Change of Guard at the Fed, the Specter of ‘Secular Stagnation,’ and Some Questions of Monetary Theory

Ben Bernanke will not seek a third term as chairperson of the Federal Reserve Board of Governors – “the Fed.” President Obama has nominated, and the U.S. Senate is expected to formally approve, economist Janet Yellen as his successor. The Federal Reserve Board is a government body that controls the operation of the U.S Federal Reserve System.

“The Fed” lies at the heart of the U.S. central banking system, which under the dollar standard is in effect the central bank of the entire world.

A professional central banker

Janet Yellen is currently vice-chairperson of the Federal Reserve Board. She has also served as an economics professor at the University of California at Berkeley and chaired President Bill Clinton’s Council of Economic advisers. She headed the Federal Reserve Bank of San Francisco from 2004 to 2010, one of the 12 Federal Reserve Banks within the Federal Reserve System. If there is such a thing as a professional central banker, Yellen is it.

Yellen will be the first woman to serve as head of the Federal Reserve Board and will hold the most powerful position within the U.S. government ever held by a woman. Yellen’s appointment therefore reflects gains for women’s equality that have been made since the modern women’s liberation movement began around 1969.

Like other social movements that emerged out of the 1960s radicalization, the modern women’s liberation movement began on the radical left. The very name of the movement was inspired by the name of the main resistance organization fighting U.S. imperialism in Vietnam – the National Liberation Front. However, as a veteran bourgeois economist and a long-time major policymaker in the U.S. government, Yellen would not be expected to have much sympathy for the 20th-century revolutions and movements that made her appointment even a remote possibility.

Significantly, Yellen was appointed only after Lawrence Summers, considered like Yellen a major (bourgeois) economist and said to be the favorite of the Obama administration to succeed Bernanke, announced his withdrawal from contention. Summers became notorious when as president of Harvard University he expressed the opinion that women are not well represented in engineering and the sciences because of mental limitations rooted in biology.

Summers was obliged to resign as president of Harvard, and his anti-woman remarks undoubtedly played a role in his failure to win enough support to be appointed Fed chairman. In addition, Summers attacked the African American Professor Cornell West for his work on Black culture and his alleged “grade inflation,” causing West to leave Harvard. This hardly made Summers popular in the African American community. His nomination would therefore have produced serious strains in the Democratic Coalition, so Summers was obliged to withdraw.

Ben Bernanke like Yellen is considered a distinguished (bourgeois) economist. He had devoted his professional life to exploring the causes of the Great Depression, much like Yellen has. Essentially, Bernanke attempted to prove that the Depression was caused by faulty policies of the Federal Reserve System and the government, and not by contradictions inherent in capitalist production – such as, for example, periodic crises of overproduction. Bernanke denied that overproduction was the cause of the Depression.

Like Milton Friedman, Bernanke blamed the Depression on the failure of the Federal Reserve System to prevent a contraction of money and credit. Bernanke put the emphasis on credit, while Friedman put the emphasis on the money supply. Blaming crises on currency and credit, according to Marx, is the most shallow and superficial crisis theory of all.

Why didn’t Bernanke seek another term?

I suspect that Bernanke’s years as Fed chairman, which began just before the outbreak of the Great Recession of 2007-08, have shaken his belief that the Depression and capitalist crises in general are largely the result of bad monetary and credit polices. He was apparently caught completely off guard by the violence of what was called back in 2007 the “sub-prime mortgage crisis.” Any excess in the home mortgage market, Bernanke believed at the time, could be easily contained with the help of the Federal Reserve, which he headed. He was to learn the hard way how wrong he was.

Bernanke learned on the job that an expansionary monetary policy could not quickly restore growth in the wake of a sharp crisis. His faith in the inherent stability of capitalist production and its alleged tendency toward “full employment” must now be in ruins. He leaves the Fed a defeated man.

Neo-classical marginalist theory – without the later Keynesian “corrections” – came to dominate bourgeois economic theory from the late 19th century onward. Though forced to concede in practice that capitalism experiences occasional crises, its supporters claimed that, left to its own devices, capitalism would quickly return to its natural “full employment” equilibrium. (1) The most that had to be done was for the central bank to help things along by lowering its (re)discount rate. (2)

The marginalists believed they had proven “scientifically” that, leaving aside distortions brought about by trade unions and social legislation, full employment was the natural state of a capitalist economy. A shock might disrupt the full-employment equilibrium from time to time but only momentarily. The best way for a government to handle a crisis of mass unemployment was therefore to do essentially nothing. (3)

Milton Friedman’s “moneterist counterrevolution” against Keynes was an attempt to turn the clock back before Keynes. Though not as dogmatic as Friedman, Bernanke was sympathetic to Friedman’s views.

Janet Yellen, also an expert on the Depression, is more of a Keynesian and thus has a somewhat more realistic view of the inherent instability of capitalist production than did her two predecessors, Alan Greenspan and Ben Bernanke. Though she lacks the belief in the inherent stability of capitalist production, this doesn’t make her any less staunchly pro-capitalist than Bernanke. Above all, she will want to do all she can to maintain the capitalist system in general and the dominance of American imperialism in particular.

The Obama administration, fearing a major social crisis if unemployment continues at current levels, believes that this is not the time to put in as head of the Federal Reserve System another right-wing ideologue who believes in the false “full employment” theories of the neo-classical economists.

The specter of secular stagnation

The combination of the Great Recession and the stubborn economic stagnation that has followed the crisis proper has caused some bourgeois economists to turn back to a view that was popular among certain economists in the late 1930s but then fell out of favor – the view that the U.S. economy was (and is) facing secular stagnation.

Both Paul Krugman and Lawrence Summers have recently expressed the view that the U.S. economy is once again in a state of secular stagnation. John Maynard Keynes, who had begun as a traditional liberal marginalist economist, first noticed the tendency toward secular stagnation in the British economy of the 1920s. Through an entire decade, or “trade cycle,” as the English call the industrial cycle, the British economy had come nowhere near to full employment as it was generally defined before the World War I. Unlike Britain, the U.S. experienced a great capitalist prosperity during the decade of the 1920s, so U.S. (bourgeois) economists did not concern themselves with secular stagnation at that time.

