A managed increase in money supply is not inflationary

A reader e-mailed to comment on this column’s proposal for the enactment of a law to require the BSP to buy government bonds. The reader reminds us that "during the Japanese occupation of the Philippines in the 1940’s, the Japanese government needed to finance a lot of items that it needed to occupy and run the country." The reader goes on to remind us that "it did this by printing Japanese occupation money, lots of it, so that this eventually became known as "mickey mouse" money, meaning no more value." He then says that as a result "there was wild inflationary increase in prices of all commodities."

In explaining the phenomenon, the reader says: "We now know that this occurred because printing money only increases demand for real goods while it doesn’t actually increase the supply of real goods. The artificial demand to buy the real goods creates the inflation and makes the money worthless. There’s too much cash chasing a limited supply of things to buy." "The result will be a disastrous inflationary bridge that would destroy the economy."

With all due respect to the reader and others like-minded, our suggestion to increase the money supply via the central bank’s purchase of government bonds will not at all be inflationary. First and foremost, the money newly-created shall be "managed money" in the sense that it shall be channelled to the productive and production sector precisely to generate economic activity. The new money will never be directed at the consumption sector, as this is the instance that will cause the inflationary effect.

To disprove this link between the increase in money supply and inflation, it will be most illustrative to analyze three situations on the effect of an expansionary monetary policy on the price level.

The first case is when a country produces below full output level and operates below full employment level. The additional spending resulting from an increase in the money supply will mobilize the idle factors of production in the economy, particularly the unemployed labor force, and will allow them to participate in the wealth-creation process. With more output resulting from greater employment, the pressure on prices will hardly be upward but may even be downward. Countries under this case, which include all developing countries, can increase the money supply to increase output and employment without increasing the prices.

The second case is when a country produces at full output level and operates at full employment level but still with room for expansion and growth. The additional spending resulting from the increase in the money supply will create greater and better opportunities for the employed factors of production and increase their productivity. This will increase the potential output level and the pressure on prices will still be downward. This is the reason why developed countries still pursue expansionary monetary policies to increase their output levels.

The third case is when a country produces at full output level and operates at full employment level but with no more room for expansion and growth. Since there are no more opportunities to increase the productivity of the already employed factors of production and no more possibility to increase the potential output level, the additional spending resulting from the increase in the supply of money will only increase the prices.

The Philippines, no doubt, falls on the first case. As illustrated, expansionary monetary policies will be a favorable and logical move for us.

As blood is the lifeline of the human body, so is money the life source of the economy. Decrease the supply of blood of a man, and then you have a pale, anemic, unhealthy human being. In the same breath, decrease and limit the level of growth of money supply and domestic liquidity, and you will stunt development. Constrict further the money supply and no sooner will you reap a moribund economy.

The Philippines, sad to say, has long suffered the consequences of an anemic monetary policy such that its maximum economic growth and growth potential has not been fully realized. Like the image of the sick man of Asia that we have not really and permanently cast aside, the Philippine economy needs a gallon shot of blood transfusion in its arm. The country desperately needs a drastic and quantum leap in its money supply.

For too long a time now, our policy-makers have disastrously held sacred the view and notion that creating money will always be inflationary in effect. They argue that money must be left instead to regenerate on its own and by itself. They, of course, fail to realize and understand that while money is a measure of value, it is also a medium of exchange.

When money is lesser in quantity than the requirement for sustained and full development, then development will naturally be stunted and impaired. The economy will be unable to fully absorb the unemployed and the underemployed into the productive arena of employment. The unemployed individuals will be unable to contribute to production and become, economically speaking, dependent on others. They will consume without producing, thus, becoming economic liabilities to society.

We must, therefore, create a level of money supply that is commensurate with the financial requirements of all our development projects. Tragically, however, among our Asian neighbors, the Philippines has the lowest level money supply. At the end of 2000, we only had $7.69 billion circulating in the economy while Malaysia had $21.2 billion, Indonesia had $17.55 billion, Thailand had $16.47 billion, Korea had $39.38 billion, Singapore had $18.81 billion, and Japan had a whopping $2.06 trillion. This level of money is abjectly low when compared with our East Asian neighbors.

The reality even looks more ominous when viewed against the ratio between actual money in circulation and the population level, and when compared to our neighbors and to some developed countries. It must be noted that the progressive countries have been steadily increasing their money supply through the years as the needs and requirements for economic development and expansion dictate. As for anemic Philippines, it has increased its money supply very meagerly – in droplets – and not in proportion to the expanding needs of the economy.

It should be evident then that there exists a positive correlation between money supply and economic development. Money, and more of it actually generates more growth, lowers the interest rate and brings down the prices of goods and commodities. This positive effect of an expansionary monetary policy is all the more evident and true in a country, such as ours, that produces way below full output level and operates below full employment.

To repeat, under such situation, the additional spending created by an increase in the money supply will mobilize the idle factors of production in the economy, particularly the unemployed labor force, and will allow them now to participate and contribute in the creation and generation of wealth. With a higher output created by more employment, the pressure in prices of goods and commodities will hardly be upward but will be downward instead.

You may write your comments / suggestion at 15/F Equitable Bank Tower Paseo de Roxas, Makati City or through e-mail at HYPERLINK "mail to: [email protected]"

(Editor’s note: Atty. Roxas is writing a limited series of articles dealing with financial matters and other important business topics. He is available for speaking engagements on the subject matters of his articles.)