Author: Lawrence

Lawrence C. Marsh is professor emeritus in the Department of Economics.  He taught graduate and undergraduate economics in the department for 30 years beginning in 1975. Marsh's "Optimal Money Flow" book was released on June 16, 2020. His latest book "Money Flow in a Dynamic Economy" was released on July 4, 2023. In 1990 he co-founded the Midwest Econometrics Group (MEG), which he directed for 15 years.  He served as the director of the graduate program in economics for 13 years. He served in 2010 as visiting professor of econometrics and statistics at the University of Chicago's Booth School of Business and in 2016-2017 at Avila University in statistics and research methods in psychology. In teaching he won the James A. Burns award for excellence in graduate teaching in 1990-1991 and was an O’Malley Award Nominee for undergraduate teaching in 1995-1996.    In 2002-2003 he was selected as a Kaneb Faculty Teaching Fellow for excellence in teaching. He has served on 80 Ph.D. dissertation committees and has given several thousand lectures in graduate and undergraduate statistics, econometrics, mathematical economics, microeconomic theory and research methods in psychology. In quasi-retirement he spends his time writing and editing a variety of articles, books and newspaper columns.  His latest book is "Optimal Money Flow: How a Dynamic-Growth Economy Can Work for Everyone" published by Avila University Press.  Professor Marsh will forgo author royalties and donate the entire book price to student scholarships for books purchased through Avila University Press at  https://www.avila.edu/aupress/optimal-money-flow-by-lawrence-c-marsh .

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

Posted on by Lawrence

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

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

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

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

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

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

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

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

Inflation from multiple causes requires multiple cures

Posted on by Lawrence

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

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

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

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

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

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

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

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

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

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Stock Market: Prudent Investment or Gambling Casino?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Distorted Money Flow Creates Chronic Disequilibrium in our Economy

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Please provide your insights and comments on “Distorted Money Flow Creates Chronic Disequilibrium in our Economy” by scrolling down to the bottom of this page and writing your comments in the textbox “Comment.”
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Lawrence C. Marsh is Professor Emeritus in Economics at the University of Notre Dame and author of the 2020 book: Optimal Money Flow: A New Vision on How a Dynamic-Growth Economy Can Work for Everyone. 
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You can donate the entire purchase price of the book to student scholarships by buying a hard-bound copy of the Optimal Money Flow book at the Avila University Press website at:  https://www.avila.edu/aupress/optimal-money-flow-by-lawrence-c-marsh with no charge for shipping and handling.  
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Economic theory must change to accommodate irrational, inconsistent and altruistic behavior

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Traditional economics is based on three key assumptions: (1) rationality, (2) consistency, and (3) self-interest. It assumes a cold, calculating, rational choice by each individual based on a stable set of preferences. It frequently doesn’t work out to be that simple, because social factors intervene.

We are all highly interdependent. Automobiles, cell phones, even breakfast cereals are created collectively. Stock market and housing bubbles are evidence of important contagion effects. Aliens from outer space may not see us as individuals at all, but rather as cells in a collective body that is spreading across the face of our planet. Economic theory needs drastic revision to better incorporate our collective interdependence.

Economists tried to devise methods of aggregating individual preference functions into a community-wide preference function, but finally had to accept economics Nobel prize laureate Kenneth Arrow’s Impossibility Theorem that said that under somewhat general circumstances no such aggregation of individual preferences could produce a legitimate community-wide preference function. Thus, no formal, mathematical proof has been forthcoming of Adam Smith’s idea that our collective, economic well-being as a nation can be improved from each individual pursuing their own economic self-interest, as expressed in his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations.

Instead economics detoured into game theory which provides many interesting results but does not solve the fundamental problem. Moreover, the outcome of any particular game tends to be sensitive to its own, game-specific assumptions. A more general economic theory is needed that is robust to a wider range of assumptions in general and allows for our collective interdependence in particular.

