Theory and Practice

The Trend of Capitalism : Genesis and Evolution
Ranjit Sau

Theoretical conception of capitalism advanced in the late nineteenth-century Europe. Up to that time England was the 'classic ground' where the stereotype of practical capitalism was in the making. 'That is the reason why England is used as the chief illustration in the development of my theoretical ideas' (Marx 1867: 8). Many of the fallacious interpretations of Marx, 'rest upon the false assumptions that Marx wishes to define where he only investigates, and that in general one might expect fixed, cut-to-measurable, once and for all applicable definitions in Marx's works. It is self-evident that while things and their inter-relationship are conceived, not as fixed, but as changing their mental images, the ideas, are likewise subject to change and transformation; and they are not encapsulate in rigid definitions, but are developed in their historical or logical process of formation' (Engels, Preface in Marx 1894: 13-14; icalics added). Over more than a century capitalism has passed through evolutions of its form of quantity and quality. This chapter studies two aspects: the making of capitalism, and its material components, including intellectual ideas.

Around the close of the Middle Ages, the great power centers were China, the Ottoman Empire, Muscovy, and Japan, while Europe was a cluster of states. At the beginning of the sixteenth century it was by no means apparent that the west-central Europe would rise above all of the rest. Europe has a highly indented coastline with five large peninsulas that approach islands in their isolation, and all evolved independent religion, languages, ethnicity, and government. There were no enormous plains over which an empire of horsemen would impose its swift domination, nor were there broad and fertile river zones providing the food for masses of toiling and easily conquerable peasants. Mountain ranges and long forests separated the scattered population centers in the valleys, politically fragmented.

Europe came to have small states with a tendency to encroach into each other's territory prompted by the felt necessity of defense as well as the material needs for space or wealth. The natural features of Europe had influence on the course of capitalism which in turn has redefined the Western civilization. How far are other parts of the world inclined to accept capitalism with its Western cognates such as democracy and free market?

Second, the nature of material products of capitalism is not constant. 'The wealth of societies with the capitalist mode of production presents itself, as an immense accumulation of commodities' (Marx: 1847). A commodity is, in the first instance, 'a thing that by its properties satisfies human wants of some sort or another, either directly as means of subsistence, or indirectly as means of production'' (italics added). This part is recognized as the real economy. Upon the foundation of the 'immense accumulation of commodities' has arisen a massive superstructure of ownership claims of private property in the shape of stocks, bonds, futures, options, virtual options, future options, swap, and the like. These claims, traded in markets, derive their values from the related commodities; these 'papers' are known as the derivative commodities, or simply 'derivative'. The physical assets held by a firm would yield to the owner of the firm—its stockholders—a stream of profits over time. And the stock price would depend mainly upon this stream of profits. So, stocks also are derivatives in this sense. Soon, myriad types of derivatives would flood the marketplace, and thereby they come to earn a distinct economic position—financial economy.

There is an increasing tendency toward abstraction of traded commodities. A typical commodity futures contract gives the holder the right to demand delivery of the commodity at the agreed upon price at the times, places, and quality grades specified in the contract. Few physical delivery of the commodity actually takes place. Most short contracts (obligations to deliver) are liquidated by offset, i.e. going into the market and buying an equivalent standardized contract. An economy as a result follows two sets of principles: one related to material commodities, the other to the derivatives. The economy looks like a pyramid of derivatives standing upon a series of commodities.

Has the 'core' of capitalism changed, or is it basically invariant? Are the days of democratic capitalism over, and the age of authoritarian capitalism on the way?

Patterns of Capitalism
Europe of the sixteenth and seventeenth centuries turned itself a battle ground: the states were constantly in the midst of the spiritual fires of Renaissance and Reformation alike. The new technology of war allowed the use of massive professionals in infantry and artillery. The wars came to an end in 1648 by the Peace Treaty of Westphalia. The main tenet of the treaty was : Each prince would have the right to determine the religion of his own state, the option being Catholicism, Lutheranism, and Calvinism.

Europe in the spirit of Renaissance conceptually recognized the individual: 'the development of a universal capacity to think of yourself, in a fundamental way, as an individual', distinct from being just the member of a family, group, clan or tribe. An individual presents himself as a repository of all that human beings had achieved, 'a point of unity for all that had been thought and done by man, within the mind restored to consciousness of its own sovereign faculty.' Eighteenth century witnessed the fervor of Enlightenment movement and the French Revolution. The declaration of the Rights of Man by the Revolution enunciated the freedom of individual. 'Men are born free and remain free and equal in rights. ... Liberty consists in the power to do everything that does not injure others.'

The kingdoms engaged in warlike rivalries were in constant efforts for military improvement, better technology, and commercial advancement. They, with their large military establishments and fleets of warships, increased the government's need to nurture the economy and create financial institutions. It was this need which was at the background to the financial revolution of seventeenth and eighteenth centuries, the prelude to the nineteenth-century Industrial Revolution. There was another reason for financial changes of this time, that is, the chronic shortage of spice. The steady increase in European commerce especially oversees with the Orient led to the growing regulatory and predictability of financial settlements.

By far the largest and most sustained boost to the financial revolution was given by war. The belligerent monarchies, even the most thriving ones, could not immediately pay for the wars of this period out of their ordinary revenue. Moreover, vast rises in taxes would provoke domestic unrest, which all regimes feared especially at the time of facing foreign challenges. The only way for a government to finance a war adequately was by borrowing. Assured of an inflow of funds, officials could authorize payments of war budgets. 'In many respects, the two-way system of raising and simultaneously spending vast sums of money acted like a bellows, fanning the development of Western capitalism and the nation-state itself (Kennedy, 1989:76).

The big landlords and capitalists were the only ones represented in the parliament of Prussia in the eventful years of 1848. With the growth of industry, commerce, and trade the capitalists had to claim their share in political power, if only for the sake of protecting their material assets. They must be able freely to debate their own interests and views and the actions of the Government. They called this freedom of the press. They had to be able to enter freely into associations. They called this the freedom of association. As a necessary consequence of free competition, they had likewise to demand religious liberty, and so on. Before March 1848 the capitalists were well on the way to realizing all their aims. Obviously, the rights and liberties which they sought for themselves could be demanded from Government only under the slogan: people's rights, and people's liberties. Seeds of the concept of democracy were planted in Germany through bourgeois initiative. England would combine its nascent capitalism with parliamentary democracy, so did the rest of the West: there democracy followed capitalism. A century later Asia and Africa would have a reversed trajectory : here democracy preceded capitalism, with unintended consequences.

Today as many as 120 countries profess democracy comprising sixty percent of all independent states of the world. The past four decades had been exceptionally active; not less than 90 countries had come to join the ranks. Recently, though, democracy's progress, measured by quality or quantity, may have come to a halt, or even gone into reverse. As many as 40 countries show the signs of reversal. The democratic wave has been slowed by a powerful authoritarian undertow, and the world has slipped into a democratic recession.

Democracy vests supreme power to the people, exercised by them directly or indirectly through representation selected by periodic free election. It is a government of the people, by the people, for the people. The prevailing theoretical idea of democracy is derived from the works of Immanuel Kant (1785) composed at the closing hours of the Enlightenment (1689-1789) in Europe. Its logic is as follows: Individual has a faculty of reason, by virtue of which he becomes a rational being, and hence he has freedom, autonomy, and free will.1 Society comprises of a plurality of individuals, each with his aims, interests, and conceptions. All persons, having been endowed with the faculty of reason, are equally entitled and capable to accomplish their objectives. This is the essence of theory of democracy.

The practical democracy had been inspired by the philosophy of Kant. The concerned countries of Europe at that time were homogeneous with their respective ethnicity, language, and religion after the Peace Treaty of Westphalia. The economy encouraged by Industrial Revolution was immensely productive. In the context of such social and economic situations individuals were indeed fairly equal, and Kantian democracy found a solid ground to flourish. About one hundred countries of Asia, Africa, and South America - most of them were till recently colonies of European powers - came to replicate Europe's model of democracy during the second half of the past century. They confront vastly heterogeneous social, economic, and political landscapes, a far cry from the images of nineteenth-century West. Their government finds the obligations of democracy like a transplanted endeavor that involves complex social transformation. Kantian thoughts seem incoherent with their historical experience. These societies are fragmented. India, for instance, is home of enormous conflicts of interest. The people of a community with a particular faith, for example, are divided by hierarchy of social status into innumerable groups; since antiquate some of them are firmly deprived of liberty or equality, let alone fraternity. Every political party of Indian Parliament had supported a proposal to count in the population census beginning in 2011 all these groups with their respective stamp of social category. Once counted in census this way the related social discriminations would remain irrevocable for ever; as a result human rights would be violated for eternity. Myriad of deeply entrenched conflicts stand in the way of people's democratic aspiration, i.e. mutual intolerance of ethnicity, religion, language and so on. Society, economy, and polity are organically related; one without the other two is incomplete.2 So are the social, economic, and political democracies.

