posted July 9, 2010
Value, Price and Epic Recession

VALUE, PRICE and EPIC RECESSION
By
Jack Rasmus
Copyright 2010

ABSTRACT

The concepts, assumptions, and models of contemporary mainstream economics are inadequate for analyzing and explaining the current global financial and economic crisis. The crisis is neither a ‘normal’ (typical post-1945) recession nor yet a classic great depression, but instead represents what is called an ‘Epic Recession’, which is a specific kind of economic contraction that is precipitated by a major financial system crash with origins in excessive global liquidity, an extended period of speculative financial asset investment, asset price inflation, extreme debt accumulation, and declining real asset investment. The failure of mainstream economics to properly understand the current crisis lies in its misunderstanding of the character and role of asset prices, credit, debt, as well as its inability to differentiate between speculative and non-speculative forms of investment. The origins of Epic Recessions are not only different from normal recessions, but the evolution and trajectory of Epic Recessions differ as well. Epic Recessions typically result in either an extended period of general economic stagnation, i.e. a ‘Type I’ Epic Recession (U.S. 1907-1914), or in a ‘Type II’ (U.S. 1929-1931) with a high probability of transitioning to a bona fide depression. To explain Epic Recession new concepts of global money parade, speculative investment shift, debt-deflation-default nexus, and financial fragility and consumption fragility are introduced as key forces underlying, and integrating, both financial and real economic aspects of the crisis. The analysis of Epic Recession that follows is undertaken at the level of price categories. However, the article concludes with an exploration of the implications of the analysis for explaining the current crisis at the level of value, in the Marxist sense of that latter term. Suggestions are made how key Marxist ratios of rate of surplus value, organic composition of capital, and falling rate of profit might be extended and expanded to include financial variables, such as credit and debt, in order to better explain the obvious critical role played by Finance Capital in causing and contributing to the current Epic Recession.

KEYWORDS: Epic Recession, Speculative Investment Shift, Financial Fragility, Consumption Fragility, Debt-Deflation-Default Nexus, Marxist ratios, Retro-Classicalists, Hybrid Keynesians.

Contemporary mainstream economists call the economic crisis that erupted worldwide in 2007 a ‘Great Recession’. By ‘Great’ they simply mean the economic contraction has been worse than a normal recession, but not as bad as a depression. Few, however, bother to explain how it has come to be ‘Great’ and thus worse than a normal recession. In this mainstream view ‘Great’ is simply because GDP declined after 2007 more than it did during prior normal recessions. Left unanswered are important quantitative questions such as why did the world economy decline so sharply and deeply this time? Or why did its rate of spread across multiple credit markets and between geographic regions transmit so swiftly? Qualitative characteristics driving the global downturn are given even less consideration in the mainstream view. Nor is there much analysis among mainstream economists about why traditional fiscal-monetary measures thus far have proved relatively ineffective in getting the global economy to return to a sustained recovery path, and why there has been no ‘V-shaped’ rapid recovery thus far that many economists have been predicting?

It is not surprising such questions have, in most cases, not even been raised, let alone answered by mainstream economics. Its two major wings are constrained by their very concepts, theories, and models from even asking the important questions, let alone answering them. Those concepts and theories are based either on a 19th century view of economics resting on absurd assumptions about the economy that never existed; or else a mid-20th century view that is a hybrid version of those same 19th century views combined with simplistic conclusions about the nature of capitalist investment and business cycles in the late 20th century. That is, both wings of mainstream economics fail to consider the destabilizing role of speculative finance, new financial institutions, financial markets and products, and the growing relative weight of speculative investing in the overall capitalist investment process and business cycle in the closing decades of the 20th century.

Not surprisingly, both wings have come to a virtual dead-end in economic analysis attempting to explain the current Epic Recession. As one of the more perplexed of the mainstream view recently commented in a Wall St. Journal editorial, “There is no consensus on the causes of the crisis or the best way forward…Perhaps what we’re doing is confirming our biases…the business cycle and the ability to steer the economy out or recession may be beyond us.? In a recent article examining ‘Why 10,000 Economists Got It Wrong’, this writer reviewed public statements of a dozen of the more well known representatives of the American economics profession, some Nobel Price laureates. A number came to a conclusion similar to that quoted above: i.e. the crisis is too complex to fully comprehend or predict. And those who did venture an explanation, either resorted to simplistic metaphors that supposedly explain why the crisis has occurred or else blamed the recent crisis on individual behavior or groups—like greedy bankers, irresponsible homebuyers, or just the frailties of human nature.

Retro-Classicalists and Hybrid Keynesians

One of the two camps, which for lack of a better term shall be called the Retro-Classicalists, believes the current crisis represents a mere temporary departure from an inherent stability within the global capitalist economic system. The current departure from stability is merely another temporary aberration that will correct itself. Just leave it alone and it will eventually return to stability. Specifically, let the bad assets and collapsed values on bank and business balance sheets simply work themselves off naturally over time. Let write-downs of losses occur, and even defaults if necessary. Don’t bail out anyone—banks and non-bank businesses alike. And especially don’t rescue homeowners facing foreclosure, local governments going broke, or consumers defaulting on loans or credit cards. Don’t even bail out sovereign countries with ballooning public debt, that represents the transfer to public balance sheets of massive losses by banks and other business institutions. If enough assets, products and wages fall in price sufficiently, so the argument of Retro-Classicalists goes, then ‘bottom feeder’ investors eventually will enter the market and buy up what’s left. Recovery will then follow. In other words, the crisis is not internal to the system—i.e. is not endogenous as they say. The crisis has nothing to do with the system’s internal dynamics. It is simply due to government policy failures. The government should therefore avoid future bank and financial institution re-regulation, and just let the system heal itself, recover on its own.

