Karl Marx thought that capitalism sowed the seeds of its own destruction. He thought that capitalism destroys itself because of its endless search for surplus value. This surplus value gets reinvested in more capital-intensive means of production, which substitutes for labor. This action decreases the returns on capital, until eventually capitalism turns in on itself.
That is one way to look at it. But Karl Marx’s analysis was incomplete, and therefore erroneous in his inevitable conclusion.
He did not anticipate the cleverness of many capitalists, particularly American financial institutions. He did not anticipate the value of debt, using other people’s money, to increase the returns on capital, when equity capital alone could no longer do the job. He did not anticipate the values of doubling down to win over the market place. After all, when everybody else is shrugging and thinking, “enough leverage already!”, who ultimately grows and eats everybody else’s lunch? That’s right, the one who’s not afraid to grow the most, regardless of the risk.
Many fall by the wayside because of the risks of leverage. But not if you know the tricks of the trade. Wall Street knows the tricks, which mainly involve accounting deception, using various derivative and off-balance sheet transactions.
Accounting gimmicks may actually just be a symptom rather than a cause of financial instability. It is a symptom of an economy where everybody is looking for yield, for investment return, where everybody thinks firms should either grow at a constant 10%, 20%, or 30%, otherwise, investors will flock in droves to the next hot entity.
How silly is it to expect a perpetual 10% increase in return? A one million dollar profit today, growing by 10% annually, will be a $2.4 million profit expectation in ten years. In twenty years, it’s $6.1 million. And if the growth expectation is 20% annually? $1 million today will grow to $5.2 million profit expectation in ten years, and $32 million in twenty years. What if it's 30% growth?
Before long, those little companies that met your 20% annual growth expectations could already make up 40% of the entire economy. Now is that realistic?
But if through the use of leverage, a firm is able to grow - much, much bigger than its competitors, it is now in a position to either: beat them down, eat them up, or take them to the cleaners.
There is another secret power that leveraging up provides the firm, particularly a capital intermediary, whose market positions affect the over-all valuation of the entire capital system. It gives them the power to realign the system. Eventually, if they grow overly big, overly leveraged, and overly connected to the system – they become too big to fail.
Too big to fail firms know this. Their failure can never be as clean as any other firm’s, because they are a pipeline of capital to the economy. Financials can take the entire economy hostage if they fail. So the goal is to become overly big, overly leveraged, and overly connected to the system.
The rules of capitalism are the rules of the jungle. The simple over-arching rule is: the biggest, strongest, fastest , will survive and thrive. But we are not animals. And not everyone can be the biggest, strongest, or fastest. If the competitors in the capitalist jungle are all thinking, scheming humans, who eventually thrives?
That’s right. The one who can credibly convince everybody else that his demise will result in the demise of the jungle itself. This is where the forward motion of capitalism will end. Not with the end of surplus value. Humans proved too clever to be stuck with a dreadful law such as that. It will end when the only remaining key players all have the ability to blow up the capitalist jungle all by themselves.
Financials can take the entire economy hostage if they fail. Remember that the next time you expect your investment in financial firms to perennially grow by double digit rates. Remember that in the next leg up in the growth of already too big financial firms.