Michael Shuman – SA visit report excerpt

In July 2023, Michael Shuman (USA), a leading global expert on local economics, presented to state government policymakers on how economic localisation can be the engine of prosperity, meaningful work, circularity and social inclusion. Shuman also met with social enterprise sector leaders, philanthropic sector leaders, economic development professionals from local government, local government authorities, and the business community. 

Key message

The basic message I conveyed was this: South Australia can achieve its economic, environmental, and social goals more quickly and at a lower cost by mobilising the untapped potential of local investment. 

By local investment, I mean grassroots, non-wealthy South Australians putting their money into local businesses, projects, and people.

I began my talks by discussing the principles and practices of economic development. The conventional economic-development paradigm emphasises 3 imperatives:

• Generate new wealth primarily through exports.
• Favour manufacturing for exports, because manufacturing jobs pay significantly more than other jobs.
• Use various incentives, grants, tax breaks and other subsidies to attract companies to serve as the foundational manufacturers.

Economists who study these policies, however, increasingly doubt the validity of each of these points. Specifically: 

• What matters for generating new wealth is not exports, per se, but a positive trade balance. And import-substitution often is a more cost-effective way of improving the trade balance than boosting exports. The greater self-reliance that comes from import substitution certainly is more consistent with the objectives of building a circular economy, as discussed below.
  
  
• Manufacturing was once a large part of the economies of developed countries like the United States and Australia, when households in the 1950s and 1960s spent two-thirds of their household budgets on goods. Today, the vast majority of our household expenses go for services – and that percentage is likely to grow. Manufacturing in the United States is responsible for under 10% of all jobs – a number that has been steadily declining and seems destined to continue to decline. The comparable number in Australia is 6.3%. Why are so few people working in manufacturing? Because manufacturing has gotten more efficient, the public’s demand for many “things” has gotten saturated, and increasingly households want to spend their wealth on health, education, and caring. Nor is the wage argument for propping up manufacturing still valid. Today, in the United States, the average wage of service industries is slightly higher than goods-producing industries, and many services sectors, such as financial services, informational services, and health services, pay significantly more.
  
  
• More than 20 studies have conclusively shown that incentives for attraction and retention of business do not work. Among the problems are:
  • the overpromised benefits of attraction rarely materialise
  • negotiations are led by self-interested corporate representatives (not communities)
  • lobbying by participating companies, undertaken in secrecy, distorts the democratic playing field
  • most jobs created are imported (with little positive benefit on communities)
  • most corporate siting decisions are made independent of incentives
  • most attractions result in greater inequality
  • incentives are usually paid by local businesses that are more important for long-term economic development.

Moreover, the per-job costs of incentives (often in the range of $500,000 per job) are two orders of magnitude greater than the costs of securing a job through local business.

A more rational and data-driven approach to economic development would focus on local business. Specifically, 3 rules would be observed:

• Maximise the percentage of jobs in locally owned business
• Minimise the leakage of purchasing dollars by expanding the number, range, and quality of locally owned businesses
• Promote an entrepreneurial ecosystem

Since my previous report to South Australia in 2016 presented extensive documentation for this approach, I will not repeat those arguments here. But one important new argument has since surfaced –resilience. The struggles communities endured during the COVID-19 pandemic to meet basic needs have made clear to economic departments everywhere that they need greater resilience against future catastrophes. But resilience is not just strengthening local defenses against rising oceans, more intense bushfires, or new viruses. It also means greater self-reliance, especially in basics like food, energy, and water. Which means that the traditional comparative advantage paradigm – produce one or two globally competitive goods and import everything else – is effectively obsolete. This has led many advocates and observers of globalisation, such as Rana Foroohar of the Financial Times in her new book Homecoming, to argue that the world is fast moving toward regionalisation and localisation. 

Finally, a critical part of promoting an entrepreneurial ecosystem is making capital available to locally owned businesses that can increase local self-reliance. By definition, local ownership requires local investment. And local investment remains challenging and expensive under outdated securities laws.

