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Money Isn't Neutral: Why Economic Stabilization Schemes Are Counterproductive

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Tags Booms and Busts


For most commentators economic stability refers to an absence of excessive fluctuations in key economic data such as real gross domestic product (GDP) and the consumer price index (CPI).

An economy with constant output growth and low and stable price inflation is likely to be regarded as stable. An economy with frequent boom-bust cycles and variable price inflation would be considered as unstable.

According to popular thinking stable economic environment in terms of stable price inflation and a stable output growth acts as a buffer against various shocks. This makes it much easier for businesses to plan. In this way of thinking in particular, price level stability is the key for economic stability.

For instance, let us say that a relative strengthening in consumer’s demand for potatoes versus tomatoes took place. This relative strengthening is depicted by the relative increase in the prices of potatoes versus tomatoes.

To be successful businesses must pay attention to consumers’ demands—failing to do so is likely to lead to losses. Hence, in our case businesses, by paying attention to relative changes in prices, are likely to increase the production of potatoes versus tomatoes.

In this way of thinking, if the price level is not stable, then the visibility of the relative price changes becomes distorted and consequently, businesses cannot ascertain the relative changes in the demand for goods and services and make correct production decisions.

This leads to a misallocation of resources and to the weakening of economic fundamentals. In this way of thinking, unstable changes in the price level obscure businessperson’s ability to ascertain changes in the relative prices of goods and services. Consequently, businesses will find it difficult to recognize a change in relative prices when the price level is unstable.

Based on this way of thinking, it is not surprising that the mandate of the central bank is to pursue policies that will bring price stability, i.e., a stable price level.

By means of various quantitative methods, the Fed’s economists have established that at present policy makers must aim at keeping price inflation at 2 percent. Any significant deviation from this figure constitutes deviation from the growth path of price stability.

The Assumption of Monetary Neutrality Is at the Root of Price Stabilization Policies

At the root of price stabilization policies is a view that money is neutral. Changes in money only have an effect on the price level while having no effect on the real economy.

For instance, if one apple exchanges for two potatoes, then the price of an apple is two potatoes or the price of one potato is half an apple. Now, if one apple exchanges for one dollar then it follows that the price of a potato is $0.5. Note that the introduction of money does not alter the fact that the relative price of potatoes versus apples is 2:1. Thus, a seller of an apple will get one dollar for it, which in turn will enable him to purchase two potatoes.

Let us assume that the amount of money has doubled and as a result, the purchasing power of money has halved, or the price level has doubled. This means that now one apple can be exchanged for two dollars while one potato for one dollar. Note that despite the doubling in prices a seller of an apple with the obtained two dollars can still purchase two potatoes.

In this way of thinking, an increase in the quantity of money leads to a proportionate increase in the price level. While a fall in the quantity of money results in a proportionate decline in the price level. All that, according to this way of thinking, does not alter the fact that one apple is exchanged for two potatoes, all other things being equal. Why this way of thinking is problematic?

Changes in Money Supply Cannot Be Neutral

When new money is injected there are always first recipients of the newly injected money who benefit from this injection. The first recipients with more money at their disposal can now acquire a greater amount of goods while the prices of these goods are still unchanged.

As money, starts to move around the prices of goods begin to rise. Consequently, the late receivers benefit to a lesser extent from monetary injections or may even find that most prices have risen so much that they can now afford fewer goods.

Increases in money supply lead to a redistribution of real wealth from later recipients, or nonrecipients of money to the earlier recipients. Obviously, this shift in real wealth alters individuals’ demands for goods and services and in turn alters the relative prices of goods and services.

Increases in money supply set in motion new dynamics that give rise to changes in demands for goods and services and to changes in their relative prices. Hence, increases in money supply cannot be neutral as far as relative prices of goods are concerned.

A change in relative demands here is on account of real wealth diversion from last recipients of money to the early recipients. This change in relative demands cannot be sustained without ongoing increases in the money supply growth rate. Once the growth rate of money supply slows down or declines all together various activities that emerged on the back of this increase in the money supply are coming under downward pressure.

It follows then that an increase in the growth rate of money supply gives rise to changes in relative prices, which set in motion an unsustainable structure of production. The outcome of all this is going to be the misallocation of resources and the economic impoverishment.

Hence, the Fed’s monetary policy that aims at stabilizing the price level by implication affects the growth rate of money supply. Since changes in money supply are not neutral with respect to relative prices of goods and services, this means that a central bank policy amounts to the tampering with relative prices, which leads to the disruption of the efficient allocation of resources.

Observe that while increases in money supply are likely to be revealed in general price increases, this need not always be the case. Prices are determined by real and monetary factors.

Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. While money growth is buoyant prices might display moderate increases.

Clearly, if we were to pay attention to changes in the price level and disregard increases in the money supply, we would reach misleading conclusions regarding the state of the economy.

On this, Rothbard wrote in America's Great Depression,

The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware.

The Price Level Cannot Be Ascertained Conceptually

Furthermore, the whole idea of the general purchasing power of money and therefore the price level cannot be even established conceptually.

When one dollar is exchanged for one loaf of bread, we can say that the purchasing power of one dollar is one loaf of bread. If one dollar is exchanged for two tomatoes, then this also means that the purchasing power of one dollar is two tomatoes. The information regarding the specific purchasing power of money does not however allow the establishment of the total purchasing power of money.

It is not possible to ascertain the total purchasing power of money because we cannot add up two tomatoes to one loaf of bread. We can only establish the purchasing power of money with respect to a particular good in a transaction at a given point in time and at a given place.

On this Rothbard wrote in Man, Economy, and State

Since the general exchange-value, or PPM (purchasing power of money), of money cannot be quantitatively defined and isolated in any historical situation, and its changes cannot be defined or measured, it is obvious that it cannot be kept stable. If we do not know what something is, we cannot very well act to keep it constant.

Summary and Conclusion

For most commentators, the key to healthy economic fundamentals is price stability. A stable price level, it is held, leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals. It is not surprising that the mandate of the Federal Reserve is to pursue policies that will generate price stability.

By means of monetary policies that aim at stabilizing price level the Fed actually undermines economic fundamentals. An ever-growing interference of the government and the central bank with the working of markets moves the US economy towards the growth path of persistent economic impoverishment and drastically low living standards as time goes by.

What is required is not a policy of economic stability but rather allowing free price fluctuations. Only in an environment free of government and central bank tampering with the economy can free fluctuations in relative prices take place. This in turn will permit businesses to abide by consumers' instructions.


Contact Frank Shostak

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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