By Dr Frank Shostak
It is held by a popular thinking that a growing economy requires a growing money supply in order to provide support to economic growth. The idea that the money supply must grow in order to support the growth rate of an economy gives the impression that money is the means of sustenance that sustains economic activity. However, money’s main function is to fulfill the role of the medium of exchange. Money does not sustain economic activity. The means of sustenance are provided by the saved consumer goods.
Historically, many different goods have been used as the medium of exchange. On this, Mises observed that, over time,
… there would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money.
Through the ongoing process of selection, individuals settled on gold as their preferred medium of exchange. Most economists, while accepting this historical evolution, cast doubt that gold can fulfill the role of money in the modern world.
It is held that, relative to the growing demand for money because of growing economies, the supply of gold is not adequate. Some commentators are of the view that the lack of a flexible mechanism that coordinates the supply vs the demand for money is the major reason why the gold standard leads to instability. It is manintained that, relative to the growing demand for money because of growing economies, the supply of gold is not growing fast enough.
This, in turn, runs the risk of destabilizing the economy. Hence, most economists, even those who express sympathy towards the idea of a free market, endorse the view that the government must control the money supply. On this according to Larry Elkin,
The basic problem is that the supply of gold is not related to the quantity of goods and services being produced………. As a result of this scarcity, prices decline. Individuals have less incentive to produce new goods and services. Economic growth is stifled. Allowing money to become scarce does the greatest harm to those who have the least. In the past, the relative inflexibility of the monetary system contributed to the chronic lack of growth in many of the world’s less developed countries. Since the 1970s, we have had one of the most flexible monetary systems the world has known, and many of these countries have flourished. With a flexible monetary system, more money can be created to accommodate more growth.
What do we mean by demand for money?
By demand for money, what we really mean is the demand for money’s purchasing power. After all, individuals do not want a greater amount of money in their pockets what they want is a greater purchasing power in their possession.
In similarity to other goods, the price of money is determined by supply and demand. If there is a decline in the quantity of money, all other things being equal, its exchange value will increase.
Conversely, the exchange value will decline when there is an increase in the quantity of money, all other things being equal.
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 or surplus of money can emerge.
Once the market has chosen a particular commodity as money, the given stock of this commodity is going to be sufficient to secure the services that money provides.
According to Mises:
. . . 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.
Furthermore, notwithstanding the increase in the demand for money the increase in the supply is going to set the foundation for the exchanges of nothing for something and to the economic impoverishment.
From commodity money to paper money
Originally, paper money was not regarded as money but merely as a representation of gold. Various paper certificates represented claims on the gold stored with the banks. The holders of paper certificates could convert them into gold whenever they believed necessary. Because individuals found it more convenient to use paper certificates to exchange for goods and services, these certificates came to be regarded as money.
Paper certificates that are accepted as the medium of exchange open the scope for fraudulent practice. Banks could now be tempted to boost their profits by lending certificates that were not covered by gold. A bank that over-issues paper certificates is likely to find out that the exchange value of its certificates in terms of goods and services will decline. To protect their purchasing power, holders of the over-issued certificates are likely to attempt to convert them back to gold.
If all of them were to demand gold back at the same time, this is going to bankrupt the bank. The threat of bankruptcy is likely to restrain banks from issuing paper certificates unbacked by gold.
This means that paper money cannot assume a “life of its own” and become independent of a commodity money. The government could however, issue a decree that makes it legal for the over-issued banks not to redeem its certificates into gold. Once banks are not obliged to redeem certificates into gold, opportunities for large profits are generated that set incentives to pursue an unrestrained expansion of the supply of certificates.
The uncontrolled expansion of certificates raises the likelihood of setting off a galloping rise in the prices of goods and services that could lead to the breakdown of the market economy.
To prevent such a breakdown, the supply of certificates must be managed. This can be achieved by establishing a monopoly bank-i.e., a central bank that manages the supply of certificates. To assert its authority, the central bank introduces its own certificate, which replaces the certificates of various banks. (The central bank’s certificate purchasing power is established on account of the fact that various banks certificates are exchanged for the central bank certificate at a fixed rate. The central bank certificate is fully backed by banks’ certificates, which have the historical link to gold.)
The central bank’s certificate, which is declared as legal tender, also serves as reserve assets for banks. This enables the central bank to set a limit on the credit expansion by the banking system via setting regulatory ratios of reserves to demand deposits.
It would then appear that the central bank could manage and stabilize the monetary system. The truth, however, is the exact opposite. Note again, that the present fiat monetary system emerged because central authorities made it legal for the over-issued banks not to redeem certificates into gold. To manage the system, the central bank must constantly generate money “out of thin air” to prevent banks from bankrupting each other during the interbank clearance of checks. This leads to persistent declines in the money’s purchasing power, which destabilizes the entire monetary system.
Even Milton Friedman’s framework to fix the money growth rate at a given percentage will not do the trick. After all, a fixed percentage growth is still money growth, which leads to the exchange of nothing for something – i.e., economic impoverishment and the boom-bust cycles.
What about keeping the current stock of paper money unchanged. Would that do the trick? An unchanged money stock is going to cause a breakdown of the present monetary system. After all, the present system survives because the central bank, by means of monetary injections, prevents the fractional reserve banks from going bankrupt.
How long can the central bank keep the present system “going” is dependent upon the state of the subsistence fund. As long as this fund is still expanding, the central bank is likely to succeed in keeping the system alive.
Once the subsistence fund begins to stagnate – or, even worse, shrink – then no amount of monetary pumping will be able to prevent the implosion of the system.
Conclusion
In an unhampered market economy without central bank interference, there is no need to be concerned with the optimum money supply growth rate. Any amount of money will do the job that is expected from money i.e., it will fulfill the role of the medium of exchange.
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