C.8 Is state control of credit the cause of the business cycle?

As explained in the last section, capitalism will suffer from a boom-and-bust cycle due to objective pressures on profit production, even if we ignore the subjective revolt against authority by working class people. It is this two-way pressure on profit rates, the subjective and objective, which causes the business cycle and such economic problems as "stagflation." However, for supporters of the free market, this conclusion is unacceptable and so they usually try to explain the business cycle in terms of external influences rather than those generated by the way capitalism works. Most pro-"free market" capitalists blame government intervention in the market, particularly state control over money, as the source of the business cycle. This analysis is defective, as will be shown below.

It should be noted that many supporters of capitalism ignore the "subjective" pressures on capitalism that we discussed in section C.7.1. In addition, the problems associated with rising capital investment (as highlighted in section C.7.3) are also usually ignored, because they usually consider capital to be "productive" and so cannot see how its use could result in crises. This leaves them with the problems associated with the price mechanism, as discussed in section C.7.2.

The idea behind the "state-control-of-money" theory of crises is that interest rates provide companies and individuals with information about how price changes will affect future trends in production. Specifically, the claim is that changes in interest rates (i.e. changes in the demand and supply of credit) indirectly inform companies of the responses of their competitors. For example, if the price of tin rises, this will lead to an expansion in investment in the tin industry, so leading to a rise in interest rates (as more credit is demanded). This rise in interest rates lowers anticipated profits and dampens the expansion. State control of money stops this process (by distorting the interest rate) and so results in the credit system being unable to perform its economic function. This results in overproduction as interest rates do not reflect real savings and so capitalists over-invest in new capital, capital which appears profitable only because the interest rate is artificially low. When the rate inevitably adjusts upwards towards its "real" value, the invested capital becomes unprofitable and so over-investment appears. Hence, according to the argument, by eliminating state control of money these negative effects of capitalism would disappear.

Before discussing whether state control of money is the cause of the business cycle, we must point out that the argument concerning the role of the interest rate does not, in fact, explain the occurrence of over-investment (and so the business cycle). In other words, the explanation of the business cycle as lying in the features of the credit system is flawed. This is because it is not clear that the relevant information is communicated by changes in interest rates. Interest rates reflect the general aggregate demand for credit in an economy. However, the information which a specific company requires is about the over-expansion in the production of the specific good they produce and so the level of demand for credit amongst competitors, not the general demand for credit in the economy as a whole. An increase in the planned production of some good by a group of competitors will be reflected in a proportional change in interest rates only if it is assumed that the change in demand for credit by that industry is identical with that found in the economy as a whole.

There is no reason to suppose such an assumption is true, given the different production cycles of different industries and their differing needs for credit (in both terms of amount and of intensity). Therefore, assuming uneven changes in the demand for credit between industries reflecting uneven changes in their requirements, it is quite possible for over-investment (and so over-production) to occur, even if the credit system is working as it should in theory (i.e. the interest rate is, in fact, accurately reflecting the real savings available). The credit system, therefore, does not communicate the relevant information, and for this reason, it cannot be the case that the business cycle can be explained by departure from an "ideal system" (i.e. laissez-faire capitalism).

Therefore, it cannot be claimed that removing state-control of money will also remove the business-cycle. However, the arguments that the state control of money do have an element of truth in them. Expansion of credit above the "natural" level which equates it with savings can and does allow capital to expand further than it otherwise would and so encourages over-investment (i.e. it builds upon trends already present rather than creating them). While we have ignored the role of credit expansion in our comments above to stress that credit is not fundamental to the business cycle, it is useful to discuss this as it is an essential factor in real capitalist economies. Indeed, without it capitalist economies would not have grown as fast as they have. Credit is fundamental to capitalism, in other words.

There are two main approaches to the question of eliminating state control of money in "free market" capitalist economics -- Monetarism and what is often called "free banking." We will take each in turn (a third possible "solution" is to impose a 100% gold reserve limit for banks, but as this is highly interventionist, and so not laissez-faire, simply impossible as there is not enough gold to go round and has all the problems associated with inflexible money regimes we highlight below, we will not discuss it).

