Booms & Busts: An Analysis of Easy Money

Booms & Busts: An Analysis of Easy Money

According to the popular way of thinking, various economic data can provide an analyst with the necessary information regarding the state of the economy. It is held that by inspecting various economic indicators such as the gross domestic product or industrial production, an analyst could ascertain the state of the economic business cycle.

Following the experts from the National Bureau of Economic Research (NBER), business cycles are seen as broad swings in many economic indicators, which upon careful inspection permit the establishment of peaks and troughs in general economic activity.

Furthermore, according to the NBER experts, because the causes of business cycles are complex and not properly understood it is much better to focus on the outcome of these causes as manifested through the economic data.1Quoted in Allan P. Layton and Anirvan Banerji “What Is a Recession?: A Reprise,” Applied Economics 35, no. 16 (2003): 1789–97,

If the driving factors of boom-bust cycles are not known, as the NBER underlying methodology holds, how could the government and the central bank introduce measures to counter them?

Contrary to the NBER way of thinking, data does not talk by itself and never issues any “signals” as such. It is the interpretation of the data guided by a theory which generates various “signals.”

By stating that business cycles are about swings in the data, one says nothing about what business cycles are. In order to establish what business cycles are the driving force that is responsible for the emergence of economic fluctuations needs to be ascetained.

Why We Have Boom-Bust Cycles

Contrary to the indicators approach, boom-bust cycles are not about the strength of the data as such (for instance, for the NBER a recession is a significant decline in activity spread across the economy lasting more than a few months). It is about activities that sprang up on the back of the loose monetary policies of the central bank.

Thus, whenever the central bank loosens its monetary stance, it sets in motion an economic boom by means of the diversion of real savings from wealth generators to various non-wealth-generating activities that a free unhampered market would not facilitate.

Whenever the central bank reverses its monetary stance, this slows down or puts to an end the diversion of real savings toward activities that do not generate real wealth and that undermines their existence. The trigger to boom-bust cycles is central bank monetary policies and not some mysterious factors.

Consequently, whenever a looser stance is introduced, this should be regarded as the beginning of an economic boom. Conversely, the introduction of a tighter stance sets in motion an economic bust, or the liquidation phase.

The severity of the liquidation phase is dictated by the extent of distortions caused during the economic boom. The greater the distortions, the more severe the liquidation phase is going to be. Any attempt by the central bank and the government to counter the liquidation phase through monetary stimulus will only undermine the pool of real savings, weakening the economy.

Again, since the central bank’s policies set the boom-bust cycles in motion, these policies are what leads to economic fluctuations.

Whenever the central bank changes its monetary stance, the effect of the new stance does not assert itself instantaneously—it takes time.

The effect starts at a particular point and shifts gradually from one market to another market, from one individual to another individual. The previous monetary stance may dominate the economic scene for many months before the new stance begins to assert itself.

Economic Slowdown versus Recession

As a rule, the symptoms of a recession emerge after the central bank tightens its monetary stance (there is a time lag). What determines whether an economy falls into a recession or just suffers an ordinary economic slowdown is the state of the pool of real savings.

As long as this pool is still expanding, a tighter central bank monetary policy will culminate in an economic slowdown. Notwithstanding that various non-wealth-generating activities will now suffer, overall economic growth will be positive, the reason being that there are more wealth generators versus wealth consumers. The expanding pool of real savings reflects this. As long as the pool of real savings is expanding, the central bank and government officials can give the impression that they have the power to undo a recession by means of monetary pumping and artificially lowering interest rates.

In reality, however, these actions only slow or arrest the liquidation of activities that emerged on easy monetary policy, thereby continuing to divert real savings from wealth generators to wealth consumers.

What in fact gives rise to a positive growth rate in economic activity is not monetary pumping but the fact that the pool of real savings is still growing. 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. Once this happens, the economy begins its downward plunge, i.e., falls into a recession.

The most aggressive loosening of money will not reverse the plunge. In fact, rather than reversing the plunge, loose monetary policy will further undermine the flow of real savings and thereby further weaken the structure of production and thus the production of goods and services.

In his writings, Milton Friedman blamed central bank policies for causing the Great Depression of the 1930s. According to Friedman, the Federal Reserve failed to pump enough reserves into the banking system to prevent the collapse in the money stock.2Milton Friedman and Rose Friedman, Free to Choose: A Personal Statement (Orlando, FL: Harcourt, Inc, 1980), p. 85. The collapse in the money stock according to Friedman was the key factor in plunging the economy into economic depression.

For Friedman, the failure of the US central bank was not that it caused the monetary bubble during the 1920s but that it allowed the deflation of the bubble.

An economic depression, however, is not caused by the collapse of the money stock, as suggested by Friedman, but rather by the collapse of the pool of real savings. The shrinkage of this pool is set in motion by the preceding monetary pumping of the central bank and by fractional reserve banking.3Murray N.Rothbard, America’s Great Depression (Kansas City: Universal Press, 1972), p.153. The monetary pumping sets in motion an exchange of nothing for something, i.e., consumption without preceding production—this undermines the pool of real savings.

Moreover, a fall in the pool of real savings triggers declines in bank lending out of “thin air” and thus in the money stock. This in turn implies that previous loose monetary policies cause the fall in the pool of real savings and trigger collapses in economic activity and in the money stock.

Declines in the prices of goods and services follow declines in money supply. Most economists erroneously regard this as bad news that must be countered by central bank policies. However, any attempt to counter price declines by means of loose monetary policies will further undermine the pool of real savings. Furthermore, even if loose monetary policies were to succeed in lifting prices and inflationary expectations, this could not revive the economy while the pool of real savings is declining.

Lastly, it is erroneous to regard a fall in stock prices as causing recessions. The popular theory argues that a fall in stock prices lowers individuals’ wealth, which in turn weakens consumers’ outlays. Since it is held that consumer spending accounts for 66 percent of GDP, this means that a fall in the stock market plunges the economy into a recession.

Again, we hold that it is the pool of real savings and not consumer demand which permits economic growth to take place.

Furthermore, the prices of stocks mirror individuals’ assessments regarding the facts of reality. Because of monetary pumping, these assessments tend to be erroneous. However, once the central bank alters its stance, individuals can see much more clearly what the facts of reality are and scale down previous erroneous evaluations.

While individuals can change their evaluations of the facts, they cannot alter the existing facts, and the latter influence the future course of events.

This article was originally featured at the Ludwig von Mises Institute and is republished with permission.

The Bank of England’s Governor Fears a Liquidity Trap

The Bank of England’s Governor Fears a Liquidity Trap

The global economy is heading towards a “liquidity trap” that could undermine central banks’ efforts to avoid a future recession according to Mark Carney, governor of the Bank of England. In a wide-ranging interview with the Financial Times (January 8, 2020), the outgoing governor warned that central banks were running out of ammunition to combat a downturn:

If there were to be a deeper downturn, more than a conventional recession, then it’s not clear that monetary policy would have sufficient space.

He is of the view that aggressive monetary and fiscal policies will be required to lift the aggregate demand.

What Is a Liquidity Trap?

In the popular framework that originates from the writings of John Maynard Keynes, 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 another individual becomes part of the first individual’s earnings.

Recessions, according to Keynes, are a response to the fact that consumers — for some psychological reasons — have decided to cut down on their expenditure and raise their savings.

For instance, if for some reason people become less confident about the future, they will cut back their outlays and hoard more money. When an individual spends less, this will supposedly worsen the situation of some other individual, who in turn will cut their spending. A vicious cycle sets in. The decline in people’s confidence causes them to spend less and to hoard more money. This lowers economic activity further, causing people to hoard even more, etc.

Following this logic, in order to prevent a recession from getting out of hand, the central bank must lift the growth rate of the money supply and aggressively lower interest rates. Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, reestablishing the circular flow of money, so it is held.

In his writings, however, Keynes suggested that a situation could emerge when an aggressive lowering of interest rates by the central bank would bring rates to such a level from which they would not fall further. As a result, the central bank would not be able to revive the economy. This, according to Keynes, could occur because people might adopt the view that interest rates have bottomed out and that rates should subsequently rise, leading to capital losses on bond holdings.

