In my Jacobin piece on finance, I observed in passing that financial commitments across borders — what’s sometimes called capital mobility — enforce the logic of markets on national governments. This disciplining role has been on vivid display in the euro area over the past few years. Here, courtesy of yesterday’s Financial Times, is a great example of the obverse: If a state does want to resist liberal “reforms”, it needs to limit financial flows across the border.
The headline in the online edition spells it right out:
Renminbi stalls on road to being a global currency. New capital controls lead to doubt, especially over hopes of forcing economic reform.
The print edition is wordier but even clearer:
Renminbi reaches its high water mark. Fresh capital controls cast doubt over the push to increase the global use of its global currency. But what does that mean for the Chinese policymakers who saw it as a ‘Trojan horse’ to force through economic reform?
The whole article is fascinating. On the substance it’s really quite good — anyone who teaches international finance or open-economy macroeconomics should bookmark it to share with students. Along with the political-economy question I’m interested in here, it touches on almost all the most important points you’d want to make about what determines exchange rates. 
The article’s starting point is that for most of the past decade, international use of the Chinese renminbi (Rmb) has been steadily increasing. Some people even saw a future rival to the dollar. For most of the period, the renminbi was appreciating against the dollar, and the Chinese government was loosening restrictions on cross-border financial transactions. But recently those trends have reversed:
The share of China’s foreign trade settled in its own currency has shrunk from 26 per cent to 16 per cent over the past year while renminbi deposits in Hong Kong — the currency’s largest offshore centre — are down 30 per cent from a 2014 peak of Rmb1tn. Foreign ownership of Chinese domestic financial assets peaked at Rmb4.6tn in May 2015; it now stands at just Rmb3.3tn. In terms of turnover on global foreign exchange markets, the renminbi is only the world’s eighth most-traded currency — squeezed between the Swiss franc and Swedish krona — barely changed from ninth position in 2013.
What appeared to be structural drivers supporting greater international use of the Chinese currency now appear more like opportunism and speculation.
Large financial outflows — including capital flight by Chinese wealthholders and currency speculators reversing their bets — have led the renminbi to lose 10 percent of its value against the dollar over the past year or so. The Chinese central bank (the People’s Bank of China, or PBoC) has had to use a substantial part of its dollar reserves to keep the renminbi from depreciating even further.
… the PBoC remains active in the foreign exchange market as buyer and seller. Over the past 18 months, this has mostly meant selling dollars from foreign exchange reserves to counteract the depreciation pressure weighing on the renminbi.
This strategy has been expensive, contributing to a decline in reserves from $4tn in June 2014 to $3.1tn at the end of November. Defenders of the PBoC believe such aggressive action to curb depreciation has been worth the price because it prevented panic selling by global investors. Critics counter that costly forex intervention has merely delayed an inevitable exchange-rate adjustment.
For years, the IMF, US Treasury and other outside experts have urged China to embrace a floating exchange rate. In theory, such a step should eliminate the need to tighten capital controls or to spend precious foreign reserves on propping up the exchange rate. Instead, the currency would weaken until inflows and outflows balance.
In the age of Trump, it’s worth stressing this point: The Chinese central bank has been intervening to make the renminbi stronger, not weaker — to keep Chinese goods relatively expensive, not cheap. This has been true for a while, actually, although you can still find prominent liberals complaining about China boosting its exports through “currency manipulation”. Also, as the article notes, the Washington Consensus line has been that China should end foreign-exchange interventions and abolish capital controls, allowing the renminbi to depreciate even further.
For most countries, continuing to spend down reserves would be the only alternative to uncontrolled depreciation. But China, unlike most countries, has maintained effective controls over cross-border financial flows, so it has another option: limiting the ability of households and businesses to trade renminbi claims for dollar ones.
The State Administration of Foreign Exchange, the regulator, last week said it would continue to encourage outbound investment deals that support the country’s efforts to transform its economy… But the agency said it would apply tighter scrutiny to acquisitions of real estate, hotels, Hollywood studios and sport teams.
That will probably mean fewer food-additive tycoons buying second-tier UK football clubs. It also suggests a crackdown on fake trade invoices, Hong Kong insurance purchases and gambling losses in Macau — all channels used to spirit money out of China. …
“They are trying to squeeze out all the low quality or suspicious or fraudulent outbound investment. But they have also made it clear they support genuine high-quality investment,” says Mr Qu.
These moves come on top of other limits on financial outflows. This passage highlights a couple additional points. First, effective controls on financial flows require controls on cross-border transactions in general. Second, there’s no sharp line between macro policy aimed at the exchange rate or other monetary aggregates, and micro-interventions aimed at channeling credit in particular directions.
Now to the political economy point:
China’s recent moves to tighten approvals for foreign acquisitions by Chinese companies, as well as other transactions that require selling renminbi for foreign currency, cast further doubt on China’s commitment to currency internationalisation.
“There is a fundamental conflict between preserving stability and allowing the freedom and flexibility required of a global currency,” says Brad Setser, senior fellow at the Council on Foreign Relations and a former US Treasury official. “Now that the cost is becoming clear, Chinese policymakers may be realising they are not willing to do what it takes to maintain a global currency. Capital controls certainly set back the cause of renminbi internationalisation but they may well be the appropriate step given the outflow pressures.”
As a topic for banking conferences and think-tank seminars, renminbi internationalisation could not be beaten. It offered a way to express dissatisfaction with the US dollar-dominated monetary system, as laid bare by the 2008 financial crisis, while signalling an eagerness to do business with China’s large, fast-growing economy.
For China’s reform-minded central bank, however, renminbi internationalisation … offered something else: a Trojan horse that could be used to persuade Communist party leaders in Beijing and financial elites to accept reforms that were, in reality, more important for China’s domestic financial system than for the renminbi’s international status. Since 2010, when the internationalisation drive began, many of those reforms have been adopted…
This is the dynamic we’ve seen over and over. Real or imagined pressure from the outside — from international creditors , institutions like the IMF, “the markets” in general — is needed to push through a liberal agenda that would not be accepted on its own merits. This is true in China, with its multiple competing power centers and effective if disorganized popular protests, just as it is for countries with more formally democratic political systems. What’s unusual about China’s case is that the “reform” side may no longer be winning.
What’s unusual about this article is that it’s spelled out so clearly. “Trojan horse”: Their words, not mine.
The article continues:
The totem of currency internationalisation also served as justification for China’s moves over the past half-decade to open up its domestic financial markets to foreign investment, a process known as capital account liberalisation, that has been crucial to the global push of the renminbi. If foreign investors are to hold large quantities of China’s currency, they must have access to a deep and diverse pool of renminbi assets — and the peace of mind of knowing that they are free to sell those assets and convert proceeds back into their home currency as needed.
Again, thinking of classroom use, this is a nice illustration of liquidity preference.
Until last week, regulators had also steadily loosened approval requirements for foreign direct investment, in to and out of the country. But those reforms occurred at a time when capital inflows and outflows were roughly balanced, which meant that liberalisation did not create strong pressure on the exchange rate. Now, the situation is very different. Beijing faces a stark choice. Either row back on freeing up capital flows — as it has already begun to do this year — or relinquish control of the exchange rate and accept a hefty devaluation.
We used to talk about a trilemma: A country cannot simultaneously peg its currency, set interest rates at the level required by the domestic economy, and allow free financial flows across its borders. At most you can manage two of the three. But it’s becoming clear that for most countries it’s more of a dilemma: If you allow free capital mobility, you can’t control either the exchange rate or domestic credit conditions. International financial shifts are so large, and so unpredictable, that for most central banks they’ll overwhelm anything that can be done with conventional tools.
And when you accept free capital mobility, with its dubious rewards, it’s not just control over interest rates and exchange rates you’re giving up. In the absence of controls over international financial flows, the whole range of economic policy — of public decisions in general — is potentially subject to the veto of finance. If you need foreign wealth-owners to voluntarily hold your assets, the only way to keep them happy — so goes the approved catechism — is to adopt the full range of market-friendly reforms. The FT again:
Economists argue that the fate of renminbi internationalisation ultimately depends on far-reaching economic reforms rather than short-term responses to rising capital outflows.
The list of course starts with privatization of state-owned companies and continues with deregulating finance.
“When you reimpose capital controls after having rolled them back, it can sometimes have a perverse effect,” says Mr Prasad… “What they need to do is something much harder — actually to get started on the broader reform agenda and show that they are serious about it. Right now the sense is that there is very little happening on other reforms.”
This is what it comes down to: If China is going to reach the grail of international-currency status, it is going to have to focus on the “reform” agenda dictated by financial markets — it’s going to have to earn their trust and prove it is “serious.” What exactly are the benefits of that status for China? It’s far from clear. (Of course it’s an attractive prospect for Chinese individuals who own lots of renminbi-denominated assets.) But it doesn’t matter as long as it serves as a seemingly objective basis for continued liberalization, which otherwise might face serious resistance.
“The question is which is to be the master — that’s all.”
 It doesn’t, of course, mention uncovered interest parity, the idea that interest rate differences between currencies exactly offset expected exchange rate changes. This doctrine dominates textbook discussion of exchange rate movements but plays no role in any real-life discussion of them.
