Shaikh’s wrong theory of interest rates
“The interest rate is the price of finance,” Shaikh writes at the beginning of Chapter 10, “Competition, Finance, and Interest Rates.” Shaikh treats the rate of interest as fluctuating around the price of production of the “provision of finance.” Late in Chapter 10, Shaikh indicates he was confused on this subject in the 1970s and the early 1980s but brought to his current views by the Sraffrian-neo-Ricardian Italian economist Carlo Panico. Is this the correct approach to ascertaining what actually determines the rate(s) of interest? I believe it is not.
Do interest rates really fluctuate around a “price” of the provision of finance the way market prices fluctuate around prices of production? Strictly speaking, price is the value of one commodity measured in terms of the use value of the commodity that serves as the universal equivalent—money. According to this definition, interest rates are not prices at all.
It is true that we often use price in a looser sense. For example, we talk about the prices of securities that are in reality legal documents that entitle their owners to flows of income. Another example is the price of unimproved land whose owners hold titles to flows of ground rent. It would be absurd to talk about the price of production of unimproved land if only because unimproved land is a form of wealth produced by nature and not by human labor.
Some other ‘non-price’ prices
Another example of a price that is not a real price is the dollar “price” of gold. This very important economic variable is not really a price at all but instead measures the amount of gold that a dollar represents at any moment. Other examples of “non-price” prices are the “price” of one currency in terms of another—exchange rates—and the price of politicians.
None of these are prices in the strict sense. There is no harm in referring to prices in the looser sense if we know that is what we are doing. But it can be harmful if we confuse the term “price” in the looser everyday sense with true commodity prices. Only in the looser everyday sense can we speak of interest as the “price” of the provision of finance.
Examples of prices in the true sense are: market prices—the prices you pay at the grocery store, for example; cost price—the price that a capitalist has to pay to carry out production of commodities that contain surplus value; direct prices—the prices of commodities that are directly proportional to values; prices of production; and the price of labor power—wages.
Let’s take a close look at the category of “price of production,” which is largely ignored by most recent Marxist writers but plays a crucial role not only in his “Capitalism” but throughout Shaikh’s work. First, price of production is indeed a price. We compare a commodity with a certain sum of money—weight of gold bullion, assuming gold bullion acts as money material. In a pure capitalist economy, every commodity except labor power and the commodity that serves as money has a price of production.
The money commodity measures the value of all other commodities in terms of its own use value but does not itself have a price and therefore cannot have a price of production. (1) Labor power, even in a pure capitalist economy, does not have a price of production because it is not produced and sold by industrial capitalists but by workers. Unlike industrial capitalists, workers sell their labor power for subsistence and not to realize a profit on invested capital. Therefore, the two “special commodities” of capitalism, the money commodity and the commodity labor power (which alone produces surplus value, the supreme aim of capitalist economy), do not have prices of production.
Equalization of the rate of profit
The most important discovery of Marx was to explain the origin and nature of surplus value. Marx was the first economist who treated surplus value as an economic category separate and apart from the terms widely used to refer to various fractions of surplus value. Once the surplus value embodied in commodities is realized in terms of the use value of the money commodity, surplus value takes the form of profit and ground rent. Profit is further divided into two sub-fractions, interest and the profit of enterprise.
Earlier writers, including pre-Marxist representatives of the working class called “Ricardian socialists,” often referred to surplus value as “interest.” When they used “interest,” they actually meant not only the part of the surplus value that is interest but also the parts that are profit of enterprise and ground rent.
It didn’t take a man of genius like Marx to understand that surplus value is produced by unpaid labor. Anyone who has ever actually produced surplus value intuitively understands this. What it did take a Marx to achieve was to reconcile the assumption that equal quantities of human labor embodied in commodities exchange with equal quantities of labor, on one hand, with the production of surplus value—income from property—through unpaid labor, on the other. Marx did this by distinguishing between (abstract) labor—the substance of value when embodied in commodities—and the value of the commodity labor power. (2)
From direct prices to prices of production
In explaining how surplus value arises out of the exchange of equal quantities of labor, Marx assumed that commodities sell at their values, or in our preferred terminology, their direct prices. These, like all other types of prices, measured in terms of quantities of the money commodity measured in terms of its use value, are necessary for the analysis of surplus value and are thus an extremely powerful analytical tool. However, direct prices (3) are only approximately equal to what Adam Smith called natural prices, the average prices that market prices fluctuate around in response to the ebbs and flows of effective demand.
