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C.8 Is state control of credit the cause of the business cycle?
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<h1>C.8 Is state control of money the cause of the business cycle?</h1> 

<p>
As explained in the <a href="secC7.html">last section</a>, 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 <i>"stagflation."</i> 
However, for supporters of the free market, this conclusion 
is unacceptable and so they usually try to explain the business 
cycle in terms of <b>external</b> 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.
</p><p>
First it should be noted that many supporters of capitalism ignore the
"subjective" pressures on capitalism that we discussed in 
<a href="secC7.html#secc71">section C.7.1</a>. In addition, the problems associated with rising capital 
investment (as highlighted in <a href="secC7.html#secc73">section C.7.3</a>) 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 <a href="secC7.html#secc72">section C.7.2</a>. It is here, in the market for credit
and money, that the role of the state comes into play, distorting
the natural workings of the market and causing the ups and downs
of business.
</p><p>
In pre-Keynesian bourgeois economics, the reason why Say's Law is
applicable in a money economy is the interest rate. As we discussed
in <a href="secC2.html#secc26">section C.2.6</a>, this is claimed to reflect the <i>"time preference"</i> of
individuals. While it is possible for sales not to be turned into
purchases in the market, the money involved is not withdrawn from the
economy. Rather, it is saved and made available to investors. The 
interest rate is the means by which savings and investment come into
line. This means that Say's Law is maintained as savings are used to 
purchase capital goods and so demand and supply match. As long as 
interest rates are working as they should, the possibility of a general
crisis is impossible. The problem is that the credit system does not 
work exactly as it claimed and this lies with the banks who introduce 
fractional reserve banking. This allows them to loan out more money than 
they have in savings in order to increase their profits. This lowers the
rate of interest below its <i>"natural"</i> (or equilibrium) rate and thus 
firms get price signals which do not reflect the wishes of consumers
for future goods rather than current ones. This causes over-investment 
and, ultimately, a crisis. This is because, eventually, interest rates 
must rise and projects which were profitable at the lower rate of 
interest will no longer be so. The moral of the theory is that if the actual rate of 
interest equalled the <i>"natural"</i> rate then a situation of <i>"neutral"</i> 
money would be achieved and so misdirections of production would be 
avoided, so ending the business cycle.
</p><p>
As far as capitalist economics had a theory of the business cycle, this
was it and it was the dominant ideological position within the profession 
until publication of Keynes' <b>The General Theory of Employment, Interest 
and Money</b> in 1936. Politically, it was very useful as it recommended that 
the state should do nothing during the crisis and this was the preferred 
position of right-wing governments in America and Britain. It was forcefully 
argued by "Austrian" economist Frederick von Hayek during the early 1930s,
who was repeating the earlier arguments of his mentor Ludwig von Mises
and has been repeated by their followers ever since. Yet, for some strange
reason, they almost always fail to mention that Hayek was roundly 
defeated in the theoretical battles of the time by Keynesians. In fact,
his former students (including John Hicks and Nicholas Kaldor) showed 
how Hayek's theory was flawed and he gave up business cycle research in the early
1940s for other work. Kaldor's first critique (<i>"Capital Intensity and
the Trade Cycle"</i>), for example, resulted in Hayek completed rewriting
his theory while Kaldor's second article (<i>"Professor Hayek and the 
Concertina-effect"</i>) showed that Hayek's Ricardo Effect was only possible 
under some very special circumstances and so highly unlikely. [Kaldor,
<b>Essays on Economic Stability and Growth</b>, pp. 120-147 and pp. 148-176]
</p><p>
Kaldor's critique was combined with an earlier critique by Piero Sraffa
who noted that Hayek's desire for <i>"neutral"</i> money was simply impossible
in any real capitalist economy for <i>"a state of things in which money is 
'neutral' is identical with a state in which there is no money at all."</i> 
Hayek <i>"completely ignored"</i> the fact that <i>"money is not 
only the medium of exchange, but also a store of value"</i> which <i>"amounts
to assuming away the very object of the inquiry."</i> Sraffa also noted that 
the starting point of Hayek's theory was flawed: <i>"An essential confusion
. . . is the belief that the divergence of rates is a characteristic of a
money economy . . . If money did not exist, and loans were made in terms of 
all sorts of commodities, there would be a single rate which satisfies the 
conditions of equilibrium, but there might be at any moment as many 'natural' 
rates of interest as there are commodities, though they would not be 
'equilibrium' rates. The 'arbitrary' action of the banks is by no means a 
necessary condition for the divergence; if loans were made in wheat and farmers
(or for that matter the weather) 'arbitrarily changed' the quantity of
wheat produced, the actual rate of interes on loans in terms of wheat would
diverge from the rate on other commodities and there would be no single
equilibrium rate."</i> [<i>"Dr. Hayek on Money and Capital,"</i> 
pp. 42-53, <b>The Economic Journal</b>, vol. 42, no. 165, p. 42, pp. 43-4 and 
p. 49] Hayek admitted that this was a possibility, to which Sraffa replied:
</p><p><blockquote>
<i>"only under conditions of equilibrium would there be a single rate, and 
that when saving was in progress there would be at any one moment be many 
'natural' rates, possibly as many as there are commodities; so that it 
would be not merely difficult in practice, but altogether inconceivable, 
that the money rate would be equal to 'the' natural rate . . . Dr. Hayek now 
acknowledges the multiplicity of the 'natural' rates, but he has nothing more 
to say on this specific point than that they 'all would be equilibrium rates.' 
The only meaning (if it be a meaning) I can attach to this is that his maxim 
of policy now requires that the money rate should be equal to all these
divergent natural rates."</i> [<i>"A Rejoinder,"</i> pp. 249-251, 
<b>Op. Cit.</b> Vol. 42, No. 166, p. 251]
</blockquote></p><p>
Then there was the practical suggestions that flowed from the analysis,
namely do nothing. It also implied that the best thing to do in a recession 
or depression is not to spend, but rather to save as this will bring the 
savings and loans back into the equilibrium position. Economist R. F. Kahn
recounted when Hayek presented his theory at a seminar in Cambridge University. 
His presentation was followed by silence. Then Kahn asked the obvious question: 
<i>"Is it your view that if I went out tomorrow and bought a new overcoat, that 
would increase unemployment?"</i> All that Hayek could offer in reply was the 
unconvincing claim that to show why would require a complicated mathematical 
argument. The notion that reducing consumption in a depression was the best
thing to do convinced few people and the impact of such saving should be 
obvious, namely a collapse in demand for goods and services. Any savings 
would, in the circumstances of a recession, be unlikely to be used for 
investing. After all, which company would start increasing its capital 
stock facing a fall in demand and which capitalist would venture to create 
a new company during a depression? Unsurprisingly, few economists thought that 
advocating a deflationary policy in the midst of the most severe economic 
crisis in history made much sense. It may have been economic orthodoxy but 
making the depression worse in order to make things better would have ensured 
either the victory of fascism or some-sort of socialist revolution. 
</p><p>
Given these practical considerations and the devastating critiques inflicted
upon it, Keynesian theory became the dominant theme in economics (particularly 
once it had been lobotomised of any ideas which threatened neo-classical 
supremacy -- see <a href="secC8.html#secc81">section C.8.1</a>). This has not, 
as noted, stopped Hayek's followers repeating his theory to this day (nor has 
its roots in equilibrium theory bothered them -- see 
<a href="secC1.html#secc16">section C.1.6</a>). Bearing this in mind, it is
useful to discuss this theory because it reflects the pre-Keynesian orthodoxy
although we must stress that our discussion of "Austrian" economics here should not be taken as suggesting 
that they are a significant school of thought or that their influence is large. 
Far from it -- they still remain on the sidelines of economics where they were
pushed after von Hayek's defeat in the 1930s. We use them simply because they
are the only school of thought which still subscribes fully to the pre-Keynesian
position. Most modern neo-classical economists pay at least lip-service to Keynes.
</p><p>
Take, for example, "Austrian" economist W. Duncan Reekie's argument that the 
business cycle <i>"is generated by monetary expansion and contraction . . . When 
new money is printed it appears as if the supply of savings has increased. 
Interest rates fall and businessmen are misled into borrowing additional 
funds to finance extra investment activity."</i> This would be of <i>"no consequence"</i> 
if it had been the outcome of genuine saving <i>"but the change was government 
induced . . . Capital goods industries will find their expansion has been in 
error and malinvestments have been incurred"</i> and so there has been <i>"wasteful 
mis-investment due to government interference with the market."</i> [<b>Markets, 
Entrepreneurs and Liberty</b>, pp. 68-9] 
</p><p>
Yet the government does <b>not</b> force banks to make excessive loans and this
is the first, and most obvious, fallacy of argument. After all, what Reekie
is actually complaining about when he argues that <i>"state action"</i> creates 
the business cycle by creating excess money is that the state <b>allows</b> bankers 
to meet the demand for credit by creating it. This makes sense, for how could 
the state force bankers to expand credit by loaning more money than they 
have savings? This is implicitly admitted when Reekie argues that <i>"[o]nce 
fractional reserve banking is introduced, however, the supply of money 
substitutes will include fiduciary media. The ingenuity of bankers, other 
financial intermediaries and the endorsement and <b>guaranteeing of their 
activities by governments and central banks</b> has ensured that the quantity 
of fiat money is immense."</i> [<b>Op. Cit.</b>, p. 73] As we will discuss in detail
below what is termed <i>"credit money"</i> (created by banks) is an essential 
part of capitalism and would exist without a system of central banks. This 
is because money is created from within the system, in response to the needs 
of capitalists. In a word, the money supply is endogenous. 
</p><p>
The second fallacy of this theory of the business cycle lies with the 
assumption that the information provided by the interest rate itself is
sufficient in itself to ensure rational investment decisions, it that 
provides companies and individuals with accurate 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. As John O'Neill argues,
the argument assumes <i>"that information about the panned responses of
producers in competition is indirectly distributed by changes in 
interest rates: the planned increase in production by separate 
producers is reflected in an increased demand for credit, and hence 
a rise in interest rates."</i> [<b>The Market</b>, p. 135]
</p><p>
For example, if the price of tin rises, this will lead to an expansion in 
investment in the tin industry to reap the higher profits this implies. 
This would lead to a rise in interest rates as more credit is demanded. 
This rise in interest rates lowers anticipated profits and dampens the 
expansion. The expansion of credit stops this process by distorting the 
interest rate and so stops it performing its economic function. This 
results in overproduction as interest rates 
do not reflect <b>real</b> 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 "natural" 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
as the credit system, if working correctly, will communicate all the
relevant information required by capitalists. 
