Recently, Mrzine, the online magazine of the Monthly Review Foundation, published the testimony of the left Keynesian economist Dean Baker to the U.S Congress. Baker attempted in his testimony to refute the claims made by right-wing bourgeois economists that the spike in oil and gasoline prices earlier this year was caused by the U.S. Federal Reserve Board’s policy of “quantitative easing.”
What is “quantitative easing”? And why has the U.S. Federal Reserve System, which under the dollar system acts in effect as the world’s central bank, been following such a policy?
Last year, the outbreak of the European sovereign debt crisis, followed by a distinct pause in the global economic recovery, brought fears of a renewed global recession. The U.S. Federal Reserve Board announced that it would purchase $600 billion worth of U.S. bonds in a bid to stave off a “double-dip” global recession. Or what comes to exactly the same thing, the Fed in effect announced that it was going to transform $600 billion in U.S. government debt into green U.S. paper dollars—or their electronic equivalent.
Since last December when the quantitative easing program actually kicked in—it had been announced earlier—the quantity of token money denominated in U.S. dollars has jumped by more than 35 percent. To put this number into perspective, during the prosperous post-World War II years, the quantity of U.S. token money rarely grew more than 3 percent per year.
Between May 21, 2010, and April 29, 2011, oil prices jumped almost 62 percent, peaking out at over $113 per barrel. In response, gasoline prices have soared. World food prices have also increased sharply in terms of the depreciated U.S. dollar.
Even before the explosion in the quantity of dollar token money began, speculators anticipating the expected increase in token dollars began to push up the dollar price of gold, oil and primary food commodities. The dollar price of gold rose from $1,177 per troy ounce on May 21, 2010, to $1,556 per troy ounce on April 29, 2011. Or what comes to exactly the same thing, the U.S. dollar was devalued against gold by more than 24 percent in the same period.
When speculators expect a change in the quantity, or rate of growth of the quantity, of token money, they act accordingly, causing currency prices of gold and primary commodities to change even before the expected change actually occurs. If the expected change fails to materialize, markets will then react sharply in the opposite direction. This is exactly what happened in late 2008. But this was not the case in 2010 and 2011, since this time the expected changes in the quantity of dollar token money have indeed materialized.
So it would seem on this issue that the right-wing bourgeois economists who blame the U.S. Federal Reserve System for the spiking oil, gasoline and food prices have a point, though the alternative might well have been a renewed global recession.
However, in his congressional testimony the progressive economist Dean Baker challenged the view that the Federal Reserve policies have had much to do with this year’s spiking oil and gasoline prices. (Baker didn’t deal with the question of food prices in his congressional testimony.) Since the MRzine editors decided that Baker’s testimony was worth publishing, it is worth examining Baker’s arguments in some detail.
Presumably, MRzine published Dean Baker’s testimony because the editors believe that Baker is the kind of left Keynesian that Marxists can and should be working with as part of Monthly Review’s general policy of attempting to push the U.S. economics profession back toward Keynesianism, which dominated it in the years immediately after World War II, as opposed to the neo-liberal theories that have dominated since the 1970s. Indeed, Baker as an economist is probably about as far to the left as you can get in the U.S. and still be a bourgeois economist. It is therefore instructive to examine Baker’s approach to the question of the recent rise in oil and gasoline prices.
“1) The main channel through which the quantitative easing policy could affect the price of gas is by lowering the value of the dollar. The decline in the dollar has been modest since this policy began, and most of it just reversed the run-up since bursting of the bubble. The decline in the value of the dollar can at most just explain a small share of the increase in the price of gas.”
“2) The dollar is over-valued at present. A decline in the value of the dollar is necessary to bring down our [emphasis added—SW] trade deficit. Such a decline is beneficial in the short run because it means more net exports and therefore more jobs. It is also beneficial in the long run since it will mean less borrowing from abroad.”
“3) The main factors behind the increase in the price of oil have nothing to do with Fed policy. Rapidly growing developing countries like China are causing the growth in demand to exceed the growth in supply. Instability in the Middle East has also created uncertainty in the market, thereby pushing prices upward. Finally, there is undoubtedly considerable speculation in this market that has likely exaggerated the upward movement in prices.”
Let’s examine Baker’s explanation for the rise in the price of oil. He sees two primary factors: (1) the rapid growth in China and a few other countries that has occurred since the crisis of 2007-09 bottomed out in the second or third quarter of 2009, and (2) the events in the Middle East that began with the January 2011 demonstrations against the Ben Ali and Mubarak dictatorships in Tunisia and Egypt, respectively.
There is no doubt that events in the Middle East, especially the war in Libya, have played a certain role in the rise of the price of oil and thus gasoline. However, oil prices began to rise before the demonstrations against Ben Ali in Tunisia began. They were already approaching $90 per barrel at the beginning of this year.
In addition, it is not very difficult for Saudi Arabia and other oil-producing countries to make up for the oil production that has been lost due to the Libyan war, which is exactly what they are now doing. The outbreak of war and revolution in Saudi Arabia would be a different matter entirely, but that has yet to happen.
Is China responsible for soaring oil and gasoline prices?
As for the rapid economic growth in China, we have to remember that the demand for oil is determined by the growth of the world economy as a whole, not by the rate of growth in one or a few countries. Indeed, even before the current “slowdown,” or pause, in the recovery from the crisis, the pace of global economic growth has been unimpressive when the depth of the preceding crisis is taken into account.
Experience with previous severe capitalist crises, including the crisis of 1929-33, would indicate a much stronger upswing than what we have been seeing. If a few fast-developing countries such as China have resumed rapid economic growth, this does not mean that global economic growth has been exceptional. Indeed, especially considering the overall weakness of the global recovery, we might expect relatively low oil prices to linger for quite a few more years. This was what we saw in the 1980s during the recovery from the severe early 1980s “Volcker Shock” recession, as well as after the far more modest recession that occurred in the early 1990s.
It is true that there is speculation about “peak oil” and a consequent relative, and perhaps even absolute, rise in the value of oil. However, these are long-term factors and cannot explain the dramatic spike of oil from barely above $30 in December 2008 to at times over $100 earlier this year. Baker’s claim that exceptional economic growth in a few countries has pushed up the price of oil does not explain the sharp rise in oil prices nor can it explain the parallel rise in the price of food that has led to mass unrest in many countries including the Middle Eastern countries. Indeed, high food prices were a crucial factor in producing the events in the Middle East in the first place.
