A Difference of Opinions

In his various writings, Murray Rothbard argued that in a free market economy that operates on a gold standard, the creation of credit that is not fully backed up by gold (fractional-reserve banking) sets in motion the menace of the boom-bust cycle. In his The Case for 100 Percent Gold Dollar Rothbard wrote:

 

I therefore advocate as the soundest monetary system and the only one fully compatible with the free market and with the absence of force or fraud from any source a 100 percent gold standard. This is the only system compatible with the fullest preservation of the rights of property. It is the only system that assures the end of inflation and, with it, of the business cycle. (1)

 

Murray Rothbard was convinced that we should return to a sound monetary system based on the market-chosen money commodity gold. Note that the use of gold as money as such cannot keep banks from issuing fiduciary media (a.k.a. uncovered money substitutes). The important thing is therefore that the monetary and banking system are free. A free banking system will develop along sound lines of its own accord, not least because banks have to continually clear transactions between each other and will tend to shun overextended lenders. A free market monetary/ banking system would likely be different from today’s system in numerous aspects, but it would be just as sophisticated and efficient. Most importantly, it would be economically sound and the likelihood that severe business cycles emerge would be vastly lower.

Photo via mises.org

 

Some economists such as George Selgin and Lawrence White have contested this view. In his article in The Independent Review George Selgin argued that it is not true that fractional-reserve banking must always set in motion the menace of the boom-bust cycle. According to Selgin:

 

In truth, whether an addition to the money stock will aggravate the business cycle depends entirely on whether or not the addition is warranted by a pre-existing increase in the public’s demand for money balances. If an expansion of the supply of bank money creates an overall excess of money, people will spend the excess. Borrowers’ increased spending will, in other words, not be offset by any corresponding decline in spending by other persons. The resulting stimulus to the overall level of demand for goods, services, and factors of production, together with changes in the pattern of spending prompted by an artificial lowering of interest rates, will have the adverse business-cycle consequences described by the Austrian theory. (2)

 

However, argues Selgin, no business cycle will emerge if the increase in the money supply is in response to a previous increase in the demand for money:

 

“Such an expansion, instead of adding to the flow of spending, merely keeps that flow from shrinking, thereby sustaining normal profits for the “average” firm. The expansion therefore serves not to trigger a boom but to avoid a bust. As far as business-cycle consequences are concerned, it makes no difference whether the new money is or is not backed by gold.”

 

Likewise in their joint article Selgin and White wrote:

 

“We deny that an increase in fiduciary media matched by an increased demand to hold fiduciary media is disequilibrating or sets in motion the Austrian business cycle.” (3)

 

According to this way of thinking the business cycle emerges only if the increase in the supply of money exceeds the increase in the demand for money.

 

Money Out of “Thin Air” and the Boom-Bust Cycle

Following this reasoning, it would appear that if counterfeit money enters the economy in response to an increase in the demand for money, no harm will be done. The increase in the supply of money is neutralized, so to speak, by an increase in the demand, or the willingness to hold a greater amount of money than before.

As a result, the counterfeiter’s newly pumped money will not have any effect on spending and therefore no boom-bust cycle will be set in motion. However, does this make sense?

What do we mean by demand for money, and how does this demand differ from the demand for goods and services.

Now, the demand for a good is not demand for a particular good as such, but a demand for the services that the good offers. For instance, an individuals’ demand for food is on account of the fact that food provides the necessary elements that sustain an individual’s life and well-being. Demand here means that people want to consume food in order to secure the necessary elements that sustain life and well-being.

Also, the demand for money arises on account of the services that money provides. Instead of consuming money, people demand money in order to exchange it for other goods and services. With the help of money, various goods become more marketable — they can secure more goods than in the barter economy. What enables this is the fact that money is the most marketable commodity.

An increase in the general demand for money, let us say, on account of a general increase in the production of goods, doesn’t imply that individuals sit on money and do nothing with it. The key reason an individual has a demand for money is that it confers the ability to exchange money for other goods and services.

 

Two charts from Rothbard’s Man, Economy and State: the effect of a change in the total demand for money on money’s purchasing power with an unchanged supply (stock of money) and the effect on the PPM of a change in the stock of money (in this case, an increase) while the demand for money remains unchanged. Note though that the effects of altering the money supply by issuance of fiduciary media has much more far-reaching effects than merely changing the purchasing power of the monetary unit – click to enlarge.

