“Loanable Funds Theory” of Banking is Wrong

The typical economics textbook describes banking as a process where people deposit money and then the bank looks for good opportunities to loan those funds out. This “Loanable Funds Theory” implies that banks will not even look for good loans if they don’t have that amount of money in deposits to loan out. That might be true under a banking system with a 100 percent reserve requirement, but our system of banking maintains a reserve requirement closer to 10 percent. A realistic theory of how a bank decides to make a loan doesn’t actually correspond to the Loanable Funds Theory. In fact, the process is somewhat the opposite. Banks first look for good loan opportunities, and if they find one, they check to see if they have enough excess reserves. Often a bank will have enough excess reserves to make the loan if it meets its risk-reward criteria. The bank creates a deposit account for the person or entity taking out the loan. The deposit account is created “out of thin air” as a result of the decision to create the loan, and not the other way around. This means that the bank is creating money. However, if the bank is already at its reserve requirement limit and needs more reserves to make the loan, it will increase the interest rate on savings and certificates of deposit to attract more money to satisfy the reserve requirement. Banks can also borrow money from each other or from the Federal Reserve Bank where the largest banks have accounts.

My wife and I have certificates of deposit (CDs) that we need to renew from time to time. We are in a metropolitan area with lots of banks. The interest rate offered on CDs can sometimes differ greatly from one branch to another of the same bank. Instead of going to bankrate.com and moving our money around over the internet, as we did when we lived in an area with fewer banks, we often find a bank locally with a CD interest rate that is at least as good as the best rate on bankrate.com. Typically the interest rates offered on CDs at most of the banks in our area are quite low. Most banks still have adequate excess reserves, or have not located any good additional loan opportunities offering a good enough risk-reward ratio to satisfy them. Consequently, most banks are not trying hard to attract more money and are happy to provide a very low interest rate on CDs to all those people who don’t check the interest rates on CDs and just let their CDs roll over at whatever rate the bank sets. After all, why would a bank want to pay to borrow money from you that it doesn’t need? Increasing costs without any corresponding increase in revenues makes no sense.

But even though the vast majority of banks offer a very low rate of return on CDs, there will often be one or two banks which offer rates that are three or four times the typical CD interest rate. Sometimes this is because those high-interest-rate banks have found some really good loan opportunity and are already at their reserve requirement limit. Sometimes a bank has gotten into trouble with loans that have defaulted. Fortunately for us the Federal Deposit Insurance Corporation (FDIC) covers us up to a specified maximum amount in case the bank goes bankrupt. What this all boils down to is that it really pays to check the interest rates each time your CDs become due. Be sure to ask if the bank is offering any CD “specials” which might be for an odd period such as for 11 months or 13 months.

The Loanable Funds Theory of banking is wrong. That theory tells us that banks wait for deposits and then loan out only that money that has already been deposited with them. But under fractional reserve banking, banks do not have to wait for enough deposit money to cover the full amount of the loan. In reality, under the current system of fractional reserve banking, banks can offer loans even if they don’t have enough money in deposits to cover those loans as long as they meet the fractional reserve requirement. Banks make loans when those loans offer a good risk-reward opportunity.

This has important implications for our economic system overall. When savers cannot get a good return on their savings, they often turn to the stock market or the bond market. But corporations often pay out dividends and engage in share buybacks precisely because they cannot find new profitable investment opportunities. Financial investments in collateralized debt obligations, credit default swaps, mortgage-backed securities, and other financial derivatives are not the same as direct investments in physical and intellectual capital. A bank may know more about the local economy and the reliability of the entity taking out the loan than reflected in the basic statistics used to securitize that loan. The temptation then is for a bank to make riskier loans than it would if it were to hold on to that loan instead of selling it off as part of a mortgage-backed security.

What this all boils down to is that the financial economy where money is traded has become more and more separated from the real economy. Money flowing into the New York financial markets is not guaranteed to end up in an expansion of our economy. Over time more and more of that money just goes around and around in the New York financial markets without ever making it out to the real economy. The velocity of money in the financial markets speeds up as second-by-second trading is replaced by nanosecond-by-nanosecond trading, while the velocity of money in the real economy slows as interest rates fall, our population ages, and income inequality becomes more extreme. All this has important implications for the effectiveness of monetary policy, which is a topic for a future blog post.

For a great YouTube video on why the “Loanable Funds Theory” is wrong go to this link: https://www.youtube.com/watch?v=OgsEyM82oCE&t=785s

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Maximizing Shareholder Value Hurts the Free Market

When teaching economics, or almost any subject, we try to portray the material we are presenting as simple, logical, and straightforward. “Introductory Economics” is supposed to be just that => a clear and compelling presentation that makes sense. If we call it “Principles of Economics,” we want to present the ideas as truths that will hold in virtually every context and hold up over time. Students should not be surprised that beginning economics is presented as reflecting rational, independent decisions of self-interested individuals with foresight and reasonable and rational expectations. We want students to believe in the “laws” of economics that move us efficiently and effectively to an equilibrium solution where supply and demand meet at the equilibrium price and quantity.

But is this the real world? Is there just one price for gasoline that clears the market or is there a wide array of prices throughout the city? Are the interest rates for certificates of deposit of the same tenure the same for all of the banks in your area? Are we leading our students astray when we present such a nice, neat package of ideas portraying economics as driven by irrefutable forces that clear the market? What about contagion effects that drive irrational exuberance in the stock market driving stock prices higher and higher until reaching such unrealistic price-earnings ratios that they finally collapse in a “Minsky moment”? Do fear and uncertainty cause investors to sell their stock shares in a rush to the exits just as stock prices bottom out in a bear market? When housing prices collapse, do we try to blame all those NIJA (no income, no job, no assets) loans on the government or face the reality of short-term profit seeking overcoming longer-term rational judgement? What about the role of securitization? Don’t mortgage-backed securities encourage the transfer of risk from the banks that knowingly make risky loans because they know that they can quickly offload them to distant investors who are clueless?

