The death of the business cycle as a regulatory mechanism was not immediately obvious in the 1930s. But in the wake of the great financial crash of 1929, as the economy plunged into crisis, the cycle went down and did not come up again by itself. It stayed down. The financial crash became generalized economic downturn, recession became depression, yet there was no restoration of growth.
This was not only true of the domestic economies of the United States and of other countries, but it was also true of the economic relationships among them. The breakdown in internal growth mechanisms was mirrored in the breakdown of international economic adjustment mechanisms. Instead of helping to solve the problems, the gold standard became a vehicle for the rapid circulation of crisis from country to country. Trade deficits accentuated the contraction of the money supply (as gold had to be exported to pay for the excess of imports over exports) and put even greater downward pressure on prices (including wages), which in turn provoked further cut backs in output and employment. Unemployment soared. In the depth of the depression, as no one wanted to submit to the discipline of the gold standard, it was abandoned. As a result of the desire to protect each economy from others, the Great Depression witnessed a rapid circulation of anti-free trade sentiment demanding tariff and quota protection for local production and employment. The capitalists in each country wanted to preserve what was left of their markets from foreign competition by setting up barriers to imports and their workers often thought such protection would help them keep their jobs. The result was a series of competitive protection measures as countries responded to export barriers by creating more walls to keep out imports.
The result was a dramatic decline in world trade, the drying up of export markets and deeper depression in output and employment. For the United States with its huge internal market, this was bad enough. For many Western European countries whose capitalists had long depended on foreign markets, the situation was even more dramatic. The breakdown in international trade was a major factor in making the Great Depression a world-wide phenomenon and in making it so deep and so prolonged. It led to the abandonment of the Gold Standard.
To understand why the downturn was not followed by growth, we can begin by looking at the relationship between wages and profits, between consumption and the availability of surplus for investment. In earlier times, when the cycle turned down and people were thrown out of work, those who had jobs were more likely to accept lower wages, lower wages which capitalists translated into lower costs, higher profits, more optimistic expectations and new investment. In the Great Depression there was large scale unemployment and wages did fall -- but this was not enough to provoke new investment. Why? If you think back to your history for a moment, the "why" seems fairly obvious. This was the period that industrial workers finally responded to the mass-production organization of work by forming industrial unions. They fought for union recognition, higher wages and such benefits as unemployment compensation.
Taylorism (the division of work into very simple deskilled jobs) and the Fordist organization of such mass production, especially the assembly line, was such that each worker had only a very limited, often boring job -- one that required little skill and was only a small part in the assembly of the whole. (The film which best captured the monotony of this kind of job and its effects on workers was Modern Times by Charlie Chaplin -- a film you should not miss!)
The generalized imposition of this kind of work resulted in the de-skilling of a whole work force and amounted to an outflanking of the older craft unions based on skills. This meant that the craft unions within the American Federation of Labor (AFL) were no longer relevant to a new generation of workers in manufacturing. The "mass workers," as they are sometimes called, developed the industry-wide union as a response -- an approach through which vast numbers of workers of differing skills (such as they were) were organized under the same union.
Thus, the 1930s saw the formation of the major industrial unions such as the United Automobile Workers (UAW), United Mine Workers (UMW), and so on -- unions which in turn came together in the Congress of Industrial Unions (CIO). (The older AFL eventually joined with the new, larger CIO to form the AFL-CIO which has dominated "organized labor" in the United States ever since.)
The struggles that led to the formation of these unions had to confront a high level of violent business resistance. The workers fought back, met violence with violence, and this wave of confrontation in the 1930s limited the reduction of wages in the face of widespread unemployment. (The movies Fist with Sylvester Stallone and more recently Hoffa with Jack Nickolson, about the birth of the Teamsters, are interesting partly because they show both the violence used by business, and the way that violence forced workers to respond in kind, and, sometimes to hire violence in the form of the mob. It thus gives us a glimpse of history and a better understanding of the much lamented links between some unions and organized crime. The recent John Sayles' movie Matewan also pictures the violence workers met with during this period, in this case in the coal mines of Appalacia.)
