Modest money flow to aristocracy becomes extreme money flow to meritocracy
Prior to 1960 America’s large corporations were dominated by an aristocracy that in some ways resembled the old English nobility. In fact, prior to the American Revolution, the King of England granted land in America to certain elite families. Wealthy east coast families dominated in America for a lot longer than most people realize or are willing to admit. Legacy was the key to success. It was legacy, not good grades, that got you accepted into elite colleges and universities. Before 1960 even an average grade of C in your prep school was not a problem in gaining admission to an elite university if your father, grandfather, uncle, or brother had attended.[1]
( There is an old joke among economists that the most important decision you make in life is your choice of parents. You want to choose rich, well-educated parents. We like to think of America as the land of opportunity, but there is still a lot of work to do to create that level playing field. )
Graduating from Yale, Harvard, Princeton, or any of the other elite schools was sufficient for finding a reasonably well-paid executive job at a leading American corporation. The noblesse oblige rules among the early English settlers were simple: (1.) stay out of politics, (2.) keep your name out of the news (except for the social register), and (3.) don’t give yourself an oversized salary. When excessive wealth is not based on merit or hard work, memories of the French revolution can be poignant. We do not want to see the rope over the platform designed for the hanging of Vice-President Mike Pence on January 6 replaced by a guillotine. Most wealthy English settlers understood the need to avoid alienating the masses.
Around 1960 Harvard James Bryant Conant led the way in introducing SAT and ACT scores into admission decisions. Scholarships were introduced to aid applicants to elite prep schools and colleges who were not from wealthy families.[2] Once ability and achievement potential became important and a geographical distribution preference was introduced to discriminate against certain high achieving non-WASP[3] ethnic and cultural groups from the New York City area and the Boston area, the entire nature of the ruling class changed. Discrimination was still present, but a new meritocracy of sorts was allowed to gradually take over.
Business schools and law schools in general, and economics departments in particular, promoted the “greed is good” philosophy, where businesses competing with one another to produce better quality products at lower prices (Adam Smith’s invisible hand) was said to justify the single-minded pursuit of one’s own self-interest even if that ultimately led to resetting the rules (e.g., tax loopholes, etc.) to benefit the nouveau riche of the new meritocracy. In recent decades, increased efficiencies due to network effects and economies of scale have been used to justify the concentration of market power even when most of the gains have gone to profits.
Underpaid government lawyers were no match for the new business and legal elite whose ability and achievements resulted in an accumulation and concentration of wealth far greater than ever desired or achieved by the old aristocracy. Adam Smith’s left invisible hand has now been countered with increased economic power which serves as a right invisible hand to block entry and drive up profits, as competitive markets have been replaced by monopolistic and oligopolistic ones. Tariffs are used to block competition from abroad. Economies of scale, network effects, patient laws and first-mover advantage are among the many effective means of suppressing competition.
The new meritocratic elite re-rigged the rules in every sphere of life to their own advantage. Rather than lowering the bar for others to follow, they raised the bar to keep others out. This diverted the money flow away from most Americans and toward the top one percent wealthiest elite.[4] The new meritocracy worked in theory to raise all boats, but failed in practice, either because the new elite either didn’t understand the implications of their exclusionary tactics or chose to ignore them. Social mobility was suppressed, instead of enhanced, with fewer low socio-economic people able to break out of the middle-class trap. The new elite made sure to give their children the best possible education and the socio-economic connections needed to establish and maintain their comparative advantage. Instead of improving upward socioeconomic mobility, the new meritocracy at best kept it from rising and at worst suppressed it even more than before.
This money flow diversion was a very fundamental and a very important change in the US economy, starting around 1973.[5] Before 1973, labor productivity and wages were highly correlated. After 1973, labor productivity continued its rise, but real, inflation-adjusted, wages flattened out as rising revenues were siphoned off as profits. Such profits piled up in the financial markets as money flowed in a circular loop as stock buybacks, dividends, and interest payments, that the wealthy then just reinvested back into the financial markets where the accumulating pool of money drove interest rates ever lower. In this case, the velocity of money just meant the speed at which these dollars were traveling around and around in the financial markets as market speculators bought and sold new and exotic financial products at ever increasing rates. There has also been a dramatic drop in the number of publicly traded companies in recent decades that has dropped from around 7,000 firms to less than 4,000 firms today. This reduction in the supply of stocks has driven up their prices by the power of the law of supply and demand. See Petrou (2021) for more details on the widening wealth gap and its causes including the major role played by the Federal Reserve.[6] Also, see “The Lords of Easy Money” (Simon & Schuster 2022) by Christopher Leonard on how the Federal Reserve has undermined our economy by pumping too much money into the New York financial markets.
The changes in the money flow, that weakened aggregate demand were due in part to this change in the ruling class and part as a result of focusing on maximizing shareholder value (including profits from dividends and stock buybacks) by increasing financial capital (the value of stocks and bonds, etc.) at the expense of labor and real capital (physical and intellectual investments). For decades inflation ran rampant in the financial markets with little benefit in the real economy where productivity and real economic growth slowed. For a deeper understanding of how over-rewarding passive investors is not justified either legally or operationally, read the book “The Shareholder Value Myth” (Berrett-Keehler Publishers, Inc. 2012) by Lynn Stout, the distinguished professor of corporate and business law at the Clarke Business Law Institute at Cornell Law School.
Simcha Barkai (2020)[7] calculated the capital costs for the US 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. Neither labor nor real capital were rewarded, as most of the money flowed to pure profits. As the wealthy grew wealthier, the rest got by with an ever-increasing private debt burden, reinforced with an ever-greater federal debt burden, both being enabled and encouraged by low interest rates.
