Does Demand Create Supply?

Amongst the first reactions when Nicola Willis announced a coming cut in Wellington's bureaucrats came the outcry that the reduced consumer spending by those unemployed grey ones will keep Wellington "at the bottom of the pack in terms of things like economic activity," their reduced demand leading (so it's said) to a downward spiral.

The most cited author of that premise is alleged economist Nick Brunsdon, who seems to labour under the illusion that economic causality can be reversed, that demand induced by govt deficits somehow creates its own productive supply -- that if government keeps on over- spending and injecting new money into the economy, then productive wealth will follow. Fortunately, Frank Shostak is here in this Guest Post to dispel that destructive illusion ...

Does Demand Create Supply?

by Frank Shostak

By popular thinking, increases in demand cause economic growth. According to such thought, whenever the economy falls into a recession what is required is to strengthen demand. Since government is seen as an important part of total demand, what is then required is to increase government outlays, thereby lifting overall demand and hence increasing economic growth.

According to the popular view, it is also possible to strengthen overall demand through the inflationary increases in money supply. With more money in their possession, and for given prices, the so-called real balances will increase and this, in turn, will strengthen individuals’ expenditure on goods and services. This allegedly will strengthen the economy’s overall demand and will strengthen economic growth. A decline in the prices for a given money supply will also boost the real balances and thus the economic growth. 

But does it make sense that demand is the key driver of the economy?

In the free market economy, wealth-generators do not produce everything for their own consumption. Part of their production is used to exchange for the products of other producers. Hence, in the free market economy, production precedes consumption. This means that something is exchanged for something else. This also means that an increase in the production of goods and services sets in motion an increase in the demand for goods and services. According to David Ricardo,

No man produces but with a view to consume or sell, and he never sells but with an intention to purchase some other commodity, which may be immediately useful to him, or which may contribute to future production. By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person.

An individual’s demand is constrained by his ability to produce goods demanded by others. The more goods that an individual can produce, the more goods he can demand.

Expanding Private Savings: Key to Economic Growth

Without the expansion and the enhancement of the production structure, it is difficult to increase the supply of goods and services. The expansion and enhancement of the production structure hinges on the expansion of production, private saving, and capital investment. Saving supports individuals in the various stages of production. It supports individuals that are employed in the enhancement and the expansion of the production structure. Hence, what matters for economic growth is not just tools, machinery, and labour, but saving and investment in capital goods.

Government Is Not a Wealth-Generator

Contrary to popular thinking, the government does not produce any wealth. Increases in government spending cannot grow the economy. By nature, the government must take from the private, productive economy to facilitate any of its actions. By doing this, the government weakens the wealth-generating process and undermines prospects for economic recovery during a downturn. According to Murray Rothbard,

Since genuine demand only comes from the supply of products, and since the government is not productive, it follows that government spending cannot truly increase demand.

Likewise, an increase in money supply only sets in motion an exchange of nothing for something. This means a weakening in the process of wealth formation and leads to economic impoverishment.

An important factor that makes the fiscal and monetary stimulus appear to “work” is if the amount of private savings is large enough to support non-wealth generating activities while still permitting a growth rate in the activities of wealth generators. It also gives the appearance of wealth as new sectors are stimulated. Additionally, if funded by inflation, the benefits of inflation appear early and are only realised later.

If, however, voluntary saving is declining, then, regardless of any increase in government spending and inflation by the central bank, overall economic activity cannot be revived. In this case, the more the government spends, and the more the central bank inflates, the more will be taken from wealth-generators, thereby weakening any prospect for a recovery. Additionally, these measures will further distort the economy.

As one can see, not only does the increase in the expansionary fiscal and monetary policies not raise overall output, but, on the contrary, it leads to a weakening in the process of wealth generation in general. According to Jean Baptiste Say,

. . .the only real consumers are those who produce on their part, because they alone can buy the produce of others, [while]. . .barren consumers can buy nothing except by the means of value created by [actual] producers.

Conclusion

By popular thinking, increases in government spending and central bank inflation strengthens the economy’s overall demand. This, in turn, sets in motion increases in the production of goods and services. What we have here is a claim that “demand creates supply.” However, to be able to exchange something for goods and services, individuals must first have something that others want. This means that, in order to demand goods and services, individuals must produce something useful first. Hence, supply drives demand and not the other way around. Governments, by nature, must take from the private, productive sector in order to fund their activities. Increases in government spending and the money supply growth rate results in the diversion of savings from the wealth-generators to non-wealth-generators, thus undermining the wealth generating process.

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Frank Shostak is an Associated Scholar of the Mises Institute. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies. He received his bachelor’s degree from Hebrew University, his master’s degree from Witwatersrand University, and his PhD from Rands Afrikaanse University and has taught at the University of Pretoria and the Graduate Business School at Witwatersrand University. Frank’s publishes frequent posts on economics and the markets on his Substack page.

His post first appeared at the Mises Wire.

 

How often do we hear that government "austerity" is destructive —that it is the job of government, or their central bank, to "stimulate demand"? Or that growth can be gussied up by gobs of government cash? In this guest post, Frank Shostak is here to dismantle those ideas, and to explain that monetary pumping does not create new wealth, it destroys it ...

Does Government Spending and Money Expansion Create New Wealth or Destroy It?

by Frank Shostak

Many economists claim that economic growth is driven by increases in the total demand for goods and services, additionally claiming that overall output increases by some multiple of the increase in expenditures by government, consumers, and businesses. Thus, it is not surprising that most economic commentators believe that a fiscal and monetary stimulus will strengthen total demand, preventing an economy from falling into a recession. [And conversely, that a withdrawal of govt spending will send it there. - Ed.]

