One of the great ironies embedded inside the structure of all complex systems is that they sow the seeds of their own demise. Such is the case for modern economies and bull markets. The collapse of the Western financial system in 2008 demonstrated beyond a shadow of a doubt that there are internal contradictions embedded in how modern capitalist societies organize themselves. The free market mantras that permitted lightly regulated financial industries to conduct business in reckless and self-serving ways over the three decades leading up to the crisis were thoroughly discredited by the need for Western governments to bail out their largest financial institutions.

The seeds of destruction were primarily ideological; they grew out of widely accepted but flawed ways of thinking about capital, economic growth, and financial regulation. Instead of basing economic growth on a modified free market model that privileges concepts such as equity, transparency, production, and prudent and limited regulation, those in positions of influence chose a radical free market path of debt, opacity, speculation, and wholesale deregulation. There were two problems with this approach. First, the United States does not have a genuine free market; government regulation and crony capitalism play an enormous role in distorting incentives and interfering with the free market. Second, this regime was based on the radical error of pretending that markets are efficient and investors are rational when precisely the opposite is true.

The choices did not have to be as stark as that—there is a middle ground that can serve the interests of all economic stakeholders. But the pendulum clearly swung too far in favor of the radical free market model. And after the financial crisis, the results lay in ruins all around us: insolvent banks, disenfranchised workers, impoverished state, local, and federal governments, a poisoned planet, embarrassed regulators, hypocritical and corrupt legislators crying for retribution between visits to the campaign feeding trough on Wall Street, and a public that lost trust in government. A capitalist system inherently prone to booms and busts became even more prone to disequilibrium. In order to understand what happened and in order to rebuild a more resilient system, we must dig deeply into basic economic principles and reevaluate them.

There are many influential economic thinkers whose work would greatly benefit market participants. In order to better understand the death of capital in 2008, four particular thinkers are worthy of extended discussion—Adam Smith, Karl Marx, John Maynard Keynes, and Hyman Minsky. But these thinkers need to be approached in a way that transcends economics. Three of the seminal works of economic theory that are examined in this chapter—The Wealth of Nations (1776); Capital (1867); and The General Theory of Employment, Interest and Money (1936)—are best considered intellectual performances that far exceed the discipline of economics and qualify as both great literature and great philosophy that have influenced intellectual debate in a variety of disciplines for generations. Each of these works has been analyzed and debated endlessly in academic and policy circles for years and continues to provide rich material for thinkers in a variety of disciplines. This is a tribute to the genius of their authors and the fact that the concepts discussed in these works are subject to multiple interpretations and misinterpretations.

What follows is a highly selective if not idiosyncratic reading of the aspects of these seminal thinkers that ties together their interpretations of some of the key characteristics of capital, capitalism, and markets. It is my contention that these intellectual giants provide insights into the nature of capital that are largely misunderstood by investors, regulators, and policymakers. The result is that little progress has been made in effectively managing the boom and bust nature of free market capitalism, which in turn has caused capitalism to fall far short of reaching its full potential to contribute to the growth and welfare of human society.

The first two thinkers, Adam Smith and Karl Marx, stand at opposite sides of the ideological spectrum yet share an enormous amount of common ground. These philosophers remain two of the most insightful students of capitalism long after their work began to influence the world. Adam Smith saw capitalism as a force for good, while Marx saw it as a cause of conflict and abuse. Their work provides important insights into the characteristics that render capital inherently unstable and crisis-prone. What follows is not intended to be a complete discussion of these two complex thinkers; rather, it is an attempt to draw out some of their key ideas as they affect the modern understanding of financial markets.

Smith and Marx speak to several of the key intellectual and moral underpinnings of our economic collapse. Both men describe markets governed by complex human relationships that at their basic level are strongly affected by people seeking social approbation. They also make powerful statements about the fact that human economic interactions, and the relationships between money and goods, are highly mediated. In discussing these two thinkers, I hope to illuminate some of the forces that drive economic actors to behave in certain ways that are ultimately very harmful to the long-term interests of society. By better understanding the profound truths that Smith and Marx described, we can hopefully address some of these flaws more effectively as we work to design a more productive economic system that serves the interests of all of us, not just the most privileged among us.

The last two thinkers wrote more recently and were particularly prominent in recent discussions surrounding the financial crisis of 2008. John Maynard Keynes and his most important modern interpreter, Hyman Minsky, understood the psychological aspects of capitalism as well as anybody who ever studied the system. In fact, Keynes may best be considered the greatest psychologist of economics, a mantle that Minsky assumed in warning of the dangers of financial instability. By focusing on the ways in which economic actors react to their environment, both men not only demonstrate great insight into human behavior but provide a road map for investors and regulators charged with navigating financial markets. Students of Minsky were undoubtedly the best prepared to recognize the unstable financing structures that led to the 2008 crisis, how these structures developed, and why such structures are endemic to the nature of capitalism and remain a serious threat.

The United States spent the last four decades—the 1980s, 1990s, 2000s, and now the 2010s—with an increasingly leveraged economic system whose primary occupation was to conceal declining productivity and weakening profitability from the eyes of investors and regulators while enriching a small elite.¹ By the end of the Bush II administration, the United States faced the most serious economic downturn since the Great Depression of the 1930s as its banking system lay broken and major industries such as housing and automobile manufacturing were on the verge of total collapse. The policies followed during the Obama administration and other governments around the world to set the global economy on a path of sustainable economic growth utterly failed to right the ship. It is necessary to analyze the deep structures of capital and capitalism in order to understand what happened and chart a new pathway to recovery. There is no better place to start such a study than the work of Adam Smith.

