On Algae and Animal Spirits

Arjun and I did a webinar recently on our book Against Money, organized by Merijn Knibbe. We’re very grateful to him for putting it together, and should have video to share soon.

Even in a friendly setting like this, it can be a challenge to explain what the real-world stakes are in debates over money. But as it happens, a Matt Levine column that came out the same day as the webinar offers a perfect application of one of the central themes of the book.

To be honest, this is not really surprising. You could almost think of our project as backfilling the economic theory behind Levine’s columns, which often describe a world far removed from the textbooks. “How Keynes explains last week’s Money Stuff” would be a decent elevator pitch for the book.

The lead item in this Money Stuff was about a hypothetical algae farming startup, and the financing thereof:

You start a startup with a far-fetched idea like genetically engineering algae to produce clean renewable fuel. You go out to investors to raise money. You say “we are going to genetically engineer algae to produce clean renewable fuel, if we succeed we will make a bajillion dollars, you want in?” The investors think that sounds cool, because it does. But they are responsible investors, they do their due diligence, they ask questions like “is that a thing” and “can you actually produce fuel algae” and “will it be cost-effective?” You do your best to answer their questions.

Do you exaggerate? Oh sure. That is the job of a startup founder. I once wrote, approximately:

What you want, when you invest in a startup, is a founder who combines (1) an insanely ambitious vision with (2) a clear-eyed plan to make it come true and (3) the ability to make people believe in the vision now. “We’ll tinker with [algae] for a while and maybe in a decade or so a fuel-[producing strain of algae] will come out of it”: True, yes, but a bad pitch. The pitch is, like, you put your arm around the shoulder of an investor, you gesture sweepingly into the distance, you close your eyes, she closes her eyes, and you say in mellifluous tones: “Can’t you see the [algae producing clean fuel oil] right now? Aren’t they beautiful? So clean and efficient, look at how nicely they [float in this pond], look at all those [genes], all built in-house, aren’t they amazing? Here, hold out your hand, you can touch the [algae] right now. Let’s go for a [swim].”

Of course, you are a startup founder; you are in essence a salesperson. Back at the lab, the algae scientists and chemical engineers and accountants are looking at your pitchbook in disbelief. “Wait, you’re telling investors that we can produce the fuel oil now? You’re telling them that we’ll have large profits in two years? Did you not read our latest status report?” The scientists and accountants are boring and conservative; it is their job to try to make the dream work in dreary reality. It is your job to sell the dream now.

(The brackets are there because he is repurposing text from an earlier column on AI.)

This is a story about finance, not about venture capital specifically. The details would be different if the algae company were getting a loan from a bank, but the fundamental situation would be the same.

I want to make a few points about this.

First, what’s being described here is not a market outcome. Nobody has yet purchased any fuel made from genetically modified algae. To the extent there are market signals here, they point in the wrong direction — at current prices, the cost of producing this fuel would be greater than what it would sell for. Nor has this business shown profits in the past — it’s a startup. Right now, the market is saying this is a value-subtracting activity. Funding it anyway is the opposite of what market signals are saying to do.

Funding the algae project is an explicit decision by someone in authority.1 It is a decision based on promises. It is based, precisely as Levine says, on dreams.

Joseph Schumpeter compared the function of banks under modern capitalism to Gosplan, the central planning agency of the old Soviet Union. Banks, through a conscious, deliberate decision, dedicate some fraction of society’s resources to some project that they have decided is worthwhile. “The issue to the entrepreneurs of new means of payments created ad hoc” by the banks, he writes, is “what corresponds in capitalist society to the order issued by the central bureau in the socialist state.”

What’s more, as Arjun and I write in Against Money, banks

are stronger in a certain way than any real central planner, because they have the authority to redistribute anything. A Soviet planner might assign a plant this many tons of some raw material, that much electricity, use of those parts of the transportation network. Money as the universal equivalent is a token granting the holder use of whatever they need. A loan then is a ticket to the entrepreneur saying, you have the authority to take whatever labor and other resources your project requires.

