23 Things They Don't Tell You About Capitalism

In the old days, when someone borrowed money from a bank and bought a house, the lending bank used to own the resulting financial product (mortgage) and that was that. However, financial innovations created mortgage-backed securities (MBSs), which bundle together up to several thousand mortgages. In turn, these MBSs, sometimes as many as 150 of them, were packed into a collateralized debt obligation (CDO). Then CDOs-squared were created by using other CDOs as collateral. And then CDOs-cubed were created by combining CDOs and CDOs-squared. Even higher-powered CDOs were created. Credit default swaps (CDSs) were created to protect you from default on the CDOs. And there are many more financial derivatives that make up the alphabet soup that is modern finance.

By now even I am getting confused (and, as it turns out, so were the people dealing with them), but the point is that the same underlying assets (that is, the houses that were in the original mortgages) and economic activities (the income-earning activities of those mortgage-holders) were being used again and again to ‘derive’ new assets. But, whatever you do in terms of financial alchemy, whether these assets deliver the expected returns depends ultimately on whether those hundreds of thousands of workers and small-scale business-owners who hold the original mortgages fall behind their mortgage payments or not.

The result was an increasingly tall structure of financial assets teetering on the same foundation of real assets (of course, the base itself was growing, in part fuelled by this activity, but let us abstract from that for the moment, since what matters here is that the size of the superstructure relative to the base was growing). If you make an existing building taller without widening the base, you increase the chance of it toppling over. It is actually a lot worse than that. As the degree of ‘derivation’ – or the distance from the underlying assets – increases, it becomes harder and harder to price the asset accurately. So, you are not only adding floors to an existing building without broadening its base, but you are using materials of increasingly uncertain quality for the higher floors. No wonder Warren Buffet, the American financier known for his down-to-earth approach to investment, called financial derivatives ‘weapons of financial mass destruction’ – well before the 2008 crisis proved their destructiveness.

Mind the gap

All my criticisms so far about the overdevelopment of the financial sector in the last two or three decades are notto say that all finance is a bad thing. Had we listened to Adam Smith, who opposed limited liability companies (see Thing 2) or Thomas Jefferson, who considered banking to be ‘more dangerous than standing armies’, our economies would still be made up of the ‘Satanic mills’ of the Victorian age, if not necessarily Adam Smith’s pin factories.

However, the fact that financial development has been crucial in developing capitalism does not mean that all forms of financial development are good.

What makes financial capital necessary for economic development but potentially counterproductive or even destructive is the fact that it is much more liquid than industrial capital. Suppose that you are a factory owner who suddenly needs money to buy raw materials or machines to fulfil unexpected extra orders. Suppose also that you have already invested everything you have in building the factory and buying the machines and the inputs needed, for the initial orders. You will be grateful that there are banks that are willing to lend you the money (using your factory as collateral) in the knowledge that you will be able to generate extra income with those new inputs. Or suppose that you want to sell half of your factory (say, to start another line of business), but that no one will buy half a building and half a production line. In this case, you will be relieved to know that you can issue shares and sell half your shares. In other words, the financial sector helps companies to expand and diversify through its ability to turn illiquid assets such as buildings and machines into liquid assets such as loans and shares.