Monetarism was very popular in the 1970s and is associated with the works of Milton Friedman. It is far less radical that the "free banking" school and argues that rather than abolish state money, its issue should be controlled. Friedman stressed, like most capitalist economists, that monetary factors are the important feature in explaining such problems of capitalism as the business cycle, inflation and so on. This is unsurprising, as it has the useful ideological effect of acquitting the inner-workings of capitalism of any involvement in such problems. Slumps, for example, may occur, but they are the fault of the state interfering in the economy. This is how Friedman explains the Great Depression of the 1930s in the USA, for example (see his "The Role of Monetary Policy" in American Economic Review, March, 1968). He also explains inflation by arguing it was a purely monetary phenomenon caused by the state printing more money than required by the growth of economic activity (for example, if the economy grew by 2% but the money supply increased by 5%, inflation would rise by 3%). This analysis of inflation is deeply flawed, as we will see.

Thus Monetarists argued for controlling the money supply, of placing the state under a "monetary constitution" which ensured that the central banks be required by law to increase the quantity of money at a constant rate of 3-5% a year. This would ensure that inflation would be banished, the economy would adjust to its natural equilibrium, the business cycle would become mild (if not disappear) and capitalism would finally work as predicted in the economics textbooks. With the "monetary constitution" money would become "depoliticised" and state influence and control over money would be eliminated. Money would go back to being what it is in neo-classical theory, essentially neutral, a link between production and consumption and capable of no mischief on its own.

Unfortunately for Monetarism, its analysis was simply wrong. Even more unfortunately for both the theory and vast numbers of people, it was proven wrong not only theoretically but also empirically. Monetarism was imposed on both the USA and the UK in the early 1980s, with disastrous results. As the Thatcher government in 1979 applied Monetarist dogma the most whole-heartedly we will concentrate on that regime (the same basic things occurred under Reagan as well).

Firstly, the attempt to control the money supply failed, as predicted in 1970 by the radical Keynesian Nicholas Kaldor (see his essay "The New Monetarism" in Further Essays on Applied Economics, for example). This is because the money supply, rather than being set by the central bank or the state (as Friedman claimed), is a function of the demand for credit, which is itself a function of economic activity. To use economic terminology, Friedman had assumed that the money supply was "exogenous" and so determined outside the economy by the state when, in fact, it is "endogenous" in nature (i.e. comes from within the economy). This means that any attempt to control the money supply will fail. Charles P. Kindleburger comments:

The experience of the Thatcher and Reagan regimes indicates this well. The Thatcher government could not meet the money controls it set -- the growth was 74%, 37% and 23% above the top of the ranges set in 1980 [Ian Gilmore, Dancing With Dogma, p. 22]. It took until 1986 before the Tory government stopped announcing monetary targets, persuaded no doubt by its inability to hit them. In addition, the variations in the money supply also showed that Milton Friedman's argument on what caused inflation was also wrong. According to his theory, inflation was caused by the money supply increasing faster than the economy, yet inflation fell as the money supply increased. As the moderate conservative Ian Gilmore points out, "[h]ad Friedmanite monetarism. . . been right, inflation would have been about 16 per cent in 1982-3, 11 per cent in 1983-4, and 8 per cent in 1984-5. In fact . . . in the relevant years it never approached the levels infallibly predicted by monetarist doctrine." [Op. Cit., p. 52] From an anarchist perspective, however, the fall in inflation was the result of the high unemployment of this period as it weakened labour, so allowing profits to be made in production rather than in circulation (see section C.7.1). With no need for capitalists to maintain their profits via price increases, inflation would naturally decrease as labour's bargaining position was weakened by massive unemployment. Rather than being a purely monetary phenomena as Friedman claimed, it is a product of the profit needs of capital and the state of the class struggle.

