Shareholders vs. Customers: Who’s Winning?

The foundation of free enterprise is Adam Smith’s invisible hand, which asserts that competition drives prices down and quality up as profit-seeking behavior results in minimal profits for the profit-seekers and maximal benefits for society as a whole. This world of free enterprise where “greed is good” is said to benefit us all because the greedy don’t end up with that much because the money is diverted into making great products that sell at low prices. This tug-of-war between shareholders and consumers in the end is a zero-sum game once the workers in the aggregate are also recognized as the consumers. In a truly competitive free market system, the consumers win and the company just gets the standard run-of-the mill profits in spite of their enormous efforts to bring about a more profitable outcome. The workers are the consumers who must earn at least enough to buy back the value of the goods and services that they are creating (as explained by the money flow paradigm). Henry Ford recognized this in the early 1900s when he doubled his workers’ pay to retain his skilled workforce and to enable his workers to buy cars that they were making. This also motivated his workers to focus on producing high-quality cars. Ford defied the common property resource problem and free rider problem where employers would like other employers to pay workers more to generate more customers for their products, but not pay their own workers more. Nevertheless, some employers complained about the “bad” example Ford was making in raising his workers’ pay.

The absence of competition leads to the opposite result. Monopoly power results in maximum profits, high prices, reduced quantity and minimal quality. Barriers to entry can result from economies of scale, network effects, first-mover advantage, economies from experience, and natural monopolies. Even industries with many firms may maintain a follow-the-leader discipline as a large dominant firm sets prices for all to follow. Adam Smith’s first invisible hand of competition is often defeated by Adam Smith’s implicit second invisible hand of market power and collusion as Smith noted when he said: “People of the same trade seldom meet together, either for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

Ultimately, this translates into a conflict between the short-term interests of shareholders, who are focused on maximizing short-term profit margins and share price, and the long-term interests of the customers and the long-term viability of the company as a whole. This is especially true in modern times as technology constantly produces new products and services and improves economic efficiency and productivity. Money going into dividends and share buybacks is not going into product development and customer satisfaction. Cutting costs to improve profit margins often means cutting quality and restricting quantity. We have all seen inflation not only raise the price of our favorite treats but also shrink the quantity in the bag or box.

Asking whether the free enterprise system will correct these diversions and distortions is asking who is in charge and what are the effects of their decisions? In a true free enterprise economy where Adam Smith invisible hand of competition dominates, it is the customer who ultimately is in charge. But in the real world of imperfect competition, the CEOs and corporate boards call the shots. They can focus on the customer and constantly improve quality, quantity and productivity, while seeing prices fall in a truly competitive environment, or they can skip all that and focus on short-term share price with an expense minimization strategy that cuts costs often by sacrificing quality.

But what about Joseph Schumpeter’s creative destruction? Won’t the noncompetitive firms lose out in the long run and be replaced by truly competitive ones? As usual, we want the world to be simple and provide us with a story where we all live happily ever after. In reality, large companies can accumulate or draw upon large amounts of cash. When an economic slowdown comes about, the small, efficient, family-owned restaurant may go belly-up, while the somewhat inefficient, but well-financed, larger firm may have enough cash to ride it out and even buy up those competitors with less access to cash. Perhaps Schumpeter would have been more realistic by calling it competition destruction when firms go under in an economic downturn. Rather than strengthening Adam Smith’s first invisible hand of competition, recessions work to shift market power to Adam Smith’s second invisible hand of collusion.

But so far we have only been looking at industry level effects. What about the economy as a whole? Is money automatically flowing in a manner to maintain a well-balanced economy with maximum productivity and economic growth? Prices may be somewhat rigid when set by dominant firms, but don’t wages adjust automatically to move us back toward an economic equilibrium of full employment? This requires a great deal of mobility and substitutability. Perhaps you lost your job in New York, but your former college roommate tips you off to a great job fit for you in San Francisco. Oh, wait a minute. I forgot. Two-thirds of Americans don’t have a college degree. They don’t have a former college roommate or anyone else on the inside track elsewhere. Or what if you have a partner who has a job and needs to stay in the area? Perhaps you own a house or have relatives you want to keep close to. Labor mobility sounds nice in theory, but can be a lot harder to achieve in reality.