As a result, people’s demand for money will become extremely high, implying that people would hoard money and refuse to spend it no matter how much the central bank tries to expand the money supply. As Keynes wrote,

There is the possibility, … that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.1

Keynes suggested that once a low–interest rate policy becomes ineffective, authorities should step in and spend. The spending can be on all sorts of projects — what matters here is that a lot of money must be pumped to boost consumers’ confidence. With a higher level of confidence, consumers will lower their savings and raise their expenditure, thereby reestablishing the circular flow of money.

Is There Too Little Spending?

In the Keynesian framework, the ever-expanding monetary flow is the key to economic prosperity. What drives economic growth is monetary expenditure, and when people spend more of their money, it implies that they save less.

Conversely, when people reduce their monetary spending in the Keynesian framework, it is viewed as a sign of increased saving. In this way of thinking, saving is considered bad news for the economy — the more people save, the worse things become. (The liquidity trap comes from too much saving and a lack of spending, so it is held.)

Observe, however, that people do not pay with money but rather with the goods that they have produced. The chief role of money is as a medium of exchange. Hence, the demand for goods is constrained by the production of goods, not the amount of money. (The role of money is to facilitate the exchange of goods.)

To suggest that people could have almost an unlimited demand for money that supposedly leads to a liquidity trap is to suggest that people do not exchange money for goods anymore.

Obviously, this is not a realistic scenario, given the fact that people require goods to support their lives and well-being. People demand money not merely in order to accumulate it but to employ it in exchange.

Money can only assist in exchanging the goods of one producer for the goods of another. The medium of exchange service that it provides has nothing to do with the production of final consumer goods. This means that it has nothing to do with real savings, either.

What permits the increase in the pool of real savings is the increase in capital goods. With more capital goods, i.e., tools and machinery, workers’ ability to produce more goods and of an improved quality is likely to increase. The state of the demand for money cannot alter the amount of final consumer goods produced — only the expansion in the pool of real savings can boost the production of these goods.

Likewise, an increase in the supply of money does not have any power to grow the real economy.

Contrary to popular thinking, a liquidity trap does not emerge in response to a massive increase in consumers’ demand for money but comes as a result of very loose monetary and fiscal policies, which inflict severe damage to the pool of real savings.

The Liquidity Trap and the Shrinking Pool of Real Savings

According to Mises in Human Action,

The sine qua non of any lengthening of the process of production adopted is saving, i.e., an excess of current production over current consumption. Saving is the first step on the way toward improvement of material well-being and toward every further progress on this way.

As long as the growth rate of the pool of real savings stays positive, productive and nonproductive activities can be sustained.

Trouble erupts, however, when, on account of loose monetary and fiscal policies, a structure of production emerges that ties up much more consumer goods than it releases. That is, the consumption of final goods exceeds the production of these goods. The excessive consumption relative to production of consumer goods leads to a decline in the pool of real savings. This in turn weakens the support for individuals that are employed in the various stages of the production structure, resulting in the economy plunging into a slump.

Once the economy falls into a recession due to the falling pool of real savings, any government or central bank attempt to revive the economy must fail. Not only will these attempts fail to revive the economy, they will deplete the pool of real savings further, prolonging the economic slump.

The shrinking pool of real savings exposes the erroneous nature of the commonly accepted view that loose monetary and fiscal policies can grow an economy. The fact that central bank policies become ineffective in reviving the economy is due not to a liquidity trap, but to the decline in the pool of real savings. This decline emerges due to loose monetary and fiscal policies. To stave off personal bankruptcy, individuals are likely to increase their holdings of money — cash becomes king in such a situation.

The ineffectiveness of loose monetary and fiscal policies to generate the illusion that the central authorities can grow an economy has nothing to do with a liquidity trap. The policy ineffectiveness is always relevant whenever the central authorities are attempting to “grow an economy.” The only reason why it appears that these policies “work” is because the pool of real savings is still expanding.

Reprinted from the Mises Institute.

Money, Expectations, and Economic Growth

Money, Expectations, and Economic Growth

In various writings, Milton Friedman argued that there is a variable lag between changes in money supply and its effect on real output and prices. Friedman held that in the short run changes in money supply will be followed by changes in real output. However, in the long run changes in money will only have an effect on prices. This means, according to Friedman, that changes in money with respect to real economic activity tend to be neutral in the long run and non-neutral in the short run.

In the short-run, which may be as much as five or ten years, monetary changes affect primarily output. Over decades, on the other hand, the rate of monetary growth affects primarily prices.

Friedman was of the view that the main reason for the non-neutrality of money in the short run is the variability in the time lag between money and the economy. On this Friedman suggested,

On the average, there is a close relation between changes in the quantity of money and the subsequent course of national income. But economic policy must deal with the individual case, not the average. In any case, there is much slippage. It is precisely this leeway, this looseness in the relation, this lack of mechanical one-to-one correspondence between changes in money and in income that is the primary reason why I have long favoured for the USA a quasi-automatic monetary policy under which the quantity of money would grow at a steady rate of 4 or 5 per cent per year, month-in, month-out.

Friedman held that if the central bank were to follow a constant money growth rule it would eliminate the variability in the time lag. Consequently, money would become neutral in the short run also.

In his Nobel lecture, Robert Lucas raised an issue with this. According to Lucas,

If everyone understands that prices will ultimately increase in proportion to the increase in money, what force stops this from happening right away?

Lucas is of the view that the reason why money generates a real effect in the short run is not so much due to the variability of monetary time lags but more bound up with whether monetary changes are anticipated or not. If monetary growth is anticipated, then people will adjust to it rather quickly and there will not be any real effect on the economy. Only unanticipated monetary expansion can stimulate production. Moreover, according to Lucas,

Unanticipated monetary expansions, on the other hand, can stimulate production as, symmetrically, unanticipated contractions can induce depression.

Both Friedman and Lucas are of the view that it is desirable to make money neutral in order to avoid unstable and therefore unsustainable economic growth.

The current practice of Fed policymakers seems to incorporate the ideas of Friedman and Lucas into the so-called transparent monetary policy framework. This framework accepts Lucas’s view that anticipated monetary policy could lead to economic stability. This framework also accepts that a gradual change in monetary policy in the spirit of Friedman’s constant money growth rule could reinforce the economic stability.

But even if the central bank policymakers could implement it precisely, Friedman’s and Lucas’s framework could not secure stable economic growth.

Money, Expectations, and Economic Growth

According to Robert Lucas, if monetary growth is expected, people will adjust to it rather quickly and there will not be any real effect on the economy. Only unanticipated monetary expansion can stimulate production.

In this way of thinking, anticipated money supply growth is going to result in the corresponding increase in the prices of goods, which is going to offset the increase in money supply.

The price of a good is the amount of money paid for the good. Hence, an increase in money supply implies that more money is going to be spent on goods, all other things being equal. This means that the average price of goods will rise.

Thus, if the money supply increases by 10 percent and as a result monetary outlays on goods increase by 10 percent, this implies that the average price of goods also rises by 10 percent. Consequently, the increase in outlays on goods in real terms is going to be zero, i.e., 10 percent minus 10 percent.

This means that anticipated money growth will not have any real effect on the economy since this increase is going to be offset by the equivalent increase in prices.

For instance, one dollar can buy one loaf of bread. An increase in money supply of 10 percent that is fully anticipated results in the price of the loaf also increasing by 10 percent. As a result, with one dollar and ten cents an individual could secure one loaf of bread — the same quantity as before the 10 percent increase in money supply. No change in real terms.

Even if everyone were to anticipate precisely the money supply growth rate and the corresponding increase in the prices of goods, however, it could not alter the fact that there are always first recipients of the new money and late recipients.

This reality will set in motion the transfer of real wealth from last recipients to the early recipients of money, i.e., an exchange of nothing for something, which in turn lays the foundation for the menace of the boom-bust cycle.

Even if the money was pumped in such a way that everybody got it instantaneously, changes in the demand for money vary. After all, every individual is different from others — there will always be somebody who will spend the newly received money before somebody else does. This, of course, will lead to the redirection of real wealth to the first spender from the last spender.