</p><p>
<i>"However,"</i> argues O'Neil, <i>"this argument is flawed. It is not clear that 
the relevant information is communicated by changes in interest rates."</i>
This is because interest rates reflect the general aggregate demand for 
credit in an economy. However, the information which a <b>specific</b> company 
requires <i>"if the over-expansion in the production of some good is to be
avoided is not the general level of demand for credit, but the level of
demand amongst competitors."</i> It does not provide the relative demands 
in different industries (the parallels with Sraffa's critique should be
obvious). <i>"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 group is identical with that found in the economy 
as a whole, i.e. if rates of change in the demand for credit are even
throughout an economy. However, there is no reason to suppose such an 
assumption is true, given the different production cycles of different 
industries."</i> This will produce differing needs for credit (in both terms 
of amount and of intensity). <i>"Assuming uneven changes in the demand for 
credit"</i> between industries reflecting uneven changes in their requirements
it is quite possible for over-investment (and so over-production) to occur
<i>"even if the credit system is working 'satisfactorily'"</i> (i.e., as it should 
in theory. The credit system, therefore, <i>"does not communicate the relevant 
information"</i> and for this reason <i>"it is not the case that we must look
to a departure from an ideal credit system to explain the business cycle."</i> 
[<b>Op. Cit.</b>, pp. 135-6] 
</p><p>
Another underlying assumption in this argument is that the economy is close to
equilibrium (a concept which "Austrian" economists claim to reject). After
all, rising interest rates will cause debt-servicing to become harder even 
if it reflects the <i>"natural"</i> rate. Equally, it also suggests that both banks
and firms are capable of seeing into the future. For even <b>if</b> the credit
market is working as postulated in the theory it does not mean that firms 
and banks do not make mistakes nor experience unexpected market situations. 
In such circumstances, firms may find it impossible to repay loans, credit
chains may start to break as more and more firms find themselves in 
economic difficulties. Just because actual interest rates somehow equal the 
natural rate does not make the future any more certain nor does it ensure
that credit is invested wisely. Crucially, it does not ensure that credit
is not used to inflate a bubble or add to over-investment in a specific
sector of the economy. To assume otherwise suggests the firms and banks
rarely make mistakes and that the accumulative impact of all decisions 
move an economy always towards, and never away from, equilibrium. As 
Post-Keynesian Paul Davidson dryly noted, <i>"Austrian subjectivists cannot 
have it both ways -- they cannot argue for the importance of time, 
uncertainty, and money, and simultaneously presume that plan or pattern 
co-ordination must exist and is waiting to be discovered."</i></i> [<i>"The economics 
of ignorance or the ignorance of economics?"</i>, pp. 467-87, <b>Critical 
Review</b>, vol. 3, no. 3-4, p. 468] 
</p><p>
In other words, the notion that if the actual interest rate somehow 
equalled the <i>"natural"</i> one is not only rooted in equilibrium but also 
the neo-classical notion of perfect knowledge of current and future 
events -- all of which "Austrian" economists are meant to reject. This
can be seen when Murray Rothbard states that entrepreneurs <i>"are trained
to forecast the market correctly; they only make mass errors when 
governmental or bank intervention distorts the 'signals' of the market."</i>
He even attacks Joseph Schumpeter's crisis theory because, in effect, Schumpeter
does not show how entrepreneurs cannot predict the future (<i>"There is no
explanation offered on the lack of accurate forecasting . . . why were
not the difficulties expected and discounted?"</i>). [<b>America's Great 
Depression</b>, p. 48 and p. 70] Rothbard does not ponder why bankers, 
who are surely entrepreneurs as well, make <b>their</b> errors nor why the 
foresight of business people in an uncertain and complex economy seems 
to fail them in the face of repeated actions of banks (which they could, 
surely, have <i>"expected and discounted"</i>). This means that the argument 
concerning distortions of the interest rate does not, as such, explain the 
occurrence of over-investment (and so the business cycle). Therefore, 
it cannot be claimed that removing state interference in the market 
for money will also remove the business-cycle. 
</p><p>
However, these arguments do have an element of truth in them. Expansion 
of credit above the <i>"natural"</i> level which equates it with savings can 
and does allow capital to expand further than it otherwise would and so 
<b>encourages</b> over-investment (i.e. it builds upon trends already present 
rather than <b>creating</b> 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 and this is the last fallacy in the pre-Keynesian argument. 
In a real economy, it is the most important. Even assuming that the actual 
rate of interest <b>could</b> 
always equal the equilibrium rate and that it reflected the natural rate 
of all commodities and all industries, it would not matter as banks would 
always seek to make profits by extending credit and so artificially lower 
the actual interest rate during booms. To understand why, we need to explain
the flaws in the main laissez-faire approaches to money.
</p><p>
There are three main approaches to the question of eliminating state 
control of money in "free market" capitalist economics -- Monetarism, 
the 100% gold reserve limit for banks and what is often called "free 
banking." All three are associated with the right and all three are 
wrong. The first two are easy to dismiss. Monetarism has been tried and 
has failed spectacularly in the early 1980s. As it was a key aspect of the
neo-liberal war on working class people at this time we will discuss its
limitations as part of our account of this period in 
<a href="secC8.html#secc83">section C.8.3</a>. 
</p><p>
The second option, namely imposing a 100% gold reserve limit for banks is 
highly interventionist and so not remotely laissez-faire (why should the
banking industry be subject to state regulation unlike the rest?). Its 
logic is simple, namely to ensure that banks do not make loans unless 
they have sufficient savings to cover them all. In other words, it seeks 
to abolish the credit cycle by abolishing credit by making banks keep 100% 
gold reserves against notes. This, in effect, abolishes banking as an 
industry. Simply put (and it seems strange to have to point this out to 
supporters of capitalism) banks seek to make a profit and do so by providing 
credit. This means that any capitalist system will be, fundamentally, one 
with credit money as banks will always seek to make a profit on the spread
between loan and deposit rates. It is a necessity for the banking system and
so non-fractional banking is simply not possible. The requirement
that banks have enough cash on hand to meet all depositors demand amounts
to the assertion that banks do not lend any money. A 100% reserve system 
is not a reformed or true banking system. It is the abolition of the 
banking system. Without fractional reserves, banks cannot make any loans 
of any kind as they would not be in a position to give their clients their 
savings if they have made loans. Only someone completely ignorant of a 
real capitalist economy could make such a suggestion and, unsurprisingly, 
this position is held by members of the "Austrian" school (particularly 
its minimum state wing).
</p><p>
This leaves "free banking." This school of thought is, again, associated 
with the "Austrian" school of economics and right-wing "libertarians" in 
general. It is advocated by those who seek to eliminate fractional reserve
banking but balk by the regulations required by a 100% gold standard (Rothbard 
gets round this by arguing this standard <i>"would be part and parcel of the 
general libertarian legal prohibition against fraud."</i> [<b>Op. Cit.</b>, p. 32]). 
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, it
must be stressed, 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.
</p><p>
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. They argue that under the 
present system, banks can create more credit than they have funds/reserves 
available as the state exists as lender of last resort and so banks will
count on it to bail them out in bad times. Market forces would ensure the 
end of fractional reserve banking and stop them pushing the rate of interest 
below its "natural rate." So 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. Knowing that the state would not step in to save them
will also force banks to be prudent in their activities.
</p><p>
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 is the endogenous nature of money 
and credit and the pressures this puts on banks. As Steve Keen notes, 
Austrian economists think that <i>"the current system of State money means 
that the money supply is entirely exogenous and under the control of 
the State authorities. They then attribute much of the cyclical behaviour 
of the economy to government meddling with the money supply and the 
rate of interest."</i> In contrast, Post-Keynesian economists argue that 
<i>"though it may appear that the State controls the money supply, the 
complex chain of causation in the finance sector actually works 
backwards"</i> with <i>"private banks and other credit-generating institutions 
largely forc[ing] the State's hand. Thus the money supply is largely 
endogenously determined by the market economy, rather than imposed 
upon it exogenously by the State."</i> He notes that the <i>"empirical record 
certainly supports Post-Keynesians rather than Austrians on this point. 
Statistical evidence about the leads and lags between the State-determined 
component of money supply and broad credit show that the latter 'leads' 
the former."</i> [<b>Debunking Economics</b>, p. 303] Moreover, as our discussion 
of the failure of Monetarism will show, central banks could <b>not</b> control 
the money supply when they tried.
</p><p>
To understand why, we need to turn to the ideas of the noted Post-Keynesian 
economist Hyman Minsky. He created an analysis of the finance and credit 
markets 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 usually called 
<i>"The Financial Instability Hypothesis."</i>
</p><p>
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, <i>"stability is destabilising."</i>
</p><p>
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. As Minsky argues, <i>"bankers live in the same 
expectational climate as businessmen"</i> and so <i>"profit-seeking bankers will 
find ways of accommodating their customers . . . Banks and bankers are not 
passive managers of money to lend or to invest; they are in business to maximise 
profits."</i> [quoted by L. Randall Wray, <b>Money and Credit in Capitalist 
Economies</b>, p. 85] Providing credit is the key way of doing this and so 
credit expansion occurs. 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.
</p><p>
To avoid this and to take advantage of 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 
<i>"that, in a more sober expectational climate, they would have rejected."</i> 
[Minsky, <b>Inflation, Recession and Economic Policy</b>, 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. Like other businesses, banks operate in an uncertain 
environment and have no way of knowing whether their actions will increase 
the fragility within the economy or push it into crisis.
</p><p>
The central banks, meanwhile, accommodate the banks activity. They do not and
cannot force them to create credit. Alan Holmes, a senior vice president at the 
New York Federal Reserve, put the process this way:
</p><p><blockquote>
<i>"In the real world, banks extend credit, creating deposits in the process, and 
look for the reserves later. The question then becomes one of whether and how 
the Federal Reserve will accommodate the demand for reserves. In the very short 
run, the Federal Reserve has little or no choice about accommodating that demand, 
over time, its influence can obviously be felt."</i> [quoted by Doug Henwood, <b>Wall 
Street</b>, p. 220]
</blockquote></p><p>
As long as profits exceed debt servicing requirements, the system will continue 
to work. Eventually, though, interest rates rise as the existing extension of 
credit appears too high to the banks or the central bank. This affects all 
firms, from the most conservatively financed to the most speculative, and 
"pushes" them up even higher up the liability structure. Refinancing existing 
debts is made at the higher rate of interest, increasing cash outflows and 
reducing demand for investment as the debt burden increases. Conservatively
financed firms can no longer can repay their debts easily, less conservative 
ones 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 state then intervenes to try and
stop the slump getting worse (with varying degrees of success and failure). 