A good beginning for thinking about developing an economic theory of our collective interdependence is the 1976 book by Fred Hirsch called Social Limits to Growth published by Harvard University Press.

A new branch of economics called behavioral economics tests these assumptions by performing scientific experiments to determine how people actually behave. Behavioral economists have recorded numerous situations where people do not behave rationally.

For example, advertisers have long understood that people will go to great expense to get something for “free.” One professor set up an auction system that caused his students to bid more than $20 for a $20 bill. An irrational sense of commitment leads people to tenaciously hold on to stocks they already own, but otherwise would not be willing to purchase. These are not just trivial irregularities. There are a wide-range of situations where people behave irrationally from the point of view of traditional economics.

From its beginning, economics has had to fend off evidence of irrationality. Giffen goods that defy the law of demand by responding positively to price increases and negatively to price cuts were dismissed as special cases with little importance for overall economic policy. When some individual consumers and investors made foolish choices, economists employed the law of averages to try to reaffirm rational market outcomes. The term rational expectations was coined when this was extended to the behavior of monetary and fiscal policy makers.

Is it enough to simply dismiss irrationality by throwing it into the error term, or could it sometimes be the main effect? Bounded rationality depicts decision making in a restricted context where information is incomplete and available choices are limited. Such analysis provides the dismal science with a new basis for moving away from excessively optimistic forecasts.

The hedge fund Long Term Capital Management collapsed in 2000 when the market did not move back toward equilibrium in a reasonable amount of time. Such unexpected events are described by Nassim Taleb in his book The Black Swan: The Impact of the Highly Improbable.  Are markets ultimately efficient in the long run or is the long run just too far off? After all, it was John Maynard Keynes, the father of macroeconomics, who pointed out that “in the long run we’re all dead.”

The Achilles heel of traditional economics was uncovered when researchers found that irrationality is often predictable. Dan Ariely’s 2008 book Predictably Irrational is a recent popular contribution while the 2004 compendium volume Advances in Behavioral Economics provides a more extensive coverage from the professional literature. Also see The Paradox of Choice by Barry Schwartz, Sway by Ori and Rom Brafman, and Free Market Madness by Peter Ubel.

Economists such as Nobel prize laureate Gary Becker led the extension of economics into the social realm in studying such things as the economics of marriage and drug addiction. Becker and his followers showed how economics can influence social behavior. The new economics is showing how social considerations can impact economics. The Nobel prize in economics was won in 2009 by Elinor Ostrom and Oliver Williamson for research that showed how organizational factors can affect economic outcomes. Social factors can have an even bigger impact on the day-to-day decisions of all of us.

For example, if you ask a friend to help you move, she may be willing to sacrifice a few of her precious Saturday hours to help out. If instead, you offer her $10 a hour to help you, she may turn you down flat. How can it make sense to be willing to work for nothing, but not be willing to do that same work for money? The answer is that social relationships are quite different from economic relationships. As soon as you make it a monetary transaction, you have changed the nature of the relationship.

An important irrational distortion occurs when a person takes possession of an item. A study randomly sorted an equal number of people into two groups. In one group each person was given a coffee mug. In the other group everyone got a candy bar. They were immediately given an opportunity to exchange the item they received for the other item. Since membership in the two groups was random, on average the ratio of people with candy bars to coffee mugs should turn out to be the same in the two groups after the final exchange. To the surprise of the researchers, the proportion of candy to mug lovers turned out to be quite different in the two groups. Each group tended to hold on to its initial gift much more than traditional economics would predict.

Decision making is more than just taking into account time and money. We also must consider the mental energy necessary to make decisions. Behavioral economists have unearthed substantial evidence of omission bias in economics. The stock market provides a perfect example. Researchers have found that people who own stock A which turns out to be a loser but could have purchased stock B which ultimately turns out to be a winner have much less regret than a person who initially owned stock B and then sold it to buy stock A. Even though both people end up with the losing stock A, they feel much different about it. A recent decision to hold onto a loser is not considered anywhere near as bad as the decision to buy that loser even when the monetary loss turns out to be exactly the same.

