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<font color="#002864" size="1" face="Verdana">http://www.mises.org/fullstory.asp?control=1211</font>
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<font face="Verdana" size="2"><font color="#002864" size="5"><strong>Does a Falling Money Stock Cause Economic Depression?</strong></font>
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<font size="4">By Frank Shostak</font>




<font size="2">[Posted April1 18, 2003]</font>




<font size="2">




<font size="2">According to Friedman, as a result of the collapse in the
money stock economic activity followed suit. Thus by July 1932 year-on-year
industrial production fell by over 31% (see chart). Also, year-on-year the
consumer price index (CPI) had plunged. By October 1932 the CPI fell by 10.7%
(see chart).</font>


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<font size="2">However, a close examination of the historical data shows
that contrary to Friedman the Fed was extremely loose and pumped reserves into
the system in its attempt to revive the economy (on this see Murray Rothbard's
<em>America's
Great Depression</em>). The extent of monetary injections is depicted by
changes in the Fed's holdings of U.S. government securities. Thus on January
1930 these holdings stood at $485 million. By December 1933 they had jumped to
$2,432 million—an increase of 401% (see chart). Moreover, the average yearly
rate of monetary injections by the Fed during this period stood at 98%.</font>


<p align="center"> &nbsp;




<font size="2">In addition to this, at some stages monetary injections were
massive. For instance, the yearly rate of growth of government securities
holdings by the Fed jumped from 19.7% in April 1924 to 608% by November 1924.
Then from 0.3% in July 1927 the yearly rate of growth accelerated to 92% by
November 1927. Needless to say that such massive monetary pumping amounted to
a massive exchange of nothing for something and to a severe depletion of the
pool of real funding, that is, the essential source of current and future
capital needed&nbsp;to sustain growth.</font>




<font size="2">As long as the pool of real funding is expanding and banks
are eager to expand credit (credit out of"thin air") various
nonproductive activities continue to prosper. Whenever the extensive creation
of credit out of"thin air" lifts the pace of real-wealth
consumption above the pace of real-wealth production the flow of real savings
is arrested and a decline in the pool of real funding is set in motion.
Consequently, the performance of various activities starts to deteriorate and
banks' bad loans start to rise. In response to this, banks curtail their
lending activities and this in turn sets in motion a decline in the money
stock.</font>




<font size="2">The fall in the money stock begins to further undermine
various nonproductive activities, i.e. an economic depression emerges. In this
regard after growing by 2.7% year-on-year in January 1930 bank loans had
fallen by a massive 29% by March 1933 (see chart).</font>


<p align="center">Mystery
of Banking</em> Murray Rothbard showed that it is the existence of the
central bank that enables fractional reserve banking to thrive).</font>




<font size="2">Observe that economic depressions are not caused by the
collapse in the money stock (as suggested by Milton Friedman), but come in
response to a shrinking pool of real funding on account of previous of loose
money. Consequently, even if the central bank were to be successful in
preventing the fall of the money stock, this would not be able to prevent a
depression if the pool of real funding is declining. Also, even if loose
monetary polices were to succeed in lifting prices and inflationary
expectations (as suggested by Paul Krugman), this would not revive the economy
as long as real funding is declining.</font>




<font size="2">Again, note that contrary to popular thinking, depressions
are not caused by tight monetary policies, but are rather the result of
previous loose monetary policies. On the contrary, a tighter monetary stance
arrests the depletion of the pool of real funding and thereby lays the
foundations for economic recovery. Furthermore, the tighter stance reveals the
damage that was done to the capital structure by previous monetary policies.&nbsp;</font>




<font size="2"><strong>Have we learned the lesson of the Great Depression?</strong></font>




<font size="2">Do central banks have all the necessary tools to prevent a
severe economic slump similar to the one that occurred in the 1930's? Most
economists are adamant that modern central banks know how to counter the
menace of a severe recession.</font>




<font size="2">But if this is the case why has the central bank of Japan
failed so far in reviving the Japanese economy? The Bank of Japan (BOJ) has
used all the known tricks as far as monetary pumping is concerned. Thus
interest rates were lowered to almost zero (see chart) while BOJ monetary
pumping as depicted by its holdings of government securities increased by 323%
between January 1990 and March 2003 (see chart).</font>


<p align="center">[img]" alt="[image]" style="margin: 5px 0px 5px 0px" /> &nbsp; &nbsp; &nbsp; &nbsp;[img][/img]




<font size="2">We suspect that there is a strong likelihood that if the
economy does not rebound soon, the Fed will lower interest rates further and
will intensify its monetary pumping. This, however, will only further prolong
the economic misery.</font>


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<font size="2">Frank Shostak is an adjunct scholar of the Mises Institute
and a frequent contributor to Mises.org.&nbsp; Send him&nbsp;<font color="#000080" size="2">MAIL</font>&nbsp;and
see his outstanding Mises.org&nbsp;<font color="#3571ca" size="2">Daily
Articles Archive</font>. Special thanks to Michael Ryan for his comments,
thanks Peter Stellios for assisting in collection of historical data.</font>


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