If Baker’s attempt to explain the rise in the price of oil as a result of rapid economic growth in China and a few other countries is unconvincing, how convincing is his argument that the sharp increases in oil and gasoline prices occurring until very recently are unrelated to the Federal Reserve System’s “quantitative easing”?
Recent falls in the price of oil, gasoline and food prices
In recent weeks, the price of oil and other primary commodities has fallen somewhat. MRzine has just published an article by another bourgeois, and I assume Keynesian, economist, David Rosnick. “The Consumer Price Index,” Rosnick writes, “rose 0.2 percent in May—the slowest rate since November—as energy prices fell for the first time since last June.” Rosnick is quoting official U.S. Labor Department statistics as though they are gospel truth, but we will let that pass.
“The rebound in energy prices,” Rosnick notes, has “abruptly reversed itself; though we should not expect a sustained fall, it seems that energy inflation is abating.” Rosnick ends his article on an optimistic note: “In addition, the effect of the fall in the dollar on trade prices has resulted in conditions favorable to a reduction in the trade deficit. Though the immediate mechanism is slightly higher inflation, the possibility of increased exports and domestic substitution of foreign goods bring welcome opportunities for the U.S. economy.”
Rosnick is saying that the Federal Reserve’s policies of lowering the exchange rate of the dollar against other currencies through its rapid expansion of the quantity of dollar token money is working, and as a result the prospects for the U.S. economy are improving.
Rosnick is defending the policies of the Federal Reserve Board under the chairmanship of the Republican economist Ben Bernanke against other bourgeois economists who claim that Bernanke’s policies are recklessly inflationary and are threatening the entire dollar system. By publishing Rosnick’s article, the MRzine editors seem to be endorsing the policies of the Bernanke Fed. Coming to the defense of the U.S. Federal Reserve System seems a rather strange stand for a socialist magazine to take.
Why have the prices of oil, gasoline, and primary food commodities fallen in the last few weeks?
In mid-2010, the world economy was in a “pause” following the first outbreak of the sovereign debt crisis in Europe. There were fears that the European sovereign debt crisis would transform the “pause” in the global economy into a full-scale renewed recession. Now, one year later, we are facing exactly the same situation.
Last year in response to the threatened renewal of the crisis, the Federal Reserve announced that it would embark on a new round of quantitative easing. And indeed, primary commodity prices along with the retail price of gasoline and food duly jumped. As this happened, stock market prices also jumped and economic data indicated a modest rise in economic growth. The feared double-dip recession was staved off. In that sense, the Federal Reserve Board’s quantitative easing program was a success.
But the announced purchasing program, dubbed QE2 by the financial press, is scheduled to finish at the end of June. If it indeed ends, the rate of growth of the quantity of U.S. dollar token money will fall sharply. It is the expectation of a sharp slowdown in the rate of growth of the quantity of token money that speculators are now beginning to react to.
Presumably, the Federal Reserve System had hoped that the global economic recovery from the crisis of 2007-09 would by now be gaining momentum, the U.S. housing crisis and European debt crisis would be under control, and they would be in a position to halt quantitative easing with little immediate danger of throwing the global economy back into recession.
However, none of these hopes have materialized notwithstanding the modest uptick in the rate of economic growth that occurred late last year. The European sovereign debt crisis is as serious as ever, and the modest rate of economic growth—considering that we should be in the early stage of a recovery from a very deep recession—has again declined. And, unlike a year ago, the Middle East is aflame with revolutions, counterrevolutions (revolution is always accompanied by counterrevolution) and increasing imperialist intervention that we see in the form of the U.S.-NATO war against Libya, but also in Yemen and perhaps in Syria as well. And as icing on the cake, the threat of a renewed world recession that was staved off last year by “quantitative easing” is again looming.
Many bourgeois economists, alarmed by the risk of a serious crisis of the U.S. dollar that would send inflation soaring in the U.S. and throughout the world, as well as threaten the dollar system, are urging the Fed to end its quantitative easing policy even at the risk of renewed global recession. Keynesian economists, on the other hand, are urging the Fed to continue its quantitative easing policy in order to hold the recession danger at bay. Not surprisingly, the Keynesian economists are playing down the danger of a major dollar crisis accompanied by a sharp acceleration of inflation. (1)
MRzine supporting Keynesian school
Instead of pointing to the dilemma that the capitalist policymakers are facing as a symptom of the impasse that the world capitalist system is facing, as well as the bankruptcy of all schools of bourgeois economics and the urgent need for a revival of the struggle for socialism, the editors of MRzine are strongly supporting one of the bankrupt schools of bourgeois economics—the Keynesian school. The implication is that what is needed is not to step up the struggle for socialism but rather step up the struggle for Keynesian policies.
Before we simply reject MRzine’s decision to fall in behind the Keynesian economists, let’s examine Dean Baker’s arguments in his recent testimony to Congress. Would continuing the policies of quantitative easing and dollar devaluation offer any realistic hope of at least easing the current unemployment crisis and improving the conditions of workers and other working people in both the U.S. and around the world?
According to Baker, the main way that the policy of quantitative easing would affect the price of oil and by implication the prices of other commodities is by lowering the value of the dollar. This seems to be a reasonable argument at first glance. Isn’t this result exactly what I demonstrated at the beginning of this article?
But what does Baker as a bourgeois economist, not a Marxist (2), mean by the value of the U.S. dollar? Since Baker, though a very progressive economist, remains for now a bourgeois Keynesian economist—not a Marxist—we can’t assume that he is using the value of the dollar in the sense that I have been using it this blog. In the sense that I use the term, the value of the dollar is the quantity of abstract human labor measured in terms of some unit of time that it takes under the current conditions of production to produce the quantity of gold that the U.S. dollar actually represents in circulation measured in terms of some unit of weight such grams or troy ounces. Of late, that has been around one-fifteen-hundredths of a troy ounce of gold.
That is the scientific—the Marxist—definition of the value of a dollar used in this blog. In this sense, the claim that the U.S. dollar—or any other currency, for that matter—is either over-valued or under-valued is meaningless. A commodity may have a price—measured in terms of the use value of the money commodity that is high or low relative to the value—or direct price—of the commodity. But the quantity of the use value of gold measured in terms of weight that we call a dollar, euro, yen, or yuan can neither be “too high” or “too low.”
