Why loose monetary policies cannot set real economic growth?

By Dr Frank Shostak

Between January 1970 and December 2020 on average changes in money supply preceded by 14 months changes in real economic activity as depicted by real gross domestic product (GDP). Based on this it is tempting to suggest that a strengthening in the growth rate of money supply will result in the strengthening of real economic growth. Conversely, a weakening in the growth rate of money supply will set in motion a decline in real economic activity.

The relationship presented in the graph above between the growth rate of money supply and the growth rate of real GDP is a display of historical information. Can such a display by itself confirm that increases in the money supply growth rate can set in motion real economic growth? We hold that history as such cannot establish that this is the case. According to Ludwig von Mises, in Human Action pp. 41-49

History cannot teach us any general rule, principle, or law. There is no means to abstract from a historical experience a posteriori any theories or theorems concerning human conduct and policies.  

Also, in the The Ultimate Foundation of Economic Science p. 74, Mises argued that,

What we can “observe” is always only complex phenomena. What economic history, observation, or experience can tell us is facts like these: Over a definite period of the past the miner John in the coal mines of the X company in the village of Y earned p dollars for a working day of n hours. There is no way that would lead from the assemblage of such and similar data to any theory concerning the factors determining the height of wage rates.  

In order to maintain their life and wellbeing what people require is final goods and services and not money as such, which is just the medium of exchange. Money only helps to facilitate trade among individuals— it does not generate any real stuff. According to Rothbard,  

Money, per se, cannot be consumed and cannot be used directly as a producers’ good in the productive process. Money per se is therefore unproductive; it is dead stock and produces nothing.

Paraphrasing Jean Baptiste Say, Mises wrote, 

Commodities, says Say, are ultimately paid for not by money, but by other commodities. Money is merely the commonly used medium of exchange; it plays only an intermediary role. What the seller wants ultimately to receive in exchange for the commodities sold is other commodities. 

Again, being the medium of exchange money enables the goods and services of one individual to be exchanged for the goods and services of another individual. This means that with the help of money we can exchange something for something else.

When money was generated out of “thin air”, it means that nothing was produced to secure the newly generated money. This means that nothing was exchanged for the newly generated money. Once this money is employed in the exchange for goods and services it sets in motion an exchange of nothing for something. Individuals that are in the possession of the newly generated money can now divert to themselves goods and services without any contribution to the production of these goods and services. What we have here is the so-called money counterfeit effect. A counterfeiter by generating bogus money, which masquerades as money proper, can divert real wealth to himself without any contribution to the pool of real wealth.

The increase in money out of “thin air” sets in motion a process of impoverishment of wealth generators i.e. those individuals that have contributed to the pool of goods and services. Hence, rather than causing economic growth, the money out of “thin air” is setting in motion the process of economic impoverishment and a weakening in real economic growth.

How does a decline in the money supply growth set in motion an economic bust? 

For most commentators the arrival of a recession is due to unexpected events such as the coronavirus pandemic that pushes the economy away from a trajectory of stable economic growth. Unexpected events or shocks weaken the economy so it is held. We suggest that a recession is not about the strength of an economy as such but about the liquidation of various nonproductive activities. Here is why.  

As a rule, a recession or an economic bust emerges in response to a decline in the growth rate of money supply. Usually this takes place in response to a tighter monetary stance of the central bank. As a result, various activities that sprang up on the back of the previous strong money growth rate come under pressure. These activities cannot support themselves – they have emerged because of the support that the increase in money supply provides by diverting real wealth to them from wealth generators. Consequently, this weakens wealth generators. 

A tighter monetary stance of the central bank and a consequent decline in the growth rate of money supply slows down the diversion of real wealth. This in turn undermines various nonproductive undertakings. 

A recession then is about the liquidation of various nonproductive i.e. bubble activities, because of the decline in the diversion of real wealth from wealth generators to them. Again, this decline in the diversion emerges once the money supply growth rate slows down or declines.

GDP framework presents misleading picture 

Economic growth presented by government statisticians is in terms of data such as gross domestic product (GDP). This indicator is designed along the line of the Keynesian framework that monetary spending equates with income. On this thinking, more spending leads to a higher national income and in turn to a higher economic growth. 

