We need to distinguish between two major monetary forces in the economy:
Money constrains expenditure to income (production)
When we sell our goods and services to the economy, the money we earn enables us to buy the equivalent of what we have produced, or have contributed to the economy. That is, money constrains our expenditure to our income; what we buy is constrained to what we sell; our demand is constrained to what we have supplied (Says law).
Creating extra money causes expenditure to exceed income
A forger is a person who steals from the economy by creating money. They use the forged money to buy goods without selling any goods or services to the economy. If they were to create a large amount of forged money they would cause the country to buy more than it produced.
Foreign debt is created when expenditure exceeds income
If a country buys more than it has produced, then it is either going to:
There is a limit to the amount that stocks can be run down and if it does happen, it causes hyper-inflation. Usually, the extra spending causes imports to exceed exports and leads to a current account deficit. This is likely to reduce foreign reserves if the country has fixed exchange rates. It is likely to increase foreign debt if the country uses the floating exchange rate system.
Bank credit the source of extra money
Of course forgeries are not responsible for foreign debt. Bank credit is the main means that we create additional money in our economies. The government does create some money and uses it to finance expenditure. But that is small, usually around 5 per cent of the total. The remaining 95 per cent of the growth in the money supply in our economy comes from bank credit. So it is not high exchange rates (as widely believed) that causes us to buy more than we produce; it is the creation of additional money through the growth of bank credit.
Creating money creates domestic debt and foreign debt
The banks create money when we borrow from them. This borrowing raises total domestic debt. When we spend that money, we are spending more than we have earned. That is we are buying more than we have produced. The only way we can buy more than we produce is to import more than we export. To pay for those additional imports, we must reduce foreign reserves, sell assets overseas (sell off the farm) or create additional foreign debt. For every extra dollar of money we create from bank credit, we can generate two dollars of extra debt: a dollar of domestic debt and a dollar of foreign debt (or reduced foreign reserves). It is no wonder that debt is a major world economic problem.
Source of economic growth
The second effect to consider is the source of economic growth. In the days of fixed exchange rates, if we increased our exports by more than our imports, we would earn more money than we had spent. The extra money we earned would enable us to increase our future spending on local products and imports. Our national income would continue to grow while our income from exports was greater than our spending on imports. When imports were equal to exports again, we would be in equilibrium: the money coming into the country being equal to the money going out and our national income would stop growing.
For example, assume that we spent 10 per cent of our national income on imports. If exports increased by $100 million, our national income and spending would have to rise by $1,000 million before our additional spending on imports increased $100 million to equal our additional income from exports. (This is the export multiplier.)
The important point to note here is that disequilibrium and the process of achieving equilibrium raised our national income and made us more prosperous. When the economy reaches equilibrium, it stops growing.
In the process of increasing exports above imports, additional money is created. It is created because the economy has produced more than it has consumed; that is, because there is saving. This saving raises foreign reserves rather than foreign debt.
Floating exchange rate constrains growth
Under the floating exchange rate system, if we increase our exports, the exchange rate rises to make imports cheaper so that;
The shift in spending from domestic products to imports reduces the income of those domestic industries supplying the domestic economy. The extra income earned by exporters is earned at the expense of those other industries supplying the domestic market. For example, increased income from exports of minerals and energy may reduce the income of manufacturing and agricultural industries.
With floating exchange rates, equilibrium between international payments and receipts is attained daily on the foreign exchange market. There is no opportunity for additional income from exports to raise national income and bring prosperity to the economy. Equilibrium between foreign payments and receipts is achieved by changing the relative price of domestic products and imports. As exports increase, the share of our income spent on imports rises and the share spent on domestic products declines. Equilibrium is not attained by raising income as under the fixed exchange rate system. So trade no longer brings economic growth.
Money and debt
During the days of fixed exchange rates there were two main sources of additional money:
As mentioned above, money from increased exports came from savings that would raise foreign reserves. Increased bank credit increased national spending above national income and would deplete foreign reserves. With fixed exchange rates it was important to regulate bank lending so that the additional imports from bank credit did not deplete foreign reserves.
When the exchange rate was floated, it eliminated the source of money that came from increased foreign reserves. That left only one main source of additional money: bank credit. Bank credit enables the economy to buy more than it has produced.
Also, because our economies need additional money for the them to grow, we needed to fill the vacuum left by the termination of money from trade with increased money from bank credit. That is why bank credit has been allowed to continue growing.
The need for the growth of bank credit left central banks in a dilemma. If they increased bank credit to increase prosperity, they also raised foreign debt. Also, money from bank credit has proved to be more inflationary than money from trade and savings. Hence countries with floating exchange rates need more money to compensate for inflation. This has driven these countries deeper into debt.
Current economic policy
Many economists have convinced themselves that foreign debt does not matter. So most central banks continue to concentrate on managing monetary policy to control inflation. The growth of bank credit is seen as necessary for prosperity. Yet bank credit that causes inflation to exceed the target rate is seen as excessive and must be constrained. The central bank constrains credit, not by restricting the amount of money the banks can lend but by raising interest rates to discourage people and business from borrowing. However, in doing so, they penalize all borrowers and raise profits for the banks.
So the state of monetary policy in many countries is that:
The solution to all this is not necessarily to return fixed exchange rates. Given the right incentives, the finance market can be induced to adjust the exchange rate in such a way that it creates money from trade to achieve full employment with low inflation. This website describes two such options, the optimum exchange rate system and the guided exchange rate and liquidity system. At the heart of these systems are policies that manage the sources of monetary growth to provide balance of payments stability.
Last update: 31 July 2016