The common arguments against local investment are that: 

• they are risky because most local businesses fail
• they deliver poor returns even if the businesses survive
• they require too much time and effort from most local investors. 

These concerns, however, are exaggerated.

Some say that local investments are foolish because most local businesses fail. This is incorrect. Most local business startups fail, but in any given year startups comprise a tiny percentage of the universe of local businesses.

Some believe local investments are not profitable. Some are, some are not – there are not great data. But we know, from some Canadian and US data, that small businesses generally have higher profit rates than larger businesses.

Some observe that local investors have to put in more time and money to be effective. This is true. Local marketplaces are immature and lack many of the features of the public markets such as well-informed investment advisors, good evaluations of local companies, well-managed local investment funds, and local stock markets. But even without these features, local investors can be successful – and it’s their strategies that ought to be studied and spread in South Australia.

Currently, the capital marketplace in Australia – and throughout the developed world – is broken. At least 66% of the Australian economy resides in small and medium scale businesses that are 99% locally owned. In a healthy capital marketplace, roughly 66% of the public’s investment would support this 66% of the economy. Today, almost none does. Australians instead, through their superannuation funds, put almost all their investments into the stocks and bonds of large, publicly traded corporations. These are companies with lower profit rates and largely disconnected from community well-being.

Consider the potential benefits of fixing this capital market failure. If 66% of the $3.5 trillion Australians have in their superannuation funds were moved from publicly traded to local businesses, about $90,000 per capita of new investment would become available to launch or expand local Australian businesses. 

Even a small shift of capital can have a huge positive impact. A study I co-authored in 2010 analysed the impact of a 25% shift in consumer food expenditures in Northeast Ohio (the region surrounding Cleveland). We found that a shift of this magnitude would create 27,000 new jobs paying $868 million in new wages and generating $126 million in new state and local taxes. Achieving this, we estimated, would require new investment in local food and farming ventures of about $735 million. As large as that number sounds, it represents 1% of what Northeast Ohioans have in their bank accounts on 0.25% of what they have in their pension funds.

The good news is that local investment has matured and expanded significantly in recent years. The United States effectively legalised investment crowdfunding in 2016. In the years since, about 1.5 million Americans have invested almost $2 billion in more than 6,000 companies.  In the second quarter of 2023, the average investor was writing a check over $1,500, and the average successful raise by companies was $400,000. Australia allowed investment crowdfunding to begin a little later, in 2018, but there’s every reason to expect the same kind of growth that occurred in the United States.

For states, cities, and towns in Australia, the opportunity is enormous. With a relatively small expense, an enormous amount of capital can be pumped into local businesses which have the potential to be game changers for economic development. Moreover, with smart initiatives, local capital can be steered into industries that public policy favours, such as circular economy businesses, affordable housing, and renewable energy. 

Recommendations for unlocking community capital 

1. Educate

Many of us believed that legalising investment crowdfunding in the United States would change people’s investing inhabits. We were wrong. Creation of a local investment ecosystem, in fact, requires significant education, marketing, and mobilisation. Investors need to be educated about how to find, evaluate, and manage local investment options. Businesses need to be educated about emerging opportunities for local investment. Investment institutions need to understand the potential in local markets and figure out business models for seizing it. And policymakers traditionally focused on angel and venture investors that impact only a tiny number of companies need to be educated about emerging local capital alternatives. In the United States, I have found a ready market for deep-dive workshops where I reach and teach these audiences. I’ve also prepared 50 short videos that you can access for free.

