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Does lack of money cause depressions?

August 9, 2001
Does lack of money cause depressions?

In his writings Milton Friedman blamed the central bank policies for causing the Great Depression. According to Friedman the Federal Reserve failed to pump enough reserves into the banking system to prevent the collapse in the money stock. For Friedman, the failure of the US central bank is not that it caused the monetary bubble but that it allowed the deflation of the bubble.

Murray Rothbard, while agreeing with Friedman that the money stock fell sharply, found that the Federal Reserve had been aggressively pumping reserves into the banking system. Notwithstanding this pumping, the money stock continued to fall. The sharp fall in the money stock, contrary to Friedman, is not indicative of the Federal Reserve's failure to pump the money supply. It is indicative of the shrinking pool of funding brought about by the loose monetary policies of the central bank.

Essentially, the pool of funding is the quantity of goods available in an economy to support future production. In the simplest of terms: a lone man on an island is able to pick 25 apples an hour. With the aid of a picking tool, he is able to raise his output to 50 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-but longer-stages of production. Trouble erupts whenever the banking system makes it appear that the pool of 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 funding continues to expand, loose monetary policies give the impression that they can boost economic activity. That this is not the case becomes apparent as soon as the pool of 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). By fulfilling the role of the intermediary, banks are an important factor in the process of real wealth formation. Banks facilitate the flow of real funding i.e. the flow of the means of asustenance by introducing suppliers of real funding to the demanders.

The introduction of money to our analysis will not alter the fact that the subject matter remains the pool of means of sustenance. When a saver lends money, what he in fact lends to borrowers is the goods he has not consumed. 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. credit out of "thin air". Once the unbacked credit is generated it creates activities that the free market would never approve, i.e. these activities are consuming and not producing real wealth. As long as the pool of 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 the flow of real savings is arrested and a decline in the pool of funding is set in motion. Consequently, the performance of various activities starts to deteriorate and bank's bad loans start to rise. In response to this, banks begin to call back their loans and this in turn sets in motion a decline in the money stock.

We can thus conclude that depression is not caused by the collapse in the money stock, but in response to the shrinking pool of funding, which also causes the disappearance of money out of "thin air". Consequently, even if the central bank were to be successful in preventing the disappearance of money, this would not be able to prevent a depression if the pool of funding is declining. Also, even if loose monetary policies were to succeed in lifting prices and inflationary expectations, this couldn't revive the economy as long as the pool of funding is declining.

Furthermore, it is the loose monetary policies of the central bank and fractional reserve banking that cause the misallocation of resources, which in turn weakens the flow of savings and hence weakens the buildup of the pool of funding. This in turn implies that the primary causes of depression are loose monetary policies of the central bank and fractional reserve banking.

Frank Shostak, Ph.D.
[email protected]

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies.

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