Miles Saltiel is a former investment banker and a Senior Fellow at the Adam Smith Institute
Marx was dead right about one big thing: capital allocation matters. But his followers were dead wrong about everything else, throwing in with the wrong scheme. Not everyone will agree with my test of capital arrangements: those which maximise economic growth through Schumpeter’s “creative destruction”, specifically the formation, expansion and extinction of companies. I like this yardstick as I want everyone on the planet to enjoy my standard of living or better; and nothing but economic growth for another century or two will achieve this.
I expect there could be more, but as best I know the modern world embraces six methods for allocating capital to enterprises. They are:
Governments
Banks
Industrial companies
Families
Criminal organisations
Markets
At one time or another, most economies have resorted to most of them. All have mixed fortunes.
Governments are in disrepute as allocators of capital following the conspicuous failings of communism as an economic system (including its de facto abandonment by China), as well as the undistinguished record of socialism in such manifestations as post-war Britain, France under Mitterrand, post-independence Africa and India, and so on. Governments turn out to be capable of supervising catch-up policies (Russia from the twenties to the sixties; France during les trente glorieuses), but too weak to resist subsequent pressure from the industries they purport to supervise. At present, the mixed approach of China is testing this limit. Britain is a textbook example of such failings; heaven help us in our current reversion.
Banks look like the real thing: marble halls and corner offices are inherently more dignified than screaming dealers. But inspection shows up capital allocation by banks as troubled, most conspicuously in its salient post-war models, Germany and Japan, largely because of the conflict of interest attaching to banks as lenders and owners. They are reluctant to allow borrowers to go bankrupt, with each country having thousands of zombie companies and several zombie banks. Both countries are now ex-growth.
Industrial companies: Growth from the retained earnings of conventional enterprises runs up against the limits of managerial expertise, eg, Jack Welch’s General Electric in the US, or Philips and Siemens in Europe - all before reconstruction.
Conglomerates such as the zaibatsu / keiretsu of Japan or the chaebols of Korea are configured to share risk internally. They are also brushing up against their limit, as their economies have attained levels at which they no longer profit from such organisations. This said, similar arrangements seem to be emerging in Russia, combined with criminality (see below).
Families: When it comes to mature companies, proprietary sources have had marked failures, eg, throughout Latin America. There have also been some successes, eg, in Sweden, where the “Wallenberg Sphere” dominates the industrial landscape; and more tentatively in the countries of the Chinese diaspora and in liberalising India. Eventually proprietary families become unable or unwilling to continue investing, giving rise to capital insufficiency which threatens growth. Proprietary companies in the German Mittelstand restricted their ambitions accordingly and prospered until the Zeitenwende. For decades the Wallenbergs addressed capital insufficiency by penalising third-party investors with junior paper, ie, with restricted voting rights. At present, tech founders want the same privilege.
Until recently, “friends and family” were the only investors willing to take start-up risk. In the last forty years, Silicon Valley (and to a lesser extent elsewhere) has developed successful organisations for accumulating and actively managing start-up funds, subscribed by risk-tolerant private persons, for choice also offering pertinent expertise. The most successful of these companies are now demonstrating the familiar problems of monopoly.
Criminal organisations also weigh in. The most familiar example would be Las Vegas from the 1940s to the 1980s. Elsewhere, criminals operate openly in Russia: much of the economy is a de facto criminal enterprise; and discreetly in Italy: organised crime forces minority investments upon private firms. I am not aware of this last interfering with everyday management, though I expect money laundering distorts operations in cash businesses. Similar arrangements apply in those parts of Latin America in which narcotraficantes prevail.
Where applying to mature enterprises, the five methods set out above are inherently self-protective. This means they make for oligarchy or monopoly - or, to put a more positive gloss on it, fraternité: order, social solidarity and stability, valued more in some places than others.
Capital markets: Taking the period since the Industrial Revolution as a whole, it has become clear that only capital markets reliably correct errors for established companies. If properly combined with arms-length regulation, there is no better system for correcting oligarchy and monopoly. Capital markets achieve this by pricing capital from day to day, cheapening the cost of new funds for established companies which are succeeding; and by extinguishing businesses which fail, through bankruptcy or takeover. No other method has the resilience to work satisfactorily in the face of the unanticipated circumstances of the long run - that is, after the success of initial catch-up which may attach to any of the other methods for a while.
The obvious defect is the tendency of markets to boom and bust, exacerbated in 2008 by defective regulation. But only the price formation arising out of liquid secondary markets for capital and derivatives turns out to offer the flexibility and detachment sufficient to allocate capital efficiently and consistently.