To counter the likely severe side effects of the lockdowns on the economy—introduced to prevent the spread of the coronavirus—the Federal Reserve has embarked on massive expansion of its balance sheet. The size of the Fed’s assets jumped to $6.2 trillion in April this year from $3.9 trillion in April last year—an increase of 58.9 percent.
In response to this pumping, the momentum of the money supply has jumped sharply, with the yearly growth rate climbing to 23.7 percent in the week ending April 13, from 13.1 percent in March and 2.4 percent in April 2019.
It seems that the Fed is eager to avoid the possibility of a severe recession, hence the reason for its aggressive stance. By this way of thinking, an increase in the growth rate of the money supply will strengthen the demand for goods, which will in turn strengthen the production of these goods.
Most economists are of the view that during periods of economic difficulties it is the duty of the central bank to pursue aggressive monetary pumping to prevent the economy falling into a severe recessionary black hole. An important influence behind this way of thinking is the work of Milton Friedman.
In his writings, Friedman blamed central bank policies for causing the Great Depression in the 1930s. According to him, the Federal Reserve failed to pump enough reserves into the banking system to prevent a collapse in the money stock. As a result of this failure, Friedman argued, the money stock M1, which stood at $28.264 billion in October 1929, had fallen to $19.039 billion by April 1933—a decline of almost 33 percent.1
Friedman held that because of the fall in the money stock, economic activity followed suit. By July 1932, year-on-year industrial production had fallen by over 31 percent. Also, year-on-year the consumer price index (CPI) had plunged: by October 1932, the CPI had fallen by 10.7 percent.
In fact, contrary to Milton Friedman’s view, the fall in the money stock took place not because of the Fed’s failure to aggressively pump money. The sharp fall in the money stock was in response to the shrinking pool of wealth brought about by the previous loose monetary policies of the central bank.
The Essence of the Pool of Wealth
Essentially, the pool of wealth is the quantity of consumer goods available in an economy to support future production. In the simplest of terms, an individual on an island is able to pick twenty-five apples an hour. With the aid of a picking tool, he is able to raise his output to fifty apples an hour. Making the tool, however, takes time.
During the time he is busy making the tool, the individual will not be able to pick any apples. In order to have the tool the individual must first have enough apples to sustain himself while he is busy making it. His pool of wealth or his means of sustenance for this period is the quantity of apples he has saved for this purpose.
The size of this pool determines whether a more sophisticated tool—a more sophisticated means of production—can be introduced. If this tool requires one year of work to build but the individual has only enough apples saved to sustain him for one month, then the tool will not be built—and the individual 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 wealth (i.e., the stock of consumer goods) puts a brake on the development of more efficient methods of production.
Trouble erupts whenever the banking system makes it appear as if the pool of wealth is larger than it is in reality. When the supply of money expands, this does not enlarge the pool of wealth. This expansion sets in motion an exchange of newly created money for existing goods. It gives rise to a consumption of goods that has not been preceded by the production of these goods. It leads to a decline in the means of sustenance. It is true that the expansion of money supply lifts the demand for goods, but this demand cannot support an expansion in the production of goods without an accompanying expansion in the pool of wealth.
If and for as long as the pool of wealth continues to expand, loose monetary policies give the impression that the expansion of the money supply is the key factor in economic growth.
However, that this is not the case becomes apparent as soon as the pool of wealth begins to stagnate or shrink. Once this happens, the economy begins its downward cycle. The most aggressive monetary pumping will not reverse the plunge (for money cannot replace apples).
How Fractional Reserve Banking Leads to the Disappearance of Money
The existence of the central bank and fractional reserve banking permits commercial banks to generate credit that is not backed by the prior creation of real wealth. Once this unbacked credit is generated, it produces the same effect that the expansion of money does: it sets in motion the consumption of goods without the preceding production of these goods.
Whenever the extensive generation of credit out of “thin air” lifts the pace of wealth consumption above the pace of wealth production (as we have described above in relation to central bank monetary pumping) this starts to undermine the pool of wealth. Consequently, the performance of various activities starts to deteriorate and banks’ bad loans start to increase. In response to this, banks curtail the expansion of lending out of “thin air,” setting in motion a decline in the money stock. An example clarifies how this decline emerges:
Let us assume that an individual, Tom, places $1,000 in saving deposit for three months with Bank A. The bank lends the $1,000 to Mark for three months. On the maturity date, Mark repays the bank $1,000 plus interest. After deducting its fees, Bank A returns the original money plus interest to Tom.
