Monday, 5 September 2016

A Crisis Carol - Stave 2 - The Ghost Of Crisis Past - Part 2

Stave 2 - The Ghost of Crisis Past

When, in 1987, the first glimpse behind the curtain was gained, as global financial markets suffered their worst ever declines, the scrooges were struck with panic. If you own a factory, a machine, or the things they produce, they have real value, determined by their price of production. In an economic crisis, an inability to sell the output, at that value, may cause a temporary loss, but, once the crisis is over, the factory and the machine still has its value, and can still produce profits, often on a greater scale than before. But, the paper wealth of the scrooges has no real value. Its only value comes from its claim to future interest. The same ephemeral causes of astronomical rises in the price of these paper assets can then lead to a catastrophic collapse in the prices of those assets. As stock and bond prices collapsed, in 1987, therefore, there seemed nothing standing in the way of them just continuing to fall further and further, wiping out all of the paper wealth of the scrooges, and many of them, at the time, thought that was going to happen.

But, there was a saviour, in the shape of Alan Greenspan, a former devotee of Ayn Rand, an advocate of sound money based on gold, who overnight became an advocate of monetary expansion to end the crisis, and end it it did. Over the next year, share prices not only recovered their losses but rose way above their previous level. But, of course, it did not resolve the underlying problem; it, in fact, exacerbated it, and created the conditions that exist today.

Marx, in Capital, briefly describes the basis of what is going on. There are two things that determine the market price of these fictitious assets:-

  1. the amount of revenue they can produce, which is a function of profits, and
  2. the average rate of interest. 
This is the process of capitalisation. If the rate of interest is 5%, you need a financial asset with a value of £1,000 to produce an annual income of £50. So, if profits are rising, and the shares you own provide a dividend of £100, there will be a tendency for demand for these shares to rise, because they will be yielding 10%. As the demand for the shares rises, their price rises, and so the yield on them falls.

Similarly, if the shares were still only paying out £50 in dividends, but the average rate of interest falls to 2.5%, the demand for them would rise, because anyone using £1,000 elsewhere would only be getting £25 p.a. The price of the shares would rise until they too were only yielding 2.5%. Of course, what the average rate of interest is depends itself on the demand and supply for money-capital. A rising mass of profit, will provide more revenues that may flow into the money market, increasing the supply of money-capital, but the higher potential profits might encourage a higher demand for money-capital also.

Marx makes the point that it is the rate of interest that can tend to have the more decisive impact on asset prices, as far as the Stock Exchange is concerned. In other words, even if profits are not rising rapidly, stock prices can, if interest rates are falling, and vice versa. Marx's view is born out by looking at a long-term, inflation adjusted chart of share prices. It shows that during these long periods when the rate of interest is rising, share prices fall, and vice versa. 

In the period, particularly after 1987, the rate of profit was rising, making more of that profit available to pay out as dividends, and interest, and the rate of interest itself was in a long-term, secular decline. Both provided a powerful boost to share prices. The extent to which this revenue simply fed back into fuelling this asset price boom, rather than financing the accumulation of real capital can be seen by comparing the rise in share prices to the growth of GDP. Between 1980 and 2000, US GDP rose by 257%, whereas the Dow Jones Index rose by a staggering 1,323%. The same kind of ballooning of asset prices could be seen in bond and property prices, and in the UK, and other developed economies.

A natural correction to such bubbles should arise, because as these asset prices rise, yields on those assets fall. The owners of those assets see their revenues falling, and so utilise their money-capital in other ways. Typically, it would be expected that they would utilise that money-capital to invest productively rather than speculatively, or even that they might increase their own unproductive consumption. As Marx put it, as the prices of these assets rise, it is an effective depreciation of the money-capital, because more and more of it has to be employed, in order to obtain the same amount of revenue. It is the equivalent of the depreciation of the currency in relation to commodity prices, i.e. more of it has to be given up to obtain the same quantity of use value. In the case of a depreciation of the currency, it buys fewer and fewer commodities, in the case of depreciated money-capital, it buys fewer and fewer shares, bonds, and less and less property etc.

The owners of money-capital should find it less and less worthwhile to use it speculatively, and increasingly attractive to use it to accumulate real capital, to build new factories, buy machines and materials and to employ workers. As Marx puts it,

“It would be still more absurd to presume that capital would yield interest on the basis of capitalist production without performing any productive function, i.e., without creating surplus-value, of which interest is just a part; that the capitalist mode of production would run its course without capitalist production. If an untowardly large section of capitalists were to convert their capital into money-capital, the result would be a frightful depreciation of money-capital and a frightful fall in the rate of interest; many would at once face the impossibility of living on their interest, and would hence be compelled to reconvert into industrial capitalists.” (Capital III, Chapter 23, p 378) 

In part, that was what the 1987 financial crisis was illustrating, and it is what every subsequent financial crisis has increasingly illustrated. Typical of the way capitalism works, this self-correction, never functions without some kind of crisis to bring it about. There is nothing particularly new about what happened this time, other than in the response of central banks and governments. The problem with this self-correction mechanism is basically this, although the owners of this money-capital are primarily, and ordinarily concerned with the revenue (yield) they can obtain from it, at times of more intense speculation, that concern becomes one instead for making large, speculative capital gains.

