Chapter 18
Aristotle, Infrastructure, and Capital

Aristotle had some very non-capitalistic views on money and wealth; however, he was also a big believer in private property and the market system and won praise from Austrian economist and libertarian leaning writer Murray Rothbard. In Mr. Rothbard’s essay61 on Aristotle he points out that the philosopher understood the importance of having market systems and believed they are extremely important for the proper functioning of society as they allow people to get what they want and need. Aristotle also strongly favored private property as a critical tenant in running a society’s legal and economic system and he recognized that laws and institutions are critical to the functioning of markets and prosperity.

The ability to raise capital is based on investors trusting they will have recourse to get paid back. Therefore to attract capital and to have a fluid capital market, the legal and financial infrastructure is as important as any physical infrastructure in a country. Rules-based capitalism and institutions that support it are keys to success.

Economic theories on comparative financial systems often contrast market-centric systems to nonmarket or bank-centric economies. The United States and United Kingdom. are often cited as market-oriented economies. Countries like France and Japan are often cited as more bank-centric systems. Market-based economies have more varied sources of capital, such as established and diverse markets for stocks and bonds. The markets can take on somewhat more exotic structures, like converts, warrants, and securitizations. Bank-centric economies tend to primarily have much less diversified capital markets and the bulk of funding comes from banks. In some cases there is an intricate network of national and regional banks and sometimes banks with industry specialization. This latter system typically allows for more regulatory control over capital and more standardization of the types of financing available. That can result in only certain types of companies and projects getting capital, stifling innovation. It also means that if the bank system faces problems, there are limited alternative financing resources to access.

In reality the lines are increasingly blurred between market and bank-centric systems. The more market centric, the more flexible and innovative the market is. Increased communication technology helps market systems react quicker and have more data on which to make decisions. Technology is changing traditional barriers and allowing new entrants to force their way into all markets. It can not just be the access and sourcing of capital that improves, it also must be improvements in information for the investors. Better information will allow the lenders to more appropriately asses the level of risk worth taking and let them price the risk appropriately. This should allow quicker response times to financial needs and can help avoid liquidity crunches from ballooning into a financial crisis.

As newer forms of capital raising increase it will disrupt some of the organizations that regulators have the most control over. These developments will put pressure on traditional bank systems to attract both sides of their balance sheets, deposits and loans. This may also weaken central banks’ and treasury departments’ control over capital flows and factors that impact the velocity of money. Of course, traders like to trade, salesmen like to sell, and regulators like to regulate, therefore, they will likely find ways to regulate new capital sources and transaction methods. While there is a constant struggle between the benefits and the detriments of regulation on the financial industry, one benefit is that when an industry is regulated there is more data available to analyze, but that is definitely not worth the price of heavy-handed innovation stifling regulation.

The more choices in capital structures and the access to varied capital the better. Different companies need specific types of capital structures and even the same company needs different types of capital structures during its lifetime. Mr. Milken wrote in an article that he used to debate his late friend Nobel laureate Merton Miller about whether capital structure was an important part of management’s job and if it impacted the valuation of a company. Mr. Milken was right in the view that the capital structure has a huge influence on valuation and risk. Just as importantly, he points out that capital structures have to evolve and be dynamic.65 This means that the ideal capital structure for a company will vary depending on many factors including where the company and industry are in their life-cycle and numerous macroeconomic factors.66

Sometimes capital is considered a competitive advantage. Uber, Airbnb, and WeWork are all innovative companies with first mover advantages that have touted their access to capital as an advantage over other start-ups that might compete with them. If capital access continues to increase more quickly and it is readily available, it will become less of a competitive advantage. It was not that long ago that some of the incumbents that these innovative new economy companies were threatening, thought they had a capital advantage. Frequently, incumbents have an opportunity to move quickly against competitors, but often may fear undermining their existing invested capital. Imagine a retailer that did not want to undermine all of the investment in retail locations, so it chose to avoid diluting the value of its stores and chose not to sell products on the internet, this would have resulted in falling way behind the competition.

There are cases where incumbents have tried to suppress innovation in what appears to have been an effort to protect invested capital, and it has led to failure. Kodak is a great example of this. Kodak was founded in 1888 and became one of the largest makers of film and cameras. At its peak Kodak was estimated to control 70% of the photographic film industry. Eventually digital cameras crushed the market for physical film and cameras. By 2012 the damage caused by the development of digital photography and bad corporate decisions forced Kodak to file for bankruptcy. Ironically, in 1975 an engineering team at the company actually invented the first digital camera. Management was likely trying to protect its existing market and the investment in it rather than looking ahead; they could not suppress a major innovation.67,68

The ability of technology to improve access to capital and quickly supply more information for investors to monitor and check on their investments is changing the economic landscape. Capital movement is faster. It can rapidly get repriced and moved to where it is needed. This can smooth out market disruptions. Nations’ infrastructures can help facilitate it and regulators need to monitor and set rules for newer forms of capital access without suppressing innovation. All of these changes make it more difficult for analysts to monitor where capital is flowing. Capital will likely move much more quickly than the data.

Selected Ideas from Part 5