Economic Theory & The Cuts - Part 1

Judging, the economic consequences of the Cuts is not easy. The Tories argument is that by cutting the deficit, the private sector will move in to fill the gap. The basis of this argument, in even orthodox economic theory, is very dubious. The basic argument, put forward, is that Government Expenditure "crowds out" the private sector, because, in borrowing money, to finance this expenditure, the Government necessarily raises interest rates above where they would otherwise have been. By raising interest rates, this increases the cost of Capital, and so at any level of economic activity the Supply of Capital will be reduced, so employment will be lower, and consequently, incomes and expenditure will be lower.

There is no doubt that, at times, this argument could be valid. But, essentially, those times are when there is a shortage of loanable funds. On any basis, there is clearly no shortage of loanable funds at the present. Despite the fact that private sector indebtedness has ballooned in Britain, at the same time, the total amount of savings has also increased, as the survey from the NS&I demonstrates here. Moreover, this figure of £18,000 average in savings accounts does not take into account the large amounts of money that many people have accumulated in ISA's and PEP's in the last 20 years or so, or the vast amounts saved in Pension Funds, currently estimated at around £800 billion. Given that Pension Funds have to place significant amounts of money in Long dated securities, the Government has had a captive market for money into its Long dated Gilts, which is one reason that the structure of UK debt tends to be of much longer duration than other EU countries.

But, that is not the only source of loanable funds. As many economists have identified from the late 1980's onwards, the rate of profit has been rising. A look at the masses of profit, of large companies, such as Tesco, racked up year after year, is a testament to that fact. Although, some of that profit is paid out as dividends, and some is utilised for investment, most large companies, in profitable sectors of the economy, have stored up large cash balances on their Balance Sheets. Moreover, Capital is now truly global, and it is not just large companies in the UK that have been amassing large cash balances. Microsoft, had at one point over $40 billion in cash. Its Total Current Assets stand at $55 billion. But, as this analyst points out,

“With almost $37 billion in cash and short term securities on their balance sheet as of June 30, the company has very little need for more cash. But two weeks ago Microsoft announced the offering of $4.75 billion in bonds at record low rates. For example, it is issuing $1 billion of 10 year bonds yielding 3%.

If you can borrow money for 10 years at 3%, why not?”

I'm tempted to say that surely what is good for Microsoft should be good for the UK Government, which can also borrow for ten years at 3%. The point is that both Microsoft and the British Government can borrow at these historically low levels, precisely because there is no shortage of loanable funds! The list of where these loanable funds can come from is by no means exhausted. In addition to the vast sums, built up on the Balance Sheets, of large companies, around the globe, there are also vast amounts, sitting in the savings accounts of individuals around the globe, particularly in Asia, whose lifestyle leads them to have a culture of “saving therapy”, rather than “retail therapy”. On top of that, countries such as China, and other Asian economies, along with countries in the Middle East, in Russia, and in Latin America, and even in Africa, have created huge Sovereign Wealth Funds with the revenues they have received as a result of booming economies, and exports to the West. All of these funds have to be put somewhere in order for them to fulfil their function as Capital, to bring in a return, and although higher returns can be made by using these funds to invest in global equities, and physically buying up companies, such investments are more risky than simply buying the debt of developed western economies such as the US and UK.

Finally, there is another reason that there is no shortage of loanable Capital, and that is that over the last year or so, countries have been engaging in Quantitative Easing, money printing. A Government can always find a buyer for its debt, simply by turning to its Central Bank, and asking it to buy that debt with newly printed money. One reason that the Tories analogy with domestic budgets is a crock is precisely that if a family did that they would end up in gaol.

There is no basis for an argument that the private sector is being crowded out. There is no basis for the Tories argument that, had they not addressed the deficit, by introducing huge cuts, that international Capital would have raised the interest rate it demanded from the UK either. As Alan Johnson said, in his response, the reality is that, despite the deficit, UK interest rates have been falling since the beginning of the year! The UK has had much higher debt to GDP ratios than this before, and no serious person believes that the UK is going to default on its debt. For one thing, it could do what the US has done many times and simply print money to cover those debts, and, just as the figure for private indebtedness hides the fact of huge domestic private savings, so Britain's Public Debts hides the fact that, as a result of several centuries of Colonialism and Imperialism, the UK has vast investments overseas. It could repatriate those investments if need be to cover the debts. The Tories say there is no alternative, but the reality is that there are many, many alternatives.

But, there is also another problem with the Crowding Out Theory. Its best viewed with the aid of a graph.



The graph shows the relation between total profits and the Supply of Capital. This can be viewed as the greater volume of profit to be made the more Capital is supplied, as Capital comes in in search of that profit. If, at any point, we divide the Total Profits by the Total Capital, (P/Q), then we get, at that point, the Rate of Profit, R. However, the theory is that if interest rates rise, the cost of Capital goes up. Consequently, because Capitalists have to pay more for that Capital, the amount left over for them (Profit of Enterprise) is reduced, so at any particularly Rate of Profit, they will tend to bring forward less Capital. The graph shows that, with higher interest rates, the curve, for the Supply of Capital, shifts to the left. In order to bring forward the same quantity of Capital at this new interest rate, the Rate of Profit has to rise from R1 to R2. In fact, at any point along this curve, R has to be higher, because, by definition, the same quantity of profit is divided by a smaller quantity of Capital.

We would expect then, if the theory is correct, to see that, in periods when the Rate of Interest is rising,the Supply of Capital would be reduced, and that consequently, the Rate of Profit would be rising. Conversely, where the Rate of Interest is falling, the Supply of Capital would be rising, and the Rate of Profit would be falling. In other words, because Capital is cheaper, Capitalists employ more of it, and as this results in an increased supply of goods, and competition between them, the Rate of Profit is squeezed. But, the problem is that from the mid to late 1980's, the trend for the Rate of Interest was falling, and continued to fall for around 20 years! In that case, we should have seen a declining Rate of Profit. But, it is precisely during this period that we have seen the opposite, the Rate of Profit has been rising from the mid to late 1980's.

That is not a surprise for a Marxist. For a Marxist, the determining factor is not the Rate of Interest, but the Rate of Profit, and the Absolute Volume of Profit. The Rate of Profit will determine the movement of Capital from one sphere to another. If the Rate of Profit is low in steel-making, but high in Chemicals, Capital will tend to move from the former to the latter. By this means the supply of steel will fall, prices and profit will rise, whilst the Supply of Chemicals will rise, prices and profits will fall, bringing about a dynamic equalisation of profits, via a constant disequilibrium. But, this cannot determine the amount of Capital in total that is supplied. As Marx points out, although there is a minimum below which wages can fall – i.e. below a certain level labour power is simply not reproduced, so its supply will fall and its price rise – the same is not true for Capital. Capital is only Capital if it self-expands, and it can only do that by being productively employed. However, its clear that Capital CAN be destroyed. Capital used to produce commodities which have no Exchange Value – because there is no demand for them, either because simply no one wants them, or because due to a recession or other economic circumstances, consumers lack the resources to buy them – is effectively destroyed, it is not reproduced. Moreover, below a certain level of profits, its likely that Capitalists will simply decide that the risk of investment is too great. Rather than use Capital as capital, they will destroy it by reducing it to simply a means of unproductive consumption i.e. they will convert it to money, and spend it on luxuries, or simply hoard it in the bank.

Forward To Part 2