People want to get the best wage they can. But they have to compete with other people who may be willing to take the same job for a bit less pay. Competition among workers is alive and well in most venues. But what about jobs? In theory, jobs compete with one another for workers. If a worker gets a job offer, but finds a comparable job for a bit more, he or she is inclined to take the better paying job. The problem is that jobs often conspire with one another to form job blocks, just as workers can conspire with one another to form unions. Think of the coal mining town. There is only one major employer in town — the coal mine. The coal mining company forms job blocks where workers are all hired at a fixed wage. Take it or leave it. The resulting wage rate can be considerably less than the free market equilibrium wage. This can be corrected. Workers can form a union and demand the free market equilibrium wage. John Kenneth Galbraith in his 1952 book: “American Capitalism” refers to this as countervailing power. Economists understand this under their Theory of the Second Best, which says that when one factor is out of whack (e.g., monopsony) and cannot be fixed, the best solution is to have another out of whack factor (e.g., union) to counter it.

Workers often confront blocks of jobs that cheat the workers out of the free market wage. Almost every employer controls more than one job and fixes the compensation for the jobs under their control. In the decades after World War II, unions controlled as much as 35 percent of the workforce and this caused even nonunionized firms to pay the union wage to their workers. Today, unionization has dropped below 10 percent and, if you don’t count government employment, unionization has dropped to below 6 percent of the private workforce. Without a union, workers are unable to counter those ubiquitous blocks of jobs. For the economy as a whole, this means that significantly less money is flowing to workers than would be the case under a truly free market economy.

The fundamental problem is that the people on Main Street can no longer afford to buy back the value of the goods and services that they are producing. Oligopolies ( just a few sellers ) and oligopsonies ( job blocks ) dominate many of our major industries. Moreover, about 60 percent of Americans are living paycheck to paycheck. Private debt has skyrocketed. But even that is not enough to maintain full employment. Politicians love to complain about the national debt and how they intend to get rid of it or at least balance the budget. But Republicans pass unpaid for tax cuts and Democrats pass unpaid for expenditures increasing public debt in order to avoid having the economy slip into a recession and end up losing votes at election time.

Why wasn’t this problem fixed after the 2007-2009 Great Recession? Yes, the Federal Reserve did pour huge amounts of money into the New York financial markets. But very little of that money tricked down to the average Joe or Jane on Main Street. With 84 percent of the stock market owned by the 10 percent richest people, quantitative easing (QE) just drove up stock prices to make the wealthy people wealthier and drove down interest rates to facilitate the private debt of most everyday Americans while the government increased its public debt. This distorted money flow was a result of too much money flowing to passive investors (shareholders) and too little money going to workers (the consumers) and to creative entrepreneurs who produce new and better products and improve productivity.

To solve these problems we need to focus on the money flow paradigm which reveals the need for a more balanced money flow that does not require huge amounts of private and public debt and does not divert enormous amounts of money to passive investors (shareholders). We need to direct more money flow to creative entrepreneurs to create new and better products and services and to all our workers who are the consumers of those goods and services. Correcting our money flow involves a variety of fundamental governmental and corporate changes, but we must first more fully appreciate our money flow problem as revealed by the money flow paradigm.

Our Winner-Take-All Economy Distorts Money Flow

The money flow paradigm explains key aspects of the American economy. Why does deficit spending prevail even though almost every politician complains about it? Why has our economy grown a glacial rate of less than 3 percent a year while the stock market has been growing for many decades at an average rate of 10 percent a year? How has the perverse incentive structure of our “free enterprise economy” been undermining and suppressing productivity and economic growth? Why have corporate boards become so focused on CEO pay and the maximization of shareholder value at the expense of innovation and creativity, and incentives for rank-and-file employees? And, finally, what does the money flow paradigm tell us to do to correct all of these problems?

The American people haven’t been receiving enough money to be able to buy back the value of the goods and services they produce. The wealthy can only wear one pair of shoes at a time, drive one car at a time, and eat out at just a few fancy restaurants each day. Rich people can bid up the price of Picasso paintings and exclusive properties, but that isn’t enough to maintain full employment. Many Americans are deep in debt. Yet, without government help, they are unable to create enough demand to avoid recession. Politicians love to complain about our national public debt, but Republicans pass unpaid for tax cuts to stimulate demand and Democrats pass unpaid for expenditures, because, otherwise, we would be in a permanent recession, and those politicians would lose votes at election time. 

