Once an economy falls into recession many commentators tend to express concern that as a result of the economic slump there are now underutilized capital and labour. Resources that can be used are now made unemployed. It is held that the key factor behind this is an insufficient demand for goods and services.
Once it is accepted that this key factor is associated with insufficient demand these commentators take the view that what is required is to somehow to boost overall demand in the economy.
With stronger demand, it is held, idle resources could be employed again. Hence it is recommended that the central bank should adopt a very loose monetary stance in order to strengthen the overall demand for goods and services.
The whole thing appears to be quite simple – boost expenditure on goods and services and this in turn, via the famous Keynesian multiplier, will strengthen overall output in the economy.
This way of thinking is succinctly summarized by Ludwig von Mises,
Here, they say, are plants and farms whose capacity to produce is either not used at all or not to its full extent. Here are piles of unsalable commodities and hosts of unemployed workers. But here are also masses of people who would be lucky if they only could satisfy their wants more amply. All that is lacking is credit. Additional credit would enable the entrepreneurs to resume or to expand production. The unemployed would find jobs again and could buy the products. This reasoning seems plausible. Nonetheless it is utterly wrong.
What those commentators who advocate monetary pumping to absorb idle resources have overlooked is the fact that these resources have become idle on account of the previous boom brought about by the previous loose monetary policy of the central bank.
As a result of the previous loose monetary stance various non-productive or “bubble” activities, emerged. These activities relied for their continued existence upon the maintenance of that loose monetary policy, which results in the diversion of real wealth from wealth generators towards bubble activities.
A tighter stance of the central bank stops this diversion, thereby reducing the number of marginal, bubble activities and ultimately strengthens the process of wealth generation. Such a stance however cannot undo the various misallocations of resources that took place as a result of the prior loose monetary position. The damage that was done cannot be undone in the short term. Once, however, the process of wealth generation gains momentum the expansion in the pool of real wealth permits the absorption of various idle resources.
According to Mises,
Out of the collapse of the boom there is only one way back to a state of affairs in which progressive accumulation of capital safeguards a steady improvement of material well-being: new saving must accumulate the capital goods needed for a harmonious equipment of all branches of production with the capital required. One must provide the capital goods lacking in those branches which were unduly neglected in the boom. Wage rates must drop; people must restrict their consumption temporarily until the capital wasted by malinvestment is restored. Those who dislike these hardships of the readjustment period must abstain in time from credit expansion.
Furthermore says Mises,
If commodities cannot be sold and workers cannot find jobs, the reason can only be that the prices and wages asked are too high. He who wants to sell his inventories or his capacity to work must reduce his demand until he finds a buyer. Such is the law of the market. Such is the device by means of which the market directs every individual’s activities into those lines in which they can best contribute to the satisfaction of the wants of the consumers.
Commentators are correct in believing that what prevents the expansion of the production and the utilisation of idle resources is the lack of credit. There is, however, the need to emphasise that the credit that is lacking is the productive credit – the one that is fully backed by real wealth. The fact that this type of credit is scarce is the outcome of previous episodes of expansionary monetary mischief by the central bank, which resulted in the diversion of wealth from wealth producers to non-wealth producers.
What most commentators advocate is the expansion of credit out of “thin air”, which the central bank is able set in motion, either by direct monetary injections or via intervention in the money markets to maintain a lower target interest rate. Such commentators advocate the expansion in credit that is not supported by real wealth.
The expansion in unbacked credit not only cannot revitalize the economy but, on the contrary, will set in motion a further weakening of the process of wealth generation.
Any attempt to “revive” economic activity by means of loose monetary policy will resume the diversion of real wealth from wealth generators to non-wealth generators, thereby weakening the process of real wealth generation.
As long as the pool of real wealth is large enough this type of policy might “work” – the central bank policies appear to be working.
Once, however, the pool is stagnant or declining the “music stops” and no amount of central bank liquidity injection is going to “work”. On the contrary, the more aggressive the central bank’s stance in attempting to revive the economy the worse things will get.
One could argue that, irrespective of the reason for the emergence of idle resources, the role of authorities and in particular the central bank is to pursue policies that will make it possible for a greater use of these resources. However we suggest that the employment of resources requires an expansion in the pool of real wealth to engage those resources. This, however, requires an increase in real savings.
Without this increase there will not be sufficient means to facilitate the employment of those idle resources. A loose monetary policy that is aimed at boosting demand will not do the trick, for an increase in demand cannot replace the real savings that are required to recruit such resources.
Some commentators are of the view that through loose monetary policies on the part of the central bank the economy can and will take off on its own, just as adding a little water to a pump i.e. priming the pump, enables water to be pumped out of a well.
This metaphor is misleading since, as we have seen, without the expansion in real savings no expansion in economic activity can take place. Again, pushing more money and, with it, credit unbacked by real wealth, cannot replace the non-existent capital goods that are required in the expansion of wealth that in turn absorbs the unemployed labour and capital.
 Ludwig von Mises – Human Action – third revised edition Contemporary Books Inc p 578-579
 Ludwig von Mises Ibid