Starting with the basics.
The basics, it turns out, are not in traditional economics but in physics. To produce a useful product or service it takes energy in order to do the work. All production requires mechanical, electrical or, chemical work be done, hence energy is required. But there are special conditions that must be met before energy can be used to do work. Namely, the energy has to be at a high potential difference compared to the 'sink' or place where the used up energy goes after the work is accomplished. Such a potential difference can be recognized in, for example, the difference in temperature between the fire in a boiler and that in the cooling coils of a steam turbine. Heat at a high temperature boils water that expands pushing the turbine blades to do mechanical work. The steam must eventually be condensed back to water to start the cycle over again. The energy in the burning of a fuel at a high temperature flows through the boiler/turbine/condenser system doing the work and exiting it from the condenser coils as waste heat. The heat flows off into the environment, which is at a much lower temperature. Generally speaking the energy is thus dissipated in an unrecoverable form. That means the waste heat can do no more work. In actuality energy loss in the form of unrecoverable heat occurs throughout the system. Heat is given off by each stage from boiler to condenser.
Let me briefly explain if you haven't had a basic physics course (if you have then skip down a paragraph). Whenever energy is converted from one form to another, say from electricity in a circuit to mechanical motion, as in a motor, some of the energy is sloughed off, so to speak, in the form of waste heat. This is one of the consequences of the Second Law of Thermodynamics. That law states that some portion of energy is lost at each conversion. A more refined version provides a way of determining what the theoretical upper limits of work that can be achieved with each kind of conversion. Details are in the geometry of the work process, friction, etc. They need not bother us here. What we do need to take away from this fact is that no work process can ever come close to one hundred percent efficiency in its use of energy. Efficiency is a ratio of work out for energy in. And typical efficiencies for ordinary chemical, electrical, and mechanical systems range from ten to eighty percent, with most on the lower end. One very important form of chemical work is the conversion of sunlight into carbohydrates (a form of stored chemical energy) accomplished by photosynthesis in plants. In this process the average efficiency is amazingly between 0.5 and 1.0 percent! As productive as plant life is in converting sunlight to biomass the thermodynamic efficiency is quite low. This does not bode well for the concept of biofuels unless the rate of use of the fuels is substantially less than the rate of production of biomass. Plants will convert sunlight as long as the sun shines. They aren't particularly fast at it, but they are steady. And they grow over large areas. That is the good news. The bad news is that we have a penchant for burning the fuels both day and night, and there are so many of us that it is not likely that photosynthesis will ever be able to supply our desires.
What does all of this have to do with capitalism? You might think I'm about to launch into a promotion for investing in alternative energy technologies. That is not a bad idea, but I want to write about something much more fundamental as a prelude to a further discussion of how we might design the economy to be sustainable in the future. Capitalism, as it is currently practiced is not particularly sustainable. It has lost its original meaning and value. Now it has become simply a means for making the rich richer, and as a consequence, the poor poorer.
If you recall, I hold that money is really just a form of information about the availability of energy to do useful work, or at least it should be viewed that way. If we put this idea together with the above concepts of work and thermodynamics we get a very interesting way to look at capitalism. Namely, capital is excess energy available to do work. It is a concentration of energy that is at a higher potential than the surrounding economy! When a capitalist accumulates wealth (money) and then invests it in, say, manufacturing facilities and wages guess what gets done? Work. The capitalist has exchanged her tokens of available energy for work to create the facilities and for the energy inputs from labor to produce products that someone else is willing to exchange their rewards for doing work (money). These are called customers, and these days we call them consumers for a good reason. If the capitalist has produced a product lots of customers want, she can charge a price that returns the original investment plus a profit and the whole cycle starts again. Adam Smith famously noted that the capitalist's self-interest (profit) would provide both incentive and fuel to keep this cycle going. But that, it turns out, isn't quite right.
There is just one problem with the standard economic view that I just summarized. If capital is excess energy, in reality, it has to come from some source. It has to be converted into a usable form. And, as work is accomplished, it is dissipated into the atmosphere as waste heat. It's a one way trip. This may be a bit subtle, but unless the product that the capitalist produces is something that increases the available energy to the whole economy (a tool; see link above), energy will be used up and lost forever without any net increase in energy in the future. In other words, the world loses energy and can do less real work in the future. [In fairness to Smith he also wrote about moral issues related to capitalism. He can't be faulted for the fact that greedy people have conveniently ignored his works in moral sentiments and find justification in his explication of the 'invisible hand'.]
The motive for being a capitalist is also questionable by Smith's report. Self-interest easily morphs into greed it seems. People begin to expect profits to grow. Somewhere in there the invisible hand lost a grip.
Originally profit amounted to skimming a bit of the excess energy produced by producing tools. Investing energy into tools that produce more energy (like plows for example) can create a situation where excess energy is produced for a time. Profit is a percentage of the excess returned to the capitalist so that she can continue investment in maintaining or even growing the production capacity (growth of equity). Perhaps, if things go well and for short periods of time, the returns may allow a small percentage of the profit to go to the capitalist as a reward (dividends). Such is a sustainable system where all of the energy inputs and outputs balance and the production of any excess is temporarily stored for future use.
Banks were originally about storing excess energy! The notion of a bank is incredibly simple. It originated in the construction of common grain storage facilities. When growing conditions were good (back in Mesopotamia) the farmers could store their excess production in the facilities. Writing was invented originally to mark the amount of grain from each farmer so that s/he could reclaim that grain when winter or bad growing seasons required it. An overseer of the granary would make a living protecting and accounting for the grain (this actually worked for all storable food products) by charging a small percentage of the grain from each farmer. Granaries are representative of a very general systems concept called buffers. A buffer is a temporary storage facility that helps smooth out the flow of energy when there are ups and downs in production. A physical inventory is another example of a buffer.
