In the early 1970s, the capitalist world economy entered a period of instability and crisis. Even though the collective GDP of the advanced economies was expanding (though at a diminished rate compared to previous decades), and the core capitalist countries were far richer than ever before, many of the problems that had plagued the capitalist economies prior to the Keynesian era – poverty, squalor, mass unemployment, inequality, instability (within as well as between nations) – reappeared. As a result, the Keynesian framework, and the institutions and policies associated with it, which until then had sustained an ever-rising tide of economic prosperity and employment in advanced countries (albeit afflicted by serious problems, as we have seen), came increasingly into question. Within two decades, full employment policies were abandoned in virtually all advanced countries, replaced by nominally ‘free-market’ policies – based upon the privatisation of state enterprises, trade liberalisation, deregulation of the financial sector and fiscal retrenchment, among other things – that today generally fall under the rubric of neoliberalism. To this day, the causes of this seismic ideological, economic and political paradigm shift are still hotly debated.
One school of thought, common to those of an idealist disposition, views the shift from the Keynesian to the neoliberal era largely as the victory of one ideology over another. According to this narrative, the Keynesian model started to crumble in the 1970s under the weight of the so-called neoliberal counter-revolution: an ideological war on Keynesianism (which initially took the form of monetarism) waged by a new generation of die-hard free-market economists, mostly based at the University of Chicago, led by Milton Friedman. As already mentioned, such a conclusion rests on a fundamental faith in the power of ideas to shape the world. And what better proof of this than Friedman’s extraordinary career? Though Friedman’s work covered a wide range of topics, his public image was largely defined by his theories on monetary policy. By the late 1960s, Friedman had already achieved star-like status, at least in the realm of the economics profession. In 1967 he was elected president of the influential American Economic Association (AEA). In his 1967 presidential address to the AEA, Friedman laid out the main tenets of monetarism, which rested on the belief in ‘the potency of monetary policy’, deemed by Friedman to be a much better tool for stabilising the economy than fiscal policy (government spending and taxation).1 Friedman’s entire theoretical edifice rested on the idea that central banks can directly control the money supply. This was somewhat of an obsession for Friedman. ‘Everything reminds Milton of the money supply. Well, everything reminds me of sex, but I keep it out of the paper’, MIT’s Robert Solow wrote in 1966.2
The monetarist or quantity theory of money asserts that banks need excess reserves before they can loan out deposits (according to the so-called ‘money multiplier’) and thus that central banks can directly, or exogenously, control the money supply by influencing the minimum reserve requirements of banks or by increasing reserves through so-called open market operations (what today we call quantitative easing). Moreover, it implies that banks and bankers are mere ‘intermediaries’ between borrowers and savers, thereby requiring pre-existing deposits before they can extend loans to other customers. For centuries, up until the 1930s, this had been the dominant view of ‘money’. As Keynes and others (such as Schumpeter) have shown, though, this is not how credit-money works in a modern economy. The causality actually works in reverse: when a bank makes a new loan, it simply makes an entry into a ledger – Keynes called this ‘fountain pen money’; nowadays it usually involves tapping some numbers into a computer – and creates brand new money ‘out of thin air’, which it then deposits into the borrower’s account. In other words, instead of deposits leading to loans, it actually works the opposite way: it is the loans that lead to newly created deposits. Banks worry about their reserve positions after the fact. Reserves are only required to ensure all the cross-bank transactions on any day will be reconciled – or, to put it more obviously, that cheques do not bounce. Only if it has insufficient reserves does the commercial bank turn to the central bank, which is obliged to provide reserves on demand. Pre-existing deposits aren’t even touched – or needed, for that matter. In short, the money supply is endogenously demand-driven and largely controlled by private banks, not central banks. At best, central banks can only hope to influence the money supply indirectly, by adjusting their key interest rates or by influencing the market interest rate through open market operations. The Bank of England summarised this succinctly: ‘The quantity of reserves is therefore a consequence, not a cause, of lending and money creation.’3 It went on to say:
The bank therefore creates its own funding, deposits, in the act of lending, in a transaction that involves no intermediation whatsoever. … The fact that banks technically face no limits to increasing the stocks of loans and deposits instantaneously and discontinuously does not, of course, mean that they do not face other limits to doing so. But the most important limit, especially during the boom periods of financial cycles when all banks simultaneously decide to lend more, is their own assessment of the implications of new lending for their profitability and solvency.4
In his early work, Keynes shared the then consensus view that ‘unconventional’ monetary policies are sufficient to pull an economy out of a slump, by bringing down the long-term market interest rates.5 By 1936, however, seven years into the Great Depression, Keynes had changed his mind about the ‘potency’ of monetary policy. In the General Theory, he argued that in a recession/depression, when interest rates are very low (close to zero or even negative), the ‘transmission mechanism’ breaks down, meaning that changes in the money supply have little effect on the economy. In such a context, an expansionary fiscal policy – in particular, an increase in government spending – is necessary to get an economy growing again. This was – and still is – Keynes’ greatest lesson, forming the post-war consensus about the primacy of fiscal policy vis-à-vis monetary policy. Since the beginning of his academic career, Friedman had been crusading against this consensus. In 1963 he published A Monetary History of the United States, 1867–1960, with Anna Schwartz, in which he argued that the Great Depression had not been caused by excessive deregulation, but, on the contrary, by excessive regulation and government intervention.6 Friedman almost single-handedly resurrected the pre-Keynesian view that market economies are inherently stable in the absence of major unexpected fluctuations in the money supply, and consequently that governments should intervene in the economy as little as possible and, more specifically, should eschew the use of discretionary fiscal and monetary policies, believed to be inherently inflationary, with the former limited to the pursuit of a balanced (or surplus) budget and the latter concentrated purely on price stability. In more philosophical terms, Friedman’s theories chimed with those of early ‘neoliberals’ such as the Austrian School economists Ludwig von Mises and Friedrich Hayek, who saw the capitalist market as something that is ‘natural’ and necessary for ensuring freedom, and viewed any form of government intervention that disturbed the (assumed) natural functioning of the market mechanism not only as unnatural and liable to fail, but also as an assault on human freedom – one that ultimately leads to the ‘road to serfdom’, as Hayek put it in the 1944 book by the same name, arguably the most celebrated publication in the neoliberal canon. Hence Friedman’s obsessive use of the word ‘freedom’ in his writing and proselytising (Capitalism and Freedom, Free to Choose, etc.).