The desire to be a winner frequently distorts economic outcomes and not just when an item is offered for “free.” A study offered people either $100 for sure or, alternatively, a chance to win $200 or nothing with a fifty-fifty probability. Since the expected value of the two alternative offers is the same, researchers expected about half of the people would take the $100 and the other half would try the gamble. A large proportion of the people chose the $100 with certainty. The $100 is enough to make the person a winner while the chance to get an additional $100 was not as important as the possibility of getting $0 and losing the winner status. The opposite was found when people were given a choice to lose $100 with certainty or lose $200 or $0 with a fifty-fifty probability. Most people chose the gamble since a loss of $0 was the only way to avoid being a loser.  Traditional economics does not provide a mechanism for understanding such an irrational inconsistency.

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Please provide your insights and comments on “Economic theory must change to accommodate irrational, inconsistent and altruistic behavior” at the bottom of this page.
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Lawrence C. Marsh is Professor Emeritus in Economics at the University of Notre Dame and author of the 2020 book: Optimal Money Flow: A New Vision on How a Dynamic-Growth Economy Can Work for Everyone. 
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You can donate the entire purchase price of the book to student scholarships by buying a hard-bound copy of the Optimal Money Flow book at the Avila University Press website at:  https://www.avila.edu/aupress/optimal-money-flow-by-lawrence-c-marsh with no charge for shipping and handling.  
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International Trade – U.S. dollars flowing around the world

Posted on by Lawrence

What are the implications of the U.S. importing lots of products from abroad? Does our trade deficit imply that we are getting ripped off and need to impose trade restrictions? For example, consider our trade with China. China takes its resources, and its people work hard producing products for us. In return, instead of sending lots of our products to China, we send them pieces of paper with George Washington’s picture on them (U.S. dollars). Ordinarily, all those U.S. dollars would find their way into the international currency exchange markets driving down the value of the U.S. dollar and raising the price of the Chinese yuan. That would make Chinese products more expensive for us to purchase and U.S. products cheaper for China to purchase.

You would think that making U.S. products less expensive for the Chinese people to purchase would be good for China. But traditionally most Chinese have been very poor and not able to afford even lower priced U.S. products. A more immediate problem for China’s government has been the flow of peasants from rural areas into the urban centers where products are produced for export. China needed a way to avoid high levels of unemployment and keep its citizens employed through the manufacture of products for export. Instead of allowing those U.S. dollars to go into the currency exchange markets, China used those U.S. dollars to buy U.S. Treasury securities. In other words, China gave us products, we gave China U.S. dollars, and China gave us our money back again by investing money in U.S. financial markets by buying U.S. Treasury securities. Who is getting ripped off here? (Hint: it is not us.)

Issuing a lot of U.S. Treasury securities attracts U.S. dollars situated abroad that would otherwise drive down the value of the U.S. dollar in international currency exchange markets. This makes it more difficult for the Federal Reserve to suppress inflation through the supply-side. Overseas investors, especially sovereign wealth funds, may move U.S. dollars into New York financial markets leaving a stronger U.S. dollar in international currency exchange markets than would otherwise be the case. Japan and China have purchased large quantities of U.S. Treasury securities with U.S. dollars that would otherwise have gone to drive down the value of the dollar, which would have lowered the price of U.S. exports and increased the price of imports into the U.S. helping move toward a better balance in tradable commodities and services.       

However, some foreign governments (e.g., China) may have motives for investing in U.S. Treasury securities other than seeking an attractive return on investment in the form of interest payments. China requires that Chinese exporters turn in U.S. dollars to the Chinese government in return for renminbi (yuan) to keep those dollars out of foreign exchange markets. China’s return on investment in U.S. Treasury securities may be less in the form of interest payments and more in keeping its population fully employed to maintain both economic and political stability by maintaining either a low value for the yuan in international exchange markets or, somewhat equivalently, a high value for the U.S. dollar. 