However, the theory of secular stagnation enjoyed a brief surge of popularity beginning with the Roosevelt recession of 1937-38, especially among the younger generation of economists influenced by Keynes and sometimes by Marx. The super-crisis of 1929-33 itself did not at first give rise to a widespread belief that the U.S. was entering a period of secular stagnation because the history of U.S. capitalism had been marked by periodic violent economic crises – called “panics” – and their associated deep depressions, though not on the scale of 1929-33.

The economists believed that every violent crisis/depression would be succeeded by a “great economic boom” that would see unemployment drop sharply while industrial production would exceed the previous peak by a considerable margin. Despite the “great panics” that occurred in 1837, 1857, 1873, 1893 and 1907 – there were many lesser recessions as well – the U.S. economy saw the greatest economic growth that the world had ever seen up to that time. Why would the panic that began in 1929 be any different? Wouldn’t another great “economic boom” occur that would far exceed the levels of production and employment reached in 1929?

Therefore, through the middle 1930s as the U.S. economy appeared to be rapidly recovering, most bourgeois economists were quite confident that a new “great boom” would replace the Depression. Their only fear was that the next great boom might be followed by an even greater depression.

But soon after industrial production reached its 1929 peak near the end of 1936, the 1937-38 recession hit. Industrial production plunged and the rate of unemployment soared once again. Nothing like this had occurred after any of the other “great panics” in U.S. history. Many young economists began to question the assumption that a new great boom had really begun. Perhaps this time American capitalism had exhausted its long-term ability to generate economic growth.

The supporters of “secular stagnation” believed that if capitalism could keep growing at all, it could do so only with the help of ever-larger levels of government spending. If government spending was productive – that is, spent on building new factories, mines, railways and so on, – this would represent the beginning of a planned economy and thus the end of capitalism, a prospect welcomed by the young Paul Sweezy and a few other young radical economists who were searching for ways to combine Marx and Keynes.

If the spending was “unproductive” – that is, designed to create purchasing power but not productive enterprises that competed with the “private sector” – which is what pro-capitalist Keynesians, including Keynes himself, recommended – wouldn’t the growing size of the “unproductive” public sector undermine long-term economic growth? Or, in Marxist terms, wouldn’t the growth of unproductive expenditure reduce expanded capitalist reproduction, the very essence of capitalist production?

In either case, the future of capitalism seemed bleak. The war economy of World War II, with its full employment, pushed the immediate fears of secular stagnation into the background. But what would happen after the war ended? The expectation of the secular stagnationists was that the return to a peacetime economy would inevitably be accompanied by huge drops in wartime government spending and a return to Depression-like conditions with permanent mass unemployment.

Much to the surprise of the supporters of secular stagnation – and to the considerable relief of their pro-capitalist opponents – private investment rose sharply as the World War II war economy gave way to normal peacetime production. The specter of secular stagnation vanished for the overwhelming majority of professional economists, though it lingered on among some left-wing Marxist groups who believed that only the large-scale war spending of both the “cold” and Korean wars was holding off a new Depression.

Among professional economists, only a small group of radical economists led by Paul Sweezy around the socialist magazine Monthly Review continued to support the view that stagnation was the normal state of American monopoly capitalism. The school of secular stagnation – mainly the Monthly Review school that attempts to combine Marx with Keynes – believes that the modern (monopoly) capitalist economy has a profound tendency toward economic stagnation – defined as a rate of economic growth insufficient to prevent the growth of unemployment across the industrial cycle, leading to a chronic crisis of mass unemployment.

The narrative of secular stagnation goes like this: After Roosevelt assumed office in March 1933, the new administration increased government spending. As a result, economic growth resumed, and unemployment gradually dropped, though at a painfully slow rate. The administration after the 1936 election, mistakenly believing that the crisis had passed, then moved to balance the federal budget. The administration cut back the WPA (4) projects. In addition, the Social Security withholding tax kicked in for the first time, and because there were not yet any benefit payments, it resulted in a withdrawal of purchasing power from the economy.

Fiscal policy after 1936, therefore, ceased to support economic growth. Could the capitalist economy on its own support continued recovery from the lingering effects of the 1929-33 slump? The traditional economists and the administration both claimed it would do so now that the depression had passed. However, when the prop of fiscal stimulation was suddenly removed in 1937, the economy went into a tailspin that was only arrested when the Roosevelt administration resumed an expansionary fiscal policy – budget deficits – in 1938. The lesson drawn by the stagnationists was that without high, and very likely growing, government spending, U.S. capitalism would be doomed to permanent stagnation and resulting mass unemployment.

The stagnationists noted that, unlike the other periods of deep recession in the U.S. – and earlier in Britain – the central bank had not raised the discount rate before the 1937-38 economic tailspin. But there was no reason to do this. Far from facing a gold drain that could only be halted by increasing interest rates, the U.S. continued to experience a massive gold inflow. Therefore, the stagnationists argued, the recession did not reflect monetary deflation but rather American capitalism’s return to its “new normal” of permanent depression as soon as the fiscal stimulus of 1933-36 was withdrawn.

Milton Friedman debunks ‘secular stagnation’

Milton Friedman, however, showed that while there was no rise in the discount rate, the U.S. Treasury and Federal Reserve System had carried out monetary policies that starting in 1936 were highly deflationary. The Federal Reserve Board had progressively raised the amount of cash that commercial banks were required to maintain to back up their deposit liabilities. This had more or less the same effect as a contraction in bank reserves. Then, in 1937, the U.S. Treasury adopted a policy of “sterilizing” the gold flowing into the U.S., mostly from a Europe that was on the verge of a new general war.

For every dollar of gold that was deposited in the U.S. under this program, the Treasury borrowed a dollar on the open market but did not spend it. The Treasury, in effect, buried the great sums of money that were flowing into the U.S. from Europe and keeping this potential purchasing power in its vaults. As a result, the growth in the reserves – the hoard of idle cash – of the U.S. commercial banking system came to a screeching halt and in effect contracted owing to the increase in bank reserve requirements.

Traditionally, bank reserves in the U.S. had contracted when the balance of payments swung against the U.S., causing gold to flow abroad. But in 1937, Friedman demonstrated, the reduction in commercial bank reserves was caused by the policies of the Treasury and the Federal Reserve Board – both government bodies.

