Why can't a country just print more Money?

It does not take rocket science for an inquisitive mind to ask this question : 

What stops any government from printing more money and distributing it to its citizens, thus elevating them from poverty, and allowing them to lead a more comfortable life?

I had that question when I started on my financial freedom journey...Read on..

The Question

RBI, or for that matter, any federal bank of a country, can print as much currency as it wants to. Well, if that is true, then where the hell is the problem? Why do we need donations for Covid-19? Why do we need to track GDP? Just print all the needed currency and distribute it, as needed. Let everyone lead a wonderful life.

I just wish if it was that easy.

Example (3 Situations)

Let me take a very simplified example.

Let us assume that I run a mini factory which manufactures 10 toffees per day. 

Each toffee costs Rs. 5. So, my total production is worth Rs. 50 every day.

Now, I have 3 other family members at my home - spouse and two daughters. Four of us are a family - akin to a mini nation.

Each of my family members, including me, need Rs. 5 to buy a toffee. And they can buy it only from me - since I am the only seller of toffees in my house.

Now, there are three (3) typical situations possible - one normal, and two extremes on either side.

Situation 1 : Normal

Each of my family member has a source of income (whether pocket money or monthly budget or a job or whatever else) through which they can pay Rs. 5 and take a toffee. 

Every day, they buy all my 10 toffees.

I get the money, which allows me to go back and manufacture another 10 toffees in the factory. 

My factory employs workers, pays for utilities and taxes to the government.

The cycle goes on. The situation is in equilibrium.

Every year, there is a nominal price increase (inflation) and my family members are able to manage the increased price of toffees because they also get an almost equivalent increase through their respective source of incomes. World is beautiful and in perfect harmony !

Situation 2 : Negative Extreme (Deflation)

- I have 10 toffees for the day, but now, my family members have run short of money to buy these toffees. 

- They want to buy, and I can produce more tomorrow if they buy today, but the challenge is lack of money with them. The lack of money is probably because they lost their jobs or there is too much uncertainty in the family to spend money on toffees at this stage. 

- Now, it does not stop here. If they do not buy toffees from me today, I will not get the money to go and produce more tomorrow. 

- If I do not produce more tomorrow, I do not pay taxes to the government and wages to my employees. 

- The entire economic cycle implodes. 

- What is the way out of this messy cycle?

- One way out is that I offer them toffees at a cheaper price thus triggering a sale. But then, I earn less, and if I earn less, I pay less to my employees, pay less taxes etc. The entire economic cycle goes into a cyclic downturn, which is popularly termed as deflation - which is never good.

- The other way out of this situation is to print more money. 

- If government prints more money and gives it to my family members, the cycle can start again. They would come and buy and I will go and produce more. When I produce more, I will pay more taxes and more wages. When I do that and the money comes back in cycle, I hope that the income of my family members will also increase and the normal economic cycle can resume. 

- Thus, in times of distress, printing more money is one of the solutions - and this option is not a bad option to exercise.

Situation 3 : Positive Extreme (Hyper Inflation)

- Now, the government started printing money and thought why to restrict giving money to my family only, and why limit only till the regular economic cycle is achieved.

- Why not to make everyone rich by printing even more money. 

- They go on and print a lot of money. They also hand over a lot of money to my family.

- My family now has a lot of money. My factory still can produce only 10 toffees in a day, while my family can afford to buy much more. 

- So, the next day, I come home with 10 toffees again but considering that I knew that my family can afford a lot of money and luxury, I thought of earning some extra profit today.

- So, I just doubled the price and priced the toffees at Rs. 10 each instead of Rs. 5 each.

- And my family was happy to pay the extra money because they had the free money with them. 

- Now, this is where the free money starts to pinch. The inflation became 100% (Rs. 5 to Rs. 10). 

- Now, my family members still can afford only 10 toffees (because I can produce only 10, just printing money cannot help me increase my production capacity overnight)

- But the government needs to continue to print extra money and give it to my family since the price of products have inflated by 100%. 

- If they print even more to improve the standard of living, inflation rises even more.

- There was only one way inflation could have been kept in control even with the extra money, and that was if I could produce more toffees since my family had the money to buy them. 

- So, printing free money can lead you to hyper-inflation if not backed up by economic activity (increased products or services)

If you have understood the above example, you would find the below economic situations a child's play...

What happens when a country tries to get rich by printing more money?

