Monetary crisis in Cyprus and the ghost of 1931

In recent weeks, a financial, banking-monetary and political crisis erupted on the small Mediterranean island country of Cyprus. Here I am interested in examining only the banking and monetary aspect of this complex crisis.

The Cyprus banking crisis was largely caused by the fact that Cypriot banks invested heavily in Greek government bonds. Government bonds appeared to be a safe investment in a period of crisis-depression. But then these bonds fell sharply in value due to Greece’s partial default in 2012—the so-called “haircut” that the holders of Greek government bonds were forced to take in order to avoid a full-scale default. The Cyprus banking and financial crisis is therefore an extension of the Greek crisis. However, in Cyprus the banking crisis went one stage beyond what has occurred so far in either the U.S. or Europe.

The European Union, the European Central Bank and the IMF imposed an agreement on Cyprus that involved massive losses for the owners of large bank deposits, over 100,000 euros. Mass protests by workers in Cyprus forced the European Union and the European Central Bank to retreat from their original plans to have small depositors take losses as well.

Since the late 19th century, central banks, like the Bank of England, have gone out of their way when they wind up the affairs of failing banks to do so in ways that preserve the currency value of bank deposits for their owners. (1) The officials charged with regulating the banks prefer instead to wipe out the stockholders and sometimes the bondholders.

Why are the central banks and other governmental regulatory organs—like the U.S. Federal Deposit Insurance Agency (2), which was created under the New Deal in hopes of avoiding bank runs in the United States—so eager to preserve the value of bank deposits, even at the expense of bank stockholders and bondholders?

The reason is that if the owners of deposits fear that they could lose their money, they will attempt to convert their deposits into hard cash all at once, causing a run on the banks. Under the present monetary system, “hard cash” is state-created legal-tender token money. Whenever depositors of a bank en mass attempt to convert their bank deposits into cash, the reserves of the banks are drained, and unless the “run” is quickly halted, the bank fails.

A bank facing a run in a last-ditch attempt to avoid failure calls in all loans it possibly can, sells off its assets such as government bonds in order to raise cash to meet its depositors’ demands, and halts additional loans to preserve cash. If there is a general run on the banks, the result is a drying up of loan money capital, creating a massive contraction in demand. This causes commodities to pile up unsold in warehouses, which results in a sharp contraction of production and employment. Soaring unemployment can then lead to a severe social crisis.

This is exactly the situation that now confronts the people of Cyprus. University of Cyprus political scientist Antonis Ellinas, according to Menelaos Hadjicostis of CNBC and AP, “predicted that unemployment, currently at 15 percent, will ‘probably go through the roof’ over the next few years.” With official unemployment in Cyprus already at a Depression-level 15 percent, what will the unemployment rate be “when it goes through the roof”? Throughout the Eurozone as a whole, official unemployment now stands at 12 percent.

In last month’s blog post, we explained that the recession that began in 1929 did not really become a Depression-breeding super-crisis until a massive run on the banks in both the U.S. and Europe developed in 1931. With long lines forming in front of their doors, the banks then called in all the loans they could, dumped their assets such as government bonds on the market, and froze new loans.

Loan money capital virtually vanished, and interest rates, which had been falling—as they normally do during a recession—spiked. When loan capital vanishes, like it did in 1931, Keynesian-style fiscal “stimulus” policies are paralyzed.

This is because government borrowing absorbs what little loan capital is left, causing interest rates to rise even more. In an attempt to restore the supply of loan capital, the Hoover administration and Congress raised taxes in order to reduce the federal budget deficit. These tax increases, in turn, further reduced demand. The result was that the recession that began 1929, which was no worse than the recent “Great Recession” up to that point, was transformed into the super-crisis of 1931-33. The Depression with a capital “D” had begun.

Considering today’s massive indebtedness and the vast extension of the system of credit money compared to the credit money system of the 1930s, a 1931-style run on the banks in the Eurozone and the United States would mean a super-crisis far worse than even that of the early 1930s.

Of course, Cyprus is only a small island country, and we can be sure that the U.S. Federal Reserve System, the European Central Bank and other government financial agencies are doing all they can to prevent the Cyprus crisis from turning into a global bank run. But the Cyprus events are a dramatic confirmation of the trend towards a collapse in the quantity of loan capital and a second super-crisis. This is what lies behind the current austerity drive that we see in both the United States and Europe. Therefore, the motivations for the austerity policies of today are not that different from the policies of the Hoover and Brüning (3) administrations in 1931.

As we explained in the last post, the force behind this increasingly visible trend toward a new super-crisis and resulting Depression II is cumulative overproduction—the fact that since the end of World War II the overproduction in each industrial cycle was not fully liquidated in the preceding recession. This trend is now dramatically illustrated by the events in Cyprus.

Not yet a new 1931

The Cyprus crisis does not in and of itself mean that a new 1931 has arrived. Perhaps a better analogy would be the numerous failures of small country banks during the 1920s in the United States that preceded the super-crisis of 1929-33. These banks operated in local farming communities. These localized banking crises were themselves far too small to bring down the U.S. and world economies at the time. But they reflected the tremendous pressures within the system that were leading the U.S. and world economies toward the coming super-crisis and Depression. (For an explanation of the 1929-33 super-crisis, see here.)