Friedman claimed that even with the cuts in federal spending and the introduction of the Social Security tax in 1937, the deep recession of 1937-38 would have been largely avoided if the Federal Reserve Board and U.S. Treasury had not carried out a policy that between them had the effect of contracting bank reserves leading to a new reduction in the money supply.

This view, which was to become the new orthodoxy, formed an important part of Ben Bernanke’s belief that both the 1929-33 super-crisis and the 1937-38 recession were caused by faulty government policies and not any tendency toward secular stagnation as Sweezy and others believed. According to Bernanke, the Depression showed that something was very wrong but what was wrong was the government’s policies including the central bank policies of the day. According to the Friedmans, Greenspans and Bernankes, there was nothing wrong with capitalism itself.

Standard stabilization theory

The mainstream Keynesian stabilization theory that emerged from the Depression advocates that the government – particularly the central government – run deficits during periods of recession and that the deficits be accompanied by an accommodative monetary policy to ensure that rising government deficits do not prevent long-term interest from falling during recessions. Once a recession is over, government deficits should be reduced or eliminated as the depressing effects of falling government deficits are more than counteracted by rising private investment.

During the period between the end of a recession and a beginning boom, deflationary monetary policies such as those pursued in 1936-1937 must therefore be avoided. Instead, there should only be a gradual reduction of the “accommodative” monetary policy after the recession as government deficits fall. Only when “full employment” threatens to turn into what bourgeois economists – not workers – call “over-employment” – an inflationary boom – should monetary policy be significantly tightened.

The supporters of Friedman, as opposed to the conservative pro-business Keynesians, believe that an expansionary monetary policy in the absence of a rise in government spending should be sufficient to bring about rapid economic recovery after a recession. Many practical macro-economists, in contrast, believe that fiscal stimulation alongside a stimulative monetary policy has a role to play in limiting recessions. Here there is a spectrum of views among bourgeois economists, with dogmatic Friedmanites on the “right” opposing all fiscal stimulation during recessions, while Keynesians on the “left” believe government deficits to generate additional demand, alongside an expansionary monetary policy, has an important role to play during recessions.

Secular stagnation returns

Once it became clear that the collapse of 2008-09 was the deepest since the 1930s, the question was posed whether the dramatic collapse would be followed by an equally rapid economic recovery. This had been the general pattern observed in the concrete history of the industrial cycle. Mild recessions were followed by weak recoveries, while deep recessions were followed by vigorous recoveries, even though it took years to restore anything like normal capitalist “full employment” – which still means a considerable amount of unemployment for workers. Even the period of 1933-36, during the Great Depression, followed this pattern. It showed a sharp “snap back” in production – though not in private investment – before the 1937 deflationary policies – both fiscal and monetary – took hold.

While government policy has been deflationary on the fiscal side since the end of the recession proper in 2009 – cuts in local government spending and the huge but now falling federal deficit – there has certainly been no deflationary monetary policy like that of 1937 – quite the contrary. Therefore, according to the views of Friedman and other “neo-liberal” economists, we should see a rapid and indeed an inflationary economic recovery as the economy quickly bounces back from whatever “shock” caused the Great Recession to what they consider its “natural” rate of unemployment.

Secular stagnation cannot be explained by monetary policies this time

But despite the reported high level of corporate profits, the rise in private investment has been so muted during the half decade following the outbreak of the Great Recession that it has barely been able to overcome the drag on the fiscal side. The reported fall in U.S. unemployment can be almost entirely explained by people dropping out of the work force, while the number of new jobs created has barely kept up with the natural growth of the population that is seeking work.

In Europe, the situation has been even worse, with European economies actually sliding back into recession for several years, and the level of unemployment, even as measured by capitalist governments, continuing to rise. Therefore, what began as a crisis of short-term mass unemployment in 2008-09 is turning into a crisis of long-term unemployment. This actually looks much more like secular stagnation than anything that occurred during the 1930s, since it cannot be explained away Friedman-style by deflationary monetary policies.

Some questions of monetary theory

Some readers have raised the question as to whether the current economic situation with its combination of economic stagnation – defined as a rate of economic growth too low to cause much of a decline in unemployment once the effect of workers dropping out of the labor force is factored in – and stable prices has confirmed the monetary theory of Keynes as opposed to the monetary theory proposed by this blog.

To answer this question, we need to first examine the theories of Keynes and Friedman and see how they stand up against the evolution of the economy since the beginning of the Great Recession.

Since panic hit in September 2008 with the collapse of the venerable Lehman Brothers investment bank, the Fed has engineered an unprecedented increase in the U.S. dollar monetary base, which under the dollar system serves as the monetary base of the entire world. Over the last year alone, the monetary base has risen by some 39 percent. This is far beyond the 3 percent or so annual rise that Milton Friedman considered compatible with stable prices.

The monetary base is not the same as the broader “money supply” – cash in circulation plus checkable deposits – that Friedman emphasized. However, Friedman believed that the growth of the monetary base – “high-powered money” as he called it – governs the growth of the broader monetary supply.

According to Friedman, the relationship between the monetary base and the broader money supply, as well as the velocity of circulation, is more or less stable over time. Assuming that the U.S. economy has an ability to grow at about 3 percent a year – the rise in labor productivity plus the growth in the working population – we should be experiencing a rate of inflation – or soon will be – of about 36 percent. Instead, prices are barely rising and there is even fear of possible deflation – falling prices.

In contrast to Friedman, Keynes held that changes in the nominal price level are largely governed by changes in hourly money wages. As long as there is mass unemployment and trade unions are weak – as they are at the present time – competition between workers will not only prevent money wages from rising, they will actually fall. Therefore, even an extremely rapid rise in the money supply will fail to bring about inflation. Unless a 30 percent plus rate of inflation suddenly develops in the near future, Keynes’s theories appear to be performing far better than Friedman’s.

Where is the price deflation predicted by Keynesian theory?

Actually, Keynesian theories have not been performing all that well either. Considering the prolonged period of massive unemployment we are passing through, combined with trade union weakness, mass unemployment should be driving hourly money wages – wages in terms of currency – lower. And to a considerable extent they have done so. Yet the cost of living has not been dropping as Keynesian theory predicts it should be.

