Charley in a comment on this post pointed out an article, “Gibson’s Paradox and the Gold Standard,” by U.S. marginalist economists Robert B. Barsky and Lawrence H. Summers, that appeared in the June 1988 edition of the Journal of Political Economy. (1)
To tell the truth I played with the idea of working Gibson’s paradox into the main series of posts but ultimately couldn’t quite find an appropriate way to do it. I therefore am delighted that Charley raised the subject.
Gibson’s paradox—a term coined by Keynes in his 1930 book “A Treatise on Monetary Reform”—is named for British economist Alfred Herbert Gibson, who noted in a 1923 article for Banker’s Magazine that the rate of interest and the general level of prices appeared to be correlated.
The “paradox” involves a major contradiction between marginalist economic theory on one hand and the actual history of prices and interest rates under the gold standard on the other.
The question of “interest” involves the holiest of holies of economics, the nature and origin of surplus value. The marginalists confuse the rate of interest, which is only a fraction of the total profit, with the rate of profit. They falsely claim that if the economy is in equilibrium, there will be only interest and no profit. They therefore make their task of explaining away surplus value much easier by first reducing the total surplus value, or profit—which is divided into interest and profit of enterprise—plus rent, into interest alone.
According to traditional marginalism—not the marginalism of Keynes in his “General Theory”—there is a natural (long-term) rate of interest whose purpose is to equalize investment and savings. (2) According to the marginalists, interest arises because capital is scarce. The scarcer capital is, the higher will be the rate of interest. By “capital” the orthodox marginalists mean real capital. In traditional marginalist theory with its quantity theory of money, money is treated as a mere means of circulation that passively reflects the value of the commodities it circulates much like the moon reflects the light of the sun.
Irving Fischer and the quantity theory of money
Irving Fisher was an American marginalist economist (1867-1947) who is best known for his contribution to the development of the marginalist version of the quantity theory of money. One of Fisher’s contributions to marginalist theory was his distinction between the money (long-term) rate of interest and the real (long-term) rate of interest. The real rate of interest is the rate of interest in terms of commodities.
Fischer held that the long-term money rate of interest is determined by the natural rate of interest plus the expected rate of inflation. Therefore, Fischer’s theory predicts that the nominal long-term rate of interest should fluctuate in line with changes in the rate of change in the general price level.
Suppose the “natural” rate of interest is 3 percent. If prices are stable, according to Fisher the nominal money long-term rate of interest rate will equal the natural long-term rate of interest, or 3 percent, according to our assumption. But suppose the general price level is rising at a rate of 2 percent. According to Fischer’s theory, the money rate of interest will be 5 percent. But the real rate of interest—the rate of interest in terms of commodities—will still equal the natural rate of interest, which I assume here is 3 percent. The difference between the money rate of interest and the real rate of interest is called the “inflation premium.”
What will happen, according to Fisher’s theory, if the general price level is falling, which it frequently was under the international gold standard? Or what comes to exactly the same thing, what will happen if the inflation premium is a negative number? For example, assuming a natural rate of interest of 3 percent and a rate of deflation of 1 percent, the money rate of interest should according to Fisher be 2 percent. We simply add a negative 1 to 3 percent, which yields a money rate of interest of 2 percent. Therefore, in terms of money the rate of interest will be 2 percent, but in terms of commodities the rate of interest will be equal to the natural rate of 3 percent.
Fischer’s theory fitted very well into the logic of marginalist economics, which stresses the alleged stability of the capitalist economy. Observed fluctuations of interest rates that were associated with the industrial cycle—which shouldn’t even exist according to marginalist theory—could be explained away as arising from changes in expectations of inflation or deflation. Therefore, the Fischer theory was widely adopted by marginalist economists.
A contradiction in Fischer’s theory
Suppose prices are falling not at a rate of 1 percent but at 5 percent—a not unheard of situation during recessions under the international gold standard. If the natural rate of interest is 3 percent, wouldn’t Fischer’s theory imply that the money rate of interest will be minus 2 percent? But the money rate of long-term interest—the interest rate in terms of currency—can never fall below zero in practice. (3) This logical contradiction should be enough to show that there is something very wrong with Fischer’s theory of money and real interest rates and with marginalist economics as a whole.
