ALLOCATION OF CAPITAL THROUGH FINANCIAL MARKETS
Financial markets offer a way to allocate capital across different productive activities. Financial firms compete to deliver returns to investors by investing in companies that are profitable.
This system has several advantages including:
- Independent judge – the capital markets act as an independent third-party to determine which companies get invested in.
- Allows comparison – annual returns provide a universal language to compare very different types of productive activities.
- Diversification of risk – the pooling of capital means that investors with small amounts of capital can diversify their risk over a large portfolio.
- Specialization of labour – centralized capital markets allow for the specialization of labour and the development of full-time financiers who can develop expertise in allocating capital.
However, this system also suffers from many problems including
- Short-run bias – financial firms cannot prove the superiority of their approach by argument, only by past performance resulting in a severe short-term bias.
- Bias against the unproven – There is also a bias against the unproven in favour of the proven which means it is difficult to put resources behind something new – even if it is important/awesome.
- No other criteria – Capital markets strip away all the other criteria to focus on profit which can lead to socially negative outcomes.
- Manias/panics – Markets are prone to bubbles because value is determined collectively rather than independently.
ALLOCATION OF CAPITAL THROUGH HUMAN CAPITAL
One alternative system of allocation is to add an additional middle-man which is the employee where the chain of investment would be
Savings/investment–> Human Capital funds –> Employees –> Companies
compared to traditional capital markets where
Savings/investment –> equity funds –> companies.
This method of capital allocation has several advantages
- More efficient capital allocation esp. for new projects – the capital markets (even VCs) lack effective methods of allocating capital for new projects. Trusting in the passions of experts may be better than any centralized financial markets and crucially may lead to earlier investment in projects before they have been proven to the market.
- Alternative criteria to returns – human capital essentially delegates the capital allocation decision to the employee but employees care about many other criteria besides the profitability of the firm (unlike the capital markets) including things like the mission of the company, social impact etc.
- Less prone to bubbles – delegating the investment decision to the employees employment decision means that the capital markets are less prone to group think and manias because employees can only work for one firm at a time. The relative illiquidity of the labour market compared to capital markets means it is less prone to bubbles. This is the democratization of capital.
- Longer-term optimization – that same illiquidity of labour is also tied to employees labour decisions where unlike capital which is optimizing over annual or even quarterly periods individuals are much more likely to optimize over years even decades.
- More equitable societies – if firms optimize return to labour treating salaries as profit rather than costs than we over time
- More innovation in capital intensive industries – lower risk (and lower return) bets on employees make investments in high risk industries like capital intensive technologies profitable and therefore leading to more innovation in those areas. Crucially human capital contracts allow diversification not just across a large portfolio of employees but also multiple companies over time (because an employee can change companies).
- Alternative to debt – Kindleberger in Manias, Panics and Crashes: A History of Financial Crises emphasises the key role of too much debt in leading to financial crises. As Adair Turner has pointed outcredit contracts come with the rigidity and irreversibility of default and bankruptcy. The obvious problem with is that all it takes is for a large negative exogenous shock for the system to not only go into recession but because of the discrete nature of many financial contracts (including debt) but to stay in recession. The advantage of continuous contracts (like percentage of income) is that there is a smoother path back to full equilibrium. Perhaps, debt should be eradicated completely, not just for individuals but for corporations and countries also!
- Equity investing when there are no more companies – some such as Sam Altman have suggested that ‘The meta company of loosely connected entities that work together is the future of work.’ Human capital investing is much better suited to this type of economy than traditional equity investing.
There are of course however, also likely to be several disadvantages including
- Dangers of commoditization of people – credentialing will become increasingly important signals for investors and people may be increasingly treated simply as a number representing their ‘future expected cashflows’. Companies may be forced to defer to wider capital markets in terms of hiring rather than their own views. Human capital may lead to the institutionalisation of various -isms such as racism/sexism based on estimates of individuals future earning power. It’s unclear how this will play out, in sports for example, extreme competitive meritocracies have been a positive force for social change but it’s not clear whether this would be true for human capital as well.
- More illiquid/slower reacting markets – bubbles are always painted as the bad guys but they do have the advantage that capital markets are very quick to uptake new technologies and in fact economist Carlota Perez puts the mania of financial markets as the driving force for new adoption of technologies. Labour and education markets which are much slower reacting may mean that new technologies cannot grow as rapidly because they do not get the support of capital quickly enough.
I was trying to research the current economic literature on efficient allocation of resources particularly as it relates to new technologies with the hope that I could try an build an economic model to see if human capital would work better (or more likely a hybrid system of both human capital and equity capital). But perhaps, that traditional economic approach although more respected is wrong. Perhaps, it is better to just test it in the real world and see what happens.