Adam Smith and the Tyranny of Crowds

When Adam Smith wrote about markets, he pictured in his mind the markets he walked in the streets of the eighteenth-century Scottish cities where he grew up (Kirkcaldy), attended school (Glasgow), and made his career (Edinburgh). These were smelly, bustling street markets filled with a huge assortment of physical goods and characters drawn out of a Charles Dickens novel. The historian Fernand Braudel gives us a vivid picture of the types of markets that Adam Smith experienced every day, filled with:

[a] varied and active proletariat: pea-shellers, who had a reputation for being inveterate gossips; frog-skinners, . . . porters, sweepers, carters, unlicensed pedlars of both sexes, fussy controllers who passed on their derisory offices from father to son; secondhand dealers, peasants and peasant women recognizable by their dress, as were respectable townswomen looking for a bargain, servant-girls who had worked out, so their employers complained, how to make something out of the shopping-money (to shoe the mule, ferrer la mule as they said); bakers selling coarse bread on the marketplace, butchers whose displays of meat encumbered the streets and squares, wholesalers . . . selling fish, butter and cheese in large quantities; tax-collectors. And everywhere of course were the piles of produce, slabs of butter, heaps of vegetables, pyramids of cheeses, fruit, wet fish, game, meat which the butcher cut up on the spot, unsold books whose pages were used to wrap up purchases. From the countryside there also came straw, hay, wood, wool, hemp, flax, and even fabrics woven on village looms.²

The overwhelming features of these markets were the smells, the sounds of people and animals, humans moving to and fro, the interaction among butchers and bakers and tradesmen buying and selling their goods. Smith had a very specific conception of what markets looked like and how the people in them behaved. Such markets still exist today, primarily in less developed countries but also in some developed countries where they remain quaint reminders of how people used to live. They are colorful emblems of the basic human relationships that remain the foundation of all economic exchanges.

Of course, the markets that drive economic activity today look very different. Physical markets of the type that Adam Smith knew are largely a sideshow or curiosity in modern Western societies. The markets that fuel modern global economies do not involve the trading of physical goods. They are largely antiseptic, electronic arenas where the only strong odors arise from the excesses of the night before. The primary commodities exchanged in modern markets are electronic bytes that represent stocks, bonds, mortgages, corporate bank loans, and currencies or, increasingly, complex derivative contracts that represent an interest in these financial instruments. To the extent there is a strong physical dimension to the proceedings, it is found in the impressive appearance that the technology that facilitates this trading assumes in the form of long rows of traders and their sleek computers and electronic computer screens. The sight is indeed impressive but has virtually no representational relationship with the underlying economic objects that are being exchanged. Unlike the street markets in eighteenth-century Glasgow or Edinburgh, the buyers and sellers rarely deal with each other face to face. Instead, they speak on the telephone or e-mail or text each other. Their communication is highly mediated; it is, to a large extent, impersonal and disembodied. This does not mean that their relationship is completely bereft of personal contact, but there is a great deal of truth to the concept that the age of gentlemanly capitalism has passed. The real question is whether the age of human capitalism has gone with it. The answer to that question is a resounding no.

Every day, on electronic trading floors around the globe, trillions of dollars of trades are effected on the basis of verbal agreements that are only later solidified into binding written contracts. A trader’s word is literally his or her bond. A simple “you’re done” is sufficient to signal that a trade is complete, whether that trade is for a million or a billion dollars of value. Despite the fact that the relationships between buyers and sellers as well as the goods they are trading are largely disembodied, a remarkably small percentage of trades end up being seriously disputed. Part of the reason for this is that technology allows for discussions between traders to be recorded. Another reason is far more elemental—nobody will deal with a trader who doesn’t keep his or her word, and word circulates very quickly about who is trustworthy and who is not in the tight-knit trading community. There are protocols that have developed over time that must be followed if traders are going to be able to make a living. All of the computer terminals in the world can’t erase the crucial human element that lies at the bottom of every single trade. This is one reason that Adam Smith has a great deal to teach us.

Adam Smith, of course, is best known as the author of what many people consider to be the bible of capitalism, An Inquiry into the Nature and Causes of the Wealth of Nations (1776). But two decades earlier, he wrote an arguably more important book, a treatise on moral philosophy entitled The Theory of Moral Sentiments (1759). In his earlier book, Smith sought to lay out the basis for moral conduct in human society and argued that people’s concern for the opinions of others ultimately leads them to act in moral and civilized ways. In Smith’s worldview, the process by which men develop a moral sense is very similar to the manner in which they develop markets. Both institutions—human societyand human markets—are the result of human beings interacting with each other in ways that make them feel good about themselves by fulfilling their own needs. Just as the desire to fulfill material needs leads to the exchange of goods and hence the development of markets, the desire to fulfill emotional needs leads men and women to be sensitive to the views of others and thereby to develop a moral sense. Neither the markets nor the morals they develop are perfect; in fact, both are constant works-in-process that are flawed, subject to emotion, and unstable. Over time, Smith believes that the process of developing and refining a moral sense leads to the formation of order in morality and markets that is superior to other forms because it fulfills human needs better than other forms. In other words, Smith argues that such a system is not only a realistic description of how men and women behave, but it is an optimal system. That does not mean, however, that these systems can simply be allowed to operate without laws or institutions. Rather, Smith was searching for the optimal institutional framework in which people’s innate qualities could be put to the best use. Taking people as they were (or, as he saw them, warts and all), Smith was trying to design a world that would make people the best they could be.³

