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Volume 21, Number 6

The Fallacy of the Money Supply

William L. Anderson

In recent newspaper columns, Paul Krugman of Princeton University and Lawrence Kudlow have sounded deflation alarms. The solution to combat falling prices, they argue, is for the Federal Reserve System to increase the money supply.

References to "the money supply" are misleading and dangerous, for they reveal a misunderstanding of the economy's most important asset. Furthermore, speaking of "a nation's money supply" presents the very inaccurate picture of money as being a necessary government entity, which it is not, despite what most people might choose to believe.

For example, in his famous book, Free to Choose, Milton Friedman rightly criticizes government schools as a failed socialistic entity. However, when it comes to money, Friedman has shown himself to be all too happy to endorse what is nothing less than a monetary Gosplan, and he is hardly alone among "free-market" economists.

Money is a medium of exchange, discovered and developed in the course of human action. It is not something that was created by government, although government has always co-opted and monopolized money, in the process debasing it into something near unrecognizable.

One cannot truly understand the role of money unless one can conceive of it as private property. In an age when government claims full ownership to all money, it is difficult for one to imagine private money. Yet, to comprehend money as private property enables one to understand what it really is.

Individuals own money because others will accept it. Those of us who work for pay literally are using our labor and talents to buy money. For example, I doubt that the local Wal-Mart would be willing to permit me to teach lessons in economics in exchange for the merchandise on their shelves, nor would I be willing to accept as full payment for my services to Frostburg State University things like future tuition payments for my young children or free parking. Both Wal-Mart and I want money, which permits the very specialized occupations that make up a modern economy, and makes it possible to raise payment for large-scale capital, permitting exchanges to occur that otherwise would not. In short, it is a productive asset.

By hijacking money and implementing what in effect is monetary socialism, government ultimately leads us to the infamous boom and bust cycles. Because governments worldwide have grabbed a monopoly over money, it has become a tool to manipulate economic activity in general, and to aid government itself in particular.

In a regime where money is used, individuals seek to increase their own personal supply, since it permits them to purchase more goods. It is obvious, however, that if everyone's personal collection of money were to increase simultaneously and in the same amount, then no particular benefit would accrue to anyone, since the value of money on the margin would decline. Or, as Ludwig von Mises once put it, money is a good that does not create a social benefit through an increase in its supply.

In a private money economy, I can increase my personal supply of money in one of two ways. The first is to "buy" money through the sale of my productive services—or, what we simply call a "job." The second would be to manufacture it myself. For example, if I owned a gold mine, I either could sell the gold on the open market or transform the gold into money directly.

In the first case, I would not be adding to the overall amount of money within an economy, but simply engaging in a process in which money would be transferred from others to me. In the second I would be adding to the overall supply, which means the effects would be different, depending upon how much money I create. If I "buy" money by performing productive services in an open market, I simply have exchanged my services with someone who pays money for them, conceivably leaving both of us better off through gains from trade.

In the second case, by creating more money, I am able to use that money directly to purchase services from others. Over time, the value of money will decrease, which ultimately results in an increase of money prices of goods. However, the system has built-in brakes. First, the supply of my gold will be finite, thus serving as an upper bound upon what I can create. Second, as the value of gold as money decreases, the opportunity costs of using gold for other uses also will change, as the value of gold as money will fall relative to those other uses. This will change my incentives for how I use my gold, whether for money or other uses like jewelry.

This occurs via individual planning and calculation on my part. At some point, it will not be in my interest to convert my gold directly into money, just as there would be an incentive for me at some point to stop performing work for pay. No central authority tells me when to do that, as the free market serves as my guide through the mechanism of relative prices.

Today, government owns all money, and while the "funny money" created by the state serves as a medium of exchange, fiat money is not the same as real money. Private, market money is chosen by individuals who seek to make themselves better off. When money becomes a government function, however, it always will be pressed into political service.

For all of the talk of the "qualifications" and "independence" of members of the board of governors for the Federal Reserve System, the Fed operates within the realm of current political realities. Moreover, the actions taken by the central banking authorities, especially during a crisis or severe economic downturn, cannot be separated from the political needs of those who are in power.

The decisions made by the Fed governors in the last five years clearly bear out my point. In 1998, when President Bill Clinton was facing personal and political crises, Alan Greenspan was there to guide the Fed through aggressive open market operations to increase bank reserves and keep interest rates artificially low. As the current economic turndown has moved into its third year—something unprecedented in post-World War II America—the Fed has moved on numerous occasions to keep interest rates low, something that many Austrian economists claim blocks the recovery by preventing the needed economic liquidation from occurring.

There are two ways of looking at this situation. The conventional approach is to claim that the Fed has "mismanaged" the "money supply." This presupposes, of course, that someone knows exactly what is the "optimal" money supply, or the true optimum policy that the Fed should be following. It also assumes that money is purely a government entity that needs professional "managers" who simply need to follow "responsible" policies.

The second way is to call modern "money management" what it is: failed centralized monetary planning. Central banking, for all of its "aura," is no less socialistic than the Soviet Union's Gosplan. One can try to influence the government's "monetary policies" but in the end, such policies will always turn out to be failures, as all of the important characters literally are flying blind without private property and real prices to guide them.

Fed decision makers may be intelligent, but they lack the vital information needed to make their decisions. Furthermore, there is nothing they can do in their present position that would enable them ever to obtain such information, just as it was impossible for the top economic planners of the USSR to do so.

The Fed governors fail because they are trying to do the impossible: take what once was a productive, private asset, socialize it, politicize it, and manipulate the amount in circulation in order to create certain economic effects. Socialist calculation problems described by Ludwig von Mises and F.A. Hayek do not apply exclusively to services, manufactured goods, and agricultural products; they also apply to money.

It should be no surprise that since the creation of the Federal Reserve System in 1914, the United States has been whipsawed through one boom and bust cycle after another, the worst being the Great Depression, along with the bouts of wild inflation also engineered by the Fed. The answer is not more schooling for the governors, or a more careful examination of the results of Fed policies, although both might have positive indirect effects (as members of the Fed find themselves learning that their policies are based upon unsound economics). Instead, money must be viewed not as a "macro variable" that is clay for the "masters" of the central bank to manipulate, but rather as a commodity owned and traded by individuals to further their own ends and chosen within a real market setting. .FM        

 

William L. Anderson teaches economics at Frostburg State University (banderson@mail.frostburg.edu).

 

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