When it comes to “economic system” we think that it is basically a process of “production and mutual exchange” of various commodities among the producers. There is nothing wrong with this assumption as such, but what we don’t know is that this hypotheses of “economic system” is valid only for a pre-industrial village/cottage economy; it doesn’t apply to modern day capitalistic production system which is a different ball game altogether. In other words, capitalism is NOT about “production and mutual exchange” of commodities among producers. So, what is capitalism about?

To understand, we will first try to understand the fundamental difference between a pre-industrial/non-industrial village economy and a modern-day industrial capitalistic economic system.

Pre-industrial village economy

A pre-industrial “village economy” is basically a set/collection of many producers who produce and exchange goods and services among themselves. In this system, a producer produces a particular commodity; keeps a certain portion for his own consumption and exchanges the remaining with other producers of the village economy. If a weaver produces 100 metres of cloth, he will keep say, 10 metres (i.e. 10 per cent) for his personal use/consumption and will exchange the remaining 90 metres with other producers in his society. Every producer of this economy does something similar; keeping a certain portion for personal consumption and exchanging the remaining with other producers. This exchange can happen either via barter or money. This type of pre-industrial village based economic system was/is the true open/free market economic system.

In this non-industrial village/town economy, the production units are basically the families (or individuals) and the “exchange value of their output” is more or less equivalent to their “consumption capacity” (need). The “exchange value of the output” is the “basket of commodities” that any family/individual ends up with after exchanging his excess production with other producers. Thus, the weaver family exchanges with the farmer, potter, cobbler, milkman, carpenter, in exchange for food, pots, shoes, milk... The “basket of commodities” that this weaver will end up with is the (1) commodities he will get in exchange for his 90-metres plus (2) 10 metres of cloth that he kept for himself. Similar will be the case with other producers.

Thus, the weaver family ended up consuming goods/services worth 100 metres of cloth (i.e. their output) without being left with any “unconsumed surplus”. This is true for each and every production unit (i.e. family) of this economic system (potter, milkman, barber) who end up consuming goods/services equivalent to the exchange value of output.

For the sake of simplicity, we have not taken into account the act of “savings” by people. But even if we take that into account and assume that all the people save something in the form of money (even in a village economy, people save in the form of money only because commodities, being perishable, cannot be stored for very long, whereas money can be stored for any length of time), the situation will not change. People save money in order to spend on festivity or contingency (marriages, socio-religious festival) and when that occasion presents itself people spend their accumulated savings. After spending their previously accumulated savings, people start saving again, only to spend the same in future. In other words, in this type of economy hardly anyone is a “perennial saver” or “perennial accumulator of money”. Therefore, what comes out of this analysis is that, over a period of time, whatever is produced in the society is consumed by the society.

The most important feature of this economy is that in this system the production units (i.e. families/individuals) end up consuming goods/services equivalent to “exchange value” of their output. This is the most important feature of this economy - an economy in equilibrium because whatever is produced gets consumed within the economic system itself; it doesn’t require an “external market”. Secondly, this economy can function at of any level of money-supply, i.e., it can adjust itself to any level of money supply. In other words, the level of money-supply is a neutral factor for this economy.

Industrial Capitalism (in Barter System)

We are made to think that modern day industrial-capitalism is much like the village economic system whose basic theme is mutual exchange of commodities (goods and services) among producers. But capitalism is NOT about mutual exchange of commodities In the village economic system, the labours and owners of production units are the “same set of people” and they “own” the entire production. In capitalism, the labours and owners are different and the labours get “wages and salaries” and industrialists/capitalists get the “surplus production” (their profit). This aspect of capitalism differentiates it from pre-industrial village economy.

To understand this, let us assume a capitalist economy functioning in barter system. In this case, the wages and salaries of industrial workers are given in form of commodities that their employer firm produces: e.g., workers of a textile mill get their wages and salaries in form of cloths, a crockery producer gives crockery as wages and salaries, soap-cake producers give soap-cakes as salary/wages and so on. Let us assume that wages pay-out ratio is 80 per cent of output uniformly across the economy i.e. 80 per cent of the output of each firm is given as wages and salaries to its employees. The remaining 20 per cent left with the owners (capitalists, industrialists) as their “surplus production” or “profit”.