When a whole country tries to get richer by printing more money, it rarely works. Because if everyone has more money, prices go up instead. And people find they need more and more money to buy the same amount of goods.

What if the country has capacity to produce, but no money?

In such a case, a country can actually get richer by printing money if it doesn’t have enough money to start with. If there’s a shortage of money, businesses can’t sell enough, or pay all their workers. People can’t even borrow money from banks, because they don’t have enough either. So, the country has the capability to produce more but the cycle of movement is not working because of lack of money. In this case, printing more money lets people spend more, which lets companies produce more (since they already had the capacity), so there are more things to buy as well as more money to buy them with. Printing money, can help you come out of deflation, if done with extreme care.

In fact, in recessionary times – countries do resort to printing money, or what is known as Quantitative Easing (QE). But, that measure is only for extreme situations, and is dangerous because you can get into hyperinflation much sooner than you think.

Examples of Deflation

Global Recession : 2008

In 2008, there was the Global financial crisis, when banks lost a lot of money, and couldn’t let their customers have it. Luckily, most countries have central banks, which help to run the other banks, and they printed extra money to get their economies moving again - because the capability to produce was never lost. It was just that the machinery was locked.

Covid-19 : 2020

We have Covid-19 which has just stalled the economic machinery because of lock downs and social distancing. Many countries like USA, Japan and China have already started printing more money.

In a recession, with periods of deflation, it is possible to increase the money supply without causing inflation.

Examples of Hyperinflation

Zimbabwe and Venezuela : 2018

- This happened as recently as in 2018 in Zimbabwe, in Africa, and in Venezuela, in South America, when these countries printed more money to try to make their economies grow.

- As the printing presses sped up, prices rose faster, until these countries started to suffer from hyperinflation. 

- That’s when prices rise by an amazing amount in a year.

- And this happened because they never had the capacity to produce in equivalence to the money they were printing.

- When Zimbabwe was hit by hyperinflation, in 2008, prices rose as much as 231,000,000% in a single year. Imagine, a sweet which cost one Zimbabwe dollar before the inflation would have cost 231 m Zimbabwean dollars a year later.

- This amount of paper would probably be worth more than the banknotes printed on it.

- Lack of certainty over prices removes the incentive for buyers and sellers. Restaurant owners in Venezuela no longer have menus with printed prices, while supermarkets have also removed prices from shelves.

- Venezuela tried to protect its people from hyperinflation by passing laws to keep a low price on things people need most, like food and medicines. But that just meant that the shops and pharmacies ran out of those things.

- Read more about Venezuela Hyperinflation Crisis and Zimbabwe Hyperinflation Crisis

Germany : 1923

- Inflation was so bad in Germany that money became worthless. 

- Children used money as a toy. Money was used as wallpaper and to make kites. 

- Towards the end of 1923, so much money was needed, people had to carry it about in wheelbarrows. You hear stories of people stealing the wheelbarrow, but leaving the money.

- The hyperinflation led to the collapse of the German economy.

- Read more about Germany Hyperinflation Crisis

Why is Hyperinflation bad for an economy?

In a period of hyperinflation, investors will try and buy a stable foreign currency because that will hold its value much better. Hyperinflation in effect destroys purchasing power and encourages hoarding of goods, as people and businesses anticipate further price increases. Periods of hyperinflation tend therefore to be self perpetuating, as shortages further drive up prices.

If not printing money, how does a country actually become rich?

To get richer, a country has to make and sell more things – whether goods or services. This makes it safe to print more money, so that people can buy those extra things.

If a country prints more money without making more things, then prices just go up.

Is there any exception to the above rules?

Yes, there is. At the moment, there is one country that can get richer by printing more money, and that’s the United States (a country that is already wealthy). This is because most of the valuable things that countries around the world buy and sell to one another, including gold and oil, are priced in US dollars. So, if the US wants to buy more things, it really can just print more dollars.

Too much, too fast

Of course, poorer counties can only print their own currency, not US dollars. And if they print a lot more, their prices will go up too fast, and people will stop using that money. Instead, people will swap goods for other goods, or ask to be paid in US dollars instead. That’s what happened in Zimbabwe and Venezuela, and many other countries that were hit by hyperinflation.

Summary

Too little money makes prices fall, which is bad. But printing more money, when there isn’t more production, makes prices rise, which can be just as bad. No wonder economics - the study of money, trade and business - is often called the dismal science.

Regards

Manoj Arora

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