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We’ve all heard or seen it before (or at least Guy Kawasaki has): a small start-up that had a promising product gets approached by a venture capitalist and suddenly has millions of dollars but no clear plan on how to spend it. Next thing you know, the headquarters move from the backyard garage over to the all glass penthouse/loft. The small accounting excel spreadsheet that was enough to cover the five founders Ramen noodles expenditure gets replaced by an MBA minted financial manager, and his PA and double espresso. And hey, presto, the venture capitalist wants some return for all that cash, the cash isn’t there, the company closes down, and meanwhile the 6 MBAs (the first MBA advised expanding his division and was quite persuasive) that it once employed are now out on the prowl making double-espressos.

Before jumping to the guns and playing the blame game, let’s look at the problem from a different angle, this time from a small sub-Saharan state trying to attract external Foreign Direct Investment. The small country believes that its infrastructure and business community really need the extra investment and therefore makes call to overseas countries, international investment funds and other interested parties to put some money into the glowing new state with fresh opportunities and an inviting government keen to attract foreign investors.

Interest Margins AfricaOh there are a few other odd things about this state too, it is actually, due to some small inefficiencies, a net lender to the rest of the world (in that it deposits more of its funds overseas rather than internally), there are only really three banks in the country but that’s fine because it’s a small country and their focus is developing their country from the ground up, not in having a diversified financial services industry. So the money comes in, the government sets up a funding window open to the three banks and private investors, the money goes into the banks who then prudently put their money in safe-investments such as those available in foreign capital markets. The banks defend their actions by stating that local investors can now borrow more from the higher capitalisation, local investors borrow only to find that the lack of competition has driven up interest margins through the roof, limiting affordability as the return required is indexed on the performance of the international ‘safe investment’ but set against local currency volatility, which again ups the margins. So all in all, investment does occur, but the effect on prices are such that high-inflation erodes most of the real-value from the productivity gains. The country understands that the inflation is encouraging capital flight, with the local population then sending its money overseas for safe keeping. Foreign direct investment continues to increase but GDP goes down in real terms.

Maybe we could go to another market again, this time a developed and mature housing market in the world’s most advanced economy? The population believes in the value of housing, in its long-term base as not only the physical abode of the family that unites parents and children and provides a moral safe base upon which to grow and prosper, but also, in part dVolatility in mortgage rates over 96 to 2006ue to its strong long-term and prudential appeal, as a valuable financial asset that can provide a store for a life’s worth of earnings. So households, rationally for the most part, dedicate an ever increasing proportion of their capital towards the abode. Everybody seems to understand that diversification is critical to avoid concentration of risk so a wide range of competing institutions offer an ever increasing wide range of competing instruments to allow capital to be allocated to the ever increasing concentrated asset base of a family household. Diminishing marginal returns on the capital force investors to seek ever more marginal gains in ever increasing risky households to the extent that, on a risk-weighted basis, the return on housing loans becomes negative. But this is okay, because households react to the nominal price gains available to them, not to a risk-adjusted aggregate cost of funding available in the market. House prices go up 300% in four years, more people have access to the houses, risky investments is shared by all, which means that the risk ends up being distributed to all once a sub-component of the market shuts down. Everyone who has a house, which is now really everyone, ends up with a large write-down to their asset’s risk-adjusted price, this reality was always there but it has only just become a very sudden nominal reality.

Clearly, the three examples set out above are over-simplifications to what are very complex issues. The aspect I would like to point out, however, is a core component of microeconomics theory that is often ignored when set out over large, national or even international capital expenditure issues. The aspect that marginal diminishing returns are as unavoidable as the winter that follows the fall. Unfortunately, we tend to believe, time and again, that if a winter is mild it might have actually been overcome, only to discover that cold places still exist and that it’s really just no fun at all to be left out there, shivering, all alone. Capital, retained earnings, charitable contributions, leverage are all faced with this dilemma at an economic level. How can we get a sufficient return for an investment over a sufficiently short period of time to justify the expense of collecting that investment? Interestingly enough, more often than not, we will also tend to assume that this is a problem of scale: well if we just increased the scale of the investment sufficiently we should get economies of scale that cover our costs fairly rapidly? Right? Well, the short and quick answer is simply put, no. Diminishing marginal returns also impact on economies of scale. To just put more money across to an issue can, in the worse of cases, actually further aggravate a situation. Indeed, this absorptive capacity of capital is quite a telling signal, figuratively speaking, much as a dam that can take a certain level of water pressure. To simply up the water pressure can therefore not only provide almost negative returns, it can also lead to the dam bursting. Not a fun prospect if you are living in the valley below.

Now I started this article with a title: when is too much capital still not enough? I wanted to re-emphasize that the reflexive reaction of limiting capital is not the solution either. Indeed, more capital can assist in times of need as long as such investments remains highly liquid. Liquidity of capital, going back to the dam analogy, is much like water in that it can, once confronted with a limited outlet, flow around, across, reach different tributaries, potentially render new green fields fertile once more. Following from the start-up, perhaps the 6 MBAs are serving espressos once more, but perhaps they’ve found a way to deliver these following tweeted orders on their phones within their segway deliverable radius. Perhaps their new direction offers a new venture, indeed, spurs forward more entrepreneurial drive, one that will have learned from the past and improve upon it. Perhaps the sub-Saharan country is setting its foreign investments in a sovereign wealth fund, to limit inflationary impacts nationally, offering loans for the tertiary education of its citizens in order to improve the human capital of its country and to assist in overcoming the critical shortage of certain local skills, eg its limited financial services sector. Perhaps the housing crisis has offered a wide range of housing options for a new generation, one that is actually affordable over the coming years and that can be maintained, thanks to excess capacity, throughout a recovering economy, further alleviating households from their most pressing expense, that of safe housing.

In summary, this article wanted to challenge past assumptions: the assumption that excessive capital is necessarily bad but also the assumption that restricted capital is therefore better. Neither assumption is really grounded in the market and in human interactions, instead, it is important to acknowledge the impact of absorptive capacity in our daily lives, both as groups and as individuals, and to then confront its challenges in a rational manner. As the three illustrative examples set forth in this post detail, the complexities of absorptive capacity can occur at multiple levels within our society and with different complexities attached with each confronting their own set of challenges and specific opportunities. I look forward to your comments on this article.

Background Articles:
Why Too Much Money is Worse Than Too Little
Worries About Tomorrow Hold Back Economic Growth Today
Example of a Capital Cost Absorption Target calculation for UK DOH
Working Capital Absorption: Measuring and Monitoring
Absorptive Capacity: On the creation and acquisition of technology in development
Absorptive Capacity And Innovative Performance: A Human Capital Approach
Absorptive Capacity and Social Capital in Regional Innovation Systems: The Case of the Lahti Region in Finland
UN Economic Commission for Africa, Economic Report on Africa 2006, Ch. 6
The Concept of Absorptive Capacity: Origins, Concepts and Practical Relevance

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