Brian Romanchuk has a characteristically thoughtful post making “the case against growth and stimulus.” He’s responding to pieces by Larry Summers and John Cochrane arguing that macroeconomic policy should focus more on output growth.
Brian has two objections to this. First, environmental resource constraints are real. Not in an absolute sense — in principle a given throughput of physical inputs can be associated with an arbitrarily high GDP. But in our economies as currently organized there is a tight connection between rising GDP and increased use of fossil fuels. Even leaving aside climate change concerns, that means that faster growth may well be cut off by a spike in oil prices.  The second objection is that the link between higher growth and better labor-market outcomes may not be as tight as Summers suggests. In Brian’s view, things like public investment may not do much for incomes at the bottom because the
U.S. labour market is obviously segmented. The “high skill” segments are doing relatively well… Non-targeted “demand management” (such as infrastructure spending) is probably going to require creating jobs for college-educated workers. (You need an engineering degree to sign off on plans, for example.) It is a safe bet that the job market for college graduates would become extremely tight before the U-6 unemployment rate even begins to close on its historical lows. This would cause inflationary pressures…
This suggests that the focus should be on direct job-creation programs for people left out of the private market, rather than policies to raise aggregate demand.
Since I am (very slowly) making an argument that there is space for more expansionary policy, evidently I disagree.
Before saying why, I should add one other argument on Brian’s side. One reason to be against “growth” as a political project is that higher GDP does not increase people’s wellbeing. In my view this is clearly true for countries with per-capita GDP above $15,000-20,000 or so. This is a moderately respectable view these days, though obviously a minority one. For most economists the case for growth is still so obvious it doesn’t even need stating — having more stuff makes people happier.
I don’t believe that. But I still think it’s worth arguing that there is more space for expansionary policy to raise GDP. For three reasons:
First, I think Summers and Cochrane are right (!) about the importance of tight labor markets to raise wages, flatten the income distribution and increase the social power of working people more broadly. I don’t think you would have had the mass social movements of the 1960s and 70s (even on such apparently non-economic ones as feminism and gay rights) if there hadn’t been a long period of very tight labor markets.  The threat of unemployment maintains the power of the boss in the workplace, and that reinforces all kinds of other hierarchies as well.
Corollary to this, I’m not convinced that the labor market is as segmented as Brian suggests. I think that in many cases, people with more credentials get to the front of the queue for the same jobs, as opposed to competing for a distinct pool of jobs. It seems to me the historical evidence is unambiguous that when overall unemployment falls there are disproportionate gains for those at the bottom.
Second, I think the idea of a hard ceiling to potential output is an important part of the logic of scarcity that hems in our political imagination in all kinds of harmful ways. Yes, infrastructure spending, and sometimes also increased social spending, even a basic income, can be presented as measures to boost demand and output. But you can also look at it the other way — these are good things on the merits, and the claim that they will boost output is just a way of defusing arguments that we “can’t afford” them. To me, the policy importance of saying we are far from any real supply constraint is not that higher output is desirable in itself (apart from its labor-market effects); it’s that it strengthens the argument for public spending that’s desirable for its own sake.
Third, on a more academic level, I think the idea of a fixed exogenous potential output is one of the most important patches (along with the “natural rate of interest”) covering up the disconnect between the “real exchange” world of economic theory and the actual monetary production economy we live in. Assuming that the long-run path of output is fixed by real supply-side factors is a way of quarantining monetary and demand factors to the short run. So the more space we open up for demand-side effects, the more space we have to analyze the economy as a system of money claims and payments and coordination problems rather than the efficient allocation of scare resources
 As it happens, this was the the topic of the first real post on this blog.
 The best discussion of this link I know of is in Armstrong, Glyn and Harrison’s Capitalism Since 1945. Jefferson Cowie’s more recent book on the ’70s makes a similar case for the US specifically.
(I wrote this post a month ago and for some reason never posted it.)
UPDATE: There’s another argument I meant to mention. When I look around I see a world full of energetic, talented, creative people forced to spend their days doing tedious shitwork and performing servility. I find it morally offensive to claim that a job at McDonald’s or in a nail salon or Amazon warehouse is the fullest use of anyone’s potential. When Keynes says that we will build “our New Jerusalem out of the labour which in our former vain folly we were keeping unused and unhappy in enforced idleness,” he doesn’t have to mean literal idleness. In a society in which aggregate expenditure was constantly pushing against supply constraints, millions of people today who spend the working hours of the day having the humanity slowly ground out of them would instead be developing their capacities as engineers, artists, electricians, doctors, scientists. To say that most of the jobs we expect people to do today make full use of their potential is a vile slander, even if we are only measuring potential by the narrow standards of GDP.
I have a new piece up at Jacobin on December’s rate hike. In my experience, the editing at Jacobin is excellent. But for better or worse, they don’t go for footnotes. So I’m reposting this here with the original notes. And also for comments, which Jacobin (perhaps wisely) doesn’t allow.
I conveyed some of the same views on “What’d You Miss?” on Bloomberg TV a couple weeks ago. (I come on around 13:30.)
To the surprise of no one, the Federal Reserve recently raised the federal funds rate — the interest rate under its direct control — from 0–0.25 percent to 0.25–0.5 percent, ending seven years of a federal funds rate of zero.
But while widely anticipated, the decision still clashes with the Fed’s supposed mandate to maintain full employment and price stability. Inflation remains well shy of the Fed’s 2 percent benchmark (its interpretation of its legal mandate to promote “price stability”) — 1.4 percent in 2015, according to the Fed’s preferred personal consumption expenditure measure, and a mere 0.4 percent using the consumer price index — and shows no sign of rising.
US GDP remains roughly 10 percent below the pre-2008 trend, so it’s hard to argue that the economy is approaching any kind of supply constraints. Set aside the fundamental incoherence of the notion of “price stability” (let alone of a single metric to measure it) — according to the Fed’s professed rulebook, the case for a rate increase is no stronger today than a year or two ago. Even the business press, for the most part, fails to see the logic for raising rates now.
Yet from another perspective, the decision to raise the federal funds rate makes perfect sense. The consensus view considers the main job of central banks to be maintaining price stability by adjusting the short-term interest rate. (Lower interest rates are supposed to raise private spending when inflation falls short of the central bank’s target, and higher interest rates are supposed to restrain spending when inflation rises above the target.) But this has never been the whole story.
More importantly, the central bank helps paper over the gap between ideals and reality — the distance between the ideological vision of the economy as a system of market exchanges of real goods, and the concrete reality of production in pursuit of money profits.
Central banks are thus, in contemporary societies, one of the main sites at which capitalism’s “Polanyi problem” is managed: a society that truly subjected itself to the logic of market exchange would tear itself to pieces. But the conscious planning that confines market outcomes within tolerable bounds has to be hidden from view because if the role of planning was acknowledged, it would undermine the idea of markets as natural and spontaneous and demonstrate the possibility of conscious planning toward other ends.
One particular problem for central bank planners is managing the pace of growth for the system as a whole. Fast growth doesn’t just lead to rising prices — left to their own devices, individual capitalists are liable to bid up the price of labor and drain the reserve army of the unemployed during boom times.  Making concessions to workers when demand is strong is rational for individual business owners, but undermines their position as a class.
Solving this coordination problem is one of modern central bankers’ central duties. They pay close attention to what is somewhat misleadingly called the labor market, and use low unemployment as a signal to raise interest rates.
So in this respect it isn’t surprising to see the Fed raising rates, given that unemployment rates have now fallen below 5 percent for the first time since the financial crisis.
Indeed, inflation targeting has always been coupled with a strong commitment to restraining the claims of workers. Paul Volcker is now widely admired as the hero who slew the inflation dragon, but as Fed chair in the 1980s, he considered rolling back the power of organized labor — in terms of both working conditions and wages — to be his number one problem.  Volcker described Reagan’s breaking of the air-traffic controllers union as “the single most important action of the administration in helping the anti-inflation fight.”
As one of Volcker’s colleagues argued, the fundamental goal of high rates was that
labor begins to get the point that if they get too much in wages they won’t have a business to work for. I think that really is beginning to happen now and that’s why I’m more optimistic. . . . When Pan Am workers are willing to take 10 percent wage cuts because the airlines are in trouble, I think those are signs that we’re at the point where something can really start to happen.
Volcker’s successors at the Fed approached the inflation problem similarly. Alan Greenspan saw the fight against rising prices as, at its essence, a project of promoting weakness and insecurity among workers; he famously claimed that “traumatized workers” were the reason strong growth with low inflation was possible in the 1990s, unlike in previous decades.
Testifying before Congress in 1997, Greenspan attributed the “extraordinary’” and “exceptional” performance of the nineties economy to “a heightened sense of job insecurity” among workers “and, as a consequence, subdued wages.”
As Greenspan’s colleague at the Fed in the 1990s, Janet Yellen took the same view. In a 1996 Federal Open Market Committee meeting, she said her biggest worry was that “firms eventually will be forced to bid up wages to retain workers.” But, she continued, she was not too concerned at the moment because
while the labor market is tight, job insecurity also seems alive and well. Real wage aspirations appear modest, and the bargaining power of workers is surprisingly low . . . senior workers and particularly those who have earned wage premia in the past, whether it is due to the power of their unions or the generous compensation policies of their employers, seem to be struggling to defend their jobs . . . auto workers are focused on securing their own benefits during their lifetimes but appear reconciled to accepting two-tier wage structures . . .