In The Wealth of Nations, Smith famously wrote that “[i]t is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.”⁴ Yet Smith’s project was not to unconditionally praise an “invisible hand”⁵ of self-interest guiding free-market behavior, but to identify those institutions and processes that could provide human beings with the best opportunity to act in constructive, decent, and moral ways. He believed that a free market in which men and women could demonstrate their worth by exchanging goods and services was among the most important of those institutions. The freedom to earn a living through exchange would, in Smith’s view, give individuals the best opportunity to avoid the types of dependency on others that leads to immoral behavior.

Smith’s view that people base their conduct on their concern for the opinion of others is wholly relativistic. As such, it provides both wisdom and warning. The wisdom comes from Smith’s recognition that human beings are strongly driven by social approbation. We desperately want to feel that we are part of a group that accepts us. And the first step to accomplishing that is understanding how others feel about us. From the first words of The Theory of Moral Sentiments, Smith focuses on our concern for the feelings of others. “How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it, except the pleasure of seeing it.” He continues, “[t]hat we often derive sorrow from the sorrow of others, is a matter of fact too obvious to require any instances to prove it.” The way we try to understand how other people feel is to put ourselves in their place. “As we have no immediate experience of what other men feel, we can form no idea of the manner in which they are affected, but by conceiving what we ourselves should feel in the like situation.” Continuing, Smith writes, “That this is the source of our fellow-feeling for the misery of others, that it is by changing places in fancy with the sufferer, that we come either to conceive or to be affected by what he feels.”⁶

In order to judge the feelings of others, Smith tries to establish an objective standard (similar to the “prudent man” rule discussed in Chapter 8 of this book) that he terms the “impartial spectator.” It is from the standpoint of this impartial spectator that others should be judged:

We conceive ourselves as acting in the presence of a person quite candid and equitable, of one who has no particular relation either to ourselves, or to those whose interests are affected by our conduct, who is neither father, nor brother, nor friend either to them or to us, but is merely a man in general, an impartial spectator who considers our conduct with the same indifference with which we regard that of other people.⁷

In Smith’s world, all moral judgments rely on the judgment of this independent man.⁸

As the scholar Dennis Rasmussen points out, Smith understood that undue concern with the opinions of others could “lead to a corruption of people’s moral sentiments, selfishly motivated appeals to others’ self-interest, and a good deal of ostentation.”⁹ Social approbation does not always bring out the best in people. Too often, people worship the wrong idols. Smith’s statement that undue admiration for the rich is the source of the corruption of our moral sentiments, which is found at the beginning of this book, speaks an uncomfortable truth that should be posted on the entryway of every financial institution and government building in the world. Smith’s philosophical project is aimed at fashioning a just society out of the fact that people are unduly concerned with the opinions of others, and that these opinions steer them to admire the wrong moral attributes in other people. But instead of simply identifying this as a flaw, Smith attempts to use worship of the rich and powerful as a basis for fashioning a more just society.

Smith believes that a commercial society is particularly well-suited to such a project. In a commercial society, people are dependent on one another to work together to meet their needs. They generally cannot meet their needs alone (even Thoreau ventured into Concord from Walden Pond regularly to replenish his stores). For this reason, people have a strong incentive to work together and depend on each other. As Dennis Rasmussen writes, for this reason Smith believed that “commerce encourages traits like reliability, decency, honesty, cooperativeness, a commitment to keeping one’s promises, and a strict adherence to society’s norms of justice.”¹⁰ In Smith’s view, it is incumbent upon people in a market society to conduct themselves in a moral way in order to be able to participate in and benefit from commercial activity.¹¹ It is in people’s interest to engage in good behavior because that will better help them fill their needs.

Of course, Smith was striving for an ideal, and commercial life is not so simple. The warning concealed in Smith’s words comes from his failure to identify any independent moral standard as the basis for human conduct. Instead of basing morality on natural law, religion, or reason, Smith argued that moral conduct originates entirely in human beings’ feelings or sentiments. The rules of morality result from feelings, not vice versa. Smith writes:

It is thus that the general rules of morality are formed. They are ultimately founded upon experience of what, in particular instances, our moral faculties, our natural sense of merit and propriety, approve or disapprove of. We do not originally approve or condemn particular actions, because, upon examination, they appear to be agreeable or inconsistent with a certain general rule. The general rule, on the contrary, is formed by finding from experience that all actions of a certain kind, or circumstanced in a certain manner, are approved or disapproved of. . . . Those general rules…are all formed from the experience we have had of the effects which actions of all different kinds naturally produce upon us.¹²

These feelings are not only our own—they are what we imagine others would feel watching our conduct. “If we saw ourselves in the light in which others see us, or in which they would see us if they knew all, a reformation would generally be unavoidable. We could not otherwise endure the sight.”¹³ By making the opinions of others the standard by which we judge ourselves rather than some independent or objective moral standard, we risk surrendering ourselves to the madness of crowds. After all, history has demonstrated repeatedly that groups are particularly susceptible to flawed thinking.

