Much confusion in economics results from the common practice of referring to money as capital. In fact money and capital are two different things. Capital is the real resources that producers use in order to make the goods that we all consume: things like factories, machine tools, trucks, and roads. All capital exists in a specific form. Money on the other hand is non-specific; it can be used to buy anything that is available in the marketplace, including capital goods. This is what leads to the common practice of referring to money as capital. Keynesian economists say that new money cannot cause inflation or other problems because the economy is not at “full employment” or that we have “excess capacity.” I have dealt with the question of “full employment” elsewhere; this article intends to address the issue of “excess capacity.”
In a nutshell “excess capacity” cannot exist because capital goods are specific, they can be used only to engage in a certain type of production. In order to use new money to produce the goods that will be demanded in the future, existing capital must be transformed or new capital goods must be produced. All of this takes time.
The basic error that occurs as a result of this process is the idea that by adding money to the economy, we can increase current consumption while at the same time setting aside more resources as capital goods to be used to produce for the future. The critical factor that this assumption leaves out is time. It takes time for a given sum of money to enter the market and transform into actual capital goods that can be used for future production. At the time the money is added to the economy, a set amount of capital exists. Increasing the money supply does not increase this amount, it simply allows those who have access to the new money to buy up some of the existing resources and use them. What they use them for depends entirely on who gets the new money first.
In our current system, new money is given to big banks and Wall Street firms. These firms then lend the money to entrepreneurs who actually produce the goods that we consume. Even if the recipient of newly printed money knows of a factory that is not being used, or other “excess” capital, he must still go onto the market and buy that resource, find people who know how to work with the machines in the factory (or train them), and find a market for the products that his factory will produce. These are all risky endeavors. Entrepreneurs evaluate risk based on the interest rate.
When new money forces interest rates down near zero, more risky investments are tried. Projects that are started at a time of loose money and low interest rates tend to fail once the central bank stops printing money and interest rates rise, making things that seemed profitable at the old rates now appear to be losers. These marginal investments that are only possible due to manipulated interest rates are what are known as “mal-investments.” It is the failure of these mal-investments which leads to the sudden business failures at the beginning of every depression or recession. Every boom-bust cycle follows this pattern: new money is printed, interest rates fall, marginal investments are made, the amount of money printing declines, interest rates rise, mal-investments are exposed, people lose their jobs and investors lose money. The loss of jobs and money causes supply and demand to fall, initiating another recession.
The attribution of the recession to a “fall in demand” misses the point. Demand is a result of production and wealth generation. People can only demand consumer goods if they have first produced something which they can offer in exchange for the products that they demand. Attempting to stimulate demand by printing money and lowering interest rates can only lead to a repeat of the boom-bust cycle and to more mal-investments that will eventually have to be liquidated, causing a repeat of the entire process.