These economists believe that increasing government spending and central bank monetary pumping will increase production of goods and services and strengthen total demand. This means that demand creates supply. However, is this the case?

Why Supply Precedes Demand

In the market economy, producers do not produce solely for their own consumption. Some of their production is used to exchange for what others produce. Hence, in the market economy, production precedes consumption. Something is exchanged for something else. This also means that an increase in the production of goods and services leads to an increase in the demand for goods and services.

According to David Ricardo,

No man produces, but with a view to consume or sell, and he never sells, but with an intention to purchase some other commodity, which may be immediately useful to him, or which may contribute to future production. By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person.

An individual’s demand is constrained by his ability to produce goods. The more goods an individual can produce, the more goods he can demand. For example, if five people produce ten potatoes and five tomatoes, this is all that they can demand and consume. The only way to consume more is to produce more.

James Mill wrote,

When goods are carried to market what is wanted is somebody to buy. But to buy, one must have the wherewithal to pay. It is obviously therefore the collective means of payment which exist in the whole nation that constitute the entire market of the nation. But wherein consist the collective means of payment of the whole nation? Do they not consist in its annual produce, in the annual revenue of the general mass of inhabitants? But if a nation’s power of purchasing is exactly measured by its annual produce, as it undoubtedly is; the more you increase the annual produce, the more by that very act you extend the national market, the power of purchasing and the actual purchases of the nation. . . . Thus it appears that the demand of a nation is always equal to the produce of a nation. This indeed must be so; for what is the demand of a nation? The demand of a nation is exactly its power of purchasing. But what is its power of purchasing? The extent undoubtedly of its annual produce. The extent of its demand therefore and the extent of its supply are always exactly commensurate.

The Expanding Pool of Real Savings Key to Economic Growth

Without the expansion and enhancement of the structure of production, it is impossible to increase the supply of goods and services in accordance with the increase in total demand. Expanding and enhancing the infrastructure depends upon expanding the pool of real savings, which is composed of consumer goods and supports those employed producing those necessary goods and services.

Consequently, it does not follow that increasing government spending and employing loose monetary policy will increase the economy’s output. It is impossible to lift overall production without the necessary support from the real savings pool.

For example, a baker produces twelve loaves of bread and saves ten loaves. He then exchanges them for a pair of shoes with a shoemaker. In this example, the baker funds the purchase of shoes by means of the ten saved loaves of bread, which maintains the shoemaker’s life and well-being. Likewise, the shoemaker has funded the purchase of bread by means of shoes that he had produced.

Assume that the baker has decided to build another oven to increase production of bread. To implement his plan, the baker hires the services of the oven maker, paying the oven maker with some of the bread he is producing. If the flow of bread production is disrupted, however, the baker cannot pay the oven maker, so the making of the oven would have to be abandoned. Therefore, what matters for economic growth is not just tools, machinery, and the pool of labour but also an adequate flow of consumer goods that meet the producer’s needs.

Government Does Not Generate Wealth

Government does not produce wealth, so how can an increase in government outlays revive the economy? People employed by the government expect compensation for their work. One way the government can pay these employees is by taxing others who are generating wealth. By doing this, the government weakens the wealth-generating process and undermines prospects for economic growth.

According to Murray Rothbard, 

Since genuine demand only comes from the supply of products, and since the government is not productive, it follows that government spending cannot truly increase demand.

If the pool of real savings is large enough to fund government spending, then a fiscal and monetary stimulus will seem to be successful. However, should the pool of real savings decline, then regardless of any increase in government outlays and monetary pumping by the central bank, overall real economic activity cannot be revived. In this case, the more government spends and the more the central bank pumps, the worse off wealth generators will be, eliminating prospects for a recovery.

When loose monetary and fiscal policies divert bread from the baker, he will have less bread at his disposal. Consequently, the baker cannot secure the services of the oven maker, making it impossible to increase the production of bread.

As the pace of loose government policies intensifies, the baker may not have enough bread left even to sustain the workability of the existing oven since he no longer can afford the services of a technician to maintain the existing oven. Consequently, the production of bread will actually decline.

Because of the increase in government outlays and monetary pumping, other wealth generators will have fewer real savings at their disposal. This in turn will hamper the production of their goods and will weaken overall real economic growth. The increase in loose fiscal and monetary policies not only fails to raise overall output, but on the contrary, it leads to a general weakening in the wealth-generation process.

According to J.B. Say, 

The only real consumers are those who produce on their part, because they alone can buy the produce of others, [while] . . . barren consumers can buy nothing except by the means of value created by producers.

Conclusion

Most economists and economic commentators claim that increases in government spending and central bank monetary pumping strengthen the economy’s overall demand. This, in turn, sets in motion increases in the production of goods and services. Thus, demand supposedly creates supply.

However, to be able to exchange something for goods and services, individuals must first have something by which to exchange. To demand goods and services individuals first must produce something useful. Hence, supply drives demand, not the other way around.

Increases in government spending divert savings from the wealth-generating private sector to the government, thereby undermining the wealth-generating process. Likewise, monetary pumping results in wealth diversion from wealth generators toward the holders of pumped money. Far from stimulating economic growth, government actions hinder it.

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Frank Shostak has over 40 years experience as a market economist and central bank analyst. He is an adjunct scholar of the Ludwig von Mises Institute and a member of the board of editors of the Quarterly Journal of Austrian Economics. He is highly regarded for his skills to convert complex economic issues into plain English. He has written articles that have appeared in The Wall Street Journal and in academic journals in Europe and the US. A follower of common -sense economics and damage inflicted from reckless money creation, his Sydney-based consulting firm, Applied Austrian Economics, provides in-depth assessments of financial markets and global economies.

