What The Federal Reserve Should Say

The US Federal Reserve today concludes its monthly two-day meeting. It will announce the conclusion of its meeting at 7.00 p.m. UK time. Although, much of the air time, on business programmes, during the day, will be spent speculating on what it will say, the truth is that no one knows, until its announced. But, this is what the Federal Reserve should say.

They should say that although they are not raising official rates, this month, they are giving markets advance notice that they intend to raise rates in July. They should make clear that, having raised in July, they will gauge the effect on the economy, and unless there is some serious downturn in economic activity, they will raise rates again in September, and again in December. They will make clear that the aim is to return the Fed Funds Rate to 1% by year end. Given actual economic conditions, such a rate would be hardly excessive.

The reason the Federal Reserve should say this is that its likely that they, and other central banks, across the globe, are already way behind the curve. There is a strong possibility that, as the global economy picks up speed, in the next few months, and given the long wave conjuncture, that inflation will rise sharply, and as it does, market interest rates will spike even more sharply, causing the bond bubble to burst, which will cause a much bigger global financial crisis thanhappened in 2008. I believe that such a crisis is inevitable anyway, because of the policies that central banks and governments have followed over the last six years, but central banks could still act now to provide themselves with some slight breathing room ahead of it.

Central banks should long ago have begun to rein in the liquidity they injected into markets, both before and after 2008. The main reason for the financial crash in 2008, was that from the 1980's onwards, a sharp rise in the global rate of profit, followed in the late 90's, and after, by a sharp rise also in the mass of profit, caused global interest rates to continuously fall. That fall in interest rates, as it always has in the past – for example, Marx and Engels analysis of the financial crisis during a similar economic boom in 1847 – encouraged speculation in financial assets.

With the majority of capitalists today being money-lending capitalists - owners of fictitious capital in the form of shares, bonds and property – such speculation, with huge and rapid capital gains to be made, over rode the fall in yields on those assets. Shares in many of the most popular and actively bought shares, for example, paid no dividend whatsoever. They were bought simply because of the potential that their price would rise massively in value over a short time.

The same has been true of property. Large amounts of property has been bought in London, New York, Shanghai and elsewhere that then lies empty, unused as accommodation by its owners, or let out to tenants. It has been built and bought by speculators, purely in the hope that its value will rise sharply, providing them with a capital gain.

The problem was compounded, therefore, because where, in the past, such bubbles were allowed to burst, with the central bank only injecting sufficient liquidity to overcome the immediate credit crunch, and so limit the damage to the actual economy, over the last 30 years, central banks have acted to protect the fictitious wealth of these speculators, by continuously injecting additional liquidity, whenever those asset prices fell.

For the last 30 years, economic policy was driven by monetary rather than fiscal policy. When the state intervened, to counter economic weakness, it did so by cutting official interest rates or printing money, rather than by a fiscal stimulus to increase government investment or current spending. Only in the aftermath of 2008 was the latter used by governments, and in the UK and Europe, even that was thrown sharply into reverse, in 2010, by conservative regimes, once again looking after the interests of those money-lending capitalists at the expense of the real economy.

The result was that the state of the economy was confused with the state of financial markets. If stock market or property market prices fell, this was presented as a weakness of the economy, which had to be remedied by the injection of yet more monetary stimulus. In the 1990's, in the US, this became known as the “Greenspan Put”, after the then Chairman of the Federal Reserve, Alan Greenspan. A “put” is an option to buy shares at a pre-determined price, at some future date. It got its name from the fact that traders knew that if the stock market fell, the Federal Reserve would step in to cut interest rates so as to push them up again, so it became rational to buy such put options ahead of Federal Reserve intervention, because the shares could be bought at the predetermined low price, and immediately sold at the current higher price.

But, in reality, the prices of financial assets usually move in the opposite direction to the health of the real economy. The Dow Jones Index rose by 1300% from 1982 to 2000, despite the fact that during the 1980's, the global economy, including the US, was suffering repeated slumps and stagnation. When the economy is really booming then, as Marx describes, the demand for loanable money-capital rises relative to its supply, pushing interest rates higher, and because interest rates move inversely to asset prices, those prices fall, as I described recently.

When firms issue more shares or bonds, to raise money to buy new factories, machines or to finance the employment of more workers, and purchase of additional materials, this increased supply of shares and bonds causes their prices to fall. The price of land is also determined by the rate of interest, because rent acts like the interest. There is no reason to pay £1 million for a piece of land that only pays £50,000 rent (5%) if instead I can buy a £1 million government bond that pays a guaranteed 6%, or £60,000.

But, this focus on the state of these financial markets had a further damaging effect on the real economy. In the 1970's, the idea was formulated that borrowing by the state acted to “crowd-out” borrowing by businesses, who found that either finance was not available, or interest rates were too high to enable them to borrow to expand their capital. The bubble in financial asset prices has had the same effect. Marx and Engels showed how, in 1847, despite high rates of profit, businesses drained money from productive activity to finance speculation in railways shares whose prices were soaring until the bubble burst.

Today, we see vast sums of money being used not to build property, but simply to push up the price of existing property by speculation. Further vast sums are used by the representatives of this fictitious capital, on company boards, not to invest in the business to expand, by taking on more workers, buying more buildings, machines and so on, but simply to push up the share price by their own speculative activity in the stock market.

