People's Democracy

(Weekly Organ of the Communist Party of India (Marxist)


No. 8

March 01, 2009


Capitalism, Socialism And Crisis

Prabhat Patnaik

A COMMON view of the current financial crisis of capitalism holds that it is essentially an aberration. Some attribute this aberration to specific mistakes committed in the past, for instance by the US Federal Reserve with regard to monetary policy. Some hold the lack of adequate regulatory mechanism as being responsible for this aberration. Paul Krugman, the current year’s Nobel laureate, blames it on insufficient supervision of the financial system. And even Joseph Stiglitz, the well-known radical economist and Nobel laureate, characterises it as a “system failure”, a term which makes the crisis a phenomenon that in principle could have been avoided with impunity. This entire perception however is untenable. The crisis is a result not of the failure of the system but of the system itself; it is a part of the mode of operation of contemporary capitalism rather than being unrelated or extraneous to it.



In a “free market” regime, asset markets tend to be subject to speculation. Speculators buy assets not because of the yield on these assets but because they expect its price to appreciate in the coming days. They have no long term interest in the assets and are concerned exclusively with capital gains. Since buying today to sell tomorrow entails carrying the asset during the intervening period for which a “carrying cost” has to be incurred, the assets most suitable for speculation are those whose carrying costs are low; and these are typically financial assets which have virtually zero carrying costs (requiring only a few taps on computer keys to effect all necessary transactions). Financial asset markets therefore are always subject to massive speculation.

Speculation generates bouts of euphoria or “speculative excitement” which have the cumulative effect of pushing up asset prices. An initial rise in some asset prices, caused no matter how, gives rise to expectations of a further rise, and hence to an increase in the demand for the assets in question which actually raises their prices further; and so the process feeds upon itself and we have asset price “bubbles”. Such “bubbles” typically characterise financial assets, which, as already mentioned, are particularly prone to speculation; but they are not confined to financial assets alone (as the housing market “bubble” in the United States has just demonstrated).

Such “bubbles” have an obvious impact on the real economy. The rise in asset prices fed by speculative euphoria improves for individuals who own these assets the estimation of their wealth position, and hence causes an increase in their consumption expenditure, and thereby in employment. Likewise such a rise in asset prices, where the assets in question are producible, causes an increase in investment expenditure on these assets, which leads to their larger production, and hence to larger employment. In short, speculative euphoria in the asset markets makes the boom in the real economy, stimulated by whatever had caused the initial rise in asset prices, more pronounced and prolonged.

Precisely because of this however if for some reason the asset price increase wanes or comes to a halt, speculators attempt to get out of the assets in question causing a crash in the asset prices. This causes a fall in aggregate expenditure on goods and services; a collapse in the state of credit, as banks face insolvency; and a possible collapse even in the inclination of depositors for holding bank deposits (since they fear banks’ insolvency), as had happened during the Great Depression. In short there is a collapse of the state of confidence all around, and hence a corresponding increase in liquidity preference; i.e. there is a disinclination to hold any asset other than pure cash, or in extreme cases only currency, and of course claims upon the government, which is considered to be the only safe and reliable borrower. Not all crises display this severity; but to a greater or lesser extent these features mark any crisis.

Speculation therefore has the effect of making the boom more pronounced and prolonged; but it has also the effect of precipitating a severe crisis, as distinct from a mere cyclical downturn. In the absence of speculation the boom in the real economy will be a much more truncated and tame affair. But precisely because it is not a tame affair, it is followed by a crisis.

Two conclusions follow from the above analysis. First, since speculation is endemic to modern capitalism, where financial markets play a major role, speculation-engendered euphoria and the consequent pronounced booms, together with the crises that invariably follow, are also endemic to modern capitalism. “Bubbles” constitute in other words the mode of operation of the system. “Bubbles”, together with the crises that follow their collapse, are not a “system-failure”; they are the system. Secondly, if “bubbles” are to be eliminated and speculation is to be curbed, then it is not enough to put in place some regulatory mechanisms; an alternative instrument for generating pronounced booms in the real economy has to be found, for otherwise the economy would remain perennially sunk in stagnation and large-scale mass unemployment.

