Having dismissed punishment as the origin of bad conscience, Nietzsche offers his own hypothesis: bad conscience came about with the transition from hunter-gatherer societies to permanent settlements. All our animal instincts of life in the wild became useless, and, in order to survive, we had to rely on our conscious mind rather than our unconscious instincts.
Nietzsche suggests that instincts that cannot be released outwardly must be turned inward. The instincts of hunting, cruelty, hostility and destruction that characterized our pre-historic lives had to be suppressed when we entered into society. As a result, we turned all this violence in toward ourselves, made ourselves a new wilderness to be struggled against and conquered. In so doing, we developed an inner life and bad conscience. Nietzsche characterizes the war we wage against our own instincts as "man's suffering of man, of himself," and sees in this struggle the suggestion that "man [is] not a goal but only a way, an episode, a bridge, a great promise."
This assessment relies on the assumption that the transition into settled communities was a violent one, that it was forced upon the majority by a tyrannical minority: the "social contract" is a myth. Deprived of freedom, the majority had to turn their instinct for freedom inward upon themselves, thus creating the bad conscience. In so doing, they also created the idea of beauty and developed selflessness as an ideal.
Next, Nietzsche traces the development of the bad conscience beginning with the sense of indebtedness early tribe members must have felt toward the founders of the tribe. As the tribe became increasingly powerful, there was an increasing debt that had to be paid to these revered ancestors. Given enough time, these ancestors came to be worshipped as gods. As "the maximum god attained so far," the Christian God also produces the maximum feeling of guilty indebtedness. This debt cannot possibly be repaid, and so we develop the concepts of eternal damnation and of all people being born with irredeemable original sin. The genius of Christianity is then to have God (as Christ) sacrifice himself in order to redeem all our sins: God, the creditor, sacrifices himself out of love for his debtor.
Nietzsche suggests that not all Gods serve to reinforce bad conscience. While the Christian God is the focal point of bad conscience, self- torture, and guilt, the Greek gods serve as a celebration of their animal instincts, as a force to ward off the bad conscience.
Nietzsche concludes by suggesting that there might be a way out of the past few millenia of bad conscience and self-torture. If the bad conscience could be turned not against our animal instincts, but against everything in us that opposes those instincts and turns against life itself, we could turn consciousness toward an affirmation of life and against the "illnesses" of Christianity and nihilism.
Nietsche often speaks very harshly about slave morality, bad conscience, and much besides that characterizes contemporary society, and it might be difficult to see his attitude going any deeper than sheer contempt. The temptation would be to read a simple "past was good, present is bad" into Nietzsche, which recommends a return to the savage, cruel, but "cheerful" past before the development of slave morality or bad conscience. This section of the text encourages a more complex and accurate reading.
While Nietzsche speaks of bad conscience as an "illness" and harshly disparages slave morality in the first essay, he sees these recent developments in human history as carrying some advance over past societies. While prehistoric people may have been more cheerful, more free spirited, less mediocre, they also lacked depth. They allowed themselves to be governed by their instincts, and their will to power was always turned outward toward conquest and survival. They had no interest in themselves and made no effort to control themselves or understand themselves.
With the formation of fixed communities, the cheerful barbarians lost the freedom to harm others, to roam free, to obey their instincts. Unable to direct their will to power outward, they turned it inward and aimed to overcome and conquer themselves. In so doing, they discovered an inner life. While this inner life led to the development of slave morality and bad conscience, Nietzsche also mentions some significant improvements: we became "interesting," we developed the concept of beauty, we distanced ourselves from other animals, and so on.
Nietzsche's objections to contemporary society aren't meant as an inducement to return to some primeval way of life: he would not have us lose our depth. Rather than going back, Nietzsche wants us going ever forward. If the inner life is the outcome of the will to power turning inward, then our inner life is essentially a struggle. Nietzsche wants us to win this struggle. Our will to power must overcome itself completely so that we no longer have a bad conscience or ressentiment. In Thus Spoke Zarathustra Nietzsche famously calls the person who has attained this final state the overman, or superman. In that work, he speaks of humanity as a rope between animal and overman. The struggle that is our lives therefore makes us interesting, and is a sign that we are walking along this rope.
Nietzsche's frustration with contemporary society, then, is not that we are headed away from our animal past, but that we are not strong enough to win the struggle. Bad conscience arises when we see ourselves as something shameful and hateful, and this bad conscience can make us tame and mediocre. To overcome ourselves we must affirm ourselves, see life, the world, and ourselves as great things, not sins to atone for. Nietzsche worries that we have come to see ourselves as fixed things, as ends in ourselves. He counters that we are neither fixed nor things: we are a jumble of battling forces, fighting to overcome one another. If we stay as we are, we are simply a mess, but if we press forward, we can be gods.