It is important to consider the underlying cause of trade imbalances, especially those that have kept the U.S. dollar strong.  China and several European countries, for example, have highly unequal internal wealth distributions such that an insufficient amount of money is flowing to their average people to sustain full employment without substantial exports. In other words, United States consumers and other foreign consumers make up for the lack of adequate demand by China’s domestic consumers. The extreme wealth inequality in China and those European countries mean that the people in those countries cannot afford to buy back the value of the goods and services they are producing, but the wealth of those countries has gone to wealthy elites who are eager to invest their money in the United States financial markets. 

Even elites in poor, developing countries are often eager to invest their money in the New York financial markets instead of investing in industrial development in their own country. This phenomenon can be viewed as another form of colonial exploitation, with the development of poorer countries held back in favor of providing more wealth to the already wealthy by driving up prices in the U.S. stock market. The U.S. stock market, and stock markets in general, have become alternatives or substitutes for real investment in the productive capacity of economies throughout the world.  Simcha Barkai published a carefully researched paper that revealed that business revenues were going increasingly to profits (financial capital) as opposed to the cost of labor or real capital (e.g. physical or intellectual capital).

This distorted money flow has created a financial economy that is more and more separated from the real economy. Ironically, it has been restraining and undermining productivity and economic growth rather than supporting and encouraging it. Yes, money is cheap for businesses to borrow, but demand is chronically inadequate without extraordinary stimulus from governments. Businesses have no incentive to expand their operations, but instead they buy up or undercut smaller competitors to increase their market share and prices.

Another major reason for the strength of the U.S. dollar in foreign exchange markets is the role of the U.S. dollar as the world’s primary reserve currency. In order to avoid the instability and risk associated with fluctuations in the value of trading one country’s currency for another, some major entities purchase imports with U.S. dollars and sell exports denoted in U.S. dollars to avoid the ups and downs of the foreign exchange markets. Trade in crude oil and other major commodities is traditionally done in terms of U.S. dollars. Consequently, as international trade continues to increase over time, the demand for U.S. dollars increases to keep the U.S. dollar highly valued in foreign exchange markets. 

In other words, a country whose currency serves as a major reserve currency is in basically the same boat as a country that suffers from the natural resource curse, otherwise known as the Dutch Disease, a term coined by The Economist to refer specifically to how the value of the Dutch guilder was driven up when the Netherlands discovered massive amounts of natural gas within its territory, and generally to any country selling large quantities of a natural resource in high demand.  A reserve currency country and a country suffering from the natural resource curse have great difficulty selling their exports because of the high price of those exports in that country’s currency in the foreign exchange markets. In other words, under these circumstances the exports of the United States and the Netherlands would be basically priced out of international markets. The Dutch escaped the Dutch Disease by dropping the guilder and joining the Euro currency union where their natural gas exports were much less impactful with little effect on the strength of the Euro overall. As a reserve currency it is not only desirable, but necessary, for the country with the reserve currency to run a current account deficit to increase the amount of their currency in foreign exchange markets to keep from being completely priced out of the markets for its exports or see its exporting industries shrink as a result of its reserve currency status and the ever increasing demand for its currency in international markets.

On the other hand, the advantage of a strong currency are low prices for imports which save consumers money and helps make up for extreme income and wealth inequality within the United States. This is particularly helpful for retired elderly people who are on fixed incomes. In real terms the Chinese and other foreign producers are taking their natural resources and working hard to produce products for us, but instead of sending comparable products to them, we are sending them pieces of paper with George Washington’s picture on it (U.S. dollars). For the most part, tariffs on Chinese goods entering the United States are not paid by China. Walmart, in competition with other businesses around the world, buys goods in China and ships them to the United States. When those goods arrive in Long Beach, California, the Federal government requires that Walmart pay a tariff on those goods from China. Walmart can compensate itself to some extent by passing along the cost of the tariff to Walmart customers. Since many of the items Walmart buys from China are relatively inexpensive to begin with, the elasticity of demand for those items may be relatively high relative to the elasticity of supply so Walmart is able to get away with passing along most of the cost of the tariff to Walmart customers without suffering a significant drop in demand for those particular items. When the price of a great pair of Chinese memory foam sneakers rises from $9.98 to $12.48, it is still a great deal relative to alternatives.