In reality, prices of production diverge from direct prices. If commodities sold at their direct prices, capitals with higher than average organic composition of capital or longer than average turnover periods would make lower than average rates of profit in equal periods of time—for example, a year—while capitals with lower than average organic compositions or higher turnover periods would make greater than average profits. This, however, violates the nature of competition. Competition forces capitalists to move their capital toward sectors that realize greater than average rates of profit and away from sectors that yield below average rates of profit.
Marx used the term “price of production” only as it applies to the owners of productive capital. He did not apply it to capitalists who own only commodity and money capital. The latter capitalists are called merchant capitalists. However, the law of the equalization of the rate of profit applies to merchant capitalists just as it applies to industrial capitalists.
When I refer to merchant capitalists, I am referring to merchant capital in the pure sense. Capitalists who transport and store commodities are carrying out productive-of-surplus value activities and are to that extent industrial, not merchant, capitalists. The pure merchant capitalist only deals in change in titles of ownership and nothing else. Though merchants will sell their commodities to the final consumer—or perhaps other merchants—that will yield the average rate of profit, no actual production of commodities that contain surplus value is involved. So the term “price of production” is out of place here.
Commercial bank capital
What about the profit earned by the commercial banker? (4) Is the banker subject like both the industrial and merchant capitalists to the equalization of profit? Now, we already know that the (average) rate of interest is by necessity—outside of exceptional periods—lower than the rate of profit. If the rate of interest rose on a permanent basis to the rate of profit, there would be no incentive for a capitalist to assume the extra risk of carrying out an industrial enterprise. The motive to actually produce surplus value would cease.
If interest rates do for a while rise to or above the average rate of profit, the industrial capitalists would gradually convert themselves into money capitalists, which would then once again lower the rate of interest to below the average rate of profit. (5) So there can be no equalization of the rate of interest and the rate of profit.
Does this mean that banks make less than the average rate of profit on their capital? No. The banker is not simply a lender but also a borrower. The profit of banking capital arises from the difference between the interest rates bankers pay on deposits—money lent to the bank—and the rate of interest banks charge on loans.
For simplification purposes, I follow Marx’s assumption that the (commercial) banker does business only with industrial and commercial capitalists. Indeed, through the middle of the 20th century, workers and middle-class people kept money at and borrowed from savings banks, savings and loans, and credit unions rather than commercial banks. So in Marx’s time and well into the last century, the assumption that commercial banks do business only with industrial and commercial capitalists or very rich money capitalists was reasonable. Even today, it can be assumed that once the interest rate for the banker on loans to large industrial and commercial capitalists is established, rates of interest on consumer loans will be scaled up from that rate according to the perceived extra risk.
For example, a working-class consumer is far more likely to default than the Apple Corporation, whose cash balance has at times exceeded the cash on hand at the U.S. Treasury. Somewhere in the middle between the high-risk consumer and Apple will be average-size industrial or commercial capitalists, who will have to pay a higher rate of interest than Apple or other so-called “prime borrowers” but considerably lower than a working-class consumer will have to pay on an auto loan. So the “base” or “prime” interest rate that banks charge on loans—or discounts—will be determined by the same economic forces that were at work in Marx’s time.
Commercial bankers appear as the middlemen of the money market just as merchant capitalists appear as the middlemen of the commodity markets. Moneyed individuals and enterprises that have monetary balances they don’t have to immediately spend on purchases of commodities or for payments coming due can in theory loan their surplus funds directly to industrial or commercial capitalists.
In practice, however, moneyed individuals are in a poor position to know what industrial enterprises and commercial enterprises are good bets to pay back loans with interest and which are likely candidates for bankruptcy. Bankers, on the other hand, specialize in determining which industrial or commercial capitalists are good credit risks and which are not. Bankers are sometimes wrong—as is revealed in every crisis—but are still far better equipped to make educated guesses about credit risk than the average moneyed man or women on the street.
Because of the above, the average moneyed persons in the street are prepared to share some of their interest income with bankers. What determines the interest rates an average money person in the street demands—or rather is forced to accept—is a question that will be examined shortly. For now, let’s assume it is given.
Just like the merchant capitalists purchase commodities cheaply in order to sell dear, the banker borrows cheaply in order to lend dear. The banker’s profit is therefore the difference between the rate the banker as borrower pays on deposits and the rate the banker as lender charges as lender. In addition, the banker has certain costs that arise from running a banking business, much as the merchant capitalist has.
A capitalist company engaged in the banking business must rent or purchase buildings, hire (purchase the labor power of) lending officers, accountants and tellers—though far less nowadays due to automated teller machines and other computerized devices. A modern commercial bank is unthinkable without automated teller machines, computers that must be purchased by the capitalists engaged in the banking business. However, the most important factor in the banks’ profit by far remains the difference at which the banks borrow—interest paid on deposits—and the interest received by the banks on loans—called in the business “the spread.”