And when a few high-profile union victories, like the Teamsters’ successful 1997 strike at UPS, seemed to indicate organized labor might be reviving, Greenspan made no effort to hide his displeasure:
I suspect we will find that the [UPS] strike has done a good deal of damage in the past couple of weeks. The settlement may go a long way toward undermining the wage flexibility that we started to get in labor markets with the air traffic controllers’ strike back in the early 1980s. Even before this strike, it appeared that the secular decline in real wages was over.
The Fed’s commitment to keeping unemployment high enough to limit wage gains is hardly a secret — it’s right there in the transcripts of FOMC meetings, and familiar to anyone who has read left critics of the Fed like William Greider and Doug Henwood. The bluntness with which Fed officials take sides in the class war is still striking, though.
Of course, Fed officials deny they’re taking sides. They justify policies that keep workers too weak, disorganized, and traumatized to demand higher wages by focusing on the purported dangers of low unemployment. Lower unemployment, they say, leads to higher money wages, and higher money wages are passed on as higher prices, ultimately leaving workers’ real pay unchanged while eroding their savings.
So while it might look like naked class warfare to deliberately raise unemployment to keep wage demands “subdued”, the Fed assures us that it’s really in the best interests of everyone, including workers.
Keeping Wages in Check
The low-unemployment-equals-high-prices story has always been problematic. But for years its naysayers were silenced by the supposed empirical fact of the Phillips curve, which links low unemployment to higher inflation.
The shaky empirical basis of the Phillips curve was the source of major macroeconomic debates in the 1970s, when monetarists claimed that any departure from unemployment’s “natural” rate would lead inflation to rise, or fall, without limit. This “vertical Phillips curve” was used to deny the possibility of any tradeoff between unemployment and inflation — a tradeoff that, in the postwar era, was supposed to be managed by a technocratic state balancing the interests of wage earners against the interest of money owners.
In the monetarist view, there were no conflicting interests to balance, since there was just one possible rate of unemployment compatible with a stable price system (the “Non Accelerating Inflation Rate of Unemployment”). This is still the view one finds in most textbooks today.
In retrospect, the 1970s debates are usually taken as a decisive blow against the “bastard Keynesian” orthodoxy of the 1960s and 1970s. They were also an important factor in the victory of monetarism and rational expectations in the economics profession, and in the defeat of fiscal policy in the policy realm.
But today there’s a different breakdown in the relationship between unemployment and inflation that threatens to dislodge orthodoxy once again. Rather than a vertical curve, we now seem to face a “horizontal” Phillips curve in which changes in unemployment have no consequences for inflation one way or another.
Despite breathless claims about the end of work, there hasn’t been any change in the link between output and employment; and low unemployment is still associated with faster wage growth. But the link between wage growth and inflation has all but disappeared.
This gap in the output-unemployment-wages-inflation causal chain creates a significant problem for central bank ideology.
When Volcker eagerly waited for news on the latest Teamsters negotiations, it was ostensibly because of the future implications for inflation. Now, if there is no longer any visible link between wage growth and inflation, then central bankers might stop worrying so much about labor market outcomes. Put differently, if the Fed’s goal was truly price stability, then the degree to which workers are traumatized would no longer matter so much.
But that’s not the only possibility. Central bankers might want to maintain their focus on unemployment and wages as immediate targets of policy for other reasons. In that case they’d need to change their story.
The current tightening suggests that this is exactly what’s happening. Targeting “wage inflation” seems to be becoming a policy goal in itself, regardless of whether it spurs price increases.
A recent piece by Justin Wolfers in the New York Times is a nice example of where conventional wisdom is heading: “It is only when nominal wage growth exceeds the sum of inflation (about 2 percent) and productivity growth (about 1.5 percent) that the Fed needs to be concerned. . .”
This sounds like technical jargon, but if taken seriously it suggests a fundamental shift in the objectives of monetary policy.
By definition, the change in the wage share of output is equal to the rise in money wages minus the sum of the inflation rate and the increase in labor productivity. To say “nominal wage growth is greater than the sum of inflation and productivity growth” is just a roundabout way of saying “the wage share is rising.” So in plain English, Wolfers is saying that the Fed should raise rates if and only if the share of GDP going to workers threatens to increase.
Think for a moment about this logic. In the textbook story, wage growth is a problem insofar as it’s associated with rising inflation. But in the new version, wage growth is more likely to be a problem when inflation stays low.
Wolfers is the farthest thing from a conservative ideologue. His declaration that the Fed needs to guard against a rise in the wage share is simply an expression of conventional elite wisdom that comes straight from the Fed. A recent post by several economists at the New York Fed uses an identical definition of “overheating” as wage growth in excess of productivity growth plus inflation.
Focusing on wage growth itself, rather than the unemployment-inflation nexus, represents a subtle but far-reaching shift in the aim of policy. According to official rhetoric, an inflation-targeting central bank should only be interested in the part of wage changes that co-varies with inflation. Otherwise changes in the wage share presumably reflect social or technological factors rather than demand conditions that are not the responsibility of the central bank.
To be fair, linking demand conditions to changes in the distribution between profits and wages, rather than to inflation, is a more realistic than the old orthodoxy that greater bargaining power for workers cannot increase their share of the product. 
But it sits awkwardly with the central bank story that higher unemployment is necessary to keep down prices. And it undermines the broader commitment in orthodox economics to a sharp distinction — both theoretically and policy-wise — between a monetary, demand-determined short run and a technology and “real”-resources-determined long run, with distributional questions firmly located in the latter.
There’s a funny disconnect in these conversations. A rising wage share supposedly indicates an overheating economy — a macroeconomic problem that requires a central bank response. But a falling wage share is the result of deep structural forces — unrelated to aggregate demand and certainly not something with which the central bank should be concerned. An increasing wage share is viewed by elites as a sign that policy is too loose, but no one ever blames a declining wage share on policy that is too tight. Instead we’re told it’s the result of technological change, Chinese competition, etc.
Logically, central bankers shouldn’t be able to have it both ways. In practice they can and do.
The European Central Bank (ECB) — not surprisingly, given its more overtly political role — has gone further down this road than the Fed. Their standard for macroeconomic balance appears to be shifting from the NAIRU (Non-Accelerating Inflation Rate of Unemployment) to the NAWRU (Non-Accelerating Wage Rate of Unemployment).
If the goal all along has been lower wage growth, then this is not surprising: when the link between wages and inflation weakens, the response is not to find other tools for controlling inflation, but other arguments for controlling wages.
Indeed finding fresh arguments for keeping wages in check may be the real content of much of the “competitiveness” discourse. Replacing price stability with elevating competitiveness as the paramount policy goal creates a convenient justification for pushing down wages even when inflation is already extremely low.
It’s interesting in this context to look back at the ransom note the ECB sent to the Spanish government during the 2011 sovereign debt crisis. (Similar letters were sent to the governments of other crisis-hit countries.) One of the top demands the ECB made as a condition of stabilizing the market for government debt was the abolition of cost-of-living (COLA) clauses in employment contracts — even if adopted voluntarily by private employers.
Needless to say this is far beyond the mandate of a central bank as normally understood.  But the most interesting thing is the rationale for ending COLA clauses. The ECB declared that cost-of-living clauses are “a structural obstacle to the adjustment of labour costs” and “contribute to hampering competitiveness.”
This is worth unpacking. For a central bank concerned with price stability, the obvious problem with indexing wages to prices (as COLA clauses do) is that it can lead to inflationary spirals, a situation in which wages and prices rise together and real wages remain the same.
But this kind of textbook concern is not the ECB’s focus; instead, the emphasis on labor costs shows an abiding interest in tamping down real wages. In the old central bank story, wage indexing was supposedly bad because it didn’t affect (i.e., raise) real wages and only led to higher inflation. In the new dispensation, wage indexing is bad precisely because it does affect real wages. The ECB’s language only makes sense if the goal is to allow inflation to erode real wages.
The Republic of the Central Banker
Does the official story matter? Perhaps not.
The period before the 2008 crisis was characterized by a series of fulsome tributes to the wisdom of central banking maestros, whose smug and uncritical tone must be causing some embarrassment in hindsight.
Liberals in particular seemed happy to declare themselves citizens of the republic of the central bankers. Cristina Romer — soon to head President Obama’s Council of Economic Advisers — described the defeat of postwar Keynesian macroeconomics as a “glorious counterrevolution” and explained that
better policy, particularly on the part of the Federal Reserve, is directly responsible for the low inflation and the virtual disappearance of the business cycle . . . The story of stabilization policy of the last quarter century is one of amazing success. We have seen the triumph of sensible ideas and have reaped the rewards in terms of macroeconomic performance. The costly wrong turn in ideas and macropolicy of the 1960s and 1970s has been righted and the future of stabilization looks bright.
The date on which the “disappearance of the business cycle” was announced? September 2007, two months before the start of the deepest recession in fifty years.
Romer’s predecessor on Clinton’s Council of Economic Advisers (and later Fed vice-chair) Alan Blinder was so impressed by the philosopher-kings at the central bank that he proposed extending the same model to a range of decisions currently made by elected legislatures.