Mercantilism: The remarkable economic prowess shown by China within so short a time as three decades of late twentieth century has puzzled the thinkers. Some observers suspect this East Asian miracle as the result of a backdated economic policy —a kind of authoritarian capitalism—known as Mercantilism. The theory of mercantilism had prevailed in Europe during first three centuries of the period of modernity. In comparison the free-market, laissez-faire economics of capitalism is two centuries old.

Mercantilism in Europe was a reaction against the economic problems of earlier times when states were too weak to guide their economies and when every town or principality levied its own tariffs on goods passing through its borders. The modern age brought the rise of powerful nations (Holland, France, Spain, and England) and was involved in almost constant warfare. Money (bullion) was too short in supply to support ever-expanding armies and navies. Mercantilist concepts emerged from this need.

The season for the departure of feudal authority had come. England, in the Middle Ages, was the largest and most important source of fine wool popular in markets across the continent particularly Italy and the Low Countries. It is the growth of trading towns where would begin the strong commercial impulse that was eventually to rule British society. The prime players in the countryside were upper landed-classes and the yeomen who look like the kulaks of nineteenth-century Russia, i.e. a class lying between the smaller gentry at the top and the less prosperous peasants at the bottom. The continuing demand for wool trade added impetus to develop commercial and even capitalist attitude in the countryside that would erode the feudal framework. One of the most striking signs of the changed outlook was a boom in the land market that began in the sixteenth century heralding structural change in the conduct of agriculture—the most significant being the Enclosures of open arable fields by feudal lords and the yeomen who gained most in the wave of agricultural capitalism. The main victims were the ordinary peasants.

The commercially inclined elements among feudal lords and the yeomen were among the main forces opposing the King and royal attempts to preserve the old order. Growth of commerce in the towns had created the countryside market for agricultural products, thereby setting in motion of commercial and capitalist agriculture. The aristocratic order survived, 'but money counted more than birth was now its basis.' The British Parliament itself became the instrument of landed capitalists. Eventually, by the nineteenth century capitalism would establish the iconic parliamentary democracy in England.

France took another route, albeit reached equivalent political destination. In the place of destruction of peasant property as it was in England, French peasants would consolidate their property both before and after the Revolution. Commerce and manufacturing in France lagged behind that in England for two centuries, fifteenth and sixteenth. Yet both countries achieved similarity in the final political outcome during the next two centuries. Without the French Revolution this convergence might not have taken place.

France in the Middle Ages was a feudal society with a powerful monarchy. The nobility lived on the farmers. Introduced in 1627, the seigniorial system was a semi-feudal form of noble privilege in France and its colonies. Land was arranged in long strips, each strip belonged to a lord, the seigneur. The lord divided the land further among his tenants who cleared the land, built houses and other buildings, and farmed the land. The toilers paid a chunk of crop, and were required to work for their lord, often building roads. The impetus toward commercial agriculture was weak in France, market areas did not extend beyond the vicinity of a few cities and certain export depots on frontier. Wine was to French agriculture what wool was to British agriculture. A long depression in wine trade was behind the generally backward state of the French economy and of the outbreak of the Revolution.

The aristocracy kept the peasant on the land and used feudal levies to extract more produce. Cultural and legal obstacles stood in the way of aristocracy to engage in commerce, any noble man who engaged in a demeaning occupation lost his noble status. The monarchy wanted prosperous nobility as a decorative adjunct to the crown and help in keeping the people in their proper place. It did not want the nobility to establish an independent economic base that could enable it to challenge royal power. Under the conditions of royal absolutism the landed upper classes adapted to the gradual intrusion of capitalism by putting great pressure on the peasants. Up into the middle of the eighteenth century modernization of the society took place through the crown. As part of this process, there grew up a fusion between nobility and bourgeoisie. The crown's power was severely limited, the collapse of order and the monarchy opened the door for the bourgeoisie to rise toward power and the peasants to dismount the seigniorial system. The French Revolution did not succeed in establishing complete liberty. Nevertheless, the 1789 Declaration of the Rights of Man and Citizens remains a landmark in the development of parliamentary democracy in Europe.

Peasants were driven out of their farms by the Enclosure movement in England. The French peasants did not have to suffer that humiliation. They had launched a series of revolts that culminated in dismantling the feudal autocracy in the light of the Revolution. In the matter of economic achievement England and France came to be at equal level. Financial and industrial capitalism spread their wings over the western part of the continent.

People in the Middle Ages counted wealth in terms of specious metals—gold, silver, diamond, etc.—to be found in rare earths, limited in quantity, and fixed for ever. So, wealth was finite. If one nation hoped to get richer, it had to do so at the expense of some other: a zero-sum game, inviting wars. The development of colonies became attractive; wealth could be accumulated in a nation if its colonies provided raw materials to the mother nation which could trade finished goods in colonies and other markets in exchange of wealth of bullion—gold, silver, diamond. This was the thesis of economics nationalism. England began the first large-scale, interrogative approach to mercantilism during Queen Elisabeth's realm (1556-1603). 'We must always take heed that we buy more from strangers than we sell them, for so we should improvise ourselves and enrich them.' England developed naval and merchant fleet capable of challenging the Spanish stranglehold on trade and expanding the bullion at home. The court of Queen Elisabeth promoted the Trade and Navigation Acts and the strength of English shipping. These efforts organized national resources sufficiently in the defense of England against the far larger and more powerful Spanish empire, and in turn established a global empire in the nineteenth century.
The bulk of the mercantilist literature appeared in the 1620s in Great Britain. English merchant Thomas Mun (1571-1641) was a major author of the mercantilist system: 'England's treasure by foreign trade, or, the balance of our foreign trade is the rule of our treasure.' If Great Britain was a pioneer of the mercantilist doctrine, so it was in providing a countervailing principle which was initiated by Adam Smith (1776).

The first school to completely reject mercantilism was the Physiocrats who presented their agriculture oriented theories in France. But the countervailing temper did not come before Smith introduced an alternative conception of 'wealth' which says: wealth of a nation is to be found not in rare stones of bullion, but in how much of goods and services—wheat, rice, clothes, shelter, health care etc.—a country produces; the wealth of the world is not fixed, but created by human labor. This fundamental thesis overturned the basis of mercantilism and created what is today known as classical economics, the economics of laissez-faire free market. Mercantilist regulations were steadily removed over the course of the eighteenth century in Britain, during the next century British government fully embraced free trade and Smith's laissez-faire.

Mercantilism was 'protectionist' in international trade by tariffs on imports, whereas the nineteenth-century capitalism was in favor of 'free-trade'—international trade in free market without government intervention. By that time, Adam Smith's ideology that a mysterious Invisible Hand is constantly at work to bring equilibrium between demand and supply of all goods and services (including labor) in the open free market without tariffs was in vogue. David Ricardo (1817) proposed a theory of international trade through the differentiation between 'absolute advantage' and 'relative advantage' of commodities of a nation. For instance, suppose Portugal was a more efficient producer of both wine and cloth than England, yet in England it was relatively cheaper to produce cloth compared to wine. Thus if Portugal specialized in wine and England in cloth, both countries would end up better off if they traded. This is an example of reciprocal benefits of trade due to a comparative advantage. Thus trade is not a zero-sum game of cutthroat competition because both sides can benefit.1 The logic of relative advantage was not known in the days of mercantilism.

John Maynard Keynes (1936: 334) had said in 1923: 'If there is one thing that Protection [mercantilism] can not do is to cure Unemployment.' It transpires that the principle of free trade with Ricardian relative advantage (also known as 'comparative advantage') does not assure positive trade balance to bring home bullion from overseas either. It may even erode the treasury's reserves by trade deficit. Consistent with Keynsian tradition, Paul Samuelson (1964) says about capitalist free trade the same thing: 'The theory of comparative advantage [in international trade] does not guarantee a country against balance-of-payments difficulties, nor does it even keep a country from being undersold.' By contrast: 'Tariffs can then reduce unemployment, can add to the NNP [Net National Product], and increase the total real wages earned (or do the same for non-labor in an extended model).' 'With employment less than full and Net National Product [NNP] suboptimal, all the debunked mercantilistic arguments turn out to be valid' (emphasis added). The free-trade policy may result in over-valuation of a country's currency, in other words, world markets would find the prices charged by a country in comparison too high. Historians argue that whatever economic benefits European mercantilism or capitalism had procured was not so much by dint of fine-tuning economic theory as much as by scientific advancement, military dominance, and colonization across the Orient in the East and the New Land of the far West.

Business columnist Robert J Samuelson argued in the 14 May 2007 issue of Newsweek that China was pursuing an essentially mercantilist trade policy that threatened the international economic structure. It is interesting that founding-father of anti-mercantilist thought Adam Smith himself praised the Navigation Acts as they greatly expanded the British merchant fleet and stimulated Britain into the naval and economic superpower that it was for several centuries. Some economists, however, think that protecting 'infant industries' can be beneficial in the long run as it did for Germany.

