## Statistics and Artificial Intelligence

As a new faculty member, when I arrived on the University of Notre Dame campus in 1975, I noticed that no one was using the IBM 360 computer in The Computer Center during the football games. Since this one computer was the only one that most faculty could use, I was eager to spend the time during the football games creating my punch cards and running them through the computer. I told my wife how eager I was to use the computer during the football games, but she said adamantly “No, we are going to the football games.” Oh, well. At least I was able to run my programs before and after, but not during, the football games.

In 1975 that one computer in The Computer Center had less computing power than the Apple watch on your wrist. But back then it was all we had, so we had to make the best of it. Randomized trials were created and developed to deal with situations, especially in medicine, where the sample sizes were relatively small. Regression analysis could serve as a substitute or a complement to randomized trials with larger samples. Artificial intelligence requires much, much larger samples and many simulations to be effective.

The scientific method recognizes that in any given sample, there are two types of relationships. The relationships we want to determine are the general population relationships that appear consistently in sample after sample. But in any given sample there are relationships that are unique to that particular sample and cannot be expected to appear in other samples and are certainly not the population relationships we are after.

To avoid overfitting to any particular sample, the scientific method requires that we fully specify the procedure and functional forms of any statistical method we plan to use. By prespecifying the functional form we attempt to avoid the problem of overfitting to the sample and picking up the relationships that are unique to that particular sample and do not represent populations relationships. Moreover, if you adjust the functional form to try to get a better fit, you are using the sample data to change your model and that undermines our ability to track the statistical distributions. We cannot track the statistical distributional effects of adjustments made through your head. Adjusting the functional form means not getting valid t-statistics or F-statistics that you need for determining the statistical significance of your results. Consequently, if you adjust the functional form of your model in any way to get a better fit to that particular sample, you lose track of the statistical distribution and are likely to overfit to that particular sample and not discover the true population relationships you want. Many people have lost their shirt in the stock market by overfitting to the sample data and getting great, but invalid, numbers labeled t-statistics, F-statistics and R-squared values but not getting at the true population relationships they are after. (Note: So called bootstrap methods use simulations to try to at least determine a good estimate of the variance of the distribution after functional form manipulation.)

The methods used for artificial intelligence intentionally violate the scientific method. They intentionally overfit to the data. They get away with this only by using simulations and a huge volume of data. They don’t just acquire one sample, but to as great an extent as possible, they attempt to acquire an extremely large number of samples to discover the population relationships that show up in sample after sample.

I don’t know the details of the Transformer model for A.I., but I know what strategy I would pursue. Find the word that most frequently starts a sentence about the subject of interest such as Alzheimer’s disease. Find the word that most frequently follows that word. Note the correlation. Then find the word that most frequently follows those two words. Here is where is gets interesting. You need to use the two-way correlations and the three-way correlations. As a fourth word is introduced in the same matter, you will need all two-way, three-way, and the four-way correlations. Basically you use these correlations to produce your first sentence in your summary essay. This procedure can be followed with the word that most frequently starts the second most frequent sentence that starts with that word. My paper on “Composite Dummy Variables” provides the basic ideas for understanding basic interactions effects such as used in ChatGPT with all available interaction effects as the basis for generating sentences that summarize the large literature on a topic such as Alzheimer’s disease. Follow this link to my paper in ResearchGate: https://www.researchgate.net/search.Search.html?query=composite+dummy+variables&type=publication

## 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.”

## 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: https://www.hoopladigital.com/title/11282038 ).

## Recreate Postal Banking to Slow Inflation

Once again we are using a dysfunctional approach to stopping inflation. Inflation is when too much money is chasing too few goods. But the Federal Reserve relies solely on a cost-of-borrowing tool, which suppresses supply as well as demand, instead of using a return-on-savings tool to absorb excess demand by getting people to spend less and save more.

When I was a young boy in the 1950s, you could go to any post office and set up a savings account. The Postal Savings Act of 1910 allowed for postal savings for 56 years from 1911 to 1966. The postal savings accounts were limited in size so you couldn’t put in much money. If postal savings accounts existed today, a high return on savings could get the marginal saver to put off buying that new phone or television and save the money. Getting people to save more and spend less will slow inflation.

