Capital is a powerful and complex phenomenon that many thinkers have struggled to define over the centuries. The statement that capital died in 2008 is intended to mean that after years of being misunderstood, abused, and wasted, capital stopped flowing around the world and became totally frozen in place. The manifestation of its death was the abrupt slowdown in economic activity that occurred in September 2008, around the time the U.S. investment banking firm Lehman Brothers declared bankruptcy and the U.S. government was forced to prop up AIG with $85 billion of loans (which ultimately rose to $170 billion in assistance).

One of the most graphic illustrations of the cessation of economic activity that occurred in late 2008 is what happened to the Baltic Dry Index, a daily measure of global shipping activity.¹

Figure 2.1 shows this index falling off a cliff in September 2008, signaling the sudden collapse of global economic activity as capital flows came to a standstill. This index was considered to be a leading indicator of global economic activity at the time and measured the price of moving the world’s raw materials around the globe. By the end of 2008, nothing was moving around the globe. Capital had indeed died.

One of the key characteristics of capital is that it is a process and not a structure, a category, or an object. Capital is a process because it is the embodiment of the human relationships that generate economic activity. Those relationships can be ones of equality or inequality (almost always the latter), but they are relationships nonetheless. A relationship involves some type of connection in which two or more parties interact and affect the behavior of the other. In the autumn of 2008, the world saw a temporary but complete breakdown in those relationships.

In the first decade of the twenty-first century, capital came to have virtually no connection with the underlying social relations that generate economic value. As the embodiment of the economic value created by human labor, capital has always maintained an indirect relationship with the actual act of wealth generation, so this is not a new phenomenon. But the distance between capital and wealth generation became attenuated beyond all previous bounds by the changes wrought by modern finance. The very concept of capital—not to mention capital itself—was devalued by modern financial practices. Rather than a precious resource used to improve the human condition through the provision of jobs, health care, education, and the like, capital was further alienated from these social purposes than in earlier historical periods.

The world experienced the death of capital that had built up for decades due to a combination of counterproductive political and economic forces. In the autumn of 2008, in the wake of the bankruptcy of Lehman Brothers and the near-collapse of AIG, capital froze, and with it the functioning of the global economy when longstanding forces coalesced into an overpowering wave of debt and disillusion. Capital was ultimately thawed out by a blowtorch of massive government stimulus and support, but its transformation into a phenomenon completely disembodied from its generative sources remained in place.

Capital was placed on life support by the emergency measures taken by the world’s wealthiest governments and central banks. These entities threw trillions of dollars at the symptoms in order to temporarily restart the flow of capital around the globe. But the measures taken in late 2008 and early 2009 to keep the patient alive were only temporary and had deleterious long-term effects. The most harmful ones included a massive build-up of global debt and the ongoing devaluation of fiat currencies. In order to return capital to permanent health instead of merely the walking dead, new long-term economic policies must be put into place. But those policies cannot be implemented without a thorough understanding of what capital is and how it functions. In order to be properly managed and regulated, capital must be understood in view of its true nature as a process rather than an object and in view of changing market conditions and market structures. The very fact that capital died in the first decade of the twenty-first century suggests that those charged with shepherding it did not understand its intrinsic nature.

How did modern capitalism manage to place capital on the endangered species list? After all, modern society had ostensibly developed far more advanced tools to manage risk—particularly man-made risk—than ever before in its history. Computer technology and mathematical ingenuity were presumably designed to protect the financial system from precisely the disruptions that it suffered in 2008. Instead, in the ultimate irony, tools implemented to reduce risk ended up increasing it—to reckless and systemically threatening levels. Students of capitalism have long known there is something inherent in the nature of capital that renders it unstable. But what is it exactly that makes capital so difficult to manage?

The Four Essential Characteristics of Capital

Coming to a working definition of capital that reflects its real-world complexity is an imposing task. But avoiding it would be like performing an autopsy without touching the corpse. If the academics who have exercised such undue influence on markets have taught us anything, it is that markets work in theory but not in practice. Accordingly, capital needs to be understood as it really is, not as we imagine it to be. That is why we cannot leave the definition to the professors; the job must be done by practitioners, meaning investors who take the field every day to do battle in flesh-and-blood markets. In order to define capital, we must combine theory and practice into a formulation that reflects the real world.

Because capital is a process, it remains in constant motion. Below are the four characteristics of capital that are essential to a proper understanding of how it functions in the actual markets where money is made and lost every day.

