The Money Flow Paradigm

The long-term fundamental problem facing our economy is the enormous diversion of money flow from everyday people on Main Street to investors in the New York financial markets on Wall Street. This diversion began in the late 1970s and early 1980s and has continued in subsequent decades such that the people on Main Street are no longer able to buy back the value of the goods and services that they produce at full employment. This distortion in the money flow has driven up stock and bond prices and driven down interest rates and caused a majority of Americans to pile up large amounts of private debt. Yet this has not been enough to maintain full employment so the federal government has had to run large deficits under both Republican (massive tax cuts) and Democratic (massive stimulus spending) to keep most of the labor force fully employed. This has resulted in an ever increasing level of both private debt and public debt.

The money flow paradigm recognizes how the financial economy has become more and more separated from the real economy and how the diversion of the money flow from Main Street to Wall Street has become a serious problem that undermines economic stability by producing both inflations and recessions and requires the continual vigilance and action by those responsible for both our fiscal and monetary policies. The financial economy has become more of a gambling casino and less of a venue for providing money for investment in the production of new goods and services in the real economy.

During the French revolution Marie Antoinette was reported to have said: “Let them eat cake.” Today Marie Antoinette is essentially saying: “Let them eat plastic” as credit cards are widely distributed as an alternative to rewarding hard work and creativity with adequate compensation. Roth accounts reward heirs with tax-free inheritances while income taxes are used to undermine work incentives and discourage workers and entrepreneurs.

Several commentators have pointed out that the most important choice you make in your life is your choice of parents. If you choose rich, well-educated parents, you have a very high probably of doing well financially, while those who have chosen poor, poorly-educated parents cannot expect to get very far financially. Hard work pays off, but not for the person doing the hard work. The workers’ hard work pays off for the shareholder who reaps the reward for many years after an initial investment, which keeps doubling in value under compound interest and dividend reinvestment.

By following the flow of money, the money flow paradigm makes the problem clear, especially since the investors on Wall Street typically have much more wealth and, therefore, much lower marginal propensities to consume than the people on Main Street. The top ten percent of wealthy people purchase new goods and services with only about 8 percent of each additional dollar while the bottom ten percent in wealth consume about 94 percent of every additional dollar on new goods and services. Giving more money to those on Wall Street is very ineffective in stimulating the economy. Such attempts to stimulate the economy during economic downturns have been described as pushing on a string. Clearly you can get more bang for the buck by stimulating the spending of the people on Main Street instead of trying to stimulate the economy by buying bonds and mortgage-backed securities from the people on Wall Street. Applying Milton Friedman’s negative income tax, which targets low income people, would be much more effective and get much faster results than giving more money to the wealthiest Americans who just buy more stocks and bonds or bid up the price of Picasso paintings and exclusive properties with little or no effect on the production of new goods and services in the real economy.

Conversely, when excessive inflation is the problem, raising the cost of borrowing by increasing interest rates in the financial markets suppresses both supply and demand with the economy driven towards recession. A business that has maxed out its production trying to satisfy excessive demand with its existing lines of production would like to add another line of production but finds that the cost of borrowing the needed funds has gone up making it harder to afford a new line of production to increase supply. Meanwhile on the demand side the people hurt by the increase in the cost of loans are those trying to replace their rusty truck or obtain a mortgage to buy a new house. These tend to be the lower income people who do not have the cash on hand to buy a vehicle or a home without a loan. Why do we continue to use a cost-of-borrowing tool to fight inflation that suppresses supply and punish the poorest Americans in a very ineffective manner when instead we could be using a much more efficient return-on-savings tool?

The money flow paradigm tells us that a much more effective and efficient method of suppressing inflation is to increase the return on savings substantially without increasing the cost of borrowing. Private banks cannot afford to do this because they must earn more on loans than they pay on savings. But the Federal Reserve, which generates many billions of dollars in profits from its investments each year, is in a position to offer high interest rates on savings. In effect this is what was done at the start of World War II when the supply of new consumer goods and services was dramatically disrupted by switching to the production of tanks, warplanes, and warships and sending large numbers of young men to fight in Europe and Asia. High interest rate war bonds were vigorously promoted with celebrities singing and dancing and extensive advertising throughout the war until approximately 50 percent of American families had purchased war bonds. This helped substantially in constraining demand for consumer goods and avoiding inflation.

The Postal Savings Act of 1910 allowed anyone to go to any post office and set up a small savings account. Such savings accounts were restricted to some maximum allowable amount and were available to all Americans for over 50 years. Such government sponsored savings accounts still exist in a number of other developed nations. However, this promotion of savings by Americans was discontinued in 1966. Were such accounts available today, the government could offer an exceptionally high interest rate on savings to get low income people to put off buying that new pair of shoes in favor of investing $100 into their own postal savings account. As with the war bonds during World War II, this would provide a return-on-savings tool that would directly impact the real economy on Main Street instead of using the cost-of-borrowing tool that operates through Wall Street and suppresses both supply and demand and typically leads to a recession. Getting people to save more not only gives them a savings account to help them deal with an unexpected rent increase, a medical emergency, an automobile accident, or a job loss, but also provides the real economy with an automatic stabilizer to allow the economy to absorb some financial disruptions without triggering inflations and recessions.

By following the money flow, the money flow paradigm provides a much deeper and more realistic understanding of our economy and what we need to do to avoid inflations and recessions. It is much better at explaining how economics actually works than the old neoclassical, monetarist, and Keynesian paradigms and their more recent variations.

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