We have drawn the line in the wrong place, leaving too many policy decisions in the realm of politics and too few in the realm of technocracy. . . . [T]he argument for the Fed’s independence applies just as forcefully to many other areas of government policy. Many policy decisions require complex technical judgments and have consequences that stretch into the distant future. . . . Yet in such cases, elected politicians make the key decisions. Why should monetary policy be different? . . . The justification for central bank independence is valid. Perhaps the model should be extended . . . The tax system would surely be simpler, fairer, and more efficient if . . . left to an independent technical body like the Federal Reserve rather than to congressional committees.
The misguided consensus a decade ago about central banks’ ability to preserve growth may be just as wrong about central banks’ ability to derail it today. (Or at least, to do so with the conventional tools of monetary policy, as opposed to the more aggressive iatrogenic techniques of the ECB.)
The business press may obsess over every movement of the Fed’s steering wheel, but we should allow ourselves some doubts that the steering wheel is even connected to the wheels.
The last time the Fed tightened was ten years ago; between June 2004 and July 2006, the federal funds rate rose from 1 percent to 5 percent. Yet longer-term interest rates — which matter much more for economic activity — did not rise at all. The Baa corporate bond rate and thirty-year mortgage, for instance, were both lower in late 2006 than they had been before the Fed started tightening.
And among heterodox macroeconomists, there is a strong argumentthat conventional monetary policy no longer plays an important role in the financial markets where longer-term interest rates are set. Which means it has at best limited sway over the level of private spending. And the largest impacts of the rate increase may not be in the US at all, but in the “emerging markets” that may be faced with a reversal of capital flows back toward the United States.
Yet whatever the concrete effects of the Fed’s decision to tighten, it still offers some useful insight into the minds of our rulers.
We sometimes assume that the capitalist class wants growth at any cost, and that the capitalist state acts to promote it. But while individual capitalists are driven by competition to accumulate endlessly, that pressure doesn’t apply to the class as a whole.
A regime of sustained zero growth, by conventional measures, might be difficult to manage. But in the absence of acute threats to social stability or external competition (as from the USSR during the postwar “Golden Age”), slow growth may well be preferable to fast growth, which after all empowers workers and destabilizes existing hierarchies. In China, 10 percent annual growth may be essential to the social contract, but slow growth does not — yet — seem to threaten the legitimacy of the state in Europe, North America, or Japan.
As Sam Gindin and Leo Panitch persuasively argue, even periodic crises are useful in maintaining the rule of money. They serve as reminders that the confidence of capital owners cannot be taken for granted. As Kalecki famously noted, the threat of a crisis when “business confidence” is shaken is a “powerful controlling device” for capitalists vis-à-vis the state. Too much success controlling crises is dangerous — it makes this threat less threatening.
So perhaps the most important thing about the Fed’s recent rate hike is that it’s a reminder that price stability and inflation management are always a pretext, or at best just one reason among others, for the managers of the capitalist state to control rapid growth and the potential gains for workers that follow. As the shifting justifications for restraining wage growth suggest, the republic of the central banker has always been run in the interests of money owners.
Some critics of the rate hike see it as a ploy to raise the profits of banks. In my opinion, this theory isn’t convincing. A better conspiracy theory is that it’s part of the larger project of keeping us all insecure and dependent on the goodwill of the owning class.
 The role of central banks in disguising the moment of conscious planning under capitalism and preserving the ideological fiction of spontaneous order is clearly visible in the way monetary policy is discussed by economists. From the concrete to the abstract. First, the “independent” status of central banks is supposed to place them outside the collective deliberation of democratic politics. Second, there is a constant attraction to the idea of a monetary policy “rule” that could be adopted once and for all, removing any element of deliberate choice even from the central bankers themselves. (Milton Friedman is only the best-known exponent of this idea, which is a central theme of discussion of central banks from the 18th century down to the present.) Third, in modern models, the “reaction function” of the central bank is typically taken as one of the basic equations of the model — the central bank’s reaction to a deviation of inflation from its chosen path has the same status as, say, the reaction of households to a change in prices. As Peter Dorman points out, there’s something very odd about putting policy inside the model this way. But it has the clear ideological advantage of treating the central bank as if it were simply part of the natural order of optimization by individual agents.
 The best analysis of the crisis of the 1970s in these terms remains Capitalism Since 1945, by Armstrong, Glyn and Harrison.
 The linked post by Peter Frase does an excellent job puncturing the bipartisan mythmaking around the Volcker and bringing out the centrality of his anti-labor politics. But it contains one important error. Frase describes the late-1970s crisis to which Volcker was responding as “capital refusing to invest, and labor refusing to take no for an answer.” The latter might be true but the former certainly is not: The late 1970s saw the greatest boom in business investment in modern US history; 1981 had the highest investment-GDP ratio since the records begin in 1929. High demand and negative real interest rates — which made machines and buildings more attractive than wealth in financial form — outweighed low profits, and investment boomed. (An oil boom in the southwest and generous tax subsidies also helped.) The problem Volcker was solving was not,as Frase imagines, that the process of accumulation was threatened by the refusal of unhappy money owners to participate. It was, in some ways, an even more threatening one — that real accumulation was proceeding fine despite the unhappiness of money owners. In the often-brilliant Buying Time, Wolfgang Streeck makes a similar mistake.
 More precisely, it’s a return to what Anwar Shaikh calls the classical Phillips curve found in the Marxist literature, for instance in the form of Goodwin cycles. (The Shaikh article is very helpful in systematically thinking through alternative relationships between nominal wages, the wage share and inflation.)
 It’s worth noting that in these cases the ECB got what it wanted, or enough of it, and did aggressively intervene to stabilize government debt markets and the banking systems in almost all the crisis countries. As a result, the governments of Spain, Italy and Portugal now borrow more cheaply than ever in history. As I periodicallypoint out, the direct cause of the crisis in Greece was the refusal of the ECB to extend it the same treatment. A common liberal criticism of the euro system is that it is too rigid, that it automatically applies a single policy to all its members even when their current needs might be different. But the reality is the opposite. The system, in the form of the ECB, has enormous discretion, and the crisis in Greece was the result of the ECB’s choice to apply a different set of policies there than elsewhere.
My view on the euro is that it has become a project to restore the rule of money over humanity. To move us back toward a world where in every sphere of life, and especially in collective choices made through government, the overriding question is, “what is most consistent with the accumulation of money claims?” or, “what will the markets think?” The euro is a project to roll back social democracy and to reimpose the “discipline of the market” on the state — or in other words to restore the logic of the gold standard, whose essential condition was that preservation of money-claims had priority over democratic government. From this point of view, crises are not a failure of the system but an essential part of its functioning, since discipline requires that punishment be sometimes visibly meted out.
This kind of Polanyian perspective is typically found on the left. But it’s increasingly clear that many of those on the other side think this way too. Here is a striking recent op-ed from the FT, by one Thomas Mayer:
Germany relied on the Maastricht treaty to make it possible to share a currency without sacrificing political accountability. The idea was to create an economic framework that was in some ways the modern equivalent of a gold standard. Monetary decisions would be made by the European Central Bank, whose only goal would be price stability. The lack of shared political institutions did not matter, because the ECB was to operate in total independence from all political influence. It would never lend to member states, even ones that were at risk of going bankrupt.
Despite these provisions, the Germans did not entirely trust their partners’ fiscal discipline, so they imposed strict limits to government budget deficits and debt…. With the benefit of hindsight, it was all rather naive. Germany should have insisted on a procedure for government insolvency, and a way of showing the door to states that were unable or unwilling to respect the rules.
Mayer, the head of a German think tank, does not mention that in the first decade of the euro Germany was one of the most frequent violators of the “strict limits” on fiscal deficits. But it’s helpful to see the idea of the euro as a new gold standard stated so plainly by a supporter. And he makes another important point, which is that even under a new gold standard, the discipline of the markets is unreliable, and needs to be supplemented with (or simulated by) overt political authority.
From early 2010, when a Greek default was narrowly avoided, until early 2012, Angela Merkel, the German chancellor, attempted to re-establish the Maastricht model … and contemplated the possibility that Greece might leave the euro. But she is risk-averse by nature and, confronted with the incalculable risks, she changed course in the spring of 2012. The Greek debt restructuring, she now said, was “exceptional and unique”. Leaving the euro was out of question for any member country. Since this decision meant markets would no longer pressurise governments into sound economic policies, she built a pan-European “shadow state” — a web of pacts to ensure that countries followed policies consistent with sound money.
It has not worked. From Greece to France, countries resist any infringement on their sovereignty and refuse to act in a way that is consistent with a hard currency policy. The ECB is forced to loosen its stance. Worse, it has allowed monetary policy to become a back channel for transfering economic resources between eurozone members. This is Germany’s worst nightmare…
A century ago, Eugen Böhm-Bawerk, the Austrian economist and finance minister, proclaimed laws of economics to be a higher authority than political power. Some Germans say that a hard currency is an essential part of their economic value system. If both are right, politicians will be powerless to prevent Germany’s departure from a monetary union that is at odds with the country’s economic convictions.