After all, in 1994 two Nobel prize winning economists (Myron Scholes and Robert Merton) help found a hedge fund called Long Term Capital Management (LTCM) which ended in bankruptcy in 1998, because they assumed that markets that were out of equilibrium would return to equilibrium before too long. Too long turned out to be longer than they thought. Their leveraged position was so large and so untenable that it put the entire financial system into jeopardy. Ultimately LTCM had to be bailed out with the help of the government.

The idea that our economic system is all about rationality and about individuals fine tuning their optimal strategies to maximize their individual well-being can be very misleading and far from the real world. Perhaps we would be better served by the story of disequilibrium economics where our economy operates in a very precarious and unstable state with anti-equilibrium forces constantly fighting against and often overcoming equilibrium forces. Instead of economic paradigms that see an efficiently operating free market economy with only occasional disruptions requiring government intervention (Keynesian paradigm) or not (Austrian paradigm), we need to adopt the more realistic money flow paradigm that sees government with all its rules, regulations, taxes, and expenditures as the heart of the free market. Pretending that government is not needed (neoclassical paradigm) or should totally dominate every major economic decision (Marxian paradigm) does not provide us with a true path to the efficient allocation of resources, which, after all, is what economics is all about.

The money flow paradigm reveals the most disruptive and destructive force that is currently undermining the economic incentive structure and the efficient and effective allocation of resources in our economy. It is the short-term, narrowly focused excuse for suppressing the entrepreneurial spirit, denigrating product quality, and undermining employee incentives called “maximizing shareholder value.”

The great success of Apple, Inc. was not due to a short-term focus on maximizing shareholder value but instead due to the determination of the entrepreneur Steve Jobs to change the world by providing new and exciting products affordable for the average consumer. After starting Apple Computer with great success but eventually being talked into hiring a professional manager, Jobs was set aside for his failure to focus on maximizing shareholder value. He then set out on his own to create Pixar Animation. However, Apple did poorly under the maximizing shareholder value mandate, and Steve Jobs was brought back in to restore the mission of producing amazing products to change the world.

Another case that reveals the destructive nature of using financialization in a short-term effort to maximize shareholder value is the case of Saluto Pizza. The pizzas produced by the pizza business, Saluto Pizza, in Saint Joseph, Michigan, became so popular that the owner began freezing the pizzas for people to reheat and eat at home. Local supermarkets soon agreed to sell the Saluto pizzas. Saluto pizzas became widely available in the Midwest. In fact, they were so popular that Saluto Pizza opened a production plant in Montgomery, Alabama to serve the grocery stores in the South. Again, the pizza was very popular and sales were brisk. But then a large food conglomerate stepped in and bought up Saluto Pizza. In an effort to maximize shareholder value using the financialization strategy of cutting costs to maximize short-term profits, the crust, marinara sauce, and other ingredients were cheapened until sales of the pizza dropped precipitously and the production of the pizza was discontinued.

Many more stories of this sort as well as turnaround success stories when companies moved away from the narrow, short-sighted emphasis on maximizing shareholder value are told by Harvard Professor Rebecca Henderson (2020) in her book: “Reimaging Capitalism in a World on Fire.”

But the emphasis on maximizing shareholder value in adding to the inefficient allocation of resources and aiding the anti-equilibrium forces in our economy manifests itself in undermining employee incentives. Before the time of John Locke (1632-1704) the natural resources of the world were viewed as the property of God or, in the case of native Americans, the spirit world. But then Kings claimed to have been given dominion over the natural resources by God. You could not take fish from the stream or deer from the forest without permission from the King. But Locke introduced the idea of private property. Locke argued that people owned their own labor and that by imbuing their labor into natural resources they established their ownership of capital such as a wooden plow or a iron tool. Initially that worked well with craftsmen and craftswomen making their own capital equipment in the form of simple tools. In other words, capital was acquired by what we would call today “sweat equity.” Hard work paid off in establishing the ownership of capital.

However, eventually the needed capital equipment became bigger and more complicated such as a water wheel or a lathe, which then had to be provided under the auspices of the nobility. This intervention by the nobility separated the ownership of capital from the labor that used that capital. Today the incentive to work hard to acquire the right to capital ownership has been undercut by shifting financial rewards away from company employees in favor of maximizing shareholder value. You can drive a truck for a trucking company for thirty years and gain no ownership rights over that truck or in that company. You can work hard in a factory for many years with no corresponding acquisition of ownership rights through sweat equity.

There are exceptions. The construction company Burns & McDonnell in Kansas City has grown enormously by maintaining employee ownership where only the current employees own the company. Efforts to work together to produce better quality results for a wider array of customers worldwide has paid off big time for B&M. See the book by former B&M CEO Greg Graves (2021) called “Create Amazing.”

Other exceptions to the emphasis on maximizing shareholder value for distant, otherwise unassociated investors have provided further evidence of the benefits of rewarding employees. Treating employees as just factor inputs like steel or plastic does not recognize the agency of employees in determining the success or failure of the business. With over 80 percent of the stock market owned by the wealthiest 10 percent of Americans, the argument that investors need extraordinary profits to continue to invest is ludicrous. In reality, the richest Americans have so much money they have no idea what to do with it other than invest it. After all, you can only wear one pair of shoes at a time, or drive one car at a time, or go out to so many fancy restaurants in a given day. At some point, arguing that a wealthy investor is taking a big risk in investing a paltry $100,000 or so in a business is laughable. To the wealthiest investors losing or gaining $100,000 here and there is no big deal. It has no effect on their lifestyle in that their marginal propensity to consume out of each additional dollar earned is extremely low.

The most obvious and damaging effect of maximizing shareholder value is to divert the money flow in our economy away from the people actually producing and consuming products in the real economy to the increasingly separate financial economy. Sending so much money to Wall Street has left very little for the people on Main Street. Lots of money pouring into the New York financial markets drives down interest rates and drives up stock market prices. Instead of money, the people on Main Street are given an ever increasing number and array of credit cards. This just makes rich people richer and drives the people on Main Street deeper and deeper into debt. But even that private debt is not enough to enable employees to be able to buy back the value of what they are capable of producing at full employment. Consequently, to avoid recession the government steps in with deficit spending as carried out by both Republicans with unpaid for tax cuts and Democrats running up unpaid for expenditures to subsidize the people on Main Street.

