Once again we are using a dysfunctional approach to stopping inflation. Inflation is when too much money is chasing too few goods. But the Federal Reserve relies solely on a cost-of-borrowing tool, which suppresses supply as well as demand, instead of using a return-on-savings tool to absorb excess demand by getting people to spend less and save more.

When I was a young boy in the 1950s, you could go to any post office and set up a savings account. The Postal Savings Act of 1910 allowed for postal savings for 56 years from 1911 to 1966. The postal savings accounts were limited in size so you couldn’t put in much money. If postal savings accounts existed today, a high return on savings could get the marginal saver to put off buying that new phone or television and save the money. Getting people to save more and spend less will slow inflation.

The Federal Reserve is raising interest rates, which is shifting demand (and inflation) from goods that require a loan (automobiles and homes) to ones that don’t require a loan. By raising the cost of borrowing, the Federal Reserve causes businesses that rely on credit to cut hours, lay off workers, and close outlets. It is suppressing supply! But it also suppresses demand, because less money to workers means less demand for goods and services. You can’t spend the money you don’t have. That slows inflation, but at a great cost to the people with the most debt – the poorest Americans. It could also push our economy into a recession.

Most poor people are too poor to save any money. The wealthy just move their money around to get the best return on savings without changing their consumption behavior. Any attempt to reduce excess demand needs to target the marginal saver, who typically earns around $50,000 a year and is among the two-thirds of Americans with no college degree. Getting marginal savers to save more and spend less will help slow inflation. To divert money from spending to saving, any opportunity for a high return on savings needs to be vigorously promoted and advertised at popular athletic contests, Nascar races, and other venues frequented by the marginal saver.

Some observers claim that 30-year U.S. Treasury I-bonds already offer a high return on savings. I-bonds work well for the wealthy, but the severe withdrawal restrictions make I-bonds a non-starter for the marginal saver, who needs immediate access to their money to deal with an automobile accident, a medical emergency, or an unexpected rent increase or job loss.

Why rely exclusively on the stick of a cost-of-borrowing tool and ignore the carrot of a return-on-savings tool? Congress needs to recreate the Postal Savings Act of 1910 and bring in the Federal Reserve to oversee savings accounts at our 30,000+ post offices. With inflation running between 6 and 7 percent, postal savings accounts could offer 10 percent on savings with a limit of no more than $10,000 per person to avoid the transfer of large amounts of money.

When the Fed acts to slow the economy, banks cut back on loans in fear of an economic downturn. You can’t rely on them at such times to offer a good return on savings. Under our fractional reserve banking system, they typically have excess reserves and don’t want more money. Banks don’t want to pay for additional deposits to get money they don’t need and won’t use.

Congress needs to act now to authorize the Federal Reserve to create savings accounts at the 30,000+ post offices throughout the United States and offer a 10 percent return on savings. Getting people to save more and spend less will slow and eventually stop inflation without causing a recession.

Once excessive inflation is fully suppressed, then the promotional advertising of postal savings accounts can be dropped and the high interest rate on postal savings can be lowered. Thus, this new return-on-savings tool can be used to counter the irrational exuberance during booms that drives inflation and the excessive contraction of the money supply by private banks during economic downturns.

Adam Smith’s invisible hand of competition has long be heralded as a mechanism for turning greed into good. Each business owner seeking their own profit works hard to make better quality products and, in competition with similar businesses, offers these products at ever lower prices. Some take this free enterprise message to an extreme and declare that “Greed is good.” Not quite. A purely greedy person, defined as someone who plays I-win-you-lose or winner-take-all, does not appreciate the need to meet the needs of others. But ultimately free trade must be a win-win situation. When you go to the store, you get what you want. But the business owner also gets what he or she wants – your money. You both win.

In some sense we all want to feel good about ourselves. But feeling good may come about through a win-win strategy of helping others or through an I-win-you-lose strategy of taking from others. A burglar may feel good about pulling off a clever burglary. The I-win-you-lose strategy tends to be a short-term strategy that more often than not fails in the long run with a failed business or an extended stay in jail.