If you were to ask an ordinary person unschooled in economics—whether bourgeois economics or the Marxist critique of it—what the value of the dollar means, they would define the “value of the dollar” as the purchasing power of the dollar. Unless they were schooled in “progressive Keynesian economics” and get their economic ideas from Keynesian economists, they would most certainly not agree with Baker that the dollar was “over-valued.”
On the contrary, they wish that their dollars bought more commodities, not fewer! The same is true of the owners of euros, yen, yuan, rupees and any other currency you name. Don’t you wish that the value of your money in the sense of its purchasing power bought more commodities? I know that I do!
So what does Baker really mean when he speaks about the “value” of the U.S. dollar—or any other currency, for that matter? And why does Baker believe that the dollar, in the sense of the term “the value of the dollar,” is “over-valued”? Why does Baker believe that it would be a good thing if the U.S. dollar had less “value”? Even a thinking layperson—unless they have been educated in “progressive Keynesian economics”—should sense that Baker is approaching the question in a false way.
The price of oil, not to speak of food, has risen not only in terms of U.S. dollars. It has also risen in terms of euros, yen, yuan, and almost every other currency as well. Haven’t all currencies fallen in value measured in terms of their purchasing power?
Our layperson is correct. The fact that the dollar has fallen relatively little against other currencies does not preclude that it along with all other currencies has fallen in terms of purchasing power. Indeed, if we imagined as a kind of thought experiment that there was only a single currency in the world, would this preclude the fall of our universal currency in terms of its purchasing power? Would it preclude inflation? Of course not!
Notice that Baker is concerned only with the value of the U.S. dollar relative to other currencies. In what sense can one currency be over-valued or for that matter under-valued against other currencies? If we think about it for a moment, aren’t Baker, and the other (bourgeois) economists, speaking pure nonsense?
Well, to be fair to economists like Baker, they are simply repeating what they have been taught by their teachers. To make sense of their peculiar concept of the the “value” of a currency and their claim that currencies can be either “over-valued” or “under-valued” against one another, we have to go back in time some two centuries to David Ricardo’s theory of international trade.
Ricardo’s theory still forms the basis of the (bourgeois) economists’ theory of world trade. Today known as the “theory of comparative advantage,” the 200-year-old Ricardian theory of world trade still reigns in university economics departments if not on the markets of the world.
Comparative advantage version I
Suppose for reasons of simplification we assume all countries that trade on the world market are capitalist. Their populations are divided into two classes, industrial capitalists who purchase the labor of the workers and the workers who sell their labor—Marx would say labor power.
Let’s further assume wages are equal to what it takes to maintain and reproduce the “race” (as Ricardo put it) of the workers. Wages can’t be less than that, because if they were, the “race” of workers would progressively die out. Nor, if we follow Ricardo, or rather Malthus, can they be more, because otherwise the workers will increase their numbers until once again wages fall to the level that simply allows them to remain alive and “reproduce their race.”
According to Ricardo, the value of a commodity is determined by the amount of socially necessary labor to produce it. In the long run, market prices will fluctuate around the values of commodities, sometimes rising above and sometimes falling below them.
The individual industrial capitalists, however, do not all own factories that have the same level of equipment or are organized equally well. The conditions of production varied from factory to factory in Ricardo’s time just as they do today. The same is true of capitalist farms and mines. Therefore, individual values, as opposed to the social values of commodities of the same use value and quality, that are produced by individual industrial capitalists will vary.
Absolute competitive advantage
Those industrial capitalists who can produce a given commodity of a given quality with the least amount of labor will, according to the Ricardian theory, be able to undersell the industrial capitalists who produce the same type of commodities of the same quality with greater quantities of labor.
Therefore, the capitalists who produce commodities with the least quantity of labor will, over time, win the battle of competition. The capitalists who use more labor to produce the same types of commodities will either have to increase their workers’ productivity to the level of the most productive competitors’ workers or sooner or later they will go out of business. Here the law of absolute advantage reigns.
Is it the same on the world market? Why shouldn’t it be? Isn’t the world market simply the sum of all the national markets? Ricardo, however, gave a negative answer to this question. According to Ricardo, while absolute advantage prevails on the national market, what the economists today call comparative advantage reigns in international trade.
What is comparative advantage, and how does it differ from absolute advantage? To understand what Ricardo was getting at, let’s imagine you are the manager of a vast socialist enterprise. You are given two instructions by the central economic organs of the socialist society. First, you must employ all the available workers regardless of their skill. No unemployment can be tolerated. After all, this is socialism. And second, you must maximize the total output of the enterprise (within the constraints of the central plan).
Our vast socialist enterprise requires workers of many different skills—joiners, plumbers, carpenters, machinists, sewers and so on—just to confine ourselves to some of the skills that existed in Ricardo’s time. Since workers are individuals, their individual abilities vary greatly. Some workers are skilled at almost every task and some at very few tasks. And some workers are far below average at every possible task. But remember, you have to provide useful employment even for the least-skilled workers. (3)
In order to maximize output under these conditions, you have to assign the workers to the tasks that each individual worker is best at, or in the case of the least-skilled workers, least bad at—even if they are far below average at all tasks. For example, I might make a lousy joiner, but I will make an even worse plumber, painter and so. So I am assigned to be a joiner. Or I might be the very best in every task. I am the best plumber, carpenter, joiner and so on, but I really excel at plumbing. So I am assigned to work on plumbing.
If we employ the available workers in this way, we get the most output from the available quantity of labor. Indeed, you have been appointed the manager, not because you are necessarily the best possible manager, but because you are better at managing than you are at any other task. Therefore, your personal comparative advantage is the labor of being a manager. By applying the principle of comparative advantage—assigning the tasks to all individuals that they are best at, or least bad at—you will maximize the total production of use values.
Ricardo did not live in a socialist society nor did he advocate or even imagine a socialist society. He lived in a capitalist society where competition, not central planning, determined the employment of the available workers among the many tasks that formed the capitalist economy of his time. In addition, Ricardo lived, like we still do, in a world that was divided into many nations engaged in trade with one another on the world market.
Some additional assumptions
In order to simplify the problem as much as possible, let’s assume that the entire world—all the nations engaged in world trade—use the same gold coin currency. The single gold currency is made up of full-weight gold coins. As soon as coins become light in circulation, they are melted down by the various national mints and replaced by newly minted full-weight gold coins. In this imagined world, there are no rates of exchange among different currencies because there is only one currency, though there are different nations.