There is a dark side to this concurrence-seeking ethos that has played itself out throughout history. It lies at the heart of the type of herd thinking that causes phenomena such as investment bubbles and, in its most pernicious form, genocide. In his classic study, Groupthink, Irving Janis identified strong consensus-seeking behavior as one of the main causes of defective decision-making in classic policy disasters such as the Kennedy and Johnson administrations’ actions with respect to the Vietnam War and the Bay of Pigs.¹⁴ The desire of members of a group to be accepted by others, which lies at the heart of Adam Smith’s theory of moral sentiments, tends to silence dissenting voices, limit the airing of unpopular views, and lead to poor decision-making.

Permitting the opinions of others to govern important human activities is a highly problematic enterprise. It is another version of conceding all wisdom to the free market. But crowds, and markets, often get things terribly wrong; in point of fact, they often act irrationally. Smith observed that human behavior and institutions evolve through the interaction of human beings attempting to satisfy their emotional or economic needs. However true this may be as a matter of fact, it need not be dispositive as a matter of prescription. Some human impulses are contrary to the health of the larger community, even deviant and dangerous. Greed and fear, two human drives that govern a great deal of market behavior, are directly contrary to the operation of healthy markets and a productive economy if they are not properly reined in. Adam Smith described how men and markets develop and believed that markets could be designed with the proper governing institutions to contain man’s worst instincts. One of the purposes of The Committee to Destroy the World is to evaluate the failure to develop the right kinds of institutional structures to manage the tyranny of crowds.

Smith wrote a long time ago, but the world has not passed him by. In many ways, the world is still trying to catch up to him. We are still trying to design the proper institutions and markets that will allow man’s best attributes to flourish while governing the demons of his nature. Recent events demonstrate that the dark side of human nature—greed, fear, arrogance, stupidity—remains a formidable foe that places humankind’s welfare at risk at regular intervals. The social approbation that Smith identified as the primary basis of man’s moral sentiments still drives many peoples’ behavior, especially their economic behavior. Sadly, free markets are all too imperfect governors of human behavior. The unfortunate truth is that financial crises, which are occurring with increasing, not decreasing, frequency are the result of deeply embedded traits of human nature and recurring failures to regulate our worst instincts. Two-and-a-half centuries after Adam Smith, mankind still needs to be protected from itself.

One of the frustrating lessons of markets is that investors continually ignore Groucho Marx’s sage advice not to join any club that would accept them as members. Financial markets should often be avoided entirely, but investors cannot help themselves when they see everyone around them clamoring to participate. Today’s markets are obviously far different from the more intimate ones that Smith walked in eighteenth-century Kirkcaldy, Glasgow, and Edinburgh. The products and economic actors he described—butchers and bakers, pin and woolen coat makers—vividly captured his frame of reference. Smith had personal, first-hand interactions with the men and women hawking their wares in these teeming and chaotic markets that somehow organized themselves into institutions that made food, clothing, and other goods available to Scottish society.

Today, the trading of goods has been replaced by the trading of bytes, and the personal relationships that defined mercantile relationships in the eighteenth century are abraded by technology and radical changes in the forms that capital assumes. But at the heart of these markets still lie the personal and social relationships between human beings that Adam Smith identified as the central feature of all human institutions. It is incumbent upon us today to take his wisdom and apply it to the new outward forms that markets assume with the understanding that the essential inward forms that drive markets are still governed by human relationships.

Karl Marx and the Origins of Opacity

It is unfortunate that many conservative thinkers dismiss the work of Karl Marx due to the damage it has caused in the hands of tyrants because it has a great deal to teach us about the system he criticized. There is a deep and bitter irony in the fact that this deep reader of man’s economic nature—and arguably the most astute interpreter of capitalism despite the tragic misreadings his work has engendered—sits at the opposite end of the ideological spectrum from Adam Smith. But a careful reading of Adam Smith and Karl Marx shows that these two thinkers share much more than is commonly believed. As we pick up the pieces of a world economy that was almost destroyed by the credit crisis of 2008, Marx’s stinging comment about history repeating itself first as tragedy and then as farce mocks capitalism’s compulsion to repeat the mistakes of the past. Marx’s economic theories are highly complex and go far beyond the concept of class struggle for which he is best known. Indeed, it would be difficult to discuss the death of capital without addressing one of capital’s most important critics. Despite the proclivity on the part of conservative economic and political commentators to dismiss Marx as a crackpot, his writings offer profound insights into capitalism and capitalist processes. In fact, his work attracted more mainstream attention in the wake of the financial crisis.²⁰

For the purposes of understanding how Western capitalism came to consume itself at the dawn of the twenty-first century, there are few better places to retreat than the writings of Marx. Three of Marx’s insights are particularly worthy of note.

1. Marx’s conception of capital as a process and not a static object, which renders capitalism a system filled with contradictions that render it highly dynamic and unstable.
2. Marx’s conceptualization of money and monetary forms as fetishes—indirect expressions of underlying social and economic relations whose meaning is obscured and distorted by their mediation through the form of money in its increasingly complex and derivative forms.
3. Marx’s insight that value is a highly changeable and unstable concept.

All three of these concepts bear on the increasingly complex forms that money assumed in the late twentieth and early twenty-first century. The more complex and opaque that forms of money became, the more unstable concepts of value (both economic and moral) also became. And with unstable value came not only unstable markets but a highly unstable economy.

