Most experts are of the view that the massive monetary pumping by the US
central bank during the 2008 financial crisis saved the US and the world from
another Great Depression. On this the Federal Reserve Chairman at the time
Ben Bernanke is considered the man that saved the world. Bernanke in turn
attributes his actions to the writings of Professor Milton Friedman who
blamed the Federal Reserve for causing the Great Depression of 1930s by
allowing the money supply to plunge by over 30 percent.
Careful analysis will however show that it is not a collapse in the money
stock that sets in motion an economic slump as such, but rather the prior
monetary pumping that undermines the pool of real funding that leads to an
economic depression.
Improving the Economy Requires Time and Savings
Essentially, the pool of real funding is the quantity of consumer goods
available in an economy to support future production. In the simplest of
terms: a lone man on an island is able to pick tewenty-five apples an hour.
With the aid of a picking tool, he is able to raise his output to fifty
apples an hour. Making the tool, (adding a stage of production) however,
takes time.
During the time he is busy making the tool, the man will not be able to
pick any apples. In order to have the tool, therefore, the man must first
have enough apples to sustain himself while he is busy making it. His pool of
funding is his means of sustenance for this period—the quantity of apples he
has saved for this purpose.
The size of this pool determines whether or not a more sophisticated means
of production can be introduced. If it requires one year of work for the man
to build this tool, but he has only enough apples saved to sustain him for
one month, then the tool will not be built—and the man will not be able to
increase his productivity.
The island scenario is complicated by the introduction of multiple
individuals who trade with each other and use money. The essence, however,
remains the same: the size of the pool of funding sets a brake on the
implementation of more productive stages of production.
When Banks Create the Illusion of More Wealth
Trouble erupts whenever the banking system makes it appear that the pool
of real funding is larger than it is in reality. When a central bank expands
the money stock, it does not enlarge the pool of funding. It gives rise to
the consumption of goods, which is not preceded by production. It leads to
less means of sustenance.
As long as the pool of real funding continues to expand, loose monetary
policies give the impression that economic activity is being boosted. That
this is not the case becomes apparent as soon as the pool of real funding
begins to stagnate or shrink. Once this happens, the economy begins its
downward plunge. The most aggressive loosening of money will not reverse the
plunge (for money cannot replace apples).
The introduction of money and lending to our analysis will not alter the
fact that the subject matter remains the pool of the means of sustenance.
When an individual lends money, what he in fact lends to borrowers is the
goods he has not consumed (money is a claim on real goods). Credit then means
that unconsumed goods are loaned by one productive individual to another, to
be repaid out of future production.
The existence of the central bank and fractional reserve banking permits
commercial banks to generate credit, which is not backed up by real funding
(i.e., it is credit created out of “thin air”).
Once the unbacked credit is generated it creates activities that the free
market would never approve. That is, these activities are consuming and not
producing real wealth. As long as the pool of real funding is expanding and
banks are eager to expand credit, various false activities continue to
prosper.
Whenever the extensive creation of credit out of “thin air” lifts the pace
of real-wealth consumption above the pace of real-wealth production this
undermines the pool of real funding.
Consequently, the performance of various activities starts to deteriorate
and banks’ bad loans start to rise. In response to this, banks curtail their
loans and this in turn sets in motion a decline in the money stock.
Does every curtailment of lending cause the decline in the money stock?
For instance, Tom places $1,000 in a savings deposit for three months with
Bank X. The bank in turn lends the $1,000 to Mark for three months. On the
maturity date, Mark repays the bank $1,000 plus interest. Bank X in turn
after deducting its fees returns the original money plus interest to Tom.
So what we have here is that Tom lends (i.e., gives up for three months)
$1,000. He transfers the $1,000 through the mediation of Bank X to Mark. On
the maturity date Mark repays the money to Bank X. Bank X in turn transfers
the $1,000 to Tom. Observe that in this case existent money is moved from Tom
to Mark and then back to Tom via the mediation of Bank X. The lending is
fully backed here by $1,000. Obviously the $1,000 here doesn’t disappear once
the loan is repaid to the bank and in turn to Tom.
Why the Money Supply Shrinks
Things are, however, completely different when Bank X lends money out of
thin air. How does this work? For instance, Tom exercises his demand for
money by holding some of his money in his pocket and the $1,000 he keeps in
the Bank X demand deposit. By placing $1,000 in the demand deposit he
maintains total claim on the $1,000. Now, Bank X helps itself and takes $100
from Tom’s deposit and lends this $100 to Mark. As a result of this lending
we now have $1,100 which is backed by $1,000 proper. In short, the money
stock has increased by $100. Observe that the $100 loaned doesn’t have an
original lender as it was generated out of “thin air” by Bank X. On the
maturity date, once Mark repays the borrowed $100 to Bank X, the money
disappears.
Obviously if the bank is continuously renewing its lending out of thin air
then the stock of money will not fall. Observe that only credit that is not
backed by money proper can disappear into thin air, which in turn causes the
shrinkage in the stock of money.
In other words, the existence of fractional reserve banking (banks
creating several claims on a given dollar) is the key instrument as far as
money disappearance is concerned. However, it is not the cause of the
disappearance of money as such.
Banks Lend Less as the Quality of Borrowers Worsens
There must be a reason why banks don’t renew lending out of thin air. The
main reason is the severe erosion of real wealth that makes it much harder to
find good quality borrowers. This in turn means that monetary deflation is on
account of prior inflation that has diluted the pool of real funding.
It follows then that a fall in the money stock is just a symptom. The fall
in the money stock reveals the damage caused by monetary inflation but it
however has nothing to do with the damage.
Contrary to Friedman and his followers (including Bernanke), it is not the
fall in the money supply and the consequent fall in prices that burdens
borrowers. It is the fact that there is less real wealth. The fall in the
money supply, which was created out of “thin air,” puts things in proper
perspective. Additionally, as a result of the fall in money, various
activities that sprang up on the back of the previously expanding money now
find it hard going.
It is those non-wealth generating activities that end up having the most
difficulties in serving their debt since these activities were never
generating any real wealth and were really supported or funded, so to speak,
by genuine wealth generators. (Money out of “thin air” sets in motion an
exchange of nothing for something — the transferring of real wealth from
wealth generators to various false activities.) With the fall in money out of
thin air their support is cut-off.
Contrary to the popular view then, a fall in the money supply (i.e., money
out of 'thin air'), is precisely what is needed to set in motion the build-up
of real wealth and a revitalizing of the economy.
Printing money only inflicts more damage and therefore should never be
considered as a means to help the economy. Also, even if the central bank
were to be successful in preventing a fall in the money supply, this would
not be able to prevent an economic slump if the pool of real funding is
falling.
