Chapter 3: Money and Capital

MONEY AND CAPITAL

1. Price System and Price Level

In the static course of an exchange economy, the prices of all goods are integrated into a system according to the laws of the vertical and horizontal connectivity of prices. For this system of prices, the monetary expression of prices is completely irrelevant. When a unit of good G₁ is equal in price to 2 units of good G₂ or 3 units of good G₃, then this relationship will not change, regardless of whether the price of G₁ in money is established at 1 or 100 as long as the prices of G₂ and G₃ are one-half or one-third respectively of this price. Any multiplication of money prices is possible without thereby disturbing the system of prices as long as this multiplication occurs to the same degree for all prices. The “value” or “purchasing power” of money (the monetary unit) is then high or low, depending on how high the prices are, or—since, of course, every price is only a part of the price system—depending on how high a given price is. Any given price could serve as the standard for the height of the price level, or as an index for the purchasing power of money.

It would now be a grave mistake if from this neutrality of the system of prices of goods regarding the height of the price level one were to draw the conclusion that the problem of money is solved by answering the question concerning the height of prices. If one can assume that a specific system of prices can exist at a higher or lower level of money prices, if consequently a system of prices can be conceived of as independent of the height of prices, one must not overlook the important fact that while it is possible to think of one and the same price system as expressed through a lower or higher level of money prices, it will never (or only under very special circumstances⁵³ which never occur in practice) be possible to move a price system from one level to another without changing the relationships between individual prices. Yet, since in an exchange economy prices determine the allocation of the factors of production, the structure of production, and the sale of goods, every change in the level of prices must also lead to changes in the allocation of goods via a change in the price system.

This immediately becomes clear if one observes the effects of a change in the money supply. Imagine, for example, that in a static economy individual economic subjects receive an amount of money which previously was not used in the economy. These economic subjects will probably not simply keep the money, but will spend it. In other words, the economic subjects will revise their supply and demand positions with respect to their newly allotted money such that for each price under consideration they will purchase more (and under certain circumstances sell less) than heretofore. This change in demand (and supply) on the market must lead to an increase in prices.

It will never be possible to assume that this price movement will become effective to the same extent for all goods. How the new money is used will determine which goods will be in greater demand. And just as the demand reaching the market is always only the sum of individual demands, every change in individual demand will also change the composition of the total demand. An increase in demand will occur for those goods which are in greater demand, especially by those economic subjects who are the recipients of the new money. The increase in the prices of these goods might release countermovements in another area. It is possible that because individual goods increase in price, those economic subjects who are not enriched by the new flow of money and who thus are hard hit by this increase in individual prices will not reduce their demand for these goods to such a degree that their money demand for other goods can remain unchanged; and the result of an increase in the prices of one group of goods can be that other prices fall. Thus, as a result of increasing money we can expect with certainty an increase in the individual prices of some goods; other prices might remain the same or even fall. Naturally, an increase of some or even all prices to a varying degree is also possible. For reasons of thoroughness, let it be remarked here that these movements will not only be caused from the side of demand. It can happen that an increase in money possessions puts individual economic subjects into the position of refraining from selling goods so that this circumstance, too, can lead to a shift in prices. Naturally, the changes will move in the same direction as those caused by demand.

In any case, each appearance of additional money on the market will lead to a disruption in the given price system. Once the new money has been spent and transferred from one hand to another, in a second turnover it will again affect the relationship between prices until, in the end, the process of price changing has rippled through the entire economic system. A new system of prices will form. It should be noted here that shifts in the relationship between prices arise not only during the period of transition but that a change in the new static price system as compared to the original state must also be expected.

The ultimate cause for this probably lies in the fact that each change in the possession of money must lead to a change in the distribution of property in the economy. Whoever has money can obtain goods and use them just as someone who owns real goods. If a change in the order of property relationships has occurred because of a new allotment of money (or because money has been taken away), this will also result in a change in the employment of goods. Even in the example of an exchange economy which does not use any money, it cannot be doubted that a change in the distribution of goods also implies a change in the entire economic system, and that the structuring of the economy is not only dependent on the amount of owned goods but also on the way the goods are distributed.

One could accept all of this and still be of the opinion that an excessively detailed description of possible movements was being developed here which in practice would not be of great significance. If a change in the distribution of real goods or the possession of money leads to a situation in which, for example, fewer luxury goods and more mass products or, in general, more of one good and less of another are produced, if this price rises and that falls—the one price more dramatically and the other less so—then we are faced with fluctuations in the economy which require corresponding adjustments. And yet the clarification of the relationship of which we have spoken here is of the greatest significance if we choose it as a point of departure for the discussion of a problem which arises precisely from the way money is employed in a modern economy.

