Part 6: What can the state do about the crisis?
Now we have reviewed the Marxist theory of crisis and compared it against the reality of the Great Recession, we need to look at how the crisis impacts on the different parts of national income. This is preliminary to a survey of government policy options intended to deal with the economic disaster. The effectiveness or otherwise of fiscal and monetary policy, and of different exchange rate regimes will be assessed. The contribution of the Keynesian and monetarist schools and their proposed remedies can then be weighed up.
Chapter 6.1: National income and the crisis
The expression national income (NI) is used quite casually throughout this book to describe the value of the flow of goods and services produced in a country over a period of time, usually a year. Gross domestic product (GDP) and gross national product (GNP) are used as equivalent to national income, and to one another. There are differences between GNP and GDP, but they are unimportant here.
National income, viewed by looking at total expenditure in the economy, is conventionally decomposed by statisticians into four elements: Government spending (G), Investment (I), Exports, (X) and Consumption (C). By ‘exports’ we mean net exports (exports minus imports), but we are trying to keep the analysis as simple as possible.
Statisticians label each element of national income as one of the above elements and in effect file them into the box they fit best. So the four elements always add up to one hundred per cent. This is just an accounting identity – it is true by definition.
Though government spending is essential for the maintenance and infrastructure of the capitalist system, and makes a lucrative market for big sections of the capitalist class, it does not directly produce surplus value (The exception to this is when the state owned and ran productive industries such as steel. This is now marginal in most capitalist countries.) The capitalists therefore systematically downplay and disregard the usefulness of government spending in a cavalier fashion, specially in a crisis when their priority is economising in a short-sighted fashion at all costs.
It is worth analysing government expenditure in more detail. Some is spent on welfare benefits. These are a cost of the capitalist system, which produces unemployment as naturally as it produces coca cola.
Much is laid out on services such as health and education. The capitalist system benefits enormously from a healthy and educated working class, but no capitalist institution has found a way to provide these services comprehensively to the mass of the people while making money out of their provision at the same time. All capitalist nations have had to have recourse to state provision of these services for the masses.
Finally the state invests, for instance on infrastructure. Public investment by definition does not directly generate surplus value. But government investment produces use values that greatly enhance the productivity of the private capitalist sector. Martin Wolf rages against the stupidity and short-sightedness of the UK coalition government in the Financial Times (12.11.10), because this is the part of state spending they are particularly anxious to cut:
“This is penny wise, pound foolish. The public sector does not only borrow; it also creates assets (or not). If, as is the case in the UK, the government slashes investment to cut borrowing, is it helping the economy or even the public finances in the longer term? Yet investment has, once again, been slashed more brutally than any other important area of spending.”
- Government spending is not just ‘waste’. It is an essential underpinning for the capitalist system.
If we see that national income has not expanded at all in recent years, that is because capital ceased to accumulate during the Great Recession, and production was thrown back. We need to know why that was the case. Economists are well aware that the most volatile component of GDP is investment. We shall see a little later the effect that the collapse of investment had on the Great Depression of 1929-33. But once again in the present, the recession has had its most dramatic effect upon investment. Here are the UK figures for 2009:
“Business investment fell 23.5 per cent last year, by far the largest decline since records began in the late 1960s. Manufacturing investment collapsed by 32.3 per cent and service sector investment plunged 29.9 per cent. Construction investment is down 21 per cent over last year, and 53 per cent from its peak.” (Fall in investment underlines growth fears. Daniel Pimlott in the Financial Times 26.03.10 commenting on the Office for National Statistics report for 2009)
This collapse in investment is bound to have knock-on effects by depressing consumption as workers lose their jobs. It makes industry ill-equipped to export and slows down the economy generally. This will in turn hit government receipts from tax and bump up spending on benefits and other recession-related subsidies, making the crisis of government finance more severe.
It is clear from the above explanation that the principal effect of the Great Recession in dragging down national income in all the major capitalist countries was through the collapse in investment. Similar figures can be recorded for the other major countries affected by the downturn, It is quite difficult to work out at this stage whether the recession started in the investment sector or not, because of the interdependence of all the components of national income. But it was here that it hit hardest.
This was also the case in the 1930s. Charles Kindleberger shows that, “Gross domestic investment in the United States amounted to $16 billion in 1929; it fell to $1 billion in 1932 and net investment to -$6.6 billion. Inventories declined, durable goods wore out, depreciation reduced fixed capital.” (The World in Depression, 1929-1939, p.191), Investment fell much more severely than consumption. This is the normal pattern of economic recession.
- Investment is the most volatile part of national income. Investment surges power booms and investment collapses lead to slumps.