The other camp of mainstream economics, the Hybrid-Keynesians, also ignores the possibility of internal forces driving the system’s instability. Like their Retro-Classicalist cousins, they concur that the cause of the crisis is bad policy. But unlike the Retro Classicalists, they believe bad policy can be replaced by good policy that in the past has been employed successfully to enable recovery from normal recessions. The current crisis may be more severe than past recessions, they admit, but in the last analysis it is essentially just another normal recession. Bailouts are not only ok but necessary, especially on the banking side. But the banking and finance system must be stabilized first, in order to ‘get credit going again’, as they say. Once bank lending returns and ample credit is once again available, investment and employment will eventually follow, according to this view. Fiscal policy—government spending and especially tax cuts— can put a temporary floor under the collapse of consumer spending while awaiting the return of bank lending. Together, financial bailouts and consumption subsidies—such as unemployment insurance assistance, medical insurance premiums subsidies, financial aid to states and local governments—will keep the real economy from also collapsing, until such time as market forces can recover and generate a sustained recovery. Once again, as with the Retro-Classicalists, Hybrid Keynesians ultimately believe true recovery is best left to the forces of the market. Government intervention is called for, but just to buy time until market-driven recovery takes hold.

Relying ultimately on the market for recovery means that, once again, there’s nothing endogenously wrong with the system. There’s no inherent destabilizing dynamic within the system itself. The dynamics of the current crisis are the same as during prior normal recessions. In the more severe current contraction, the costs of ‘buying time’ waiting for the market to recover are just somewhat higher. These views, however, are in error on all counts.

The Current Crisis as Epic Recession

Epic Recession, in both its financial and non-financial dimensions, is a consequence of internal, endogenous forces within the economic system that develop long term over the course of a business cycle that result in a major destabilization of that system. Epic Recessions are fundamentally different from ‘normal’ recessions, the latter of which are never precipitated by financial instability and crises. Normal recessions may be caused by external shocks, policy or non-policy induced. But Epic Recessions do not originate due to external supply or demand shocks or as a result of government policy errors. They originate ultimately as a consequence of a relative shift from real physical asset investment to speculative asset investing over the course of an extended boom phase that produces a financial crisis and implosion.

The speculative investment shift not only causes a relative slowing of real capital accumulation in the boom phase, but accelerates the relative shift toward speculative investment in the subsequent bust phase as well. As speculative asset investing accelerates in the boom phase, leading to excess debt accumulation and escalating asset price inflation, it subsequently ‘crowds out’ real asset investment as the cycle progresses. In the real economy’s contraction that inevitably follows a financial system collapse, both real asset investment and speculative investment decline. However, speculative investment recovers more rapidly, thus further enforcing the relative shift at the expense of real asset investment in the recovery phase. Thus, both in the ‘up’ and ‘down’ phases of the overall cycle investment shifts in favor of speculative forms. That shift has a long run destabilizing effect on the financial system causing repeated (with growing intensity and global synchronization) financial implosions.

The fundamental theoretical point is that real asset investment, i.e. capital accumulation, is influenced and even determined long term increasingly by speculative forms of finance and investment.

Epic Recessions are thus the consequence of major financial system implosions. The important question, however, is what causes the extreme financial implosions that result in exceptionally severe credit crashes that bring the economy to its knees? And why thereafter does the economy have such difficulty generating a sustained economic recovery in the wake of an Epic Recession once again?

If Epic Recessions are precipitated by financial implosion, then financial busts are in turn the consequence of prior speculative investing excesses, which drive debt and asset price inflation to dangerous levels. When financial bust occurs, it produces greater than normal debt unwinding that leads to deflation and defaults. During the boom-speculative phase of the cycle the financial system becomes more ‘fragile’ and prone to implosion while the rest of the real economy becomes correspondingly more consumption fragile. Both forms of fragility—financial and consumption—fracture when the bust occurs, setting in motion debt-deflation-default processes that drive the economy in a contractionary spiral.

The still more fundamental question is what produces the shift to speculative investment in the first place, thus causing the fragility and the subsequent downward spiral of debt-deflation and default? Underlying the speculative shift are forces of escalating global income inequality, exploding global liquidity, and the expanding ‘global money parade’ of speculators, sustained by a global network of financial institutions, new financial markets, and multiplying new financial instruments created for those markets (most notably derivatives). The global money parade of speculators, institutions and markets, with more than $20 trillion on hand today, drives the speculative boom. In the process it creates a mountain of debt in the system. Following each financial bust, part of the debt is ‘unwound’—but only part. Much of it remains, obstructing a return to normal lending, investing and household consumption. That remaining mountain of debt is what differentiates Epic Recessions from normal recessions. Policies designed for normal recessions do not address that debt overhang, and that is primarily the reason for the relative ineffectiveness of traditional fiscal and monetary policies in generating a sustained recovery in instances of Epic Recession.

To allow the ‘logjam’ of debt to be slowly ‘worked off’—as is the case in most advanced economies today—does not resolve the economic crisis, but instead results in an extended period of relative economic stagnation. To simply transfer the debt from banks and businesses to the public balance sheet (i.e. government debt) does nothing to remove it, but only shifts the crisis to the public sector. Putting a ‘floor’ under bank and business debt in the private sector may prevent a meltdown of the banking system core for a while, but it does not remove the bad assets and debt or their effects on real economic recovery.. The unwinding of debt load, in other words, must be accelerated and expunged, not simply shifted or transferred. However, that cannot be achieved piecemeal and incrementally. It must be done with major structural economic reforms, not with normal fiscal-monetary policies.

In the past century in the U.S. there have been two actual historical cases remarkably similar to what has been occurring in today’s crisis—one we have chosen to call a ‘Type I’ and another a ‘Type II’ Epic Recession. The former occurred in the equally major 1907 financial collapse and years immediately following. Like today, the big banks were stabilized by massive government liquidity injections, while thousands of others were allowed to fail. Inestimable thousands of businesses failed. The unemployed rose to double digit levels. Wages and incomes stagnated. Recovery after 1907 followed a trajectory of brief, weak growth of 12-18 months, followed in turn by similar economic relapses, by growth, and by relapse once again. Only massive government spending injections with the onset of the First World War brought the stagnation to an end. The same thing occurred in the wake of the speculative boom and bust of the 1920s. Only this time the government failed to stem banking system collapses that followed the initial financial bust of 1929. Subsequent banking crises followed in 1930, 1931, 1932, and 1933. Debt-deflation-defaults processes worsened. Financial and consumption fragility deteriorated further and drove the processes to even greater extremes. 1929-1930 may have been a Type II Epic Recession event—i.e. one that was transformed into a bona fide depression.

Short of another financial-banking system implosion, which may originate anywhere globally given the now global nature of the capitalist financial system, the current economic crisis thus far shares many characteristics with a Type I Epic Recession. That is, a stubborn extended economic stagnation that may go on for years, with short, unsustainable recoveries and brief, equally unsustainable economic relapses. This can go on until massive fiscal spending in the form of major government public investment occurs and appropriate structural reforms take place. These structural reforms will almost certainly have to address the banking-financial system, the tax system, and the serious income mal-distribution problem today in the U.S. economy.

Characteristics and Processes of Epic Recessions

What occurs in Epic Recessions is a dual, mutually reinforcing dynamic between financial collapse and the real non-financial sectors of the economy. This dynamic is reflected in the causal interactions between debt, deflation, and defaults (business, household and public sector) following the financial bust. The excessive debt accumulation in the boom phase produces severe financial fragility that drives asset deflation and defaults in the contraction phase. Deflation and defaults in turn exacerbate real debt levels further. The dynamic of debt-deflation-default processes intensifies. Asset deflation continues and subsequently spills over to product price deflation, and in turn wage deflation, as businesses facing excessive debt loads and refinancing resort to reducing product prices, and turn to wage deflation in various forms, in order to raise revenue and cut costs. Financial fragility is represented by a growing ratio of debt-to-cash flow and liquid assets for businesses, deteriorating terms of debt servicing, and a growing inability to obtain credit to refinance debt. Financial fragility rises from either rising real debt loads and declining terms of debt payments, or a decline in cash flow, or both. Deflation in its three forms (asset, product, wage) are responses to raise cash flow as debt servicing strains increase as a consequence of the financial collapse. The attempt to ‘unwind debt’ is the initiating driver in the debt-deflation-default process, but the latter reinforce the debt problem in the downturn.

But Epic Recessions are set in motion not only due to growing financial fragility in the boom phase and its intensification in the contraction phrase, driving the debt unwinding and related deflation and business defaults. Epic Recessions are also the consequence of a corresponding consumption fragility that grows in the boom phase. That consumption fragility rises based on growing household debt and disposable income stagnation in the boom phase, which then deteriorates in the contraction phase further as real debt rises and real income falls as a consequence of layoffs, wage cutting, and reduction in household credit availability.

Already deteriorating in the boom phase, financial and consumption fragility thus both deteriorate further in the wake of debt-deflation-default processes set in motion in the contraction phase. Moreover, both forms of fragility—financial and consumption—exacerbate each other, and are rendered more fragile by processes of worsening debt-deflation-default. The result of all this in real economic terms is that real asset business investment (that creates jobs and income) stagnates after the financial bust. Real investment is difficult to regenerate in the wake of an Epic Recession. Similarly, households are unable to work off (unwind) their debt loads in the post-financial bust period. Consumption therefore does not recover and real disposable income stagnates or falls. The failure to regenerate consumption holds back investment and business spending recovery.

Only the government sector is able to increase its level of spending. But that too has its limits, as in later stages of the Epic Recession cycle government’s economic fragility rises as well. As a result of its efforts to bail out banks and financial institutions, to subsidize general corporate profits by tax cuts and other subsidies, and to supplement household consumption, government debt levels rise. Government income levels simultaneously deteriorate as tax revenues lag, especially at state and local levels, as no sustained economic recovery occurs. Government debt-to-tax income ratios thus worsen, much as for financial and consumption fragility, albeit with a lag period once Epic Recession has begun. Financial and consumption fragility are, in other words, simply in part transferred from corporate and household balance sheets to government-public balance sheets. Fundamental debt and debt servicing problems are not resolved; just reshuffled around between various sectoral balance sheets.

The outcome of deterioration in the various forms of fragility (business, household, government) is an extended period of short, unsustainable, weak recoveries, followed by periods of short, moderate subsequent contractions in what appears to be a ‘double dip’ or ‘W-shape’ recovery, and even a double-double dip. In other words, at best an extended period of general economic stagnation that may last at minimum for 7-10 years. During that stagnation, should subsequent major financial implosions or general banking crises occur, the stagnation may well develop into a classic depression scenario.

The foregoing analysis of Epic Recession is undertaken at the level of price variables. In Epic Recession, price has been shown to play an important role, asset prices in general and financial asset prices in particular, in the growth in both scope and magnitude of financial crises in the global capitalist system in recent decades. Key forces and price variables have included: the shift to speculative investing (enabled by the network of ‘shadow’ financial institutions, proliferation of new financial markets and products; the explosion in global liquidity, credit, and debt (business, household, government); the dual development of financial fragility and consumption fragility; the interaction of debt with deflation (asset, product, and wage) and defaults (business, consumer, and government); and the interaction of debt-deflation-defaults with financial and consumption fragility.

These key price variables, and the causal relations between them, are depicted in oversimplified form in the following diagram:

Fundamental Forces & Relationships of Epic Recession

Global Liquidity Explosion

Global Money Parade

Speculative Investing Shift

Debt Deflation Default

Financial Institutions Asset Price Banks & Finance
Non-Financial Business Product Prices Non-Bank Business
Consumer-Household Labor Wages Consumer-Household

Financial Fragility Consumption Fragility

Declining Real Economic Indicators

Real Asset Investment
Household Consumption
Global Trade & Exports
Industrial Production
Employment

Retros and Hybrids on Investment and Price

Neither of the two wings of mainstream economics are able to predict Epic Recessions—neither their origins or their evolution. Neither wings are able to propose workable programs for recovery, because their models do not consider the key forces driving such contractions. Neither wings’ analyses of investment or consumption consider fundamental the relationship of credit and debt to either investment and consumption. There is no distinction between investment in real assets vs. investing in speculative financial assets, nor do they explain how and why the latter has been growing in recent decades at the expense of the former. There is no accounting of how financial crises transmit into real economic contractions or how they feedback upon each other, despite the overwhelming evidence of this causal relationship. The role of debt and credit, and how they interact differently with the three price systems (asset, product, wage) is largely absent. Mainstream economics views investment simplistically, as determined primarily by levels in interest rates, which in turn are a function ultimately of levels of savings. Thus, in mainstream economics savings is viewed as determining investment, instead of profits determining investment and in turn savings. There is no accounting of the role of growing income concentration and inequality, its influence on debt and, in turn, on investment and consumption. Most important, mainstream economics sees price behaving similarly across assets, products and wages, and the price system is the force ensuring system stabilization and equilibrium, instead of a force causing system destabilization and disequilibrium.

Because mainstream economics does not understand the fundamental dynamics and forces above, it cannot suggest proposals that result in sustained economic recovery. Because it erroneously views ‘Epic’ recessions as just another ‘normal’ recession, it holds that traditional fiscal-monetary policies are sufficient to generate a sustained recovery. But monetary and fiscal policies applied in situations of normal recessions do not effectively address either forms of fragility or processes of debt-deflation-default very well. Stabilizing the banking system with massive liquidity injections may temporarily contain banking insolvency but not resolve it, and simply offset the bad debt to the government and/or household sectors of the economy. Fiscal policies that merely seek to place a ‘floor’ under consumption to prevent further collapse prove similarly insufficient. Normal fiscal policy does not resolve problems of continuing household debt load or stagnating income levels. Central bank liquidity injections cannot resolve insolvency problems. Fundamental structural changes are therefore necessary for a sustained economic recovery.

There are two basic approaches possible to explaining the origins, evolution and future direction of today’s continuing economic crisis. One is to explain it from the perspective of value determination; the other is to explain it from the level of representations of value—i.e. in terms of concrete price variables as those variables are reflected in forms of investment, credit, debt, output, and so forth. Thus far this essay has focused primarily on analysis of the crisis at the level of ‘price’ categories. It is important to note, however, that it does so fundamentally differently to the manner in which mainstream economics argues in terms of price.

The Retro-Classicalist mainstream economics view rests upon an assumption that the price system in the capitalist economy is inherently stabilizing. In fact, price is considered the central stabilizing factor. The system will always return to a stable state (called equilibrium), the Retros believe, because the price system will adjust supply and demand to ensure it does so. Given this assumption, in the long run there are no departures from instability—i.e. economic crises (whether normal, Epic, or depression)—that will not eventually return to stability automatically, on their own, due to the workings of the price system. Given that assumption that the system is inherently stable, it follows that any departure from that stability is due to ‘external’ forces, which may be policy based or other ‘shocks’ to the system causing it to depart from stability. If external shocks set the system on a path of instability (i.e. disequilibrium), then any delay in its return to stability is due to something interfering with the workings of the price system performing its re-stabilizing function, according to the Retro-Classical view.

This view of price as stabilizer for the economy at large derives from a micro view of how individual markets for products adjust to ensure stability between supply and demand and equilibrium—a micro view that is then simply transferred to the macro economy at large. The Retro view also assumes there is only one kind of price system. A ‘one price system fits all’. There are prices for products. For prices for labor—i.e. ‘wages’. For prices for money—i.e. ‘interest rates’. And price, according to the Retro view, behaves everywhere and always the same way; that is, adjusting to ensure balance between supply and demand and thus stability and equilibrium.

For the price a specific product it works as follows: If there is an excess of demand for a product, then price will rise for that product. That rise will incent businesses to produce more supply. The additional supply will subsequently reduce the price. An iterative process will occur, shifting the price of the product back toward stability and equilibrium. Similarly, if there is insufficient demand for the product, lowering its price, supply will decline and cause price to rise back to equilibrium. The opposite occurs if supply initially rises or falls, provoking offsetting responses by demand.

Price is thus the great stabilizer and equilibrator. And it works in the same manner whether it is a price for a product, for labor (wages), for money (interest rates) or whatever. But for the ‘Retros’, one price system fits all. Moreover, this price behavior scenario operates not only at the micro level (products, wages, interest for an individual business) but for the economy at large (macro) level as well. Macro analysis is only micro ‘writ large’.

But as our analysis of Epic Recession fundamentally argues, there is NOT only one price system. And the idea that market price is the great stabilizer is fundamentally in error. There are three distinct price systems and each operates differently at times: asset prices, product prices, and labor prices (wages). And they interact with each other in a severe contraction—whether Epic Recession or depression—producing a mutually reinforcing downward spiral of contraction. Asset prices in particular do not respond in the assumed theoretical way, adjusting to changes in supply and demand, with a perpetual tendency toward equilibrium. Asset prices in particular follow an independent dynamic, and serve to drive product-wage-money prices in an economic contraction, and toward disequilibrium. Price in this view is thus actually a great destabilizer that drives the system toward increasing volatility and instability. Moreover, asset price system destabilization is endogenous to the system and plays a key role in the dynamic tendency of Epic Recession to potentially transform into bona fide depressions.

The logic underlying the Retro-Classicalist view of price as the great stabilizer is a simple but incorrect assumption. It is called the ‘substitution effect’. For price to behave as described, whoever purchases the product the Retro view assumes has both a desire to obtain one more unit of that product as well as a desire not to obtain that one more unit. For each purchase there is a satisfaction in obtaining one more unit as well as a parallel dissatisfaction from obtaining it—i.e. a utility and a disutility. The utility and disutility it further assumes are perfect substitutes for each other. When the trade off in utility-disutility is equal, then adding one more of the product (or of labor, money, etc.) is all the same to the purchaser. The product’s utility is perfectly substitutable by its disutility. The purchaser at that point, where utility-disutility are equal, therefore stops buying. At that point supply and demand are in equilibrium and stability occurs.

To employ another illustration, using the price for labor (wages), when the utility of one more hire is equal to its disutility then the capitalist won’t hire any more workers. That is, when the cost of hiring one more worker is equal (perfectly substitutable) for the revenue that one more worker might produce, the utility and disutility of that one more unit of labor is equal. Equilibrium in labor supply and demand is achieved. The system is stable. No more hiring and no layoffs. The key point of all this is that without the assumption and application of the principle of the ‘substitution effect’, price cannot play the stabilizer role. There can be no equilibrium. Supply and demand no longer work to return the system to equilibrium and stability.

Retro-classicalists today still preach this view. They then take this logic, expressed initially at the level of an individual business’s output of products, hiring of workers, or borrowing of money, and extrapolate it to the level of the economic system itself at large. Thus price becomes the great stabilizer for an economic system in crisis, not just a product or hiring of labor by an employer. It is the force and variable that can end a recession, Epic recession, and even a depression. External shocks to the economic system may indeed occur, according to the Retro view, but price adjustment via supply and demand will return the system to stability. If empirically price fails to return the system to stability, the argument goes, that is due to interference with the price system’s natural workings as described. Failure to achieve stability is the result of either government or workers and their unions refusing to permit the price system to adjust. The economy is like one big price system. Specifically, failure to recover from a recession or depression is due to workers refusing to lower their wages (i.e. adjust wages-price downward) or even businesses failing to sufficiently reduce their prices ( i.e. adjust product prices downward). If they would only allow their prices to fall, it would stimulate more supply from producers that would result in more investment, more rehiring of workers, and a rise in general demand that would end the recession or depression.

This is the famous ‘real balance effect’ (sometimes called the ‘Pigou effect’) that was so prominent among economists during the last Great Depression in the 1930s. This view was thoroughly demolished by John Maynard Keynes in 1936, but was subsequently resurrected in new form by the Hybrid Keynesians following World War II. And its vestiges still remain today among both wings of mainstream economists, who still argue that part of the problem of recovery from severe economic contractions is that prices and wages are ‘sticky’ downwards and interrupt the adjustment process. In other words, the victims of recession and depression—workers and their unions—are the cause of the recession or depression not ending in a quick, ‘V-shape’ like recovery.

There is no single price system, behaving the same regardless of its forms (product, wage, money), always moving the economic system toward stability. There are several price systems, not one. And they all don’t behave the same way, with supply and demand working in consort to restore equilibrium. In fact, price may serve as a major force exacerbating disequilibrium, causing increasing instability in the economy at large, both at the level of finance and the real economy.

The analysis of Epic Recession fundamentally argues there is NOT only one price system. And the idea that market price is the great stabilizer is fundamentally in error. There are three distinct price systems and each operates differently at times: asset prices, product prices, and labor prices (wages). And they interact with each other—not in response to supply and demand—in a severe real economic contraction, producing a mutually reinforcing downward spiral of contraction. Asset prices in particular do not respond in the assumed theoretical way, adjusting to changes in supply and demand, with a tendency toward equilibrium. Asset prices follow an independent dynamic, apart from normal forces of supply and demand, with the consequence of driving the system toward instability and disequilibrium. With asset prices, financial securities in particular, and derivative financial securities like mortgage and asset backed securities (RMBS, CMBS, ABS), collateralized debt and loan obligations (CDOs, CLOs), and credit default swaps (CDS) especially, price escalation is driven increasingly by demand over the course of the boom phase. Supply is not a factor. Rising asset prices due to speculative demand drive up prices of the securities, which in turn brings in a flood of additional demand as prices rise. Supply as a force constraining this process is virtually non-existant. There are no appreciable supply constraints to financial securities, no cost of goods, cost of sales or distribution costs for electronic financial instruments. Without supply constraints, inflation over the boom cycle continues and asset prices escalate unchecked until the inevitable financial implosion occurs. Thereafter, asset price ‘unwinding’ drives product price deflation and wage deflation. Following the financial bust, asset price unwinding results in an accelerating decline in demand for assets, causing further price deflation and further asset demand declines. Supply once again plays little if any role in the price ‘race to the bottom’. Demand only is the driver. All this is impossible in the Retro-Classicalist view of price as the great stabilizer and driver toward equilibrium, where demand and supply work as forces inherent within the system and in consort to ensure long run stability.

In contrast to Retro Classicalists, price in this view is thus actually a great destabilizer that drives the system toward increasing volatility and instability. Moreover, asset price system destabilization is endogenous to the system and may play a key role in the dynamic tendency of Epic Recession to potentially transform into bona fide depressions.

Asset prices are inherently destabilizing both during the boom phase and in the subsequent bust phase. And in the contraction phase, it is asset price deflation that increasingly drive product price deflation, both of which in turn, drive wage deflation. It is not ‘normal supply and demand’ that determine price deflation, as Retro Classicalist theories argue.