The world works for us and we work for ourselves, yet we are told that we are being exploited by others by importing actual physical goods and services and paying for them with pieces of paper (U.S. dollars). The actual truth is the exact opposite of what those U.S. citizens who see themselves as “victims” tell us, the world is working hard and sacrificing their resources to keep us fat and happy!  In reality, we are the ones in the dominant and exploitative position in foreign trade. The absence of tariffs works to our advantage. The lumber and steel tariffs we placed on Canada only increased the cost of housing, automobiles and appliances in the United States. We need to remove those tariffs so we can get Canadian lumber and steel for less.

Yes, the overseas competition for the dollars of U.S. consumers means that the wages and jobs of U.S. workers are suppressed. Tariffs do not necessarily solve this problem since they would raise prices without guaranteeing that the money from the higher prices would go to workers in the form of higher wages and more jobs. Both the flow of dollars from abroad into U.S. financial markets in New York and the role of the U.S. dollar as a reserve currency in foreign trade have kept the value of the U.S. dollar strong in foreign exchange markets. The high value of the U.S. dollar makes U.S. exports expensive for people in other countries to purchase. A strong dollar means that we export less than we would otherwise and end up primarily producing our own goods and services for our own citizens.

The idea that there are a limited number of jobs in this world, and we must fight over them is what economists call The Lump of Labor Fallacy. The number and quality of jobs in the United States is not fixed. Fiscal and monetary policies can create as many jobs as we need. The current shortage of workers is in part due to stimulus policies that have been implemented in response to the COVID-19 pandemic. We should not raise prices in Walmart, Target, Amazon and many other low cost venues by imposing tariffs on imports coming from abroad. A better approach is to gain a tighter control over the number and quality of jobs here in the U.S. to keep our workers fully employed while still enjoying the low prices offered by imports from abroad.

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Lawrence C. Marsh (http://sites.nd.edu/lawrence-c-marsh/home/) is Professor Emeritus in Economics at the University of Notre Dame and author of the 2020 book: Optimal Money Flow: A New Vision on How a Dynamic-Growth Economy Can Work for Everyone (https://emeritipublishing.com/) .
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You can donate the entire purchase price of the book to student scholarships by buying a hard-bound copy of the Optimal Money Flow book at the Avila University Press website at:  https://www.avila.edu/aupress/optimal-money-flow-by-lawrence-c-marsh
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To sign up for this free monthly Money Flow Newsletter =>  click here. (https://emeritipublishing.us4.list-manage.com/subscribe?u=9f045b890bf0da60df9208ec5&id=c656af03b6)
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For additional details see the Optimal Money Flow book website at:
http://optimal-money-flow.website (http://optimal-money-flow.website/)
or the 2018 "Money Flow in a Dynamic Economy" paper presented at 2019 American Economic Association conference in Atlanta, GA:
https://www.aeaweb.org/conference/2019/preliminary/paper/FT7A95eS
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The full purchase price will go into the student scholarship fund when purchased through Avila University Press at the link:  https://www.avila.edu/aupress/optimal-money-flow-by-lawrence-c-marsh
Link to my Notre Dame webpage (http://sites.nd.edu/lawrence-c-marsh/home/)

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Stop Inflation Without Causing Recession

Posted on by Lawrence

Don’t repeat our historically dysfunctional approach to stopping excessive price inflation. The Federal Reserve uses a supply-side tool to stop excessive inflation by raising interest rates that works by constraining business enough to cause a cutback in working hours and layoffs that suppresses consumer demand. But postal bank accounts could be created to provide the Federal Reserve with a demand-side tool to directly reduce demand pressure to stop inflation without throwing the economy into recession.

