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Economic growth and the pool of funding

By Dr Frank Shostak

The heart of economic growth is the availability of the means of sustenance to support the maintenance and the improvement of an economy’s infrastructure. The means of sustenance are final goods and services that are required to support individuals’ lives and well being.

The size of the pool of the means of sustenance, which we label as the pool of funding, determines the quality and the quantity of various tools that can be made. If the pool of sustenance or funding is only sufficient to support one day of work, then the making of a tool that requires two days of work cannot be undertaken. In short, the size of the pool of funding sets the limit on the projects that can be implemented.

As a rule the larger the pool of funding that can be generated with the help of the infrastructure the more can be allocated towards a further improvement of the infrastructure and consequently a higher living standard can be secured.

Note that the means of sustenance are generated in order to be consumed by individuals – promoting people’s life and well being. Also note that a pool of funding supports both productive and non-productive activities.

When the means of sustenance are used in the expansion of an economy’s ability to generate wealth this is called productive consumption.

We also label the part of the pool of funding that is allocated towards the maintenance and the expansion of the infrastructure as real savings.

When the means of sustenance are used in non-productive activities this is called non-productive consumption. (Note again the part of the pool of funding that is allocated towards activities that don’t expand the economy’s ability to generate more real wealth is non productive consumption. Observe when real savings are employed non – productively this results in non – productive consumption).

The pool of funding and money
The introduction of money doesn’t alter the essence of what the pool of funding is. Money can be seen as a permit to access the pool of funding, or we can also say that money is a claim on the goods in the pool of funding, so to speak.

Various producers who have exchanged their produce for money can now access the pool of funding whenever they deem this to be necessary. If a baker has exchanged 10 loaves of bread for 10 units of money, it means that he has received a claim on final goods that is worth 10 units of money.

Furthermore, when an individual exchanges his money for goods, all that we have here is an act of an exchange and not an act of payment – money is just the medium of exchange.

Payment is always done by means of various goods and services. For instance, a baker pays for shoes by means of the bread he produced, while the shoemaker pays for the bread by means of the shoes he made. (Both shoes and bread are part of the pool of funding as they are final goods). When the baker exchanges his money for shoes, he has already paid for the shoes, so to speak, with the bread that he produced prior to this exchange.

As long as the flow of production is maintained, the baker can always exchange his money for the final consumer goods he deems necessary (i.e. he can always exercise his claim on final goods and services). Obviously, if for some reason the flow of production is disrupted, the baker will not be able to fully exercise his claim.

Monetary expansion and the pool of funding
When money is created out of “thin air” it leads to a weakening of the pool of funding. What is the reason for this? The newly created money doesn’t have any back-up behind it as far as the production of goods is concerned – it sprang into existence out of “thin air” so to speak. The holder of the newly created money can use it to withdraw final consumer goods from the pool of funding with no prior contribution to the pool. Hence this act of consumption, or non-productive consumption, puts pressure on the pool of funding. (The individual consumes goods without making any contribution to the pool of funding).

We can infer from this that when money is created out of “thin air” it diverts means of sustenance away from wealth producers who have contributed to the pool of funding towards the holders of the newly created money.

For a previously given pool of funding this will imply that wealth producers will discover that the purchasing power of their money has fallen since there are now less goods left in the pool – they cannot fully exercise their claim over final goods since these goods are not there.

As the pace of money creation out of “thin air” intensifies it puts greater pressure on the pool of funding. This in turn makes it much harder to implement various projects as far as the maintenance and the improvement of the infrastructure is concerned. Consequently the flow of production of various final consumer goods weakens, which in turn makes it much harder to make provisions for savings. All this in turn further weakens the infrastructure and so undermines the flow of production of final consumer goods.

We can thus conclude that contrary to assumed ways of thinking, monetary growth cannot produce a general expansion in economic activity – also labeled economic growth. On the contrary, by diverting means of sustenance from wealth generating activities towards non-wealth generating activities monetary expansion only weakens economic growth.

As long as the pool of funding is expanding the central bank’s monetary policies appear to work. For instance, by employing so-called counter-cyclical policies the central bank seems to be able to “navigate” the economy. However, all of this is just an illusion. By means of loose monetary policies the central bank can only create non-wealth-generating activities. But as various unpleasant side effects of this loose monetary policy emerge – such as rising price inflation – the central bank reverses its loose stance. The reversal of the stance undermines various activities that sprang-up on the back of the previous loose monetary stance and this in turn leads to an economic bust.

After a certain “cooling off” period the central bank reactivates its loose stance. This again revives various “artificial forms of life”, and the so-called economic boom emerges again.

It must be realised though that the emerging economic growth that accompanies the boom is on account of the fact that the pool of funding is still expanding. In other words, the pool of funding still manages to support not only wealth producers but also various non-wealth-generating activities.

If, however, the pool of funding becomes so depleted that it ceases to grow, or it even declines, then the economy falls into a “black hole”. Once this happens the central bank can print as much money as it likes but finds that it cannot “revive” the economy.

On the contrary it only weakens the pool of funding further and delays the date for a meaningful economic recovery. A stagnant or shrinking pool of funding therefore shatters the myth that central bank policies can grow and navigate the economy.

Summary and conclusions
Most individuals in the western world take the ample availability of goods and services for granted. Indeed, the complex structure of production gives the impression that what is required is simply the existence of demand and the rest will follow suit.

It is, however, much less appreciated that the sophisticated structure of production, which generates seemingly unlimited goods and services, does not have life of its own – it requires a key ingredient, which is the pool of funding. It is the pool of funding which not only maintains, but also enhances the production structure and thereby promotes our lives and well being.

There is, however, a growing threat to this pool and to the high living standards that we have become accustomed to. This threat emanates from the view that there is no need to worry about the supply of goods, and that what matters is only demand. These ideas, which were popularized by John Maynard Keynes, dominate the thinking of today’s western economists.

Given the assumption that goods will always be there, most economists are preoccupied with how the demand for goods and services can be boosted. When asked how demand is going to be funded most modern economists reply: by means of monetary pumping and low interest rate policies of the central bank. For them funding is something that can be created out of “thin air.” Cheap monetary and fiscal policies, which masquerade as policies that aim to grow the economy, are in fact achieving the exact opposite.

The only reason why economies are still growing is not because of central bank and government policies but in spite of these policies. So long as the pool of funding is still big enough to support various economic activities, the central bank and government can give the false impression that it is their policies that made economic growth possible. Once, however, the pool of funding becomes stagnant or begins to shrink, economic growth follows suit and the myth that government and central bank policies can grow the economy is shattered.

Since the end of 2007 the US pool of funding has been subjected to the most vicious attack in the form of the aggressive lowering of interest rates and monetary pumping. Yet despite all the monetary pumping and the aggressive lowering of interest rates the economy has continued to struggle. The fact that the economy has failed to respond as in the past to aggressive loose monetary and fiscal policies should be seen as an indication that the pool of funding is in serious trouble. This in turn means that all the aggression against this pool must be stopped as soon as possible in order to prevent the unpleasant economic side effects that are the inevitable results.

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Dr Frank Shostak on Mises.org

View more articles by Dr Frank Shostak on mises.org