</p><p>
Thus the generation of credit is a spontaneous
process rooted in the nature of capitalism and is fundamentally endogenous
in nature. This means that the business cycle is an inherent part of capitalism
even if we assume that it is caused purely by disequilibrium in the credit 
market. In other words, it is more than likely that the credit market will be
in disequilibrium like every other market in any real capitalist economy -- and 
for the same reasons. As such, the natural rate of interest relies on concepts
of equilibrium that are not only inconsistent with reality but also with
the broader principles of "Austrian" economic ideology.
</p><p>
The "free banking" school reject this claim and argue that private banks in 
competition would <b>not</b> 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). However, 
it is <b>because</b> the banks are competing that they innovate -- if they do not, 
another bank or company would in order to get more profits. Keynesian economist 
Charles P. Kindleburger comments:
</p><p><blockquote>
<i>"As a historical generalisation, it can be said that every time the authorities 
stabilise or control some quantity of money. . . in moments of euphoria more 
will be produced. Or if the definition of money is fixed in terms of particular 
assets, and the euphoria happens to 'monetise' credit in new ways that are 
excluded from the definition, the amount of money defined in the old way will 
not grow, but its velocity will increase . . . fix any [definition of money] and 
the market will create new forms of money in periods of boom to get round the 
limit."</i> [<b>Manias, Panics and Crashes</b>, p. 48]
</blockquote></p><p>
This can be seen from the fact that <i>"[b]ank notes . . . and bills of exchange 
. . . were initially developed because of an inelastic supply of coin."</i> Thus 
monetary expansion <i>"is systematic and endogenous rather than random and 
exogenous."</i> [Kindleburger, <b>Op. Cit.</b>, p. 51 and p. 150] This means that <i>"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."</i> If the state tries to regulate one form of money,
<i>"lending and borrowing is diverted to other sources."</i> [Nicholas Kaldor, 
<i>"The New Monetarism"</i>, <b>The Essential Kaldor</b>, p. 481 and p. 482] This means
that the notion that abolishing central banking will result in the use of
gold and 100% reverses and so eliminate the business cycle is misplaced:
</p><p><blockquote>
<i>"This view overlooks the fact that the <b>emergence</b> of money-substitutes 
-- whether in the form of bank notes, bank accounts, or credit cards -- 
was a spontaneous process, not planned or regulated 'from above' by some
central authority, and for that reason alone it is impossible to treat 
some arbitrary definition of money (which included specific forms of such 
money-substitutes in the definition of money) as an exogenous variable. 
The emergence of surrogate money was a spontaneous process resulting 
from the development of the banking system; this development brought a 
steady increase in the ratio of money substitutes of 'real' money."</i> 
[Nicholas Kaldor, <b>The Scourge of Monetarism</b>, p. 44f]
</blockquote></p><p>
This process can be seen at work in Adam Smith's time. Then Scotland was 
based on a competitive banking system in which baking firms issued their
own money and maintained their own reverse of gold. Yet, as Smith notes, 
they issued more money than was available in the banks coffers:
</p><p><blockquote>
<i>"Though some of those notes [the banks issued] are continually coming back 
for payment, part of them continue to circulate for months and years together. 
Though he [the banker] has generally in circulation, therefore, notes to the 
extent of a hundred thousand pounds, twenty thousand pounds in gold and silver
may frequently be a sufficient provision for answering occasional demands."</i> 
[<b>The Wealth of Nations</b>, pp. 257-8]
</blockquote></p><p>
In other words, the competitive banking system did not, in fact, eliminate 
fractional reserve banking. Ironically enough, Smith noted that <i>"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."</i> Thus the 
central bank was more conservative in its money and 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 for <i>"had every particular banking company always 
understood and attended to its own particular interest, the circulation never 
could have been overstocked with paper money. But every particular baking 
company has not always understood and attended to its own particular interest, 
and the circulation has frequently been overstocked with paper money."</i> 
Thus we have reserve banking plus bankers acting in ways opposed to their 
<i>"particular interest"</i> (i.e. what economists 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
<i>"the high profits of trade afforded a great temptation to over-trading"</i> 
and that while a <i>"multiplication of banking companies . . . increases the 
security of the public"</i> by forcing them <i>"to be more circumspect in their 
conduct"</i> it also <i>"obliges all bankers to be more liberal in their dealings 
with their customers, lest their rivals should carry them away."</i> [<b>Op. Cit.</b>, 
p. 269, p. 267, p. 274 and p. 294]
</p><p>
Thus the banks were pulled in two directions at once, to accommodate their 
loan customers and make more profits while being circumspect in their 
activities to maintain sufficient reserves for the demands of their 
savers. Which factor prevails would depend on the state of the economy, 
with up-swings provoking liberal lending (as described by Minsky). Moreover, 
given that credit generation is meant to produce the business cycle, it is 
clear from the case of Scotland that competitive banking would not, in 
fact, stop either. This also was the case with 19th century America, which 
did not have a central bank for most of that period and that <i>"left the 
volatile US financial system without any kind of lender of last resort,
but in booms all kinds of funny money passed."</i>  This lead to <i>"thousands
of decentralised banks . . . hoarding reserves"</i> and so <i>"starving the
system of liquidity precisely at the moment it was most badly needed"</i>
while <i>"the up cycles were also extraordinary, powered by loose credit 
and kinky currencies (like privately issued banknotes)."</i> [Doug Henwood, 
<b>Op. Cit.</b>, p. 93 and p. 94] 
</p><p>
As Nicholas Kaldor argued, <i>"the essential function of banks in the creation
of 'finance' (or credit) was well understood by Adam Smith, who . . . 
regarded branch-banking as a most important invention for the enrichment of
society. He described how, as a result of the finance  banks were able to
place at the disposal of producers, the real income of Scotland doubled or
trebled in a remarkably short time. Expressed in Keynesian terms, the 
'finance' provided by banks made it possible to increase investments ahead
of income or savings, and to provide the savings counterpart of the 
investment out of the additional income generated through a multiplier 
process by the additional spending."</i> This process, however, was unstable
which naturally lead to the rise of central banks. <i>"Since the notes issued 
by some banks were found more acceptable than those of others, giving rise 
to periodic payments crises and uncertainty, it was sooner or later everywhere
found necessary to concentrate the right of issuing bank notes in the hands
of a single institution."</i> [<i>"How Monetarism Failed,"</i> <b>Further Essays on
Economic Theory and Policy</b>, p. 181] In addition, from an anarchist 
perspective, no ruling class wants economic instability to undermine 
its wealth and income generating ability (Doug Henwood provides a useful 
summary of this process, and the arguments used to justify it within the 
American ruling class, for the creation of the US Federal Reserve at the 
start of the 20th century. [<b>Wall Street</b>, pp. 92-5]). Nor would 
any ruling class want too easy credit undermining its power over 
the working class by holding down unemployment too long (or allowing 
working class people to create their own financial institutions). 
</p><p>
Thus the over supply of credit, rather than being the <b>cause</b> of the crisis 
is actually a symptom. Competitive investment 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" capitalism 
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 allows 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. Ultimately, 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). 
</p><p>
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 <b>results</b> 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. So while there are some similarities in the
pre-Keynesian/"Austrian" theory and the radical one outlined here, the
key differences are two-fold. Firstly, the pro-capitalist theory argues
that it is possible for capitalist banks <b>not</b> to act, well, like 
capitalists if subject to competition (or regulated enough). This 
seems highly unlikely and fits as badly into their general theories as
the notion that disequilibrium in the credit market is the root of the
business cycle. Secondly, the radical position stresses that the
role of credit reflect deeper causes. Paul Mattick gives the correct 
analysis: 
</p><p><blockquote>
<i>"[M]oney and credit policies can themselves change nothing with 
regard to profitability or insufficient profits. Profits come only 
from production, from the surplus value produced by workers . . . 
The expansion of credit has always been taken as a sign of a coming 
crisis, in the sense that it reflected the attempt of individual 
capital entities to expand despite sharpening competition, and 
hence survive the crisis. . . Although the expansion of credit has
staved off crisis for a short time, it has never prevented it, since
ultimately it is the real relationship between total profits and the 
needs of social capital to expand in value which is the decisive factor, 
and that cannot be altered by credit."</i> [<b>Economics, Politics and the 
Age of Inflation</b>, pp. 17-18]
</blockquote></p><p>
In short, the apologists of capitalism confuse the symptoms for the 
disease. 
</p><p>
The cyclical movements on the real side of the economy will be enhanced 
(both upwards and downwards) by events in its financial side and this may 
result in greater amplitudes in the cycle but the latter does not create 
the former. Where there <i>"is no profit to be had, credit will not be sought."</i> 
While extension of the credit system <i>"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."</i> [Paul Mattick, 
<b>Economic Crisis and Crisis Theory</b>, p. 138] But this is also a problem 
facing competing private companies using the gold standard. 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 Mutualists
and the US Individualist Anarchists).
</p><p>
It must always be remembered that a loan is not like other commodities.
Its exchange value is set by its use value. As its use value lies in
investing and so generating a stream of income, the market rate of interest
is governed by the average expectations of profits for the capitalist class.
Thus credit is driven by its <b>perceived</b> use-value rather than its cost of 
production or the amount of money a bank has. Its possible use value reflects
the prospective exchange-values (prices and profits) it can help produce. 
This means that uncertainty and expectations play a key role in the credit 
and financial markets and these impact on the real economy. This means that 
money can <b>never</b> be neutral and so capitalism will be 
subject to the business cycle and so unemployment will remain a constant 
threat over the heads of working class people. In such circumstances, the 
notion that capitalism results in a level playing field for classes is simply 
not possible and so, except in boom times, working class will be at a 
disadvantage on the labour market.
</p><p>
To sum up, <i>"[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."</i> [Paul Mattick, 
<b>Economics, Politics and the Age of Inflation</b>, p. 18] Hence credit 
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 reflect, and not vice versa.</p>

<h2><a name="secc81">C.8.1 Does this mean that Keynesianism works?</a></h2>

<p>
If state interference in credit generation does not cause the business cycle, 
does that mean Keynesianism capitalism can work? Keynesian economics, as 
opposed to free market capitalism, maintains that the state can and should 
intervene in the economy in order to stop economic crises from occurring. 