Capital as It Is, Not as We Want It to Be

1. It is a process, not a structure, an object, or a category.
2. It is constantly changing form.
3. It is a construct of the human mind.
4. It is unstable.

The Oxford English Dictionary describes financial capital as “the accumulated wealth of an individual, company, or community, used as a fund for carrying on fresh production; wealth in any form used to help in producing more wealth” (emphasis added).² “Wealth in any form used to help in producing more wealth” is the key to understanding capital because it describes a process, not an object or a structure or a category.

How Capital Dies

Once we understand what capital is, we can also understand how it ceases to exist. Capital’s essential quality is change. When capital loses the ability to change, it dies. This is another way of saying what was said above: Capital must remain in motion at all times or retain the potential to be in motion. Static capital is dead capital. Unrelated, unconnected, or isolated capital is dead capital. When investors speak about “dead money” or “dead capital,” they are speaking metaphorically about an investment that is neither generating a return nor likely to generate a return in the foreseeable future. The reasons for this are legion; the primary one is that it can’t be turned into another kind of asset that can generate a return. When Western capitalism came to a grinding halt in the fourth quarter of 2008, capital stopped living and breathing. Capital literally and figuratively stopped moving and changing.

Because it is a relationship, capital requires at least two parties to bring it to life. This is where markets come into being. Capital requires some type of mechanism of exchange, initially of information about capital and ultimately of capital itself. Understanding market information requires market participants to share certain intellectual and moral assumptions. The parties do not have to like each other, they do not have to trust each other, but they have to be able to agree on the value of something and believe that the system in which they are acting will enforce their bargain. There must be some kind of meeting of the minds, which is a human and social phenomenon. So we see again that at the all-important level of exchange, where capital creates value, capital is a social construct. Capital dies when it loses its human and social content and context. Inhuman capital is dead capital.

The Failure of Risk Management

Ironically, the incessant march toward financial instability occurred in a world that had claimed to master risk. In 1992, Peter Bernstein wrote what is still rightly considered to be a modern classic on the subject of finance, Capital Ideas. Bernstein’s book was widely admired for its insightful discussion of the academic theories that laid the groundwork for the revolution in finance that led to the development of derivative products, portfolio management techniques, and what many believed to be the advanced management of risk. In an early passage, Bernstein wrote the following:

Today investors are more keenly aware of risk, and better able to deal with it, than at any time in the past. They have a more sophisticated understanding of how financial markets behave and are capable of using to advantage the vast array of new vehicles and new trading strategies specifically tailored to their needs. Innovative techniques of corporate finance have led to more careful evaluation of corporate wealth and more effective allocation of capital. The financial restructuring of the 1980s created novel solutions to the problems arising from the separation of ownership and control and made corporate managers more responsive to the interests of shareholders.⁶

Investors and regulators came to believe—falsely as it turned out—that new products such as securitization and credit derivatives were effectively dispersing risk throughout the global financial system where it could better be absorbed. In fact, they were doing precisely the opposite. Bernstein’s imprimatur regarding the ability of the new tools of finance carried a great deal of weight within the financial industry; unfortunately it was profoundly misplaced.

The risk management techniques praised by Bernstein relied on advanced computer programming power to better capture relationships between the prices of different securities and markets and to more accurately measure the correlation among different securities and asset classes. The intellectual assumptions underlying such risk management approaches, however, included reliance on two basic premises that were completely unfounded: first, markets are efficient; and second, investors are rational. Beyond these erroneous assumptions lay other flawed theories, such as the belief that diversification of portfolios would protect investors from losses and that relying on historical performance serves as a valid basis for forecasting future price movements. Among other errors, all of these assumptions failed to adequately account for low-probability high-impact events (what have come to be known as “Black Swans” thanks to the insights of Nassim Nicholas Taleb). Accordingly, risk management models assumed normal distributions of events and did not stress test for so-called “fat tails” that have occurred with increasing regularity during the past 20 years. This turned out to be a fatal omission.

Another problem was that the models guiding investors failed to evolve to reflect the increasingly networked nature of financial markets, which created a situation in which the actions of a single large financial institution can have a systemic impact. The technical term for such effects are “network externalities,” which means that market developments will induce different firms to react in similar ways rather than act independently. Thus, the financial condition of an individual company proved to be an inadequate measure of systemic risk, and systemic disturbances increased the riskiness of individual companies that on their own may have looked stable. Finally, such risk management techniques sought to apply the laws of mathematics and physics to financial markets, which are socially and economically driven worlds that do not operate according to physical laws. Markets tend to be irrational; subjecting them to the rational laws of science is unlikely to lead to meaningful results. The damage wrought from such intellectual confusion was extreme.