One big difference that our economists always point to between 1931 and today is that in 1931 much of the world was on a gold standard of some kind, while today the system of paper money is universal. In 1931, the Federal Reserve Banks were obliged to exchange the paper dollars they issued for gold coin, whether the bearers of the dollars were U.S. residents or foreign central banks. This meant that the Federal Reserve Banks could not issue dollars at will like the Federal Reserve System and the European Central Bank that issue euros can do today. In 1931, it was at least in theory possible for the Federal Reserve Banks to run out of cash—gold—and actually fail, just like a commercial bank facing a run.

However, this raises an interesting question: Why when the European Central Bank can create euros at will is a 1931-style banking crisis allowed to unfold in Cyprus? Even though the “little 1931” in Cyprus won’t in and of itself lead to a 1931-33 type super-crisis, it will tend to deepen the ongoing European recession and risks further slowing the U.S. recovery. In the worst case, it could actually tip the U.S. economy into renewed recession. This danger is greatly increased by ongoing cuts in U.S. government spending under the “sequester.”

This danger was underlined with news that U.S. employment growth slowed dramatically in March, when only 88,000 new jobs were created according to the U.S. government, far below the level necessary to prevent unemployment from rising due to the growth in the population. (4)

Is the failure of the European monetary authority to take whatever measures are necessary to safeguard the euro value of bank deposits in Cyprus caused by the fact that today’s policymakers have simply forgotten the lessons known not only to Keynes but even Milton Friedman, and long before the time of Keynes to late-19th century British banking regulators? To understand the seemingly irrational behavior of the governments and monetary authorities of the U.S. and Europe, we should review how the crisis of 2007-09 and the recovery from that crisis—such as it has been—have unfolded.

The present international monetary system

Today’s international monetary system is not simply a system of token money. It is a system centered on a particular token currency, the U.S. dollar, which is issued by the Federal Reserve System. Other countries—and the European Central Bank that issues the token currency of the Eurozone—are obliged to maintain reserves in the form of U.S. dollars.

Under this system, though U.S. dollars are legal tender only in the U.S. and its territories (colonies), as well as Ecuador and Panama, they are widely accepted as a means of payment in many other countries. The U.S. maintains a gold reserve that backs the U.S. dollar—though the dollar is not redeemable into gold. The currencies of other nations back their currencies in U.S. dollars. Though oversimplified, this is the essence of the present-day international monetary system.

The present-day U.S. dollar is a “fiat currency”—that is, a form of token and not credit money. It is therefore not convertible into gold. However, the currency price of gold is quoted in terms of U.S. dollars. The current dollar-centered global monetary system, however, does not preclude the sale of gold on the open market from time to time in order to counteract depreciation of the U.S. dollar and its satellite currencies—virtually all other currencies—when the masters of the Empire find this desirable.

The central bankers’ problem

The law that governs the value of token currency reflects itself in the minds of the central bankers—above all, the leaders of the Federal Reserve System and its Open Market Committee—in the form of the contradiction between their need to maintain “stable” prices—defined as prices rising between 1 and 3 percent, as calculated by government statisticians—and the need to keep unemployment low enough to prevent a serious social crisis but high enough to prevent “wage inflation.”

Though economists of the Keynesian school claim that “wage inflation” causes a general rise in the prices of commodities, in reality rising wages threaten the rate of surplus value and the rate of profit. I plan to take a fresh look at this question next month in light of John Bellamy Foster’s Review of the Month in the April 2013 issue of Monthly Review magazine.

The contradiction between the need of the central bank to maintain “stable prices” and “full employment” is explained in every introductory economics textbook in the section that deals with macroeconomics.

During most of the industrial cycle, this contradiction does not appear in the minds of the central bankers to be acute. As the upswing in the industrial cycle proceeds, the economy is growing, prices are rising only gradually and the rate of unemployment is slowly falling.

The task of the central bankers is simply to create enough additional token money to prevent interest rates from rising sharply while inflation remains “low.” But when the critical stage of the industrial cycle is reached, these two aims of central banking—maintaining a rate of inflation between 1 and 3 percent and an “approximation to full employment,” as defined by bourgeois economists of course—suddenly come into conflict. This forces the central bank to allow unemployment to soar under pain of currency collapse. A recession is at hand.

To understand what lies behind the appearance of things and why they appear as they do to the central bankers—and the writers of those introductory economics textbooks—we must start with the general law that governs the value of token money and then explore how this law is modified by various factors, including the industrial cycle.

The general law that governs the value of token money

The general economic law that governs the gold value of token money as stated by Marx is that the value of monetary tokens is governed by their quantity. For example, if the quantity of token money is doubled—all else remaining equal, including the quantity of money material—the value of each unit of the token currency will drop by 50 percent. In other words, the price of gold in terms of the token currency will double. If the prices of commodities in terms of gold are to remain unchanged, the prices of commodities in terms of the monetary tokens that have doubled in quantity—for example, U.S. dollars—must also double.

The general law that governs the value of token money implies that the value of token currency units will depreciate if the token currency increases faster than the rate of growth of gold bullion in the area in which the token currency circulates. If the rate of growth of token currency is less than the rate of increase of gold bullion, the token currency will appreciate against gold. That is, the currency price of gold will fall. If the prices of commodities are to remain unchanged in terms of gold, the prices of commodities will also fall in terms of the token currency.

Modifications of the general law that governs the value of token money

The general law is, however, subject to certain shorter-term modifications that as far as I am aware were not examined by Marx. In the time of Marx, Britain was on a strong gold coin standard, and the rest of the world under the pressure of Britain was moving toward a gold standard as well. But today the world is on a U.S. dollar-centered token money standard. This forces us to examine the resulting modifications of the general law that establish the value of token money in terms of the use value of money material.

