Relation between general decline in prices and wealth

By Dr Frank Shostak

A general decline in the prices of goods and services is regarded as bad news since it is seen to be associated with major economic slumps such as the Great Depression of the 1930’s. In July 1932, the yearly growth rate of US industrial production stood at -31% whilst in September 1932 the yearly growth rate of the US consumer price index (CPI) stood at -10.7%. 

It is argued by many commentators that a general fall in prices is always “bad news” for it postpones people’s buying of goods and services, which in turn undermines investment in plant and machinery. All this sets in motion an economic slump. Moreover, as the slump further depresses the prices of goods, this intensifies the pace of economic decline. 

In contrast, thinkers such as Murray Rothbard held that in a free market the rising purchasing power of money i.e. declining prices is the mechanism that makes the great variety of goods produced accessible to many people. 

On this Rothbard wrote, 

Improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices (and costs) and thereby distribute the fruits of free enterprise to all the public, raising the standard of living of all consumers. Forcible propping up of the price level prevents this spread of higher living standards.

Also, according to Joseph Salerno,  

 ….. Historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard. For example, in the US from 1880 to 1896, the wholesale price level fell by about 30 percent, or by 1.75% per year, while real income rose by about 85 percent, or around 5 percent per year.

Pumping money to counter general decline in prices weakens the economy

Whenever a central bank pumps money into the economy to counter a general decline in the prices of goods and services, this benefits various individuals engaged in activities, which sprang up on the back of loose monetary policy, and occurs at the expense of wealth generators. 

Through loose monetary policy, some individuals become consumers without the prerequisite of contributing to the pool of real saving. Their consumption is made possible through the diversion of real savings from wealth producers. 

If the pool of real savings is growing, various goods and services that are patronized by non-wealth producers appear to be profitable. However, once the central bank reverses its loose monetary stance the diversion of real savings from wealth producers to non-wealth producers is arrested. This in turn undermines the demand of non-wealth producers for various goods and services thereby exerting downward pressure on their prices. 

As long as the pool of real savings is expanding, the monetary pumping generates the illusion that the loose monetary policy is the right remedy to counter a general decline in the prices of goods and services. This is because the loose monetary stance, which renews the flow of real savings to non-wealth producers, props up their demand for goods and services thereby arresting or even reversing general decline in prices.  

Furthermore, since the pool of real savings is still growing the pace of economic growth stays positive. Hence the mistaken belief that a loose monetary stance that reverses a fall in prices is the key in reviving economic activity. The illusion that through monetary pumping it is possible to keep the economy going is shattered once the pool of real savings begins to decline. 

Lending out of “thin air” sets the platform for non-productive activities and price deflation

When loaned money is fully backed by savings on the day of the loan’s maturity, it is returned to the original lender. For instance, Bob – the borrower of $5 – will pay back on the maturity date the borrowed sum and interest to the bank. The bank in turn will pass to Joe the lender his $5 plus interest adjusted for bank fees. The money makes a full circle and goes back to the original lender. 

In contrast, when the lending originates out of “thin air” and the borrowed money is returned on the maturity date to the bank, this leads to a withdrawal of money from the economy i.e. to the decline in the money supply. 

The reason being because in this case we never had a saver/lender, since this lending emerged out of “thin air”. Now, when Bob repays the $5, the money leaves the economy since there is no original lender to whom the loaned money should be returned – the bank has generated the $5 loan out of “thin air”.  Observe that the $5 loan out of “thin air” is a catalyst for an exchange of nothing for something. This provides a platform for various non-productive activities that prior to the generation of lending out of “thin air” would not have emerged. 

As long as banks continue to expand credit out of “thin air”, various non-productive activities continue to prosper. At some point however, because of the expansion in the money supply, which sets the diversion of wealth, a structure of production emerges that ties up much more consumer goods than the amount it releases. (The consumption of final consumer goods exceeds the production of these goods). The positive flow of savings is arrested and a decline in the pool of real savings is set in motion. 

Consequently, the performance of various activities starts to deteriorate and banks’ bad loans start to pile up.  In response to this, banks curtail their lending out of “thin air” and this in turn triggers a decline in the money supply. 

A decline in the money supply begins to undermine various non-productive activities i.e. an economic recession emerges. Note that an economic slump is not caused by the decline in the money supply as such, but comes in response to the shrinking pool of real savings because of previous easy monetary policies. The shrinking pool of real savings leads to the decline in economic activity and in turn to the decline in the lending out of “thin air”. This in turn results in the decline in money supply. 

Consequently, even if the central bank were to be successful in preventing the decline in the money supply, for instance by means of the helicopter money, this cannot prevent an economic slump if the pool of real savings is declining. 

Hence, the more the central bank attempts to lift the economy by attempting countering the fall in prices and rising unemployment, the worse things become.  Once various non-productive activities are allowed to go bankrupt, and the sources of money supply out of “thin air” are sealed off, one can expect wealth expansion to emerge. 

Note again that a fall in the money supply that precedes price deflation and an economic slump is triggered by the previous loose monetary policies of the central bank. Loose monetary policies of the central bank provide support to the generation of un-backed by savings credit. 

Without this support, banks would have difficulty offering an unbacked by savings credit since some of them will not be able to clear their checks because they will not have enough cash.  By means of open market operations, the central bank makes sure that there is enough cash in the banking system to prevent banks bankrupting each other. 

Summary and conclusion

We suggest that an economic slump is not caused by the decline in the money supply as such, but comes in response to the shrinking pool of real savings because of the previous easy monetary policies. The shrinking pool of real savings leads to the decline in economic activity and in turn to the decline in the lending out of “thin air”. This in turn results in the decline in money supply. 

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