Can it work? To begin to answer that question, we must first quickly define
what is meant by Keynesianism as there are different kinds of Keynesianist 
policies and economics.
</p><p>
As far as economics goes, Keynes' co-worker Joan Robinson coined the 
phrase <i>"Bastard Keynesianism"</i> to describe the vulgarisation of his
economics and its stripping of all aspects which were
incompatible with the assumptions of neo-classical economics. Thus 
the key notion of uncertainty was eliminated and his analysis of the
labour market reduced to the position he explicitly rejected, namely 
that unemployment was caused by price rigidities. This process was 
aided by the fact that Keynes retained significant parts of the 
neo-classical position in his analysis and argued that the role of 
the state was limited to creating the overall conditions necessary to 
allow the neo-classical system to come <i>"into its own again"</i> and allow 
capitalism <i>"to realise the full potentialities of production."</i> [<b>The 
General Theory</b>, pp. 378-9] Unlike many of his more radical followers, 
Keynes was blind to real nature of capitalism as a class based system 
and so failed to understand the functional role that unemployment plays 
within it (see <a href="secC5.html#secc15">section C.1.5</a>).
</p><p>
However, the context in which Keynes worked explains much. Faced with 
the dire situation capitalism faced during the 1930s, he presented 
a new theoretical analysis of capitalism that both explained the 
crisis and suggested policies that would, without interfering with 
its general principles, end it. Keynes' work was aided both by the 
practical failure of traditional solutions and growing fear of 
revolution and so even the most died-in-the-wool neo-classical 
economists could not keep his theory from being tried. When it 
appeared to work that, on one level, ended the argument. However, at 
a deeper level, at the level of theory, the struggle was just beginning. 
As  the neo-classical (and Austrian) tradition is axiom-led rather than 
empirically-led (otherwise their axioms would have been abandoned long 
ago), the mere fact that capitalism was in crisis and that Keynes had 
presented a theory more in line with the reality was not enough to 
change mainstream economics. From the start, neo-classical economists 
began their counter-attack. Led by Paul Samuelson in the US and John 
Hicks in the UK, they set about making Keynes' theories safe for 
neo-classical economics. They did this by using mathematics on a part 
of his theory, leaving out all those bits that were inconsistent with 
neo-classical axioms. This bowdlerised version of Keynes soon became the 
standard in undergraduate courses. 
</p><p>
The fate of Keynes reinforces the comment of French revolutionary Louis de 
Saint-Just that <i>"those who make revolution half way only dig their own 
graves."</i> Keynes ideas were only a partial break with the neo-classical 
orthodoxy and, as such, allowed the basis for the neo-classical-Keynesian 
synthesis which dominated post-war economics until the mid-1970s as well as 
giving the Monetarist counter-revolution space to grow. Perhaps this partial 
break is understandable, given the dominance of neo-classical ideas in the 
economics profession it may have been too much to expect them to renounce 
all their dogmas yet it ensured that any developments towards an economics 
based on science rather than ideology would be resigned to the sidelines.
</p><p>
It is important to stress that Keynes was, first and foremost, a
supporter of capitalism. He aimed to save it, not to end it. As he
put it the <i>"<b>class war</b> will find me on the side of the educated 
bourgeoisie."</i> [quoted by Henwood, <b>Wall Street</b>, p. 212] That he 
presented a more accurate picture of capitalism and exposed some of 
the contradictions within neo-classical economics is part of the 
reason he was and is so hated by many on the right, although his 
argument that the state should limit some of the power of individual 
firms and capitalists and redistribute some income and wealth was a 
far more important source of that hatred. That he helped save capitalism 
from itself (and secure their fortunes) did not seem to concern his 
wealthy detractors. They failed to understand Keynes often sounded more
radical than he actually was. Doug Henwood gives a good overview of
Keynes' ideas (and limitations) in chapter 5 of his book <b>Wall Street</b>. 
</p><p>
What of Keynesian policies? The <i>"Bastard Keynesianism"</i> of the post-war period
(for all its limitations) did seem to have some impact on capitalism. This 
can be seen from comparing Keynesianism with what came before. The more 
laissez-faire period was nowhere near as stable as modern day supporters of
free(r) market capitalists like to suggest. There were continual economic 
booms and slumps. The last third of the 19th century (often considered 
as the heyday of private enterprise) was a period of profound instability
and anxiety as it <i>"was characterised by violent booms and busts, in nearly 
equal measure, since almost half the period was one of panic and depression."</i> 
American spent nearly half of the late 19th century in periods of recession 
and depression. By way of comparison, since the end of world war II, only 
about a fifth of the time has been. [Doug Henwood, <b>Wall Street</b>, p. 94
and p. 54] Between 1867 and 1900 there were 8 complete business cycles. 
Over these 396 months, the economy expanded during 199 months and contracted 
during 197. Hardly a sign of great stability. Overall, the economy went into 
a slump, panic or crisis in 1807, 1817, 1828, 1834, 1837, 1854, 1857, 1873, 
1882, and 1893 (in addition, 1903 and 1907 were also crisis years). 
</p><p>
Then there is what is often called the <i>"Golden Age of Capitalism,"</i> the
boom years of (approximately) 1945 to 1975. This post-war boom presents 
compelling evidence that Keynesianism can effect the business cycle for 
the better by reducing its tendency to develop into a full depression.
By intervening in the economy, the state would reduce uncertainty for
capitalists by maintaining overall demand which will, in turn, ensure
conditions where they will invest their money rather than holding onto
it (what Keynes termed <i>"liquidity-preference"</i>). In other words, to
create conditions where capitalists will desire to invest and ensure
the willingness on the part of capitalists to act as capitalists. 
</p><p>
This period of social Keynesianism after the war was marked by reduced
inequality, increased rights for working class people, less unemployment, a 
welfare state you could actually use and so on. Compared to present-day 
capitalism, it had much going for it. However, Keynesian capitalism is still 
capitalism and so is still based upon oppression and exploitation. It was, in 
fact, a more refined form of capitalism, within which the state intervention 
was used to protect capitalism from itself while trying to ensure that 
working class struggle against it was directed, via productivity deals, into 
keeping the system going. For the population at large, the general idea 
was that the welfare state (especially in Europe) was a way for society 
to get a grip on capitalism by putting some humanity into it. In a confused
way, the welfare state was promoted as an attempt to create a society in 
which the economy existed for people, not people for the economy.
</p><p>
While the state has always had a share in the total surplus value produced 
by the working class, only under Keynesianism is this share increased 
and used actively to manage the economy. Traditionally, placing checks on 
state appropriation of surplus value had been one of the aims of classical 
capitalist thought (simply put, cheap government means more surplus value 
available for capitalists to compete for). But as capital has accumulated, 
so has the state increased and its share in social surplus (for control over 
the domestic enemy has to be expanded and society protected from the 
destruction caused by free market capitalism). It must be stressed 
that state intervention was not <b>totally</b> new for <i>"[f]rom its origins, the 
United States had relied heavily on state intervention and protection for 
the development of industry and agriculture, from the textile industry in the 
early nineteenth century, through the steel industry at the end of the century,
to computers, electronics, and biotechnology today. Furthermore, the same has
been true of every other successful industrial society."</i> [Noam Chomsky, 
<b>World Orders, Old and New</b>, p. 101] The difference was that such state
action was directed to social goals as well as bolstering capitalist 
profits (much to the hatred of the right).
</p><p>
The roots of the new policy of higher levels and different forms of state 
intervention lie in two related factors. The Great Depression of the 1930s 
had lead to the realisation that attempts to enforce widespread reductions 
in money wages and costs (the traditional means to overcome depression) 
simply did not work. As Keynes stressed, cutting wages reduced prices and
so left real wages unaffected. Worse, it reduced aggregate demand and lead
to a deepening of the slump (see <a href="secC9.html#secc91">section C.9.1</a> for details). This meant that 
leaving the market to solve its own problems would make things a lot worse
before they became better. Such a policy would, moreover, be impossible 
because the social and economic costs would have been too expensive. Working
class people simply would not tolerate more austerity imposed on them and 
increasingly took direct action to solve their problems. For example, America 
saw a militant strike wave involving a half million workers in 1934, with 
factory occupations and other forms of militant direct action commonplace. It 
was only a matter of time before capitalism was either ended by revolution 
or saved by fascism, with neither prospect appealing to large sections of the 
ruling class. 
</p><p>
So instead of attempting the usual class war (which may have had revolutionary
results), sections of the capitalist class thought a new approach was required. 
This involved using the state to manipulate demand in order to increase the 
funds available for capital. By means of demand bolstered by state borrowing
and investment, aggregate demand could be increased and the slump ended. In
effect, the state acts to encourage capitalists to act like capitalists by
creating an environment when they think it is wise to invest again. As 
Paul Mattick points out, the <i>"additional production made possible by deficit 
financing does appear as additional demand, but as demand unaccompanied by a 
corresponding increase in total profits. . . [this] functions immediately as 
an increase in demand that stimulates the economy as a whole and can become 
the point for a new prosperity"</i> if objective conditions allow it. [<b>Economic
Crisis and Crisis Theory</b>, p. 143]
</p><p>
State intervention can, in the short term, postpone crises by stimulating
production. This can be seen from the in 1930s New Deal period under Roosevelt
when the economy grew five years out of seven compared to it shrinking
every year under the pro-laissez-faire Republican President Herbert Hoover
(under Hoover, the GNP shrank an average of -8.4 percent a year, under
Roosevelt it grew by 6.4 percent). The 1938 slump after 3 years of growth
under Roosevelt was due to a decrease in state intervention:
</p><p><blockquote>
<i>"The forces of recovery operating within the depression, as well as the
decrease in unemployment via public expenditures, increased production 
up to the output level of 1929. This was sufficient for the Roosevelt 
administration to drastically reduce public works . . . in a new effort to
balance the budget in response to the demands of the business world. . . 
The recovery proved to be short-lived. At the end of 1937 the Business Index
fell from 110 to 85, bringing the economy back to the state in which it had
found itself in 1935 . . . Millions of workers lost their jobs once again."</i>
[Paul Mattick, <b>Economics, Politics and the Age of Inflation</b>, p. 138]
</blockquote></p><p>
The rush to war made Keynesian policies permanent. With the success of state 
intervention during the second world war, Keynesianism was seen as a way of 
ensuring capitalist survival. The resulting boom is well known, with state 
intervention being seen as the way of ensuring prosperity for all sections 
of society. It had not fully recovered from the Great Depression and 
the boom economy during the war had obviously contrasted deeply with the 
stagnation of the 1930s. Plus, of course, a militant working class, which 
had put up with years of denial in the struggle against fascist-capitalism 
would not have taken lightly to a return to mass unemployment and poverty. 