What then is the solution to move us away from the maximization of shareholder value and CEO pay maximization? One answer used by Germany and some other countries is to require employee representatives on corporate boards. Replace some of the CEO’s golf buddies with representatives from and elected by the rank-and-file employees to make sure that employee ideas and compensation are given careful consideration at corporate board meetings. Perhaps as much as 40 percent of corporate boards should be elected by the company’s employees. This could be structured to distribute the employee representation around the different departments with a balance between representatives from engineering, operations, marketing, et cetera. Each division or aspect of the company would be represented by the rank-and-file employees who are on the front lines of carrying out that division’s mission.

Pretending that the free market can and should operate on its own is a total deception. The government is and should play a major role in appropriately guiding the free market. Government should be accepted as the heart of the free market. The question is not whether the government should be at the center of things, but how the government’s role should be adjusted to keep the free market working for everyone in efficiently allocating our nation’s resources.

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Wealth Creation Advice for Your Children and Grandchildren

“You can either pretend to be rich now, or really be rich later, but not both.” In other words, frugality now is essential to building wealth. The key to obtaining great wealth is to first recognize that in most cases the return to capital is much greater than the return to labor. In fact, in some sense, the whole point of your career is to make the transition from getting your money from labor to getting your money from capital. Once you are generating a lot more wealth from your investments than from your work, you can retire comfortably and confidently.

Whether you are part of the poor getting poorer or the rich getting richer usually depends upon which side of the interest rate you are on. When the interest rate goes up, the poor say: “Oh, no. Now I will have to pay more.” while the rich say: “Oh, great. Now I will be getting a better return on my money.” But to invest, you need money to make money. Where does that money come from?

There are some investments that pay off big time. A college education is one of them. But that doesn’t mean that you should borrow excessively to go to college. Keep the expense down by getting tuition waivers, scholarships, and student-work arrangements. Going into debt should never be taken lightly. It is a major barrier to wealth creation. Avoid debt whenever you can. Debt is only to be taken on as a last resort when the payoff is clear.

Take public transportation, especially if it is subsidized or free as in Kansas City. If you must have a car, buy a dependable used car, and not a fancy new car. With a car, you need liability insurance, because it is often required by law, and you probably can’t afford to hire a gang of lawyers to defend yourself if you get sued. But if you have enough money to replace your rusty old car with another dependable rusty old car, you may not need collision insurance unless you are an especially poor driver. It is important to remember that insurance has to have a negative expected value. The odds have to be against you in a gambling casino. The house on average has to make money, which means you on average have to lose money. The same is true in insurance. Self-insurance is usually better on average than commercial insurance if you have enough money to self-insure.

The key to wealth creation is to appreciate the power and importance of compound interest. The number of years it takes to double your money after checking the box that says “Reinvest Dividends” is given as follow: Number of years = ln(2) / ln(1+(APY/100)) where “ln” refers to the natural logarithm and “APY” is the annual percentage yield of your investment including the value of the additional shares you obtained by reinvesting your dividends. For example, if APY=10 percent, then APY/100 = 0.10 so the number of years to double your money = ln(2)/ln(1.10) = 7.27254 or about seven and a quarter years. To calculate how many years it would take at 10 percent APY to grow your investment by a multiple of 10 use the formula: Number of years = ln(10)/ln(1.10) = 24.1588579 or just over twenty-four years before your investment reaches ten times its initial value. An investment of $10,000 becomes $100,000 in a little over 24 years, and $1,000,000 in just over 48 years. At that rate, an investment of just $10,000 at age 20 becomes more than $10,000,000 by age 93.  Young people who ignore the power of compound interest may be leaving a lot of money on the table.

But where do you get a good return on your money? For most people the answer is the stock market. As long as corporations keep emphasizing shareholder value with great dividends and stock buybacks that drives up their stock price, you can expect to get a good return over the long term. One conservative strategy is to simply invest in broad market exchange traded index funds with very low expense fees such as Schwab’s SCHB, Vanguard’s VTI, or iShares’ ITOT. When you get older you may want to transition to the corresponding broad market dividend funds. Purchasing shares in individual stocks sometimes amounts to gambling while investing in broad market funds tends to be less volatile and does not require the day-to-day attention to a particular stock’s performance.

Young people tend to think in terms of the next few weeks or the next few months and not so much in decades. Old people in their 80s and 90s have learned to think in terms of decades, but it is too late. Thinking long-term can pay off big time if you are young, and not so much if you are really old. In retirement my wife and I often go trash walking in the campus parking lots. Unfortunately, it is in the student parking lots where we often find (in addition to lots of trash) loose change — pennies, nickels, dimes, and quarters, and occasionally a few dollars. We hardly ever find money in the faculty-staff parking lots. 

When you and your friends eat at McDonalds, do you buy the big mac or the quarter pounder with cheese, or do you buy the chicken sandwich off the dollar menu? Being secretly rebellious can be fun. Don’t let them know that you are beating them at the frugality game. Take pride in being secretly “cheap.” Buy as little as possible and pay as little as possible for what you buy. Thinking longer term means not trying to impress your friends by buying the latest, most expensive gizmos or keeping up with the latest fashions but knowing that many years from now at your class reunion, you may be the wealthiest person in your graduating class.

( Important Note: The author takes no responsibility for any investment decisions, decisions regarding insurance, or other actions you may take in response to reading this column. The author is not a certified investment advisor. If you want specific investment advice, you need to contact a professional, certified investment advisor. )

Winning as a Team Takes Us Beyond Individual Identity

We all love the story of the rugged individual — hard-working, self-reliant, and through the magic of Adam Smith’s invisible hand, inadvertently helping others while pursuing one’s own self-interest. An entire world of economics has been built around this story. There is a lot of truth to the idea that this country was built on the frontier spirit of individual efforts overcoming difficult challenges to get ahead.