John Maynard Keynes

Reading The General Theory of Employment, Interest and Money (1936) should be sufficient to disabuse people of the dominant thought paradigms that have guided investors into serial investment disasters in recent years. The concepts of efficient markets or rational investors are rendered mincemeat in the hands of John Maynard Keynes, who writes with a flair that few before or after have been able to match. The irony is that his great wisdom about so many aspects of market behavior has also led to such grotesquely wrong conclusions about how to solve market crises and revive troubled economies. The Keynesian prescription for recovery involves doing more of what was done in the first place to create the crisis: governments spending, printing, and borrowing more money. This may solve the immediate crisis, but it creates long-term imbalances that must be resolved at some point in the future, either through currency devaluation, inflation, or other destabilizing economic and social processes. The problem is that nobody has come up with a viable short-term alternative to the Keynesian solution that does not involve swallowing some very distasteful short-term medicine: bank and business failures, high rates of unemployment, social upheaval, and similar distresses. In the midst of a crisis, Keynes’ prescription makes sense as a means of preventing immediate economic calamity. But it leaves a much bigger mess to clean up in the long run.

Accordingly, Keynesianism is best limited to a prescription for crisis management. As Hyman Minsky stresses in his seminal study of the master, “[i]n 1936, when The General Theory appeared, the world was in the seventh year of the Great Depression.”³⁹ The so-called “classical school of economics” had failed to predict the coming of the depression, and Keynes’ work was an attempt to come up with both an explanation of the causes and proposed solutions. Keynes developed his economic insights within the context of a global collapse of unparalleled depth and duration. The real goal of economic policy should be to minimize the types of imbalances that lead to crisis in the first place, which requires a sophisticated understanding of the processes of capital and the behavior of capitalists.

A careful reading of The General Theory reveals that a book considered to be one of the great economic texts of all time is as much an economics treatise as a psychological primer on how investors behave and what this means for the market as a whole. While the book is filled with its fair share of economic jargon and mathematical formulas, it is primarily memorable for its passages describing human behavior. Perhaps this is what accounts for the fact that its lasting value lies more in its psychological insights into the markets and investor behavior than in its prescriptions for economic policy management. In fact, as noted earlier, its policy prescriptions tend to promulgate economic imbalances. The proper way to employ them proscriptively to reduce the boom and bust cycles of capitalism would be to apply them in a countercyclical manner outside of the crisis context for which they are primarily designed.

Keynes argues that emotion, not reason, is what dominates investment markets. The distinction he draws between speculation and productive investment is based on this view. Keynes defines “speculation” as “the activity of forecasting the psychology of the market” and “enterprise” as “the activity of forecasting the prospective yield of assets over their whole life.”⁴⁰ Unfortunately, the more developed markets become, the more speculative they become because of the fact that market participants are primarily emotional animals. “As the organisation of investment markets improves,” he writes, “the risk of the predominance of speculation . . . increase[s].”⁴¹ Capitalism is highly unstable because it is inherently prone to the imbalances resulting from the fact that capitalists are driven by emotion rather than reason. “The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is ‘to beat the gun,’ as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.”⁴² In other words, the primary objective of investors is not to determine the fundamental value of an investment; rather, it is to determine what other investors think the value is.

In a famous passage, Keynes compares investing to a newspaper competition in which people have to choose the six prettiest faces out of a hundred photographs:

[P]rofessional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth, and higher degrees.⁴³

All financial instruments, not merely stocks and bonds, are subject to this type of beauty contest in which the goal is to pick the most average-looking girl. Keynes writes with respect to interest rates: “the rate of interest is a highly psychological phenomenon . . . The long-term market-rate of interest will depend, not only on the current policy of the monetary authority but also on market expectations concerning its future policy.”⁴⁴ The problem arises when all the faces look pretty or ugly at the same time. At such times, all anchors of value are lost and men are left to the vagaries of the crowd to guide their behavior. The outcome is rarely favorable for individual investors or for the market as a whole.

Keynes’ famous description of the “animal spirits” that drive financial markets captures his emphasis on the emotional component that he views as central to the investment process. This famous passage is worth quoting in its entirety:

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die—though fears of loss may have a basis no more reasonable than hopes of profit had before.⁴⁵

Finally, he writes that “human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and…it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.”⁴⁶ As insightful as these words are, we should also remember that they were written by the man on whom modern policymakers are relying to revive the global economy. Policymakers need to understand the entirety of Keynes’ message, not just the parts that they want to hear in a quest for politically expedient solutions to intractable economic problems.

Perhaps Keynes’ most significant insight into human behavior involves what he termed the “paradox of thrift,” the phenomenon that is a version of the “fallacy of composition” discussed earlier. Keynes did not originate this phenomenon; it appears to date back to the 1714 allegorical poem “The Fable of the Bees,” which Keynes quotes from rather extensively in Chapter 23 of The General Theory (who says there is no place for literature in economics—even mediocre literature?). This phenomenon turns on its head all concepts of rational behavior. It also renders most market theories useless in practice. The paradox of thrift holds that if too many people seek to save rather than spend money at one time, the economy will be starved of investment and consumption and economic growth will suffer. The paradox comes from the fact that saving rather than spending is believed to be a constructive activity, yet it leads to economic harm when engaged in by too many people at the same time. This is also true with respect to investment activity. When market conditions lead too many investors to sell at the same time, markets tends to fall rapidly and in some cases collapse. Individual selling decisions may well be rational and designed to protect capital, but when too many investors make such decisions at the same time it leads to massive market losses. Few if any of the classic investment theories such as Harry Markowitz’s modern portfolio theory or William Sharpe’s capital asset pricing model or the Black-Scholes model effectively capture this reality (or other discontinuities, which are admittedly difficult to capture in mathematical language). Moreover, mass selling has the psychological effect of causing panic and leading to further selling, another phenomenon for which the classic investment theories fail to account.

