Money Supply Confuses Deflation's Confused Proponents

The great British political economist John Stuart Mill long ago noted that "the whole of goods in the market" composes "the demand for money." To put it more simply, money is just the measuring rod that facilitates the real exchange of actual goods and labor.

As such, when production and labor increases, so does the supply of money. Conversely, when both decrease the supply of money declines. To make basic what is basic, money supply's expansion and decline is a function of production.

This is important in light of all the handwringing among deflation's confused proponents at present, Ambrose Evans-Pritchard of the Daily Telegraph the most notable in this regard. Watching the "Ms" in decline, Evans-Pritchard notes that they did much the same in the 1930s, and naturally suggests we're headed for a 1930s style Great Depression.

Assuming we are, it can't be stressed enough that a decline in the monetary aggregates would be and is a symptom of reduced economic activity, not a driver of same as Evans-Pritchard supposes.

Considering deflation itself, the total perversion of its meaning continues to reach staggering heights. That deflation is always and everywhere a symptom of rising currency values doesn't seem to concern its true believers despite the fact that the world's currencies are mostly in decline.  That Japan's deflation was a function of the yen tripling in value against gold (the opposite direction of the world's currencies today) is wholly ignored by a deflation cult convinced that Japan's sufferance of an overly strong yen mirrors a period of broad currency weakness. That prices fall all the time thanks to productivity enhancements doesn't concern its religionists either. That there's little interest in accessing credit during periods of deflation (borrowers aren't eager to take out loans that will rise in cost) hasn't shaken the beliefs of an economic sect that mistakes an inflationary lack of credit for deflation.

Back to money supply, naturally it's in decline at present precisely because production is declining. None of this should surprise us considering how governments are raising taxes, increasing regulations, devaluing money, and generally fostering an economic environment of uncertainty that makes it difficult for producers to create or do anything with confidence. The decline in the monetary aggregates is a logical result of too much government intervention, not central banks failing to create enough "money."

In that certain sense, Evans-Pritchard and his myriad followers are putting the proverbial cart before the horse. Captives all to the absurd notion that money creation itself is a source of economic energy, they get what drives supply up exactly backwards.

Rather than the author of our present economic ills, money supply is down now, much as it was in the 1930s precisely because production has wilted. We produce in order to consume, our production money demand, but back in the ‘30s tariffs made production in exchange for the surplus of others a loser's game. Tax increases reduced the consumptive reward for production, and currency devaluation made investment in economy-enhancing activities a gamble.

To increase the monetary aggregates we don't need central banks to create more money; rather we simply need hubristic governments the world over to get out of the way. Once they do production will increase, and those monetary aggregates that have the Evans-Pritchards of the world totally confused will rise anew.

Examples supporting the above contention are many, but for the purposes of this piece we can find the most notable examples in the U.S. in the 1920s, 1980s, and in the latter half of the 1990s. During the 1920s, the U.S. economy boomed thanks to falling tax rates, reduced government spending, and a stable dollar which regularly authors the kind of economic certainty so necessary for growth.

And with the government largely out of the way thanks to President Calvin Coolidge's dislike of federal activism, productivity and stocks skyrocketed; General Motors and RCA two notable "new economy" darlings that characterized the era. When production increases, so does money supply, and the latter rose 55% from 1921 to 1929. Quantity theorists then and now thought the increase was a signal of inflation, but as evidenced by falling commodity prices during parts of the ‘20s, inflation was non-existent.

Moving to the 1980s, Ronald Reagan entered office with deregulation during the Carter era having already begun, and to that he added tax cuts and a rising dollar to the policy mix. Production naturally rose with great gusto, and with it the supply of money.

The quantity theorists yet again wailed about inflation that was certainly belied by a strong dollar driving down commodities. The modern father of quantity theory, Milton Friedman, complained during this period of rising productivity that money growth was "dangerously high" and inflationary, but as the dollar's health revealed, inflationary pressures were in decline.

Moving to the latter half of the ‘90s, the U.S. economy boomed again thanks to rates of taxation low by historical standards, and a president (Clinton) who embraced both free trade and a strong dollar. With the Internet economy roaring, money supply rose 52% and the quantity theorists yet again complained about inflation. That the strong dollar was crushing commodities during this period didn't concern them, nor did the more basic truth that production always and everywhere increases the quantity of money.

The obvious irony here for quantity types is that when money is most stable in terms of value, and taxes/regulations light, that's when money quantities boom. Rising monetary aggregates, rather than a sign of monetary error, are in fact a sign that Treasury is doing a good job of stabilizing the unit of account.

Returning to the present, governance is anti-growth which is driving down production, and with reduced economic activity, the supply of money is going south. In this case, the Fed can try in vain to push all the dollars it wants into the banks through rate machinations, but so long as productivity is low, taxes are increasing and the dollar weak and unsteady, money aggregates will fall in concert with a flaccid economy.

The answer at this point is not more liquidity as the Evans-Pritchard School would suggest, but instead a ‘20s/'80s/'90s policy combination that drives producers back into the market. Only then will money supply grow.

But to suggest as Evans-Pritchard et al do that money creation itself is the path to our economic salvation, is to totally misunderstand the abilities of central banks, and the purpose of money itself. Neither wealth nor the driver of wealth creation, money's sole role is as a lubricant meant to facilitate the actual exchange of wealth after production.

When governments the world over finally get out of the way, production will increase, and with it the supply of money necessary to foster real exchange. Until then, Evans-Pritchard and the rest can moan all they want about "deflationary" monetary policy that redefines deflation as inflation, but their thinking will be backwards.

In truth, money supply is in decline because production is, and no amount of central bank activity will reverse reality. Deflation's proponents are quite simply confused.