Capitalism : The line of separation drawn above between mercantilism and capitalism was meant for analytical purpose. Difference between the two was significantly less than what their similarities were. One was the essential prelude, a founding step, for the incoming other; mercantilism was the young capitalism as it were, while the post-eighteenth century capitalism became the mature one. Mercantilism witnessed commercial and financial capitalism to be combined with the subsequent mature industrial capitalism. Large part of the world still continues with feudal traditions. A more relevant question at the present context is what the procedure was by which feudalism came to meet with capitalism and transferred the baton of society to it. Social history of the decline of feudalism and the origins of capitalism is instructive for the modern world. The influence of surviving feudalism and its relations with capitalism, and the retardation of development, are urgent matters in history-making.

Feudalism of Western Europe was vulnerable to internal conflicts between serfs and feudal lords within the manors, or to external challenges of trade and commerce outside the precinct of lords, or maybe to both. Historians represented feudalism in two ways : (a) equal to the presence of serfs—a serfdom as it were—toiling in the countryside to produce crop for seigneur the lord's use (Dobb, 1946); or, (b) characterized as having a 'natural economy' with no active market and money (Sweezy, 1950).

By the 'internal'-pressure conception (a): The internal cause of the breakdown of feudalism was over-exploitation of the labor-force: serfs deserted the lord's estates en masse, and those who remained were too few and too overworked to enable the system to maintain itself on the old basis. It was the incapability of feudalism as a system of production coupled with growing needs of ruling classes for revenue arising from the ever greater luxury of the feudal nobility, which was primarily responsible for its decline. This demand for additional revenue arising from the ever-growing luxury of the feudal nobility (Sombart, 1922, ch. 1) led to increasing pressure on the serfs to a point where they could bear it no longer. At the end it resulted in disappearance of the labor-force by which the system was nourished. It was these developments rather than the rise of trade which finally brought transformation of productive relations in the countryside.

But where did the vagrant serfs, asked the 'external'-force school, move to and to live on what? The serfs could not simply desert the manors, no matter how exacting their masters might have become, unless they had somewhere else to go. They needed a better source of livelihood, and they must have found a more remunerative job outside manors. When trade first began in the tenth century or before, it was in the sphere of long-distance, as distinguished from local, exchange of relatively expensive goods. Long-distance trade had a creative effect of generating a system of production for exchange alongside the old feudal system of production. The two systems interacted with each other so much so that feudal lords had to go. 'In England serfdom had practically disappeared in the last part of the fourteenth century. The immense majority of the population consisted then, and to a still longer extent in the fifteenth century, of free peasants proprietors, whatever the feudal title under which their right of property was hidden' (Marx, 1867: 788).

Now, disintegration of feudalism is one event; the emergence of capitalism is another story. The question of transition from feudalism to capitalism is not merely one of transformation in forms of economic and social institutions. The basic problem must be the change in the social existence forms of the labor-force. The question to ask about a given social structure is not whether commodities and money were present, but rather how those commodities are produced, how that money serves as a medium in production (Takahashi, 1952). In essence it is the status of human beings in society that differentiates capitalism from feudalism.

Western Europe's feudalism and the arrival of capitalism had an intervening period between them. Feudalism entered an acute crisis in the fourteenth century because of the extravagant profligacy of the feudal lords, and thereafter disintegrated; capitalism waited until the second half of the sixteenth century. The interim time between the two had no clear identity in terms of stage or the stage of society.

Capitalism, more precisely industrial capital, emerges in two ways. In one: 'the producer [free peasant] becomes merchant and capitalist'; in the other: 'the merchant establishes direct sway over production'. The first process is 'the really revolutionary path'. What is distinguishing the two is that the first one is 'in contrast to the natural agricultural economy and the guild-bound handicrafts of the medieval industries' (Marx, 1894:334). This conception of the 'revolutionary' origin of capitalism holds precisely in the history of Western Europe. According to the first path, a section of the producers themselves accumulated capital and took to trade, and in course of time began to organize production on a capitalist basis free from the handicrafts restrictions of the guilds. According to the second, a section of the existing merchant class began to 'take possession directly of production'; thereby 'serving historically as a mode of transition', but became eventually 'an obstacle to a real capitalist mode of transition', but declining later (emphasis added).

Behind the history that Western Europe took the first path—revolutionary—to capitalism lies the classical bourgeois revolution. In both England and France the revolutions had been based on the class of free and independent peasants and the class of small and middle-scale petty-commodity producers. It was a struggle for the state power between a group of the middle class and a group of the haute bourgeoisie originating in the feudal aristocracy, the merchant and financial monopolists. The formers routed the latter.

On the contrary, in Prussia and Japan the path for capitalism was paved by the patronage of the feudal absolute state. In general, the way in which capitalism took shape in every country closely depends on the previous social structure, of which the experience of India is a historic evidence. The organization of feudal land property remained intact and the classes of free and independent peasants as well as middle-class bourgeoisie were underdeveloped. The socio-economic conditions for establishment of capitalism were not present; capitalism had to make its way within an oligarchic system.

One could contemplate that ancient India had certain prospects to work for the purpose of transition to capitalism, more than two millennia earlier, about the time of Maurya Empire (320-120 BC), but it was thwarted by the then social conditions. Germination of the seeds of capitalism is induced by a combination of three elements: free land, free and independent labor, and entrepreneurs to invest capital. In the fourth century BC such a constellation of ingredients was available in India. The Maurya state during the reign of Chandragupta was the largest land-clearing agency, the biggest landowner, and the most enthusiastic landlord using serf labor of thousands of tribesmen hurdled into village settlements. Side by side, merchants were allowed to lease-in uncultivated crown lands, reclaim wastelands, clear forests, build villages, and get those fields cultivated by share-croppers. And the merchants were obliged to invest money in those frontier projects. By the time of coronation of King Asoka in 271 BC, difference between state-controlled farms and private farms had disappeared in favor of the latter. Those who plied the private-owned lands were neither slaves nor serfs of the type found in medieval Europe; they were all free and independent farmers. History records, the Maurya realm had 'a free working class without claim to land, vast virgin territory awaiting productive exploitation, and a class of merchants willing and able to invest capital in agriculture' (Kosambi, 1970: 151-52; 1975:225-26). Thus all ingredients to pursue the path to capitalism were present in ancient India, but it was blocked by social superstitions. Because the farmers were at the bottom of the social ladder; they all belonged to the sudra group, the lowest category in the scale of social standing. They were, by sacred religious dictums of lawgiver Manu, prohibited from accumulating resources to be an entrepreneur for any kind: 'A servant [sudra] should not amass wealth, even if he has the ability, for a servant [sudra] who has amassed wealth annoys priests'. Could a sudra borrow money? A money-lender 'may take as monthly interest two, three, four, or five percent, in order of class' (Doniger, 1991: 250, 167: italics added). That is, of the four classes in descending order of social status—brahman, kshatriya, vaishya, sudra —the fourth one among them would have to bear a burden of interest charge at the rate of as much as 60 percent per year. The 'revolutionary' (first) path of transition to capitalism was foreclosed. Takahashi (1952) refers to such types of social inhibition when he says :

'The question of the transition from feudalism to capitalism is not merely one of a transformation in forms of economic and social institutions. The basic problem must be the change in the social existence-form of labor power [labor-force]'. It is the core of The Laws of Manu that continues to hold the structure of a large part of India's social order till today, and there is no sign of its effective reform.

Europe had democracy as a byproduct of the rise of capitalism, whereas countries such as India, South Africa, and Zimbabwe, recently liberated from colonial bondage, have got their share of democracy the other way around: democracy precedes nascent capitalism. The society of these new-capitalist countries is exceptionally torn into multiple conflicts of tribes, sects, traditions, and the like. Capitalism has a problem, it faces a problem. It has two targets to meet, but only one instrument to handle them. Capitalism is known to have bred democracy, albeit for its own material interests. Democracy raises people's self-confidence and elevates demands for a better life, which capitalism cannot serve with satisfaction. It is said: by throwing one arrow you cannot touch two birds at the same time. Likewise, capitalism has only one tool at its hand, i.e. the payment of wages of workers. But increasing wages in order to satisfy them only results in erosion of capitalist's profits—a dilemma hard to resolve. On top of that there are myriad of unprecedented social unrests in newly-democratic semi-capitalist nations. They might offer fertile soils for the re-appearance of authoritarian capitalism ruled by the hand of the state with the support of monopolist capital. An authoritarian social-political system may emerge as an instrument of capitalism to compliment with the other one, namely, wages of workers.

Recently, a new species of political formation has been sighted. In the past the middle class (to be more precise, lower-middle-class and rich peasantry), had rarely, if at all, assumed the role of the ruling class. Now, specific conditions favoring the emergence of governments representing the interests of the middle class have arisen, in the developing countries in particular.