The conflicts created a situation in which wages became "sticky downwards." In other words, wages could rise but even with high levels of unemployment, they could no longer be forced down enough to restore profits. Therefore, the old economic strategies of recession could no longer be relied upon to solve business' problems with workers and the encroachment of consumption on surplus.
This was a dramatic point in history, to say the least. It was a moment when the whole future of the system was in question. The old solutions did not work and new solutions had to be found or the economy and the society organized around it might slip into decay or revolution. This was the crisis in the United States and there were similar crises in other important areas of the world.
This crisis had begun more than a decade before. In the Soviet Union there had been a revolution in 1917, followed by a civil war and massive economic and social upheaval. In Western Europe there was also crisis, of which the upheavals associated with the German Revolution of 1918-19 were perhaps the most dramatic.
The leadership of different countries responded to this challenge in different ways, according to their historical, social and political contexts. Stalin sought to solve the problem of raising the surplus through the forced labor camps of the Gulag, generalized police state repression and collectivization of the peasantry (mainly to collect their produce). Hitler took power amidst the crisis of the Weimar Republic and solved the problem of workers' revolt and capitalist accumulation by instituting Nazism, corporatism and labor camps. In the United States and in much of the Western world the solution that emerged slowly through the New Deal politics of Franklin Roosevelt was what we call today Keynesianism -- after John Maynard Keynes (1883-1946), an English economist who theorized and argued for a whole new kind of analysis and policy. This was the solution which was to prove the most progressive and the most effective. By 1945 the Nazi option would be removed by war. By 1953, when Stalin died, the Soviets would begin a long and ineffective process of trying to reform their solution --the failure of which would be complete with Gorbachev.
With respect to politics, he was one of the first to perceive the growing power of labor to resist traditional adjustment through lowered wages. As early as 1925, during the debate over the post-WWI return to the Gold Standard, Keynes had opposed adjustment through wage cuts. One of his points of reference was the English coal industry where attempts by owners to push down wages led to a lock out and the general strike of 1926. Three years later, in a July 31, 1928 article on "How to Organize a Wave of Prosperity", he also rejected a "general assault on money wages" in favor of an expansion in public expenditure.
Again in 1930, in his work on the Macmillan Committee and the Economic Advisory Council (ECA), Keynes rejected arguments for trying to solve the problems of the economic crisis through a cut in wages. He appealed both to social justice and to the dangers that workers would not submit to the level of reductions required. He also argued that the international crisis and the Bank of England's tight money policy were much more to blame than high wages. For example, in July of 1930, in response to a series of questions drafted by the Prime Minister, Keynes recognized that the combination of "almost complete rigidity of our wage rates since 1929" coupled with "the great reduction of all other price levels" had resulted in real wage increases greater "than ever before in our history." But he went on to argue that the politics of the situation was such that this could not be reversed: "there is now, in my judgement, a very set and deliberate determination in almost all quarters of the community not to go back on this as a general policy." Therefore, he concluded, reductions in costs (such as lower per unit labor costs and lower interest rates) and increases in sales had to be sought through other means, e.g., labor cooperation to raise productivity, lower interest rates and trade protection. Two months later, in a September 1930 memorandum to a subgroup of the ECA, Keynes again warned of "social resistance" to any efforts to cut money wages; indeed, he evoked the spector of "a social catastrophe" that such efforts might bring on.
With respect to theory, he pointed a way to a solution in which both wages and profits could rise. Although the political balance of power between labor and business had shifted in favor of labor, and wages would mainly rise henceforth, there was still a solution in which surplus or profits could also rise.
That solution required the active intervention of the state (especially the national government) to stimulate a growth in productivity and output. Partly this could be achieved, Keynes thought, through a high wage policy which would force the restructuring of industry around the firms with the highest productivity (low productivity, high cost firms would be forced out of business). Partly it could be sought through an expansion of government expenditure (with accompanying accomodating monetary policy) which, by enlarging the market, would induce firms to increase investment, employment and output Ņall of which would allow higher wages.
