By Frank Shostak *
According to the popular narrative, the role of the central bank is to steer the economy on the so-called path of economic stability. According to this way of thinking, if various shocks cause the economy to deviate from this path, then it is the role of central bank policymakers to compensate for those shocks. This requires appropriate monetary policies. In line with this way of thinking to counter the shocks of covid-19, the US central bank, the US Federal Reserve, has pumped a huge amount of money into the economy. This is illustrated by the increase in the Fed’s balance sheet from $ 4.2 trillion in January 2020 to $ 8.5 trillion in October of this year, an increase of 102.7%. As a result of this massive increase, the measure of Austria’s money supply (AMS) increased from $ 5.28 trillion in January 2020 to $ 9.59 trillion in October 2021, an increase of 81.6%.
Conventional thinking suggests that with more money in their pockets, individuals are likely to increase their spending, and thanks to the magic of the Keynesian multiplier, others will follow. According to this way of thinking, the increase in the money supply allows individuals to cope with the increase in their demand for goods and services. It is also recognized that in response to increased demand, producers are likely to oblige by increasing supply by increasing production of goods and services. What we have here is that demand creates supply.
Note that in a free and unfettered market economy, people pay with the goods in their possession for the goods they need to maintain their lives and well-being. In order for an individual to get anything, he must have something else. People exchange goods and services for other goods and services. (Note that trade is also about goods and services present for future goods and services).
The role of money in all of this is, among other things, to facilitate trade. Money was born out of the fact that barter could not support the market economy. A distinguishing feature of money is that it is the general medium of exchange. Money allows a producer to exchange his output for that of another producer. Means of payment are always goods and services, which pay for other goods and services.
So a baker trades his bread for money and then uses the money to buy fruit. The baker pays for the fruit not with money but with the bread produced. The money just allows the baker to make that payment. Also, note that the baker’s bread production gives rise to his demand for money. By demand for money, we really mean the demand for the purchasing power of money. After all, people don’t want more money in their pockets, but more purchasing power in their possession.
On this subject, Ludwig von Mises wrote: “The services rendered by money are conditioned by the height of its purchasing power. No one wants to have a set number of silver coins or a set weight of silver in their cash; he wants to keep a defined amount of purchasing power in cash.
In a free market, like other goods, the price of silver is determined by supply and demand. Therefore, if there is less money, its exchange value will increase. Conversely, the exchange value will drop when there is more money. In a free market, there cannot be “too little” or “too much” money. As long as the market is allowed to empty, no shortage of money can arise.
Therefore, once the market chooses a particular commodity as a currency, the given stock of that commodity will be sufficient to secure the services provided by the currency. Therefore, in a free market, the whole idea of the optimal rate of growth of money is absurd. According to Mises:
As the functioning of the market tends to determine the end state of the purchasing power of money at a level where the supply and demand of money coincide, there can never be an excess or deficit of money. Each individual and all individuals together always fully enjoy the benefits they can derive from the indirect exchange and use of money, whether the total amount of money is large or small…. the services provided by money can neither be improved nor repaired by changing the money supply…. There is always enough money available in the economy as a whole to provide everything that money does and can do for everyone.
Consumption without production harms the well-being of individuals
People produce and exchange goods and services with each other in order to promote their lives and well-being, their ultimate goal. Thus, in a free market economy, consumption and production are in harmony. In a free market economy, consumption is fully supported by production.
Note that bread making allows the baker to consume bread and fruit. Part of the bread produced is used for personal consumption while the other part is used to pay for the fruit. It should be noted that the baker’s consumption is entirely backed up, that is to say paid, by his production. Any attempt to increase consumption without a corresponding increase in production therefore results in unsupported consumption, which must come at someone else’s expense. This is precisely what monetary pumping does. It generates a demand which is not supported by any production. Once exercised, this type of demand weakens the flow of savings and weakens the savings pool. A weakening of the savings pool compromises capital formation, thus stifling economic growth.
Saving, not money, is the key to economic growth
It is savings, not money, that finance and make possible the production of better tools and machines. With better tools and machines, it is possible to increase the production of final goods and services – this is the essence of economic growth. Thus, contrary to popular thought, setting in motion non-production consumption by pumping money will stifle, not promote, economic growth.
If it had been otherwise, poverty in the world would have been eliminated long ago. After all, everyone knows how to demand and how to consume. The only reason accommodating monetary policies may appear to grow the economy is that the pace of savings generation is still strong enough to absorb increases in unsupported consumption.
Once, however, that the pace of unsupported consumption reaches a point where the flow of savings weakens, the economy falls into a severe recession. Any attempt by the central bank to pull the economy out of the doldrums by increasing the pumping of money only makes matters worse, as it only further bolsters unbacked consumption, further undermining the savings pool.
A weakening of the savings reserve – the heart of economic growth – exposes fractional reserve loans from commercial banks and increases the risk of leakage. Therefore, to protect themselves, banks limit the generation of credit from “thin air”. Under these conditions, additional monetary pumping cannot get the banks to increase their loans. On the contrary, an increase in pumping weakens savings and undermines business activity, making banks reluctant to increase lending.
Note that after closing at 43.1% in December 2020, the annual growth rate of banks’ inflationary credit (non-savings backed credit) fell to 15.7% in October of this year (see chart below). below). Declining inflationary credit dynamics are already putting downward pressure on the annual growth rate of money. This growth rate fell from 79% in February 2021 to 17.1% in October.
In addition, due to lax monetary policy, the low interest rate environment in a context of increasing risk increases the likelihood that banks are likely to further reduce inflationary lending expansion. All of this puts downward pressure on the money supply. Note that our monetary measure, which closed at $ 9.8 trillion in June 2021, fell to $ 96 trillion in October. Therefore, the central bank may find that despite its attempt to inflate the economy, the dynamics of the money supply could follow a downward trajectory. A decline in the dynamics of the money supply will undermine various activities that have emerged thanks to the Fed’s money pumping, thus posing a threat to economic activity.
The Fed will probably try to offset this decline in economic activity by aggressive direct monetary pumping. For example, the central bank could monetize the government’s budget deficit or it could send checks to all citizens of the United States. All of this, however, will further undermine savings and devastate the economy.
The government and the central bank should certainly do something to prevent further deterioration in the economy. Unfortunately, neither the central bank nor the government have the resources to grow the economy. Neither the central bank nor the government are wealth generators – they are supported by diverting resources from the wealth-generating private sector.
This means that any measure taken by the government must be done to the detriment of wealth-generating activities. Needless to say, this is likely to weaken the economy’s ability to generate goods and services.
Some commentators are of the opinion that monetary pumping, which generates a temporary illusion of increased wealth, will boost the demand for goods and services and that this increase in demand is likely to trigger an increase in the production of goods and services. services. But without an expanding savings pool, it is not possible to increase the production of goods and services. Therefore, if this pool stagnates or shrinks, the growth rate of the economy will follow suit.
The Fed’s massive monetary pumping has probably already undermined the savings pool. Therefore, the rate of economic growth is likely to weaken in the future. According to most commentators, increasing the money supply will increase the demand for goods and services. As a result, they argue, it will trigger an increase in the production of these goods and services. But the reality is that if the savings pool is in trouble, it will not be possible to increase production.
* About the Author: Frank Shostak’s consultancy, Applied Austrian School Economics, provides in-depth assessments of global financial markets and economies. Contact email.
Source: This article was published by the MISES Institute