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Mon Jul 26th, 2010 at 12:21:10 AM EST
Systemic Fear, Modern Finance and the Future of Capitalism by Shimshon Bichler and Jonathan Nitzan
Jerusalem and Montreal, July 2010
Existing theories of political economy, liberal as well as Marxist, see capital as a dual entity. According to these theories, the "real" essence of capital consists of material/productive commodities, while the "financial" appearance of capital either accurately mirrors or fictitiously distorts this underlying reality. We reject this duality. Capital, we argue, is finance, and only finance. In its modern incarnation, capital exists as forward-looking capitalization, a universal financial ritual that discounts expected future earnings to a singular present value. emphasis added.
The part in bold is the essence of modern finance. And the times when that forward looking principle is violated is fundamental to understanding the present situation.
The universality of this reduction makes capitalization the most supple power instrument ever known to humanity. Previously, distributive power was associated with clear socio-ecological distinctions - differences between king and subject, owner and slave, tiller and landlord, field and citadel, village and town. Capitalization flattens these qualitative features to the point of irrelevance. In principle, anyone can be a capitalist, and what distinguishes one capitalist from another is the quantity of their capitalization: the most powerful are those with the greatest capitalization (dominant capital), and those that hold that power achieve and augment it by increasing their capitalization faster than others (differential accumulation). In this way, capitalization crystallizes the power of capitalists to shape their world, as well as the resistance of those that oppose this power. It gauges the capitalists' success in directing production and consumption, in shaping ideology and culture, in affecting the law, public policy, conflict, war and even the environment. It is the all-encompassing algorithm that creorders - or creates the order - of the capitalist mode of power.
The purpose of our paper is to examine the breakdown of this algorithm. To be sure, this type of inquiry is hardly novel. Marxists have longed searched for objective signs of capitalist collapse, preliminary omens that would foretell the system's imminent disintegration. However, because of their dual conception of capital, they've tended to look for such signs in the so-called real sphere of production and consumption, while paying far less attention to finance, which, in their view, is merely a distorted mirror of that reality. But finance isn't a mirror of real capital; it is real capital - and indeed the only real capital. So if we want to look for signs of systemic crisis and possible disintegration, our search should begin here, in the very ritual of capitalization.
The specific focus of the article is two historical ruptures of modern finance - the periods of 1929-1939 and 2000-2010. During both periods, capitalists abandoned the conventional forward-looking ritual of capitalization, resorting instead to the backward-looking posture of pre-modern finance. In our view, these rare episodes are of great importance for understanding the nature of capitalist confidence and the capitalists' ability to rule - as well as the possibility that this system of rule will collapse. Our inquiry seeks, first, to characterize key features of these episodes; second, to speculate on their causes; and third, to assess, however speculatively, what they might imply for the future of capitalism.
Next the authors set forth some Propositions that are the underlying framework of their analysis:
We set the stage with a number of related propositions. These propositions aim to establish a "nested relationship" between a series of entities - beginning from the broad concept of a mode of power, and continuing with confidence in obedience, dominant ideology, the ritual of capitalization and the forward-looking disposition of modern finance. Most of time, the components of this nested relationship are mutually reinforcing. But on rare occasions the relationship implodes. The trigger for such implosion is systemic fear: fearing for the collapse of their system, capitalists lose sight of the future; with the future having become opaque, the ritual of capitalization falls into disarray; with capitalization having been punctured, dominant ideology is deeply shaken; with dominant ideology having cracked, the capitalists' confidence in obedience tumbles; and with no confidence in obedience, the very continuation of the capitalist mode of power is put into question. Let's examine the relationship between these concepts more closely, beginning with power.
This latter conviction is necessary for the existence of modern capitalism, at least in its present form, and the easiest way to demonstrate that necessity is to assume it away. Suppose for argument's sake that capitalists, instead of expecting capitalization to continue indefinitely, believed that the process would cease to exist at some future point. At that point, with capitalization gone, their assets would have a nil value, by definition; and with future prices being zero, current prices would have nowhere to trend but down. Now, the fact that capitalists invest shows that they expect the very opposite - i.e., that the value of their assets will grow, not contract - and that expectation means that, consciously or not, they also think that the ritual that valuates their assets will never end.
