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Council Post: Capital Destruction: A Necessary Evil



Ivan Illan is Chief Investment Officer at AWAIM® and bestselling author of Success as a Financial Advisor For Dummies.

There are only two ways to destroy capital: bombs or bankruptcy/default. Capital has been defined as “wealth in the form of money or other assets owned by a person or organization or available or contributed for a particular purpose such as starting a company or investing.” It’s a broad definition but includes anything you can imagine that has value, including real estate, collectibles, securities, etc. Although there are places in the world where bombs unfortunately and unfairly are being dropped, leveling buildings and other tangible assets, the focus of this article is on liquid capital that must be necessarily destroyed in the aftermath of the Fed’s aggressive financial engineering.

To better understand why capital destruction is necessary to the economic and business cycles, let’s review a key underlying driver of capital growth or decline—monetary policy. After years of ultra-accommodative and expansionary monetary policy (particularly in the U.S.), where interest rates were artificially held down through the Federal Reserve’s FOMC activities, various consequences have blossomed. These include looser bank lending conditions, higher rates of inflation and asset bubbles (as inexpensive money meant a lower investment risk assessment due to lower costs of capital).

The ebb and flow between expansionary and contractionary monetary cycles are directly linked to the financial and business cycles, as articulated clearly by the Federal Reserve Bank of New York in their January 2012 staff reports publication entitled “Monetary Cycles, Financial Cycles, and the Business Cycle.” Economic “good times” are accompanied by greater risk-taking, as capital allocations are more readily directed toward riskier and unproven business and economic models. This is an important aspect of the monetary cycle; without it many revolutionary or simply evolution ideas for technology, workflows or other goods/services solutions produced in an economy would not be able to find funding to get started.

Conversely, extended periods of monetary base expansion mean that more than a rational amount of capital could end up flowing into ideas, businesses or other ventures that have little to no long-term value or economic contribution. Therefore, during the contractionary phase of a monetary cycle, those same ventures, ideas and other assets would necessarily become worthless as the money tide ebbs away. In this ebbing process, tremendous capital is eviscerated into thin air, just as easily and quickly as it was created into existence by the highly coordinated efforts of the Federal Reserve and the U.S. Treasury Department. The key to mastering the understanding of this dynamic is simple. Remember that the most prudent capital allocation decisions are made when interest rates are at historical averages, not several hundred basis points below (expansionary) or above (contractionary).


As business owners and investors plan for their futures, I would recommend a careful and extended analysis of your cash flow needs over the next two to three years. During this forward-looking period, the availability of affordable capital will necessarily become scarcer. This will favor businesses and investors that utilize a dynamic cash management program that could meet expenses and other liabilities in a timely manner. An effective cash management strategy includes a clear projection of needs over the next six to 12 months (or longer) versus a prudent (perhaps even more conservative) estimate of income generated during the same period. If there’s little margin, consider increasing your cash position by 20%-40% more than the amount of the projected deficit.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

Forbes Finance Council is an invitation-only organization for executives in successful accounting, financial planning and wealth management firms. Do I qualify?

Source: Forbes

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