While the anticipated money supply growth rate does not generate a real effect on the economy, this is not the case with respect to unanticipated money growth.

Now if we begin with the same assumption as before, that one dollar can buy one loaf of bread, an unexpected increase of 10 percent in money supply by does not produce an immediate increase in the price of bread in the short run. The increase in money supply by 10 percent will lift temporarily the people’s holdings of money. Once people decide to spend the money they will discover that, given unchanged prices, their buying power has increased.

If previously our individual had only one dollar now he has one dollar and ten cents. Our individual can now secure 1.1 loaves of bread versus one loaf before the unexpected increase of 10 percent in money supply.

Clearly, what we have here is an increase in the real buying power of individuals of 10 percent — an increase in real demand by 10 percent. This will lead to a 10 percent increase in the production of goods, i.e., demand creates supply — so it is argued by mainstream economists.

While it is possible that the unexpected monetary increase is going to result in stronger economic growth in the short run through the overuse of the existing infrastructure, in the medium to longer term, because of the exchange of nothing for something, the infrastructure will weaken. Hence, we suggest that over time unanticipated money growth will undermine real economic growth via the dilution of the pool of real savings.

It follows that unanticipated monetary growth will eventually weaken the real economy by undermining the pool of real savings.

Thus, both anticipated and unanticipated money supply growth will weaken the pool of real savings, which over time will lead to a weakening in real economic growth, setting in motion economic instability.

In fact, Milton Friedman’s constant money growth rule cannot make money neutral, since the constant money growth rule is about increases in money supply, although at a constant rate. In Friedman’s framework we will still have an exchange of nothing for something, and therefore boom-bust cycles and economic instability.

What is required for economic growth is a growing pool of real savings, which supports various individuals engaged in the enhancement and the maintenance of the capital infrastructure.

We can thus conclude that neither Friedman’s constant money growth rule nor people’s perfect anticipation of money growth can eliminate boom-bust cycles and establish economic stability.

To make money truly neutral with respect to the real economy it is necessary to close all the loopholes for the generation of money out of “thin air”. The major loopholes are the central bank’s asset purchasing and fractional reserve banking.

Reprinted from the Mises Institute.

Good Economic Theory Focuses on Explanation, Not Prediction

Good Economic Theory Focuses on Explanation, Not Prediction

In order to establish the state of the economy, economists employ various theories. Yet what are the criteria for how they decide whether the theory employed is helpful in ascertaining the facts of reality?

According to the popular way of thinking, our knowledge of the world of economics is elusive — it is not possible to ascertain how the world of economics really works. Hence, it is held that the criterion for the selection of a theory should be its predictive power.

So long as the theory “works,” it is regarded as a valid framework as far as the assessment of an economy is concerned. Once the theory breaks down, the search for a new theory begins.

For instance, an economist forms the view that consumer outlays on goods and services are determined by disposable income. Once this view is validated by means of statistical methods, it is employed as a tool in assessments of the future direction of consumer spending. If the theory fails to produce accurate forecasts, it is either replaced or modified by adding some other explanatory variables.

Again, in this way of thinking, the tentative nature of theories implies that our knowledge of the world of economics is elusive. Since it is not possible to establish “how things really work,” then it does not really matter what the underlying assumptions of a theory are. In fact, anything goes as long as the theory can yield good predictions. According to Milton Friedman,

The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximation for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.1

The popular view that sets predictive capability as the criterion for accepting a theory is questionable.

We can say confidently that, all other things being equal, an increase in the demand for bread will raise its price. This conclusion is true, and not tentative. Will the price of bread go up tomorrow, or sometime in the future? This cannot be established by the theory of supply and demand. Should we then dismiss this theory as useless because it cannot predict the future price of bread? According to Mises,

Economics can predict the effects to be expected from resorting to definite measures of economic policies. It can answer the question whether a definite policy is able to attain the ends aimed at and, if the answer is in the negative, what its real effects will be. But, of course, this prediction can be only “qualitative.”2

Do We Know Something about Ourselves?

Economic theory should be able to explain economic activity. However, statistical methods are of no help in this regard. All that the various statistical methods can do is compare the movements of various historical pieces of information. These methods cannot identify the driving forces of economic activity. Contrary to popular thinking, economics is not about gross domestic product (GDP), the consumer price index (CPI), or other economic indicators as such, but about human beings who interact with each other. It is about activities that seek to promote people’s lives and well-being.

One can observe that people are engaged in a variety of activities. For instance, one can observe that people are performing manual work, that they drive cars, and that they walk on the street and dine in restaurants. The distinguishing characteristic of these activities is that they are all purposeful.

Thus, manual work may be a means for some people to earn money, which in turn enables them to achieve various goals such as buying food or clothing. Dining in a restaurant could be a means to establishing business relationships. Driving a car could be a means for reaching a particular destination. People operate within a framework of means and ends — they are using various means to secure ends.

Purposeful action implies that people assess or evaluate various means at their disposal against their ends. At any point in time, people have an abundance of ends that they would like to achieve. What limits the attainment of various ends is the scarcity of means. Hence, once more means become available, a greater number of ends, or goals, can be accommodated — i.e., people’s living standards will increase.

Another limitation on reaching various goals is the availability of suitable means. Thus, to quell my thirst in the desert, I require water. Diamonds in my possession will be of no help in this regard.

The fact that people consciously pursue purposeful actions provides us with definite knowledge, which is always valid as far as human beings are concerned. This knowledge creates the base for a coherent framework that permits a meaningful assessment of the state of an economy.

For instance, during an economic slump, a general fall in the demand for goods and services is observed. Are we then to conclude that the fall in the demand is the cause of an economic recession?

We know that people persistently strive to improve their lives and well-being, hence their demand for goods and services is likely to be rising and not declining. Consequently, the decline in general demand is a result of people’s inability to support their demand. Problems on the production side are the likely causes of an observed general fall in demand. Once we have established that the likely causes of the economic slump are associated with supply factors, we can proceed to assess the possible reasons behind this.

The knowledge that people are acting purposefully also permits us to evaluate the popular theory that the “motor” of an economy is consumer spending — i.e., demand creates supply. We know, however, that without means, no goals can be met. However, means do not emerge out of “the blue” — they must be produced first. Hence, contrary to the popular thinking, the driving force is supply, not demand.

Or, for example, to counter an emerging economic slump, various experts urge the central bank to increase the pace of monetary pumping. By means of an increase in the money supply growth rate it is held that individuals’ well-being is going to be protected. Money, however, does not promote real wealth generation as it can only fulfill the role of the medium of the exchange. On the contrary, an increase in the supply of money will undermine the wealth generation process and will set in motion the menace of the boom-bust cycle.

The fact that man pursues purposeful actions implies that causes in the world of economics emanate from human beings and not from outside factors. Thus, contrary to popular thinking, individual outlays of goods are not caused by real income as such. In his own unique context, every individual decides how much of a given income will be used for consumption and how much for investment. While it is true that people will respond to changes in their incomes, the response is not automatic. Every individual assesses the increase in income against the particular set of goals he wants to achieve. He might decide that it is more beneficial to raise his investment in financial assets than to raise his consumption.

One example that Mises liked to use in his class to demonstrate the difference between two fundamental ways of approaching human behavior was to look at Grand Central Station behavior during rush hour. The “objective” or “truly scientific” behaviorist, he pointed out, would observe the empirical events, e.g., people rushing back and forth aimlessly at certain predictable times of day. And that is all he would know. But the true student of human action would start from the fact that all human behavior is purposive, and he would see that the purpose is to get from home to the train, to work in the morning, the opposite at night, etc. It is obvious which of them would discover and know more about human behavior, and therefore which one would be the genuine “scientist”3

Reprinted from the Mises Institute

More Money Pumping Won’t Make Us Richer

More Money Pumping Won’t Make Us Richer

Whenever a central bank introduces easy monetary policy, as a rule this leads to an economic boom — or economic prosperity. At least this is what most commentators hold. If this is however the case then it means that an easy monetary policy can grow an economy.

But loose monetary policies do not generate economic growth. These policies set in motion the diversion of real savings from wealth generators to the holders of the newly pumped money. Real savings, rather than supporting individuals that specialize in the enhancement and expansion of the infrastructure are consumed by various individuals that are employed in non-wealth generating activities.

