Money Creation and the Boom-Bust Cycle

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)

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.

Effect of a Change in the Total Demand for Money

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.

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.