Gibson’s paradox proper involves yet another contradiction in the marginalist-Fischer theory of interest. It is not a logical contradiction but rather a contradiction between the predictions of the marginalist-Fischer theory and reality. More precisely, Gibson’s paradox involves a contradictions between the observed movement of the general price level and long-term interest rates under the international gold standard, on one hand, and the predictions of the marginalist-Fisher theory, on the other.
If Fisher was right, under a gold standard interest rates should be at their highest when prices are rising at their fastest rate and lowest when prices are falling at the fastest rate. At the peak of the industrial cycle, prices have stopped rising and are about to fall more or less sharply as the recession sets in. Therefore, according to the Fischer theory the money rate of long-term interest should be at or near its lowest point. (4) But the concrete history of long-term interest rates and prices under the gold standard shows that they reach their highest point at the peak of the industrial cycle when the general price level also peaks.
At the bottom of the industrial cycle—the trough of the recession—prices have stopped falling and are about to rise. Therefore, if Fischer’s theory was correct, long-term interest rates should have been much higher than they were at the peak the industrial cycle. But under the gold standard, long-term interest rates, like the general price level, were at their lowest at this point of the industrial cycle.
This relationship between long-term interest rates and the general price level remained true under the gold standard whether the interest rates were measured in terms of money—nominal interest rates—or commodities—real interest rates.
Therefore, under the gold standard long-term interest were highest when the general price level was highest, and lowest when the general price level was at its lowest point.
Or what comes to exactly the same thing, long-term interest rates moved in sympathy with the absolute level of the general price level and not the rate of change in the general price as the marginalist Fischer theory predicted.
This is why Keynes in 1930 called the relationship of long-term interest rates and the general price level that was observed empirically a paradox. The paradox was the contradiction between what the reigning marginalist theory predicted and what was observed in the real world.
At the end of a boom with its accelerated accumulation of capital, interest rates should be at their lowest point of the cycle according to the basic marginalist theory of interest. But in reality it is after the destruction of a great deal of real capital, which makes capital “scarcer,” that interest rates whether measured in terms of money or commodities are at their lowest point of the industrial cycle.
No paradox from standpoint of Marx-based theory
However, Gibson’s “paradox” is no paradox at all according to the theory of the industrial cycle based on Marx that I developed in my posts over the last year. The observed fluctuations of prices and interest rates under the international gold standard behave exactly as my Marx-based theory predicts they should.
Let’s review this theory here with the so-called Gibson’s paradox in mind.
Remember, according to Marx there is no such thing as a natural rate of interest. Interest is merely a subset of the total profit—interest plus profit of enterprise—which in turn is merely a subset of the total surplus value—profit plus rent. In other words, profit—total surplus value minus rent—is divided between the interest and the profit of enterprise. Within the limits set by the total profit, the rate of interest reflects the balance of forces in the market between the money capitalists on one side and the industrial and commercial capitalists on the other.
This balance of forces is largely determined by the amount of money capital—ultimately the total quantity of gold—relative to real capital—productive capital plus commodity capital. The scarcer gold is relative to real capital, the stronger the money capitalists will be relative to the industrial and commercial capitalists and therefore the higher the rate of interest will be. Conversely the more plentiful the supply of gold relative to real capital, the lower the rate of interest.
During the upward phase of the industrial cycle, gold becomes progressively scarcer relative to real capital. This reflects both rising commodity prices in terms of gold and the fact that real capital, even leaving aside prices changes, grows faster then the total quantity of gold does on the world market. This is the essence of “overproduction.”
The growing scarcity of gold relative to real capital progressively improves the position of the money capitalists relative to the industrial and commercial capitalists. Therefore, the supply and demand for loans can only be equalized at higher and higher rates of interest. Assuming that the total rate of profit remains unchanged, the rate of interest rises and the the profit of enterprise falls. (5)
This cannot, however, go on forever. When the interest equals the total profit—that is, when the profit of enterprise falls to zero—the very motivation to produce surplus value ceases.
