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A pure gold standard is immune from boom-bust cycles, since on the pure gold standard an increase in the money supply does not trigger an…
According to Milton Friedman, the key cause of the business cycles is the fluctuations in the growth rate of money supply. Friedman held that what is required for the elimination of these cycles is for central bank policymakers to aim at a fixed growth rate of money supply:
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My choice at the moment would be a legislated rule instructing the monetary authority to achieve a specified rate of growth in the stock of money. For this purpose, I would define the stock of money as including currency outside commercial banks plus all deposits of commercial banks. I would specify that the Reserve System should see to it that the total stock of money so defined rises month by month, and indeed, so far as possible, day by day, at an annual rate of X per cent, where X is some number between 3 and 5. The precise definition of money adopted and the precise rate of growth chosen make far less difference than the definite choice of a particular definition and a particular rate of growth.1
Could, however, the implementation of the constant money supply growth rule eliminate economic fluctuations?
Honest Money versus Money out of “Thin Air”
Originally, paper money was not regarded as money but merely as a representation of gold. Various paper money receipts represented claims on gold stored with the banks. The holders of paper receipts could convert them into gold whenever they deemed necessary. Because people found it more convenient to use paper receipts to exchange for goods and services, these receipts came to be regarded as money.
In fulfilling the role of the medium of exchange, money enables something to be exchanged for it and this in turn enables the received money to be exchanged for something else. That is, something is exchanged for something else by means of money.
For instance, a potato farmer exchanges ten potatoes for the one ounce of gold. The received money, i.e., the ounce of gold, is employed to pay a shoemaker for a pair of shoes. What we have here is an exchange of ten potatoes for a pair of shoes with the help of money, in this case the ounce of gold. This is an exchange of something for something, or an exchange of the produce of one producer for the produce of another producer with the help of money.
Now, as long as the receipts for gold that are accepted as genuine money are backed by gold there is going to be an honest exchange, i.e., something for something, or wealth for wealth.
In contrast, employing receipts that are not backed by gold in an exchange sets in motion an exchange of nothing for something. The unbacked gold receipts do not have any backup of proper money, which is gold. By means of the unbacked gold receipts, goods are diverted from wealth generators to the holders of the unbacked receipts. This weakens wealth generators and in turn weakens the process of wealth formation.
To clarify this point further, consider counterfeit money that was generated by a forger. The forged money looks exactly like the genuine money. Also, note that honest money is obtained by selling some useful goods for it: the potato farmer has obtained one ounce of gold by selling ten potatoes for it. In contrast, no goods were exchanged to obtain the phony money. The forger just printed it; hence, the counterfeit money emerged out of “thin air.”
When the forged money is exchanged for goods, this results in nothing being exchanged for something. It leads to the channeling of goods from those individuals that have produced goods to the forger in return for nothing.
In this sense, increases in the money supply out of “thin air” always set in motion an exchange of nothing for something. Alternatively, we can also say that the money supply out of “thin air” leads to consumption without the preceding production of goods.
Observe that the act of wealth channeling is going to take place regardless of whether the growth rate of the money supply out of “thin air” is above or below the growth rate in real economic activity, or whether it is proceeding along a constant growth path.
Again, as long as there is an increase in the money supply out of “thin air,” this is going to set in motion an exchange of nothing for something, i.e., this will give rise to consumption that is not supported by the preceding production.
Money Supply out of “Thin Air” and Boom-Bust Cycles
On a pure gold standard, where money is gold, an increase in unbacked gold receipts constitutes an increase in the money supply out of “thin air.”2
Now, in the modern world, the money supply is similar to the unbacked gold receipts, since the money supply is without any gold backing. Hence, in the modern world any increase in the money supply constitutes an increase in the money supply out of “thin air.”
Consequently, in the modern world an increase in the money supply, i.e., money supply out of “thin air,” creates a scaffold for nonproductive activities, which consume and add nothing to the pool of wealth. (Again, the increase in the money supply out of “thin air” diverts wealth from wealth-generating activities to non-wealth-generating activities, thus weakening the wealth-generating process).