When the Federal Reserve raises interest rates, it suppresses supply for seasonal, cyclical and other businesses that depend on short term liquidity to maintain and establish inventory and cash flow.  It suppresses business.  For example, farmers borrow money from the financial system to pay for seed, fertilizer and irrigation in the spring and to pay workers to harvest the crop in the fall, and pay it back after the harvest is sold. 

But production is cut back when borrowing costs increase as interest rates rise. This traditional approach suppresses both supply and demand as workers find less work and their incomes fall. High interest rates also cause businesses to put off long-term investments in plant and equipment that would increase supply. The economy slides into recession.

Inflation occurs when too much demand for goods and services is chasing too little supply. The financial markets exist to offer liquidity to businesses to maintain or expand the supply of goods and services. Countering the rapidly rising prices requires increasing supply while reducing demand. Current supply shortages call for encouraging supply. But the traditional Federal Reserve policy approach will do the opposite of what is needed.

Sure, suppressing business to lay off workers to reduce demand will work if you slam on the brakes hard enough. But trashing our economy to stop inflation is not necessary. What the Federal Reserve is missing is a demand-side tool to ratchet down demand when markets for goods and services become overheated.  

Under the Postal Savings Act of 1910, our post offices served as banks for 56 years from 1911 to 1966. You could go to any of our 34,000 post offices to cash a check or set up a savings account. The Public Banking Act, which was recently introduced in the Congress to create postal bank accounts, could be modified to provide the Federal Reserve with a demand-side tool to curb excessive inflation without throwing our economy into a recession.

Demand can be tamped down and supply encouraged by recreating the postal savings accounts and offering high interest rates in those savings accounts on balances up to some specified limit, such as $10,000 (with no interest earned on amounts above that limit), while leaving the rates in the New York financial markets relatively low to stimulate, not suppress, supply. 

Higher interest rates will encourage savings. Saving more and spending less is obviously what is needed when too much money is chasing too few goods. If we offer high enough interest rates in postal bank accounts dispersed in our 34,000 post offices around the country, excess demand can be reduced enough to stop inflation without forcing the economy into an unnecessary recession. This approach withdraws money from the economy by offering a return on investment, not by taxation. People will still be able to purchase their necessities, but will be motivated to delay or cut back on luxuries until the economy cools off and postal bank interest rates return to normal. 

This will especially benefit the elderly who need a good return on their savings to help finance their retirement. Having more people save more money will also serve as an automatic stabilizer by providing people with the savings they need to ride out economic downturns, which, in turn, will make such downturns shorter and less extreme.

Note that the Federal Reserve is independently financed from its bank fees and investments, which produce enough revenue such that the Federal Reserve donates more than $80 billion to the U.S Treasury each year. The Federal Reserve, not the taxpayers, can pay for setting up and operating the postal banks. The Federal Reserve could also help pay for postal employee pensions. This will reduce, not increase, the overall tax burden. 

With reasonable limits on the savings and loan amounts restricted to one account per person or small business, these postal banks can avoid interfering with the normal functioning of the commercial banking industry. Of course, banks will oppose any intrusion onto their turf, but the broader benefit to the country as a whole must be taken into account.

When the opposite conditions develop with low demand, high unemployment, and the start of a deflationary cycle, postal banks could offer small loans at relatively low interest rates to individuals and small businesses. Such a loan program has already been proposed in bills formulated in both the Senate and the House in the last few years such as Senator Kirsten Gillibrand’s Postal Banking Act as Senate bill S.2755 or Representative Rashida Tlaib’s Public Banking Act as House bill H.R.8721. These bills are aimed at helping unbanked and underbanked people who live paycheck to paycheck and suddenly face job loss, a medical emergency, an automobile accident, or some other event that forces them to go to loan sharks, pawn shops, payday loan dealers, or “cash now” providers who typically charge exorbitant interest rates.