Friedman argued that central bankers had to ‘prevent money itself from being a major source of economic disturbance’ and provide a ‘stable background for the economy’.7 The best way to achieve this, he said, was for the central bank to target ‘magnitudes that it can control’, and he considered the ‘monetary total-currency plus adjusted demand deposits’ to be the most desirable of these magnitudes. The policy advice that emerged was the famous ‘monetary targeting’ approach, whereby the central bank should aim to achieve ‘a steady rate of growth’ in the money supply (of, say, 3 per cent a year) – and not deviate from that target, no matter what. ‘The idea was to put monetary policy on autopilot, removing any discretion on the part of government officials’, Paul Krugman notes.8 Friedman rejected the idea that central banks could use changes in the money supply to target a politically desirable unemployment rate (or any other rate, such as the interest rate or exchange rate, for that matter).
This was related to Friedman’s theories about inflation. In 1958, the New Zealand economist A. W. Phillips had shown that there was a historical correlation between unemployment and inflation, with high inflation associated with low unemployment and vice versa (this relationship is known as called the ‘Phillips curve’). This meant that there was a trade-off between unemployment and inflation – a discovery that obviously had serious implications for policymaking, because it meant that governments always had the choice of accepting a higher inflation rate in exchange for a lower unemployment rate. In his 1967 speech, however, Friedman argued that ‘there is no long-run, stable trade-off between inflation and unemployment’.9 In other words, if policymakers were to try to keep unemployment low through a policy of higher inflation, they would achieve only temporary success. According to Friedman, unemployment would eventually rise again, even as inflation remained high. The economy would, in other words, suffer the condition that Paul Samuelson would later dub ‘stagflation’. Friedman’s argument was that after a sustained period of inflation, people would build the history of past inflation and the expectations of future inflation into their decisions. So workers, for example, once they understand that the purchasing power of their wages will be eroded by inflation, will demand higher wage settlements in advance, so that real wages keep up with prices, giving rise to a self-reinforcing feedback loop and ultimately leading to both higher unemployment (as firms will be forced to lay off workers to reduce costs) and higher inflation.
Friedman’s argument wasn’t new: the idea that in a period of sustained expansion inflation may accelerate as a result of workers building the history of inflation into their bargaining behaviour – leading to a so-called ‘wage–price spiral’ – was well understood by Keynesian economists. However, this misses the fundamental agenda that Friedman was pursuing. In attacking the prevailing view that there was a stable trade-off between inflation and unemployment, Friedman was attempting to reclaim the terrain that neoclassical monetary theory had lost after the Great Depression, by denying the effectiveness of fiscal and monetary interventions by government in sustaining full employment.
Central to this conclusion was the concept of the ‘natural rate of unemployment’ that Friedman introduced. Put simply, it argued that a free market would deliver a unique unemployment rate that was associated with price stability (implying that whatever the level may be, it was the ‘full’ employment level, because it was consistent with price stability), and that government attempts to manipulate that rate using fiscal and/or monetary policy would only lead to accelerating inflation. To accept the monetarists’ logic was to also realise that there was now a policy lacuna, which required a fundamental reassessment of the way in which the government operated in the economy. The prescription was for policymakers to concentrate on price stability by controlling the rate of monetary growth and to let unemployment settle at this ‘natural’ rate, ignoring popular concerns that it might be too high. So, by maintaining price stability, central banks would simultaneously fulfil any charter to maintain full employment. It was sleight of hand but it would come to be increasingly accepted by policymakers. Monetarism was born. It was soon discovered by central banks that they could not, indeed, control the growth of the money supply, and attempts to do so were quickly abandoned. But this evidential failure didn’t quell the thirst in academic and policymaking circles for the anti-government monetarist doctrine.
It is largely believed that these ideas gained (once again) a sudden popularity during the oil crisis of the early to mid-1970s, as the stagflationary scenario predicted by Friedman – the simultaneous incidence of high unemployment and accelerating inflation – became a reality, catching most Keynesians off guard and confirming Friedman’s status as a prophetic economist. To a certain extent this is true. But what most accounts of the rise of monetarism fail to acknowledge is that monetarist theories had started to percolate into policymaking well before the 1970s oil crisis. Britain is a perfect case in point. In 1968, the British professional magazine The Banker published four articles in its December issue that were devoted to the issue of changes in the money supply and the prominence of these changes in determining GDP and inflation.10 Friedman himself wrote one of the articles – ‘Taxes, Money and Stabilization’ – in which he reiterated his rejection of fiscal policy as a reliable way of stabilising the economy and promoted his monetary targeting idea. It was essentially a dumbed-down version of his 1967 speech to the AEA, targeted at the professional policymaking community rather than the academy. Other articles claimed that Britain was suffering from excessive liquidity and that the central bank should severely restrict the amount of ‘spending money’ that the non-government sector had access to. One article directly attributed the so-called excessive liquidity to government fiscal deficits.
Up until then, the Radcliffe Report, a 339-page study of Britain’s monetary system after 1931, published in 1959, had been the major framework for conducting monetary policy in Britain. The report rejected the view that ‘the central task of the monetary authorities is to keep a tight control on the supply of money’.11 It also rejected the view that increases in the money supply would inevitably translate into increasing inflation, a core proposition that Milton Friedman was advancing in his 1967 speech, and reiterated the accepted consensus at the time that it was spending that created the inflation risk, not the level of bank reserves or currency in existence. The opening article of the December 1968 edition of The Banker explicitly attacked this orthodoxy. It essentially rehearsed Friedman’s claim that the Bank of England had to focus on controlling the money supply if Britain was to achieve any sense of economic stability. Aled Davies provides an excellent account of this period in his paper ‘The Evolution of British Monetarism: 1968–1979’.12 As Davies recounts, following Friedman’s 1967 speech, influential media outlets such as the Financial Times ran stories that promoted his ideas. Davies also notes that Friedman’s message was reverberating throughout the financial markets and business sector in Britain; he lists a range of leading firms that were starting to propagate the message about monetary targets. By the end of 1968, the Bank of England was catching the virus. In its December edition of the Quarterly Bulletin, a new section was introduced, ‘Money Supply: April–September 1968’, which discussed movements in the broad aggregate (deposits plus notes and coins) in the previous quarter. Importantly, the Bank explicitly linked the budget deficit to monetary growth (alongside private bank lending) – a relationship that would play a central role in Margaret Thatcher’s 1980s slash-and-burn anti-inflationary strategy.
Moreover, as part of the conditionality that the Labour government accepted in relation to two stand-by arrangements that it negotiated with the International Monetary Fund (IMF) in 1967–9 to deal with the country’s chronic balance-of-payments deficit, it was agreed that the Bank of England would start controlling the money supply – and in particular domestic credit expansion, which was the aggregate that the IMF wanted governments to control. In International Monetary Cooperation Since Bretton Woods, Harold James writes that this decision formalised the ‘beginnings of an intellectual conversion’ within the British Treasury.13 This leads to a rather stark conclusion: Britain – and the British Labour Party – effectively succumbed to monetarism in the immediate aftermath of Friedman’s 1967 speech, long before Margaret Thatcher came to power.
By the early 1970s, however, the government was forced to acknowledge that controlling the money supply was a practical impossibility: credit controls were abandoned and money supply targets effectively lost all practical significance. This demonstrated that the basic principles of Milton Friedman’s monetarist theory were deeply flawed. However, this didn’t stop the monetarists in the UK and elsewhere from broadening their offensive from a concern with monetary policy to ‘a frontal assault on the fiscal, legal and administrative powers of the state, and on the supposed power of the trades unions, providing the ideological rationale for a fundamental restructuring of the Keynesian political and industrial relations apparatuses’.14
Meanwhile, in France, Valéry Giscard d’Estaing was elected president in 1974. In the traditional struggle between the French policymakers in the planning ministry and the technocrats in the ministry of finance (who were increasingly absorbing the monetarist doctrine), Giscard d’Estaing was in the latter camp. He introduced a vicious austerity programme – the Barre Plan, from the name of the finance minister Raymond Barre – which was the world’s first real monetarist experiment, one that Margaret Thatcher would more or less copy later on.
The context, as mentioned, was that of the global stagflation – stagnation plus inflation – of the early to mid-1970s. In the mid-1960s, inflation began ratcheting upwards in most developed nations, largely as a result of rising commodity prices (particularly food, beverages and metal) and US spending associated with the Vietnam War, which overheated the domestic economy and marked the first significant deficit in the country’s balance of payments. As we saw, the resulting inflation was then transmitted through the fixed exchange rate system to Europe and beyond, because the increased trade deficit in the US fuelled stimulatory trade surpluses in other nations. This caused US liquidity to expand in world markets at an unprecedented rate, raising the prospect of a potential run on its stock of gold: as the number of US dollars in circulation rose, other countries started to worry about the value of their growing dollar holdings, and to question whether the US would continue to maintain the gold convertibility indefinitely. This increasingly led nations to exercise their right to convert their dollar holdings into gold, which significantly reduced the stock of US-held gold reserves. General De Gaulle was particularly vocal in his denouncement of America’s privilège exorbitant, which enabled the country to amass ‘tearless deficits’ (déficits sans pleurs): thereupon, the French demanded the immediate redemption of their liabilities in gold. It is estimated that by the mid-1960s American paper-dollar liabilities to foreign official agencies exceeded the gold cover. The US authorities devised all sorts of methods to soak up the excess liquidity in the hands of foreigners that might otherwise have been tempted to buy gold (T-bills, higher domestic interest rates, the two-tier gold system, etc.), but they all proved futile. As Leo Panitch and Sam Gindin note, ‘[i]n less than a generation, the contradictions inherent in the Bretton Woods agreement were exposed’.15 By 1971, during Richard Nixon’s first presidential mandate, it had become apparent that the Bretton Woods system had reached breaking point: on 15 August 1971, US president Nixon unilaterally ended the gold– dollar convertibility (that is, ended the ability of foreign central banks to convert their dollar holdings into gold), effectively transforming the dollar into a non-convertible fiat currency. He also applied a 10 per cent surcharge on imported goods. Together with wage and price controls to reduce inflation, these surprise actions became known as the ‘Nixon shock’. Commentators around the world reported it as a resounding defeat for the United States – it was anything but. Buttressed by the power of the dollar as the world’s reserve currency, the US succeeded in creating a new global hegemonic regime based on a so-called ‘T-bill standard’. In short, the United States relinquished the imperative of competing with other nations for world market shares and came to accept its role as ‘consumer of last resort’, by deliberately buying more than it sold abroad and running large, chronic trade deficits; countries with chronic trade surpluses (such as Japan, Germany, subsequently China, etc.), on the other hand, had little choice but to ‘finance’ this trade deficit via the buying of large quantities of US securities.16
An attempt by the world’s major powers to revive the previous system of fixed exchange rates (but without the backing of silver or gold), through the so-called Smithsonian Agreement, failed. By 1973, all the major currencies had begun to float against each other, inaugurating the new era of the ‘managed float’, whereby the central banks regularly intervened in the currency markets to resist fluctuations that were deemed undesirable, by buying/selling domestic and foreign currencies in the foreign exchange market or by adjusting their bank rates (most European currencies, on the other hand, continued to experiment with various forms of currency arrangements all the way up to the creation of the single currency). As we will see, this new system raised new problems but reduced the constraints on domestic policy, because monetary and fiscal policy was no longer defined by the need to defend an agreed parity. Governments were now free to use fiscal and monetary policy – within limits – to pursue domestic objectives previously unattainable on a sustainable basis. Initially, however, the collapse of the Bretton Woods system was accompanied by significant instability on the foreign exchange markets, which further exacerbated the inflationary pressures in a number of countries, giving renewed impetus to the anti-inflationary mantra of the monetarists.