The problem is that the determination of the temporal structure of production; that is, the determination of the roundabout methods of production, depends in our economic system decisively on the way in which owned money is employed. A change in the ownership of money will change property relationships such that with each shift in property a change in the demand for one or another good will occur; moreover it can be expected that a change in the possession of money will cause a change in the structure of production regarding the employment of factors of production and the length of roundabout methods of production. If it can be shown, however, that the distribution of money to individual economic subjects also determines the structure of production, then it is thereby demonstrated that the economy’s supply of money is not only decisive for the price level, but that beyond this it determines the conditions for the possibility of producing finished products.

The point of departure for treating this question must be an analysis of the function of money capital.

2. Capital in the Form of Money Assets

Earlier we explained the role of capital in production such that we only considered events in the realm of real goods without paying attention to the more complicated form of these relationships which result from the introduction of money. The intention was to present the process of employing capital, which in essence can only be an employment of material goods in such a manner that the relationships within the sphere of material goods can become totally clear. We saw that a time-consuming roundabout process of production could only be described as one in which free capital, or subsistence means, are made available by their owners for production in order to “support” originary factors of production which require continuous compensation for their employment, while a return for their use could only be expected at a later time. Each use of factors of production in roundabout production means tying up free capital—its transformation into capital goods (relatively durable investments or intermediate products) from which a return can only later be expected. However, with a successful course of production, each such binding of free capital can be regarded as temporary; all invested capital will sooner or later be free again, although, especially when capital is bound up in durable factors of production, a freeing of this capital can often only be expected very late. The final freeing up of capital can only occur in the form of proceeds from the production of consumer goods. All production processes preceding this can only be maintained by continually making a portion of the proceeds from the production of consumer goods available to them. The production of consumer goods will first use part of its return to pay for the originary factors of production it employs, another share will serve to purchase raw materials and in turn make their reproduction possible, and another part will serve as a renewal fund for the fixed capital investments in the production of consumer goods and will be transferred to those lines of production which work towards renewing this equipment. And in each stage of the preceding production processes, the free capital acquired from consumer-goods production—insofar as it does not serve for the payment of originary factors of production in this very stage itself, will be distributed further back to preceding production stages until all of the free capital is accorded to originary factors of production whose employment occurs relatively early in the temporal course of the roundabout method of production. Although a lengthening of roundabout production, and thus in particular a more extensive investment of free capital in durable capital goods, occurs in the interest of increased production, there is a limit to expanding roundabout production methods due to the limitations of free capital. The interest rate to be paid for the use of free capital provides the individual entrepreneur with an indication of the possibility of expanding production. The interest rate establishes itself at such a level that all production processes possible at this rate can find a supply of free capital and all production that can no longer afford the interest must remain undone because it would not be economic. Hence, as we have shown, it is guaranteed that a roundabout method of production will only be lengthened to such an extent that a timely freeing up of capital which is required for its maintenance occurs.

This brief recapitulation of the physical process of the employment of capital should serve here as an introduction to our analysis of capital employing production in the form it takes in a money economy. In this analysis we must always keep in mind the movements in the world of real goods which in the framework of a money economy are kept in flux by the turnover of money. If a money economy calculates in terms of money and has money at its disposal, then the movements caused by money can only have an impact on production insofar as the employment of money causes movements in the employment of material goods. During the following discussion we must keep this obvious fact in mind.

In a money economy the owner of capital initially possesses a supply of money. The question now is how the money can function as capital. We can continue from what we said during our first analysis of the function of capital, where we characterized capital exclusively as supplies of means of subsistence which were employed by their owners to support roundabout methods of production. We originally had to restrict the range of capital to subsistence means, as only these are suited to provide support for the duration of production to those who have made originary factors of production available for time-consuming roundabout methods of production. Furthermore, we have seen that it is not means of subsistence as such that can be considered capital, but rather only insofar as they, too, are employed by their owners as capital, i.e., insofar as they are made available now in exchange for a later return. Thus, we have divided the function of capital in the process of time-consuming roundabout production into two complementary parts. Capital must first be physically capable of providing support for those who make the originary factors of production available for the duration of the roundabout production. Second, it must be available for the duration of the roundabout production process: It must be expended today in order to be returned only later, or—metaphorically—it must serve to bridge the time absorbed by the roundabout method of production. Now a clear perspective of the question of capital money has been gained. Money can never serve to “support” factors of production—only actually available material goods that can be bought with money can do this. However, the owning of money can make a bridging of the temporal duration of the roundabout production process possible: The owner of capital does not make natural means of subsistence available to those who provide originary factors of production for roundabout methods of production, but instead he pays them in money; and he who has received the money in turn buys the needed means of subsistence on the market. What is employed today and only paid back later is money. And insofar as money assumes the “timebridging” function of capital, one can label it monetary capital. The employment of natural means of subsistence in the function of capital by their owners is thereby eliminated. The grounds on which an owner of wealth decides not to consume his wealth but rather to use it as capital from now on exclusively concerns the possession of money. Roundabout production will no longer be “supported” by owners of capital in the sense that a subsistence fund is offered to secure a living for those offering originary factors of production, but instead it will be “financed” by a payment of money. The entrepreneur who wishes to adopt a roundabout method of production does not need a supply of material goods, of means of subsistence, but only a supply of money.