His post first appeared at the Mises blog.

Pic: Mises Wire

A reminder for everyone, as you all wait patiently for economic miracles from a new government, that while Keynesians claim that the source of economic growth is consumer (and government) spending, so-called Austrian economists such as our guest poster Frank Shostak know that the key to a growing economy is net savings . . .

Real Economic Growth Depends on Savings

by Frank Shostak

New Zealand's consumer confidence index is slowly climbing off the floor from its March low, but only weakly. Meanwhile in the US, their consumer sentiment index fell to 69.5 in August from 71.6 in July. 

What does this portend? A weakening consumer sentiment index is seen as indicating a potential downturn in consumer spending and -- to many economists -- of the economy in general.

Why is this? It's because most mainstream economic commentators agree with each other (and with their mentor, John Maynard Keynes) that the key to economic prosperity is individual consumption rather than saving. Saving, they believe, hinders economic growth because it coincides with weakening demand for consumer goods. In this theory, economic activity is depicted as a circular flow of money in which one individual’s spending is part of the earnings of another.

If, however, individuals become less confident about the future, they are likely to cut back on their outlays and "hoard" more money, thereby diminishing the earnings of some other individual, who in turn also spends less. A vicious circle emerges: the decline in confidence leads to less spending and more hoarding, further weakening the economy and eroding confidence in it.

To arrest the downward spiral, according to this theory, the central bank must increase the supply of money. By putting more money in people’s hands, confidence and spending will increase, and the circular flow of money will pick up again.

All this sounds very convincing, and, indeed, business surveys show that a lack of individual demand is the major factor behind poor performance during recessions. But can demand by itself generate economic growth? What about the supply of goods? Are goods always around, just waiting for demand? Is it even possible for demand itself to be scarce?

Scarcity of Means Thwarts Demand

In the real world, demand is not just desire -- it is desire backed up by wherewithal. It is necessary to produce useful goods that can be exchanged for other useful goods. Bakers who produce bread don’t produce everything for their own consumption, but exchange most of it for the goods of other producers. Through the production of bread, bakers exercise demand for other goods. According to David Ricardo:

No man produces but with a view to consume or sell, and he never sells but with an intention to purchase some other commodity, which may be immediately useful to him, or which may contribute to future production. By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person.

Tools and machinery (i.e., capital goods) raise worker productivity: they must be made, and they increase growth in the production of consumer goods.

Consumer goods must be available to those who produce capital goods, in order to sustain their life and well-being during production. This allocation of consumer goods is made possible by saving—that is, a decision by some individuals to transfer a portion of their consumer goods now, in return for a greater quantity in the future, to those who are producing capital goods now. Despite what the Keynesians assert, it is saving that enables the production of capital goods. and thereby raises individual living standards. It is  saving, therefore, that is the beating heart of economic growth.

Money and Saving—What Is the Relationship?

Money does not alter the essence of saving but does make it easier for producers to exchange their products with one another. It does not produce goods but only facilitates their exchange. According to Rothbard,

Money, per se, cannot be consumed and cannot be used directly as a producers’ good in the productive process. Money per se is therefore unproductive; it is dead stock and produces nothing.

In a money economy, payments for goods are still made with other goods—money only facilitates the payment. Thus, a baker exchanges saved bread for money and then exchanges the money for other goods, effectively paying with the saved bread. When a baker exchanges with a shoemaker saved bread for money, the shoemaker receives sustenance to continue making shoes.

Saving makes economic activity possible by means of money. We do not save money itself but employ it to channel the unconsumed consumer goods we have saved toward individuals engaged in production. An individual who hoards money is not saving money per se but rather exercising a demand for it, which is never the bad news that popular thinking believes it to be. Saving does not weaken but rather strengthens economic growth.

Money out of Thin Air and Economic Growth

When money is generated out of thin air however it sets in motion an exchange of nothing for money, followed by money for something—that is, an exchange of nothing for something. This leads to consumption not supported by production, i.e., a diversion of saved consumer goods—which are the products of wealth-generating activities—toward those who hold money made from nothing. Diminishing the flow of saved consumer goods toward producers of wealth weakens the production of goods and in turn the demand for goods, setting in motion an economic recession.

What weakens the demand for goods is not the capricious behavior of consumers but an increase in the money supply out of thin air. As long as the pool of consumer goods is expanding, the central bank and government officials can give the impression that loose monetary and fiscal policies are driving the economy. This illusion, however, is shattered once the pool becomes stagnant or declines. Without expanding the production of consumer goods, all other things being equal, economic growth is not possible.

Conclusion

Most people aspire to a good and comfortable life. Standing in the way of this goal are the means that must be produced to achieve it. Saving permits the expansion of these means. The increase in saving, which supports the increase in the production of goods, also generates an increase in demand for goods. Any illusion that demand can somehow be strengthened through the monetary presses is sooner or later shattered by the impossibility of getting something for nothing.

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Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

His post first appeared at the Mises Wire.

Government Budget Deficits: Not Good, and Never-Ending

Amidst news that Grant Robertson' budget deficit is tracking higher than forecast, showing a deficit of $3.2 billion for the eight months ended February, questions should be asked about what the hell he means by saying the unbalanced books are in "solid shape" --- how he plans to ever get the deficit down -- and what will be impact on already squeezed cost-of-living increases caused by the government's monetary inflation and over-spending.