First, anything that threatens to disrupt the process of capitalist expanded reproduction tends to cause the demand for gold to rise. This will cause a rise in the price of gold in terms of token money. The reason is that market speculators believe that the monetary authority will increase the quantity of monetary tokens in an attempt to counteract the force that is threatening expanded reproduction, or capitalist prosperity. If the expected increase in the quantity of monetary tokens does not take place, the price of gold in token money will drop, returning more or less to its previous level.

The most common disturbance of capitalist expanded reproduction occurs in every industrial cycle during its upward phase. It involves the disproportion between a higher rate of growth of the total quantity of commodities—measured in terms of hours of abstract human labor—and a lower rate of growth of the quantity of gold bullion—also measured in terms of hours of abstract human labor. This disproportionate rate of growth is nothing other than the general overproduction of commodities, which sooner or later leads to a crisis that then forcibly halts the overproduction.

If the rate of growth of money material were by chance to be higher than the rate of growth of commodities during an economic boom, the resulting accelerated boom would inevitably raise the general price level in terms of money material, squeezing the profits of gold-mining and refining companies, and thereby lower the rate of growth of money material until it falls below the rate of growth of most other commodities.

This would remain just as true if some other commodity rather than gold bullion functioned as money material. So it is not a question of the nature of gold that we are referring to but rather a characteristic of money as a social relationship of production that is mediated by—represented by—money material, whether gold bullion or some other commodity.

Therefore, the general overproduction of commodities relative to money material is not accidental but inherent in the very nature of the commodity relationship of production in embryo, though it doesn’t fully manifest itself until commodity production has reached a very high level of development. More specifically, commodity production must become generalized to the point where labor power becomes a commodity—capitalist production.

In addition, capitalism must become the dominate mode of production and the mechanization of industry must develop to the point that capitalism can increase the level of industrial production very rapidly. Historically, this wasn’t achieved until 1825, when the first modern cyclical crisis of generalized overproduction broke out.

The general overproduction of commodities, however, is not the only type of disturbance that can threaten capitalist expanded reproduction. For example, there can be, and to some extent there always is, disproportionate production—overproduction of some commodities backed by under-production of other commodities. If there is an under-production of some commodity vital to production and reproduction as a whole—such as commodities that function as energy sources or food commodities—then the entire process of capitalist expanded reproduction can be thrown into crisis.

We have also seen how world wars slow capitalist reproduction—even if they stimulate production in the short run—and can even bring expanded capitalist reproduction to a halt for awhile. In coming decades, there is a growing chance that massive disruptions of expanded capitalist reproduction will be caused by the effects of global warming—itself a byproduct of capitalist expanded reproduction.

Under the current dollar system, the short-term fluctuations in the dollar price of gold is extremely speculative and thus subject to considerable short-term fluctuations, most of which cancel each other out over time. Gold traders “in the pit” are interested not in the long-term factors that determine the dollar price of gold but in the minute-to-minute changes in the dollar gold price. So-called “herd reactions” can sometimes move the dollar price of gold in directions that have little to do with the long-term factors that determine its dollar price.

However, if these price fluctuations do not correspond to the long-term relationship between the rate of growth of the quantity of gold bullion and the rate of growth of the quantity of token money, they will over time cancel each other out.

The most important single factor today in short-term movements of the dollar gold price is changes in the rate of interest on U.S. government bonds. A rise in this interest rate implies, all things remaining equal, which is certainly not always the case, that the rate of growth of the quantity of token money is slowing relative to the rate of increase of gold bullion. A fall in the rate of interest on government bonds implies that the rate of growth of U.S. dollar token money is increasing relative to the rate of increase of gold bullion.

However, the depreciation of paper currency tends to raise nominal long-term interest rates, and if it persists, real interest rates as well. So if the market believes that the rate of growth of token money is “excessive”—that is, likely to lead to the depreciation of the paper money in terms of gold and then commodities—long-term interest rates will actually rise.

Rising interest rates on government bonds may also reflect the fact that the total quantity of loan capital is growing more slowly than the demand for loan capital. Conversely, falling interest rates on U.S. government bonds may mean that the demand for loan capital relative to the supply of loan capital is falling, such as happens during recessions.

As a general rule under the present-day token dollar international monetary system, during the upward phase of the industrial cycle a gradual rise in the rate of interest on U.S. government bonds tends to accompany a gradual rise in the dollar price of gold. During periods of actual recession, interest rates on government bonds will almost certainly fall, even if the rate of growth of the dollar monetary base is growing much faster than the rate of growth of the quantity of gold bullion in the area in which the U.S. dollar circulates.

Gold traders “in the pit” are also strongly influenced by statements of those who control the quantity of dollar token money—the leaders of U.S. Federal Reserve System. Any unexpected—by the market—statements by these leaders are sure to have a considerable impact on the dollar gold price, because they alter expectations on what the rate of growth of the quantity of dollar token money will be in the near future. If the new expectations are not fulfilled in practice, however, the market will sooner or later move in the opposite direction.

With all these qualifications, it remains true that in the long run—across a number of industrial cycles—the dollar price of gold is determined by the ratio of the growth of dollar-denominated token money and its satellite currencies to the growth of gold bullion.

Remember, the rate of growth of the quantity of gold bullion is not subject to central control. Like commodity production in general, the production of gold bullion as a commodity—the mining and refining of gold—is decentralized.

Sometime ago a reader asked whether capitalist governments could eliminate industrial cycles by nationalizing gold production and putting it under planned, centralized control. If capitalist governments were in the future to attempt to eliminate economic cycles by establishing a centralized control of gold production, gold would cease to be the money commodity and be replaced by another commodity, probably another precious metal.