Three factors, namely, the numerical dominance of the middle class at the time of achieving independence from colonial bondage, the extensive involvement of governments in economic activities, and the availability of credits from global markets facilitate the middle class to rise at the top of the political ladder.

Michal Kalecki, an eminent economist from Poland, first recognized this phenomenon in 1964. He called the middle-class rule an intermediate regime, intermediate between the small land-holders and landless peasants from below; and the upper-middle class and feudal landowners from above. The regime hovers between full-scale private capitalism and complete socialist development; instead it resorts to state capitalism. To keep the power the ruling middle-class (a) must achieve not only political but also economic freedom; (b) carry out a land reform; and (c) assure continuous economic growth. India is a typical case of intermediate regime.

Dichotomy of Economy :Real and Financial
Marx opens Capital, Part 11, with the circuit of money-capital. 'The circular movement of capital takes place in three stages. First Stage : The capitalist appears as a buyer on the commodity and the labor-market; this money is transformed into commodities; it goes through the circulation act : M–C.

Second Stage : Productive consumption of the purchased commodities by the capitalist. He acts as a capitalist producer of commodities; his capital passes through the process of production. The result is a commodity of more value than that of the elements entering into its production.

Third Stage : The capitalist returns to the market as a seller; his commodities are turned into money; they pass through the circulation act : C+ .... M+.

Hence the formula for the circuit of money-capital is : M – C .... P .... C+ –M+, the dots on two sides of P indicating that the process of circulation is interrupted, and C+ and M+ designating C and M increased by surplus-value.

This description is about the commodity market, also called the real economy. Recently, another kind of market, i.e. the financial market, has emerged. Its circuit is thus: money M begets more money, M+, through the processes called securitization designated by S. This circulation can be written as : M – S – M+. This money market is a recent creation constituting the financial economy, which is outside of the economy that Marx dealt with.

Adam Smith is the founder of the modern economics. The classical school of Adam Smith and Leon Walras and its neoclassical refinement by Alfred Marshall shared a static view of the economy which was in a steady-state equilibrium being guided by an 'Invisible Hand. By contrast, Keynes living in the eventful period of the late 1920s followed by the Great Depression and World War II apprehended an economy that knew no time to rest, but for a fleeting moment of equilibrium if at all. The economy of Keynes's perception passes through cycles of boom, crisis, debt deflation, stagnation, recovery, or expansion. Thus he discovered a realm of ceaseless movement of 'states' in course of time. Keynes characterized his contribution 'as a theory of why output and employment are so liable to fluctuation.' That is to say, the Keynesian economy has two critical features, namely, relentless movement with changing states—boom, bust, stagnation, etc.; and an ergodic nature which makes it forget its initial state as it moves through time. Since the experience of the late 1960s, the world economy looks more like what Keynes visualized than what the classical or neoclassical theorists had imagined.

In pure theory, where government and foreign demand are ignored, employment depends upon the aggregate demand, i.e. consumption plus investment. Consumption demand is a passive element, it depends primarily on the level of income. Investment is the active, driving force causing that which must be explained, namely, fluctuations. To begin with, we shall analyze the general process of capitalist investment; then we shall take up the specific elements related to the present economic system.

Keynes has two theories of investment —one in the General Theory, the other in two articles written in 1937 in the course of rebuttal to Viner's critique3. First one is in terms of the concept of marginal efficiency of capital, the second one on the basis of asset price that makes a substantial difference.

Capital assets consist of real wealth such as buildings, plant, equipments, stocks of commodities, goods in course of manufacture, transport, and so forth. A fundamental theme of Keynes is that the asset-valuation process is the proximate determinant of investment. In a marked departure from the classical and neoclassical economics, it says that assets, in addition to having characteristics of annuities, may also provide protection by being sellable in the event that an uninsurable unfavorable contingency occurs. To an investor, the value (also called, demand price) of a capital asset has two components. One is the money that accrues as the capital asset is used in production; the second is the cash that can be received if the asset is sold or pledged. The ability of an asset to yield cash by selling it if and when needed is called the asset's liquidity. An investment may take place if the value of the asset exceeds its prevailing market price and the cost of financing is acceptable, subject to an acceptable probability of risk.

In terms of financing, three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified. Hedge financing units are those which can fulfil all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. The speculative finance units are units that can meet their payment commitments on income account on their liabilities, even as they cannot repay the principal out of income cash flow. Such units need to roll over their liabilities: e.g., issue new debt to meet commitments on maturing debt.

For Ponzi units, the cash flows from operations are not sufficient to fulfil either the repayment of principal or the interest due to outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Either way, it lowers the equity of a unit, and lowers the margin of safety that the unit offers the holders of its debts.

In an economy with sophisticated financial system, ‘stability is destabilizing.' To see how instability unfolds, we begin with an economy which has recovered from a slump and is on the way to a boom. Having come out of the ordeal of weak markets, units are now cautious in their portfolio management: debt-to-equity ratios are low and the profit to interest ratio is high. Because of their recent experience, both borrowers and lenders prefer rather conservative estimates of prospective cash flow; the risk premiums are high.

As the economy begins to gather momentum, managers and bankers come to regard the previously accepted risk premium as excessive. Investment projects are evaluated using less conservative estimates of prospective cash flows. With a stock market boom accompanied by investors' enthusiasm there is a reciprocating stimulus —a positive feedback—between speculation on stock exchanges and speculation by firms. A rise in the market price of common stock of a firm means that the market valuation of the firm has increased. To bankers and other financiers such market valuation implies that the firm can issue more debt and undertake additional commitments to pay. Furthermore, common shares, either by new public issues or by direct payment, being the virtual currency used to acquire capital assets, the price of capital assets falls in terms of the investor's virtual currency of common shares, even though their money price may have risen. The general decline in risk aversion thus sets off both growth in investment and rapid rise in the price level of assets, which is the foundation of both the boom and its eventual collapse.

The condition of momentary euphoria permits the rise of Ponzi financiers. These units profit by trading assets on a rising market, and incur significant debt in the process. The servicing costs of Ponzi debtors exceed the cash flows of the business they own. They thus help push up the market interest rate, and in effect increase the fragility of the financial system. Growth of asset values is reversed leading to a panic: the boom turns into a slump.

In short, Ponzi business, that is, reckless leverage, is the nemesis of financial markets which would fall from the peak of boom taking the economy down with them. The consequent depression is generally self-reinforcing in the absence of external stimulus. While the financial instability of Keynesian economics deals with the leverage within an economy, Bernanke and Krugman in their saving-glut thesis refer in essence to a comparable phenomenon at the international level.

Modern theory of finance was founded in early fifties as Harry Markowitz rigorously proved the merits of portfolio diversification. Risks of a portfolio are of two kinds, namely, systemic and specific. Systemic risk is the one that is common to all securities, which is also known as market risk. On the other hand, specific risk is related to a specific asset; each individual asset has its particular risk. The specific risk of a portfolio can be diversified away. Depending on the market, a portfolio of approximately 15 (or more) well selected shares might be sufficiently diversified to leave the portfolio to systemic risk alone.4

In the next decade, the capital asset pricing model (CAPM) was introduced. CAPM computes the theoretically expected return on a given asset with the help of three parameters, viz. the risk-free rate of interest, the sensitivity of an asset's return to the market return, i.e. the systemic risk (denoted by b or by beta), and the return on the entire market portfolio.5 Now, to get the present value, the future cash flow of the asset can be discounted using the percentage rate of return derived from the CAPM formula; and this estimated present value is theoretically the correct price of the asset. If the price observed in the market is higher than the valuation by CAPM, then the asset is considered overvalued (or undervalued if observed price is below the CAPM valuation). Investors would buy undervalued assets in the hope that the market price in equilibrium would conform to the CAPM model's computation. Assured with the CAPM technique, stock markets were rejuvenated.

The seventies heralded a profound mutation in finance literature with the arrival of a gene : the Black-Scholes options pricing model.6 Physicists, mathematicians and computer programmers have applied their skills to explore the relation between asset value and risk using the principles of relativity, quantum mechanics, and electromagnetic theory, within the framework of Black-Scholes model.7 No new branch of knowledge has ever developed so swiftly as finance did within a few decades of its birth. This record-breaking performance of finance has not been precisely an unmixed blessing.

A renowned professor of financial economics exclaimed: 'options pricing theory is the most successful theory in not only in finance, but in all of economics. On the other hand, a redoubtable American investor characterized options as 'financial weapons of mass destruction.' While the former was impressed with the logic of the model, the latter deprecated its possible practical fallouts. Each of the two comments has a kernel of truth.