Kindleberger fleshes out his analysis of the Great Depression by noting that, in the case of less developed countries, exports are actually the driving force of economic development. So, in the metropolitan heartlands of capitalism, investment is key, but for the dependent economies their impetus for growth must come from outside in order to stimulate their export industries. That is the transmission mechanism of the crisis as well as of growth. Exports are the most volatile sector of less developed country GDP. It was the loss of their export markets in the advanced capitalist countries that devastated their economies in the 1930s:
“Business decline in industrial countries spread to the less developed countries of the world, primarily by means of reduced exports. In these economies the level of exports is generally a critical autonomous variable in the determination of national income – more important than investment, which is often dependent on export sales, and surely more than government expenditure.” (ibid p.188)
The volatility of the export sector, and the shattering effect it can have on the rest of the economy, has been shown in the Great Recession. In the last quarter of 2008 world exports fell by 10%, an annual rate of 40%. For Germany the annualised rate for that quarter was 80%! On the other hand in 2011 the German economy has been turning in a stellar export performance which is lifting its economy much faster than those of its European trading partners.
- Exports are also volatile, and overseas markets are particularly important for less developed countries.
Consumption is the biggest element of GDP. It has been as much as 70% of the total in recent years. In modern capitalist economies it is roughly equivalent to workers’ wages, since the working class is a big majority of the population and they spend most of the money they receive. Consumption is the most stable sector of national income, passively adapting to the more dynamic driving forces of the economy. In the USA national income fell by 31% between 1929 and 1933 at constant prices (Prices fell steadily over the period.). Devastating as this was to the livelihoods of millions, it was a much smaller fall than the collapse of investment.
- Though the biggest component of national income, consumption is relatively stable and responds to the changes in other elements of GDP.
Chapter 6.2: Government economic policy options
What can governments do?
Government is a much bigger player in the capitalist economy than it was when Marx was writing. The state is a significant spender and provider of goods and services. It also plays a vital regulatory function. For instance, without the government laying down what side of the road motorists should drive on or what size a standard electric plug should be, a society composed only of markets would dissolve into chaos.
We ignore here the coercive role of the state in defending the interests of the ruling capitalist class. That is central, and from its effective monopoly of force the state gets legitimacy and can carry out all its ancillary functions. We are concerned with its economic role, and particularly to what extent it can effectively pursue counter-cyclical policies.
Conventional economic theory ascribes two policy levers that the state can use to influence the working of a capitalist economy. These are fiscal and monetary policy. Fiscal policy (from the Latin fiscus, meaning the Roman treasury) is supposed to work on the level of economic output by the government altering its taxing and spending plans. People entirely ignorant of the modern capitalist economy may assume that the government only spends exactly as much as it gets in taxes and other receipts, that is that it balances its budget.
This is by no means necessarily the case. The government can run a surplus, meaning that it pays off part of the national debt that has been built up historically. This is a contractionary fiscal policy, since it is effectively taking money out of people’s pockets. Or it can run a deficit by spending more than it gets in, leading to deeper indebtedness. It can do this by cutting taxes or by increasing public expenditure. Both of these count as an expansionary fiscal policy, since they effectively put more money in people’s pockets. If the government increases government spending or reduces taxes, it is believed by Keynesians that this will have a knock-on, ‘multiplier’ effect on economic activity.
How should the government pay for the deficit? It could do so by borrowing, usually by issuing bonds. This would increase the national debt. It is not necessarily inflationary any more than one person lending money to another must increase the general level of prices. On the other hand the government could pay for the deficit by simply printing money, which may well increase inflationary pressures. This is an aspect of monetary policy, which is dealt with later. (Chapter 6.4: Monetarism)
It can be argued quite forcefully that most governments are now so deep in debt as a result of the recession and the cost of bailing out the banks that discretionary fiscal policy is no longer really an option. Countries are head over heels in debt; could they borrow still more money? But expansionary fiscal policy remains a theoretical possibility. We need to look at whether it could be effective.
The other lever available to the government to affect the level of economic activity is monetary policy. In recent years this has been achieved by altering interest rates. It is believed that raising interest rates will reduce some economic activity, while cutting rates will cause the economy to grow faster.
It can also be argued persuasively that interest rates are now so low in most capitalist countries that further reducing interest rates would likewise be ineffective in stimulating the economy. The Keynesian adage has it that ‘you can pull on a piece of string’ (by raising interest rates), ‘but you can’t push on a piece of string’ by reducing them. So neither expansionary fiscal nor monetary policy is likely to work at present! If so, it is surely an indictment of capitalism that it is unable to solve its own problems.
In the past the monetary authorities, under the influence of the right wing economist Milton Friedman, believed that they could directly target the money supply. This monetarist policy was abandoned in the 1980s, principally because it was a complete fiasco as we shall see.