The financial economy exists to provide money to invest in the real economy. For many decades the Federal Reserve has pumped so much money into the New York financial markets that stock prices have risen at an average annual rate of 10 percent. Under these circumstances even non-financial companies have come to realize that they can make more money in the New York financial markets than in investing in their own businesses. This has caused a reverse money flow with money flowing out of the real economy and into the financial economy. Consequently the real economy has been growing at an average of less than 3 percent.  This reverse money flow has suppressed productivity and economic growth in the real economy with big increases in stock share buybacks and dividends. The Federal Reserve needs to stop pumping up the financial economy every time the money flow into the real economy is weak and instead inject money directly into the real economy via “FedAccounts” for everyone with a social security number.  Again, the fundamental problem (as explained by the money flow paradigm) is that so much money is being diverted to the top ten percent of wealthiest people (who own 84 percent of the stock market) that the American people cannot afford to buy back the value of the goods and services that they are producing.

CEOs often get fellow CEOs and other corporate leaders (their golf buddies) to serve on their corporate boards. The CEO provides reports revealing what a great job that CEO is doing. This helps maximize CEO compensation and motivates short-term stock price manipulation and maximization, which is rationalized under the maximization of shareholder value mantra but does not incentivize long-term innovative physical and intellectual investments in the long-term health and profitability of the company.

 SOLUTION: Follow Germany’s example and require that 40 percent of corporate boards be elected directly by the company employees in product development, production, marketing, sales, and product distribution.  ALSO: Require that all stock buybacks be immediately given to the company’s rank and file employees and not set aside. Company stock ownership will motivate employees both individually and as a team to work hard and do the very best for their company. Redistributing stock buybacks to a company’s employees will help make the transition from companies owned by outsiders (passive investors) to companies owned by insiders (company workers).

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.


Reverse Money Flow Suppresses Productivity and Economic Growth as Revealed by Money Flow Paradigm

Several economists such as George Cooper, Ray Dalio, and Hyman Minsky, among others, have pointed out that the financial markets operate in a fundamentally different manner than the markets for ordinary goods and services. In ordinary markets, demand retreats as prices rise.  In financial markets, particularly in the stock market, rising prices induce people to buy more stock, not less. Conversely, when stock prices drop dramatically, people pull their money out of the market, making prices drop even more dramatically. While most markets exhibit a negative feedback loop where higher prices curb demand, the financial markets tend display a positive feedback loop with irrational exuberance as prices rise and a downward spiral as prices fall.

However, the Money Flow Paradigm has now revealed the full picture of how the separation of the financial markets from the real economy can reverse the flow of money, which normally flows from the financial markets into the real economy, and instead cause a backward flow from the real economy into the financial markets in a manner that can be self-enforcing, especially when assisted by major national and international movements of money into the financial markets.

This regurgitation of money from the real economy back into the financial economy is a product of the maximization of shareholder value as in maximizing short-term share stock price, often using money for stock buybacks instead of for investments in the real economy.  The GDP in the real economy has been growing at an average of three percent per year for several decades while stock market prices have averaged ten percent per year.  This has caused many non-financial businesses to invest money that would otherwise go for improving productivity and product offerings and instead invest that money in the stock market.

Before 1982 the Securities and Exchange Commission (SEC) treated stock buybacks as insider trading and forbid them. Starting in 1982 the SEC allowed stock buybacks, a change in regulations that has significantly and substantially undermined productivity and economic growth in the real economy. In the past banks made loans locally and stayed with those loans until they were paid back. More recently banks have been making riskier loans because they know they can sell off or securitize the loan in the financial markets. This has increased the instability of the financial markets and our economy overall. 

Bed, Bath & Beyond under CEO Mark Tritton is only one of many U.S. firms that have engaged in “financialization” where the focus is on saving money and investing it in stock buybacks to boost the firm’s short=term stock share price instead of in offering better products at lower prices through improvements in productivity and customer satisfaction. Tritton swapped cheaper in-house brands for the quality national brands in his financialization efforts.