Moreover, not all consumption is a good thing. The consumption of real savings by individuals engaged in the enhancements and the expansion of the infrastructure is productive consumption. Conversely, the consumption of real savings by individuals that are employed in non-wealth generating activities is non-productive consumption.

It is non-productive consumption that sets the foundation for the weakening of the existing infrastructure thereby weakening future economic growth. In contrast, productive consumption sets the foundation for a better infrastructure, which permits stronger future economic growth. Needless to say, productive consumption leads to the increase in individuals living standards while non-productive consumption results in the lowering of living standards.

Why then is loose monetary policy seen as a major contributor towards economic growth?

Given that economic growth is assessed by means of the gross domestic product (GDP) framework — which is nothing more than a monetary turnover — obviously then when the central bank embarks on monetary pumping (i.e., loose monetary policy) it strengthens the monetary turnover in the economy and thus GDP.

After deflating the monetary turnover by a dubious price deflator one obtains the so-called real GDP. By means of real GDP, economists and various other experts are supposedly in a position to ascertain the state of economic growth, or so it is held. (Note that the increase in the monetary turnover because of the increase in the money supply is regarded as reflecting economic growth). In such a framework, it is not surprising that central bank policies are an important factor in setting in motion an economic boom.

From this, economists and various other experts conclude that the central bank by being able to grow the economy can also make sure that the economy follows the correct growth path. (The growth path as outlined by policy makers of the central bank).

Whenever the economy deviates from the path outlined by central bank policy makers and the government, this will allow them the opportunity to intervene by either raising or slowing the pace of monetary pumping.

The economy in this way of thinking is depicted as a helpless creature that must be guided by the all-knowing bureaucrats all the time. The passivity of the creature called the economy is also reflected by the fact that the output generated must be distributed by the all-knowing bureaucrats. In fact, one gets the impression that bureaucrats supervise the entire production process and individuals are just submissive entities that have hardly anything to say here.

If loose monetary policies of the central bank are able to generate through the GDP statistic so-called economic growth, then this must mean that a tighter monetary stance sets an economic bust.

“Economic bust” is here associated with the liquidation of various non wealth-generating activities. That is, the economic bust results in the curtailment of non-productive consumption.

Note that an important vehicle in setting the boom-bust cycle is the existence of the fractional reserve banking, which through the expansion of money out of thin air sets an economic boom while through the contraction of money out of thin air sets an economic bust.

Observe that in fractional reserve banking an expansion of money out of thin air emerges because of the ownerless lending. Consequently, when banks curtail the ownerless lending this leads to the contraction of money out of thin air.

Can Government Policies Grow the Economy?

While loose monetary policy, which results in an exchange of nothing for something, cannot cause economic growth, can the same be said about an increase in government outlays? Will this not result in a strengthening in economic growth?

Given that in the GDP framework one of the components is government outlays, obviously then once there is an increase in these outlays, all other things being equal, we will have an increase in the GDP and thus in so-called economic growth.

But if the government is not a wealth generating entity, how can an increase in government outlays grow the economy? Various individuals who are employed by the government expect compensation for their work. Note that the government can pay these individuals by taxing others who are still generating real wealth. By doing this, the government weakens the wealth-generating process and undermines prospects for economic growth. (We ignore here borrowings from foreigners).

Now, fiscal stimulus could “work” if the flow of real savings is large enough to fund government activities while still permitting a positive growth rate in the activities of the private sector. (Note that the overall increase in real economic activity is in this case erroneously attributed to the government’s loose fiscal policy).

If, however, the flow of real savings is declining, then regardless of any increase in government outlays, overall real economic activity cannot be expanded. In this case the more the government spends (i.e., the more it takes from wealth generators) the more it weakens prospects for a recovery.

Thus when government by means of taxes diverts bread to its own activities the baker will have less bread at his disposal. Consequently, the baker will not be able to secure the services of the oven maker. As a result, it will not be possible to boost the production of bread, all other things being equal.

As the pace of government spending increases a situation could emerge that the baker will not have enough bread to even maintain the workability of the existing oven. (The baker will not have enough bread to pay for the services of a technician to maintain the existing oven). Consequently, his production of bread will actually decline.

Similarly, as a result of the increase in government outlays other wealth generators will have less real savings at their disposal. This in turn will hamper the production of their goods and services and in turn will retard and not promote overall real economic growth.

As one can see, the increase in government outlays will lead to the weakening in the process of wealth generation in general.

Many commentators are of the view that lowering of taxes could be an important catalyst for the strengthening of economic growth. This could be so if the government also curtails its outlays. It must be realized that as long as government outlays continue to grow no effective cut in taxes is possible. Remember that the expansion in government outlays implies an increase in the diversion of real savings from wealth generators to government. Hence, an effective cut in taxes can only emerge once the government curtails its outlays.

For instance, government announces that it will cut the income tax by 5% at the same time it outlays are planned to increase by 10%. What matters here is that the government will require to increase the diversion of real savings by 10% in order to support the increase in its activities.

It does not matter how the government is going to collect the required real savings – it can be by means of various forms of indirect taxes or by means of borrowings or by means of money pumping. The essence in all this is that once the government requires more real savings it will get it from the private wealth generating sector. Hence in this case rather than having a tax cut what we have here is an effective increase in the tax burden because of the increase in government outlays.


Neither loose monetary policy, nor big-spending fiscal policy cannot grow an economy. All that these policies can do is to redistribute a given pool of real savings from wealth generators towards non-wealth generating activities. Hence, we can conclude that both loose monetary and fiscal policies cannot set in motion an economic boom but rather an economic impoverishment.

Reprinted with permission from the Mises Institute.

Myth: Gold Makes Boom-Bust Cycles Worse

Myth: Gold Makes Boom-Bust Cycles Worse

According to some commentators on the gold standard, an increase in the supply of gold generates similar distortions as money out of “thin air” does.
Let us start with a barter economy. John the miner produces ten ounces of gold. The reason why he mines gold is because he believes there is a market for it. Gold contributes to the well-being of individuals.
He exchanges his ten ounces of gold for various goods such as potatoes and tomatoes.
Now people have discovered that gold apart from being useful in making jewelry is also useful for some other applications.
They now assign a much greater exchange value to gold than before. As a result, John the miner could exchange his ten ounces of gold for more potatoes and tomatoes.
Should we condemn this as bad news because John is now diverting more resources to himself? This however, is just what is happening all the time in the market.
As time goes by people assign greater importance to some goods and diminish the importance of some other goods. Some goods now then considered as more important than other goods in supporting people’s life and well-being.
Now people have discovered that gold is useful for another use, such as the medium of the exchange. Consequently, they lift further the price of gold in terms of tomatoes and potatoes. Gold is now predominantly demanded as a medium of exchange — the demand for the other uses of gold, such as for ornaments is now much lower than before.
Let us see what is going to happen if John were to increase the production of gold. The benefit that gold now supplies people is by providing the services of the medium of the exchange. In this sense, it is a part of the pool of real wealth and promotes people’s life and well-being.
One of the attributes for selecting gold as the medium of exchange is that it is relatively scarce. This means that a producer of a good who has exchanged this good for gold expects the purchasing power of his effort to be preserved over time by holding gold.
If for some reason there is a large increase in the production of gold and this trend were to persist, the exchange value of the gold would be subject to a persistent decline versus other goods, all other things being equal. Within such conditions, people are likely to abandon gold as the medium of the exchange and look for another commodity to fulfill this role.
As the supply of gold starts to increase its role as the medium of exchange diminishes while the demand for it for some other usages is likely to be retained or increase.
Therefore, in this sense the increase in the production of gold is not a waste and adds to the pool of real wealth. When John the miner exchanges gold for goods, he is engaged in an exchange of something for something. He is exchanging wealth for wealth.
Contrast all this with the printing of gold receipts, i.e., receipts that are not backed 100% by gold. This is an act of fraud, which is what inflation is all about, it sets a platform for consumption without contributing to the pool of real wealth. Empty certificates set in motion an exchange of nothing for something, which in turn leads to boom-bust cycles.
The printing of unbacked gold certificates divert real savings from wealth generating activities to the holders of unbacked certificates. This leads to the so-called economic boom.
The diversion of real savings is done by means of unbacked certificates, i.e., unbacked money. Once the printing of unbacked money slows down or stops all together this stops the flow of real savings to various activities that emerged on the back of unbacked money.
As a result, these activities fall apart — an economic bust emerges. (Note that these activities do not produce real wealth, they only consume. Obviously then without the unbacked money, which diverts real savings to them, they are in trouble. These activities did not produce any wealth hence without money given to them they cannot secure the goods they want.)
In the case of the increase in the supply of gold, no fraud is committed here. The supplier of gold — the gold mine — has increased the production of a useful commodity. Therefore, in this sense we do not have here an exchange of nothing for something. Consequently, we also do not have an emergence of bubble activities. Again, the wealth producer, because of the fact that he has produced something useful, can exchange it for other goods. He does not require empty money to divert real wealth to him.
Note that a major factor for the emergence of a boom is the injections into the economy of money out of “thin air.” The disappearance of money out of “thin air” is the major cause of an economic bust. The injection of money out of “thin air” generates bubble activities while the disappearance of money out of “thin air” destroys these bubble activities.
On the gold standard, this cannot take place. On a pure gold standard without a central bank, money is gold. Consequently, on the gold standard money cannot disappear since gold cannot disappear.
We can thus conclude that the gold standard, if not abused, is not conducive to boom-bust cycles.
Reprinted from
Myth: Gold Makes Boom-Bust Cycles Worse

