Storm over the Federal Reserve System
U.S. President Donald Trump has indicated that he will nominate right-wing economic commentator Stephen Moore and businessman Herman Cain to fill two vacancies on the
Federal Reserve System’s Board of Governors – called the Federal Reserve Board for short. If confirmed, both Moore and Cain would serve for 14 years. While Trump’s other nominees to the “Fed” have been conventional conservative Republicans, Moore and especially Cain have been strongly attacked in the media and by economists and some Republicans for being completely unqualified.
Of the two, Cain has drawn the most opposition from within the Republican Party. As of this writing, his confirmation by the U.S. Senate looks unlikely. Republican Senators Mitt Romney (who ran against Obama for president in 2012), Lisa Murkowski, Cory Gardner, and Kevin Cramer have all indicated that they are leaning against voting to confirm Cain. If all them vote no, Cain’s nomination will fail unless he can win over some Democratic senators.
Cain – one of the few African-Americans Trump has nominated for high office – throughout his business career has expressed opposition to even elementary labor rights. In 2016, he briefly ran for president as a Republican on a platform of reforming the federal tax system in an extremely regressive way going beyond Trump’s own tax cut for the rich. Cain was then forced to withdraw from the presidential campaign when several women came forward alleging that he had sexually assaulted them. For Donald Trump, this was not a disqualification but it might be for some U.S. senators who have to face re-election.
Cain has not indicated that he supports inflationary monetary policies. On the contrary, he has said that he would like to see a return to the gold standard. For taking this stand, he has been ridiculed by liberals and progressives as well as mainstream economists. However, Cain does have actual central bank experience having served as head of the Federal Reserve Bank of Kansas City, one of 12 regional banks that make up the Federal Reserve System.
Capitalist opponents of Cain’s nomination – Cain has been a strong supporter of Trump – fear that Cain would do Donald Trump’s bidding on the Fed’s Open Market Committee (1). With the 2020 presidential election approaching, it is widely suspected that Cain would push for an “easy” monetary policy and cuts to the Fed’s target for the federal funds rate in a bid to stave off the looming recession until after the November 2020 election. Not only would such a policy put the dollar-centered international monetary system in danger in the short run, it would also erode the Federal Reserve System’s independence over the long run.
Trump’s other prospective nominee, Stephen Moore, has drawn much criticism from mainstream media and professional economists but so far less from Senate Republicans. Like most of Trump’s nominees for high positions, Moore is white. He is not even a professional economist. Although majoring in economics in college, he does not hold a PhD. Unlike Cain, Moore has never directed either a business enterprise – Cain in addition to serving as head the Federal Reserve Bank of Kansas City was also head of the Godfather Pizza Chain. However, like Cain, Moore has been accused of mistreating women. This raises the question whether Cain’s race could be a factor in the apparent lack of opposition to Moore on the part of Senate Republicans.
The “modern” Republican Party depends heavily on the votes of middle-class and working-class racist whites, a layer of the U.S. population that historically supported the Democratic Party when it was considered to be the white people’s party. Many Republican politicians privately despise Trump. However, they are afraid that if they oppose him by voting against his nominees to high positions, the racist Republican base, which has displayed a cult-like adoration for Trump, will vote against them in the primaries and stay home on election day. However, by opposing an African-American nominee, they can hint that on this issue they are even more racist than Trump.
Moore, like Cain, is a far-right Republican. He is a devoted follower of the Reagan-era economist Arthur Laffer and has co-authored a series of books with Laffer. During the Reagan years, Laffer became famous for his “Laffer curve,” which was supposed to prove that if taxes were cut the government’s revenue would actually rise. This was supposed to happen because though taxable incomes (mostly profits) would be taxed at a lower rate, the mass of taxable income (again mostly profits) would, according to Laffer, rise so much that the government would actually collect more revenue.
Translated into Marxist terms, which enables us to see what Laffer is actually thinking, the argument comes down to this: If we lower taxes and cut government services that benefit the working class, we will be able to achieve a radical increase in the rate of surplus value – a rise in the ratio between the part of the working day when workers work free of charge for the bosses and the part of the workday when workers work for themselves.
The rise in the rate of profit this will bring will strongly increase the rate of business investment. The higher the rate of profit the higher will be business investment and the stronger will be the rate of economic growth. Laffer is an outspoken supporter of Say’s Law. Say’s Law denies that there can be a “general glut” or overproduction of commodities. Most mainstream economists, though their theories support Say’s Law implicitly, prefer to avoid referring to Say’s Law by name. But not Laffer.
Again translating Laffer into Marxist terms to get to the essence of his argument, Laffer is saying that recessions are not caused by the general overproduction of commodities, as Marx and Engels held, but rather by the insufficient production of surplus value. As long as a sufficient quantity of surplus value is produced, the realization of the value (including the surplus value) contained in commodities will not be a problem. If “we” the capitalists exploit the workers more, Laffer and his supporter Stephen Moore say, the problem of who will buy the increased mass of commodities that the now even more exploited workers produce but do not consume will take care of itself.
Moore as a true disciple of Laffer backed a series of massive tax cuts in Kansas carried out by the former Republican governor. Moore claimed that the tax cuts would cause the Kansas economy to soar, filling the state treasury with extra revenue relative to that collected before the tax cut. However, the opposite happened as state government faced a massive fiscal shortfall and was forced to cut basic services. The voters of Kansas, which is generally considered a “hopelessly” Republican state, finally had enough of the GOP regressive tax cuts for the rich and elected a Democratic governor in last year’s election.
Stephen Moore and monetary policy
Moore has been all over the map on monetary policy. He has indicated in the past that he like Cain would like to see a return to the gold standard. “We have got to get rid of the Federal Reserve,” Reuters quoted Moore as saying in 2015, “and move toward a gold standard in this country.” Here Moore is quoted as not only indicating a desire to return to the gold standard but to abolish the Federal Reserve altogether. This is similar to the view of Ron Paul, who advocates a return to “free banking.” Now Trump has nominated Moore to serve on the board of the very organization that he has advocated be abolished.