In terms of the key political economic variables, the solution was very simple. You could have rising wages and rising profits (surplus) if, and only if, you could link the growth of wages to the growth of productivity. (Productivity here refers to labor productivity or output per worker hour.) If the amount of production per hour is growing, and if the proportions of consumed versus surplus output remain constant, then the absolute amounts of output going to consumption (wages) and to surplus (profits) can grow simultaneously.
If we think about this in terms of the analogy so often used, of a growing pie, then letting the division of output between C and S be 75/25 and the pie grows from period t1 to period t2, then wages can grow at the same time that profits grow while guarding the same proportionality. Et voila! Profits grow rather than fall as wages grow. Obviously business would be even better off if it could shift the proportion more in its favor. But as long as the shift didn't entirely offset the growth in wages it's own profit growth would be compatible with rising wages.It was a simple enough notion but it took some time to get it into the thick heads of a lot of economists and even more trouble to get many businessmen to accept the idea. In fact, so strong was business resistance to the notion that wages could grow without hurting surplus that Roosevelt had to force them into the new situation. By supporting unions and rising wages through legislation and propaganda, Roosevelt put pressure on business to respond progressively rather than backwardly to rises in wages. Essentially he was saying "raise productivity to pay for wages or give up your managerial role. Those businesses that can respond with innovation, will survive, and those which can not will die and others will replace them." This was harsh medicine and unheard of for the government to take such a position. Not surprisingly, many businessmen have hated Roosevelt ever since --even though the essentially Keynesian solution that he was supporting saved their system.
We should note in passing that in a sense Keynesianism amounted to a generalization and institutionalization at the national level of an insight developed some years earlier by Henry Ford (or his publicists). Ford, the innovating father of mass production, produced a product aimed at a mass market. He wanted everybody --including his own workers-- to buy his automobiles. Because of this, he saw something that many other businessmen had missed. He saw that wages were not simply a deduction from profits, but were essential to the growth and expansion of consumption oriented production. Therefore, Henry Ford paid the highest wages in American manufacturing. He paid high wages both to give his workers incentives to work hard (while reducing turnover which was very high in the alienating conditions of an assembly line), and money to buy his cars. His was a singular insight into the essential role of wages as final demand. For some commentators, this insight was so important, and Ford's role so key in the evolution of modern capitalism that they speak of "Fordism" to denote the new strategy of production for a well paid, mass market.
With Keynes, this insight was applied at the national level. Keynes saw that wages had become "sticky downward" and could no longer be viewed as being purely negative, but could rather be seen as a part of final demand for industrial output --a demand absolutely essential for that output to be sold. As long as wages and productivity grew together, growing wages played the vital role of absorbing increased production.
The major vehicle for the institutionalization of the link between wages and productivity --"the productivity deal" as it came to be called-- was the trade union, especially the industrial union. These institutions, which had emerged as weapons of workers in their battles with business, came to accept a deal that guaranteed profits. They thus wound up being the means to harness and control worker struggle. Or at any rate, it was through them that business sought to control workers --they did not always succeed of course.
Similarly, the union "contract" became a way to stabilize conflict and to harness it so that it would not impede growth. The contract converts open-ended conflict into struggles for a contract that is periodized according to the length of the contract. Conflict flares shortly before the contract is to be renegotiated, and then, once agreed upon, the union bureaucracy is expected to impose the contract on the membership.
As we have just said, a central clause in such contracts of collective bargaining came to be the "productivity deal" --in which workers accept various changes in work rules or the introduction of productivity raising innovations in exchange for higher wages and benefits. Under the new Keynesian regime, cyclical massive unemployment was out, collective bargaining and productivity deals were in.-P> If, at any point, wages tended to rise more rapidly than productivity, the government could also act at the macro level, through the use of monetary and fiscal policy. It could use a little inflation to undermine real wages so that they grew no faster than productivity (this was an alternative which Keynes prefered in the Depression), or create enough unemployment to slow down (not reduce absolutely) the growth of wages (this was an alternative which he objected to partly because it was unjust, and partly because it might provoke massive resistance).
With these developments, periodic slowdowns or recessions in growth, became the creations of government policy --deliberate, planned efforts to regulate the conditions of economic growth. They were no longer the simple by-product of autonomous business reactions to problems with profits.