For instance, a forger of money who embarks on purchases of various goods is stimulating support for these goods. The increase in the demand for the goods wanted by the forger emerges because of the increase in the counterfeit money, or the money out of “thin air.”
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The increase in the production of these goods would not emerge, all other things being equal, in the absence of the increase in the money supply, i.e., money out of “thin air.”
The real savings that are required to support the production of goods demanded by the counterfeiter are now channeled toward\ the production of these goods. As a result, this undermines the production of goods that are in demand by genuine wealth generators.
Once the counterfeiter’s activities are exposed and the falsifier is forced to slow down the falsification activities or stop the act of forgery entirely, the support for the various goods that the counterfeiter demands begins to slow down, or comes to a halt altogether. As a result, the production of these goods also begins to slow down or come to a halt.
Take note that because of the increase in the money supply out of “thin air” an increase in the production of goods emerges on the back of such money. A decline in the money supply out of “thin air” results in the decline in the production of these goods.
The increase in the production of goods as a result of the increase in the money supply out of “thin air” is an economic boom. A decline in the production of goods because of the decline in the money supply out of “thin air” is called an economic bust. Hence, what we have here is a boom and bust due to changes in the growth rate of money supply out of “thin air.”
Note again that as a rule the increase in the money supply out of “thin air” leads to nonproductive or wealth-consuming activities. Once the increase in the money supply slows down or is curtailed, the diversion of wealth from wealth generators toward nonproductive activities also slows down or comes to a halt.
Once there is a renewed increase in the supply of money, a new boom will emerge. When the growth rate of the money supply slows down, this results in an economic bust. In the modern world, the key source of the variability in the growth rate of the money supply is the policies of the central bank.
Gold Standard and Boom-Bust Cycles
Would the introduction of the gold standard eliminate boom-bust cycles? According to Friedman, what causes boom-bust cycles is fluctuations in the growth rate of money supply. On the gold standard there are going to be fluctuations in the growth rate of the money supply as a result of fluctuations in the production of gold. Hence, according to Friedman, the gold standard is not going to eliminate business cycles.
It is true that the variability in the production of gold is going to generate fluctuations in the growth rate of money supply. (Remember that on the gold standard money is gold.)
However, the increase in the money supply on the gold standard is not going to generate an exchange of nothing for something. It will not result in the diversion of wealth from wealth producers toward non-wealth-generating activities.
Being a commodity, apart from providing the services of the medium of exchange, gold is also demanded for various industrial usages including jewelry. From this perspective, it is part of the pool of wealth. Therefore, when gold is exchanged for goods and services, wealth is exchanged for wealth—something is exchanged for something else. Hence, an increase in the supply of gold is not going to trigger an exchange of nothing for something. (Since gold is part of wealth, it is backed, so to speak, by wealth.)
Contrast this with the printing of phony gold receipts, i.e., receipts that are not backed by gold. This creates a platform for consumption without the contribution to the pool of wealth. Empty receipts set in motion an exchange of nothing for something, which in turn leads to boom-bust cycles. (Observe that the phony receipts are backed by nothing.)
Consequently, on the gold standard an increase in the growth rate of money supply will not result in the emergence of false activities, i.e., a false economic boom. Hence, a fall in the growth rate of money supply is not going to generate an economic bust—no false activities were generated that are going to be liquidated by a decline in the money supply growth rate. (Note that a wealth-generating activity is not dependent on increases in the money supply out of “thin air” for its existence. It stands on its own feet.)
We can thus conclude that the gold standard, if not abused, is not conducive of boom-bust cycles. If Friedman’s fixed money rule were to be introduced, it would lead to the expansion in the money supply out of “thin air” and thus to boom-bust cycles. (A fixed money supply rule is still about the expansion of the money supply out of “thin air,” although at a fixed rate.)
This is going to weaken the wealth generators and thus undermine the real economy. We can conclude that Friedman’s monetary rule is simply another way of tampering with the economy and, hence, it cannot lead to economic stability and prevent boom-bust cycles.