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Lack of money and money creation:
the economicsThe concept of money creation for investment in sustainable development is based on the premise that the global economy is plagued by a structural lack of money. This lack not only inhibits investment in sustainable development but also, contributes to the growing gap between productive capacity and demand and impedes the reversal of the current economic downturn. This page elaborates this premise further, gives arguments in support of it, and explains why economists fail to recognize the problem.
Question: What again are the causes of the lack of money in the global economy?
Answer: This was amply discussed in the pages on poverty in the poor countries and economic stagnation in the rich nations. Let’s recapitulate. One cause is that due to growing income disparities, strengthened by tax regimes that increasingly favor the wealthy, money is concentrated more and more among wealthy individuals and corporations. These parties redirect huge sums of money from the normal economy, where goods and services are produced, traded and consumed, to a virtual economy, where it is used for speculation. When times are good and stock markets are up some of that money flows back to the regular economy, and increases demand. When times are bad and stocks go down the effects on the normal economy are even stronger. This is because companies engage in cost cutting and in some cases, go bankrupt. The resulting job losses and downward effect on wages decrease demand.Orthodox economic theory does not distinguish between the real and the virtual economy, or, for that matter, between investment (aimed at creating wealth in the real economy by expanding production capacity) and speculation (aimed at increasing wealth in the virtual economy). That is why the withdrawal of money from the real economy into the virtual economy, and the corresponding shortage of money in the real economy, is not recognized. The problem is worsened because orthodox economics calls for countries to have a restrictive monetary policy, or in other words, a tight money supply. Simply put, that means that the increase in the quantity of money should never exceed economic growth.
Question: Why insist on a tight money supply?
Answer: Orthodox economics, especially a branch called monetarism, focuses on the influence of the quantity of money on the economy. It holds that the main economic task of governments, in particular central banks, is to keep down inflation. That is achieved by keeping a tight money supply – that is, by ensuring that the influx of new money into the economy stays in line with the quantity of goods and services. The thought behind this strategy is that if more money is released the amount of money will rise more than the amount of goods and services that can be purchased with it. Relatively speaking this will make goods and services scarcer then money. That, according to one of the most basic tenets of economics, will force up the prices of goods and services or, put another way, lower the value of money – the phenomenon we’ve dubbed inflation.Question: That seems to make sense. Does it?
Answer: The problem is that it’s a gross simplification of reality. There are two main shortcomings. One is the implicit assumption that economic actors know how much money there is in relation to the quantity of good and services. That knowledge is crucial for both producers and consumers to determine if they can sell at higher prices, respectively, have to pay more to obtain the required goods and services. In practice, of course, neither buyers nor sellers have this information: economies are much to complex. Even monetary specialists, including those of Central Banks, don’t have a complete overview of the quantity of money in relation to that of goods and services. This assumption of a perfectly transparent market in which all actors have full knowledge of prices and of the supply of and demand for money, goods and services is one of the many examples of economic theory deviating from real life.The second assumption underlying this monetary theory is just as faulty: the concept of a closed market where the entire money supply keeps circulating and is used for consumption or investment (directly, or through savings). Real life is, of course, much different. Especially in this age of globalization enormous flows of money and especially capital cross borders every minute. Today there are no closed markets. Thus fiddling around, as central banks do, with minor increases or decreases in the growth of the national money supply has little meaning in the grand scheme of things. And of course, no economic actor sets his prices on the basis of the amount of money circulating in the economy.
For a further discussion of the scientific weaknesses of economics click on:
Economics: poor science, strong faithIn short: the whole concept that the money supply directly influences prices because relatively speaking, an increase makes goods and services scarcer (leading to price increases and thus, inflation), and a decrease makes goods and services more abundant (leading to a decrease in prices, deflation) is nonsense. That’s bad enough for economic science. But when a fault in economic theory has implications in real life it’s worse. Today, in a worldwide economic downturn, and in general, with the structural problem of the growing gap between productivity and demand, the implications of the error are disastrous. These implications are that even in the current economic downturn, marked by a shortfall in demand, an increase in the money supply so as to increase demand is not considered an option – because according to economic theory, it would cause inflation.
See also Global Development - Chapter XII, Money creation: Money and faith and Money creation and inflation
Another key shortcoming in standard economic theory on inflation is that it parts from the actual supply of goods and services rather then from the potential supply. The latter is based on the combination of existing production capacity and production capacity that can be developed on fairly short notice – that is, productive capacity.
Question: Now if the above is right, and there is a global shortage of money, shouldn’t there be deflation?