- Modes of power and confidence in obedience. Hierarchical societies, we argue, are characterized by their modes of power. Every mode of power - whether slave-based, feudal or capitalist - rests on confidence in obedience: the confidence of rulers in the obedience of their subjects. This confidence is never perfect: the ruled often resist, rise up and revolt; occasionally they demand and periodically achieve moderate change; sometimes they even manage to effect significant reform; and in very rare instances they take over power, though only for a brief historical moment. But as long as the bottom-up disobedience of the underlying population does not significantly undermine the top-down confidence of those who rule them - a breach that seldom happens on a large enough scale - the mode of power itself remains intact.
- Confidence in obedience and dominant ideology. The framework that shapes and fixates this confidence in obedience is the dominant dogma, or ideology: the broad belief system that propels and restricts the social imagination. The dogma or ideology that dominates a given mode of power conditions action and inaction, justifies the prevailing social structure and provides its organizing principles. It molds rulers and ruled alike - and in so doing locks them both into the same mode of power.
- Dominant ideology and capitalization. The dominant ideology of modern capitalism revolves around the ritual of capitalization: the financial algorithm that discounts expected future earnings to their present value. This ritual is all pervasive. The capitalist system is denominated in prices, and for the past century or so, the habitual price-setting mechanism has been capitalization. Discounting seems to pervade every thing and every process: it determines the prices of human life and its genomic code; it sets the prices of consumer goods and services, it generates the prices of corporate assets and government debt; it calculates the prices of military operations and humanitarian aid; it is even used to compute the price of our ecological future. The imperatives of capitalization are accepted, internalized and obeyed, usually without question, by the rulers as well as the ruled - and that acceptance makes capitalization central to the dominant ideology of our society.
- Capitalization and the forward-looking outlook. The ritual of capitalization is feverishly forward looking: it is concerned not with the past or the present, but with the future. The elementary particles of capitalization - earnings, investors' hype, risk perceptions and the normal rate of return - represent not what is known to have happened, but what is expected to happen. The expectations themselves are inherently uncertain and always in flux. But underneath their shifts and turns, one thing remains constant: the conviction that the capitalization process itself will continue to rule and organize humanity, forever.
These propositions lead to two related conclusions. First, they suggest that the very existence of capitalization attests to the capitalist confidence in obedience. The fact that this ritual is so pervasive implies that most people believe it will remain so; and the only way for this ritual to remain pervasive is if capitalists are convinced that they can continue to impose it on a society that is unwilling or unable to oppose it. The second conclusion is that a protracted breach of capitalization - a period during which the ritual breaks down - signifies the loss of confidence in obedience, the potential disintegration of the dominant ideology and, ultimately, a threat to the very existence of the capitalist mode of power. If correct, these conclusions can offer a quantitative insight into the long-term outlook of the ruling capitalist class - and, by extension, into the prospect of systemic change to the capitalist mode of power.
Some may recall an earlier discussion of Systemic Fear and Forward-Looking Finance on ET. In essence, the authors note that, per the tenants of modern finance as set forth by Irving Fisher in and later by Graham and Dodd, investors should not be making investment decisions on the basis of current or recent past market behavior. Investments should be, and usually are, forward looking. After all, the investment decision is based on the present value of a future stream of income, not the present situation. So, why the problem this time?
The authors note that share price and earnings per share have usually fluctuated widely and attribute this to the forward looking nature of the investors. In this paper this is shown in Figure 2, below:
However there are two periods in which share price and earnings per share tracked quite closely: the 1930s and the first decade of the 21st century. In their 2009 article they asserted that during such times as the 1930s and the previous decade capitalists lose confidence in the forward looking nature of investments because they lose confidence in the nature and future of that system and are gripped by systemic fear. In the period before 1917 earnings usually led prices by a significant degree because the idea of forward pricing had not yet obtained widespread acceptance and investors closely followed "par" values.