- There are possibilities, but also limits, for governments trying to affect the level of economic activity in a capitalist economy.
The problem with the Euro
The Euro is a single currency that has been adopted by seventeen countries in the European Union (EU) since 1999. Overwhelmingly the years since 1999 were prosperous – till recently – and national antagonisms within the Eurozone have been muted as a result. So the Euro has survived without a major test – till the present.
There were and are arguments in favour of being part of the Eurozone. Certainly Germany has found the Euro to be an excellent monetary mechanism for building trade surpluses with their trading partners in the European Union.
The Euro has the might of the German economy behind it. Low inflation, radiating out from Germany, would prevail throughout the Eurozone as well. That was the theory. After all the functionaries of the European Central Bank (ECB) were the direct successors of the officials who ran the famously austere German central bank and the Deutschmark.
Also countries such as Greece were supposed to be guaranteed the right to borrow at low interest rates. The rate of interest would, after all, be set by the ECB. In principle there would be one interest rate throughout the Eurozone. Since holding national bonds denominated in Euros would be ‘as safe as houses’, governments in Greece, Portugal and the rest of the peripheral zone would be able to finance themselves at low rates. That was the theory. The reality proved to be different when crisis struck.
Since the EU as an entity is a bigger economy than the USA, membership of the Eurozone was seen by small countries as offering some protection from being tossed helplessly on the waves by world economic forces. This expectation also proved completely wrong.
The real problem for governments is that membership of the Eurozone is an additional restraint on government action. It involves giving up the important levers of fiscal and monetary policy to try to control the economy. It also rules out devaluation as an option. It actually makes small member states in particular more helplessly dependent on outside events.
Kenneth Rogoff explains in the Financial Times how the fiscal crisis was exacerbated by the illusory protection of the Euro (05.05.10):
“Euro members were allowed to have their cake and eat it, too. Instead of starting to hit a ceiling of 90 per cent of GDP as might a ‘normal’ developing country, Greece could run its public debt to more than 115 per cent of GDP. Even more stunning a figure is Greece’s total external debt to GDP, which is more than 170 per cent, counting both public and private debt. Prof Reinhart and I find that most emerging markets run into trouble at external debt levels of merely 60 per cent of GDP. Indeed the external debt levels of Spain, Portugal and Ireland are all sky high if one were to judge them by emerging market standards.”
The article goes on, “In our book” (Reinhart and Rogoff-This time is different) “on financial history, Prof Reinhart and I find that international banking crises are almost inevitably followed by sovereign debt crises. Will the Euro prove to be a firewall against this process, or a debt machine that fuels it?”
Before the introduction of the single currency, EU countries running a deficit had the option of devaluing their currency if it was fixed, or allow it to depreciate if it was floating. In either case the Drachma, Lire or Peseta would become cheaper compared with the Deutschmark. So would their exports. This would make it easier for Greek, Italian or Spanish capitalists to export to Germany. This is not a comprehensive solution to a country’s lack of competiveness. It can provide a quick fix. It can get the authorities, and the national capitalist class, out of a hole for the time being. Its consequences are not so good for the national working class. Imported goods will be more expensive when denominated in the local currency, and the cost of living will rise.
Once a country has agreed to adopt the Euro the option of devaluation is blocked off, in principle for ever. The currencies of the Eurozone have become in effect permanently fused together.
- Devaluation is only ever a quick fix for a country in difficulties, but it is ruled out by membership of the Euro.
If devaluation is ruled out, then the only other way to gain competitiveness is by deflation. This means that the entire working class has to take cuts in living standards. Eventually, it is believed the price and wage levels will fall so far that the country will gain competiveness. How to get fit by starving to death! Apart from being extremely painful, this is not a very realistic solution.
Winston Churchill was the Chancellor of the Exchequer (finance minister) in the 1920s who decided to return Britain to the gold standard at an overvalued rate. The gold standard was a form of fixed exchange rate like the Euro. Tory Prime Minister Baldwin made it clear that deflation was the way to adjust the price level. “Every worker in the country has got to take a cut in their standard of living,” he declared. To achieve their aim the ruling class provoked the General Strike of 1926. Even after their victory, the pressures put upon the UK economy by deflation proved unbearable. Britain was bombed out of the gold standard in the crisis of 1931. The pound was floated (devalued).
Ultimately a sustained policy of deflation is usually insupportable. It is also ineffective. Mussolini, armed with a fascist dictatorship, was able to drive down workers’ living standards in Italy in response to the Great Depression. This policy did not lead to an economic recovery.
- Deflation is a ‘solution’ to problems of competitiveness that has been shown over and over again to be both painful and ineffective.
Chapter 6.3: Keynesianism
What is Keynesian economics?
