In the “7 Fallacies of Economics” series, I have covered the fallacies of “collective terms” and “composition,” and now turn to the third fallacy: Money is Wealth. FEE president Lawrence Reed writes:

The mercantilists of the 1600s raised this error to the pinnacle of national policy. Always bent upon heaping up hoards of gold and silver, they made war on their neighbors and looted their treasures. If England was richer than France, it was, according to the mercantilists, because England had more precious metals in its possession, which usually meant in the king’s coffers. It was Adam Smith, in The Wealth of Nations, who exploded this silly notion. A people are prosperous to the extent they possess goods and services, not money, Smith declared. All the money in the world—paper or metallic—will still leave one starving if goods and services are not available. The “money is wealth” error is the affliction of the currency crank. From John Law to John Maynard Keynes, great populations have hyperinflated themselves to ruin in pursuit of this illusion. Even today we hear cries of “we need more money” as the government’s monetary authorities crank it out at double digit rates. The good economist will recognize that money creation is no short-cut to wealth. Only the production of valued goods and services in a market which reflects the consumer’s wishes can relieve poverty and promote prosperity.

Those words are still true, if only because our political and financial “leaders” want us to believe that they can end the current recession if the Federal Reserve System creates “liquidity.” Thus, we see the Fed doing whatever it can to push more money into the economy.

One reason that the “money is wealth” fallacy has thrived for so long is that many people – including academic economists – fall prey to another fallacy, the fallacy of composition (discussed last week). In the case of money, it is especially pernicious.

Assume, for example, that I had a printing press in my house which could crank out undetectable counterfeit money. I could print huge amounts and purchase whatever I pleased. No doubt, I would be better off (as long as the authorities did not discover what I was doing), but others would be made worse off.

First, and most important, is the nature of money. Money is a good that is used to trade for other goods, and by making trade easier (and more abundant), it is a productive asset.

However, as Adam Smith understood, money itself is not wealth; instead, it is a good that we use in order to obtain wealth. (Pieces of government-produced green paper do not qualify as historical “money.” Government’s monopoly on money has led to its debasement.)

Second, money follows the same economic laws that govern all other goods. The more money created, the less its marginal value. (In other words, money is subject to the Law of Decreasing Marginal Utility.) Many economists have missed this point.

In typical academic classes, money is described as a quantity variable. Double the amount of money and the “price level” doubles as well, but the monetary increase has brought about no real harm. Other academic models note that an increase in the amount of money will increase the amount of wealth (call it “Gross Domestic Product”), even if it also raises the “price levels.”

While such models are easy to teach (and to use for solving math problems), nonetheless they are inaccurate at best and dangerous at worst. They do not demonstrate what really happens when the amount of money in an economy is increased. If the process of creating more and more money by fiat (called inflation) goes on unchecked, as it did during the past decade, then not only does the value of money on the margin fall, but its growth triggers an unsustainable boom that ultimately collapses in a bust.

This process has repeated itself time and again, which demonstrates that most policy makers do not understand that money is not wealth. The lesson still has not been learned.

Next Week: The Fallacy of Production for its Own Sake