2. Unleash LIONS

LION stands for the Local Investment Opportunity Network of Port Townsend, Washington, which was established in 2007. Port Townsend is a 10,000-person town about 2 hours’ drive north of Seattle. It began as a potluck dinner bringing together local businesses interested in raising capital with potentially interested local investors. To stay compliant with securities laws, meetings had no structured speaker or pitching. Instead, the gatherings were all about forming relationships. This very simple social invention since has locked nearly $1 million of new local investment per year in this small town. Recognising the power of this framework, the Washington State Department of Commerce has been replicating the creation of local investment networks (LINs) throughout rural areas of the state. Organising groups is a cost-effective (and fun!) way of facilitating education, conversations, relationships, and capital flows.

3. Publish a list

A chief complaint of early adopter local investors is the difficulty they have in finding local investments. An easy fix is to create a website with an updated list of local companies looking for capital. In Baltimore, a colleague and I created the Maryland Neighborhood Exchange, which presents local investors with a list of companies with active investment crowdfunding campaigns. We don’t do any transactions, but just direct people to the investment portals permitted to sell securities. During the 2 years of COVID lockdowns, this website helped about 44 companies raise $3.3 million from 6,000 Maryland investors. A site like this belongs on every economic developer’s website across South Australia.

4. Circulate offerings

For those who do not receive their information primarily from the web, or who need repeated reminders to act, it’s useful to place lists of local investment opportunities every week into their inboxes. My newsletter, The Main Street Journal, which has 8,000 subscribers (including several hundred Australians), is about to start doing that in the United States. Again, it just presents information and hyperlinks that connect interested investors to potential local investment opportunities. South Australia should create a similar newsletter to inform and mobilise local investors in the state.

5. Organise investment advisors

One of the biggest unappreciated obstacles to local investment is the profession of investment advisors, who instinctively encourage their clients to stick with public markets. Many, for example, repeat the idea that all local businesses have high failure rates. In the United States, however, a small but growth number of investment advisors, such as Angela Barbash of Revalue (based in Ypsilanti, Michigan), are specialising in local investments and educating their peers to work together in identifying and evaluating them. Every community needs to find at least one simpatico investment advisor to start building an alternative analytical framework for local investors.

6. Promote pre-selling

Investment crowdfunding necessarily requires compliance with securities law, and even if those costs are brought down, they still may be too large for some small businesses. But there is a lower-cost way for businesses to “test the waters” and see if they might succeed with crowdfunding – and that’s preselling. Preselling occurs when buyers buy bulk items in advantage – say, 25 discounted meals from a restaurant – which effectively provides investment-like capital injections into the seller. In the United States, most preselling is not covered by securities law, and I suspect – but haven’t been able to confirm – the same is true in Australia. If it is true, then creating local platforms for pre-sales might prepare companies for the more demanding rigors of investment crowdfunding.

7. Facilitate self-direction 

Another impediment to local investment is that most non-wealthy investors have their investment capital tied up in government-regulated accounts that provide only public market investing options. In the United States, however, we have discovered ways in which traditional accounts (IRAs, 401ks, and others) can be rolled over into self-directed accounts that then can be locally invested. Australia provides self-direction options for superfund accounts, and currently about a quarter of all superfund capital is invested this way – primarily by wealthy investors. There is no requirement, however, the self-directed supers be done only by wealthy people, and a concerted community effort – to provide compliant fill-in-the-blank forms, for example – could open this option for millions of Australians. My colleague Gilbert Rochecouste, founder and CEO of the Village Well in Melbourne, recently created a self-directed super with 3 other people that manages a conference space called the Epoch Center. In the United States, an organisation called the Next Egg was founded to assist Americans seeking to create self-directed retirement accounts. A similar organisation is needed in South Australia.

8. Create funds

Even for those people interested in local investing, the huge effort required now is a deterrent to participation. As long as only highly motivated individuals can find, evaluate, and manage their investments, few people will do it. That’s why most busy people turn to funds to oversee most of their investments. Funds give investors professional management, diversification, and liquidity. But outdated securities laws, again, make it very difficult for communities to create their own funds. The United States has perhaps 10,000 investment funds, but only about three dozen focus on local business and allow grassroots investors to participate. There are even fewer examples in Australia. Developing new models of funds is essential to spreading local investment, and local governments have the resources to do this. One bright note is that Ethical Fields has a Place Based Capital Program, funded by 20 municipalities in Australia, to explore plausible community fund designs.