Yet, in the process of capitalist production within a monetary economy, money can function as capital only because financing a roundabout production process at the same time makes it possible to support this production process; because those who provide the originary factors of production can be satisfied with payment in money rather than a payment with real means of subsistence, since means of subsistence can be bought on the market with this money. Money capital serves the purpose of delivering the means of subsistence actually available in an economy to those who need them as support for the duration of the roundabout method of production. Even if the control of something serving as capital is not control of real goods but of money, then in a certain sense money is still the representative of material goods, and employing money as capital means that material goods will be drawn upon to support roundabout methods of production. It is now our goal to show how financing a roundabout method of production also leads to support of the originary factors of production employed in this process. We will proceed by first considering the course of a static economy.

We will assume a freeing up of capital in the production of consumer goods. The entrepreneur sells his product of finished consumer goods for money and thereby acquires control of a sum of money. Here, money capital is naturally only that part of the monetary return from sales which is not consumed as entrepreneurial profit or capital interest.⁵⁴ In the same way, only that part of the money returns is available as “money capital” for financing roundabout methods of production which is “maintained” as savings. If the entrepreneur now uses this money capital to pay for originary factors of production, then it has thereby become possible for whoever supplied the originary factors of production to buy means of subsistence. If we compare the total revenue acquired from the sale of consumer goods as it reappears on the market in the form of a demand for consumer goods with the output of consumer goods, we arrive at the following picture: Part of the monetary return is capital interest and entrepreneurial profit. The capitalist and entrepreneur each buy part of the consumer goods with the monetary income they have received. By way of financing roundabout production processes another part of the monetary return becomes income for those supplying originary factors of production who also then enter the consumer goods market with their monetary income. This picture only presents a very simple model which will have to be enriched later in varying ways. In particular, it will still have to be asked what consequences follow from the fact that the investment of money capital does not always imply an immediate payment for originary factors of production, but instead frequently first implies the purchase of already available capital goods. We can disregard these complications for the moment. Here the simplified model shall only serve to point out a few principles important for the analysis of the function of money capital.

It must first be seen that the introduction of money in the turnover of consumer goods is nothing but a way of dividing them up for two uses that are both consumer uses, but that with respect to their function within the temporal framework of production must be categorically distinguished. Those consumer goods which are employed in support of originary factors used in roundabout methods of production serve “reproductive” consumption as was previously described: They make it possible that originary factors of production are provided with means of support now, while the product only later takes on the form of a finished consumer good. Hand in hand with the consumer good being used up goes the production of an “economic successor” to this consumer good; simultaneous to this consumption is the commencement of the reproduction of the expended consumer good. Clearly, as long as the economy runs in a static way this “economic successor” is equal in value and price to the “invested” subsistence means. This is true regarding one part of the used up consumer goods. The other part—that part of the consumer goods which is used up by entrepreneurs and capitalists—is the object of “pure consumption.” This part of the consumer goods becomes the payment, so to speak, for a previously expended service; it is not a prerequisite for the adoption of a roundabout method of production. This should be beyond any doubt after the previous explanations.

What we now see here—the partitioning of the consumer goods product into reproductive and pure consumption, that is, the division of production returns into one part that functions as capital and another that does not—we have already encountered during our discussion of the economy of real goods. The difference that emerges in a money economy is first exclusively the one already mentioned repeatedly: that a subsistence fund is not employed in the function of capital directly, but that this function is taken over by owned money. What we have in our simple model is a complete parallel between the process in a monetary economy and that in the material goods economy. In the latter, those economic subjects who attain finished products—subsistence means—at the end of production will employ part of these as capital, and invest it either themselves or through a middleman. In a money economy, only money will be invested; but all owned money that is a return from the sale of a product represents a share of subsistence means, investing money simultaneously means setting aside means of subsistence for roundabout methods of production. Financing production is the same as subsidizing it. And just as in the non-monetary economy the owner of means of subsistence may decide to invest more or less than heretofore, the same can occur in a money economy regarding one’s money possessions. If the owners of money invest more money, this means that they draw upon fewer means of subsistence and leave more for the support of roundabout methods of production. The same is true the other way around: less investment of money simultaneously implies the consumption of more means of subsistence by the owners of money. Accordingly, an expansion or limitation of the investment of money capital cannot bring about a change in the size of the demand for consumer goods.

This statement will be very important later. Here it has been explained within the framework of a very simple model, and in a different connection it will become apparent that whenever certain conditions arise, this statement can lose its validity. For this reason, the reader must again be reminded that here we began with the assumption of a static economy and only considered those changes which arise when a sum of money obtained from the sale of products is saved to a greater or lesser extent. The model of the static economy, however, shall be considered from yet another perspective.

First, let me mention a circumstance that is irrelevant for the construction of our model, but that might make the kind of analysis presented here difficult for some to understand. The entire money return from the sale of consumer goods—not more and not less—reappears on the consumer goods market and the entire output of consumer goods will be bought with this money. It follows from this that the price level at which the consumer goods are sold on the market is the same as the price level at which these consumer goods will in turn be bought by the consumers.⁵⁵ Thus, a relationship between the whole supply of consumer goods and the entire demand for these is established. Now, will the detailed composition of the social product correspond to the structure of demand regarding the various consumer goods? Will it not be possible that too much of good A and too little of good B have been produced so that the structure of demand must lead to a decline in the price of A and an increase in the price of B? This is, of course, not only possible, but it is to be expected with certainty whenever there is a shift in the relative distribution of the consumers-good output among originary factors of production on the one hand, and owners of capital and entrepreneurs on the other. For the rich man will naturally not only buy more than the poor man, but above all he will buy other things. Thus, for example, with increased savings activity to which production has not yet adjusted in its decisions about which goods to produce, it can happen that too few goods for use by the masses and too many luxury goods for the rich are produced. This will express itself in the relationship between the prices of both of these groups of goods. It is clear, however, that this situation has nothing to do with what we are concerned with here. Here we are discussing the principle that the extent of investments is restricted by the fact that part of the means of subsistence must be made available for subsidizing them, and that in a monetary economy nothing regarding this principle changes when money rather than means of subsistence is invested. We are thus concerned with the quantitative correspondence between monetary capital and the subsistence fund, not with the correspondence between the composition of the consumer goods fund and the type of demand for consumer goods. We have shown that an “incorrect” composition of the consumer goods fund is possible. The problems that might arise from this, however, lie outside the realm of what is treated by the theory of capital.

More important for us is a question which we were able to ignore when considering our model by simplifying assumptions to the greatest extent. In contrast to the given situation of a horizontally partitioned structure of production, our assumption that the entrepreneur employs the money capital he has received from the sale of his products in its entirety directly for the payment of originary factors of production was an assumption foreign to reality. It is clear that one part—depending on the individual case a larger or smaller, but as a rule a highly significant part—of the money capital will not be employed by the entrepreneurs producing finished consumer goods for the payment of originary factors of production, but will be used instead for the purchase of capital goods; for intermediate products as well as for durable capital goods. It is easy to see that this complicated configuration need not change anything regarding the relationship between money capital and means of subsistence. If the entrepreneur producing consumer goods employs part of his money capital to buy capital goods from a preceding production stage, he thereby transfers his monetary capital to another entrepreneur.⁵⁶ For this entrepreneur, what in the hands of his buyer was monetary capital is the return from his product, just as the entrepreneur producing consumer goods receives a monetary return for his products. The same possibilities exist for the employment of these monetary returns in preceding production stages as for the employment of returns from the production of consumer goods. If we assume that in this stage, too, saving will be maintained—this being a prerequisite for a static economy—then the monetary return will partially be consumed as capital interest and entrepreneurial profit. However, it will also partially be used as monetary capital, that is, it will be invested and here—as in the previous case—this means that it will be used to purchase originary factors of production and capital goods which are the output of an even more antecedent production process. The same applies to each antecedent production process. In total, we see a partitioning of the monetary returns received from the sale of consumer goods among the two elementary employments: pure consumption of capital interest and entrepreneurial profits on the one hand, and payment of originary factors of production on the other. In both cases, however, we see the final transformation of monetary returns from the production of consumer goods into monetary income which demands consumer goods. The vertical structuring of production into a chain of successive stages has not brought about a change here. The turnover of capital goods which arises from this vertical chain is an intermediate link in the process of transforming monetary returns from the sale of consumer goods into monetary income. It is entirely unimportant here how many steps this process takes. The entire process can be explained in terms of a single formula: The monetary return from a product will change hands until it is transformed into income, be it income of capital owners and entrepreneurs or income of economic subjects who sell originary factors of production in exchange for this monetary income. Just as the monetary return from the production of consumer goods is not entirely monetary capital, but instead a part of this return will be split off by the entrepreneur and used for the payment of capital interest and entrepreneurial profit while only the remainder of it functions as capital, so will a splitting off of both kinds of income also occur in the preceding stages through which money circulates when capital goods are purchased. It must be beyond doubt, however, that partitioning monetary returns from the production of consumer goods into various incomes, which exercise a demand for means of subsistence, must occur even if an intermediate stage in the form of a purchase of capital goods is inserted, and even if there are several intermediate stages of this kind.

There is only one thing that must be noted here. If entrepreneurs in the production of consumer goods employ all of their monetary capital for the purchase of originary factors of production, an immediate transformation of this monetary capital into monetary income will result. The monetary return which has been obtained from the sale of products reaches, in the next round of payment, the economic subjects who provide the originary factors of production and these economic subjects at once purchase consumer goods from whose sales the entrepreneurs’ monetary capital has come. But wherever a purchase of intermediate products has been introduced between the spending of money capital by the entrepreneur in the production of consumer goods and the transformation of this monetary capital into monetary income, a turnover in the form of the purchase of a capital good is inserted—once or several times. We would like to consider this situation using a model in which for the sake of simplicity we can disregard the splitting off of capital interest and entrepreneurial profit as regards the use of monetary returns from the production of consumer goods. The entrepreneurs in the production of consumer goods (CG) obtain a return of 100 money units. Of these they pass on 25 directly to originary factors of production, while with 75 they purchase capital goods from the first antecedent production stage (I). Here again, 25 will be passed on to originary factors of production, while 50 go to a second antecedent production stage (II) of which 25 again go to originary factors of production, while 25 are passed on to yet another even earlier stage of capital goods production (III) which finally exclusively pays for originary factors of production.⁵⁷ For us a new question now arises from the fact that money capital does not immediately travel from the realm of consumer-goods production into the hands of the income recipients, but that on the way there are certain obstacles in the form of turnovers of monetary capital for capital goods which make the temporal course of the turnovers problematic. This becomes clear if in our model we relate each act of payment as well as the completion of production processes to a time unit. We will assume, for example, that all purchases and sales as well as all production processes are carried out for the period of one week and the next payment occurs only at the end of one week for the demands of the following week. The entrepreneurs of consumer-goods production sell their product and immediately transfer part of the revenue to those who provide originary factors of production who—we assume—immediately purchase their weekly needs. The rest of the monetary returns of the producers of consumer goods serves simultaneously to purchase capital goods for their weekly needs. In each of the antecedent production processes, the turnover at the end of the week will be financed by the money received at the beginning of that week. At the same time, production is structured such that in the production of consumer goods, a certain amount of consumer goods are finished at the end of each week, and in every antecedent production stage just enough capital goods are finished each week as are needed in the next antecedent stage in one week. Hence, we arrive at a simplified representation of the turnover of monetary capital. The first week a sum of 25 goes to originary factors of production from the production of consumer goods and thence in turn onto the market for means of subsistence (MS); simultaneously, a sum of 75 goes to the first preceding production stage. The second week a sum of 25 goes from this first preceding production stage to originary factors of production, and a sum of 50 to the second preceding stage of production. In the third week a sum of 25 goes from the second stage to originary factors of production, and a sum of 25 to the third stage of antecedent production, and only in the fourth week does the sum of 25 from this last stage—as the remainder of 100 units of capital expended in the first week in consumer-goods production—reach the recipients of income and from these, in turn, the consumer goods market. Of this monetary capital, one-fourth has directly—without running into any obstacles—become income, one-fourth has had to overcome one obstacle, and the other quarters have had to overcome two and three obstacles respectively. Each obstacle has tied up a share of the monetary capital for one week on its way to being transformed into monetary income for those providing originary factors of production. Clearly an undisturbed, and at all stages continuous, course of production organized in this way was only possible under the condition that in addition to the monetary capital of 100, whose passage through the various stages of production we have followed, there is still other money being turned over. It is easy to see that during the same time span in which the sum of 100 from the realm of consumer goods production becomes one-fourth income, while three-fourths is directed to the first preceding stage, a sum of 75 must be directed further from this stage: namely, 25 to originary factors of production and 50 to the second antecedent production stage. Furthermore, in the same time span a sum of 50 must be directed from the second stage—half to recipients of income and half to the third stage. Finally, in the same time span, a sum of 25 must go from the third stage directly to the recipients of income. Consequently, the economy must be supplied with money in the sum of 250 so that in this multi-stage structure, an undisturbed course of turnovers can occur, although only 100 are turned over each week in the production of consumer goods. It is also clear that those sums of money which are spent during the first week in the three stages preceding consumer goods production could only have reached these stages as the return from a previous sale of capital goods. The sums of money which run through the four stages of production will be invested in these stages as monetary capital, i.e., either for the payment of originary factors of production or for that of capital goods. Yet, that more money will be needed to maintain the “layered” production structure than will be freed up in consumer goods production is only related to the fact that—as an obstacle in the turnover of monetary capital on its way to income recipients—the purchase of capital goods is interpolated.

Our model is greatly simplified as compared to the situation in reality. It is clear that the time spans for which the purchases of capital goods occur will vary in lengths, that the renewal of capital goods will occur over varying periods of time and that the turnover of money from one stage to another will by no means always be as regular as the model indicates. Yet here we are only concerned with following the path of monetary capital in financing production and showing how monetary capital is transformed into income. And we can add to the first even further-reaching simplification we made when considering the turnover of monetary capital and clear a significant difficulty from our path. When we began with the assumption that in the production of consumer goods the entrepreneur made monetary capital available directly to originary factors of production, we conceived of the entire turnover as being carried out with a sum of money corresponding to the monetary return from the production of consumer goods. A case for this would exist in reality if, in the vertical structure of production, there were a large combination of all stages of production, including all stages from the production of the first raw materials through the completion of the finished product. Since the vertical divisions in the structure of production make it necessary that a turnover of capital goods also be financed with monetary capital, the undisturbed course of production requires a more extensive supply of money. However, it is this expanded supply of money that makes it possible—and this is what we were concerned with—that in the same time period in which an output of consumers goods is thrown onto the market for means of subsistence, a demand by the recipients of income for these consumer goods appears that can cover these means of subsistence by paying with money from their income.⁵⁸ The economic subjects who appear here as recipients of income are those who make originary factors of production available and—we will again drop our assumption of an exclusion of these income expenditures—those who receive income from capital interest or entrepreneurial profit. The vertical division of production thus changes nothing regarding the relationship we recognized in our first simplified presentation.

Now we must look beyond the example of a static economy and, in a first step, include those movements which result from an increase or decrease in the supply of capital. The problem is clear: If saving occurs in a barter economy, the means of subsistence that its owner could consume and which—we are assuming a static course of the economy—in the previous sequence he did consume, are employed to support roundabout production methods. If capital is consumed, then the means of subsistence are consumed by its owner, whereas in the previous course of the economy he used them to support roundabout methods of production. In both cases, the change affects the way consumer goods are used. In a monetary economy, saving capital as well as its consumption always refers only to the ownership of money. A sum of money which in the previous course of the economy an owner himself consumed will be employed to finance a new roundabout method of production, or a sum of money which an owner previously invested will now be consumed by himself. The question again is one of the parallel between the employment of a sum of money and the economy’s supply of means of subsistence. We have already addressed this briefly.

If an economic subject with control over a sum of money which he has obtained as income invests this money, this means that this economic subject refrains from consuming means of subsistence which instead go to an originary factor of production whose employment in the roundabout production process will be financed with it. In contrast, if an economic subject consumes a sum of money formerly invested in the economic process, i.e., for the purchase of a means of subsistence, this implies that financing has been withdrawn from an originary factor of production and with this, its support. Capital formation as well as capital consumption entails an increase or a decrease in the subsistence fund available for the support of roundabout production methods. Thus, the parallel between the processes within the sphere of money and the sphere of material goods is established.

3. Credit and Money Interest

In every economy there is a distribution of goods among the individual economic subjects, and this distribution of goods constitutes an economic datum. A transfer of goods from one economic subject to another through an exchange thus has the function of changing the way goods are distributed such that an economic subject receives a good for which he has a better use in exchange for another that he needs less urgently. In this sense, the socioeconomic function of an exchange is to bring about a correction in the distribution of goods without changing the distribution of wealth other than through exchange acts striving towards an improvement in provisions. With an unchanged supply of material goods in the economy each person’s provisions become better when an exchange act is carried out, since each individual only engages in an exchange if he prefers it over the original distribution of goods.

If we now include those particular kinds of exchanges in the system of exchange acts which consist of trading present goods for future goods, then here too we will see a correction in the distribution of goods that has an entirely different socioeconomic function. First, it is clear that time-bridging exchange acts are by no means a necessary condition for roundabout production methods. One could easily imagine an economy in which only owners of capital appear as entrepreneurs. Individual economic subjects collect a stock of subsistence means through saving which they invest in roundabout production methods. They pay laborers with these means of subsistence (we will ignore the other originary factor of production for the sake of simplicity) and attain a large return from production, one part of which they reinvest—which in a static economy corresponds to the previously saved capital—while they consume the remainder as capital interest and entrepreneurial profit. Every exchange—including the payment for laborers—occurs step by step. One can easily imagine that production structured in this way will also be partitioned vertically, without including an exchange of present goods for future goods. The capital good will be purchased step by step from the preceding production stage with means of subsistence. One can even go one step further and imagine such a production process occurring in a money economy: The payment takes place step by step with cash. Exchanging a good for a later return, in particular exchanging currently available money for a later return (i.e., credit) is in no way a necessary condition for an economy based on division of labor employing roundabout production methods. In this, too, the exchange can be restricted to correcting the distribution of property in the sense that individual economic subjects exchange what they have step by step for something they need more urgently: Laborers exchange their labor for immediate payment, the owner of capital goods sells these for cash, the producer of consumer goods also sells for immediate payment and, finally, those who function in general as entrepreneurs purchase originary and produced factors of production for cash, just as they sell products for cash. However, it is now clear that under these circumstances the assumption of the entrepreneurial function is tied to the possession of wealth. Only he who owns wealth—either a means of subsistence that can serve as free capital, other goods that can be exchanged for subsistence means and capital goods, or cash—can adopt a roundabout method of production. Furthermore, he who has saved capital can only let this function as capital if he invests it. The moment an owner of capital makes wealth of any kind available to an entrepreneur so that a roundabout method of production can be carried out, there is an exchange of present goods for future goods. For it is the nature of roundabout methods of production that an expenditure occurs today for which a return is available only later. A division of labor between the owner of capital and the entrepreneur only becomes possible if the owner of capital makes his wealth available to an entrepreneur for a later return, i.e., if there is an exchange of present goods for future goods.⁵⁹ This interests us here only in the form in which it actually occurs in a modern economy: as the exchange of money for a later return, as the crediting of money, or simply as credit. The introduction of credit means the possibility of correcting the distribution of property in a special sense, namely in the sense that someone who owns monetary capital that he himself cannot or does not wish to use in production can transfer this to another person who can let it “work” in production; in the sense that someone who has more capital than he presently needs for production can temporarily transfer it to someone else; and finally, in the sense that someone who has less capital than he needs for production can borrow from others to whom it will later be returned. The distribution of goods will be corrected here in the sense that the distribution of wealth will be maintained; but in maintaining the distribution of wealth, the partitioning of the assets among those who employ it or cannot employ it and do not wish to employ it in production will be changed. Clearly, the introduction of credit makes a significant increase in economic returns possible, because the interpersonal transfer of capital will make it easier to direct capital into those usages in which its return—and consequently also the return from the other cooperating factors of production—will be greater. It is clear that only a smoothly operating credit market, or one operating with the least possible friction, will provide the prerequisite for “correctly” taking advantage of the supply of capital in the economy. Finally, it is also clear that a fully developed credit market is the prerequisite for the formation of a uniform interest rate, and that only a uniform interest rate makes the reliable calculation for the use of capital possible. Although we have said that credit is not a necessary prerequisite for an exchange economy using capital, we must qualify this here by adding that the institution of credit is certainly an adequate prerequisite for a relatively developed economy using roundabout methods of production. Furthermore, let it be mentioned that here we are only interested in credit as “productive credit.”