Keynesianism became the dominant school of macroeconomics in the years after the Second World War. Whether what was adopted by the economics profession was the pure milk of Keynes’ theory or what his close collaborator Joan Robinson called “bastard Keynesianism” is not particularly important for our purposes here (Joan Robinson was right).
In the 1930s Keynes confronted a long period of stagnation within capitalism. He argued that the level of output was determined by aggregate demand and that demand was stagnant. In a situation with unused resources like the Great Depression in the 1930s Keynes advocated an expansionary fiscal policy. He advocated that the government spend money in order to create jobs and stimulate the economy. He did not think monetary policy would be as effective in the circumstances of the Great Depression, since interest rates were then quite low, as they are now. Keynes wanted above all to save capitalism from itself. He was not a socialist.
The widespread adoption of Keynesian economics after the War, and the prolonged post-War boom, spread the iimpression that Keynes’ policy prescriptions meant that capitalism could be tamed and controlled. Keynes’ policies were not used to avert a recession, which was not on the horizon and which most people thought had disappeared into history. Policy levers and instruments were used to attempt to fine tune the economy. Of course this was all an illusion, as the 1973-4 recession showed.
One of the conundrums economic policy-makers are confronted with under capitalism is what effect their policies will actually have upon the economy. In particular they need to know whether an expansionary policy will increase output or evaporate in rising prices. Likewise, if they are confronted with inflation, they need to know whether contractionary policy will cure the problem by bringing down the rate of price increases, cause unemployment or both.
A puzzling feature of the economy in the 1970s to the orthodox economists was the co-existence of inflation and unemployment – stagflation, as it was called. Keynesians believed that they could control the pace at which the economy grew. If it was run too fast, so that all resources were in use, the effect would be inflation. If it was not allowed to grow fast enough, unemployment would be the result. But the mixed signals they were getting suggested that the economy was growing simultaneously too fast and too slow! In reality they could not control the capitalist economy.
So Keynesian analysis failed in the 1970s and mass unemployment returned. Were expansionary policies actually tried? In the case of the UK the answer is a clear ‘no’. Britain emerged from the Second World War with a massive government debt to pay for the War effort. At one point the debt was more than 250% of GDP. In that situation the main aims of both Labour and Conservative governments after the War were to slim the national debt down and repay it over time.
Effectively post-War governments were running a contractionary fiscal policy, taking money out of the people’s pockets rather than pumping it in. Writing in the Economic Journal in 1968 R.C.O. Matthews pointed out, “Throughout the post-War period, the government, so far from injecting demand into the system…has persistently had a large surplus.” He went on, “The explanation of the rise in investment must lie at the heart of the rise in the level of economic activity.”
Christopher Dow, a Keynesian, agrees. Speaking more generally of the post-War boom, he comments, “Governments had accepted responsibility for maintaining a high level of demand and employment. But governments were never called on to do much to achieve this aim…The continuation of high employment cannot therefore be attributed directly to government policy.” (Dow-Major Recessions)
Some commentators have seen the recent U-turn on government intervention as a return to Keynes. This is quite wrong. Action to save the banks has been seen as a pragmatic emergency measure by governments of all political persuasions. Governments have indeed intervened massively to save capitalism with our money. They have suddenly abandoned apparently deeply held beliefs that free markets are best and that state intervention is always harmful.
Actually governments have in the past been slaves to the interests of the capitalists, not to ideology. The capitalist class needed the banks to be bailed out. The Troubled Asset Recovery Programme (TARP) in the USA and equivalent projects elsewhere are not classic Keynesian interventions. They have no effect on aggregate demand and they are not intended to. Buying up toxic assets and in effect burying them in the ground diverts resources from other areas of the economy and creates a strain on the system.
Yet there seemed no limit as to the amount that governments were prepared to blow on bailing out the banks. The inevitable result of this massively expensive rescue is to load up the public debt. Now the representatives of the system return to their old watchword – after the money has all gone: ‘Cut back government spending. Keep state interference out of the economy’. Having clocked up this enormous bill, they argue that we must all tighten our belts in order to trim the government deficits and pay off the national debts.
- Keynesian measures do not work to save capitalism from crisis. They have been abandoned for that reason.
- Recent measures to bail out the banks are not a return to Keynesianism but a panic stricken response to the emergency.
Keynesianism is based on the proposition that the level of aggregate demand determines the level of economic activity. If that is really the case, then the government should be able to control the capitalist economy. Expansionary fiscal and monetary policy should serve to restore full employment in the event of a crisis. It has been clearly demonstrated over past decades that the capitalist economy is out of government control. This is because the critical determinant of growth under capitalism is actually the rate of profit. The profit rate in turn has its effect in the first place on the level of investment.
