Systemic Weakness in the U.S. Economy:
Inefficiency and Unconstitutionality Of
The Federal Reserve Act of 1913,
The Federal Deposit Insurance Corporation Act 1933
Security Exchange Corporation Act 1933
( created via Glass-Steagall Act of 1933)
,
Act of 2000 that repealed the Glass-Steagall Act's provision
(separating investment banking and commercial banking),
Housing Economic Recovery Act of 2008, and
Dood-Frank Act of 2010

Unanimously Agreeable Safe Central Banking Act Proposed to Correct Systemic Weakness

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

October 18, 2010

 

Systemic Weakness in the U.S. Economy

The punditry is now suspecting that some structural weakness must be impeding employment growth. Such suspicion surfaces after a failure to revive the economy with trillions of dollars in Keynesian government spending and massive Federal Reserve easing.

Is the punditry now tacitly agreeing with the systemic weakness and preemptive policies discovered in my selfless research (1990-2010) that I have communicated with warnings to the Congress since 2003 which has proved to be completely accurate with respect to the occurrence and causes of the recent financial meltdown, the Great Recession of 2008. There is a widespread worry about whether the Great Recession is a harbinger of the Great Depression.

In a recent seminar on this research, entitled, "economic theory of constitutional governance," several well informed colleagues were not only impressed by the identification of the systemic weakness and by the preemptive policies needed to rectify it. They were also surprised about how this paper is still not published in a top journal and, more importantly, how President Obama has "wasted" his political capital to not accord priority to rectifying the systemic weakness. They were afraid, though, that another Great Depression is likely if the systemic weakness is not corrected soon enough. The Main Street sees the urgency and importance of constitutionally efficient policies for the betterment of the economy.

I. Identification and Correction of Systemic Weakness

The Constitutional Model: The economy comprises a group of leveraged firms (including households) who choose their assets to maximize their net-worth, with an efficient not-for-profit government enacting and administering constitutional rules for free trading of goods, services and assets.[Footnote 1]

The equilibrium in the Constitutional Model:

  • Some firms choose the safest asset (riskless deposits), while other firms choose risky assets to earn returns consistent with asset risk and a asset risk-return efficient frontier obtains. The asset risk (volatility) is the total of unsystematic risk and the systematic (market beta) risk. The standard model of economics claims that the unsystematic risk cannot be priced in equilibrium. In the constitutional model, the total risk is priced by arbitrage and an efficient frontier of risk premium versus total risk is obtained.
  • The constitutional government does not intervene in the markets, but offers a secure custody of riskless deposits in a government entity called Safe Bank. [The Safe Bank obtained here is structurally different from that presented in earlier 2003 paper, “Safe Banking,” published in the Journal of the American Academy of Business and the 2008 paper, “Safe Banking to Avoid Moral Hazard,” published in the Journal of Risk Management in Financial Institutions, though the abstract concepts are the same.

This constitutional model does not yield, in equilibrium, either a Federal Reserve Act (FRA) passed in 1913 or a Federal Deposit Insurance Corporation Act (FDICA) included in the Glass-Steagall Act passed in 1933 in the U.S. The current Federal Reserve (the U.S. central bank) will, however, be identical to the Safe Bank if the FRA-FDICA is reformed according to the constitution, as follows:

  1. Abolish the Federal Deposit Insurance Corporation by repealing the FDICA.
  2. Amend the FRA to let the Federal Reserve grant equal privilege of its secured custody to the riskless deposits of all firms including households without any limit. The amended FRA will, for example, ensure that the Federal Reserve extends the same privilege of securing riskless deposits, currently available for only the capital reserve accounts of financial firms and foreign central banks, to all firms including households.
  3. Amend the FRA to let the government borrow directly from the Federal Reserve.

The model proves that the Federal Reserve Act (FRA) of 1913 is unconstitutional. The FRA has been the incipient source of systemic weakness in the U.S. economy. This Act was imposed when the Congress and the President had ceded all their economic powers to the financial institutions that had survived after the banking panics of 1907.