Because whatever his favourite Keynesian economists tell him, government deficits are always bad, explains Frank Shostak in this Guest Post, and especially in a slump like this one ...

Government Budget Deficits Cannot Stimulate True Economic Growth

by Frank Shostak

Keynesian economists say that during an economic slump, the government must run large budget deficits in order to keep the economy going. In contrast, Austrian economists maintain that increased budget deficits are usually monetised, leading to general price increases. Therefore, from this perspective, the government should avoid increasing budget deficits and instead balance the budget.

Government Spending Takes Resources from Wealth Generators

Governments do not generate wealth, as government spending uses resources that must be taken from people who generate wealth. This, in turn, undermines the wealth-generating process of the economy. This means that the effective level of tax is the size of the government.

For instance, if the government plans to spend $3 trillion and collects $2 trillion in taxes, there will be a shortfall, or deficit, of $1 trillion. The government will attempt to obtain resources from wealth generators to support its activities. Hence, what matters here is that government outlays are $3 trillion and not that the deficit is $1 trillion.

For instance, if the government lifts taxes to $3 trillion, resulting in a balanced budget, would this alter the fact that it still takes $3 trillion of resources from wealth generators? We hold that government outlays set into motion a diversion of wealth from wealth-generating activities to non-wealth-generating activities, leading to economic impoverishment. Therefore, government outlays ostensibly to boost economic activity actually should be regarded as bad news for the economy.

Government Taxes Stifle Market Processes

Wealth producers exchange their products with each other, a voluntary activity. The key point is that trade must be free and reflect the individual’s priorities. Government taxes, however, are coercive, forcing producers to part with their wealth in exchange for unwanted services. This implies that producers are forced to exchange more for less, reducing their well-being.

The more non-market-related projects the government undertakes, the more real wealth is transferred from wealth producers. We can conclude that the amount of taxes taken from the wealth-generating private sector is directly determined by the expanse of government activities.

As a wealth consumer, the government cannot contribute to the pool of real savings. Moreover, if government activities could produce wealth, then they would have been self-funded and would not have required any support from other wealth generators. Therefore, the issue of taxes would never arise.

None of this is altered by introducing money into the economy. In the money economy, the government will tax wealth generators and pay out the take to people employed directly or indirectly by the government. This money gives government employees and contractors access to the pool of real savings. Government-employed individuals are now able to exchange the tax money for consumer goods.

The Meaning of a Budget Surplus in a Money Economy

What then is the meaning of a budget surplus in a money economy? It means that the inflow of money to the government exceeds its expenditure of money. The budget surplus here is just a monetary surplus. The emergence of a surplus produces the same effect as any tight monetary policy. On this Ludwig von Mises wrote:

Now, restriction of government expenditure may certainly be a good thing. But it does not provide the funds a government needs for a later expansion of its expenditure. An individual may conduct his affairs in this way. He may accumulate savings when his income is high and spend them later when his income drops. But it is different with a nation or all nations together. The treasury may hoard a considerable part of the lavish revenue from taxes which flows into the public exchequer as a result of the boom. As far and as long as it withholds these funds from circulation, its policy is really deflationary and contracyclical and may to this extent weaken the boom created by credit expansion. But when these funds are spent again, they alter the money relation and create a cash-induced tendency toward a drop in the monetary unit’s purchasing power. By no means can these funds provide the capital goods required for the execution of the shelved public works.

Lower government outlays imply that wealth generators will now have a larger portion of the pool of real savings at their disposal. If, however, government outlays continue to increase, no effective tax reduction is possible; on the contrary, the share of the pool of real savings at the disposal of wealth producers will diminish.

Critics of smaller governments hold that the private sector cannot be trusted to build up and enhance the nation’s infrastructure. However, can individuals afford the improvement of the infrastructure?

The referee should be the free market where individuals, by buying or abstaining from buying, decide what infrastructure will emerge. If the pool of savings cannot afford better infrastructure, then time is needed to accumulate savings to build a better infrastructure. Increased government outlays cannot raise the pool of savings, and increased government spending will only reduce it.

Government Can Force Non-market-chosen Projects but Cannot Make Them Viable

The government can force the creation of non-market-chosen projects, but it cannot make them viable. Over time, these projects will impose burdens on the economy that undermine individual well-being and will make these projects even more costly.

Will lowering taxes on businesses boost capital investment and strengthen the process of wealth formation? If lowering taxes is not matched by a reduction in government spending, this will encourage a misallocation of savings. The emerging budget deficit will be funded either by borrowing money or by creating new money. Obviously, this diverts real wealth from wealth-generating activities to non-wealth-generating activities. Various capital projects that emerge on the backs of such government policies are likely to be the equivalent of useless pyramids.

Why Government Cannot Be a Genuine Borrower

One way the government secures necessary funds for nonmarket infrastructure is through borrowing. However, a borrower must be a wealth generator to be able to repay the principal loan plus interest.

That is not the case as far as the government is concerned. It is not a wealth generator. So, how then can the government as a borrower ever repay its debt? The way it can do this is by borrowing again from the same lender—the wealth-generating private sector. It amounts to a process whereby the government borrows from you to repay you.

Conclusion

The government does not generate wealth, and the more it spends, the more resources it must take from wealth generators. This, in turn, undermines the wealth-generating process of the economy, meaning that the effective level of tax is the size of the government.

Government outlays divert wealth from wealth-generating activities to non-wealth-generating activities, leading to economic impoverishment. Thus, an increase in government outlays to boost economic activity should be regarded as bad news for wealth generation and to the economy.