But since the policymakers do not want a falling cost of living and actually fear it, because they believe that it would greatly deepen the stagnation, and since almost nobody alive remembers the days when drops in the cost of living were as common as rises in the cost of living, Keynes is getting a pass. But in reality, the current situation of low inflation – below 2 percent, according to government figures – is actually somewhere between the double-digit inflation predicted by Friedman’s theory and the considerable price deflation predicted by Keynes’s theory.

This blog holds that both the theories of Friedman and Keynes, though they contain elements of truth, are incomplete and on some questions wrong. Instead, the blog holds to the view that in the long run – that is, abstracting the industrial cycle and assuming everything else remains unchanged – a doubling of the quantity of paper money relative to the quantity of gold will lead to a doubling of the currency price of gold and therefore a doubling of the currency price of all other commodities including the commodity labor power.

This includes the assumption that the prices of commodities in terms of gold are determined – with some modifications (5) – by the labor values of commodities compared to the labor value of gold – that is, the prices of commodities in gold terms will not be affected by changes in the quantity of paper money. So aren’t the predictions of this blog similar to Friedman’s theory and thus inferior to Keynes’s theories?

The key phrases here are “abstracting the industrial cycle” and “assuming everything else remains unchanged.” Friedman was such a strong believer in the stability of the capitalist economy that he believed that there would be essentially no industrial cycle if changes in the rate of growth of the money supply were avoided. It goes without saying that Friedman as a supporter of the marginalist theory of value had no concept of prices being determined by labor values. These assumptions are very far from the assumptions of this blog.

Unlike Friedman, this blog defines the price of a given commodity as the quantity of the use value of the money commodity – weights of gold bullion – that the given commodity exchanges for. Both Ricardo and Marx held that prices are determined with some modifications by the quantity of labor it takes on average to produce a given commodity relative to the quantity of labor that it takes to produce the quantity of gold that it exchanges for. But in the short term, as both Ricardo and Marx were well aware – as is every vulgar economist as well – prices move up and down according to supply and demand.

The supporters of Ricardo and Marx answer this objection by pointing out that while changes in supply and demand govern short-term fluctuations in prices, over the long term supply and demand cancel each other out. Therefore, market prices fluctuate around an axis determined more or less by the quantity of labor it takes under given conditions of production to produce a commodity.

As early as his polemic against Proudhon’s “Poverty of Philosophy,” written in 1847, Marx explained that the law of prices selling at their labor values is realized in practice by the constant deviations of prices from their labor values, first on the upside and then on the downward side. Indeed, understanding this basic fact of economics is the first step toward understanding the industrial cycle and crises. During periods of economic boom, prices rise above the values of commodities, and during the crisis prices fall below the values of commodities.

But in the messy real world, prices in terms of the use value of the money commodity – gold – are not only fluctuating around the values of commodities, the values of both particular commodities and commodities in general as expressed in the use value of gold are constantly changing. And the value of gold itself, which is after all also a commodity, is itself constantly varying.

In some periods – for example, after the gold discoveries of 1848-51 or after the widespread adoption of the cyanide process in the refining of gold ore in the 1890s – the value of gold has fallen relative to the value of most other commodities. In other periods, the value of gold has risen. In light of the depletion of the South African gold mines in the final decades of the 20th century, there is every reason to assume that the value of gold rose considerably relative to the values of most other commodities.

Therefore, the prices of commodities in terms of gold that directly reflect the values of commodities fell considerably in the final decades of the 20th century. If the world economy had remained on the gold standard, this would have been expressed sooner or later in a fall in currency prices, since under the gold standard currencies were defined in terms of weights of gold of a specific fineness.

Under the dollar standard, however, the values of currencies other than the dollar are defined by the amount of U.S. dollars they represent, while the value of the dollar in terms of the money commodity gold is not a fixed quantity but varies with the changing gold quotes on the London gold market. Since commodity prices have remained more or less unchanged in terms of dollars since the Fed began its “quantitative easing” program despite the dramatic decline in the gold value of the U.S. dollar since 2001, the prices of commodities in terms of gold have actually fallen sharply. Considering the depletion of South African gold mines, this is what we would expect according to Marx’s – and Ricardo’s – theory of value. And this is exactly what we see.

Since the 2007-2009 financial panic, we have seen a dramatic depreciation of the U.S. dollar relative to gold. Just before the crisis, the dollar price of gold was $675 – up sharply from around $250 an ounce at the turn of the 21st century. At the peak of the depreciation of the dollar relative to gold, in September 2011, the dollar price of gold exceeded $1,900 an ounce. Even at the present “low” price of about $1,200 an ounce, the dollar still shows a considerable depreciation relative to $675 at the beginning of the last crisis in 2007 and a huge depreciation compared to well under $300 an ounce around the turn of the century.

Yet the dollar price of most commodities has changed little since 2009, and in some areas, like high-tech devices that require rapidly declining labor time to produce, prices have continued to fall even in dollar terms.

Overall, therefore, since the turn of the century and especially since the 2007-09 crisis, the prices of commodities in terms of gold have been exactly what we would expect in light of the evolution of the relative labor values of most commodities versus the money commodity.

However, over the last year despite a rise of 39 percent in the quantity of dollars measured by the U.S. monetary base – not deposit dollars (credit money) created by the commercial banking system – the price of gold has fallen rather than risen, from around $1,600 or so to today’s $1,200. This clearly violates the general law that a rise in the quantity of token dollars relative to the quantity of gold bullion should lead to a rise in the dollar price of gold.

But remember, this general law ignores the industrial cycle. The very existence of the industrial cycle converts the economic law that governs the dollar – or other currency – price of gold into a law that operates only over the long run.

Clearly over the last year, other economic laws that modify the general law have been at work within the industrial cycle and have overridden the more general law that the U.S. dollar should depreciate to the extent that the quantity of dollars increases faster than the quantity of gold bullion. Understanding exactly what these laws are is actually crucial to understanding this industrial cycle, since these laws work within the industrial cycle rather than across the industrial cycle like the more general law does. As we will see below, if you don’t understand these laws, you do not really understand the industrial cycle.