9. Recruit local government

Another way local government could help is to provide at least one local investment opportunity for residents, and that opportunity could be municipal bonds. In the United States, the state of Connecticut recently issued $25 million of “baby bonds” – low denomination bonds purchasable by grassroots investors – to support the spread of solar energy in low-income communities. There was so much excitement about the offering that it sold out in 48 hours. While many Australian states prohibit municipalities from issuing bonds like these, South Australia apparently is exceptional. Cities in the state – or perhaps a coalition of cities – should issue bonds around critical local priorities, including the seeding of city-run, local investment funds.

10. Incentivise participation

Finally, it’s worth considering ways of capturing the attention of grassroots investors and shifting their behavior. One way of doing so is through tax credits. The Canadian province of New Brunswick provides grassroots investors with a 50% state income tax credit for local investment. In the United States, the state of Michigan is about to pass a similar piece of legislation. Australian jurisdictions – probably states – should consider ways of building these kinds of incentives into their tax systems.

Top 3 recommendations

For state policymakers

• Jettison the “attract and retain” model of economic development (even when it’s put in green packaging) and articulate a new model rooted in local ownership, local self-reliance, and entrepreneurship. Focus on localisation.
• Rethink investing government capital in one promising industry. If you want to deploy public money, hold a transparent auction and allow all kinds of companies to bid. Each might show how many good, long-term jobs could be produced per public dollar. Then allocate funds to the lowest bidders. A rational system for the efficient allocation of public money could help prevent favouritism, wasteful, and catastrophic failures.
• Unlock the potential for local investment by facilitating each of the 10 action points highlighted. Most of the items can be promoted immediately. For those that require legal reforms, such as local funds, push for them at the state and national levels. There should be at least some staff at the state level – perhaps housed at Green Industries SA – focused on this challenge.

For local policymakers

• Appoint a local investment czar, who will promote as many of the 10 items as possible. Educate, mobilise, and support businesses seeking local investment, and residents and institutions that are interested in making local investments.
• Create at least one city-investment option by issuing municipal bonds at low-denominations (perhaps to capitalise a fund) that can be purchased directly by residents.
• Perform a leakage analysis to determine gaps in the economy – all the places where residents are unnecessarily buying outside goods and services. Use this gap analysis to prioritise economic development initiatives.

For businesspeople

• Think about the best ways to grow your business and consider investment crowdfunding as a method for raising the necessary capital.
• Partner with other local businesses (even competitors) to achieve greater economies of scale through joint procurement, joint bidding on government contracts, joint products and projects, and joint financing schemes.
• Insist that economic developers focus on local businesses rather non-local businesses that are least connected with your community’s wellbeing.

For social enterprise leaders

• Think about the best ways to grow your business and consider investment crowdfunding as a viable option. While non-profits cannot accept equity investment, they can borrow funds from grassroots lenders. For example, owning your own building – or having your members own your building – can make significantly more of a social enterprise’s budget available to programs.
• Consider creating new local businesses that promote local investment, such as investment advisory services, local business evaluation services, or self-directed superfund facilitators. In time, these will be run by major financial companies. For now, at a small scale, these efforts will be experimental but essential for building a healthy local investment ecosystem.
• Be wary of social purpose bonds. While there are instances where these financial instruments are useful, the “pay days” for investors are often poorly defined and the bonds can be used to excuse public sector laziness. Difficult-to-monetise securities like these, if they go sideways, can discredit more basic local investment opportunities.

For grassroots investors in South Australia

• Aim to move each year at least one percent of your investment portfolio from publicly traded companies into local businesses and projects.
• Develop neighborhood teams to find, evaluate, and manage local investments more effectively.
• Work with your teams to develop low-cost structures for self-directed superannuation funds.