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The Democratization of Capital
By Michael Milken

(Reprinted with permission from California Lawyer magazine, July 2000.)

The smoke drifting from burned-out buildings in the South-Central area of Los Angeles made my eyes sting. Despite my father's misgivings, I had left my safe San Fernando Valley home on a hot August morning in 1965 to find out for myself what was causing the Watts Riot, which had begun just a few days before. Growing up in Los Angeles, I'd never personally experienced discrimination. I retained an idealist's view that America was a land of opportunity for all its citizens, especially in this city of dreams, the place where movies were made.

I'd spent a lot of time in South Central as a kid, working at summer jobs, competing in high school speech tournaments, tutoring, going to museums and attending sporting events. But as a 19-year-old college student I walked the riot-torn streets that were still patrolled by the National Guard and met an African-American man staring at the charred remains of a factory where he had been an employee. He had no savings and now he had no job. We talked for awhile, and then he told me something that sent a chill through me despite the heat. He had stood on the sidewalk and actually yelled encouragement as rioters set fire to the structure. "But they were burning down your job!" I said. "How could you feel good about that?" He said he had always felt like an outsider in white society. The building was theirs, not his.

I had thought I was fairly worldly, and had chosen to go to the University of California at Berkeley because it seemed like the best place to see the entire world in one place. I'd experienced the Free Speech movement and civil rights protests. But standing with that man in Watts, I began to understand that civil rights the great and worthy cause of my youth meant more than the right to sit in the front of a bus or go to a good school. It also encompassed what has made America different: the chance to fail. No one should be denied the right to participate in economic society, to aspire to ownership of a business rather than just a job. Two weeks later, when I returned to Berkeley for the fall term, I changed my major from math to business and began pursuing what has been a lifelong quest: the global democratization of financial capital.

My studies showed that access to capital the lifeblood of business had always been restricted. In medieval times, it vested in royalty and the church. With the 19th-century revolution in manufacturing, capital access broadened to a small group of industrialists and their bankers. And even as late as the 1960s, capital was controlled by a few large financial institutions that doled it out to their privileged clientele, who invariably were male, white, and "established." As one of the most highly regulated industries in the nation, the banks were encouraged to provide loans only to borrowers perceived as "safe." In the view of large financial institutions and regulators, a company like Singer, the sewing machine company, seemed like a great place to invest. After all, Singer sported an "investment-grade" rating based on a record of paying dividends for more than 100 years. Never mind that its primary customers women were joining the workforce (and abandoning sewing) in droves. This bias toward the past, what I call financing in the rear-view mirror, served to deny capital to those who had great business ideas but no establishment credentials. Among its many victims were entrepreneurial minorities and women.

Seeing the World Through New Eyes

You can't blame lenders for trying to avoid risk. They had to deal with restrictive regulations that were generally based on past performance. They also had a duty to shareholders and depositors to stay with "safer" investments, which they assumed were securities of governments and those few hundred large companies rated investment grade. But if these big lenders had studied history, they would have seen that they were wrong. Government securities weren't the "safest" investments. In fact, my research at Berkeley (and later at the University of Pennsylvania's Wharton School) showed that throughout history, governments regularly defaulted on their debt. Those that didn't default often hyperinflated their currency, which had a similar effect. And, as the experience of the 20th century, (especially the last 30 years), has proven, a portfolio of high-yield (a.k.a. junk) bonds, which are loans to non-investment-grade businesses, yields a better return than low-interest loans to blue-chip companies.

The myth of safety in government and large-company securities is one of many myths that emerge from a skewed frame of reference. Think back to your grade-school geography lessons.

There was that big map of the world on the wall. Africa and South America were huge, dwarfing Europe; and the Soviet Union was a colossus that spanned more than a dozen time zones, making the United States look puny by comparison. No wonder we feared the Soviets and built fallout shelters! But if we had looked at the world in economic terms, the Russian bear would have shrunk drastically. In fact, at current exchange rates, the gross domestic product of today's Russia approximates the economic output of Maryland and New Jersey. Even adjusting for purchasing power, Russia's GDP is still a small fraction of the U.S. economy.

Europe, with only 8 percent of the world's land mass, produces 35 percent of world economic output, while Africa and South America combined can claim only 6 percent. Looking 30 years into the future, economists predict that the GDP share of Africa and South America will actually shrink to 5 percent. Asia, meanwhile, will produce more than half the world's output within a generation.

Even when we look at the world economically, however, there are still major distortions because of our reliance on traditional accounting measurements. For example, based on historical valuations, the financial balance sheet of the United States and its people contains some $45 trillion in assets-natural resources, factories, stocks, bonds, and other "real assets"-all calculated to the penny. But there's a slight problem the numbers are off by about $140 trillion. Left off the balance sheet is the value of the asset that Gary Becker, Nobel Laureate in Economics, calls human capital. Professor Becker says that the skills and experience of our people are worth more than half a million dollars per person. By this calculation, traditional assets comprise less than 25 percent of the national balance sheet, which means that true U.S. assets exceed $180 trillion.