We have seen other dramatic short-term deviations since the current paper dollar standard was established in the early 1970s, some considerably more dramatic than anything we have seen over the last year but in the opposite direction. For example, between September 1979 and January 1980 the dollar lost more than half its gold value – the dollar price of gold went from around $300 to $825, yet the quantity of dollars measured by the U.S. monetary base didn’t come any where close to doubling over that period of time – it was growing around 7 percent per year and the quantity of gold bullion in existence never shrinks. Why did the dollar price of gold more than double over that time period?

During the 1979-80 surge in gold prices, it was feared that the Federal Reserve System would dramatically increase the quantity of dollars – maybe more than double the quantity of the dollar monetary base – in a bid to prevent interest rates from rising sharply. Remember, short-term movements in dollar gold prices under the present dollar system have a strong speculative element. If the actual policies of the Fed deviates from the policy gold traders “in the pits” expect, the market corrects the “mistake” of the speculators by moving sharply in the opposite direction.

Just before the “Volcker shock,” the Federal Reserve System was doing all it could to keep the recovery from the deep recession of 1974-75 alive. Since there was still mass unemployment and excess capacity left over from the 1974-75 recession, the Keynesian stabilization theories that had generally guided Fed policymakers since World War II indicated that the Fed should fight any rise in interest rates.

The prevailing economic orthodoxy of the time held that do otherwise would be to repeat the mistake the Fed and Treasury made back in 1936-37. The fear was – or more accurately speculators in gold were betting – that the Fed would move to greatly accelerate the rate of growth of the amount of dollars it was printing in order to hold down interest rates. As a result, speculators moved to bid up the price of gold bullion, more than doubling the dollar price of gold between August 1979 and January 1980, even though the actual growth in the monetary base in that period didn’t come close to justifying such a price move.

But the price move occurred all the same. This caused the prices of primary commodities to soar threatening to transform the prevailing double-digit inflation into triple-digit inflation. It was precisely this short-term but dramatic violation of the general law that governs movements in the dollar price of gold that forced the Fed’s hand.

Paul Volcker, the newly appointed Fed chairman, felt that there was no alternative under these conditions but to put Keynesian theory temporarily aside and instead carry out monetary policies that in some ways resembled the monetary policy of 1936-37 – even if for quite different reasons – but with similar results. The Volcker Fed did not actually slow down the rapid rate at which the Fed was creating dollars – compared to the historical norm of about 2 to 3 percent a year. But he stubbornly refused to accelerate the rate of growth of the dollars the Fed was creating and the gold “bulls” were betting on. The result was a sharp rise in the rate of interest, which the speculators could not resist. As I have explained before, any boom in the dollar price of gold can always be broken by a sufficient rise in interest rates.

As interest rates soared, the “speculators in the pits” began to dump gold bullion in favor of interest-bearing securities, and the price of bullion plummeted. The danger of runaway inflation, perhaps degenerating into hyper-inflation, was ended. The only problem was that the real economy also plummeted, with both unemployment and excess capacity soaring. The Volcker shock recession was on.

Indeed, despite the Volcker shock, the dollar monetary base created by the Federal Reserve System continued to grow by around 7 percent annually – considerably faster than the growth in the quantity of gold bullion in the world – until the middle of the 2000s when the Greenspan- and then Bernanke-led Fed began to reduce this rate of growth back towards its historic level of 2 to 3 percent a year, which more or less reflects the long-term rate of growth of the quantity of gold bullion in the world.

For many years, fears – or hopes on the part of the gold bugs – lingered that the Fed would sooner or later rapidly accelerate the 7 percent rate of growth – fears that were indeed realized but only with the banking and credit crisis that hit with full force in September 2008.

The result was that the U.S. dollar continued to show more depreciation – a high dollar price of gold compared to the actual rate of growth of dollars relative to the monetary base than it actually should have according to the general law that governs the dollar price of gold bullion. Years of Keynesian policies that climaxed in the 1970s had undermined the Fed’s credibility. Speculators suspected that sooner or later the Fed would send the monetary base soaring once again. But as the years went on and the Fed failed to increase the rate of growth of the monetary base, the price of gold drifted lower, finally falling below the $300 level at times during the late 1990s, about the level that prevailed just before the “gold price boom” of late 1979 and early 1980 that had forced the Volcker Fed’s hand.

What governs the short-term movement of the dollar price of gold under the dollar standard?

But what determines the short-term fluctuations of the currency price of gold under the dollar system, and most importantly how does the industrial cycle interact with these short-term fluctuations? Marx, though he touched on the long-term laws that govern paper money in Chapter 3, Volume I of “Capital” and elsewhere, didn’t explore this question in depth because in his day the world monetary system was evolving from earlier silver and paper standards towards a universal gold standard. For example, the U.S. had a paper dollar standard during the Civil War era – 1861-1879 – as did Czarist Russia before 1900, while European countries like Germany and France had silver standards.

Indeed, the classic gold standard of the 19th century, both in the U.S. – leaving aside the “greenback” era between 1861 and 1879 when the U.S. had a paper standard – and Britain, approximated a 100 percent reserve system. When gold flowed into the Bank of England, the bank printed additional pound notes, and when gold flowed out, the pound notes were canceled.

The U.S. didn’t even have a central bank in Marx’s era. As a result, U.S. commercial reserves were governed directly by the flow of gold into or out of the the country plus the additional gold reserves that were created by domestic gold production. It was the operations of this system that Marx was interested in exploring.

The classic gold standard was actually a very simple system. Marx criticized this system – and this criticism is actually extremely important in understanding how the industrial cycle interacts with the currency price of gold under a paper system – because it failed to take into account the sharp increase in demand for pound notes as a means of payment and hoarding during periods of crisis.

During 19th-century crises, the mere knowledge that the amount of pound notes was limited by the amount of gold and could not be increased to meet the extra demand for them as a means of payment was sufficient to drive the demand for pound notes into a frenzy.

This led to massive runs on the commercial banks when the owners of British commercial bank deposits that were payable in Bank of England bank notes would move to withdraw them all at once. Unlike the supporters of the quantity theory of money, Marx realized that the Bank of England could increase the amount of banknotes it issued to meet the extra demand for these notes during crises as a means of payment and hoarding without triggering a run on the Bank of England’s gold reserve.