If the government's power to enact and administer constitutional acts is voided within my model, the current FRA-FDICA will prevail in equilibrium. But a government with the power to enact and administer constitutional acts within my model makes the current FRA-FDICA unconstitutional and inefficient as compared to the Safe Bank:

  • The FRA-FDICA forces nonfinancial firms including households to hold their safe deposits in risky financial firms and to receive a government (FDIC) guarantee up to a maximum ceiling, which was raised from $100000 to $250000 in 2008. The FDIC collects a deposit insurance premium from risky financial firms to recover losses due to such insurance. The risky financial firms efficiently transfer the cost of deposit insurance to depositors by lowering the rate of interest on deposits. The depositors thus receive a lower rate of interest than they that they can get by directly lending the government through the Safe Bank in the constitutional model. This makes the FRA-FDICA inefficient and unconstitutional and Safe Bank efficient and constitutional for deposits below the ceiling on federal deposit insurance.
  • Savings greater than the FDIC insurance ceiling, deposited in risky financial firms, have no government security like that extended by the FRA to the reserve accounts of financial firms and foreign central banks without limit. Such unequal treatment makes the FRA-FDIC unconstitutional. The unconstitutionality is precluded by the Safe Bank in the constitutional model.
  • Nonfinancial firms and most small financial firms cannot participate in primary auctions of Treasury securities like a few privileged large financial firms currently enjoy, making the FRA-FDICA unconstitutional and inefficient. The Safe Bank averts such unconstitutionality and inefficiency by granting equal opportunity to all firms to efficiently lend their funds at the same rate directly to the government. The Safe Bank obviates and stops the primary auction of Treasury securities and offers the same efficient privilege of lending the government to all firms.

The constitutional model also proves unconstitutionality and inefficiency of all forms of government subsidies to special interest groups including via government sponsored enterprises like Fannie Mae and Freddie Mac. For example, transferring of massive quantities of worthless toxic mortgage assets from non-government financial firms to Fannie and Freddie was a form of inefficient and unconstitutional subsidy that the government gave to the private financial firms at a huge cost to the GSE stakeholders including taxpayers. The 10% preferred dividend collected by the Treasury Department from its Fannie and Freddie preferred stocks for money created by the Federal Reserve at no cost is also a form subsidy that penalizes GSE stakeholders and benefits private short-sellers of GSE securities; this is inefficient and unconstitutional. Existing models are not built on axioms for constitutional governance and so cannot prove if any policy is unconstitutional.

The Security and Exchange Commission's short-selling rule is likewise inefficient and unconstitutional. The New York Times has reported recently that $2.5 trillion of securities have been lent by mutual funds and pension plans to banks and hedge funds for such inefficient and unconstitutional short-selling, perhaps without the permission of the owners of the securities. It can even be shown that short-selling is illegal within the currently prevailing laws in the U.S.

The constitutional model thus offers an efficient and constitutional platform to analyze every government policy that involves subsidies, directly or indirectly. Existing models are not based on axioms of the constitution and are, therefore, incapable of proving if certain government policies they advocate are constitutional.

II. Great Depression to Great Recession

After the passage of the Federal Reserve Act in 1913, even the biggest financial firms faced a crisis of survival as the small financial
firms, nonfinancial firms and households lost trust in the system and kept their savings under their pillows, leading to the Great
Depression. The government ceded its power to the few largest bankers that could still control the credits. The powerful biggest financial firms then forced the then toothless government to create the FDIC in 1933 to guarantee only a limited amount of savings deposits of other firms and households.

Even after the FDIC came into being, the system remained vulnerable as the productive nonfinancial firms continually withdrew parts of their savings deposits above the government deposit insurance ceiling, held in risky financial firms but not guaranteed by the FDIC. This made the financial firms continually vulnerable to liquidity shocks. The investors in these financial firms were thus jolted from time to time, as was vivid with the run on the $3 trillion money market funds in 2008.

The FDIC has invariably facilitated mergers of the failed banks with the major financial firms to minimize its insurance losses. This has made the biggest financial firms bigger over time. This is unsustainable. This also leads to violation of anti-trust laws.