 

Individual vs. General Demand for Money

In the process of exercising their demand for money, some individuals lower their demand by exchanging their money for goods and services, while other individuals raise their demand for money by exchanging goods and services for money. Note that whilst overall demand did not change, individuals’ demand did change. But, it is individuals’ demand and not the overall demand for money which is what matters in setting boom-bust cycles into motion.

Now let us assume that for some reason the demand for money of some individuals has risen. One way to accommodate this demand is for banks to find willing lenders of money. In short, with the help of the mediation of banks, willing lenders can transfer their gold money to borrowers. Obviously, such a transaction is not harmful to anyone.

Another way to accommodate the demand is instead of finding willing lenders, the bank can create fictitious money — money unbacked by gold — and lend it out.

Note that the increase in the supply of newly created money is given to some individuals. There must always be a first recipient of the money that is newly created by banks.

 

Creation of New Money Leads to a Something-for-Nothing Situation

This money, which was created out of “thin air,” is going to be employed in an exchange for goods and services. That is, it will set in motion an exchange of nothing for something.

The exchange of nothing for something amounts to the diversion of real wealth from wealth to non-wealth generating activities, which masquerades as economic prosperity. In the process, genuine wealth generators are left with fewer resources at their disposal, which in turn weakens their ability to grow the economy.

 

Banks can create money substitutes ex nihilo – but the new money doesn’t really come for “free”. Someone always ends up paying for exchanges of nothing for something.

 

On the other hand, once banks curtail their supply of credit out of “thin air,” this slows down the process of an exchange of nothing for something. This in turn undermines the existence of various false activities that sprang up on the back of the previous expansion in credit out of “thin” air — an economic bust emerges.

 

Conclusion

We can thus conclude that what sets in motion the boom-bust cycle is the expansion of credit out of “thin air”, regardless of the state of the general demand for money. Again, irrespective of whether the total demand for money is rising or falling, what matters is that individuals employ money in their transactions.

As we have seen, once money out of “thin air” is introduced into the process of exchange this lays the foundation for the boom-bust cycle.

We can further infer that it is not the failure to accommodate the increase in general demand for money that causes an economic bust, but actually the accommodation by means of money out of “thin air” that does it.

 

References:

 

(1) Murray N. Rothbard, The Case For A 100 Percent Gold Dollar  (Cobden Press 1984)

(2) George Selgin, “Should We Let Banks Create Money? ” The Independent Review (Summer 2000): 93–100

(3) George Selgin and Lawrence White,  “In Defense of Fiduciary Media; or, We Are Not Devolutionists, We Are Misesians! ” Review of Austrian Economics 9 (1996): 83–107.

 

Charts by Murray N. Rothbard

 

Chart and image captions by PT

 

Note by PT: we have edited the original text very lightly in a few spots. Also, the emphasis on two sentences under the sub-heading “Money Out of “Thin Air” and the Boom-Bust Cycle” has been added by us, in order to highlight what we believe to be important points (all other emphasized passages are in the original).

 

 

 

Emigrate While You Can... Learn More

 


 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke

   
 

One Response to “Money Creation and the Boom-Bust Cycle”

  • Hans:

    I am sorry, but Murray Rothbard is completely wong
    on this issue.

    No and I do mean No economic theory or system is immune
    to a boom and bust cycle.

    Those whom think to the contrary have left the world
    of reality.