It is also of interest to note that even in Friedman's own test of his basic contention, the Great Depression of 1929-33, he got it wrong. Kaldor noted pointed out that "[a]ccording to Friedman's own figures, the amount of 'high-powered money'. . . in the US increased, not decreased, throughout the Great Contraction: in July 1932, it was more than 10 per cent higher than in July, 1929. . . The Great Contraction of the money supply . . . occurred despite this increase in the monetary base." [Op. Cit., pp. 11-12] Other economists also investigated Friedman's claims, with similar result -- "Peter Temin took issue with Friedman and Schwartz from a Keynesian point of view [in the book Did Monetary Forces Cause the Great Depression?]. He asked whether the decline in spending resulted from a decline in the money supply or the other way round. . . [He found that] the money supply not only did not decline but actually increased 5 percent between August 1929 and August 1931. . . Temin concluded that there is no evidence that money caused the depression between the stock market crash and. . . September 1931." [Charles P. Kindleburger, Op. Cit., p. 60]

In other words, causality runs from the real economy to money, not vice versa, and fluctuations in the money supply results from fluctuations in the economy. If the money supply is endogenous, and it is, this would be expected. Attempts to control the money supply would, of necessity, fail and the only tool available would take the form of raising interest rates. This would reduce inflation, for example, by depressing investment, generating unemployment, and so (eventually) slowing the growth in wages. Which is what happened in the 1980s. Trying to "control" the money supply actually meant increasing interest rates to extremely high levels, which helped produce the worse depression since the end of the war (a depression which Friedman notably failed to predict).

Given the absolute failure of Monetarism, in both theory and practice, it is little talked about now. However, in the 1970s it was the leading economic dogma of the right -- the right which usually likes to portray itself as being strong on the economy. It is useful to indicate that this is not the case. In addition, we discuss the failure of Monetarism in order to highlight the problems with the "free banking" solution to state control of money. This school of thought is associated with the "Austrian" school of economics and right-wing libertarians in general (we also discuss this theory in section F.10.1). It is based on totally privatising the banking system and creating a system in which banks and other private companies compete on the market to get their coins and notes accepted by the general population. This position is not the same as anarchist mutual banking as it is seen not as a way of reducing usury to zero but rather as a means of ensuring that interest rates work as they are claimed to do in capitalist theory.

The "free banking" school argues that under competitive pressures, banks would maintain a 100% ratio between the credit they provide and the money they issue with the reserves they actually have (i.e. market forces would ensure the end of fractional reserve banking). They argue that under the present system, banks can create more credit than they have funds/reserves available. This pushes the rate of interest below its "natural rate" (i.e. the rate which equates savings with investment). Capitalists, mis-informed by the artificially low interest rates invest in more capital intensive equipment and this, eventually, results in a crisis, a crisis caused by over-investment ("Austrian" economists term this "malinvestment"). If banks were subject to market forces, it is argued, then they would not generate credit money, interest rates would reflect the real rate and so over-investment, and so crisis, would be a thing of the past.

This analysis, however, is flawed. We have noted one flaw above, namely the problem that interest rates do not provide sufficient or correct information for investment decisions. Thus relative over-investment could still occur. Another problem follows on from our discussion of Monetarism, namely the endogenous nature of money and the pressures this puts on banks. The noted post-keynesian economist Hyman Minsky created an analysis which gives an insight into why it is doubtful that even a "free banking" system would resist the temptation to create credit money (i.e. loaning more money than available savings). This model is often called "The Financial Instability Hypothesis."

Let us assume that the economy is going into the recovery period after a crash. Initially firms would be conservative in their investment while banks would lend within their savings limit and to low-risk investments. In this way the banks do ensure that the interest rate reflects the natural rate. However, this combination of a growing economy and conservatively financed investment means that most projects succeed and this gradually becomes clear to managers/capitalists and bankers. As a result, both managers and bankers come to regard the present risk premium as excessive. New investment projects are evaluated using less conservative estimates of future cash flows. This is the foundation of the new boom and its eventual bust. In Minsky's words, "stability is destabilising."

