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Memo to David Frum: More Money Not Necessary for Economic Growth

January 10, 2008
In discussion of gold as a monetary institution I often hear that the supply cannot expand fast enough to accomodate economic growth. But why should this be true? (For a related discussion, see Bob Murphy's response to David Frum's articles on the gold standard.). The idea that economic growth requires more money is based on a confusion of the real and the nominal. In fact, economic growth does not depend on the quantity of money at all. Any rate of economic growth can occur with any quantity of money. Economic growth occurs when savings are used to fund investment. Any level of real savings and real investment can take place with any quantity of money. It doesn't matter, for example, if Apple Computer saves and invests 10,000 ounces of gold in a factory that produces 10,000 iPods each selling for 1oz of gold, or if it saves and invests 1,000 oz of gold to produce 10,000 iPods each selling for 1/10 oz of gold. Return on investment, (revenues divided by invested cost) is a dimensionless quantity. The nominal monetary prices cancel out. Over time if the growth in total spending within the economy grows faster than the supply of money, prices will fall. This happened during the era of the classical gold standard. But falling prices of consumption goods does not restrict economic growth because costs are falling as well, so business is profitable. As Hayek explained when there is an increase in real savings investment, the structure of production expands relative to consumption, so producers costs fall faster than their selling prices and their sales volume increases, so in real terms, their profits increase, even though in nominal terms (say measured in gold oz) they might be falling or the same. Another way to understand real savings and real investment is to think of Robinson Crusoe washed up on a desert island. He starts with nothing. He eats with fish that he catches with his bare hands. He catches 10 fish per day. He only needs to eat 5. He saves the other five. One day he desides to make a fishing rod, which will take 5 days. He invests 25 saved fish by giving himself five days of time. He uses the five days to make the fishing rod. With the rod he can catch 20 fish per day. Now banker gets washed up on the island and starts issuing bank notes. You can see that it doesn't matter if the fish are priced at $5 and the rod $100 or $50 and $1000. The amount of real investment -- 25 fish -- is the same. The idea that more money is required for economic growth is based on a confusion between money and wealth. Money does not fund economic growth. Money only allows savings and investment to take place in a price system. In a monetary economy, people can save in terms of money and invest by transferring their saved money to capital investment projects. But any amount of money could transfer any amount of savings -- at some price. The price system can work with any quantity of money. Money is important to economic growth only so that that a functioning price system can only exist with money. Prices enable entrepreneurs and investors to make a rational calculation of costs versus revenues in determining where to invest. Entrepreneurs and investors are smart enough to take into account some variation in money as well. Suppose that economic growth is 3%/year and the gold money supply is growing by about 1%/year. Then there will be on average a 2% fall in prices. Investors can take this into account. This is a lot like what people do today with inflation, where they build the COLA or CPI into their wages and prices. As Rothbard wrote,
    Goods are useful and scarce, and any increment in goods is a social benefit. But money is useful not directly, but only in exchanges. And we have just seen that as the stock of money in society changes, the objective exchange-value of money changes inversely (though not necessarily proportionally) until the money relation is again in equilibrium. When there is less money, the exchange-value of the monetary unit rises; when there is more money, the exchange-value of the monetary unit falls. We con­clude that there is no such thing as "too little” or "too much” money, that, whatever the social money stock, the benefits of money are always utilized to the maximum extent. An increase in the supply of money confers no social benefit whatever; it simply benefits some at the expense of others, as will be detailed further below. Similarly, a decrease in the money stock involves no social loss. For money is used only for its purchasing power in exchange, and an increase in the money stock simply dilutes the purchasing power of each monetary unit. Conversely, a fall in the money stock increases the purchasing power of each unit.

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