In this sense, markets are not an alternative to planning, they are a tool for planning. Money is the substrate within which planning takes place.

People used to talk about a “soft budget constraint” as a defining feature of the Soviet economy — enterprises could continue operating even if their costs exceeded their sales, as long as the planners saw some social value in their continued operation.2

Startups like the algae power company have the softest of soft budget constraints. They are able to incur substantial costs, often over many years, without any sales at all.

This is not some weird quirk of venture capital. This is a central purpose of finance – to direct society’s resources to some activity that has not yet been successful in the market, but that somebody think could be. The defining characteristic of an entrepreneur is that they are doing something new, something that has not yet been proved in the market, with funding provided by someone else. An entrepreneur by definition faces a soft budget constraint.

This is not, again, an anomaly, it is not a breakdown of the normal operation of capitalism. It is essential to what makes capital such a powerful force for transforming our material existence. And it needs to be central to our theoretical accounts of capital and of the investment process.

It certainly was for Keynes. As he famously observed in Chapter 12 of the General Theory,

a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die;—though fears of loss may have a basis no more reasonable than hopes of profit had before.

It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits.

Markets and the pursuit of private profit have existed for much longer than the their fusion with long-lived means of production command over wage labor that we call capital. One important reason for the failure of profit-seeking, through most of its history, to revolutionize production, is that these activities were subject to hard budget constraints and forced to adhere closely to market signals. Through most of their history, they couldn’t create new forms of production on the basis of dreams.

The algae company is getting access to real resources — authority over other people’s labor — because they have convinced a planner that their project is worthwhile.

Market socialists — whose belief in the virtue of markets is exceeded only, perhaps, by 19 year olds who have recently discovered Ayn Rand — like to ask how socialism can maintain the material accomplishments of capitalism without markets. But it isn’t markets that produced the genuine and immense material accomplishments of capitalism.

The initial investments in AI or algae farming — or automobiles or airplanes or antibiotics — are not a response to market signals. They are conscious choices by some group of people to try something that hasn’t been done before. We might like algae and dislike AI (I certainly do), but getting more of one and less of the other requires neither more nor less attention to market signals, which are not responsible for either one. It requires some substantive improvement in the planning system.

Now, some people might say: This planning is based on the hope of future profit, it will eventually have to be validated by markets. But it is not incidental that the market outcome and the pursuit of profit are mediated by conscious planning. They do not happen automatically. The judgement of the market can be deferred, in principle indefinitely. And there are many other projects that might equally well be validated markets, if their early stages were attractive to finance.

We must guard against the idea that the assessment of future profitability is rational or objective, an observation of existing facts about the world. This is one reason the Levine story is useful – it focuses our attention on the ways that financing decisions are made in practice. Making energy from algae is cool! As he says, this a critical aspect of the investment process. That should not be abstracted from.

There are many potentially profitable businesses that never get access to financing. The required return for most startups is very high, or effectively infinite. Manias may be essential to maintain an adequate level of investment. The irrationally high discount rate applied to future returns can only be offset by an irrationally high expectation of future profits. (See, as for much of this post, the current AI boom.)

Nor is it clear that future profit always is the motivation, certainly not the only one, and certainly in the early stages. It’s not incidental that Levine emphasis that algae energy could get funding in part because it is cool. It’s not, perhaps, incidental that OpenAI started its existence as nonprofit. The pursuit of profit is not always what motivates investment, especially when it involves fundamental departures from existing forms of production.

This conflict between the pursuit of profit and large-scale fixed investment goes back to the beginning of industrial capitalism. As Eric Hobsbawm observes in his classic account of the Industrial Revolution, the textile industry — small scale, labor-intensive — could develop through largely self-financed improvements on existing production methods serving existing markets. But the large-scale capital-goods industry, using novel techniques to serve a market that was only brought into existence by the Industrial Revolution itself, required something more. The pursuit of profit was an inadequate spur in the absence of some additional non-pecuniary motive.