Silicon Valley Bank is another example where the company invested too much money into bonds in the New York financial markets and failed to invest adequately in developing exciting new products for consumers. There is an inverse relationship between bond prices and interest rates. This occurs because bonds fix the coupon value at some initial interest rate. This coupon value does not change after the bond is issued. When interest rates rise on new bonds, the old bonds lose value so that the coupon value relative to the bond prices reflects the proper interest rate relative to price as established by the new higher-interest rate bonds. Silicon Valley Bank had overinvested in bonds in the financial markets and as interest rates rose the value of its bond portfolio fell dramatically triggering its financial crisis. 

Back in the day, our economic system rewarded customer-focused entrepreneurs such as Steve Jobs of Apple, Inc. who came up with new and innovative products.  But then John Sculley came along and told Steve that he needed a professional manager, someone who could increase profit margins and more quickly raise Apple’s short-term share price. By diverting money from product development and innovation to share buybacks and cost cutting, Sculley undermined Apple’s competitive position. When Microsoft and others began to surpass Apple in creativity and innovation, Apple’s board realized their mistake, removed Sculley and brought back Steve Jobs. Companies that forget about their customers and emphasize cost cutting over product development jeopardize their competitive advantage and future profitability.

The U.S. Federal Reserve has also played a role in the suppression of productivity and economic growth in the U.S. economy.  Back in 1996 Fed Chair Alan Greenspan complained of irrational exuberance in the New York financial markets but did little or nothing to counter it and instead contributed to the problem by having the Fed purchase more U.S. Treasury securities. Later under Ben Bernanke and subsequent Fed Chairs the pumping of money into the financial markets continued under the rubric of quantitative easing. This pumping of money into the financial markets increased the wealth gap by driving up prices in the financial markets at the expense of productivity and economic growth in the real economy as revealed by Christopher Leonard in his book “The Lords of Easy Money” and by Karen Petrou in her book “The Engine of Inequality.”

China has played a role in this suppression of U.S. productivity and economic growth along with the U.S. Federal Reserve Bank. For several decades the Chinese has taken their resources and worked hard to produce good quality products sold at low prices in the U.S.  However, instead of sending our products back in return to China, we have seen sending them pieces of paper with George Washington’s picture on it (U.S. dollars).  Ordinarily, these U.S. dollars would flow into the foreign exchange markets and drive down the value of the U.S. dollar, making our products cheaper for the Chinese to purchase and Chinese products more expensive in the U.S.  However, the Chinese government does not allow this to happen. Instead, they require that Chinese businesses turn in those U.S. dollars to the Chinese government in return for Chinese currency (yuan, aka renminbi).  China then has its sovereign wealth fund invest those dollars in U.S. Treasury securities in the New York financial markets. The Chinese government now owns trillions of dollars of U.S. Treasury securities. In effect, we gave China a lot of money in purchasing their products, but instead of using that money to buy our products, China has loaned us our money back again by purchasing U.S. Treasury securities. This has contributed to the suppression of productivity and economic growth in the U.S.  Other nations have followed China’s lead in this regard and also have trillions of dollars invested in U.S. financial markets.

Rewarding Risk Under Free Enterprise

Free enterprise works well when incentives are set to encourage hard work and creativity, but free enterprise can perform poorly when risk taking just for the sake of risk taking is encouraged and rewarded. A 65 year-old with only $100,000 to invest may be taking a big risk, but a multi-millionaire putting $100,000 on the line can hardly be said to be taking the same degree of risk. To say that we should always reward risk means that encouraging casino gambling, cyber-coin gambling, and stock market gambling on highly volatile stocks somehow enhances the efficient allocation of resources. It is all too clear that increasing volatility by excessive risk taking does not contribute to the efficient allocation of resources, but makes the economy more unstable and less likely to operate efficiently or productively.

The maximization of shareholder value mantra has distorted incentives by diverting money away from the real creative entrepreneurs and their workers and, instead, rewarded passive investors who may be taking very little real risk. I came to realize this personally when I recently discovered that I had obtained a seven thousand percent return on some stock that I had purchased a number of years ago. I had even forgotten that I had made the investment. I certainly deserve a descent return on my investment, but seven thousand percent makes no sense. As far as this creative enterprise (Adobe) was concerned, I was a complete deadbeat. Other than provide a little money, I did nothing to help the company. The hard work of creative entrepreneurs and their workers pays off, but not always all that much for them. Their hard work pays off for the shareholder, who gets most of the reward.

