Fictitious Capital Eats Real Capital
Two things were going on in the early 2000's that conditioned the background to the 2008 crisis. Firstly, this new global long wave boom had started, and was causing the demand for primary products to rise sharply, causing primary product prices to rise sharply. Primary products constitute a large part of the circulating constant capital of manufacturing industry, and so, as Marx sets out in Capital III, Chapter 6, surges in these market prices, cause a sudden squeeze on the rate of profit, by increasing the value of c in the fraction s/(c+v). In other words a rise in the value composition of capital rather than in the technical, and thereby organic composition of capital. As Marx describes in Capital III, Chapter 6, and in Theories of Surplus Value, these sharp rises in the value composition of capital, as market prices for inputs rise sharply are a cause of crises of overproduction, during these boom periods. Secondly, the increase in the price of c causes the value of output to rise, because output value is c + v + s, or as price of production, ((c + v) = k) + p, i.e. cost of production plus average profit, and to the extent this causes the price of wage goods to rise, it causes the value of labour-power to rise, putting upward pressure on wages, which reduces the rate of surplus value, s/v, and acts to further squeeze profits, because both s falls, whilst v, and so c + v, rises. Finally, primary products includes food, and higher food prices directly causes the value of labour-power to rise, and so similarly causes the rate of surplus value to fall, and further squeezes profits. 
Yet, the conditions created by the onset of the long wave boom meant that demand was rising sharply, and competition, therefore, means that each capital is driven to attempt to capture as much of this rising demand as possible, so as to maximise its profits, and avoid being squeezed out of the market by its competitors. Additional workers means more wages demanding more wage goods, and higher wages enhances that tendency; increased demand for primary products, and higher prices for primary products, means that countries producing primary products have greater revenues, which they use to demand additional manufactured imports, to accumulate additional capital of their own etc. Each capital is led to accumulate more capital so as to expand its output, driven on by competition, even if the rate of profit it obtains on this additional output is lower, due to this squeeze on its profits, due to rising costs of inputs. After all, as previously described, the rate of surplus value, and rate and mass of profit had already been driven up considerably in the previous 20 years, providing a sizeable buffer. Moreover, the technological developments of that period meant that whilst input costs might rise, higher levels of productivity meant that production costs were lower, and fall with economies of scale, so that end product prices do not rise proportionate to input costs. The extent to which the rise in demand, where it is sustained, causes capital accumulation to increase was itself illustrated by the large investments in new sources of primary production, in the early 2000's, which in turn leads to another partial crisis of overproduction, in 2014, when all of this new supply of oil, copper, iron ore, and agricultural products starts to hit the market, and leads to sharp falls in their market prices, as I described in a series of posts in relation to oil, at the end of 2014.
The consequence of such boom conditions, as Marx sets out in Capital III, in describing the relation of the interest rate cycle to the business cycle, is that the demand for money-capital rises relative to the supply of money-capital. The supply of money-capital comes from the existing stock of savings, but increases in that supply are determined, essentially, by the growth in the mass of realised profits. Firms can either use their own realised profits to finance their expansion, or they can borrow in the money market, and the increase in money market funds comes, essentially, from the realised profits of firms that have not been utilised for their own expansion. As an increasing proportion of firms seek to expand, so, on average, each firm uses more of its own realised profits to finance such expansion, rather than depositing those profits in the money market, and similarly, a larger proportion of firms go to the money market seeking money-capital to finance their expansion, even if that expansion is only in terms of buying more materials and labour-power, or to cover the higher cost of those inputs, as the prices of materials, and wages rise.
The market rate of interest, as opposed to the highly manipulated central bank interest rates, or interest rates on government bonds, is determined by the interaction between this demand for, and supply of money-capital. So, as the demand for money-capital rose, relative to the supply, global interest rates began to rise. In my post of March 2008, setting out a first draft of a thesis on the World Economy, I noted a comment by Richard Durrant, writing in the Daily Reckoning, in June 2007, which said,
“If you were tuned into BBC 1’s dumbed down 6 o’clock show masquerading as a news programme you would have missed it. But while the world’s gaze was fixed on the stage-managed junket called the G8 summit, something sensational was happening in the US Treasury market that may have lasting implications for your investments.