Capitalism had to turn to continued state intervention as it is not a 
viable system. So, politically and economically a change was required. This 
change was provided by the ideas of Keynes, a change which occurred under 
working class pressure but in the interests of the ruling class.
</p><p>
So there is no denying that for a considerable time, capitalism has been able 
to prevent the rise of depressions which so plagued the pre-war world and 
that this was accomplished by government interventions. This is because 
Keynesianism can serve to initiate a new prosperity and postpone crisis by 
state intervention to bolster demand and encourage profit investment. 
This can mitigate the conditions of crisis, since one of its short-term 
effects is that it offers private capital a wider range of action and an 
improved basis for its own efforts to escape the shortage of profits for 
accumulation. In addition, Keynesianism can fund Research and Development 
in new technologies and working methods (such as automation) which can 
increase profits, guarantee markets for goods as well as transferring
wealth from the working class to capital via indirect taxation and inflation.
In the long run, however, Keynesian <i>"management of the economy by means of 
monetary and credit policies and by means of state-induced production must 
eventually find its end in the contradictions of the accumulation process."</i> 
[Paul Mattick, <b>Op. Cit.</b>, p. 18] This is because it cannot stop the tendency
to (relative) over-investment, disproportionalities and profits squeeze
we outlined in <a href="secC7.html">section C.7</a>. In fact, due to its 
maintenance of full employment it increases the possibility of a crisis 
arising due to increased workers' power at the point of production.
</p><p>
So, these interventions did not actually set aside the underlying causes 
of economic and social crisis. The modifications of the capitalist system 
could not totally countermand the subjective and objective limitations
of a system based upon wage slavery and social hierarchy. This can be seen 
when the rosy picture of post-war prosperity changed drastically in the 
1970s when economic crisis returned with a vengeance, with high unemployment 
occurring along with high inflation. This soon lead to a return to a more 
"free market" capitalism with, in Chomsky's words, <i>"state protection and 
public subsidy for the rich, market discipline for the poor."</i> This process 
and its aftermath are discussed in the <a href="secC8.html#secc82">next section</a>.
</p>

<h2><a name="secc82">C.8.2 What happened to Keynesianism in the 1970s?</a></h2>

<p>
Basically, the subjective and objective limitations to Keynesianism we
highlighted in the <a href="secC8.html#secc81">last section</a> were finally reached in the early 1970s. 
It, in effect, came into conflict with the reality of capitalism as a 
class and hierarchical system. It faced either revolution to increase
popular participation in social, political and economic life (and so
eliminate capitalist power), an increase in social democratic tendencies
(and so become some kind of democratic state capitalist regime) or a 
return to free(r) market capitalist principles by increasing unemployment 
and so placing a rebellious people in its place. Under the name of 
fighting inflation, the ruling class unsurprisingly picked the latter 
option.
</p><p>
The 1970s are a key time in modern capitalism. In comparison to the two
previous decades, it suffered from high unemployment and high inflation
rates (the term stagflation is usually used to describe this). This 
crisis was reflected in mass strikes and protests across the world.
Economic crisis returned, with the state interventions that for so long 
kept capitalism healthy either being ineffective or making the crisis 
worse. In other words, a combination of social 
struggle and a lack of surplus value available to capital resulted in 
the breakdown of the successful post-war consensus. Both subjected the 
<i>"Bastard Keynesianism"</i> of the post-war period to serious political and 
ideological challenges. This lead to a rise in neo-classical economic 
ideology and the advocating of free(r) market capitalism as the solution 
to capitalism's problems. This challenge took, in the main, the form of 
Milton Friedman's Monetarism.
</p><p>
The roots and legacy of this breakdown in Keynesianism are informative and
worth analysing. The post-war period marked a distinct change for capitalism, 
with new, higher levels of state intervention. The mix of intervention 
obviously differed from country to country, based upon the needs and 
ideologies of the ruling parties and social elites as well as the impact
of social movements and protests. In Europe, nationalisation was widespread 
as inefficient capital was taken over by the state and reinvigorated by state 
funding while social spending was more important as Social Democratic parties 
attempted to introduce reforms. Chomsky describes the process in the USA:
</p><p><blockquote>
<i>"Business leaders recognised that social spending could stimulate the
economy, but much preferred the military Keynesian alternative -- for
reasons having to do with privilege and power, not 'economic rationality.'
This approach was adopted at once, the Cold War serving as the justification.
. . . The Pentagon system was considered ideal for these purposes. It extends
well beyond the military establishment, incorporating also the Department of
Energy. . . and the space agency NASA, converted by the Kennedy administration
to a significant component of the state-directed public subsidy to advanced
industry. These arrangements impose on the public a large burden of the
costs of industry (research and development, R&D) and provide a guaranteed
market for excess production, a useful cushion for management decisions.
Furthermore, this form of industrial policy does not have the undesirable
side-effects of social spending directed to human needs. Apart from unwelcome
redistributive effects, the latter policies tend to interfere with managerial
prerogatives; useful production may undercut private gain, while 
state-subsidised waste production. . . is a gift to the owner and manager,
to whom any marketable spin-offs will be promptly delivered. Social
spending may also arouse public interest and participation, thus enhancing
the threat of democracy. . . The defects of social spending do not taint
the military Keynesian alternative. For such reasons, <b>Business Week</b>
explained, 'there's a tremendous social and economic difference between
welfare pump-priming and military pump-priming,' the latter being far
preferable."</i> [<b>World Orders, Old and New</b>, pp. 100-1]
</blockquote></p><p>
Over time, social Keynesianism took increasing hold even in the USA, partly
in response to working class struggle, partly due to the need for popular
support at elections and partly due to <i>"[p]opular opposition to the Vietnam 
war [which] prevented Washington from carrying out a national mobilisation . . . 
which might have made it possible to complete the conquest without harm to 
the domestic economy. Washington was forced to fight a 'guns-and-butter' war 
to placate the population, at considerable economic cost."</i> [Chomsky, <b>Op. Cit.</b>, 
pp. 157-8]
</p><p>
Social Keynesianism directs part of the total surplus value to workers
and unemployed while military Keynesianism transfers surplus value from
the general population to capital and from capital to capital. This allows
R&D and capital to be publicly subsidised, as well as essential but 
unprofitable capital to survive. As long as real wages did not exceed a 
rise in productivity, Keynesianism would continue. However, both functions 
have objective limits as the transfer of profits from successful capital to 
essential, but less successful, or long term investment can cause a crisis 
is there is not enough profit available to the system as a whole. The 
surplus value producing capital, in this case, would be handicapped due 
to the transfers and cannot respond to economic problems as freely as 
before. This was compounded by the world becoming economically "tripolar," 
with a revitalised Europe and a Japan-based Asian region emerging as major 
economic forces. This placed the USA under increased pressure, as did the 
Vietnam War. Increased international competition meant the firms were 
limited in how they could adjust to the increased pressures they faced
in the class struggle.
</p><p>
This factor, class struggle, cannot be underestimated. In fact, the main reason 
for the 1970s breakdown was social struggle by working people. The only limit 
to the rate of growth required by Keynesianism to function is the degree to 
which final output consists of consumption goods for the presently employed 
population instead of investment. As long as wages rise in line with 
productivity, capitalism does well and firms invest (indeed, investment is the 
most basic means by which work, i.e. capitalist domination, is imposed). 
However, faced with a workforce which is able to increase its wages and resist 
the introduction of new technologies then capitalism will face a crisis. The 
net effect of full employment was the increased rebellious of the working class 
(both inside and outside the workplace). This struggle was directed against 
hierarchy in general, with workers, students, women, ethnic groups, anti-war 
protesters and the unemployed all organising successful struggles against 
authority. This struggle attacked the hierarchical core of capitalism as well as
increasing the amount of income going to labour, resulting in a profit squeeze 
(see <a href="secC7.html">section C.7</a>). By the 1970s, capitalism and the state could no longer ensure 
that working class struggles could be contained within the system. 
</p><p>
This profits squeeze reflected the rise in inflation. While it has become
commonplace to argue that Keynesianism did not predict the possibility of
exploding inflation, this is not entirely true. While Keynes and the 
mainstream Keynesians failed to take into account the impact of full
employment on class relations and power, his left-wing followers did not.
Influenced by Michal Kalecki, the argued that full employment would impact 
on power at the point of production and, consequently, prices. To quote 
Joan Robinson from 1943:
</p><p><blockquote>
<i>"The first function of unemployment (which has always existed in open or 
disguised forms) is that it maintains the authority of master over man. 
The master has normally been in a position to say: 'If you don't want 
the job, there are plenty of others who do.' When the man can say: 'If 
you don't want to employ me, there are plenty of others who will', the 
situation is radically altered. One effect of such a change might be to 
remove a number of abuses to which the workers have been compelled to 
submit in the past . . . [Another is that] the absence of fear of 
unemployment might go further and have a disruptive effect upon factory 
discipline . . . [He may] us[e] his newly-found freedom from fear to 
snatch every advantage that he can . . .
</p><p>
"The change in the workers' bargaining position which would follow from 
the abolition of unemployment would show itself in another and more 
subtle way. Unemployment . . . has not only the function of preserving 
discipline in industry, but also indirectly the function of preserving the 
value of money . . . there would be a constant upward pressure upon money 
wage-rates . . . the vicious spiral of wages and prices might become 
chronic . . . if it moved too fast, it might precipitate a violent 
inflation."</i> [<b>Collected Economic Papers</b>, vol. 1, pp. 84-5]
</blockquote></p><p>
Thus left-wing Keynesians (who later founded the Post-Keynesian school
of economics) recognised that capitalists <i>"could recoup themselves for 
rising costs by raising prices."</i> [<b>Op. Cit.</b>, p. 85] This perspective
was reflected in a watered-down fashion in mainstream economics by means
of the Philips Curve. When first suggested in the 1958, this was taken
to indicate a stable relationship between unemployment and inflation.
As unemployment fell, inflation rose. This relationship fell apart in
the 1970s, as inflation rose as unemployment rose. 
</p><p>
Neo-classical (and other pro-"free market" capitalist) economics usually 
argues that inflation is purely a monetary phenomenon, the result of there 
being more money in circulation than is needed for the sale of the various 
commodities on the market. This was the position of Milton Friedman and his 
Monetarist school during the 1960s and 1970s. However, this is not true. In 
general, there is no relationship between the money supply and inflation. 
