Gold News

Money Supply and Real Economic Growth

Why the Fed cannot create wealth...

A DECLINE in the US unemployment rate to 8.3% in January from 8.5% in the month before has prompted many commentators to suggest that the loose monetary policy of the Fed is starting to produce results, and that the US economy is starting to show a positive rate of growth, writes Frank Shostak for the Cobden Centre.

In his testimony to the Senate Budget Committee the Fed Chairman Ben Bernanke said:

"Over the past two and a half years, the US economy has been gradually recovering from the recent deep recession."

Although Bernanke expressed satisfaction about the fall in the unemployment rate he nevertheless remains cautious on the speedy recovery of the economy. What bothers the Fed boss is that the share of working age people in the labor force had declined to the lowest level in 29 years. The so-called participation rate fell to 63.7%. Consequently, this understates the true unemployment rate in the economy. Bernanke reiterated that the benchmark interest rate will probably stay near zero at least through late 2014 in order to bring the economy onto a self-generating growth path.

We suggest that an increase in the yearly rate of growth of our measure of money supply, AMS, from 2.2% in June 2010 to 14.7% in October 2011 is a major driving force behind the currently emerging strengthening in US economic data.

This increase however cannot activate the process of wealth expansion i.e. real economic growth. It can only set in motion a diversion of real savings from wealth generators to non-productive economic activities. (This in fact weakens the pool of real wealth).

The key to economic growth is an increase in capital goods per capita. With better quality and a greater quantity of tools and machinery a greater production of goods and services can be generated.

The prerequisite for a greater quantity and a better quality of capital goods is a growing pool of real savings. It is real savings that support i.e. funds the enhancement and the expansion of capital goods.

The Fed's loose monetary policy cannot, however, replace capital goods and cause economic growth. Again all that these policies can achieve is a redistribution of the given pool of real savings – a diversion of real savings from wealth generators to non-wealth generating activities.

Elsewhere we have suggested that real economic activity cannot be measured since it is not possible to add potatoes to tomatoes, i.e. the so-called real total cannot be established arithmetically. All that various so-called real economic indicators depict is changes in monetary turnover brought about by changes in the money supply. The stronger the rate of increase in money supply, the stronger monetary turnover is going to be.

As we have seen, an increase in money supply can only cause a diversion of real savings (i.e. real funding) from wealth generating activities to non-wealth generating activities.

Also, an increase in economic indicators that are presented in real terms, such as the number of cars or the number of houses produced, currently mirrors the shift of real funding from wealth generating activities. (Again this diversion of real funding is on account of an increase in money supply).

Without the support coming from loose monetary policy, real savings wouldn't have been diverted from wealth generators to various false bubble activities. These activities cannot stand on their own feet without the funding (real savings) diverted to them by means of loose monetary policy. Once the central bank tightens its stance, this slows down the diversion of real savings and puts pressure on false activities. Contrast this with wealth generators who do not require loose monetary policy to prosper since wealth generators can fund themselves.

In short, the Fed's loose monetary policies can only create an illusion of economic growth, which in fact is a further dilution of the foundations of the economy. It remains to be seen whether the overall pool of real savings is still there to support this illusion.

Hence, contrary to popular thinking, we can conclude that an aggressive loose monetary policy cannot shield the economy from recessions but on the contrary can only weaken the process of real wealth generation.

On this score, various comments that the Fed under the leadership of Bernanke has saved the US economy from a depression are misleading. If anything Bernanke's monetary policy has severely damaged the pool of real savings.

Mainstream thinkers, even those who agree that printing money cannot grow the economy, hold that loose monetary policy can revive the economy by boosting the demand for goods and services. With a greater level of demand the production of goods and services i.e. economic growth, will follow suit, so it is held.

We suggest that an individual's effective demand is constrained by his ability to produce goods. Demand cannot stand by itself and be independent – it is limited by production. What drives the economy is not demand as such, but the production of goods and services.  The more goods an individual produces, the more of other goods he can secure for himself.

According to James Mill:

'When goods are carried to market what is wanted is somebody to buy. But to buy, one must have the wherewithal to pay. It is obviously therefore the collective means of payment which exist in the whole nation constitute the entire market of the nation. But wherein consist the collective means of payment of the whole nation? Do they not consist in its annual produce, in the annual revenue of the general mass of inhabitants? But if a nation's power of purchasing is exactly measured by its annual produce, as it undoubtedly is; the more you increase the annual produce, the more by that very act you extend the national market, the power of purchasing and the actual purchases of the nation…. Thus it appears that the demand of a nation is always equal to the produce of a nation. This indeed must be so; for what is the demand of a nation? The demand of a nation is exactly its power of purchasing. But what is its power of purchasing? The extent undoubtedly of its annual produce. The extent of its demand therefore and the extent of its supply are always exactly commensurate.'

If a population of five individuals produces ten potatoes and five tomatoes – this is all that they can demand and consume. No government and central bank tricks can make it possible to increase effective demand. The only way to raise the ability to consume more is to raise the ability to produce more.

The dependence of demand on the production of goods cannot be removed by means of loose interest rate policy and monetary pumping.

On the contrary the loose Fed's interest rate stance and money printing will only impoverish real wealth generators and weaken their ability to produce goods and services – it will weaken effective demand.

Buying Gold today?...

Built on anti-Corn Law radical Richard Cobden's vision that "Peace will come to earth when the people have more to do with each other and governments less," the Cobden Centre promotes sound scholarship on honest money and free trade. Chaired by Toby Baxendale, founder of the Hayek Visiting Teaching Fellowship Program at the London School of Economics, the Cobden Centre brings together economists, businesspeople and finance professionals to better help these ideas influence policy.

Cobden Centre articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

Follow Us

Facebook Youtube Twitter LinkedIn



Market Fundamentals