But the risk, the risk! Aren’t shareholder bearing the burden of the risk? If you are about to retire and only have $100,000 in your retirement account, then you are certainly taking a serious risk in any uncertain investment. However, eighty-four percent of the stocks are owned the richest ten percent. When you have a lot of money, the question is not whether to invest or not, but where to invest. What else are you going to do with the money? Are you going to take it home and stuff it in your mattress? You can only wear one pair of shoes at a time and only drive one car at a time. Do you really want to buy a lot of cars and have to arrange to change the oil from time to time and get all those state inspections? How many vacation homes do you want to take care of? Sure, you can bid up the price of Picasso paintings and exclusive properties, but at the end of the day investing in the stock market for most stock market investors is not a risky business that could seriously affect their lives. Losing a few million dollars here and there is no serious problem. Just give stock market investors a decent return, but not seven thousand percent. Save most of that money for the creative entrepreneurs and their hard-working employees. If you really believe in rewarding entrepreneurs and their hardworking employees in a free market economy, drop this maximization of shareholder value nonsense and get real about who is taking the real risk.

( Note: Lynn Stout in her book “The Shareholder Value Myth” provides a more complete understanding of this issue. I both bought a copy of her book and also listened to it for free at: ).

Are CEOs and their golf buddies suppressing innovation and productivity in their effort to maximize shareholder value?

My father was a Wall Street investment banker in the 1950s and 1960s. His industries included steel, aluminum, automotive, and grocery-store chains. He was paid partially on the basis of his investment recommendations, regardless as to whether the investment committee accepted them or not. If his recommendations did well, he did well. He worked hard and often spent evenings and weekends with his long, yellow, legal pads working out mathematical calculations. Computers were not widely available back then. He earned a modest, but comfortable salary, that enabled him to send me in third grade and my sister off to summer camp and boarding school (and later to college and graduate school) when my mother came down with tuberculosis.

I learned to set my limit orders and stop-loss orders as the stock market opened and to expect a reasonable return on my investments. Back then, Wall Street was not a gambling casino. People were rewarded for their creativity, innovation and productivity. Unions represented 35 percent of the labor force. As output per labor hour rose with the introduction of automation, the real wages of employees rose correspondingly. Hard work paid off. The agency of employees as the heart and soul of a business was recognized. Their initiatives in improving product development, production, marketing, sales, and distribution were rewarded. Adam Smith’s invisible hand of competition seemed to be working well in producing better quality products at ever lower prices.

However, starting as early as the mid-1970s, the behavior of many corporations began to change. The “we’re all in this together” attitude coming out of World War II began to dissipate. Some firms began to treat employees as just another factor input like steel or plastic, as if they had no agency. The performance of the exceptions to this rule were striking. The employee-owned construction company Burns & McDonnell in Kansas City grew over the years from a small, local company to a nation-wide and, ultimately, a world-wide construction company. It was entirely employee owned. Its amazing success has been recounted by former B&M CEO Greg Graves in his recent book: “Create Amazing.”

Warren Buffett and others have noted the limited scope of understanding of some corporate boards of the company’s operations. Often board members get most, if not all, of their information about company operations from the CEO. Based on his experience on corporate boards, Steven Clifford has written the book: “The CEO Pay Machine” where he implies that board members are often basically the CEOs golf buddies. CEOs often serve on each other’s corporate boards. They may feel obligated to maximize the CEO’s compensation in return for his vote on their board to maximize theirs. Before 1982, stock buybacks were considered insider trading and were illegal. Starting in 1982 the Securities and Exchange Commission (SEC) began allowing stock buybacks, which are now frequently used to jack up the stock price at the corporate board’s discretion in controlling the amount and timing of such buybacks.