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Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies.

Central banks' unprecedented monetary expansion over recent years has created damage they cannot simply undo by switching directions now - as Frank Shostak explains in this guest post, their tight interest stance now will struggle to undo the damage caused by their previously ultra-profligate position.

Central Banks Cannot Undo the Damage They Have Already Caused

by Frank Shostak

On March 16 this year, the US central bank (aka the Federal Reserve) raised the target for their federal funds rate by 0.25 percent, to 0.50 percent. According to officials of "The Fed," their increase was in response to the strong increases in the yearly growth rate of the Consumer Price Index (CPI), which in February stood at 7.9 percent (risen from 7.5 percent in January, and from 1.7 percent in February of the year before).

Most commentators believe that by raising the interest rate target, the central bank can slow the increase of prices of goods and services. Supporters of this strategy often refer to May 1981, when then Fed chairman Paul Volcker raised the Fed's funds-rate target from 11.25 percent to 19 percent. The change was dramatic. By December 1986, the yearly growth rate in the CPI, which in April 1980 had stood at 14.8 percent, had fallen to 1.1 percent (see Fig. 1 below).

Fig. 1: CPI vs Federal Funds Rate, 1980 to 1986

Note that commentators commonly identify the growth rate measured by the CPI, i.e. rising prices, as "inflation." We hold, however, that what inflation is all about is increases in money supply. 

As such, we do not say that inflation is caused by increases in money supply, as some commentators are suggesting. Instead, we hold that increases in money supply are what inflation is all about. 

The price of a good is the amount of money paid for it, but whenever there is an increase in the money injected into a particular goods market, this means that the price of the goods in money terms will tend to rise. All things being equal, however, this increase in money in one market will be offset by a decrease elsewhere. It is only an increase in the money supply itself that allows all prices to raise across all markets. This general increase in prices is itself not inflation, however, but rather the manifestation of inflation as a result of the increase in money supply, all other things being equal.

Bad as this is, what is even more important than the increases it causes in the prices of retail goods is the damage that monetary inflation inflicts to the process of wealth generation. This is because increases in money supply set in motion an exchange of nothing for something, which generates a similar outcome to what counterfeit money does. This counterfeit capital progressively weakens wealth generators, thereby weakening their ability to generate wealth. This, in turn, undermines living standards even as real capital is consumed.

Also, note that when this new money is injected, it initially enters a particular goods market. Once the price of those goods rises to a level at which they are perceived as fully valued, the money begins spilling over into other markets that are now considered under-valued. This gradual shift from one market to other markets gives rise to a time lag between these increases in new money, and their effect on the wealth generation process.

Central Banks do not set interest rates. Individuals do.

Note that contrary to popular thinking, interest rates are determined not by central bank monetary policy. Instead, they are driven by the time preferences of individuals. According to the founder of the Austrian school of economics, Carl Menger, the phenomenon of interest is the outcome of the fact that individuals assign a greater importance to goods and services now than they do to identical goods and services in the future. I is this that we call "time preference."

For example, most people will generally prefer being given $100 now rather than, say, $103 a year from now. It is this evaluation by multiple individuals that is the driving force of interest rates across all markets.

Observe that the higher valuation of present goods is not the result of capricious behaviour, but rather the identification that life in the future is impossible without sustaining it in the present. According to Menger:

Human life is a process in which the course of future development is always influenced by previous development. It is a process that cannot be continued once it has been interrupted, and that cannot be completely rehabilitated once it has become seriously disordered. A necessary prerequisite of our provision for the maintenance of our lives and for our development in future periods is a concern for the preceding periods of our lives. Setting aside the irregularities of economic activity, we can conclude that economising men generally endeavour to ensure the satisfaction of needs of the immediate future first, and that only after this has been done, do they attempt to ensure the satisfaction of needs of more distant periods, in accordance with their remoteness in time.1

Hence, various goods and services required to sustain one’s life at present must therefore be of a greater importance to that individual than the same goods and services in the future. The individual is likely to assign higher value to the same good in the present versus the same good in the future.

Naturally, each individual's time preference is different. Those with paltry means often have shorter time horizons -- they can contemplate only short-term goals, such as making a basic tool. As his means increase, however, he can consider undertaking the making of better tools. With the expansion in the pool of means, individuals are able to allocate more means towards the accomplishment of ever-more remote goals in order to improve their quality of life over time.

Again, while prior to the expansion of means, the need to sustain life and wellbeing in the present made it impossible to undertake various long-term projects, with more resources now this has become possible.

Not that few, if any, individuals will embark on a business venture promises a zero rate-of-return. The maintenance of the process of life, over and above hand-to-mouth existence, requires an expansion in wealth. Wealth expansion implies positive returns.

Is the lowering of rates the key cause behind the increase in capital-goods investment?

Contrary to the popular thinking, a decline in the interest rate is not the driving cause behind the increases in capital-goods investment. What permits the expansion of capital goods is not the lowering of the interest rate but rather the increase in the pool of savings.

This "pool of savings" comprises of finished consumer goods -- finished consumer goods produced, but not yet consumed. It is this pool of savings that sustains people employed in the enhancement and the expansion of capital goods such as tools and machinery. With these increased and enhanced capital goods, it is then possible to increase the production of future consumer goods.

Note that in an unhampered market it is not the interest rate per se that drives this pool of savings towards more (or less) future-directed production -- it is the sum of individuals' time preferences toward more (or less) future focus that compel producers to make this choice.

