A Marxist Guide to Capitalist Crises
“A Marxist Guide to Capitalist Crises,” an eBook created from the key posts on the Critique of Crisis Theory blog, is currently in production. We’ll be sharing the completed chapters between our regular postings.
Chapter 14: Ricardo’s Theories of International Trade Challenged by the Crises of 1825 and 1837
In 1825, shortly after Ricardo’s death, the first global crisis of overproduction swept over Britain. A second global crisis erupted in 1837 with far more devastating results. It was followed by years of industrial depression and mass unemployment. Stormy class struggles broke out, from which came the Chartist movement, the first mass working-class political party. It was during the depression that followed the 1837 crisis that Marx and Engels were themselves radicalized.
External gold drains and the Ricardian theory
In Britain, the crises of 1825 and 1837 were preceded by major external drains of gold. To halt the drain that threatened the continued convertibility of the pound sterling into gold, the Bank of England raised its discount rate. This reversed the gold drain, but financial panic followed by severe recession hit and spread to other trading nations.
According to the Ricardian theory of world trade and comparative advantage, this was not supposed to happen. This theory predicted that trade would remain in balance among the trading nations. The gold reserves of the Bank of England would grow as newly mined gold flowed in, but there should be no severe external drains.
Ricardo said that any external gold drain implied prices were too high compared to Britain’s trading partners. Further, such a situation could not be sustained, and prices and nominal wages would start to fall. At worst, a negative balance of trade and payments meant Britain had “too much” gold. So a reduction in gold reserves would reduce nominal prices and wages to levels where trade and balance of payments would again be in balance.
This process would unfold gradually on a day-to-day basis. It would ensure that the world’s gold reserves would be distributed in proportions necessary to allow the law of comparative advantage to operate to the mutual benefit of all trading nations, regardless of their degree of development. Crises could not occur. However, what was excluded in theory occurred in practice in 1825 and again in 1837. Something was seriously amiss.
Ricardo’s supporters surmised that the British currency system was too far removed from pure gold circulation. Banks were issuing banknotes well beyond the amount of gold in their vaults, keeping prices higher than they should be.
To deal with this problem, Ricardian economists, also known as the “currency school,” proposed a series of reforms that would tie the number of banknotes to the quantity of gold held by the banking system. They expected these reforms would prevent any repeat of the crises of 1825 and 1837, with their mass unemployment and suffering leading to working-class radicalization.
The proposed reforms
The reformers argued that since both banknotes and gold were acting as money, it was necessary to ensure the number of banknotes was the same as the quantity of gold within the banking system. The problem was not the capitalist system or even the reigning Ricardian theories of international trade but rather a lack of proper bank regulation, which appropriate legislation could correct.
The centerpiece of the reform was the Bank Act of 1844. First, the right of commercial banks to issue banknotes was to be phased out. The total quantity of Bank of England banknotes was then tied to the actual quantity of gold bullion in its vaults. The Bank of England was divided into the Issue Department and the Banking Department to achieve this. (1)
The job of the Issue Department was to issue and cancel banknotes in proportion to the fluctuations in the quantity of gold in its vaults. The Banking Department was charged with taking deposits from commercial banks and the government; discounting or re-discounting commercial paper; and granting loans, mainly to commercial banks.
Except for a fixed fiduciary issue backed by government bonds, the Issue Department could only issue banknotes backed by gold bullion. (2) If gold flowed into the bank, additional banknotes were created in direct proportion. If gold flowed out, banknotes were canceled in an amount that matched.
When the Banking Department needed additional banknotes, it would turn to the Issue Department to supply them — assuming it had enough gold to cover the request. The Banking Department could not simply print additional banknotes when it desired to increase its profits.
There were, however, no such restrictions on the number of checkable deposits the Banking Department could create. This meant the possibility existed that the Bank of England could run out of its notes and go bankrupt, even if the Issue Department had a substantial quantity of gold like an ordinary commercial bank could go bankrupt if it lacked the banknotes to meet demands for payments on its deposit liabilities to its depositors.
Under this legislation, if the balance of trade and payments began to turn against England, gold would flow out of the bank, and the number of banknotes in Britain would immediately begin to decline. Ricardo’s theory of comparative advantage and the quantity theory of money was now put to the test.
The currency school predicted that the “general gluts” of commodities that followed the panics of 1825 and 1837 would not recur.