Therefore, we would expect at the peak of the industrial cycle when the general price level is at its highest, the rate of interest, including long-term interest rates, would be at its peak. This would be true both in terms of the real money (gold) rate of interest and in terms of the commodity, or real, rate of interest. The currency rate of interest would be the same as the gold rate of interest under the gold standard.
In contrast, there isn’t there any contraction in the physical quantity of gold measured in terms of weight. Instead, the physical quantity of gold tends to grow at an accelerated rate as the profitability of gold production rise both absolutely and relative to other branches of production.
Therefore, what is a paradox for marginalist theory is simply a consequence of Marx’s theory of value, surplus value, profit, money and interest.
Notice that Gibson’s paradox between the predictions of marginalist theory and reality applies only as long as the gold standard is in effect. The “paradox”—in terms of marginalist theory, not our Marx-based theory—is weakened when the gold standard is weakened and pretty much disappears when the gold standard is abandoned. Why is Gibson’s paradox dependent on the gold standard being in effect?
For one thing, under the post-1971 dollar standard—a global paper money system—with the limited exception of the brief fall in the general price level associated with the panic in the fall of 2008, prices in terms of currency never actually peak but pretty much rise continuously. If Gibson’s paradox applied under the post-1971 dollar standard, interest rates would also rise continuously. (6) This is hardly possible, because in that case the interest would soon swallow up the entire profit of enterprise, destroying the incentive to produce surplus value.
In my main posts, I explained that, within the limits set by the need for long-term interest rates to be below the rate of profit in the long run, not one but two factors determine the long-term rate of interest—in terms of paper money but also in terms of commodities as well as in terms of real money, or gold: One is the relative plentifulness or scarcity of gold relative to real capital; the other is the perceived chance that the paper currency will be either devalued or revalued against real money—gold.
Under the rules of the international gold standard, currencies were strictly defined in terms of a given quantity of gold measured in terms of weight. Or what comes to exactly the same thing, a pound, dollar, franc, mark and so on were simply names for specific weights of gold of a certain fineness. Therefore, as long as the gold standard was in effect and expected to remain in effect for the foreseeable future, either devaluation or revaluation of currencies was viewed as highly unlikely by the capitalists. With the fear of devaluation or the hope of revaluation both low and stable, changes in the long-term rate of interest in the course of the industrial cycle were in practice decided by only one factor—by changes in the amount of gold relative to real capital.
But under a regime of paper money such as we have had since 1971, big changes in the gold value of currency are not only possible but quite likely. We have certainly seen this during the current industrial cycle. The U.S. Federal Reserve System has allowed the dollar price of gold to rise from around $675 at the beginning of the crisis in the summer of 2007 to around $1,100 at present in a bid to force a recovery. If the rules of the international gold standard were in effect, the Federal Reserve System would not have been allowed to let the dollar price of gold rise. Or what comes to exactly the same thing, it would not have been allowed to devalue the dollar.
In addition to the changes in the industrial cycle, the political and military situation—war—can lead to changes in the gold value of the capitalist currencies as well.
Since the end of what was left of the international gold standard in 1971, the general rule has been that major rises in the dollar price of gold have been followed by rising long-term interest rates, first in terms of paper money but then in real—commodity—terms as well. (7)
Conversely, falling dollar gold prices have seen movements in long-term interest rates in the opposite direction. These swings in interest rates induced by fluctuations in the gold value of the U.S. dollar—with the value of other currencies more or less tied to changes in the gold value of the dollar under the dollar system—have overshadowed fluctuations in interest rates caused by changes in the ratio of real capital to gold. This has been true even though cyclical fluctuations of interest rates can still be traced.
That is why bourgeois economists who have written about Gibson’s paradox have noticed that the paradox is a gold standard phenomena only. The weaker the gold standard—the greater the chances of a change in the gold value of the currency—the weaker the “paradox.” The “paradox” disappears completely when the currency becomes completely inconvertible into gold, making the currency subject to dramatic changes—mostly downward but sometimes upward—in its gold value.