For example, during the Tulipmania, tulips themselves brought no revenue of any kind, but who was concerned with revenue when the tulip bulbs you bought last week, had risen in price by 20% by this week? And so it is with all speculative bubbles whether it be in tulips, land, railways, shares, bonds, property, gold, or anything else. What the owner of such assets becomes fixated with is not whether the yield on the asset has fallen from 10% to 5%, but on the fact that the asset itself has risen in price by 20%, 50% and more during the year!

Rather than the fall in yields prompting a move into investment in real productive-capital, what it prompts, despite high and rising rates of profit, is instead, yet more financial speculation, as the bubble gets blown up bigger and bigger. Once again, why would you be interested in putting your money-capital into productive investment, even if it brought you a 20-30% rate of profit, if instead you could buy a selection of shares, that you expect to rise by 50-100% during the year? Marx and Engels described exactly that situation, during the boom of the 1840's, when high and rising rates of profit were being made, and yet, despite that, owners of money-capital diverted it from such business activity, to engage in the Railway Mania that created a huge speculative bubble in railway shares.

"The thirst for speculation of manufacturers and merchants at first found gratification in this field, and as early as in the summer of 1844, stock was fully underwritten, i.e., so far as there was money to cover the initial payments. As for the rest, time would show! But when further payments were due — Question 1059, C. D. 1848/57, indicates that the capital invested in railways in 1846-47 amounted to £75 million — recourse had to be taken to credit, and in most cases the basic enterprises of the firm had also to bleed.”

(Capital III, Chapter 25) 

Where money-capital is used to buy bonds or shares, that are issued to finance new productive investment, that creates the basis for the production of the profits out of which the interest on those bonds and shares is paid. If A buys shares at issue, for £1,000, and the £1,000, the firm issuing the shares obtains, is used to buy machines, materials etc., it has financed productive investment. If B, buys A's shares, some time later, for £2,000, the £2,000 that B hands over does not thereby finance any additional productive investment. B's £2,000 does not go to the firm issuing the shares, but to A, who owns the shares. If A uses the £2,000 to buy newly issued shares in some other company, that money-capital does then finance some new productive investment, but there is no guarantee that A will use the £2,000 in that way.

Instead, A may decide that the shares of some other company, now offer a better speculative opportunity than their old shares. So, they may then use the £2,000 to buy shares from C, who had originally paid only £1,000 for them. Rather than ever financing any additional productive activity, therefore, this speculation can simply act to drive the prices of assets to ever higher levels. So, long as the money realised from the sale of these assets by their owners simply goes to buy a different set of those assets, and so long as additional funds continues to flow in, to keep buying those existing assets, at a faster rate than new such assets are created, the bubble will continue to inflate. Indeed that is what the astronomical rise in the Dow Jones between 1980 and 2000, compared to the rise in GDP, indicates did happen during that period.

But, ultimately, such speculative bubbles necessarily burst. They can only continue to be inflated so long as the potential buyers of these assets believe that the prices will continue to rise, and rise significantly over a relatively short period. They may see slight corrections as buying opportunities, provided they continue to believe that, in the next year, or two years, the inexorable rise in prices will continue. Its only when they think that prices are likely to fall massively, or that the inexorable rise in prices has ended, that they will start to sell, and cause the bubble to burst.

Because the inflation of these bubbles essentially has no correlation to the underlying real economy, so the bursting of those bubbles should have no necessary impact on the real economy either. Its rather like if all the money-capitalists had got together and used their money to bet on the outcome of the spin of a roulette wheel, or a horse race. Many of the gamblers may lose their money, and one or two might win, but there is no reason why their individual fortunes in that respect, should have any impact on the functioning of the rest of the real economy.

“As regards the fall in the purely nominal capital, State bonds, shares etc.—in so far as it does not lead to the bankruptcy of the state or of the share company, or to the complete stoppage of reproduction through undermining the credit of the industrial capitalists who hold such securities—it amounts only to the transfer of wealth from one hand to another and will, on the whole, act favourably upon reproduction, since the parvenus into whose hands these stocks or shares fall cheaply, are mostly more enterprising than their former owners.” (TOSV2 p 496) 

As Marx points out, after the bubble of the Railway Mania burst, there was a sharp economic contraction of around 37%. But, the real cause of this contraction was not the financial crisis. It was that the Bank of England has passed the 1844 Bank Act, which created a credit crunch, as the demand for liquidity rose sharply. Once the act was suspended, and liquidity was provided, the credit crunch ended, and economic activity responded vigorously, the boom continuing until around 1865.

Back To Part 1

Forward To Part 3

No comments: