The Federal Reserve System, Its History and Function, Part 1

This is a special post in two parts on the U.S. Federal Reserve System. It is in response to the rise of the Occupy Wall Street movement. Part 2 will be published on November 6, and the next regularly scheduled reply on the crisis of the dollar system will be published on November 20.

The last weeks in the United States have seen a sudden surge of anti-Wall Street demonstrations that have targeted the policy of the U.S. government of “bailing out banks and not people.” The occupation movement has since spread first across the United States and now the world.

The followers of Ron Paul, a right-wing Republican congressman and presidential primary candidate from Texas, have appeared at some of the occupations and raised the slogan “End the Fed.” Paul believes that not only “the Fed” but democracy in any form should be abolished. Paul’s followers blame the Federal Reserve System for virtually all the problems faced by the lower 99 percent—high unemployment, the high cost of living, mass indebtedness, “underwater” homes, and foreclosures.

But what actually is the Fed, or to use its formal name, the Federal Reserve System? Is it some kind of privately owned bank, or is it a government agency? What is the difference between the Federal Reserve Board and a Federal Reserve bank? Is the Fed really to blame for the problems of the lower 99 percent of the population? And if the answer is yes, why would such an evil institution have been established in the first place?

The Bloody Rise of the Dollar System

The current dollar-centered international monetary system is the result of a century of competition among the capitalist nations, especially the imperialist countries. The competition that led to the current dollar system was not only economic but also political and not least military. The military competition took the form of not one but two of the bloodiest wars in world history.

Relationship between economic, political and military competition

Although there is not a one-to-one relationship between political-military and economic competition among capitalist countries, political-military competition is ultimately rooted in economic competition. So in examining competition among capitalist countries, we first have to look at economic competition. What are the economic laws that govern competition and trade among different capitalist countries?

First, let’s review the laws that do not govern international trade under the capitalist system. Using the quantity theory of money and, at least implicitly, Say’s Law, the (bourgeois) economists picture competition among capitalist nations as a friendly game in which everybody emerges the winner. Within each country, according to the economists, “full employment” reigns.

According to the modern marginalist economists, under perfect competition each “factor of production”—land represented by landowners, capital represented by capitalists, and labor represented by workers—gets back in rent on land, interest on capital, and the wages of labor precisely the value each creates. Our economists claim that as long as “perfect competition” exists, no “factor of production” can exploit another factor of production.

Similarly in world trade, every country benefits by “free trade.” According to the theory of comparative advantage, each country concentrates its production on what it is comparatively best at, not necessarily absolutely best at. According to this theory, even if a given country has a below-average level of labor productivity in every branch of production, there will always be some branch where it will enjoy a comparative advantage enabling it to prevail in international competition.

Therefore, if we are to believe the economists, countries that are deficient in modern productive forces benefit from international trade just as much as the countries that monopolize the world’s most advanced productive forces. The result, the economists claim, is the most efficient system of global production that the prevailing technical and natural conditions of production allow.

World Trade and the False Theory of Comparative Advantage

Some introductory remarks

This reply and the one that will follow should be seen as a continuation of my reply criticizing the view of economist Dean Baker that the U.S. dollar is “overvalued” and his claim that the U.S. trade deficit could easily be corrected and the U.S. unemployment crisis eased by simply lowering the exchange rate of the U.S. dollar against other currencies.

I had originally planned to continue the discussion of world trade and currency exchange rates the following month but the contrived U.S. government debt crisis in August forced a change of plans.

Reader Mike has made some interesting remarks about world trade and the dollar system—the foundation of the American empire, which has dominated the world politically, militarily as well as economically since World War II. To understand the growing threat of a renewed crisis barely two years after the official end of the “Great Recession” of 2007-09, it is important to understand both world trade and the dollar system.

Discussing Baker’s arguments for a lower dollar, Mike wants to know if there is an objective basis for determining if currencies are “high” or “low” in relation to one another. Baker summarizes his argument as follows:

“The U.S. pattern of spending more than it takes in is due to the fact that the dollar is too high. In a system of floating exchange rates, like the one we have, the price of currencies is supposed to fluctuate to bring trade into balance. This means that the trade deficit is caused by the over-valued dollar and a decline in the dollar is the predictable result.”

The obvious problem with the view that the U.S. dollar is “overvalued” is that ever since the end of the Bretton Woods system 40 years ago, the exchange rate of the U.S. dollar has shown a secular tendency to decline against other currencies. If the dollar was “too high” in the sense that there is a correct level of exchange rates that would end the U.S. trade deficit, why hasn’t the secular fall in the dollar brought the U.S. trade account into balance?

Crises Real and Artificial, and Why a New ‘New Deal’ is Not Feasible

I had originally planned to answer questions by Mike on exchange rates, which were partially taken up in my critique of an article by Dean Baker. While the factors that determine exchange rates are an important question in economics, especially for the theory of world trade, events over the last few weeks dictate that my reply to Mike’s questions be postponed.

These events include the threatened default of the U.S. government on its debt payments, the decision of the Obama administration to accept a compromise that includes no tax increases for the rich, a wave of panic selling on Wall Street and other world stock exchanges, a new plunge of the dollar against gold, the downgrading of the U.S. debt from AAA to AA+ by Standard and Poor’s, and a rare split vote by the Federal Reserve’s Open Market Committee on what to do next concerning the Federal Reserve’s monetary policy.

Any one of these events would probably have necessitated the decision to postpone the reply to Mike’s questions on exchange rates. However, the events of the last few weeks are closely intertwined with and relate to questions that this blog has been examining since its inception in the January following the late 2008 panic. In order to keep this reply within reasonable limits, I will concentrate on the question of the debt of the U.S. federal government and the threatened default by that government.

Debt default crisis a political and not a true financial crisis

Since World War I, the maximum debt that the U.S. government could carry has been determined by law. Every so often as the maximum debt limit was approached, Congress routinely voted to raise the debt limit. But this year the Republican-controlled House balked. The Republican majority threatened to refuse to raise the debt ceiling unless the Obama administration agreed not to raise taxes on the rich and corporations or even close tax loopholes that have often enabled the rich and corporations to pay no taxes at all.

The U.S. Treasury warned that if the debt limit was not raised by August 2, it would not have enough cash on hand to pay all its bills coming due, forcing it to default. The crisis was purely a legal and political one, since the U.S. government has been having no trouble recently selling its notes and bonds. Indeed, the federal government was able to sell them at prices that yielded some of the lowest interest rates it has ever had to pay. This would hardly be the case if there was a real threat of a federal default.

The media were taking the default threat seriously, but the markets—the capitalists in the know—were not. The markets were right. Over the weekend of July 30-August 1, the Democratic and Republican parties came up with a deal that raised the debt limit and averted the “danger” that the U.S. government would run out of money and default on payments on its huge debt.

A Keynesian Takes on Karl Marx

In this reply, unless otherwise noted, text in italics and in brackets in Marx quotes is carried over from the version taken from the Marxist Internet Archive.

A friend N has asked if there is any difference between “the over-accumulation of capital” and “the overproduction of commodities.” Another friend M sent me a critical article by leading American Keynesian economist Brad DeLong on Chapter 17 of Marx’s “Theories of Surplus Value.” DeLong’s article is titled “Marx’s Half Baked Crisis Theory and His Theories of Surplus Value, Chapter 17.”

It so happens that in Chapter 17 Marx deals with the relationship between the “overproduction of capital”—also called the “over-accumulation of capital”—and “the overproduction of commodities.” The economists of Marx’s time—the middle years of the 19th century—admitted the “overproduction of capital”—equivalent to the over-accumulation of capital—while denying the “overproduction of commodities.”

Therefore, DeLong’s critique of Marx and N’s question about the relationship between the overproduction of commodities and the over-accumulation of capital are connected by Chapter 17 of “Theories of Surplus Value,” the target of Brad DeLong. It is therefore possible to deal with DeLong’s critique and N’s question in a single reply.

Is the Economic Crisis Over?

