Averting the Next Looming Disaster: Busting of Dollar

September 20, 2008

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development


September 28, 2008

Sub:    Restoring Trust in the Venerable American Banking and Monetary System

Dear Honorable Speaker Pelosi and Senators,

Your speedy approval of a buyout of toxic debts from bankrupt financials shows real personal sacrifice, because you risk reprisal from angry voters.  Your credible sacrifice, however, indicates to an independent observer that you now recognize that the venerable American banking and monetary system has lost the trust of investors at home and abroad. 

This memo points out (i) how a buyout can become a bailout in the real world of capital markets, (ii) how even a pure bailout may not revive a fundamentally weak economy, and (ii) some policies to restore the trust in the system to make America and the world prosperous again. 

A.   Buyout can become bailout

1.      When a fundamentally weak company buys out its stock, the market makers manipulate the price upwards to sell the stock short to the company and then push down the price to even a lower level than before to cover their short positions.  The buyout may thus become a bailout because the price of even toxic worthless assets can be manipulated upwards to siphon/transfer taxpayer funds to the bankrupt financials. 

2.      Congress should not buy “hedged” portfolios of financial companies because that would involve taxpayers assuming all short-sold or “written” obligations.  The financials are in trouble because they “wrote,” which means “short-sold” too many contracts involving massive obligations for upfront prices that generated immediate incomes.  They did so because managements take away portions of those immediate incomes (not future obligations) as bonuses.  The balance sheets of these companies are fictitious because they do not generally report fair values of their obligations to boost short-term profits.  If the government assumes such balance sheets, the burden on taxpayers will shoot up due to the latent obligations stemming from short-sold or written contracts. 

3.      Only if the U.S. government becomes an efficient trader will the buyout not become a bailout.  This rosy scenario is a main reason for the Congressional agreement intended to ease an unprecedented credit crunch poised to destabilize the markets and real economy.

B.    Buying toxic debt may not revive economic growth.

Even a pure buyout may not induce the bankrupt financials to lend again to rejuvenate a credit-based growth of the economy.  It will restore a decimated trust in the American financial system, but only temporarily as per my analysis below.

 

The American households, corporations and governments (federal, state and local) have already borrowed to the hilt, as indicated by rising defaults.  If the vast majority has positive net debt, then there is an imbalance in a democratic system.  A few households must have piled up all the credits because of their manipulative (not democratic) power of fixing (i) usurious prices for every necessity of life (education, energy, governance, housing, healthcare, defense and artificially set cost of such credit) and (ii) precariously low real wages (computed by true inflation facing workers not by fictitiously published low government inflation figures) for the vast majority of borrowers. 

Some of these credits have become toxic debt assets held by the bankrupt financial companies.  There are few buyers of these debts.  The creditors are frightened.  The current issue is how they will respond when the government offers to buy out the toxic debt.  They will happily unload their toxic debts to get cash and lend their new cash only to the government, because they are smart enough to know that households and corporations cannot service any more debt.  This is exactly how the Japanese banks responded when their government created such a program to pump new money into the bankrupt financials after the busting of equity and real estate.  Japan did not see thereafter much credit-based economic growth again.  We should rationally expect that there will likewise be little credit-based economic growth in the U.S. after the government buys out the toxic financial assets. 

A pure buyout plan will thus yield little economic growth and lower long-term interest rates close to zero as the new money recycles back to Treasury securities. Even without a buyout, we could presage little economic growth and low long-term interest rate due to a decimated demand for new debt. [1]   

A pure buyout will thus make no difference to the economy.  It will, however, force the taxpayers to own a toxic baggage by (i) sacrificing good money now and (ii) paying interests periodically on the new Treasury securities to be bought by the creditors due to buyout. 

C.     Fundamental Causes of the Financial Crisis

The fundamental causes for the crisis brewing under the veneer of a pseudo government-hooted growth in gross domestic product (argued in my earlier memos) are as follows:

(a)   Erosion of real net incomes due to continual money injection, made to suppress financial distress.

(b)   Emigration of good-paying jobs, thanks to a system that often pays little to the more productive contributors of society.  The Wall Street hedge funds including top investment banks produce no food or social service, except continual financial distress for the vast majority and induce the Federal Reserve to inject new money to contain such distress.  The Wall Street bankers usurp the most mainly because they have engineered rules and practices with the help of lobbyists and lawmakers to nibble away the financial savings of the vast majority of households and to create financial depression continually.     

(c)    Piling up large amounts of debt on the vast majority of households due to shrinkage of net incomes, thanks to the usurious creation of credits by a few powerful chieftains and guardians of society with the help of rules and procedures to facilitate such usurpation.[2]

A rational examination of the history of the crises before the Great Depression, the subsequent policy actions of the Congress, and the reinvention of Wall Street strategies to circumvent new laws (notwithstanding the monitoring by a plethora of new regulatory bodies created over time) should show that the few powerful beneficiaries (chieftains and guardians) never wanted to resolve the real problem until the system crashed and the vast majority revolted:

·         The gamble with savers’ deposits led to bank runs and panics in 1907 that led to a serious loss of trust in the financial system and then the Great Depression. 