We can think of this capitalist economy as a “two tier economy”: one comprising of industrial workers who are given 80 per cent of output and other comprising capitalists/ industrialists who own the remaining 20 per cent of output. After getting their share of output, the industrial workers “exchange” it further to end up with a “basket of commodities” that comprises almost all types of commodities produced and needed. Similarly, the industrialists too exchange their share of output with each another. However, in a capitalist economy, the industrial workers are quite large in absolute numbers and their share of output (i.e. 80 per cent) is very thinly distributed, that is, average per head wages/salaries are not very high.

Therefore, after exchanging his wages with labours of other industries, an average industrial worker ends up with a “basket of commodities” that is well within his consumption capacity (he will/can end up consuming the entire basket of commodities he receives as exchange value of his wages/salary). Here too, we have ignored the savings of individual workers since it will not affect the overall analysis. The crux of the issue is that the portion of output given as wages and salaries to industrial workers gets consumed by them.

But what about the share of industrialists (or capitalists)? Although capitalists/industrialists get only 20 per cent of output as their share, since they are basically very few in absolute numbers, the “per capita profit or surplus production” that an “individual capitalist/ industrialist” gets as his share of output is thousands of times more than “per capita wages”. Therefore, the per capita “basket of commodities” that an average industrialist will end up with (after exchanging his goods with fellow industrialists) will also be thousands of times more than that of an average industrial worker.

The important question here is whether an average capitalist (or industrialist family) can consume thousands of times more goods/commodities than an average industrial worker can consume? Obviously not. Even if capitalists live an extremely lavish life, it is impossible for them to consume thousands of times more goods/services than an average industrial worker.

In fact, capitalists will keep accumulating huge volumes of “surplus production” in every production cycle. Over a period of time, the surplus of commodities accumulated by them will simply get rotten and emaciated without benefitting anyone. Now we can see why capitalism is not like the open market village/town economy. In the open market village economy, no producer was left with any “forced unconsumed surplus”, but in capitalist economy every producer (capitalist) is left with a “forced and extremely huge unconsumed surplus” (in each production cycle). Whereas the industrial workers’ share of output (wages/ salaries) is “fully consumed” by them, the industrialists’ share (surplus production) is not consumed by them. This “unconsumed surplus” is not voluntary but compulsive because industrialists cannot consume this “surplus” even if they wish so.

So, what the capitalists would do with their “surplus production”? Although, in our text-books, this “surplus production” is considered as “profit”, this is an absurd notion of profit. It is only when this “surplus production” is converted into money that capitalists can make any profit. For capitalists and capitalism, the only thing that matters is monetary profit, not the accumulation of surplus production in the form of good/services.

Yet our economics text-books stop the analysis of capitalism on this point by assuming surplus production as profit of industries. In reality, the profit of industries is “surplus production converted into money” and the process of conversion of surplus production into money is of “central importance” if one is to understand the functioning of modern capitalist economic system.

That is why capitalism cannot work in barter system even theoretically; the “monetary profit” of the capitalist is the crux and driving force of capitalism. Not only this, almost all problems that capitalism has encountered so far have been but various variants of this issue only. Therefore, to fully understand the intricacies of capitalist system we will have to analyse it in monetary environment. But before that, we can draw some useful conclusions from the above analysis.

-        Whereas the ultimate aim of a non-industrial village economy is production and mutual exchange of goods/services, the ultimate aim of capitalist system is conversion of surplus production into money.

-        Whereas a non-industrial village economy can adjust itself to any level of money supply, the capitalist economy needs ever increasing money supply to sustain itself. This is because a capitalist economy keeps accumulating the “surplus production” in each production cycle and all of this needs to be converted into money.

The moment the process of conversion of surplus production into money stops, the capitalist economy runs into trouble i.e. it starts incurring losses. In fact, the incurring of loss by any industrial firm of a capitalist economy is nothing but the non-conversion of surplus production into money. If industrial firms start incurring continuous losses, they will stop further operations and will close down their production units and lay off their employees.