Following President Reagan’s firing of the 11,000 striking air traffic controllers and temporarily replacing them with military air traffic controllers on August 5, 1981 and barring them from ever working again for the federal government under the Taft-Hartley Act of 1947, unions began to lose their clout and have now dropped to less than 10 percent of the overall labor force, including just 6 percent of the private (non-government) labor force. Meanwhile, industries throughout the United States have become increasingly concentrated. Denise Hearn and Jonathan Tepper have carefully documented this rise in industrial concentration in their book: “The Myth of Capitalism,” which perhaps should have been titled: “The Myth of Competition.” Jan Eeckhout followed this with the book: “The Profit Paradox,” which documents the dramatic rise in market power both nationally and internationally. Patents have been extended way beyond the period needed to recoup the costs of investment. Patent trolls create nothing but file patents on some company’s unpatented processes and products to get them to settle out of court to avoid expensive court battles. Government regulations have been subject to regulatory capture where regulators develop close relationships with companies that are then able to twist regulations to block entry to their industry.

The collapse of anti-trust and effective market oversight has been rationalized on the basis on lower prices through economies of scale and network effects. While prices have fallen somewhat, they have not fallen as much as they would have in markets where corporate market power was not so strong. In effect, the benefits of economies of scale and network effects have been countered to a great extent by what might be called Adam Smith’s second invisible hand. Some free market enthusiasts have conveniently forgotten that Adam Smith said: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the publick (sic), or in some contrivance to raise prices.” While Smith’s first invisible hand of competition lowers prices, his second invisible hand of collusion raises prices (or at least limits their fall under economies of scale).

I did not fully understand or appreciate the effect of market power until I read Simcha Barkai’s article “Declining Labor and Capital Shares” in The Journal of Finance (no. 75, issue 5, 2020). Barkai noted that over the period 1984 to 2014, while labor’s share of revenues dropped by 11 percent, the share of real capital dropped by 22 percent. It was only then that I realized that the money flowing to Wall Street was not primarily going into new investments in plant and equipment, but was being retained as profits and used primarily for dividends and share buybacks. Efforts to improve productivity through innovation has largely been replaced with financialization where cutting costs (including a drop in employee compensation in real terms) has taken precedent over efforts to create new and exciting products to grow the company. As a result, gross domestic product (GDP) has typically grown less than 2 percent a year, while the stock market has averaged an annual growth rate of about 10 percent in recent decades. Corporate boards are diverting money away from innovation, employee compensation, and better quality at lower prices for customers, in favor of maximizing shareholder value (as well as maximizing CEO and upper management pay).

Given all this, I should not have been surprised when an investment I had made back in the 1990s gave me a 7,000 percent return. I had forgotten about this investment and did absolutely nothing to help the company, other than loan them a bit of money. I thought that free enterprise was all about rewarding hard work and creativity. Why was so much of the money going to me? Oh, but the risk, the risk!!! Please, give me a break, what was I supposed to do with this extra money, other than invest it? Was the alternative for me to take the money home and hide it in my mattress? Sure, give me a decent return, but stop this insanity. A 7,000 percent return is way over the top. The rise in market power and the maximization of shareholder value is stifling our economy and hurting our country. Much of this money should have gone as incentives for rewarding employees for their creativity and hard work. Some should have allowed for providing customers with better quality products at lower prices as promised under Adam Smith’s first invisible hand.

Proposing solutions for all of these problems is way beyond the scope of this commentary. Clearly, government anti-trust procedures and the role of government regulators needs to be reexamined. However, I recommend a couple of simple solutions in the commentary below.

First of all, Germany has led the way in solving the problem of empowering and incentivizing employees in improving the productivity of their companies. In addition to work councils, Germany requires employee representation on corporate boards. We could greatly improve the performance of our companies while enhancing the compensation of employees and benefiting from their knowledge of company operations by requiring that 40 percent of all corporate board members be elected by rank and file employees. For larger companies, such representation could be distributed throughout the company by areas of operation such as representation from product development, production, sales, marketing, and distribution.

Finally, I recommend that the SEC rules be changed to require that all stock purchased in a company’s stock buybacks be distributed to the company’s employees based on their hard work, productivity, and tenure. This would block the manipulation of the stock’s market price and give employees more of a stake in the company. It would also help transform companies from a simple authoritarian command structure into more of a team of players focused on growing the company over the longer term.

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Maximizing Shareholder Value Hurts the Free Market

When teaching economics, or almost any subject, we try to portray the material we are presenting as simple, logical, and straightforward. “Introductory Economics” is supposed to be just that => a clear and compelling presentation that makes sense. If we call it “Principles of Economics,” we want to present the ideas as truths that will hold in virtually every context and hold up over time. Students should not be surprised that beginning economics is presented as reflecting rational, independent decisions of self-interested individuals with foresight and reasonable and rational expectations. We want students to believe in the “laws” of economics that move us efficiently and effectively to an equilibrium solution where supply and demand meet at the equilibrium price and quantity.