In addition, Ricardo assumed that free trade reigned. Though the world is divided up into many nations, they have no tariffs, subsidies, quotas or other “mercantilist” trade restraints. These were the policies that Ricardo as an economic liberal advocated. Making these assumptions, Ricardo had to explain how comparative advantage would prevail over absolute advantage, not in our imagined socialist enterprise (4) but in a world capitalist society engaged in free competition and free trade. If Ricardo could not do this, then his whole case for free trade would collapse. And we must remember that unlike many of today’s “progressive” economists, Ricardo was always extremely logical even when he was wrong.
The quantity theory of money comes to Ricardo’s rescue
Ricardo resorted to the quantity theory of money to explain that while absolute advantage prevails within the national market, comparative advantage would in his opinion prevail on the world market. Let’s look at a country where all branches of industry, agriculture and mining are below the world average. We will call it the country of the all-thumbs people—equivalent to our worker in our socialist enterprise who is least skilled at all productive tasks—whose industries including agriculture and mining lag behind the world market average in terms of labor productivity in all branches of production. (5)
Suppose that market prices correspond to national—as opposed to international—values of commodities. That is, market prices throughout the world will be equal to the average values of commodities within the national markets. Therefore, the prices of commodities of the same use value and quality will be different in different countries.
Commodity prices will be highest of all in All-Thumbs, because All-Thumbs has the lowest productivity of labor in the world. In that country, prices of all commodities will be above the world average. But let’s assume that they are least above the world average when it comes to fine wines, because when it comes to the production of that commodity its productivity of labor is less below the world average than in any other branch of production. Therefore, our country, while it has an absolute competitive disadvantage in all branches of production, including fine wines, enjoys a comparative advantage in fine wines.
We would expect All-Thumbs to experience a terrible deficit in its balance of trade and payments—who wants to buy All-Thumbs’s “overpriced” commodities on either its home market or foreign markets?
Since we assume a single circulating gold currency throughout the world, gold coins will steadily flow out of All-Thumbs. Or what comes to exactly the same thing, the money supply in All-Thumbs will start to shrink. According to the quantity theory of money supported by Ricardo, prices and money wages within a nation will fall as the quantity of money contracts. At some point, the prices will have fallen so much that the price of its fine wine will be lower than in any other country in the world.
Therefore, with the help of the quantity theory of money All-Thumbs will be able undersell all other countries when it comes to the production of fine wine. This marvelous result will be achieved as soon as the distribution of gold coins is such that comparative and not absolute advantage prevails.
And how do we achieve a distribution of gold coins among the nations of the world that guarantees the triumph of comparative over competitive advantage? Not through any form of central planning or state intervention or through international trade agreements but through free trade!
Did Ricardo prove his case? Only if the quantity theory of money is true. If it isn’t, Ricardo’s demonstration that under free trade comparative rather than absolute advantage will prevail on the world market falls to the ground. Ricardo’s theory was even put to a practical test by the policymakers of the 19th century. How did it fare?
Practical policy conclusions
In England, the supporters of Ricardo’s theories of international trade became known as “the currency school.” They drew the conclusion that in addition to free trade the quantity of money—defined as coin plus banknotes—must vary in exactly the same way a purely gold coin currency would.
According to the currency school, if the balance of trade and payments were positive, the gold reserve of the Bank of England would rise and the Bank should increase the quantity of its banknotes in exact proportion to its rising gold reserves. If, on the contrary, the balance of trade and payments were against England, the Bank should contract the quantity of its banknotes in proportion to its falling gold reserve.
The Bank didn’t even have to look at the balance of payments and trade statistics; it simply had to check on the quantity of gold it had in its vaults. If this were done, the currency school predicted, the “commercial crises”—now called “financial crises”—that had occurred in 1825 and 1837 would not recur.
These proposals were actually put into effect—with a few modifications—in the Bank Charter Act of 1844. This splendid legislation, based on Ricardo’s theory of comparative advantage and the quantity theory of money, had to be suspended during the crises of 1847, 1857 and 1866 to prevent economic disaster in Britain. The problem, Marx explained in Volume III of “Capital,” was that prices didn’t respond to ebbs and flows of gold as predicted by the quantity theory of money that Ricardo used but rather interest rates did. So Ricardo’s beautiful idea of comparative advantage prevailing on the capitalist world market failed the experiment.
Comparative advantage version II
As we have seen, bourgeois political economy dumped most of Ricardo’s theories—especially his labor law of value—soon after his death. But Ricardo’s theory of comparative advantage was retained and made its way into modern-day marginalist economic theory. Ricardo’s theory of comparative advantage is highly congenial to the marginalists not only because of its mathematical beauty and logic but because if it were true it would show that both rich countries and poor countries have the same interests in free trade. This supplements the marginalist economists’ argument that both capitalists and workers have the same interests in unregulated capitalism within a nation.
The fact is that most countries that have become industrialized in the past—not least the United States but earlier even Britain itself—did so through a policy of protectionism, not “free trade.” This fact does not prevent the United States today from lecturing countries that are trying to develop about the need to follow “free trade” policies justified by the old Ricardian theory of comparative advantage.
Comparative advantage adapted to a world of paper currencies
Today, we are very far from having a single gold coin world currency, which even in Ricardo’s time was a considerable abstraction from reality. Instead, the world is divided up into nations that have paper currencies that are issued by their various “monetary authorities” and declared legal tender for all debts public and private that are created within the country. (6)
None of this legal-tender paper money is redeemable into gold, or has been for many years, in any country. Since the current world monetary system bears no relationship to Ricardo’s early 19th-century abstraction, how exactly then is comparative advantage supposed to assert itself in our world of paper currencies?
Milton Friedman and his neo-liberal supporters developed a version of the theory of comparative advantage that is adapted to a paper currency world. And just like Ricardo did, Friedman and his supporters relied on the quantity theory of money.
According to Friedman’s quantity theory of money—sometimes called “monetarism”—the general price level is determined by the quantity of money relative to the quantity of commodities within a country. On this point, if not on Ricardo’s theory of labor value, Friedman is close to the views of Ricardo.