According to the media, the world capitalist economy has been in a recovery for almost two years. Yet there remains a widespread impression that the economic crisis that began in 2007 is far from over. True, the rate of profit has risen sharply since 2009, and the mass of profits is at record levels. Yet the crisis of mass unemployment persists.

At the current rates of job creation in the U.S. and other imperialist countries, it will be years before the number of jobs returns to the levels that prevailed in 2007 on the eve of the crisis. And even the pre-crisis 2007 levels were far from full employment. Therefore, is the economic crisis that began in 2007 really over?

The passage of a cyclical crisis described

Rosa Luxemburg in “What Is Economics?”—which was written shortly after the economic crisis of 1907-08—gave this vivid description of how a cyclical crisis of overproduction is reflected in the capitalist media:

“…once the crisis is in full swing, then the argument starts about who is to blame for it. The businessmen blame the abrupt credit refusals by the banks, the speculative mania of the stockbrokers; the stockbrokers blame the industrialists; the industrialists blame the shortage of money, etc.”

Though these words were written a century ago shortly after the 1907-08 crisis, they could just as well have been written to describe the crisis that began exactly a century later in 2007.

The recovery

“And when business finally picks up again,” Luxemburg continued, “then the stock exchange and the newspapers note the first signs of improvement with relief, until, at last, hope, peace, and security stop over for a short stay once more.”

“Modern society,” Luxemburg further explained, “notes its [the cyclical crisis—SW] approach with horror; it bows its head trembling under the blows coming down as thick as hail; it waits for the end of the ordeal, then lifts its head once more—at first timidly and skeptically; only much later is society almost reassured again.”

Crisis of 1907-08 in historical perspective

As it turned out, after the crisis of 1907-08 capitalist society had little time to get “reassured again.” If the industrial cycle that began with the crisis of 1907 had followed the typical 10-year course, the next crisis of overproduction would have been due around 1917.

Instead, a new worldwide recession began in 1913, about four years early. In Europe, this new recession did not end with a new upswing that left society “almost reassured again.” Instead, it ended with the “Guns of August”—the outbreak of World War I.

Capitalism ‘celebrates’ the anniversary of 1907 crisis

The capitalist economy “celebrated” the 100-year anniversary of the crisis of 1907 in the most “appropriate” way possible—with yet another crisis. And like its predecessor a century earlier, the crisis that began in 2007 proved to be unusually severe. There is a feeling now that the crisis of 2007-09 is perhaps, like the crisis of 1907-08, no ordinary crisis. Could this crisis, too, be the herald of a far more fundamental crisis of capitalist society?

A New Imperialist War

The last few weeks have seen the beginning of a new imperialist war, this time against the small oil-rich country of Libya. The war began on March 19, when the United States, Britain and France launched a missile attack against Libya’s air defenses.

The opening of this new U.S.-led imperialist war of aggression occurred on the eighth anniversary of the U.S.-led invasion of Iraq. To add to the irony, the first missiles began to fall during U.S. West Coast anti-war demonstrations timed to mark the beginning of the imperialist invasion of Iraq—a first in the history of anti-war demonstrations, I believe.

I had been asked what is my opinion of the current economic conjuncture. I had intended to devote a reply to this question, since I have not written about this for some time and there have been some interesting developments on this front. However, the explosive events in North Africa and the Persian Gulf region combined with the Japanese earthquake, tsunami and nuclear disasters are raising a different set of questions that should be dealt with first.

What will be the effects of these events on the world capitalist economy? These events are external to the industrial cycle, though they will no doubt exert an influence on the evolution of the current global industrial cycle that began with the outbreak of the last general crisis of overproduction in 2007. Therefore, this month I will examine the effects of the North African and Persian Gulf events and the Japanese disasters on the capitalist world economy. I will postpone until next month an examination of the current conjuncture in the global industrial cycle.

Are Marx and Keynes Compatible? Pt 7

Last week, I examined the letter Baran sent to Sweezy in 1960 that dealt with the concept of the “economic surplus.” Over the next two weeks, I will examine the letter Sweezy sent to Baran dated September 25, 1962, which deals with monopoly, capitalist stagnation and Keynes.