As long as gold production remains de-centralized and profit driven, any fall in the purchasing power of gold that does not reflect an actual drop in the value of gold relative to other commodities will lead to a drop in gold production and therefore sooner or later a recovery in gold’s purchasing power. This mechanism would cease to operate if gold production were centralized in the hands of the state in an attempt to maintain the growth of the market. Under those conditions, gold would therefore cease to be money. I will explore this question much more closely in my planned post on bitcoins that I hope to publish following the next post.

The rate of growth of the global quantity of gold measured in terms of hours of abstract human labor is governed by absolute as well as relative (to other branches of production) rates of profit in the gold mining and refining industries. In regard to the need to earn the highest rate and mass of profit possible under the pressure of competition, the position of the industrial capitalists that produce money material is no different than the capitalists that produce other commodities.

In contrast, the quantity of dollar token money must be centralized in the hands of a monetary authority.

The demand for gold bullion and the industrial cycle

Having examined the general law that determines the gold value of token money, and how it can be modified by accidental factors, let’s examine how this law is modified by a non-accidental factor, the industrial cycle. Remember, the change in the phases of the industrial cycle, though they can be strongly modified by “accidental” factors ranging from crop failures to wars, are governed by highly lawful processes. Most importantly, under modern capitalism it is only through the industrial cycle that the general price level over the long run is kept more or less in line with the underlying values of commodities.

As we saw above, the general overproduction of commodities, a situation where the quantity of produced commodities measured in terms of value—quantities of abstract human labor measured in some unit of time—grows faster than the value of the quantity of gold bullion, inevitably disrupts capitalist expanded reproduction at a certain point. It does so by making gold bullion relatively scarce compared to all other commodities. Or to look at it from the other side, it does so by making commodities abundant relative to the quantity of gold bullion, and ultimately to monetarily effective demand.

It is a basic law of market competition that whenever a given commodity grows ever scarcer, at some point the demand for that commodity will spike. If the commodity in question is not the money commodity—gold bullion—the spike in demand will cause the market price of the commodity in question to rise above its price of production. When a commodity other than the money commodity is under-produced, we have a local disturbance in capitalist reproduction.

This will a cause a rise in the production of the scarce commodity, because the producers of that commodity will realize super-profits, and additional industrial capital will enter that branch of production, which soon ends the relative scarcity of the commodity. The disproportions in capitalist production that are the inevitable result of the anarchy of production cause such localized disturbances in capitalist reproduction.

A relative scarcity of gold bullion, in contrast, leads to a crisis of generalized overproduction, which causes a general disruption in the process of capitalist expanded reproduction—a recession—and can even temporarily halt expanded reproduction altogether for a number of years.

Therefore, as the industrial cycle approaches its critical phase—defined as a situation where the overproduction of commodities relative to the production of gold bullion cannot be sustained much longer—we would expect to see a sharp rise in the demand for gold bullion unless the rate of growth of the quantity of token money is curtailed by the state and its monetary authority. The overproduction of commodities relative to gold bullion is then overcome by a general contraction of production of most commodities—recession—combined with an increase in the production of gold bullion.

This ends the relative shortage of gold bullion, which then ends the extraordinary demand for gold bullion. Therefore, in the wake of a crisis, the high demand for gold bullion that immediately precedes the crisis is followed by a drop in the demand for gold bullion. This enables the monetary authority for a time to increase the quantity of token currency relative to the quantity of gold bullion without a rise in the currency price of gold.

Is money imaginary?

As far as individual capitalists are concerned, as long as sales of their commodities are proceeding smoothly and they have no problems obtaining the money they need to obtain additional means of production (constant capital) and labor power (variable capital), our industrial capitalists are indifferent to the physical forms that their capital actually take, since as far as they are concerned, all their capital is “money.”

To the capitalists, capital appears as a sum of money that is growing ever larger, even though most of this “money” is not actually money at all but instead consists of commodities whose value is expressed in terms of the use value of the money commodity. This is why the economists tend toward the view that money is essentially imaginary. This view that money is imaginary is the whole basis of Say’s Law, which has been formalized in the mathematical equations of the marginalist economists.

Indeed, it is in the interests of the capitalists to reduce to an absolute minimum the quantity of capital that exists in the form of actual money—not imaginary money—because capital in the form of money does not absorb surplus labor, which alone produces surplus value. Only productive capital does that. Ideally—though this is absolutely impossible in reality—all capital would consist of productive capital that would be absorbing surplus labor all the time. Our liberal economists assume that this impossible ideal is reality and build their mathematical models accordingly.

But when the conversion of commodity capital into money is suddenly interrupted by a crisis of generalized overproduction, the amount of capital that exists in the form of actual money as opposed to “ideal money” becomes a matter of life and death for the particular capitalists in question. The capitalists’ creditors do not accept payment in factories, machine tools, assembly lines or computers; they insist on payment in money.

Therefore, just before the crisis, money that was previously abundant relative to demand suddenly grows scarce. This is indicated by a sharp rise in the rate of interest. The monetary authorities who are charged with “stabilizing” capitalism are always tempted at this point to increase the quantity of token money that they issue in an attempt to stave off, or at least moderate, the developing crisis. They above all aim at preventing a 1931-style banking run where much of the credit money is destroyed, and where the quantity of loan money capital doesn’t simply contract like it does in a “normal” recession but almost completely vanishes.

