Do we ever need to create more money?

Today, all mainstream schools of economics believe in the need to create more money in order for the economy to grow.

Keynesianism

Keynesians tend to favour money creation during times of recession, to boost “aggregate demand” – roughly speaking, the total amount of spending in the economy. Recent examples of this would be the various programs of quantitative easing carried out by various central banks, including the Bank of England. Such policies are often carried out when interest rates are near zero, and hence cannot be lowered further in the hope of stimulating economic growth.

Inflation target

Monetarists gave us the current 2% annual inflation target at the Bank of England. This means if inflation fell below 2%, they would be required to create more money until inflation again hit at least 2%. This target is designed both to keep a cap on inflation, and to prevent deflation.

Nominal GDP targeting

In a twist on the standard monetarism above, “market monetarists” suggest that money creation should follow nominal GDP. (Nominal GDP  is the GDP without adjusting for inflation  whereas real GDP is adjusted for inflation.) This attempts to manage both GDP growth and inflation in one target. So, if the normal growth rate is 2.5%, then a nominal GDP target of 4% would give a long term inflation rate of 1.5%. When the growth rate falls, such as during a recession, the nominal GDP target would instruct the central bank to create money to meet the target – so if growth rate fell to 1%, then inflation should rise to 3% to match the overall 4% target.

Sound money

But why do all these schools of thought believe in the printing press? Is it really necessary to increase the money supply, either in times of economic crisis, or continuously? Should we fear deflation?

It is commonly believed that without some underlying growth in the money supply raising prices, consumers would postpone their purchases, thus inhibiting economic growth. This is clearly contradicted by the recent growth of the computer industry, as Frank Shostak explains:

For instance, since January 1998 the price of personal computers has fallen by 93%. Did this fall in prices cause people to postpone buying personal computers? Not at all. Consumer outlays on personal computers have increased by over 2,700% since January 1998.

Even if this applied to all goods and services in the economy, as consumers we ultimately desire the product in question. We won’t wait forever just because the price is falling.

If we accept the above argument, there is still the problem of recessions. Surely, if anything were to justify creating money, this would be it. This is sometimes linked to the notion of the “deflationary spiral”. This occurs when prices falling in one industry results in workers in that industry losing jobs, and as the effects of their reduced spending ripples through the economy, further job losses occur. The only way to stop the spiral from continuing is to print money in order to raise prices, and protect jobs. Other economists reject the idea of a deflationary spiral, but instead see printing money as the quickest way to reduce unemployment and get the economy back on track.

Austrian school economists reject both justifications. According to their understanding of the business cycle, which I have explained in previous posts, recessions are the inevitable result of previous increases in the money supply, which lead to dislocations in the economy where supply and demand are no longer in agreement. The fall in the money supply during a recession is a necessary part of the recovery process, to return the economy to a sustainable path. Attempting to delay this recovery process through further money printing will work for a time, but at the cost of a greater bust to follow. Deflation is like a hangover after a night of heavy drinking. No one likes a hangover, but you’ve got to stop drinking eventually.

During the time of the classical gold standard in the late 19th century, overall prices fell, and the world experienced some of the most rapid economic growth ever seen. The money supply was very stable, and if you kept money under your bed it would be worth more years later when you wanted it, as the growth of goods and services outweighed the growth in the money supply.

A stable money supply – and a gradual deflation in the price level – would not only not be harmful, it would be of great benefit to all in society. Saving for retirement would no longer require the risky investment in the stock market just to beat inflation. Consumers at all levels would see their paycheck go further, without needing inflation linked pay rises just to stand still. House prices would not keep rising out of reach of first time buyers. Perhaps best of all, the boom bust cycle would be tamed, leading to sustainable and lasting economic growth.

Still sceptical? Can a successful economy really work without ever increasing money? Thing back to the days of barter – when goods were traded directly for one another – bread for bricks, wood for wool. Such an economy can only grow so far, as without money there can only be a very limited division of labour. But economic growth can still occur – a farmer can discover ways to grow more crops, or a some enterprising soul refines iron for the first time. All people living in barter gain the goods and services they require by trading the goods and services they produce. This is still how our economy works today – but it is confused by the use of money as a medium of exchange. Money itself now becomes the goal, rather than the goods and services we can buy with money. No poor country ever got rich just by using a printing press – they must produce in order to consume – there is no free lunch. All the programs of quantitative easing don’t produce more cars, more houses or more food, they just make them more expensive.

In an economy with a fixed money supply, but increasing goods and services, the purchasing power of money increases – prices fall. No new money is needed to purchase the new goods. What if the population increases? No problem, the new people just trade what they produce in order to earn money, and as there are now more goods being produced, again the purchasing power of money increases – prices fall. Rather than the money supply changing, the value of money changes instead.

I’ll end this rather long post with a quote from Detlev Schlichter, author of the book “Paper Money Collapse”. It’s a great introduction to the Austrian school of thought on this subject.

Inelasticity of supply is no hindrance for a commodity to be used as money. Or to put it differently, there is no basis for the widespread belief that somebody has to meet the growing demand for money in a growing economy – or in an economy that may for other reasons have a growing demand for money – by creating more of the money substance. This fallacy is based on an inappropriate transfer of the laws of supply and demand from the sphere of goods and services that are demanded for their use-value to the sphere of money, which is demanded only for its exchange-value. (p33)

 

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2 Responses to Do we ever need to create more money?

  1. Pingback: Shout Out across the Pond | Freedom at Bethsaida

  2. Pingback: The new man at the helm | Abolish the Bank of England

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