The amount of money can increase while the rate of inflation falls, for 
example (as we will discuss in the <a href="secC8.html#secc83">next section</a>, Monetarism itself
ironically proved there is no relationship). Inflation has other roots, namely 
it is <i>"an expression of inadequate profits 
that must be offset by price and money policies . . . Under any circumstances, 
inflation spells the need for higher profits."</i> [Paul Mattick, <b>Economics, 
Politics and the Age of Inflation</b>, p. 19] Inflation leads to higher profits 
by making labour cheaper. That is, it reduces <i>"the real wages of workers. . . 
[which] directly benefits employers. . . [as] prices rise faster than wages, 
income that would have gone to workers goes to business instead."</i> [J. Brecher 
and T. Costello, <b>Common Sense for Hard Times</b>, p. 120] 
</p><p>
Inflation, in other words, is a symptom of an on-going struggle over
income distribution between classes. It is caused when capitalist profit 
margins are reduced (for whatever reason, subjective or objective) and the
bosses try to maintain them by increasing prices, i.e. by passing costs
onto consumers. This means that it would be wrong to conclude that wage 
increases "cause" inflation as such. To do so ignores the fact that 
workers do not set prices, capitalists do. Any increase in costs could,
after all, be absorbed by lowering profits. Instead working class people
get denounced for being "greedy" and are subjected to calls for "restraint" 
-- in order for their bosses to make sufficient profits! As Joan Robinson
put it, while capitalist economies denies it (unlike, significantly, Adam 
Smith) there is an <i>"inflationary pressure that arises from an increase in 
the share of gross profits in gross income. How are workers to be asked 
to accept 'wage restraint' unless there is a restraint on profits? . . .
unemployment is the problem. If it could be relived by tax cuts, generating 
purchasing power, would not a general cut in profit margins be still more 
effective? These are the questions that all the rigmarole about marginal 
productivity is designed to prevent us from discussing."</i> [<b>Collected 
Economic Papers</b>, vol. 4, p. 134]
</p><p>
Inflation and the response by the capitalist class to it, in their own 
ways, shows the hypocrisy of capitalism. After all, wages are increasing 
due to "natural" market forces of supply and demand. It is the <b>capitalists</b> 
who are trying to buck the market by refusing to accept lower profits 
caused by conditions on it. Obviously, to use Benjamin Tucker's expression, 
under capitalism market forces are good for the goose (labour) but bad for 
the gander (capital). The so-called "wages explosion" of the late 1960s was 
a symptom of this shift in class power away from capital and to labour which 
full employment had created. The growing expectations and aspirations of 
working class people led them not only to demand more of the goods they 
produced, it had start many questioning why social hierarchies were needed in 
the first place. Rather than accept this as a natural outcome of the eternal 
laws of supply and demand, the boss class used the state to create a more 
favourable labour market environment (as, it should be stressed, it has 
always done).
</p><p>
This does not mean that inflation suits all capitalists equally (nor,
obviously, does it suit those social layers who live on fixed incomes and 
who thus suffer when prices increase but such people are irrelevant in the
eyes of capital). Far from it -- during periods of inflation, lenders tend to 
lose and borrowers tend to gain. The opposition to high levels of inflation 
by many supporters of capitalism is based upon this fact and the division 
within the capitalist class it indicates. There are two main groups of 
capitalists, finance capitalists and industrial capitalists. The latter can 
and do benefit from inflation (as indicated above) but the former sees high
inflation as a threat. When inflation is accelerating it can push the real
interest rate into negative territory and this is a horrifying prospect 
to those for whom interest income is fundamental (i.e. finance capital).
In addition, high levels of inflation can also fuel social struggle, as 
workers and other sections of society try to keep their income at a steady
level. As social struggle has a politicising effect on those involved, a
condition of high inflation could have serious impacts on the political 
stability of capitalism and so cause problems for the ruling class.
</p><p>
How inflation is viewed in the media and by governments is an expression 
of the relative strengths of the two sections of the capitalist class and
of the level of class struggle within society. For example, in the 1970s, 
with the increased international mobility of capital, the balance of power 
came to rest with finance capital and inflation became the source of all 
evil. This shift of influence to finance capital can be seen from the rise
of rentier income. The distribution of US manufacturing profits indicate
this process -- comparing the periods 1965-73 to 1990-96, we find that 
interest payments rose from 11% to 24%, dividend payments rose from 
26% to 36% while retained earnings fell from 65% to 40%. Given that
retained earnings are the most important source of investment funds,
the rise of finance capital helps explain why, in contradiction to the
claims of the right-wing, economic growth has become steadily worse 
as markets have been liberalised -- funds that could have been resulted
in real investment have ended up in the finance machine. In addition, 
the waves of strikes and protests that inflation produced had worrying 
implications for the ruling class as they showed a working class able 
and willing to contest their power and, perhaps, start questioning <b>why</b>
economic and social decisions were being made by a few rather than by
those affected by them. However, as the underlying reasons for inflation 
remained (namely to increase profits) inflation itself was only reduced 
to acceptable levels, levels that ensured a positive real interest rate 
and acceptable profits. 
</p><p>
Thus, Keynesianism sowed the seeds of its own destruction. Full employment
had altered the balance of power in the workplace and economy from capital
to labour. The prediction of socialist economist Michal Kalecki that full 
employment would erode social discipline had become true (see 
<a href="secB4.html#secb44">section B.4.4</a>).
Faced with rising direct and indirect costs due to this, firms passed them 
on to consumers. Yet consumers are also, usually, working class and this 
provoked more direct action to increase real wages in the face of inflation. 
Within the capitalist class, finance capital was increasing in strength at 
the expense of industrial capital. Facing the erosion of their loan income, 
states were subject to economic pressures to place fighting inflation above 
maintaining full employment. While Keynes had hoped that <i>"the rentier aspect
of capitalism [was] a transitional phase"</i> and his ideas would lead to <i>"the
euthanasia of the rentier,"</i> finance capital was not so willing to see this
happen. [<b>The General Theory</b>, p. 376] The 1970s saw the influence of an 
increasingly assertive finance capital rise at a time when significant 
numbers within ranks of industrial capitalists were sick of full employment
and wanted compliant workers again. The resulting recessions may have harmed
individual capitalists (particularly smaller ones) but the capitalist class
as a whole did very well of them (and, as we noted in 
<a href="secB2.html">section B.2</a>, one of
the roles of the state is to manage the system in the interests of the 
capitalist class <b>as a whole</b> and this can lead it into conflict with <b>some</b>
members of that class). Thus the maintenance of sufficiently high 
unemployment under the mantra of fighting inflation as the de facto 
state policy from the 1980s onwards (see <a href="secC9.html">section C.9</a>). 
While industrial 
capital might want a slightly stronger economy and a slightly lower rate 
of unemployment than finance capital, the differences are not significant 
enough to inspire major conflict. After all, bosses in any industry <i>"like
slack in the labour market"</i> as it <i>"makes for a pliant workforce"</i> and, of
course, <i>"many non-financial corporations have heavy financial interests."</i>
[Doug Henwood, <b>Wall Street</b>, pp. 123-4 and p. 135]
</p><p>
It was these processes and pressures which came to a head 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. In the 1970s, it was the subjective pressure 
which played the key role, namely social struggle was the fundamental 
factor in economic developments. The system could not handle the struggle
of human beings against the oppression, exploitation, hierarchy and 
alienation they are subject to under capitalism.</p>

<h2><a name="secc83">C.8.3 How did capitalism adjust to the crisis in Keynesianism?</a></h2>

<p>
Basically by using, and then managing, the 1970s crisis to discipline the 
working class in order to reap increased profits and secure and extend the
ruling classes' power. It did this using a combination of crisis, free(r) 
markets and adjusted Keynesianism as part of a ruling elite lead class war 
against labour. 
</p><p>
In the face of crisis in the 1970s, Keynesianist redirection of profits 
between capitals and classes had become a burden to capital as a whole 
and had increased the expectations and militancy of working people to 
dangerous levels. The crisis of the 1970s and early 1980s helped control 
working class power and unemployment was utilised as a means of saving 
capitalism and imposing the costs of free(r) markets onto society as whole. 
The policies implemented were ostensibly to combat high inflation. However, 
as left-wing economist Nicholas Kaldor summarised, inflation may have dropped 
but this lay <i>"in their success in transforming the labour market from a 
twentieth-century sellers' market to a nineteenth-century buyers' market, with 
wholesome effects on factory discipline, wage claims, and proneness to strike."</i> 
[<b>The Scourge of Monetarism</b>, p. xxiii] Another British economist described this
policy memorably as <i>"deliberately setting out to base the viability of the 
capitalist system on the maintenance of a large 'industrial reserve army'
[of the unemployed] . . . [it is] the incomes policy of Karl Marx."</i> [Thomas 
Balogh, <b>The Irrelevance of Conventional Economics</b>, pp. 177-8] The aim, 
in summary, was to swing the balance of social, economic and political power
back to capital and ensure the road to (private) serfdom was followed. The
rationale was fighting inflation.
</p><p>
Initially the crisis was used to justify attacks on working class people 
in the name of the free market. And, indeed, capitalism was made more market 
based, although with a "safety net" and "welfare state" for the wealthy. We 
have seen a partial return to <i>"what economists have called freedom of industry 
and commerce, but which really meant the relieving of industry from the 
harassing and repressive supervision of the State, and the giving to it 
full liberty to exploit the worker, whom was still to be deprived of his 
freedom."</i> The <i>"crisis of democracy"</i> which so haunted the ruling class in
the 1960s and 1970s was overcome and replaced with, to use Kropotkin's words, 
the <i>"liberty to exploit human labour without any safeguard for the victims of 
such exploitation and the political power organised as to assure freedom of 
exploitation to the middle-class."</i> [Kropotkin, <b>The Great French Revolution</b>, 
vol.1, p. 28 and p. 30] 
</p><p>
Fighting inflation, in other words, was simply code used by the ruling 
class for fighting the class war and putting the working class back in 
its place in the social hierarchy. <i>"Behind the economic concept of 
inflation was a fear among elites that they were losing control"</i> as the 
<i>"sting of unemployment was lessened and workers became progressively 
less docile."</i> [Doug Henwood, <b>After the New Economy</b>, p. 204] Milton 
Friedman's Monetarism was the means by which this was achieved. While
(deservedly) mostly forgotten now, Monetarism was very popular in the 1970s 
and was the economic ideology of choice of both Reagan and Thatcher. This 
was the economic justification for the restructuring of capitalism and the
end of social Keynesianism. Its legacy remains to some degree in the 
overriding concern over inflation which haunts the world's central banks
and other financial institutions, but its specific policy recommendations
have been dropped in practice after failing spectacularly when applied (a 
fact which, strangely, was not mentioned in the eulogies from the right
that marked Friedman's death).