Fortunately for British capitalism, the system had an escape clause. The rule that the central bank could only issue pound notes backed 100 percent by gold could be suspended. The very knowledge that the central bank could create additional pound notes dramatically reduced the demand for them, the bank runs would halt, and the crisis was broken. Nor did this lead to any run on gold bullion – an attempt by the owners of pounds to convert them into gold coin at their nearest Bank of England branch – though under the rules of the gold standard they had this right.

If the Bank of England had kept on inflating the quantity of pound notes relative to its bullion reserves, at some point such a run would have occurred. But before 1914, the bank never came close to doing this. The mere knowledge that the bank could issue extra notes – in the sense that there was no legal reason why it could not do so – had halted two crises, one in 1847 and the other in 1866, without it actually having to create any additional notes in excess of its gold reserve. Only in 1857 did the Bank of England actually issue notes in excess of its gold reserve and then only briefly. There was no run on the bank’s gold reserve in 1857 as a result of this issuing of the extra notes and that crisis too quickly passed.

The industrial cycle and the movement of the dollar price of gold under the dollar standard

The general formula of capitalist production is M-C..P..C’-M’. Here money appears only momentarily as a means of circulation. The capitalists begin with a sum of money M but immediately throw it into circulation to purchase C means of production and labor power. They then carry out P – combining the means of production with labor power – to produce C’ commodities containing surplus value. The capitalists then sell the commodities and realize both the value and the surplus value of the commodities in M’ money and then immediately throw the M’ – minus whatever is necessary to provide personal subsistence to the capitalists and their families – back into circulation to purchase additional C as the cycle of reproduction is repeated.

Periodically, however, the cycle of capitalist production is disrupted, usually by an inability to fully realize the value of C’ in money M’ – overproduction. When this happens, the capitalists suddenly hold onto M. The demand for M increases sharply, reducing the demand for commodities.

Such a situation represents a crisis or stagnation in capitalist (re)production. Under these conditions, the role of money as a means of payment and a means of accumulation (hoarding) overshadows its role as a means of circulation, which dominates when capitalist (re)production is developing in full vigor. This is something that was not understood by liberal economists from Ricardo to Friedman but was well understood by Keynes once he broke with economic liberalism.

The liberal bourgeois economists, with their quantity theory of money and denial of crises of general overproduction, pointed out that capitalists get rich by investing money – either directly by plowing it back into their businesses or indirectly by lending out the money at interest. Why would a rational capitalist ever hoard money? According to the liberals, any money that passes into the capitalists’ possession is quickly spent – or lent out – because only by spending and lending money can they make a profit. Since profit is, after all, measured in terms of money; hoarded money by definition yields no profit and indeed does not function as capital.

Money as a means as payment

When a crisis begins, capitalists are fearful that the commodities they sold on credit – accounts receivable – may not be paid for. Also, they fear that if they cannot convert their accounts receivable into cash on time, they might not be able to meet demands for payment on their accounts payable owed to their creditors. Such a situation can land them in bankruptcy court and runs the risk of a partial or complete loss of their capital. As long as prosperity lasts, this seems like a remote danger, since accounts receivable are paid on time and appear to be practically the same as cash.

Indeed, even unsold commodities appear to be practically cash as far as the capitalists are concerned as long as sales are strong and rising. Both commodities and accounts receivable that are backed by commodities appear under these conditions to be equivalent to cash. While these conditions last, any attempt to build up a reserve of actual cash will only lead to loss of potential profits. It is the making of an ever greater mass of profits measured in terms of money but not the actual accumulation of money that is the sole aim of capitalist production.

Therefore, as long as capitalist (re)production is proceeding smoothly, money that flows into the capitalists’ hands is either thrown immediately back into the cycle of capitalist production or is quickly spent on personal means of subsistence for the capitalists and their families. During such periods, they behave exactly as the liberal economists from Ricardo to Friedman assumed they would always behave.

The crisis

But when a crisis strikes, the capitalists in order to minimize the risk of a loss of all or a part of their capital are forced to attempt to convert all their accounts receivable into cash as quickly as they can. They therefore demand immediate payment on accounts that are only slightly overdue, become very reluctant to sell commodities for anything but cash, and demand payment on all “callable” loans. Similarly, the capitalists are faced with demands for immediate payment of any payables that have fallen even slightly behind their due dates or are in any sense “callable.” The whole chain of credit suddenly contracts.

Money as a means hoarding

For the capitalists, the means of defense against such a situation is a large cash hoard. With profits low if not negative, the “opportunity cost” of holding cash is not nearly as great as it would be in times of prosperity. And unlike real capital (factory buildings, machines, raw materials and so on), cash can be used to pay off any debts they owe to their fellow capitalists.

Therefore, during periods of credit contraction – “de-leveraging” – that begin with the crisis and extend through the post-crisis stagnation, the capitalists do all they can to build up their cash hoards. As a result of this process, the jerry-built structure of credit is replaced with a system based far more on solid cash. The economy reverts to a much “sounder” cash economy but at the price of a more or less extended period of economic stagnation.

During the period of “de-leveraging,” as the phase of credit contraction is called, new investments in either commodity capital – inventories – or fixed assets is postponed as long as possible. The amount of cash grows, but its velocity as currency slows, so the rise in potential purchasing power represented by the growing quantity of cash is not matched by an expansion of actual demand. This is exactly the situation that we have seen since the last crisis began in 2007-08. The banks and corporations are building up large cash balances that if they were spent – or lent out – would quickly end the current stagnation.

Stagnation illustrated in numbers

Between 2008 and 2012, in the first four year following the crisis, the value of “total assets” of the U.S. economy, according to the Federal Reserve, increased a modest 12.65 percent. The value of non-financial assets – more or less real capital – increased a mere 4.37 percent. In contrast, financial assets increased 23.48 percent.

But the real star among financial assets has been checkable deposits – deposits that yield little or no interest but are used as means of payment. These types of deposits increased an astounding 2,700 percent in the four years that followed the crisis. The increase in interest-bearing time deposits that cannot be used as a means of payment increased at a still substantial but far more modest 56 percent. This is the classic symptom of profound stagnation in the process of capitalist expanded reproduction.

