Capital Structure
I’ve been on a roll lately with economics posts (see Time Preference) so I thought I might as well follow up with another on capital structure.
What is Capital Structure
One of the most basic tenets of free market economics is capital structure. Capital structure, at least solid capital structure, requires that capital be able to flow freely throughout the economy, first assembling itself in areas with high profit margins (most demand, least supply) and trickling into the lowest profit margin industries. In doing so, an economy can expect stability, as the largest planks of the economy are at the footing of the structure, and the smallest are at the top.
Ruining Capital Structure
A solid capital structure requires solid monetary policy. To create a strong structure, the market requires interest rates that aren’t set by central banks or authorities, but by the marketplace. Consider this idea: During the “Great Recession,” capital became scarce due to a credit crunch, but rates plummeted due to intervention by a central bank. In an unmoderated economy, interest rates would have risen to the point where only the most profitable (most demanded, least supplied) industries could afford it. Once those businesses or entities have become sufficiently capitalized, and producing returns all in their own, the new capital could then flow into less profitable industries.
So, whereas you might put together $10,000 of concrete, $2,000 of labor and $500 of accessories to make a tennis court that retails for $25,000 (a 100% profit) or a roadway with $10,000 of concrete, $2,000 of labor and $500 of bits and pieces that produces $15,000 of utility, money (resources) are near equally useful in both areas due to low rates. Are you following me? The roadway created an ROI of 20%, while the tennis court created an ROI of 100%. If each takes 1 year to complete, the tennis court could outbid the roadway for capital, and pay 21% per year and still be profitable. The roadway would lose to the tennis court, and rightfully so, since the buyer of the tennis court is willing to pay more for finite resources.
Consumption Satisfied
Once the buyer of the tennis court has been satisfied with his purchase, the new capital can then flow into the roadway, which yields a much smaller return. Down through the least profitable industries capital flows to a point at which the price of capital is no longer equal to its usefulness, but also to the perceived risks of funding such venture. When we get to this point, of course, we have reached equilibrium in the capital markets, and have sustained an economy that is as functional as it is stable.