This speculative activity drains resources away from productive investment. It thereby has further deleterious effects on the real economy. Firstly, by draining resources from productive investment it reduces the potential growth in the economy, including, therefore, the potential to put more people to work and increase incomes. As Ihave set out elsewhere, by draining resources from the real economy into speculation, it acts to cause a deflation of prices in the real economy, whilst causing a hyper-inflation of prices in the fictitious economy.

This latter has a further bad effect on the real economy. By artificially blowing up property prices, it not only makes home ownership impossible for a large part of society, and also makes it impossible for existing home owners to move up to a better house, it also causes rents to rise. The consequence is then that workers face much higher costs to buy or rent property. That raises the value of labour-power. Either wages rise to cover these costs or the state has to provide support, as seen by the massive rise in Housing Benefit, or else the additional spending on housing causes a reduction in spending on other commodities, causing their prices to fall, and with it the profits of the producers of those commodities.

In all these different ways, the effect is to significantly reduce the rate of surplus value, and thereby to undermine the potential for capital accumulation. The same thing applies to other areas of workers' necessary expenditure. For example, a central component of the value of labour-power is provision for old age, via pensions. But, as share and bond prices have rocketed, as a result of speculation, so the more or less fixed monthly contributions by workers and employers into pension funds has been able to buy fewer and fewer of those shares and bonds. To compensate for that additional cost of pension provision, wages and/or employers' contributions should have risen massively. That again would have caused profits to fall, and reduced the ability for capital accumulation.

In fact, the problem was compounded because as bond and share prices soared, so thee yields on them went to near zero, which means pension funds income, required to pay out pensions disappeared. It was this which created the massive black holes in company pension funds. But, the failure to raise wages or employer contributions into these funds has only deferred the problem. At some point, it will have to be made good by much higher wages or state support.

A look at the rise in stock markets and property markets since the early 1980's shows just how much they have risen compared to the growth in the real economy. I estimate that when the financial crash does come, stock, bond and property markets will fall by around 80%. That would take the Dow Jones index down to around 3,600. In 1982, it stood at around 800, so that would still be a rise of around 450%, which is more in line with the actual growth in the US economy. It would mean that yields on US and UK 10 Year Bonds would rise to around 10%, which again is not excessive by historical standards. It would also mean that the average price of a house in the UK would fall to around £40,000, which is still a four-fold increase from where it was in the late 1970's, before the property bubble begun to be inflated.

All of this massive inflation of asset prices is highly damaging to the economy, let alone the vast majority of ordinary people. Not only does it do nothing to promote economic growth, but it does the opposite and creates huge economic distortions, not least of which, as was seen in 2008, is the potential for financial crises, which themselves can then impact the real economy via a credit crunch.

Central banks need to act to burst these bubbles, whilst acting to limit the damage to the real economy. Avoiding the latter may be difficult. According to Marx, the 1847 crisis caused a 37% drop in UK economic activity, but that was quickly reversed by allowing the bubble to burst. Last month, Mario Draghi refused to act when European bond yields began to spike higher. He warned speculators against expecting a Draghi Put, by stating that they had to get used to the fact that with interest rates near zero, there would be increased volatility, as these rates increase.

Despite all the claims that the danger of contagion from a Greek default has been contained, the reality was seen in EU bond yields this week. On Monday, the yield on Spanish short dated paper rose by 265%! On Tuesday it rose by a further 25%. There were similar moves in Italian short dated paper, with money flowing into the safe haven of German Bunds, which nevertheless have yields nearly 1000% higher than a few weeks ago.

The processes which governed conditions for the last thirty years have been thrown into reverse. The US appeared to grow very little in the first quarter of this year. But, there seems to be some anomaly with the US data, because there was a similar drop last year, and the figure was anomalous with every other quarter. This year's first quarter figure was not as bad as last year, despite a large dock strike in California and a repeat of the bad weather, and it is likely to be revised higher.

US second quarter growth could, on some estimates, be as high as 3.5%. Moreover, as i've pointed out previously, the US, along with other economies, has been in a period of slower growth since Q3 2014, due to the three year business cycle. That should see growth strengthen from around Q3 of this year. US unemployment is falling, with some workers coming back into the labour force who had dropped out. Wages are rising with labour shortages in some areas. Core inflation is also picking up. A similar pattern can be seen in the UK, and some parts of Europe, as well as in Asia.

With employment and wages rising, this provides a further base for a rise in consumer spending, especially as the fall in oil prices and other primary products will work through into lower prices. Rising consumer demand will cause businesses to run down inventories and begin restocking, which will mean producers will need to invest in additional circulating capital – materials and labour-power – pushing employment and wages higher again. They may soon need to invest in additional capacity, once existing utilisation rates rise.

With all the liquidity sloshing around in global markets, this could result in rapid, unforeseen price rises. Rising wages will reduce the rate of surplus value, at a time when businesses need to invest to meet rising demand, causing interest rates to rise and asset prices to fall.

Once the psychology that asset prices only ever rise is broken – the myth put around that when share or property prices fall its always a “buying opportunity” - the bubbles will burst quickly, and money-capital will begin to flow into the plethora of very profitable avenues for productive investment that exist across the globe.