The essential points here are, first, that the goal of the euro system to create a situation where markets can “pressurise governments into sound economic policies,” meaning first and foremost, policies that preserve the value of money; second, that this requires limits on national sovereignty, which will be resisted by democratic governments; and third, that this resistance can only be overcome through the threat of a crisis. In this sense, from Mayer’s perspective, the steps that were taken to resolve the crisis were a terrible mistake, and required the use of direct political control by a “shadow state” to substitute for the blunted threat of financial catastrophe. This is all very clarifying; the one piece of mystification still intact is the substitution of “Germany” as the social actor, rather than European wealth owners as a class.
Mayer is just one guy, of course, but presumably he speaks to some extent for his old colleagues at Deutsche Bank, Goldman Sachs and the IMF.  And anyway this kind of language is everywhere these days.
The FT’s review of “Lords of Secrecy,” for instance, acknowledges that we increasingly seem to be subjects of “a vast secret state beyond control.” That sounds bad! But the reviewer concludes on a cheerful note:
The “lords of secrecy” do need to be kept in check, of course. But that may soon happen anyway. After all, principles go only so far in holding the clandestine arms of the state to account; money goes a lot further. But money is one thing that is not quite so freely available in Washington, or many other capitals in the west, no matter how many secrets they have.
Here, subservience to the bond markets doesn’t just require limits on democracy or the rule of law, it makes them superfluous.
Returning to the euro, here, via Bill Mitchell, is Graham Bishop on the “revolutionary political implications” of unified interbank payments in the euro area:
While payments are an intensely technical area, the political implications are immense… SEPA establishes an effective ‘referendum veto’ to be exercised by citizens whose national governments might contemplate leaving the euro. In SEPA, citizens are empowered to embed the freedom and the choices associated with the single market so deeply in the economy to make it impossible for any EU government which adopted the euro to abandon the common currency. It is hard to imagine that citizens and enterprises accustomed to these choices would want to leave the euro once they considered what they individually would give up by way of returning to narrow, national offerings for trade in goods and services.
With SEPA, any citizen who fears that his home state is about to leave the euro to implement a major devaluation can protect themselves by transferring their liquid funds into a bank in another euro country – in an instant and at negligible cost. In effect, this is a free option for all citizens and amounts to an instantaneous referendum on government policy. Such an outflow of retail liquidity from a banking system would cause its rapid collapse. The quiet run out of deposits in the Irish banks last year demonstrated the power of depositors to force radical political change.
There’s not much to say about that unctuous, preening first paragraph, with its cant about freedom and choices, except to hope that some future novelist (or screenwriter, I guess) can do justice to the horrible people who rule us. (Also, notice the classic bait-and-switch in which the only alternative to complete liberalization of capital flows is autarchy.) But what’s interesting for the argument I’m making here is the claim that the great political innovation of the euro is that it gives money-owners the right to a veto or referendum over government policy — up to the point of forcing through “radical change,” on pain of a bank crisis. And to be clear: This is being presented as one of the great benefits of the system, and an argument for the UK to join the single currency.
(Also, if I’m correct that the effect of a withdrawal of ECB liquidity support for Greek banks would just prevent transfers to banks elsewhere, this suggests the threat is self-negating.)
The masters of the euro themselves talk the same way. The “analytic note” just released by European Commission President Jean-Claude Juncker, “in close cooperation with Donald Tusk, Jeroen Dijsselbloem and Mario Draghi,” begins with the usual claims about the crisis as due ultimately to lack of competitiveness in the southern countries, thanks to their “labor market rigidities.” (They don’t say what specific rigidities they have in mind, but they do nod to a World Bank report that identifies such distortions as minimum wages, limitations on working hours, and requirements for severance pay.) “While the Maastricht Treaty was based on the assumption that market discipline would be a key element in preventing a divergent development of the euro area economies and their fiscal positions, with increasing government bond interest rates having a signalling effect.” But in practice divergent policies were not prevented, as bond markets were happy to lend regardless. Then, “when the crisis hit… and markets reappraised the risk and growth potential of individual countries, the loss of competitiveness became visible and led to outflows.”  What’s most interesting is their analysis of the political economy of removing these “rigidities” and restoring “competitiveness”:
The policy commitments of euro area countries, made individually or collectively, to growth-enhancing structural reforms have not been implemented satisfactorily. Often, commitments are strong in crisis times and then weakened again when the overall economic climate has improved. In this sense, the stabilising effect of the single currency has certain counterproductive effects with regard to the willingness of national governments to start and implement the necessary structural reforms…
Naomi Klein couldn’t have said it better. Crises are a great time to roll back “employment protection legislation” and force down labor costs — the unambiguous content of “structural reforms” in this context. If your goal is to to roll back protective legislation and re-commodify labor, then resolving economic crises too quickly is, well, counterproductive.
A couple years ago, Paul Krugman was expressing incredulity at the idea that prolonging the European crisis could be a rational act in the service of any political agenda. Last week, he was still hoping that Draghi would emerge as the defender of European democracy. No disrespect to my CUNY colleague, who understands most of this stuff much better than I ever will. But in this case, it seems simpler to take Draghi at his word. Restricting the scope of democratic government was the entire point of the euro system. And since the automatic operation of bond markets failed to do the job, a crisis is required.
UPDATE: Schauble today: “If we go deeper into the [debt] discount debate, there will be no more reforms in Europe. There will be joyful celebrations in the Elysée and probably in Rome, too, if we go down this path.” Thee is not even a pretense now that this is about resolving the crisis, as opposed to using the crisis as leverage to promote a particular policy agenda. It’s surprising, though, that he would suggest that the Euro zone’s second and third largest economies are on the side of the debtors. Would that it were so.
 It’s almost too good that he hosts a lecture series on “The Order of Money.”
 The funny thing is that, after talking about the “misallocation of financing” by markets, and describing the crisis as “a crisis of markets in terms of their capacity to price risk correctly,” they go on to recommend the removal of all remaining restrictions on capital flows: “we need to address remaining barriers to investment and the free movement of capital and make capital market integration a political priority.” Reminds me of the opening paragraphs of this Rodrik essay.
The last post got some very helpful comments from MisterMR (the regular commenter formerly known as Random Lurker) and Kevin Donoghue. Both of them raise issues that are worth posts of their own. I’ll reply to MisterMR now, and perhaps to Kevin Donoghue later. Or perhaps not — the biggest thing I’ve learned in four years of blogging is: Never make promises about future posts.
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MisterMR is coming from what I hope he won’t mind my calling a classical Marxian perspective — a perspective I’m simpatico with, tho I haven’t been taking it here. One aspect of this perspective is the idea that capital can be understood in physical terms, as embodied labor. Now I agree that Marx does clearly say this, but I think this can be seen as a concession he is making to the orthodoxy of the day for the sake of the argument. Capital is subtitled “A Critique of Political Economy,” and I think we should take that subtitle seriously. In effect, he is saying to Ricardo: OK, let’s accept your way of thinking about capital, the system based on it is still conflictual, exploitative and in contradiction with its own conditions of existence.
I’m not sure how widely this view is held — that Marx adopts the labor theory of value ironically. Anyway, that’s not the argument I want to have here. What I want to do is clarify the perspective I’m offering in place of the labor theory. It’s more in the spirit of the other core Marxian idea about capital, that it is a social relation between people.
I think that there are 4 different kinds of capital assets (though in reality most capital assets are a mix of the four kinds).
1) There are some capital goods that are stuff that is materially produced, such as factories. This stuff has a cost of production, that arguably has some relationship with its “value”. This is what I would call “real” capital. The ambiguity in Piketty comes from the fact that he speaks as if all capital is “real” capital, and as if every money flow translates in “real” capital.
2) There are some assets that are a finite resource that someone controls, like land. In fact, classical economists distinguished between “capital” and “land”. The value of land can’t be linked to the “cost of production” of land, because said cost doesn’t exist. So arguably the value is just the cashflow derived from the asset divided by the normal rate of profit. I’d call this kind of assets simply “land”.
3) While land is certainly something that exists, there are some assets that have an economic value but that don’t relate to something that clearly exists or that can be produced: for example, ownership on patents, or a famous brand that has an high market penetration and visibility etc. I think that these assets have dinamics that are similar to land, although they are mostly non material.
4) Finally, there is credit. Credit also is a non material thing, and is different from all the 3 previous classes of capital for these reasons:
4.1) It doesn’t have a “cost of production”;
4.2) It isn’t related to any fixed resource, something that differentiates credit from both 2 and 3;
4.3) It has a fixed nominal value (which implies that the currency provider can literally print it out of existence).
4.4) It usually has a nominally fixed interest rate, something that can obviously cause chain bankruptcies.
My problem with the “monetary view” is that it sounds like if assets of the 2 and 3 classes all are just a “montary” thing, as opposed to a “real stuff view” that sees all assets as if they were of the 1 class.
My response is that the money view is not a substantive claim about the nature of particular assets, but a way of looking at assets in general — “real” capital goods as much as the more vaporous claims in categories 2 through 4. It does imply some kind of ontology, but in itself, the money view is just a choice to focus on money payments.
But I do want to explain the broader view of social reality that, for me at least, lies behind the money view. Here’s the way I want to look at things.