Then came the oil crisis. In October 1973, the Organization of the Petroleum Exporting Countries (OPEC) announced an oil embargo in response to the outbreak of hostilities in the Middle East (the 1973 Arab-Israeli War, or Yom Kippur War). A few days later, on 16 October, the Arab nations increased the price of oil by 17 per cent and indicated that they would cut production by 25 per cent as part of a leveraged retaliation against the United States’ decision to provide arms to Israel. This was a major shock to the world: the price of oil rose by around three times within eight months and the US dollar appreciated by 17 per cent in the six months to February 1974. Financial markets reacted badly and significant instability emerged in world currency markets. The impact on the fixed exchange rate regime in Europe was particularly severe, with European currencies experiencing major depreciations, causing growing pressure on those countries’ balance of payments. There were multiple effects of a varied nature across different economies. Suffice to say that real GDP growth fell significantly in many countries, resulting in rising unemployment, at the same time as the imported oil price rises and the depreciating exchange values triggered accelerating inflation. In an attempt to control inflation governments pursued deflationary policies, but this led to higher unemployment and growing industrial unrest and electoral dissatisfaction, while doing little to curb inflation. Thus deflationary policies would be reversed and expansionary policies reintroduced to combat unemployment and raise living standards. But this would simply exacerbate the inflationary pressures, and the cycle would begin again.
For many neo-Keynesians, this stagflationary scenario represented a major quandary. Up until the 1960s, many neo-Keynesian economists ignored the possibility of stagflation, because historical experience suggested that high unemployment was typically associated with low inflation, and vice versa (the so-called ‘Phillips curve’). The conventional neo-Keynesian view was: (i) that inflation could only result if overall spending in the economy outstripped the capacity of firms to produce goods and services, leaving them no option but to increase prices; and (ii) that unemployment could easily be prevented through demand-side stimulus, that is, more spending. In the context of the early to mid-1970s, though, that would have simply exacerbated the rising inflation; in fact, stagflation appeared to point to the need for the simultaneous application of expansionary (anti-recessionary) and contractionary (anti-inflationary) policies.
Not everyone was perplexed, though. Various economists of the post-war period – most notably John Kenneth Galbraith, Nicholas Kaldor, John Cornwall and Sydney Weintraub – understood quite well that a full employment regime could generate self-reinforcing inflationary pressures, as organised labour and capital used their wage-setting and price-setting powers, respectively, to claim a greater share of the national income, thus leading to a so-called wage–price or price–wage spiral (depending on who tried to push their price up first, workers or capital), which in turn could be further exacerbated by supply-side factors (such as an increase in oil and commodity prices). This meant that at a time when a major deterioration in a nation’s terms of trade occurred (say, due to an oil price rise), there were no mechanisms in place to allow the economy to adjust to the decline in real income that the external input price shock generated: real wage resistance and profit margin push both prevented a non-inflationary resolution to a national real income loss from occurring. In 1970, Galbraith stated that Keynes had ‘become obsolete’ as a result of the monopoly power exerted by big business and powerful trade unions. The problems that Keynes had addressed related to demand-side (spending) deficiencies, which led to mass unemployment, whereas the contemporary problems related to the supply side – the struggle between labour and capital for greater shares of national income.17 John Cornwall noted that this problem did not prove ‘that the Keynesian emphasis on aggregate demand is incorrect’; it simply showed that ‘demand management is a most unsuitable instrument for reducing inflation’.18 These economists understood the need for a consensual approach to the problem, via wage and price guidelines that would distribute the burden of disinflation equitably among labour and capital. Rather than try to discipline these inflationary tendencies with austerity, which meant using unemployment as a means of quelling wage demands and flat sales as a means of moderating profit margin pushes, a growing chorus of economists, including Galbraith, advocated the use of incomes policies (wage and price guidelines) to deal with the cost push while avoiding mass unemployment.
These insights, however, were lost in the public debate, as most macro-economists – including many Keynesians – grew increasingly sceptical of Keynesian theories, and started to reconsider their ideas in search of an explanation for stagflation. This provided the monetarists with the perfect opportunity to deal the final blow to the post-war Western economic orthodoxy. A perfect case in point is the debate that took place in Italy in the mid-1970s. The Italian government’s reaction to the oil crisis and resulting economic slowdown followed the same pattern as that of other countries: restrictive monetary and fiscal policies in order to contain inflation, and repeated currency devaluation to maintain competitiveness in export markets and to keep the balance-of-payments deficit under control. As elsewhere, though, this policy mix failed to prevent the economy from repeatedly falling into recession. The rapid growth of inflation led trade unions to demand the establishment of a 100 per cent indexation of wages to the rate of inflation (the so-called escalator clause), which they obtained in 1975. It is in this context that the so-called ‘Modigliani controversy’ took place. In a series of articles in the Italian press, the prominent economist Franco Modigliani, one of the forefathers of the neoclassical synthesis, sharply criticised the escalator clause, arguing that it would produce an unnecessary increase in labour costs. From a theoretical standpoint, he offered an extensive criticism of the agreement in his essay ‘The Management of an Open Economy with “100% Plus” Wage Indexation’, written in collaboration with Tommaso Padoa-Schioppa and first published in 1977 in the journal Moneta e Credito.19 In it, the two economists argued that the escalator clause was inherently inflationary and that a reduction in real wages was necessary in order to bring Italy out of the crisis. Modigliani was also keen to stress that real wage compression was a painful but necessary step to bring down unemployment. The fact that ‘Keynesians’ like Modigliani were arriving at such distinctly un-Keynesian conclusions – Keynes would never have accepted the proposition of a wage cut leading to an increase in the demand for labour, Luigi Pasinetti later noted in a scathing critique of Modigliani’s theories20 – shows the extent to which the neoclassical synthesis, by remaining wedded to the pre-Keynesian orthodoxy, effectively paved the way for monetarism, which easily discredited neo-Keynesianism on the grounds of a logical inconsistency between its microeconomic foundations and the ‘Keynesian’ macroeconomic policy prescriptions.