Dollar gold price tends to rise sharply just before the crisis

Fearing that the monetary authorities will expand the quantity of token money, some money capitalists tend to panic and move to convert on the open market a portion of their credit or token money into real money—gold bullion. Therefore, under the current token dollar monetary system, this means that there is a strong tendency for the dollar price of gold to rise sharply just before the crisis. A sharp rise in the demand for money in the form of gold bullion immediately precedes a sharp rise in the demand for money in the form of token money—or “safe” credit money—which marks the crisis proper. This is exactly what happened just before the panic of 2008.

A rising dollar price of gold precedes panic of 2008

In 2001, the dollar price of gold, which had been trending down during the 1990s, bottomed out at around $250 an ounce. By July-August 2007, it had risen to around $675, the highest since the “Volcker shock.” The production of gold, which had been rising since the early 1980s, had begun to decline around 2001, meaning that the rate of accumulation of real money capital was slowing sharply. This meant that gold bullion relative to commodities as a whole was becoming much scarcer.

The increasing scarcity of gold reflected in the change of direction in the dollar price of gold was a clear signal that a major new economic crisis was approaching, even as the economists and the media continued to rave about the glories of the “Great Moderation” and predict its indefinite continuation.

However, the resulting inflation in the prices of primary commodities caused the Federal Reserve to fear a return to the stagflation of the 1970s. In a move to prevent this, it progressively reduced the rate of growth of the dollar token money it was creating. Despite the reduced rate of growth of the quantity of dollar token money, the dollar price of gold continued to rise.

The combination of accelerating price increases of primary commodities—which foreshadow changes in the general rate of inflation if they persist—combined with a slower rate of growth of the quantity of token money and bank reserves meant that loan money capital was growing scarcer relative to real capital. However, this did not immediately translate into higher interest rates due to “de-regulation” that encouraged the reckless expansion of credit money and credit on an increasingly stagnant dollar monetary base—so-called “financial engineering.”

After the initial crisis in August 2007, the rise in the dollar price of gold accelerated from around $675 a troy ounce to above $900 for the first time ever, and even briefly hit the $1,000 level. As we explained in the last post, fearing a full-scale crisis of the dollar system, the Federal Reserve Board felt obliged to all but halt the rate of growth in the quantity of dollar token money. Loan capital began to contract, the highly credit-sensitive housing sector began to collapse and the overall economy began to stagnate. However, certain sectors of the economy in Department I—means of production—continued to expand, because the industrial capitalists were eager to buy the products of these industries before the dollar prices of these products rose further.

The Federal Reserve and the media gave the impression that the “Fed” was taking “bold actions” and that everything would be all right. But because the Fed did not actually expand the monetary base, the wave of inflation in primary commodity prices spreading to wholesale prices could not be maintained. The rising prices had the effect under these conditions of sharply reducing the quantity of loan capital. Through this mechanism, the slowdown in the accumulation of real money capital—gold bullion—was transformed into the biggest contraction of the quantity of loan capital since the 1930s. The crisis was about to break out with full force.

The crisis breaks

The dollar price of gold and primary commodity prices in terms of dollars began to decline in August 2008. The storm finally broke with the collapse of Lehman Brothers the following month and the subsequent collapse of stock market and primary commodity prices. World industrial production and trade plunged.

The Federal Reserve reversed course and began printing money in such quantities that the dollar monetary base grew by thousands of percent on an annualized basis. But under the extreme crisis conditions of late 2008, the demand for U.S. dollars as a means of payment was now so great that for a few months the dollar actually gained gold value even as the dollar monetary base grew. This momentarily turned the general law that governs the value of token money on its head. The panic of 2008, coming when it did, saved the dollar system for the time being, though only at the price of accelerating the arrival of a worldwide unemployment crisis that persists five and a half years later with no end in sight.

Where is the exit strategy?

While the unemployment crisis goes on, the crisis phase of the industrial cycle—by no means the same thing—bottomed out around July 2009. The media then announced that the Federal Reserve would put into effect an “exit strategy” as the cyclical recovery gained momentum. It is well known to the central bankers that central banks can take advantage of the extraordinary demand for their notes—or the electronic equivalent of notes—during a crisis that they could never do outside of a crisis. After the crisis subsides, they then destroy the extra notes—or central bank money—that they created during the crisis.

This was supposedly the Federal Reserve strategy following the 2007-09 crisis as well. The plan was that once the crisis phase proper was over, the Federal Reserve would withdraw the huge amount of dollar token money that it had created while the crisis raged and the demand for money in the form of U.S. dollars appeared to have no limit. The media even gave it a name—the “exit strategy.” In order to prevent a new run on the dollar at some point in the future, the Federal Reserve System must sooner or later bring the rate of growth of its dollar-denominated token money into line more or less with the rate of growth of gold bullion in the world.

The problem that faces the Federal Reserve is that the recovery from the recession proved extremely weak—and one major section of the world economy, Europe, is actually experiencing renewed recession, even though up to now this renewed recession has not been nearly as sharp as the recession triggered by the crash of 2008. As of February 2013, U.S. industrial production by official Federal Reserve Board figures is still below the previous peak reached in 2007. If the current trends continue, the depression phase proper of the current industrial cycle in the U.S. should end later this year, though the depression phase will drag on much longer in Europe, which as we noted had fallen back into recession even before the Cyprus crisis. (5)

As a result of the continuing depression and the broader crisis of mass unemployment, which will outlast the “official” end of the depression, the Fed was not only afraid of what would happen if it actually started to withdraw reserves from the banking system, it continued to expand the dollar monetary base though at a much slower pace than it had at the height of the panic in 2008-09. Between the fourth quarter of 2008 and the current quarter, the Federal Reserve System has increased the dollar monetary base by more than 300 percent. This amounts to an annualized rate of growth in excess of 30 percent.