Individuals' decisions to allocate a greater amount of means towards the production of capital goods is signalled by the lowering of individuals' time preferences, i.e., assigning a relatively greater importance to the future goods versus the present goods. 

Hence, the interest rate is just an indicator as it were, which reflects individuals’ decisions regarding their present consumption versus future consumption. (Again, the decline of the interest rate is not the cause of the increase in capital investment. The decline simply mirrors the decision to invest a greater portion of savings towards capital-goods investment).

In a free unhampered market, a decline in the interest rate informs businesses that individuals have increased their preference towards future consumer goods versus present consumer goods. Businesses that want to be successful in their ventures must abide by consumers’ instructions, and organise a suitable infrastructure to accommodate this signalled demand for more consumer goods in the future (rather than now). 

Note that through the lowering of time preferences, individuals have signalled that they have increased savings which will support the expansion of the production structure to become more future-directed. In the unhampered market, the decline in interest rate is therefore both a signal for more future-directed production, and a reward for undertaking it.

Observe that in an unhampered market, fluctuations in interest rates will tend to be in line with changes in consumers’ time preferences. Thus, a decline in the interest rate is in response to the lowering of individuals’ time preferences. Consequently, when businesses observe a decline in the market interest rate, they respond to it by increasing their investment in capital goods to accommodate the likely increase in demand for future consumer goods. (Note again that in a free-market economy, a decline in the interest rate indicates that on a relative basis individuals have lifted their preference towards future consumer goods versus present consumer goods).

What I have described here however is what happens in a free unhampered market -- in particular, one unencumbered by a government central bank. A major reason for the discrepancy between the so-called 'market interest rate' and the interest rate described here (i.e., the interest rate that fully reflects individuals' time preferences) is caused by the central bank. For instance, an aggressive loose monetary policy by the central bank leads to the lowering of the observed interest rate regardless of individuals' expressed time preference. Businesses respond to this lowering by increasing the production of capital goods, i.e., tools and machinery, in order to be able to accommodate the demand for consumer goods in the future. Note, however, that consumers have not actually indicated a change in their preferences toward present consumer goods. The time-preference interest rate did not go down. And so a gap emerges between the time-preference rate and the market rate.

It is this gap that causes the dislocations between consumption and consumption that presage economic corrections in future, and encourage over-consumption of capital now.

Because of this breach between the time-preference interest rate and the market interest rate, businesses responding to the declining market interest rate have essentially malinvested in capital goods relative to the production of present consumer goods. At some stage, by incurring losses, businesses are likely to discover that pass decisions with regard to the capital-goods expansion were in error.

Why tightening now cannot undo the negatives of a previous loose stance

According to Ludwig von Mises, a tight monetary stance cannot undo the negatives of the previous loose stance. (In other words, the central bank cannot generate a “soft landing” for the economy.) The misallocation of resources due to a loose monetary policy has already happened, and cannot simply be reversed by a tighter stance. (Mises likens the attempted correction to attempting to cure a road-accident victim by reversing over him.) According to Percy L. Greaves Jr. in the introduction to Mises's The Causes of the Economic Crisis, and Other Essays before and after the Great Depression:

Mises also refers to the fact that deflation can never repair the damage of a prior inflation.... Inflation so scrambles the changes in wealth and income that it becomes impossible to undo the effects. Then too, deflationary manipulations of the quantity of money are just as destructive of market processes, guided by unhampered market prices, wage rates and interest rates, as are such inflationary manipulations of the quantity of money.

A tighter interest-rate stance, while likely to undermine current bubble activities, is also however still likely to generate various distortions, thereby inflicting damage to wealth generators. Note that a tighter stance is still intervention by the central bank, and in this sense it still falsifies the interest-rate signal set by consumers. A tighter interest-rate stance still doesn't result in the allocation of resources in line with consumers’ top priorities. Hence, it does not follow that a tighter interest rate stance can reverse the damage caused by inflationary policy. 

Now, if we were to accept that inflation is about increases in money supply, then all that is required to erase inflation is to seal off the loopholes for the generation of money out of “thin air” by the central bank. A careful scrutiny of this is going to reveal that the culprit behind the increases in money supply is the monetary policies of the central bank. 

Policies aimed at stabilising price increases are in fact producing economic upheavals. Observe that by February 2021, the yearly growth rate of our monetary measure for the USA jumped to almost 80 percent! This is truly astonishing. Against the background of this massive increase, one should not be at all surprised that the yearly growth-rate of the CPI has accelerated. And against the background of this article, one might begin to understand why policies that aim only at slowing the growth rate of the CPI rather than arresting the growth rate of money supply are likely to undermine economic conditions rather than improve them.

Conclusion

As long as sustaining our lives remains individuals' ultimate goal of individuals (that is, as long as our species continues to breathe), they will go on assigning a higher valuation to present goods than they will to future goods -- to $100 now rather than to $103 a year from now -- and no amount of central-bank interest-rate manipulation is going to change this reality. 

But this will not stop them trying. Any attempt by central bank policy makers to overrule this fact however will undermine the process of wealth formation, and will lower individual living standards.

On the one hand, if individuals have not allocated adequate savings to support the expansion of capital goods investments, then it  is not going to help economic growth if the central bank artificially lowers interest rates. It is not going to help, because it it not possible to replace real savings with more money and an artificial lowering of the interest rate. It is not possible, because it it not possible to generate something from nothing. 

Likewise, by raising interest rates the central bank cannot undo the damage from its previously easy interest-rate stance. A tighter stance will likely generate various other distortions. Hence, what is required is that policy makers should leave the economy alone -- and let the market be completely free from central-bank tampering.