The Federal Reserve is raising interest rates, which is shifting demand (and inflation) from goods that require a loan (automobiles and homes) to ones that don’t require a loan. By raising the cost of borrowing, the Federal Reserve causes businesses that rely on credit to cut hours, lay off workers, and close outlets. It is suppressing supply! But it also suppresses demand, because less money to workers means less demand for goods and services. You can’t spend the money you don’t have. That slows inflation, but at a great cost to the people with the most debt – the poorest Americans. It could also push our economy into a recession.

Most poor people are too poor to save any money. The wealthy just move their money around to get the best return on savings without changing their consumption behavior. Any attempt to reduce excess demand needs to target the marginal saver, who typically earns around \$50,000 a year and is among the two-thirds of Americans with no college degree. Getting marginal savers to save more and spend less will help slow inflation. To divert money from spending to saving, any opportunity for a high return on savings needs to be vigorously promoted and advertised at popular athletic contests, Nascar races, and other venues frequented by the marginal saver.

Some observers claim that 30-year U.S. Treasury I-bonds already offer a high return on savings. I-bonds work well for the wealthy, but the severe withdrawal restrictions make I-bonds a non-starter for the marginal saver, who needs immediate access to their money to deal with an automobile accident, a medical emergency, or an unexpected rent increase or job loss.

Why rely exclusively on the stick of a cost-of-borrowing tool and ignore the carrot of a return-on-savings tool? Congress needs to recreate the Postal Savings Act of 1910 and bring in the Federal Reserve to oversee savings accounts at our 30,000+ post offices. With inflation running between 6 and 7 percent, postal savings accounts could offer 10 percent on savings with a limit of no more than \$10,000 per person to avoid the transfer of large amounts of money.

When the Fed acts to slow the economy, banks cut back on loans in fear of an economic downturn. You can’t rely on them at such times to offer a good return on savings. Under our fractional reserve banking system, they typically have excess reserves and don’t want more money. Banks don’t want to pay for additional deposits to get money they don’t need and won’t use.

Congress needs to act now to authorize the Federal Reserve to create savings accounts at the 30,000+ post offices throughout the United States and offer a 10 percent return on savings. Getting people to save more and spend less will slow and eventually stop inflation without causing a recession.

Once excessive inflation is fully suppressed, then the promotional advertising of postal savings accounts can be dropped and the high interest rate on postal savings can be lowered. Thus, this new return-on-savings tool can be used to counter the irrational exuberance during booms that drives inflation and the excessive contraction of the money supply by private banks during economic downturns.

Adam Smith’s invisible hand of competition has long be heralded as a mechanism for turning greed into good. Each business owner seeking their own profit works hard to make better quality products and, in competition with similar businesses, offers these products at ever lower prices. Some take this free enterprise message to an extreme and declare that “Greed is good.” Not quite. A purely greedy person, defined as someone who plays I-win-you-lose or winner-take-all, does not appreciate the need to meet the needs of others. But ultimately free trade must be a win-win situation. When you go to the store, you get what you want. But the business owner also gets what he or she wants – your money. You both win.

In some sense we all want to feel good about ourselves. But feeling good may come about through a win-win strategy of helping others or through an I-win-you-lose strategy of taking from others. A burglar may feel good about pulling off a clever burglary. The I-win-you-lose strategy tends to be a short-term strategy that more often than not fails in the long run with a failed business or an extended stay in jail.

Moreover, in focusing on their own money flow, individual businesses may lose sight of the bigger picture of the money flow in the overall economy. On an isolated island, a business owner that owned the only general store, bar and restaurant would quickly realize that being too stingy with their store, bar and restaurant workers and with the farmers and fishermen that supplied the food would cause their customer base to dry up. Keeping the businesses going would mean paying people enough to be able to maintain a good money flow. Increasing the money flow or velocity of money would mean raising the annual production and distribution of goods and services until the yearly limits of consumption and work effort reached their natural limits. Here again the win-win strategy wins out. Being too greedy in maximizing short-term profits may undermine the long-term profitability of the business.

