Only a few months ago, most economic commentators were sanguine about prospects for the US economy. Most of them did not expect an imminent downturn. Now, all that has changed, with most experts expecting the economy to enter a downward phase of the economic cycle by 2019. According to experts, the key factor behind the emerging downturn is the policies of the US President Trump, in particular, the imposition of tariffs on imports. Very few analysts, however, attribute the possible downturn to the decline in the annual growth rate of the money supply. The exceptions here are the monetarists (i.e., the followers of Milton Friedman).
According to Friedman, the root of the business cycle is the fluctuation in the growth rate of the money supply.
Friedman held that what is required for the elimination of these cycles is for central bank policymakers to aim at a fixed rate of growth of money supply:
My choice at the moment would be a legislated rule instructing the monetary authority to achieve a specified rate of growth in the stock of money. For this purpose, I would define the stock of money as including currency outside commercial banks plus all deposits of commercial banks. I would specify that the Reserve System should see to it that the total stock of money so defined rises month by month, and indeed, so far as possible, day by day, at an annual rate of X per cent, where X is some number between 3 and 5. The precise definition of money adopted and the precise rate of growth chosen make far less difference than the definite choice of a particular definition and a particular rate of growth.1
If economic cycles are caused by fluctuations in money supply growth, then it makes a lot of sense to eliminate such fluctuations. In this sense, the constant money growth rate rule seems to be the right remedy to eliminate such cycles.
Money out of Thin Air
What sets in motion these cycles is not fluctuations in the growth rate of the money supply as such, but the fluctuations in the growth rate of the money supply generated out of “thin air.” By money “out of thin air,” we mean money that is created by the central bank and amplified by fractional reserve lending by commercial banks.
An increase in the money supply out of “thin air” provides a platform for non-productive activities, which consume and add nothing to the pool of real wealth. Money out of “thin air” diverts real wealth from wealth generators to non-wealth generating activities, thus weakening the wealth-generating process.
The diversion occurs once various individuals who are the early receivers of this newly created money are exchanging new money for goods and services but contributing nothing to the pool of goods and services. Wealth generators who have not received this newly printed money discover they can now secure fewer goods than before. (The increase in the prices of goods and services manifests this.)
While the increase in the growth rate of such money stimulates non-productive activities, a fall in its growth rate undermines those activities. Their ability to divert real wealth from wealth generators is thereby curtailed.
Since non-productive or bubble activities do not generate any real wealth, they cannot secure the goods they require without the support from newly created money.
Note that since non-productive or bubble activities do not generate any real wealth, they cannot secure the goods they require without the support from newly created money.
Once the proportion of non-productive activities to overall activities starts to increase, this tends to put pressure on the profitability of companies. This, in turn, raises the likelihood of an increase in banks’ bad assets. Consequently, banks' expansion of credit through fractional reserve lending (i.e., the expansion of lending out of “thin air”) is likely to slow down, and this, in turn, is likely to weaken the growth rate of the money supply.
In a fractional reserve lending world, once the borrowed money is repaid to the bank and the bank does not renew the loan, the money disappears. In the case of non-fractional reserve lending, once the money is repaid by the borrower, it is transferred to the original lender, and no change in the money supply is going to occur. (In the case of fractional reserve lending, once the money is repaid to the bank, it disappears from the economy, as there is no original lender here to whom money is going to be returned).
A fall in the growth rate of money out of “thin air” is thereby going to undermine various non-productive activities that arose from and were supported by the fractional reserve bank lending. This sets in motion an economic downturn.
The expansion in the money supply supports the emergence of non-productive activities. So if the fixed money rule were to be enforced, over time it would lead to the expansion of non-productive activities. (A fixed money supply rule is still about the expansion of money out of “thin air,” though at a fixed rate). This is going to weaken the wealth generators and thus undermine the real economy.
We can conclude that Friedman’s monetary rule is simply another way of tampering with the economy and, hence, it cannot lead to economic stability.
The Gold Standard and Boom-Bust Cycles
Would the introduction of a gold standard eliminate boom-bust cycles? According to Friedman, what causes boom-bust cycles is fluctuations in the growth rate of the money supply. On the gold standard, there are going to be fluctuations in the growth rate of the money supply. Hence, according to Friedman, the introduction of a gold standard is not going to eliminate business cycles.
It is true that the variability in the growth rate in the production of gold will create fluctuations in the growth rate of the money supply. As opposed to the expansion in the money supply on a paper standard, however, the increase in the money supply on a gold standard will not result in an exchange of nothing for something. It will not result in the diversion of wealth from wealth producers towards non-wealth generating activities.
Being a commodity, apart from providing the services of the medium of exchange, gold is also demanded for various industrial uses, including jewelry. From this perspective, it is part of the pool of real wealth. So when gold is exchanged for goods and services, something is exchanged for something else.
Note that the increase in the supply of gold is not an act of embezzlement or fraud. The increase in the supply of gold does not produce an exchange of nothing for something. Contrast this with the printing of gold receipts i.e. receipts that are not backed 100 percent by gold. This is an act of fraud, which is what inflation is all about. It sets a platform for consumption without contributing to the pool of real wealth. Empty certificates set in motion an exchange of nothing for something, which in turn leads to recurrent cycles.
In the case of the increase in the supply of gold, no fraud is committed. The supplier of gold—the gold mine—has increased the production of a useful commodity. Therefore, in this sense, here we do not have an exchange of nothing for something. Consequently, we also do not have an emergence of bubble activities. A wealth producer (because of the fact that he has produced something useful) can exchange it for other goods. He does not require money out of “thin air” to divert real wealth to him.
On the gold standard, a fall in the growth rate of the money supply is not going to create an economic bust—no bubble or false activities were created that are going to be destroyed by a slower money supply growth rate.
On the gold standard, an increase in the growth rate of money, which is gold, will not set in motion the emergence of bubble or false activities, i.e. an economic boom. Hence, a fall in the growth rate of the money supply is not going to create an economic bust—no bubble or false activities were created that are going to be destroyed by a slower money supply growth rate.
We hold that the disappearance of money out of “thin air” is the major cause of economic downturns. (The injection of money out of “thin air” generates bubble activities, while the disappearance of money out of “thin air” destroys these bubble activities.) On the gold standard, this cannot occur. On a pure gold standard, without the central bank, money is gold. Consequently, on the gold standard, money cannot disappear since gold cannot disappear unless it is physically destroyed, which is an unlikely proposition. We can thus conclude that the gold standard, if not abused, is not conducive to boom-bust cycles.