To make things worse, in the late 1960s and early 1970s, left-wing academics became besotted with notions that the crisis which accompanied the OPEC oil price hikes was to be found in the lack of taxing capacity of governments. Furthermore, they started incorporating the increasingly global nature of finance and production supply chains into their analysis, concluding that these trends undermined the capacity of states to spend and maintain full employment. This became the perceived wisdom among most left-wing intellectuals throughout the 1970s, lending credibility (unwittingly) to the emerging monetarist/neoliberal anti-statist mantra. One of the most influential texts in this respect was the 1973 book, The Fiscal Crisis of the State, by American sociologist and economist James O’Connor.21 Approaching the problem of budgetary analysis from a Marxist perspective, O’Connor correctly noted that the capitalistic state is in a contradictory position, where it has to keep private profits high and growing, by socialising various costs of production that would otherwise be borne by the private sector, while at the same time providing a redistributive function to ensure that workers enjoy some of the prosperity created by the capitalist production process. Both functions require the government to expand its expenditure shares relentlessly. O’Connor placed the source of the crisis of Keynesianism directly within ‘this tendency for government expenditures to outrace revenues’, which is further exacerbated by the constant struggle between classes over the composition of state spending.22 He termed this the ‘fiscal crisis of the state’.
Consistent with his Marxist leanings, O’Connor believed that the government would increasingly place the tax burden on the working class, which would heighten the class conflict inherent in American capitalism. O’Connor’s analysis contains many worthy insights, but ultimately they are all overshadowed by the macroscopic flaw underpinning his entire theory: his adherence to the mainstream belief that currency-issuing governments are financially constrained because they need to ‘finance’ their spending through taxes or selling debt to the private sector. While that was certainly true during the 1960s, when O’Connor started writing the book – as we noted, under the Bretton Woods fixed exchange rate system governments had to constrain their expenditures to meet the central bank requirements to sustain the currency parity (and, in the case of the US, avoid a run on its gold reserves) – it was not true after 1971, when president Nixon effectively ended the gold convertibility and floated the US dollar. The floating of exchange rates freed governments, to a large degree, from the balance-of-payments constraint. But it appears that O’Connor didn’t grasp the significance of what had happened and proceeded as if nothing significant had changed.
This blunder would have far-reaching consequences. In the period following the publication of The Fiscal Crisis of the State, a myriad of left-wing articles, academic papers and books emerged reflecting (and cementing) the new common sense: that the breakdown of the Bretton Woods system had reduced, rather than increased, the ability of national governments to pursue expansionary policies and maintain full employment. This idea gained strength once left academics started incorporating ‘globalisation’ into their analysis, going on to become a self-evident truth in left circles. Even an insightful thinker like Marxist historian Eric Hobsbawm would later write in his magnum opus, The Age of Extremes, that the Keynesian model was ‘undermined by the globalisation of the economy after 1970, which put the governments of all states – except perhaps the USA, with in enormous economy – at the mercy of an uncontrollable “world market”’.23
Such arguments were not unfounded, but often overemphasised the inflationary effects of currency depreciation or underplayed the role that capital and/or import controls could play in moderating speculative attacks and reducing pressure on the exchange rate (for a more detailed discussion of this topic, see pages 211–14). In this context we can better appreciate the early literature on globalisation and economic sovereignty loss. In his 1971 book, Sovereignty at Bay: The Multinational Spread of US Enterprises, the late Raymond Vernon, eulogised as ‘the discoverer of globalisation’, was one of the earliest proponents of the view that the state had lost its fiscal authority.24 Vernon argued that ‘as far as the advanced countries are concerned, the generalization holds: the pattern of coordination, consultation and commitment has evolved to such a point that freedom of economic action on the part of those nations is materially qualified’.25
Vernon was referring to two developments that had taken place in the post-war period: (i) the establishment of various multilateral trade agreements and exchange rate arrangements (he was writing before the Bretton Woods system of fixed exchange rates broke down in 1971); and (ii) the extraordinary growth in world trade, due to technological improvements in transport and communications, which led to a substantial increase in the volume of capital flows between advanced nations (particularly in the form of US foreign direct investment, or FDI) and laid the basis for a new internationalisation of production (exemplified by the growing presence of US corporations in Europe). Vernon noted that the burgeoning power of multinational enterprises raised fears that ‘as long as the multinational enterprise has the power, difficult or improbable though its use may sometimes be, to dry up technology or export technicians or drain off capital or reduce production or shift profits or alter prices or allocate export markets, there is a latent or active tension associated with its presence’.26
As we discuss in Chapter 5, these tensions persist today and are used as the basis for the claim that states must compromise domestic policy to ensure that they do not trigger a negative response from international capital that is ‘parked’ within their borders. Vernon also claimed that the advent of multinational enterprises had rendered the nature of international transactions more complex, as many financial flows were now conducted within the same enterprise but across national borders. He concluded that ‘any state which senses an inadequacy in its capacity to impose effective restrictions at the border has ample reason for harboring that feeling’.27 He argued that while governments could block flows for a short time, companies would develop new ways of shifting capital, which would leave ‘the regulating sovereign … increasingly at a disadvantage’.28
Over the years, many commentators have used this line of reasoning to suggest that taxation bases are now unstable because transnational corporations can easily move across national borders in search of the most favourable tax regimes, which leads governments to engage in tax competition with each other, lowering corporate taxes as well as taxes on high incomes and assets, in a bid to attract capital. This argument was (and is) used to show that the capacity of the government to spend is undermined by the erosion of the taxation base needed to ‘finance’ spending (without resorting to large-scale deficit financing, deemed to be inherently unsustainable). This, in turn, has allowed governments of all colours in recent decades to falsely construe rising welfare payments as a threat to the fiscal viability of the state, and to lecture citizens about how governments, like households, have to live within their means. As we argue in Chapter 8, much of this concern about tax shifting is misplaced when considering the options facing a currency-issuing government. It is one of the many myths of mainstream macroeconomics whose origins can (also) be traced back to the left’s inability to understand correctly the true implications of the shift from fixed to floating exchange rates.
