How do you measure the size of an economy?

GDP, right?

By that measure, US is the biggest economy in the world today with GDP in excess of $20 trillion. That’s the total value of the goods and services the country produced in FY17. The churn out of that kind of produce was achieved on the foundation of $12 trillion of national debt.

It’s not surprising to anyone that largest economic powerhouse runs and grows on the engine fuelled by debt.

In the modern world, the definition of progress is unquestionably linked to the word growth. In his book Sapiens, Historian Yuval Harari writes —

To understand modern economic history, you really need to understand just a single word. The word is growth. For better or worse in sickness and in health, the modern economy has been growing like a hormone-soused teenager. It eats up everything it can find and puts on inches faster than you can count.

 

Now growth isn’t a modern construct. It was understood well by pre-modern societies also but pre-modern era remained a frozen economy for many years. Not because they did not have the ability to grow but because of a psychological problem which Harari calls The Entrepreneur’s Dilemma.

For an enterprising individual, there was no money to begin with. When you don’t have money you can’t pay the contractor to build a Bakery. As it is not possible to construct a bakery, the cakes will never be produced. Since the cakes can’t be produced, there can’t be any trade and hence no profits and eventually no growth.

Click here if you can’t see the image above.

This deadlock was broken by a simple idea — trust in the future. Harari writes —

The way out of the trap was discovered only in the modern era, with the appearance of a new system based on trust in the future. In it, people agreed to represent imaginary goods. Goods that do not exist in the present at the expense of the future. It’s founded on the assumption that our future resources are sure to be far more abundant than our present resources. A host of new and wonderful opportunities open up if we can build things in the present using future incomes.

 

The wonderful arrangement of credit transforms the Entrepreneur’s Dilemma into A Magic Circle of Modern Economy as shown below.

Click here if you can’t see the image above.

Let me explain with another example. A vacation ownership company promises you a week of holiday for the next twenty-five years. Now, you might be thinking that as so many people are joining the members’ list of the company, how will the company expand its resorts and rooms to cater to this growing list of members. It again uses the same philosophy where things are built in the present using future incomes. Call it credit or leverage. Since the customer pays the full amount for the twenty-five years of service in advance, the company has a financial leverage which they use to build the present in order to grow and benefit all the stakeholders in the future.

If you read history you will discover interesting analogy between Christopher Columbus and the hi-tech start-ups of today. Columbus kept pitching his novel idea to potential investors in Italy, France, and Portugal. His idea got rejected everywhere but like any modern start-up he didn’t lose heart and kept on pitching till Spain finally agreed to finance Columbus’ (ad)venture.

What made the rulers of Spain invest in Columbus? They trusted in the future. But it was his good luck that he succeeded as many similar expeditions in those times failed miserably. Like most start-ups fail today. But what happened with the success of the idea? The trust in the future increased many-fold. It is being told that as with Columbus’ help Spaniards conquered America, even a hundred years later princes and bankers were willing to extend far more credit to Columbus’ successors.

Doesn’t this sound similar to how today venture capitalists fund tech start-ups where things are built in the present based on the promise of future incomes? While people like us keep raising our eyebrows as to how these start-ups get funds when their profits seem so far away, these VCs keep their gaze fixed on a distant future when these startups-ups would grow and eventually be profitable.

So, availability of capital is a necessary condition but it’s not a sufficient one. The second piece of the puzzle is profit.

In his classic book, The Wealth of Nations, Adam Smith made an argument, “When a landlord, a weaver, or a shoemaker has greater profits than he needs to maintain his own family, he uses the surplus to employ more assistants, in order to further increase his profits. The more profits he has, the more assistants he can employ. It follows that an increase in profits of private entrepreneurs is the basis for the increase in collective wealth and prosperity.”

Increase in profits of private entrepreneurs is the basis for the rise in collective wealth and prosperity. An entrepreneur’s incentive is profit and also the possibility of reinvesting those profits for even more profits.

Debt makes the growth possible. Profits make the growth probable.

But those two things by themselves still don’t explain the breakneck speed at which the modern economy is cruising. Debt plus profit are the necessary ingredients but the catalyst is something else. Warren Buffett, in his 1995 letter to shareholders, gives some clues —

Any company’s level of profitability is determined by three items:

  • What its asset earns
  • What its liabilities cost
  • Its utilization of “leverage”

That is, the degree to which its asset are funded by liabilities rather than by equity. Over the years, we have done well on Point (i), having produced high returns on our assets. But we have also benefitted greatly — to a degree that is not generally well-understood — because our liabilities have cost us very little. An important reason for this low cost is that we have obtained float on very advantageous terms. The same cannot be said by many other property and casualty insurers, who may generate plenty of float, but at a cost that exceeds what the funds are worth to them. In those circumstances, leverage becomes a disadvantage. Since our float has cost us virtually nothing over the years, it has in effect served as equity.

The third important piece is — the cost of capital. How cheap or expensive the debt is?

For Buffett, the float generated by the insurance business is a free debt. For startup entrepreneurs, VC money is free capital. Of course, like profits, the cost for the entrepreneur is in the future (in terms of VC’s claim on the equity) but for today’s growth, the capital is free.

Harari again —

Over the last 500 years the idea of progress convinced people to put more and more trust in the future. This trust created credit; credit brought real economic growth; and growth strengthened the trust in the future and opened the way for even more credit. It didn’t happen overnight- the economy behaved more like a roller coaster than a balloon. But over the long run, with the bumps evened out, the general direction was unmistakable. Today, there is so much credit in the world that governments, business corporations and private individuals easily obtain large, long-term and low-interest loans that far exceed current income.

With the glorifying successes that credit achieved for so many years, today a country’s credit rating is far more important to its economic well-being than its natural resources. For example, a country with abundant natural resources (like oil) but a corrupt government and judicial systems, usually gets a lower credit rating. As a result, it will not be able to raise enough capital to utilize its natural resources for public well-being. On the other hand, another country may be devoid of any rich natural resource and still receive a higher credit rating because of political stability, a free government, and a fair judicial system. So, this country can raise enough cheap capital to support a good education system and build human resources to make a flourishing high-tech industry.

So it’s this never-ending cycle — credit driving profits and profits making credit cheaper — from where the Capitalist Creed derives its strength.

But isn’t an ever increasing trust in the future akin to a pyramid scheme?

Can the economic pie grow indefinitely, questions Harari, “Every pie requires raw materials and energy. Prophets of doom warn that sooner or later Homo sapiens will exhaust the raw materials and energy of planet Earth. And what will happen then?”

All I know is that I don’t know.

Would love to hear your thoughts. Please use the comments section below to reply.

One thought on “The Perpetuating Forces of The Capitalist Creed”

  1. Really great article. I enjoyed reading. This Columbus analogy is wonderful.
    “if you read history you will discover interesting analogy between Christopher Columbus and the hi-tech start-ups of today. Columbus kept pitching his novel idea to potential investors in Italy, France, and Portugal. His idea got rejected everywhere but like any modern start-up he didn’t lose heart and kept on pitching till Spain finally agreed to finance Columbus’ (ad)venture.”
    I read your book “Mental models and investing”. Learned many things from it.
    I am big fan of your writings. Keep writing and posting.

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