In the period after the 2008 crisis, Moore opposed the Bernanke Fed’s “quantitative easing,” claiming that it would lead to runaway inflation. More recently, however, he has criticized the Fed for raising interest rates too much.
Trump, far from adopting “populist economics,” has followed the suggestions of “supply-side economists.” He has slashed taxes and regulations and cut what few labor rights still exist in the U.S. and has encouraged increased production of carbon-based fuels, predicting that this will cause the U.S. economy to enter into the greatest economic expansion in its history.
However, last year showed at best only a modest acceleration of economic growth. The problem in Keynesian terms was that though the increased deficit spending provided “stimulus,” the stimulus was much less than expected. The reason was that a rise in interest rates largely offset the effect on demand of increased government deficit spending.
Or, in the supply-side terms of Moore and Laffer, the increased rate of profit didn’t stimulate capitalist investment as expected because sales of new homes and autos began to slow due to the rise in interest rates. But this is exactly what is not supposed to happen according to Say’s Law, so dear to the hearts of Laffer and Moore.
Who then is to blame for that outcome? The Federal Reserve System, of course. The “supply-siders” simply refuse to accept the fact that due to the massive tax cuts and cutting regulation, combined with the steady reduction of the Fed’s balance sheet (aimed at “normalizing” monetary policy but drawing money out of the banking system), the potential for the U.S. economy to grow has not expanded but fallen. The Fed should have, according to the logic of the supply-siders, responded to this situation by creating still more money and lowering the fed funds target rate.
The Reagan administration and the Federal Reserve System in those days could get away with such policies – though even then the claims of Laffer that the Reagan tax cuts would actually reduce the deficit proved false in practice when the federal deficits grew instead. Unlike Reagan, who had the good fortune to take office near the end of the “Volcker shock,” Trump is presiding over an economy in the late stage – the “critical stage” – of the industrial cycle that precedes the recession.
The Fed decides
On March 21, the Federal Reserve System’s Open Market Committee announced the results of its most recent deliberations. The committee made two decisions. The first and least surprising was to keep the target for the fed funds rate at 2.5 percent. Second and far more significant was its decision to end the monthly reduction of the Fed’s balance sheet by September, much earlier than had been expected.
The term balance sheet is actually misleading in that it is used by the media to conceal from the uninformed public what is really happening. Technically, under the present U.S. currency system, all U.S. paper dollars – but not coins (2) – are considered liabilities of the Federal Reserve Banks. Originally, Federal Reserve Notes were promissory notes – liabilities – of the Federal Reserve Bank that issued them, payable in “lawful money,” understood to be gold coin. Similarly, the Federal Reserve Banks were legally obliged to redeem deposits held by the commercial banks in Federal Reserve Notes or other forms of U.S. paper currency or gold coin on the demand of the owner. The owner, in this, case was a commercial bank or the U.S. Treasury.
But those days are long gone. Today, the Federal Reserve Banks are obligated to “redeem” their Federal Reserve Notes only in other Federal Reserves Notes. As for deposits owned by the commercial banks and U.S. Treasury in checking accounts held by the Federal Reserve System’s 12 banks, if an individual Federal Reserve Bank runs low on its supply of Federal Reserve Notes it simply has to contact the U.S. Treasury Department’s mint and it will be supplied with crisp newly printed Federal Reserve Notes. Therefore, Federal Reserve Notes and promises to pay in Federal Reserve Notes are not comparable to accounts payable on the balance sheet of a normal business. Instead, in economic terms, they represent what Marx called token money – not to be confused with credit money – a common mistake. (3)
The laws that govern token money are not the same as those that govern credit money. The main difference between the two is that when credit money is over-issued, there is a run on the issuing bank as the credit money owners scramble to get their credit money redeemed in “hard cash” before the bank runs out of money. However, when token money issued by a state power is over-issued, each individual piece of money loses the same amount of value against real or gold money as every other piece of money as the price of gold in terms of the over-issued currency rises on the open market.
So when the financial press talks about the huge size of the Fed’s balance sheet, what they refer to is this: In response to the panic of 2008 and then the weak recovery that followed, the Fed in effect “ran the printing presses.” However, in order to limit the depreciation, the Fed promised that it would destroy much – though not all – of the printing press money it created in the wake of the crisis.
Now the Fed says that it will destroy far less of this “paper money” than it until recently expected to do. Since October 2015, the rate of growth of the U.S. dollar “monetary base” – which as we saw above is closely related to the Fed balance sheet – has actually been negative. Indeed, between October 14, 2015, and April 10, 2019, the U.S. dollar monetary base fell at an annual rate of about 5.6 percent after growing at an annual rate of about 20 percent during the previous seven years. The Fed’s recent announcement implies that after four years of shrinkage the monetary base will start to grow once again.
That is – assuming things go as the Fed expects – the growth rate of the monetary base will again become positive. But what will this positive rate be? Will it be the 5 to 6 percent rate of growth that prevailed from the stagflation years of the 1970s until 2004? Or will it be around the 2.7 percent that prevailed in the four years leading up to the panic that began with the failure of the giant Lehman Brothers investment bank in September 2008? It will almost certainly be more than 1.5 percent – assuming this will be the rate of growth of the global hoard of gold bullion in the coming years, which would be consistent with the dollar price of gold not deviating very far from the $1,150 to $1,350 range in coming years
The reason we can be pretty sure of this is that the Fed wants a gradual rise in the dollar price of gold consistent with its “target” of an overall average rate of increase in the dollar price of commodities of about 2 percent over the long run. But the Fed certainly hopes that it will be far less than the average 20 percent increase that occurred between September 2008 and October 2015, the period of quantitative easing. Returning to the rate at which new dollars are being created by the Fed at a sustainable rate is what the Fed calls the “normalization of monetary policy.”
