In this book summary of Sapiens, we review Chapter 16: The Capitalist Creed- How credit was born and how we started trusting the future.
Sapiens is like a marathon. The author starts from around 13.5 billion years before the present time and then tirelessly moves towards the present time and even beyond. While as a child I always found history very boring but after viewing a couple of videos about the book on YouTube made me curious. I feel a slow and thoughtful reading of the book can help anyone learn a lot about the evolution of mankind. But as I am writing this piece for an investment blog, I guess, limiting myself to the chapter of The Capitalist Creed makes much more sense.
The author, in the opening page of this chapter, makes an intriguing point as mentioned below:
“To understand modern economic history, you really need to understand just a single word. The word is growth. For better or worse in sickness and in health, the modern economy has been growing like a hormone-soused teenager. It eats up everything it can find and puts on inches faster than you can count.”
Growth is not a new concept or a concept designed by the modern economy. It was understood even in the pre-modern era. But as we move further we will discover how the pre-modern era remained a frozen economy for many years. Not because they did not have the ability to grow. It was a psychological problem. Let’s dig further into that problem…
Entrepreneur’s Dilemma (The Pre-Modern Era)
In the pre-modern era, humans believed that the total amount of wealth was limited. So, they considered it risky to assume that they personally, or their kingdom, or the entire world would be producing more wealth ten years down the line.
Hence it basically created an Entrepreneur’s Dilemma as shown above. There was no money to begin with. So when you don’t have the money you can’t pay the contractor to build a Bakery.
As it is not possible to construct a bakery, the cakes will never be produced. Since the cakes can’t be produced, there can’t be any trade and hence no profits and eventually no growth.
In the next segment below, let’s find out how a simple idea in the modern economy solved this problem and how growth came and came at such a swift pace that nobody could have envisaged.
The Magic Circle of the Modern Economy, Trust in the Future and Birth of Credit
The author writes as below:
“Humankind was trapped in this predicament for thousands of years. As a result, economies remained frozen. The way out of the trap was discovered only in the modern era, with the appearance of a new system based on trust in the future.
In it, people agreed to represent imaginary goods- goods that do not exist in the present at the expense of the future. It’s founded on the assumption that our future resources are sure to be far more abundant than our present resources.
A host of new and wonderful opportunities open up if we can build things in the present using future incomes. “
Doesn’t it sound similar to how today venture capitalists keep funding e-commerce start-ups where things are built in the present using future incomes? So they are also doing the same thing of having a trust in the future that these start-ups would grow and eventually be profitable. People like you and me keep raising our eyebrows as to how these start-ups get funds when their profits seem so far away.
People in the pre-modern era went through the same dilemma which we are going through today.
Here’s another example, a vacation ownership company promises you a week of holiday for the next twenty-five years. Now, you might be thinking that as so many people are joining the members’ list of the company, how the company will expand its count of resorts and rooms so as to cater to so many members which keep on increasing every year. It again uses the same philosophy where things are built in the present using future incomes. You can call it credit or leverage.
Since the customer pays them the full amount for the twenty-five years of service in advance, they have financial leverage which they use to build the present in order to grow and benefit all the stakeholders in the future.
Mr. Warren Buffett, in his 1995 letter to shareholders, makes the same point in a different way:
“Any company’s level of profitability is determined by three items:
- What its asset earns
- What its liabilities cost
- Its utilization of “leverage”
That is the degree to which its asset is funded by liabilities rather than by equity.
Over the years, we have done well on Point (i), having produced high returns on our assets. But we have also benefitted greatly-to a degree that is not generally well-understood-because our liabilities have cost us very little.
An important reason for this low cost is that we have obtained float on very advantageous terms. The same cannot be said by many other property and casualty insurers, who may generate plenty of floats, but at a cost that exceeds what the funds are worth to them. In those circumstances, leverage becomes a disadvantage.
Since our float has cost us virtually nothing over the years, it has in effect served as equity.”
Now coming back to our point, we get to know that this wonderful arrangement of credit basically changes the Entrepreneur’s Dilemma into A Magic Circle of Modern Economy as shown below:
The mantra of the New Capitalist Creed: “The Profits of production must be reinvested in increasing production”
After demonstrating the advantages of credit, the author moves further to establish how important growth is and how the belief in the growing global pie eventually turned revolutionary.
He later brings the argument presented by renowned economist Adam Smith in the eighteenth century.
In his classic book, The Wealth of Nations, Adam Smith made an argument, “When a landlord, a weaver, or a shoemaker has greater profits than he needs to maintain his own family, he uses the surplus to employ more assistants, in order to further increase his profits. The more profits he has, the more assistants he can employ. It follows that an increase in profits of private entrepreneurs is the basis for the increase in collective wealth and prosperity.”