·         Only after the revolt and dismay during the banking panics did the Congress produce the Federal Reserve, Glass-Steagall, and Federal Deposit Insurance Acts to restore the trust of savers.

·         The federal insurance gave rise to government-sponsored moral hazard by which banks could gamble on the deposits insured by taxpayers.  Bank executives could concoct short-term profit to take it away in the form of pays, perquisites and golden parachutes by leaving massive residual risks in their institutions for taxpayers to bear.   Until the next crash, they could simply use a small part of their massive gains from such gamble to bribe any lawmaker or change agent or use other scare tactics to muzzle the vociferous dissenters.  Such a government-facilitated moral hazard system would definitely collapse as the eruption of the S&L crisis proved. 

·         The FDIC Act of 1991 was conceived to contain moral hazard: banks were forced to hold minimum capitals, failing which they would be foreclosed even before reaching the (previously allowed) level of zero capital.  The idea of the FDIC Act was that banks with sufficient capitals will have little incentive to gamble, lest they lose their own equity.

But the bank holding companies were allowed to operate with as little as one-tenth of the minimum required capital on a consolidated basis.  BHCs gambled on insured deposits through insanely high leverages in their off-balance-sheet subsidiaries or embedded hedge funds.  The current financial meltdown is due to such gambling.    

D.   Fundamental Policy Reform

To preclude all current or future forms of conning, the society must have “Safe Banking,” comprising (i) Safe Banks that must invest only in government securities, protected by the government, and monitored closely by the Federal Reserve for minimum capital, executive compensation and efficiency of operation, and (ii) Universal Banks that should be free to invest in whatever assets desired by their stakeholders without federal guarantee or monitoring.  Safe Banks should not be allowed to lend to Universal Banks.  This will obviate the myriad inefficient regulators that tend to operate as parasites on taxpayers and enterprising financial institutions.  Such regulators have rarely detected budding financial crises, let alone preemptively resolve them. 

The banking economics profession must have become corrupt or ivory-towerish.  How else would it say until the crisis erupted that the U.S. banking system was safe and sound, despite many papers, memos and a book by yours truly that vividly depicted in simple English the current meltdown?  Well, the profession has remained very busy and fat by writing papers to repeal the sagacious Glass-Steagall Act to justify universal banking riddled with government-sponsored moral hazard! 

No matter what the banking economics profession or the universal bankers want, the markets have spoken very vividly in favor of Safe Banking.  The government was forced to insure money market funds following the panic withdrawals.  These money market funds are now my Safe Banks.   To consummate the safe banking policy, the current universal bank holdings companies like Citigroup, JPM Chase and Bank of America will need to be morphed into uninsured and unregulated institutions.  If this is not facilitated by the government, the markets may speak again as follows:

(a)   The major debt holders of these universal bank holding companies will continue to sell off their securities because of the fundamental weakness of the economy. 

(b)   The prices of their debts are already depressed and will continue to fall. 

(c)    The government may keep buying those bank holding company debt securities under the current bailout plan by increasing the outlay from $700 billion to perhaps a much larger figure.  

(d)   The capital-starved universal bank holdings companies will continue to gamble with the insured deposits through their investment banking subsidiaries to enhance their capitals by upstaging markets once again that will result in another bout of panics and depletion of capitals in those bank holding companies. 

(e)    The government will then be forced to incur a very large amount of taxpayer funds to seize all the bank holdings companies and then be forced to not extend deposit insurance to them.    

I have argued about “Safe Banking” being optimal from the point of view of the long-run interests of the vast majority of American households.  I am eager, though, to learn about any other long-run optimal rules of governance of the American banking and financial markets. 

With profound regards,

Sankarshan Acharya



[1] I now feel humbled about how “prescient” my call was to reduce the rate of interest from 5.5% to 2% or less when the mandarins of capital markets were asking to raise the interest rate.  Actually, it is not prescience or clairvoyance. It results from a sincere search for the Truth that is not predicated by any self interest except a desire to strive for long-run stability and prosperity of mankind in a beautiful earth.  Such search often hurts myopic self-interests, but that is moot.

[2] I have written such things in my book, “Prosperity: Optimal Governance, Banking, Capital Markets, Global Trade and Exchange Rate,” written in 2003 and published in 2005 and offered real remedial policies.  I am sure the usurpers will not like my proposed remedial policies: (i) safe banking to avoid continual moral hazard, (ii) abolishing government protection of patent rights to enhance efficiency in production, (iii) banning the pre-Great Depression era short-selling of financial securities to stop illegal and clandestine transfer of hard earned retirement savings of the vast majority to a few, (iv) improving the system of job evaluation designed and exploited by the chieftains in government, industry and academia to fatten their own pays and perquisites by cannibalizing the effective contributors, etc. 

[3]http://www.pro-prosperity.com/Research/OptimalCEOCompensation.pdf