No industrial economy can develop beyond a certain point until it possesses adequate capital-goods capacity. … But it is also evident that under conditions of private enterprise the extremely costly capital investment necessary for much of this development is not likely to be undertaken… For [consumer goods] a mass market already exists, at least potentially: even very primitive men wear shirts or use household equipment and foodstuffs. The problem is merely how to put a sufficiently vast market sufficiently quickly within the purview of businessmen.

But no such market exists, e.g., for heavy iron equipment such as girders. It only comes into existence in the course of an industrial revolution (and not always then), and those who lock up their money in the very heavy investments required even by quite modest iron-works … are more likely to be speculators, adventurers and dreamers than sound businessmen. In fact in France a sect of such speculative technological adventurers, the Saint-Simonians, acted as chief propagandists of the kind of industrialization which needed heavy and long-range investment.

The Saint-Simonians driving the investment boom of the 19th century, the rationalists and long-termists and Zizians driving investment in the 21st — perhaps it’s not such a far-fetched analogy. (Though personally I find Saint Simon more appealing.) However different the content, they are filling the same essential function. And that is the key point here — a system that relies on private initiative for irreversible commitments to projects that transform production, cannot be based on rational calculation, on objective market signals. The market outcomes of these kinds of projects cannot be known until long after the die is cast. A different kind of motivation is needed.

A related point: Nobody knows, right now, if the algae thing will work. Nobody knows if AI will turn out to be useful (I think not, or not very, but I am well aware I could be wrong.) The tradeoff is not about allocating real resources to their best use, among the known uses available. The tradeoff is not a quantifiable one between the expected returns on this project and the expected return on that project. If the algae thing doesn’t get funding — and we can be sure that many, many projects as well founded are not getting funded — the reason will not be because society had a more urgent use for those resources. It will be because people couldn’t figure out a way to cooperate — that the mechanisms to convert promises (or dreams) into command over labor did not operate in that case.

(A flip side of this vision, which I can’t go into here but is essential to the larger argument, is that society has resources to spare. Many many people’s time is being spent much less usefully than it could be.)

There’s another, more subtle point. It is not just that we don’t know how profitable these projects will be until someone finances them and they are carried out. There is not any fact of the matter about how profitable these projects are, even in retrospect, independent of how they are financed.

This is the point where Arjun’s and my argument may be challenging for a certain strand of Marxists. (It is not, I think, a challenge to Marx himself, who said a lot of different things on these questions, at different levels of abstraction.)

There is an idea — Anwar Shaikh offers a contemporary example — that the rate of profit is determined first, in production, and then the rate of interest is secondary, a special case of profit, governed by it, or a deduction from it. But we can’t say what the profitability of the algae business even is, prior to the question of what terms it is financed. At one rate of interest it may be very profitable, at another less so or not worthier pursuing at all.

Now maybe you will say: sure, anyone can make a profit if they get that free Fed money. But it’s not just that. The relative profitability of different projects depends on the term on which they are financed.

Let’s consider two projects. One will make energy from burning oil, the other from growing algae. The oil project is straightforward: 100 dollars laid today will yield 120 dollars worth of fossil-fuel energy a year from now. The algae project requires a lot more upfront costs — you have to first, you know, figure out how to make energy from algae. But your best guess is that $100 invested today will allow you to produce $50 worth of fuel from $10 worth of inputs every year starting 15 years from now.

So, which of these two projects should you commit your capital to? Which of them is more profitable?

The answer, of course, is that you can’t say until you know how the projects will be financed.

Partly this is just a simple matter of discount rates. In these narrow terms, the algae project is more profitable if the interest rate is 5 percent; the fossil-fuel project is more profitable if the interest rate is 10 percent. This specific example is hypothetical. But it is clearly true as a general matter that lower interest rates increase returns on renewable energy relative to fossil fuels.

More broadly we have to consider, for instance, whether the financing will have to be rolled over if, say, the project takes longer than expected. What are financing conditions are likely to be at that point? If the loan is due and can’t be rolled over and the project has not yet generated sufficient returns to repay it, then the return on whatever capital the entrepreneur put in themselves will be negative 100 percent. The chance of this happening — which, again, depends as much on future financial conditions as on the income generated by the project itself — has to be factored in to the expected returns.