In this scenario, Tom has lent his $1,000 for three months, i.e., he has transferred the $1,000 to Mark through the mediation of Bank A. The lending is fully backed, since existent money from Tom to Mark and then back via the mediation of Bank A.
Things are different when Bank A lends money out of “thin air.” For instance, let’s say Tom exercises his demand for money by placing $1,000 in demand deposit with Bank A. By placing the money in demand deposit, he retains total claim to the $1,000. This means that the $1,000 is Tom’s exclusive property and no one is allowed to violate this right.
Now, Bank A may decide to take $100 from Tom’s demand deposit without Tom’s agreement and lend it to Mark. As a result, Bank A generates a demand deposit for Mark to the tune of $100. The money stock has now increased by $100. Because of this lending, we now have $1,100 that is only backed by $1,000 proper. In this case the $100 loaned also does not have an original lender, as it was generated out of “thin air” by Bank A.
When Mark repays the borrowed $100 to Bank A on the maturity date, it disappears. The money supply is now back at $1,000. If the bank continues to renew its lending out of thin air, then the stock of money will not decline. Indeed, the more lending out of “thin air” supplied by the bank, the greater the expansion of money supply will be.
The existence of fractional reserve banking (banks creating several claims on a given dollar) coupled with the subsequent unwillingness to renew and expand this lending out of “thin air” is the key factor in money disappearance. There must be a reason, however, why banks do not renew their “thin air” lending, causing this disappearance of money.
What Causes Banks to Curtail Lending?
A key reason is the weakening of the process of wealth generation, which makes it much harder to find quality borrowers. Remember that what weakens this process is the expansion in money supply due the easy monetary policies of the central bank.
Loose monetary policies set in motion an exchange of nothing for something—i.e., consumption that is not supported by the prior production of wealth. This results in the transfer of real wealth from wealth generators to non–wealth generators.
This means that a decline in the money supply (i.e., monetary deflation) emerges because of the prior monetary inflation that diluted the pool of wealth. It follows that a fall in the money supply is really just a symptom. The fall in the money stock comes in response to the damage that the previous monetary inflation caused to the process of wealth formation.
Note that between December 1920 and August 1924, the Fed was pursuing a very easy interest rate policy and as a result the yield on the three-month T-bill fell from 5.9 percent in December 1920 to 1.9 percent by August 1924. By December 1925 the yield had climbed back to 3.5 percent before declining to 3.1 percent by April 1926. Thereafter the yield followed a rising trend, closing at 5.1 closing by May 1929. (Observe that the average of the yield on the three-month Treasury Bill from September 1924 to October 1929 stood at 3.5 percent—below the average of 3.9 percent from December 1920 to August 1924.)
Coupled with the increase in money supply from January 1927 to October 1929 (the yearly growth rate of M1 money supply shot up from –2.2 percent in January 1927 to almost 8 percent by October 1929), this set in motion an economic boom, which had inflicted damage on the process of wealth generation, i.e., undermined the pool of wealth severely. Note that the yearly growth rate of industrial production stood at 22 percent by April 1929. Also, note that the previous massive booms had likely damaged the pool of wealth when the yearly growth rate of industrial production had stood at 42 percent in December 1922 and 28 percent in June 1926.
Because of the fall in the money stock from October 1929 to April 1933, various activities that had sprang up on the back of the previous monetary expansion found it hard going.
It is those non–wealth generating activities that ended up having the most difficulties in serving their debt, since those activities never really generated any real wealth and were, so to speak, riding on the coattails of genuine wealth generators. After closing at 8.7 percent in November 1929, the yearly growth rate of bank loans had plunged to –20.8 percent by September 1932 (see chart). In response to this the money supply M1 collapsed (see chart).
With the fall in the money out of “thin air,” the support provided to non–wealth generators was arrested. This set in motion the demise of various non–wealth generating activities, which manifested in the economic nightmare that we now label the Great Depression.
Summary and Conclusions
Contrary to the popular view, it was the loose monetary policy of the Fed during the 1920s that was behind the Great Depression of the 1930s, rather than the Fed’s failure to pump aggressively during the 1930s.
Even if the central bank had been successful in preventing the fall in the money stock, this would not have been able to prevent the economic slump if the pool of wealth had been declining.
Contrary to popular thinking, the lifting of the money stock to reverse an economic slump undermines the process of wealth generation and prolongs the slump. Being the medium of exchange, money can only facilitate the flow of goods and services in an economy—it cannot expand the of production of goods and services as such. The key to this expansion is an increase in the pool of wealth.
- 1Milton Friedman and Rose Friedman, Free To Choose: A Personal Statement (Melbourne: Macmillan Company of Australia, 1980), pp. 70–90.
