Thursday, October 23, 2014

Ex Ante versus Ex Post Social Policy

I have written various posts on social policy related to the question of whether and how we redistribute income. One argument of equal opportunity and social egalitarianism is that it is fair to control for the randomness of life. For example, take the luck of the draw in who your parents are. If your best career choice was to be born into a wealthy family, if you got ahead because your father could pull strings to get you an internship at a big investment bank; because you built up your high school resume by spending a summer building houses in Tibet while a classmate had to spend the summer working at the 7-11; or because you could afford two years of one-on-one tutoring for the SAT, the result might be to score higher in an objective standard of selection and have a thriving career and high income as a result. But is that objective standard a fair standard, is it really merit based?

I think of income redistribution as an ex post policy. Another approach is to make ex ante adjustments to level the playing field, and then step away and let the chips fall where they may. When properly executed the ex ante approach is consistent with a meritocracy, and indeed creates a better, deeper and more successful meritocracy than ignoring the differences in essential endowments. 

Assume that there is an objective standard for merit, and a test that correctly ranks the subjects in terms of that standard. (For the record, though basing merit on a testing regime is common in many societies, I do not advocate it). Also assume that we can identify the factors that govern success on the test that are within the control of those taking the test, such as how hard they work, as well identify as the factors that are beyond their control. Given these two assumptions, one scheme for the redistribution, suggested by John Roemer (and in this short post I cannot do justice to his argument and stray from it in various respect), is first to define what constitutes the endowment of important characteristics that are outside a person's control, and then assign people to cohorts based on their levels of this endowment.  For example, if the endowment is parents' wealth and parents’ education, we place people into cohorts based on the level of these two factors, with the cohorts made narrow enough so that we can take all those in each cohort as being the same with respect to the endowment.

The social policy is to reward the top one percent of those in each cohort equally, and redistribute as need be in order to do so, and do so for the next percentile across each cohort, and so on all the way down. The idea is that the cohorts take into account differences due to what is beyond a person’s control – the endowments on which the cohorts were based – whereas the person’s place within the cohort is based on those things that are within their control, such as how much effort they expend. That is, by definition a person is not responsible for his cohort, and should not be rewarded or disadvantaged by it, but he is responsible for where he sits in that cohort.  So when we make decisions in terms of social policy, whether it be redistribution of income or equal opportunity, we adjust percentile by percentile across the cohorts.

Redistributing income or other rewards percentile by percentile across the cohorts is an ex post approach to social egalitarianism. It is ex post because we look at results versus the endowment and ask how we can make things fairer given the outcomes, where we have determined that fairness means people should be accountable and rewarded only for those things that are within their control.  

We can use this methodology on an ex ante basis, where we adjust to create equal opportunity rather than equal ex post reward. Applying the cohort approach ex ante is consistent with a merit-based policy.  Doing so requires one more assumption, namely that we only put in the endowment things that are both outside the person’s control and also are improvable if targeted with resources. The aspects of the endowment that we adjust for are those that only make a difference over time and where any reallocation occurs before that difference is significant. This means we do not adjust for innate ability or genetically-based advantage, even though these are things that are outside of one’s control. We do not define the cohorts based on these things, we do not equilibrate these through matching percentile by percentile across the cohorts. 

To give a sense of the ex ante social program which melds social egalitarianism with the objectives of a meritocracy, consider the following, which makes a good story and also happens to relate to an actual situation. A number of ten year-olds are trying out for a spot on the school's tennis team.  There is one spot available, and at the end of the day it comes down to a match between two boys. One has taken tennis lessons for years and practiced many times a week, the other has only played casually every now and then. The well-trained boy wins the match, but only barely. Given his lower endowment of lessons and practice, the loser is a remarkable talent. On the basis of an ex post meritocracy where the established metric was who won the match, the comparatively mediocre boy got the spot.  Yet what is a meritocracy ex post is a mediocrity ex ante. Absent the resources for training and competition the inexperienced boy would receive from being on the team, he goes back to other activities, and the world must make due with one less exceptional tennis player.  We will all survive; but the point repeats itself many times over in fields that are weightier.