But, excepting the 1930s and the first decade of the 21st century share prices have fluctuated with respect to earnings per share and overall have been negatively correlated. During those two anomalous periods the authors note that share price and earnings per share were significantly and positively correlated. The authors assert that, during those two times capitalists lost confidence in the forward looking nature of investments and, in fact, became backwards looking. This was due to systemic fear.
Systemic fear is a class of its own. It has little to do with the periodic downswings that make capitalists cautious, and it has no connection to the dread and apprehension that regularly puncture their habitual greed. "Business as usual" is always uncertain, and with capitalism constantly in flux, investors are forever fearful about profit and wary about risk: they are concerned that earnings may not rise as quickly as they hope, or that they might fall; that volatility will increase; that interest rates will rise; and so on.
But these fears, no matter how intense, are self-contained. They pertain to the level and pattern of profit, not to its existence. They do not impinge on the normality of profit - i.e., on the belief that assets have a "natural" tendency to grow and that capitalists have the power and right to enforce and appropriate such expansion. And most crucially, they reflect the belief that expected profits, whether high or low, could always be priced to their present value. Regardless of the market's ups and downs, the underlying assumption is that the capitalization process itself - the ritual that creorders modern capitalism and anchors its dominant ideology - will remain intact.
Occasionally, though, there arises a very different and far deeper type of fear: the terrifying thought that profit might cease to exist. This latter fear is associated with systemic crisis--that is, with periods during which the very future of capitalism is put into question. It is what Hegel meant when he spoke of the bondsman's "fear of death":
For this consciousness [of the capitalist bound to the steering wheel of a megamachine gone wild] was not in peril and fear for this element or that [such as falling profit or rising volatility], nor for this or that moment of time [like a sharp market correction or a declaration of war], it was afraid for its entire being; it felt the fear of death, the sovereign master [the ultimate wrath of the ruled]. It has been in that experience melted to its inmost soul, has trembled throughout its every fibre, and all that was fixed and steadfast has quaked within it [will capitalism survive?] [Georg Wilhelm Friedrich Hegel, The Phenomenology of Mind,]
The first time capitalists were gripped by such systemic terror was during the Great Depression of the 1930s. The second time is during the present crisis, a protracted turbulence that started in the early 2000s and is still ongoing.
The authors note that the first crisis ended abruptly in 1939 with the ramp up of war production:
This situation lasted for sixty years. During that period, capitalism went through many ups and downs, and there was the occasional scare that sent markets reeling. But none of the jolts was serious enough to evoke the Hegelian fear of death. At no point was the existence of the system itself in doubt. It was business as usual, with greed and fear easily incorporated into future earnings projections and risk calculations. The financial model seemed to work like clockwork.
But in 2000, the machine stopped. The threat of a new systemic crisis suddenly loomed large, and the specter of backward-looking pricing, having been dormant for decades, returned to haunt the markets.
Figure 4 displays price and earnings per share data from 1970 to the present, with the shaded area denoting a period of systemic crisis. The two top series, denoting levels, are rebased with December 2007=100 and graphed against the left arithmetic scale. The bottom series express the annual rates of change (smoothed as 3-year moving averages) and are plotted against the right arithmetic scale.
As the data in Figure 2 and Figure 4 show, from 1939 to the early 2000s, both price and earnings per share trended upwards. But in line with the "New-Era Theory" - which by now had become mainstream finance - the short-term correlation between them remained loose and indeed negative (see Table 2). During that long stretch, earnings went through several sharp declines. For instance, during the end-of-communism crisis of 1989-1991 they dropped 37%, and following the emerging markets scare of 1997-1998 they fell 6% - yet in both cases stock prices continued to soar. And conversely, in 1972-1974 earnings increased by 42% while prices dropped by 43%; similarly, at the end of 1987 earnings increased by 14% while prices dropped by 27%. All in all, then, investors seemed perfectly happy to obey the theory. Throughout the period, they ignored the ephemeral present in favor of the eternal future.