Banking capital is subject to equalization of the rate of profit
Individual capitalists—these can include corporations—who are not satisfied with the rate of interest, do not want to depend on risky speculation, and want to retain control of their own capital have a choice of being industrial capitalists, merchant capitalists, or banking capitalists. Since their only concern as capitalists is to make at least the average rate of profit on their capital, it is a matter of indifference to them whether they function as industrial, merchant or banking capitalists.
If the bankers’ rate of profit is significantly less than the rate of profit of the industrial or commercial capitalists, a portion of the capitalists engaged in the banking business will close down their banks and open up industrial or merchant enterprises instead. This will reduce the number of banks, which will enable the remaining bankers to get away with paying lower interest rates on deposits and charging higher interest rates on loans to industrial and commercial borrowers. This will continue until the rate of profit on the bankers’ capital rises to or above the average rate of profit. (6)
Similarly, if bankers get a yield on their invested capital that is greater than the return on industrial or commercial capital, a portion of the capitalists acting as industrial and merchant capitalists will shut down their enterprises and enter the banking business. The increased number of banks leads to a situation where the banks have to offer a higher rate of interest to their depositors and charge a lower rate of interest on loans. This will continue until the rate of return on banker capital falls to or below the average rate.
Shaikh is therefore correct when he holds that banking capital participates in the equalization of the rate of profit just as productive and merchant capital does. It appears that just like industrial capitalists sell commodities on average at the price of production, and merchant capitalists sell commodities at prices that on average yield them the average rate of profit, the banking capitalists lend money at interest rates that seem (to them) pretty much like the price of production. However, as Marxists we are not primarily interested in how things appear to the capitalists but what are the underlying economic relationships often hidden from the capitalists and their bought-and-paid-for economists.
Here we come to a peculiar fact. The owners of bank capital—the banks’ stockholders, not the depositors, share a part of the interest income with their depositors—creditors. If we look at the total capital on a social scale, the interest income earned by depositors and the profits earned by bank stockholders fall under the “interest” fraction of the total surplus value. Yet, the bank’s profits on its capital appears to be divided into interest that accrues to the bank’s creditors—depositors—insomuch as the bank works with borrowed money but to the bank’s owners insomuch as it works with the stockholders’ capital. Another portion of the profit yield on the bank’s capital appears as the profit of enterprise. This is another example that things are not always as they appear under the capitalist mode of production.
But what determines the rate of interest that bankers must pay on the money capital their creditors lend to them—what Shaikh calls the base interest rate? Or for that matter, what determines the portion of the profit that falls to interest—the sum of the base interest rate plus administrative expenses plus the interest the bankers get on their loans—the total interest.
Adam Smith and David Ricardo assumed that there was a fixed division between the portion, to use Marx’s terminology, of the profit (surplus value minus rent) that goes to profit of enterprise and the portion that goes to interest. Smith and Ricardo generally assumed a fifty-fifty division, and Shaikh is sympathetic to this view. But Marx rejected it. Shaikh is a little embarrassed to find that he is at odds with Marx on this question. Shaikh claims that Marx was inconsistent and that much of what is written on interest rates in Volume III of “Capital” was actually written by Frederich Engels. Better to disagree with Engels than with Marx.
But at the end of the day, what interests us here isn’t what Engels believed or even what Marx believed but what is true. Shaikh and Panico put forward the notion that the primary interest rate is equivalent to the price of production of the provision of finance. As far as I know, this view is held by only Shaikh and Panico. No other economist whether Marx, Keynes, or Roy Harrod (1900-1978), an English economist who was a contemporary of and biographer of Keynes and who Shaikh admires, supports such a notion.
Imagine if you can that you are a wealthy capitalist. One day you go to the branch office of one of the large commercial banks and open up an account. You are engaged in the “provision of finance.” But is this really economically speaking the same thing as creating an industrial or commercial enterprise? If you create an industrial enterprise—and since I assume you are a wealthy capitalist, this is within your power—you must buy or rent a factory building, purchase raw and auxiliary materials, and purchase the labor power of industrial workers with the aim of producing surplus value that you hope you will realize when you actually sell the commodities. You also have to worry about selling commodities at prices that will enable you to realize at least the average rate of profit if you are a merchant capitalist. This is not a concern if you are merely opening up a bank account.
For that reason, you will not even consider creating a new industrial business unless you have what you believe will earn a considerably greater return on your invested capital than you will by collecting interest on a commercial bank account. Therefore, the interest you collect as a bank depositor will as a rule be below what you would earn if you create a new industrial or merchant business—or invest in—not merely lend to—an existing industrial or commercial enterprise.