To create this situation, business and government had to do a lot of political work within the emerging union structure. Not all workers agreed with these policies. The New Deal politicians and Roosevelt had to work with certain union organizers and not with others (especially Leftists) so that those who were willing to accept this kind of deal would be the ones running things. In this fashion they were fairly successful in making unions into integral parts of the institutional apparatus of capitalist growth.
In the "Keynesian state" business learned to act collectively through the government to do what individual businessmen refused to do. Along with regulating the growth of wages, the state stimulated the growth of productivity to help business respond progressively to labor's demands. During the depression, getting productivity to grow was a serious problem because business was not investing. It was sitting on its money instead of plowing it into plant and equipment (sitting on it = holding cash or short term securities to earn interest). That was why the government began to intervene massively in investment. On the one side, the government would tax uninvested corporate income and then spend it to expand the market and induce a response from business. On the other, it would put tax monies directly into research and development to come up with new technologies to raise output per worker hour. Really large-scale and significant investment of this sort began during the Second World War.
To understand the relationship between the war and the economy requires careful investigation of how government expenditures financed the rapid expansion of industrial investment and output. The economy was transformed very quickly during the war. Government was plowing vast amounts of funds into business to expand the production of all items required for the war, from tanks and planes to food and clothing. War was definitely good for business in that it created a whole new set of markets and a great deal of government subsidization of new investment. There were vast operations built during the war by business, but run by government, which were subsequently turned over to private business. One example was the nitrogen plants built to produce TNT. After the war they were turned over to private business to stimulate a boom in the production of inorganic fertilizer.
Business also took advantage of the war-time changes in the composition of the labor force. As men were drafted into the army and navy, women entered the labor force in unprecedented numbers. Many of those who had been active in the factory occupation of the 1930s, were gotten rid of in the maelstrom of the 1940s. However, it must be said, that despite this, the war period was one of often intense labor-management conflict in which the government was forced to intervene to keep workers' strikes from shutting down production. Both management and labor were well aware that the period of the war could solidify or undo labor's gains in the 1930s and conflicts were acute.
The war, then, constituted a massive government intervention that stimulated productivity and launched the Keynesian solution to the Great Depression on a large scale. It was the beginning of a pattern which persisted throughout the post-WWII period. The government has continued to do what business could or would not do by itself. The result was a long period of growth, slower in the 1950s when there was still much conflict over these new relationships --like the later Reagan administration, the Eisenhower policy makers frequently resorted to recession to curb labor demands-- faster in the 1960s under Kennedy and Johnson who vastly expanded government programs of investment in both industry (aerospace, war) and in social programs (the Great Society) designed to produce a disciplined, more highly productive labor force. Throughout this period there was no depression. There were several slowdowns in growth, recessionary slowdowns, but nothing even remotely resembling the Great Depression. For twenty five years, the Keynesian system worked. In the late 1960s and early 1970s these methods failed and the system was plunged into a state of crisis.
Keynesianism was institutionalized in the international monetary system through agreements signed at a conference at Bretton Woods, New Hampshire in 1944. The Bretton Woods agreements replaced the pre-war system of the gold standard that had broken down during the global depression of the 1930s. Under these new agreements, exchange rates between national currencies would be more or less fixed --to be changed only in exceptional circumstances. What made this a codification of Keynesianism is the assumption that adjustments in international relations could be carried out by national governments.
Under the gold standard, deficits or surpluses in the balance of payments would tend to be corrected by automatic changes in gold flows, money supply and prices. But under the Bretton Woods' regime of fixed exchange rates, although gold was still used for international payments, domestic money supplies were no longer tied to gold and it was up to governments to take whatever measures they deemed appropriate to correct imbalances. For example, in the case of a persistent trade deficit, when a country is importing more than it exports, the government might use restrictive monetary and fiscal policy to slow down growth and the rate of inflation, and thus reduce the demand for imports while making exports more competitive. (It is generally assumed that the demand for imports is a positive function of growth.) Let's examine these relationships a little more closely.