If we take the amount of tennis training as the endowment that is outside one’s control, the boy without the past training might be at the top one percent of the bottom cohort, while the boy who beat him might be in the middle range of the top cohort. A merit-based social policy will reallocate resources for training to the inexperienced boy; perhaps a level of resources equal to that which the top one percent of the top cohort is receiving.  If our measures are correct, and if, as assumed above, the reallocation is given early enough in the child’s formative period, we will have someone who is exceptional at tennis who otherwise would have fallen by the wayside. And we will have used those resources more efficiently than if we kept them with the other boy.

The approach I am describing is not the one we are take in the U.S. when we attempt to level the playing field by making adjustments to create equal opportunity. The social program we follow in the U.S. fails in part because it does not distinguish between that which is within and outside of one’s control. It does not even attempt to define cohorts and pick across the various percentiles to reflect effort.  And when it moves into ex ante sphere, it throws resources at differences that are not improvable. (There is one program that might appear to move in this direction: The top ten percent of students from every Texas high school are admitted into the university system. We can think of each school as representing a cohort, with the program giving the same opportunity to those in the top decile of each. But it is pointed in the direction of ex post rather than ex ante social egalitarianism because by the time of high school graduation a student who has had poor preparation is likely to be too far gone for the equal opportunity to yield equal results).

In addition to fostering a fairer society, the ex ante approach described above will yield better results than running people through the merit-based process absent this social policy because there will be a  larger group that is equivalent to the top decile of the top cohort. But no matter how well we execute ex ante social egalitarianism, we cannot get away from addressing it ex post as well. Not everything can be measured, and some things that can be measured cannot be mitigated. At some point we have to say we have done enough; we do not want the end result to be physicians equally drawn from the top of each cohort if, at the end of the day, all of the ameliorative actions have failed to close the gap. The question that remains then is at that point, ex post, do we enact a social policy to redistribute income, or do we consider the social task to be completed?

Thursday, October 16, 2014

My Recent Work on Agent-based Modeling

As is obvious by looking at the time span between recent posts, I have not been active in blogging. I am planning to get back into things.  As a start, to help catch up on what I have been doing, here are a couple of papers and a presentation I recently made on the area of my focus, using agent-based modeling to help assess financial vulnerabilities.

The model is presented here.

For a concise presentation on the model and its application you can look at a talk I did in August at the Newton Institute for Mathematical Sciences at Cambridge University.  (Despite what is suggested by the venue, I did the presentation mathlessly).

Related to the model is work I have been doing to develop a map of sorts for the key agents in the financial system and the ways in which they link to one another. The fist step is what I call the funding map.

Wednesday, May 7, 2014

Piketty Myopia

Thomas Piketty's book Capital in the Twenty-First Century has been lauded for its detailed analysis of data and for the end result of that analysis, a sweeping statement of an inexorable widening of the distribution of wealth between those with capital and those without. There is unabashed glee among those who have bemoaned the plight of the middle class as the one percent has pulled away, waving the book as the gotcha ya for income redistribution.  As should be clear from some of my previous posts, I am one of those people bemoaning the plight, but I am a little slower than many others to take up the Piketty banner.

The book's argument looks at wealth and growth data over the past three centuries, and takes its implications forward with a similar, historical scope.  “In the twenty-first century” is just that; Piketty is willing to push the implications of his analysis not just over the next decade or two, but about as far as you want.  To hear people discuss it, he has discovered the equivalent of a law of physics, namely that capital grows faster than GDP, and if those who own the capital are taking a larger share than GDP has to offer, those without capital must be taking less.  Given the miracle of compounding, this is going to lead the capitalists not only to pull away from the proletariat, but pretty much to own everything.

It is easy to run into problems when you are assuming the future will look the past, all the more so when you are also assuming exponential growth.  Capitalism is not a law of nature; it need not look the same in the future as in the past; it doesn’t even need to be at the core of society. In the sweep of history, capitalism is a recent development, one that happens to encompass roughly the three hundred years Piketty is using for his analysis. So we should temper our excitement; his work is really based on one, very long-term, sample. To see this point, rather than looking back for three hundred years, go back a few thousand.  In the West we have had two other periods comparable in many respects to that of the Industrial Era of today: The Roman Era, and then roughly a thousand years later the Commercial Era. Capital has been the dominating force this time around; in the others it was the military/political complex and the Church, respectively. And in both cases, the writers of the time assumed the structure of the era would go on indefinitely. It was just the way the world worked.  If we went back to the these times, the theme would be the consolidation of the political corpus or of the Church, the analysis would not have been centered on the divisions between those with capital and those without. (I won’t get into the comparable time period in China’s history, but given that Piketty cloaks his thesis with the scope of all human history, he should add a second sample to his analysis and see how his thesis fits the dynasties in China over the past couple of millennium. My bet is, not so well).