Four years later, in an enlightening 1996 book on the subject of risk, Against the Gods, Bernstein sounded a warning about undue reliance on some of the forecasting tools he had praised in Capital Ideas:

Likeness to truth is not the same as truth. Without any theoretical structure to explain why patterns seem to repeat themselves across time or across systems, these innovations provide little assurance that today’s signals will trigger tomorrow’s events. We are left with only the subtle sequences of data that the enormous power of the computer can reveal. Thus forecasting tools based on nonlinear models or on computer gymnastics are subject to many of the same hurdles that stand in the way of conventional probability theory: the raw material of the model is the data of the past.⁷

And of course the history of financial markets since Bernstein wrote Capital Ideas and Against the Gods belies any rational observer’s optimism about the ability of investors to properly utilize and profit from scientific, computer-driven risk management tools. In the last two decades alone, there have been five severe disruptions in the credit markets—four manageable ones in 1990–1991, 1994, 1998, and 2001–2002, and the truly catastrophic collapse in 2007–2008 that required unprecedented governmental intervention. Even though the financial system emerged basically intact from the first four of these debacles, it clearly gained little wisdom about the risks it was running. In fact, each succeeding market crisis revealed that the financial system had increased its risk profile after the previous one. The underlying causes of instability were left unaddressed, and the imbalances bred by increasing global debt levels were increasing. The world repeated that pattern after the 2008 financial crisis.

One clear lesson of episodes such as the junk bond/savings and loan scandal of 1990–1991, the Long-Term Capital Management crisis of 1998, and the credit crisis of 2001–2002 was that neither investors nor regulators learned very much from their mistakes. That, or they were too brainwashed with free market and risk management mantras to open their minds to the possibility that the conditions of underlying instability were worsening. In their blindness, they continued to cling to flawed assumptions and blatant misunderstandings about the basic ways in which markets work and the nature of capital itself. Even after the near-death experience of the 2008 financial crisis, these errors persisted and the world moved closer to another crisis caused by too much debt. A system that is unwilling to question its assumptions is unlikely to be prepared for the adverse consequences that result from them.

The risk management ideology lauded in Capital Ideas exercised an enormous influence on the thinking of market practitioners, politicians, and regulators throughout the 1990s and early 2000s. This was extremely unfortunate because confidence in mankind’s ability to master risk was profoundly misplaced. Moreover, the almost religious belief that computers and mathematical models could master risk and that regulation was increasingly unnecessary came at the worst possible time in history in terms of man’s ability to inflict damage on the economic system, because radical changes in human economic and political arrangements were occurring.

At the beginning of the 1980s, Ronald Reagan and Margaret Thatcher entered office a year apart and led the ideological charge in favor of free markets. By the time Ronald Reagan left office in 1988, Soviet-style communism was coming apart and the Chinese version was tossed aside by Deng Xiaoping in favor of a market-based economy. Less than a year after Ronald Reagan left the presidency, he watched the fall of the Berlin Wall that he had implored Mikhail Gorbachev to tear down. The victory of capitalism over communism that Reagan led was complete.

It is all too rare when external events validate a political ideology, but that is what occurred when the Berlin Wall fell, the Soviet Union split apart, and China embraced capitalism. This historic endorsement of free markets validated capitalism throughout the world, overlooking the fact that communism collapsed under its own weight as much as from the so-called genius of capitalism. Nonetheless, the fall of communism was an unequivocally positive development for mankind. Billions of people around the world began to taste economic freedom for the first time. But the collapse of one flawed system was accompanied, particularly in the United States and the United Kingdom, by a virtually blind adoption of another flawed system: unfettered free market capitalism—a belief in the ability of the markets to cure all ills and to effectively manage all risks.

During this period, Alan Greenspan was anointed the high priest of free market capitalism as chairman of the Federal Reserve. Many books have already been written criticizing his ostensible adherence to free market dogma,⁸ yet it should not be overlooked that Greenspan’s own Federal Reserve was all too willing to bail out markets on numerous occasions. Greenspan was more than prepared to toss out the window his free market principles in the face of true or perceived systemic risk. The bailout of Mexico in 1994, the Asian financial crisis of 1997–1998, Russia’s debt default in 1998, Long-Term Capital Management’s collapse in 1998, the Enron and WorldCom frauds in 2001, the 2001–2002 credit market collapse—in each of these cases, Greenspan’s Federal Reserve intervened in the markets in one form or another. It did so either by lowering interest rates or directly or indirectly intervening in financial markets. Greenspan’s frequent exercise of the central bank’s lender of last resort function stood as a constant warning (for those who wanted to heed it) that the free market was not as free as it was cracked up to be, and that if allowed to continue functioning as it was, it would end up cracking up. Sadly, we came to discover in 2008 that the Soviet Union wasn’t the only empire capable of being driven into insolvency and instability by the potency of the free market.