The biggest financial firms too faced the same liquidity shock, continually, due to withdrawals of unsecured deposits. The FRA,
however, permits unconstitutional usurpation of public resources to guarantee replenishment of depleted capital at the biggest privileged financial firms. This is done with (a) the Federal Reserve lowering its interest to lend vast sums of artificially created money to these privileged financial firms and to force the depositors to accept lower interest rates from these firms, and (b) the Treasury borrowing these funds at a significantly higher rate. The spread between the Treasury's higher borrowing rate and the Federal Reserve's lower lending rate generates a significant profit for the privileged financial firms to replenish their depleted capitals to reach the required minimum. This unconstitutional system perpetuates an inefficient method of lavishing the bank executives and associated government facilitators with exorbitant pays and perquisites.

The FRA is unconstitutional because it is designed for the privileged financial firms to usurp from the non-privileged firms and households. It is unsustainable because it leads to bankruptcy of most non-privileged firms and households, causing widespread depression. The FRA is unconstitutional because it is designed to bestow power, privilege and lavish pays and perquisites on executives of privileged financial firms while depriving, ironically, the non-privileged firms that produce globally competitive goods and services to secure the nation and prop the dollar.

The Federal Reserve Act and the FDICA thus guarantee (a) bankruptcy of most firms and households and (b) emergence of a few mega privileged financial firms like those prevailing before the Great Depression. This designed systemic weakness, prevailing over a century, can be rectified only through my Safe Bank that emerges in equilibrium within the economic model of constitutional governance. This behooves upon the Congress and Administration to amend the Federal Reserve Act and to repeal the FDICA to make the Federal Reserve my Safe Bank in order to prevent a recurrence of the Great Depression.

The Keynesian government spending to keep the bankrupted households underemployed cannot mask forever (a) the systemic process of bankrupting firms and households that persevere and produce globally competitive goods and services to prop the nation and (b) the unconstitutional usurpation of artificially created money by the privileged firms that produce little. The process of masking is the gravest source of systemic risk to national security and prosperity.

The prevailing unconstitutional system catastrophically nosedived as the Federal Reserve's econometric forecasting model proved to be dangerous. It continued to feed data on rising commodity prices to predict inflation and to raise interest rates beyond 6% at the behest of the privileged financial firms, who borrowed from productive nonfinancial firms and households and from the Federal Reserve, to bid up the commodity prices by multi-leveraging through their holding company structure while transgressing the FDICIA minimum capital requirement on a consolidated basis. The privileged financial firms, through their influence over the Federal Reserve and the FDIC, have thus creamed off the savings of every productive nonfinancial firm including households. This has become modern usury.

The research on constitutional governance has challenged the Federal Reserve's econometric forecasting model while such usurious usurpation was rampantly taking place and the interest rate was hovering near 6% in 2007, by asserting then that the equilibrium rate of interest would be near zero if the unconstitutional and inefficient shenanigans were disallowed. The challenge was not based on some other econometric forecasting model. It was based on knowledge gained from selfless research to identify the systemic weakness in the prevailing unconstitutional system of money and finance since 1989, when the first published research led to an unprecedented "optimal bank foreclosure rule" enacted by the Congress in FDICIA 1991. This knowledge has been reinforced by the frivolous rejections of the research on constitutional governance by "top" journals without reviews and with refunds of paid submission fees; indicating as if the journals have been in league with the unconstitutional and inefficient usurpers.[Footnote 2]

So, the financial firms have provably used the Federal Reserve to lock up the borrowers (mostly nonfinancial firms and households) at usurious interest rates. The borrowing rates are usurious because they have been set deliberately at far greater level than the
equilibrium zero rate that my research has uncovered even when the Fed was mulling to raise interest rates beyond 6% to contain an artificially cooked up inflation. Many nonfinancial firms (the nerve centers of American business) have become bankrupt, as a result, to drive up the unemployment among households. Unemployed households have been foreclosed to lose their houses. It is due to the modern usury imputed unconstitutionally and inefficiently by the FRA and FDICA.

The FDIC has only exacerbated the unconstitutional and inefficient process by foreclosing even highly solvent banks and by zeroing out the legitimate stakeholders-investors. This has created panic among investors who would have normally taken risk of funding productive firms that create jobs, produce globally competitive goods and services to secure the nation and prop the currency. The panic is measurable by the quantum of transfer of savings to Treasury securities from investments in firms that create and prop jobs.

