Perhaps among Marxists today, the tendency of the rate of profit to fall is the most popular explanation for capitalism’s cyclical economic crises, with underconsumption a distant second.

This theory, which naively leaves out the question of realizing surplus value, goes something like this: During the boom, the combination of technological progress, competition of the industrial capitalists among themselves, and, especially, competition between the industrial capitalists and the working class forces the industrial capitalists to increasingly substitute machinery—dead labor—for living labor. (1) This is especially true near the peak of the boom, when conditions are most favorable for the working class on the labor market.

More and more of the surplus value that is consumed productively is transformed into constant capital, and less and less is transformed into variable capital. The result is a rise in the organic composition of capital and a fall in the rate of profit.

To make things worse for the industrial capitalists, the forces that tend to counteract the fall in the rate of profit and transform it into a mere tendency are more or less paralyzed during the boom. The strong demand for labor power makes it very difficult, if not impossible, to increase the rate of surplus value. If anything, the rate of surplus value may even fall, as the profit squeeze school emphasizes.

Second, the devaluation of the elements of constant capital is essentially neutralized by the strong demand for the commodities that make up constant capital—both constant fixed capital and constant circulating capital. Even if the values of these elements fall, their prices won’t fall as long as the demand remains strong, which will be the case as long as the boom lasts.

As far as the industrial capitalists are concerned, the quantity of constant capital is always measured in terms of money. They have no way of knowing what the actual labor value of their constant capital is. And it is not only the monetary value of fixed capital that grows. Booms tend to lead to a rise in the prices of raw and auxiliary materials, which make up the elements of constant circulating capital.

The result is a further rise in the value of the constant capital—in terms of prices if not in terms of values. (2) As a result of the rise in the organic composition of capital during an economic boom, the naive falling rate of profit theory holds, the rate of profit on the total social capital begins to fall rapidly. Sooner or later, the rate of profit falls so low that the industrial capitalists can no longer find new fields of investment that yield an adequate rate of profit. The industrial capitalists begin to slash new investments and the whole process of accumulation begins to grind to a halt due to “overaccumulation.”

Instead of making new productive investments, the industrial capitalists either hoard money or engage increasingly in speculation. As productive investments decline, the overproduction of commodities relative to money appears in Department I, the department of production that produces means of production. It then spreads to Department II, the department of production that produces the means of consumption. The crisis now appears to be a crisis of the general overproduction of commodities relative to money. But according to the falling rate of profit school, it is really a crisis of the low rate of profit. The rate of profit is too low to maintain the normal process of reproduction of the capitalist economy.

A problem for the falling rate of profit school

Here, I should note a problem with the falling rate of profit school of crises. Concretely, most if not all capitalist crises since 1825 have tended to begin in the consumer goods sector, especially residential construction. Other durable consumer goods industries such as the auto industry, which became important during the last century, also tend to turn down before the rest of the economy does. Recoveries also tend to begin in these industries.

The current crisis provides a good example. It began in the U.S. residential construction industry as residential construction in the United States peaked in 2006. As this crisis deepened over the following year, loans for so-called sub-prime mortgages began to dry up, and home prices began to fall. (3)

However, the Department I industries such steel, other metal-producing industries, mining, and of course energy continued to boom until the fall of 2008. Indeed, companies in these sectors, especially energy, were making the highest profits in the entire history of capitalism through the summer of 2008. Only in the fall of 2008 did the crisis in residential construction and the auto and related industries finally spread to the steel, metal and energy industries—resulting in the severe general recession that now grips the entire capitalist world.

This seems to go counter to the prediction of the naive falling rate of profit theory, which would indicate that the crisis should first start in Department I industries such as the steel industry, where demand is determined by the level of capital investment, and spread from there to the rest of the economy.

How the recovery begins, according to the falling rate of profit theory

As the boom turns into slump, workers are laid off, and prices—at least in crises before World War II—begin to fall. (4) Once again, the rate of surplus value begins to rise and thus to offset the fall in the rate of profit brought on by the rise in the organic composition of capital. Under crisis conditions, the labor market once again shifts against the sellers of labor power and back in favor of the buyers of labor power. The prices of the elements of constant capital—both fixed and circulating—fall, lowering the value of the constant capital in terms of money, which reflects the previous falls in labor values.

