Most economic commentators are of the view that when an economy is starting to experience difficult times the central bank should provide support to the economy by means of large increases in money supply. These increases are expected to strengthen the economic growth through the strengthening of individuals’ demand for goods and services.
In this way of thinking, economic activity is presented in terms of a “circular flow” of money. Spending by one individual becomes part of the earnings of another individual, and spending by some other individual becomes part of the first individual’s earnings. If an individual spends less, this allegedly worsens the situation of some other individual, who, in turn, also reduces his spending.
Following this logic, in order to prevent a recession from getting out of hand, the central bank should step in and increase the monetary inflation, thereby filling the shortfall in the private sector spending. With more money in their pockets, individuals are likely to increase their expenditure on goods and services. Consequently, an increase in demand will strengthen supply (i.e., the production of goods and services). It is held that once the circular monetary flow is reestablished, things are likely to go back to normal and sound economic growth will be reestablished.
In the market economy, wealth generators do not produce everything for their own consumption. Part of their production is used to exchange for the production of others. This means that something is exchanged for something else. Before an exchange can take place, goods have to be produced. Production must precede consumption. An increase in the production of goods and services enables an increase in the demand for goods and services (i.e., supply “creates” demand). The more goods that an individual can produce the more goods he can demand (i.e., acquire). In other words, even when people exchange money for goods or services, people accept the money, not for itself, but because it allows them to purchase other goods and services. However, money printing, without an increase in produced goods, only artificially increases demand for the existing goods.
The key for economic growth then is the supply (i.e., the production of goods and services that consumers value or demand). All that money does is facilitate payments for goods and services. Individuals ultimately pay for goods and services with other goods and services. Hence, in order to be able to purchase goods, individuals must produce and exchange other valued goods. For example, a baker exchanges his bread for money, but only because that money can then be used to buy something else (either then or later). If he buys shoes, he pays for shoes, not with money, but with the bread he produced. Money allows him to make this exchange.
In a free market, both consumption and production are likely to be in harmony with each other. This means that consumption is likely to be fully backed up by production, all other things being equal. In a free-market economy, individuals exchange wealth for wealth (i.e., goods and services for other goods and services). What enables consumption is production and exchange.
Any attempt then to increase consumption without the corresponding increase in production will either be impossible, use up previous saved production, or may even be at somebody else’s expense. This is what monetary inflation from a central bank does. It generates new demand, which is not supported by production. Once exercised, this type of demand undermines production, existing savings, and, in turn, weakens capital formation and stifles economic growth. The monetary policy of inflation leads to the exchange of nothing for something. Simply “stimulating demand” by artificially inflating more money does stimulate certain economic activity, but it does not bring about true economic growth.
It is production and saving, not money, that enables capital investment, that is, investment in the structure of production (e.g., usually better tools and machinery). With better tools and machinery, it is possible to increase productivity and efficiency, lower costs, and lower prices of final consumer goods. This is what economic growth is all about.
Hence, contrary to much popular thinking, setting in motion more demand and consumption through inflation actually stifles, and does not promote, economic growth. In fact, it regresses economic growth by undermining previous production, saving, and investment. This further weakens the sources that generate true economic growth.
If true growth could simply be realized by artificially inflating new money into a system—artificially stimulating demand while undermining production, saving, and capital investment—then poverty would have been eliminated a long time ago. After all, everybody knows how to demand and to consume. A major reason as to why in the past expansionary monetary policies seemed to grow the economy is because the pace of real production was in excess of the artificial growth. However, once inflationary monetary policy slows down or ceases—since inflation cannot last forever without causing massive price inflation or even destroying the monetary system—the economy falls into a recession. At that point, any attempt by the central bank to then pull the economy out of the slump by inflation makes things much worse.
The collapse in the sources of artificial economic growth exposes commercial banks’ fractional reserve lending and raises the risk of a run on banks. Consequently, to protect themselves, banks curtail the inflationary generation of credit. In these conditions, even further monetary inflation by the central bank is unlikely to encourage bank lending. Banks would likely agree to lend only to the creditworthy businesses. However, as an economic slump deepens, it becomes much harder to find many creditworthy borrowers. Furthermore, because of the low interest rate policy, the low-interest return against the background of a growing risk further diminishes banks’ willingness to expand credit. All this puts downward pressure on the stock of money. Hence, the central bank may find that, despite attempts to inflate, the economy’s money supply will start falling.
Obviously, the central bank could offset this decline by an aggressive round of inflation. The central bank could monetize government outlays. It could also mail checks to every citizen in the country. All this, however, only further undermines genuine production, savings, and capital investment.
In such circumstances, it is often assumed that surely the government and the central bank should “do something” to prevent the economic deterioration, however, neither the central bank nor the government have the resources to grow the economy. Neither the central bank nor the government are wealth generators. They are supported by diverting resources from the wealth-generating private sector. Any actions taken by the government and/or central bank necessarily involve taking from the private economy and will only further distort the structure of production. Any measures that the government or the central bank could undertake would be at the expense of generating wealth.
One could, however, argue that the inflationary monetary policy generates a temporary illusion of greater wealth and production (i.e., a boom) and this boosts demand for goods and services. According to such thinking, an increase in the demand triggers an increase in supply (i.e., in the production of goods and services). However, without the increase in stable production, artificial stimulations of demand will only undermine economic growth. Without the increase in savings, it is not possible to increase the production of goods and services, and hence, the possibility for increased demand. If the ability of the economy to produce goods and services was damaged, boosting the demand is not going to repair the damage.
It is not possible to grow an economy through inflationary increases in money supply. All that such increases generate is the increase in consumption without increasing production, which weakens the formation of savings. This weakens economic growth.
Courtesy of Mises.org
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