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.
The Economic History of the World in a Nutshell
The belief in the growing global pie eventually turned revolutionary. In 1776 the Scottish economist Adam Smith published The Wealth of Nations, probably the most important economics manifesto of all time. In the eighth chapter of its first volume, Smith made the following novel 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 the profits of private entrepreneurs is the basis for the increase in collective wealth and prosperity.
This may not strike you as very original, because we all live in a capitalist world that takes Smith’s argument for granted. We hear variations on this theme every day in the news. Yet Smith’s claim that the selfish human urge to increase private profits is the basis for collective wealth is one of the most revolutionary ideas in human history – revolutionary not just from an economic perspective, but even more so from a moral and political perspective. What Smith says is, in fact, that greed is good, and that by becoming richer I benefit everybody, not just myself. Egoism is altruism.
Smith taught people to think about the economy as a ‘win-win situation’, in which my profits are also your profits. Not only can we both enjoy a bigger slice of pie at the same time, but the increase in your slice depends upon the increase in my slice. If I am poor, you too will be poor since I cannot buy your products or services. If I am rich, you too will be enriched since you can now sell me something. Smith denied the traditional contradiction between wealth and morality, and threw open the gates of heaven for the rich. Being rich meant being moral. In Smith’s story, people become rich not by despoiling their neighbours, but by increasing the overall size of the pie. And when the pie grows, everyone benefits. The rich are accordingly the most useful and benevolent people in society, because they turn the wheels of growth for everyone’s advantage.
All this depends, however, on the rich using their profits to open new factories and hire new employees, rather than wasting them on non-productive activities. Smith therefore repeated like a mantra the maxim that ‘When profits increase, the landlord or weaver will employ more assistants’ and not ‘When profits increase, Scrooge will hoard his money in a chest and take it out only to count his coins.’ A crucial part of the modern capitalist economy was the emergence of a new ethic, according to which profits ought to be reinvested in production. This brings about more profits, which are again reinvested in production, which brings more profits, et cetera ad infinitum. Investments can be made in many ways: enlarging the factory, conducting scientific research, developing new products. Yet all these investments must somehow increase production and translate into larger profits. In the new capitalist creed, the first and most sacred commandment is: ‘The profits of production must be reinvested in increasing production.’
That’s why capitalism is called ‘capitalism’. Capitalism distinguishes ‘capital’ from mere ‘wealth’. Capital consists of money, goods and resources that are invested in production. Wealth, on the other hand, is buried in the ground or wasted on unproductive activities. A pharaoh who pours resources into a non-productive pyramid is not a capitalist. A pirate who loots a Spanish treasure fleet and buries a chest full of glittering coins on the beach of some Caribbean island is not a capitalist. But a hard-working factory hand who reinvests part of his income in the stock market is.
The idea that ‘The profits of production must be reinvested in increasing production’ sounds trivial. Yet it was alien to most people throughout history. In premodern times, people believed that production was more or less constant. So why reinvest your profits if production won’t increase by much, no matter what you do? Thus medieval noblemen espoused an ethic of generosity and conspicuous consumption. They spent their revenues on tournaments, banquets, palaces and wars, and on charity and monumental cathedrals. Few tried to reinvest profits in increasing their manors’ output, developing better kinds of wheat, or looking for new markets.
In the modern era, the nobility has been overtaken by a new elite whose members are true believers in the capitalist creed. The new capitalist elite is made up not of dukes and marquises, but of board chairmen, stock traders and industrialists. These magnates are far richer than the medieval nobility, but they are far less interested in extravagant consumption, and they spend a much smaller part of their profits on non-productive activities.
Medieval noblemen wore colourful robes of gold and silk, and devoted much of their time to attending banquets, carnivals and glamorous tournaments. In comparison, modern CEOs don dreary uniforms called suits that afford them all the panache of a flock of crows, and they have little time for festivities. The typical venture capitalist rushes from one business meeting to another, trying to figure out where to invest his capital and following the ups and downs of the stocks and bonds he owns. True, his suits might be Versace and he might get to travel in a private jet, but these expenses are nothing compared to what he invests in increasing human production.
It’s not just Versace-clad business moguls who invest to increase productivity. Ordinary folk and government agencies think along similar lines. How many dinner conversations in modest neighbourhoods sooner or later bog down in interminable debate about whether it is better to invest one’s savings in the stock market, bonds or property? Governments too strive to invest their tax revenues in productive enterprises that will increase future income – for example, building a new port could make it easier for factories to export their products, enabling them to make more taxable income, thereby increasing the government’s future revenues. Another government might prefer to invest in education, on the grounds that educated people form the basis for the lucrative high-tech industries, which pay lots of taxes without needing extensive port facilities.
