How Private Banks Create Bubbles — With The Help Of Central Banks

By Frank Shostak,

With meagre resources at his disposal, an individual is likely to allocate these resources (i.e., his wealth) towards essentials such as food, clothing and a roof over his head.

He is unlikely to allocate his meagre wealth to less essential goods as far as life and wellbeing is concerned. His variety of consumer goods is likely to be very limited.

As his real wealth begins to expand, the individual is likely to expand the variety of goods consumed, thereby raising his living standard.

Instead of being limited to basic essentials, he can now afford a bit of luxury, or less essential goods, so to speak.

It follows then that one would expect an increase in personal wealth to be associated with a tendency to expand the variety of goods and services consumed. The key to the expansion in real wealth is savings.

The Essence of Real Savings

If a baker produces ten loaves of bread and consumes one loaf, his real savings are nine loaves of bread.

He can now exchange his savings for a pair of shoes with a shoemaker. Observe that his real savings are his real means of payments-he pays for the shoes with the saved bread.

Likewise, the shoemaker pays with the shoes that are his real savings for the nine loaves of bread. Note that what gives rise to the demand for consumer goods is the production of consumer goods — the demand for consumer goods is supported by the preceding production of consumer goods.

The introduction of money does not alter our analyses. All that money does, through its role as the medium of exchange is to facilitate the flow of consumer goods. By means of money, the produce of one producer is exchanged for the produce of another producer.

When a baker sells his bread for $1 to a shoemaker, he has supplied the shoemaker with his saved (i.e., unconsumed) bread. The supplied bread sustains the shoemaker and allows him to continue making shoes.

Being the medium of exchange, money enables the baker to secure goods and services sometime in the future whenever he requires them. Note that money here fulfills the role not only of the medium of exchange but also of the medium of saving. With the help of money, the baker can save his bread. Note that by being able to sell his bread for money the baker can now save without being concerned that the bread will be spoiled.

Observe that while fulfilling the role of the medium of savings, money is not savings. An increase in money will not result in more savings. An increase in savings requires the increase in the production of consumer goods all other things being equal. Through money, people channel real savings, which provide support to economic activity.

Once real savings are exchanged for money it is of no consequence what the holder of money does with the money. Whether he uses it immediately in exchange for other goods or puts it under the mattress, it will not alter the fact that his real savings are already employed towards the expansion of real wealth.

In a free unhampered market economy there will be a harmonious and sustained change in the pattern of consumption with a rise in consumers’ real wealth. With an increase in real wealth, individuals are likely to strive to acquire various less essential goods and more goods that are luxurious. This harmony however, tends to be disrupted whenever the central bank pumps money.

How Central Bank Policies Disrupt the Harmonious Pattern of Consumption

The monetary pumping disrupts the harmony because of the fact that when money is injected not everybody gets it first. The injection of new money to the economy benefits individuals that receive the newly created money first at the expense of those individuals who did not receive the new money at all, or received it late. The early recipients can now purchase a greater amount of goods while the prices of these goods are still unaffected. The early recipients’ real wealth has increased. According to Rothbard in Man, Economy and State,

The individuals who receive the new money first are the greatest gainers from the increased money; those who receive it last are the greatest losers.

Again, as the prices of various goods and services start to rise this hurts those individuals who did not receive the newly printed money at all — or received it last.

We have seen that in an unhampered market economy demand for consumer goods is exercised through the production of consumer goods.

In a hampered environment, though, in response to the central bank loose monetary policies, a situation emerges where the demand for consumer goods arises without the prior production of goods.

The monetary pumping by the central bank sets in motion an exchange of nothing for something (i.e. gives rise to the consumption of goods without the preceding production). Note that an exchange of nothing for something is also known as the counterfeiter effect. Also note that in an environment where no one prints money, it leads to an exchange of something for something (i.e., something useful is exchanged for money and then money is exchanged for something else useful hence something for something).

Furthermore, the newly created money gives rise to the diversion of real wealth (i.e., consumer goods towards the early recipients of money at the expense of other individuals). Since the early recipients of money are much wealthier now than before the monetary injections took place, they are likely to alter their pattern of consumption.

With a greater wealth at their disposal, their demand for less essential consumer goods as far as life is concerned increases.

The increase in the real wealth of the early recipients of money gives rise to the demand for goods and services that prior to the monetary pumping was on a very low priority list of consumers.

In contrast, the late recipients of money, and those who did not receive the newly printed money at all, have less real funding at their disposal. This undermines their demand for various essential goods required to sustain life and wellbeing.

How changes in the pattern of consumption alter the pattern of production

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