By Dr Frank Shostak
By popular thinking a growing economy requires a growing money stock on the ground that economic growth gives rise to a greater demand for money, which must be accommodated. It is held that failing to do so, 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.
Some commentators are of the view that the lack of a flexible mechanism that coordinates the demand vs the supply of money is the major reason why the gold standard leads to instability. It is held that, relative to the growing demand for money because of growing economies, the supply of gold is not growing fast enough.
It seems that to prevent various economic shocks emanating from imbalances between the demand and the supply of money the Fed must make sure that supply and demand are synchronized. Consequently, whenever an increase in the demand for money occurs, to maintain economic stability the accommodation of the demand by the Fed seems as a necessary action.
Since the growth in money supply is of such an importance, it is not surprising that economists are continuously searching for the optimum growth rate in the money supply. For instance, the head of the monetarist school of thinking Milton Friedman held that the central bank should target the money supply growth rate to a fixed percentage. On this thinking if a fixed percentage is maintained over a prolonged period, it will usher in an era of economic stability.
The whole idea that money must grow in order to sustain economic growth gives the impression that money sustains the economy. 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.
Money, does not sustain or fund economic activity. The means of sustenance are provided by saved consumer goods. By fulfilling the role of the medium of exchange, money just facilitates the flow of goods and services.
Individuals want more purchasing power not more money
Note that individuals’ do not want a greater amount of money in their pockets but rather they want a greater purchasing power in their possession. In a free market, in similarity to other goods, the price of money is determined by supply and demand. Within all other things being equal a decline in the supply of money, is going to support an increase in the purchasing power of money.
Conversely, the purchasing power will fall with the increase in the supply of 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. 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.
Consequently, once the market has chosen a particular commodity as money, the given stock of this commodity is going to be sufficient to secure the services that money provides. Hence, in a free market, the whole idea of the optimum growth rate of money is absurd.
How paper certificates displaced gold as money
Originally, paper money was not regarded as money but merely as a representative of gold. Various paper certificates were 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 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 certificates will quickly find out that the exchange value of its certificates in terms of goods and services will decline.
To protect their purchasing power, holders of the bank’s unbacked by gold 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 market then, the threat of bankruptcy would restrain banks from issuing paper certificates unbacked by gold. This means that in a free-market economy, paper money cannot assume a “life of its own” and become an independent of a commodity money.
The government however, can bypass the free-market discipline. It can issue a decree that makes it legal for banks not to redeem certificates into gold. Once banks are not obliged to redeem certificates, opportunities for large profits are generated. This sets incentives to pursue an unrestrained expansion of the supply of certificates. The unrestrained expansion of certificates raises the likelihood of the 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 certificates must be managed. This can be achieved by establishing a monopoly bank-i.e., a central bank that manages the expansion of certificates.
To assert its authority, the central bank introduces its certificate, which replaces the certificates of various banks. The central bank certificate is fully backed by banks certificates, which have the historical link to gold. The central bank certificate, labelled as money – 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. (The central bank’s money purchasing power is established because of the fact that various certificates, which have purchasing power, are exchanged for the central bank certificate at a fixed rate).
It would appear that the central bank could manage and stabilize the monetary system. The truth, however, is the exact opposite. To manage the system, the central bank must constantly generate money “out of thin air” to prevent banks bankrupting each other during the clearance of their checks. This leads to the persistent declines in the money’s purchasing power, which destabilizes the entire monetary system.
It does not really matter what scheme the central bank adopts i.e. pumping money in line with economic growth or pumping money at a constant growth. Regardless of the mode of monetary injections, the boom-bust cycles are likely to become more ferocious as time goes by.
Note that Milton Friedman’s scheme to fix the money growth rate at a given percentage will not 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. It is not surprising that the central bank must always resort to large monetary injections when there is a threat to the economy from various shocks. These monetary pumping is the key cause that depletes the pool of real savings through the exchange of nothing for something.
How long the central bank can keep the present system going is dependent upon the state of the pool of real savings. As long as this pool is still expanding, the central bank is likely to appear to be successful in keeping the economy flourishing. Once the economy falls into an economic slump because of a decline in the pool of real savings, any government or central bank attempts to revive the economy is going to fail. Not only will these attempts fail to revive the economy, they will deplete the pool of real savings further, thereby prolonging the economic slump. On this Mises wrote,
An essential point in the social philosophy of interventionism is the existence of an inexhaustible fund, which can be squeezed forever. The whole system of interventionism collapses when this fountain is drained off: The Santa Claus principle liquidates itself.
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.