In the case where you take an “equity stake” in a business, you are entitled to both interest and the profit of enterprise. In the case where you merely loan money to a business, you are entitled only to the interest. And if you loan money indirectly to businesses through the commercial banking system, you have to share a part of the interest with the commercial bank. But what exactly determines the difference between the rate of interest and the rate profit?
Loan and money capital
Both real capital and money capital can be loaned out. But money capital is much more likely to be loaned out than real capital. It’s hard to imagine going down to your local commercial bank branch and opening an account by depositing a drill press, a lathe or an industrial robot.
Experience over centuries has demonstrated that, contrary to the quantity theory of money, fluctuations in the quantity of money have little effect on prices. Indeed, a shortage of money will only affect prices if it leads to a contraction of the market resulting in not all commodities on the market finding buyers at existing prices.
Similarly, an increase in the quantity of money will only affect prices if it leads to a major expansion in the market beyond the ability of the industrial capitalists to quickly meet the increase in demand at existing prices. If industrial capitalists can meet the increased demand at existing prices, an expansion of the market will lead to an increase in production and employment but not to a rise in prices. The rate(s) of interest, in contrast, are extremely sensitive to fluctuations in the quantity of money, with virtually no time lags.
Monetary reserve fund and currency
In any given nation as well as on a world scale, the total money supply is divided into currency and a reserve fund. In the modern monetary system, the reserve fund is made up of layers. The uppermost layer is taken up by bank reserves—both vault cash and the deposits of the banks at the central bank (called central bank money)—in terms of the local (non-U. S. dollar currency) in countries that have local currencies other than the U.S. dollar. In addition, central banks maintain a reserve of U.S. dollars—and sometimes of euros outside of the eurozone—in the form of short-term government securities that can quickly be converted into actual currency on the open money market.
Finally, the U.S. government maintains a reserve of gold bullion at Fort Knox and a few other depositories, which backs the U.S. dollar. Another part of the reserve fund that backs the U.S. dollar is the gold owned by foreign governments or central banks that the U.S. government holds “for safekeeping” in the vaults of the Federal Reserve Bank of New York. This “public sector” gold is also available to be mobilized in a centralized way against a run on the U.S. dollar into gold.
Another part of the reserve fund is owned by private hoarders. In the event of a run from the U.S. dollar into gold, private hoarders will attempt to further increase their gold hoards making the crisis even worse, while central banks would be expected to dump, or at least threaten to dump, a portion of their holdings of gold on the market in a bid to break the crisis.
If the centralized public gold hoard did not exist, the full weight of breaking a run into gold would be borne by a rise in the rate of interest. In this case, a higher rate of interest would be necessary to break the crisis than is the case where the government or central bank maintains a gold hoard. This would worsen—perhaps very considerably—the recession/depression that would follow a run from the dollar into gold. This is why Milton Friedman’s proposal that the U.S. government and other governments and central banks sell off all their gold was rejected.
The private-sector gold hoard is also layered. The first layer consists of gold coins and bars owned by private “investors”/hoarders. Beyond gold bars and coins in private hands, there is jewelery made of gold and physically convertible into bullion. Historically, this has been the main form of hoarding wealth in India and China and in pre-capitalist societies in general.
In addition, we have gold knickknacks and gold plate as a way to hoard wealth. In addition to gold’s undeniable artistic value, gold jewelery, other objects made of gold, and gold plating is a way of flaunting wealth as well as hoarding it. U.S. President Donald Trump’s New York City residence atop Trump Tower makes liberal use of gold for these purposes.
Finally, gold has use values other than storing and flaunting wealth. The most well known non-monetary use for gold is filling cavities in teeth and in electronics. (7) These are entirely non-monetary use values of gold. However, during periods of exceptional demand for gold, old electronic circuit boards are “mined for gold,” and at the peak of the 2011 surge in demand for gold there were reports that some people may even have yanked the gold out of their teeth in order to convert it into gold bullion. There are also the grisly stories of the Nazis mining the teeth of Nazi death camp victims and depositing it in the Reich bank.
Therefore, any gold that can potentially be physically melted down into bullion forms a secondary monetary reserve fund that can be mobilized to back currencies under exceptional circumstances.