Lawrence Summers’ attempt to explain Gibson’s paradox on a marginalist basis
Lawrence Summers, an arch-reactionary American marginalist economist, is now serving as director of the White House National Economic Council. In a series of articles in the mid-1980s, Summers attempted to develop a marginalist explanation of Gibson’s paradox. Essentially, Summers was attempting to plug a major hole in marginalist economic theory. How successful was he in this endeavor?
I will attempt to translate Summers’ and Barsky’s explanation of Gibson’s paradox written in the obscure language of modern professional marginalist economists into the terminology that I have been using in these posts.
Before I proceed in my “translation,” we should remember that there was no chance that Summers would come up with a correct explanation of Gibson’s paradox. In order to do so, he would have had to dump marginalism and come over Marxist economics—not least Marx’s explanation of surplus value! Summers, it goes without saying, was not about do that! He was, after all, trying to save, not bury, marginalism.
Like marginalists in general, Summers confuses the rate of interest with the rate of profit. Remember, traditional marginalists claim that when the economy is in equilibrium there is no profit, only interest. Summers did notice correctly that all things remaining equal, the supply and demand for gold varies with the rate of interest, much like the supply and demand for a commodity vary with changes in its price.
What will happen according to Summers if capital becomes suddenly more scarce due to some economic “shock”? Or what comes to exactly the same thing, within the framework of marginalist theory, the (real) long-term rate interest rises. Summers reasons that since the demand for gold will drop when real long-term interest rates rise, prices defined in terms of gold will also rise, or as Summers puts it, the price of gold will fall relative to the prices of (most) other commodities.
Under the gold standard, since currencies are defined as specific weights of gold, currency prices are by definition prices in terms of gold. Therefore, Summers reasoned that under the gold standard a rise in the (real) long-term rate of interest will mean a rise in the general price level.
The converse will also be true according to Summers’ theory. If the “capital” becomes “less scarce,” the rate of interest will fall. Summers reasoned that lower long-term real interest rates will cause the demand for gold to rise, leading to a lower general price level under the gold standard.
Therefore, Summers’ great “discovery” is that under a gold standard the (real) long-term rate of interest—the interest rate in terms of commodities—determines the general price level.
This “discovery” of Summers is in conflict with both the traditional marginalist quantity theory of money and Marxist theory.
What then explains the general price level according to Marxist theory? According to Marx, the general price level will fluctuate around an axis determined by the relative values of the money commodity, which functions as the universal measure of value and the standard of price, and all other commodities.
In the course of the industrial cycle—or perhaps long waves—the general price level is sometimes above the level that would be established if prices always equaled values and sometimes below that level.
Just like the price of an individual commodity expresses its value—relative to the money commodity—by constantly deviating from it, sometimes exceeding it, sometimes falling below it, so the general price level measures the value of commodities as a whole in terms of ever fluctuating market prices.
A change in the relative values of gold and other commodities will change the axis around which the general price level fluctuates. This happened, for example, after the discovery of gold in California and Australia in 1848-1851, which lowered the value of gold relative to that of most other commodities. It happened again after the discovery of gold in Alaska and northern Canada combined with the introduction of the cyanide process, which allowed the extraction of gold from much poorer ores than before. In both these cases, we saw a decline in the value of gold compared to the value of most other commodities. In both cases, a major rise in the general price level followed.
In contrast, a rise in the value of gold relative to the values of other commodities will lead to a fall of the axis around which the general price level fluctuates, assuming that prices are measured in terms of gold, which is the case under a gold standard. This has been the long trend of the general price level measured in terms of gold since the end of World War I. This reflects in part the lack of any major gold discoveries over that period that are comparable to the major gold discoveries of the 16th and 19th centuries.
The quantity theory of money, the traditional theory supported by mainstream marginalism, claims that the general price level is simply determined by the ratio of money and the quantity of commodities. No distinction is made between real—gold—money, token money, and credit money. For the marginalists, money is simply whatever is used as currency. If the quantity of currency grows faster than the quantity of commodities, prices will rise. If the quantity of currency grows slower than the quantity of commodities, the general price level will decline.
Summers tried to argue that Gibson’s paradox remained true even under the paper money dollar standard that replaced what was left of the international gold standard after 1971 if prices are measured in terms of gold rather than in terms of paper money.
‘Gibson’s paradox’ after the gold standard
It is true that in the post-1971 world a fall in long-term interest rates—or what comes to exactly the same thing, a rise in the price of government bonds—has often—but not always—been followed by a rise in the dollar gold price. This, in turn, is accompanied by a similar rise in the dollar price of primary commodities—such as oil, for example.
However, for the rise in the dollar price of primary commodity prices to be translated into a rise in dollar commodity prices as a whole, the rise in primary commodity prices must be maintained over a considerable period of time. It takes many years for rises—or falls—in primary commodity prices in terms of currency to work themselves through the price pipeline, including the prices of means of production all the way through to changes in the currency prices of items of personal consumption. Therefore, as a general rule, it takes many years—even a few decades—before changes in the gold value of the paper currency is fully reflected in commodity prices in terms of currency.
Under the dollar standard paper money system that has prevailed since 1971, the immediate effect of a drop in long-term interest rates has often been a drop in the general price level measured in terms of gold. If a drop in long-term interest rates causes dollar gold prices to rise faster than the general price level in terms of paper dollars—or other paper currencies—by definition the general price level in terms of gold has fallen.
The converse movement has also often occurred under the post-1971 dollar standard when long-term interest rates rise—or what comes to exactly the same thing, U.S. government bond prices fall. Primary commodity prices in terms of paper dollars drop, but the general price level, when measured in terms of gold, rises.
These movements of price and interest rates peculiar to a system of paper money apparently inspired Summers’ great “discovery” that the general price level when measured in terms of gold is determined by the “rate of return”— or real long-term interest rate—on capital.
Summers’ theory springs a leak
Unfortunately for Summers’ proposed resolution of Gibson’s paradox, between 1983 and 2001 the relationship between the general price level measured in terms of gold and the real long-term interest ratedid not behave the way Summers’ theory predicted.
During the period from the Volcker shock of 1979-82 to 2001—especially during the 1997-98 “Asian crisis”—a huge rise in the confidence of the capitalists in the paper currencies of the imperialist countries occurred. This was especially true during the so-called “Asian crisis” of 1997-1998—which hit the markets of the oppressed countries as a whole, not just those in Asia.
During that crisis, a huge flight of money capital from the “third world”—including Russia—to the imperialist countries, especially the United States, occurred. (8) As a result, the dollar gold price fell from about $328 an ounce in July 1997 to below $255 an ounce in August 1999. In contrast, in January 1980 near the beginning of the Volcker shock, the dollar price of gold at one point rose to $875 an ounce.
The consequent sharp decline in long-term interest rates—both in currency and real terms—triggered the huge housing boom and resulting real estate speculation that engulfed the imperialist countries, especially the United States. The housing boom meant a huge wave of “overbuilding”—overproduction of houses—that ended with the collapse in the residential construction industry and real estate prices of 2006-09.
Though dollar primary commodity prices declined in sympathy with dollar gold prices, prices as a whole continued to drift up. The result was a significant rise in the general price level in terms of gold between the end of the Volcker shock and 2001.
But according to Summers’ theory, this should not have occurred. If Summers was right, the fall in (real) long-term interest rates in those years should have led to a rise in demand for gold and a fall, not a rise, in the general price level in terms of gold. Summers’ new theory of the general price level and his proposed resolution of Gibson’s paradox sprung a huge leak!
It seems that the so-called “Gibson’s paradox” can be resolved only by dumping marginalism and adopting Marx’s economic discoveries after all. Especially Marx’s epoch-making discovery that surplus value is produced by the unpaid labor of the working class even when commodities exchange at their values.
1 Lawrence H. Summers, a supporter of the U.S. Democratic Party, now heads the National Economic Council under President Barack Obama. He had previously served as secretary of the treasury under President Bill Clinton. After serving as treasury secretary, Summers became president of Harvard University. However, he was forced out of that position partly because of his role in the Cornel West affair. West was head of the Afro-American Studies department at Harvard Divinity School.
