agents of an economy.  The current clearing house members having full access to private asset holdings of every agent can ruin the financial wealth, and thus existence, of anyone (including lawmakers, political parties or first-best policy researchers) who is opposed to the current system. The Clearing House GSE will constitute equilibrium, not the CH LLC. 

6. After taking the above policy steps and eliminating all subsidies, raise taxes on income and wealth above a certain threshold to balance the budget in a few years.  This would be consistent with first-best efficient governance: high income and accumulated wealth stemmed primarily and provably from the current second-best system which has burdened the public exchequer, ballooned public debt and Fed money creation, and drained household wealth.

The Great Recession of 2008 has virtually pushed the Federal Reserve (thanks to Chairman Ben Bernanke) to act like my safe central bank by (i) dissociating from the Clearing House’s lawsuit on confidentiality of detailed Fed financial assistance during the 2008 crisis, (ii) buying corporate debt and home-mortgage backed securities, (iii) providing safety to $3.5 trillion of previously uninsured money market funds and $7.8 trillion of uninsured bank deposits, and (iv) supporting Fannie and Freddie.  Fed Chairman Ben Bernanke surely recognized the mega game, transparently, as soon as his support to end the Fed was solicited by Treasury Secretary Hank Paulson in 2008, after, of course, Congress granted TARP funds to recapitalize the mega banks.  The current Fed Chairman also recognized the need to cut the interest rate to near zero and to support the GSEs.  This amounts to recognition of the truth about first-best efficient polices attained in general equilibrium and about the failure of the second-best mega game that had gripped the US and that continues to hobble economic recovery.  

With profound regards,

Sankarshan Acharya 
Founder, Citizens for Development & Pro-Prosperity.Com
http://pro-prosperity.com/About.html
http://pro-prosperity.com/Pro-Prosperity-ranking.pdf

[1] Acharya, S. (2013), “Constitutional Capitalism for First-best Governance,” and all published and unpublished papers referenced therein, available at http://pro-prosperity.com/Constitutional%20Capitalism.html

[2] Acharya, S. (April 6-12, 2013), “First-best Governance of Fannie and Freddie,” http://pro-prosperity.com/First-best%20governance%20of%20home%20mortgage%20market%20%28Fannie%20and%20Freddie%29.html