If the government is to create resources, in order to pay for public works for instance, where will it get them from? It must come from the capitalists or the workers. If it comes from the capitalists, that will hit the rate of profit, investment and output. If the money comes from the workers, that is robbing Peter to pay Paul. If the workers are taxed to create public works or other expansionary fiscal measures, all that is happening is that demand is being shifted around in the economy, cutting one market to create another. Demand is not being increased overall.
Keynesians have argued that the government should not raise taxes on either workers or capitalists but borrow instead. In effect they should spend money they haven’t got. By priming the pump when there are unused resources in the economy, idle workers and capital are brought into action, output is increased and so are the tax receipts of the government. If this fiscal tweak indeed has a multiplier effect on output, then it has sometimes been argued that the boost could eventually pay for itself by returning money to the treasury equal to the stimulus originally laid out.
If we accept the basic premises of Keynesian economics, then public works should get the economy moving. But Marxists do not accept that output is demand determined. We know that for the capitalists the decisive incentive to invest is profit. And public works don’t raise the rate of profit. In a crisis, what the capitalists need are profitable markets. Merely providing them with a potential market is no use if profits are still on the floor. And the very process of providing a market through government spending is likely to cut profits further.
In fact the capitalists have a contradictory attitude towards the working class as a market. As far as the workers who toil for other capitalists are concerned, they would be all in favour of their getting the most generous wages possible. After all, it’s not their money. And these workers would indeed by spending their wage rises, directly or indirectly, expand the market for the goods that the capitalists want to sell.
It’s a different matter when it comes to ‘their own’ workforce. They are not seen as a market to be wooed. They are workers to be exploited. Their wages must be reduced. That is the way to maximise profits. Now you might think this contradictory attitude towards workers as consumers would put the capitalist class collectively in a spin. Not a bit of it. The attitude of the capitalist class as a whole to the working class is the same as their attitude to their own workforce. After all they are collectively their own workforce. They need to be squeezed to the utmost, specially in a crisis.
Keynesian economics doesn’t work because it misunderstands the dynamics of the system. Profits are decisive, rather than markets. When capitalism comes into crisis the response of the ruling class is to attack the workers, not to conciliate them. Because profits are the driving force of the system, the capitalists are desperate to restore the rate of profit at all costs. Since profits are the unpaid labour of the working class, that means an attack on workers’ living standards.
Critics may argue that Roosevelt’s New Deal in the 1930s showed that, in desperation, the powers that be may launch a quite ambitious programme of public works in order to mop up the worst of the unemployment created by their system. It is quite true that, though the capitalists may aspire to crack down on the workers, they may be forced to offer concessions instead because of their political weakness. Capitalism was widely called into question in the 1930s in the USA on account of the deprivations wrought by the Great Depression, no doubt about it. After 1934 the workers were on the march. A huge working class movement, organising the mass production workers into unions, industrial unionism, swept across the country.
Roosevelt rode the radical mood of the 1930s skilfully on behalf of the capitalist class. His aim was to institute reforms in order to preserve the rule of capital. But it is not true that the New Deal worked to restore full employment. Unemployment in 1939 at 17.2 million was actually higher than it had been in 1936 (17 million). Only the outbreak of the Second World War, in exchanging one horror for another, gave everyone in the States the opportunity of a job.
There is an overwhelming case for a mass programme of useful public works to mop up unemployment; but it is a socialist case. A programme of public works will have to be fought for by the working class against the opposition of the ruling class.
- The working class needs emergency measures such as public works to create jobs. The ruling class will resist such measures.
- The New Deal was the product of concessions from the capitalists. It did not eliminate unemployment.
The Treasury view
Though Keynesian economics doesn’t work, that is not to say that their capitalist opponents are correct. Keynes criticised the ‘Treasury view’ that the best thing a government can do in a crisis is to balance the budget. This economic orthodoxy was imposed on Prime Minister Ramsay MacDonald’s minority Labour government in 1931. In order to balance the government budget and eliminate the deficit Labour was instructed to cut unemployment benefit and cut service and public sector workers’ pay. The wave of monetarist policies which swept across the capitalist world in the 1970s and 1980s was really just a revival of the Treasury view, of pre-Keynesian economics, the ‘true religion’ of the capitalist class.
The only way MacDonald and his fellow traitors could achieve what the ruling class felt they needed was to split from the Labour Party and go into coalition with the Tories and Liberals. But the policy of cutting wages and benefits didn’t work either; it didn’t create full employment. Actually the ruling class in a crisis are not principally interested in working towards full employment. They are determined to restore the rate of profit, and that means attacking working class living standards, including public services and public sector wages.