We also have to consider the terms of the financing — what kind of collateral will be required? Will it have to be periodically marked to market? What control rights are demanded by investors or lenders? The viability of the project from the point of view of the person carrying it out depends as much on these considerations as on the physical problem of converting algae to energy.

I recall a Wall Street Journal article years ago – unfortunately I can’t find a link – on the economics of putting power plants on barges. There were technical issues pro and con, but the decisive advantage of putting a plant on a barge was that it is better collateral that way. Lenders are more willing to finance a power plant when they can physically tow it away in the event of default.

So if we are going to evaluate the profitability of a power plant on a barge versus one on land, we have to consider how important it is to keep lenders happy — how scarce or abundant financing is. We also have to consider other monetary factors. A big utility, or one guaranteed by a state, can be counted on to pay its debt, so collateral is less important than it is for a smaller business without public backing.

Another angle one could come at this from is that the distribution of profits has a variance as well as a mean. How much the higher moments matter, depends how confident we are that contracts will be honored in alls states of the world. It depends on how confident we are that short-term deficits can be financed and that only the long-term outcome matters. To the extent that that’s true, we should just focus on mean expected profits. But if defaults are possible, or if some claims on the income are senior to others — another core question of financing — then the higher moments matter too. We can’t evaluate the relative profitability of profits without thinking about the whole distribution, and how we do that will depend on who is providing the funding. Banks strongly prefer lower-variance projects, venture capitalists seem to positively prefer high-variance ones.

This is the fundamental point Hyman Minsky was making with his two-price model. It is why he insisted that money is not neutral. The price of long-lived assets depends on the interest rate (or as he put it, the supply of money), in a way that the price of current output does not. The price of a factory relative to the stuff coming out of it will shift as money (or credit) becomes scarcer or more abundant.

And of course it’s not just two prices. It’s a whole set of prices, for capital goods that are more and less long-lived and are more or less specialized to particular production processes. The more scarce money is, the higher will be the price of the power plant on the barge relative to the power plant on land.

Again, this is not just a time discount. It’s a discount for uncertainty. It’s a discount for commitment. It’s a discount on hopes and dreams relative to money on the table.

For every interest rate there is a different schedule of labor values. For every interest rate there is a different set of market signals. A tight-money market socialism does different things from a loose-money market socialism.

This is a version of Sraffa’s argument that one can’t calculate labor inputs for different commodities unless we already know the profit rate, which must be determined from outside the production process — for instance, he says, “by the rate of money interest.” Even if we assume that all production possibilities are already known and available, we can’t decide which are most profitable unless we know the terms on which production will be financed.

In the real world, again, the possibilities for production are not known in advance. And contrary to Sraffa’s preferred assumption of content returns to scale, industrial production tends to have increasing returns, implying the existence of multiple equilibria. But directionally, all these considerations point the same way. Easy money makes projects with longer-term returns, higher-variance or more uncertain returns, more specialized capital goods, more increasing returns, and greater departures from current production processes more attractive. Tight money, the opposite.

This would be true even if we knew the physical outcomes of all possible production processes in advance. And of course, this is very far from the case. Instead, someone has to make big, irreversible decisions based on what seems cool.

A central function of discourse around finance, and the stock market in particular, is to obscure this role of finance in shaping and directing production. The stock market creates the situation it pretends to reflect, in which one production process can be smoothly traded off against another.

If the algae-company investment is successful, it will eventually result in the creation of a listing on a stock market, creating a tradable claim on the future profits from algae trading. At that point, income from algae energy will have a market price reflecting its exchangeability with all sorts of other incomes. You will be able to swap a claim on one future dollar of algae-energy income with a claim on future income from any of thousands of other listed companies.

It is tempting to treat this exchangeability of claims as simply a fact of nature, to retroactively project it back to the whole process of building this company. It is tempting to treat the investment decision that created the algae company as a process of market exchange just like swapping one share for another.

Showing how a system of hierarchical authority and conscious planning presents itself as the operation of an anonymous market — that, in a sense, is what our book is trying to do.