Friedman assumed that the ratio of token money plus credit money to the quantity of commodities, as well as the velocity of circulation, are stable. He therefore believed that the monetary authority that issues token money can easily control the quantity of the entire money supply as it is typically defined by today’s economists—token coin money, token paper currency and checkable banking deposits, or credit money.
Therefore, Friedman and his followers have argued that changes in exchange rates of a given nation’s currency against other currencies will have little or no effect on the general price level within a given country. To Friedman, much like it was to Ricardo, money is simply a token that circulates commodities. Unless coined gold is used for currency, gold is “just another commodity.”
Friedman claimed old dollar price of gold artificially high
Therefore, exactly like the progressive Keynesian economists, Friedman attached no special significance to the currency price of gold. Indeed, Friedman criticized the old Bretton Woods system, where gold coins no longer circulated, because the price of gold was kept “artificially high.” According to Friedman, by agreeing to buy all the gold that was offered to it at a price of $35 an ounce, the U.S. Treasury was supporting an artificially high price of gold.
Friedman likened this to farm price supports where the government buys agricultural commodities at higher prices than the prices that would prevail in the absence of such support in order to keep farmers who would otherwise be driven off the land in business. (7) Therefore, just like the Keynesians, he hailed the decision of the Nixon administration to “close the gold window” in August 1971, completing the transformation of the U.S. dollar from credit money to token money. (8)
Friedman held that neither governments nor their monetary authorities should be concerned with the prices of their currencies in terms of other currencies any more than they should be concerned with commodity prices. Both the prices of commodities in terms of the various currencies and the prices of currencies in terms of one another should be left to the operations of the “free market.”
Therefore, he reasoned, nations and their monetary authorities should not hold reserves of either foreign currencies or gold. Under such a system, Friedman claimed, if a country were to start running a deficit the exchange rate of its currency would fall in terms of the currencies of its trading partners. Or, what comes to exactly the same thing, if we were to accept Friedman’s assumptions, the price of other currencies in terms of its own currency would rise.
Following the quantity theory of money, Friedman believed that as long as there is no increase in the rate of growth of the quantity of money the general price level in the devaluing country should not be affected. Therefore, a fall in a country’s exchange rate will mean that the prices of commodities of the devaluing country will fall relative to the commodity prices of its trading partners.
These lower commodity prices will mean that capitalists of our deficit country will start to win a larger share of the world market, including its home market—its exports will rise and its imports will fall—until the deficit disappears. The converse will happen with any country running a surplus. Therefore, the rates of exchange among the currencies play the same role in Friedman’s theory that the distribution of gold coins among the trading nations played in Ricardo’s theory.
How do we, according to Friedman, find the correct level of exchange rates among the various trading countries? Exactly how Ricardo found the correct distribution of gold coins—through free trade! No country, whether its industries are highly productive or very unproductive, will for any period run either a surplus or deficit in their trade balance. Comparative, not absolute, advantage will reign among the trading nations of the world. Or rather, it will if the quantity theory of money is valid.
Just like Ricardo and his supporters did, Friedman held that both rich and poor countries had the same interest in free trade that allows the law of comparative advantage to operate in the interest of rich and poor countries alike.
Though Dean Baker is a Keynesian and not a supporter of Milton Friedman, budding Keynesians and Friedmanite economists alike are taught the same theory of comparative advantage in their university economic studies.
So now we understand exactly what Dean Baker means when he says the U.S. dollar is “over-valued” and should be devalued. Baker, like Friedman did, believes that a schedule of exchange rates exists that if it was brought into existence would balance international trade. No country would for any period of time run either a substantial deficit in its balance of trade or a substantial surplus. Under these conditions, there would be no dangerous buildup of debt between nations that leads to world credit crises with all their consequences.
Keynesians call for government help
As a Keynesian, however, while Baker believes in markets, unlike Friedman he doesn’t believe that markets alone can bring about the best results unless they are aided by the government. This is one of the reasons why progressives are attracted to Keynesian economics. Progressives understand full well that economists such as Milton Friedman who advocate unfettered markets are actually the most consistent supporters of capitalist exploitation. However, it took a Marx to explain why this is true through his theory of surplus value.
Keynesians, however, besides their general belief that markets need considerable help from the government, would make some modifications in the “Friedmanite” argument I described above. First, unlike Ricardo and Friedman, they reject the quantity theory of money as well as Say’s Law, which is closely linked to that false theory. They concede that a general overproduction of commodities is possible.
However, unlike Ricardo and Marx, or for that matter Friedman, Keynesians believe that the general price level within a country is determined by the level of money wages. While Friedman argued that the devaluation of the currency will not bring about inflation as long as the rate of growth of the quantity of money isn’t increased, the Keynesians argue that currency devaluations are not inflationary—or only “slightly” inflationary—because of the effects of higher import prices—as long as the level of money wages does not rise.
Therefore, Keynesians believe that the key to correcting a chronic trade deficit, such as the U.S. has experienced for most of the last 40 years, and the associated buildup of the debt—both governmental and to a far greater degree private—is to devalue the currency against other currencies without any offsetting rise in money wages. Since unions are very weak today compared to the 1970s, Keynesian economists see little “danger” that money wages in the U.S. will rise if the U.S. dollar is devalued against other currencies.
There might be some “slight” increase in inflation due to higher import prices, but there is no real threat of severe inflation until unemployment falls to the levels that will allow a significant rise in money wages. Or what comes to more or less the same thing, inflation is not a danger until we get close to “full employment.”
In addition, Keynesians who follow Keynes himself on this question believe in bringing down real wages during periods of mass unemployment because they believe that unemployment is caused by real—not money—wages being too high relative to the value that the workers’ labor would create if “full employment” existed. Therefore, if only the U.S. dollar is devalued sufficiently, the U.S. trade deficit will painlessly go away and the large U.S. foreign debt will be progressively paid down.
According to this Keynesian analysis, it is therefore “over-valuation” of the U.S. dollar that is responsible for the U.S. trade deficits and consequent dangerous buildup of the U.S. foreign debt—and not the long-term decline of the U.S. economy in terms of industrial production and the operation of the basic economic laws of capitalism that has brought this decline about.
How currencies devaluations really work
If prices, including the price of labor power, instantly adapted to changes in the gold value of a currency, a currency devaluation would not work at all. The fall in the value of the currency, whether against other currencies or against gold, or both, would be exactly offset by opposite movements of prices.
