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ELEMENT 2.4
To realize its potential, a nation must have a mechanism that channels capital into wealth-
creating projects.
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Not all investment projects, however, are productive. An investment project will
enhance the wealth of a nation only if the value of the additional output from the investment
exceeds the cost. When it does not, the project is counterproductive and reduces wealth.
Investments can never be made with perfect foresight, so even the most promising investment
projects will sometimes fail to enhance wealth. To make the most of its potential for economic
progress, a nation must have a mechanism that will attract savings and channel them into the
investments that are most likely to create wealth.
In a market economy, the capital market
(?)
performs this function. Broadly defined, it
includes the markets for stocks, bonds, and real estate. Financial institutions
(?)
such as stock
exchanges
(?)
, banks, insurance companies, mutual funds, and investment firms play important
roles in the operation of the capital market.
Private investors, such as small business owners, corporate stockholders
(?)
and
venture capitalists
(?)
place their own funds at risk in the capital market. Investors sometimes
make mistakes, however. Sometimes they undertake projects that prove to be unprofitable. If
investors were unwilling to take such chances, many new ideas would go untested and many
worthwhile but risky projects would not be undertaken.
Consider the role of entrepreneurship, risk-taking, and the capital market in the
development of Internet services. In the mid-1990s, Sergey Brin (an immigrant from Russia)
and Larry Page were graduate students at Stanford University in California, working on a
research project designed to make it easier to find things on the Internet. They might have
seemed unlikely candidates for entrepreneurial success. But in 1998, Brin and Page founded
Google Inc., a business providing free Internet services that generates revenues through
advertising. The powerful Internet search engine that they developed increases the productivity
of millions of individuals and businesses each day. They have earned a fortune and Google is a
household name with more than 85,000 employees (including its parent company Alphabet) in
2018. Other Internet-based companies, such as eBay and Amazon, have also earned profits and
achieved substantial growth during the past decade.
But the experience of numerous other Internet start-ups was quite different. Many “dot-
coms,” like Broadband Sports and eVineyard, went bust because their revenues were
insufficient to cover their costs. The high hopes of these firms did not materialize.
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In a world of uncertainty, mistaken investments are a necessary price that must be paid
for fruitful innovations in new technologies and products. Such counterproductive projects,
however, must be recognized and brought to a halt. In a market economy, the capital market
performs this function. If a firm continues to experience losses, eventually investors will
terminate the project and stop wasting their money.
Given the pace of change and the diversity of entrepreneurial talent, the knowledge
required for sound decision-making about the allocation of capital is far beyond the scope of
any single leader, industrial planning committee, or government agency. Without a private
capital market, there is no mechanism that can be counted on to consistently channel
investment funds into wealth-creating projects.
Why? When investment funds are allocated by the government, rather than by the
market, an entirely different set of factors comes into play. Political influence rather than
market returns will determine which projects will be undertaken. Investment projects that
reduce rather than create wealth will become far more likely. Political decision making is also
biased towards new projects rather then maintenance. Ribbon cutting on a new highway is
much more visible than pothole repair.
The experiences of the centrally planned socialist economies during the Soviet era
illustrate this point. For four decades (1950–1990), the investment rates in these countries were
among the highest in the world. Central planners allocated approximately one-third of the
national output into capital investment. Even these high rates of investment, however, did little
to improve living standards because political rather than economic considerations determined
which projects would be funded. Resources were often wasted on economically impractical
projects and important political leaders favored investments with high political visibility
(“prestige”). Two examples illustrate this misallocation. Stalin insisted on building the White
Sea Canal, but to meet his unreasonable schedule the canal was too shallow to be useful.
Khrushchev’s campaign to make Kazakhstan produce wheat at the level of American and
Canadian prairies resulted in vast irrigation schemes, which eventually destroyed the Aral
Sea
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.
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