The problem with this story is that it ignores, or at least relegates to the background, the idea of each of us being part of a larger entity — be it our family, our neighborhood, our work team, or our country as a whole. Yes, we are out for ourselves to some extent, but we are also very likely to sacrifice our own interests to help others. Few people totally ignore the best interests of their family or community in their day-to-day choices. Our community identity can be as strong, and sometimes stronger, than our individual identity. Think of the basketball player who passes up the chance for glory in making the long shot and, instead, passes to a teammate closer to the basket. Think of the medic in combat who puts his or her own life at risk to save others. We thank our soldiers, police and firemen for their service knowing that they are risking their lives on a day-to-day basis to help protect us.

In some ways we are so interconnected that it is not clear that an intelligent alien entity from elsewhere in the universe would see us as separate individuals at all. To such an entity, we might be seen as the mass of humanity spread out across the globe. The dangers of world war, asteroid strikes, and irreversible climate change bind us together in a way not fully appreciated by Adam Smith’s invisible hand.

In displaying and waving the American flag, we are revealing and relishing in our larger identity as Americans. We are proud to be part of the greater team. Hopefully, we feel that same about our family. Some explore their genealogy to better appreciate their family heritage. But what about our work team. For some, there is great pride in the team’s efforts and achievements. For others, not so much.

If each individual is directly and completely responsible for a specific output or outcome, it is easy to provide incentives to reward their work. But what if your work team is producing and selling a product or service where the quality of the work in production and the marketing of the product in advertising is combined to produce sales. Are those sales the direct result of better quality or better advertising? It is sometimes hard to tell.

Moreover, the outcome of a team effort might only be determined by the interaction of team members in supporting and enhancing the efforts of the individuals on the team. This interaction and support is enhanced when the team as a whole is rewarded. For sports teams, the glory comes in winning as a team. Each member of the team understands that the others must do their part to enable the team to win. Rewarding the team as a whole can sometimes be just as important as rewarding each individual team member.

Going to one extreme or another in this regard can lead us astray. To the extent that it is possible to identity and measure an individual’s contribution that individual should be rewarded to that extent. However, it is also important to recognize and reward the team as a whole so that each team member will have an incentive to encourage, and sometimes cajole, other team members to do their best for the team. Success often requires team cohesion and coordination that cannot be achieved by each member just doing their own thing. We have our individual identity, but we also have our collective identity. Only rewarding individual identity misses the importance of our group identity in enabling good outcomes for the team.

On the other hand, if we only reward the team, as a team, and ignore the extent to which a particular individual has contributed to the team’s success, we run the risk of encouraging free riders who make little effort with the hope that their teammates will make up the difference. This was the fundamental mistake of communism — simply dividing up the team’s profits equally without regard to individual efforts. Clearly, maximizing economic productivity requires just the right combination of rewarding the team as a whole and rewarding individuals according to their individual contributions. Every enterprise may be different in this regard so broad oversimplifications of this complicated challenge are likely to be misleading. Too much emphasis on individual effort alone can be just as foolish as simply rewarding the team as a whole without regard to each member’s contribution.

Disequilibrium Economics and Adam Smith’s Two Invisible Hands

In competitive markets with sufficient elasticity, equilibrium is established and maintained relatively easily. Consumer demand and supply respond quickly to the mantra: “The solution to high prices is high prices; and the solution to low prices is low prices.” Obviously, the point is that in the face of high prices, consumers cut back demand and suppliers increase supply to bring down prices. Conversely, in the face of low prices, consumers increase demand and suppliers cut back supply to raise prices. We achieve equilibrium quickly and efficiently.

Except this doesn’t work very well or very quickly in the financial markets and in the economy overall. The problem is that traditional equilibrium economics assumes rational, independent decision makers with full information and sufficient mental energy to compute and re-compute their optimal behavior in complex situations that can quickly change and invoke emotional responses. Contagion effects in financial markets can drive prices dramatically higher in irrational exuberance as higher prices cause people to jump in and follow the crowd to purchase even more in the face of those higher prices instead of less. Conversely, a downward price spiral can be hard to stop when fear overtakes hope and prices fall precipitously. Dan Ariely’s book “Predictably Irrational” reveals a problem that economists have tried to ignore and marketers have profited by exploiting. An irrational herd effect can quickly overwhelm market participants to leave markets in disequilibrium for an extended period. It is hard to understand why economists have taken so long to catch on to consumer irrationality when the people in marketing have understood consumer irrationality and have been exploiting it for hundreds of years.

Moreover, too many people confuse optimal microeconomic behavior with optimal macroeconomic outcomes. The aggregate economy does not converge toward equilibrium when microeconomic incentives do not lead to the intended desirable macroeconomic effects. The classic example is the paradox of thrift where during a recession, when people see friends and neighbors losing their jobs, they try to save a larger share of their earnings in case they might lose their jobs, but the total amount of savings falls because the drop in spending causes more cutbacks in working hours and jobs as consumer demand and prices fall causing businesses to cut back production of goods and services. The microeconomic incentive to save more leads to less total savings at the macroeconomic level. My spending contributing to your earnings and your spending contributing to my earnings can sometimes lead to greater disequilibrium instead of a convergence toward an overall equilibrium for the economy as a whole.

It would be nice to have a world that even in primitive times would have allowed individuals to compete freely and fairly with perfect competition resulting in a natural, efficient and dynamic equilibrium being established in every market. But that is far from reality. In most primitive and many modern societies, the big guy gets what he wants. The equal opportunity and competitive environment is not the natural state. Far from it. It takes a strong and active government to enforce freedom with equal opportunity and competitive markets. In his book “The Myth of Capitalism” Jonathan Tepper has revealed the surprising extent of reduced competition and increased concentration in most major industries in the United States.

For example, consider the market for eyeglasses. Glass and plastic should be very cheap. After all, we throw a lot of glass and plastic into recycling bins every week. But instead of two or three dollars, eyeglasses typically cost about one-hundred and thirty dollars or more. In reality eyeglass manufacturing is basically a duopoly with only two eyeglass manufacturers dominating the market. In the eyeglass market, Adam Smith’s first invisible hand of competition has been suppressed by Adam Smith’s second invisible hand of market power where he said: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the publick, or in some contrivance to raise prices.”