The growth of the quantity of gold in the reserve fund
The global gold monetary reserve fund grows continuously over time as more gold is mined and refined. A certain amount of this gold in the past was lost through the wearing down of gold coins in circulation. After 1914, gold coins were withdrawn from circulation in Europe, and in 1933 they were withdrawn from circulation in the United States as well. Though gold is still used as currency in illegal trade—though the $100 U.S. bill seems to be the preferred currency in this area—gold still remains the coin of last resort. In the event of a global currency collapse, for example, gold would again be forced back into circulation. That being said, compared to the pre-1914 situation very little gold is lost today through wear and tear of gold coinage. (8)
A certain amount of monetary gold can be lost to the reserve fund if it is transferred to non-monetary uses—though as we saw above, a portion of this gold can be converted back to monetary use, so it becomes part of the secondary monetary reserve fund. In addition, gold on ships that are sunk is no longer available to the gold reserve fund unless and until it is recovered. And from time to time, stories appear in the media about rumored lost “Nazi gold” hidden away in mountain caves or at the bottom of mountain lakes.
Finally, there may be gold in the circuit boards on spacecraft. If there is gold in the circuitry in any of the NASA probes now exploring Mars, it is out of the monetary reserve fund until and if the spacecraft or at least its circuit boards are recovered, returned to earth and “mined” for gold. Finally, there may be gold in circuit boards of NASA space probes that are leaving the solar system completely. Any gold in these spacecraft is probably gone from the monetary reserve fund for good.
It can be assumed that the amount of gold that “leaks away” either temporarily or permanently every year is far less than the amount of new gold that is annually mined and refined. Over time, the quantity of gold in the various reserve monetary funds never shrinks but grows. But the rate at which this reserve fund grows relative to overall commodity production does vary.
For example, during periods of recession the quantity of commodities for sale throughout the world market can actually decline while the quantity of gold that is available to the various layers of the reserve fund grows through boom and recession alike. This is why no recession lasts indefinitely but inevitably gives way to a new upswing in the industrial cycle—as long as capitalism is not overthrown. Therefore, no individual recession no matter how severe will automatically lead to the end of capitalism.
Changes in the ratio of the gold reserve fund and currency
Where would the additional gold coins come from? In the absence of additional domestic production of gold or an inflow from abroad, the coins would have to come from the reserve fund. The “money supply,” defined as currency in circulation—not the reserve fund—would expand while the gold reserve hoard would shrink. The shrinkage of the reserve gold hoard would lead to a rise in the rate(s) of interest.
Suppose the opposite happened. An extraordinarily bountiful harvest causes food prices to plunge more than compensating for the greater quantity of food commodities in circulation in terms of their use values. All else remaining unchanged, less currency would be needed to circulate commodities than before. Some portion of the circulating gold coins would fall out of circulation and become part of the reserve fund. The gold hoard would expand causing the money market to ease. This would be expressed in a fall in interest rates.
While the actual monetary system, as we saw above, is considerably more complex, it works on the same principle as the simple monetary system described. All else remaining equal, rising commodity prices cause the money market to tighten leading to a rise in interest rates, while falling prices cause the money market to “ease” leading to lower interest rates.
The monetary reserve fund and the modern credit system
In imperialist countries with the most developed banking systems, such as the United States, the amount of cash that circulates even for petty transactions such as fast-food meals has declined drastically in recent years. Instead, debit and credit cards—most recently even smart phones—are used to make purchases.
Debit cards make use of existing bank—credit—money. Cash in the form of central bank money (9)—which can be converted to actual legal tender cash on the demand of the commercial banks—is used to settle transactions among the banks that do not offset each other. The more debit cards are used in a given period of time, the faster the velocity of central bank money will be for the purposes of settling these payments. This will mean a greater quantity of central bank money will be necessary to settle payments among the commercial banks in a given period of time.
When this happens, commercial banks that owe money will be obliged to borrow money from other commercial banks at what is called the “federal funds” rate in the U.S. or at central bank discount windows. All other things remaining equal, since a given quantity of central bank money will have to used as means of payment if the use of debit cards as means of purchases rises in term of the sum of the prices of the total number of commodities purchased, there will be a shrinkage in the quantity of central bank money relative to the demand for it as a means of purchase. The opposite is the case if the quantity of debit card purchases—measured in terms of the sum of the prices of the commodities purchased—declines relative to the total sum of their prices.
In the case of credit cards, new commercial bank credit money is created. Assuming bank reserves remain unchanged, the ratio between the total quantity of credit money relative to total commercial bank reserves rises. Therefore, assuming the quantity of commercial bank reserves remains unchanged, increased use of credit cards in a given period means a shrinkage of the quantity of bank reserves relative to the total amount of credit money created by the commercial banks, which will put upward pressure on interest rates.
Marginalist theory claims that there is a natural rate of interest reflecting the “scarcity of capital.” According to marginalists, commodities have prices because they are scarce and capital has a “price” in the form of interest because capital, like commodities, is also “scarce.” In addition, nominal interest rates will also include, the economists claim, an expected rate of change in prices.
If the natural rate of interest, according to this view, is 2 percent but the expected rate of inflation is 3 percent, the market rate of interest will be 5 percent. If prices, however, are falling or are expected to fall at a rate of 1 percent, the market rate of interest will be 1 percent.
Shaikh explains that the English economist A.H. Gibson, however, in the early 1920s rediscovered what Thomas Tooke (10) had already known in the 19th century. Peaks that Tooke observed in interest rates coincided with peaks in prices, and troughs in interest rates coincided with troughs in prices.
This contradicts the marginalist theory of the natural rate of interest, which predicts that price peaks with the prospect of lower prices should see the lowest interest rates while price troughs with the prospect of higher prices should see the highest interest rates. Keynes dubbed the conflict between marginalist theory and the reality as “Gibson’s paradox.” However, this is a paradox only in terms of marginalist theory.
In the days of Tooke, and to some extent Gibson, things were simpler than they are now, since currency units represented fixed quantities of gold and not variable quantities like they do today. Under the gold standard, price peaks coincided with peaks in the industrial cycle, while price troughs coincided with troughs in the industrial cycle. At the cyclical peak, the imaginary mass of gold represented by the prices of commodities was highest relative to the mass of actual gold in the vaults of the Bank of England as well gold in England held by private commercial banks and individuals.
This was true because the price tags attached to commodities were at their cyclical peaks and the mass of actual commodities in circulation measured in terms of their various use values were always at record levels at cyclical peaks. The credit system was stretched to the limit because credit money and credit increasingly replaced cash—gold coin—as a means of settling payments and making purchases. In full accord with the theory of interest rates developed here, interest rates were at their highest level of the industrial cycle.
At the price troughs, the opposite conditions prevail. Recession reduces the size of the commodities in terms of their individual use values while cutting their price tags. Not surprisingly, the ratio of actual gold in the bank vaults plus any other gold held in Britain was much higher than average relative to the imaginary gold represented by the total mass of (non-money) commodities for sale than at other times. Not surprisingly the rate of interest was at its lowest point.
Gibson’s paradox reflects false bourgeois economic theories, but in reality there is no paradox. Gibson’s so-called paradox is just another example of bourgeois economic theory put to the test of reality and failing.
Both what I will call the Shaikh-Panico theory of determination of interest rates and the theory I develop here can explain Gibson’s so-called paradox. Gibson’s paradox shows that the bourgeois theories of value, capital, interest rates are wrong. But this so-called paradox does not enable us to determine whether the Shaikh-Panico theory or the theory developed here is the correct one.
Putting the Shaikh-Panico theory of interest rates to the test
During the 19th century, the Bank of England increasingly monopolized Britain’s monetary gold supply, which formed the lowest layer of Britain’s monetary reserve fund. Bank of England banknotes formed the reserves of commercial banks. But ultimately, the ability of the Bank of England to issue banknotes depended on the size of its gold reserve.
Over time, gold mining and refining caused the Bank of England gold reserves to grow. But they did not grow in a straight line. If the balance of payments turned against Britain—which it often did—the Bank would suffer a “drain.” Britain’s gold reserve—the monetary reserve fund within Britain—would drop not simply relatively but absolutely. Here we have an empirical test between the two theories of interest.
If the rate of interest is the price of money that ultimately fluctuates around the price of the provision of finance—akin to a price of production—then interest rates and prices should always move in the same direction. However, if the rate of interest is determined by the balance of forces between the owners of loan money capital and real capital, it would be quite possible for the rate of interest and the price level to move in opposite directions.
In Volume III of “Capital,” Marx collected data on this. What do we see? According to Marx’s tables, between March 1, 1834, and March 1, 1835, the Bank of England’s gold reserves dropped from 9,104,000 pounds-sterling to 6,274,000. (11) Britain’s monetary reserve fund therefore dropped absolutely during this period. The prices of seven major items rose, seven major items fell, and one major item remained unchanged. Therefore, commodity prices remained roughly unchanged.
Shaikh-Panico theory fails
If interest rates follow prices, as they should according to the Shaikh-Panico theory, interest rates should have remained unchanged. If interest rates, however, reflect changes in the reserve fund, the decline of gold reserves should have led to a rise in interest rates despite the general price level remaining more or less unchanged. According to Marx’s table, the market rate of discount rose in that period from 2.75 to 3.75 percent. This is in accord with theory of interest rates developed here but contradicts the Shaikh-Panico theory that would predict that interest rates should have remained unchanged.
Let’s see what happened the following year that begins on March 1, 1835, and ends on March 1, 1836. This period provides an even stronger test of our two competing theories. During this year, prices showed a strong upward movement. The prices of 11 major items rose, only three declined, and one remained unchanged.