For the last twenty years, the yield on US ten-year Treasury bonds has been falling steadily. This reflected a mounting confidence that the inflation dragon had been vanquished. Yields have fluctuated, but each successive peak in yields has been lower than the preceding one. Those peaks provide the points of contact for a downtrend line that has survived for 20 years. Traders that have bought Treasury bonds when yields were on the line made money time after time. Accordingly the line has been a source of great confidence. Such trends give traders something to hang on to.
But when a trend that has been in place for so long breaks, there is pandemonium in dealing rooms. This is what happened in the US Treasuries market on Thursday June 7. Once the downtrend line had been crossed at the yield of 5.05% on 10-year paper, there was indiscriminate selling of US Treasury bonds. By the end of the New York session, 10-year yields came to rest at 5.13%. Then Asian traders took up the mantle and initiated a fresh wave of selling pushing yields to a high of 5.24%. At that point the cost of money had effectively risen by 5.7% in 30 hours.
The yield on 10-year US Treasuries is the single most important interest rate around. It provides the basis for the yields on a range of securities throughout the world. So what caused this trend line to break? There was no economic news of importance released on the day, rather the accumulated evidence that the next move in Fed rates would not necessarily be down, forced the trend line to cave in. For more than a month now official data has shown that the US and world economy had been growing faster than anticipated. Earlier in the week investment bank heavyweights Goldman Sachs and Merrill Lynch abandoned their forecasts that the Fed would cut rates this year.
To some traders the breaking of the trend line marks the end of an era of ever-cheaper credit. Hitherto the stock market has gained enormously from cheap credit. It has made it worthwhile for companies to buy back their stock at a record rate. It has also enabled the private equity industry to go on its buy-out binge, taking out public companies at values significantly higher than priced by the market. Moreover the long-term optimism engendered by low stable bond yields allowed the rapid development of credit derivatives. These have made it easier for lenders to spread their risks. This in turn reduced the rates at which companies could borrow to levels close to the virtually risk-free rate at which the US Treasury borrows.
It follows that higher bond yields have a habit of dragging down share prices. The last time bond yields were as high was in mid-2002 when stock markets were in free fall. Also the only other time in the last five years when US 10-year yields were above 5% was last summer when equity markets got a bout of the jitters.
In the last three months the cost of 10-year money has risen from 4.5% to a high of 5.33%. If bond market losses are compounded in the future, it will force a more widespread flight out of risky investments that have been founded on cheap money and low volatility. Possible positions under threat include high yield currencies, investments in emerging market government bonds and commodities that have been enjoying a price squeeze. Although it is too early to say that we are at the end of the four-year rally in equities, we may be at the beginning of the end.”
In fact, as Marx pointed out in Capital, even 150 years ago, neither the official interest rates, set by central banks, nor government bond yields are a good measure of average market rates of interest, because, even then, they were heavily manipulated. The rates of interest that firms charged each other were a better gauge of the real market rate of interest, Marx said. But, the rise in the US 10 Year yield, in 2007, was significant, because of what it represented, and that was this change in the secular trend of global interest rates, and the credit crunch that was about to unfold. In fact, as I wrote a few weeks ago, global bond yields were about to gap higher. As I set out in a post shortly after that, it was typical of making such predictions that immediately afterwards, US yields fell back, but I explained why that was. It was that rising global bond yields, had caused a sell-off in Emerging Markets, with funds flowing from them, back to safe havens in US assets. Turkey was a case, in point. But, we have now seen Turkey raise its official interest rates to 24%, to try to stabilise the Lira. Argentina has gone even further, raising its official interest rates to a staggering 60%.
Now we see the effects of those higher yields, and the potential for sizeable capital gains from currency appreciation, reversing the flow of recent months. Global bond yields have once more surged, with the US 10 Year Treasury, having again risen sharply from around 2.85% to over 3.10%, before settling back at around 3.07%. In the meantime, confounding the financial market pundits, but confirming the argument I have set out over the last few years, as global interest rates have risen, consumer goods prices have continued to rise, as global demand rises, and liquidity from all that QE begins to flow away from assets towards the real economy. Already, it is causing central banks to have to try to get from behind the curve. The Bank of England is having to give forward guidance of further rate hikes, even as it warns of the dangers of Brexit, and a 35% drop in UK house prices. The Federal Reserve, contrary to the financial pundits' hopes of an end to rate hikes, is stepping them up, with a rate hike expected next week, and a further hike in December.
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