While this is what happens in the long run, these adjustments do in the real world take place over considerable periods of time. A downward movement of a currency against gold, for example, is reflected first in the movements of the prices of primary commodities as measured in terms of that currency.
Traders on commodity markets who spend their days constantly betting on minute to minute changes of commodity prices have learned from long experience that if the currency price of gold rises significantly, it is a signal to buy other commodities, pushing up their prices. This is what Baker in his testimony called “speculation.”
We have to remember that even if currencies remain unchanged in terms of the quantity of gold they represent and therefore against each other, primary commodity prices are always fluctuating. They are by no means fixed against gold. But any sharp changes in the dollar price of gold, whether upward or downward, is almost always accompanied by changes in the same direction, if not in the same degree, by most primary commodity prices including the price of oil.
However, since primary commodity prices are volatile even when the values of currencies remain unchanged, capitalists at the wholesale level and even more so at the retail level are slow to change their prices in response to daily changes in primary commodity prices. One day the price of coffee might spike sharply but the next day will likely fall just as sharply wiping out its previous rise. Only if a rise—or a fall—in primary commodity prices persists for a period of time will primary price movements be reflected first in wholesale prices and then work their way through to retail prices.
Therefore daily spikes in the dollar price of gold do not set off waves of inflation at the retail level. As long as the the dollar price of gold falls back again—as it usually does—and with it other primary commodity prices, these day-to-day fluctuations are not reflected in retail prices.
The role of the credit system
A major factor that slows the adjustment of prices in terms of currency to changes in the gold value—or the value of a given currency in terms of other currencies that remain unchanged in gold value—is the credit system. Unless the currency has been completely discredited by repeated devaluations, debts denominated in terms of a currency are not revalued in currency terms when the currency is devalued.
This, by the way, is why retail prices of oppressed countries respond much faster to changes in their currency values than is the case for the U.S. In oppressed countries, only local debts are denominated in terms of the local currencies. On the world market, international debts are usually denominated in terms of U.S. dollars. Therefore, when the currency of an oppressed country is devalued, to the extent its debts are denominated not in its local currency but rather in dollars, those debts measured in its local currency are indeed increased in proportion to the devaluation of that currency.
For example, if a country’s local currency is devalued against the dollar by 50 percent, debts of that country measured in its local currency but denominated in dollars will double. Retail prices will then be quickly marked up to compensate.
However, when the dollar price of gold spikes, the debts that a U.S. business owes that are denominated in the local currency—the U.S. dollar, which so happens to be the de facto global currency under the dollar system—remain unchanged in terms of dollars. As long as this remains true, most U.S. businesspeople, unlike traders in primary commodities, simply ignore short-term fluctuations in the U.S. dollar against gold when determining the prices they charge in terms of dollars.
However, if the dollar continues to fall against gold and it becomes clear that the devaluation is permanent—even the greatest gold “bears” do not expect the dollar price of gold to fall back to $35 an ounce in the foreseeable future—dollar prices under the dollar system will over time adjust to the lower gold value of the dollar.
Sweet oil is perhaps the primary commodity whose price is most sensitive to changes in the gold value—whether up or down—of the U.S. dollar. In addition, changes in the dollar price of the primary commodity sweet oil is rapidly transmitted to the retail price of gasoline. The same tends to be true of food prices.
This is why the changes in gasoline and food prices often precede changes in the so-called “core-rate” of inflation. If a rise in the dollar price of gold persists, eventually the surge in prices of gasoline and food will be reflected in the prices of other commodities as well. For example, the general cost of living in the U.S. measured in dollars—leaving aside food and gasoline—is far higher today than it was when Nixon decided to close the “gold window” 40 years ago.
Wages respond last
The price of the commodity labor power is among the last commodity prices to respond to the devaluation of the currency. Experience has shown that only if the devaluation of the currency reaches extreme levels, such as was the case with the German mark in 1923, do workers learn to immediately demand increases in wages in terms of the devalued currency. In the days of the Great Inflation of 1923, everybody in Germany learned to pay the closest attention to the rises in the “price of the dollar” in terms of marks—which measured the collapse of the mark not only against the U.S. dollar but also against gold, since the dollar was defined in those days as 1/20.67 of a troy ounce of gold.
In explaining Ricardo’s theory of world trade, I assumed that wages were the same throughout the world market. When explaining why higher wages do not cause rises in the general price level, both Ricardo and Marx assumed that all capitalists pay the same price for labor power.
Of course, in the real world this as we know is far from the case. If one capitalist pays vastly lower wages than another, all other things remaining equal, the capitalists who pay lower wages will beat out the capitalists who pay higher wages. What matters to the capitalists engaged in competition is not the value—the amount of labor it costs society to produce the given commodity the capitalists produce—but rather the portion of the value of those commodities that these capitalists actually pay for.
Therefore, if wage differentials are great enough, a capitalist whose commodities have a much higher individual value might still enjoy a lower cost price. This is especially true in industries with a low organic composition of capital—labor-intensive industries—where “labor costs” are a much larger share of the cost price than in high organic composition—capital-intensive—industries. This is why individual capitalists engaged in competition are constantly trying to find ways to lower the wages they pay their workers.
Suppose a country devalues its currency against gold and that the value of all other currencies in terms of gold remain unchanged. In terms of real money—gold—and all other currencies of other countries that do not devalue, the workers in the devaluing country have suffered a general wage cut in terms of both gold and foreign currencies. Keynesians then “explain” to the workers that they should not seek increases in their wages to compensate for the new lower value of their currency in order to avoid inflation.
Keynesians urge wage restraint but never profit restraint
These same Keynesians, however, never urge profit restraint on the part of the capitalists, only wage restraint on the part of the workers. Indeed, Keynesians see higher profits for the capitalists as the key to economic recovery—which it indeed is as long as we remain within the capitalist system—and the achievement of “full employment.”
The capitalists of the devaluing nation then find that they are in a more favorable position to compete with the capitalists in other countries that do not devalue, since they have received the benefits of a general reduction in wages. In addition, the industrial capitalists have also had their debts reduced insomuch as these debts are denominated in terms of the devalued currency. They are thus in a position to lower their selling prices in terms of foreign currencies—as well as gold—which enables them to take a larger share of the world market, including the home market. Higher import prices lower the sales of imported commodities, while lower export prices in terms of foreign currencies lead to higher exports.
But the promises of the Keynesian economists that inflation will not increase—or only increase slightly—after a devaluation—assuming that there is a significant devaluation against gold as well as foreign currencies—always turns out to be false. In the long run, the market will work toward raising the prices of commodities so that once again prices when measured in terms of the use value of the money commodity will be more or less in line with the actual prices of production. The latter, in the final analysis, are determined by the underlying labor values. Let’s examine this process a little more closely.
As we saw above, the first effect of a currency devaluation is to lower the wages of the workers both in terms of real money—gold—and in terms of the currencies of the countries that do not devalue. The capitalists of the devaluing nation are then in a position to undersell their rivals in other nations. As a result, they capture a larger share of the world market, including the home market in the form of lower imports and foreign markets in the form of higher exports.
In the wake of the devaluation, more of the nation’s wealth in terms of the use values of commodities is exported, while imports from foreign countries decline and the standard of living of the people of the devaluing nation drops.
To be sure, the decline in the standard of living will not be evenly distributed among the classes. Far from it! As imports fall and more domestic production is exported, prices do start to rise even if not to the full extent of the devaluation. Rising prices in terms of the devalued currencies start to eat into real wages. Though the more progressive Keynesian economists play this down, Keynes himself stressed the necessity of lowering real wages as opposed to money wages to lower unemployment and eventually achieve “full employment.”
Even in the “General Theory,” Keynes accepted the marginalist claim that, assuming “free competition,” the workers receive in the value of their wages exactly the value their labor produces. Marx’s greatest economic discovery, his theory of surplus value, proves this claim of Keynes and all the other “modern” bourgeois economists false.
Keynesian economics based on false theories of value, surplus value and money
So when currencies are devalued, things never turn out the way Keynesians expect precisely because Keynesian economics is based on false theories of value, surplus value and money. Devaluations lead to more than “expected” or “desired” inflation. After a significant devaluation, prices often start to rise relative to the rate of growth of the quantity of money—whatever it is—within the country. The velocity of circulations increases and interest rates rise as the real money supply—the purchasing power of the total quantity of money—shrinks.
In our gold coin world, we saw that a deficit in the balance of trade and payments caused gold coins to leave the country leading to a contraction of the money supply. In a paper money world, the fall of the rates of exchange of the currency—both against foreign currencies and gold—leads to the same result in terms of the real as opposed to the purely nominal money supply.
When a country runs a deficit, unless the “monetary authorities” support the currency by liquidating some of their reserves of foreign currency or gold—the gold value of the currency falls independent of an increase in its quantity. Each currency unit will now represent less gold. As prices in terms of the now devalued currency start to rise to compensate for the reduction in the quantity of gold that each currency unit represents, the real as opposed to the merely nominal quantity of money starts to contract.
When this happens, “progressive” Keynesians will urge the monetary authority to create still more money to make up for the fall in the real money supply that has resulted from inflation caused by the initial devaluation. They will attempt to show that the danger of inflation is not so great, just like Baker and Rosnick are doing today.
But that only leads to further inflation, and if continued, at some point the capitalists will lose faith in the currency and attempt to convert it into gold, commodities or other currencies. A “flight of (money) capital” develops, the currency plunges and inflation accelerates to runaway inflation. The workers and the middle classes are impoverished and the economy nears collapse.
In the end, the central bank is forced to slam on the brakes to avoid a complete collapse of the currency. Interest rates soar, first in nominal terms but then in real (commodity) terms, and industrial production and employment contract sharply. Real wages, already lowered by inflation, are now further lowered by mass unemployment, the very unemployment that the devaluation was supposed to prevent in the first place. Since the mass impoverishment of the workers and also the middle class does greatly reduce imports, the industrial capitalists, unable to sell much at home, are forced to find markets abroad or go out of business.
We have seen this happen many times, for example in Latin American. The currency collapses and runaway inflation develops. In desperation, the country’s government is forced to turn to the International Monetary Fund—controlled by the U.S. Treasury Department. The IMF agrees to provide short-terms loans in terms of dollars but with strings attached. These strings include slashes in food subsidies and tariffs that protect developing industries, and the privatization of state-owned industries.
The currency is finally stabilized through the impoverishment of the workers and the ruin of the urban middle class and the peasantry. A portion of the “national” capitalists is also liquidated. Imperialist foreign capital can then move in and buy up what remains of the nation’s wealth for a song. But the trade deficit becomes a trade surplus, and in that sense the devaluation works.
Therefore, “devaluations” do correct trade imbalances just like deflationary policies do, but contrary to the Keynesians it is far from a painless process. And the main burden of adjustment inevitably falls on the workers and their allies.
Why publishing Baker’s testimony was a mistake
There is nothing wrong with a socialist magazine publishing the testimony of a bourgeois economist if that economist reveals certain facts about imperialism or the capitalist system. However, Dean Baker’s testimony to the U.S. Congress did no such thing. His claim that the recent spurt in oil and gasoline prices has nothing to do with the Federal Reserve Board’s renewed “quantitative easing” is frankly nonsense. It only gives credibility to right-wing economists who can easily refute his arguments.
Keynesian economists, just like the right-wing neo-liberal economists, hide the real nature of capitalism and the depth of its contradictions. Indeed, the theories of both Keynesian and neo-liberal economists share the same marginalist foundations. The arguments of the Keynesians—or neo-liberals, for that matter—that the current crises wracking capitalism are the result of faulty policies that can easily be corrected paint an idealized and false picture of capitalism. That is indeed the role of modern bourgeois economists. But is it really the proper role of an online socialist magazine that has done much good work in exposing the role of U.S. imperialism?
I believe there is an even more important reason why Baker’s testimony had no place in a socialist magazine. In his testimony, Baker made no distinction between the American capitalists and the American workers. He seems to take for granted that both the American workers and the American capitalists have the same interests. Instead of talking about the classes and their conflicting interests, he talks in terms of “our” economy.
Baker argues that if the United States devalues the dollar, the American capitalists and the American workers together will be in a position to take markets from “them”—foreign capitalists and foreign workers. The U.S. workers are supposed to become more competitive by accepting payment in devalued U.S. dollars without compensating increases in their dollar wages. As a result of dollar devaluation, the U.S. capitalists gain a larger share of the world market—both the U.S. home market and the markets in other countries—and some of the currently high unemployment will then be “exported” to foreign countries.
