7. A Growing/Shrinking Money Supply: More Causes and Effects

Discussing the effect of changing money supply in isolation from other economic factors is difficult because in the real world the money supply so often changes in tandem with other events. So just for the sake of argument, let us tease out the money supply aspect of an economy with a thought experiment.

A money supply thought experiment

Let’s assume that the economy is undergoing a relatively stable period. We are playing God (this is a thought experiment after all) and can increase or decrease the money supply at will, by magic. When we want to increase the money supply (let’s say we want to double it), we will simply increase the amount of money everyone has simultaneously overnight, i.e. if you go to bed having $10 in your wallet, you will wake up with $20 the next morning. This will apply equally to electronically stored money, but importantly it won’t affect financial agreements in any way. If you’ve signed a document saying that you owe someone $50, you will still owe them $50.

Under the conditions of this thought experiment, it is easy to imagine the effect on prices of a big jump in the money supply. Imagine that overnight the money supply increases tenfold. Now imagine you are the owner of an electrical goods store. When you open up the shop the next day, you notice a flood of gleeful customers excitedly buying up everything they can get their hands on. Using what we have learned from the section on supply and demand, it is clear that the shopkeepers would soon start raising their prices. Indeed it should be obvious that a new equilibrium would be reached in which the prices are approximately ten times what they had been previously.

Some aspects of economic activity are relatively immune to changes in the money supply. Consider produce that can be made from scratch in a short period by a flexible workforce where the chain from raw materials to final product is short and there is no expensive equipment used in the manufacturing process. These people can simply adjust their wages and prices up or down to suit the current level of money supply. If the money supply went up, they would increase both their prices and their wages; if it went down, they would decrease both their prices and their wages. The company is perfectly able to cope with the changes without significant disruption. Indeed the overall wealth of its employees in terms of their ability to purchase goods and services could remain approximately constant. Not all aspects of economic activity get off so lightly, however. The real problems arise with long-term loan arrangements:

An unexpected increase in the money supply

Say that Person A has made a long-term loan to Person B on the basis of a fixed interest rate. If the money supply unexpectedly increased during the loan repayment period, then B is delighted. It will become easier for them to gather together the money to pay back the loan. A, however, is hurt because the money they get back will have less purchasing power then they expected.

An unexpected decrease in the money supply

Say that Person A makes a loan to B for a car. At the time of the loan the borrower may think to themselves something like, “I just need to pay back 10% of my income each month and after a few years the car will be mine.” Now comes the unexpected shrinking of the money supply. The person’s numerical income will decrease (as will everyone else’s and as will prices); they will now have to pay back a higher percentage of their income in order to keep up with the obligations of the loan. This higher percentage may be too much to bear, and there is a risk B may default. If B does succeed in paying back the loan then A is delighted. A may only get back the same numerical amount of money as they were originally expecting but now that same amount of money will have more purchasing power. Let’s summarise the situation in a table:

Effects of money supply changes on fixed interest rate loan arrangements

	Unexpected increase in the money supply	Unexpected decrease in the money supply
Lender (A)	Worse off. They will get back the predicted numerical amount of cash, but that cash will purchase less than they had hoped.	Better off if he gets paid back. May have option of seizing B’s possessions.
Borrower (B)	Better off. They have to give back the same numerical amount of cash, but obtaining the cash will be easier than expected.	Worse off. More painful repayments. May have to forfeit their possessions (depending on the loan agreement).

This vandalism of loan and payback arrangements is generally a bad thing for an economy and generally bad politically. After all, everyone who is now worse off will be complaining bitterly, and some may even go bankrupt or lose their homes.

Unexpected changes in the money supply clearly cause great harm.

Mortgages are particularly sensitive to money supply changes

Let’s consider one type of loan/repayment arrangement that is particularly sensitive to money supply changes, namely mortgages. If interest rates are held at a low rate for too long this can cause a rise in house prices, risking a house price bubble. The lower interest rates will mean that people will be able to afford larger mortgages. This corresponds to money creation, with the new money flowing into the housing sector. If this carries on for a sustained period people may think that prices will inevitably carry on rising. They will want to join the bandwagon and buy a new/bigger house too. This causes further rises in house prices and yet more people will want to join in, stretching themselves to the limit. The overall money supply will grow and grow during the years that this housing boom takes to pan out.

At some point people will be able to stretch no more without a further drop in interest rates. If that is not forthcoming then the upward march in house prices will cease and the business cycle mechanism will switch into reverse gear. The money supply will suddenly and “unexpectedly” (at least for most mainstream economists) start to contract. Governments now cannot stand to have the money supply shrink because people will find it harder to make their mortgage repayments, possibly resulting in them losing their homes. Banks may suffer because if people start to default then the banks go bust. As with the bursting of any asset bubble, people who had previously been under an illusion of great future wealth now realise that they were deluded and will be keen to save more and consume less. This causes job losses and a downward spiral as discussed earlier.

Governments throughout the world have repeatedly assumed that the only solution to this ugly situation is to a) lower interest rates and b) inject new money into the economy. They call this “stimulating” the economy. The idea is to achieve the following effects:

• Hope that the low interest rates will encourage bigger mortgages and so prevent a big fall in house prices.

• Prevent those with existing large mortgages from losing their homes.

• Help prevent the banks from going bust.

But there are problems with this “cure”. It is attempting to prop up the previously wasteful scenario with too many real estate agents, too much house building and a too large financial sector.

Excessively low interest rates are a banking subsidy. They correspond to a continuous flow of wealth from society at large to banks. This props up a wastefully bloated financial sector, depriving the real economy of so much talent that could be employed more productively elsewhere.

The bad side-effects of the “cure” are every bit as bad as the disease. The longer that interest rates are held at unreasonably low levels, the more people will get tied into oversized mortgages. This makes it ever more painful to raise interest rates in the future. Society can get locked in to low rates, painted into a corner.

An alternative solution to a post-housing-bubble depression

Before we describe the alternative solution, we need a quick digression on loan sharks...

Loan sharks exist in many if not all societies. They prey on the poorest, least educated people, offering loans to people they know may struggle to pay the money back. Their interest rates are exorbitantly high and so a few late or missed repayments can quickly lead to astronomical debts that can never be repaid, leaving the borrower a virtual slave to the lender, with the loan shark using threats of physical violence to collect repayments. Loan shark debts are not normally enforceable in law. The idea is that loans made recklessly to people the lender knows will struggle to pay back is seen by society as an evil committed by the lender.

By the same logic that dictates that debts to loan sharks should not be enforceable, we would suggest that the solution to a bursting house price bubble would be to realise and accept that the financial sector, in combination with central banks, had been making reckless loans. Therefore repaying the full amount of the loans should not be enforceable. We would suggest that if someone had been given a mortgage of five or six times their annual income, based on the fact that interest rates just happened to be at some unusual and unsustainable low, then the law should step in and dictate that the borrower be held accountable for only an amount corresponding to a more reasonable multiple of their annual income, perhaps 2.5 or 3 times their income. The effects of this plan would be as follows:

The desire to “cut back” or “consume less than you produce” resulting from realising your house is not so valuable after all, would be countered by the fact that your mortgage costs will be lowered dramatically. House prices would collapse simultaneously, but this is a good thing.

Many banks will go bust or be forced to downsize because the income from mortgage interest will be far smaller. This is a good and necessary thing because the banking sector was previously wastefully large. The money supply will certainly shrink in the process, but this could be replaced with debt-free base money created by the government.

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