Rise in gold production

One positive development for capitalism that came out of the crisis was the sharp fall in commodity prices in terms of gold. Overall, commodity prices in terms of dollars have not changed much due to the Federal Reserve’s rapid expansion of the dollar monetary base, but neither have they fallen. However, when account is taken of the much lower gold value of the dollar—around 1/1500th or less of a troy ounce of gold compared to 1/675th of a troy ounce of gold in August 2007—commodity prices in terms of gold have indeed declined considerably, making the production and refining of gold bullion both relatively and absolutely more profitable than was the case on the eve of the crisis.

The result has been a rise in gold production above the previous peak of 2001. However, there are some indications that this rise began to taper off last year (2012).

But even if the growth in gold production that began in 2008 continues, there is no possibility that the rate of growth of the total volume of gold bullion in the world will rise much beyond 3 percent or so a year. If we look only at the rate of growth of the monetary base since the crisis proper ended around July 2009, it comes to an annual rate of growth of over 20 percent. While this is far below the rate of growth of the dollar-denominated monetary base that occurred during the crisis proper, it is not compatible with the continuation of the dollar system in the long run.

The problem that the Federal Reserve is facing is to end the abnormal rate of growth of the U.S. dollar-denominated monetary base without throwing the U.S. and global economy back into acute crisis. Even if the Federal Reserve succeeds, a period of rising prices is guaranteed for years ahead once the current depression finally ends, something that we should keep in mind when unions sign contracts that lack cost-of-living protection and President Obama proposes to weaken cost-of-living protections for Social Security benefits.

For a year and a half, the Federal Reserve System actually halted the growth in the dollar-denominated base without throwing the global economy back into full-scale crisis, though the crisis of government finances in the Eurozone has already led to a new European recession. How did the Federal Reserve System achieve this success, modest though it was?

The spike in dollar gold prices in September 2011 and the launching of ‘operation twist’

In September 2011, the dollar price of gold suddenly soared. This happened after the Federal Reserve announced that it was going to keep interest rates at extremely low levels for years to come. This indicated to the market that the rate of growth of U.S. dollar token money would continue to grow at a high and possibly accelerated rate. The “speculators in the pits” smelled runaway inflation and acted accordingly.

It seemed that the Federal Reserve’s latest “bold” move to accelerate the upturn in the industrial cycle was about to backfire. It looked as if soaring demand for gold bullion would trigger a new wave of inflation in primary commodity prices, threatening a new crisis in the near future including a crisis of the dollar system that could lead to the financial collapse of the entire U.S. global empire. In those circumstances, any move to expand the quantity of loan money would actually lead to a contraction of loan money capital that would cripple the government’s ability to fight recession and to postpone a new recession-depression through deficit spending.

However, the Federal Reserve System was not yet out of ammunition. It launched “operation twist.” With operation twist, the Federal Reserve could push down long-term interest rates and halt the growth in the dollar-denominated monetary base at the same time. It announced it would continue to support through purchases the price (or low interest rates) on long-term government bonds but would offset these purchases by selling off its portfolio of short-term government securities.

The Federal Reserve Board went ahead with its massive purchases of government bonds, driving interest rates on 10-year U.S. government bonds to well below 2 percent during much of 2012. These extremely low long-term interest rates led to a fall in mortgage rates (for those who qualified) and finally began to reverse the fall in housing prices—actually the price of land on which houses are built.

In addition, the expansion of the quantity of loan money for consumer goods purchases helped finance a recovery in auto sales, though auto sales are still below the best pre-crisis levels. Rising home prices and construction of new homes plus strong auto sales and increases in automobile production to meet them are two bright spots in what otherwise remains an overall dismal U.S. economy.

However, under “twist,” the Federal Reserve began to sell off its portfolio of short-term government securities in order to halt the growth in the monetary base. Every time the Fed bought a dollar’s worth of long-term government bonds it in effect created the electronic equivalent of a crisp new one-dollar bill. But every time the Fed sold a dollar’s worth of short-term government securities, it in effect tore up the newly created dollar bill. As a result, the Federal Reserve System was able to have its cake and eat it too—as long as it didn’t run out of short term securities.

Twist would have failed in the critical phase of the industrial cycle

It should be pointed out here that “operation twist” would not have worked even in the short run if the worldwide industrial cycle had been in the critical phase like it was in 2007-08. Under those conditions, the Fed’s sale of short-term securities would have sent short-term interest rates soaring even more than they would have otherwise just before the crisis hit with full force. This would have forced a rapid inventory liquidation and intensified the recession.

But because of the still depressed state of the economy—which means that industrial capitalists are not overproducing—there was little demand for new real capital and therefore little demand for loan money capital. Therefore, under “twist” the short-term interest rates have risen very little.

During periods of rapid economic expansion, the demand for loan money capital is actually demand for productive capital and commodity capital (inventory building). The industrial and commercial capitalists need money not as money but as a means of circulation and move to quickly convert the money they borrow into real capital—productive capital in the form of constant and variable capital in the case of the industrial capitalists—and commodity capital in the case of the commercial capitalists. But because of the very slow pace of the current industrial cycle, a rising demand for real capital has been slow to develop.