In the absence of adequate aggregate demand to employ all available American workers, politicians called for tariffs to block low-priced imports that compete with American products and take jobs away from Americans. The politicians have fallen for what economics call The Lump of Labor Fallacy where somehow there is a fixed number of jobs for the world to fight over. However, proper fiscal and monetary policies can increase or decrease the number of available jobs while tariffs just block competition and raise prices for everyone including elderly living on limited Social Security payments. A better approach is to redirect the money flow from Wall Street back to Main Street so that there would be enough consumer demand on Main Street to employ both international workers making products for Americans as well as all Americans who are willing and able to work at good wages. Trade can be and should be a win-win situation where everyone is made better off. Getting high quality, low-priced products from abroad should not in any way prevent Americans from getting good jobs that pay well. Tariffs are just an excuse for not properly addressing the money flow diversion from Main Street to Wall Street within the United States.
Blocking overseas competition is associated with a dramatic increase in industrial concentration where one-by-one competitive industries have been turning into duopolies or monopolistic competition where one firm or a handful of firms controls the market. Keynesian and Austrian economists recognized the inevitability of economic downturns, but the Austrians saw such downturns as a cleansing process where weak and inefficient firms were driven out of the market in what Austrian economist Joseph Schumpeter called “creative” destruction, but with larger firms undercutting or buying up weaker ones should more accurately be called “competition” destruction. Firms that survive economic downturns are not necessarily more efficient, but just have more cash reserves to ride out a downturn. A popular and efficient local restaurant may not survive an economic downturn such as the one associated with the COVID-19 pandemic while a larger company with lots of cash on hand may be able to get away with running some aspects of its business inefficiently in both good times and bad. When Amazon started up, it ran in the red for an extended period without facing bankruptcy, because it had lots of cash on hand. Tepper and Hearn (2019) reveal the surprising number of noncompetitive industries and quasi-duopolies in the United States in their book The Myth of Capitalism which could have been more specifically titled The Myth of Competition.[8]
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.”
Government is often dismissed as inefficient, partly because it may have goals other than profit maximization, and also because, unlike private businesses, the government’s operations are subject to close public scrutiny such as under the Freedom of Information Act and the Open Meetings Act. But large businesses can be and often are even more inefficient than government. For example, Saluto Pizza started as a small pizza place in St. Joseph, Michigan. Its pizzas were so popular it started freezing them to sell to people to take home to reheat for consumption later. The frozen Saluto Pizzas became so popular that a frozen pizza manufacturing plant was created to produce them to sell to grocery chains around the nearby region. Their popularity was such that another factory for making the frozen Saluto Pizzas was created in Birmingham, Alabama. Then General Mills bought out Saluto Pizza. But following the financialization strategy of cutting costs, the Saluto Pizzas were then made with cheaper ingredients which made them unpopular. Before long the Saluto Pizza brand was discontinued. Such cost cutting and removal of unpopular products is then described as enforcing efficiency in private business, in contrast to alleged government waste and inefficiency. The executives who cut costs and cut out unprofitable products were probably rewarded and promoted. By contrast, so-called government “bureaucrats” who serve the public are seen as unproductive and wasting the taxpayer’s money.
America thrives when entrepreneurs such as Steve Jobs and Elon Musk focus on creating new products. But productivity and economic growth are suppressed when companies focus on financialization by excessive cost cutting and shareholder payouts, instead of investing in new products that capture the imagination and desires of both their existing customers and potential new customers. When business fails to generate sufficient economic growth to employ the available workforce, government has to step in and increase the national debt using tax cuts and expenditures to generate enough demand for goods and services to avoid recessions.
John Locke’s original conception of gaining ownership of land and other forms of capital through the sweat equity of labor quickly reverted back to ownership of capital by an elite class (i.e., the nobility). Labor saving technologies such as automated vehicle production and mountaintop removal in coal extraction have dominated over labor augmenting technological change provided by computers generating a need for computer programmers or Amazon’s need for delivery drivers (soon to be replaced by driverless vehicles). Future economic prospects remain bleak for unskilled and semi-skilled labor. However, it is important to note that real capital has not won. As Simcha Barkai (2020) has revealed, the ultimate winner is profits (especially profits in the form of financial capital in the stock and bond markets). The shares of labor and real capital have declined significantly while that of profits has increased substantially.
Today the huge pile up of wealth at the top of the wealth pyramid has flooded the financial markets with money and has driven interest rates down toward zero. But this money has not primarily gone into productive investment in real capital, but instead has driven up stock and bond prices as alternatives to investment in the real economy. Why invest in improvements in real productivity when you can make a lot more money in the financial economy? Ultimately the financialization of our economy has become a drag on productivity and not a catalyst for it.
[1] Brooks, David. Bobos in Paradise. New York: Simon and Schuster, 2000.
[2] At prep school and college reunions, it is interesting to note that the scholarship students are more likely to show up driving expensive, prestigious vehicles than their former classmates from wealthier families, who were taught to hide their wealth to some degree, or at least not flaunt their wealth publicly.
[3] WASP = White Anglo-Saxon Protestant.
[4] Brill, Steven. Tailspin: The People and Forces Behind America’s Fifty-Year Fall — And Those Trying to Reverse It. New York: Alfred F. Knopf, 2018.
[5] Data from Economic Policy Institute: https://www.epi.org/productivity-pay-gap/
[6] Petrou, Karen. Engine of Inequality: The Fed and the Future of Wealth in America. New York: John Wiley & Sons, 2021.
[7] Barkai, Simcha. “Declining Labor and Capital Shares,” Journal of Finance, 2020, vol. 75, issue 5, pp. 2421-2463.
[8] Tepper, Jonathan with Denise Hearn. The Myth of Capitalism: Monopolies and the Death of Competition. Hoboken, NJ: John Wiley & Sons, 2019.