The alternative instrument suggested by John Maynard Keynes, the well-known English economist, was State intervention through fiscal measures to ensure that the level of demand remained as close to full employment as possible. Keynes’ suggestion, made in the 1930s during the Great Depression, was strongly opposed by finance capital, which always opposes all State intervention that does not promote its own exclusive interest. The Keynesian remedy got accepted only in the post-war period when the balance of class forces had shifted, with the working class, which had made immense sacrifices during the war, acquiring greater social and political weight, and finance capital, experiencing a corresponding weakening of its position, forced to make concessions.

Over time however this balance changed once again. “Centralisation of capital” and the formation of larger and larger blocs of finance capital, during the period of Keynesian demand management itself, forced open the barriers imposed on cross border financial flows. Finance capital consequently acquired the nature of international finance capital, through a process of “globalisation of finance”. Since the whims of international finance capital necessarily had to triumph over the autonomous predilections the nation-State, in order to avoid capital flight, Keynesian “demand management” was rejected, and neo-liberal capitalism emerged triumphant again, bringing back the era of speculative financial crises, leading to real crises, in the capitalist world. This is the phenomenon we are currently witnessing, a phenomenon that has been compared with the Great Depression of the 1930s.



One of the hallmarks of the 1930s Great Depression is that the Soviet Union, the only socialist economy of the time, had been completely unaffected by it. In fact, when capitalism had been afflicted by the severe crisis, the Soviet Union had experienced such unprecedented economic construction that it had completely got rid of unemployment. This fact, as is well-known, had so impressed a whole generation of Indian freedom fighters like E M S Namboodiripad that they had embraced Communism because of it.

This contrast arises owing to a fundamental difference between the mode of operation of the two systems. A socialist economy is fundamentally immune not just to speculation-induced crises but to all crises arising from a deficiency of aggregate demand. This fact is recognised even by staunch opponents of socialism like the Hungarian economist Janos Kornai who calls capitalism a “demand-constrained system” and socialism a “resource-constrained system” where the available resources are fully utilised without being constrained by insufficient demand.

A socialist economy of course has the usual fiscal instrument suggested by Keynes for overcoming deficiency of aggregate demand, unlike a capitalist economy where the use of this instrument requires overcoming opposition from finance capital, and where, even when the instrument is perchance used, there is a limit to its use arising from the fact that the system, being based on antagonism, needs a sufficiently large reserve army of labour to prevent inflation and maintain “work discipline”. But even apart from this, a socialist economy can overcome deficiency of aggregate demand in another way which brings out its basic character.

In any economy where in any period the money wages are given, the production of a certain output requires a certain unit cost of production to be incurred. The term “deficiency of aggregate demand” or “insufficient demand” simply means that the level of demand in the economy is such that this output can be sold only at a price that falls below this unit cost of production plus the customary profit margin. When this happens, then in a capitalist economy firms cut back on output, so that there is unemployment; and this gives rise to a further reduction in demand since the workers’ demand shrinks owing to unemployment; and this causes a further reduction in output and employment; and so the process, referred to as the “multiplier” effect of the initial output/employment decline, goes on and the economy is caught in a crisis.

In a socialist economy however since firms are socially owned, the State can issue a directive asking them to lower prices when they initially find that the demand for output at the base price, i.e. at the price equal to the unit cost plus profit margin, is less than the output. While issuing this directive it can assure the firms that any losses they make will be covered from the State budget. In such a case, firms simply lower their prices to clear the market, and there is no question of any unemployment to start with, and hence no question of any “multiplier effect”. Putting it differently, in a capitalist economy any decrease in demand gives rise to “output adjustment” and hence “employment adjustment”; in a socialist economy it can give rise only to “price adjustment” and keep output unchanged.