The Black-Scholes equation is derived under the assumed condition of equilibrium of markets themselves. Equilibrium is a common and very powerful concept in physics: in equilibrium, numerical values we observe for quantities in a stable system are values that cause two opposite forces to cancel exactly. It demands that an option to stock and the stock itself be in equilibrium with each other, in the sense that their respective prices should each provide investors with the same expected return per unit of risk they carried. An investor would then be impartial between buying the stock and buying the option. This condition, written down mathematically, was the Black-Sholes equation; it determined the value of option. Robert Merton, working, in parallel, went deeper. He showed that there was a recipe for synthesizing a stock option out of a mixture of shares of stock and cash, a mixture whose proportions must be readjusted continuously over time by exchanging some shares for cash, or vice versa: a procedure known among theorists as dynamic replication. Looked at more naively, the fair price of an option can be expressed in terms of the current market price of the stock and the current price of a reckless bond. By this kind of reasoning, several economists, Paul Samuelson (1972) among them, had come almost imperceptivity close to obtaining the Black-Scholes formula before Black and Scholes.

We now know how to manufacture, for example, an IBM option by mixing together some shares of IBM stock and cash, much as we can create a fruit salad by mixing together apples and oranges. Of course, option synthesis must be somewhat more complex than making fruit salad, otherwise someone could have discovered it earlier. Whereas a fruit salad's proportions (say, 50 percent apples and 50 percent oranges) might remain fixed, an option's proportions must continually change. Options require constant adjustments to the amount of stock and cash in the mixture as the stock price changes. The exact recipe the option maker needs to follow is generated by the Black-Scholes equation which also tells the cost of following the recipe. This discovery accelerated modern finance. Dealers could now manufacture and sell options on any assets (by definition, an asset has cash flow), creating the precise degree of risk clients wanted without taking on the risk themselves. Conversely, they can deconstruct an option someone sells to them by converting it back to its ingredients and sell them in the market. Just as problem arises in the salad if some of the fruits were rotten, similarly in the case of subprime mortgage crisis in the US some of the housing mortgages were dubious.

The Black-Scholes equation is about option of stock, not of bond. Bonds are different from stock in that they have a known maturity date. Financial engineers, also known as quants, adapted the Black-Scholes to manufacture option of bond; instead of price of bond they focused on its yield. They now have to determine the range of future one-year rates at every year in the future. Their key principle was to think of longer-term bonds as being generated by successive investments in short-term bonds. Two years of interest is obtained by two successive one-year investments, the first at a known rate, the second at an uncertain one. At any point of time market has bonds of several maturity dates: one-year, two-year, three-year, and so one; quants would draw upon the information contained in those securities to determine the expectation of the market in time future.

The market's price for a two-year bond today depends on its view of the distribution of future one-year rates. From this perspective, quants could calculate the logical value of the current two-year bond yield, from the current one-year yield and the probability distribution of one-year rates one year hence. The probability is assumed to follow the normal distribution.8 Quants could measure the volatility (standard deviation) of the current two-year yield from the volatility of the distribution of one-year rates one year hence. Alternatively, working backwards, since the current two-year yield and its volatility is known from the current market, they can deduce the distribution of one-year rates one-year hence. Continuing in this way, the current yield curve at any instant could be utilized to figure out the range of all future one-year rates. With the bond's yield-flow now at hand, creating options of bond is a matter of mixing some cash or other riskfree assets with it.

This algorithm presumes three postulates, namely, general equilibrium, efficient-market hypothesis (EMH), and rational expectations (RE). EMH asserts that financial markets are "information efficient", that is to say, prices on traded assets such as stocks, bonds, or property, already reflect all known 'information;' it is impossible to consistently outperform the market by using any information that the market already knows. Information, or news, in the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.

Samuelson (1972) has proved that 'properly anticipated prices fluctuate randomly;' it takes us to the concept of rational expectations, which is a synonym of properly anticipated prices. The RE says that the actual price will only deviate from the expectation if there is an information shock caused by the information unseeable at the time expectations were formed. In symbol, the actual price P is equal to its rational expectation P*, only if e, the random error term, has a statistical expected value of zero and is independent of P*. Formally, P = P* + e, and E(P) = P*.

But, the degree of rational belief or probability, attached to a proposition, a, is conditional upon the evidence, b, written as a/b. For some simple cases, such as tossing of a coin to count head or tail, a/b can be assigned a precise numerical measure by understanding the objective circumstances. In other cases, more relevant to economics, objective criteria may not lead to any such precise quantification. Nevertheless, even in cases where no precise number can be objectively assigned, decisions need to be taken. And decisions are taken assuming as if some objective assignment of probability could be made. Keynes called such assigned probabilities subjective probabilities, in the absence of sufficient knowledge. Such subjective probabilities, assigned on the absence of sufficient knowledge, are subject to quick and substantial changes; and processes due to decision based upon such estimates can change both rapidly and markedly.

In addition to the objective or subjective probabilities, there is another subjective factor which informs decision-making. This is the weight or confidence with which the assigned probability is used as a guide to action or decision. There is, however, no way of replacing uncertainty with certainty equivalent (Keynes, 1930). Nonetheless, a redeeming feature is that the relevant probabilistic propositions in economics and the weight attached to such propositions change, not in a random or unpredictable manner, but in a consistent manner in response to events. That is to say, in terms of a/b, b may change, and with it a also may change in a consistent manner, but not necessarily be known to the market.

In quantum physics Heisenberg's uncertainty principle speaks of uncertainty, as its name suggests. But that uncertainty itself has a principle (Hawking, 1988: 53-61). By analogy, in economics, the future is uncertain in that it is not accessible to us; but, we know or assume, there is a cause which makes the future. From this viewpoint, the term e of the rational-expectations theory is not a random variable with the statistical expected value of zero; for e is cause-driven which negates the RE theory. In physics the chaos theory does not say that chaos is lawless. It can be conceptually captured and expressed in equation, though cannot be always accurately traced as Kelsey (1988) has explained in pure mathematics and Keen (1995) in computer simulation.

Markets operate with several models. Even calling data isn't as easy as it seems —models are everywhere. What one thinks as 'market data' are often prices filtered through another model or calculation. Yields are extracted from collections of bond prices. Volatility is calculated from historical returns. Each year, as markets mature, products become more liquid and traders calibrate their quotes to greater numbers of related securities, sometimes so many that their prices must be obtained via electronic price feeds. All of this involves software. Sooner or later everyone who creates a useful model gets exposed to the truth that building a trading and risk management system around the model is a huge and often overwhelming software project that requires many more programmers than quants. Models, critical though they are, are only a small part of the story. Hence, by no means, market is omniscient of everything including future probability distribution. To the market, future, therefore, may not be predictable; so no expectations can be 'rational.' "Emerging events can both change subjective-probability distribution assigned to future events and increase or decrease the confidence with which views are held" (Minsky, 1975 : 64-66 : italics added).

In the absence of so-called rational expectations there would be no random variable with predictable distribution, let alone the normal distribution. Equilibrium in the Black-Scholes model is supposed to equalize the risk-return ratio across all assets every year. But with the asset's price having no known distribution, its risk cannot be measured; so the proposed equilibrium is impossible.

An efficient-market is to have security prices accurately reflecting all available information. In the 1990s dotcom companies with no profits and barely any earnings were valued billions of dollars; and in 2006 investors massively underestimated the risks in bundling together portfolios of American subprime mortgages. Furthermore, investors are evidently capable of behaving irrationally. A study by the London Business School finds that the practice of buying the stockmarket's best performers over the previous time period - the investment strategy of momentum effect - is not always profitable. Since 1900 up to 2008, buying British stocks with the best momentum would have fetched 1.9 pounds per pound of investment. The same sum invested in the worst performers would have grown to 31 pounds. In efficient markets such anomaly should have been arbitraged away. The year-by-year risk-return optimizing process of the Black-Scholes algorithm might not be prudent all the time.

Then, what are all these models for? A veteran sage of quants has realized: 'A model is a model; you want to capture the essence of the phenomenon, not the thing itself. It is far too easy, in the name of realism, to add complexity to the simple evolution of stock prices assumed by Black-Scholes, but complexity without calibration is pointless' (Derman 2004:231).

Securitization : One of the proximate factors to help bring down financial markets around the world was the ingenious invention of costless manufacturing of derivatives. The idea of investment trust goes back to England and Scotland of one century and three decades ago. Mostly small investors pooled their resources by buying stock in an investment trust. This formation took three decades to reach the US, where it turned into a corporation and began to sell its own securities to the public. This innovation was the genesis of securitization as the creation of tradable security on the basis of a simple debt agreement. It brought about an almost complete divorce of the volume of securities outstanding from the volume of corporate asset in existence. The former could be twice, thrice, or any multiple of the latter.9

In order to stem inflation of the 1970s, the US followed a restrictive monetary policy which put banks at a comparative disadvantage in terms of short-term growth of their ability to fund assets, and favored the market-funding capabilities by nonbank financial entities. Securitization reflects this change in the weight of market and bank funding capabilities. It began in the mortgage market and extended far beyond.