Perhaps, it is sometimes suggested by the falling rate of profit school of crisis theory, the industrial capitalists become somewhat reconciled to a lower average rate of profit and are willing to accept a lower rate of profit on a larger mass of capital. Recovery begins and gradually builds up to a new boom as expanding industries react on one and other. The fall in the rate of profit resumes and ends in a new crisis.

Like is the case with the profit squeeze, class-struggle school, the falling rate of profit school sees the increase in the rate of surplus value achieved by the industrial capitalists during and immediately after the crisis as the key to the recovery. The falling rate of profit of school implies that industrial capitalists can keep the expansion going as long as they are able to increase the rate of surplus value sufficiently to offset the rise in the organic composition of capital.

For example, they might achieve this through successful union busting campaigns, or if they find sufficient new sources of exploitable labor power. (5) This is, of course, exactly what we have seen over the last 30 years with the opening up of the Peoples Republic of China for capitalist exploitation, and the dismantling of the planned economies of the Soviet Union and Eastern Europe.

Marx on the falling rate of profit and overproduction

“On the other hand,” Marx wrote in chapter 15 of volume III of “Capital,” “the rate of self-expansion of the total capital, or the rate of profit, being the goad of capitalist production (just as self-expansion of capital is its only purpose), its fall checks the formation of new independent capitals and thus appears as a threat to the development of the capitalist production process. It breeds over-production, speculation, crises, and surplus-capital alongside surplus-population.”

This passage is often quoted by those who trace the periodic economic crises of capitalism to the tendency of the rate of profit to fall due to the growth in the organic composition of capital. Marx says the fall in the rate of profit “breeds” overproduction and crises. But he doesn’t say that overproduction is identical with a fall in the rate of profit caused by a rise in the organic composition of capital.

How does a fall in the rate of profit “breed” overproduction and crises? Marx does not really explain it here, and indeed if he had, he would have had to dive into crisis theory which is exactly what he did not want to do in any part of “Capital.” But I think we can say this much. The lower the general rate of profit, the greater must be the magnitude of capitals, where the fall in the rate of profit is compensated for by the growth in the mass of profit. Large capitals imply huge factories that can very quickly increase production, and thus rapidly flood the market, leading to glutted markets and crises.

Second, profit proper—as opposed to rent—is the sum of interest plus the profit of enterprise. The industrial capitalists “earn” in addition to the interest appropriated by the money capitalists an additional profit above and beyond this that Marx called the profit of enterprise. The only reason that industrial capitalists take the greater risk of engaging in industrial production as opposed to acting as mere money capitalists is the prospect of appropriating this additional profit. (6) This implies that it isn’t so much the rate of profit as such, but the profit of enterprise that is the real motive for the production of surplus value.

If the rate of profit is 25 percent and the interest rate is 5 percent, the profit of enterprise is 20 percent. But if the rate of profit were to fall to, let’s say 7 percent, without a fall in the rate of interest, the profit of enterprise will be only 2 percent. And if the general rate of profit falls to 5 percent, while the rate of interest remains at 5 percent, the profit of enterprise falls to zero. The motive to produce surplus value disappears and the industrial capitalists begin to turn into money capitalists.

This point is often overlooked by Marxists, though John Maynard Keynes was highly aware of it. Indeed, it is central to his “General Theory of Employment, Interest and Money,” first published in 1936. This book forms the foundation of “Keynesian economics.”

Before I explore this question, I will first have to examine what exactly determines the division between interest and profit. In my opinion, no crisis theory can be anywhere near complete if it doesn’t explain this division. Unfortunately, this question has traditionally been ignored by Marxists. However, it obviously has implications for the “financialization” phenomena that has developed since the 1970s, which drew the attention of Paul Sweezy in the final years of his life. Therefore, it is a question that I will have to examine closely in future posts.

Bill Jefferies’ fruitful mistake

Bourgeois economists like to sneer that Marxists have predicted 100 of the last 10 recessions. Marxists can answer that bourgeois economists, with very few exceptions, have predicted exactly zero of the last 10 recessions. This shows that even the most superficial “vulgar” Marxism is superior to present-day “orthodox” marginalist bourgeois economics.

Naturally, the bourgeois economists claim that capitalism would be crisis free if only the right policies are followed. For example, after every recession the bourgeois economists generally “explain” that if only the Federal Reserve System—or other central banks—hadn’t “tightened” so much, or if the Wall Street bankers hadn’t been so “greedy” or “reckless,” there would have been no crisis. The bourgeois economists then praise the bankers, the corporations, the governments and the central banks for following correct policies that are avoiding the mistakes of the past—until the next crisis arrives.