Just as the sole owner of a lake understands that fish are a resource that can be destroyed by overfishing, a sole business on an isolated island may come to see money flow as a common property resource problem. But what if other businesses come to the island. As more and more businesses establish themselves on the island, each business wants the other businesses to provide the money flow to customers and suppliers but naturally wants to act as a free rider in not having to pay more itself. In other words, money flow as a common property resource exhibits the moral hazard problem of businesses losing their motivation to contribute fully to the island’s money flow to ensure full resource utilization including the full employment of the farmers, fishermen, and workers. Ironically, this common property resource problem that motivates business owners to pay as little as possible creates slack in the labor and resource markets that further enables businesses to pay less. This has been referred to as the reserve army of the unemployed. Consequently, we see that the economic conditions that work best for individual businesses do not always correspond to full employment utilization and maximum production.

Other common property resource problems include the failure of individual businesses to create and pay for interstate highways or standing armies. Even locally, maximizing productivity and overall production may require the building of roads and bridges. Electricity and water supply may require the establishment of a natural monopoly that must be regulated by government for the common good. Positive externalities in the form of vaccination for highly contagious diseases and negative externalities such as water and air pollution all provide examples of where government intervention is needed to ensure the efficient allocation of resources, which is the very essence of the economic problem.

What this all boils down to is that government plays an essential role at the heart of the free enterprise system. Without government, the system would fail to allocate resources efficiently and would fail to maximize productivity and overall production. Getting the money flowing to allow businesses to prosper means imposing taxes to benefit everyone in achieving the optimal money flow for the economy as a whole. When applied fairly and efficiently, taxes and the corresponding government expenditures can contribute to the common good as a key part of the win-win strategy that makes us all better off in the long run.

## Central Bank Digital Currency as a Monetary Policy Tool

While the Federal Reserve is trying to decide whether to recommend that Congress authorize creating a central bank digital currency (CBDC) for the United States, many other countries have already committed to creating their own CBDCs to avoid having their currencies replaced by Facebook’s Diem or some other stablecoin that has established or will establish strong financial networks. Dubbed “FedAccounts,” a Federal Reserve CBDC would provide a basis for a new return-on-savings monetary policy tool.

To serve as a tool for monetary policy, a Federal Reserve CBDC would need to be account-based (“FedAccounts”) as opposed to token-based. To protect individual privacy, while still deterring criminal behavior, the names and identifying information of account holders (including some personal transactions) would be kept in a separate file from their general transaction histories. The two files would be linked by a 60-digit alphanumeric code. If authorities observed suspicious activity in the general transaction histories, they would need a judge’s permission to access the corresponding identifying information file.

In addition to the 60-digit alphanumeric code, the transaction histories file would contain a single-digit yes-or-no dummy variable indicating whether this account had an associated Social Security number. This would be important, because only accounts with an associated Social Security number could earn a high positive interest rate during an inflation and that positive interest rate would only apply to a base amount of no more than \$10,000. If \$12,000 were in an account with a Social Security number, only the first \$10,000 would earn the high positive interest rate, while the remaining \$2,000 would be subject to a negative interest rate, as would all the money in accounts without a Social Security number. Anyone in the world could use US dollars to create their own US Federal Reserve “FedAccount.” People in Zimbabwe or Venezuela experiencing very high inflation in their local currency may be glad to pay a small or modest negative interest rate for the security and safety of holding their money as US dollars in FedAccounts.

To stop inflation the Federal Reserve has been raising the cost of borrowing, which suppresses supply as well as demand. Businesses that can’t afford the higher cost of borrowing may have to cut hours, lay off employees, or close outlets. Lower income people are generally the ones with the most debt so they get hit the hardest when the cost of borrowing goes up. If the economy slows because of the rate increase, it is the lower income people who are most likely to be unable to make their mortgage payments and lose their homes to foreclosure.