How monetary policy became de-normalized
In September 2008, the entire capitalist world banking system tottered on the brink of collapse. The Fed and its satellite central banks created an enormous number of new dollars and other currencies backed by the U.S. dollar. Between September 2008 and October 2015, the Fed increased the number of dollars it created in waves of quantitative easing. At first, the Fed’s aim was to prevent a massive run on the banks leading to the kind of collapse in the quantity of bank credit money and credit that last occurred between 1931 and 1933. This would have led to a full-scale repeat of the Great Depression but on an even more devastating scale. At the height of the crisis, the annual rate of growth of the U.S. dollar monetary base exceeded 1,000 percent. These policies succeeded in preventing a full-scale repeat of 1931-33.
Later on, when the recovery turned out to be very weak despite the massive “Keynesian stimulation” and threatened to run out of steam altogether, the Fed carried on further quantitative easing in an attempt to transform the weak recovery into a strong one. This policy proved largely unsuccessful as overall world economic growth remained subdued and a series of recessions hit many industries – and entire countries in the case of southern Europe and Latin America.
Some economists expressed fears that the unprecedented series of money-printing operations carried out by the Fed between September 2008 and October 2015 would trigger a new wave of runaway inflation as had occurred during the 1970s. They feared that this time the inflation would be on a much bigger scale because the growth in the U.S. dollar monetary base – high-powered money – was, as previously indicated, around 20 percent over a seven-year period compared to around 6 percent in the 1970s. But up to now, this hasn’t happened either.
The reason was an extraordinary demand for the U.S. dollar as a means of payment during the crisis and then after the crisis proper had passed as a means of hoarding by capitalists eager to build their cash reserves as an insurance fund against a new crisis. The hoarding was further encouraged by the Fed’s decision to pay interest to the commercial banks on the massive reserves now lying idle in their Federal Reserve accounts.
Instead of an extraordinary economic boom or surge of inflation – both of which would have been predicted by Milton Friedman’s “monetarist theory” – the increase in the quantity of high-powered money and bank reserves was largely absorbed by a slowdown in the velocity of money and a rise in the ratio of bank reserves to the credit money created by the commercial banks through making loans.
Still, the Fed is nervous about this huge quantity of high-powered money lying idle in the system. The problem is that between 2008 and 2015 the quantity of money increased at a rate far higher than the rate at which gold bullion grew. However, this huge amount high-powered money created by the Federal Reserve System has up to now had remarkably little effect beyond reducing interest rates to historically low levels. But the huge amount of “paper money” created during the waves of quantitative easing represents a potentially inflationary time bomb that could still explode.
The Fed’s hopes were that over many years of largely negative growth in the monetary base, its long-term average rate of growth would finally converge on a target compatible with a 2 percent rate of inflation and an unemployment rate that the U.S. Labor Department, the media, and the economists could pan off as “full employment.” (4) Only then would the “inflationary bomb” be fully disarmed and monetary policy successfully normalized.
The problem is that signs are appearing that the post-Great Recession upswing in the worldwide industrial cycle is about to give way to a new recession. If the Federal Reserve continues its policies of “monetary normalization,” the fear is that, instead of a “normal” recession, another severe recession will occur. The Fed hoped that it would have more time to carry out “monetary normalization” before a new recession threatened.
Here an observation that I believe that Marx made is worth mentioning. Whether interest rates are high or low, a business expansion can continue if the rise in interest rates is gradual – assuming interest rates remain below the rate of profit. But whenever interest rates, especially short-term rates, rise rapidly, the business expansion soon gives way to recession.
In the wake of a recession and especially in the wake of a sharp crisis like in 2008, large amounts of money lie idle in the banking system. When a recovery begins, interest rates initially rise very little if at all. But at a certain point, the demand for loan money capital exceeds the supply at existing interest rates. This is the “critical point.” If central banks attempt to keep the expansion going by “printing” additional money, the rate of growth of the monetary base starts to exceed the rate of growth of the quantity of gold bullion.
The extent that this is the case will depend on two factors. One will be the rate at which the central bank creates new currency. The other will be the rate at which the gold miners and refiners create new gold bullion. That, in turn, will be determined by the rate of profit in gold mining and refining relative to the rate of profit in the non-money commodity-producing industries. Once the “critical point” arrives, if the central bank attempts to keep the expansion going by issuing additional means of circulation not backed up by additional gold emerging from the gold mines, it will face depreciation of its currency. Eventually, currency-devaluation inflation will drive up the rate of interest. Under today’s concrete conditions, the still only partially disarmed inflationary bomb created by years of quantitative easing could easily go off if the Fed once again starts creating dollars at a faster rate than the gold miners and refiners are creating new gold bullion.
What if the inflationary bomb does go off?
In today’s concrete conditions, a new major devaluation of the U.S. dollar – a sharp rise in the dollar price for gold over a short period of time – would threaten the dollar-centered global monetary system, which forms the financial basis of the entire U.S. empire, with collapse. In addition, the abnormal expansion of credit that occurred in the wake of the Volcker shock means that a new explosion in the rate of interest would lead to a new “Volcker shock-like recession” that would be far worse than the Volcker shock recession that occurred in the early 1980s.
This is especially true because not only are debts relative to the “real economy” much higher than in the pre-Volcker shock years but business has become accustomed to very low interest rates. Interest rates would not have to get anywhere near the Volcker shock levels before the U.S. economy would be hit by a massive crippling credit crunch – a new panic.
Normally, the depressed economic conditions that follow a deeper-than-average economic crisis leads to very low interest rates. This was indeed the case with the crisis of 2008. The low rate of interest, which means that less of the surplus value goes to the money capitalists and more goes to the industrial and commercial capitalists, encourages capitalists to act as industrial or commercial capitalists rather than money capitalists.
But in the early 1980s, the aftermath of the “stagflation crisis” left interest rates extraordinarily high, both absolutely and relative to the profit of enterprise. This encouraged traditional industrial capitalists like the General Electric Company to act as money capitalists, causing debt levels relative to incomes to explode. This credit inflation – often called “financialization” – created a “debt bomb” that was only partially disarmed during the Great Recession. If a new wave of “stagflation” occurs, the resulting rise in interest rates will have a far more devastating effect than the Volcker shock did in the early 1980s. Indeed, the only way to disarm the debt bomb is to set it off. But a full- scale explosion of the debt bomb, a massive debt deflation, would mean a full-scale repeat of the Great Depression – or worse – something that capitalist governments and the central banks headed by the Federal Reserve System are still determined to avoid at all costs.
