Increases in Money Supply Can’t Create Economic Growth

"No amount of increase in the money supply will make genuine, sustainable economic growth possible."

By Frank Shostak, Mises Institute

The view that an increase in the money supply could revive an economy is based on the idea that money transmits its effect through the aggregate expenditure. With more money in their pockets, people will be able to spend more, and the rest will follow suit. Money, however, only enables one producer to exchange his produce with another producer. 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.

The ultimate means of payment are always goods and services, which pay for other goods and services. All that money does is to facilitate these payments; it makes certain payments possible.

For instance, a baker exchanges his bread for money and then uses the money to buy shoes. He ultimately pays for the shoes not with money but with the bread he produced. Money just allows him to make this transaction. Also, note that the baker’s production of bread gives rise to his demand for money.

By demand for money, what we really mean here is the demand for money’s purchasing power. After all, people do not want a greater amount of money in their pockets but rather they want a greater purchasing power in their possession. According to Mises,

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.

In a free market, in similarity to other goods, the price of money is determined by supply and demand. If there is less money, all other things being equal, its exchange value will increase. Conversely, the exchange value will fall, all other things being equal, 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 the optimum growth rate 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.

In a market economy, the purpose of production is consumption. People produce and exchange goods and services with each other in order to improve their state by removing felt uneasiness. This means that consumption cannot arise without production while production without consumption will be a meaningless undertaking. Hence, in a free-market economy, both consumption and production are in harmony with each other. In a free market economy, consumption will tend to be fully backed by production.

What permits the baker to consume bread and shoes is his production of bread. A portion of his bread production is allocated for his direct consumption while the other portion is used to pay for shoes. His consumption is fully backed (i.e., paid for) by his production. Any attempt then to increase consumption without a corresponding increase in production leads to unbacked consumption, which must come at somebody else’s expense.

This is precisely what monetary inflation does. It generates demand which is not supported by any production. Once exercised, this type of demand undermines the flow of production and savings and, in turn, weakens the formation of capital and suppresses economic growth rather than boosting it.

It is production, saving, and capital investment, not money, that funds and enables the production of a greater capital structure. With concrete capital goods in the form of better tools and machinery, it is then possible to increase production of final consumer goods and services. This is what genuine economic growth is.

Contrary to much popular thinking, setting in motion more consumption and spending unbacked by production by means of monetary inflation will only suffocate and not promote economic growth. In fact, it will promote false growth. This is because unbacked consumption will weaken the flow of production and savings, and thus weaken the source that supports economic growth. If it had been otherwise, then poverty in the world would have been eliminated a long time ago. After all, everybody knows how to demand and to consume.

The only reason why loose monetary policies may appear to grow the economy is that it starts a visible increase of production and employment within certain sectors and the pace of savings may be strong enough to absorb the increases of unbacked consumption. However, once the growth rate of unbacked consumption reaches a stage where the flow of savings disappears altogether, the economy falls into an economic slump. Further, the structure of production has been warped by the creation of projects that cannot be profitably completed.

Any attempt by the central bank to pull the economy out of the slump by means of monetary inflation to lower interest rates and “stimulate” the economy makes things much worse because it only aggravates unproductive consumption. The collapse in the sources of economic growth exposes banks’ fractional-reserve lending and raises the risk of a run on banks. To protect themselves banks curtail the inflationary creation of credit.

Under these conditions, further monetary inflation cannot increase banks’ lending. On the contrary, more inflation destroys savings, further distorts the structure of production, and destroys more businesses. This, in turn, makes banks reluctant to expand lending. Within these conditions, banks would likely agree to lend only to creditworthy businesses. However, as an economic slump deepens, it becomes much harder to find many creditworthy businesses.

Hence, the central bank may find that, despite its attempt to inflate the economy, the money supply will start falling. Obviously, the central bank could offset this decline by aggressive monetary inflation. The central bank could also monetize the government budget deficit and it could also mail checks to every citizen. All this, however, would only further undermine production, saving, and capital investment and devastate the economy.

Does an increase in demand set in motion economic growth?

Most commentators are of the view that an increase in money supply will strengthen demand for consumer goods and services. As a result, production will be stimulated. However, to accommodate the strengthening in the production of consumer goods and services, there is the need for a suitable capital structure. If, however, the capital structure was not developed because not enough savings had been allocated toward capital investment, this will not generate economic growth.

No amount of increase in the money supply will make genuine, sustainable economic growth possible. On the contrary, inflationary increases in the money supply will undermine the process of savings formation and delay rather than promote the prospects for economic recovery.

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