The dotcom bubble burst in 2000. The Fed responded by cutting the federal fund rate from 6.5 percent to 3.5 percent within three months, and continued to lower rates —all the way to almost zero. Cheap money engendered a housing bubble, an explosion of leveraged buyouts, and other excesses. With money almost free, banks extended loans without regards to collateral. And financial innovations broke out: Wall Street produced a series of complex new securities. These included bonds backed by pools of mortgages, auto loans, credit card debt, and commercial bank loans—'tranched' (French for sliced) and sorted according to their presumed levels of risk; in other words, they were 'securitized,' having been transformed from simple debt agreements into securities that could be traded, just as with other bonds and stocks, among investors worldwide. These derivatives came to be known as collateralized debt obligations (CDO). Investment banks carried large portions of CDOs off their own balance sheet in so-called structured investment vehicles (SIV). The SIVs financed their positions by using asset-backed commercial papers. Thus the original lenders, banks, washed their hands off the liabilities of securitization, once the derivatives were manufactured and passed on to SIV. As the value of CDOs came into question, the asset-backed commercial paper market dried up and the investment banks were forced to bailout their SIVs. A financial crisis broke out in mid-2007. Stockmarket meltdown would come in the following year.

This type of securitization came to imply that there is no limit to bank initiative in creating credits for there is no recourse to bank capital, and because the credits do not absorb 'high-powered' money, i.e. bank reserves. Both capital and reserve absorption may occur at the initiating stage of the credit, that is, before the securities can be created and sold. Securitization is thus infinitely creative; it lowers the weight of that part of the financial structure that the central bank is committed to protect.

Now, some of these CDOs, in turn, were treated into another form of CDOs, repeating the process apparently at infinitum. Moreover, in no time, options of these CDOs could be created into a series of CDS (credit default swap) of different mixes, some built upon the shoulder of another in the pattern of an inverted pyramid. Should a crack appear somewhere at a point of the pyramid, the whole edifice would collapse.10

The expansion of finance has outstripped the growth of the 'real' economy. Here is some indicator. In 2006, the estimated output of 'real' economic goods and services of the world was about 50 trillion dollars. The total market capitalization of the world's stock markets and the total values of bonds added up to 120 trillion dollars. The volume of derivatives—contracts derived from securities such as interest swap, or credit default  swap (CDS)—has grown even faster, so that by 2007 the notional value of all over-the-counter (excluding those traded on public exchanges) was some 600 trillion dollars. In short, the cited financial products were more than 14 times the output of'real' goods and services.

The real economy produces goods and services for our consumption and for investment in factory and farm (machines, equipment, and gadgets of construction). The financial sector produces the mediums of exchange and instruments of ownership. Conceptual disjunction between real economy and finance can be perceived from the following illustration. In finance, the systemic risk is equivalent to the market risk, that is, the risk of a market portfolio, remaining after having been diversified enough to eliminate specific risks. The CAPM measures the market risk as the excess of market return over riskfree interest rate: in symbol, (rm–rf); see Note 5 below. In the real economy, on the other hand, a firm in dire crisis such as the hedge fund, Long-Term Capital Management, being short of liquidity a few years ago, was considered "too-big-to-fall", that is to say, it was declared a case of systemic risk to the economy. Similarly, not long ago, the General Motors was apparently on the brink of bankruptcy; if so, it would have been another sample of systemic risk to the economy as it provides, directly or indirectly, sustenance to thousands of people.12

The economy comprising of two segments, viz. the real economy and the financial sector, is governed in theory by two separate sets of principles: one concerned with real commodities, the other with their financial counterparts. The economics literature has not yet assimilated them. Despite its increasing real world prominence over the centuries, financial capital never gained analytical status within the hard core of economic theory. In particular, unlike the 'real' capital, it failed to be integrated into the theory of value and distribution (Burgstaller, 1994:3-10; Sau, 1997).

Consider, for illustration, the case of Ricardo. In his corn model, two resources exist at a given moment: a periodically constituted wage fund and land. In the two-good version of the model Ricardo shows how competition entails both a determinate land rental and an sector-wise uniform rate on corn. The latter, of course, is the well known principle of uniform rate of profit—the guiding idea in classical and Marxian thinking of capitalist competition.

Ricardo, however, has not asked this question. What happens if a stock exchange springs up and allows instantaneous and quasi-costless exchange of equity claims on wage fund and land? He has not analyzed the consequences for the dynamics of a capitalist economy due to the equalization of profit rates, not merely across sectors of production, but also across all forms of wealth holding.
Modern theories of general equilibrium suffer from the same limitation. In the celebrated Arrow-Debreu model equity markets are conspicuous by absence, the problem of value being analyzed as one of only flow-pricing of inputs and outputs. The fact that wealth-holders must at each instant be satisfied with the stock composition of their instantly tradable portfolios of ownership claims, is wrongly thought to be of no consequence for the determination of relative prices.

A similar statement can be made on finance. Financial engineering has advanced with the insights of economics, physics and mathematics. But its theoretical literature is oblivious of the real economy. Models of partial equilibrium are myopic unless seen in the perspective of general equilibrium, both microeconomic and macroeconomic.

Depression? From the non-monetarist point of view, a sharp economic downturn might be initiated by two kinds of deficit—the one of aggregate demand, and the other of aggregate supply. The latter refers to the inflexibility of labour markets. In their classic study on US monetary history, Friedman and Schwartz (1963) presented a monetarist interpretation of the Great Depression arguing that the main lines of causation ran from monetarist contraction—the result of poor policy-making and continuing crisis in the banking system—to declining prices and output. Opposing the monetarist version, Temin (1976) contended that much of the monetary contraction in fact reflected a passive response of money to output; and that the main source of the Depression lays on the real side of the economy—for example, the famous autonomous drop in consumption in 1930. To some extent the proponents of these two views argued past each other, with monetarists stressing the monetary sources of the later stages of the Great Contraction (from 1930 until 1933), and anti-monetarists emphasizing the likely importance of non-monetary factors in the initial downturn. In short, the real economy was affected first, and it dragged monetary and financial sectors on its trail (Bernanke, 2004:6-7).

In the present context of global recession, decline in aggregate demand seems to have been a dominant factor. Well before the stock market strains came to light in September 2008, the real economy was weakening under demand deficiency. Since the early summer the prices of various kinds of steel had fallen by 20 to 70 percent, iron ore was down by a third, and the key rate of bulk shipping of commodities such as iron ore, coal, and grain was down by more than four-fifths. The most spectacular reflection of falling activity has been the Baltic Dry Index (BDI), which traces prices for shipping bulk cargoes around the world from producers such as Brazil and Australia to markets in America, Europe and China. By October, the index had plunged 86 percent after hitting a record high in late May. The consequent monetary instability, in turn, would rebound on the real economy with vengeance.

In the course of explaining the Great Depression, Galbraith (1961:173-99) cited five causes of the severe and prolonged downturn, of which at the top of the list was this : 'The Bad Distribution of Income.'13 Throughout the 1920s production and productivity per worker in the US grew steadily. In the decade to 1929, wages, salaries and prices all remained comparatively stable. Accordingly, costs fell and with prices the same, profits increased. These profits sustained the spending of well-to-do, and they also nourished at least some of the expectations behind the stock market boom. Most of all they encouraged a very high level of capital investment. The rate of increase of durable consumer goods such as cars, dwellings, home furnishings, and the like, much of it representing expenditures of the well-off to well-to-do, was six percent. The rate of increase of non-durable consumer goods—a category that includes such items of mass consumption as food and clothing—was a mere half of it.

In 1929 the rich were indubitably rich. Five percent of the population with the highest income in that year received one-third of all personal income. The proportion of personal income received in the form of interest, dividends and rent - the income, broadly speaking, of the well-to-do - was about twice as great as in the years following World War II. The highly unequal income distribution meant that the economy was dependent of high level of investment or a high level of luxury consumer spending, or both. But both were especially susceptible to the crushing news from the stock market in October 1929.

The story of American income distribution in the decade to 2009 bears significant resemblance with the above narrative about the US of eight decades before, especially in respect of "the bad income distribution." To be more specific, the year 1979 marked a watershed in the annals of income distribution, compared between the preceding three postwar-decades on the one hand, and the following three decades on the other. The former offered growing equality; the latter an unmistakable trend of soaring inequality. This transformation was initiated by the policy of deregulation and assisted by financial expansion.

The 1980s were a golden age of financial wheeling and dealing; and explosion of profits in financial operations helped swell the ranks of the really rich - those earning hundreds of thousands or even millions a year. Also, it became the first decade since the 1930s in which large numbers of Americans actually suffered a serious decline in living standards (Krugman, 1990:19-24). The top 20 percent of taxpayers absorbed three quarters of all income gains from 1979 to 2000. The financial-services sector's share of total American corporate profits rose from 10 percent in the early 1980s to four times as much in 2008.