Moreover, government can interfere with freedom and competition by imposing patents, copyrights and licensing requirements, among other restrictions such as child labor laws and government sponsored monopolies. Sometimes government intervention is good in solving problems that the free market is incapable of solving on its own. At other times, government intervention can create problems or make problems worse, so it is important to distinguish between good government intervention and bad government intervention. With limited mental energy, we have a natural tendency to think in all-or-nothing terms, but reality requires careful analysis to devise effective and efficient policies to fix free market problems without introducing significant other inadvertent difficulties. For a better understanding of the role of government in our economy see Mariana Mazzucato’s three books: “The Entrepreneurial State,” “The Value of Everything,” and “Mission Economy.”

Adam Smith’s explicit invisible hand of competition suggested that we just need to focus on maximizing our own personal utility function or profits, and others will benefit from our self-centered behavior. But Adam Smith wrote implicitly about a second invisible hand where competitors conspired together to block competition and exploit consumers. While the invisible hand of competition led to lower prices with a focus on quality, the second invisible hand led to higher prices with less concern for quality. Assuming that the first invisible hand will always dominate is naive at best. The rules and regulations set by government play an important role in determining the balance of power between these two invisible hands.

As of May 1st, I-Bonds now offer 9.62 percent interest

Great news!!! As of May 1st, I-Bonds offer a 9.62 percent interest rate. But for most middle-class Americans, there is nothing here to celebrate. As currently structured, I-Bonds are not designed for lower or middle-class people.

I-Bonds were presumably created to try to get middle-class people to save more money and spend less. In theory I-Bonds should be especially helpful in times of inflation to reduce overall consumer demand as well as in recessions in providing savings to draw upon to keep consumer demand from falling too abruptly. The I-Bond savings limit of $10,000 per person was supposed to benefit the middle class without giving the wealthy another way of leveraging their wealth to further exacerbate economic inequality.

We all like to think of ourselves as being in the middle class. But remember that two-thirds of Americans do not have a college degree and forty percent of Americans could not come up with $400 in an emergency without having to borrow money. Most of the wealth of the sixty-six percent of Americans who own their own home is tied up in the value of that home. Still, getting people to save more money is a worthy goal.

However, the other features of an I-Bond limit its usefulness to the very people that I-Bonds were created to benefit.  Money invested in I-Bonds may not be withdrawn for one year. Money withdrawn after a year, but before five years, is subject to a loss of three months of interest payments. Wealthy people have very low marginal propensities to consume because giving them a little bit more or less money has virtually no effect on their spending patterns. However, poor and middle-class people have high marginal propensities to consume in that they adjust their spending up or down significantly as they get more or less money at the margin. Consequently, for I-Bonds to serve as an automatic stabilizer in times of inflation and recession, the poor and middle-class should be the primary beneficiaries of I-Bonds, but they are not.

The challenge is to design an attractive flexible investment that will work for poor and middle-class people and to make sure that they know about it and how to access it easily even if they are currently unbanked or underbanked.

People with little money need access to their money whenever an unexpected expense arises. For example, an automobile accident may require the repair or replacement of their vehicle. A medical problem may require unexpected expenditures. An unanticipated increase in rent may mean withdrawing money from savings while looking for a cheaper place to live. I-Bonds just don’t work well for people who would like to save more but can’t afford to tie up their money for extended periods.

Since most people in the middle-class are not familiar with the bond market anyway, they probably don’t know about I-Bonds to begin with so they may not feel left out of this opportunity to try to stay ahead of inflation.

Unfortunately, what at first appears to be a great wealth-building opportunity for the middle-class, turns out to be just another snack for the wealthy (or at least for those wealthy who want to bother with such a small amount of money ($10,000)).

Inflation from multiple causes requires multiple cures

Consider all the relevant and important factors that have generated our current inflation.

First, the pandemic has played an important role in interfering with our unexpectedly fragile supply chain. Other commentators have already pointed out that too much emphasis on efficiency created our rather unstable “just-in-time” system. This needs to be replaced with a more secure “just-in-case” system that is robust and resilient to disruptions.

Second, many economists have reported that COVID-19 also caused people to cut way back on services (e.g., travel and dining) and to use those savings to increase demand for durable goods such as automobiles. This occurred just as the vehicle computer chips were in short supply. There has also been a significant increase in demand for housing driving up prices partially due to a new, widespread effort by some Wall Street investors to buy up single family homes around the country and turn them into rental units. Perhaps you have received a phone call recently from one of them offering to buy your home.

Third, consider the stimulus packages. Larry Summers was among the first to point out that the Biden stimulus package was too big and would result in too strong consumer demand. Ironically, President Obama had made the opposite mistake in 2009 in trying to compromise with Republicans who sought to minimize the stimulus to minimize the role of government in recovering from the Great Recession. Ultimately, Obama failed to gain bipartisan support for his stimulus package anyway. Obama’s stimulus bill was too small, but President Biden went too far in the other direction and produced a stimulus that was too big.

The pandemic also discouraged some people from going to work so the workforce was reduced just when more supply was needed to meet an increase in demand. At the same time demand increased for medical and other essential workers. The surge in demand led to a shortage of workers in general and truck drivers in particular who are needed to provide the corresponding increase in supply. The increase in wages due to the shortage of workers helped raise prices of many commodities including food and fuel. President Trump had better relations with the OPEC countries, especially Saudi Arabia, than President Biden, due, in part, to their different reactions to the murder of Jamal Khashoggi, which didn’t seem to bother Trump, but deeply upset Biden. Biden’s pleas to the OPEC countries to increase the supply of oil have gone largely unanswered. Obviously, the war in Ukraine will only make things worse so expect prices (especially food and oil prices) to continue to rise substantially.