Interest, as the price forming on the market for exchanging a presently available good for a later return, in particular money interest as the price for lending money for a later return, can only arise when there is a market on which presently available goods can be traded for a later return. In an economy—as we have seen, even conceivably with a roundabout structure of production—which does not have an exchange of present goods for future goods, interest does not appear as a price. To point out an analogous case, in roundabout production in which no vertical structuring of production exists, but in which instead every entrepreneur only purchases originary factor of production and sells finished products (means of subsistence), the capital good also does not appear on the market and has no price. Nonetheless, each capital good is worth something at all times; its cost price as well as its discounted return value can be calculated. And with regard to interest, even if interest is not formed on the market because those exchange acts out of which interest can emerge as a price are not carried out, even then the value of presently available goods is greater than those only available later, because the entrepreneur can attain a greater return by using factors of production earlier. Even if interest does not appear as a price, the length of the roundabout production process is still limited by the available capital, and the calculation of interest is a prerequisite for the correct structuring of roundabout production processes. Assume the following: In an economy that knows no market on which an interest rate forms, an omniscient institution exists that announces which interest rate is the “correct” one under all given conditions and in particular given the supply of capital. The entrepreneurs base their calculation of production on this interest rate; that is, they only carry out those roundabout production processes which provide a return exceeding the expenditures of such interest payments—naturally taking into account the time the capital is tied up. The economy is apparently not subjected to any disruption arising from an incorrect choice in the length of the roundabout production process. However, if the institution announcing the interest rate erred or if the entrepreneur did not abide by the correct announcement, then severe disruptions would certainly have to be expected. Calculating with too low an interest rate would mean that too lengthy roundabout production processes would be commenced. The results of this have already been presented in detail. Calculating with too high an interest rate would mean that too short roundabout production processes would be adopted, a part of the free capital would remain unused, and the return from production would be smaller than it could be.

Now it is clear that in an economy in which a market for capital does not exist and thus the interest rate does not appear as a price, the entrepreneur will have great difficulty finding the “correct” interest rate on which he should base his calculations. However, it is also undoubtedly clear that wherever a market emerges which lets an interest rate appear as the price for exchanging present goods for future goods, this market assumes the role of that institution which in the just mentioned example prescribes the interest rate. The entrepreneur will receive capital only at this interest rate, and he will know that he can use his own capital only after taking this rate into consideration if he wants to remain successful. We must say here, however, that the example we have used of an institution outside the market that prescribes the interest rate is by no means pure fantasy. We will have more to say on this later. We will only need to change this model slightly to recognize something that is peculiar to the position of a modern central bank.