In wealth distribution, top one percent of US householders now account for as much of the nation's total wealth—not less than seven percent—as they did in 1913, when monopolistic business practices were the order of the day. Now, the net worth of this top one-percent is greater than that of the bottom 90 percent of nation's households combined (Kotkin, 2009).14

On the derivative securities, 'the view in Chicago is that the world's economic system has never been better protected against the unexpected" (Ferguson, 2008:228). "The fact nevertheless remains that this financial revolution has effectively divided the world in two: those who are (or can be) hedged, and those who are not (or cannot be).' Hedging is expensive. "Hedge funds typically ask for a minimum six-or-seven-figure investment and charge a management fee of at least 2 percent of your money and 20 percent of profits." Most big corporations can afford to be hedged against unexpected increases in interest rates, exchange rates, or commodity prices. If they want to, they can also hedge against future hurricanes or terrorist attacks. By comparison, most ordinary households cannot afford to hedge at all and would not know how to.

Rapid expansion of finance may come into conflict with the real economy. "Each of the two branches of business [real economy and finance] utilizes certain part of the total stock of money" (Keynes, 1930:27). The "monetary base", or the "high-powered money" consists of the total liabilities of the central bank, that is, cash plus the reserves of private sector banks. The high-powered money, being issued by the central bank, is exogenous. The "total stock of money" in this sense is fixed; the sum of demands on it by the two branches of business may exceed the supply. Such a situation is not unlikely in the present circumstances.'15

Structure of the Economy : Bernanke has identified too-big-to-fall corporations, extensively interconnected, as possible avenues of systemic risks in the economy. Keen(1995) simulated a macroeconomic model which displayed tendency toward chaotic motion. Who does not know that stock markets and currency markets are not always well-behaved? In pure theory too it can be shown that, with simple reasonable assumptions, markets of stocks and currencies may move in complex patterns, described as chaotic.16

In the last three decades, globalization brought over a billion workers to the world marketplace from economies that had been insulated so long. These workers being geographically immobile, foreign capital rushed to their location. In the process America suffered an industrial decline not only in older manufactures such as textiles, iron and steel, shipbuilding, and basic chemicals, but also in global shares of robotics, aerospace, automobiles, machine tools, and computers. The second sector of decline was agriculture. Joseph Stiglitz says 'the present economy [of America] is largely a service sector-based one.' Meanwhile, entry of one billion workers into the global workplace reduced world wages, inflation, and interest rates. Cheap imports into the US encouraged common consumption and the luxury expenditure by the well-to-do who had amassed huge wealth. Personal savings shrank to zero by 2007, leaving nothing of the national output for investment. As a result, the economy was thrown into a complex orbit, if not a chaotic one.

The crystal-ball of Ferguson had flashed an ominous massage that a financial crisis would signal the twilight of America's supremacy. That was last year. It was followed immediately by a reassuring image on the same screen: "But it is much too early to conclude that the American century is over" (Ferguson 2008b).

The current trend of de-industrialization of the US is obvious. Optimists, however, maintain that the country, putatively the leading pioneer of technology, has absolute dominance in scientific research in such crucial fields as nanotechnology and biotechnology, mother of the industries of future. In course of time America would establish formidable comparative advantage in designing downstream industries. And, of course, best industry of the US is in the realm of knowledge personified by its universities which attract the best talents from all over the world (Zakaria, 2008a, b).

But, it appears, the leap of research findings from the country's science labs to the tests of experiment for innovation and then to factories to fashion marketable products is a long haul, maybe as long as half-a-century, too much of a wait. Meanwhile, the proverbial foreign students after completing their study in the US would head back to their homeland until America's industries of future mature enough to come out of their incubation.

Some financial crises are endogenous, formed and burst both within the financial sector. Such disturbances happen every ten years without leaving behind durable footprint. But the other kind of financial meltdown which emanates from economic recession, if prolonged, might transform the global economic landscape. But a depression like that would bear upon many a country more or less. Which ones among the countries of the world would be affected relatively less or recover faster? Answer to this question holds the key to America's future status. One can add that the US economic resurgence is contingent upon two critical conditions: on the one hand, improvement of the rate of savings and of concomitant investment, and on the other, significant moderation of the 'bad income distribution,'—not an easy task.

The Scope of Capitalism
Within five centuries of its life capitalism has made remarkable progress in the sphere of scientific discovery, innovation, invention, and technology. The information system - Internet, cellphones, wireless bandwidths, and social networks - has brought billions of people into a global conversation. So many now have access to education and cheap tools of innovation, innovation that happens from the bottom. An active middle class has arisen to the high point of leading political uprising of the Arab Spring. The Tahrir movement in Egypt, for example, was launched by young professionals, mostly technicians, doctors, and lawyers.

It was not about technology alone. As the Russian historian Leon Aron has noted, the Arab uprisings closely resemble the Russian revolution of 1991 in one key aspect: 'They both were not so much about freedom or food as about dignity.' 'It is the quest of dignity.' 'Dignity before bread' was the slogan of the Tunisian revolution. 'The spark that lights the fuse is always the quest of dignity,' said Aron. 'Today's technology just makes the fire much more difficult to put out.'

The conversion of a feudal territory into a field of capitalism involves social and intellectual initiative and adjustment. An increasing number of people are needed to take part in various scientific and industrial projects at quite humble levels - as printers, clerks, factory workers - and in order to acquire a modicum of the new standards, they have to receive some kind of education. More people are needed to buy the mass-produced of goods. In order to keep the economy growing, an increasing number of people have to live above subsistence level. As more of the workers become literate, they demand a greater share in decisions of government. If a nation wants to use all its human resources to enhance its productivity, it has to bring groups who have hitherto been segregated and marginalized. Religious differences and spiritual ideals must not be allowed to impede the progress of society. Thus the ideals of democracy, pluralism, toleration, recognition of dignity, human rights, and secularism are not simply concepts of political imagination, but essential for a modern society to make progress.

Capitalism engenders democracy; the two have a contradictory relation. For the capitalist pursues profits, while labor seeks self-development. In consequence, capitalism is burdened with two 'targets': on the one hand, make maximum profits; and on the other, help human development. By the process of division of labor capitalism creates an underclass, often poor and deprived of social standing. It is thus over-determined, having the aforesaid two targets, but only one 'instrument', i.e. wages of labor. It cannot, therefore, have a unique trajectory of stability or equilibrium. Conflict between capital and labor is perennial; capitalism knows no permanent solution; hence the outcome is unpredictable.17 However, capitalism at a certain stage might turn into imperialism.

Concluding Remarks
Feudalism and communism obey the rules of Darwinian evolution, as it were: pedigree shapes their form. European feudalism was separate from Indian feudalism; likewise French capitalism is not like its American counterpart. By definition, of course, capitalism has some unique properties everywhere.

Marxian literature is concerted with capital, labor, and commodity. It gives little attention to society and individual. 'But the social order is a sacred right which is the basis of all other rights. Nevertheless, this right does not come from nature, and must therefore be founded on conventions', —Jean-Jacques Rousseau. Capitalism is not about commodity alone, it impinges on many aspects of human life. In 1848 Germany's history, the bourgeois paved willy-nilly the way for democracy; but also hindered it in many ways. The prevailing theory of capitalism, thereby, exposes it with narrow view, a tendency of 'reductionism.'

Capitalism continues with its evolutionary mood; it would not rest in steady-state equilibrium. Finance overwhelms commodity market and it would go on with innovations. The middle class in society holds a possible balance between capital and labor. Greed of capitalists has not receded; deprivation of the underclass remains. Technology opens new doors of production, but at the same time it works for attempted destruction of it all. A 'structural' analysis would tell a fuller story of capitalism. In this case, pure theory and empirical experiment would be mutually complementary.

Notes :
1.    'Comparative advantage' is distinct from 'absolute advantage'. Consider two persons, A and B. Person A is proficient in the practice of law in court as well as in typing, so much so that he excels B in both professions. In that case, A is said to have absolute advantage in all vis-a-vis B. Person B has little knowledge of law, but he is good in typing, so he does not have absolute advantage in any of the two areas. Nevertheless, B has comparative advantage, relative to A, in typing, in the sense that he is less 'worse' in typing than in law. By similar logic A has comparative advantage in law. Income in law practice is higher than that in typing works. It would be prudent for both, if A takes up law, and B does typing; and it is optimal for the economy as a whole. The central meaning behind this exercise is that everyone in general has comparative advantage in one activity or the other. This theory proposed by Ricardo has an implicit assumption: every one in the economy is employed; the economy is in the state of full employment. Mercantilists were not aware of this theory.

2.   According to the orthodox interpretation of Hicks, Hansen, Samuelson, and Solow, a Keynesian economy has a short-run equilibrium with less than full employment, but it would eventually tend towards full employment provided the endogenous variables of the system are flexible. This theory came to be-labeled as the neoclassical synthesis.

3.   For the Keynesian theories of investment, see Keynes (1936; 1937a and b).

4.   As a rule, portfolio risk declines as the number of stocks in the portfolio increases. The extent of the decline due to the added stocks depends on the degree of correlation among the stocks. The smaller the correlation coefficients, the lower the risk is in a large portfolio. A set of stocks whose correlations were zero, all risks will be eliminated. Since some individual stocks are riskier than others, some stocks will help more than others in terms of reducing the portfolio risk.