Why does this difference arise? When price adjusts downwards, since the money wage rate is given, there is an increase in the real wage rate. So, a socialist economy, faced with a decline in aggregate demand, gets rid of it by raising real wages of workers, i.e. by raising the demand of the workers. But a capitalist economy, precisely because it is based on class antagonism, where the slightest increase in the wage rate is bitterly opposed by capitalists, will never raise real wages to get rid of demand deficiency. This is why any such deficiency gives rise to output adjustment, and hence mass unemployment.

But now we come to the real crux of the matter. It was mentioned above that the socialist State, while directing firms to reduce prices to clear markets, would assure them that any losses they incur would be covered by the State budget, i.e. that they would get a State subsidy to cover their losses. The question may be asked: how does the State finance these losses? And the answer interestingly is that for all the firms taken together there will be no losses. In other words, while the State issues this directive it will never be actually called upon to make any additional budgetary provisions for subsidies. True, firms in the aggregate will make less profits after price adjustment than they otherwise would have done in the absence of the original deficiency of aggregate demand; but they will make profits in the aggregate all the same. The State may at the most have to divert the profits of some firms to cover the losses of others, but it will have to make no additional provisions. This follows from the fact that since profits in any period in a socialist economy are more or less synonymous with the savings of the economy, and since (ignoring external borrowing/lending), investment in any period must equal savings, as long as investment remains positive, profits in the aggregate must remain positive no matter what the level of aggregate demand.

A socialist economy, being both free of antagonism (so that real wages can be raised) and free of anarchy (so that some firms’ profits can be diverted to cover others’ losses), has thus a mode of functioning that makes it in principle immune to crises, caused by the deficiency of aggregate demand, which afflict capitalism.



So far we have discussed the inner workings of a socialist economy that is unconnected with world capitalism through trade and financial relations. Since the Soviet Union in the 1930s was unconnected with world capitalism, and even later had only tenuous links, it remained actually immune to crises of aggregate demand. But what can be said of a socialist economy that is closely linked to the capitalist world through trade and financial relationships? Does such an economy continue to remain immune to crises of aggregate demand, especially those emanating from the capitalist world?

In an economy where all important means of production are socially owned, the answer in principle should still be “yes”. When exports of such an economy decline, it is always open to it to raise domestic demand, either through the fiscal route suggested to capitalism by Keynes, i.e. through larger State expenditure, or through larger workers’ consumption via a rise in the real wage rate, caused by the lowering of prices for a given money wage rate, as discussed above. Since the rationale of the socialist economy’s participation in the world market is that it has generally lower prices than the capitalist world (at the prevailing exchange rate), which after all is why it is able to out-compete the capitalist countries and have burgeoning trade with them, any further lowering of its domestic prices in response to the reduced demand owing to world recession, should cause no “leakages” in the form of larger imports. Such reduction in other words should boost its own domestic demand, and, if anything, even help somewhat in countering export decline. Likewise, if it provided a larger fiscal stimulus, as China has announced it would, then the main impact of such a stimulus should be on its own domestic demand. In short the socialist weapons against crises mentioned earlier remain intact even when the socialist country has trade relations with the capitalist world.

Of course switching from export production to production for the home market may take some time, during which there may be transitional unemployment, but this is very different from the unemployment encountered in capitalist countries during a crisis.

The problem however may arise from a different source, namely when in the process of entering into relations with capitalist countries, the socialist economy has also accommodated within its midst a large private sector, owned by powerful capitalists from home and abroad. There would be resistance from them to the use of the standard socialist weapons against crises, just as there is resistance from capitalists in capitalist countries to the use of similar weapons, and indeed for the very same reasons. It follows in such a case that the capacity of the socialist economy to thwart a crisis arising from the deficiency of aggregate demand, depends upon the strength of the socialist State in confronting the opposition of the internal capitalists to the socialist measures against the crisis.