Should the Fed Print More Money When "Demand for Money" Rises?

For most economists and commentators the main role of the Fed is to keep the supply and demand for money in equilibrium. Whenever an increase in the demand for money occurs — in order to maintain the state of equilibrium — it is held that the Fed must increase the money supply as a necessary action in order to keep the economy on a path of economic and price stability.
The accommodation of the increase in the demand for money is not considered as money printing and therefore not harmful to the economy. That is,  this sort of  increase, it is held, does not set in motion the boom-bust cycle as long as the growth rate of money supply does not exceed the growth rate in the demand for money.
Note that by this way of thinking, since the growth rate in the demand for money is offset by the growth rate of the supply of money, then no effective increase in the supply of money occurs. From this perspective, no harm is inflicted on the economy.

Why Accommodating Demand for Money Is Always Harmful

What do we mean by demand for money? In addition, how does this demand differs from the demand for goods and services?
The demand for a good does not reflect the demand for a particular good as such, but the demand for the services that the good offers. For instance, an individual demands food because this provides the necessary elements that sustain his life and wellbeing. Demand here means that people want to consume the food in order to secure the necessary elements that sustain their life and wellbeing.
The demand for money arises because of the services that money provides. However, instead of consuming money people demand money in order to exchange it for goods and services.
With the help of money, various goods become more marketable — they can secure more goods than in the barter economy. What enables this is the fact that money is the most marketable commodity.
An increase in the general demand for money, let us say, on account of a general increase in the production of goods, doesn’t imply that individuals’ sit on the money and do nothing with it.
The key reason an individual demand’s money is in order to be able to exchange money for other goods and services. So in this sense an increase in the supply of money is not going to be neutralized by a corresponding increase in the demand for money, as will be the case with various goods.
An increase in the supply of apples is neutralized by the increase in the demand for apples i.e. people want to consume more apples. For instance, the supply of apples, which increased by 5%, is absorbed by the increase in the demand for apples by 5%. The same cannot however, be said with regard to the increase in the supply of money, which has taken place in response to the same increase in the demand for money.

Money Isn’t Like Other Goods

We have seen that contrary to other goods, an increase in the demand for money implies an increase in the employment of money to facilitate transactions. This means that an increase in the demand for money by 5% is not going to neutralize an increase in the supply of money by 5%. The increase in the demand by 5% implies that people’s demand for the services of money has increased by 5%.
An increase in the supply of money, in response to an increase in the demand for money, does not imply that its effect on the economy will be neutral. Consequently, any increase in the supply of money out of “thin air” is going to set in motion all the negatives that an increase in money out of “thin air” does.

There Is Always Enough Money

Again, irrespective of whether the total demand for money is rising or falling what matters is that individuals employ money in their transactions.
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, it is futile to accommodate the increase in the demand for money by the increase in the supply. An increase in the demand for money does not require an increase in the supply as is the case with respect to other goods.
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.1

It is held that if the Fed accommodates an increase in the demand for money this accommodation should not be regarded as an increase in the supply of money as such. But in practice, this accommodation, like any other accommodation by the Fed, results in the increase in money supply out of “thin air.” All other things being equal, this leads to an exchange of nothing for something that sets in motion the menace of the boom-bust cycle.

  • 1. Ludwig von Mises, Human Action, 3rd rev. ed. (Chicago: Contemporary Books, 1966), p.421.

Retrieved from

The Connection Between Money-Supply Growth and Inflation

The Connection Between Money-Supply Growth and Inflation

In the article “Rapid money supply growth does not cause inflation” written by Richard Vague at the Institute for New Economic Thinking, December 2, 2016, the author argues that empirical evidence shows that increases in money supply has nothing to do with inflation. According to Vague,

Monetarist theory, which came to dominate economic thinking in the 1980s and the decades that followed, holds that rapid money supply growth is the cause of inflation. The theory, however, fails an actual test of the available evidence. In our review of 47 countries, generally from 1960 forward, we found that more often than not high inflation does not follow rapid money supply growth, and in contrast to this, high inflation has occurred frequently when it has not been preceded by rapid money supply growth.

Now Vague defines inflation as, three or five consecutive years of increases in the consumer price index (CPI) of 5% or more. Based on this he has concluded that an increase in the money supply does not cause inflation.

The main problem here is that inflation is not changes in prices but rather changes in money supply. The fact that Vague could not find strong correlation between increases in money supply M2 and changes in the CPI does not prove much.

To begin with the price of a good is the amount of dollars paid for the good. If the growth rate of money is 5% and the growth rate of goods is also 5% then there will not be any increase in the prices of goods. If one were to follow that inflation is the increase in the CPI then one will conclude that despite the increase in money supply by 5% inflation is 0%.

However, if we were to follow the definition that inflation is about increases in the money supply then we will conclude that inflation is 5%.

So how are we to decide about the correct definition of inflation? Is it about increases in the money supply or increases in prices?

The Essence of Inflation

The purpose of a definition is to present the essence, the distinguishing characteristic of the subject we are trying to identify. A definition is to tell us what the fundamentals of a particular entity are. To define a thing we need to go to the origin of how it has emerged.

Historically inflation originated when a country’s ruler such as the king would force his citizens to give him all their gold coins under the pretext that a new gold coin was going to replace the old one. In the process the king would falsify the content of the gold coins by mixing it with some other metal and return diluted gold coins to the citizens. On this Rothbard wrote,

More characteristically, the mint melted and recoined all the coins of the realm, giving the subjects back the same number of “pounds” or “marks,” but of a lighter weight. The leftover ounces of gold or silver were pocketed by the King and used to pay his expenses.

On account of the dilution of the gold coins, the ruler could now mint a greater amount of coins and pocket for his own use the extra coins minted. What was now passing as a pure gold coin was in fact a diluted gold coin.

The increase in the number of coins brought about by the dilution of gold coins is what inflation is all about.

Note that what we have here is an inflation of coins, i.e., an expansion of coins. As a result of inflation, the ruler can engage in an exchange of nothing for something (he can engage in an act of diverting resources from citizens to himself).

Under the gold standard, the technique of abusing the medium of exchange became much more advanced through the issuance of paper money un-backed by gold. Inflation therefore means an increase in the amount of receipts for gold on account of receipts that are not backed by gold yet masquerade as the true representatives of money proper, gold.

The holder of un-backed receipts can now engage in an exchange of nothing for something. What we have is a situation where the issuers of the un-backed paper receipts divert real goods to themselves without making any contribution to the production of goods.

In the modern world money proper is no longer gold but rather paper money; hence inflation in this case is an increase in the stock of paper money.