To stave off the detonation of the debt bomb, the Fed must also stave off the detonation of the inflation bomb. This is why the Bernanke Fed, contrary to Wall Street’s expectations, did not move to radically expand the monetary base until the global banking panic hit in September 2008.
The Fed hopes, therefore, that the U.S. and world recession that is virtually inevitable over the next few years will be an ordinary “garden variety” recession with a minimal contraction of the inflated credit system – one the media will describe as “very mild.” This, realistically, is the best-case scenario as far as the Fed is concerned.
One thing working in their favor in this industrial cycle is that thanks to the crisis of 2008 gold production has again risen to record levels, though there are signs that it may be leveling off. Of course, such a “success” will mean that the debt bomb will still be there to explode in some future cycle. But if they get away with a “mild recession” without further complications this time, from the viewpoint of the Powell Fed this will be a success. However, what would be a success for Powell would be a disaster for Trump, who faces what is at best a difficult re-election campaign in 2020.
William Jennings Trump?
Horrified that he might face recession conditions in November 2020 – even if they are “mild” – Trump has responded by increasing his attacks on the Federal Reserve System. It was in this context that he nominated Moore and Cain to the Federal Reserve Board.
“On Friday [April 4 – SW],” Jim Tankersley reported in the April 5 edition of The New York Times, “[Trump] escalated his previous critiques of the Fed by pressing for it to resume the type of stimulus campaign it undertook after the recession to jump-start economic growth. That program, known as quantitative easing, resulted in the Fed buying more than $4 trillion worth of Treasury bonds and mortgage-backed securities as a way to increase the supply of money in the financial system.”
If the Fed actually were to repeat this operation in the absence of a September 2008-type panic (which, as previously indicated, created an exceptional demand for U.S. dollars as means of payment), there would likely be a 1970s – or worse – flight into gold bullion as the demand for money in the form of gold as a means of saving the value of existing money capital took off. In other words, the only partially disarmed inflationary bomb created by the earlier quantitative easing would go off. The ghost of William Jennings Bryan is once again haunting Wall Street, this time in the form of William Jennings Trump.
Of course, Trump may be engaging in pure demagoguery. He may – or may not (5) – realize that engaging in 2008-type quantitative easing under present conditions would have disastrous consequences for the U.S. world empire and for capitalism in general. Powell may figure that by September 2019 the U.S. economy will be in recession or very close to it. Under those conditions, it would be central banking 101 to halt any further contraction of the Fed balance sheet, more or less the same thing as the U.S. dollar-denominated monetary base, and begin to think about lowering rather than further raising the target for the fed funds rate.
But because Trump’s attacks are motivated by his re-election needs, if the Fed is perceived as yielding to Trump this could set off a very dangerous “bull movement” in the gold market. To prevent this, the Fed may be obliged to follow a “tighter policy” than otherwise would be indicated – the very opposite of what Trump wants. Therefore, the danger of a more than ordinary recession is increased by the political instability created by the Trump presidency.
The yield curve inverts
William Watts reported on MarketWatch March 22 that a “closely watched measure of the yield curve briefly inverted Friday — with the yield on the 10-year Treasury note falling below the yield on the three-month T-bill — and rattled the stock market by underlining investor worries over a potential recession.” “Inversions of that spread,” Watts continued, “have preceded each of the past seven recessions, including the 2007-2009 contraction, according to the Cleveland Fed. They say it’s offered only two false positives — an inversion in late 1966 and a ‘very flat’ curve in late 1998.”
It is interesting to note that the two exceptions listed by Watts and the Federal Reserve Bank of Cleveland – 1966 and 1998 – are not really exceptions. In 1966, the Vietnam War-era boom was underway, fueled by cyclical factors plus the regressive Democratic tax cut of 1964 and escalating outlays for the Vietnam War.
Then, in the first quarter of 1967, the U.S. economy experienced a “mini-recession” while West Germany experienced its first major postwar recession. The continued escalation of the Vietnam War and quick Fed easing halted the 1967 recession after only one quarter. At the time, the quick end of the mini-recession of 1967 was hailed as a victory for Keynesian economics. But was it?
The collapse of the gold pool in March 1968 – up to that time the biggest financial crisis since the banking crisis of 1931-33 soon followed. In order to prevent a massive fall in the value of the U.S. dollar at that time, the Fed was forced to resume tightening.
In order to prevent the federal budget deficit from crowding out the private sector as money tightened, the Johnson administration had to ask Congress for a tax increase, which briefly eliminated the federal budget deficit in 1969. The Johnson administration’s policies of both guns and butter financed by borrowing and an accommodative Fed were over. As a result of these developments and the rise of a huge anti-war movement, including among U.S. troops, the U.S. government was forced to open negotiations with the Vietnamese government. The 1969-70 recession soon followed, which marked the beginning of the “stagflationary” 1970s that only ended with the 1979-82 Volcker shock.
The other exception pointed to by Watts was 1998, when the yield curve was flat but not actually inverted. Notwithstanding this fact, recession was not that far off. In 2000, the dot.com crash occurred, though the National Bureau of Economic Research claims the general U.S. recession did not begin until April 2001. However, Silicon Valley, which was the center of that economic storm, was clearly in deep recession by the fourth quarter of 2000. Employment didn’t even begin to rebound “in the Valley” until 2003.
Why is the yield curve such an accurate predictor of approaching recession or worse? Though the yield curve is officially measured by the relationship of the yields of long-term versus short-term government bonds, in reality, it mirrors the relationship between long-term and short-term interest rates in the private sector. As the yield curve flattens – and begins to invert – experience tells us that at the very least we can expect a recession, not necessarily immediately but over the following few years.