With a very low return, your suppliers may be able to continue to supply your business with the inputs you need in the short run, but in the long run your suppliers must cover both their variable costs and ultimately their fixed costs. As long as your suppliers are covering variable costs, you may be able to pressure your suppliers to provide those inputs at a very low price. But when your suppliers’ equipment wears out or rental contracts end, your stinginess in cutting your suppliers’ profits to the bare bones may backfire as your suppliers refuse to continue supplying you at prices that fail to cover their full costs. Suppliers may choose to shift their production to supply businesses that are more reliable and willing to pay more. Business relationships matter so playing hard ball with your suppliers may not a good long-term business strategy.

Moreover, in focusing on their own money flow, individual businesses may lose sight of the bigger picture of the money flow in the overall economy. On an isolated island, a business owner that owned the only general store, bar and restaurant would quickly realize that being too stingy with their store, bar and restaurant workers and with the farmers and fishermen that supplied the food would cause their customer base to dry up. Keeping the businesses going would mean paying people enough to be able to maintain a good money flow. Increasing the money flow or velocity of money would mean raising the annual production and distribution of goods and services until the yearly limits of consumption and work effort reached their natural limits. Here again the win-win strategy wins out. Being too greedy in maximizing short-term profits may undermine the long-term profitability of the business.

Just as the sole owner of a lake understands that fish are a resource that can be destroyed by overfishing, a sole business on an isolated island may come to see money flow as a common property resource problem. But what if other businesses come to the island. As more and more businesses establish themselves on the island, each business wants the other businesses to provide the money flow to customers and suppliers but naturally wants to act as a free rider in not having to pay more itself. In other words, money flow as a common property resource exhibits the moral hazard problem of businesses losing their motivation to contribute fully to the island’s money flow to ensure full resource utilization including the full employment of the farmers, fishermen, and workers. Ironically, this common property resource problem that motivates business owners to pay as little as possible creates slack in the labor and resource markets that further enables businesses to pay less. This has been referred to as the reserve army of the unemployed. Consequently, we see that the economic conditions that work best for individual businesses do not always correspond to full employment utilization and maximum production.

Other common property resource problems include the failure of individual businesses to create and pay for interstate highways or standing armies. Even locally, maximizing productivity and overall production may require the building of roads and bridges. Electricity and water supply may require the establishment of a natural monopoly that must be regulated by government for the common good. Positive externalities in the form of vaccination for highly contagious diseases and negative externalities such as water and air pollution all provide examples of where government intervention is needed to ensure the efficient allocation of resources, which is the very essence of the economic problem.

What this all boils down to is that government plays an essential role at the heart of the free enterprise system. Without government, the system would fail to allocate resources efficiently and would fail to maximize productivity and overall production. Getting the money flowing to allow businesses to prosper means imposing taxes to benefit everyone in achieving the optimal money flow for the economy as a whole. When applied fairly and efficiently, taxes and the corresponding government expenditures can contribute to the common good as a key part of the win-win strategy that makes us all better off in the long run.

While the Federal Reserve is trying to decide whether to recommend that Congress authorize creating a central bank digital currency (CBDC) for the United States, many other countries have already committed to creating their own CBDCs to avoid having their currencies replaced by Facebook’s Diem or some other stablecoin that has established or will establish strong financial networks. Dubbed “FedAccounts,” a Federal Reserve CBDC would provide a basis for a new return-on-savings monetary policy tool.

To serve as a tool for monetary policy, a Federal Reserve CBDC would need to be account-based (“FedAccounts”) as opposed to token-based. To protect individual privacy, while still deterring criminal behavior, the names and identifying information of account holders (including some personal transactions) would be kept in a separate file from their general transaction histories. The two files would be linked by a 60-digit alphanumeric code. If authorities observed suspicious activity in the general transaction histories, they would need a judge’s permission to access the corresponding identifying information file.

In addition to the 60-digit alphanumeric code, the transaction histories file would contain a single-digit yes-or-no dummy variable indicating whether this account had an associated Social Security number. This would be important, because only accounts with an associated Social Security number could earn a high positive interest rate during an inflation and that positive interest rate would only apply to a base amount of no more than $10,000. If $12,000 were in an account with a Social Security number, only the first $10,000 would earn the high positive interest rate, while the remaining $2,000 would be subject to a negative interest rate, as would all the money in accounts without a Social Security number. Anyone in the world could use US dollars to create their own US Federal Reserve “FedAccount.” People in Zimbabwe or Venezuela experiencing very high inflation in their local currency may be glad to pay a small or modest negative interest rate for the security and safety of holding their money as US dollars in FedAccounts.

