A New Series: The Hierarchy of Finance in a Capitalist Economy

For a long time I’ve been thinking about doing a series about the concept of a “hierarchy of finance”. This phrase refers to the fact that different households and institutions have access to financing for their current—or desired—activities, at both different quantities and qualities. To put it in the simplest terms: some of us can borrow a million dollars easily with good terms…While some of us can’t borrow a hundred dollars at any interest rate. And that difference is not random, it is constructed! A panoply of legal instruments have been created over the centuries—particularly the past three centuries—which influence the quantities and qualities of finance different institutions have access to. Institutions that would otherwise be low down the hierarchy of finance can use specific legal instruments—which we will discuss at length in this series—to access financing on terms, and in quantities, they would not be able to access in any other way. 

I’ve long been interested in this area but a few years ago my interest intensified as I began to focus more closely on the private equity industry. Those who have read my work—especially the 2020 Monetary Policy 101 series—will know that I prefer to build up my analysis from the basic building blocks of the subject in question to ensure that I am coherently analyzing what I am writing about. It also serves a pedagogical role to take otherwise uninitiated readers with me by building up from a foundation that they can follow along with. In a sense, this series is starting from the other end of the Monetary Policy 101 series. Rather than following the “hierarchy of money” down to the financial assets with the “least moneyness”, I’m going to climb the hierarchy of finance up to the point that the instruments begin to appear “money-like”. 

This will also be my way of catching up and analyzing what has been going on with the AI boom, which many refer to as a “bubble”. Complex financial arrangements undergird this ecosystem—which I believe can only be truly understood by building up from such foundations. Yet, I’m not going to rush this series in the hopes of “getting to” AI’s complex financial structures before a potential crash, or any AI specific downturn takes place. I hope that this series becomes an enduring foundation for understanding the hierarchy of finance.

This series will focus on three core elements of the hierarchy of finance: 

1. Instruments
2. Criteria
3. Organizational Forms

Instruments here refers to a legal agreement between two (or more) parties which provides finance to one (or more) parties. This legal agreement can be specific to those parties or it can be sold to a third party. A “negotiable” instrument is one that can be traded openly and an “assignable” instrument—that is,  one that requires a specific process to be transferred to a third party (often meaning notice to the debtor is required.)

“Criteria” in the sense used in this series refers to the assessment of a potential borrower (or equity issuer) for the various possible “worthinesses” that could justify providing them credit (or purchasing their equity). This ranges from an assessment of their “collateral worthiness” or “credit worthiness”, the liquidity of their instruments, or their uncertain potential for explosive cash flow growth. 

Finally there are the “organizational forms” of businesses. Different organizational forms can affect both the judgment of a business enterprise’s “worthinesses”, and the possible instruments they can issue. Since this impact on the hierarchy of finance is sufficiently distinct, this will be assessed separately from the other two categories. An important thing to keep in mind about the forms of organization business enterprises have, is that different types of economically valuable rights—which are allocated to different respective organizational forms. 

This series is called “The Hierarchy of Finance in a Capitalist Economy” because we are examining institutions, and criteria, that are specific to a capitalist economy. Finance existed before capitalism and understanding pre-capitalist finance is important. Yet to assess the world around us we must think through the complex interrelations between instruments, organizations and economic environment that we currently confront. The series’s name is also an allusion to the late, great economist Hyman Minsky. Minsky’s career was defined by his relentless focus on cash flows and balance sheets, grounded in an analysis of capitalism through its financial institutions, instruments and innovations. As Minsky said many times:

A capitalist economy is characterized by a financial structure which leads to the prior commitment of cash flows received, by households, businesses, governments, banks and non-bank financial institutions, to validate their liabilities. 

In this sense, this series is an ode to Minsky.