As I discussed before matching the money supply to economic output is a big part of what makes a healthy economy. The problem comes with how to do that. What goes into “the money supply” as it is meant by economists.
Part of it is simple. Back in the era of “hard currency” (money consisting of, or at least backed by, precious metals) how much precious metal you had determined (more or less–we’ll get to that in a moment) the money supply. However, increasing the money supply to match increases in economic output was another matter. The world economy in the 20th century far, far outstripped any new finds of precious metals.
Even before abandoning the gold standard it became fairly common for governments to issue more currency “backed by” gold than they could redeem with the actual physical gold they had on hand. This worked out fine so long as most people accepted the “gold certificates” and did not insist on redeeming them for physical gold. The effect was similar to that of older cultures–where coins made of the precious metals were the currency–debasing the currency by admixture of base metals. So long as the increase of money supply this way approximately matched growth in economic output, all was well. But the temptation, as always, remained to increase the money supply still more leading to inflation and all the problems that causes.
Once governments went to so-called “fiat money,” that is, money backed up by no more than the “faith and credit” of the issuing agency, it became simpler. The money supply is then simply the number of pieces of paper with elaborate printing on them combined with the number of cheap stamped metal trinkets. Want more? Print/stamp more. Again, this is “more or less” the money supply.
And now, in the era of electronic banking, it’s not even that. “Money” can be created by simply changing figures in a computer.
Most of these influences on the money supply are “top down” and controlled by whatever authority happens to be in place, generally the government. In principle, these could be set up to create a stable, entirely predictable money supply.
However, government isn’t the only factor controlling the effective money supply.
Consider fractional reserve banking. People, rather than stuff their money into mattresses, put their money into banks and other institutions. The idea is that the money is safer there. Banks can afford a lot more security than can the typical individual and in the modern age there is insurance protecting depositors against losses. That money, however, doesn’t just sit in the bank’s vaults. Money sitting in the vault is nothing but a cost to the bank and the bank wants to make money. So, what the bank does is lend out some of that money, keeping only a fraction on hand (the “fractional reserve”). From an economic standpoint, the money is serving two purposes. People have their savings. That’s one use. A large chunk of this same money is also being used by others to buy houses, cars, and consumer goods, and is back in circulation working in the economy until someone else puts it back into their savings. Like this case with the gold certificates mentioned above, this works well so long as most people leave most of their savings in the banks and you don’t have everyone trying to withdraw all their money at once (a “run” on the bank).
This has the effect of an increase in the money supply. This one is a lot more dynamic and a lot less amenable to top-down control than simply determining how much money is printed or what credits are granted by issuing banks (i.e. the Federal Reserve). An example of that is when you get a “panic.” When you get a run on one bank, that’s bad for the bank and its depositors (less so for the depositors in the era of deposit insurance) but when you get a run on a lot of banks or banks in genera, a “panic”, the result is that you lose this double use of the money leading to a contraction of the effective money supply.
A big factor in the Great Depression was just that–widespread bank failures causing a contraction in the effective money supply. Normally, this would lead to deflation causing prices to plummet which would be bad for borrowers and pain caused because some things will fall faster in price than others. However, the federal government tried to bypass part of that “correction” by shoring up one of the prices from falling–labor prices. But by forcing labor prices to be higher than the “market clearing” price, this created a surplus–more labor available at that price than people were willing to buy at that price. Translated into more common terms: rampant unemployment. And the Federal Reserve, which had been created as a result of previous bank panics to help stabilize the money supply and prevent just that, failed utterly for reasons that are more than I can really cover in this post but that I may go into later. The interested reader could find more in Milton Friedman’s “Free to Choose“.
Thus, the problem of keeping a stable money supply and avoiding the twin pitfalls of inflation and deflation is not a simple one. In the real world, any system attempted is likely to have occasional mismatches between the money supply and economic output. When that happens the the urge to “do something” becomes strong indeed but almost always this is an urge that should be resisted. Left to itself, the issue will generally sort itself out, usually more quickly than if the many wrong “somethings” are done.
Better to do nothing than to do the wrong “something.”