</p><p>
According to Monetarism, the problem with capitalism was money related,
namely that the state and its central bank printed too much money and,
therefore, its issue should be controlled. Friedman stressed, like most 
capitalist economists, that monetary factors are <b>the</b> most 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 developments. Slumps, for example, may occur, but 
they are the fault of the state interfering in the economy. Inflation 
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.
This was how Friedman explained the Great Depression of the 1930s in the 
USA, for example (see, for example, his <i>"The Role of Monetary Policy"</i> 
[<b>American Economic Review</b>, Vol. 68, No. 1, pp. 1-17]).
</p><p>
Thus Monetarists argued for controlling the money supply, of placing the 
state under a <i>"monetary constitution"</i> 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 <i>"monetary constitution"</i> money would become 
<i>"depoliticised"</i> 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. Hence the need for a <i>"legislated rule"</i> 
which would control <i>"the behaviour of the stock of money"</i> by 
<i>"instructing the monetary authority to achieve a specified rate of 
growth in the stock of money."</i> [<b>Capitalism and Freedom</b>, p. 54]
</p><p>
Unfortunately for Monetarism, its analysis was simply wrong. It cannot 
be stressed enough how deeply flawed and ideological Friedman's 
arguments were. As one critique noted, his assumptions have <i>"been shown to 
be fallacious and the empirical evidence questionable if not totally 
misinterpreted."</i> Moreover, <i>"none of the assumptions which Friedman made 
to reach his extraordinary conclusions bears any relation to reality. They
were chosen precisely because they led to the desired conclusion, that 
inflation is a purely monetary phenomenon, originating solely in excess 
monetary demand."</i> [Thomas Balogh, <b>Op. Cit.</b>, p. 165 and p. 167] For Kaldor,
Friedman's claims that empirical evidence supported his ideology were
false. <i>"Friedman's assertions lack[ed] any factual foundation whatsoever."</i>
He stressed, <i>"They ha[d] no basis in fact, and he seems to me have 
invented them on the spur of the moment."</i> [<b>Op. Cit.</b>, p. 26] There was no 
relationship between the money supply and inflation. 
</p><p>
Even more unfortunately for both the theory and (far more importantly) vast 
numbers of working class 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 but he embraced 
military Keynesianism sooner and so mitigated its worse effects. [Michael 
Stewart, <b>Keynes and After</b>, p. 181] This did not stop the right proclaiming 
the Reagan boom as validation of "free market" economics!). 
</p><p>
Firstly, the attempt to control the money supply failed, as predicted by Nicholas 
Kaldor (see his 1970 essay <i>"The New Monetarism"</i>). 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 <b>within</b> the economy). 
[<b>The Essential Kaldor</b>, p. 483] This means that any attempt by the central
bank to control the money supply, as desired by Friedman, will fail. 
</p><p>
The experience of the Thatcher and Reagan regimes indicates this well. 
The Thatcher government could not meet the money controls it set. It 
took until 1986 before the Tory government stopped announcing monetary 
targets, persuaded no doubt by the embarrassment caused by its inability 
to hit them. In addition, the variations in the money supply showed 
that 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 <b>fell</b> as the money supply increased. 
Between 1979 and 1981-2, its growth rose and was still higher in 1982-3 
than it had been in 1978-9 yet inflation was down to 4.6% in 1983. As the 
moderate conservative MP Ian Gilmore pointed out, <i>"[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."</i> [Ian Gilmore, <b>Dancing With Dogma</b>, 
p. 57 and pp. 62-3] So, as Henwood summarises, <i>"even the periods of
recession and recovery disprove monetarist dogma."</i> [<b>Wall Street</b>,
p. 202]
</p><p>
However, the failed attempt to control the money supply had other, more
important effects, namely exploding interest and unemployment rates.
Being unable to control the supply of money, the government did the
next best thing: it tried to control the demand for money by rising
interest rates. Unfortunately for the Tories their preferred measure
for the money supply included interest-bearing bank deposits. This
meant, as the government raised interest rates in its attempts to 
control the money supply, it was profitable for people to put more
money on deposit. Thus the rise in interest rates promoted people to
put money in the bank, so increasing the particular measure of the 
money supply the government sought to control which, in turn, lead
them to increase interest rates. [Michael Stewart, <b>Keynes in the 
1990s</b>, p. 50] 
</p><p>
The exploding interest rates used in a vain attempt to control the 
money supply was the last thing Britain needed in the early 1980s. 
The economy was already sliding into recession and government 
attempts to control the money supply deepened it. While Milton Friedman
predicted <i>"only a modest reduction in output and employment"</i> as
a <i>"side effect of reducing inflation to single figures by 1982,"</i>
in fact Britain experienced its deepest recession since the 1930s.
[quoted by Michael Stewart, <b>Keynes and After</b>, p. 179] As Michael
Stewart dryly notes, it <i>"would be difficult to find an economic 
prediction that that proved more comprehensively inaccurate."</i> 
Unemployment rose from around 5% in 1979 to 13% in the middle of
1985 (and would have been even higher but for a change in the method
used for measuring it, a change implemented to knock numbers off of
this disgraceful figure). In 1984 manufacturing output was still 10% 
lower than it had been in 1979. [<b>Op. Cit.</b>, p. 180] Little wonder
Kaldor stated that Monetarism was <i>"a terrible curse, a visitation
of evil spirits, with particularly unfortunate, one could almost say
devastating, effects on"</i> Britain. [<i>"The Origins of the New Monetarism,"</i>
pp. 160-177, <b>Further Essays on Economic Theory and Policy</b>, p. 160]
</p><p>
Eventually, inflation did fall. From an anarchist perspective, however, 
this 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 <a href="secC8.html#secc82">last section</a> for this aspect of inflation). 
With no need for capitalists to maintain their profits via price increases, 
inflation would naturally decrease as labour's bargaining position was 
weakened by the fear mass unemployment produced in the workforce. Rather 
than being a purely monetary phenomena as Friedman claimed, inflation was 
a product of the profit needs of capital and the state of the class struggle. 
The net effect of the deep recession of the early 1980s and mass unemployment
during the 1980s (and 1990s) was to control working class people by putting 
the fear of being fired back. The money supply had nothing to do with it
and attempts to control it would, of necessity, fail and the only tool 
available to governments would be raising interest rates. This would reduce 
inflation only by depressing investment, generating unemployment, and so 
(eventually) slowing the growth in wages as workers bear the brunt of the
recessions by lowering their real income (i.e., paying higher prices on
the same wages). Which is what happened in the 1980s. 
</p><p>
It is also of interest to note that even in Friedman's own test case
of his basic contention, the Great Depression of 1929-33, he got it 
wrong. For Friedman, the <i>"fact is that the Great Depression, like 
most other periods of severe unemployment, was produced by government
mismanagement rather than by any inherent instability of the private
economy."</i> [<b>Op. Cit.</b>, p. 54] Kaldor pointed out that <i>"[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 <b>despite</b> 
this increase in the monetary base."</i> [<i>"The New Monetarism"</i>, <b>The 
Essential Kaldor</b>, pp. 487-8] Other economists also investigated
Friedman's claims, with similar result. Peter Temin, for example,
critiqued them from a Keynesian point of view, asking whether the 
decline in spending resulted from a decline in the money supply or 
the other way round. He noted that while the Monetarist <i>"narrative
is long and complex"</i> it <i>"offers far less support for [its] assertions
than appears at first. In fact, it assumes the conclusion and describes
the Depression in terms of it; it does not test or prove it at all."</i>
He examined the changes in the real money balances and found that they
increased between 1929 and 1931 from between 1 and 18% (depending on
choice of money aggregate used and how it was deflated). Overall, the 
money supply not only did not decline but actually increased 5% between 
August 1929 and August 1931. Temin concluded that there is no evidence 
that money caused the depression after the stock market crash. [<b>Did 
Monetary Forces Cause the Great Depression?</b>, pp. 15-6 and p. 141]
</p><p>
There is, of course, a slight irony about Friedman's account of the Great 
Depression. Friedman suggested that the Federal Reserve actually caused 
the Great Depression, that it was in some sense a demonstration of the 
evils of government intervention. In his view, the US monetary authorities 
followed highly deflationary policies and so the money supply fell because 
they forced or permitted a sharp reduction in the monetary base. In other 
words, because they failed to exercise the responsibilities assigned to 
them. This is the core of his argument. Yet it is important to stress 
that by this he did not, in fact, mean that it happened because the 
government had intervened in the market. Ironically, Friedman argued 
it happened because the government did <b>not</b> intervene fast or far 
enough thus making a bad situation much worse. In other words, it was 
not interventionist enough! 
</p><p>
This self-contradictory argument arises because Friedman was an ideologue 
for capitalism and so sought to show that it was a stable system, to exempt 
capitalism from any systemic responsibility for recessions. That he ended
up arguing that the state caused the Great Depression by doing nothing 
(which, ironically, was what Friedman usually argued it should do) just
shows the power of ideology over logic or facts. Its fleeting popularity 
was due to its utility in the class war for the ruling class at that time.
Given the absolute failure of Monetarism, in both theory and practice, it 
is little talked about now. That in the 1970s it was the leading economic 
dogma of the right explains why this is the case. Given that the right 
usually likes to portray itself as being strong on the economy it is useful 
to indicate that this is <b>not</b> the case -- unless you think causing the
deepest recessions since the 1930s in order to create conditions where 
working class people are put in their place so the rich get richer is
your definition of sound economic policy. As Doug Henwood summarises, 
there <i>"can be no doubt that monetarism . . . throughout the world from the
Chilean coup onward, has been an important part of a conscious policy to
crush labour and redistribute income and power toward capital."</i> [<b>Wall
Street</b>, pp. 201-2]
</p><p>
For more on Monetarism, the work of its greatest critic, Nicholas Kaldor, 
is essential reading (see for example, <i>"Origins of the new Monetarism"</i> 
and <i>"How Monetarism Failed"</i> in <b>Further Essays on Economic Theory 
and Policy</b>, <i>"The New Monetarism"</i> in <b>The Essential Kaldor</b> 
and <b>The Scourge of Monetarism</b>).