On top of all this is an economy dominated by less than fully competitive firms which took advantage of the new inflationary environment to raise their prices even if not justified by supply shortages or excessive demand. Jonathan Tepper wrote “The Myth of Capitalism” to reveal the amazing amount of concentration in American industries. For example, our patent laws have allowed the production of eye glasses to be dominated by just two companies. You would think that a small amount of glass and plastic would cost just a few dollars, but glasses typically cost close to 100 dollars or more. Patent laws originally were intended to encourage innovation, but in many cases have suppressed both competition and innovation. Adam Smith actually provided us with two invisible hands: (1) the explicit invisible hand of competition to increase quality and lower prices, and (2) the implicit invisible hand of economic power where firms conspired together to suppress competition and raise prices. It is this second invisible hand that has become so active in our current inflationary economy. To restore competition and reduce prices patent laws must be severely limited in their application and large dominant firms must be broken up. Some import duties may be necessary to avoid excessive dependence on production in overseas countries. 

Our politicians have been reluctant to take responsibility for all this and have instead relied on the Federal Reserve to stop excessive inflation. The Fed, in turn, has emphasized the need to ‘’stay in its lane” by limiting its action to cutting back or even reversing its purchases of securities and raising interest rates. This means increasing the cost of borrowing. Unfortunately the Fed’s restrictive policies suppress both supply and demand. To meet excessive demand for its products, a firm may want to add another line of production. This requires investment. Borrowing the money to invest in another line of production may turn out to be too expensive after the Federal  Reserve raises interest rates to suppress borrowing. This approach to stopping inflation slows the economy to the point of causing a recession.

It would be much better if the Fed could target demand by those people with the highest marginal propensities to consume (hundreds of millions of poor and middle class Americans). The whole point of the existence of interest rates is to pay someone to delay consumption. Private banks cannot afford to offer a higher interest rate on savings than the interest rate they charge on borrowing. But the Federal Reserve could offer a high interest rate on savings if it was limited to relatively small balances aimed at reducing consumer demand by those most likely to spend any extra dollars. Such small balances would not have much effect on private banks or the rates that they set for borrowing and saving. Most of the money in our banking system is owned by a few thousand wealthy families who have very low marginal propensities to consume and would probably not bother taking the time to move such a relatively small amount of money. However, the total increase in savings by hundreds of millions of Americans could amount to billions of dollars in reduced spending. Most prices would stabilize in the face of such a substantial reduction in consumer demand.

Too often policy is devised by politicians, who interact with the bankers, doctors, and lawyers who represent the small minority of Americans who are exceptionally wealthy. Instead we need to target middle class families who would save more money and spend less if offered a high enough interest rate on relatively small amounts of savings. This could be done by creating Federal Reserve digital currency bank accounts for every American. To combat excessive inflation very high interest rates could be offered on small balances for only one account per Social Security number. Anyone else in the world would be allowed to have a digital currency account with the Federal Reserve (unless sanctioned by Congress) but they would not be allowed to earn interest on their account balance. The Federal Reserve is currently considering the possibility of offering such digital currency bank accounts, and I have answered the 22 questions they have asked on how this new policy tool could be implemented. Going forward we will see if they follow my never-too-humble advice.

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Stock Market: Prudent Investment or Gambling Casino?

My father, Edward Cady Marsh, was a Wall Street investment banker. He took the train in to Wall Street each morning from Westfield, New Jersey and returned in the late afternoon. He specialized in industries such as the automobile industry, the steel industry, and the grocery industry. His compensation was based in part on his recommendations to the board, regardless of whether the board accepted and acted on his recommendations. As someone who lived through the stock market exuberance of the late 1920s and the crash and depression thereafter, he was very aware of the downside of stock market investing.

I learned early on that the profitability of a company was only one aspect to consider. The stock’s price was of equal importance. Overpaying for a very profitable company’s stock could be just as big a mistake as buying a cheap stock that had poor profitability prospects. Another factor that retail investors often overlook is the time horizon of stock market pricing. My own experience suggests that the typical stock is evaluated on a six month return basis. In other words, on average the market appears to be pricing stocks on the basis of how well they are expected to perform in six months. After the Great Recession the stock market bottomed out in March of 2009, but the economy took about six months before it was clearly heading up again.

If you get into a great stock too early, your investment may just flounder around rising and falling without much direction before it finally takes off, whenever that might be. Getting in to a good stock too early can be just as bad as getting in too late after its price to earnings ratio has reached unrealistic levels.

Another common mistake made by retail investors is sitting on too much cash and not investing for fear of short term losses. The general pattern of the stock market is to fluctuate up and down for some time and occasionally slip into a bear market, but, more importantly, suddenly move upward to establish a new level. It is these sudden upward moves, when you have too much of your investable funds in cash, that can make stock investing unprofitable. Many studies have pointed out that missing out on just of couple days of extraordinary gains in a very profitable year can eliminate most of the profit.

For the retail investor, investing in individual stocks can be very dangerous. Although most stocks tend to move up and down with the market over the short run, individual stocks can drop dramatically or move up unexpectedly. For the retail investor, investing in individual stocks is more akin to gambling that investing. As a retail investor, I have benefited from investing in broad market index funds with very low expense fees. Professional investors are much better positioned to determine which stocks are best to invest in at a particular price and time. However, sorting out the good professional investors from the bad and overcoming the fees charged by professional investors might not be worth the time and trouble. Index funds with low fees can sometimes be more cost effective and efficient than actively managed funds.

Clearly there are trends that may signal substantial increases in profitability going forward. A professional investor might consider whether the time is right to invest in stocks of companies producing lithium in anticipation of a big increase in the sales of electric vehicles that require lithium batteries. But what if there is a breakthrough in battery technology that replaces lithium with some other ingredient? In that case, the value of lithium stocks could drop dramatically.

Individualized medicine is another area ripe for expansion in coming years. Most of our doctors do not even have a sample of our DNA. Moreover, the randomized trials compare the average person’s response in the experimental condition with the average person’s response in the control condition to determine the statistical significance of the average person’s response to a drug or other medical intervention. But if the distribution is bimodal with half the people at one end and the other half at the other end, the average person may not exist. With more and more individualized data becoming more widely available, a professional investor may want to consider investing in companies with personalized medical data (e.g., DNA) that are able to zoom in to subsets of individuals sharing common characteristics to get closer to the uniqueness of an individual patient in order to provide individualized diagnosis and prognosis. For the retail investor these potential breakthroughs may introduce too much uncertainly and potential volatility but may be of interest to the professional investor.