But despite the fact that the world’s most esteemed central banker’s actions did not live up to his free market reputation, the political and thinking classes continued to worship free markets (and Mr. Greenspan). The Glass-Steagall Act, which separated commercial and investmentbanking, fell by the wayside in 1999 under the lobbying of Citigroup, the now failed financial supermarket that spent the late 1990s and first decade of the 2000s engaged in combining its different businesses while committing a series of ethical, legal, and financial breaches that should have shamed its executives and board members rather than lifting them higher and higher in public esteem.

Once the barrier between deposit-taking and risk-taking institutions fell, the next step was to eliminate regulations that limited the amount of leverage that these newly empowered investment banks could employ in their businesses. In 2004, the Securities and Exchange Commission, under heavy lobbying from the leaders of two firms that survived 2008 after agreeing to turn themselves back into commercial banks (Morgan Stanley and Goldman Sachs) and three that did not (Merrill Lynch, Lehman Brothers, and Bear Stearns), decided to lift the 12-to-1 limit on balance sheet leverage on the large Wall Street investment banks. Few questioned the wisdom of these moves and most praised the freeing of the financial industry from rules that were considered archaic and antigrowth. A few Cassandras suspected that the old rule was necessary to prevent Wall Street from destroying itself. But proponents of what turned out to be a suicide pact argued that Wall Street would lose business to London and other jurisdictions that permitted higher leverage, and the race to the bottom was on. By the time the walls came crashing down, several of the largest investment banks sported debt-to-equity ratios in excess of 30 to 1. When the public learned how leveraged these firms had become, regulators and politicians began tripping over themselves to express their shock that gambling had been allowed at Rick’s Cabaret. But by then it was too late—the chips were called in, and the casino stopped extending credit to even its best customers.

To the bitter end, however, free market acolytes continued to carry forward the belief that risk was conquered and the markets could handle whatever came their way. In early 2007, shortly before the financial markets almost collapsed, Bernstein published a sequel to Capital Ideas, which he titled Capital Ideas Evolving. He should have named his new book Capital Ideas Devolving, for the net result of these ideas turned out to be the near obliteration of the Western financial system. On the eve of financial Armageddon, Bernstein wrote:

It may sound ironic, but as investors increasingly draw on Capital Ideas to shape their strategies, to innovate new financial instruments, and to motivate the drive for higher returns in relation to risk, the real world itself is on a path toward an increasing resemblance to the theoretical world described in Capital Ideas. Subsequent pages repeat that observation on more than a few occasions. Baloney those ideas were not.⁹

It is too late for Bernstein to retract that last sentence, but I will be presumptuous enough to do it for him. For if the financial world has come to resemble anything, it is the aftermath of the attack of the Martians in H.G. Wells’ The War of the Worlds. Never have so many technically overeducated but morally undereducated people done so much damage to so many. The models and products that were developed to conquer risk instead turned on their inventors and destroyed them. The finance professors who concocted portfolio theory, the Black-Scholes model, credit default swaps, and collateralized default obligations did little more than demonstrate the truth of the adage, “Markets work in theory but they don’t work in practice.”

Even worse, the post-World War II economic model that served as the basis of so much apparent prosperity had morphed into an edifice of debt and delusion. This model took a sharp turn for the worse in the 1980s, when debt assumed a much greater role in all levels of the U.S. economy. The ideological and intellectual assumptions that supported rampant debt growth and the triumph of speculation over production turned out to be profoundly flawed in their basic precepts.¹⁰ As always happens in markets, which are primarily driven by emotion, the pendulum swung too far. Free markets required prudent regulation, and computer technology and quantitative thinking couldn’t free the world from the demons of risk. In order to understand how the Western financial system destroyed itself, and to place this system back on a sound economic track, the post-World War II understanding of markets and capital must be revised. New answers are needed. The best place to start looking for them, as the next chapter suggests, is by rereading some great philosophers who happened to write about economics.