Why more money can’t generate economic growth?

By Dr Frank Shostak

The view that more money can revive an economy is based on the belief that money transmits its stimulatory effect through aggregate expenditure. With more money in their pockets, people will be able to spend more and the rest will follow suit. Money in this way of thinking is a means of payments. 

Money, however, is not a means of payments but the medium of exchange. It only enables one producer to exchange his produce with another producer. According to Murray 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.  

The means of payments are always goods and services, which pay for other goods and services. All that money does is to facilitate these payments – it makes the payments possible. 

For instance, a baker exchanges his bread for money and then uses the money to buy shoes. He pays for the shoes not with money but with the bread, he produced. Money just allows him to make this payment. Also, note that the baker’s production of bread gives rise to his demand for money.

By demand for money, what we really mean here is the demand for money’s purchasing power. After all, people do not want a greater amount of money in their pockets but rather they want a greater purchasing power in their possession. 

According to Mises,

The services money renders are conditioned by the height of its purchasing power. Nobody wants to have in his cash holding a definite number of pieces of money or a definite weight of money; he wants to keep a cash holding of a definite amount of purchasing power.

In a free market, in similarity to other goods, the price of money is determined by supply and demand. If there is less money, all other things being equal, its exchange value will increase. 

Conversely, the exchange value will fall, all other things being equal, when there is more money. Within the framework of a free market, there cannot be such thing as “too little” or “too much” money. As long as the market is allowed to clear, no shortage of money can emerge. 

Once the market has chosen a particular commodity as money, the given stock of this commodity will always be sufficient to secure the services that money provides. Hence, in a free market, the whole idea of the optimum growth rate of money is absurd. According to Mises:

As the operation of the market tends to determine the final state of money’s purchasing power at a height at which the supply of and the demand for money coincide, there can never be an excess or deficiency of money. Each individual and all individuals together always enjoy fully the advantages which they can derive from indirect exchange and the use of money, no matter whether the total quantity of money is great, or small. . . . the services which money renders can be neither improved nor repaired by changing the supply of money. . . . The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do.

In a market economy, the purpose of production is consumption. People produce and exchange goods and services with each other in order to promote their life and wellbeing – their ultimate purpose. 

This means that consumption cannot arise without production whilst production without consumption will be a meaningless undertaking. Hence, in a free market economy both consumption and production are in harmony with each other. In a free market economy, consumption will tend to be fully backed by production. 

What permits the baker to consume bread and shoes is his production of bread.  A portion of his bread production is allocated for his direct consumption while the other portion is used to pay for shoes. 

Note that his consumption is fully backed i.e. paid by his production. Any attempt then to raise consumption without the corresponding increase in production leads to unbacked consumption, which must come at somebody else’s expense.  

This is precisely what monetary pumping does. It generates demand, which is not supported by any production. Once exercised, this type of demand undermines the flow of savings and in turn weakens the formation of capital and suppresses rather than boosting the economic growth. 

It is savings and not money that funds and makes possible the production of better tools and machinery. With better tools and machinery, it is then possible to lift the production of final consumer goods and services – this is what the economic growth is.

Again, contrary to the popular way of thinking, setting in motion an unbacked-by-production consumption by means of monetary pumping will only suffocate and not promote economic growth. 

Again, this is because unbacked consumption will weaken the flow of savings and thus weaken the source that funds economic growth. If it had been otherwise then poverty in the world would have been eliminated a long time ago. After all everybody knows how to demand and to consume. 

The only reason why loose monetary policies may appear to grow the economy is that the pace of savings generation is strong enough to absorb the increases in unbacked consumption. 

Once, however, the growth rate of unbacked consumption reaches a stage where the flow of savings disappears all together the economy falls into an economic slump. 

Any attempt by the central bank to pull the economy out of the slump by means of monetary pumping makes things much worse for it only further strengthens the unbacked consumption, thereby destroying whatever is left of savings.

The collapse in the sources of economic growth exposes banks’ fractional reserve lending and raises the risk of a run on banks. To protect themselves banks curtail the creation of credit and the credit out of “thin air”. 

Under these conditions, a further monetary pumping cannot lift banks’ lending. On the contrary, more pumping destroys more savings and destroys more businesses, which in turn makes banks reluctant to expand lending. Note, what matters for economic growth is the increase in savings and not the increase in the credit out of “thin air” i.e. unbacked money. 

Within these conditions, banks would likely agree to lend only to creditworthy businesses. However, as an economic slump deepens it becomes much harder to find many creditworthy businesses. 

Hence, the central bank may find that despite its attempt to inflate the economy, money supply will start falling. Obviously, the central bank could offset this decline by an aggressive monetary pumping. 

The central bank could also monetize the government budget deficit – it could mail checks to every citizen. All this, however, will only further undermine the pool of savings and devastate the economy. 

Does increase in demand set in motion economic growth?

Most commentators are of the view that an increase in money supply is going to strengthen the demand for consumer goods and services. As a result of this a strengthening in the production of consumer goods and services is going to emerge i.e. a strengthening in the economic growth will take place. 

However, to accommodate the strengthening in the production of consumer goods and services there is the need for a suitable infrastructure. 

If however, the infrastructure was not made because of not enough savings being allocated for this it will not be possible to have the strengthening in the economic growth. 

No amount of increase in the money supply is going to make it possible. On the contrary, an increase in the money supply is going to undermine the process of savings formation and delay rather than promote the prospects for the economic recovery.

Summary and conclusion

Contrary to popular thinking, money is not the means of payment – it serves the role of the medium of exchange.  Hence, the increase in money supply cannot strengthen economic growth. On the contrary, more money is going to weaken the saving generation process thereby weakening prospects for a sustained economic growth.

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