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On the one hand, there is the human productive activity of collectively transforming the world and maintaining our conditions of existence, along with the conditions that make that activity possible. When you sit down and write a blog post, you are engaged in creative activity with the goal of building up our collective knowledge of the world, and you are also maintaining the network of social ties through which this kind of activity is carried out. Your ability to engage in this activity depends on a great number of objective conditions, ranging from your physical health to the infrastructure that communicates your words to the rest of the world. Many of these conditions are the result of past human activity.
Under capitalism, a subset of human productive activity gets marked off as “labor.” Labor has a number of special characteristics, most obviously that it is carried out at the direction of a boss. But for current purposes, the most important distinctive characteristics of the activity that we call “labor” are (a) it carries a price tag, the “wage,” with labor that is somehow similar carrying a similar wage. And (b) labor becomes substantively more similar over time, with the disappearance of specific skills and increasing interchangeability among the human beings performing it; it follows from this that the wage also become uniform. To the extent that (a) is true, we can attribute a “cost” to some particular set of conditions and to the extent (b) is also true, that cost will correspond to the hours of labor expended maintaining those conditions. Of course all productive activity additionally requires many conditions, both natural and social, that are not reflected in labor hours. In particular, a great deal of passive social cooperation is required for any productive activity, especially when there is an extensive division of labor.
Even in the pure case, where labor is completely homogeneous and all production is carried out for profit, under identical conditions and with no barriers to competition, there will not in general be a unique mapping from labor hours to costs or relative prices. The best we can do is to reduce all the infinite possible sets of relative prices to variation along a single dimension, with one set of relative prices corresponding to each possible profit rate. (I think this is Sraffa’s point.)
So the description of assets in group 1 is correct — but only with respect to one particular way of describing one particular way of organizing production, not as statements about reality in general. The productive activity that takes place in a factory does, of course, require the past activity that resulted in the existence of the factory. But it requires lots of other activity as well, much of which is not counted as “labor.” And the fact that “labor” is a measurable input at all only holds to the extent that the productive activity has been deskilled and homogenized, a sociological fact that is never completely true and is not true at all in most historical contexts.
The think you have to avoid is believing that quantities like “value” or “cost” have any existence outside the specific social relations of capitalism.
The next question is what it means to “own” some conditions for productive activity, like a factory. The beginning of wisdom here is to recognize that ownership is a legal relationship between persons, not a relationship with a physical object. To own a piece of land means you have certain legal rights with respect to other people — to exclude them from the use of that land, to receive some equivalent from them if you do permit use of the land, to transfer those rights to someone else — and that no one else has those rights with respect to you. However, that’s only the first step. Next, we have to recognize that what constitutes “use” of piece of an asset is not a physical fact, but a social one. (As in the old story, the baker can exclude others from eating his rolls, but not from enjoying the smell of them.) So it would be more accurate to say that ownership of a piece of property is simply a form of social authority — a bundle of rights over other people. Indeed, if we want to relate the world of money flows to broader social reality, the most fundamental fact is probably this: The person who receives a money payment labeled “profit” gives orders, and the people who receive money payments labeled “wages” have to follow them. To say you own a piece of property is simply to say there is a set of commands that, if you issue them, other people are compelled to obey. Those rights are metonymously referred to by a label which bears a picture of some tangible good, just like the insignia on an officer’s uniform bear a picture of a leaf or a bird.
When you say, here is a means of production, a factory, with a certain cost, you have already chosen: to ignore all the various conditions that make a certain form of collective productive activity possible, and let the existence of this one tangible object, the factory, stand in for all the rest; to ignore all the various forms of productive activity and social coordination that were necessary to bring the factory (and the rest of the conditions of production) into existence, except for those we class as wage labor; to convert that wage labor to some common quantitative standard by measuring it in wage payments; to assume some exogenously given profit rate, to give you the discount rate you need to add up wage payments made at different dates. Only then can you say the factory has a cost — and even then, this money cost is calculated by adding up a certain set of money payments.
At that point we have MisterMR’s category (1) as a concrete social reality. We still have to establish the profit rate, since it cannot be reduced to a marginal physical product. Only then do the issues specific to the other three categories come into play.
I should be clear: the money view is not a complete account of the sphere of social reality we call the economy. (And again, I’ve adopted the term from Perry Mehrling, it’s not my invention.) The money view is defined by making the atomic units of analysis bundles of money payments. I would argue that it is logically consistent to think of any capital good as simply a bundle of income streams contingent on different states of the world, in a way that it is not logically consistent to think of it as a physical object producing a stream of physical outputs.
The fact that this is a logically consistent account doesn’t mean it’s sufficient. Obviously the money view doesn’t give a complete story, since we don’t know why the income streams attached to different assets are what they are, or why they change over time, or why assets in the monetary sense are attached to tangible goods or production processes, or for that matter why anyone cares about money payments in the first place. But by adopting a consistent story about money payments and assets, we get a clearer view of these other questions. We distinguish the questions that can be addressed with the formal techniques of economics from other questions that require a different approach. This is a step forward from the perspective that mixes up questions about money flows with questions about tangible productive activities and so can’t give a coherent story about either.
There’s been some discussion recently of the new estimates from Emmanuel Saez and Gabriel Zucman of the distribution of household wealth in the US. Using the capital income reported in the tax data, and applying appropriate rates of return to different kinds of assets, they are able to estimate the distribution of household wealth holdings going back to the beginning of the income tax in 1913. They find that wealth inequality is back to the levels of the 1920s, with 40% of net worth accounted for the richest one percent of households. The bottom 50% of households have a net worth of zero.
There’s a natural reaction to see this as posing the same kind of problem as the distribution of income — only more extreme — and respond with proposals to redistribute wealth. This case is argued by the very smart Steve Roth in comments here and on his own blog. But I’m not convinced. It’s worth recalling that proposals for broadening the ranks of property-owners are more likely to come from the right. What else was Bush’s “ownership society”? Social Security privatization, if he’d been able to pull it off, would have dramatically broadened the distribution of wealth. In general, I think the distribution of wealth has a more ambiguous relationship than the distribution of income to broader social inequality.
Case in point: Last summer, the ECB released a survey of European household wealth. And unexpectedly, the Germans turned out to be among the poorest people in Europe. The median German household reported net worth of just €50,000, compared with €100,000 in Greece, €110,000 in France, and €180,000 in Spain. The pattern is essentially the same if you look at assets rather than net worth — median household assets are lower in Germany than almost anywhere else in Europe, including the crisis countries of the Mediterranean.
At the time, this finding was mostly received in terms the familiar North-South morality tale, as one more argument for forcing austerity on the shiftless South. Not only are the thrifty Germans being asked to bail out the wastrel Mediterraneans, now it turns out the Southerners are actually richer? Why can’t they take responsibility for their own debts? No more bailouts!
No surprise there. But how do we make sense of the results themselves, given what we know about the economies of Germany and the rest of Europe? I think that understood correctly, they speak directly to the political implications of wealth distribution.
First, though: Did the survey really find what it claimed to find? The answer seems to be more or less yes, but with caveats.
Paul de Grauwe points out some distortions in the headline numbers reported by the ECB. First, this is a survey of household wealth, but, de Grauwe says, households are larger in the South than in the North. This is true, but it turns out not to make much of a difference — converting from household wealth to wealth per capita leaves the basic pattern unchanged.
Per capita wealth in selected European countries. From de Grauwe.
Second, the survey focuses on median wealth, which ignores distribution. If we look at the mean household instead of the median one, we find Germany closer to the middle of the pack — ahead of Greece, though still behind France, Italy and Spain. The difference between the two measures results from the highly unequal distribution of wealth in Germany — the most unequal in Europe, according to the ECB survey. For the poorest quintile, median net worth is ten times higher in Greece and in Italy than in Germany, and 30 times higher in Spain.
This helps answer the question of apparent low German wealth — part of the reason the median German household is wealth-poor is because household wealth is concentrated at the top. But that just raises a new puzzle. Income distribution Germany is among the most equal in Europe. Why is the distribution of wealth so much more unequal? The puzzle deepens when we see that the other European countries with high levels of wealth inequality are France, Austria, and Finland, all of which also have relatively equal income distribution.
Another distortion pointed to by De Grauwe is that the housing bubble in southern Europe had not fully deflated in 2009, when the survey was taken — home prices were still significantly higher than a decade earlier. Since Germany never had a housing boom, this tends to depress measured wealth there. This explains some of the discrepancy, but not all of it. Using current home prices, the median Spanish household has more than triple the net wealth of the median German household; with 2002 home prices, only double. But this only moves Germany up from the lowest median household wealth in Europe, to the second lowest.
The puzzle posed by the wealth survey seems to be genuine. Even correcting for home prices and household size, the median Spanish or Italian household reports substantially more net wealth than the median German one, and the median Greek household about an equal amount. Yet Germany is, by most measures, a much richer country, with median household income of €33,000, compared with €22,000, €25,000 and €26,000 in Greece, Spain and Italy respectively. Use mean wealth instead of median, and German wealth is well above Greek and about equal to Spanish, but still below Italian — even though, again, average household income is much higher in Germany than in Italy. And the discrepancy between the median and mean raises the puzzle of why German wealth distribution is so much more uneven than German income distribution.
De Grauwe suggests one more correction: look at the total stock of fixed capital in each country, rather than household wealth. Measuring capital consistently across countries is notoriously dicey, but on his estimate, Germany and the Netherlands have as much as three times the capital per head as the southern countries. So Germany is richer in real terms than the South, as we all know; the difference is just that “a large part of German wealth is not held by households and therefore must be held by the corporate sector.” Problem solved!