Will the future look like the past?
What might move us away from capitalism being the universal underpinning for society? Can the world look different in the future? Of course it can. How that happens and what comes next is an open question – people can't even agree on what led to the end of the Roman Era, and there we have the advantage of history to guide us. But here are some things just to give a flavor of the ways in which the capitalist system might be nudged from the current being the true and final state of mankind:

Maybe the need for capital will diminish. All of the discussion of labor and capital presupposes that labor and capital matter. Will we move into a production mode where our demands are met with low capital expenditure? Piketty recognizes the obvious point that if there is little need for capital – and technology could bring that about – then his argument is no longer valid: “If capital is of no use as a factor of production, then by definition its marginal productivity is zero. In the abstract, one can easily imagine a society in which capital is of no use in the production process.” It might be something to think about in the abstract, but in his view it is not worth lingering, because “in all known human societies, including the most primitive, things have been arranged differently.” That is a pretty broad statement. Even if true, if extrapolating exponential growth is one red flag, a dismissal based on an its-never-happened-before argument is a second.

Maybe we will all become capitalists. Look at the low amount of capital that has been needed for many recent start-ups. Those supplying the labor are also the owners and bring with them their own capital. Perhaps those who labor also be those who own the capital with which they labor? In subsistence agriculture, each farmer owns his own capital, his plot of land. Why not subsistence capitalism? We already have outsourced many tasks to ourselves by using the cheap capital of computers and the Internet; and will be able to do more as 3-D printing and crowd sourcing comes of age.

Maybe the implications of differences in income and wealth will diminish. All of the discussion of wealth and income distribution presupposes that differences in income and wealth matter. As Piketty notes, the nineteenth century novels focused on wealth. Wealth was measured by the number of servants, and thus wealth as a multiple of average earnings x income from capital was key determinant of status. What is the focus today; what might it be twenty or thirty years from now? Looking at the middle class, which is the focus for both Piketty and many of his adherents, could we end up in a world where the differences from a day-to-day lifestyle standpoint are compressed between the super rich and the 'doing OK'? This can happen if what both the super rich and we spend our time on is inexpensive. We are heading in the direction already. We share the same smart phones and spend time in front of the same screen consuming the same content. Of course when it comes to rare wines, contemporary art, and airplane views of Central Park, a gap will remain. But for many of the super rich, we already are seeing erosion; a generation ago cars divided the rich from the middle class; now some of the wealthiest drive the same car I do.

Maybe the consumption of capital-intensive goods will diminish. Consumption drives capitalism. What happens to the consumption of the products of the Industrial Age if we move into a more virtual economy? Consumption of virtual goods almost by definition does not require a lot of the brick and mortar capitalism that has dominated the Industrial Age. Some things, like cell phones and televisions are getting cheaper and cheaper, others like education more and more expensive. If those in the lower rung weight the former more heavily than the latter – and if at the end of the day we find the day-to-day consumption of even the wealthy is also biased that way (I say “at the end of the day” to mean in the post-college years), then much of the discussion of the distribution of wealth becomes moot.

The Exception is the Rule
Piketty notes that the events from 1914 through 1945 altered the course of expanding inequality, and did so even into the 1970’s and 1980’s. “One major lesson is already clear: it was the wars of the twentieth century that, to a large extent, wiped away the past and transformed the structure of inequality.” But that is now the past, and we are back on track:  “Today, in the second decade of the twenty-first century, inequalities of wealth that had supposedly disappeared are close to regaining or even surpassing their historical highs.”

The period of retrenchment from his law of growing inequality is hard to take as an aberration given that it extends nearly seventy years. That is a big chunk of time, even if you are looking at a period from the 1700’s to the present. But Piketty does pull out this period as an aberration, as an exception to the rule. But it is not. It is part of the rule. It is an example of the ebb and flow of society and nature, of the noise that destroys and supplants family fortunes, states, and civilizations. It is not unique: for example, in the fourteenth century we had the Black Death, the Hundred Years’ War, and years of devastating famine. Not to mention financial failures that dwarf those of the Great Depression – but they in turn were so dwarfed by the other calamities that they hardly merit a footnote for the period.

Piketty is unequivocal about the effects in the early twentieth century being an aberration, but not about why it was a period when his thesis did not obtain. “…we must insist on the fact that the fall in the capital/income ratio between 1914 and 1945 is explained to only a limited extent by the physical destruction of capital (buildings, factories, infrastructure, etc.) due to the two world wars…In fact, the budgetary and political shocks of two wars proved far more destructive to capital than combat itself.”

So it was not just the destruction of capital, but political shocks. But if that, here is another idea: The period between 1914 and 1980 was the only extended period from the ushering in of the Industrial Age to now where there was no industrial revolution. The first industrial revolution ran from about 1760 to 1840.  The second went from the latter half of the 19th century (around the time of the introduction of Bessemer steel in the 1860s) until World Was I. And the third industrial revolution, the computer age, began to gather steam in the 1980s. So I could take Piketty's data and argue that the disparity occurs during periods of industrial revolution, and falters otherwise. No industrial revolution, no problem.

But I'm not going to move into a teleological discussion on how our society could be transformed, anymore than I would talk about the demise of the Roman or the Commercial Era, except to point out the obvious, that unexpected things come along. And to note that, as I have pointed out elsewhere for the financial markets, the more complex and tightly coupled a society or era, the more likely something that does come along can exact a fatal toll.

Conclusions are Opinions
We can move on from Piketty’s thesis to his policy conclusions, and do so independent of the arguments that make up the bulk of the book. It is enough to have the opinion, as many already do, that the disparity in income and wealth is too great, and that the immobility up and down the ladder also is too great.  Or that, absent political action, these will become too great in the future. What disparity and immobility is too great is a matter of opinion, and after his analysis, that is how it remains. And if the issue is that the disparity will become too great in the future, the prudent course might be to wait and see what the future brings. The question of redistribution is a political, even a philosophical issue, not an economic one. (A side note: He differs from some others in arguing for taxes on wealth, but that is nothing new. Indeed that is how things were taxed in the China’s Song Dynasty).

Piketty’s opinion seems to be that if we project out to the point that the wealth gap becomes what it was during the Belle Epoque of the early 1900's, we have gone too far. Another person could argue that such a disparity is fine, and then we are at the “agree to disagree” point of the argument.  He does ask, “Taking all these elements into account, what is the “right” split between capital and labor? Can we be sure that an economy based on the “free market” and private property always and everywhere leads to an optimal division, as if by magic?” There are not many who really believe in that magic. The question of the ideal split between labor and capital has been debated for over two centuries, which is to say it is a question that will probably never arrive at an answer. Marx stated it as the center of class warfare, couching it in terms of the working day:

The capitalist maintains his rights as a purchaser when he tries to make the working-day as long as possible…. On the other hand...the laborer maintains his right as seller when he wishes to reduce the working-day to one of definite normal duration. There is here, therefore, an antinomy, right against right, both equally bearing the seal of the law of exchanges. Between equal rights force decides. Hence is it that in the history of capitalist production, the determination of what is a working-day, presents itself as the result of a struggle, a struggle between collective capital, i.e., the class of capitalists, and collective labour, i.e., the working-class.

Marx begins with an acknowledgement of the perception of rights on the part of both the capitalist and the laborer, but then argues that the question of the length of the working day cannot be solved by an appeal to rights, but only through class struggle, wherein “force” decides between “equal rights”. (Force can mean physical force, but can also mean the force of the political process).

It is difficult to do much more than simply take sides when it comes to economic rights, because what we call economic rights are really nothing more than the bargaining in an exchange between those providing labor and those providing capital. The social and economic pie has to be split, and there is no objective way to do so. There are some areas of fairness in the civil sphere – freedom from slavery and torture – but what are the rights inherent for a particular term of exchange between the parties in a trade?

Where does this battle lead? For Marx, left unfettered capital digs it own grave, for Piketty, it grows without bound and swallows the world. For Marx, the return on capital falls to zero, for Piketty it persists above the growth rate of the economy. We can argue that Marx is wrong because up to this point we have not witnessed his outcome. I argue that Piketty is also wrong, because he makes the common error of assuming the future will look like the past, even as he recognizes that the past holds a source of failure for his thesis.

Views and opinions expressed are those of the authors and do not necessarily represent official OFR or Treasury positions or policy. 

Tuesday, March 18, 2014

Big Data versus the SAT

In a recent Time Magazine article, the president of Bard College, Leon Botstein, joined a chorus of criticism of the SAT, going so far as to call it “part hoax and part fraud.”  Criticism is coming fast and furious because the SAT has just unveiled a new, improved product to try to fend off a trend among competitive colleges to downplay the role of the SAT, and even to eliminate its use entirely.  (The not-for-profit status of the College Board, which produces the SAT, does not put the company beyond reacting to a profit motive; not-for-profit does not exactly mean you don’t get benefits from pulling in more revenue).

Among the critiques are that performance during one afternoon in the junior year of high school should not govern a student’s future (the SAT is not only used for college admission, but also by employers further down the road); that the SAT has little to do with what really constitutes learning and productivity (I haven’t done anything useful in my work by pulling the right answer off of a multiple choice test for as long as I can remember); that it correlates with income more than it does with anything else; and that what has now become years of SAT preparation detracts from more productive learning.

And that is just the start of the list. By its very nature as a standardized test, to the extent colleges rely on the SAT they are looking at exactly the same criteria, so the same sort of students will percolate to the top of the stack. The creative and off-the-wall student who adds the richness and intellectual diversity that a college seeks might be blown off course because there is no reason to think that such a student will do well in a timed, multiple choice test – or even that such a student will have an interest in the many hours of preparation courses required to be competitive in the test. To take the effect of the SAT exam on creativity to the extreme, read a previous blog post I wrote on the effect standardized testing has had on creativity in Asian countries.

You would think that in the emerging world of big data, where Amazon has gone from recommending books to predicting what your next purchase will be, we should be able to find ways to predict how well a student will do in college, and more than that, predict the colleges where he will thrive and reach his potential.  Colleges have a rich database at their disposal: high school transcripts, socio-economic data such as household income and family educational background, recommendations and the extra-curricular activities of every applicant, and data on performance ex post for those who have attended. For many universities, this is a database that encompasses hundreds of thousands of students.

There are differences from one high school to the next, and the sample a college has from any one high school might be sparse, but high schools and school districts can augment the data with further detail, so that the database can extend beyond those who have applied. And the data available to the colleges can be expanded by orders of magnitude if students agree to share their admission data and their college performance on an anonymized basis. There already are common applications forms used by many schools, so as far as admission data goes, this requires little more than adding an agreement in the college applications to share data; the sort of agreement we already make with Facebook or Google.

The end result, achievable in a few years, is a vast database of high school performance, drilling down to the specific high school, coupled with the colleges where each student applied, was accepted and attended, along with subsequent college performance. Of course, the nature of big data is that it is data, so students are still converted into numerical representations.  But these will cover many dimensions, and those dimensions will better reflect what the students actually do. Each college can approach and analyze the data differently to focus on what they care about.  It is the end of the SAT version of standardization. Colleges can still follow up with interviews, campus tours, and reviews of musical performances, articles, videos of sports, and the like.  But they will have a much better filter in place as they do so.

Wednesday, November 20, 2013

Live to Eat, Eat to Live

In a recent New York Times opinion piece, Paul Krugman assessed the possibility that the economy is in a new, constant state of mild depression, and suggests several reasons why this might be occurring, including slowing population growth and a persistent trade deficit.

To this I would like to suggest another one, which has been a topic of some of my previous posts: We simply demand less in terms of the consumption of produced, brick and mortar types of goods because that is not where we are spending our lives. Granted, we need a place to live, food to eat, a car to get around, but now we are not living to eat, we are eating to live; we are living to do things that do not require a huge industrial machine. (I won't even get into the point that insofar as we require the output of the industrial machine, it is now being run with less labor required).

Take a look at how people are spending their non-working, non-sleeping, non-eating time. It is increasingly doing things where the sum of the goods required are a chair, a table, and the machinery necessary to get a window into the virtual world, whether for binge-watching Breaking Bad, juggling texting with downloading photos, watching YouTube, or, for those who are creatively engaged, producing those YouTubes, in the case of my nine-year old, making movies on Movie Star Planet. The more we are focused on these activities, the less we feel invested in the homes where we generally occupy a five by ten space for our virtual activities, or in our car, which we now use as a transportation vehicle for those occasions where we venture out.