But is this the real world? Is there just one price for gasoline that clears the market or is there a wide array of prices throughout the city? Are the interest rates for certificates of deposit of the same tenure the same for all of the banks in your area? Are we leading our students astray when we present such a nice, neat package of ideas portraying economics as driven by irrefutable forces that clear the market? What about contagion effects that drive irrational exuberance in the stock market driving stock prices higher and higher until reaching such unrealistic price-earnings ratios that they finally collapse in a “Minsky moment”? Do fear and uncertainty cause investors to sell their stock shares in a rush to the exits just as stock prices bottom out in a bear market? When housing prices collapse, do we try to blame all those NIJA (no income, no job, no assets) loans on the government or face the reality of short-term profit seeking overcoming longer-term rational judgement? What about the role of securitization? Don’t mortgage-backed securities encourage the transfer of risk from the banks that knowingly make risky loans because they know that they can quickly offload them to distant investors who are clueless?

After all, in 1994 two Nobel prize winning economists (Myron Scholes and Robert Merton) help found a hedge fund called Long Term Capital Management (LTCM) which ended in bankruptcy in 1998, because they assumed that markets that were out of equilibrium would return to equilibrium before too long. Too long turned out to be longer than they thought. Their leveraged position was so large and so untenable that it put the entire financial system into jeopardy. Ultimately LTCM had to be bailed out with the help of the government.

The idea that our economic system is all about rationality and about individuals fine tuning their optimal strategies to maximize their individual well-being can be very misleading and far from the real world. Perhaps we would be better served by the story of disequilibrium economics where our economy operates in a very precarious and unstable state with anti-equilibrium forces constantly fighting against and often overcoming equilibrium forces. Instead of economic paradigms that see an efficiently operating free market economy with only occasional disruptions requiring government intervention (Keynesian paradigm) or not (Austrian paradigm), we need to adopt the more realistic money flow paradigm that sees government with all its rules, regulations, taxes, and expenditures as the heart of the free market. Pretending that government is not needed (neoclassical paradigm) or should totally dominate every major economic decision (Marxian paradigm) does not provide us with a true path to the efficient allocation of resources, which, after all, is what economics is all about.

The money flow paradigm reveals the most disruptive and destructive force that is currently undermining the economic incentive structure and the efficient and effective allocation of resources in our economy. It is the short-term, narrowly focused excuse for suppressing the entrepreneurial spirit, denigrating product quality, and undermining employee incentives called “maximizing shareholder value.”

The great success of Apple, Inc. was not due to a short-term focus on maximizing shareholder value but instead due to the determination of the entrepreneur Steve Jobs to change the world by providing new and exciting products affordable for the average consumer. After starting Apple Computer with great success but eventually being talked into hiring a professional manager, Jobs was set aside for his failure to focus on maximizing shareholder value. He then set out on his own to create Pixar Animation. However, Apple did poorly under the maximizing shareholder value mandate, and Steve Jobs was brought back in to restore the mission of producing amazing products to change the world.

Another case that reveals the destructive nature of using financialization in a short-term effort to maximize shareholder value is the case of Saluto Pizza. The pizzas produced by the pizza business, Saluto Pizza, in Saint Joseph, Michigan, became so popular that the owner began freezing the pizzas for people to reheat and eat at home. Local supermarkets soon agreed to sell the Saluto pizzas. Saluto pizzas became widely available in the Midwest. In fact, they were so popular that Saluto Pizza opened a production plant in Montgomery, Alabama to serve the grocery stores in the South. Again, the pizza was very popular and sales were brisk. But then a large food conglomerate stepped in and bought up Saluto Pizza. In an effort to maximize shareholder value using the financialization strategy of cutting costs to maximize short-term profits, the crust, marinara sauce, and other ingredients were cheapened until sales of the pizza dropped precipitously and the production of the pizza was discontinued.