The movements of stock and dollar gold prices within the industrial cycle

The financial markets more or less accurately anticipate the movements of real capital. They are sometimes wrong, and when they are wrong, there are dramatic “corrections” either upward or downward. In the financial markets, the “smart money” is the money that correctly anticipates what will happen next. The “dumb money” simply assumes what has been happening will continue to happen.

This means that during periods of post-crisis stagnation such as the present, skilled capitalist speculators who possess an empirical knowledge of the industrial cycle will anticipate the arrival of average prosperity and eventual boom. Especially over the last year, with the residential construction industry as measured both in terms of housing prices and housing starts finally beginning to recover from their deep prolonged slump, stock market speculators have begun to bet that the current cyclical stagnation phase may be ending.

The current stage in the world industrial cycle and gold and stock markets

The preceding period has been a period first of great crisis and then profound stagnation. The industrial capitalists with the significant exception of the gold capitalists have cut back on their investments during the period of crisis/stagnation. In contrast, the gold capitalists have greatly increased their investments.

Despite the depletion of the South African gold mines since the crisis, gold production has increased and has again reached record levels. This has been achieved by opening up many mines that would not have been profitable at the prevailing level of commodity prices measured in terms of gold before the crisis.

But since the crisis lowered the prices of commodities in terms of gold, these mines became profitable in gold terms. Therefore, in the current industrial cycle gold production exhibited in textbook form its classic countercyclical movement.

It also seems likely that increased capital investments in gold have somewhat lowered the labor value of gold relative to most other commodities, reversing to a certain extent the relative movements of the values of gold and commodities that preceded the crisis. Far from indicating that the theories of “non-commodity” money are correct, the movements of production and prices since the beginning of the crisis provide a powerful empirical demonstration that gold very much remains money and that the Keynesian “new monetary theories” that deny this fact are quite wrong on this point, however correct some of their criticisms of Friedmanite monetary theory have been.

Sooner or later, every period of stagnation that follows a crisis, no matter how severe, ends – until the next crisis, that is. Stock market speculators, as we have seen, have been anticipating for some time – especially over the last year – the coming capitalist expansion and the subsequent rise in profits. Therefore, stock market prices – with the significant exception of the stocks of gold mining companies – have been discounting the expected end of the current stagnation and the arrival of the next boom.

The arrival of hard times for gold miners and refiners

It is the opposite in the gold market. Gold stocks performed “brilliantly” over more than a decade. During the “gold boom” that began before the outbreak of the crisis of 2007-08, and reached it peak in 2011, the industrial capitalists engaged in the mining and refining of gold enjoyed a profit bonanza.

But nothing lasts forever, not even for the producers of that very special commodity that serves as money. As the gold mining capitalists invested their profits in new mines and capital equipment, the production of gold has risen – with bearish implications for the dollar price of gold. Now the profit prospects for the gold mining companies don’t look all that good, especially when compared to other branches of production.

Speculators, therefore, have been pushing the dollar price of gold down and now are helping pave the way for the next crisis. By lowering the dollar price of gold, they are helping to raise the prices of other commodities calculated in terms of gold. As a result, these speculators are lowering the profits in the gold mining and refining industry relative to other industries, and even absolutely, including making losses in marginal mines.

With lower profits, both relative and absolute, in gold mining and refining, investment in new mines and capital investments in existing mines can be expected to decline. At some point, gold production will stagnate and decline as the level of production of other commodities rises. Indeed, this point may not be that far off. The production of gold in 2013 is only expected to rise about 1 percent over the record high of 2012. Unless the dollar gold price rallies – or the prices of commodities in terms of dollars decline – deflation – gold production may start to decline, perhaps as early as 2014.

However long it lasts, the current bear market in gold therefore in no sense indicates that gold is not money. On the contrary, it confirms from the other side the countercyclical character of the gold mining and refining industries – in terms of the dollar gold price, profits, and production – that gold continues to play its role as the money commodity.

Why no inflation? Why no deflation?

Despite the sharp rise of the monetary base since the panic in 2008, and the associated fall of value of the U.S. dollar, there has been very little overall inflation in commodity prices. But the question as we saw can also be posed in reverse. Why, despite the most profound crisis/stagnation since the 1930s, has there been no general deflation in commodity prices?

In any earlier period, the prolonged period of massive unemployment of both workers and machines would have led to a considerable drop in the cost of living and a rise in real hourly wages. The Fed has been doing all it can to prevent deflation by creating huge amounts of new token dollars and allowing the dollars to depreciate against gold, with that depreciation reaching its peak in September 2011. So far, it has been able to walk the “middle road” between feared soaring inflation and equally feared deflation.

How has the Fed done this, and how much longer will it be able to pull this off?

‘Operation Twist’

As late as July 2011, the interest on 10-year U.S. government bonds was still above 3 percent and the U.S. residential construction market was still showing virtually no signs of recovering from its dramatic collapse. Recoveries in the residential construction markets – housing prices and housing starts – have preceded virtually every recovery that the U.S. economy has experienced throughout its cyclical history.

When the housing market failed to show signs of recovery after 2009, the Fed was determined to drive long-term interest rates on government bonds, which govern mortgage rates, still lower. But they had to do this without igniting a new run on gold, which if it led to sharply higher dollar gold prices would unleash inflation and end up with sharply higher mortgage rates in the housing market, which would quickly lead to a renewed slump in the residential construction industry. The question facing the Bernanke Fed was how to do this. It wasn’t all that easy to pull off.

In August 2011, the Fed announced that it would keep short-term interest rates near zero for two years. Long-term interest rates as measured by the 10-year government bond began to drop sharply, falling at times below 2 percent. But fearing that the Fed was embarking on a runaway money printing spree – technically a rapid rise in the U.S. dollar monetary base – the dollar price of gold began to soar, approaching $2,000 an ounce for the first time.

The dreaded run into gold appeared to be beginning. Something had to be done, and done quickly, to halt it. The classic way to do this would be to raise interest rates. But if this were done, the housing market and probably the economy as a whole would go into a renewed tailspin, the very thing the Fed was desperately trying to avoid.