Postal bank savings accounts offering high interest rates could attract middle-class and working-class people, and those with high marginal propensities to consume who tend to spend most of their income except when offered an exceptionally high interest rate on savings. This will provide the Federal Reserve with a demand-side tool to directly impact Main Street instead of relying on indirectly influencing demand through a supply-side tool aimed at Wall Street.  Targeting demand through postal bank accounts to stop excessive inflation or, alternatively, to stimulate demand in a weak economy will be much more cost effective in offering more bang for the buck, will be more direct and have a more immediate impact, use less money and be less disruptive of our economy than current Federal Reserve supply-side stabilization strategies. 

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Use More Creativity in Funding Government

Posted on by Lawrence

USE MORE CREATIVITY IN FUNDING GOVERNMENT
Get your name on buildings, streets, programs and positions.

How did America create and pay for the best teaching and research universities in the world? What can government learn from this success story? When both carrots and sticks are known to motivate, why restrict funding to sticks (tuition or taxes) when carrots (donations and endowed chairs) could also provide money?

In my recent book (“Optimal Money Flow”) I proposed the taxpayer appreciation program (TAP), which would allow the naming of a taxpayer supported institution or edifice after those who pay an especially high estate tax. For example, at some point in the future, and with the approval of the appropriate board, a primary school in Omaha, Nebraska might be named “The Warren Buffett Elementary School.” Of course, you only get to die once so under TAP you could only get one institution or edifice named in your honor.

However, there is no reason that such naming should be limited to estate taxes or taxes in general. Universities allow donors to have their names attached to campus buildings, programs, scholarships and professorships. Whatever people are willing and able to fund might be considered for approval. Why shouldn’t the public sector explore this approach as well? Voters or their representatives could approve a particular donor to have their name attached to a building or road. You might be able to pay to have “Union” in Union Station or “Country” in Country Lane replaced with your name.

But what about funding actual government positions as endowed chairs? A donor named John Smith could donate a few million dollars to make Mayor Bill de Blasio the John Smith Mayor of New York City. If several wealthy people want to bid for naming an official government position, the naming of the position could be auctioned off. Of course the funding for these positions need to be large enough to pay both the future salaries and operating expenses of the named position. This would free up tax money to pay other expenses, or that tax money could be earmarked for a reserve fund to be used in an economic downturn instead of cutting back services or going into the red.

If having individual donors pay to have their names associated with key positions seems unseemly, with the approval of her family and next of kin why not create a “Go Fund Me” page to create a Ruth Bader Ginsburg Justice of the Supreme Court? The nation as a whole could show their respect and appreciation along with that of her important and wealthy friends and colleagues by funding a Supreme Court position in her honor. One of Georgia’s senators could be named the John R. Lewis Senator of Georgia. Endowed positions could eventually be created for every position in the Congress of the United States.

As the wealthiest Americans accumulate more and more money, they may wish to use their money more creatively than just investing it all in the stock market. Not every wealthy person has the ability and ambition to create an Amazon or a Tesla so offering them another way to get their name out there may be just what they were looking for. Alternatively, a “Go Fund Me” page for honoring our fallen heroes may be exactly what we need to reestablish our sense of commitment and unity as a nation. Let’s hope that our leaders will have the courage to give it a try. It has got to be more popular than raising taxes or running up the national debt.

Ranked-Choice Voting Blocks Extremists From Power

Posted on by Lawrence

New York City has joined Maine in recognizing the danger of traditional plurality voting methods and has embraced ranked-choice voting. Ranked-choice voting is not new. Australia started using it in state elections in 1918, and Ireland started using it in presidential elections in 1937. Commentators have frequently pointed out that ranked-choice voting eliminates extremist candidates who are not favored by a majority of the electorate and allows a more moderate candidate to get elected. But the best way to understand the pitfalls of our traditional plurality voting system and the advantages of ranked-choice voting is with some simple examples.