But in 2000, they suddenly lost their forward-looking vision, and they haven't regained it since. Over the past decade, earnings have experienced two very violent swings; yet stock prices, instead of remaining impartial to the immediate gyrations of the earnings cycle, have traced it, and rather tightly: the correlation coefficient between the rates of growth series, smoothed as 3-years moving averages, jumped to +0.64, up from to -0.15 in the preceding six decades.
The authors note the concern that surrounded the dot.com crash and the collapse of the "new economy" followed swiftly by 9-11. While that crash bottomed in early 2003 and a nice "V" shaped recovery ensued until 2008, more players were now aware of the limits of that recovery.
These limits become visible when we take a bird's eye view of the postwar period. During that period, U.S. market capitalization was fueled by a highly favorable combination of several power processes. First, after the Great Depression, capitalists managed to force a systematic redistribution in their favor, seeing the combined share of their pretax profit and interest in national income rise from about 12% in the 1930s and 1940s to roughly 17% in the 2000s. Second, they also succeeded in pushing down the effective corporate tax rate - from 55% in the 1940s to less than 30% in the 2000s - a decline that caused their after-tax corporate earnings to increase even further. Third, the broader consolidation of power relations and the establishment of capital-friendly regulations and macro stabilization policies helped them reduce earning volatility - and, by extension, their own perceptions of risk. This decline in perceived risk, along with the general fall in interest rates since the late 1970s, lowered the rate at which they discount their expected earnings, thereby boosting their present value even more.
These power processes all had the same impact on the stock market: they pushed it up. The effect of income redistribution and falling corporate taxes convinced capitalists that net profits would continue to rise much faster than national income, while falling risk perception along with the drop in interest rates over the past thirty years allowed them to re-price this steep earning trend at ever lower discount rates. The net consequence was that the overall stock market capitalization rose more than four times faster than the gross national income: it soared from $167 billion in 1952 to $20.3 trillion in 2007 - a 127-fold increase - compared with a mere 39-fold increase in dollar value of gross national income, which grew from $312 billion to $12.4 trillion. 
The trouble was that, by the early 2000s, after half a century in overdrive, these power processes have already run much of their course, making future increases in stock prices more difficult to achieve. Capitalism is inherently conflictual, so power is always imposed against opposition. This built-in conflict means that from a certain point onward, there tends to be a positive relationship between the existing level of capitalist power on the one hand, and the force that needs to be exerted in order to further increase that power on the other. Thus, the higher the income inequality, the harder it is to make it more unequal; the lower the corporate tax rate, the harder it is to cut it further; the smaller the volatility of earnings, the harder it is to stabilize them further; and the lower the rate of interest, the harder it is to see it fall further.
The exhaustion of these redistributional/conflictual fuels left the stock market at the mercy of aggregate growth - and yet the "real economy" too seemed to be running into the sand. Expressed in purchasing power parity, annual GDP growth in the United States has drifted downwards, from 3.6% in the period from 1950 to 1975 to 3.1% since then, while world GDP growth dropped from 4.7% to 3.5%. Since the late 1990s, official growth measures seemed to have recovered, leading capitalists to hype the unlimited potential of "high technology" and the "knowledge economy," along with the fabulous riches promised by rapid urbanization in the so-called "emerging markets." But by the early 2000s, these hopes were increasingly spoiled by new doomsday scenarios, ranging from "peak oil" and "climate tipping" to "runaway pandemics" and "environmental devastation"
While the authors do not delve into the debt driven causes of the post 2003 bubble led recovery they do note the renewed crisis that came in 2007-2008.
Is the Dominant Ideology Broken?