Sweezy and stagnation

Sweezy described himself as a “stagnationist.” In his mature writings, he came to believe that the “default” condition of monopoly capitalism is a state of “stagnation.” But what exactly did Sweezy mean by “stagnation”? To understand what he meant, we have to understand the traditional marginalism that formed the starting point of Sweezy’s economic studies.

Marginalist, or “neoclassical,” economics claims that a capitalist economy has a strong tendency toward full employment of both the means of production and workers. Remember, the marginalists hold that, assuming there are no unions or social legislation, the capitalist economy will have as its normal condition a situation of full employment of both the means of production and workers.

When Sweezy began his economic studies at Harvard before both the New Deal and the rise of the CIO (Congress of Industrial Organizations), there was virtually no social legislation or social insurance of any kind in the United States. The union movement was very weak and, outside of mining, in basic large-scale industries was virtually nonexistent.

Therefore, according to marginalist theory the U.S. economy should have been very close to a situation of full employment of both the means of production and the workers. But in the early 1930s as Sweezy was studying economics at Harvard, the U.S. was facing an extreme crisis of mass unemployment. Clearly, there was something very wrong with the economics that Sweezy was learning.

Are Marx and Keynes Compatible? Pt 5

Keynesian economists blame their failure on the trade unions

Keynesian economists in general—and some Marxists influenced by them—blame the failure of the Keynesian policies of the 1970s on the trade unions. Basing themselves on Keynes, they falsely blame the inflation of the 1970s not on the inflationary monetary policies of the central banks that were so strongly supported by Keynesian economists at the time but on the trade unions.

These economists claim that by achieving raises in money wages during the inflation, “over-strong” unions were responsible for the inflation of the 1970s. Supposedly, a “wage-price spiral” pushed money wages relentlessly higher forcing the central banks to periodically raise interest rates to prevent even worse inflation, which in turn led to the recessions and unemployment of the 1970s and early 1980s.

However, in reality it was the trade unions that found themselves increasingly on the defensive as both inflation and unemployment rose during the 1970s and into the early 1980s. What the Keynesian economists call the “wage-price spiral” of the 1970s was really a “price-wage spiral.” The unions were only reacting to the ongoing inflation in their attempts to maintain—not entirely successfully—the living standards of their members.

Are Marx and Keynes Compatible? Pt 4

The Keynesian revolution in economic policy

Before Keynes, neo-classical marginalist economists believed that capitalism was stable if left to its own devices. These economists held that a capitalist economy tended strongly toward an equilibrium at full employment of both workers and machines. Therefore, if a recession were to occur the response of the authorities should be pretty much confined to having the central bank lower the discount rate. Otherwise, the government should stay out of the way. As long as it did, the marginalists claimed, the capitalist economy would quickly move back to its only possible equilibrium position, “full employment.”

The events that followed World War I, especially the U.S.-centered Great Depression of 1929-1941, discredited this view. Under the influence of Keynes—and more importantly the Depression itself—most of the new generation of (bourgeois) economists believed that it was now the duty of the capitalist government to actively intervene whenever recession threatened.

Bourgeois economics split in two. One branch, purely theoretical, is called “microeconomics.” Microeconomics is simply the old marginalism. The branch that emerged from the Keynesian revolution is called “macroeconomics.”

Macroeconomics tries to explain the movements of the industrial cycle. More importantly, it seeks to arm the capitalist governments and “monetary authorities” with “tools” that will keep the capitalist economy from sinking again into deep depression with the resulting mass unemployment. The new stance of the bourgeois economists was that if the capitalist governments and their monetary authorities use the “tool chest” provided them by macroeconomics correctly, they should be able to maintain “near to full employment with low inflation.”

Full employment was defined by this new generation of (bourgeois) economists not the way workers would define it—everybody who desires a job can quickly find one—but rather as a level of unemployment sufficiently high to keep the wage demands of the workers and their unions in check but low enough to prevent wide-scale unrest that could lead to working-class radicalization and eventually socialist revolution.