The current world-wide inflation is due in large part to the COVID-19 supply disruptions which are continuing. We have forgotten when we had to absorb excess demand to fend off inflation in the face of the mother of all supply disruptions at the beginning of World War II. We suddenly had to transition from civilian cars and trucks to tanks, armored personal carriers, warplanes, and warships. We also had to send a lot of our young, male workforce overseas to fight the Nazis in Europe and Imperial Japan in Asia. We needed a way to absorb a lot of money that would otherwise go to consumer demand to ward off inflation. We did it with “Liberty Bonds.” Celebrities were singing and dancing in promoting “Liberty Bonds.” Billboards and radio broadcasts were intensely advertising “Liberty Bonds.” By the end of he war, about 50 percent of American families had purchased “Liberty Bonds.”

It would be great if we could do the same with U.S. Treasury Direct Series-I bonds. For six months ending October 31, 2022, the 30-year I-bonds were paying 9.62 percent interest. Beginning on November 1, 2022, I-bonds are now paying 6.89 percent interest. A major problem preventing I-bonds from absorbing excess demand to stop inflation is the severe withdrawal restrictions that I-bonds currently enforce. No withdrawals are allowed for the first year, and there is no secondary market for I-bonds. Withdrawals after the first year are heavily penalized up until the end of the fifth year. This does not work for marginal savers who need immediate access to their money in case of an automobile accident, a medical emergency, an unexpected increase in rent, or a job loss. Yet it is the marginal savers with relatively high marginal propensities to consume who can stop inflation by saving their money to reduce excess consumer demand.

An alternative approach would have been the postal savings accounts that existed under “The Postal Savings Act of 1910” where for 56 years from 1911 to 1966 anyone could go to any post office in the United States and set up a savings account. The amount of money allowed in these accounts was severely restricted so it was aimed at people with only small amounts of money to save. But, again, the marginal savers with relatively high marginal propensities to consume are the very ones we want to influence to save more and spend less. If these postal savings accounts still existed, they could be used to absorb excess demand to stop inflation without causing a recession by offering a very high interest rate and heavily advertising them.

To make these accounts as attractive as possible to lower-income people, any interest earned in the new CBDC “FedAccounts” should be tax free. Every baby born in the United States should be assigned a Social Security number and a FedAccount at birth with \$1,000 put in it, which could not be withdrawn until age 70. However, any interest in the account could be withdrawn at any time along with any additional money put into the account. This would make these CBDC accounts as attractive as possible. With everyone having a FedAccount, whenever someone cut your grass, mowed your lawn, or shoveled your snow, you could pay them instantly with a smartphone to smartphone transfer from your FedAccount to their FedAccount.

Finally, when an economic downturn comes, the Federal Reserve can use the FedAccounts with Social Security numbers to offer small low-interest-rate loans and give stimulus money directly to the people on Main Street to stimulate the economy as necessary instead of going through the New York financial markets on Wall Street. This new monetary policy CBDC tool would provide the Fed with more bang for the buck in controlling our economy more efficiently and more effectively in avoiding both recessions and excessive inflation.

( Note: Economists at the Bank of England have asked me to present my paper entitled: “New Central Bank Digital Currency (CBDC) Monetary Policy Tool” in their Bank of England session at the American Economics Association Conference in New Orleans on January 8, 2023. If you would like to see the abstract (“View Abstract”), the PowerPoint slides (“Presentation”), or the paper itself (“Preview”), you can find them at this link: https://tinyurl.com/2wr39xak )

Larry => be sure to go into html mode in MailChimp to hyperlink both this tinyurl and the link to this ND Economist commentary.