To have fixed exchange rates means that the prices of currencies are fixed in terms of other currencies. The number of French francs per U.S. dollar was set. The number of British pounds per franc was set. And so on. One reason why exchange rates were fixed was to avoid speculation and to maintain stability in expectations about international exchange --both in order to create a stable environment for international trade and investment. Those countries that came together at Bretton Woods did not want countries randomly, or competitively, changing their exchange rates as had been done in the 1930s. Such changes were destabilizing to the international economy and tended to disrupt trade and capital flows. The appeal of such competitive changes was strong and the agreements were an attempt to undercut their likelihood.
For example, suppose France was having a hard time selling its goods at 5 NF/dollar. If it were to one-sidedly change its rate to 6 NF/dollar then American dollars could buy more French goods than before and French exports would expand. However, American exports would now be less attractive because it would take more francs to buy them and so US exports would decline. This might well provoke a competitive change in rates by the United States. It was partly to avoid such activities that fixed rates were adopted.
But even with fixed rates, it is rare that a country's imports and exports balance exactly. (Not to mention its capital flows.) In the old species-flow mechanism, gold would flow to make up for the differences. Under Bretton Woods, there was a different "adjustment mechanism." That mechanism included the following elements. First, to cover short term imbalances each country would hold foreign exchange reserves with which it could pay its debts (e.g., for imports over export earnings). These reserves of foreign exchange may have been held over from previous trade surpluses or they may have simply been purchased by the central bank.
Second, because there is the possibility that a given country might be in balance of payment deficit over a multi-year period, and its foreign exchange reserves might prove too small to finance that deficit, the Bretton Woods agreements set up a special institution, the International Monetary Fund (IMF), to help out. The IMF manages a pool of currencies contributed by all members according to the size of their economic activity. (Thus the United States is the biggest contributor --and has the most votes in the IMF.) Individual countries can draw on this pool (buy currencies they need with their own money), according to certain rules and conditions set down by the Fund. Because the pool is limited and the rules restrict the extent to which individual countries can draw on the Fund, it is expected that medium term adjustments of trade imbalances (or other balance of payments imbalances) shall be corrected through the actions of the governments of the countries involved (as in the case cited above of slowing down growth to reduce demand for imports). In extreme cases of "fundamental disequilibrium" the Fund would even sanction official changes in exchange rates (e.g., devaluation to make exports more competitive). In other words, the IMF assumes that fundamental adjustment is the responsibility of local governments. That assumption is based on the further, implicit, assumption that those governments do in fact have such power through the application of Keynesian economic policies. This is the sense in which the international system is global Keynesianism.
Along with "adjustment," another of the basic problems of the international financial system was that of "liquidity." With rapid growth occurring in most, if not all, countries after World War II, there was a need for growing amounts of international money to finance expanding world trade. Traditionally, under the gold standard, gold had been the universally accepted international money (except in colonial areas where the currency of the colonizing country was used). After Bretton Woods, however, world trade grew much more rapidly than the supply of gold and the result of using only gold to settle accounts would have been deflation as the price of gold would have had to be raised constantly. In terms of the quantity theory of money of the classics the relationship M = PQ/V must be read in a new way. Instead of seeing P vary with changes in M, we can see that as far as the international financial scene went, M must rise enough to finance increases in Q if P is not to fall steadily.
With fixed exchange rates, especially with the American dollar fixed to gold, it was possible for many countries to use the dollar in place of gold. Dollars could be held as foreign exchange reserves and could be used to pay debts because they were "as good as gold." In principle any currency could be so used; but in practice, over the years, only the dollar maintained its fixed tie to gold and thus was thought the safest currency to hold. The result was that the dollar came not only to complement gold as the major international money, but eventually more dollars were held as reserves than the equivalent value of gold. For this reason the Bretton Woods system came to be called a "dollar standard" system. In the 1960s when the primacy of the dollar came to be challenged by some Europeans, it became clear that the dollar had replaced gold because the U.S. economy was the strongest in the world, not just because the dollar was hooked to gold. In fact, for many economists, it could be said that "gold was as good as the dollar," not the other way around. The dollar was held, not because it could be exchanged for gold, but because it could be exchanged against the goods being produced by the world's most powerful, and dependable, economy.