Like Retro-Classicalists, the Hybrid Keynesians also fail to understand the role of asset prices in producing financial instability and in exacerbating real economic contraction in the downturns following financial implosions. They do not argue as strongly that price is a stabilizer in the system. However, they have no accounting of asset prices in the system. Prices are limited to products, wages and money (interest rates). Asset prices are largely unaccounted for. Moreover, in a mechanical fashion, they envision an unrealistic ‘substitution effect’ between product price and wage inflation, on the one hand, and between money and product prices on the other. Through a device called the ‘Phillips Curve’, Hybrid Keynesians maintain that rising product prices (due to either product costs and/or product demand—not asset price movements) can be ‘traded off’ (i.e. substituted for) by lowering labor prices (wages) as a consequence of raising unemployment. Unemployment is in turn raised by raising interest rates (money prices). The opposite is also possible: Lowering money prices results in more employment and higher wages and eventually more product price inflation. It all occurs in a very manageable manipulation by fiscal and monetary policies. And there are no financial variables, no speculative investment (only real asset investment exists), no excessive credit and debt accumulation, and no asset price instability and volatility driving financial implosions (which also do not exist). Hybrid Keynesianism thus also misunderstands the role of price as a major destabilizer endogenous to the economic system itself.

What then lies behind the growing weight and influence of asset price volatility in the economy? Asset prices are driven by speculative forms of investing, by the increasing resort to debt, by multiplying and growing forms of leverage feeding that debt in the boom cycle, by the worldwide explosion of liquidity generated by growing income inequality and concentration among professional investors, and by the institutions and professional investors that lay behind the speculative investing shift in the world economy. That body of institutions and investors, their multiplying forms of financial offerings, their speculative markets created to absorb those offerings, and the explosion in global liquidity, credit and debt are the real material forces underlying the speculative investing shift and the system destabilizing asset price volatility that has been spreading and growing rapidly in recent decades as a consequence of that shift.

Analysis at the Level of Value

What are the implications of the foregoing analysis of Epic Recession, undertaken at the level of price, for a yet deeper analysis of Epic Recession at the level of value categories—the latter specifically in the Marxist sense of value? How might the preceding explanation of Epic Recession using price variables be expressed in terms of Marxist variables like fixed and variable capital and surplus value? Or the three key Marxist economic ratios—the rate of surplus value, the organic composition of capital, and the falling rate of profit?

In Marxist economic analysis, price variables operate at the level of exchange and are viewed as an approximation to real values. Price fluctuates around a core of real value based on labor time content in various ways, sometimes exceeding the average value and sometimes falling below that average. Unfortunately, capitalist governments do not maintain sufficient data on value categories and quantities. Thus analysis of Epic Recession may be undertaken at the level of price categories, for which abundant data exists, but is not yet possible quantitatively in terms of Marxist value categories due to unavailability of adequate data. However, one can theorize abstractly how financial crises and subsequent severe contract of the real economy—i.e. Epic Recession—might might be expressed in Marxist value terms. The remainder of this essay explores some possible new directions in this regard.

Marxist economics approaches the analysis of crises simultaneously from two directions: from the direction of surplus value extraction as commodities are produced with labor and appropriated by capital from labor; and from the direction of realization of value as those commodities are in turn exchanged for money. Both are essential for the reproduction and circuit of capital. Yet these two approaches are often incorrectly separated into explanations of ‘overproduction’ and ‘underconsumption’. This type of bifurcation of theory has caused no minor amount of confusion in the past for analyses of economic crises using Marxist categories of analysis. But overproduction and underconsumption are really two inseparable parts of the same process. Marxist crisis theory is neither overproductionist nor underconsumptionist. It is simultaneously both.

At the core of Marxist analysis are the three key ratios: rate of surplus value (RSV), organic composition of capital (OCK), and falling rate of profit (FRP). It is not that these ratios are ‘wrong’. It is that they are incomplete. What’s missing are key intermediate variables that provide a description of the various transmission mechanisms that occur in the process of surplus value extraction and its ultimate impact on profit rates. The missing intermediate variables are credit, debt, and time. By expanding the Marxist ratios with a consideration of at least these three intermediate variables it is perhaps possible to begin a consideration of the clearly obvious impact of finance and speculation on today’s global economic crisis.

A problem with the Marxist ratios is that the element of fixed capital © is considered only in terms of real physical assets. Financial assets play no role in the ratios. While some forms of financial assets, such as derivatives, may be considered ‘fictitious capital’, credit and its analog, debt, are not financial assets per se and therefore are not fictitious capital. Nevertheless, there is no role for credit in the three ratios, despite their obvious critical impact at times on the process of the circuit of capital necessary for the realization of value in Marxist analysis. Credit and debt have an obvious impact on financial crises and financial system collapse, which, in turn, directly influence the subsequent collapse in turn of real asset investment (i.e. fixed capital). To deny credit and debt a direct effect role in determining crises is, in effect, to deny the obvious causal impact of financial instability on the current global economic downturn.

Unlike derivatives and other financial instruments, credit is not fictitious capital. It is a form of financing, specifically debt financing. A borrower obtains credit from a lender and in the process incurs a debt. The credit may or may not assume a money form. For example, in speculative forms of investing in derivatives in the 21st century, credit may simply take the form of an electronic entry made by the lender to the borrower. No money in the sense of a universal equivalent is exchanged. Moreover, credit may be used to invest either in real assets (fixed capital) or in speculative financial assets, which may or may not represent fictitious capital. Apart from debt, other forms of financing are equity, or stock, financing and, thirdly, financing from retained business earnings. Equity or stock is correctly viewed by Marx as a form of fictitious capital. It is merely a legalistic transfer of a form of value, and does not represent a net increase in value. Using retained earnings for investment is a third form of financing. However, it is simply recycling capital in money form to commodity production, or C-M-C’. Thus the three basic forms of financing—i.e. debt(credit), equity, and retained earnings—are fundamentally different. Equity is fictitious capital by definition. Retained earnings is basically money capital. And credit has characteristics fundamentally different from both.