With this in mind, we can better understand why, over the course of the 1970s, most economists – including many well-known Keynesian and left-wing economists – gradually shunned the Keynesian paradigm (even in its ‘bastardised’ neo-Keynesian form) in favour of monetarist macroeconomics. As American economist Alan Blinder wrote: ‘By about 1980, it was hard to find an American academic macroeconomist under the age of 40 who professed to be a Keynesian. That was an astonishing intellectual turnabout in less than a decade, an intellectual revolution for sure.’29
Meanwhile, Friedman’s simplistic monetarism gave way to a much broader and more sophisticated anti-statist pensée unique, based upon the virtues of supply-side economics, financial and trade liberalisation, privatisation and deregulation, and more generally on the superiority of the market economy over state intervention – what today we generally refer to as neoliberalism. This coincided with the gradual dismantling of the post-war Keynesian framework (though not in the direction officially preached by neoliberal ideology, as we shall see). It is important to note that neoliberal ideology did not spring out of nowhere; it had been waiting in the wings of Keynesianism for over 50 years. As Philip Mirowski and Dieter Plehwe have shown, intellectuals associated with the Mont Pèlerin Society (founded by Friedrich Hayek and others in 1947) had been elaborating and promoting ‘a total thought collective of more than one thousand scholars, journalists, (think tank) professionals, and corporate and political leaders around the globe’ since the end of World War II – a fact that in itself starkly contradicts the neoliberals’ proclaimed confidence in the inherent spontaneity of the market.30
From this perspective, one would be easily tempted to attribute the neoliberal restructuring of society that has occurred from the late 1970s onwards to the theories developed by Friedman and other academics (most notably those at the University of Chicago). But, as Simon Clarke noted, to view the shift from the Keynesian to the neoliberal era primarily as the victory of one ideology over another
is to attribute too much coherence and too much power to theories that serve more to legitimate than to guide political practice. The ideas of monetarism are important, but their importance is ideological, in giving coherence and direction to political forces which have deeper roots. … The debate between monetarism and Keynesianism was not resolved in the seminar room, but on the political stage.31
This gives rise to another explanation for the rise of monetarist theory, which ascribes its success not (only) to its intellectual or analytical clout, but to the fact that it provided a convenient justification for the restoration of the unfettered power of capital. Gérard Duménil and Dominique Lévy, for example, frame the rise of neoliberalism as a ‘counter-revolution’, or even a ‘coup’:
The profitability of capital plunged during the 1960s and 1970s; corporations distributed dividends sparingly, and real interest rates were low, or even negative, during the 1970s. The stock market (also corrected for inflation) had collapsed during the mid-1970s, and was stagnating. It is easy to understand that, under such conditions, the income and wealth of ruling classes was strongly affected. Seen from this angle, this could be read as a dramatic decline in inequality. Neoliberalism can be interpreted as an attempt by the wealthiest fraction of the population to stem this comparative decline.32
Monetarism was thus the ideological mask used to conceal this capitalist counter-offensive. The rise in the acceptance of monetarism was not based on an empirical rejection of the Keynesian orthodoxy; rather, in Alan Blinder’s words, it was ‘a triumph of a priori theorising over empiricism, of intellectual aesthetics over observation and, in some measure, of conservative ideology over liberalism. It was not, in a word, a Kuhnian scientific revolution’.33 However, the right sought to promote monetarism as a way of undermining the commitment to full employment and various financial and labour market regulations, irrespective of the facts. As Alan Budd, economic advisor to the Thatcher government, would later admit:
There may have been people making the actual policy decisions … who never believed for a moment that this was the correct way to bring down inflation. They did, however, see that [monetarism] would be a very, very good way to raise unemployment, and raising unemployment was an extremely desirable way of reducing the strength of the working classes – if you like, that what was engineered there in Marxist terms was a crisis of capitalism which re-created a reserve army of labour and has allowed the capitalists to make high profits ever since.34
A similar argument is put forward by David Harvey, who claims that the capitalists adopted the neoliberal approach because their class power had been diluted under Keynesianism and was threatened in the mid-1970s. Their response was determined by their need for a ‘restoration of class power’:
One condition of the post-war settlement in almost all countries was that the economic power of the upper classes be restrained and that labour be accorded a much larger share of the economic pie. … While growth was strong this restraint seemed not to matter. To have a stable share of an increasing pie is one thing. But when growth collapsed in the 1970s, when real interest rates went negative and paltry dividends and profits were the norm, then upper classes everywhere felt threatened. In the US the control of wealth (as opposed to income) by the top 1 per cent of the population had remained fairly stable throughout the twentieth century. But in the 1970s it plunged precipitously as asset values (stocks, property, savings) collapsed. The upper classes had to move decisively if they were to protect themselves from political and economic annihilation.35