It doesn't take much of a reorientation in this direction to make a difference; and it takes even less when, as Krugman points out, there already is a drop in the demographically-driven demand even if everything else is held constant. And the forward path from here has the potential to be far more troubling that for the demographics, which at this point are mostly behind us. As I have written elsewhere:

We are in the year 2025: Because of advances in production technology, much of the path from extracting the required renewable resources through to the production and distribution of most of the items we demand can be accomplished with automated methods overseen by a small cadre of engineers. The main items we demand, beyond food, clothing and shelter, are the nth generation social connection systems. We are approaching the level of Nozick’s experience machine; we can anyone we want in whatever world we want, accompanied by whomever we want. If you think you used to burn a lot of your free waking hours with your jumping between email, video games, Facebook, and HBO way back when….

Given our evolved interests, most of us are spending a fraction of our income on consumption. There just isn’t a lot that we demand. What we do demand is cheap, and doesn’t require much of any labor to produce.
Or, doesn’t require production at all. For those who have the money to burn, demand is moving increasingly toward things like land, art, rare wines and Super Bowl tickets, by and large transfers without any economic impact. These notwithstanding, conspicuous consumption is also being dampened; what you wear or drive no longer is so dominating a signal; a far better picture of you and your status is just a few clicks away.

We are a society that basically eats, sleeps, works and then veges out. Not surprising, I guess, given that the tip of the spear of the economy, such as it is, are those same kids who a decade or two earlier were living at home with their parents after college, after graduate school – well, some still are. Though many of us now have our own prefabricated SmallHouse® (McMansions are a thing of the past; no one needs all that space, and, like mink stoles post-Mad Men, social norms regard these as the extravagances of a bygone era). That plus a car, food (the former rarely used, and both produced very inexpensively), our two-hundred dollar experience machine, and we are happy as a clam.

I don’t know exactly how this economy of the future works, but I can tell you that it is not working well. Where is the money coming from for even this minimally consumptive society? What levers can we pull to get ourselves out of this stagnant economy, to reduce unemployment? 

Sunday, March 3, 2013

The Product is the Promise: Finance and Social Values

In the first paragraph of my book A Demon of Our Own Design (Wiley, 2007) I observe that “You don't deliberately obliterate hundreds of billions of dollars of investor money. And that is at the heart of this book – it is going to happen again. The financial markets that we have constructed are now so complex, and the speed of transactions so fast, that apparently isolated actions and even minor events can have catastrophic consequences.” I then spend a significant portion of the book explaining the mechanics that lead the financial markets to lurch from crisis to crisis; why is it that while engineering in other fields increases safety, financial engineering seems to make things get worse. I suggest that the problem stems from the complexity and tight coupling that we introduce into the markets; complexity through financial innovations, tight coupling through leverage.

A system that is both complex and tightly coupled will almost inevitably have occasional accidents, what engineers term “normal accidents.” Attempts to reduce these accidents by adding in safety measures might actually increase their frequency because the safety measures add further complexity. This is not merely a philosophical point; in my book I go into detail on how some notable accidents – Chernobyl, Three Mile Island and Value Jet – occurred because of the added complexity from safety measures.

We can delve more deeply into the question, because even if we accept the argument from normal accidents, it still seems that financial markets have more than their fair share. Crises seem integral in financial sphere in a way that they do not in other industries. So we can pose the question of what it is about financial markets and the financial industry that make them different. There is an obvious and at the same time deep answer, one that relates to the essence of social interaction.

Lender or Borrower Be
To breed an animal with the right to make promises—is not this the paradoxical task that nature has set itself in the case of man?” – Nietzsche

In the Stanford “Marshmallow Test”, a child is placed in a room alone with a marshmallow and told that he may eat the marshmallow now, but if he waits ten minutes without eating it he will get two marshmallows. The punchline for the test is that there appears to be a relationship between the ability to wait and success later in life. (Not considered is how much the child actually likes marshmallows – I imagine an astute child who hates marshmallows eating the one immediately so as not to face eating two later. Neither is considered how much the subject ate for lunch before the test).

This is a test of an innately human trait: the willingness to sacrifice today for a later reward. For Toynbee, this trait is the mark of civilization, because it is only through building structures, clearing land, planting trees, all designed to find function beyond one's own life, that civilization can take root. When this trait occurs between two parties, we have created the relationship of the creditor and debtor. For Nietzsche, the promise enacted between creditor and debtor is the source of conscience and mercy. And, ultimately it is also the source of feudal classes and of what we now call capitalism.