But don’t workers in other countries need jobs just as much as U.S. workers? Should we value the jobs of U.S. workers more than we value the jobs of European workers, Japanese workers, Latin American workers, Chinese workers, Indian workers or African workers? Whatever became of the great slogan advanced by Marx and Engels in the Communist Manifesto “Workers of the World Unite!”? In his testimony to the U.S. Congress, Baker, no matter how well-meaning, comes across as a U.S. economic nationalist.
But I don’t want to be too hard on the editors of MRzine. It is possible that they have never had the time or inclination to study the fine points of economic theory, especially the theory of international trade and currency exchange rates.
I think the problem lies rather with the reaction of the editors of Monthly Review Magazine to the economic crisis of 2007-09 and what has turned out to be the stormy aftermath of the crisis, both economically and politically. Instead of using the crisis to show that once again the economic theories of Karl Marx have been vindicated over all schools of bourgeois economics, they have gone on a campaign to revive the economic theories of one of these bourgeois schools—that of John Maynard Keynes.
The editors have ignored the fact that as an economic scientist Marx is far superior to Keynes—or any other bourgeois economist—in every way, as I have labored to show in this blog. I will mention just one example that should be of particular interest to Monthly Review readers.
While Keynes had absolutely nothing to say about monopoly and continued to assume “free competition” to the day he died, the evolution of capitalism based on “free competition” to capitalism dominated by monopolies is built into the very foundation of Marx’s theory. Indeed, it was crucial to Marx’s whole prediction that capitalism must eventually give rise to a higher mode of production—socialism. And this was true notwithstanding the fact that Marx died in 1883, some 17 years before the beginning of monopoly capitalism proper—if we are to follow Lenin in his “Imperialism, the Highest Stage of Capitalism.”
Perhaps because of the pro-Keynesian position taken by the editors of Monthly Review, the editors of MRzine have assumed the stance of championing the views of the more “progressive” Keynesian economists such as Dean Baker and David Rosnick against “neo-liberals.” Isn’t that what the editors of Monthly Review have been urging?
If Baker says that the Fed’s campaign of quantitative easing has had nothing do with the recent rise in the price of oil, then it must be so. If Baker claims that the U.S. dollar is “over-valued,” whatever that means, then the dollar must be “over-valued.” If Baker supports a further devaluation of the U.S. dollar so that the U.S. can become more competitive against other nations, then socialists must follow the “progressive” economists in supporting that even if we become U.S. “economic nationalists” in the process. Who cares what Marx had to say about these things when we have progressive Keynesian economists such as Dean Baker to explain economic questions to us!
The workers’ and socialist movement is lucky indeed to have had in its ranks the greatest economic scientist of all time. What a resource we have in Marx and what mighty weapons Marx has given us to fight against all the supporters and apologists for capitalist exploitation and imperialist oppression. Isn’t it time that the editors of Monthly Review started using this precious resource and educating young people who are becoming radicalized by the crisis and its aftermath in Marxism rather then turning them back to Keynesian bourgeois economics?
1 A sudden collapse of the dollar system would be good in the sense that it would greatly weaken U.S. imperialism, the main enemy of the world working class and oppressed nations and people in general. But such a collapse would also cause a violent global economic crisis that would likely be far worse than even the crisis of 2007-09. The main burden of this new “super-crisis” would inevitably fall on the backs of the working class, the peasantry, the urban middle class and oppressed people in general. Such a crisis could also lead to a return of wars among the imperialist countries unknown since 1945 unless it were quickly followed by a successful world socialist revolution. Keynesians close their eyes to these dangers, since they fear—not without reason—that if the U.S. Federal Reserve Board does not continue its “quantitative easing policies” the world economy will fall back into recession.
2 Baker seems to be a well-meaning man. For example, unlike most other Keynesians he opposed the bank bailout bill that gave billions to the banks in the name of fighting the crisis. Could Baker in the future become a Marxist? I would not rule this out. If MRzine published Baker’s testimony and subjected it to Marxist criticism this could help open the door to such a welcome development. However, by publishing him without comment and seeming to endorse Baker’s Keynesian views, MRzine makes the possible “discovery” of Marx by Baker that much less likely. Baker will simply figure that if even the Marxists of MRzine endorse his Keynesian analysis, then there must be no real difference between the Keynesian economics he learned in his university studies and Marxism, putting an additional obstacle to his possible discovery of Marx.
3 To what extent different levels of skill among individuals are of biological origin and to what extent they are of social origin is a vast topic. Considering the realities of class, national and, not least, racial oppression, the social and cultural factors are substantial. However, this does not affect our argument. Whatever the causes of the differences of abilities among individuals, here we have to take them as a given.
4 Even if comparative advantage does not apply to capitalism, will it come into its own under socialism? To some extent perhaps, but again we must remember the economic and social origins of the vast differences in the productivity of labor among different countries.
5 Again, the origins of the differences in the productivity among the nations are of no interest here. Since greater numbers of individuals are involved, they are certainly not biological like the racists claim but of economic and social origin.
6 However, once the paper currency that is overwhelmingly dominant is the U.S. dollar, the prices of primary commodities and the currency price of gold are quoted in terms of dollars, and more world debts than is the case for any other currencies are denominated in terms of dollars. As a consequence, central banks, government treasuries, corporations and banks are all forced to hold considerable reserves of dollars.
7 So-called gold bugs who speculate on rises in the currency price of gold as well as the owners of gold mines and refineries can be quite happy that gold has done well without “government price supports.” Its price has risen from its “supported” price of $35 an ounce under the old Bretton Woods system to around $1,500 at present.
8 Unlike the Keynesian economists of the time, Friedman denounced as “socialist” Nixon’s wage and price controls. Keynesians, in contrast, strongly supported the mostly wage controls because they believed that as long as money wages were held down, inflation would not accelerate even as the Federal Reserve system followed an “expansionary monetary policy.” As we know, this ended with the “Volcker Shock,” which ushered in the age of “neo-liberalism.”
But just like the Keynesians, Friedman strongly supported “closing the gold window.” He argued that as long as the Federal Reserve Board maintained a steady and low rate of monetary growth, there was no need for a gold standard, and inflation would not accelerate. According to Friedman, the gold standard had the disadvantage of tying the rate of growth in the quantity of money to variations in the production of gold. Remember, Friedman held that the main cause of instability in the otherwise “amazingly stable” capitalist system was the variation in the rate of growth in the quantity of money.