Ricardo’s theory of comparative advantage and the quantity theory of money fails the test
It did not work. Three years after the Bank Act was passed, in October 1847, a new panic hit Britain. The Bank Act had to be suspended to quell the panic. A decade later, the crisis of 1857 forced the suspension of the Bank Act again. It had to be suspended a third time during the panic of 1866. Why wasn’t the Bank Act working? Why did crises keep breaking out?
The problem was that prices did not react like the quantity theory of money claimed they would. Instead, interest rates, not prices, proved to be sensitive to an expansion and contraction in the quantity of gold in the vaults and the consequent changes in the number of banknotes.
Between 1844, when the legislation went into effect, and 1873, the trend of prices in Britain was upward, reflecting the fall in the value of gold relative to the value of most commodities in the wake of the gold discoveries of 1848 and 1851. And since these were years of rapid overall economic growth, the number of commodities in circulation within Britain expanded rapidly. But the number of banknotes in circulation progressively declined. This is because banknotes were being replaced by checkable bank deposits, significantly reducing the need for banknotes.
When Britain suffered a gold drain, interest rates, not prices, reacted. Instead of prices falling, the rate of interest rose. These higher interest rates attracted “hot money” from abroad as money capitalists invested in Britain to obtain a higher return on their “moneyed capital.”
Then, as the global industrial cycle approached a peak, Britain found it increasingly difficult to attract the additional money-capital necessary to finance its current account deficit in the face of a growing global money shortage. As explained in the preceding chapters dealing with an “ideal industrial cycle,” the growing global money famine was merely the flip side of global overproduction.
As long as the balance of payments deficit continued, interest rates kept rising. And as the boom continued, prices rose at the cost of a growing strain on the British domestic money market. More and more bank money — checkable deposits — was being created, backed by less and less cash — banknotes and gold — in the banking system. Finally, panic erupted as the owners of the bank deposits tried to convert their deposits into banknotes all at once. Credit vanished, the stock market crashed, and commercial paper became un-discountable. Most importantly, commodities piled up unsold in warehouses, and industrial production plunged, leading to massive layoffs and unemployment.
The financial panic and subsequent industrial crisis finally lowered prices and wages, but at the cost of recession and mass unemployment. As the domestic market contracted, British industrial and commercial capitalists were forced to export more, while the contraction of the home market meant that Britain imported less. Instead of painless and gradual adjustments of prices and money wages, the balance of trade and payments deficits were indeed corrected but violently through the crisis itself.
The crisis then broke out successively in the various trading countries. For example, the crisis might begin in the United States as a negative trade balance drained gold from its banks. As the United States sank into recession, British exports to America declined, while American exports to Britain rose. British industries began to experience difficulties due to declining exports to the United States and increasing competition from U.S. products within the British home market. At the same time, gold began to flow from Britain to the U.S.
At first, this was a response to high interest rates in the United States as British money capitalists took advantage of these rates and the consequent opportunity to purchase American securities at rock-bottom prices. Prices of these securities then rose sharply as the U.S. crisis subsided, creating windfall profits for their new British owners.
As the recession took hold in the United States, its balance of trade and payments swung from deficit back to surplus. As a result, more gold returned to the U.S. banking system, and U.S. interest rates fell. However, much of the gold flowing into the United States came from the now-dwindling gold reserve of the Bank of England’s Issue Department. Under the 1844 banking legislation, the number of banknotes created by the Issue Department was declining, causing interest rates to soar on the domestic British money market.
But prices in Britain only started to decline when the developing British recession brought about a contraction of monetarily effective demand within the British home market. Commodities piled up in British warehouses, leading to production cutbacks and mass layoffs. To get rid of the massive buildup in unsold commodities and meet the demands for immediate payment on the part of their creditors, British industrial and commercial capitalists were forced to cut prices while rising unemployment forced the sellers of the commodity labor power to cut their prices, that is, accept lower wages.
As recession-bound Britain imported less and exported more, Britain’s balance-of-payments account swung back into surplus, leading to balance-of-trade and payments deficits in France, Germany, and other continental European countries. Soon, financial panics, or at least “tight money” and recession, spread throughout continental Europe.
Therefore, before the crisis finally subsided, it affected all the major trading nations of the time. Say’s Law, the quantity theory of money, and Ricardo’s law of comparative advantage, the holy trinity of economic liberalism, were all missing in action.
Bank Act made crises worse
The Bank Act of 1844 not only failed to eliminate crises but also worsened them. Why was this? Before the Bank Act, the Bank of England could always issue additional banknotes to meet the increased demand as a means of payment and means of hoarding during a crisis. True, the bank had to maintain the convertibility of its banknotes into gold. However, it still could issue additional banknotes while retaining their convertibility until the return flow of gold broke the crisis.
Under the Bank Act, however, the Bank’s hands were tied. The demand for banknotes as a means of payment increased considerably during crises. The industrial, commercial, and money capitalists demanded immediate payment in banknotes of debts owed to them, fearing their debtors would go under.
However, the capitalist creditors knew that the Bank of England could not issue additional banknotes to meet the additional demand, not because of any economic law but due to the 1844 banking legislation. The banking regulation that was supposed to eliminate crises instead made them worse.
Public knowledge that the central bank could not issue additional banknotes to meet the extra demand whipped up the demand for banknotes into a frenzy. A debtor would drag down creditors. As runs developed on commercial banks, banknotes would flow out of the banking system into private hoards, and the industrial recession, with its mass unemployment, was greatly intensified.
Fortunately for British capitalism, the authors of the Bank Act of 1844 provided a loophole. With economic collapse threatening, the Bank Act could be suspended. During the suspension of the act, the Bank of England, though it was still obliged to pay five gold sovereigns for every five-pound banknote presented to it, was free to create additional banknotes.
As soon as the public got word that the Bank Act was suspended, the demand for banknotes would immediately plummet, and the panic would end. Banknotes would be returned to the commercial banking system and the Issue Department from private hoards. Interest rates would then fall, and the money market promptly eased. Then industrial overproduction, the real cause of the crisis, would gradually be liquidated, and the economy would begin to recover.
As it turned out, with a brief exception during the 1857 crisis, the Bank of England did not even have to issue banknotes over those allowed by the Bank Act. The mere knowledge that the bank could issue such notes so reduced the demand that no issue of extra banknotes was necessary. The crises of 1847, 1857, and 1866, unlike that of 1837, did not lead to prolonged depressions for reasons that will be explored when I examine the controversial “theory of long cycles” under capitalism.
Still, the Bank Act succeeded in making crises worse than they would have been otherwise. As Marx put it, no banking legislation can eliminate banking crises — we have to abolish capitalism to accomplish that — but bad banking legislation can make the inevitable banking crises and the unemployment that results worse. Marx’s observation should be borne in mind today when evaluating the consequences of various proposals to increase regulation of the banking system to eliminate banking crises in our day.
The Bank Act of 1844 turned out to be bad legislation even from the viewpoint of the capitalists because the theories it was based on — the quantity theory of money, Say’s Law, and Ricardo’s theory of comparative advantage — did not reflect the actual economic laws that rule the capitalist system.
Toward a correct theory of international trade and crises under capitalism
During an economic boom, when credit is freely available on the world market, some countries can run large deficits in their balance of trade and payments on “current account” by borrowing from other countries that can run offsetting balance of trade and payments surpluses. But when the crisis strikes and credit is paralyzed internationally and nationally, debtor countries are forced to slash imports, and creditor countries see a collapse of their export markets.
Here we see yet another function of crises. Crises force countries to keep their trade and payments more or less in balance in the long run. During the global crisis, deficit countries are forced to slash imports while surplus countries see their exports contract. The expansion of international credit during the boom enables the balance of trade and payments among the trading nations to become increasingly lopsided. The crisis forces things back into balance, more or less, once again.
Therefore, the first significant attempt to eliminate periodic crises of generalized overproduction, without eliminating capitalist production, through banking regulation reforms came to grief. In the following chapter, we will examine the work of John Maynard Keynes — the English economist whose name has become synonymous with attempts to eliminate or at least mitigate crises of overproduction under capitalism. Keynes himself was greatly influenced by both the debacles that occurred under the Bank Act of 1844 as well as the Great Depression of the 1930s.
(1) The Issue Department could also back the banknotes it created by silver to a certain extent — many countries were still on the silver standard in 1844 — but this does not affect the essence of the argument. (back)
(2) To this day, some commercial banks in Scotland still have a limited legal right to issue banknotes backed by legal tender Bank of England notes. (back)
A Critique of Crisis Theory 