5.   The CAPM equation is as follows: r\ ¦ rt + b\(rm -rf), where i represents a stock in the portfolio, r, the return on stock i, rf risk-free interest rate (usually the Treasury bill is taken as a proxy), bx the beta of the stock, and rm the return on the market portfolio as a whole; (rm - r{) is known as the market premium or risk premium. Evidently, it is a linear equation, with r{ and rm being given parameters: so r, linearly changes with b\, that is to say, returns of all stocks fall in a straight line according to their respective beta. The assumptions of the model are: a) all investors have rational expectations; b) all investors are risk averse; c) returns are normally distributed; d) the quantity of assets is fixed; e) capital markets are perfect; f) financial and production sectors are mutually independent; and g) the risk-free interest rate exists.

The buyer of a call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial asset from the seller ('writer') of the option at a certain time (the expiration date) for a certain price (known as strike price). A put option is just the opposite: the buyer has the right, but not the obligation, to sell an agreed quantity of something to the seller of the option. The intrinsic asymmetry arises from the fact that the buyer of option has right sans obligation, whereas the seller has obligation all the way.

The invention of radar and the construction of the atomic bomb confirmed the usefulness of physics to postwar governments. Shocked by the successful voyage of Sputnik, the US Departments of Defence and Energy began to fund pure research more copiously, and physicists received grants to do research in view of the spin-off benefits of their work. Physics departments in the 1960s grew and academic posts multiplied. A wave of ardent graduate students entered the filed. By the end of the Vietnam War a deteriorating economy and a public revulsion with science in the service of war made research grant scarce. During the following two decades job prospects in academia dimmed. A number of physicists were gravitated to the financial services markets. Physics has always been concerned with dynamics, the way things change with time, not of prices of stocks or bonds, but of particles of nature. Physicists and engineers were simultaneously skilled mathematicians, modellers, and computer programmers who prided themselves on their ability to adapt to new fields and put their expertise in practice. Wall Street began to beckon them. In the 1980s so many physicists flocked to investment banks that one head-hunter referred to them as "POWs" - physicists on Wall Street. Formerly called 'rocket scientists' by those who mysteriously thought rocketry was the most advanced branch of science, they are now commonly called 'quants'. Quants and their cohorts practice 'financial engineering', better termed quantitative finance (Derman, 2004, pp. 2-5.)

'In the Black-Scholes model, for instance, one assumes that future stock returns lie on the common bell-shaped distribution. This distribution is specified when you know the parameters that determine its centre and width; or to put more mathematically, its mean and its standard deviation (Deaman, 2004:214). Galbraith (1962: 51-70) cited securitization as a factor to explain the Great Depression.
Soros (2008: xviii) symbolized the series thus: "Enterprising investment banks sliced up CDOs and repackaged them into CDOs of CDOs, that is, CDO2s. There were even CDO3s." And so on. See also Zandi (2009: 10-13). Ferguson (2008: 64) wrote: the prime cause of the financial crisis that began in August 2007 'had relatively little to do with traditional bank lending, or indeed, with bankruptcies. ... Its prime cause was the rise and fall of securitized lending which allowed banks to originate loans but then repackage and sell them.'

Keynes (1930:217) calls them respectively 'industry' and 'finance.' By industry he means: 'the business of maintaining the normal process of current output, distribution and exchange and paying the factors of production their incomes for the various duties which they perform from the first beginning of production to the final satisfaction of the consumer.' By finance, on the other hand, he means: 'the business of holding and exchanging titles to wealth (other than exchanges resulting from the specialization of industry), including stock exchange and money market transactions, speculation and the process of conveying current savings and profits into the hands of entrepreneurs.' In his speech on financial reform to address systemic risk, Bernanke (2009) said in part: "First, we must address the problem of financial institutions that are deemed too big - or perhaps too interconnected - to fall. ... The first element of my proposed reform agenda covers systemically important institutions considered individually. ... Macro-prudential policies focus on risks to the financial systems as a whole.'

The other four causes cited by Galbraith were: the bad corporate structure, the bad banking structure, the dubious state of the foreign balance, and the poor state of economic intelligence (Galbraith, 1961: 179-91). Keen (1995) simulated an extended version of Minsky' financial instability hypothesis, using the format of Goodwin's nonlinear, time-dependant limit cycle model. His four basic insights also included "the devastating impact of income inequality", together with the following three: the tendency of capitalists to incur debt on the basis of euphoric expectations; the importance of long-term debt; and the stabilizing effect of government. Introduction of these concepts into Goodwin's framework converts his stable but cyclical system into a chaotic one, with the possibility of a divergent breakdown—the simulation equivalent of depression.

"No one stays happily on the Wall Street for long. The people who work there don't usually think of it as an avocation, like physics or medicine. Instead, most investment bankers want to get rich as fast as they can and then retire. ...[T]he route to getting really rich was to become a partner and acquire a stake in the profits of the firm. Those who succeeded in gaining a partnership tended to last another decade or so and then retire, some voluntarily, some forcibly. Many partners were gone by their late thirties." (Derman, 2004, p. 175). "If the late nineteenth century was the era of the robber barons, the 1980s were to even greater extent that of the financial wizards. Indeed, the achievements of the sudden rich of the 1980s in many ways eclipsed those of the robber barons. The great nineteenth-century fortunes grew slowly, along with the enterprises they were tied to: mile by mile of railroads, steel mill by still mill, refinery by refinery. The great fortunes of the 1980s came swiftly, sometimes in a matter of weeks, and often while their owners were still young to enjoy them to the fullest. The emergence of sudden wealth in the financial markets is one of the greatest spectacles of the age." (Krugman, 1990: 153-54).

Today the volume of private trade in currency is a staggering daily volume of some two trillion (1012) dollars. Less than two percent of this trade is meant for financing export and import of goods and services, and even less for financing the current level of direct foreign investment. That is to say, not even five percent of the currency exchange is engaged in international trade of goods and services or direct foreign investment. It implies that the remaining, over ninety-five percent of those transactions are pawns at the hand of speculators in currencies. No less amazing is that evidently four-fifths of speculative currency trade involve round-trips of as little as seven days or less; and more than two-fifths of those transactions incur round-trips of two days or less. These trips are motivated by short-range expectations and risks, not at all by long-run fundamentals. It thus reveals that huge amount of "cash" is being diverted from potentially productive use in industry to the gamble of currency speculation. Moreover, all this is "hot money", short-term restless guest. Hot money can bring down, in a few days, a country's economy to its knees by hostile withdrawal (Felix and Sau, 1996; Haq et al, 1996;Tobin, 1978).

Conditions of Chaos in Currency Markets: Consider a country's currency (home currency) traded in global currency markets. Let e represent the price of foreign currency in terms of the home currency. Interest rate at home is denoted by /, and foreign interest rate by /*. The covered interest rate parity means: (1) /, = /* - (et+ , - ex)lex, where subscript / indicates time. Suppose that high interest rate at home attracts foreign funds, and as a result the home currency appreciates. In symbol: (2) et = a + b(it - /'*); foreign interest rate i is assumed to be constant. Rearrange (2) to find the value of /, and use it in 1) to get: (3) et+i = et(u - e{)lb, where u = a + b. Construct a variable: (4) xx = et/u. From (3) and (4) follows this equation: (5) xt+1 = rx,(\ -xt), where r = ufb m (1 + a/6). It is a mathematical theorem that for r having value between 0 and 4, there is at most one cycle which is stable. The cycle that is stable changes as r increases. For r between 0 and 1, the stationary solution is stable. In (5), however, r is greater than 1. At r ™ 3, the system undergoes a bifurcation. That is, there is a change in the structure of the set of solutions. After r = 3, the solution is no longer stable. Although the difference equation (5) is completely deterministic the behavior of the system appears random. Practical attempts to observe the system will involve errors, in initial measurement, and rounding errors in computation. The concomitant gap in our knowledge implies another "uncertainty principle" (apology to Heisenberg), this time it's in economics, or another source of systemic risk in the real economy. It is this kind of behaviour which has been called chaotic. At r = 4, the system crosses the Rubicon: at 4 and beyond, many complicated changes occur in the system—a mathematical equivalent of depression. (Devaney, 1989; Kelsey, 1988; Sau, 1995, 1998a, b). 17. For the unique solution, a linear simultaneous equation system generally needs as many endogenous variables as there are independent equations. But capitalism has two equations (representing two targets relating to respectively capitalist's profits and labor's human development), but one variable (wages of labor) that it can manipulate. Hence the system is over-determined with possibly no solution. It would become determinate if there were another endogenous variable (Tinbergen: 1952).

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Frontier
Vol. 45, No. 14 - 17, Oct 14 - Nov 10 2012

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