Capitalism began as a theory about how the economy functions. It was both descriptive and prescriptive – it offered an account of how money worked and promoted the idea that reinvesting profits in production leads to fast economic growth. But capitalism gradually became far more than just an economic doctrine. It now encompasses an ethic – a set of teachings about how people should behave, educate their children and even think. Its principal tenet is that economic growth is the supreme good, or at least a proxy for the supreme good, because justice, freedom and even happiness all depend on economic growth. Ask a capitalist how to bring justice and political freedom to a place like Zimbabwe or Afghanistan, and you are likely to get a lecture on how economic affluence and a thriving middle class are essential for stable democratic institutions, and about the need therefore to inculcate Afghan tribesmen in the values of free enterprise, thrift and self-reliance.
This new religion has had a decisive influence on the development of modern science, too. Scientific research is usually funded by either governments or private businesses. When capitalist governments and businesses consider investing in a particular scientific project, the first questions are usually, ‘Will this project enable us to increase production and profits? Will it produce economic growth?’ A project that can’t clear these hurdles has little chance of finding a sponsor. No history of modern science can leave capitalism out of the picture.
Conversely, the history of capitalism is unintelligible without taking science into acc
ount. Capitalism’s belief in perpetual economic growth flies in the face of almost everything we know about the universe. A society of wolves would be extremely foolish to believe that the supply of sheep would keep on growing indefinitely. The human economy has nevertheless managed to keep on growing throughout the modern era, thanks only to the fact that scientists come up with another discovery or gadget every few years – such as the continent of America, the internal combustion engine, or genetically engineered sheep. Banks and governments print money, but ultimately, it is the scientists who foot the bill.
Over the last few years, banks and governments have been frenziedly printing money. Everybody is terrified that the current economic crisis may stop the growth of the economy. So they are creating trillions of dollars, euros and yen out of thin air, pumping cheap credit into the system, and hoping that the scientists, technicians and engineers will manage to come up with something really big, before the bubble bursts. Everything depends on the people in the labs. New discoveries in fields such as biotechnology and nanotechnology could create entire new industries, whose profits could back the trillions of make-believe money that the banks and governments have created since 2008. If the labs do not fulfil these expectations before the bubble bursts, we are heading towards very rough times.
Columbus Searches for an Investor
Capitalism played a decisive role not only in the rise of modern science, but also in the emergence of European imperialism. And it was European imperialism that created the capitalist credit system in the first place. Of course, credit was not invented in modern Europe. It existed in almost all agricultural societies, and in the early modern period the emergence of European capitalism was closely linked to economic developments in Asia. Remember, too, that until the late eighteenth century, Asia was the world’s economic powerhouse, meaning that Europeans had far less capital at their disposal than the Chinese, Muslims or Indians.
However, in the sociopolitical systems of China, India and the Muslim world, credit played only a secondary role. Merchants and bankers in the markets of Istanbul, Isfahan, Delhi and Beijing may have thought along capitalist lines, but the kings and generals in the palaces and forts tended to despise merchants and mercantile thinking. Most non-European empires of the early modern era were established by great conquerors such as Nurhaci and Nader Shah, or by bureaucratic and military elites as in the Qing and Ottoman empires. Financing wars through taxes and plunder (without making fine distinctions between the two), they owed little to credit systems, and they cared even less about the interests of bankers and investors.
In Europe, on the other hand, kings and generals gradually adopted the mercantile way of thinking, until merchants and bankers became the ruling elite. The European conquest of the world was increasingly financed through credit rather than taxes, and was increasingly directed by capitalists whose main ambition was to receive maximum returns on their investments. The empires built by bankers and merchants in frock coats and top hats defeated the empires built by kings and noblemen in gold clothes and shining armour. The mercantile empires were simply much shrewder in financing their conquests. Nobody wants to pay taxes, but everyone is happy to invest.
In 1484 Christopher Columbus approached the king of Portugal with the proposal that he finance a fleet that would sail westward to find a new trade route to East Asia. Such explorations were a very risky and costly business. A lot of money was needed in order to build ships, buy supplies, and pay sailors and soldiers – and there was no guarantee that the investment would yield a return. The king of Portugal declined.
Like a present-day start-up entrepreneur, Columbus did not give up. He pitched his idea to other potential investors in Italy, France, England, and again in Portugal. Each time he was rejected. He then tried his luck with Ferdinand and Isabella, rulers of newly united Spain. He took on some experienced lobbyists, and with their help he managed to convince Queen Isabella to invest. As every schoolchild knows, Isabella hit the jackpot. Columbus’ discoveries enabled the Spaniards to conquer America, where they established gold and silver mines as well as sugar and tobacco plantations that enriched the Spanish kings, bankers and merchants beyond their wildest dreams.