Answer: To some extent. As said, economic theory, based on the premise of perfectly transparent, closed markets, would assume so. The fact that there is no or only limited deflation can, within this theory, be used to argue the money supply is in line with the amount of goods and services. In practice, with imperfectly functioning, open markets, a decrease in the money supply does not necessarily lead to deflation - just as an increase does not necessarily lead to inflation. That is because producers react to reduced demand by decreasing production capacity: deliberately by closing down factories, or involuntarily through bankruptcies. Thus supply is reduced and prices are maintained – more or less.Also, deflation does in fact occur. Of some items, for example, consumer electronics, prices do decline. This is the case especially if technological developments make it possible to produce such items at lower cost, so that they can be sold at lower prices while still maintaining acceptable profit margins.
Question: Is there any evidence that money creation, i.e., an increase in the money supply, does not necessarily cause inflation?
Answer: Sure. Take the stock market rally of the late 1990s. Speculation created, in a few years time, hundreds of billions, even trillions of dollars. That meant that especially in the rich countries, the amount of capital increased much more than the supply of goods and services. According to monetary theory, that should have caused massive inflation. But it didn’t. Likewise, the downturn in 2001 and 2002 led to the loss of hundreds of billions, even trillions of dollars and Euro’s. With money becoming scarcer relative to goods and services, that should have led to a lowering of prices. Didn’t happen either. Another example: countries that have ample natural resources, and sell these in the world market, such as the oil states in the Middle East. The money that has come in, and is still coming in from the sale of such resources, i.e. oil, is not matched by an increase in the supply of goods and services. According to monetary theory such an enormous influx of money without a matching increase in production should have wrecked those economies. Didn’t happen. Yes, there was inflation, but nothing out of this world.Question: How come economists see no major problem with money created through speculation in stock markets or the sale of natural resources, but have a major problem with money creation by governments for public investment?
Answer: Money creation in stock exchanges takes place in the private sector. That means that it is subject to, as economic theorists call it, the "invisible hand of the market".
Whereas there may be temporary disruptions, in the end, so economic theory goes, markets always return to a state of equilibrium, or balance. That means a situation in which the demand and supply of money, goods and services are more or less in line with each other. So temporary imbalances are nothing to worry about, as sooner or later, the "invisible hand of the market" will adjust these automatically.Overall, then, economist have no problem with money creation by the private sector – neither through speculation in stocks or real estate or, as is generally accepted practice, by banks lending larger sums to consumers and business then they receive in deposits. As long as the invisible hand of the market is allowed to do its work the balance will be restored, and things will be OK. Economic purists do, however, object to government intervention in markets. This is because any government rule, regulation or other form of action that affects the market fetters the invisible hand and thus, affects the hand’s capacity to restore equilibrium.
Fortunately, in practice there are few economists and less decision-makers that think governments should never interfere in markets. Most governments, therefore, do tinker a little in the margin of markets, to try and temper very wide swings caused by excessive optimism or pessimism in the market. For example, interest rates (charged by central banks on loans to private banks) may be raised to temper lending. That is usually done in a market in which central bankers consider consumers and producers are consuming and investing to energetically with borrowed money – in what is called an overheating economy. Vice versa, in an economy in which due to negative prospects consumers and producers consume and invest too little, interest rates are lowered. Overall, though, the basic faith remains that the invisible hand, that mysterious natural force that guides economies, should be tampered with as little as possible. In line with that faith interventions are presented only as efforts to arrive at a new equilibrium, on a level more in line with the prime goal of economic policy: sustained economic growth in an economy with near to full employment, healthy profits and low inflation.
Tampering with interest rates, then, is a key instrument of economic policy. So is money creation for the private sector. That happens when a central bank lends money to commercial banks, which in turn lend it to consumers (for consumption) and producers (for investment). However, money creation for governments is considered a cardinal sin. So much so that the creation of money for investment in sustainable development is not even debatable. Creating money for the public sector, so goes the argument, means – by definition – that it does not take place in the "real" market, and therefore, is not subject to market forces. Instead it distorts market forces and thereby, upsets the balance between demand and supply.
Apart from this more theoretical objection economists also reject money creation for public purposes for a more practical reason. Not without reason (and they’re not alone in this either) economists have little confidence in the self-discipline of governments Once politicians would be able to finance government programs and projects through creating money, fiscal discipline, already a weak spot in most countries, would diminish even further. Governments would be too easily tempted to let the money presses roll extra hours. That has indeed happened on a number of occasions over the past centuries – often, with hyperinflation as a result. Hyperinflation, that is, money loosing its value by the day with decreases in the tens of percentage points, is the great fear of especially people with money – the wealthy - and creditors – such as banks. Of course these are two of the most influential (and partially overlapping) groups in society. Hence the relentless drive for monetary stability by especially the wealthy, conservative parts of society.