Contrary to the Treasury view, Keynes realised that there is a tendency for governments to run deficits in a recession in any case, as tax receipts dip and unemployment pay and other recession-related subsidies soar. It is therefore a myth, nourished by the Treasury view, that there are two sorts of governments – spendthrifts and those that cut their coat according to their cloth. This was a myth that Thatcher found useful as well in her crusade against state spending and the organised working class in Britain in the 1980s. It is the same myth that the coalition government is dusting down in Britain once again in 2011. In fact this myth is the dominant ideology of the global capitalist class at present. The purpose of the myth is purely ideological. It is a justification for imposing all the burden of the crisis onto the working class.
Attempts to prematurely choke off recession-induced deficits in the past have served to choke off the recovery instead. The US economy got up off the floor after 1932 and began to recover. Unemployment fell (from an unprecedentedly high level) and output and government spending grew. So did the budget deficit which was about 5% of GDP in these years of slow and partial recovery. After his re-election in 1936 Roosevelt, influenced by advisers who held to the Treasury view, decided he had to balance the budget. It was a big mistake. Unemployment climbed upward again. Roosevelt was astute enough to quickly reverse government policy.
The Treasury view didn’t ‘work’ in Britain in 1931; it didn’t solve the crisis. It made things worse in the States five years later. Still we are hearing a barely modified version of the theory nearly eighty years afterwards. Why? An all-out assault on the working class, and the gains they have won in the form of the welfare state, is the inevitable way the ruling class will respond in the teeth of the crisis. They will try to make the working class pay. In a crisis output falls. Someone has to take a cut. The capitalists are determined that it won’t be them. And this attitude doesn’t flow from simple vindictiveness. It arises from the nature of a system based on profit. It is the logic of capitalism.
- The Treasury view was the pre-Keynesian response to crisis. It called for the government to balance the budget and impose austerity on the working class.
- The same ideas are being unearthed now because they represent the interests of the bosses.
- Austerity didn’t solve the problem of unemployment in the 1930s. It just made people poorer. It will have the same effect today – if we let them get away with it.
Chapter 6.4: Monetarism
The theory of monetarism
Keynesian economic analysis failed and was seen to have failed in the 1970s. The idea that the authorities could control the capitalist economy was shown to be an illusion. During the post-War boom a minority of right wing economists around Milton Friedman offered a different perspective. The monetarists argued (correctly) that the government could not guarantee full employment under capitalism. In fact they wanted to tear up the formal commitment that most capitalist governments had entered into to try to guarantee that everyone had the chance of a job. The long period of relatively full employment (in the advanced capitalist countries at least) had led to an enormous accession of power and self-confidence by the organised working class. Friedman and his gang welcomed the prospect of mass unemployment as an opportunity to cut the workers down to size.
Since, they said, the government could not influence the rate of growth of the economy they argued that the authorities should take measures against something they could affect – the rate of inflation. Friedman identified inflation as public enemy number one. The rate of inflation had been rising steadily since the Second World War. By the 1970s it was rising at 20% a year or more in some countries and was indeed a serious economic problem.
Inflation, in its turn, was said to be caused by an increase in the money supply. The monetarists adhered to the quantity theory of money. Ricardo adopted this theory from Hume. Marx sided with the post-Ricardians such as Tooke and the Banking School, who found that Ricardo was wrong on this point.
The quantity theory of money holds that there is a strict one to one relation between the supply of money and the price level. The only effect of pumping out more money is to raise prices. It stipulates that the sole and exclusive cause of inflation is an increase in the money supply.
The monetarists did not argue for discretionary monetary policy. They wanted strict rules on the supply of money issue that they declared would squeeze inflation out of the system, instead of the usual policy of targeting interest rates.
Some of them were stupid enough to argue that these tough policies would not cause unemployment even in the short term. This was because the quantity theory of money held that money was a ‘veil’ that had no effect on the real economy. In fact none of them cared about jobless workers. The Tory Chancellor Lamont, a convinced monetarist, argued in the 1990s that, “Rising unemployment and the recession have been the price that we have had to pay to get inflation down. That price is well worth paying.”
- Monetarism represents a return to pre-Keynesian orthodox economics. The theory is preparation for an attack on the working class.
Monetarism in practice
During the 1970s Keynesian economists were driven out of one academic redoubt after another. Monetarism swept all before it. It became the official philosophy of the Thatcher Tory government in Britain from 1979 and the guiding spirit of Reagan’s presidency at the same time. In fact the Callaghan Labour government that preceded Thatcher had been forcibly converted to monetarist policies by a capital outflow that provoked a sterling crisis in 1976. This forced the administration into the arms of the International Monetary Fund in exchange for an emergency loan. The IMF for its part demanded cuts and economic orthodoxy instead of the reform programme which Labour had been elected on in 1974. At Labour Party Conference in 1976 Callaghan bowed to international capital, and repudiated Keynesianism as a fool’s paradise:
“For too long, perhaps ever since the war, we [have] postponed facing up to fundamental choices and fundamental changes in our economy…. We’ve been living on borrowed time… The cosy world we were told would go on for ever, where full employment could be guaranteed by a stroke of the chancellor’s pen – that cosy world is gone.”