Various documents that appeared throughout the 1970s, which expressed this very concept in no uncertain terms, would appear to validate this thesis. One of the most famous ones is the Powell Memorandum (also known as the Powell Manifesto), which Harvey considers to be the founding document of US neoliberalism. In 1971, Lewis Powell, then a corporate lawyer and member of the boards of eleven corporations, wrote a memo to his friend Eugene Sydnor, Jr., the director of the US Chamber of Commerce. The memo was written two months prior to Powell’s nomination by Nixon to the US Supreme Court, but its contents were not made public prior to his elevation. The memo called for corporate America to become more aggressive in moulding society’s thinking about business, government, politics and law in the US. Powell noted that the threat to economic elites and ruling classes was not just economic, but political as well. Bolstered by strong unions and low unemployment, the labour movement had begun to advance proposals ‘to restrict the prerogatives of capital within its own sphere – private business’, Andrew Glyn writes.36 ‘A range of plans emerged in the later 1960s and 1970s going well beyond the customary collective bargaining issues of jobs and working conditions.’ These included proposals in Germany to extend co-determination rights (which guaranteed equal representation of employees and shareholders on company boards) to one-half of the country’s larger companies; a Swedish scheme requiring companies to issue new stocks to wage-earner funds corresponding to a percentage of annual profits, which effectively amounted to a form of gradual collectivisation; and various planning agreements and nationalisation plans, such as the ones put forward by the British government in the mid-1970s and by the French government in the early 1980s (both of which are analysed in detail further on). Understandably, employers vigorously opposed these plans. This was the realisation of what Polish economist Michał Kalecki had predicted 30 years earlier: that even though business leaders had acquiesced to, if not enthusiastically supported, the use of government intervention after World War II, ‘the social and political changes resulting from the maintenance of full employment’ was bound to engender a reaction from the business community sooner or later. In 1943 he wrote:
Indeed, under a regime of permanent full employment, the ‘sack’ would cease to play its role as a disciplinary measure. The social position of the boss would be undermined, and the self-assurance and class-consciousness of the working class would grow. Strikes for wage increases and improvements in conditions of work would create political tension.37
Kalecki noted that even if a regime of full employment were not to reduce profits, ‘“discipline in the factories” and “political stability” are more appreciated than profits by business leaders. Their class instinct tells them that lasting full employment is unsound from their point of view, and that unemployment is an integral part of the “normal” capitalist system.’38 From this perspective, we can better understand the Trilateral Commission’s oft-cited Crisis of Democracy report of 1975, written by Michel Crozier, Samuel Huntington and Joji Watanuki.39 The report was the first explicit proposal to roll back the democratic format of the compromise with organised labour in production. It stated that: ‘In recent years, the operations of the democratic process … have generated a breakdown of traditional means of social control, a de-legitimation of political and other forms of authority, and an overload of demands on government, exceeding its capacity to respond.’40 The report argued that this required, from the establishment’s perspective, a multi-level response, based not only on a reduction of the bargaining power of labour, but also on ‘a greater degree of moderation in democracy’ and a greater disengagement (‘non-involvement’) of civil society from the operations of the political system, to be achieved through the diffusion of ‘apathy’.41 Lewis Powell was even more explicit. He argued that businesses should ‘assiduously cultivate’ the state and when necessary use it ‘aggressively and with determination’. He appreciated that ultimately ‘the payoff – short of revolution – is what government does’. Powell’s appeal to American capitalists to engage in class war represented a major turning point in the way the corporate sector approached the political system. It became the blueprint for the American conservative movement and for the formation of a network of influential right-wing think tanks and lobbying organisations, such as the Heritage Foundation, the American Legislative Exchange Council, the Manhattan Institute, the Cato Institute and other organisations, as well as inspiring the US Chamber of Commerce to become far more politically active. Milton Friedman was obviously deeply involved in the burgeoning American right-wing movement, even producing a ten-part PBS miniseries, Free to Choose – underwritten by some of the largest corporations in the world, including Getty Oil, Firestone Tire & Rubber Co., PepsiCo, General Motors, Bechtel and General Mills42 – to disseminate his views. This corporate counterattack was by no means limited to the United States, however: throughout the 1970s and 1980s, right-wing think tanks and lobbying organisations multiplied across the entire capitalist world. In the UK, for example, the Centre for Policy Studies was founded by Tory MPs Keith Joseph and Margaret Thatcher to develop material that would ‘limit the role of the state, to encourage enterprise and to enable the institutions of society – such as families and voluntary organizations – to flourish’. Similarly, the influential Adam Smith Institute was also formed in the 1970s as part of this concerted movement to advance the interests of the corporate sector. In Australia, the formation of the business-funded Centre of Independent Studies and the H. G. Nicholls Society promoted the conservative cause. The latter, in particular, launched a head-on attack on the trade union movement, which would later result in legislative constraints on the unions’ ability to extract wage demands.
In light of the above, it is clear that neoliberalisation was in part a conscious effort by ruling elites to achieve a restoration of class power. But the counter-revolution argument, while having the benefit of bringing class into the picture, fails to acknowledge the extent to which these political and ideological developments expressed a deeper crisis, of which they were themselves part. This brings us to the third major school of thought concerning the crisis of Keynesianism. It is one that emphasises the structural nature of the crisis.