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Dr Frank Shostak is a leading Austrian economist and director of Applied Austrian School Economics Ltd, which aims to assess the direction of various markets using the Austrian School methodology. AASE aims to make Austrian economics accessible to businessmen.

Versions of this post previously appeared at the Mises Wire and Cobden Centre.

Money Pumping Won’t Fix What’s Wrong with the Economic System

Central banks everywhere, including our own, are in the process of "expanding their balance sheets" to "counter the side-effects of lockdowns, to buy exploding government debt, to "stimulate" the economy, to avoid the possibility of a severe recession ... but as Frank Shostak argues in this guest post, both history and sound economics tell us that expanding the money stock to reverse an economic slump undermines the process of wealth generation, and it prolongs the slump. In other words ...

Money Pumping Won’t Fix What’s Wrong with the Economic System

by Frank Shostak

To counter the likely severe side effects of the "lockdowns" on the economy—introduced to prevent the spread of the coronavirus—the U.S 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 NZ, the size of the Reserve Bank's assets jumped to $42.3 billion in March this year from $26.0 last year, an increase of 62.7%!]

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. [In NZ

, the increase to March was 8.3%. The April number is not yet in.]

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 regardless of the Fed’s alleged 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.

More sophistication is added to the island scenario 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 instead sets in motion an exchange of newly-created money for existing goods. It gives rise to the 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.

That this is not the case however 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. [The result of a declining marginal productivity of debt.] Remember that what weakens this process is the previous expansion in money supply due to 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 U.S. Federal Reserve was pursuing a very easy interest rate policy and as a result the yield on the three-month government Treasury 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 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), setting in motion an economic boom, and inflicting severe damage on the process of wealth generation, i.e., severely undermined the pool of wealth. 

Note that the yearly growth rate of industrial production by April 1929 stood at 22 percent! 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 servicing their debt, since those activities never really generated any real wealth and were, so to speak, riding on the coattails of genuine wealth generators. [As Warren Buffett says, it's only once the tide goes out that you see who has been swimming naked.] 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). As a result 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 not the Fed’s failure to pump aggressively during the 1930s  that was behind the Great Depression of the 1930s, instead it was the loose monetary policy of the Fed during the 1920s.

Even if the central bank had been successful in preventing the fall in the money stock, if the pool of wealth had been declining this would not have been able to prevent the economic slump.

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 real wealth.

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1.Milton Friedman and Rose Friedman, Free To Choose: A Personal Statement (Melbourne: Macmillan Company of Australia, 1980), pp. 70–90.
Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. His post previously appeared at the Mises Wire.
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The coronavirus isn't the cause of this next bust, but it will make it worse

And now, here's the good news: The coming economic hit from the coronavirus will be exacerbated by the already-arriving hit from the bursting of the "everything bubble." That's the bubble, inflated by central banks, in the price of virtually every asset from shares to houses -- the bursting of which announced the collapse of the phony boom and the end of this business cycle.
    The likely emergence of an economic bust is not due to the coronavirus, as suggested by popular thinking, but is rather the outcome of the Fed's monetary policy. Boom-bust cycles are not caused by shocks such as the coronavirus. The mechanism that is responsible for the them is central bank monetary policy. The coronavirus shock is likely to weaken the pool of real savings, thereby amplifying the economic bust, but it has nothing to do with the boom-bust cycle as such.
    As Frank Shostak explains in this guest post, in a free, unhampered market economy there is a tendency toward harmony between production and consumption; but in trying to "fix" what they've already broken, the central bank disrupts this harmony....

The coronavirus isn't the cause of this next bust, but it will make it worse

As analysts warned of a severe slowdown in growth and a possible recession if the virus continues to spread, government policymakers everywhere moved to ease public anxiety over the coming economic hit. Central banks cut interest rates. The World Bank and International Monetary Fund signalled that they were also ready to assist, particularly poor nations. Monetary policymakers from Japan to Europe pledged to act as needed to stem any economic fallout as infections spread.

The Organization for Economic Co-operation and Development (OECD) says global growth could plummet to just 1.5 percent in 2020, far less than the 3 percent it projected before the virus surfaced, should the outbreak sweep through the Asia-Pacific, Europe, and North America. If things get bad enough, Japan and Europe could plunge into recession, the OECD warned. Predictions for the United States were nearly as bad: Most analysts expect zero or negative growth in the second quarter, with some forecasting a potential recession before year’s end.

Mainstream analysts however are blindsided by their misunderstanding of the causes of the business cycle. In the mainstream view, the coronavirus is seen as inflicting both supply and demand shocks, which economists hold makes it difficult for policymakers to handle. But this only a symptom, not a cause.

Economic Shocks: The Mainstream View

From the Great Depression of the 1930s until the early 1970s, most economists viewed economic fluctuations as the outcome of "shocks" to aggregate demand. Sudden changes in consumer preferences were said to cause a fall in aggregate demand, which would drag the entire economy below a path of stable economic growth. In contrast, a sudden increase in optimism was said to lead to excessive consumer expenditure, which would push the economy above a stable growth path.

Mainstream economists regarded these deviations from stable growth paths as failures of the market economy to coordinate demand and supply. Consequently, it was seen as necessary for the government and central bank to interfere in order to bring the economy onto a stable growth path.

This way of thinking views "the economy" as an entity in itself rather than as the sum total of human economic interaction -- as an object that moves along a path of stable economic growth, and which is occasionally pushed off course by shocks. In this view, whenever a shock pushes the economy above the path, it sets in motion an unsustainable economic boom. Likewise, a shock or a sequence of shocks that push the economy below a trajectory of stable economic growth results in an economic bust.