Wall Street economists explain why ‘this time it is different’
In the past, the flattening and inversion of the yield curve has proven to be an extremely reliable indicator of approaching recession – and sometimes a more serious economic crisis such as the super-crisis/Great Depression of the 1930s, the “stagflation” recessions ending with the Volcker shock in the 1970s, and most recently the Great Recession.
This has not prevented Wall Street economists from explaining to the stock-buying public that “this time it is different.” Among the current members of the “this time is different” party is Ed Yardeni, veteran Wall Street economic forecaster and “expert on the business cycle.” Let’s examine Yardeni’s arguments in his article that appeared, appropriately enough, on April 1 in MarketWatch.
Yardeni repeats the orthodoxy that “The Yield Curve Model is based on investors’ expectations of how the Fed will respond to inflation.” In other words, it is not the objective conditions developing within the capitalist economy but rather the expectations of “investors” about how the U.S. Federal Reserve System will respond to “inflation.”
“The Fed,” Yardeni notes, “recently signaled that there won’t be any rate hikes this year and only one next year. If so, this should reduce the chances of a recession.” In other words, Yardeni argues that investors expected the Fed to continue to tighten, causing the yield curve to flatten and then at least briefly to invert. But happily, the Fed has now indicated that it is not going to tighten any more. Investors were, according to Yardeni, just plain wrong about the Fed’s intentions when they bought long-term government bonds and sold shorter-term government bonds causing the yield curve to invert. Yardeni is here assuming, not unlike the supporters of Modern Monetary Theory, that the Fed can create all the money and credit – credit is based on money after all – that is necessary to prevent a recession.
Yardeni makes an astonishing economic discovery
“More specifically,” Yardeni writes, “after studying the relationship between the yield curve and the monetary, credit, and business cycles, we have concluded that it is credit crunches, not [an] inverted yield curve, and not aging economic expansions that cause recessions.” Yardeni has discovered that “credit crunches” – shortages of credit – precede periods of business recession, stagnation. This would indeed be an important empirical discovery by Yardeni if it hadn’t already been known for centuries.
Yardeni is, however, right when he says that inverted yield curves do not actually cause recessions. What yield curve flattenings and inversions do indicate is that a “credit crunch” is developing and will be expected to produce a recession – or something more serious – in the relatively near future. This leaves unanswered the reason why periodic credit shortages that flatten and then invert the yield curve and end in recession-producing crunches occur in the first place. Yardeni implies that credit crunches are caused by the “mistakes” of the “monetary authority” – today the U.S. Federal Reserve System.
Yardeni‘s claim that “this time is different” comes down to arguing that the Fed has finally learned from its past mistakes and is reacting to an incipient credit crunch by moving in a timely matter to create additional money that will straighten out the yield curve and ensure many more years of prosperity.
The implication of this Wall Street economist’s arguments is that with prosperity extending as far as the eye can see this is a great time to buy stocks. One obvious problem with Yardeni’s argument is that it has been made on the eve of every economic downturn, most recently in the lead-up to the Great Recession.
But let’s go back to the heyday of Keynesian economics. In 1967, the Fed did move to expand the supply of money, holding the length of the recession down to a single quarter. But we now know what followed shortly thereafter. I in no way want to deny the possibility that the Fed might follow similar policies that will drag out the critical stage of the cycle for a longer period than usual. Nor is it to deny that stock prices may make new highs before the arrival of the inevitable “bear market.”
But this doesn’t change the fact that the road out of the critical stage of the industrial cycle involves at best an “ordinary” recession, and possibly something far worse. It also doesn’t change the fact that if the central bank – Federal Reserve System – follows policies that drag out the critical stage of the industrial cycle, the chances of something “far worse” – which was indeed the case in 1967 – than an ordinary recession happening are increased. To understand why this true, we have to look at what actually causes inverted yield curves and credit crunches that at best end in ordinary recessions and sometimes far worse. Here Yardeni isn’t any help at all. Let’s begin with the yield curve, the relationship between long-term and short-term interest rates.
The yield curve
Everything else remaining equal, a loan of money for a longer period of time yields a higher interest rate than a loan for a shorter period of time. The reason is that the longer a sum of money is loaned out the more time there is for something to go wrong. To take an early 20th-century example, a thriving carriage-producing company goes bankrupt because of the introduction of the automobile. However, a commodity use value such as a means of transportation is unlikely to go obsolete in three months. But in 30 years, who knows? Carriages give way to automobiles, typewriters to personal computers, over-the-air TV to cable, cable to Youtube. Over decades, technical revolutions destroy many capitalists while making other capitalists fabulously rich.
In the case of government securities payable in the currency of the government that issues them , it is true –though not impossible – that it is unlikely, as Modern Monetary Theory supporters point out, that the government will fail to pay the interest and principle – that is, go formally bankrupt. What is much more likely is that a massive devaluation of currency will lead to a currency devaluation-driven inflation wiping out much of the value of the currency that the interest and principle will be paid in. However, under anything like normal conditions this will be extremely unlikely to happen over the next three months. But who would want to bet their life – or their fortune – that a new massive devaluation of the U.S. dollar won’t occur sometime over the next 30 years?
The longer a sum of money is loaned out the greater the risk to the lender that the interest and principle will not be fully paid or be paid in a currency of greatly reduced purchasing power – and gold value. These factors establish the normal positive slope of the yield curve, with interest rates low at the short end and high at the long end.
However, short-term interest rates rise relative to long-term rates as every successive industrial cycle progresses. This causes a graph or chart of the difference over time between interest rates on long-term government securities and short-term interest rates to at least flatten – drop to zero – and very late in the industrial cycle actually go negative, or invert. When interest rates are generally low, as they are at present, the yield curve flattens but may not actually invert.
Why does this flattening occur? The writers for the financial pages and the economists claim it is because investors – money capitalists – sensing the approach of recession get out of risky investments and shift to safer investments like long-term government bonds. Such bonds ensure the money capitalists a safe if low rate of return just before and during recessions when stock market prices decline. The problem with this explanation is that it assumes that the money capitalists, at least collectively, have an uncanny ability to predict the course of the economy. But do they?
