Few problems in economics are so fundamental and so misunderstood as the issue of capital allocation. We live in a world of finite resources that need to be allocated towards satisfying infinite wants – this is what is sometimes referred to as the ‘original economic problem’. The allocation of capital, the part of production that is not consumed but is used in production of other goods, is the foundation for economic growth.
In economic theory, an optimal allocation of capital implies that the marginal productivity of a unit of capital is the same in all production processes (under the standard assumptions of no transaction costs and diminishing marginal return). An industry or business that has low productivity will lose capital, which will be allocated towards production processes with higher marginal output. That marginal output is measured in the market price, or in other words what alternative consumption consumers are willing to give up to acquire said output. The optimal allocation of resources is of course always changing with technology, innovation and consumer preferences. An innovative businessman who optimizes a production process will attract capital that was previously in the hands of his competitor. As consumer preferences changes, whole industries may succumb – picture how the automobile shattered the horse carriage industry. This process of capital flows is what the economist Joseph Schumpeter dubbed creative destruction, the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”
An efficient capital structure requires efficient capital markets where shrewd investors like Warren Buffet, by directing capital away from failing ventures towards companies that serve the consumer better, play an instrumental role in resource allocation. The popular image of the investor as an unproductive fat cat is of course wrong. The myriad of investors who make up the world’s capital markets all contribute to provide liquidity to the markets and facilitate the process of optimizing capital allocation.
In the real world, capital allocation is unfortunately rarely optimal. When resources are spent in the public sector and the output therefore not sold in the free market, supply and demand is not allowed to determine a price structure. This absence of price signals gives rise to what Ludwig von Mises dubbed the ‘economic calculation problem’ where efficient resource allocation becomes impossible. In the private sector, it is easy to imagine how subsidies, taxes, regulation or other artificial production cost will skew the optimal allocation of resources as consumers shift their preferences from the taxed product to another, politically favoured output.
Efficient (re)allocation of capital will be crucial to the economic recovery after the Coronavirus pandemic. Some hard-hit industries will avoid bankruptcy thanks to government bailouts as the state steps in with grants, subsidies or loan guarantees to support businesses who have failed to raise the funds to tide them over. But the reason private capital has proven elusive is of course a lack of confidence in the business model and the prospects of the business in the light of Covid-19. It seems certain that the crisis will change consumer habits and preferences, from reduced demand for airline tickets to a likely increase in online shopping and less demand for office space as working-from-home becomes more commonplace. Bailouts and other schemes will serve to maintain a pre Covid-19 capital structure in a post Covid-19 world. In Britain, more than 8 million furloughed workers are paid by the government to do nothing while they remain employed in firms who were set up to meet consumer demand in a pre Covid-19 world that might look very different. A study suggests that 42% of US pandemic-related job losses will be permanent.
Of course, the crisis has also prompted central banks to accelerate their super-easy monetary policies. The suppression of interest rates has for years kept alive ‘zombie companies’, businesses that faced with market based interest rates would not be able to produce a return on capital to attract investors. But with plenty of money seeking a home and interest rates at rock bottom, investors have taken increasing risk for increasingly meagre returns, allowing companies to survive despite producing poor real returns. This has prevented the re-allocation of capital that would otherwise happen in a recession. An extension of these programmes will of course only compound the problems (we address the problems of quantitative easing here).
Decades of a boom-and-bust business cycle and increasing government intervention in response has left us with an outdated capital structure that does not reflect the underlying economic reality of supply and demand. Only by allowing unimpeded price discovery in a free market can we return to an economy where capital is not tied up in unproductive ventures but is directed towards its most productive use. Sadly, the response to the Corona pandemic is a giant step in the wrong direction.