It has now become settled wisdom that the massive monetary pumping by the US central bank during and after the 2008 financial crisis saved the US and the world from another Great Depression. Hence Federal Reserve Chairman at the time – Ben Bernanke (AKA “Helicopter Ben”) – is considered the man that saved the world. Bernanke in turn attributes his actions to the writings of Professor Milton Friedman who blamed the Federal Reserve for causing the Great Depression of the 1930’s by allowing the money supply to plunge by over 30%.
The reality, however, is quite different – it is not a collapse in the money stock that sets in motion an economic slump but rather the prior monetary pumping that undermines the economy’s pool of real wealth by falsifying market signals and creating massive distortions that “prime” the economy for any subsequent reduction of the flow of credit.
Essentially, the pool of real wealth is the quantity of consumer goods available in an economy to support activities engaged in the production of present consumer goods and activities that are engaged in the enhancement and the buildup of the infrastructure. That part of this pool of real wealth that is put aside to provide for the buildup of the infrastructure is known as real savings whilst the act of allocation itself is known as investment. Hence, the size of the pool of real wealth, all other things being equal, determines the level of capital investment (i.e. the amount of real wealth directed towards the enhancement and the buildup of the investment infrastructure) and therefore the productivity growth of the economy.
How is this relevant to the policies of central bank monetary policy committees who, like “Helicopter Ben”, regularly flood the market with cash?
The artificial inflation of the money supply by central banks, magnified through the commercial banks’ fractional reserve lending policies whereby more money is created “out of thin air”, means that there is an artificial increase in current consumption by individuals as their preferences are altered and their ability to fund additional expenditure is increased. This increased consumption of goods is not preceded by production. To the extent that consumption is now expanding at a rate above that at which it was before the artificial increase in money supply, this extra consumption is in fact eroding the natural growth rate of real wealth.
But in parallel with this long term erosion of the growth rate of real wealth is a more cyclical process. The inflation and distortion of resource allocation occasioned by this monetary pumping creates a vulnerability – a vulnerability that the new activities that arise in response to this monetary bonanza are now reliant on its continuation for their survival. Further, the banks that have built their loan books (and their profits) on the growth of companies engaged in these new activities have themselves become more vulnerable to any difficulties that such companies may face. There is now a genuine systemic susceptibility to any reduction in money and credit growth.
As long as the genuine pool of real wealth continues to expand, loose monetary policies give the impression that economic activity is being boosted. That this is not the case becomes apparent as soon as the pool of real 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 physical consumer goods and services).
What can cause this house of cards to collapse? Two sets of factors are clear.
The first is that the erosion of real wealth makes it more difficult for newer business activities to generate the profits on which their loans were based. In a sense this is an endogenous process but set in train by the exogenous and artificial stimulatory policies of the central and commercial banks. Here the rate of profit declines – in many cases profits turn to losses – and the banks are forced to increase loan collateral or call for repayments. From here the scene is all too familiar: a self-reinforcing downward spiral of business failure, credit contraction and further business contraction commences. No amount of monetary pumping will now offset the visceral experiences of banks and businesses.
The second is a contractionary response by the central bank to perceived inflation or other distortions which, tragicomically, were caused by their own activities in the first place. Here the growth rate of new money supplied to the banking system is reduced. Those businesses who were latest to the party begin to see their revenues contract and their (often rising) costs start to overwhelm them. Once again their bankers get cold feet and the credit contraction process starts to move through the economy, first as a ripple and then as a tsunami.
In both of these cases, there is a decline in the growth rate in the monetary aggregates. But the important point is that it is the decline the growth rate in real wealth that is driving the economic slowdown and this decline in the growth rate in real wealth commenced with the original artificial expansion of money by the central and commercial banks.
It is also important to note that the decline in monetary aggregates is in fact a decline in the money that was created out of nothing. The fall in the money stock is just a symptom – it reveals the damage caused by the previous monetary inflation. It is not the fall in the money supply and the consequent fall in prices that burdens borrowers but the fact that there is less real wealth.
In what appears to be a contrarian perspective, the fall in artificial money that accompanies the economic contraction actually facilitates the destruction of artificially created economic activities and thereby allows the survival of those activities which served the needs of consumers without this monetary mischief. In a sense the contraction is like a cleansing mechanism where the primacy of the market – directed at serving the needs of consumers and generating the real wealth and savings that can fuel genuine productivity growth – is once more reasserted.
The problem, however, is that central banks refuse to allow this to fully happen and once again they insist on trying to fight the adjustment by returning to the printing presses. There is always, sadly, another Helicopter Ben just around the corner.