According to this way of thinking, a major source of disturbances is a sudden change in people's psychology. Hence, if “out of the blue” consumers and businesspeople become optimistic and embark on a buying spree, this pushes the economy above the stable trajectory and sets in motion an economic boom. Likewise, recessions or economic busts are set in motion if people suddenly change their psychology and stop spending.

Since deviations from the path of stable economic growth are costly, it is held that the government and the central bank must always be on guard to introduce policies that will offset these deviations. For instance, if people become pessimistic the central bank must offset this by accelerating the money supply growth rate and by lowering interest rates and vice versa. In addition, the government must raise its expenditure in order to offset their sudden unwillingness to spend. Similarly, it is the role of government authorities to be vigilant to various other shocks such as the coronavirus spread and counter their effects by means of suitable policies.

Although it is held that one can devise a set of rules that would enable authorities to keep the economy on a stable trajectory, in reality it is not that simple. Because of variable lags between policy changes and their effect on various parts of the economy, it is not possible, so it is argued, to establish the correct timing of various policy measures. It is also maintained that a lack of sufficient knowledge regarding the strength of the economy makes it very hard to decide on the required degree of monetary and fiscal measures.

Consequently, in many instances monetary and fiscal policies rather than stabilising the economy have instead become a major source of instability.

The Market Economy Does Not Move along a Trajectory

A market economy cannot be compared to an object that moves along a particular trajectory. In a market economy, producers exchange among themselves various goods and services. Through the production of goods and services a producer acquires means that enables him to secure the goods and services of other producers. A producer exchanges things he has produced for things he prefers more.

In a free market economy, every producer pays for his consumption, or funds it, by means of the goods and services he has produced. It is, however, the availability of final goods and services that ultimately determine people's well-being. The stock of these goods is what the pool of real savings is all about.

Although shocks can disrupt the pace of economic activity, they have nothing to do with the phenomenon of recurrent boom-bust cycles. This phenomenon requires a mechanism that persistently and systematically feeds and supports it. The only mechanism that does this is central bank monetary policy.

Monetary Policies and Cycles

While in a free, unhampered market economy there is a tendency toward harmony between production and consumption, this is not so once we introduce to our discussion the central bank, which disrupts this harmony.

In a free unhampered market economy, money facilitates the exchange of one producer’s production for the production of another. By means of money, something is exchanged for something else. However, this is not so when the loose monetary policies of the central bank set in motion the creation of money that is borrowed into existence out of “thin air.”

This newly generated money gives rise to new consumption that is not supported by the production of real wealth. Money out of “thin air” gives rise to various activities not fully demanded by consumers that would not emerge in a free-market environment. The emergence of a welter of these nonproductive "zombie" activities constitutes an economic boom. During an economic boom, real savings are diverted from more productive activities to more nonproductive activities by way of money out of “thin air,” weakening the production of real wealth.

Whenever the central bank tightens its stance, i.e., raises interest rates and curtails this monetary pumping, the existence of various nonproductive activities is undermined and their existence becomes threatened. This is the essence of an economic bust, or recession. (Observe however that a tighter monetary stance during a boom slows down this diversion of real savings to nonproductive activities, which helps wealth generating activities.)

It follows that an economic bust is nothing more than the liquidation of nonproductive activities that had emerged under the support of previous loose monetary policy. Note that the reason recurring boom-bust cycles is that central bank authorities continuously pursue so-called monetary policies that are aimed at navigating the economy toward a path of stability and prosperity.

So How Do We Categorise the Effect of the Coronavirus?

So, if recessions are about the liquidation of nonproductive activities how do we categorise an event such as the coronavirus? What is the contribution of a virus to a recession? The answer is this: that the coronavirus has nothing to do with the phenomenon of a recurrent boom-bust cycle; however, it does have the potential to paralyse production activity, which undermines the pool of real savings and therefore future prospects for economic growth. 

This could especially be worse if the lagged money-supply growth was declining too, which would mean that we would also be observing a decline in nonproductive activities. In this case the impact could be profound.

This means that any economic bust we see emerging because of the fall in the growth momentum of money is amplified by the economic effects of the coronavirus. This is likely to magnify the bust. 

So, is this what we are observing currently in the money supply? In the shorter term from a monetary perspective, the slight pickup in the growth rate in the AMS at the beginning of 2018 indicates that we may see a slight improvement in the economic picture for at least the first half of this year before reverting to slowing down. It is also worth noting that over the long term the yearly growth rate of the AMS fell from 13.9 percent in April 2012 to –0.6percent by August 2019 (see chart).

The coronavirus can only make things much worse as far as the pool of real savings is concerned. It is questionable how the loosening of the monetary stance by the central bank can defend an economy from the coronavirus. All that such policies are going to generate is a further depletion of the pool of real savings. Loose monetary policy cannot speed up the development of the necessary vaccine to fight the coronavirus, for example. Such a policy is going to damage further the pool of real savings, delaying any future economic revival.

The Coronavirus Will Not Be the Cause of a Bust

Contrary to popular thinking, the likely emergence of an economic bust is not due to the coronavirus, but is rather the outcome of the Fed's monetary policy. Boom-bust cycles are not caused by shocks such as the coronavirus. The mechanism that is responsible for the them is central bank monetary policy. 

The coronavirus shock is likely to weaken the pool of real savings, thereby amplifying the economic bust, but it has nothing to do with the boom-bust cycle as such.

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Author: Frank Shostak
Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. 

His post first appeared at the Mises Wire.

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