As the economy starts to grow, companies increasingly turn to external finance and these funds are forthcoming because the banking sector shares the increased optimism of investors. Let us not forget that banks are private companies too and so seek profits as well. Providing credit is the key way of doing this and so banks start to accommodate their customers and they have to do this by credit expansion. If they did not, the boom would soon turn into slump as investors would have no funds available for them and interest rates would increase, thus forcing firms to pay more in debt repayment, an increase which many firms may not be able to do or find difficult. This in turn would suppress investment and so production, generating unemployment (as companies cannot "fire" investments as easily as they can fire workers), so reducing consumption demand along with investment demand, so deepening the slump.

However, due to the rising economy bankers accommodate their customers and generate credit rather than rise interest rates. In this way they accept liability structures both for themselves and for their customers "that, in a more sober expectational climate, they would have rejected." [Minsky, Inflation, Recession and Economic Policy, p. 123] The banks innovate their financial products, in other words, in line with demand. Firms increase their indebtedness and banks are more than willing to allow this due to the few signs of financial strain in the economy. The individual firms and banks increase their financial liability, and so the whole economy moves up the liability structure.

However, eventually interest rates rise (as the existing extension of credit appears too high) and this affects all firms, from the most conservative to the most speculative, and "pushes" them up even higher up the liability structure (conservative firms no longer can repay their debts easily, less conservative firms fail to pay them and so on). The margin of error narrows and firms and banks become more vulnerable to unexpected developments, such a new competitors, strikes, investments which do not generate the expected rate of return, credit becoming hard to get, interest rates increase and so on. In the end, the boom turns to slump and firms and banks fail.

The "free banking" school reject this claim and argue that private banks in competition would not do this as this would make them appear less competitive on the market and so customers would frequent other banks (this is the same process by which inflation would be solved by a "free banking" system). However, it is because the banks are competing that they innovate -- if they do not, another bank or company would in order to get more profits. This can be seen from the fact that "[b]ank notes. . . and bills of exchange. . . were initially developed because of an inelastic supply of coin" [Kindleburger, Op. Cit., p. 51] and "any shortage of commonly-used types [of money] is bound to lead to the emergence of new types; indeed, this is how, historically, first bank notes and the chequing account emerged" [Kaldor, Op. Cit., p. 10]

This process can be seen at work in Adam Smith's The Wealth of Nations. Scotland in Smith's time was based on a competitive banking system and, as Smith notes, they issued more money than was available in the banks coffers:

In other words, the competitive banking system did not, in fact, eliminate fractional reserve banking. Ironically enough, Smith noted that "the Bank of England paid very dearly, not only for its own imprudence, but for the much greater imprudence of almost all of the Scotch [sic!] banks." [Op. Cit., p. 269] Thus the central bank was more conservative in its credit generation than the banks under competitive pressures! Indeed, Smith argues that the banking companies did not, in fact, act in line with their interests as assumed by the "free banking" school:

Thus we have reserve banking plus bankers acting in ways opposed to their "particular interest" (i.e. what economics consider to be their actual self-interest rather than what the bankers actually thought was their self-interest!) in a system of competitive banking. Why could this be the case? Smith mentions, in passing, a possible reason. He notes that "the high profits of trade afforded a great temptation to over-trading" and that while a "multiplication of banking companies. . . increases the security of the public" by forcing them "to be more circumspect in their conduct" it also "obliges all bankers to be more liberal in their dealings with their customers, lest their rivals should carry them away." [Op. Cit., p. 274, p. 294]

Thus "free banking" is pulled in two directions at once, to accommodate their customers while being circumspect in their activities. Which factor prevails would depend on the state of the economy, with up-swings provoking liberal lending (as described by Minsky). Moreover, given that the "free banking" school argues that credit generation produces the business cycle, it is clear from the case of Scotland that competitive banking does not, in fact, stop credit generation (and so the business cycle, according to "Austrian" theory). This also seemed the case with 19th century America, which did not have a central bank for most of that period -- "the up cycles were also extraordinary [like the busts], powered by loose credit and kinky currencies (like privately issued banknotes)." [Doug Henwood, Wall Street, p. 94]

Most "free banking" supporters also argue that regulated systems of free banking were more unstable than unregulated. Perhaps this is the case, but that implies that the regulated systems could not freely accommodate their customers by generating credit and the resulting inflexible money regime created problems by increasing interest rates and reducing the amount of money available, which would result in a slump sooner rather than later. Thus the over supply of credit, rather than being the cause of the crisis is actually a symptom. Competitive investment also drives the business-cycle expansion, which is allowed and encouraged by the competition among banks in supplying credit. Such expansion complements -- and thus amplifies -- other objective tendencies towards crisis, such as over-investment and disportionalities.

