What should be the correct money supply growth rate?

Most economists believe that a growing economy requires a growing money stock, on grounds that growth gives rise to a greater demand for money, which must be accommodated.

Failing to do so, it is maintained, will lead to a decline in the prices of goods and services, which in turn will destabilize the economy and lead to an economic recession or, even worse, depression.

Since growth in money supply is of such importance, it is not surprising that economists are continuously searching for the right, or the optimum, growth rate of the money supply.

Some economists who are the followers of Milton Friedman – also known as monetarists – want the central bank to target the money supply growth rate to a fixed percentage. They hold that if this percentage is maintained over a prolonged period of time it will usher in an era of economic stability.

The idea that money must grow in order to sustain economic growth gives the impression that money somehow sustains economic activity.

According to Rothbard,

Money, per se, cannot be consumed and cannot be used directly as a producers’ good in the productive process. Money per se is therefore unproductive; it is dead stock and produces nothing[1].

Money’s main job is simply to fulfill the role of the medium of exchange. Money doesn’t sustain or fund real economic activity. The means of sustenance, or funding, is provided by saved real goods and services. By fulfilling its role as a medium of exchange, money just facilitates the flow of goods and services between producers and consumers.

Historically, many different goods have been used as the medium of exchange. On this, Mises observed that, over time,

. . . there would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money[2].

Through the ongoing process of selection over thousands of years, people settled on gold as their preferred general medium of exchange.

Most mainstream economists, while accepting this historical evolution, cast doubt that gold can fulfill the role of money in the modern world. It is held that, relative to the growing demand for money as a result of growing economies, the supply of gold is not adequate.

Furthermore, if one takes into the account the fact that that a large portion of gold mined is used for jewelry, this leaves the stock of money almost unchanged over long periods of time.

It is argued that the free market, by failing to provide enough gold, will cause money supply shortages. This, in turn, runs the risk of destabilizing the economy. It is for this reason that most economists, even those who express sympathy toward the idea of a free market, endorse the view that the money supply must be controlled by the government.

What do we mean by demand for money?

When we talk about demand for money, what we really mean is the demand for money’s purchasing power. After all, people don’t want a greater amount of money in their pockets so much as they want greater purchasing power in their possession. On this Mises wrote,

The services money renders are conditioned by the height of its purchasing power. Nobody wants to have in his cash holding a definite number of pieces of money or a definite weight of money; he wants to keep a cash holding of a definite amount of purchasing power[3].

In a free market, in similarity to other goods, the price of money is determined by supply and demand.

Consequently, if there is less money, its exchange value will increase. Conversely, the exchange value will fall when there is more money.

Within the framework of a free market, there cannot be such thing as “too little” or “too much” money. As long as the market is allowed to clear, no shortage of money can emerge.

Once the market has chosen a particular commodity as money, the given stock of this commodity will always be sufficient to secure the services that money provides.

Hence, in a free market, the whole idea of an optimum rate of growth of money is absurd.

According to Mises:

As the operation of the market tends to determine the final state of money’s purchasing power at a height at which the supply of and the demand for money coincide, there can never be an excess or deficiency of money. Each individual and all individuals together always enjoy fully the advantages which they can derive from indirect exchange and the use of money, no matter whether the total quantity of money is great, or small. . . . the services which money renders can be neither improved nor repaired by changing the supply of money. . . . The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do[4].

However, how can we be sure that the supply of a selected commodity as money will not start to rapidly expand because of unforeseen events? Would it not undermine people’s well-being?

If this were to happen, then people would probably abandon this commodity and settle on some other commodity. Individuals who are striving to preserve their lives and well-being will not choose a commodity that is subject to a steady decline in its purchasing power as money.

This is the essence of the market selection process and the reason why it took several thousand years for gold to be chosen as the most marketable commodity.

The prolonged market selection process raises the likelihood that gold is the most suitable commodity to fulfill the role of money.

But even if we were to agree that the world under the gold standard would have been a much better place to live than under the present monetary system, surely we must be practical and come up with solutions that are in tune with contemporary reality. Namely, that in the world in which we presently live, we do have central banks, and we are not on the gold standard. Given these facts, what then should be the correct money supply growth rate?

It is not possible, however, to devise a scheme for a “correct” money growth rate while central authorities have coercively displaced the market-selected money with paper money. Here is why.

From commodity money to paper money

Originally, paper money was not regarded as money but merely as a representation of gold. Various paper certificates represented claims on gold stored with the banks. Holders of paper certificates could convert them into gold whenever they deemed necessary. Because people found it more convenient to use paper certificates to exchange for goods and services, these certificates came to be regarded as money.

Paper certificates that are accepted as the medium of exchange open the scope for fraudulent practice. Banks could now be tempted to boost their profits by lending certificates that were not covered by gold. In a free-market economy, a bank that over-issues paper certificates will quickly find out that the exchange value of its certificates in terms of goods and services will fall.

To protect their purchasing power, holders of the over-issued certificates are likely to attempt to convert them back to gold. If all of them were to demand gold back at the same time, this would bankrupt the bank. In a free, competitive market then, the threat of bankruptcy would restrain banks from issuing paper certificates unbacked by gold. On this Mises wrote,

People often refer to the dictum of an anonymous American quoted by Tooke: “Free trade in banking is free trade in swindling.” However, freedom in the issuance of banknotes would have narrowed down the use of banknotes considerably if it had not entirely suppressed it. It was this idea which Cernuschi advanced in the hearings of the French Banking Inquiry on October 24, 1865: “I believe that what is called freedom of banking would result in a total suppression of banknotes in France. I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer[5].”