Following this logic, a tighter monetary stance by the Fed leads to a slower economic growth whilst increases in the money pumping produce higher economic growth. A stronger growth rate of money supply leads to a stronger pace of expenditure. (In the GDP framework this results in the increase in overall income in the economy and hence in a higher GDP growth rate).

We suggest that in reality the exact opposite actually takes place – printing more money weakens wealth generators’ ability to grow the economy whilst a decline in the money supply growth rate strengthens their ability to grow the economy. Once the central bank raises the pace of money pumping in order to lift the economy from a recession this arrests the demise of various bubble activities. It also gives rise to new bubble activities. 

An outcome of the so-called economic growth in terms of GDP is nothing more here than the strengthening of the consumption of wealth and the impoverishment of wealth-generators. All this undermines the process of wealth generation and weakens real economic growth. Because of the increase in the money supply growth rate the erosion in the real wealth formation process is not always portrayed by the GDP data. Once however, the pool of real savings – the heart of economic growth- starts to decline the real GDP growth rate is likely to follow suit (see discussion on this below). 

Real savings and economic activity  

At any point in time the number and the size of activities that can be undertaken is determined by the pool of real savings. This pool comprises of final consumer goods. Note that this pool sustains individuals that are engaged in the enhancement and the increase of the infrastructure. This pool also sustains individuals that are engaged in the production of final consumer goods. 

The improved infrastructure permits the increase in the production of intermediate goods, the increase in the production of services, and the increase in final consumer goods. Once an increase in the production of final goods and services happens, this increase can now support a corresponding increase in the demand for final goods and services. Note that one must produce something useful before demanding things. 

Observe that this runs contrary to the GDP framework where the increase in the monetary expenditure i.e. money pumping strengthens the demand for final consumer goods and services. This in turn it is held triggers the increase in the supply of these goods and services i.e. demand creates supply. If however, the infrastructure was not enhanced and expanded it will not be possible, all other things being equal, to increase the production of final consumer goods and services and therefore to accommodate the increase in the demand. Hence, an increase in the demand will not automatically result in the increase in supply. Because the supply of goods is taken for granted, the GDP framework completely ignores the importance of the various stages of production that precede the emergence of the final consumer goods. 

In the real world, it is not enough to have demand for final consumer goods: one must have various intermediate goods that are required in the production of final consumer goods. The intermediate goods are not readily available; they have to be produced. 

Observe that individuals, whether in productive or non-productive activities must have access to real savings in order to sustain their life and wellbeing.  As long as wealth producers can generate enough real savings to support productive and non-productive activities, loose monetary policies will appear to be successful.  

Over time however, a situation can emerge as a result of the persistent loose monetary policies that there are not enough wealth generators left. (Wealth generators have been badly damaged by expansionary monetary policies). Consequently, generated real savings are not large enough to support an increase in real economic activity. 

Once this happens, the illusion that easy monetary policy can grow an economy is shattered – real economic growth must come under pressure.  Even in terms of real GDP, which mirrors monetary changes, it will be difficult to show an economic growth. The only reason why in such an event real GDP could display a rising growth rate is due to the employment of misleading price deflators that understate the true rate of price increases. If the Fed were to accelerate the monetary pumping whilst the pool of real savings is declining this runs the risk of further depleting the pool. 

Those commentators who subscribe to the view that the acceleration in the money pumping could revive real economic growth imply that something can be generated out of nothing.  Printing more money however cannot replace real savings. If stimulatory monetary policies could strengthen real economic growth then world poverty should have been eliminated a long time ago.

Conclusions

We hold that increases in money supply cannot grow an economy. All that increases in money supply can do is to divert real wealth from wealth generating activities to non-productive activities. In the process, this weakens wealth generators ability to grow the economy. What we observe is that economic growth in terms of data such as GDP mirrors increases in bubble activities because of increases in the growth rate of money supply. Consequently, the more money pumped by the Fed the larger the so-called economic growth is going to be. Over time, a situation can emerge where because of persistent loose monetary policies, the ability of wealth generators to expand the pool of real wealth is severely undermined. Subsequently, generated real wealth is not large enough to support an increase in real savings and an increase in real economic activity. If the central bank were to persist in aggressive monetary pumping this runs the risk of further depleting the pool of real savings, thereby pushing the economy into an economic slump.