Dogma Premise # 12

Capital markets ensure that investment is directed to the most profitable projects.

There are two very different problems with how Capital markets allocate investment.  The more common and serious critique is that the most profitable products are not the most socially useful products.  For example, creating weapons and arming combatants may be profitable, without being good.  Similarly, finding a long-term treatment for a disease is more profitable than finding a simple cure, but finding a simple cure would be more socially useful. This is the subject of Dogma Premise 13.

But to defeat Dogma Premise #12 we must instead prove that Capital markets do not EVEN direct investment to the most profitable projects.

It is certainly true that Capital markets are intended to find the most profitable projects, and sometimes they do, but less often than you would imagine.  There a two reasons for this.  First, not all significant capital investment allocations result from the work of capital markets.  Second, the institutions that participate in capital markets suffer from the same kind of bureaucratic, and information inefficiencies that plague most organizations -- actually, even a bit worse.

Let's start with the first point, that not all significant capital investment is allocated by capital markets, and therefore much capital investment has no chance of being efficiently allocated by market forces.  The reason for this is simple: not all projects seek their funding from capital markets; instead they are funded by patrons.

For example, suppose I have a hare-brained business idea that would not be supported by most investors.  But, I have a wealthy uncle or parent who would indulge me for personal reasons -- they think I'll learn a lesson or get an education, they want me to keep out of trouble, or just because they like me.  In this scenario, investment is intentionally allocated inefficiently, because the goal isn't to seek profits, or to fill a market need. It is just a vanity project.  Nonetheless, it is a vanity project that takes real investment dollars and directs society's capital in that way.  In case you didn't know it, this kind of thing happens among the wealthy ALL the time.  It is not an insignificant part of the economy.

An even more common misallocation of capital for vanity reasons occurs when wealthy people invest in a business to achieve non-business ends.  For example, it is not at all uncommon for wealthy people considering a political career or hoping to influence the political process to purchase a newspaper or magazine that will allow them to influence public opinion or do favors for infuential people.  They may invest in sports teams so they can have good seats or prestige.  They might buid a skyscraper and name it after themselves, not because it was the best investment, but because suited some ulterior publicity motive secondary to profitability.

Philanthropy falls into ts same category.  When a philanthropist dedicates a million dollars, or millions of dollars to a school or a project or a cause, that represents a very significant investment, resulting in jobs, buildings, and sometimes long-term revenue streams dedicated to very specific kinds of activity, which may be wholly unrelated to profitability or the kinds of investments that capital markets would choose.

Thus, the presence of capital markets does not ensure that capital is efficiently invested, because even if capital markets were good at choosing profitable projects, not all investment capital is allocated this way.

However, capital markets are also not that good at choosing profitable projects.

First, investment funds may feel pressure to generate short-term results.  Therefore, a more profitable project that would yield great profits ten years away might be passed up in favor of a worse opportunity with a quicker payback.

Second, capital investors are just as susceptible as anyone to investing in a bubble economy, and are just as adept at losing money that way.  Many large firms have vanished as a result.  Therefore, to the extent that professional investors get caught up in the latest financial scam (savings and loans, derivatives, dot-coms, mortgage-backed securities, etc.), they are entitled to no more reverence than any other ponzi scheme investor.

Third, capital markets have a well-known bias toward orthodoxy in approach, which leads to all kinds of bias toward easily understood business models and markets.  Anyone who has tried to get funding for an unorthodox business idea knows how difficult a task it can be, and for many reasons that have nothing to do with profit potential -- the venture funds have predetermined rules governing the types of businesses they are willing to work with, which can severely limit the success opportunities for a really new idea.

Fourth, and rarely discussed, capital markets have a very strong bias in favor of ideas advocated by rich people.  Lending a million dollars to entrepreneurs with plenty of collateral, or who have the means to have already assembled a high power executive team, is a much easier decision than to fund an unknown entrepreneur who might require more oversight.  This would not matter if every good idea might eventually come from an experienced, wealthy team.  However, an economically and ethnically diverse population is likely to investigate a wide variety of problems and solutions, so the bias toward wealthy and experienced entrepreneurs is likely convenient and comfortable, but not necessarily efficient or effective.

Finally, whether those who control capital fund a particular project depends not only on the projects potential profitability and anticipated risk, but also extraneous factors, such as how the project will be perceived by others in the organization, and the person's social circle.  Whether the project will disturb the revenue stream of an important colleague, patron, or decision-maker.  There are information inefficiencies, too: some projects are easier to understand and easier to explain.  Portfolio managers and their staff are skilled at quickly sizing up a market-space and business model, but often will avoid the serious research necessary to validate an unusual model if there are simpler alternatives that meet their profitability guidelines.  Unless the project is advocated by the boss's cousin, or an influential figure, in which case it may be doted upon.

Some of these problems are severe and recurring corruptions of the capital markets peculiar to capitalism  Others are difficult decision factors that would have to be carefully handled by any proposed method for allocating investment capital.  However, the notion that capital markets are intrinsically efficient and assure that capital supports the most profitable projects, or could do so better than any other conceivable system, is clearly false.  Instead, there are so many different factors preventing an efficient allocation of capital that private capital markets cannot be considered reliable, and alternatives should be carefully considered.

Dogma Premise 13

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