The significance of this admission is that it shows that economic orthodoxy is what the ruling class pursues in a crisis, because these are the policies that load the burden on to the working class. The ruling class will crush a government that tries to resist if they can. The capitalist class of the entire world repudiated Keynesianism in the teeth of the crisis during the 1970s and rearmed with monetarist orthodoxy. More recently we have seen exactly the same process as the G20 (group of 20 leading countries) in June 2010 repudiated measures of reflation and enthusiastically endorsed policies of harsh fiscal retrenchment and attacks on the working class in the name of cutting government deficits and debts.
But the monetarists had a problem in implementing the new religion when Thatcher came to office in 1979. Which measure of the money supply should they actually target? In Britain there was any number of different measures, including from M0 to M4. They were all moving at different speeds and sometimes in different directions. In the end the Conservatives decided to target sterling M3. They set targets to restrict its growth. These targets were consistently overshot in the early years of the Thatcher government. Restricting the money supply was supposed to be the way to control inflation. In the end inflation came down but the money supply continued to overshoot its target. This was not a mere technical problem for monetary economists. It was advance warning that the central premises of the theory were bunkum intellectually – but useful politically to the ruling class.
The policy was accompanied by desperate attempts to cut government spending. This amounted in Keynesian terms to a ferocious fiscal squeeze. This was another reason for the rise in unemployment under Thatcher.
There were also unintended consequences of the monetarist policy. If the supply and demand for money are conceived by economists as like a simple demand and supply diagram in a textbook, with interest as the ‘price’ of money, attempting to throttle the money supply had the inevitable consequence of putting up interest rates. At one point in the first Thatcher administration of 1979-83 bank rate was 17%. These interest rates had a devastating effect on industry. Firms that were teetering on the edge of bankruptcy in the midst of a world recession were confronted with the prospect of borrowing at prohibitive rates.
On top of that, high interest rates attracted hot money into London. Rising interest rates drove sterling up on the foreign exchanges. Sterling tanked at $1.56 in 1976. It recovered to $2.05 in May 1979 when Thatcher was elected. The pound went from $2.05 to $2.42 in little more than a year under the Tory government. British exports were priced out of one overseas market after another. Unemployment soared from 1.2 million to more than 3 million and manufacturing output fell by 17% in two years. This was in part because of the world recession, but partly on account of government policy. The world recession bit first and deepest in Thatcher’s Britain, partly because of monetarist policies.
Thatcher actually gloried in the mass unemployment she had helped to create. It was undermining the power of the working class movement. The revival in the rate of profit after its nadir in 1982 was partly because of the increase in the rate of exploitation made possible by the labour shake-out, the use of mass unemployment as a weapon against the employed workers and the one-sided war on the working class on the shop floor. It was also partly because of the massive capital destruction caused by the recession. Millions of workers not only lost their jobs. The factories where they had earned their living were destroyed.
Monetarist theory and policy was effectively ridiculed by Labour’s Nicholas Kaldor in the 1980s in speeches in the House of Lords, of all places. He noted that the money supply usually expanded from the end of November in preparation for the pre-Christmas shopping rush. ‘Did that show that the increase in the money supply causes Christmas, as monetarist theory would suggest?’ he asked. Of course the pre-Christmas rise in the money supply is to accommodate a spending rush the authorities know is likely to happen anyway. This example shows that the money supply may be demand-determined. If so, that turns the whole of monetarist theory into nonsense.
In the end the central tenet of monetarism was abandoned. The Monetary Policy Committee of the Bank of England has targeted the interest rate, not the money supply in recent years. Interest rates influence the demand for money, not the supply. But the harsh economic orthodoxy that underpinned monetarist principles remains.
Gordon Brown moved in 1997 that interest rates should be set by the Bank of England rather than by the democratically elected government. That decision embeds the monetarist premise that monetary policy is best left to the experts following rules, and that monetary policy cannot and should not be used to try to create jobs s part of an activist economic policy. So we see that monetarism still represents the interests and beliefs of the ruling class.
- The adoption of monetarism was part of increasing attacks on the working class in a harsher economic climate.
Governments lose control
Further evidence that the stable, automatic relationship between monetary aggregates and economic activity assumed by the monetarists is wrong was provided more recently in the credit crunch. The monetarists predict that all the authorities have to do is pull the right monetary levers in order to work their magic. In the course of the credit crunch the money supply went bonkers.