Marxists, on the other hand, especially during periods of the kind of extreme reaction that has dominated world politics for the last 30 years, hope that an economic crisis will radicalize the workers and lead to a new era of upsurge for the workers’ movement.

The British Marxist Bill Jefferies, however, to his credit rose above this sort of superficial analysis, based more on wishful thinking than on a scientific analysis of the capitalist system. When the first stage of the current global economic crisis began in August 2007 with the initial credit market freeze-up centered around the market for sub-prime mortgages in the United States, the question was posed: Is the world on the brink of a new major worldwide capitalist economic crisis?

Jefferies, basing himself on the view that it is fluctuations in the production of surplus value, and in the rate of profit calculated in terms of values, not money, that determine the alteration of boom and crisis, predicted that a major worldwide recession would not occur at this time. Any downturn, Jefferies predicted, that grew out of the U.S. sub-prime mortgage crisis and the resulting credit market disturbances would be a minor one and would soon give way to renewed capitalist expansion.

Jefferies reasoned like this: The last few decades have seen vast defeats for the working class worldwide. As a result of these reactionary developments, vast numbers of workers, especially in the Peoples Republic of China, but also in the former Soviet Union and Eastern Europe, which were outside the sphere of capitalist exploitation, have now been transformed into surplus-value producers, both for the emerging native capitalists of these regions and for Western and Japanese corporations.

These developments have not only affected the workers in the former Soviet Union, Eastern Europe and China but also workers throughout the world. Everywhere, the trade unions have been weakened, and the workers’ political parties have been pushed back. Both the rate of surplus value and the number of workers who are available for exploitation by private capital has greatly increased. Jefferies explained that these developments have been a powerful offset to the long-term tendency of the rate of profit to fall.

As Jefferies has also noted, with this huge increase in the quantity of cheap labor power, the industrial capitalists have far less incentive to replace living labor with machinery, which slows down, if it does not reverse, the rise in the organic composition of capital.

These events are indeed a powerful example of Marx’s “counteracting influences” that turn the law of the falling rate of profit into the tendency of the rate of profit to fall.

Based on this rise in the rate of profit in terms of values, Jefferies predicted that a major new economic crisis—or series of crises—would not occur until a combination of the growing demand for labor power combined with a recovery of the workers’ movements from the disastrous end of the 20th century again puts downward pressure on the rate of surplus value. This will in turn stimulate a renewed growth in the organic composition of capital. A renewed fall in the rate of profit will once again lead to a new era of crises and revolutionary opportunities. With the workers’ movement, however, still reeling from the defeats of the last 30 years, this process, Jefferies assumed, will take several more decades.

We now know that Jefferies was wrong about the crisis, and the sub-prime mortgage fiasco that began in the U.S. mortgage market was indeed simply the first stage of a major worldwide downturn. But exactly where was the flaw in Jefferies’ logic?

Jefferies’ mistake points to what I believe to be the greatest weakness of the naive falling rate of profit theory, as well as the profit-squeeze and class-struggle theories. While the underconsumption theory looks only at the problem of realizing the surplus value, the insufficient surplus value theories look only at the problem of producing surplus value. If the crisis problem could be reduced to the problem of producing surplus value, I believe Jefferies’ economic prediction would have proven correct.

Not enough for surplus value to be produced, it must be realized

But Marx pointed out that it was not enough for the industrial capitalists to produce surplus value, they must also be able to realize it in the form of money. If they don’t, there is no profit no matter how much surplus value is produced. This is what I believe Jefferies overlooked.

The possibilities open to the industrial capitalists of producing surplus value, as Jefferies explained, have indeed vastly increased. But this still leaves the problem of realizing the surplus value in money form. To the industrial capitalists, it is not the rate of profit in terms of values but the rate of profit in terms of money that matters. Of course, we know from the law of the labor value of commodities that prices are determined by values—but only in the final analysis. Or, as Marx pointed out already in his early book “The Poverty of Philosophy,” prices tend to equal values only by constantly not equaling them. (7)

The process by which prices are ultimately brought into line with values is a complex one and provides many opportunities for crises to form. The failure to realize this is, in my opinion, the root of Jefferies’ mistake. Hopefully, he will learn from it and make many more fruitful contributions in the future.