Throughout The General Theory, Keynes stresses the importance of human expectations in economics. In fact, he writes that “the part played by expectations in economic analysis” was one of three “perplexities” that most impeded the writing of his great book.⁴⁷ For Keynes, expectations about the future are everything. “During a boom,” he writes, “the popular estimation of the magnitude of both these risks, both borrower’s risk and lender’s risk, is apt to become unusually and imprudently low.”⁴⁸ Human beings tend to believe that the current state of affairs will continue, although their belief is not based on anything to which they can point. “In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual even though there are no express grounds to anticipate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.”⁴⁹ This leads to the uncomfortable reality that whatever the models purport to tell us, markets tend to seize up when large numbers of investors decide to sell at the same time because “there is no such thing as liquidity of investment for the community as a whole.”⁵⁰

One dramatic example of this phenomenon occurred in 1998 when the hedge fund Long Term Capital Management collapsed. Investors suddenly discovered correlations among different asset classes for which their models had failed to account. This was largely due to the fact that these correlations arose from factors such as overlapping ownership of assets by a concentrated group of institutions and hedge funds, the use of exorbitant amounts of leverage by these holders to own these assets, and other factors that even Nobel Prize winning economists failed to grasp (probably because they were Nobel Prize winners!). These factors led investors to simultaneously sell positions that in theory should not have been correlated but in practice became instantly and highly correlated. One of Keynes’ great strengths is that he didn’t allow mathematical formulas to distract him from the human realities of investing. Hence, the famous adage that is attributed to him, “The market can stay irrational longer than you can stay solvent.” In a world heading ever deeper into insolvency, such words should ring in our ears.

Hyman Minsky

The 2008 financial crisis did a great deal to revive the reputation of Hyman Minsky. The revival was long overdue. Minsky remains a grossly underappreciated thinker, but he understood and acknowledged the importance of those who preceded him. Minsky rightly considered Keynes’ The General Theory to be one of the most important works of modern thought: “[i]f Keynes, along with Marx, Darwin, Freud, and Einstein, belongs in the pantheon of seminal thinkers who triggered modern intellectual revolutions, it is because of the contribution to economics, both as a science and as a relevant guide to public policy, that is contained in his General Theory of Employment, Interest and Money.”⁵¹ Minsky’s work is based on his interpretation of Keynes, and it is difficult to read one today without reading the other.

Minsky is known for his “financial-instability hypothesis,” which argues that stable economies sow the seeds of their own demise. Minsky traces this idea back to Keynes’ thinking in The General Theory. Minsky explains that “implicit in [Keynes’] analysis is a view that a capitalist economy is fundamentally flawed.” He continues:

This flaw exists because the financial system necessary for capitalist vitality and vigor—which translates entrepreneurial animal spirits into effective demand for investment—contains the potential for runaway expansion, powered by an investment boom. This runaway expansion is brought to a halt because accumulated financial changes render the financial system fragile, so that not unusual changes can trigger serious financial difficulties. Because Keynes arrived at his views on how a capitalist economy operates by examining problems of decision-making under conditions of intractable uncertainty, in his system, stability, even if it is the result of policy, is destabilizing. Even if policy succeeds in eliminating the waste of great depressions, the fundamental financial attributes of capitalism mean that periodic difficulties in constraining and then sustaining demand will ensue.⁵²

Minsky traced his “financial-instability hypothesis” to Keynes, but there is an even deeper connection that links these two men’s thinking. Keynes’ focus on the importance of human expectations in the face of uncertainty strongly influenced Minsky’s view of how economic actors react to conditions of financial stability.

Implicit in Minsky’s “financial-instability hypothesis” is the assumption that economic actors conduct themselves based on how they feel about their economic environment. When they experience a stable environment, they are emboldened to take risk; when they experience instability and hardship, they tend to act more conservatively. These are primarily psychological reactions to their experiences, an exercise of their “animal spirits” as Keynes described them. These two great economists understood that economic behavior was human behavior, and, as such, was influenced by the forces that govern human beings—feelings and emotion. This relates their work back to Adam Smith, who believed that human beings acted in a certain manner in order to gain the approval of other people. Acting in a manner that gained other peoples’ approval, Smith believed, would reinforce certain types of behavior that were conducive to the development of a fair and just society. The essentially social and psychological nature of all economic behavior then calls us back to Marx’s criticism of capitalism. Marx believed that capitalism would fail because it insufficiently acknowledged the social and human components of labor and instead reduced human relations through the process of fetishism to relationships between things in the form of money. These four thinkers believed that human relationships and emotions lie at the heart of all capitalist processes. As we have learned often enough over the past two decades, any system that fails to adequately account for the human element that lies at the heart of all economic activity is prone to instability and potential failure.