Finally, one might consider the use of leveraged funds. Such funds provide multiples of the price movements of their corresponding indices either in the same direction (leveraged longs, UDOW) or in the opposite direction (leveraged shorts, SDOW). The opposite strategy would be to seek out the least volatile stock indices which tend to the ones that emphasize dividends. One approach might be to move from a broad based stock index fund into a fund emphasizing dividends when the stock market seems overextended in an irrational exuberance phase. If one is really into gambling, substituting broad-market leveraged shorts would be an alternative strategy at such times. On the other hand, when the stock prices have fallen significantly, one could move into broad-market leveraged longs, which could dramatically increase yields when (and if) the market recovers. Note that the expense ratios for these leveraged funds tend to be quite high and may be restricted to accredited investors.

In general, successful stock market investing requires being reasonably cautious and very patient. Most importantly, the investors style and strategy must match their personality. What works for one person may be entirely inappropriate for someone else. If you become distraught and tear your hair out when your portfolio’s value drops with a market decline, including a bear market that lasts for some time, then your style and strategy do not match your personality.

( Note none of the above commentary should be considered professional investment advice. This commentator does not accept any responsibility for losses incurred as a result of reading this commentary. Investors who want professional advice should seek out a professional investment advisor.)

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Why Punish the Poor to Stop Inflation and Make It Harder for Firms to Increase Supply?

Why Punish the Poor to Stop Inflation and Make it Harder for Firms to Increase Supply?

When the Federal Reserve raises interest rates in New York financial markets, it becomes harder for businesses to borrow, which causes businesses to cut hours, lay off workers and close outlets. This is an indirect and rather brutal way to reduce demand for goods and services that also reduces supply. The effect is to make it harder for firms to increase supply and harder for people working paycheck-to-paycheck to handle medical emergencies, automobile accidents and other situations where they need a small loan just to get by.

But trashing the economy to stop inflation is not necessary. A more direct, more efficient and more effective way to stop inflation is possible. When the demand for goods and services exceeds the supply, prices rise. Demand can be reduced with either a carrot or stick approach. Why use the stick of raising interest rates on loans that punishes poor people facing a personal crisis and businesses that want to supply more, and instead offer the carrot of higher interest rates on savings to get people to voluntarily put off unnecessary spending and save some money?

In 2018 Senator Kirsten Gillibrand introduced Senate bill S.2755 as “The Postal Banking Act” as a way to use post offices to restore the “The Postal Savings Act” of 1910 which allowed people to cash checks and set up savings accounts in the over 30,000 post offices throughout the United States from 1911 to 1966. Senator Gillibrand sought to use our local post offices as a venue for the poor to get small loans to deal with various crises without becoming prey to loan sharks, pawn shops, payday loan dealers, or “cash now” providers who typically charge exorbitant interest rates.

The Federal Reserve is already considering creating a central bank digital currency (CBDC) as China and several other countries have already done. The Federal Reserve could use post offices as physical locations to access individual CBDC savings accounts. People could also register their smartphones at post offices for more direct and immediate access to their CBDC accounts. When excessive inflation threatens, these CBDC accounts could offer a high interest rate on savings. Encouraging people to save money and spend less will reduce the excess demand where too much money is chasing too few goods and driving up prices.

Ordinarily, to make a profit a bank must charge a higher interest rate on loans than it pays on savings. But as the creator of money, the Federal Reserve is in a unique position. To reduce demand for goods and services, the Fed can offer a higher interest rate on savings. However, in line with “The Postal Savings Act” of 1910 and in order to avoid disrupting commercial banking, the Fed will need to set a limit on the size of savings accounts. With one account per Social Security number and a limit of $10,000 per account, the Fed can avoid competing with private banks for the large savings of wealthy investors.

Encouraging people to build up their savings will also serve as an automatic stabilizer for the economy. Whenever an economic downturn threatens, people with savings do not have to cut their expenditures so dramatically. This avoids a sudden drop in expenditures which would just make economic downturns more severe. A larger pool of savings would shorten and lessen the severity of recessions.

If everyone had a Federal Reserve bank account accessible from their computer or smartphone, it would become easier to transfer money. If someone cuts your grass, rakes your leaves or shovels your snow, you can pay them easily with a smartphone-to-smartphone transfer between your individual Federal Reserve accounts.

Alternatively, when inflation is low and unemployment rises, the Fed could lower the interest rates on both savings and loans to help stimulate the economy. This new tool would give the Fed much tighter control in meeting its mandate of maintaining full employment with stable prices.

Large banks already have bank accounts with the Federal Reserve. There is no reason why the rest of us couldn’t also have bank accounts with the Fed. The rise of digital currencies, especially stablecoins, threaten the Federal Reserve’s dominance and control over our currency. By setting up digital currency smartphone postal savings accounts for every American, the Fed can reestablish its control over our currency and gain a much better way of dealing with the challenge of excessive inflation on one hand and high levels of unemployment on the other.

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Distorted Money Flow Creates Chronic Disequilibrium in our Economy

January 7 – 9  is the American Economic Association Conference with 115,000 economists attending virtually where I present a rough draft of my new book in a poster session, followed later by a presentation at the Midwest Economics Association meeting in Minneapolis. Instead of emailing you my 70+ page research paper, I am providing below the content of the PowerPoint slides that summarize the paper.  

 “The Public Banking Act ” Should Allow for Individual Federal Reserve CBDC Bank Accounts (“FedAccounts”) To Transform Monetary Policy.  Adjusting interest rates on Wall Street is ineffective in stimulating and too brutal in slowing the economy, but injecting stimulus money and adjusting interest rates on small individual consumer Federal Reserve bank accounts could impact consumer demand more effectively and more immediately.  Note the author’s  proposal for stopping inflation using “FedAccounts” at: https://www.youtube.com/watch?v=nnMT7DVyK0g This follows from the money flow paradigm in the author’s book “Optimal Money Flow” which also considers the case of deflation where aggregate demand is inadequate to match aggregate supply which is summarized on YouTube at: https://www.youtube.com/watch?v=-hqBD3ZEhIM  

Digital Currency Threat => Will Central Banks lose control of money?  Banks creating their own money caused bank panics that continued even after adopting a common currency (dollars).  Wide use of private digital currencies could cause excessive volatility, tax avoidance, and criminal activities. Central Banks need to create their own digital currencies.