Question: So how to prevent governments misusing the principle of money creation for sustainable development? How to avoid excessive government on the wrong items?
Answer: As indicated, the solution is to take the capacity to create money out of the hands of governments. As discussed elsewhere in more detail (Money creation for sustainable development) money creation should not be left to governments or their central banks, but to a politically independent international agency that would impose strict conditions. The agency would have the authority to stop the transfers of newly created money at any given moment and thus, hold major leverage over the recipient governments. Under those conditions money creation would not only be possible, but hugely beneficial.Question: How come the solution of money creation for sustainable development has not been proposed before?
Answer: It’s a combination of things. One is that people see money as some kind of independent entity, a phenomenon answering to natural laws. Therefore, its creation - or destruction - is perceived to be outside the control of ordinary mortals. People do not realize that money is nothing more than a man-made instrument created to facilitate trade – an instrument that in principle can be made at will. Money creation is, perhaps, too self-evident and especially, too easy: the solution to many problems can’t be that simple!Another factor explaining why money creation does not figure in the development debate is the strength of economic dogma. That dogma holds that money creation for governments, for whatever purpose, is a cardinal sin: it will cause uncontrollable inflation. Moreover, most economists agree that governments cannot be trusted: give them access to extra money, and they will only spend even more irresponsibly that they already do. Since most people consider economics a science they don’t feel confident to challenge its practitioners or tenets – at least not on these issue (the story is different with regard to such issues as trade, a hotly debated issue also among economists themselves).
Question: So money creation has no place in economics?
Answer: Actually, it does appear in economic debates, mostly in the form of suggestions to increase the money supply of a particular country. This as a remedy against a persistent recession accompanied by deflation at interest rates that are close to zero. For example, some economists have suggested it as a theoretical option for Japan: the Japanese economy has been in or close to a recession for the better part of the past fifteen years and is suffering from deflation. Likewise, in late 2003, with the US economy close to recession in spite of record low interest rates, and the looming threat of deflation, it was suggested as an option of last resort for US monetary policy. In the Financial Times of December 4 2002, newly appointed Fed Governor Mr. Ben Bernanke was quoted as naming it as a possible action the US Federal Reserve could take to counter deflation. Former Fed governor Laurence Meijer was quoted as saying: it makes sense for the Fed to keep all options laid out by Ben Bernanke open.
Question: If such pre-eminent economists and financial specialists already take money creation serious, then what’s the problem?
Answer: Money creation is only mentioned as a very last resort, and then only for rich countries mired in recession and threatened by deflation. For example, after mentioning the option of money creation Mr. Bernanke immediately returned to the familiar terrain of monetary orthodoxy. He did so by comparing the Fed’s ability to create money with an alchemist who had discovered how to create gold: "The potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Similarly, a central bank that can create infinite amounts of money would eventually see the value of that money relative to goods and services fall, and hence inflation return."In another return to economic dogma Mr. Bernanke proposed to use the created money to finance tax cuts. In other words: the money should be channeled as quickly as possible to consumers and producers – not to the government. Thus, even though the principle of money creation was suggested as a topic for discussion, the use of that money for public investment remained a taboo.
Perhaps there are economists and other academics, as well as responsible politicians, who have toyed with the idea of money creation for sustainable development – if only because it is such a tempting option. The problem is that even so little as raising the issue as a topic for discussion would be a major danger to one’s reputation. Economists could face the ridicule of their colleagues, loose their reputation, and be banished to the fringes of academic life. For politicians the risks could be even greater: financial pundits and political opponents would call their suggestions dangerous and brandish them as economic nitwits. In the case of really powerful politicians, markets could react by selling off the currency involved. In short: the professional risks of proposing to even consider the option of large scale money creation are such that presently, few pundits, possibly none at all, would dare to put the topic on the agenda.
For a further discussion of economics and sustainable development click on:
A new economicsFor a further discussion of the scientific weaknesses of economics click on:
Economics: poor science, strong faith
Question: If nobody dares to put the topic on the agenda, what should be done?
Answer: All individuals and groups with a genuine concern for what’s going on in our world should rally into a coalition for sustainable development to argue, jointly, for opening the debate on money creation.Click on: Action for sustainable development
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