It is obvious that in capitalist system the livelihood of people (industrial workers) is contingent upon profit making by industrial firms. In capitalist economies, a vast section of the population gets their livelihood in form of wages and salaries from industrial firms. Even those who do not get their livelihood directly from industrial firms (as wages and salaries from firms) are indirectly dependent on wages and salaries from industrial firms only. For example, doctors, lawyers, school teachers, various kinds of other utility services providers etc. are almost entirely dependent on employees of industrial firms. If the livelihood of wages and salary earners from industries is stopped, so will be the livelihood of these sections. If the industrial firms keep making profits, people keep getting their livelihood but if the firms keep incurring continuous losses, the livelihood of people stops because industrial firms stop the production itself, laying-off their workers.

How the Capitalist System makes profits

In “normal circumstances” a capitalist economy cannot make any profit because all their production cannot be “bought back” by the wages and salaries.  Previously, we assumed that wages payout ratio is 80 per cent. Translated to “real-life money wages scenario” this means that industrial firms give only that much of “money wages” to their employees that is sufficient to buy-back 80 per cent of the output; the remaining 20 per cent of production remains unsold.

Thus, the firms seek a 25 per cent profit on their cost of production. If cost of production of any commodity is Rs.80 they will sell it for Rs.100 to recover the “cost of production”. In a normal real-life scenario, this will cause heavy losses on account of savings by the people and intermediary stages profits.

Simply put, if the total output of any capitalist economy (i.e., the selling price of entire output of consumer goods and services) put together is Rs.1000 then the total demand (or total purchase of commodities) will be not be more than Rs.500/600; thus leaving the economy (industrial firms) in deep losses. Therefore, profit making in capitalism is a theoretical impossibility; capitalism is a non-starter from day one. Yet, we see that the capitalist economic system is making continuous profits since last 250 years or so. How?

How the system works

To make a profit, the capitalist economy will have to sell its “surplus production” to some “external economy” i.e., to people other than own employees and factors of production. So, is there really any “external market” available to the capitalist system and if so, what is this “external market”?

Exports seem a plausible answer. But for this to happen all the capitalist economies of the world should be simultaneous “net-exporter” and their entire profit must be drawn from exports only. But, as we see in modern times, this is not the case with any capitalist economy, although some capitalist economies are net-exporters (e.g. Germany, Japan, China etc.) but the proportion of their “export-based profit” is only a small fraction of their total corporate profit. Secondly many highly developed capitalist economies are “net-importers”, e.g., USA. So, exports don’t seem to be the solution to the problem. To understand this riddle, we must dive into the history of capitalism pre-great depression and post-great depression.

Pre Great Depression Era

In pre-great depression era (i.e. from the onset of capitalism in late 18th century to 1930), the capitalistic system derived its profit primarily by exporting its “surplus production” to the colonies. All capitalist nations had substantial “colonial empires” that were basically markets for their surplus production. Britain was the first and only significant capitalist economy till the 1830s when France joined the league, and till the 1860s Britain and France were the only capitalist economies in the world. In the 1860s and 1870s Germany, Japan and Italy jumped into capitalism and immediately began to capture colonies, as capitalism was not possible without colonization.

Capitalism was like a “money-sucking pump” that sucked money (i.e. gold/silver) from colonies by exporting (read forcibly dumping) its surplus on them. This continued for around 150 years. Since the advent of capitalism, the industrial base (i.e. the volume of production) of capitalist nations kept on expanding, requiring ever larger markets for their surplus production, but the money stock of colonies kept on dwindling due to continuous sucking of money by western capitalist nations. Therefore, after some time the colonies were no longer capable of absorbing the ever-increasing volumes of surplus production of capitalist nations in volumes that could keep the system in profit. This system collapsed in the form of the Great Depression.

Post Great Depression Era

To revive the capitalist system, the only plausible solution was to discover money (i.e. gold) in substantial volumes, from wherever it could have been found, and to distribute the same among the masses so they could buy consumer goods from that money. How ludicrous.