Observe that we don’t say as monetarists are saying that the increase in the money supply causes inflation. What we are saying is that inflation is the increase in the money supply.

If we were to accept that inflation is increases in the money supply then we will reach the conclusion that inflation results in the diversion of real wealth from wealth generators toward the holders of newly printed money. We will also reach the conclusion that monetary pumping, i.e., inflation is bad news for the wealth generating process. No empirical study is required to confirm or to refute this.

As we have shown in the example at the beginning increases in the money supply need not always to be followed by general increases in prices. Prices are determined by both real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. In other words, while money growth is buoyant, prices might display low increases.

Reprinted with permission from the Ludwig von Mises Institute.

Myth: Gold Makes Boom-Bust Cycles Worse

What Is the “Correct” Growth Rate of the Money Supply?

Most economists believe that a growing economy requires a growing money stock, on grounds that growth gives rise to a greater demand for money, which must be accommodated.

Failing to do so, it is maintained, will lead to a decline in the prices of goods and services, which in turn will destabilize the economy and lead to an economic recession or, even worse, depression.

Since growth in money supply is of such importance, it is not surprising that economists are continuously searching for the right, or the optimum, growth rate of the money supply.

Some economists who are the followers of Milton Friedman — also known as monetarists — want the central bank to target the money supply growth rate to a fixed percentage. They hold that if this percentage is maintained over a prolonged period of time it will usher in an era of economic stability.

The idea that money must grow in order to sustain economic growth gives the impression that money somehow sustains economic activity.

But, 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.”1

What Is Money For?

Money’s main job is simply to fulfill the role of the medium of exchange. Money doesn’t sustain or fund real economic activity. The means of sustenance, or funding, is provided by saved real goods and services. By fulfilling its role as a medium of exchange, money just facilitates the flow of goods and services between producers and consumers.

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.”2

Through the ongoing process of selection over thousands of years, people settled on gold as their preferred general medium of exchange.

Most mainstream 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 as a result of growing economies, the supply of gold is not adequate.

Furthermore, if one takes into the account the fact that a large portion of gold mined is used for jewelry, this leaves the stock of money almost unchanged over long periods of time.

It is argued that the free market, by failing to provide enough gold, will cause money supply shortages. This, in turn, runs the risk of destabilizing the economy. It is for this reason that most economists, even those who express sympathy toward the idea of a free market, endorse the view that the money supply must be controlled by the government.

What Do We Mean by Demand for Money?

When we talk about demand for money, what we really mean is the demand for money’s purchasing power. After all, people don’t want a greater amount of money in their pockets so much as they want greater purchasing power in their possession. On this Mises wrote,

“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.”3

In a free market, in similarity to other goods, the price of money is determined by supply and demand.

Consequently, if there is less money, its exchange value will increase. Conversely, the exchange value will fall when there is more money.

Within the framework of a free market, there cannot be such a 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 an optimum rate of growth 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.”

However, how can we be sure that the supply of a selected commodity as money will not start to rapidly expand because of unforeseen events? Would it not undermine people’s well-being?

If this were to happen, then people would probably abandon this commodity and settle on some other commodity. Individuals who are striving to preserve their lives and well-being will not choose a commodity that is subject to a steady decline in its purchasing power as money.

This is the essence of the market selection process and the reason why it took several thousand years for gold to be chosen as the most marketable commodity.

The prolonged market selection process raises the likelihood that gold is the most suitable commodity to fulfill the role of money.

But even if we were to agree that the world under the gold standard would have been a much better place to live than under the present monetary system, surely we must be practical and come up with solutions that are in tune with contemporary reality. Namely, that in the world in which we presently live, we do have central banks, and we are not on the gold standard. Given these facts, what then should be the correct money supply growth rate?

It is not possible, however, to devise a scheme for a “correct” money growth rate while central authorities have coercively displaced the market-selected money with paper money. Here is why.

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 gold stored with the banks. Holders of paper certificates could convert them into gold whenever they deemed necessary. Because people 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. In a free-market economy, a bank that over-issues paper certificates will quickly find out that the exchange value of its certificates in terms of goods and services will fall.

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 would bankrupt the bank. In a free, competitive market then, the threat of bankruptcy would restrain banks from issuing paper certificates unbacked by gold. On this Mises wrote,

“People often refer to the dictum of an anonymous American quoted by Tooke: “Free trade in banking is free trade in swindling.” However, freedom in the issuance of banknotes would have narrowed down the use of banknotes considerably if it had not entirely suppressed it. It was this idea which Cernuschi advanced in the hearings of the French Banking Inquiry on October 24, 1865: ‘I believe that what is called freedom of banking would result in a total suppression of banknotes in France. I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer.'”

This means that in a free-market economy, paper money cannot assume a “life of its own” and become independent of commodity money.

The government can, however, bypass this free-market discipline. It can issue a decree that makes it legal for the over-issued bank not to redeem paper certificates into gold.

Once banks are not obliged to redeem paper certificates into gold, opportunities for large profits are created that set incentives to pursue an unrestrained expansion of the supply of paper certificates.4

This uncurbed expansion of paper certificates raises the likelihood of setting off a galloping rise in the prices of goods and services that can lead to the breakdown of the market economy.

Why We “Need” Central Banks

To prevent such a breakdown, the supply of the paper money must be managed. The main purpose of managing the supply is to prevent various competing banks from over-issuing paper certificates and from bankrupting each other.

This can be achieved by establishing a monopoly bank — i.e., a central bank that manages the supply of paper money.

According to Hans-Hermann Hoppe, “If one is to succeed in replacing commodity money by fiat money, then, an additional requirement must be fulfilled: Free entry into the note-production business must be restricted, and a money monopoly must be established.”

To assert its authority, the central bank introduces its paper certificates, which replace the certificates of various banks. (The central bank’s money purchasing power is established on account of the fact that various paper certificates, which carry purchasing power, are exchanged for the central bank money at a fixed rate. The central bank paper certificates are fully backed by banks’ certificates, which have the historical link to gold.)

The central bank paper money, which is declared as legal tender, also serves as a reserve asset 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 loans.

It would then appear that the central bank can manage and stabilize the monetary system. The truth, however, is the exact opposite. To manage the system, the central bank must constantly create money “out of thin air” to prevent banks from bankrupting each other.

This leads to persistent declines in money’s purchasing power, which destabilizes the entire monetary system. This tendency to destabilize the system is also reinforced by the fact that a money monopolist naturally has the incentive to look after his own interest.

According to Hoppe,

“He can print notes at practically zero cost and then turn around and purchase real assets (consumer or producer goods) or use them for the repayment of real debts. The real wealth of the non-bank public will be reduced-they own less goods and more money of lower purchasing power. However, the monopolist’s real wealth will increase-he owns more non-money goods (and he always has as much money as he wants). Who, in this situation, except angels, would not engage in a steady expansion of the money supply and hence in a continuous depreciation of the currency?”

Observe that while, in the free market, people will not accept a commodity as money if its purchasing power is subject to a persistent decline, in the present environment central banking authorities are coercively imposing money that suffers from a steady decline in its purchasing power.

Since the present monetary system is fundamentally unstable, the central bank is compelled to print money out of thin air to prevent the collapse of the system. It doesn’t really matter what scheme the central bank adopts as far as monetary injections are concerned — they can print money directly or they can act in the money markets to target interest rates, as is now more frequently the case. Regardless of the mode of monetary injections, the boom-bust cycles will become more ferocious as time goes by.

Even Milton Friedman’s scheme to fix the money growth rate at a given percentage won’t 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 cycle.

But what about removing the central bank altogether and keeping the current stock of paper money unchanged? Would that not do the trick?

No, it would not.

An unchanged money stock will cause an almost immediate 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.

It is therefore not surprising that the central bank must always resort to large monetary injections when there is a threat from various political or economic shocks.

Observe that the same fate is likely with other schemes. The only difference, of course, is that with these other schemes it may take some time before the final breakdown occurs.

How long the central bank can keep the present system going is dependent upon the state of the pool of real wealth. As long as this pool is still growing, the central bank is likely to succeed in keeping the system alive. Once the real pool of wealth begins to stagnate — or, even worse, shrink — then no amount of monetary pumping will be able to prevent the implosion of the system.

