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.
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.
(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).
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”
Most read in the last 20 days:
- Gold Sector: Positioning and Sentiment
A Case of Botched Timing, But... When last we wrote about the gold sector in mid February, we discussed historical patterns in the HUI following breaches of its 200-day moving average from below. Given that we expected such a breach to occur relatively soon, the post turned out to be rather ill-timed. Luckily we always advise readers that we are not exactly Nostradamus (occasionally our timing is a bit better). Below is a chart of the HUI Index depicting the action since the January...
- India: The next Pakistan?
India’s Rapid Degradation This is Part XI of a series of articles (the most recent of which is linked here) in which I have provided regular updates on what started as the demonetization of 86% of India's currency. The story of demonetization and the ensuing developments were merely a vehicle for me to explore Indian institutions, culture and society. The Modimobile is making the rounds amid a flower shower. [PT] Photo credit: PTI Photo Tribal cultures face...
- The Long Run Economics of Debt Based Stimulus
Onward vs. Upward Something both unwanted and unexpected has tormented western economies in the 21st century. Gross domestic product (GDP) has moderated onward while government debt has spiked upward. Orthodox economists continue to be flummoxed by what has transpired. What happened to the miracle? The Keynesian wet dream of an unfettered fiat debt money system has been realized, and debt has been duly expanded at every opportunity. Although the fat lady has so far only...
- Welcome to Totalitarian America, President Trump!
Trump vs. the Deep State If there had been any doubt that the land of the free and home of the brave is now a totalitarian society, the revelations that its Chief Executive Officer has been spied upon while campaigning for that office and during his brief tenure as president should now be allayed. Image adapted from the cover of “Deep State #5” - depicting an assassin from the future President Trump joins the very crowded list of opponents of the American...
- Boosting Stock Market Returns With A Simple Trick
Systematic Trading Based on Statistics Trading methods based on statistics represent an unusual approach for many investors. Evaluation of a security's fundamental merits is not of concern, even though it can of course be done additionally. Rather, the only important criterion consists of typical price patterns determined by statistical examination of past trends. Fundamental considerations such as the valuation of stocks are not really relevant to the statistics-based trading...
- Searching for Truth
Heresy or Truth? RANCHO SANTANA, NICARAGUA – In the fifth century, Christian scholars counted 88 different heresies. Arianism. Eutychianism. Nestorianism. If there was a way to “offend” God, they had a name for it. One group of “heretics” argued that there was no such thing as “original sin.” Another denied the trinity. And another claimed Jesus was not divine. Which one had the truth? Depiction of the first Council of Ephesus in 431 AD, convened by Emperor...
- March to Default
Style Over Substance “May you live in interesting times,” says the ancient Chinese curse. No doubt about it, we live in interesting times. Hardly a day goes by that we’re not aghast and astounded by a series of grotesque caricatures of the world as at devolves towards vulgarity. Just this week, for instance, U.S. Representative Maxine Waters tweeted, “Get ready for impeachment.” Well, Maxine Waters is obviously right – impeaching the president is an urgent...
- Why the 21st Century Sucks - Turtles All the Way Down
A Truly Sucky Century BALTIMORE – What an awful century! Worst we’ve ever seen. Household incomes are down. Employment is down, with 7 million people in the U.S. of working age without jobs. Productivity growth is down. GDP growth is down – to only about 0.5% per capita last year. Even life expectancies are down. Drug overdoses are up. Suicides are up. One out of every eight children lives in a family getting food stamps. One of out every eight adults takes psychoactive drugs...
- Gold and the Fed's Looming Rate Hike in March
Long Term Technical Backdrop Constructive After a challenging Q4 in 2016 in the context of rising bond yields and a stronger US dollar, gold seems to be getting its shine back in Q1. The technical picture is beginning to look a little more constructive and the “reflation trade”, spurred on further by expectations of higher infrastructure spending and tax cuts in the US, has thus far also benefited gold. From a technical perspective, there are indications that the low at $1045.40,...
- The Unstable Empire – A Campfire Tale
Campfire Tale Caesar: The Ides of March are come. Soothsayer: Ay, Caesar, but not gone. — Julius Caesar, Shakespeare GRANADA, NICARAGUA – Today, we stop the horses and circle the wagons. For 19 years, we have been rolling along, exploring, discovering. We began with the assumption that we didn’t “know” anything - so we kept our eyes open. Now we know even less. Famous people who knew nothing and were not shy to admit it: Sergeant Schultz...
- Off the Beaten Path in Mesoamerica
Greeted by Rooster There’s an endearing quality to a steadfast rooster call at the crack of dawn when overheard from a warm country farmhouse. There’s a reassuring charm that comes with the committed gallinaceous greeting of daybreak that’s particularly suited to a rural ambiance. The allure of a morning cock-a-doodle-doo somehow falls flat in all other settings. Good morning everyone! Before meteorological forecasts were available on TV and smart phones, people...
- Why Silver Went Down – Precious Metals Supply and Demand
Rumor-Mongering vs. Data The question on the lips of everyone who plans to exchange his metal for dollars—widely thought to be money—is why did silver go down? The price of silver in dollar terms dropped from about 18 bucks to about 17, or about 5 percent. Reportedly silver was already assassinated in the late 19th century... so last week they must have assassinated its corpse. [PT] Illustration taken from 'Coin's Financial School' The facile answer is...