The ability to sense an approaching recession before it actually begins is a talent that is conspicuously lacking among the writers for the financial press and the economists who consider themselves experts on the business cycle. Typically, these people – with some exceptions – predict continued prosperity right up until the recession becomes so obvious that it cannot be denied. More importantly, this does not explain why the money capitalists who buy government bonds are so much better at predicting the approach of recession than the money capitalists – often the same individuals – who purchase stocks.
The real reason the yield curve flattens and inverts
Unlike most if not all of today’s academic Marxists, who at best emphasize the “over-accumulation of capital” but avoid the term “overproduction of commodities,” Marx and Engels emphasized the general relative (6) overproduction of commodities as the cause of cyclical capitalist crises. Marx also criticized the economists of his time who acknowledged the overproduction of capital but denied the overproduction of commodities.
Marx and Engels from the 1840s till the end of their lives insisted that recessions and sharper crises were caused by the general relative overproduction of commodities. We can rephrase this more precisely as recessions and sharper crises are caused by the relative overproduction of commodity capital.
Commodity capital generally has very different use values than the use values that make up productive capital used to produce the commodity capital. More importantly, as far as the capitalists are concerned the commodity capital has a higher value than the money capital the capitalist started out with or the productive capital. These still unsold commodities that make up commodity capital contain not only the value the industrial capitalist started out with but an additional value – surplus value.
All commodities produced capitalistically – defined as all commodities produced by wage labor – before they are sold function as commodity capital. In a “pure” capitalist economy assumed by Marx – no chattel slavery and no simple commodity production – this means all commodities except labor power. No industrial capitalist produces labor power as a commodity. However, a portion of industrial capitalists do produce the commodities that are necessary for production and reproduction of labor power. The value of these commodities is transferred to the value of labor power when the wage workers consume them – reproducing their labor power.
The value that includes surplus value is realized when it is exchanged for gold or its representatives in circulation. Only then does the surplus value become profit. No surplus value no profit, but also no realization no profit.
This gives rise to the illusion that surplus value itself arises in circulation. Profit cannot be measured in terms of the use value of non-money commodities but only in the use value of the money commodity. Today’s fiat money systems obscure this so that even an economist as sophisticated as Anwar Shaikh in the vulgar parts of his writing falls into the illusion that profit can somehow be measured in terms of the rising volume of production of non-monetary commodities.
The industrial capitalists who produce their commodity capital in the form of money material are a special case. Like all capitalists, their profits are measured in terms of money material. But in their case, there is no need for them to sell their commodities because they already are money.
Again, fiat money obscures this difference because the industrial capitalists that produce gold bullion sell their gold on the market for fiat money – actually bank credit money payable in fiat money – just like all other industrial capitalists. In the days of the gold standard, the industrial capitalists who produced gold bullion would “sell” their gold to the central banks in exchange for credit money that was payable to the bearer on demand in gold coins of a given weight. Or they might send their gold bullion to be minted into legal-tender gold coins, which made things clearer still.
However, the industrial capitalists who produce money material cannot simply sit on their commodity capital, which includes their profits. You can’t eat gold, nor is gold a means of production to produce more gold. Like every other industrial capitalist, gold capitalists have to exchange the money they made – it is only in the case of gold capitalists that the term “making money” is literally true – once again into means of consumption for themselves and their families and into means of production.
In this sense, the gold capitalists “realize” the value of their commodity capital when they transform that commodity capital (also their money capital) into commodities that function as means of subsistence – both necessaries and luxuries – for themselves and their families and into new means of production and labor power.
Most modern Marxists – especially those who are professional economists as opposed to “popular” writers for the socialist press – always avoid the term “overproduction.” These Marxists don’t understand that money is created by the gold miner and not the government. These academic Marxists do not understand how a general relative overproduction of commodities can still occur in the age of fiat money. The over-accumulation of capital is a much less precise expression than the relative overproduction commodities.
The term over-accumulation of commodities, for example, can refer to the over-accumulation of capital relative to the available supply of workers. Marx referred to this situation as the “absolute” – as opposed to the “relative” – overproduction of capital in Volume III of “Capital.” This is a crucial distinction missed by many Marxists. If you don’t fully understand Marx’s theory of value, surplus value, money, price and profit, it is far easier to explain crises in the age of fiat money in terms of the absolute overproduction of capital relative to the quantity of wage workers than it is to explain crises as the relative general overproduction of commodities relative to the market.
Thanks to the development of the credit system – and we couldn’t speak about a yield curve without a credit system – the act of purchasing commodities (the legal transfer of ownership from one person to another) can become separated from the act of payment where the seller of the commodity actually receives a sum of money that represents the realized value of the sold commodity. Only when the commodity is finally paid for can it be said that the labor that went into its production has truly proven itself to a part of the total social labor.
When it comes to purchasing the commodities that make up the means of production, industrial capitalists during the early phase of the industrial cycle are usually able to use their own money as opposed to borrowing. This is called self-financing. The industrial capitalists as they carry out on the books the depreciation of existing “fixed assets” set aside a sum of money that is thrown on the money market to earn interest but then is transformed back into cash when the depreciation process is completed and the fixed assets must be replaced. Expanded reproduction is carried out through utilizing a portion of the profit to finance the expansion of existing factories, mines, farms, and so on. Again, the part of the profit slated to be used to expand the scale of production is put on the money market to “earn” interest but is reassembled into money when the purchases necessary to expand the scale of production have to be made. (7)
It is different from the production of commodity capital. Industrial capitalists have produced a certain quantity of commodity capital. But they cannot use the commodities to meet the payroll or to utilize them as either raw or auxiliary materials because their unsold commodities have as a rule the wrong use values for these purposes. Instead, they must have a sum of money that can be used to purchase the necessary commodities on the open market that have the right use values to continue production without interruption. These commodities include raw materials, auxiliary materials, and labor power (which alone produces surplus value).