Unlike equity and money capital, credit (and debt) is not neutral in its impact on fixed capital accumulation. As Marx noted in Vol. III of Capital, credit may accelerate the rate of investment in fixed capital. As it does, it lowers the relative value of variable capital, V, in the organic composition of capital ratio as it accelerates the rate of fixed capital accumulation, C. This means the organic composition of capital, OCK, rises as the use of credit grows and/or intensifies. But if credit can have that effect, should it not be represented in the OCK ratio as an intermediate variable in some form? And if credit served to accelerate fixed capital accumulation, what of other possible relationships between credit and fixed capital? Might it also slow the rate of accumulation of fixed capital, C, under certain conditions—even as it may accelerate it under other conditions? However, the OCK and the three ratios are expressed in purely physical asset terms. There is no role for credit in the ratio OCK despite the potential impact on the rate of growth of fixed capital, C. Credit (and debt financing) plays no direct role in the growth of the organic composition of capital in the traditional statement of the three ratios.

Marx also foresaw that credit had a dual, even contradictory effect, on the capital accumulation process. It was two-sided. Credit also introduced and expanded the element of time in the fixed capital-real asset investment process. This made credit tend toward encouraging speculation; that is “credit helps keep the acts of buying and selling longer apart and serves thereby as a basis for speculation?. New forms of credit also “reproduces a new financial aristocracy, a new variety of parasites in the shape of promoters, speculators and …a whole system of swindling and cheating?. So credit has a double nature: accelerating fixed capital and similarly encouraging speculative investment. But if credit serves to encourage speculation, might not the development of speculation also result in a diversion of credit, that might have otherwise gone to accelerating fixed capital investment, but now instead toward speculative, fictitious forms of investment? And might not that same diversion possibly slow the rate of fixed capital accumulation? “The credit system appears as the main lever of over-production and over-speculation?, Marx summarized.

Clearly then, by introducing credit and thus the factor of ‘time’ credit plays a key role in driving speculative forms of investment, as well as real asset investment, or fixed capital, C. Credit may not just accelerate fixed capital investment, but also may slow it. Credit may be extended to finance speculative forms of investment in financial securities. As just one example, more than $60 trillion was invested over the past decade in derivatives called Credit Default Swaps, CDS. Less than 10% of that was actual money capital put up by investors. The rest was highly leveraged (more than 10 to 1) debt extended by lenders to speculators. And if speculative investing ‘crowds out’ real asset investing, as our analysis of Epic Recession argues, then credit serves to slow the rate of investment in real physical assets, i.e. fixed capital, C.

Unfortunately, Marx did not pursue the implications of the speculative side of credit. He went on to discuss banks, money and interest in the traditional sense of loaning (debt) to industrial capitalists. Non-traditional ‘shadow’ banks, which focused primarily on speculative investing, were not analyzed: “Special credit institutions, like special forms of banks, need no further consideration for our purpose?, he noted.

But credit can affect fixed capital, C, in multiple, different, even opposite ways: it may accelerate C, as Marx noted; and it may slow fixed capital accumulation. Which it does more, in net terms, so far as its impact on C, depends upon the stage of the real business cycle. In the early phases of the cycle, credit may well accelerate C, as Marx envisioned. But as the cycle progresses, investment in speculative forms of finance capital accelerates at a faster rate than real asset investment. Speculative finance results in a greater than average rate of profit than the average rate for real asset investment, with the result that money capital flows to speculative investing at a growing rate over the course of the cycle and thus diverts money capital and credit increasingly over the boom phase of the cycle to speculative forms of investment. Credit thus serves to ‘crowd out’ fixed capital investment in the later stages of the cycle, just as it served to accelerate the rate of C in the early stages. This view and analysis requires an understanding of the interdependencies between real asset © investment and speculative forms of investment in financial assets. The growing importance of the latter in late capitalism in the closing decades of the 20th century could not be foreseen by Marx, but were nonetheless anticipated in his early views on the role of credit in the rate and timing of fixed capital production.

This analysis of the role of credit can be developed still further. Investment in speculative securities, enabled by credit, clearly does not represent capital, C and V, with real value content. What then does speculative investment in financial securities represent? One possible answer is investing in financial securities of a speculative nature represent forms of capitalist consumption, not fixed capital investment. For example, the explosion of speculative investing in financial derivatives of various kinds today, in the amount of trillions of dollars outstanding globally, is not ‘investing’ per se. It is more akin to forms of gambling. But ‘investing’ in financial derivatives is based fundamentally on the availability of credit. Speculator-investors borrow credit (i.e. take on a debt) with which they then speculate in financial derivatives. Credit provided by a ‘lender’ represents debt incurred by the ‘borrower’. In turn, that debt also represents credit that potentially might have been employed in fixed capital, but is now diverted to gambling forms of capitalist consumption. So the rising rate of speculative forms of investing in derivatives and other financial securities, which intensifies in the late boom phase of the business cycle, in effect represents capitalist consumption diverting credit from capitalist reproduction of fixed capital, C. Moreover, this diversion to gambling forms of investment accelerates in the later stages of the business cycle.

But credit and debt may not only have different, sometimes opposite, impact on the OCK at the level of production, but on the realization of that value at the level of exchange as well. That is, credit (and debt) may also delay the process of realization of value, not just its production and extraction. Here an analysis needs to be introduced that considers not only the role of credit and debt in the process of fixed capital production, but the role of credit and debt in recovering by capital of part of the value of labor power previously paid to workers. Like businesses, households and consumers also accelerate their use of credit, and take on larger percentage of debt, as the business cycle advances. The analysis must include household credit-debt as well as capitalist usage of credit-debt. Workers’ consumption based on rising consumer debt in effect reduces the future value of labor power. Consumer or household debt is in effect the spending of future wages not yet earned, which must be repaid at interest (and thus reduced). In effect, interest charged by Capital for credit-debt extended to consumers represents a ‘taking back’ of part of paid labor power.

