Over-Rewarding Passive Investors Undermines Productivity and Economic Growth

There are two types of investors: (1) active investors working to create new and better products as well as greater efficiency and productivity on a day-by-day basis inside their company, and (2) passive investors who may or may not even remember that they have invested in the company either directly or indirectly through mutual funds, exchange traded funds and other such remote means. It is important to distinguish between these two fundamentally different types of investors.

Free enterprise is all about incentives to drive economic growth and productivity in a free market economy. Rewarding creative entrepreneurs and their employees is the key to maximizing the long-run profits for an individual company and to bringing about the efficient allocation of resources for the economy overall. Money diverted away from rewarding creative entrepreneurs and their employees undermines these objectives. Such diversion under the goal of maximizing shareholder value has been examined by law professor Lynn Stout in her book The Shareholder Value Myth. Stout explains that the maximization of shareholder value has been carried out under the assumption that the shareholders own the company and deserve the lion’s share of the profits. She systematically examines this claim and emphatically rejects this assumption both on legal and practical grounds. In the long run maximizing shareholder value works to reduce a company’s long-run profitability and hurt the free market’s ability to bring about the efficient allocation of resources. It is bad for the company and bad for the efficiency of free enterprise.

Doesn’t the free market take care of this by bringing about the failure and ultimately the bankruptcy of the inefficient businesses? Doesn’t Schumpeter’s “creative destruction” get rid of unsuccessful enterprises? No, not if a big firm has been successful in blocking entry by creating barriers to entry such as with economies of scale, as with Amazon, or network effects, as with Facebook. Many dominant firms buy up rivals or run them out of the market. A small, efficient family restaurant may be quite profitable during normal times, but be driven into bankruptcy during a pandemic or an economic downturn. More often than not, Schumpeter’s “creative destruction” should be called “competition destruction” when the key to survival during a recession is possessing an enormous amount of cash on hand as provided by uninformed and/or speculative passive investors. The key is to exploit first mover advantage by effectively blocking the entry of potential competitors. 

Financial markets were created to provide funds for entrepreneurs to pursue potentially profitable enterprises. The financial economy exists to supply the real economy with funds for this purpose. Passive investors typically take on considerably less risk through diversification than the active investors who are putting in a great deal of their time and effort to create, maintain and improve a particular profitable enterprise. Logically, those taking the greater risk should be receiving the greater reward. A reversal of this principle could bring about a reversal in the money flow and undermine the objectives of free enterprise both for individual businesses and the economy as a whole. Financial markets exist to provide money for real investment in productive enterprises in the real economy. A reversal of the money flow takes money out of the real economy and, thereby, reduces the money going into the creation of new products and services and improvements in productivity that require some monetary investment. 

The owners of most of the stock in the New York stock market are not a random draw from our population. They are not representative of typical Americans. Two-thirds of Americans do not have a college degree. Sixty percent are living paycheck to paycheck. Consequently, it should be no surprise that eighty-four percent of stocks are owned by the ten percent wealthiest Americans. This is important because it tells us about the marginal propensity to consume of the typical stock owner (very low) compared with the average American (quite high). Just as you can only wear one pair of shoes at a time, you can only drive one car at a time. Having more than a few cars quickly becomes a hassle in maintaining each vehicle and carrying out the required inspections and license renewals. How many exclusive vacation homes do you want to have to take care of? One or two might be all you really need or want. How many fancy restaurants do you want to frequent in the typical day? If you are already very rich and gain more money, will the additional money cause you to go out to eat at your favorite fancy restaurants more often? You would quickly hit the limit of seven days a week and three times a day.

Once you have a few million dollars, it is the relative amount of money and not the absolute amount of money that you have that matters. At that point the objective is to feel good about having more money that someone else. Perhaps the Federal Reserve chair, Jerome Powell, with a net worth of about $55 million feels good about having more money than the Treasury Secretary, Janet Yellen, whose net worth is only around $16 million, or Janet Yellen’s husband, Nobel prize winner George Akerlof, whose net worth is reported to be only $5 million. Taxing the wealthy in a fair and equivalent manner would not alter the relative ranking and certainly not prevent millionaires from going to their favorite expensive restaurant as often as they want.

