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Does a Falling Money Supply Cause Economic Slumps?

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Tags Money and BanksMoney and Banking

11/13/2018

In his writings, Professor Milton Friedman blamed central bank policies for causing the Great Depression. According to Friedman, the Federal Reserve failed to pump enough reserves into the banking system to prevent a collapse in the money stock. In response to this failure, Friedman argued the money stock M1, which stood at $28.264 billion in October 1929; fell to $19.039 billion by April 1933 — a decline of almost 33%.1

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Because of the fall in the money stock argued Friedman, economic activity followed suit. By July 1932 year-on-year industrial production fell by over 31%. Also, year-on-year the consumer price index (CPI) had plunged. By October 1932, the CPI fell by 10.7%.

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Contrary to Friedman's conclusions, the fall in the money stock was a result — and not the cause — of the shrinking pool of wealth brought about by the previous loose monetary policies of the central bank.

The Essence of the Pool of Wealth

Essentially, the pool of wealth is the quantity of consumer goods available in an economy to support future production. In the simplest of terms — a lone man on an island is able to pick 25 apples an hour. With the aid of a picking tool, he is able to raise his output to 50 apples an hour. Making the tool however, takes time.

During the time he is busy making the tool the man will not be able to pick any apples. In order to have the tool, therefore, the man must first have enough apples to sustain himself while he is busy making it. His pool of wealth is his means of sustenance for this period — the quantity of apples he has saved for this purpose.

The size of this pool determines whether or not a more sophisticated means of production can be introduced. If it requires one year of work for the man to build this tool, but he has only enough apples saved to sustain him for one month, then the tool will not be built — and the man will not be able to increase his productivity.

The island scenario is complicated by the introduction of multiple individuals who trade with each other and use money. The essence, however, remains the same — the size of the pool of wealth sets a brake on the introduction of more productive stages of production.

Trouble erupts whenever the banking system makes it appear that the pool of wealth is larger than it is in reality. When a central bank expands the money stock, this does not enlarge the pool of wealth. It gives rise to the consumption of goods, which is not preceded by production. It leads to less means of sustenance.

As long as the pool of wealth continues to expand, loose monetary policies give the impression that it is actually the key factor for economic growth. That this is not the case becomes apparent as soon as the pool of wealth begins to stagnate or shrink. Once this happens, the economy begins its downward plunge. The most aggressive loosening of money will not reverse the plunge (for money cannot replace apples).

Introducing Money to our Analysis

The existence of the central bank and fractional reserve banking permits commercial banks to generate credit, which is not backed up by wealth, i.e., credit out of "thin air." Once the unbacked credit is generated, it sets in motion activities that give rise to the production of goods and services that are not on the highest consumers’ preference list. As long as the pool of wealth is expanding and banks are eager to expand credit, then various activities that in a free unhampered economy would most likely not emerge continue to prosper.

Whenever the extensive creation of credit out of "thin air" lifts the pace of wealth consumption above the pace of wealth production this starts to undermine the pool of wealth. Consequently, the performance of various activities starts to deteriorate and bank’s bad loans start to rise. In response to this, banks curtail their loans and this in turn sets in motion a decline in the money stock.

Does every curtailment of lending result in a decline in the money stock?

Let us assume Tom places $1000 in a saving deposit for three months with Bank X. The bank in turn lends the $1000 to Mark for three months. On the maturity date Mark repays the bank $1000 plus interest. Bank X in turn, after deducting its fees, returns the original money plus interest to Tom. Therefore, what we have here is that Tom lends for three months $1000. He transfers the $1000 through the mediation of Bank X to Mark.

On the maturity date Mark repays the money to Bank X — who in turn transfers the $1000 to Tom. Observe that in this case, existent money moved from Tom to Mark and then back to Tom via the mediation of Bank X — the lending is fully backed here by $ 1000. Obviously, the $1000 here does not disappear once the loan is repaid to the bank and in turn to Tom.

Things are, however, different when Bank X lends money out of thin air. For instance, Tom exercises his demand for money by holding some of his money in his pocket and placing $1000 with Bank X in a demand deposit.

By placing $1000 in a demand deposit, he still maintains total claim on the $1000. However Bank X may decide to take $100 from Tom's deposit, and lend this $100 to Mark. The money stock has now increased by $100. Because of this lending, we now have $1,100, which is only backed by $1000 proper. Observe that in this case the $100 loaned does not have an original lender as it was generated out of “thin air” by the Bank X. On maturity date, once Mark repays the borrowed $100 to Bank X, the money disappears. Obviously if the bank is continuously renewing its lending out of thin air then the stock of money will not fall. The existence of fractional reserve banking (banks creating several claims on a given dollar) is the key instrument as far as money disappearance is concerned. However, it is not the cause of the disappearance of money as such. There must be a reason why banks do not renew lending out of thin air.

What Causes Banks to Curtail Lending?

The main reason is the weakening of the process of wealth generation that makes it much harder to find good quality borrowers. This in turn means that monetary deflation emerges because of prior monetary inflation that has diluted the pool of wealth. It follows then that a fall in the money stock is just a symptom as it were. The fall in the money stock is in response to the damage caused to the process of wealth formation by the previous monetary inflation.

Note that between December 1920 and August 1924 the Fed was pursuing a very easy interest rate policy and as a result the yield on the 3-months T-Bill fell from 5.88% in December 1920 to 1.9% by August 1924. The yearly growth rate of M1 money supply shot up from minus 2.2% in January 1927 to almost 8% by October 1929.

Furthermore, it is not the fall in the money stock, and the consequent fall in prices, that burdens borrowers but the fact that there is less real wealth. The fall in the money stock is because of the money out of “thin air,” puts things in proper perspective.

Additionally, because of the fall in the money stock various activities that sprang up on the back of the previously expanding money now find it hard going.

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It is those non-wealth generating activities that end up having the most difficulties in serving their debt since these activities were never generating any real wealth and were really supported or funded, so to speak, by genuine wealth generators.

With the fall in the money out of thin air, their support is cut-off. (Remember an increase in money out of thin air sets the transfer of wealth from wealth producers to the holders of the newly increased money.)

Contrary to popular view then, a fall in the money stock as a result of banks curtailing fractional reserve lending is precisely what is needed to set in motion the build-up of real wealth and revitalize the economy.

Printing money only inflicts more damage and therefore should never be considered as a means to help the economy.

In addition, even if the central bank were to be successful in preventing a fall in the money stock, this would not be able to prevent an economic slump if the pool of wealth is falling. Remember money is just the medium of the exchange.

Contrary to popular thinking, the lifting of the money stock to prevent an economic slump undermines the process of wealth generation and sets the platform for a prolonged economic slump. Being the medium of exchange money can only facilitate the flow of goods and services in an economy. It however cannot cause the expansion in goods and services as such. The key for this expansion is the expansion in the pool of wealth.

  • 1. Milton Friedman and Rose Friedman, Free To Choose (Macmillan Company of Australia, Melbourne), pp. 70–90.

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

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