The London Inter Bank Offered Rate (LIBOR) is a pretty recondite concept in monetary economics. The TED-spread is its direct equivalent in the USA. The banks lend money to one another all the time, purely for housekeeping purposes. Loans are short term, often overnight. LIBOR or TED-spread is the rate at which they borrow from each other, and it is usually low, predictable and stable. Since the commercial banks are ultimately borrowing from the government via the central bank, loans are risk-free and rates of interest low. Normally it is a fraction of a per cent above the rate at which the banks can borrow from the central bank. Though this latter rate has gone through some name changes, it is usually called bank rate.
As we point out in the section earlier, one of the levers that the government uses to influence the level of activity in the economy is monetary policy. This is usually conducted by adjusting interest rates. Bank rate is the apex at the pyramid of interest rates in the economy. It is assumed that, by adjusting bank rate, the whole structure of interest rates can be raised or lowered.
Suddenly during the credit crunch LIBOR started to misbehave. It soared above bank rate. This meant that the government lost control of one of its principal mechanisms for steering the economy. It was like driving a car whose steering wheel no longer worked. Once more the stable, predictable relationship that monetarists assume exists between the money supply and the rest of the economy went hopelessly out of kilter.
- Intellectually and practically monetarism has been a failure. Politically it has been a useful weapon for the capitalists.
Since the Great Recession, targeting the money supply rather than interest rates has been revived as an emergency measure of monetary policy under the title of ‘quantitative easing.’ The reason for this new approach is because interest rates are so low that reducing them still further will not have much of an effect in stimulating the economy. Quantitative easing (QE) is really just printing money. Of course in the twenty-first century the printing presses do not actually roll. The money is created electronically. The central bank buys bonds with money. Where does it get the money from? It creates it out of nothing. The result is that more money is injected into the economy.
In early 2009 the Bank of England pumped £200bn into the British economy. The Fed followed suit with a $1.25trn injection in the USA. What happened to all this money? We don’t really know. Some of the American dollars ended up in some very strange and murky places, as we saw in Part 1: What happened in the Great Recession.
The reader may be astounded to know that, having injected vast quantities of purchasing power into the economy, the authorities don’t actually know if QE works and, if it does, how. It is the economic equivalent of witchcraft. What seems to have happened is that this ‘free’ money issued has been hoovered up by the banks, who have papered their vaults with it (deleveraging is the technical term for this), and of course enhanced their profits enormously by lending the money on to selected borrowers at a respectable rate of interest.
Quantitative easing shares the monetarist belief that there is a mechanical way for the government to control the money supply. In reality, as we saw when we discussed the fate of the London Inter Bank Offered Rate (LIBOR) during the credit crunch, the authorities are no longer in complete control of interest rates and the money supply, it they ever were. The government can pump money into the economy till the cows come home. If the banks refuse to lend, no increase in the money supply will be forthcoming.
As we know banks effectively create money by lending out more to the public. But at the moment they are desperately deleveraging. This means that they have belatedly discovered that their credit lines were overextended, and are unraveling their commitments as fast as they can. The banks can create money when they want to; at the moment they don’t want to. They have severed the link that is supposed to exist between government control of the money supply and the credit creation mechanism.
Unfortunately for the rest of us, the banks are denying they have any obligation to working class consumers or to small business people, who have been brought to the edge of despair by the crisis precipitated by the banks themselves. Now the banks are depriving them of the succour of emergency loans.
Having tried once to no certain effect, in late 2010 the Fed launched a second round of quantitative easing, called QE2. ‘If at first you don’t succeed, try, try, and try again’ seems to be their motto. Insiders suggested that the $600bn to be injected is peanuts if it was really intended to relaunch the US economy into a boom.
Trade rivals believe that this monetary creation would have the effect of making US goods cheaper and their own products dearer on world markets by depreciating the dollar. This would provide the USA with an unfair trade advantage. So it is all part of the ‘currency wars’, the present form of protectionist manoeuvring on the world market. Some of the money created by quantitative easing probably found its way into the hands of the speculators, fuelling the boom in food and energy prices taking place in 2011. In the insecure atmosphere of the fragile recovery both deflationary pressures and the prospect of inflation loom.
So far the policy of QE seems to have been unclear rather than catastrophic. It is possible that, in conjunction with the battery of other emergency measures taken by the authorities in the course of the crisis, it has made the situation better than it would otherwise have been. On the other hand it might have been completely ineffective.
Critics who have predicted levels of inflation like those of Zimbabwe in recent years or Weimar Germany in 1923 have come away disappointed. There is a serious debate to be had as to whether the world economy faces a prospect of inflation or deflation in the next few years. We shall take that up in Economic Perspectives.
- The adoption of quantitative easing is a sign of desperation on the part of the authorities. Nobody knows if it works and, if so, how.