We should not confuse the rising demand for loan money capital that occurs following the crisis with the panicky demand for loan money capital that occurs during the crisis. During the crisis, capitalists of all types desire money as such, since money is necessary to pay off creditors who are suddenly demanding increased payments because they fear demands for payment from their creditors. Under these conditions, capitalists move to build up large monetary hoards so that they can meet any demand for immediate repayment by their creditors. Any shortfall in capital in the form of money can cause capitalists to lose their entire capital. They will then cease to be capitalists.

During the period of operation twist, however, the demand for real capital was still low on the part of the industrial and commercial capitalists, who were still in the process of digging themselves out of the preceding overproduction. Compared to 2008, the quantity of loan money capital has greatly expanded—both absolutely and especially relative to demand for it—and the panic has subsided. Therefore, there has been less demand for capital as money to meet debts and stave off bankruptcy compared to 2008. The overall relatively low demand for loan money capital allowed operation twist to have some success—that is, until the Federal Reserve System exhausted its supply of short-term securities.

After operation twist

The problem was that the Fed had only a limited amount of short-term securities. Since these are now exhausted, the Fed can no longer offset the rise in the dollar monetary base that occurs when it buys a long-term government bond or mortgage-backed security by selling off an equal amount of short-term securities like it did under twist. As a result, in recent weeks the growth in the monetary base has resumed, as indicated by the figures released by the Federal Reserve Bank of St. Louis.

By the end of 2012, the Federal Reserve System had pretty much exhausted its hoard of short-term U.S. government securities. The Federal Reserve System—which since the New Deal reforms cannot itself deal in gold—had two choices. It could have halted its purchases of long-term government bonds and mortgage-backed securities. This would have prevented the resumption of a rapid rate of growth of the U.S. dollar-denominated monetary base, relieving pressure on the dollar system.

However, this would have almost certainly meant a considerable rise in the rate of interest on long-term governments bonds that would also have meant a rise in mortgage interest rates. This would have likely ended the rise in U.S. housing prices and sales and undermined the recovery in the auto market as well.

Or it could allow the rate of growth in the monetary base to resume in a bid to keep the housing and auto recoveries going until they spread throughout the economy through the operations of the multiplier and accelerator effects. The Federal Reserve chose the latter course.

Even so, the rate of interest on 10-year government bonds has risen, hitting 2 percent at times, though the long-term rate of interest on government bonds have again fallen back in the wake of Cyprus crisis. The reason is that the Cyprus crisis has once again raised the demand for U.S. dollars as the chief means of payment on the world market and thus the demand for dollar-denominated U.S. government bonds.

Rather surprisingly, the dollar price of gold has not risen but actually fallen back below $1,600 an ounce. It is highly unlikely the fall in the dollar price of gold reflects any sudden rise in gold production.

Why are dollar gold prices falling?

There are many reasons why this may be occurring. One is that despite the resumption of the growth of the monetary base, long-term interest rates on U.S. government bonds have indeed risen—at least before the Cyprus crisis. As we saw above, the gold market is extremely sensitive to these interest rates. If this rise in long-term interest rates halts, the dollar price of gold will likely soon rise.

In addition, it is possible that the central banks of the satellite imperialist countries have been either selling or lending gold or gold futures contracts on the open market in a bid to prevent a new surge in the dollar gold price that could abort the current industrial cycle. Another possibility is that the U.S. government and the large private banks and hedge funds may have agreed to pump gold or gold futures contracts onto the market in order to prevent a new surge in the gold dollar price as the growth in the monetary base resumes in order to prevent a run into gold and thus keep the weak upturn in the industrial cycle alive.

Recent announcements by George Soros that he is selling some his gold, and the lowering of estimates of this year’s average dollar price of gold by large banks, can also be interpreted as an organized attempt by some of the large capitalists, perhaps working hand and hand with the governments and central banks, to drive the dollar gold price down during the renewed rise of the dollar-denominated monetary base.

During the stock market crash of 1929, as part of the attempt to halt the market panic, John D. Rockefeller Sr, then over 90, announced in a newsreel that he and his son John D. Rockefeller Jr were buying sound common stocks.

Whether our speculations are true or not, we are in a phase of the industrial cycle—near the end of the depression, assuming that the current cycle doesn’t abort—where the demand for gold bullion tends to fall. This means that any attempt to organize a “gold pool” or even simply “talk down” the price of gold is much more likely to succeed now than it will later on when the industrial cycle is once again in the critical phase just before the crisis when the demand for gold tends to soar.

Unless the current industrial cycle completely aborts—and this would be unusual—the global industrial cycle should soon transition from the post-crisis depression phase to the phase of average prosperity on the way to the next industrial boom.

Of course, “average prosperity” and “industrial boom” are relative. Average prosperity will hardly solve the current unemployment crisis. And unless the coming cyclical industrial boom—due in several years’ time—is extremely strong, even that may put only a modest dent in unemployment. We should be careful not to confuse the long-term crisis of capitalist mass unemployment with the crisis-depression phase of the industrial cycle.

Just as importantly, around 2017, give or take a year assuming a 10-year cycle, a new global crisis of overproduction will be due that will again sharply increase unemployment. Then the long-term unemployment crisis will be reinforced.

Until then, based on past experience, the capitalists have good reason to expect a sharp rise in both the rate and mass of profit as the “late depression” transitions into average prosperity and then boom. After all, the rate of surplus value has increased considerably during, first, the crisis and then the depression, and the problem of realizing surplus value will ease as the upswing in the industrial cycle unfolds.

