The view that more money can revive an economy is based on the belief that money transmits its stimulatory effect through aggregate expenditure. With more money in their pockets, people will be able to spend more and the rest will follow suit. Money, in this way of thinking, is a means of payment and funding.
Money, however, is not a means of payment but a medium of exchange. It only enables one producer to exchange his produce with another producer. The means of payment are always real goods and services, which pay for other goods and services. All that money does is facilitate these payments. It makes the payments for goods and services possible.
For instance, a baker exchanges his bread for money and then uses the money to buy shoes. He pays for shoes not with money, but with the bread he produced. Money just allows him to make this payment. (The baker’s production of bread also gives rise to his demand for money.)
When we talk about 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 greater purchasing power.
On this Mises wrote in Human Action,
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, the price of money is determined by supply and demand, similar to the way the prices of other goods are. 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 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 ultimately consumption. People produce and exchange goods and services in order to improve their lives and well-being — their ultimate purpose. This means that consumption cannot arise without production, while production without consumption would be a meaningless venture. Hence, in a free market economy consumption and production are in harmony. In a free market economy, consumption is 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 to his direct consumption while the other portion is used to pay for shoes. His consumption is fully backed, i.e., paid by his production. Any attempt, then, to elevate consumption without the corresponding production leads to unbacked consumption, which must come at somebody else’s expense.
This is precisely what monetary pumping does. It generates demand, which is not supported by any production. Once exercised, this type of demand undermines the flow of real savings and in turn weakens the formation of real capital, stifing rather than boosting economic growth.
It is real savings, not money, that fund and make possible the production of better tools and machinery. With better tools and machinery, it becomes possible to lift the production of final goods and services — this is what economic growth is all about.
The Real Source of Wealth
Contrary to the popular way of thinking, setting in motion an unbacked consumption through monetary pumping will only stifle, and not promote, economic growth. This is because unbacked consumption weakens the flow of real savings and thus drains the source that funds real economic growth. If it were otherwise, poverty in the world would have been eliminated a long time ago. After all, everybody knows how to demand and consume.
The only reason loose monetary policies may appear to grow the economy is because the pace of real savings generation is strong enough to absorb the increases in unbacked consumption.
Once the pace of unbacked consumption reaches a stage where the flow of real savings disappears altogether, however, the economy falls into an economic slump. Any attempt by the central bank to pull the economy out of the slump by means of more monetary pumping makes things much worse, for it only strengthens unbacked, or unproductive, consumption, destroying whatever is left of real savings.
The collapse in the sources of real economic growth exposes commercial banks’ fractional reserve lending and raises the risk of a run on banks. To protect themselves, banks curtail their creation of credit out of “thin air.” Under these conditions, further monetary pumping cannot lift banks’ lending. On the contrary, more pumping destroys more real savings and destroys more businesses, which in turn makes banks reluctant to expand lending.
In these conditions, banks would likely agree to lend only to creditworthy businesses. However, as an economic slump deepens, it becomes much harder to find creditworthy businesses. Furthermore, because of loose monetary policy, the lower interest environment against the background of growing risk further diminishes banks’ willingness to extend credit. All this puts downward pressure on the stock of money.
Hence, the central bank may find that despite its attempt to inflate the economy, the money supply will start to fall. Obviously, the central bank could offset this fall through aggressive monetary pumping. The central bank could also monetize the government budget deficit. It could mail checks to every citizen. All this, however, would only further undermine real savings and devastate the real economy.