As Figure 4 shows, between their June 2007 peak and their May 2009 bottom, earnings fell by 91% - a decline greater than the 75% collapse experienced during the first three years of the Great Depression. If capitalism were here to stay, this must have been the mother of all investment opportunities: with profits bound to rebound back to their long-term trend, their rise was sure to be spectacular - as were the gains to investors loyal to the forward-looking ritual. But few seemed convinced. And, so...share prices continued to slide, closely following the footsteps of current earnings.
Given that the bear market, measured in rates of change, was approaching historical lows, and since such bottoms had previously always been followed by major upswings, many forward-looking strategists - from permanent bull Barton Biggs, to Wizard of Omaha Warren Buffet, to doom-and-gloom Martin Wolf - were advising their followers to fasten their seat belts in preparation for an imminent takeoff. And in early 2009 they were finally vindicated.
But the rebound had to do neither with the advice of analysts nor with the prescience of capitalists. The real trigger was earnings. Recall that, by now, investors had lost their belief in the inevitable, at least for the time being, and that instead of looking forward to eternity they kept staring at the past. Everyone was glued to the earning cycle, anxiously waiting for it to find a bottom. And, sure enough, it was only after profits finally started to increase that stock prices began to rise. By April 2010, the market was up 60%; but as with the decline, the increase, too, merely traced the path of earnings. Given the thrust of the profit up-cycle, though, with earnings having risen more than nine-fold from their near-zero level at the 2008 bottom, the question arises again: why are investors still behaving as if they doubt that the upswing is real, not to say sustainable?
In our view, the answer is that the crisis of the late 2000s reintroduced an additional and far deeper form of fear. During the early 2000s, the concern was largely practical: the stock market appeared to be running out of fuel, and the main fear, however fuzzy, was that the level of capitalization may have been approaching a glass ceiling. But since the late 2000s, the very ideology of capitalization has been put into question: the capitalist class seems to have lost confidence in its own theories and rituals - and, therefore, in its ability to rule.
To show the present uncertain state of affairs the authors proceed to cite the FT's "dense fog of uncertainty" editorial, Alan Greenspan's "state of shocked disbelief" testimony, John Kay's attempt to answer the Queen's question, many of Martin Wolf's observations and culminate with Gillian Tett's 2010 observation: "In this new world of sovereign risk, what really matters is a set of issues that cannot be plugged into a spreadsheet. The old compass no longer works."
They then ask:
Is Capitalism Heading for Systemic Collapse?
The decade-long breakdown of capitalization is no fluke. The fact that for ten years now capitalists have been pricing equities based on past profit betrays deep distress. Their fear now is not only that the level of capitalization may be bumping into a glass ceiling; it is also that the very ritual of capitalization - the universal crystal ball through which they have been "seeing" the future for nearly a century - may be giving them awfully wrong signals. And when the future looks bleak, and the dominant ideology appears opaque if not misleading, there arises the specter of systemic fear.
Given the foregoing, the obvious question to ask is: does systemic fear signal the imminent collapse of capitalism?
This is by no means an easy question to answer. The difficulty is threefold. First, systemic fear - in capitalism as in other modes of power - is rare and therefore difficult to generalize about. Second, although much has been written about previous episodes of social collapse, it is unclear how much of it applies to the capitalist mode of power. Third and finally, systemic fear and systemic collapse are deeply intertwined in ways that may not be easy to disentangle. Nonetheless, given that we are dealing with the very existence of capitalism, discussing these questions - even speculatively, as we do in the remainder of the paper - seems appropriate.
They note that, while decline can be a lengthy affair, collapse is often sudden and often occurs in an environment of loss of confidence by elites.
But, in our view, for a mode of power to finally implode, these reasons must be complemented by the loss of confidence in obedience. When the ruling class is no longer certain of its ability to govern, it becomes indecisive; indecision inhibits ruthlessness; lack of ruthlessness fuels opposition; and effective opposition is the other side of disintegrating rule. It is only at that point, when it becomes obvious that the ruling class, benumbed by systemic fear, has lost control, that final collapse becomes possible.