Hyman Minsky was largely unknown outside the world of economic professionals until the financial crisis, although some observers such as PIMCO’s Paul McCulley, The Credit Bubble Bulletin’s Doug Noland, GMO LLC’s Jeremy Grantham, and I were writing about him for several years before his work came all too vividly to life in the summer of 2007.⁵³ Today everybody is a Minsky disciple—or should be. Those who were familiar with Minsky’s work before the crisis were in the best position to predict the credit cataclysm that occurred. Minsky should now take his place next to John Maynard Keynes as one of the twentieth century’s most important economic thinkers. Like those in the pantheon he joins, his contributions were inspired by his keen insights into noneconomic areas of thought such as human psychology.

The “financial-instability hypothesis” can be summarized as follows: The better things get, the better they are expected to continue to be. Human beings tend to extrapolate current conditions indefinitely into the future. Based on the assumption that positive economic conditions will continue, people let their guards down with respect to risk, which leads them to take more of it. As each individual takes more risk, the overall riskiness of the system increases. This is not an insight into economics; it is an insight into human behavior. Minsky did not require a degree in mathematics or physics to come up with his “financial-instability hypothesis”—what he possessed was keen insight into human nature and human psychology.

Minsky expounded on his theory at greatest length in his seminal work, Stabilizing an Unstable Economy (1986). Minsky divided the process of risk absorption into three phases. In the first phase, which he called “hedge finance,” economic actors expect cash flows from their business operations to be sufficient to meet their obligations now and in the future. In the second phase, termed “speculative finance,” economic actors do not expect cash flows from operations to be sufficient to meet all of their cash payment obligations, particularly their short-term obligations. In this phase, actors must roll over existing debt in order to remain solvent. The third phase, which was given the colorful and somewhat controversial name of “Ponzi finance,” involves a situation in which economic actors know that they will not be able to meet their cash obligations through operations and will have to borrow to meet them. In this phase, additional debt must be raised in order to retain solvency.⁵⁴ Ponzi finance is the dominant characteristic of the global economy today. It is a decidedly unhealthy state of affairs.

The stability of an economy is determined by the mix of these three types of financing structures within it. Hedge finance structures are subject to the risk that business operations will not generate sufficient cash flows to meet future obligations. Speculative and Ponzi finance structures are not only subject to that risk but are vulnerable to a much more significant risk that is outside the control of individual businessmen—the risk that financial markets will become inhospitable and render it difficult to roll over existing debt or raise additional debt to meet future obligations. As Minsky writes, “[s]peculative and Ponzi units must issue debt in order to meet payments and commitments. This means that they must always meet the market. Furthermore, they are vulnerable to any disruption, in the form of transitory unfavorable financing terms, that may occur in financial markets.”⁵⁵ For this reason, speculative and Ponzi finance structures are far riskier than hedge finance structures, and an economy whose composition is weighted more toward Ponzi financing rather than hedge financing is prone to instability.

Large Western economies became Ponzi economies by the mid-1990s. By the mid-2000s, conditions were so Ponzi-like that it was only a question of “when,” not “if” the system would succumb to internal instability. From homebuyers who borrowed more than their homes were worth based on the belief that home prices would continue rising, to private equity firms that purchased companies at exorbitant prices using debt structures that enabled them to pay interest in additional debt rather than cash, the entire financial system was engaged in one massive Ponzi scheme in the sense that Hyman Minsky used the term. This does not mean that such financing schemes were fraudulent or illegal (although in the case of the mortgage market many reportedly were). It does mean, however, that in most cases they were imprudently or even recklessly constructed.

Minsky’s use of the term Ponzi should not be glossed over. Minsky responded to harsh criticism of his use of the term in a long footnote to his seminal article titled, “The financial-instability hypothesis” (1982): “[t]he type of financial relations that I label Ponzi finance is a quite general and not necessarily fraudulent characteristic of a capitalist financial structure. Financial relations the validation of which depends on the selling out of positions are a normal functioning part of the capitalist process. Furthermore, every ‘bubble’ or stock-market speculation in which profitability depends on the timing of entry and exit is of the nature of a ‘Ponzi scheme.’”⁵⁶ Recent commentators who have brought Minsky’s work back to the prominence that it deserves have devoted little attention to Minsky’s terminology, but it deserves further emphasis than it has received.

Minsky’s use of the term “Ponzi” in describing the type of financial structure that grew predominant in the late twentieth and early twenty-first century should not be considered disingenuous. Ponzi is not a morally neutral word. It refers to Charles Ponzi, an infamous swindler who, for a short period in 1920, employed the technique of using money raised from later investors to repay earlier investors. He was not the first and certainly not the last crook to employ such a scheme, but his name stuck to it (although Bernie Madoff has offered himself as an alternative, with the new term “being Madoff’d” starting to sneak into modern vernacular). Minsky was making a point in using such a value-laden term, and despite his seemingly innocent disclaimer about his intent, there can be no question of his disapproval:

However, the label attached to the financing relations I identify as Ponzi is not important. What is important is whether or not such structures exist and what effect such financing has on system behavior. In particular, if Ponzi financing exists, if the extent of Ponzi financing determines the domain of instability of the economy, and if Ponzi financing is a normal adjunct of investment production, then there are normally functioning endogenous factors that make for significant instabilities.⁵⁷

Minsky’s insight about Ponzi structures is of crucial importance in understanding modern capitalism. Ponzi finance is highly unstable; it is vulnerable not only to changes in conditions of borrowers, but to deterioration in market conditions. Ponzi finance is closely associated with financial instability. Describing such a state of affairs with a term associated with a swindler should not be understood as value neutral; it is a way of suggesting that such financing structures are irresponsible and immoral, even if they are not illegal. The fact that they lead to financial instability that causes social unrest, higher unemployment, a widening of the gap between rich and poor, and other adverse consequences suggests that such financing structures should be viewed as reckless and socially damaging. In his own deadpan way, this is what Minsky was trying to tell us.