Even if we ignore the ludicrousness of the idea, the real issue was that gold could not have been discovered at will; that too in wishful quantities. To overcome the great depression, the first thing that was done was to abandon the gold standard and the era of fiat money began. Once this was done, the banking system got equipped with “unlimited powers” to create money (in the guise of debt) and thereafter the capitalist system was and is sustained by monetary / credit expansion (i.e. money creation in the guise of debt) by the banking system. There are two main tools for monetary/credit expansion (a) deficit financing by governments and (b) consumer credit.

Deficit Financing by Governments

Once the gold-standard was gone, there was no restriction on further monetary-expansion (i.e. on money creation by banking system). To revive the industrial economy, the governments of industrialised nations undertook heavy expenditure programs, mostly on so-called “infrastructure development” and in so-called “social sector”. The most remarkable thing to note here is that the money that governments spent on these programs was NOT collected through taxes, rather this money was taken as debt from banks (created out of thin air by the banks)!

While spending huge sums on so-called “infrastructure development” the governments purchased huge quantities of goods from industries and hired a vast number of people to develop “infrastructure”. Purchasing goods from industries for infrastructure development stimulated the sales of industries (mainly of capital goods industries) to a considerable extent and they bounced back into profit. The huge army of people hired by governments for “infrastructure” development also received huge sums of money as salary/wages and they spent this on buying consumer goods. Hence, the consumer goods industries also registered huge jumps in their sales. This massive “infrastructural development spree” was not for any specific purposes; it was just an excuse to buy huge volume of goods/services from industries to artificially stimulate their sales/revenues.

Besides hiring people for “infrastructure” development, the governments also employed an army of people in other areas (so-called social sector). As in the case of “infrastructure development”, job creation in these sectors was not for any needful purpose. These jobs were created for the sake of creating jobs so that Governments could have some kind of excuse for giving the newly created money into the hands of people so they could buy “consumer goods” from industries! All these measures, put together, brought the industrial economic system back to life once again.

Consumer Credit

Consumer Credit is simply the loan given by the banking system to the general public for buying various types of consumer goods, including homes. All such loans by are nothing but “creation of new money out of thin air” in the guise of debt. This goes a long way in creating additional (and artificial) purchasing power in the industrial economic system since the loan taker(s) will spend this amount in addition to their salary income.

Asset Bubble Creation

Although the primary motive behind asset bubble creation has been the artificial propping-up of the financial sector and NOT the real economy, the sheer volume of money in this game is so tremendously high that its trickle-feed impact ends up creating substantial income for common people and helps in sustaining the real economy quite substantially.

Under this methodology, the banking sector creates a series of debt in ever increasing amounts, to financial institutions, enabling them to buy some assets (like shares/bonds and mortgage-backed securities) from each other at successively higher prices. This leads to massive boom in these asset prices. Between 1980 to 2000, the average share prices in USA increased by almost 15 times. The increase in prices of so-called tech-shares was much more phenomenal; on an average, they jumped 10.81 times within 10 years from 1990 (596.28 Nasdaq in October 1990) to 2000 (6447.69 Nasdaq March 2000). Needless to say, asset-bubble creation is an absurd, illogical and brainless activity, to say the least. But it is the backbone of entire financial system of the so-called developed world!

How does this help to sustain the real economy? Most of the “income generation” by this method is pocketed by big financial institutions but a small portion is pocketed by common people and this goes a long way in artificially sustaining the capitalist system.

Conclusion

We can thus see that the capitalistic economy is “artificially sustained” in the post-depression era. It was only after this that capitalism got rid of its chronic problem of recurring depressions because the system was now able to generate the required purchasing power, in any volume whatsoever, to absorb its surplus production “within” the system itself. That is why it expanded at frenetic pace after World War II and it was this phenomenon that gave rise to so-called consumer culture - because any volume of production could get absorbed within the capitalist economy itself.

Once the capitalist system got itself sustained in this “artificial manner”, it had no further need of colonial markets. Therefore, soon after the World War II (after fully realizing the “magical powers” of fiat money) the colonial era came to an end.

Strangely, no school of economics explains modern industrial economics in this way. Students do not have the faintest hint of this reality; what could be the reason behind this?