STOP  INFLATION without causing a RECESSION. The supply-side tool of raising interest rates in New York financial markets causes layoffs as businesses cut back. Don’t trash the economy to stop inflation. A demand-side tool can be created to stop inflation more effectively and more efficiently.  

Control demand to avoid economic downturns. NYC financial markets already have more money than can be put to work. Lowering interest rates further and supplying more money is just “pushing on a string.” A demand-side tool can be created to stimulate economy more directly using much less money. 

Velocity of Money Falls => Milton Friedman  M V = P Q  inflation always a monetary phenomenon with V (velocity) constant, and P (prices) constant only if M (quantity of money) rises at same rate as Q (economic output) rises. But V falls as population ages. And V falls as economic inequality increases. To keep Q growing at full employment, M must rise faster than V is falling so P can be constant.

Adam Smith =>  Two  Invisible  Hands: 1. Economic competition (lower prices). 2. Economic concentration (higher prices). USA economy has become less competitive with greater oligopoly and monopoly (as well as oligopsony and monopsony) power. See Jonathan Tepper’s book: “The Myth of Capitalism” about the dramatic drop in competition in the USA economy.

Pure Profits at Zero Marginal Cost => The explosion of information on the Internet has produced a commodity with essentially zero marginal cost. For example, with premium access you can gain access to extra information that already exists but only requires changing a zero to a one in computer code for you to access, which is done automatically when you make your payment for premium access. See book by Jeremy Rifkin: The Zero Marginal Cost Society. New York: St. Martin’s Press, 1014.

Profits rise as labor and capital shares fall => Barkai (2020) calculated the capital costs for the U.S. non-financial corporate sector over the period 1984 to 2014 and found that while labor’s share has dropped by 11 percent, the share of real capital has declined 22 percent with a corresponding increase in pure profits. Barkai, Simcha. “Declining Labor and Capital Shares.” The Journal of Finance, 75(5), pp. 2421-2463. 2020.  https://doi.org/10.1111/jofi.12909 

Distorted Money Flow => extreme wealth inequality leads to instability. Most of the money flows to the already wealthy who put it into the New York financial markets (stocks and bonds). The money flow has become so distorted the middle class can no longer afford to buy back the value it creates. Individuals go deep into debt while the government runs large deficits to keep the economy from sliding into recession. However, recently a combination of a large stimulus and COVID related supply shortages temporarily disrupted this chronic problem of inadequate demand relative to extensive global supply.

Disequilibrium Economics => Hyman Minsky explained that while most markets for well-defined goods and services move toward equilibrium, the economy as a whole and especially the financial markets are prone to swing between an upward irrational exuberance and a downward recessionary spiral. As John Maynard Keynes said: “In the long run we are all dead. Economists set themselves too easy, too useless a task if, in tempestuous seasons, they can only tell us that when the storm is long past the ocean is flat again.”

Darwinian Natural Selection Paradox => As countries reach about $6,000 per capita, birth rates drop like a rock, eventually falling below the 2.1 replacement rate. Wealthy and well-educated countries and families have fewer and fewer children in recent decades. Instead of success in education and wealth breeding bigger populations, human populations fall dramatically. As world population shrinks to zero, last one remember to “turn off the lights.”

Private and Public Debt => Decline of unions and Citizens United’s one dollar = one vote cuts workers’ real pay. Middle class unable to buy back the value of the goods and services it produces. Low pay and low interest rates drive people on Main Street deep into debt as more and more money flows to Wall Street. Government debt needed to fill in for the money flow going to Wall Street to maintain full employment.

Financial vs. real economy => Money flow to wealthy goes mainly into stock and bond markets on Wall Street driving down interest rates and inflating stock prices. Large amount of money not used for real investment (physical and intellectual) but goes into financial investments (dividends and stock buybacks). Consequently, the middle class is unable to purchase the value of the goods and services it is capable of producing at full employment.

Money Flow Paradigm => George Cooper in “Fixing Economics” identified key problem of too much money flowing to Wall Street and not enough money flowing to Main Street. Government sets the rules and regulations, and provides the money for free enterprise system. Government investment in common property resources is key to economic efficiency and growth. See Mariana Mazzucato’s 3 books: The Entrepreneurial State, The Value of Everything, and Mission Economy. 

The Age of Oversupply => Globalization and the collapse of communism. Cheap labor makes large quantities of high quality products available at very low prices and leads to deflation in prices of goods and services when demand is inadequate relative to enormous global supply. Read Daniel Alpert’s book: “The Age of Oversupply.”

Policy Driven Excess Supply => Chinese take resources and work hard to make products for USA in return for pieces of paper with George Washington’s picture on it. To keep Chinese products inexpensive for USA and Chinese workers employed, China collects USA dollars and buys U.S. Treasury securities in New York financial markets instead of driving down value of dollar in foreign exchange markets.

Antithesis of Say’s Law => population growth > food supply  reversed!!! Global supply exceeds demand when too much money flows to Wall Street and too little money left on Main Street. Supply-side economics replaced with demand-side economics. “Supply creates its own demand” replaced with “Demand creates it own supply.”

Distorted Money Flow => extreme wealth inequality leads to instability. To understand how “Distorted Money Flow” can become “Optimal Money Flow” visit the following website: https://optimal-money-flow.website/  For more information on the author visit the author’s public website at: https://sites.nd.edu/lawrence-c-marsh/home/ 

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Lawrence C. Marsh is Professor Emeritus in Economics at the University of Notre Dame and author of the 2020 book: Optimal Money Flow: A New Vision on How a Dynamic-Growth Economy Can Work for Everyone
You can donate the entire purchase price of the book to student scholarships by buying a hard-bound copy of the Optimal Money Flow book at the Avila University Press website at:  https://www.avila.edu/aupress/optimal-money-flow-by-lawrence-c-marsh with no charge for shipping and handling.  

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