The Shaikh-Panico theory predicts that interest rates should have risen during that year because of rising British commodity prices. But the Bank of England reserve fund also rose during this year from 6,724,000 to 7,918,000 pounds sterling. The absolute rise of the monetary reserve fund as measured by the total quantity of gold in the vaults of the Bank of England indicated that the absolute rise in monetary reserves could have actually lowered the rate of interest in this period according to our theory. However, according to the Shaikh-Panico theory of interest rates, rising commodity prices should have increased the “price of provision of finance,” meaning higher interest rates. What actually happened?
According to Marx’s table, the market rate of discount fell from 3.75 to 3.25 percent, in direct opposition to the predictions of the Shaikh-Panico theory but in full accord with the theory developed here.
How the reserve fund and the total quantity of commodities is compared
The size of the reserve fund has to be measured relative to money in terms of currency units, which ultimately represent definite weights of gold bullion. Under any form of gold standard, these units are stable, while under “paper money” standards such as those that prevail today, they are variable. But at any given moment in time, the currency units represent definite quantities of gold bullion. This is why the “dollar price of gold” is so closely watched today, despite the claims of most economists that this variable has no particular significance!
We can imagine the wealth of the nation being split between two very unequal piles. In the smaller pile, we have the monetary reserve fund that is measured in some unit of weight of gold bullion. In the other pile, we have an immense mass of commodities of many different use values that are qualitatively different and therefore quantitatively incomparable, not only with gold bullion of the reserve fund but with each other. However, all the commodities come with price tags attached to them, and these price tags are ultimately denominated in terms of gold bullion, though in this case the gold bullion is imaginary—called by Marx “money of account.”
If we add up the price tags, we can convert the mass of commodities of disparate use values into an imaginary mass of gold bullion of specific weight. The heavier the mass of imaginary gold represented by the commodity pile is relative to the weight of the real gold in the monetary reserve fund the more “stretched out” the credit system will be and the higher the rate of interest will be. The smaller the mass of imaginary gold represented by the commodity mass—or rather by their attached price tags—the lower the rate of interest will be.
In addition to commodities, we have fictitious commodities like corporate stocks—capitalized dividend flows that contain a strong speculative element based on expected increases in the flow of dividends—and land prices based on expected increases in the flow of ground rents, which express themselves as rising real estate prices. These contrast with the flow of income due to the owners of government and corporate bonds. Leaving aside possible bankruptcy in the case of corporate bonds, the value of these flows is precisely known—in terms of legal tender currency units—in advance.
A rise in the prices of these assets puts upward pressure on the rate of interest because the currency has to circulate not only real commodities but fictitious commodities as well. If you follow financial markets for any period of time, you will quickly notice that a day when stock market prices and primary commodity prices rise decisively will with few exceptions see a rise in the interest rates on government securities. Similarly, a strong downward movement in stock market prices, especially if it is combined with a fall in most primary commodity prices, will see a rise in government bond prices—falling interest rates on government securities and in the money market in general.
Other factors determine the rate(s) of interest
Another factor affecting the rate of interest is the percentage of gold reserves—both in government and central bank hands and in private hands—that is offered for sale in exchange for currency in a given period of time. Over the long haul, this can be seen as more or less unchanged, so the evolution of interest rates will be driven by the increase in the quantity of commodities in circulation on one side versus the increase in the quantity of gold in the various layers of the reserve fund, governed in the last analysis by the level of global gold production, minus the amount of gold that disappears from the various monetary reserve funds.
If the quantity of gold grows faster than the quantity of commodities, interest rates will tend to fall; and if the quantity of commodities grows faster than the quantity of gold bullion, interest rates will be expected to rise. Keeping in mind that in the long run the rate of interest cannot equal or exceed the rate of profit, the extent to which the quantity of (non)monetary commodities can grow relative to the quantity of gold is limited by that proviso.
If the rate of increase of gold production lags behind the rate of increase in the production of commodities—which occurs during the boom phase of every industrial cycle—at some point gold will be perceived as growing, relatively speaking, increasingly “scarce,” which leads to a smaller percentage of the total gold in a given period of time being offered for sale into currency. Quantity becomes quality here and an economic boom is transformed into a crisis.
If the quantity of gold is growing at a faster rate than the growth of the total quantity of commodities, a greater percentage of gold will be offered for sale into currency in a given period of time, which helps transform a recession into a recovery.
Finally, under paper money systems the total percentage of the total gold reserve that will be offered for sale into currency in a given period of time will be affected by the perceived likelihood (12) of the currency either appreciating or depreciating against gold. If there is fear or belief “in the market” that the currency will soon depreciate, the amount of gold offered for sale at existing currency prices of gold will fall, which will end in a sharp rise in the rate of interest. On the other hand, if the currency is expected to appreciate—for example, as the result of a “Volcker shock” such as occurred in 1979-1982—the amount of gold offered for sale will increase, leading to a fall in the rate of interest.
