A Less Costly Proposal to Save the Real Economy

October 11, 2008

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development

October 11, 2008

Written to the U.S. Treasury Secretary and Senators

Sub:    A Less Costly Proposal to Save the Real Economy

Dear Mr. Paulson,

It is very heartening that the government is flexible to enunciate new policies to save the real economy and the jobs. 

The real economy, fortunately, is not as bad as it is hooted by those unwilling or unable to produce globally competitive goods and services.  The non-producers are among the rich financials and the poor, as well as their media and political patrons.  The non-producing poor are demanding more handouts. The non-producing rich are pleading for ways to save, if not to enhance, their credits.  The highly endowed creditors pull down the markets to remain hedged (because they are short and long in comparable financial securities) before the government takes any action to enhance only their credits.  The income and saving of the real productive savers are squeezed in the process.  The real economy is thus hurt, willy-nilly, by the non-producers. 

The global financial panic is mainly due to creditors.  They want their governments to take steps to protect and enhance their credits.  But most borrowers-households, corporations, banks and governments-are bankrupt.  One bankrupt entity (the government) now wants to borrow in the name of taxpayers to recapitalize the other bankrupt entities.  Should every bankrupt entity be recapitalized? From whom would the government borrow, if it should? 

The prevailing wisdom within the government and elsewhere is to somehow maintain or grow the quantum of credit in the economy by generating new credible demand for new debt.  Credible demand for new debt refers to new ventures that can generate sufficient return to service the debt at the current lending rate.  Such demand has shrunk badly and so the lenders are unwilling to lend.  If the lending rate drops to zero, as it should, new credible demand for debt may grow.    

Recapitalization of the bankrupt entities is not a magic wand to enhance credit growth as a means to save, let alone grow, the real economy.  Credit contraction is inevitable, as creditors suffer losses due to default and debtors use their shrunken net incomes to service their rerestructured debt.  Household debt restructuring will follow through pain (e.g., depression) in the market place, if the government does not amend the household bankruptcy law. 

The wisdom already gained by the government is profound:

1.      The Treasury and Federal Reserve on their own (before going to Congress) have injected debt funds to many bankrupt financials, which are effectively hedge funds.  The financials used the government-supplied debt funds to build up their lost capitals from earnings based on ask-bid spread in trading.  But they failed to enhance their capitals.  They have indeed lost whatever little capital they already had or sunk deeper into negative capitals to erode their debt funds. 

2.      The Congress approved a proposal to buy nonperforming assets from the bankrupt financials.  If implemented, this proposal will simply give taxpayer funds to acquire the nonperforming financial assets.  The frightened financials will simply stash these funds into Treasury securities, as it happened in Japan.  This will not rejuvenate new economic activity. 

3.      The wisdom gained in Europe is to infuse equity capital into the bankrupt creditors to garner private debt funds from investors at home and abroad to resuscitate lending to real businesses and households.  This is consistent with the prevailing wisdom and the Congressional desire: taxpayers should benefit from future profits of the financials through equity interest. 

4.      The government equity invested in commercial banks appears to be a good short-term rescue strategy, as it has worked for Fannie and Freddie. 

What is our goal? Is it to revive the financial markets or save the real economy?  We need ascertain afresh if a revival of the financial markets is crucial for the real economy within the new economic environment already created by the government:

1.      The two pillars of the new environment are (i) direct lending to grass-root borrowers (engines of economic growth) like the households and corporations, and (ii) debt relief to households.  These are consistent with my proposals made in a memo dated October 2, 2008. 

2.      The government should now simply formalize this environment by institutionalizing the two pillars.  To do so, the government needs to make a national commercial bank by merging the bankrupt or nearly bankrupt private banks including the Citibank, Wachovia, Washington Mutual and National City.  Make Fannie and Freddie a national mortgage bank.  Recapitalize these banks sufficiently with government funds infused as preferred stocks bearing dividends, but not cancel their original equity interests. 

3.      The government should not use taxpayer funds to recapitalize other private financial companies. The experience so far shows that new capitals will be eventually lost, while encouraging government-sponsored moral hazard.  The Federal Reserve or Treasury funds, already infused as loans to the financials, have only migrated to large creditors, not grass-root borrowers that regenerate new economic activity.

4.      Create a new government-owned security clearinghouse to compete with NASDAQ and NYSE to clear all trades.  The clearinghouse considered for credit default swaps should be extended in its mission.

5.      Shut down the leveraged hedge funds, including investment banks and firewalled subsidiaries of commercial banks, which have borrowed from the federally insured deposit base.  Gradually liquidate these funds to pay off the federally insured debts in an orderly way to avoid the currently observed market spasms.

6.      Disband mutual fund company charters to restore pure mutual funds that existed before.  This is needed to avoid the potential moral hazard in trading between hedge funds floated by principals of mutual fund companies and fund managers.

7.      Reinstate the Glass-Steagall Act.

8.      Adopt safe banking policy to avoid government-sponsored moral hazard.  This would mean (a) withdrawing federal insurance of deposits in private banks and bank holding companies that would like to retain their charter of universal banking and (b) making the other banks safe banks or nationalized banks.  The nationalized banks will be less efficient, but they will provide less costly banking service due to competition with the private banks.  More crucially, the safe banking policy will provide financial security to panic-prone savers and obviate continual meltdown in the financial markets due to moral hazard and abnormal risk-taking.  


With best regards,

Sankarshan Acharya