Economically Efficient Constitutional Governance

Abstract

The economy is modeled as a set of leveraged firms (including households) with potentially superior information who choose their assets to maximize their net-worth, while an efficient, not-for-profit government enacts and administers constitutional rules for free trading of goods, services and assets. This paper shows that enforcement of rules consistent with the constitutional tenet of equal protection of everybody’s earned wealth are necessary to achieve economic efficiency and equilibrium. In equilibrium, potential moral hazard is efficiently resolved at the firm level due to free trading and at the government level due to a constitutionally efficient safe central bank. The safe central bank offers equal security of the safe asset (deposits), chosen by any firm. The safe central bank obviates financial panics and the federal guarantee of bank deposits. The model proves that eliminating the Federal Deposit Insurance Corporation and amending the Federal Reserve Act to grant equal privilege to all firms (not just financial firms) is constitutional and efficient, which then makes the Federal Reserve identical to the equilibrium safe central bank. In equilibrium, (a) the asset risk premium is negatively related to volatility of a levered firm, (b) the asset volatility and risk premium are both increasing functions of the asset-to-debt ratio, and (c) the minimum threshold asset-to-debt ratio below which the firm goes bankrupt is an increasing function of the asset risk premium.