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CAPITAL

Capital is popularly thought of in terms of monetary assets or investment flows. However, capital is far more inclusive as a factor of production. Capital is an inventory of plant, equipment and other productive resources such as infrastructure and technology. While the ability to accumulate or attract funds for future investment in fixed capital is clearly important to the production process, finance is just one element of capital.

Private sector institutions arrange the bulk of development finance. Public sector intervention aims to lower the cost of finance either by providing access to sheltered pools of money, by passing on the favorable tax treatment of funds, or by accepting risks greater than private institutions are willing to bear. Development finance usually involves several tiers of debt and occasionally requires equity, or near-equity, investments. Public sector programs generally serve to fill gaps in the debt structure - they bear the extra risk or take a lower rate of return on a portion of the financing. The justification for public subsidy is the belief that the social benefits to be generated from the projects exceed the cost involved in the financing. (Hill and Shelley 1990).

Evidence suggests that the establishment of financial intermediaries was a politically motivated response to downturns in the business cycle and economic restructuring in the U.S. rather than a response to failures in capital markets (Hill and Shelly 1990). However, others have argued that capital market failure does exist and public intervention can correct for these failures. Bartik contends that private financial markets fail to achieve efficiency if socially profitable loans or investments are not made (Bartik 1990).

He identifies three possible causes of financial market failure: 1) financial markets are regulated, and this may limit credit availability or restrict the ability of financial institutions to make risky loans or investments; 2) even without regulation, the absence of complete insurance markets, or the absence of secondary markets (where loans can be sold), may restrict the amount of risk that financial institutions are willing to take; 3) the costs of borrowing at private market interest rates may be too high to encourage investment, particularly long-term investment that will benefit society in the future (Bartik 1990).

These three factors may provide a rationale for economic development programs that directly supply capital to businesses or indirectly encourage greater private capital availability to business. If the rationale for these programs is excessive risk aversion by the private market, then intervention should focus on expanding credit availability to riskier ventures whose expected profitability yields a normal rate of return.

If the rationale for intervention in financial markets is that private interest rates are too high, public or nonprofit lending programs should target businesses that will generate enough profit to cover the opportunity costs associated with investing, but would not generate enough profit to justify the cost of borrowing at private market interest rates. This will encourage long-term investing that will benefit future generations (Bartik 1990).

Often, economic development investments are intended to establish or demonstrate the viability of new markets. When this is done successfully, private sector investment should replace public investment as the product matures. This approach is taken with many lending programs, as they are often designed to absorb the initial risk of investing in new markets with the ultimate goal of attracting private investors.

Economic development strategies designed to impact financial markets are discussed in the following section.

see corresponding section in What Works