A desperate move

The Bernanke Fed, therefore, made a desperate move. It announced that it would sell off its portfolio of short-term government securities and use the proceeds to purchase government bonds, thus lowering their yield without any increase in the dollar monetary base. The housing market was in effect put on life support. Long- term interest – and mortgage – rates would be driven to levels that were briefly even lower than those that followed the super-crisis of 1929-33 and World War II without an explosion in the monetary base. The gold market, relieved – or in the case of gold bulls disappointed – that there would not after all be an immediate explosion in the monetary base, then stabilized with dollar gold prices falling several hundred dollars.

Housing recovery

Finally, with long-term interest rates at perhaps the lowest levels in the history of capitalism, the U.S. residential construction market began to show signs of life as housing prices and the number of new houses built finally began to climb for the first time since the housing downturn began in 2006. But there was a catch. The Federal Reserve Board would exhaust its supply of short-term government bonds in about a year. What would happen then?

Stagnation continues

While the housing market, thanks to the life support, was improving, the percentage of the population actively engaged in the work force, either employed or looking for work, continued if anything to shrink. The crisis of short-term unemployment was turning into a far more serious crisis of long-term unemployment, despite the housing recovery. In the meantime, the European economy had slipped back into outright recession with rising short-term as well as long-term unemployment.

Experience shows that it is prolonged long-term unemployment, not relatively brief cyclical unemployment, that breeds the kind of social crisis that can threaten the capitalist system.

When the Fed’s inventory of short-term securities was run down about a year ago, the Fed announced that it would spend $85 billion a month purchasing government bonds and mortgage-backed securities. This was a compromise. The Fed allowed the monetary base to resume its growth but it was not creating enough “paper” money to prevent the price of government bonds from slipping, resulting in a rise of long-term interest rates.

It is important to realize that even if the Fed were to keep spending $85 billion a month indefinitely on government bonds and mortgage securities, the rate of growth in the monetary base would gradually slow. So a certain amount of “tightening” was built into the announcement of what was dubbed QE3. This tightening has now been augmented by the Fed’s recent announcement that it would begin “tapering” its purchases of bonds and mortgage securities by $10 billion per month beginning in January 2014.

While there are many articles being published in the media claiming that this will not amount to an outright tightening, this is exactly what it will be. Indeed, a neutral monetary policy would require the Fed to gradually increase the amount of dollars it is spending – and producing – on government bonds beyond $85 billion a month. But notwithstanding the bear market in gold, the Fed has at least so far avoided this.

The “men in the pits” have been factoring in the expectation of a slowing growth in the dollar monetary base, not only relatively but absolutely, by driving down the dollar price of gold to the present $1,200 an ounce. If these expectations are not realized, the dollar price of gold could reverse course and move, perhaps very sharply, in the opposite direction.

The result has been a renewed rise in the rate of interest on 10-year government bonds. The rate is now well above 2.5 and threatening to again rise above 3 percent. The rise in long-term interest rates has, along with the cyclical factors discussed above, “killed” the gold market for now, with the dollar price of gold falling back below $1,200 an ounce – still well above the $675 it was at the beginning of the crisis in mid 2007.

But the renewed rise in long-term interest rates is threatening to slow and perhaps soon end the housing recovery, both in terms of an increased number of housing starts and a continued rise in home prices, which is so important for the long-term stability of U.S. imperialism. The Fed policymakers, soon to be headed by Janet Yellen, fear that the housing recovery will peter out before a strong rise in private investment finally occurs.

In a normal industrial cycle, the passing of the peak in the housing construction cycle is compensated by a rise in capital spending. When residential construction begins to decline, the construction of factories and commercial buildings rises. Indeed, the level of residential construction is sometimes described as “countercyclical.” This is no accident. As the demand for credit by the industrial capitalists begins to rise, there is simply less credit left over for would-be home buyers. The residential construction industry then typically enters the recession phase of its cycle.

To be continued.

Next month, we will examine the options that are open to the soon-to-be Yellen Fed.


1 Since neo-classical marginalism sees value as arising from the scarcity of use values, it cannot explain how a crisis of generalized overproduction is even possible. Logically, general economic crises should not occur under capitalism. Before Keynes, the marginalists generally largely ignored crises, dismissing them as accidental “shocks” that momentarily disrupt what would otherwise be a full-employment equilibrium. The empirical work that was done on crises was carried out by economists who largely ignored marginalist theory. Long-term unemployment was dismissed by the marginalists as either “voluntary” – people choosing “leisure” rather than work at wages that reflected the value their labor was capable of creating – or the result of social legislation and trade unions that interfered with the working of the “free market,” especially the workings of the labor market. (back)

2  Re-discounting is the act of buying commercial paper of member banks, which has already been discounted once for someone else, before its normal payment date for less than it will be worth on that date, or making secured advances to member banks on their own notes. (back)

3 Bernanke proclaimed in a speech honoring Milton Friedman’s 90th birthday in 2002: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna [Schwartz, Friedman’s coauthor]: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” In other words, the Depression was the fault of bad policies by the Federal Reserve and had nothing to do with the inherent contradictions in the capitalist mode of production. (back)

4 WPA, or Works Progress Administration, was the name of the federal public works program launched by the Roosevelt administration. Though it did not compete with the private sector except for the labor power of unemployed workers, it did employ unemployed artists and writers and built many useful public buildings, many of them still in use today. (back)

It was, however, unpopular among the capitalists because they didn’t like the idea of the government employing unemployed workers, since this tended to reduce competition among workers and thus weakened the downward pressure on wages of the Depression-swollen reserve army of unemployed. It also made the organization of new unions that much easier. Under the pressure of the capitalists and claiming the Depression was over, the Roosevelt administration moved to cut back the WPA right after the 1936 election but felt obliged to expand it again during the 1938 recession.

5 Prices that directly reflect labor values – direct prices – are transformed into prices of production that equalize the rate of profit so that capitals of equal size yield to their owners equal profits in equal periods of time. Market prices actually fluctuate around prices of production. (back)


2 thoughts on “Change of Guard at the Fed, the Specter of ‘Secular Stagnation,’ and Some Questions of Monetary Theory

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