In a true free market, if people raised their demand for gold as a result of a major upheaval, this would lift money’s purchasing power, and that would be about it; no further disruptions would emerge. The monetary system would remain intact. Also, as opposed to the present monetary system, in a true free market money can’t disappear and set in motion the menace of the boom-bust cycle.

In fractional reserve banking, when money is repaid and the bank doesn’t renew the loan, money evaporates. Because the loan has originated out of nothing, it obviously couldn’t have had an owner. In a free market, in contrast, when the gold is repaid, it is passed back to the original lender; the money stock stays intact.

The only way to make the system truly stable is to permit the free market to take over. In a truly free market there is no need to be concerned with the issue of the “correct” rate of money supply growth and no institution is required to regulate the supply of money.

  • 1.Murray N. Rothbard, Man, Economy and State (Los Angeles: Nash Publishing, 1970), p. 670.
  • 2.Ludwig von Mises, The Theory of Money and Credit (Irvington-on-Hudson, N.Y: The Foundation of Economic Education, 1971), pp. 32–33.
  • 3.Ludwig von Mises, Human Action, 3rd rev. ed. (Chicago: Contemporary Books, 1966), p. 421.
  • 4.Hans-Hermann Hoppe, “How is Fiat Money Possible?-or, The Devoluton of Money and Credit,” The Review of Austrian Economics 7, no. 2 (1994): 49–74.

Republished from the Mises Institute.

How the Fed Operates — And Why It’s a Problem

How the Fed Operates — And Why It’s a Problem

We are often asked about the mechanisms by which the US Federal Reserve Board (the Fed) influences the level of US interest rates and whether these mechanisms also influence the level of the US money supply. It has long been regarded that the Fed no longer inflates and contracts the money supply but rather simply acts to target interest rates. The purpose of this brief paper is to clarify how the Fed works and the impact that its operations have on the money supply.

The main market through which the Fed adjusts interest rates is the federal funds market. The federal funds market is, as the name implies, the market for federal funds. But what are federal funds?

Depository institutions such as commercial banks keep a portion of money that is deposited with them with the Federal Reserve banks. The money that commercial banks keep with the Fed is also labeled as reserves.

Banks require reserves in order to meet their reserve requirements and in order to be able to clear financial transactions. When checks written against a bank are presented, the bank must have the money to honor those checks.

On any particular day there are some banks that have more reserves than they require, i.e., they have excess reserves. Conversely, there are banks that have far too little reserves, i.e., they have deficiency of reserves.

The existence of excess and deficiency of reserves among various depository institutions sets a platform for a market for these reserves, which are also labeled as federal funds.

The interest rate charged for the use of federal funds is called the federal funds rate. This is the rate applied to short-term lending — mostly overnight loans.

The main vehicle that the US central bank employs to influence the quantity of money in the economy is the purchase and sale of assets. In the present set-up though, the Fed is not attempting to directly influence the money supply through the buying and selling of assets in the open market.

Rather, the US central bank aims at bringing the Federal funds rate to a particular level, or target, which it believes will enable it to achieve stable, non-inflationary economic growth.

Once the target is set it is the role of the Federal Open Market Desk to make sure that the target is maintained on a daily basis.

As a rule, once the target is announced the market tends to bring the interest rate toward the target in anticipation that the Fed will be successful in achieving the goal.

To succeed in keeping the rate at the target the Fed’s Open Market Desk monitors various factors that have the potential to disrupt the balance between the supply of and the demand for Federal funds.

Once these disruptive factors are identified, Fed operators counter them by means of buying or selling assets in the market.

Several factors have significant potential to act as major disrupters in this context.

Treasury Activity

The first of these is the activity of the US Treasury, which has an account with the Federal Reserve in which it maintains working balances for making and receiving various government payments.

When, for instance, individuals pay taxes to the Treasury this results in an increase in the Treasury account with the Fed. At the same time, however, this lowers reserve balances of depository institutions at the Fed by the amount of tax money paid to the Treasury (as these moneys are withdrawn from the commercial banks by taxpayers). Hence, what we see is a decline in the supply of Federal funds.

This fall in the supply of reserves, or the supply of Federal funds, all other things being equal, puts upward pressure on the Federal funds interest rate. Consequently, the Federal funds rate in the market will, in the absence of Fed intervention, tend to rise above its target. In order to keep the Federal funds rate at the target level the central bank is compelled to act in the market by buying assets such as Treasury securities.

Note that this payment of taxes causes a temporary decline in the supply of reserves in the Fed funds market. This decline in reserves however does not have any effect on the money supply. When a taxpayer pays $1,000 in tax to the Treasury his money, i.e., $1,000, is transferred to the Treasury — there is no change in the money supply. Yet the Fed, in order to protect its rate target in the face of money leaving the fed funds market, is adding new money.

Hence, the collection of taxes by the Treasury results in an increase in the money supply as the Fed intervenes to maintain the Fed funds rate target.

Conversely, when the Treasury spends the money — i.e., its deposits with the Fed decline — this raises commercial banks’ reserves and thus raises the supply of Federal funds. As a result, for a given demand this puts downward pressure on the Fed funds rate.

To prevent the Fed funds rate from falling below its target the central bank will initiate sales of assets, thereby removing money from the economy.

Changes in Demand for Cash

A second potential disrupter of the Fed funds target rate is changes in the demand for cash.

If individuals’ demand for cash increases then banks’ reserves held with the Fed are reduced.

Although this, of itself, does not change the money supply (as money simply leaves the banks and sits in the pockets of individuals) the reduced level of funds in the Federal funds market leads, all other things being equal, to upward pressure on the Fed’s target interest rate.

In response to this upward pressure the Fed is forced to pump money by buying assets.

An increase in the demand for cash therefore results in an increase in the money supply occasioned by monetary pumping (i.e., asset purchases in the open market) by the central bank.

Conversely, if individuals’ demand for cash falls, all other things being equal, the Fed is compelled to take money from the economy by selling assets in order to prevent the Federal funds rate from falling below the target level.

Strong Economic Activity and Crises

A third source of potential disruption to the Fed’s policy target rate is the situation of a strengthening in economic activity — for example, due to the expansionary business cycle impact of past loose monetary policy. The strengthening in banks’ lending as a result of the cyclical boom, and the consequent increase in demand deposits, now require more reserves, which in turn leads to a strengthening in demand for Federal funds.

In this situation the Fed needs to intervene to prevent the Fed funds rate from increasing, and it does so by buying assets — i.e., by inflating the money supply.

In addition, in times of economic crisis the chase for liquidity by financial institutions can put strong upward pressure on the fed funds rate. In this case, in order to prevent the rate from rising sharply above target, the Federal Reserve initiates significant buying of assets — it boosts the supply of federal funds in line with the strong increase in the demand.

Once again, the maintenance of the target rate requires the Fed to intervene and thereby inflate the money supply.

Note that once the interest rate target is set, absent some change in the supply of or demand for fed funds, any monetary pumping by the Fed will force the rate strongly below the target level, all other things being equal. In other words, in order for the Fed to increase the money supply via monetary pumping without upsetting the Federal funds rate, there must be a suitable trigger — e.g., an increase in the demand for currency by the public or an increase in Treasury’s tax receipts from the economy.

In both cases, the Fed would be compelled to pump money to prevent the Fed funds rate from overshooting the target.

Thus it appears that, in the current framework, the Fed performs a passive balancing act. It accommodates the demand for money and is not seen as actively engaging in monetary pumping. Indeed, it is officially stated by Fed officers themselves in the Federal Board of Governors papers that the US central bank is not printing money.

In an exchange with readers on Time magazine’s website on December 22, 2010, the Fed chief — at the time Ben Bernanke — when asked why the Fed is creating dollars “out of thin air,” replied that the Fed is not printing money.

In fact, for most economists and commentators the Fed’s accommodation of the demand for money is not regarded as money printing but, on the contrary, as necessary action in order to keep the economy on a path of economic and price stability. The Fed is therefore simply viewed as preventing disequilibria in the supply of and demand for money in the economy.

Note that following this logic the role of the central bank is always to accommodate the demand for money. Failing to do so will disrupt this equilibrium and potentially result in an economic crisis.