After the invention of money as tokens of wealth (grain in this case) things got a little more complicated. Banks as buffers for tokens, vs. grain, became an abstraction of the real underlying process — storing energy directly. Then some inventive banker came up with a clever, but not wise, idea. Money could be used to purchase stuff, like more seed and plows, etc. Banks could lend money to farmers who could show promise for bringing in a bumper crop, thus increasing the excess in the granaries. So the idea that we could take some of the prior excess energy and use it to 'invest' in future production was born. At one fell swoop we got debt financing and capitalism. At first the idea was quite worthy, as long as no one got greedy and the crops came in as expected. Occasionally the weather didn't cooperate and the whole society suffered. People, especially bankers, quickly developed the notion of risk. And it was a short step from that to the idea of those doing the lending mitigating risk by extracting a profit from the practice of lending. Wow! What an idea! If you were in the business of managing the flow of energy (money) you could have your cake and eat it too! Not a bad invention, for a few, that is.
Banking soon invented the concept of lending some peoples' rightfully owned assets to other people who promised to increase production and thereby pay back even more excess than would have otherwise been expected. If you could get the excess back before the rightful owners demanded to withdraw their portions, hey you could make a handy profit and nobody would be harmed. Right?
Fractional reserve banking is the greatest rip-off of all time. It has the effect of creating new energy, or seeming to. Today we recognize different kinds of money. There is the basic currency printed by the government and used for normal buying and selling (economists call it M1). Then there is the money created by banks through fractional reserves. This allows banks to loan out of their savings accounts (other people's money) as long as they retain a fixed percentage of those funds on hand, in case the rightful owner comes knocking on the door wanting their money. This magically creates more money (M2 and above). The original money is simultaneously in the bank, as far as the owner is concerned, but it is also back in circulation supposedly being invested in new wealth creation. Of course no new energy was actually created in this process. It just appears to have been.
Then we get to the final act in this drama. The borrowers no longer are constrained to produce new wealth (produce tools) with this phantom capital. They are permitted to buy toys and entertainment. They are permitted to buy bigger houses and cars that add no new wealth to the economy. Its all on the theory that economic growth is a good thing and when we spend money we are creating jobs. But what we are buying are just for pleasure and egos. No new work can be accomplished as a result of these expenditures, we just feel better about ourselves. Meanwhile the capitalists are attracting and concentrating capital by enticing many more who, because they were able to borrow money for frivolous purposes now feel like they actually have excess capital to spare, willingly buy the stocks of companies that make toys and entertainment. Stock, the original mechanism for aggregating enough capital for investment, is now traded on secondary and tertiary markets; not so that the companies are particularly better off, capital wise, but to provide so-called liquidity to the market players. And then, additionally, to provide hedges against bad investments, to become a huge legalized gambling game for those who felt a little rich. And we are led at last to the greatest scheme of them all, market bubbles as people actually believe that they can create wealth out of nothing but speculation on... what? Just on speculation.
Bringing us back to energy. The basis of the speculative frenzy is a belief that we will have more capacity to do work in the future, in other words more energy. People are willing to take a risk, either borrowing or lending, because they believe that tomorrow will bring more wealth than today. They believe it because that is the way things have worked out in the past, for the most part. Most people think about it in terms of getting richer. The more money you own the more work you can have done for you in the future. They have forgotten that money (wealth, riches) really only represents energy, or should. Money, today, is based on pure fluff. Banking has been perverted to generate economic activity even when that activity is purely based on consuming energy without producing new tools — to produce future energy. The only way we got away with this is that the run up in fossil fuel production, especially oil, over the last hundred years has masked the reality. As long as we could pump more oil, with its tremendous energy concentration value, the scheme seemed to be working. People did get rich, some obscenely so. But because the reality was only a mask it also depended on depleting natural resources at an increasing rate and ripping off those less able to look out for their own economic interest. The twin perversions - capitalism and banking - combined to produce many more poor people than rich.
Real capitalism would be the process of concentrating energy resources in order to do work that would ultimately produce tools — implements and procedures. Those, in turn, would increase our net available energy to do even more work in the future. An automobile, for example, is a transportation tool when it is used to get one to and from one's job, assuming that job involves increasing net energy (so a yacht salesman would not count). It ceases being a tool when it is oversized and wasteful, when it is more an adornment or status symbol. Not that some form of adornment/symbolism doesn't have a place in society. It does. But it just can't be the main reason for existence of our objects. Capitalists are people who organize the concentration of energy and deploy means of production for the benefit of society. What passes as capitalism today is more about making a quick buck for one's self. There is little thought of what is good for society. The evidence — Enron, the Dot Com bubble, the current bad debt financial debacle, shall I go on?
And real banking? We still need to be able to buffer energy and material flows due to surges and delays. If we make excess wealth we need to have a safe haven to store it until it is needed to generate new wealth. Real banking, without the fractional reserves allowance, and real capitalism combined would be the boon to humanity that they started out to be. But it takes a healthy dose of ethics, moral courage, and understanding of the real currency flow (energy) to eschew a selfish desire to get rich and game the system. It also takes a special responsibility by capitalists and bankers to manage resources for the good of humanity. Adam Smith's invisible hand is the wisdom demonstrated by these people to make the right choices. Unfortunately Human 1.89, as a rule, doesn't seem to have the capacity to have this level of wisdom. That is why capitalism and banking have gotten so perverted. It will take Human 2.0, Homo eusapiens to manage it.