Next month I will examine Shaikh’s grave errors on the theory of money, which are the source not only of Shaikh’s mistakes on the theory of the determination of interest rates but in other matters as well, not least the nature of cyclical
1 The “neo-Ricardian” economists think they have disproved Marx’s law of value because they fail to take into account the fact that not all commodities have prices of production. The price of labor power—wages—can be seen as the sum of the prices of production that the workers pay for the commodities necessary to reproduce their labor power. That still leaves one commodity out of the calculations, the one that serves as money. (back)
2 Marx attributes the discovery of the distinction between labor and labor power to the British materialist philosopher Thomas Hobbes (1588-1679). However, Hobbes’ crucial distinction was not taken up by the classical economists, so it fell to Marx to use Hobbes’ distinction between labor and labor power to finally uncover the secret of surplus value. (back)
3 Shaikh has calculated that about 80 percent of changes in the production price of commodities are explained by changes in the quantity of labor necessary to produce them, leaving only about 20 percent to the different organic compositions of capital and periods of turnover. So the theory that commodity prices are determined by the quantity of labor socially necessary to produce the commodities is approximately true under any realistic assumptions. In their rush to refute Marx, neo-Ricardian economists have lost sight of the forest of the law of (labor) value for the tree of the transformation problem. (back)
4 For simplicity sake, I deal here only with commercial banking. However, investment banking works on the same principle. While the commercial banker makes profits—net of administrative expenses—by pocketing the difference between the interest the commercial bank charges borrowers and the interest rates that it pays on deposits, the investment banker takes advantage of the difference between the interest rate paid by the company whose securities the investment bank underwrites and the lower interest that those who purchase the securities from the investment bank receive. (back)
5 This is exactly what happened at the end of the 20th and beginning of the 21st centuries. Due to the currency crisis that involved the huge devaluation of the U.S. dollar and its satellite currencies in the 1970s, the rate of interest reached unprecedented levels that for awhile exceeded the rate of profit. Traditional industrial companies began to convert themselves into money-lending institutions as part of the process called financialization. As a result, huge amounts of money loan capital appeared on the market, which eventually drove interest rates to record low levels. (back)
6 The financial press refers to areas where competition among the banks has driven the rate of profit on bank capital below the average rate of profit as being “over banked.” When I refer to the bankers’ capital, I mean not the capital of the depositors but the capital that is owned by the bank’s stockholders. This is calculated by subtracting the value of deposits and other liabilities owned by the bankers from the total assets. The difference is the capital, or the stockholder equity. It is the return on the stockholders’ capital that is subject to the equalization of the rate of profit. (back)
7 The high value of gold, which makes it a good money commodity, is a hindrance for gold’s use in other fields such electronics. Driven by competition to constantly lower their cost prices, industrial capitalists replace gold with cheaper metals whenever they can. (back)
8 This shows that gold coins are not the ideal circulating media. Using gold directly as currency both reduces the size of the reserve fund and shrinks the quantity of gold through the wear and tear and “clipping” of the gold coinage. (back)
9 Commercial banks maintain accounts at the central banks. The central bank becomes the bankers’ bank. They can use these accounts just like non-banking companies and individuals use their accounts at commercial banks. The commercial banks have two forms of cash on hand. One is vault cash, made up of legal tender cash that they use to redeem bank withdrawals—which is relatively much smaller than it used to be due to the use of debit, credit, and other electronic forms of payment. The other is their accounts at the central bank, which can be converted into legal tender cash whenever the commercial banks and indirectly their customers demand cash. (back)
10 Thomas Tooke (1774-1858) was the leader of the Banking School, which opposed the Currency School. Tooke believed correctly that it was rising prices that increased the quantity of (convertible into gold) banknotes in circulation as opposed to the claim of the Currency School that it was an increased quantity of banknotes that caused prices to rise. Marx greatly admired Tooke’s work. (back)
11 Since Britain was on a gold coin standard in the 1830s, each pound-sterling represented a definite quantity of gold. More specifically, the pound-sterling was defined as equal to the quantity of gold contained in a gold Sovereign, which was 7.988052 g (0.2817702 oz). So if you want to do the math, you can calculate the exact weight of the gold held in the vaults of the Bank of England using the unit of weight of your choice. (back)
12 Even under the gold standard, there is always the possibility that the currency will be taken “off gold,” since a gold standard is a policy that can be changed. Everything else remaining equal, the more “solid” the gold standard is perceived to be the lower the interest rate will be. (back)