To stop inflation the Federal Reserve has been raising the cost of borrowing, which suppresses supply as well as demand. Businesses that can’t afford the higher cost of borrowing may have to cut hours, lay off employees, or close outlets. Lower income people are generally the ones with the most debt so they get hit the hardest when the cost of borrowing goes up. If the economy slows because of the rate increase, it is the lower income people who are most likely to be unable to make their mortgage payments and lose their homes to foreclosure.

The current world-wide inflation is due in large part to the COVID-19 supply disruptions which are continuing. We have forgotten when we had to absorb excess demand to fend off inflation in the face of the mother of all supply disruptions at the beginning of World War II. We suddenly had to transition from civilian cars and trucks to tanks, armored personal carriers, warplanes, and warships. We also had to send a lot of our young, male workforce overseas to fight the Nazis in Europe and Imperial Japan in Asia. We needed a way to absorb a lot of money that would otherwise go to consumer demand to ward off inflation. We did it with “Liberty Bonds.” Celebrities were singing and dancing in promoting “Liberty Bonds.” Billboards and radio broadcasts were intensely advertising “Liberty Bonds.” By the end of he war, about 50 percent of American families had purchased “Liberty Bonds.”

It would be great if we could do the same with U.S. Treasury Direct Series-I bonds. For six months ending October 31, 2022, the 30-year I-bonds were paying 9.62 percent interest. Beginning on November 1, 2022, I-bonds are now paying 6.89 percent interest. A major problem preventing I-bonds from absorbing excess demand to stop inflation is the severe withdrawal restrictions that I-bonds currently enforce. No withdrawals are allowed for the first year, and there is no secondary market for I-bonds. Withdrawals after the first year are heavily penalized up until the end of the fifth year. This does not work for marginal savers who need immediate access to their money in case of an automobile accident, a medical emergency, an unexpected increase in rent, or a job loss. Yet it is the marginal savers with relatively high marginal propensities to consume who can stop inflation by saving their money to reduce excess consumer demand.

An alternative approach would have been the postal savings accounts that existed under “The Postal Savings Act of 1910” where for 56 years from 1911 to 1966 anyone could go to any post office in the United States and set up a savings account. The amount of money allowed in these accounts was severely restricted so it was aimed at people with only small amounts of money to save. But, again, the marginal savers with relatively high marginal propensities to consume are the very ones we want to influence to save more and spend less. If these postal savings accounts still existed, they could be used to absorb excess demand to stop inflation without causing a recession by offering a very high interest rate and heavily advertising them.

To make these accounts as attractive as possible to lower-income people, any interest earned in the new CBDC “FedAccounts” should be tax free. Every baby born in the United States should be assigned a Social Security number and a FedAccount at birth with $1,000 put in it, which could not be withdrawn until age 70. However, any interest in the account could be withdrawn at any time along with any additional money put into the account. This would make these CBDC accounts as attractive as possible. With everyone having a FedAccount, whenever someone cut your grass, mowed your lawn, or shoveled your snow, you could pay them instantly with a smartphone to smartphone transfer from your FedAccount to their FedAccount.

Finally, when an economic downturn comes, the Federal Reserve can use the FedAccounts with Social Security numbers to offer small low-interest-rate loans and give stimulus money directly to the people on Main Street to stimulate the economy as necessary instead of going through the New York financial markets on Wall Street. This new monetary policy CBDC tool would provide the Fed with more bang for the buck in controlling our economy more efficiently and more effectively in avoiding both recessions and excessive inflation.

( Note: Economists at the Bank of England have asked me to present my paper entitled: “New Central Bank Digital Currency (CBDC) Monetary Policy Tool” in their Bank of England session at the American Economics Association Conference in New Orleans on January 8, 2023. If you would like to see the abstract (“View Abstract”), the PowerPoint slides (“Presentation”), or the paper itself (“Preview”), you can find them at this link: https://tinyurl.com/2wr39xak )

Larry => be sure to go into html mode in MailChimp to hyperlink both this tinyurl and the link to this ND Economist commentary.

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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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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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“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. )

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.

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.