The on-line encyclopedia Wikipedia writes: “In an October 2001 meeting, Summers criticized African American Studies department head Cornell West for allegedly missing three weeks of classes to work on the Bill Bradley presidential campaign, and complained that West was contributing to grade inflation. Summers also said that West’s rap album was an embarrassment to the university, and that West needed to do more scholarly work.”
Summers’ criticism led to West quitting Harvard and returning to Princeton.
In 1991, when Summers was working at the World Bank, a memo signed by him was leaked to the press. The memo held that “the economic logic behind dumping a load of toxic waste in the lowest wage country is impeccable and we should face up to that. … I’ve always thought that under-populated countries in Africa are vastly under polluted.”
Another factor in Summers’ forced departure from Harvard was his expressed view that women are underrepresented in the sciences because due to biological factors fewer women have the intellectual capacity to succeed in the sciences than men.
Yet another scandal that cast a cloud over Summers’ reputation involved his protégé, the Russian-American economist Andrei Scheifer. Scheifer served as an advisor for Russian President Boris Yeltsin’s massive privatization program. The privatization involved the wealth that had been created by and belonged to the Soviet working class before Mikhail Gorbachev’s “perestroika.”
Under Summers’ presidency, Scheifer obtained a position in the Harvard Economics department. Apparently, there was evidence that Scheifer had profited personally from the Yeltsin privatization program he had in part designed, through his purchase of stock in privatized former Soviet enterprises.
While Summers was head of Harvard, charges were bought against Scheifer by the U.S. government. The charges were settled by the payment of $28.5 million, most of which was paid by Harvard. Under normal circumstances, Scheifer would have been expected to resign from Harvard, but in this case Schiefer retained his position.
Ironically, despite his reputation as a brilliant economist, Summers’ investments for Harvard cost the university about a billion dollars. Wikipedia states: “During Summers’ presidency at Harvard, the University entered into a series totaling US$3.52 billion of interest rate swaps, financial derivatives that can be used for either hedging or speculation. By late 2008, those positions had lost approximately $1 billion in value. This forced Harvard to borrow significant sums in distressed market conditions to meet margin calls on the swaps. The decision to enter into the swap positions has been attributed to Summers and has been termed a ‘massive interest-rate gamble’ that ended badly.”
3 Actually banks do “pay” negative interest rates on small deposits, when the effects of “service charges” that are levied on deposits below a certain minimum level are taken into account. But interest rates in terms of currency are never negative on substantial quantities of money capital.
There are, however, times when the commodity—real—rate of interest is negative. And when currencies depreciate against gold, the gold rate of interest—can be temporary negative, though in this case, if the depreciation of the currency is not quickly halted, the negative gold rate of interest becomes sharply positive sooner or later. This is exactly what we saw in the wake of the Volcker shock of 1979-82.
If the central bank or other “monetary authority” tried to keep the rate of interest negative in terms of gold for a prolonged period of time, the result would be hyperinflation and collapse of the currency.
5 Actually, the rate of profit tends to increase during the upswing in the industrial cycle—first because of the effects of rising prices. More importantly, it increases due to the rising turnover of variable capital, which means that more surplus value can be produced in a given period of time. This increases the profit that the money capitalist can capture.
6 During the period when a “weak” form of the gold standard under the post-World War II Bretton Woods system was in effect, though interest did fluctuate with the stages of the industrial cycle, the overall trend of the rate of interest was strongly upward across the cycle. Under the “classic” international gold standard that prevailed before 1914, there was no such secular rise in interest rates across the industrial cycle.
7 Under the dollar standard, major changes in the gold value of the dollar bring greater or lesser changes in the value of the other paper currencies in the same direction, since under the dollar standard other currencies are more or less tied to the dollar.
8 Since the liquidation of Soviet power under Gorbachev, the countries of the former Soviet Union including Russia have become for all practical purposes part of the “third world” of non-imperialist capitalist countries.