Government policies that permit Ponzi finance to flourish end up imposing an enormous burden on society. This is why an increasing number of economists take issue with former Federal Reserve Chairman Alan Greenspan’s view that a central bank should not take action with respect to a sharp increase in asset prices. In fact, Minsky teaches that it is not rising asset prices per se that should trigger countercyclical policy by central banks so much as the reasons behind the rise. If Ponzi finance structures are responsible for pushing prices higher, central banks should begin tightening policy and taking other steps to counter the process. Failing to take any action in the face of sharply rising asset prices that were being fed by an orgy of leverage in the form of Ponzi finance turned out to be a catastrophic error on Greenspan’s part during his term, a mistake that was repeated by his successor Ben Bernanke during the first two years of his term and, after being interrupted by the financial crisis, were again perpetuated by the Janet Yellen-led Federal Reserve and other major central banks in the post-crisis years. Minsky’s “financial-instability hypothesis” also renders highly dubious concepts such as “the great moderation” that Bernanke endorsed in advocating that the economy had reached a new era of stability in the mid-2000s. Bernanke promulgated this view in a widely noted speech in 2004 and again in a 2006 speech and clung to it until 2007. A careful reading of Minsky, however, would have led Bernanke to reach just the opposite conclusion—that benign economic conditions would lead, not to further stability, but to instability. This turned out to be a profound intellectual error as it led the Federal Reserve to follow a lax monetary policy for far too long.

It is one thing when manufacturing firms collapse under the weight of their debts and other obligations; their balance sheets can be restructured and their assets sold or liquidated in the process Joseph Schumpeter described as “creative destruction.” The presumption is that more productive businesses will take their place in the economy. But when financial firms run into trouble because they cannot pay their debts, a larger societal interest is harmed because of the public utility function that financial institutions play in the economy. This is particularly true in regulated industries where the government has provided an explicit or implicit guarantee. The collapse of a financial firm leads to deflationary debt destruction as capital is wiped out. This leads to a loss of confidence among economic actors that leads to the death of capital. When that occurs, governments must act through their central banks and fulfill their functions as lenders of last resort. In 2008, conditions became so desperate that the world saw its central banks and governments perform this function in previously unimagined ways.

Lessons on Capital from the Masters

Smith, Marx, Keynes, and Minsky are deserving of a much more thorough examination than they have received here. The point of this discussion of their work is to draw out some common insights that these intellectual giants offer with respect to capital and capitalist processes. First, all of them consider capital and capitalism to be highly unstable phenomena that are subject to the emotions of economic actors in the marketplace. This renders markets themselves highly unstable and subject to cycles of boom and bust. Second, the unavoidable conclusion that reading these men’s work leads to is that understanding capital, capitalism, and markets requires a deep understanding of human nature, in particular the irrational and emotional side of human nature. Mathematical understanding is of limited utility when it comes to navigating financial markets because the forces that drive these markets are not mathematical or rational in nature. Third, these four thinkers believe that capitalist processes bear within themselves the seeds of their own instability and potential destruction. The innate nature of capital and capitalism involves contradictions and conflicts that lead to instability. Further, mathematical and rational thinking often leads to instability and irrational outcomes. From a practical standpoint, this means that every bull market sows the seeds of its own demise, a lesson investors forget at their own peril.

Reading these seminal thinkers then raises the question about what one should think about the fact that so much of modern finance theory and market dogma is guided by belief in concepts such as efficient markets, quantitative finance, and other rational constructs that are repeatedly contradicted by the real world experience of investors. Why do investors ignore not only the best that has been thought about markets but their own experiences, and as a result repeatedly subject themselves to catastrophic losses? The answer lies in the fact that investors, who also happen to be human beings, cannot escape their essential nature. Emotion is such a powerful phenomenon precisely because it trumps reason. Men are made to believe that the future will resemble the past, and in some respects it does. But they tend to be extremely selective about which parts of the past they choose to remember.

As with so many complex systems, markets discovered in 2007 and 2008 that the tools designed to reduce risk introduced new risks that hadn’t been contemplated before. Even worse, these risks were hidden by the complex and opaque nature of the new financial instruments that were sold as risk management tools. These products contained within them the seeds of their own demise because they were not in fact new creations but just another form of capital and subject to the same laws that always govern capital. If we are to contain the madness of crowds, we need to help them understand what is driving them insane. In uncovering the answer to this question, we learn that the fault lies not in the stars but in ourselves. For while every individual rationally pursues economic goals that he believes will enrich him or her, the aggregation of those individual desires tends to lead to instability. It is no accident, therefore, that each of the four thinkers discussed in this chapter emphasizes the important role played in the markets by the “fallacy of composition.” Cycles of boom and bust will remain with us as long as we remain human. Try as we might to remove the human element from economics, the dismal science remains in its essence trapped by who we are.