This means that in a free-market economy, paper money cannot assume a “life of its own” and become independent of commodity money.

The government can, however, bypass the free-market discipline. It can issue a decree that makes it legal for the over-issued bank not to redeem paper certificates into gold.

Once banks are not obliged to redeem paper certificates into gold, opportunities for large profits are created that set incentives to pursue an unrestrained expansion of the supply of paper certificates[6].

This uncurbed expansion of paper certificates raises the likelihood of setting off a galloping rise in the prices of goods and services that can lead to the breakdown of the market economy.

To prevent such a breakdown, the supply of the paper money must be managed. The main purpose of managing the supply is to prevent various competing banks from over-issuing paper certificates and from bankrupting each other.

This can be achieved by establishing a monopoly bank-i.e., a central bank that manages the supply of paper money.

According to Hoppe, “If one is to succeed in replacing commodity money by fiat money, then, an additional requirement must be fulfilled: Free entry into the note-production business must be restricted, and a money monopoly must be established[7].”

To assert its authority, the central bank introduces its paper certificates, which replace the certificates of various banks. (The central bank’s money purchasing power is established on account of the fact that various paper certificates, which carry purchasing power, are exchanged for the central bank money at a fixed rate. The central bank paper certificates are fully backed by banks’ certificates, which have the historical link to gold.)

The central bank paper money, which is declared as legal tender, also serves as a reserve asset for banks. This enables the central bank to set a limit on the credit expansion by the banking system via setting regulatory ratios of reserves to loans.

It would then appear that the central bank can manage and stabilize the monetary system. The truth, however, is the exact opposite. To manage the system, the central bank must constantly create money “out of thin air” to prevent banks from bankrupting each other.

This leads to persistent declines in money’s purchasing power, which destabilizes the entire monetary system. This tendency to destabilize the system is also reinforced by the fact that a money monopolist naturally has the incentive to look after his own interest.

According to Hoppe,

He can print notes at practically zero cost and then turn around and purchase real assets (consumer or producer goods) or use them for the repayment of real debts. The real wealth of the non-bank public will be reduced-they own less goods and more money of lower purchasing power. However, the monopolist’s real wealth will increase-he owns more non-money goods (and he always has as much money as he wants). Who, in this situation, except angels, would not engage in a steady expansion of the money supply and hence in a continuous depreciation of the currency?[8]

Observe that while, in the free market, people will not accept a commodity as money if its purchasing power is subject to a persistent decline, in the present environment central banking authorities are coercively imposing money that suffers from a steady decline in its purchasing power.

Since the present monetary system is fundamentally unstable, the central bank is compelled to print money out of thin air to prevent the collapse of the system. It doesn’t really matter what scheme the central bank adopts as far as monetary injections are concerned – they can print money directly or they can act in the money markets to target interest rates, as is now more frequently the case. Regardless of the mode of monetary injections, the boom-bust cycles will become more ferocious as time goes by.

Even Milton Friedman’s scheme to fix the money growth rate at a given percentage won’t do the trick. After all a fixed percentage growth is still money growth, which leads to the exchange of nothing for something – i.e., economic impoverishment and the boom-bust cycle.

What about removing the central bank altogether and keeping the current stock of paper money unchanged? Would that not do the trick?

No, it would not.

An unchanged money stock will cause an almost immediate breakdown of the present monetary system. After all, the present system survives because the central bank, by means of monetary injections, prevents the fractional reserve banks from going bankrupt.

It is therefore not surprising that the central bank must always resort to large monetary injections when there is a threat from various political or economic shocks.

Observe that the same fate is likely with other schemes. The only difference, of course, is that with these other schemes it may take some time before the final breakdown occurs.

How long the central bank can keep the present system going is dependent upon the state of the pool of real wealth. As long as this pool is still growing, the central bank is likely to succeed in keeping the system alive. Once the real pool of wealth begins to stagnate – or, even worse, shrink – then no amount of monetary pumping will be able to prevent the implosion of the system.

In a true free market, if people raised their demand for gold as a result of a major upheaval, this would lift money’s purchasing power, and that would be about it; no further disruptions would emerge. The monetary system would remain intact. Also, as opposed to the present monetary system, in a true free market money can’t disappear and set in motion the menace of the boom-bust cycles.

In fractional reserve banking, when money is repaid and the bank doesn’t renew the loan, money evaporates. Because the loan has originated out of nothing, it obviously couldn’t have had an owner. In a free market, in contrast, when the gold is repaid, it is passed back to the original lender; the money stock stays intact.

Conclusion

Since the present monetary system is fundamentally unstable, there cannot be a “correct” money supply growth rate. Whether the central bank injects money in accordance with economic activity or fixes the growth rate, it further destabilizes the system. The only way to make the system truly stable is to permit the free market to take over. In a truly free market there is no need to be concerned with the issue of the “correct” rate of money supply growth and no institution is required to regulate the supply of money.

[1] Murray N. Rothbard, Man, Economy and State (Los Angeles: Nash Publishing, 1970), p.670.

[2] Ludwig von Mises, The Theory of Money and Credit (Irvington-on-Hudson, N.Y: The Foundation of Economic Education, 1971) pp. 32-33.

[3] Ludwig von Mises, Human Action, 3^rd rev. ed. (Chicago: Contemporary Books, 1966), p.421.

[4] Ibid.

[5] Ibid., p.446.

[6] Hans-Hermann Hoppe, “How is Fiat Money Possible?-or, The Devoluton of Money and Credit,” The Review of Austrian Economics 7, no.2 (1994), pp.49-74.

[7] Ibid., p.59.

[8] Ibid., p.62.