Alternative finance, capital formation and inequality

Here at Entrepreneurial Underground, one of our main themes is that of market innovation, especially that which departs from the status quo or the current “system” however broadly one may define it. Evolution and change in the state of systems are the key drivers of organic growth.

While we are in an age of rapid innovation, including finance (specifically financial technology), one space that is behind due mostly to antiquated regulation is the realm of private investment and capital formation. The standard formation system is of large capital markets with public issuers where the supply of capital is essentially the savings of the public. This model works by funneling capital to business supported, in effect, by Wall Street and its related institutions.

The “disruptor” to the status quo, we believe, is set forth in many ways by this book and is a wealth of introductory knowledge for both entrepreneurs and prospective investors alike. The basic premise is that nearly all household savings goes to Wall Street, with very little toward Main Street when it accounts for about half the economic output of the country, and is in many ways just as good if not a better investment. The description is as follow:

Americans’ long-term savings in stocks, bonds, mutual funds, pension funds, and life insurance funds total about $30 trillion. But not even 1 percent of these savings touch local small business—even though roughly half the jobs and the output in the private economy come from them. So, how can people increasingly concerned with the poor returns from Wall Street and the devastating impact of global companies on their communities invest in Main Street?

In Local Dollars, Local Sense, local economy pioneer Michael Shuman shows investors, including the nearly 99% who are unaccredited, how to put their money into building local businesses and resilient regional economies—and profit in the process. A revolutionary toolbox for social change, written with compelling personal stories, the book delivers the most thorough overview available of local investment options, explains the obstacles, and profiles investors who have paved the way. Shuman demystifies the growing realm of local investment choices—from institutional lending to investment clubs and networks, local investment funds, community ownership, direct public offerings, local stock exchanges, crowdfunding, and more. He also guides readers through the lucrative opportunities to invest locally in their homes, energy efficiency, and themselves.

We are not here to advertise or sell this book and nothing is gained personally from recommending it (though I recommend reading it, its a quick read), but it forms a starting point for the basis of thinking we will be developing extensively here as it aligns well with our motto – “commerce, decentralized”.

How does this relate to inequality? The basis of wealth creation is capital formation and asset accumulation. Capital formation is the demand side for capital – entrepreneurs. Asset accumulation is the supply side of capital – investors and “capitalists”. Business owners in many way intersect with these two as they are usually the entrepreneurs, but often with Main Street businesses are also the largest capitalists in their firms. Wealth inequality stems from the basic segmentation of asset ownership. The current system of channeling the vast majority of savings to Wall Street (with their fees and plethora of unknown tail risks) is, in our view, the biggest factor in exacerbating the wealth divide from a causal standpoint. Think – in the idyllic 50’s and 60’s, that golden age of the middle class, Wall Street was a backwater and much of the country’s savings was tied up locally (Jim Rogers interview).

We will be delving into this topic with more specifics in the coming weeks, but in our mind this is a synthesis of systems that may be able to satisfy those who cherish market entrepreneurship and liberty with those who are concerned about wealth inequality and creeping oligarchy.

How to survive in a deflationary world

For almost all of the 20th century that anyone currently alive remembers, and all but a few months of the 21st century, inflation has been a given. Everyone talks about inflation in prices – what a movie used to cost vs. today, the price of a candy bar back in the day, the menu at restaurants rising a few cents etc. While there are different causes, in general a steady expansion of the money supply to match increasing demand and GDP growth have made this a reality. Prices and incomes in the 60s are compared to those of today. Some costs that are not included in the CPI have risen at a rate much higher than inflation – you know them – housing (rent, prices), medical care and education. These have risen for reasons other than standard demand or money supply pressures (oligopolistic behavior, debt bubbles).

Welcome to the coming age of deflation. What is key is not the price level, but the debt level. Debt is fixed, and thus extremely fragile with respect to a decrease in cash flows and asset prices. The ability to service the fixed debt declines in a deflationary environment. This in turn creates waves of defaults and elimination of cash flows, furthering the “deflationary spiral”. There is additionally the secular trend of the “fourth Industrial Revolution” (hat tip to Davos..) that may mean further deflationary pressures due to increased productivity and further segmenting of incomes between the skilled and the unskilled. I use unskilled here not to mean those without a college education, but those without the tech skills needed to reap benefit from the so called rise of the robots.

We then must ask what are some ways in which one can survive this age of deflation and shift in the workforce?

Pay down debt – now!

Debt becomes harder to service and the real return on investment of every dollar toward debt increases. One of the best investments you can make is to pay down your debt NOW! In an inflationary environment, specifically one in which nominal wages and returns on capital are increasing, debt becomes relatively cheaper to pay off so one can often defer paying more than minimum requirements and invest their money in better alternatives. Any excess cash over what is needed for an emergency fund should be put toward paying down debt – specifically credit card and other high interest debt. Reducing these cash outflows so one can stockpile more cash is extremely critical, especially at risk of lower wage pressures.


Start a high cash flow business

This should be a business with a focus on good positive cash flows NOW rather than a growth proposition with high upside but high uncertainty (such as many a tech startup). Much of these rely on asset price inflation, and that is one of the first “givens”This is more about survival than growth, but survival in this sort of environment will often beget thriving. Holding too much cash in a normal low-inflation environment is not ideal as there are many alternatives and the opportunity cost of cash is too high. In a deflationary / disinflationary environment, cash is King. These can be (and often are) relatively boring businesses such as vending machines, coin laundries, low-overhead food business (such as a taco stand), car wash, simple online businesses etc.

Invest in Bonds?

This one is tricky. While on the one hand bond prices tend to go up in a deflationary environment, so often does default risk – especially on corporate bonds (lower revenues) and EM debt. US short term bonds look to be the best bet here as they will continue to be a magnet for capital inflows with uncertainty abounding throughout markets worldwide. But as for traditional investments, USGOV bonds look to keep shining.

**NOTE** The author is not to be taken as giving any direct investment advice.