We are at that stage, they assert. They describe the collapse of Babylon from the Book of Daniel, the collapse of the Easter Island civilization per Jared Diamond and the collapse of the Soviet Union under Gorbachev.
The collapse of a mode of power is always underwritten by its own historical circumstances. But as these and numerous other examples suggest, it is the rulers' systemic fear and loss of confidence that makes those circumstances - whatever they are - culminate in an abrupt crash. In and of themselves, fear and loss of confidence are rarely if ever sufficient to set off the implosion; but they are always necessary, and that necessity makes them important to analyze.
In the case of the capitalist mode of power there are additional factors:
Complex Systems and Time Transformers
As noted, systemic fear is not unique to capitalism. But in our opinion, the likelihood of systemic fear turning gradual decline into rapid collapse is much greater in capitalism than in any prior mode of power. There are two related reasons for this claim. First, modern capitalism is much more "complex" than earlier modes of power, and that complexity makes it susceptible to implosion. Second, unlike other modes of power, the ritual of capitalization acts as a "time transformer": it condenses the long future into the singular present, and that reduction can turn capitalist expectations - particularly during times of systemic fear - into an immediate reality. Let's consider these reasons more closely.
Most of the time, the high complexity of capitalism allows it to quell and encompass limited challenges to power and local breakdowns of rule. But the agility and flexibility of capitalism have limits, and when these limits are crossed, complexity can turn "against the system." At that point, internal challenge, external attack and ecological calamity, instead of being counteracted and absorbed, get amplified. And as the reverberations spread, the system doesn't simply weaken; it implodes.
This type of scenario, in which complexity facilitates collapse, is spelled out in David Korowicz's Tipping Point (2010). His argument, like others in this genre, builds mainly on standard "real-growth" economics, of which we are critical, and it offers very little discussion of the power relations that we emphasize. But his analysis of complexity could easily be extended to a broader power perspective and therefore is worth exploring in some detail.
Korowicz claims that the imminent peaking of oil production is a "tipping point" - a threshold beyond which capitalist civilization will not simply decline, but rapidly disintegrate. His initial premises are similar to those of most peak-oil analysts: (1) capitalism requires continuous economic growth; (2) ongoing economic growth necessitates ever-increasing energy inputs; (3) the key energy input - oil and its derivatives - has no immediate substitutes; and (4) once the production of oil - and of fossil fuels more generally - peaks and starts to decline, economic growth and the capitalism that is based on it must follow suit. The disagreement is over what follows. According to most analysts, the systemic consequences of peak oil are likely to be gradual: the optimists envisage an unstable period during which the piecemeal development of renewable energy sources and energy-saving techniques substitutes for the decline of fossil fuels, while the pessimists see a drawn-out process of deindustrialization and social decline. For Korowicz, though, these gradual scripts all suffer from a crucial omission: they ignore the operational fabric of capitalism, and that oversight leads them to the wrong conclusion.
Global production, he says, is mediated through highly complex and deeply intertwined critical infrastructures - including money, trade, transportation, communications, water, and electricity, among others. The operation of these integrated infrastructures rests on and presupposes the ongoing expansion of credit and debt. And that expansion is possible only because investors believe that the additional credit and debt will be serviced and ultimately repaid. According to Korowicz, though, this latter belief - and therefore the entire operational fabric that rests on it - can only hold in a growing economy. And here lies the trap.
Once humanity passes the threshold of peak oil, economic growth must turn negative - and, at that point, the assumption of ever-growing credit and debt breaks down. Investors suddenly realize that, looking forward, their assets have an inherently negative yield. And since this realization inverts the basis on which the whole society operates, the result is not a gradual decline but sudden collapse. The first to tank are the equity and debt markets; these are followed by mutually reinforcing reverberations and the eventual rupture of money, trade, investment, communications and other critical infrastructures; and the process is then sealed by conflict, war and die-off (as argued for example by Jay Hanson).
As long as this diary is, the paper on which it is based is much longer and much better developed.
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