In other words, a pure "free market" capitalist would still have a business cycle as this cycle is caused by the nature of capitalism, not by state intervention. In reality (i.e. in "actually existing" capitalism), state manipulation of money (via interest rates) is essential for the capitalist class as it is more related to indirect profit-generating activity, such as ensuring a "natural" level of unemployment to keep profits up, an acceptable level of inflation to ensure increased profits, and so forth, as well as providing a means of tempering the business cycle, organising bailouts and injecting money into the economy during panics. If state manipulation of money caused the problems of capitalism, we would not have seen the economic successes of the post-war Keynesian experiment or the business cycle in pre-Keynesian days and in countries which had a more free banking system (for example, nearly half of the late 19th century in the US was spent in periods of recession and depression, compared to a fifth since the end of World War II).

It is true that all crises have been preceded by a speculatively-enhanced expansion of production and credit. This does not mean, however, that crisis results from speculation and the expansion of credit. The connection is not causal in free market capitalism. The expansion and contraction of credit is a mere symptom of the periodic changes in the business cycle, as the decline of profitability contracts credit just as an increase enlarges it.

In short, the apologists of "free market" capitalism confuse the symptoms for the disease.

Where there is no profit to be had, credit will not be sought. While extension of the credit system "can be a factor deferring crisis, the actual outbreak of crisis makes it into an aggravating factor because of the larger amount of capital that must be devalued." [Paul Mattick, Economic Crisis and Crisis Theory, p. 138] But this is also a problem facing private companies using the gold standard, as advocated by right-wing Libertarians (who are supporters of "free market" capitalism and banking). The money supply reflects the economic activity within a country and if that supply cannot adjust, interest rates rise and provoke a crisis. Thus the need for a flexible money supply (as desired, for example, by the US Individualist Anarchists). As Adam Smith pointed out, "the quantity of coin in every country is regulated by the value of the commodities which are to be circulated by it: increase that value and . . . the additional quantity of coin requisite for circulating them [will be found]." [Op. Cit., p. 385]

Token money came into being because commodity money proved to be too inflexible for this to occur, as "the expansion of production or trade unaccompanied by an increase in the amount of money must cause a fall in the price level. . . Token money was developed at an early date to shelter trade from the enforced deflations that accompanied the use of specie when the volume of business swelled. . . Specie is an inadequate money just because it is a commodity and its amount cannot be increased at will. The amount of gold available may be increased by a few per cent a year, but not by as many dozen within a few weeks, as might be required to carry out a sudden expansion of transactions. In the absence of token money business would have to be either curtailed or carried on at very much lower prices, thus inducing a slump and creating unemployment." [Karl Polyani, The Great Transformation, p. 193]

To sum up, "[i]t is not credit but only the increase in production made possible by it that increases surplus value. It is then the rate of exploitation which determines credit expansion." [Paul Mattick, Economics, Politics and the Age of Inflation, p. 18] Hence token money would increase and decrease in line with capitalist profitability, as predicted in capitalist economic theory. But this could not affect the business cycle, which has its roots in production for capital (i.e. profit) and capitalist authority relations, to which the credit supply would obviously be tied, and not vice versa.

C.8.1 Does this mean that Keynesianism works?

C.8.2 What happened to Keynesianism in the 1970s?

In other words, post-war Keynesianism failed simply because it could not, in the long term, stop the subjective and objective pressures which capitalism always faces.

C.8.3 How did capitalism adjust to the crisis in Keynesianism?

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C.8 Is state control of money the cause of the business cycle?

C.8.1 Does this mean that Keynesianism works?

C.8.2 What happened to Keynesianism in the 1970s?

C.8.3 How did capitalism adjust to the crisis in Keynesianism?