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • How to Survive the Winter
      A Flawless Flock of Scoundrels One of the fringe benefits of living in a country that’s in dire need of a political, financial, and cultural reset, is the twisted amusement that comes with bearing witness to its unraveling.  Day by day we’re greeted with escalating madness.  Indeed, the great fiasco must be taken lightly, so as not to be demoralized by its enormity.   Symphony grotesque in Washington [PT]   Of particular note is the present cast of characters. ...
  • Credit Spreads: The Coming Resurrection of Polly
      Suspicion isn't Merely Asleep – It is in a Coma (or Dead) There is an old Monty Python skit about a parrot whose lack of movement and refusal to respond to prodding leads to an intense debate over what state it is in. Is it just sleeping, as the proprietor of the shop that sold it insists? A very tired parrot taking a really deep rest? Or is it actually dead, as the customer who bought it asserts, offering the fact that it was nailed to its perch as prima facie evidence that what...
  • The Strange Behavior of Gold Investors from Monday to Thursday
      Known and Unknown Anomalies Readers are undoubtedly aware of one or another stock market anomaly, such as e.g. the frequently observed weakness in stock markets in the summer months, which the well-known saying “sell in May and go away” refers to. Apart from such widely known anomalies, there are many others though, which most investors have never heard of. These anomalies can be particularly interesting and profitable for investors – and there are several in the precious metals...
  • Business Cycles and Inflation – Part I
      Incrementum Advisory Board Meeting Q4 2017 -  Special Guest Ben Hunt, Author and Editor of Epsilon Theory The quarterly meeting of the Incrementum Fund's Advisory Board took place on October 10 and we had the great pleasure to be joined by special guest Ben Hunt this time, who is probably known to many of our readers as the main author and editor of Epsilon Theory. He is also chief risk officer at investment management firm Salient Partners. As always, a transcript of the discussion is...
  • What President Trump and the West Can Learn from China
      Expensive Politics Instead of a demonstration of its overwhelming military might intended to intimidate tiny North Korea and pressure China to lean on its defiant communist neighbor, President Trump and the West should try to learn a few things from China.   President Trump meets President Xi. The POTUS reportedly had a very good time in China. [PT] Photo credit: AP   The President’s trip to the Far East came on the heels of the completion of China’s...
  • Business Cycles and Inflation, Part II
      Early Warning Signals in a Fragile System [ed note: here is Part 1; if you have missed it, best go there and start reading from the beginning] We recently received the following charts via email with a query whether they should worry stock market investors. They show two short term interest rates, namely the 2-year t-note yield and 3 month t-bill discount rate. Evidently the moves in short term rates over the past ~18 - 24 months were quite large, even if their absolute levels remain...
  • Is Fed Chair Nominee Jay Powell, Count Dracula?
      A Date with Dracula The gray hue of dawn quickly slipped to a bright clear sky as we set out last Saturday morning.  The season’s autumn tinge abounded around us as the distant mountain peaks, and their mighty rifts, grew closer.  The nighttime chill stubbornly lingered in the crisp air.   “Who lives in yonder castle?” Harker asked. “Pardon, Sire?” Up front in the driver's seat it was evidently hard to understand what was said over the racket made by the team of...
  • A Different Powelling - Precious Metals Supply and Demand Report
      New Chief Monetary Bureaucrat Goes from Good to Bad for Silver The prices of the metals ended all but unchanged last week, though they hit spike highs on Thursday. Particularly silver his $17.24 before falling back 43 cents, to close at $16.82.   Never drop silver carelessly, since it might land on your toes. If you are at loggerheads with gravity for some reason, only try to handle smaller-sized bars than the ones depicted above. The snapshot to the right shows the governor...
  • Heat Death of the Economic Universe
      Big Crunch or Big Chill Physicists say that the universe is expanding. However, they hotly debate (OK, pun intended as a foreshadowing device) if the rate of expansion is sufficient to overcome gravity—called escape velocity. It may seem like an arcane topic, but the consequences are dire either way.   OT – a little cosmology excursion from your editor: Observations so far suggest that the expansion of the universe is indeed accelerating – the “big crunch”, in...
  • Claudio Grass Interviews Mark Thornton
      Introduction Mark Thornton of the Mises Institute and our good friend Claudio Grass recently discussed a number of key issues, sharing their perspectives on important economic and geopolitical developments that are currently on the minds of many US and European citizens. A video of the interview can be found at the end of this post. Claudio provided us with a written summary of the interview which we present below – we have added a few remarks in brackets (we strongly recommend...
  • Inflation and Gold - Precious Metals Supply and Demand
      Reasons to Buy Gold The price of gold went up $19, and the price of silver 42 cents. The price action occurred on Monday, Wednesday and Friday though so far, only the first two price jumps reversed. We promise to take a look at the intraday action on Friday.   File under “reasons to buy gold”: A famous photograph by Henri Cartier-Bresson of a rather unruly queue in front of a bank in Shanghai in 1949 in the final days of Kuomintang rule. When it dawned on people that the...
  • Precious Metals Supply and Demand
      A Different Vantage Point The prices of the metals were up slightly this week. But in between, there was some exciting price action. Monday morning (as reckoned in Arizona), the prices of the metals spiked up, taking silver from under $16.90 to over $17.25. Then, in a series of waves, the price came back down to within pennies of last Friday’s close. The biggest occurred on Friday.   Silver ended slightly up on the week after a somewhat bigger rally was rudely interrupted...

Support Acting Man

Top10BestPro
j9TJzzN

Austrian Theory and Investment

Archive

350x200

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com