Suppose that there are only three candidates. Candidate A gets 35 percent of the vote, Candidate B gets 33 percent, and Candidate C gets 32 percent. Without a runoff election, Candidate A wins even if most of those who voted for Candidate C would have preferred candidate B. In the extreme case, Candidate A was preferred by only 35 percent of the voters with 65 percent opposed, yet Candidate A wins, while a majority of the voters favor Candidate B. With Ross Perot running as a third party candidate in 1996, neither Bill Clinton nor Bob Dole was able to get a majority of the votes. We will never know who would have won if Ross Perot had not been in the race.

A runoff election could solve the problem, but only with an expense that would be unnecessary if the original ballots had allowed each voter to rank the candidates as first choice, second choice, and third choice. In a three-candidate race under ranked-choice voting, if none of the candidates received 50 percent or more of the votes in the first round, the third-choice candidate would be eliminated and the ballots of all those who had ranked that candidate as their first choice would be recounted, moving their second choice candidate up to first place. In the extreme example above, this ranked-choice voting procedure would enable Candidate B to win with 65 percent of the vote without requiring an expensive runoff election.

In the 2000 election both in Florida and nationally, George Bush beat Al Gore, but failed to get a majority of the votes, with Ralph Nader as the spoiler candidate. If ranked-choice voting or a runoff election had been used in Florida in 2000, Al Gore might have won the presidential election, but we will never know. In November of 2018 in the Australian state of Victoria in a race with several candidates, a Green’s party candidate, who came in third in the first round of voting, won the election under the ranked-choice voting system. In other words, ranked-choice voting can sometimes make a dramatic difference in an election outcome.

Now consider an election with 13 candidates as in the June 22 Democratic primary for New York City mayor where ranked-choice voting was used with voters ranking up to five candidates. First suppose that the traditional plurality voting method was followed. Imagine that an extreme left-wing candidate got 17 percent of the vote and an extreme right-wing candidate got 17 percent of the vote, and each of the 11 moderate candidates got 6 percent. Even in a runoff election between those top two extremist candidates, the winner might be truly favored by only 17 percent of the electorate with a majority of the voters preferring any of the more moderate candidates. In other words, in the extreme case, a candidate with just over 17 percent of the vote could get elected under traditional plurality voting even with almost 83 percent of the electorate strongly opposed to that candidate. If ranked-choice voting had been used instead, the most likely outcome would be the election of one of the more moderate candidates. In other words, under traditional plurality voting, even in the case of a runoff election between the top two candidates, one of the extreme candidates would win, but under ranked-choice voting, a more moderate candidate, preferred by a majority of the electorate, would ultimately win.

Maine is the first state to mandate ranked-choice voting in federal elections. Losing Republican incumbent Bruce Poliquin from Maine’s Second Congressional District challenged the use of ranked-choice voting in federal court. He was in the lead in the first round, but lost after the votes of third-party candidates were reassigned under the ranked-choice voting procedure. After losing the recount and after a federal judge rejected the claim that ranked-choice voting was unconstitutional, Poliquin ceased his challenges to the outcome of the election.

In Maine and several cities throughout the United States, ranked-choice voting has been successfully implemented without much confusion or disruption. Once the voters get used to it, they will see how easy it is and the advantages of ensuring that only candidates with widespread support get elected. The delay in the New York City tabulation is not due to the use of ranked-choice voting, but because of the need to wait until all the votes, including all those mailed-in ballots, are received. Once all the votes are in, it only takes a few nanoseconds for the computer to determine the winner under ranked-choice voting.

We like to think of the United States as that “shining city on a hill” as President Reagan said, yet our democracy has serious drawbacks and disadvantages. A combination of our traditional plurality voting system, especially as used in primary elections to defeat more moderate candidates, along with gerrymandering, influencing politicians through massive campaign contributions, and other aspects of partisan politics, has produced a much less attractive version of democracy. The widespread use of ranked-choice voting could be one step in the right direction toward correcting these deficiencies.

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