A hundred years later, princes and bankers were willing to extend far more credit to Columbus’ successors, and they had more capital at their disposal, thanks to the treasures reaped from America. Equally important, princes and bankers had far more trust in the potential of exploration, and were more willing to part with their money. This was the magic circle of imperial capitalism: credit financed new discoveries; discoveries led to colonies; colonies provided profits; profits built trust; and trust translated into more credit. Nurhaci and Nader Shah ran out of fuel after a few thousand miles. Capitalist entrepreneurs only increased their financial momentum from conquest to conquest.
But these expeditions remained chancy affairs, so credit markets nevertheless remained quite cautious. Many expeditions returned to Europe empty-handed, having discovered nothing of value. The English, for instance, wasted a lot of capital in fruitless attempts to discover a north-western passage to Asia through the Arctic. Many other expeditions didn’t return at all. Ships hit icebergs, foundered in tropical storms, or fell victim to pirates. In order to increase the number of potential investors and reduce the risk they incurred, Europeans turned to limited liability joint-stock companies. Instead of a single investor betting all his money on a single rickety ship, the joint-stock company collected money from a large number of investors, each risking only a small portion of his capital. The risks were thereby curtailed, but no cap was placed on the profits. Even a small investment in the right ship could turn you into a millionaire.
Decade by decade, western Europe witnessed the development of a sophisticated financial system that could raise large amounts of credit on short notice and put it at the disposal of private entrepreneurs and governments. This system could finance explorations and conquests far more efficiently than any kingdom or empire. The new-found power of credit can be seen in the bitter struggle between Spain and the Netherlands. In the sixteenth century, Spain was the most powerful state in Europe, holding sway over a vast global empire. It ruled much of Europe, huge chunks of North and South America, the Philippine Islands, and a string of bases along the coasts of Africa and Asia. Every year, fleets heavy with American and Asian treasures returned to the ports of Seville and Cadiz. The Netherlands was a small and windy swamp, devoid of natural resources, a small corner of the king of Spain’s dominions.
In 1568 the Dutch, who were mainly Protestant, revolted against their Catholic Spanish overlord. At first the rebels seemed to play the role of Don Quixote, courageously tilting at invincible windmills. Yet within eighty years the Dutch had not only secured their independence from Spain, but had managed to replace the Spaniards and their Portuguese allies as masters of the ocean highways, build a global Dutch empire, and become the richest state in Europe.
The secret of Dutch success was credit. The Dutch burghers, who had little taste for combat on land, hired mercenary armies to fight the Spanish for them. The Dutch themselves meanwhile took to the sea in ever-larger fleets. Mercenary armies and cannon-brandishing fleets cost a fortune, but the Dutch were able to finance their military expeditions more easily than the mighty Spanish Empire because they secured the trust of the burgeoning European financial system at a time when the Spanish king was carelessly eroding its trust in him. Financiers extended the Dutch enough credit to set up armies and fleets, and these armies and fleets gave the Dutch control of world trade routes, which in turn yielded handsome profits. The profits allowed the Dutch to repay the loans, which strengthened the trust of the financiers. Amsterdam was fast becoming not only one of the most important ports of Europe, but also the continent’s financial Mecca.
How exactly did the Dutch win the trust of the financial system? Firstly, they were sticklers about repaying their loans on time and in full, making the extension of credit less risky for lenders. Se
condly, their country’s judicial system enjoyed independence and protected private rights – in particular private property rights. Capital trickles away from dictatorial states that fail to defend private individuals and their property. Instead, it flows into states upholding the rule of law and private property.
Imagine that you are the son of a solid family of German financiers. Your father sees an opportunity to expand the business by opening branches in major European cities. He sends you to Amsterdam and your younger brother to Madrid, giving you each 10,000 gold coins to invest. Your brother lends his start-up capital at interest to the king of Spain, who needs it to raise an army to fight the king of France. You decide to lend yours to a Dutch merchant, who wants to invest in scrubland on the southern end of a desolate island called Manhattan, certain that property values there will skyrocket as the Hudson River turns into a major trade artery. Both loans are to be repaid within a year.
The year passes. The Dutch merchant sells the land he’s bought at a handsome markup and repays your money with the interest he promised. Your father is pleased. But your little brother in Madrid is getting nervous. The war with France ended well for the king of Spain, but he has now embroiled himself in a conflict with the Turks. He needs every penny to finance the new war, and thinks this is far more important than repaying old debts. Your brother sends letters to the palace and asks friends with connections at court to intercede, but to no avail. Not only has your brother not earned the promised interest – he’s lost the principal. Your father is not pleased.