Many more stories of this sort as well as turnaround success stories when companies moved away from the narrow, short-sighted emphasis on maximizing shareholder value are told by Harvard Professor Rebecca Henderson (2020) in her book: “Reimaging Capitalism in a World on Fire.”

But the emphasis on maximizing shareholder value in adding to the inefficient allocation of resources and aiding the anti-equilibrium forces in our economy manifests itself in undermining employee incentives. Before the time of John Locke (1632-1704) the natural resources of the world were viewed as the property of God or, in the case of native Americans, the spirit world. But then Kings claimed to have been given dominion over the natural resources by God. You could not take fish from the stream or deer from the forest without permission from the King. But Locke introduced the idea of private property. Locke argued that people owned their own labor and that by imbuing their labor into natural resources they established their ownership of capital such as a wooden plow or a iron tool. Initially that worked well with craftsmen and craftswomen making their own capital equipment in the form of simple tools. In other words, capital was acquired by what we would call today “sweat equity.” Hard work paid off in establishing the ownership of capital.

However, eventually the needed capital equipment became bigger and more complicated such as a water wheel or a lathe, which then had to be provided under the auspices of the nobility. This intervention by the nobility separated the ownership of capital from the labor that used that capital. Today the incentive to work hard to acquire the right to capital ownership has been undercut by shifting financial rewards away from company employees in favor of maximizing shareholder value. You can drive a truck for a trucking company for thirty years and gain no ownership rights over that truck or in that company. You can work hard in a factory for many years with no corresponding acquisition of ownership rights through sweat equity.

There are exceptions. The construction company Burns & McDonnell in Kansas City has grown enormously by maintaining employee ownership where only the current employees own the company. Efforts to work together to produce better quality results for a wider array of customers worldwide has paid off big time for B&M. See the book by former B&M CEO Greg Graves (2021) called “Create Amazing.”

Other exceptions to the emphasis on maximizing shareholder value for distant, otherwise unassociated investors have provided further evidence of the benefits of rewarding employees. Treating employees as just factor inputs like steel or plastic does not recognize the agency of employees in determining the success or failure of the business. With over 80 percent of the stock market owned by the wealthiest 10 percent of Americans, the argument that investors need extraordinary profits to continue to invest is ludicrous. In reality, the richest Americans have so much money they have no idea what to do with it other than invest it. After all, you can only wear one pair of shoes at a time, or drive one car at a time, or go out to so many fancy restaurants in a given day. At some point, arguing that a wealthy investor is taking a big risk in investing a paltry $100,000 or so in a business is laughable. To the wealthiest investors losing or gaining $100,000 here and there is no big deal. It has no effect on their lifestyle in that their marginal propensity to consume out of each additional dollar earned is extremely low.

The most obvious and damaging effect of maximizing shareholder value is to divert the money flow in our economy away from the people actually producing and consuming products in the real economy to the increasingly separate financial economy. Sending so much money to Wall Street has left very little for the people on Main Street. Lots of money pouring into the New York financial markets drives down interest rates and drives up stock market prices. Instead of money, the people on Main Street are given an ever increasing number and array of credit cards. This just makes rich people richer and drives the people on Main Street deeper and deeper into debt. But even that private debt is not enough to enable employees to be able to buy back the value of what they are capable of producing at full employment. Consequently, to avoid recession the government steps in with deficit spending as carried out by both Republicans with unpaid for tax cuts and Democrats running up unpaid for expenditures to subsidize the people on Main Street.

What then is the solution to move us away from the maximization of shareholder value and CEO pay maximization? One answer used by Germany and some other countries is to require employee representatives on corporate boards. Replace some of the CEO’s golf buddies with representatives from and elected by the rank-and-file employees to make sure that employee ideas and compensation are given careful consideration at corporate board meetings. Perhaps as much as 40 percent of corporate boards should be elected by the company’s employees. This could be structured to distribute the employee representation around the different departments with a balance between representatives from engineering, operations, marketing, et cetera. Each division or aspect of the company would be represented by the rank-and-file employees who are on the front lines of carrying out that division’s mission.

Pretending that the free market can and should operate on its own is a total deception. The government is and should play a major role in appropriately guiding the free market. Government should be accepted as the heart of the free market. The question is not whether the government should be at the center of things, but how the government’s role should be adjusted to keep the free market working for everyone in efficiently allocating our nation’s resources.

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