</p><p>
So under the rhetoric of "free market" capitalism, Keynesianism was used 
to manage the crisis as it had previously managed the prosperity. "Supply
Side" economics (combined with neo-classical dogma) was used to undercut
working class power and consumption and so allow capital to reap more
profits off working class people by a combination of reduced regulation for the
capitalist class and state intervention to control the working class. 
Unemployment was used to discipline a militant workforce and as a means 
of getting workers to struggle <b>for</b> work instead of <b>against</b> wage 
labour. With the fear of job loss hanging over their heads, workers put up 
with speedups, longer hours, worse conditions and lower wages and this 
increased the profits that could be 
extracted directly from workers as well as reducing business costs by 
allowing employers to reduce on-job safety and protection and so on. The 
labour "market" was fragmented to a large degree into powerless, atomised 
units with unions fighting a losing battle in the face of a recession made
much worse by government policy (and justified by economic ideology). In 
this way capitalism could successfully change the composition of demand 
from the working class to capital.
</p><p>
Needless to say, we still living under the legacy of this process. As
we indicated in <a href="secC3.html">section C.3</a>, there has been a significant shift in income
from labour to capital in the USA. The same holds true in the UK, as does
rising inequality and higher rates of poverty. While the economy is doing
well for the few, the many are finding it harder to make ends meet and, 
as a result, are working harder for longer and getting into debt to maintain
their income levels (in a sense, it could be argued that aggregate demand 
management has been partially privatised as so many working class people
are in debt). Unsurprisingly 70% of the recent gain in per capita income 
in the Reagan-Bush years went to the top 1% of income earners (while the 
bottom lost absolutely). Income inequality increased, with the income 
of the bottom fifth of the US population falling by 18% while that of the 
richest fifth rose by 8%. [Noam Chomsky, <b>World Orders, Old and New</b>, p. 141] 
Combined with bubbles in stocks and housing, the illusion of a good economy 
is maintained while only those at the top are doing well (see 
<a href="secB7.html">section B.7</a> on rising inequality). This disciplining 
of the working class has been successful, resulting in the benefits of rising 
productivity and growth going to the elite. Unemployment and underemployment 
are still widespread, with most newly created jobs being part-time and insecure.
</p><p>
Indirect means of increasing capital's share in the social income were also 
used, such as reducing environment regulations, so externalising pollution
costs onto current and future generations. In Britain, state owned
monopolies were privatised at knock-down prices allowing private capital 
to increase its resources at a fraction of the real cost. Indeed, some 
nationalised industries were privatised <b>as monopolies</b> for a period allowing 
monopoly profits to be extracted from consumers before the state allowed 
competition in those markets. Indirect taxation also increased, reducing 
working class consumption by getting us to foot the bill for capitalist
restructuring as well as military-style Keynesianism. Internationally,
the exploitation of under-developed nations increased with $418 billion being 
transferred to the developed world between 1982 and 1990 [Chomsky, <b>Op. Cit.</b>, 
p. 130] Capital also became increasingly international in scope, as it used 
advances in technology to move capital to third world countries where state 
repression ensured a less militant working class. This transfer had the 
advantage of increasing unemployment in the developed world, so placing 
more pressures upon working class resistance.
</p><p>
This policy of capital-led class war, a response to the successful working 
class struggles of the 1960s and 1970s, obviously reaped the benefits it
was intended to for capital. Income going to capital has increased and
that going to labour has declined and the "labour market" has been disciplined
to a large degree (but not totally we must add). Working people have been
turned, to a large degree, from participants into spectators, as required 
for any hierarchical system. The human impact of these policies cannot be 
calculated. Little wonder, then, the utility of neo-classical dogma to the 
elite -- it could be used by rich, powerful people to justify the fact that 
they are pursuing social policies that create poverty and force children 
to die. As Chomsky argues, <i>"one aspect of the internationalisation of the 
economy is the extension of the two-tiered Third World mode to the core countries.
Market doctrine thus becomes an essential ideological weapon at home as
well, its highly selective application safely obscured by the doctrinal
system. Wealth and power are increasingly concentrated. Service for 
the general public - education, health, transportation, libraries, etc. --
become as superfluous as those they serve, and can therefore be limited
or dispensed with entirely."</i> [<b>Year 501</b>, p. 109]
</p><p>
The state managed recession has had its successes. Company profits are
up as the <i>"competitive cost"</i> of workers is reduced due to fear of job
losses. The Wall Street Journal's review of economic performance 
for the last quarter of 1995 is headlined <i>"Companies' Profits Surged 61% 
on Higher Prices, Cost Cuts."</i> After-tax profits rose 62% from 1993, up 
from 34% for the third quarter. While working America faces stagnant wages,
Corporate America posted record profits in 1994. <b>Business Week</b>
estimated 1994 profits to be up <i>"an enormous 41% over [1993],"</i> despite
a bare 9% increase in sales, a <i>"colossal success,"</i> resulting in large part
from a <i>"sharp"</i> drop in the <i>"share going to labour,"</i> though <i>"economists say
labour will benefit -- eventually."</i> [quoted by Noam Chomsky, <i>"Rollback III"</i>,
<b>Z Magazine</b>, April 1995] Labour was still waiting over a decade later.
</p><p>
Moreover, for capital, Keynesianism is still goes on as before, combined 
(as usual) with praises to market miracles. For example, Michael Borrus,
co-director of the Berkeley Roundtable on the International Economy (a 
corporate-funded trade and technology research institute), cites a 1988 
Department of Commerce study that states that <i>"five of the top six fastest 
growing U.S. industries from 1972 to 1988 were sponsored or sustained, 
directly or indirectly, by federal investment."</i> He goes on to state
that the <i>"winners [in earlier years were] computers, biotechnology, jet 
engines, and airframes"</i> all <i>"the by-product of public spending."</i> [quoted by 
Chomsky, <b>World Orders, Old and New</b>, p. 109] As James Midgley points out, 
<i>"the aggregate size of the public sector did not decrease during the 1980s 
and instead, budgetary policy resulted in a significant shift in existing 
allocations from social to military and law enforcement."</i> [<i>"The radical 
right, politics and society"</i>, <b>The Radical Right and the Welfare State</b>, 
Howard Glennerster and James Midgley (eds.), p. 11] Indeed, the US state 
funds one third of all civil R&D projects, and the UK state provides a 
similar subsidy. [Chomsky, <b>Op. Cit.</b>, p. 107] And, of course, the state 
remains waiting to save the elite from their own market follies (for
example, after the widespread collapse of Savings and Loans Associations 
in deregulated corruption and speculation, the 1980s pro-"free market" 
Republican administration happily bailed them out, showing that market 
forces were only for one class).
</p><p>
The corporate owned media attacks social Keynesianism, while remaining
silent or justifying pro-business state intervention. Combined with
extensive corporate funding of right-wing "think-tanks" which explain why
(the wrong sort of) social programmes are counter-productive, the corporate 
state system tries to fool the population into thinking that there is no
alternative to the rule by the market while the elite enrich themselves
at the public's expense. This means that state intervention has not ended
as such. We are still in the age of Keynes, but social Keynesianism has 
been replaced by military Keynesianism cloaked beneath the rhetoric of 
"free market" dogma. This is a mix of free(r) markets (for the many) and 
varying degrees of state intervention (for the select few), while the state 
has become stronger and more centralised (<i>"prisons also offer a Keynesian 
stimulus to the economy, both to the construction business and white 
collar employment; the fastest growing profession is reported to be 
security personnel."</i> [Chomsky, <b>Year 501</b>, p. 110]). In other words, 
pretty much the same situation that has existed since the dawn of 
capitalism (see <a href="secD1.html">section D.1</a>) -- free(r) markets supported by ready 
use of state power as and when required.
</p><p>
The continued role of the state means that it is unlikely that a repeat
of the Great Depression is possible. The large size of state consumption 
means that it stabilises aggregate demand to a degree unknown in 1929 or
in the 19th century period of free(r) market capitalism. This is <b>not</b> to 
suggest that deep recessions will not happen (they have and will). It is 
simply to suggest that they will <b>not</b> turn into a deep depression. Unless, 
of course, ideologues who believe the "just-so" stories of economic 
textbooks and the gurus of capitalism gain political office and start to
dismantle too much of the modern state. As Thatcher showed in 1979, it is 
possible to deepen recessions considerably if you subscribe to flawed 
economic theory (ideology would be a better word) and do not care about 
the impact it is having on the general public -- and, more importantly,
if the general public cannot stop you).
</p><p>
However, as we discuss in <a href="secC10.html">section C.10</a> the net effect of this one-sided 
class war has not been as good as has been suggested by the ideologues of
capitalism and the media. Faced with the re-imposition of hierarchy, the 
quality of life for the majority has fallen (consumption, i.e. the quantity
of life, may not but that is due to a combination of debt, increased hours
 at work and more family members taking jobs to make ends meet). This, in 
turn, has lead to a fetish over economic growth. As Joan Robinson put 
it in the 1970s when this process started the <i>"economists have relapsed 
into the slogans of laisser faire -- what is profitable promotes growth; 
what is most profitable is best. But people have began to notice that the 
growth of statistical GNP is not the same thing as an increase in welfare."</i>
[<b>Collected Economic Papers</b>, vol. 4, p. 128] Yet even here, the post-1970s
experience is not great. A quarter century of top heavy growth in which 
the vast majority of economic gains have gone to the richest 10% of the 
population has not produced the rate of GDP growth promised for it. In fact, 
the key stimulus for growth in the 1990s and 2000s was bubbles, first in 
the stock market and then in the housing market. Moreover, rising personal 
debt has bolstered the economy in a manner which are as unsustainable as 
the stock and housing bubbles which, in part, supported it. How long the
system will stagger on depends, ultimately, on how long working class people
will put up with it and having to pay the costs inflicted onto society and
the environment in the pursuit of increasing the wealth of the few.
</p><p>
While working class resistance continues, it is largely defensive, but, as
in the past, this can and will change. Even the darkest night ends with
the dawn and the lights of working class resistance can be seen across
the globe. For example, the anti-Poll Tax struggle in Britain against the
Thatcher Government was successful as have been many anti-cuts struggles
across the USA and Western Europe, the Zapatista uprising in Mexico was
inspiring as was the Argentine revolt against neo-liberalism and its wave
of popular assemblies and occupied workplaces. In France, the anti-CPE 
protests showed a new generation of working class people know not only
how to protest but also nonsense when they hear it. In general, there has 
been continual strikes and protests across the world. Even in the face of 
state repression and managed economic recession, working class people are 
still fighting back. The job for anarchists to is encourage these sparks 
of liberty and help them win.
</p>

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