Does that ring any bells? Well, it reminds me of two things. Firstly, I again recall Buffett when he said something like this to his shareholders in his 1992 letter:
“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”
So, Mr. Buffett concurs with Adam Smith on the point that profits of production must be reinvested in increasing production.
Secondly, all investors with a long term view in the stock market agree with Adam Smith on the point that increases in profits of private entrepreneurs is the basis for an increase in collective wealth and prosperity because we all tend to take cues from the earnings trajectory of listed corporations as to whether the collective economy or market is becoming wealthier and prosperous or not.
Columbus eventually found an Investor for his start-up
If we read history in the way the author wants us to read, we will find an interesting analogy between Christopher Columbus of that time and the hi-tech start-ups of today. Columbus kept pitching his novel idea to potential investors in Italy, France, and Portugal.
His idea got rejected everywhere but like any modern start-up he didn’t lose heart and kept on pitching till Spain finally agreed to become the Venture Capitalist putting huge some on his novel idea of discovering a place no one knew of, i.e., America.
So what made the rulers of Spain invest in Columbus?
They trusted in the future. But it was by good luck that he succeeded as many similar expeditions in those times failed miserably as many start-ups fail today. But what happened with the success of the idea? Trust in the future increased many-fold.
It is being told that as with Columbus’ help Spaniards conquered America, even a hundred years later princes and bankers were willing to extend far more credit to Columbus’ successors.
Credit Rating Vs Natural Resources: Which is Mightier?
With reference to the evolution of credit author further makes another compelling point. With the glorifying successes that credit achieved for so many years, today a country’s credit rating is far more important to its economic well-being than are its natural resources.
For example, if a country is blessed with rich natural resources like oil but has a corrupt government and judicial systems, it will in all probability get a lower credit rating. As a result, it will not be able to raise enough capital to utilize its natural resources for public well-being.
On the other- hand if a country devoid of any rich natural resource, but which enjoys peace, a fair judicial system, and a free government is likely to receive a higher credit rating. So, this country can raise enough cheap capital to support a good education system and build a human resource to make a flourishing high-tech industry.
The Dichotomy of Free Markets
Let us pause a little and reflect back as to how far we have progressed up until now. So, we started from the pre-modern era of no credit and Entrepreneur’s Dilemma from which we moved ahead to the magic circle of the Modern economy to Adam Smith and the Capitalist Creed, then to Columbus finding an investor to fund his project and then finally to realize the importance of credit and credit rating in today’s world.
So, the natural extension of all this should be a proposal of an extremely free market devoid of any political or bureaucratic intervention. But then it pays to ponder upon the dichotomy of free markets has been reflected in this wonderful argument made by the author:
“The most enthusiastic advocates of free-market criticize military adventures abroad with as much zeal as welfare programs at home. They offer governments the same advice that Zen masters offer initiates: just do nothing.
But in its extreme form, belief in the free market is as naive as belief in Santa Claus. There simply is no such thing as a market free of all political bias.
The most important economic resource is trust in the future, and this resource is constantly threatened by thieves and charlatans. Markets by themselves offer no protection against fraud, theft and violence.
It is the job of the political systems to ensure trust by legislating sanctions against cheats and to establish and support police forces, courts and jails which will enforce the law.”
Now we understand why even in a free economy we are not free to do any damn thing just because it comes to our mind. We must follow the law. This is the reason we have RBI, SEBI, government, parliament, and Supreme Court.
Conclusion: Credit, Growth, but How long?
In the end, I would want to sign off with two conflicting arguments which the author makes in this chapter of The Capitalist Creed. At one instance he says:
“Over the last 500 years, the idea of progress convinced people to put more and more trust in the future. This trust created credit; credit brought real economic growth, and growth strengthened the trust in the future and opened the way for even more credit. It didn’t happen overnight- the economy behaved more like a roller coaster than a balloon. But over the long run, with the bumps evened out, the general direction was unmistakable. Today, there is so much credit in the world that governments, business corporations and private individuals easily obtain large, long-term and low-interest loans that far exceed current income.”
And then later he ends this chapter with a completely opposite view:
“Yet can the economic pie grow indefinitely? Every pie requires raw materials and energy. Prophets of doom warn that sooner or later Homo sapiens will exhaust the raw materials and energy of planet Earth. And what will happen then?”
So? What do you think? Which of the two views look more believable? All I know is that I don’t know. If you know, please share it with me in the comments section. And if you don’t, I would recommend a slow and thorough reading of the book. In fact, one reading is too little to digest the book and its contents so go for multiple readings for best results.
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