This error of historical accounting didn't amount to much when the most valuable assets were natural resources. In the 1920s, for example, raw materials and energy made up 60 percent of the cost of producing an automobile. Not surprisingly, U.S. Steel was the largest company in the world. By the 1990s, however, raw materials and energy were only 2 percent of the cost of producing computer chips, and Intel's market value was more than 150 times greater than U.S. Steel's. Its key asset is not silicon, but human capital. As the shift to a knowledge-based economy accelerates, traditional balance sheets become increasingly inaccurate. Today, any knowledge-based organization that doesn't carry the value of its human capital on the balance sheet is miscalculating its assets.

Where's Cuba?

A perfect example of the importance of human capital is Cuba. If you ask someone where Cuba is, the response is likely to be that it's an island in the Caribbean, 90 miles off the coast of Florida. But by the 1980s the real Cuba had moved to the United States, where so many of Cuba's entrepreneurs, artists, scientists, and scholars fled. Cuban revolutionary leaders made a mistake if they thought its assets were sugar-cane fields, roads, and factories. The true assets of any country are in the intellectual capacity of its people. In fact, the economic contribution of Cuban immigrants in Florida long ago exceeded the entire gross domestic product of their homeland.

One reason these immigrants and other entrepreneurial people have thrived in the United States is the increased access to capital they've enjoyed. This access is a direct result of a shift in control of capital from institutions to markets over the past 30 years. It is a historic shift that has "democratized" capital by making it more broadly available, and it accounts for much of our nation's recent prosperity.

In the past two decades, we've seen a dramatic expansion of new nonbank financial institutions closed-end mutual funds, venture capital funds, brokerage firms, department stores, auto manufacturers, mortgage companies, e-financial institutions and others that have jumped into the financial services business. With far less balance-sheet leverage than traditional banks, these financial institutions have been able to extend capital to entities not normally serviced by the banking industry.

Democratizing capital has encouraged the growth of such new financial entities, especially mutual funds, to challenge the dominance of the few large banks and insurance companies that used to decide who received financing. Thirty years ago, bank assets were 30 times greater than those of mutual funds. Today, fund assets outstrip those of banks, and the number of funds is greater than the number of stocks on the New York Stock Exchange. Banks, frustrated by lack of flexibility and a dramatic loss of market share, finally got the Financial Modernization Act passed last year, allowing them to offer insurance, merchant banking, and mutual funds. Many mutual funds have invested in the smaller, growing companies that are the engines of job creation vastly expanding career opportunities. In fact, as a result of the democratization of capital, small and medium-size companies have created 57 million new jobs in the United States since 1970. During the same period, the Fortune 500 companies have reduced workforce levels by more than 3 million despite generally increasing revenues.

Financial Technology Broadens Capital Access

Noninvestment-grade companies could create so many jobs because, for the first time, they had access to growth capital supplied by new market mechanisms that I call financial technology. These include derivatives of currencies, stock market indexes, interest rates, and commodities; securitized mortgages; securitized bank loans; and collateralized loan and bond obligations (junk bonds). Because these financial technologies create anonymous, efficient markets, borrowers are less dependent on the old relationship-based system. With the widespread use of computers and adoption of modern portfolio theory, today's markets let providers of capital (a pension fund, for example) buy packages of loans-mortgages, business loans, student loans, credit-card debt, etc.-and spread the risk across thousands of borrowers. That provides growth capital for entrepreneurs and encourages the expansion of human capital through such worthwhile pursuits as higher education. It also contributes to social capital by helping finance home building and strengthening communities. (Social capital also includes the underlying incentives to invest provided by the rule of law and secure property rights.)

The multiplier effect of financial technology suggests a theory of prosperity that I developed in the 1960s. It can be stated as a simple formula:

Prosperity equals the collective value of financial technologies multiplied by the total of human capital, social capital, and real assets.

Powerful new financial technologies were developed in the 1960s, widely tested in the 1970s, and increasingly deployed throughout the '80s and '90s, allowing thousands of companies access to the financial capital that helped fuel their growth. The multiplier effect of these financial techniques produced an unprecedented economic boom over the past 20 years.

At least in America.

Other parts of the world didn't adopt the new methods because their financial assets remained under the control of relatively few financial institutions institutions that generally held large ownership positions in existing businesses. When you own major stakes in a country's largest businesses, you have little incentive to invest in new businesses that will compete with your established portfolio. Another factor inhibiting growth outside the United States was a relative lack of both financial transparency and consistent regulatory standards. The absence of these structures has tended to slow any move to the kind of market-based economy we've enjoyed in the United States. As a result, much of the world has failed to create jobs or broad-based prosperity.

In 1970 Europe had twice the population of the United States. Yet for most of the past 30 years, it produced virtually no new jobs. That's starting to change, however. In the mid-1990s, the United Kingdom began importing American financial techniques and proceeded to reduce unemployment significantly through job creation. Now continental Europe is following and unemployment rates are declining in a number of countries. Other parts of the world will eventually do the same.

Just as it has in the United States, the worldwide democratization of capital will democratize industrial assets and produce an explosion of job creation. But the capital revolution, which so changed America in the last third of the 20th century, is only the prelude to the other two major revolutions of the 21st century the worldwide democratization of health care and of knowledge. These three revolutions, each aided by emerging technology, provide hope that the 21st century will be able to avoid the terrible conflicts of the past hundred years and become a new Age of Enlightenment.

Michael Milken is a philanthropist and financier. He chairs the Milken Institute, a nonprofit economic think tank in Santa Monica, Calif.