The reality, however, is that, irrespective of whether the monetary pumping is done passively (through mechanisms such as those described above) or actively, it is nonetheless just that — the artificial inflation of the money supply by the central bank.

As such it always sets in motion an exchange of nothing (newly created money out of “thin air”) for something. And as a result, this leads to the diversion of wealth from wealth generators to non-wealth generators — resulting in the menace of the boom-bust cycle.

Unrecognized Moral Hazard & Bank-Driven Monetary Expansion

It is important to note — and seldom acknowledged — that the Fed’s passive balancing act in the Fed funds market ensures that there is sufficient monetary liquidity to prevent banks from bankrupting each other during check-clearing (also called the exchange settlement) process.

In doing this the central bank is facilitating the continued expansion of credit by the commercial banks, which in turn results in an increase in the money supply.

Whichever way one looks at it, then, without the existence of the central bank, no sustained monetary expansion can take place.

Reprinted with permission from

Myth: Gold Makes Boom-Bust Cycles Worse

Tightening the Money Supply will Inevitably Lead to a Bust

Fed policymakers are of the view that the correct interest rate policy could bring the economy onto a path of economic stability and low price inflation. The idea is to guide interest rates toward what is called the “natural” interest rate. The natural rate is believed to be one that is consistent with stable prices and a balanced economy.

What is required then is that Fed policymakers successfully target the federal funds rate toward this natural interest rate.

One of the tools that policymakers are employing in their decision making process is the Taylor rule. This rule was designed to provide an indication to Fed policymakers about the “correct” level of the federal funds rate for a given state of price inflation and the output gap. It is meant to provide policymakers with an indicative measure regarding the “correct” measures they need to introduce in order to attain the natural rate.

The interest rate obtained from the Taylor rule is determined by changes in the price index, the equilibrium real interest rate (which is assumed to be 2%), the difference between price inflation and the inflation target (multiplied by 0.5). The inflation target is assumed to be 2%. Finally, the rule is determined by the output gap expressed in percentage terms. The output gap is the difference between real gross domestic product and potential real gross domestic product (which is also multiplied by 0.5).

Taylor rule = price inflation + 2 + 0.5*(price inflation – 2) + 0.5*(output gap)

Historically the rule has tracked the movements in the federal funds rate rather well (see chart).


According to the Taylor rule the federal funds rate should have been set at 3.62% in September compared to the federal funds rate target of 0.5%.

Given the gap of 3.12% between the Taylor rule and the federal funds rate target, it is tempting to suggest that Fed policymakers have been too loose regarding their interest rate policy. (The federal funds rate target currently stands at 0.75%).

One could however, argue that the rule is only valid if Fed policymakers are blindly following it, which is never the case.

In remarks prepared for delivery to the Stanford Institute for Economic Policy Research, Federal Reserve Chair Janet Yellen expressed doubts about using a rigid formula to set interest rates. She said the Fed consults a range of policy rules, including one developed by Stanford Professor John Taylor, to guide its decisions on rates. But the Federal Reserve head ruled out an automatic reliance on such rules because they do not provide the necessary flexibility during the occurrence of various shocks.

In her speech, she suggested that the US central bank should continue to raise interest rates slowly to keep jobs plentiful and inflation low. “I consider it prudent to adjust the stance of monetary policy gradually over time.”

Yellen warned that a delay in tightening monetary policy could drive up inflation and force the Fed to raise rates in response, sending the economy into a tailspin that could have been prevented if the rate hikes had been more gradual.

But, she said, it “will not be easy” to find a path of rate hikes that can foster strong jobs growth and 2% inflation, given the uncertainties of global growth, slow domestic productivity growth, and a change in fiscal policies, among others.

Unfortunately, a gradual tightening cannot prevent a subsequent economic bust. Economic busts are simply the inevitable removal of various activities that emerge on the back of loose monetary policy. Such activities grow thanks to that policy and disappear when this distortionary intervention disappears — they simply cannot survive without the continued support of an “accommodating” central bank. The distortions occasioned by these interventions do great harm to the economy — diverting investment away from genuine wealth generating activities.

From this perspective, a tighter monetary stance is in fact a welcome move from the perspective of wealth generators since less wealth is going to be diverted from them toward misallocated activities.

The belief that economic hardship could be avoided by a gradual tightening is naive. A gradual tightening of the interest rate will hurt various marginal activities first. After time elapses this is going to spill over to other activities and lead to the decline in bank lending — fractional reserve lending or lending out of “thin air” — which in turn deepens the economic downturn.

If the percentage of wealth generating activities relative to non-wealth generating activities is large enough then the impact of the demise of non-wealth-generating activities may be easily absorbed as individuals in misallocated activities would have more scope to be absorbed in wealth generating activities.

A gradual tightening is merely going to delay the process of adjustment, thereby preventing a speedy recovery of the process of real wealth generation and hence of the economy.

In fact, the Greenspan’s Fed had tried the gradual approach, which culminated in a serious recession. Between October 2004 and June 2006, the Fed tightened its interest rate stance by gradually lifting the federal funds rate target from 1.75% in October 2004 to 5.25% by June 2006. Each time the Fed was raising the target in increments of 0.25%.

At that time Chairman Greenspan, similar to Yellen, was of the view that a gradual tightening would prevent a serious economic bust. In fact, however, this was exactly what we got, when the US economy suffered a massive plunge during 2008 notwithstanding a policy of gradual tightening.

The implication here is clear: the Fed and economic analysts are likely to be wrong if they believe that the use of the Taylor rule — or any other rule for that matter — will somehow lessen the risks of an economic downturn pursuant to their tightening.

What various supporters of these “rules” and of other forms of market intervention are trying to establish is the “correct” level for the interest rate. This level, however, can only be set in a free unhampered market. Such an interest rate cannot be known without freeing the market from the Fed’s tampering.

At a freely established interest rate the issue of systemic misallocation of resources is not going to emerge, nor will the curse of economic cycles that follow central bank meddling. Obviously businesses are still going to makes errors, however, these errors are going to be self-corrected and not of an enduring nature.

For Fed policymakers to be able to establish the “correct” path toward the natural interest rate they have to know individuals time preferences, which however, cannot be established beforehand. One thing we do know however is that any policy that undermines the process of real wealth formation tends to raise individuals’ time preferences — pushing real interest rates higher.

Reprinted from the Mises Institute.

Why Fractional-Reserve Banking Would Be Limited in an Unhampered Market

Why Fractional-Reserve Banking Would Be Limited in an Unhampered Market

The so-called multiplier arises as a result of the fact that banks are legally permitted to use money that is placed in demand deposits. Banks treat this type of money as if it was loaned to them, thus loaning it out while simultaneously allowing depositors to spend that money.

RELATED: “Austrians, Fractional Reserves, and the Money Multiplier” by Robert Batemarco

For example, if John places $100 in demand deposit at Bank One he doesn’t relinquish his claim over the deposited $100. He has unlimited claim against his $100.

However, let us also say that Bank One lends $50 to Mike. By lending Mike $50, the bank creates a deposit for $50 that Mike can now use. Remember that John still has a claim against $100 while Mike has now a claim against $50.

This type of lending is what fractional-reserve banking is all about. The bank has $100 in cash against claims, or deposits of $150. The bank therefore holds 66.7 percent reserves against demand deposits. The bank has created $50 out of “thin air” since these $50 are not supported by any genuine money.

Now Mike uses that $50 to buy goods from Tom and pays Tom by check. Tom places the check with his bank, Bank B. After clearing the check, Bank B will have an increase in cash of $50, which it may take advantage of, and lends say $25 to Bob.

As one can see, the fact that banks make use of demand deposits whilst the holders of deposits did not relinquish their claims sets in motion the money multiplier.

A case could be made that people who place their money in demand deposits do not mind banks using their money. But, if an individual grants a bank permission to lend out his money, he cannot at the same time also expect to be able to use that money.

Regardless of people’s psychological disposition what matters here is that individuals did not relinquish their claim on deposited money that is being also lent out. Once banks use the deposited money, an expansion of money out of “thin air” is set in motion.

Read the rest at the Mises Institute here.

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