The main cause of the current crisis, in my opinion, is that while the industrial capitalists have been squeezing much more surplus value out of the working class than ever before, they have stumbled on the problem of finding enough paying customers to actually realize the value and surplus value embodied in the greatly increased mass of commodities they have been producing.

The underconsumptionists, for example Monthly Review‘s John Bellamy Foster, share my opinion on this point. But as we saw in earlier posts, there are also big problems with the underconsumptionist theories. Perhaps something other then “underconsumption”—the inability of the workers to buy back the entire mass of commodities they produce—lies behind the problem of realizing the value and surplus value contained in commodities produced under capitalism.

One such theory of crises exists. This theory holds that crises are caused by disproportions among the various branches of production. A century ago this was a very popular crisis theory among Marxists, but it has few supporters today, at least on the Internet. Still, I think it is important to take a new look at this long-neglected theory, especially in light of the current crisis. Could the answer to the crisis puzzle lie in that direction? I will began to explore this question in the next post.

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1 Assuming the rate of technological progress is given, the rate of increase in the organic composition of capital is regulated by the rate of surplus value. If the organic composition of capital grows so rapidly that the fall in the rate of profit seriously endangers the continued existence of capitalism, the resulting unemployment will drive up the rate of surplus value, which will then slow down the growth in the organic composition of capital.

2 The demand for agricultural commodities that enter into the consumption of the workers, such as food commodities and cotton, for example, also tends to rise during booms. This puts downward pressure on the rate of surplus value, even if the real wages of the workers do not rise. The place to examine this, however, is the next several posts, where I will deal with the theory that crises are caused by disproportionate production.

3 During the recent U.S. residential construction boom, the mortgage bankers extended mortgages to buyers who did not have the means to repay them. These mortgages often featured low initial “teaser rates,” which gave the buyers the false impression that they had the means to pay for the homes. However, the low “teaser” rates soon went up. Somehow, the mortgage bankers failed to get this point across to the home buyers when they granted the mortgages. The mortgage bankers themselves didn’t worry much about whether these home buyers could actually pay the mortgages plus interest, because they were able to then sell the mortgages to large capitalist investors through the investment banks—many of which subsequently either failed or had to be merged with large universal banks.

Perhaps the big capitalists figured that since they had no problem meeting their own mortgage credit and interest obligations, why should anybody else? Therefore, the extension of this credit gave many people who needed homes the ability to purchase them but not the ability to pay for them. You didn’t actually need money to buy the home, all you needed was credit. And the means certainly existed in the form of potential workers with the right skills, building materials, machinery, and so on to build the needed homes. However, though a home could be purchased for credit, it ultimately had to be paid for—with interest—in money. It was money functioning here as a means of payment that many of the home buyers lacked.

This is a classic example of how the credit system allows overproduction to develop on a large scale by separating the act of purchasing from the act of paying.

4 Before World War II, even minor economic downturns generally led to a fall in the general price level. The workers had to face unemployment during recessions, but they at least benefited from a fall in the cost of living. Since World War II, the cost of living has kept on rising during booms and recessions alike. This new phenomena was most marked during the deep recessions of 1974-75 and 1979-82. However, wholesale prices, raw materials prices and sometimes agricultural prices—the prices that businesses pay—have still tended to fall somewhat even during post-World War II recessions. The current crisis now threatens to lead to the first substantial fall in retail prices since World War II. However, the U.S. Federal Reserve Board has been working overtime to prevent this threatened fall in the cost of living from actually materializing. I will examine the reasons for this change in the behavior of prices in periods of recession in future posts. This change is very important not only for the current crisis but for the future evolution of capitalism.

5 A problem I find with the whole insufficient surplus value family of crisis theories that are so popular today among Internet Marxists is the implication that if only the workers did not struggle so much to protect their standard of living, crises would be avoided. While it could be argued that the economic crises of the 1970s and early 1980s followed huge gains in terms of trade union and political organization and social benefits for the workers, at least in the imperialist countries after World War II, this has hardly been true of the current world crisis.

6 The profit of enterprise should not be confused with the concept of super-profit, which is a profit above and beyond the average rate of interest plus the average rate of profit of enterprise. In the next post, I will begin to examine super-profits.

7 To be fair to Jefferies, the relationship between prices and values has been a subject that, in my opinion, has not been dealt with very well by Marxists since the death of Engels. In future posts, I plan to take a much closer look at this relationship.