The human trait of binding oneself now to gain a reward in the future leads to our ability to make promises. And the ability to make promises leads to three other traits: First, a conscience. And, because conscience only goes so far, the right to mete out punishment for non-performance. It also requires that people be similar, or at least predictable, because unlike a trade in the present, a promise is an abstraction that requires both parties share the same context.

It is through the creditor/debtor relationship that the rudimentary concepts of economic exchange – setting prices, determining values, agreeing on equivalences – evolved to introduce concepts of rights, contract, obligation, and means of settlement into society. With regard to the ability to enforce the terms and to punish those who fail, it also introduced the concepts of measuring one's power against another. And the promise required yet other characteristics we find essential to civilization: the ability to reach and record an abstract understanding, and to trust.

Nietzsche takes this beyond the corporeal to the extreme of the spiritual, where the realization of the promise is not in one's lifetime. The creditor becomes Christ, salvation to the debtor in the future for obedience and faith in the present. Nietzsche states, “we stand before the paradoxical and horrifying expedient that afforded temporary relief for tormented humanity, that stroke of genius on the part of Christianity: God himself sacrifices himself for the guilt of mankind, God himself makes payment to himself."

The Abstraction of Promises
It is the role of creditor and debtor that differentiates finance from economics. The most common and primitive economic act, that of trading goods, whether in kind or through a medium of exchange, does not have an temporal separation and does not invoke a promise. The promise and its traits come about once the roles of creditor and debtor become part of society, that is, once a financial exchange occurs.

In measured steps, finance has added layers of abstraction to the creditor/debtor relationship. In early society promises were made in kind. One good was delivered in exchange for the promise of another. Then collateral was attached to the loan – if the item being loaned formed the collateral, it was the equivalent of modern-day mortgage bonds. Collateral also could take the form of an agreement to be punished in the face of non-performance; the preverbal pound of flesh. With the advent of money came the promise made in terms of a payment that required a notion of equivalence, a general obligation bond. As with any promise there was the risk of default, but otherwise the payment made and received was fully defined in monetary terms. This made debts more easily transferable, creating what was essentially a bearer bond rather than an obligation to a specific creditor.

With the advent of mercantile trade in Medieval Europe came capital for financing the fleet and crew in exchange for the promise of a share of the bounty. This is the critical step in differentiating promises in finance from those in other areas, because the promise was defined in terms of unknown value. The final step in the chain of increasing abstraction and uncertainty came with forward contracts, where both the roles of the creditor and debtor were blurred. Both parties owed and were paid, but the exchange occurred in the future. One or the other part of the exchange was of uncertain value – indeed it did not yet exist – and funds could be more easily borrowed if the uncertain value was converted to a certain one.

Promises, Punishment and Mercy
In a primitive society, the punishment for reneging on a promise could be severe. This was because the “shadow of the future” was short, and because the debtor might not be brought to punishment. But as the structure of society progressed, punishment became more certain. People formed societies where reputation was critical, and as the societies became more stable, the failures of the debtor could be absorbed more easily. As people became more wealthy and their status secure – and those with wealth were the likely creditors – they could afford to reduce the severity of punishment. One path of this social evolution led to the feudal relationship of lord and vassal: the beneficent creditor and the loyal debtor. This process came to the point of contributing to a societal role for forgiveness and mercy. Nietzsche observes that:

It is not unthinkable that a society might attain such a consciousness of power that it could allow itself the noblest luxury possible to it— letting those who harm it go unpunished. “What are my parasites to me?” it might say. “May they live and prosper: I am strong enough for that!” The justice which began with, “everything is dischargeable, everything must be discharged,” ends by winking and letting those incapable of discharging their debt go free: it ends, as does every good thing on earth, by overcoming itself. This self-overcoming of justice: one knows the beautiful name it has given itself—mercy.

So we can see the path from the trait of sacrificing for the future leading to the concept of creditor and debtor; the creditor and debtor bound by a promise; and the concept of a promise helping to establish the form of society and its moral structure. It is no wonder, given its genealogy, that many view capitalism as something more basic than a form of economic organization, indeed that it is viewed by some as having moral, even religious, overtones.

Note: This post draws heavily from Nietzsche: On The Genealogy of Morals, from which the quotes are taken.