Except… you know, Mitt Romney was right: corporations are people, in the sense that they are owned by people. The wealth of German corporations should also show up as the wealth of the owners of German stocks, bonds, or other claims on those corporations — which means, overwhelmingly, German households. Indeed, in mainstream economic theory, the “wealth” of the corporate sector just is the wealth of the households that own it. According to de Grauwe, the per capita value of the capital stock is more than twice as large in Germany as in Spain. Yet the average financial wealth held by a German household is only 25% higher than in Spain. So as in the case of distribution, this solution to the net-wealth puzzle just creates a new puzzle: Why is a dollar of capital in a German firm worth so much less to its ultimate owners than a dollar of capital in a Spanish or Italian firm?
And this, I think, points us toward the answer, or at least toward the right question.
The question is, what is the relationship between the level of market production in an economy, and the claims on future production represented by wealth? It’s a truism — tho often forgotten — that the market production counted in GDP is only a part of all the productive activity that takes place in society. In the same way, not all market production is capitalized into assets. Wealth in an economic sense represents only those claims on future income that are exercised by virtue of a legal title that is freely transferable, and hence has a market value.
For example, imagine two otherwise similar countries, one of which makes provision for retirement income through a pay-as-you-go public pension system, and the other of which uses some form of funded pension. The two countries may have identical levels of output and income, and retirees may receive exactly the same payments in both. But because the assets held by the pension funds show up on balance sheets while the right to future public pension payments does not, the first country will have less wealth than the second one. Again, this does not imply any difference in production, or income, or who ultimately bears the cost of supporting retirees; it is simply a question of how much of those future payments are capitalized into assets.
This is just an analogy; I don’t think retirement savings are the story here. The story is about home ownership and the value of corporate stock.
First, home ownership. Only 44 percent of German households own their own homes, compared with 70-80 percent in Greece, Italy and Spain. Among both homeowners and non-homeowners considered separately, median household wealth is comparable in Germany and in the southern countries. It’s only the much higher proportion of home ownership that produces higher median wealth in the South. And this is especially true at the bottom end of the distribution — almost all the bottom quintile (by income) of German households are renters, whereas in Greece, Spain and Italy there is a large fraction of homeowners even at the lowest incomes. Furthermore, German renters have far more protections than elsewhere. As I understand it, German renters are sufficiently protected against both rent increases and loss of their lease that their occupancy of their home is not much less secure than that of home owners. These protections are, in a sense, a form of property right — they are a claim on the future flow of housing services in the same way that a title to a house would be. But with a critical difference: the protections from rent regulation can’t be sold, don’t show up on the household’s balance sheet, and do not get counted as wealth.
In short: The biggest reason that German household wealth is lower than than elsewhere is that less claims on the future output of the housing sector take the form of assets. Housing is just as commodified in Germany as elsewhere (I don’t think public housing is unusually important there). But it is less capitalized.
Home ownership is the biggest and clearest part of the story here, but it’s not the whole story. Correct for home ownership rates, use mean rather than median, and you find that German household wealth is comparable to household wealth in Italy or Spain. But given that GDP per capita is much higher in Germany, and the capital stock seems to be so much larger, why isn’t household wealth higher in Germany too?
One possible answer is that income produced in the corporate sector is also less capitalized in Germany.
In a recent paper with Zucman, Thomas Piketty suggests that the relationship between equity values and the real value of corporate assets depends on who exercises power over the corporation. Piketty and Zucman:
Investors who wish to take control of a corporation typically have to pay a large premium to obtain majority ownership. This mechanism might explain why Tobin’s Q tends to be structurally below 1. It can also provide an explanation for some of the cross-country variation… : the higher Tobin’s Q in Anglo-Saxon countries might be related to the fact that shareholders have more control over corporations than in Germany, France, and Japan. This would be consistent with the results of Gompers, Ishii and Metrick (2003), who find that firms with stronger shareholders rights have higher Tobin’s Q. Relatedly, the control rights valuation story may explain part of the rising trend in Tobin’s Q in rich countries. … the ”control right” or ”stakeholder” view of the firm can in principle explain why the market value of corporations is particularly low in Germany (where worker representatives have voting rights in corporate boards without any equity stake in the company). According to this ”stakeholder” view of the firm, the market value of corporations can be interpreted as the value for the owner, while the book value can be interpreted as the value for all stakeholders.
In other words, one reason household wealth is low in Germany is because German households exercise their claims on the business sector not via financial assets, but as workers.
The corporate sector is also relatively larger in Germany than in the southern countries, where small business remains widespread. 14 percent of Spanish households and 18 percent of Italian households report ownership of a business, compared with only 9 percent of German households. Again, this is a way in which lower wealth reflects a shift in claims on the social product from property ownership to labor.
It’s not a coincidence that Europe’s dominant economy has the least market wealth. The truth is, success in the world market has depended for a long time now on limiting dependence on asset markets, just as the most successful competitors within national economies are the giant corporations that suppress the market mechanism internally. Germany, as with late industrializers like Japan, Korea, and now China, has succeeded largely by ensuring that investment is not guided by market signals, but through active planning by banks and/or the state. There’s nothing new in the fact that greater real wealth in the sense of productive capacity goes hand hand with less wealth in the sense of claims on the social product capitalized into assets. Only in the poorest and most backward countries does a significant fraction of the claims of working people on the product take the form of asset ownership.
The world of small farmers and self-employed artisans isn’t one we can, or should, return to. Perhaps the world of homeowners managing their own retirement savings isn’t one we can, or should, preserve.
Part II of Capital begins with a puzzle: In markets, commodities are supposed to trade only for other commodities of equal value, yet somehow capitalists end up with more value than they start with.
In the world of simple exchange, money is just a convenience for enabling the exchange of commodities: C-M-C is easier to arrange than C-C. But profit-making business is different: the sequence there is M-C-M’. The capitalist enters the market and buys some commodities for a certain sum of money. Later, he sells some commodities, and has a larger sum of money. This increase — from M to M’ — is the whole point of being capitalist. But in a world of free market exchange, how can it exist?
Let’s put some obvious misunderstandings out of the way. There’s nothing mysterious about the fact that people can accomplish things with tools and previously acquired materials that they would be unable to with unaided labor. The problem is not that “capital,” in the sense of a stock of tools and materials, is productive in this sense. To the extent that what appears as “profit” in the national accounts is just the cost of replacing worn-out tools and materials, there’s no puzzle. 
The mystery is, how can someone enter the market with money and, after some series of exchanges, exit with more money? In the sequence M-C-M’, how can M’ be greater than M? How can the mere possession of money seemingly allow one to acquire more money, seemingly without end?
Before trying to understand Marx’s answer, let’s consider how non-Marxist economists answer this question.
1. Truck and barter. The most popular answer, among both classical and modern economists, is that the M-C-M’ sequence does not exist. All economic activity is aimed at consumption, market exchange is only intended to acquire specific use-values; when you think you see M-C-M you’re really looking at part of some C-M-C sequence(s). The classical economists are full of blunt statements that the only possible end of exchange is consumption. In today’s economics we find this assumption in the form of the “transversality condition” that says that wealth must go to zero as time goes to infinity. That’s right, it is an axiom in modern economics that accumulation cannot be a goal in itself. Or in the words of Simon Wren-Lewis (my new go-to source for the unexamined conventional wisdom of economists): “It would be stupid to accumulate infinite wealth.” Well OK then!
2. You earned it. Another answer is that the capitalist brings some additional unmeasured commodity to the production process. They are providing not just money M but also management ability, risk-bearing capacity, etc. In this view, if we correctly measured inputs, we would find that M’=M. In its most blatantly apologetic form this is effectively skewered by comrades Ackerman and Beggs in the current Jacobin. For unincorporated businesses, it is true, it is not straightforward to distinguish between profits proper and the wages of managerial labor, but that can’t account for profits in general, or for the skewed distribution of income across households. If anything, much of what is reported as managerial salaries should probably be called profits. This is a point made in different ways by Piketty and Saez and Dumenil and Levy; you can also find it offered as straightforward business advice.
3. It was the pictures that got small. The other main classical answer is that profit is the reward for “abstinence” (Senior) or “waiting” (Cassel). (I guess this is also the theory of Bohm-Bawerk and the other Austrians, but I admit I don’t know much about that stuff.) It appears today as a discount rate on future consumption. This invites the same question as the first answer: Is capitalist accumulation really motivated by future consumption? It also invites a second question: In what sense is a good tomorrow less valuable than the same good today? Is the utility derived from a glass of wine in 2013 really less than the utility derived from the same glass consumed in 2012,or 2010, or 1995? (So far this has not been my experience.) The logically consistent answer, if you want to defend profit as the return to waiting, is to say Yes. The capital owner’s pure time preference then represents an objective inferiority of output at a later date compared with the same output at an earlier date.