In order to get hold of this money, the industrial capitalists borrow short term against the expected sales proceeds of the commodities that have already been produced but not yet sold. Early in the industrial cycle, when cash is abundant, industrial capitalists might be able to pay for the commodities needed to carry on production from their idle reserves of cash. But the longer the business upswing lasts with its expanded scale of production, the more the growth of the “money supply” lags behind production. Both the industrial capitalists who are acting as merchant capitalists here and the pure merchant capitalists have to resort to credit in order to ensure the uninterrupted production and circulation of commodities.
This means that during the expansion phase of the industrial cycle the demand for short-term loans grows faster than the demand for long-term loans, whether from the consumer (for example, home mortgages), the government, or industrial capitalists, and always grows slower than the demand for short-term credit to finance inventories.
As the industrial cycle approaches its end, the industrial and merchant capitalists become almost completely dependent on credit to maintain the growing volume of production and circulation. This reflects the fact that the growth in the quantity of money – which in the final analysis even under fiat money systems comes down to the growth of money material – the ultimate basis of the credit system – lags more and more behind the growth in the number of commodities.
As a result, short-term interest rates do not only rise in absolute terms but relative to long-term interest rates. The yield curve flattens and then, just before the crisis, can finally invert. A flattening and inverting yield curve shows that the credit system is losing – though has not quite entirely – its ability to expand much further on the now stagnating quantity of money. It is like a rubber band that is about to snap. (8)
Ed Yardeni is therefore right that the inverted yield curve doesn’t cause a recession. But the inverted yield curve is a good indication that the overproduction of commodities has proceeded almost to the point where the credit system will begin to break in a thousand and one places – what Yardeni calls the credit crunch. Merchant capitalists, stuck with swelling inventories that they can no longer finance by further borrowing, are now threatened with bankruptcy. They have plenty of capital but capital in the wrong form. They need capital in the form of money capital but increasingly only have capital in the form of commodity capital.
The economists don’t understand why the yield curve inverts
Here the economists are puzzled. Why does the shortage of money occur that causes the yield curve to invert? At least under today’s “fiat money system,” isn’t it the government that, through its organs such as the central bank that creates the money, allows the credit system to expand in the first case? Why can’t the monetary authority – today the Federal Reserve System, within the U.S. economy and under the dollar system the world economy, as well – simply create more money in order to meet the needs of an expanding economy?
Economists like Ed Yardeni can’t really answer this question. Yardeni believes now that the Fed under Jerome Powell will get things right and create an adequate amount of money to get out of the yield curve inversion without a credit crunch-breeding recession. Thanks to the Powell Fed, “this time is different.” The only problem is, why didn’t they ever get things right before?
From where does the money come?
It all comes down to, from where does the money come? If you believe, like virtually all the economists – especially but not only the supporters of Modern Monetary Theory – that the money comes from the government, it is hard to explain why an inverted yield curve develops in the first place, let alone why the yield curve then proceeds to the recession-breeding credit-crunch stage and all the consequences that follow. Perhaps under the gold and silver standards of the past, the gold- and silver-mining industry might not for some reason have produced gold and silver fast enough to meet the rising demand for capital in the form of money, leading to rising interest rates and eventually an inverted yield curve and finally a credit crunch that forced merchant capitalists to liquidate their “excess” inventories leading to unemployment, stagnation and mass unemployment.
But today, under our modern monetary systems based on “non-commodity money” – the monetary authority should be able to create the right amount of money to prevent interest rates from rising sharply during prosperous periods and prevent the yield curve from inverting and then turning into a fatal credit crunch. But if even under “modern” monetary systems, the money actually comes from gold miners, the mystery disappears.
Rising golden prices (prices expressed in ounces of gold) that occur during prosperity increase the rate of profit for the industrial capitalists who produce non-monetary commodities – the overwhelming majority. But they at the same time reduce the profit of the small sector of industrial capitalists who produce their commodities as money material. The capitalists in the gold-mining industry do not experience an increase in their profits due to the shortening time of turnover of their capital that non-money material-producing industrial capitalists experience as depression gives way to renewed prosperity. Still less do they experience the absolute decline in the rate of profit brought about by the increased cost of their inputs measured in the use value of the commodity they produce – money material. For the gold capitalists, good times for the other industrial capitalists are bad times for them and visa versa.
As the rate of profit declines both relatively and absolutely for the gold-producing capitalists, the equalization of the rate of profit will see to it that a portion of the capital invested in the production of money material shifts to other, now far more profitable, sectors of production. Indeed, the tendency of gold production to move counter-cyclically is well known to economic historians.
The rate of growth in the sector that produces money material will decline and eventually turn negative if prosperity lasts long enough. As a result, just as expanded reproduction hits high gear – boom – increasing the need for additional means of circulation, the rate of growth of the means of circulation is doomed to decline further and further behind meeting that need.
There won’t be an immediate crisis. At the beginning of the industrial cycle, there is always a huge surplus of cash left over from the last downturn, the greater the downturn the bigger this surplus pile of cash in the vaults – or on the books of commercial banks in the form of deposits with the central banks – will be. But the mass of idle money in banks will now grow more slowly than the rise in the production of commodities. Overproduction is underway.
For a while, the difference between the need for additional means of circulation and the rate of growth of the means of circulation can be made up for by the drawing down of idle hoards of cash in the banks; increasing the velocity of the means of circulation; replacing money as a means of circulation with various forms of credit money; and, finally, expanding use of credit as a means of purchase in place of money. The terms of loans are stretched out and debts are “rolled over” as the “monetary system” that prevailed at the beginning of the expansion becomes a “credit system.”
Interest rates rise, with short-term interest rates rising faster than long-term rates. The yield curve flattens and then inverts. Credit tightens owing to the failure of cash to grow as fast as the circulation of commodities rises. But eventually, the chain of payments and credit cannot be stretched out any further. Breaks in the chain begin first with the weakest links – such as the subprime mortgages in 2007. But then the chain of payments breaks in a thousand and one other places and credit dries up. This is what Yardeni calls the credit crunch, and the recession is on.
These contradictions don’t fully express themselves until commodity production reaches the stage of highly developed capitalism. And then they are fully expressed only when the industrial cycle has reached its climax. Then in the words of Marx, “The use-value of commodities becomes valueless, and their value vanishes in the presence of its own independent form [money – SW].”
To be continued.
1 The Fed’s Open Market Committee, which meets about every six weeks, determines the interest rate targets on overnight loans commercial banks make to one another called federal funds, and most other aspects of monetary policy. Its members include all seven members of the Board of Governors, the head of the Federal Reserve Bank of New York, and four other heads of regional Federal Reserve Banks who serve one-year terms on a rotating basis. If Cain were to be confirmed, he would have a seat on the Open Market Committee throughout his entire 14-year term. (back)
2 Though economically there is no difference between circulating coins – the familiar pennies, nickels, dimes, quarters, half dollars, and dollar coins made of base metals in the U.S. – and Federal Reserve Notes, there is for historical reasons a legal difference. Under the gold and silver standards of the past, the government would mint gold and silver bullion in unlimited quantities. Here money material was literally being minted into coin. The money material did not become money because it was minted. Rather because the money material was money, it was minted.
However, it was not possible to mint gold and silver into the tiny quantities needed for retail trade. So the government mint purchased base metals such as copper and nickel in limited quantities to meet the needs of retail trade. In the 19th century, workers were paid in such coins. It was rare for workers to see either a gold coin or a banknote. The nominal values of the coins designed for circulation are always far more than those of the metal they physically contain. Otherwise, they would be melted down for other uses. However, legally they were (and are) still viewed as “minted money” as though the base metals making up these tokens are actual money material.
To this day, U.S. coins designed for circulation are considered “Treasury money” because they are minted by the Treasury, while Federal Reserve Notes that were once actual promissory notes to pay the bearer on demand in “lawful money” – actual coined gold – are still treated as “liabilities” on the Federal Reserve’s balance sheet. (back)
3 The economists and modern Marxists who believe in non-commodity money not only confuse credit money – bank notes convertible into gold and “checkbook money” created by commercial banks – with the token money issued by the state power. They confuse the categories of credit and money in general, believing that money is based on credit. In reality, money is the basis of credit – and like money is a social relation of production – but credit is not the same thing as money. Money does not arise out of credit; rather credit arises out of money. (back)
4 By “full employment,” capitalist economists and the media really mean the optimum unemployment rate for the capitalists. This is where unemployment is low enough to limit the costs to the capitalists of keeping the unemployed alive and prevent massive social unrest but high enough to hold wages in check, preventing downward pressure on the rate of surplus value. (back)
5 In recent weeks, speculation has been mounting in the anti-Trump media that Trump may be suffering from dementia or some other serious mental or neurological condition. He was unable to pronounce or recall the word “origin” and instead pronounced it as “orange.” More bizarrely, he claimed that his father Fred Trump – who died of Alzheimer disease in his 90s – was born in Germany. However, it is a matter of public record that Fred Trump was born in New York. It was his grandfather who was born in Germany. If Trump can’t distinguish his father from his grandfather – but then again he is a chronic liar – he is indeed in bad shape.
Of course the anti-Trump “Party of Order” may be blowing all this out of proportion. Since the Mueller report didn’t contain anything that would indicate that Trump is a “Putin puppet,” as Hillary Clinton claimed during the election campaign, or engaged in any illegal dealings with the Russians during his successful run for the president, the Democratic Party-sponsored impeachment movement received a massive blow.
But the Party of Order has reasons to be concerned by new threats by Trump to escalate his trade war with Europe as well as his attacks on the “independent” Fed, including his plans to nominate Herman Cain and Stephan Moore to its board. On top of all this, despite constant reports of progress in the negotiations to end the trade war, an agreement with China on trade has yet to be reached.
With the Trump administration in constant turmoil – most recently Trump purged most of the officials of the Department of Homeland Security, the U.S. Ministry of Internal Affairs, which oversees the U.S. federal police apparatus, claiming they weren’t tough enough on “illegal aliens” – there is always the possibly that Trump will purge the very officials that are trying to reach an agreement with the Chinese. The Chinese must be wondering who exactly they are negotiating with.
If Trump was to make some radical move against the Federal Reserve – beyond nominating Cain and Moore to its Board of Governors – that can be blocked in the Senate or in the trade war with Europe that would threaten the whole post-1945 relationship among the imperialist powers, the Party of Order might conclude that there is no alternative but to remove Trump under the 25th Amendment if not through impeachment.
On the other hand, it is quite possible that Trump likely has little understanding of monetary policy, which is, after all, a mystery not only to the lay public – which includes Trump – but also to the economists themselves. Trump might simply not understand the dangers of trying to pressure the Fed to “soup up the economy” in time for the 2020 elections. (back)
6 By relative overproduction, Marx and Engels meant not overproduction relative to human need but relative to the ability to pay – the market. Relative overproduction in the sense it was used by Marx and Engels also does not refer to overproduction relative to the environment. For example, the burning of fossil fuels for energy is causing emissions of carbon dioxide, which plays a crucial role in the regulation of the Earth’s climate, to rise sharply. Relative to what is required to preserve the current climate, fossil fuels are being massively overproduced. However, though this type of overproduction can cause terrible crises, these crises are not the same as the periodic crises of overproduction that occur every 10 years or so in the course of the industrial cycle. (back)
7 Exceptions to this rule are regulated natural monopolies such as utilities. Since the normal laws of competition don’t apply here, the state has to step in and set the price. In principle, at least, the state sets the price at a level that covers the cost price plus a rate of interest but not the profit – or at least not all of the profit of enterprise.
Regulated monopolies then pay out interest to the stockholders in the form of dividends and to their executives in the form of salaries and bonuses. But when it comes to expanding their operations as the economy grows, they must turn to the capital market to borrow the money capital to pay for the expansion. (back)
8 It is no accident, nor does it merely reflect the transition to “e-commerce,”that a wave of bankruptcies, including Sears Roebuck, Toys “R” Us, Payless Shoes, and others, have occurred. This is the developing “commercial crisis” that will lead to the industrial crisis – the recession proper. (back)