The rapid growth of foreign holdings of dollars in the post-WWII period occurred partly because of the expansion of trade and partly because of international capital mobility. After the war, American capital flowed out of the United States, away from a strong labor force (one that had won WWII and returned home to launch the great 1946 strike wave) and into Western Europe to take advantage of its skilled, but weakened, labor force. The vehicle of this invasion was the so-called multinational corporation. The multinational corporation got the name from its character of having production and marketing facilities in several countries at once. Operating in several countries made such firms "multi-" national and led them to be preoccupied with international finance as well as production.
Located in several countries at the same time and operating through several countries' banking systems, the multinational corporations were in a position to take advantage of variations in exchange rates, or variations in interest rates for the investment of their cash holdings. Since the dollar was by far the preferred international money, they mainly used dollars for such investments. The result was the emergence of a huge "Eurodollar Market" of dollars held in foreign banks outside the United States --held not as foreign exchange reserves but simply for the purpose of investment and speculation. Over time the growth of this market not only helped finance multinational corporate activities but also destabilized the fixed exchange rate system. Corporations would move massive amounts of money from currency to currency in speculative anticipation of devaluations --and by so doing force such devaluations!
Eventually the dominant role of the dollar in the Bretton Woods system came under fierce attack, mainly by Europeans led by French President Charles DeGaulle. The Europeans charged that American corporations had been exchanging pieces of paper for factories, buying up European industry. As the 1960s progressed and with it the American war in Vietnam, they also accused the US of financing the war by flooding the world with dollars, thus contributing to global inflation. Finally, the central role of the dollar, it was charged, undercut the ability of countries to have independent monetary policies because the central bank had to keep offsetting the influx of American dollars in the Eurodollar market to avoid or limit inflation.
The most common objection to the continued role of the dollar was the growing American balance of payment deficit. However, as some economists pointed out at the time, that was inevitable given the fact that foreign countries were holding dollars as international liquidity. A debate then emerged on possible reforms of the system that included such options as free floating exchange rates or a return to the gold standard (with the price of gold as much as tripled). The debate would continue until the system actually did break down in 1971.
Having some grasp of the reasons why classical economics no longer worked is important today because of the recent revival of many classical ideas by economists around the Reagan and Bush Administrations. If they did not work in the 1930s, will they work today? Have conditions changed enough so they will work now?
Understanding the origins and central ideas of Keynesian economics is important not only because they constituted the economic principles employed and taught for the last 30 years, but also because the breakdown of growth during the last twenty years has simultaneously meant a crisis in Keynesian economics.
Today, the crisis of the Keynesian era persists and with it a wide variety of on-going disputes and debates over possible solutions and theoretical approaches. Now, as never before in the last two decades, there is a need for some grounding in history of both policy and theory.
2. What changed during the Great Depression that made it difficult for the traditional mechanisms of the cycle to restore prosperity during the 1930s?
3. Explain these terms: Fordism, mass production, mass worker, de-skilling. Explain their interrelationships.
4. In terms of the variables we have used to discuss growth, what was the Keyensian solution to the Great Depression and to the maintenance of growth? In what sense was that solution implemented by Roosevelt?
5. In what sense was Keynesianism a generalization of Fordism? In what sense did it embody the principles of a non-zero-sum game?
6. What is a "productivity deal" and how is it related to Keynesianism?
7. What kinds of things could government do to stimulate the growth of productivity?
8. What were the Bretton Woods agreements signed in 1944? How were they an attempt to avoid the problems of the gold standard? In what sense were they an international expression of Keynesianism?
9. Explain the functioning of a fixed exchange rate system. Why do you have to have foreign exchange reserves and what was the intended role of the IMF?
10. What problems emerged in the Post-WWII period with respect to international liquidity? How were they solved?
11. Why did the dollar and its role in the international economy come under attack in the 1960s?
12. What are IMF "stand-by arrangements?" How do they work? What is "conditionality?" What are typical "conditions"?