## 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.

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

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

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

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

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

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

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

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

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

## “Loanable Funds Theory” of Banking is Wrong

The typical economics textbook describes banking as a process where people deposit money and then the bank looks for good opportunities to loan those funds out. This “Loanable Funds Theory” implies that banks will not even look for good loans if they don’t have that amount of money in deposits to loan out. That might be true under a banking system with a 100 percent reserve requirement, but our system of banking maintains a reserve requirement closer to 10 percent. A realistic theory of how a bank decides to make a loan doesn’t actually correspond to the Loanable Funds Theory. In fact, the process is somewhat the opposite. Banks first look for good loan opportunities, and if they find one, they check to see if they have enough excess reserves. Often a bank will have enough excess reserves to make the loan if it meets its risk-reward criteria. The bank creates a deposit account for the person or entity taking out the loan. The deposit account is created “out of thin air” as a result of the decision to create the loan, and not the other way around. This means that the bank is creating money. However, if the bank is already at its reserve requirement limit and needs more reserves to make the loan, it will increase the interest rate on savings and certificates of deposit to attract more money to satisfy the reserve requirement. Banks can also borrow money from each other or from the Federal Reserve Bank where the largest banks have accounts.

My wife and I have certificates of deposit (CDs) that we need to renew from time to time. We are in a metropolitan area with lots of banks. The interest rate offered on CDs can sometimes differ greatly from one branch to another of the same bank. Instead of going to bankrate.com and moving our money around over the internet, as we did when we lived in an area with fewer banks, we often find a bank locally with a CD interest rate that is at least as good as the best rate on bankrate.com. Typically the interest rates offered on CDs at most of the banks in our area are quite low. Most banks still have adequate excess reserves, or have not located any good additional loan opportunities offering a good enough risk-reward ratio to satisfy them. Consequently, most banks are not trying hard to attract more money and are happy to provide a very low interest rate on CDs to all those people who don’t check the interest rates on CDs and just let their CDs roll over at whatever rate the bank sets. After all, why would a bank want to pay to borrow money from you that it doesn’t need? Increasing costs without any corresponding increase in revenues makes no sense.

But even though the vast majority of banks offer a very low rate of return on CDs, there will often be one or two banks which offer rates that are three or four times the typical CD interest rate. Sometimes this is because those high-interest-rate banks have found some really good loan opportunity and are already at their reserve requirement limit. Sometimes a bank has gotten into trouble with loans that have defaulted. Fortunately for us the Federal Deposit Insurance Corporation (FDIC) covers us up to a specified maximum amount in case the bank goes bankrupt. What this all boils down to is that it really pays to check the interest rates each time your CDs become due. Be sure to ask if the bank is offering any CD “specials” which might be for an odd period such as for 11 months or 13 months.

The Loanable Funds Theory of banking is wrong. That theory tells us that banks wait for deposits and then loan out only that money that has already been deposited with them. But under fractional reserve banking, banks do not have to wait for enough deposit money to cover the full amount of the loan. In reality, under the current system of fractional reserve banking, banks can offer loans even if they don’t have enough money in deposits to cover those loans as long as they meet the fractional reserve requirement. Banks make loans when those loans offer a good risk-reward opportunity.

This has important implications for our economic system overall. When savers cannot get a good return on their savings, they often turn to the stock market or the bond market. But corporations often pay out dividends and engage in share buybacks precisely because they cannot find new profitable investment opportunities. Financial investments in collateralized debt obligations, credit default swaps, mortgage-backed securities, and other financial derivatives are not the same as direct investments in physical and intellectual capital. A bank may know more about the local economy and the reliability of the entity taking out the loan than reflected in the basic statistics used to securitize that loan. The temptation then is for a bank to make riskier loans than it would if it were to hold on to that loan instead of selling it off as part of a mortgage-backed security.

What this all boils down to is that the financial economy where money is traded has become more and more separated from the real economy. Money flowing into the New York financial markets is not guaranteed to end up in an expansion of our economy. Over time more and more of that money just goes around and around in the New York financial markets without ever making it out to the real economy. The velocity of money in the financial markets speeds up as second-by-second trading is replaced by nanosecond-by-nanosecond trading, while the velocity of money in the real economy slows as interest rates fall, our population ages, and income inequality becomes more extreme. All this has important implications for the effectiveness of monetary policy, which is a topic for a future blog post.

For a great YouTube video on why the “Loanable Funds Theory” is wrong go to this link: https://www.youtube.com/watch?v=OgsEyM82oCE&t=785s

## 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 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.