As mentioned already, a common trait of most advanced economies in the early to mid-1970s was a dramatic decline in the profitability of capital: by the mid-1970s, the gross profit share in manufacturing, for example, had sunk by more than one-quarter in a decade, having been pretty stable until the late 1960s.43 This reflected a combination of factors: a depreciating capital stock (in part because more of the capital stock was machinery, which depreciates faster than factory building), worsening terms of trade (as a result of increased international competition due to the emergence of new centres of economic power such as Germany and Japan), the rise in imported material costs, weak productivity growth and, perhaps most importantly in terms of its political consequences, militant wage pressure. As we have seen, the post-war decades were characterised by a strengthening of trade unionism and institutional changes supporting labour’s bargaining position, which in turn was further strengthened by low rates of unemployment. In this context, labour was able to successfully resist attempts by hard-pressed capitalists to raise profits by pushing real wages down. An important manifestation of labour’s strong position was the extraordinarily high level of industrial conflict during this period.44
This intense distributional struggle between labour and capital over (shrinking) income shares – characterised by inflationary pressures (further exacerbated by supply-side factors, such as the oil crisis), wage–price (or price–wage) spirals and squeezed profit margins – posed a serious barrier to output and employment growth. In such a context, it was (is) easy to construe trade unions as job killers, selfishly tending to the interests of their members rather than considering the interests of workers and the economy as a whole. This is certainly how the mainstream narrative increasingly portrayed them in the 1970s. By resuscitating the neoclassical view that trade unions are ‘imperfections’ that interfere with the free market’s ability to deliver optimal outcomes for all if left to its own devices, monetarism provided the ideological rationale for cracking down on the unions.
But was (and is) it fair to blame the trade unions for the stagflation of the 1970s? Analysing in detail the role played by trade unions in that historical context is beyond the scope of this text. As Richard Freeman wrote, trade unions ‘are probably the most idiosyncratic institutions in modern capitalism’.45 However, while there are substantial differences in the way unions are structured and operate across nations, the one salient aspect of unions that transcends these ‘idiosyncrasies’ and provides a common organising framework is that trade unions are an institutional construct of capitalism. They obey the logic of capitalism; they are embedded in the class conflict that defines capitalism. This means that the nature of capitalist relations defines what unions are and what they (can) do.
In 1865, Karl Marx responded to those who claimed that wage increases are of no benefit to workers and that for this reason trade unions are to be considered harmful, by outlining the many ways in which unions do in fact work in the interests of workers.46 This includes pushing for wage increases to defend real wages after prices have been pushed up; gaining wage increases to match productivity increases; and gaining higher wages to compensate for longer working days. He characterised these actions, which define union action in ‘ninety-nine out of a hundred’ instances, ‘as reactions of labour against the previous action of capital’. In other words, the logic of trade unions in capitalism, according to Marx, is to respond to the actions of capital. He reiterated that the underlying nature of capitalism involves disputes over the length of the working day and the wages to be paid, which ‘is only settled by the continuous struggle between capital and labour, the capitalist constantly tending to reduce wages to their physical minimum, and to extend the working day to its physical maximum, while the working man constantly presses in the opposite direction’.47
In other words, trade unions work ‘as centers of resistance against the encroachments of capital’: even within the narrow logic of the labour– capital conflict, unions can achieve substantial gains for their members. That is their institutional raison d’être. At the same time, Marx knew better than anyone else that there are limits to what trade unions can achieve. These are defined by the power relations within capitalism: simply put, the owners of capital control the means of production and employment, and their expectations of future returns dictate the rate at which the capital stock accumulates over time. In his essay Inflation and Crisis, Robert Rowthorn wrote:
Capitalists control production and they will not invest unless they receive a certain ‘normal’ rate of profit. If wages rise too rapidly, either because of extreme labour shortage or because of militant trade unionism, the rate of profit falls below its ‘normal’ level, capitalists refuse to invest, expansion grinds to a standstill and there is a crisis.48
So, when assessing the role of trade unions in any given historical period we must be cognisant of the logic of the union as an institution and the limits to its effectiveness within the conflictual relationships that define capitalism. This is how Rowthorn summed up the issue:
A strong and militant trade union movement may force up wages and resist wage cuts even in the face of high unemployment. In a boom situation this may squeeze profits and bring expansion to a premature end, whilst there is still a large surplus of labour; and in a depression it may delay recovery by reducing profitability. This may sound like a condemnation of the trade union movement, but it is not. It is simply stating the obvious fact that, so long as capitalists control production, they hold the whip hand, and workers cannot afford to be too successful in the wages struggle. If they are, capitalists respond by refusing to invest, and the result is a premature or longer crisis. To escape from this dilemma workers must go beyond purely economic struggle and must fight at the political level to exert control over production itself.49
From this perspective, it doesn’t make much sense to attack the unions for being successful at what they do – that is, increase wages and reduce working hours (among other things). That is the logic of capitalism. As Rowthorn notes, however, unions can also be ‘too successful’ in their struggle, in which case a crisis ensues until a resolution in the form of an abatement in the distributional conflict is found – usually through rising unemployment, but also, in more recent times, through harsh legislative constraints being placed on the capacity of the unions.
In the context of the 1970s, things were further exacerbated by the fact that the entire Fordist-Keynesian ‘class compromise’ rested on the system’s ability to accommodate the popular demand for rising incomes and employment in the private sector, which could only be satisfied by the growth of production, as well as the capitalist need to subordinate production to profit. Thus, as the demands and expectations of labour and capital went from being mutually supportive (the virtuous wages–demand–profit–investment cycle) – or at least non-exclusive, as they had been throughout most of the 1950s and 1960s – to being mutually exclusive (with big business and big labour bound in a ‘dysfunctional embrace’, or zero-sum game as David Harvey put it),50 the Keynesian political, institutional and ideological framework came under increased pressure from both sides. On the one hand, workers used the trade unions and left/social-democratic political parties to assert their material and political claims, regardless of the constraints of profitability; on the other hand, ‘individual capitals sought the support of the state to maintain profitability in the face of rising costs and more intense international competition’.51