To summarize, at the level of production credit may have a ‘net negative effect’ on fixed capital investment. That is, it may speed up fixed capital investment, as Marx envisioned, but may also slow fixed capital expansion by facilitating the diversion to speculative forms of financial asset investment. At the level of realization of value, credit may also result in an increase in capitalist consumption at the expense of fixed capital, while household debt may further slow the realization of value over the longer run.

One of the still unresolved tasks of Marxist economic analysis is how to more clearly unify the production of value, expressed by the three ratios, with the realization of value. The two processes stand largely apart, giving rise to two views of Marxist crisis theory: one based on the three production ratios, culminating in the ratio expressing the tendency of the rate of profit to fall; the other expressing conceptually that somehow the commodities produced in the process must be purchased, or exchanged, to re-convert value back into its money form. The money form then ‘finances’ the further investment in fixed capital. However, as was noted, money capital is only one form of ‘finance’. And increasingly less necessary for even real asset investment, and virtually unnecessary for speculative financial investment. Missing are the transmission mechanisms between value in production and value in realization. This lack of unification is one reason why confusion exists whether Marx was an ‘overproductionist’ or an ‘underconsumptionist’. As noted earlier, this is a false dichotomy and Marx was neither and was both. But perhaps developing further the mechanism of credit, since it impacts both fixed capital and realization of value, might provide an approach to analysis of some potential.

A further comment on the absence of Time as a direct variable in the three Marxist ratios is perhaps appropriate at this point. First, Time does not appear as a direct variable in the OCK ratio, despite Marx having given labor time a precise and important role in his theory of value. Time is considered as a factor for V, variable capital, but not for C, fixed capital—at least not directly in the OCK ratio. However, Marx considers elsewhere something of a role for Time as a variable indirectly when he discusses money hoarding by banks in Volume III of Capital, pointing out that hoarding not only serves to slow the rate of investment in fixed capital but also slows down the period of time necessary for the completion of the circuit of capital. In other words, a Time factor can slow the process of the realization of value as well as the process of the production of value. One might add that the impact of Time on value is clearly not a constant, but has different effects depending on the stage of the business cycle. In the contraction phase of a cycle, bankers hoard money capital and refuse to extend credit. This, as noted above, affects the rate of fixed capital accumulation and in turn the OCK and FRP. On the other hand, by creating credit independent of the central bank’s effort to control it via money supply, private banks may accelerate both fixed capital and speculative forms of financial asset investment. Which has the greater effect? What’s the net impact on fixed capital? It depends on timing and the phase of the business cycle.

Concluding Remarks

It is necessary to distinguish between fixed asset investment and investment in speculative financial assets. Neither mainstream economics nor Marx make a sufficient distinction between the two, or explain how the two interact over the course of a business cycle and together contribute to economic instability. Mainstream economics considers only real asset investment as a variable, determined largely by changes in interest rates, which in turn are a consequence of money supply actions by central banks and money demand. In mechanical fashion, money supply changes determine interest rates, which in turn determine investment, according to Retro-Classicalists; whereas Hybrid Keynesians give token acknowledgement to money demand as well as money supply. But it is still a singular focus on real investment. Causal relationships and interdependencies between real asset investment and speculative forms of financial asset investment are ignored. Additionally, for mainstream economics there is only one price system and all prices—whether asset, product or labor wages—behave the same. The price system always stabilizes the economic system and makes possible as a result the fiction of ‘equilibrium’. This view of price fails to recognize the fundamentally destabilizing nature of asset prices in general and financial asset prices in particular. This failure prevents mainstream economics from properly understanding events like Epic Recessions and depressions. Nor is the ability of the banking system to create credit independently of the central bank acknowledged, and the role of debt in both consumption and investment is not addressed. Epic recessions are not distinguished from normal recessions despite their profound qualitative differences. Epic recessions are considered just normal recessions slightly write large. (Just as depressions are viewed as normal recessions writ significantly large). Consequently, mainstream economics can only suggest traditional fiscal and monetary policy measures as solutions to Epic Recession events, which is why they typically fail and result in either an extended stagnation or in limited instances in transitions to classic depressions.

In contrast to mainstream economics, Marx began to analyze the role of credit, debt and even speculative investment in Volume III of Capital, but did not adjust his classic three ratios to reflect the growing importance and role of financial factors in provoking capitalist instability. Marxists repeatedly have become embroiled in unproductive debates as to whether Marx was an ‘overproductionist’ or an ‘underconsumptionist’, misunderstand what is meant by fictitious capital by assuming credit itself is fictitious capital, and have yet to clarify the relationships between different forms of money—whether commodity money, fiat money-currency, and credit as used by Marx.

To better understand the character of deep crises in the 21st century, in which finance capital plays an increasingly important and growing role, it is necessary to adapt and extend Marx’s key three key ratios to reflect the influence of credit, debt, and time in both the process of fixed capital accumulation as well as value realization. A more thorough consideration of credit, debt, and time—i.e. a consideration of how they differently determine speculative and real asset (fixed capital) investment, and how they ultimately lead to greater fragility and crises in the economy, is necessary for a more complete understanding of the current crisis.

With its fundamental focus on equilibrium and denial of endogenous instability, it is unlikely that mainstream economics will be successful in amending its analysis to acknowledge the fundamental endogenous instability within the financial system of today’s global capitalist economy. In contrast, since Marxist economics assumes the basic instability of the system, it could potentially develop such an analysis. But Marxist economics will first have to amend its analysis beyond pure physical asset variables, like fixed capital and OCK. It will have to introduce intermediate, transmission variables that allow the integration of finance, credit, and debt within its three ratios, as well as within processes of value in production and value in realization.

Jack Rasmus
April 7, 2010

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