If the Federal Reserve Act is amended and the FDIC is eliminated to make the Federal Reserve my Safe Bank, the U.S. will correct the structural weakness, ensure constitutional governance by averting unconstitutional usurpation, and avoid systemic panics and systemic risks.

III. How can it be done?

The Americans in the left, right and center now want to know the real problem that made them bankrupt and they want a solution by yesterday. They had thought during 2008 that you would not only articulate the problem for them through your oratory, but also solve it on arrival at the White House, using all the political capital bestowed on you.

The constitution guarantees equality. The founding fathers dreamed of equality, denied by colonial rulers. The anti-colonial fervor is
genetically present in every American longing for liberty. It is ingrained in every human soul anywhere. No one cherishes domination
crafted by shenanigans to usurp the fruits of his labor. The Great Depression proved to be a pervert equalizer, after decades of panics, when the government lost its power and most financial and nonfinancial firms including households were bankrupted.

Are we then heading for another round of Great Depression to attain equality under the constitution? Some of my respected colleagues at UIC think so. I still harbor, though, a lot of hope that the U.S. will avert another Great Depression. How?

  1. The nation is fortunate to have a constitutional expert as president, with education from prestigious universities and teaching
    in a prestigious university. His Administration also has the most revered constitutional scholar as the advisor in the Department of Justice. This Administration is thus the most scholarly and responsible body to referee the economic theory of constitutional governance.
  2. We the People (from left, right and center) are bound by the constitution and by only the constitutional rules of governance.
  3. Irrespective of current parochial affiliation to any party or group, We the People are afraid of being jointly doomed by the
    perpetuation of structural weaknesses.
  4. What are the competing economic paradigms that identify the systemic weakness to rectify the same constitutionally? The economic theory of constitutional governance is the only such theory obtained via selfless research spanning 1990-2010 that has conclusively and successfully identified the systemic weakness and offered preemptive policy proposals to rectify the same constitutionally and efficiently. The only competing alternative paradigm that has prevailed for centuries, which is antithetic to the constitutional theory, and which (a) permits unconstitutional and inefficient usurpation of private wealth systemically and (b) explains continual depressions as slaps by the invisible hands (acts of god) to resolve such depressions by further unconstitutional and inefficient usurpation, until widespread depression leaves little left to be usurped.
  5. There is nobody as qualified as the current Administration to referee the paper on economic theory of constitutional governance. We the People should ask this Administration to produce a "referee report" on (i) the premises for the economic theory of constitutional governance, (ii) the method of inferring the systemic weaknesses in the current system of money and finance, and (iii) preemptive proposed solutions. This is necessary because the U.S. is facing a grave crisis and "top" journals are rejecting this paper with "cursory" reviews or without reviews by even refunding submission fees, while other journals are soliciting it for publication. It feels as if the top journals are unwilling to reform the structural/systemic weakness and are even angry with selfless research that has uncovered the weakness and has proposed constitutional reforms. The paper has been revised substantially to subsume the thoughts in this memo, but within the same mathematical model and constitutional premises.
  6. Use the referee report to officially identify the systemic weakness and enunciate constitutional policies for efficient rectification of the weakness.

[1] The mathematical model is presented in my unpublished paper that was originally mimeographed in the Board of Governors of the Federal Reserve System (U.S.) Finance and Economics Discussion Series number 95-15, entitled, “Efficient Resolution of Moral Hazard under no Arbitrage: Risk Premium, Volatility and Leverage.”  This paper has been substantially revised with a new title, “An Economic Theory of Constitutional Governance,” to elicit the constitutionality and efficiency of the Safe Bank in equilibrium and unconstitutionality and inefficiency of the Federal Reserve Act passed in 1913 and the Federal Deposit Insurance Corporation Act passed within the Glass-Steagall Act in 1933.

[2] The FDICIA minimum capital requirement stems from the equilibrium bank foreclosure rule obtained in Acharya, S, and Dreyfus, J. (1989), “Optimal Bank Reorganization Policies and Pricing of Federal Deposit Insurance, Journal of Finance.