This is a logically consistent answer to the profits puzzle, and it could even be true with the right assumptions about the probability of an extinction-event asteroid impact/Khmer Rouge takeover/zombie apocalypse. With a sufficiently high estimate of the probability of some such contingency, M’ is really equal to M when discounted appropriately; capitalists aren’t really gaining anything when you take into account their odds of being eaten by zombies and/or suffocated by plastic bag, before they get to enjoy their profits.  But I don’t think anyone wants to really own this point of view — to hold it consistently you must believe that economic activity becomes objectively less able to satisfy human needs as time goes by. 
4. Oops, underpaid again. We can take the same “profit as reward for waiting” idea, but instead of seeing a pure time preference as consistent with rational behavior, as modern economists (somehow) do, instead interpret it like the classical economists (including Cassel, whose fascinating Nature and Necessity of Interest I just read), as a psychological or sociological phenomenon. Consumption in the future is objectively identical to the same consumption today, but people for some reason fail to assign it the same subjective value it the same. Either they suffer from a lack of “telescopic facility,” or, in Cassel’s (and Leijonhufvud’s) more sophisticated formulation, the discount rate is a reflection of the human life expectancy: People are not motivated to provide for their descendants beyond their children, and future generations are not around to bargain for themselves. Either way, the outcome is that exchange does not happen at value — production is systematically organized around a higher valuation of goods today than goods tomorrow, even though their actual capacity to provide for satisfaction of human needs is the same. Which implies that workers — who provide labor today for a good tomorrow — are systematically underpaid.
5. Property is theft. The last and simplest possibility is that profits are always just rents. Capitalists and workers start out as just “agents” with their respective “endowments.” By whatever accident of circumstances, the former just end up underpaying the latter. Maybe they are better informed.
We could develop all these points further — and will, I hope, in the future. But I want to move on to (my idea of) Marx’s answer to the puzzle.
One other thing to clear up first: profit versus interest. Both refer to money tomorrow you receive by virtue of possessing money today. The difference is that in the case of profit, you must purchase and sell commodities in between. What is the relationship between these two forms of income? For someone like Cassel, interest has priority; profit is a derived form combining interest with income from managerial skill and/or a rent. For Marx on the other hand, and also for Smith, Ricardo, etc., profit is the primitive and interest is the derived form; interest is redistribution of profits already earned in production. (Smith: “The interest of money is always a derivative revenue, which, if it is not paid from the profit which is made by the use of the money, must be paid from some other source of revenue.”) In other words, are profits an addition to interest, or is interest as a subtraction from profit? For Marx, the latter. The fundamental question is how money profits can arise through exchange of commodities. 
Marx gives his answer in chapter four: The capitalist purchases labor-power at its value, but gets the results of the labor expended by that labor-power. The latter exceeds the former. In other words, people are capable of producing more than it takes to reproduce themselves, and that increment is captured by the capitalist. In four hours, you can produce what you need to live on. The next four or six or eight or twelve hours, you are working for The Man.
This is the answer, as Marx gives it. Labor power is paid for at its value. But having purchased labor power, the capitalist now has access to living labor, which can produce more than the the cost of its own reproduction.
I think this is right. But it’s not really a satisfactory answer, is it? It’s formally correct. But what does it mean?
One way of fleshing it out is to ask: Why is it even possible that labor can produce more than the reproduction-costs of labor power? Think of Ricardo’s world. Profits are positive because we have not yet reached the steady state — there are still natural resources available whose more intensive use will yield a surplus beyond the cost of the labor and capital required to use them. The capitalist captures that surplus because capital has the short side of both markets — there is currently excess land going unutilized, and excess labor going unutilized. 
Another way: There is something in the production process other than exchange, but which is captured via exchange.
I want to think of it this way: Humanity does have the ability to increase social value of output, or in other words the aggregate capacity to satisfy human needs from nature does in general grow over time. This “growth” happens through our collective creative interchange with nature — it is about pushing into the unknown, a process of discovery — it is not captured beforehand in the market values of commodities.
In a proper market, you cannot exchange a good in your possession for a good with a greater value, that is, with a greater capacity to satisfy human needs in general. (Your own particular needs, yes.) But you can, through creative activity, through a development of your own potential, increase the general level of satisfaction of human needs. The capitalist by buying labor power at its value, is able to capture this creative increment and call it their private property.
Our potential is realized through a creative interchange with nature. It’s not known in advance. What can we do, what can’t we do — we only learn by trying. We push against the world, and discover how the world pushes back, in so doing understand it better and find how it can be reshaped to better suit our needs. Individually or collectively, it’s a process of active discovery.
You as a person can exchange the various things you are in possession of, including your labor power, for other things of equal value. (Though for different use values, which are more desired by you.) But you will also discover, through a process of active learning and struggle, what you are capable of, what are the limits of your powers, what creative work you can do that you cannot fully conceive of now.
Through the process of education, you don’t just acquire something that you understood clearly at the outset. You transform yourself and learn things you didn’t even know you didn’t know. When you do creative work you don’t know what the finished product will be until you’ve finished it. I still — and I hope for the rest of my life — find myself reading economics and having those aha moments where you say, “oh that’s what this debate is all about, I never got it before!” And science and technology above all involve the discovery of new possibilities through a process of active pushing against the limits of our knowledge of the world.
The results of these active process of self-development and exploration form use-values, but they are not commodities. They were not produced for exchange. They were not even known of before they came into being. But while they are not themselves commodities, they are attached to commodities, they cannot be realized except through existing commodities. I may produce in myself, through this process of self-testing, a capacity for musical performance, let’s say. But I cannot realize this capacity without, at least, a sufficient claim on my own time, and probably also concrete use-values in the form of an instrument, an appropriate performance space, etc., and also some claim on the time of others. In this case one can imagine acquiring these things individually, but many — increasingly over time — processes of self-discovery are inherently collective. Science and technology especially. So specifically a discovery that allows cheaper production of an existing commodity, or the creation of a new commodity with new use-values, can only become become concrete in the hands of those who control the process of production of commodities. By purchasing labor power — in the market, at its value — capitalists gain control of the production process. They are thus able to claim the fruits of humanity’s collective self-discovery and interchange with nature as their own private property.
In some cases, this is quite literal. Recall Smith’s argument that one of the great advantages of the division of labor is that it allows specialized workers to discover improved ways of carrying out their tasks. “A great part of the machines made use of in those manufactures in which labour is most subdivided, were originally the inventions of common workmen, who, being each of them employed in some very simple operation, naturally turned their thoughts towards finding out easier and readier methods of performing it.” Who do you think gained the surplus from these inventions? This still happens. Read any good account of work under capitalism, like Barbara Garson’s classic books All the Livelong Day and The Electronic Sweatshop. You’ll find people actively struggling to do their jobs better — the customer service representative who wants to get the caller to the person who can actually solve their problem, the bookshelf installer who wants it to fit in the room just right. The results of these struggles are realized as profits for their employers. But these are exceptional. The normal case today is the large-scale collective process of discovery, which is then privately appropriated. Every new technology draws on a vast history of publicly-available scientific work — sometimes we see this directly as with biomedical research, but even when it’s not so obvious it’s still there. Every Hollywood movie draws on a vast collective project of storytelling, a general collective effort to imbue certain symbols with meaning. Again see this most directly in the movies that draw on folktales and other public-domain work, but it’s true generically.
It is this vast collective effort at transformation of nature and ourselves that allows the value of output to be greater than the value of what existed before it. Without it, we would eventually reach the classical steady state where the exercise of labor could produce no more than the value of the labor power that yielded it. So when Marx says the source of profits is the fact that labor can produce more than the value of labor power, lying behind this is the fact that, due to humanity’s collective creative efforts, we are continuing to find new ways to shape the world to our use.
Capital is coordination before it is tangible means of production. Initially (logically and historically) the capitalist simply occupies a strategic point in exchange between independent producers thanks to the possession of liquid wealth; but as the extension of the division of labor requires more detailed coordination between the separate producers, the capitalist takes over a more direct role in managing production itself. “That a capitalist should command on the field of production, is now as indispensable as that a general should command on the field of battle.”
There is another way of looking at this: in terms of the extension of cooperation and the division of labor, which is realized in and through capitalist production, but in principle is independent of it. I’ll take this up in a following post.
 Marx makes this point clearly in his critique of the Gotha program. Elimination of surplus as such cannot be a goal of socialism.
 It would seem that we have enough evidence to rule out a sufficiently high probability of world-ending catastrophe to explain observed interest rates, assuming the minimum possible return on accumulated wealth is zero. But of course in some conceivable circumstances it could be negative — that’s why I include the Khmer Rouge takeover, where your chance of summary execution is presumably positively related to your accumulated wealth. Also, maybe we have reason to think that catastrophe is more likely in the future than we would naively infer from the past. It would be funny if someone tried to explain interest rates in terms of the doomsday argument.
 There has been a lot of discussion of appropriate social discount rates in the context of climate change. But nobody in that debate, as far as I can tell, takes the logical next step of arguing that excessively high discount rates imply a comprehensive market failure, not just with respect to climate change. There is not a special social discount rate for climate, there is an appropriate social discount rate for all future costs and benefits. If market interest rates are not the right tool for weighing current costs against future benefits for climate, they are not the right guide for anything, including the market activities where they currently govern.
 Yes, interest exists independently of profits from production, and indeed is much older. Marx recognizes this. But capitalism is not generalized usury.
 And substitution between factors is impossible — Marx’s “iron law of proportions” — or at least limited.