People with lots of money are already consuming as much as they want so there is no compelling reason to want to or need to consume more. Aside from bidding up the price of Picasso paintings or buying up exclusive properties, what else is the typical rich person going to do as an alternative to investing in the financial markets? If there are no attractive investments, would they take their money home and stuff it in their mattress, or pile up a large number of one hundred dollar bills in the family room? If there were no place to invest their money, they would probably be willing to pay a bank to hold onto their money for them, which is why banks were created in the first place. After all, banks were created when gold miners took the gold they were accumulating in their tent at the riverside or mine site and took it to the bank in exchange for a note of deposit. Such notes eventually became transferable to become circulating money.

Do CEOs and company presidents always act as entrepreneurs or does their compensation packages sometimes lead them to divert money to artificially jack up the company’s stock price in the short-run in a manner that maximizes their short-term compensation but undermines the longer-term profitability of their company? Often their compensation package provides for a golden parachute to benefit them when they leave the company even if their decisions were not in the best interest of maximizing the long term profitability of the company. Steven Clifford, who served on a number of corporate boards, helps us better understand executive compensation in his book The CEO Pay Machine where he explains that such compensation is not the result of the free market forces of executive supply and demand, but very much the result of a rigged system. Too often corporate board members turn out to be the CEO’s golf buddies. When CEOs also serve on the corporate boards of the CEOs on their own corporate board, they reward one another by maximizing each other’s compensation. You vote to maximize my pay, and then I’ll vote to maximize your pay. Often a corporate board member’s knowledge of the company may be limited to the reports provided by the CEO that explain what a great job the CEO is doing.

Germany has recognized this problem and requires that a certain proportion of corporate boards be elected directly by the company’s employees. This requirement allows for corporate board representation from product development, production, marketing, sales, and product distribution. The United States needs to follow Germany’s example of requiring employee representation on corporate boards in order to direct more money towards improving companies and their products and away from diverting excessive amounts of money to passive investors by bidding up short-term stock prices.

A classic example of this problem would be the case of Apple, Inc. Steve Jobs created Apple to design innovative products. Earning money was a necessary side issue for him but not his primary objective. Jobs was primarily motivated by his desire to change the world for the better. He was focused on creating new and better products and not on Apple’s current share price. Then John Scully came along and essentially said: “You know Steve, you really need to focus more on Apple’s profit margin and drive up Apple’s share price.” The Apple board members voted to set Steve Jobs aside and bring in John Scully to head up this effort. Scully focused on cutting expenses. He had little or no interest in creating new and better products. As a result, Microsoft and other competitors began moving ahead of Apple in computer technology. Apple was falling behind. Once the Apple board realized their mistake, they removed Scully and brought back Jobs.

How much of a reward do these passive investors need and what are the consequences of over-rewarding passive investors and under-rewarding real entrepreneurs and their employees?

After the 2007-2008 financial crisis, the Federal Reserve poured enormous amounts of money into the New York financial markets to lower interest rates. This injection of money into Wall Street has sometimes been referred to as “pushing on a string” because very little money was trickling down to the people in the real economy on Main Street. China and other countries have also invested trillions of dollars in the purchase of U.S. Treasury securities in the New York financial markets. Most of this money has primarily gone to benefit the passive investors who have made no contributions of time, energy or creativity in an effort to improve the performance of the company. Hard work pays off. But not for the people doing the hard work. The hard work of the employees and creative entrepreneurs have paid off for the passive investors under the maximization of shareholder value mantra.

In recent decades our economy has had an average growth rate of three percent while the stock market has averaged a growth rate of ten percent. This disparity in return to investment has led many non-financial firms to invest money in the stock market rather than in creating new and better products for their customers or motivating and rewarding their employees with better pay and benefits. This diversion of money to the New York financial markets has suppressed economic growth and productivity,

Meanwhile, the maximization of shareholder value mantra has caused corporations to divert money to stock buybacks and dividends instead of creating better products for their customers or better pay for their rank-and-file employees. Before 1982 the Securities and Exchange Commission (SEC) ruled that stock buybacks were a form of insider trading and illegal. However, corporate donors convinced our politicians to pressure the SEC to allow stock buybacks starting in 1982. Congress needs to reverse this mistake and go back to forbidding corporate stock buybacks that have been aimed at unnecessarily and excessively enriching passive investors. Stock buybacks should be allowed only when the shares bought back are immediately distributed to the company’s rank-and-file employees.

All this diversion of money to Wall Street has left so little money on Main Street that the people on Main Street do not have enough money to buy back the value of the goods and services that they are capable of producing at full employment.

This distorted money flow has led to a massive increase in private debt and a big increase in public debt with Republicans passing unpaid for trillion-dollar tax cuts and Democrats passing unpaid for stimulus spending. Eliminating deficit spending without solving the underlying distorted money flow would lead to high levels of unemployment in a permanent recession. Politicians often talk about reducing the deficit but ultimately realize that they need to increase deficit spending to avoid recession and the resulting loss of votes at election time. Politicians love to complain about the national debt, but then when push comes to shove, they increase it to avoid being blamed for a bad economy. Someone has to buy all those goods and services to keep the people employed and the rich are just not up to the job all on their own. If you want to have a thriving economy, you need to make sure that enough money is flowing to poor and middle class people who will actually spend it to keep the economy at or close to full employment.

The over-rewarding of passive investors and the suppression of productivity and economic growth is not only the fault of self-serving CEOs, corporate boards and the SEC, but also reflects the increasing separation of the financial economy on Wall Street from the real economy on Main Street that has been facilitated by the Federal Reserve over many decades. Unfortunately the Federal Reserve’s powers have been limited to overseeing the twelve regional Federal Reserve Banks, dealing with the reserve funds of major banks, and the buying and selling of US Treasury securities and other financial products (quantitative easing (QE) and quantitative tightening (QT)) in the New York financial markets. The Federal Reserve needs new and better policy tools if it is to operate effectively and efficiently in stopping excessive inflation and avoiding recessions while allowing for increased productivity and economic growth in the real economy.

For many decades, but especially since the Great Recession of 2007-2008, the Federal Reserve has pumped enormous amounts of money into the New York financial markets with little trickling down to the real economy on Main Street. This inefficient and ineffective method of stimulating the economy has driven excessive inflation of stock prices on Wall Street to the great delight and benefit of passive investors without stimulating much demand on Main Street, especially relative to the fiscal policy stimulus spending by the Congress which is much more direct and cost effective than monetary policy. The problem is that the politicians in Congress cannot agree on the correct level and timing of changes in taxes and spending. The Federal Reserve Board is often unanimous in agreeing on monetary policy but does not have the proper tools to do the job efficiently and effectively.

To stop inflation the Federal Reserve currently uses a cost-of-borrowing tool that raises interest rates on loans. During excessive inflation people want to spend their money quickly to avoid its loss of value due to the rising prices. Raising the cost of loans just shifts the inflation from expensive items that require a loan to less expensive items that don’t require a loan. However, businesses that routinely borrow money to operate will cut hours, lay off employees, and close outlets when the interest rate on loans increases. Workers can’t spend money that they don’t have so they cut their demand for goods and services. This reduces inflationary pressure when too much money is chasing too few goods. But it also suppresses supply and runs the risk of driving the economy into a recession.

To impact the real economy on Main Street directly to stop inflation without causing a recession the Federal Reserve needs a new return-on-savings tool. Since prices are set on the margin and not on the average, the marginal saver is the key player in setting prices. The marginal saver may be deciding whether to buy that expensive new pair of shoes or put off buying the shoes and instead invest that money in a savings account. However, when too much money is chasing too few goods causing inflation and the Federal Reserve is trying to slow the economy to reduce excessive inflation, banks, which often have excess reserves under our fractional reserve banking system, realize the risk of an economic slowdown or even a serious recession and cut back on making loans. Under those circumstances most banks don’t really want additional money. They often offer interest rates on savings that are less than the rate of inflation and are therefore negative in real terms. They don’t like paying for money that they don’t really need.

One approach to stopping excessive inflation is for Congress to reissue the Postal Savings Act of 1910 and offer an interest rate of ten percent for amounts up to $10,000 at our 30,000+ post offices throughout the United States. The marginal saver who typically has no college degree and may make around $50,000 a year will hopefully notice the big sign at the entryway of each post office offering ten percent on savings and decide to put off nonessential expenditures in order to take advantage of the high return on savings. Allowing the Federal Reserve to run these postal savings accounts would mean that there would be no increase in taxes or in the national debt because the Federal Reserve typically makes billions of dollars in profits from its member banks and from it operations in the New York financial markets, or it could just print up whatever money it might need regardless of any profits or losses it might make in day-to-day operations. This would provide the Federal Reserve with a return-on-savings tool so that it was not totally dependent on using its cost-of-borrowing tool that threatens to send our economy into a recession.

But what can the Federal Reserve do when the economy has slipped into a recession and needs some stimulus to restore full employment? Quantitative easing (QE) is where the Federal Reserve buys debt instruments such as US Treasury bonds and mortgage backed securities to pump money into the New York financial markets with the hope that some of that money will trickle down to the average person on Main Street. This is clearly a very expensive and inefficient method that runs the risk of encouraging even non-financial firms to divert their investment funds to buy into the financial markets as stock and bond prices rise rapidly instead of investing in their own businesses. The relatively high return on investments in the financial economy suppresses productivity and economic growth in the real economy which offers a much lower return on investments. In other words, pouring money into the financial markets on Wall Street ends up suppressing economic growth on Main Street.

When the economy is in a recession, the Federal Reserve needs an entirely different tool to control the real economy on Main Street instead of trying to control everything through the financial markets on Wall Street. Right now only large banks have accounts directly with the Federal Reserve. But a number of lawyers and economists have proposed creating “FedAccounts” to directly impact the people on Main Street. If everyone with a Social Security number was issued a bank account with the Federal Reserve, the Fed could inject money into these accounts as needed to stimulate the real economy directly, more immediately, and more efficiently than trying to influence the real economy by buying securities in the New York financial markets. This money would become immediately available to spend. And it would take less money to increase the demand for goods and services. The Fed would get more bang for the buck. You could pay someone to cut your grass, rake your leaves, or shovel your snow by a simple transfer of money from your “FedAccount” to their “FedAccount.”

The maximization of shareholder value through dividends and stock buybacks has driven up stock prices as has trillions of dollars invested in the New York financial markets by foreign governments and other foreign investors. The Federal Reserve has made matters worse by further rewarding passive investors through its quantitative easing policy. Financial markets were originally created to make money available for investments in the real economy, but the rapid rise in stock and bond prices especially in the decades following the 2007-2008 Great Recession has caused a reversal of the money flow. Under the maximization of shareholder value mantra and a misguided and inefficient Federal Reserve policy, too much money has been diverted to passive investors that should have gone to reward entrepreneurs and hard working employees making new and better products in the real economy. The sooner Congress restores postal banking and creates a “FedAccount” for every American, the sooner we can achieve much higher productivity and economic growth in the real economy.


the rise and fall of inflation

The rise in inflation to just over 9 percent in June 2022 is no mystery. Excess demand and insufficient supply were caused by a combination of an abrupt supply disruption due to the COVID-19 pandemic and a spike in demand from the Trump and Biden stimulus expenditures. The fall in inflation more recently to between 3 and 3.5 percent is more interesting and more complicated.

On the supply side American manufacturers have learned that minimizing inventory costs following just-in-time delivery of their products that they manufacture cheaply overseas has caused them dearly in the face of the sudden supply disruption. Their revenues and profits dropped dramatically in the face of the sudden cutoff in the supply of their products. With the encouragement of the Biden administration, manufactures have created just-in-case production facilities here in America. They now want to have some manufacturing production in America that is designed to be easily expanded in the face of another overseas supply disruption. This is especially important in the face of the increasing tension between China and the United States, especially if China were to invade Taiwan.