Therefore, the capitalists figure, why hold onto gold bullion, which as money does not entitle its owner to a share of the surplus value that is being produced by the working class, when they can sell the gold bullion that preserved the value of their capital during the crisis and buy assets such as corporate stocks that do yield their owners surplus value, in the form of dividends and rising prices on the stock exchange.

Capitalist production is, after all, a process of expanding the quantity of capital measured in terms of exchange value—that is, money, ultimately gold bullion. We have known since Marx that exchange value is the form that value—quantities of abstract human labor—must take. So in essence, capitalist production aims at increasing the value of capital measured in terms hours of abstract human labor, though this fact is well hidden from the consciousness of individual capitalists or capitalist corporations by the form of value—money.

The most optimistic case

Let’s assume the most optimistic case—not a prediction but a possible scenario. The Cyprus crisis is contained, U.S. industrial production makes a new high in the next few months bringing a formal end to the depression phase of the current industrial cycle in the U.S. Let’s further assume that there are no more surprises like Cyprus in Europe over the next few years. Perhaps in a year or so, Europe finally climbs out of the depression phase of the current industrial cycle as well and enters into average prosperity and then the boom phase.

This is clearly what the financial markets have been anticipating. But what then? The arrival of the boom phase will mean that the industrial cycle will again be approaching a new crisis. This will likely mean, first, a surge in the demand for gold bullion and then a move by the Fed to restrict the further growth of token money in order to prevent—or, more realistically, once again postpone—the final collapse of the dollar system. Will a collapse of the dollar system force the governments or monetary authorities to reduce the value of bank deposits? Will this cause a general run on the banking system?

Such a development would almost certainly be preceded by a much greater run out of the U.S. dollar and into gold than anything we experienced either during the 1970s or in 2007-09. But the huge growth in the dollar monetary base makes such a development seem unavoidable, especially when the industrial cycle once again approaches the critical point.

In addition, any measures that the government and central banks may now be taking to push down the dollar price of gold—such as informal gold pools and or campaigns to talk down gold in the media—will make such a disaster even more likely at the end of the current industrial cycle. The same is true if the current weakness in dollar gold prices simply reflects a wave of genuine capitalist optimism about a coming profits surge. The reason is that a fall in dollar gold prices will tend to reduce gold production making the feared run into gold all the more likely when the industrial crisis once again comes around to the point where the demand for gold begins to soar.

Somewhere out there lurks the menace of Great Depression II, if not at the end of the current industrial cycle than at the end of one of its successors. This is reason enough to transform capitalism into socialism, hopefully in time to avoid just such a disaster, though there are many other reasons as well!

Note on future posts

This post ends the series on current economic prospects. The next post will deal with John Bellamy Foster’s Review of the Month—much of which I agree with—in the April 2013 Monthly Review, which deals with the profit squeeze theory of crisis. Foster also has interesting things to say about the alleged compatibility of the theories of Marx, Keynes and Kalecki. Over the next month, I urge all readers to read both Foster’s article and Marx’s “Value, Price, and Profit.”

The following month, I plan a special post on bitcoins, the attempt to create a new currency based on a “social de-centralized computer network.” If readers have time, they can Google “bitcoins” and read up on this new 21st-century attempt to reform capitalism by creating a new Internet-based currency. Writing on this topic will make it possible to probe deeper into the nature of commodities, money, capital and the nature of capitalist crisis than I have done up to now. I hope to publish this online in early summer northern hemisphere or early winter southern hemisphere.

I am not urging readers to buy bitcoins, however, since they have risen sharply and then fallen sharply in value recently, creating a strong possibility of more violent fluctuations in the not-too-distant future. This is part of the general policy of this blog of avoiding giving any “investment advice,” whether for stocks, bonds, commodities, gold or other.


1 The last large-scale run on the banks in Britain occurred in the crisis that hit Britain in 1866, and even then the crisis was quickly halted by the suspension of the Bank Act of 1844. Since then, the owners of pound-denominated deposits in British banks have not lost any money in pound terms, though they have lost money in terms of other currencies and gold as a result of repeated devaluations of the pound after 1914.

2 The creation of the Federal Deposit Insurance Corporation, which insures U.S. bank deposits, is virtually the only New Deal legislation Milton Friedman supported. He did so because he believed that by ending bank runs, insuring bank deposits would prevent the kind of massive contraction of the money supply that he claimed was responsible for severe recessions, especially the extraordinary severity of the “contraction” (as he called it) of 1929-33.

3 Heinrich Brüning (1885-1970) was the chancellor of Germany between 1930 and 1932. He followed a vicious austerity policy that earned him the title “the hunger chancellor.” The resulting mass social and political crisis led directly to the coming to power of Adolf Hitler in 1933.

4 The U.S. Labor Department has again outrageously reported a decline of the unemployment rate in March 2013 from 7.7 to 7.6 percent. The reason was that the number of people either working or seeking work fell, and the Labor Department does not consider those who are not “actively” looking for work to be unemployed.

5 According to the February report of the Federal Reserve Board, U.S. industrial production is still slightly below the record high reached in 2007, so the U.S. economy is still in depression, according to the traditional definition of a depression as the period between the low point of industrial production at the bottom of the crisis and achieving the previous peak.

In terms of mass unemployment, what are usually considered depression conditions will continue even when the industrial production index makes a new high. The situation is much worse in Europe, where industrial production has actually begun declining again as a result of the crisis in government finances that hit in 2011. In Greece, the hardest-hit country in Europe, the recession never ended, so technically speaking the Greek depression has not even begun.

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