The demand for construction workers initially put upward pressure on wages and prices. But the resulting increase in the supply of manufactured products here in America in addition to the renewed supply from overseas has put downward pressure on inflation. Economy-wide demand is also falling due to the end of the stimulus expenditures, the end of the deferment of student loan payments, and the increase in work requirements for welfare recipients recently imposed by Congress. This combination of increased supply and decreased demand is putting downward pressure on the rate of inflation. Prices are then rising at not nearly the rate that they were at the height of this inflationary cycle.

But what role has the Federal Reserve played in all this? What effect has the Fed’s raising of interest rates had on our economy? When the Federal Reserve raises interest rates, wealthy people say: “Oh, good. I will be earning more on my savings.” Poor and middle class people say: “Oh, no. I will have to pay more on my debts.” People often need a loan to buy a car, purchase a home, or get a college degree. Raising the cost of borrowing blocks these options for many people. During times of excessive inflation, people need to spend their money quickly before it loses more of its purchasing power. The longer they wait, the less their money is worth. Consequently, by raising the cost of borrowing when too much money is chasing too few goods, the Fed just shifts the inflation from things that require a loan to less expensive things that don’t require a loan.

However, raising the cost of borrowing stops excess inflation by suppressing supply in a manner that ultimately effectively suppresses demand. Many firms borrow money to operate. Some retail firms run in the red most of the year until reaching the holiday season at the end of the year where they cover their costs and make their profit. Farmers borrow to prepare fields with plowing, fertilizing and watering their crop and then pay back their loans when the harvest comes in. When the cost of borrowing goes up, firms that borrow money will cut hours, lay off workers, and close outlets. Workers get less money and some lose their paychecks altogether. They can’t spend money they don’t have, so this effectively suppresses demand and stops excessive inflation, but at the risk of creating a recession.

The current Federal Reserve strategy that relies exclusively on their cost-of-borrowing tool rewards the rich and punishes the poor for inflation. A more equitable approach that avoids the threat of recession is for Congress to reissue the Postal Savings Act of 1910 to allow the Federal Reserve to off 10 percent interest on savings for relatively small amounts (no more than ten thousand dollars) for any person with a Social Security number. As explained in introductory economics, prices are set on the margin and not on the average. Stopping inflation requires getting the marginal saver to save more and spend less. The poorest of the poor cannot afford to save any money and the richest people are just moving their money around to get the best return with little or no effect on their consumption behavior. Two thirds of Americans have no college degree and typically earn fifty thousand dollars a year or less. These are the marginal savers who have to decide whether to buy that new expensive pair of shoes or instead put that money in a savings account. A big sign at the entrance of each neighborhood post office offering ten percent on savings might be just what is needed to stop too much money chasing too few goods.

Asking your Congressional representative to support reissuing the Postal Savings Act of 1910 would provide the Federal Reserve with a return-on-savings tool that will help stop excessive inflation without causing a recession so that the Federal Reserve does not have to rely exclusively on their cost-of-borrowing tool. This will not have a big impact on banks when the Fed is trying to slow the economy because banks typically have excess reserves under our fractional reserve banking system and cut back on loans when the Fed is trying to slow the economy. Banks don’t want to be overextended with lots of loans in default as the economy slows. At such a time banks do not want to have to pay for more savings that they don’t need and don’t want. The Federal Reserve can run the postal savings accounts with its own money from the profits and fees it makes in the financial markets so reissuing the Postal Savings Act of 1910 would not cost the taxpayer a penny. Typically the Federal Reserve makes profits of fifty billion dollars or more each year. The Federal Reserve could afford to run these postal savings accounts without having to print any additional money. In any case there would be no need to increase taxes to pay for these postal savings accounts and inflation could be brought under control without punishing the poor by using this new return-on-savings tool and not relying exclusively on the Fed’s cost-of-borrowing tool.