This general presentation of the function of credit and interest shall make a precise description of the static course of a “money and credit economy” possible. If we assume the complete separation of the function of the entrepreneur and the owner of capital, i.e., if the capital employed in production is always acquired by the entrepreneur on the capital market by paying interest, then on this capital market we will initially see the entire supply of capital appearing in the form of monetary capital. After the previous explanation it is clear that the supply of monetary capital is identical to the supply of previously or presently saved monetary income. The capitalist who offers capital owns money which he can either use for his own consumption or invest. And it has already been explained clearly that all monetary capital represents actually available subsistence means, i.e., that in offering monetary capital actual means of subsistence which can serve to support roundabout production methods are being made available. Accordingly, the interest rate that forms on the market on which monetary capital is offered, i.e., the interest rate which is just high enough so that all of the monetary capital offered will be taken up by the demand for capital—is the rate at which the entire supply of subsistence means available for the support of roundabout production processes will be directed to this use, and also the interest rate at which the length of the roundabout production processes will be directed to this use, and also the interest rate at which the length of the roundabout methods of production is extended just so far that it can be supported with the available subsistence fund. The monetary interest determined on the free market by the supply of money capital is the “natural” or “equilibrium” interest rate. Expressed another way: The supply of monetary capital is a supply of “real savings capital,” and the interest rate at which monetary capital is absorbed on the market is simultaneously that rate which supplies the demanders of capital with actually saved capital. In other words, the introduction of money into the circulatory system of goods and the regulation of the structure of production by the monetary interest rate do not imply any disruption in the functioning of those principles which regulate the length of the roundabout methods of production.

All of this initially holds true under the conditions of the static system which we have always assumed here.⁶⁰ Now, however, we will move on to the explanation of a possible, and in practice highly important, error in the functioning of the money market when, continuing from our general characterization of credit, we speak of a particular kind of credit that can cause a correction in the distribution of property in a sense other than the one we have discussed up to now. Let it be pointed out in advance that the form in which credit is granted has in itself nothing to do with its function. The “formal purchasing power” which all owned money represents can be made available as credit in the form of cash money (currency, coins), bank notes, or money deposits (checking accounts). Now, with regard to bank notes and checking accounts, however, it is essential that their quantities can be modified without difficulty, and this modification of the supply of means of payment in the economy interests us here primarily when it is caused by an expansion or restriction in the granting of credit.

With regard to credit, here we are faced with a new function we have previously ignored. Here we are not primarily interested in the effect that it has on the price level, i.e., that under otherwise equal circumstances an increase or decrease in the supply of payment must result in a rise or fall in the level of most prices—but rather in its effect on the economy’s supply of capital. It is clear that influencing the supply of capital by changing the supply of money, i.e., by expanding or restricting the granting of credit, must influence the temporal structure of production—the length of the roundabout production processes. Here, in order to simplify the presentation we are only speaking of the expanded distribution of notes by the central bank. It is obvious that regarding credit expansion by other banks, the problem is in no way different.

If the central bank offers “additional” credit and thereby expands the economy’s supply of money, then the initial effect of this credit expansion will be that individual economic subjects will have more money available than previously. In addition to the money that has been in circulation this money will demand goods. The wealth of those who have received the additional credit has not increased, for they must compare their monetary assets with their debts to the central bank. This idea disguises the real situation, however, insofar as it considers what today can be realized in the economy as compensated by something which only later takes effect. Such a false classification of effect and countereffect in their temporal order is not permitted if we wish to analyze the effect of additional credit, in particular with regard to the temporal structure of production. What has an immediate effect is the additional money, not the obligation to repay. And regarding the given supply of credit, the situation is one in which economic subjects appear to be supplied with money who do not own their money supply as a result of a former—as we must assume, static—economic process. Here lies the decisive criterion for what the theory must consider novel regarding additional credit.

When presenting the function of money capital in a static economy, we have always assumed that an economic subject has access to a monetary income that he can either consume or use to finance roundabout production methods. The monetary income thereby has come parallel to the creation of finished consumer goods, such that directing this money towards investment is synonymous with setting aside means of subsistence for the support of this roundabout production process. And wherever previously formed capital is set free and made available again for production this freeing-up of money capital is identical to the creation of consumer goods. The economic subject who receives the freed-up money capital in turn has the choice of consuming these means of subsistence himself, or of continuing his previous saving and thereby making these subsistence means available for the support of roundabout production methods. It is only because free monetary capital always has an equivalent in the form of subsistence that we could conclude that financing a roundabout production method simultaneously supports the same, and hence, that the adjustments of production to the supply of saved material goods occurs through the mechanism of the money market, the formation of a monetary interest rate and its regulation of roundabout production methods. In the case we are now considering, the situation is different: When additional credit is granted, the money thereby made available to the economy provides the possibility of financing production processes without there simultaneously being that support for production which automatically occurs with the investment of savings capital.

We are only interested here in additional credit the central bank gives insofar as it is productive credit, i.e., credit which makes the financing of production possible. For this reason, credit is only of interest to us as it appears on the capital market—on that market on which otherwise monetary capital created by savings is offered in exchange for a later return and an interest rate arises from supply and demand. If we assume that additional credit appears on such an existing capital market, then it is clear that it will only be able to be accommodated by demand if it is offered at a rate below the ruling interest rate. The interest rate has a selective function regarding the length of the roundabout production processes, as we have already said once. If demand is now to be satisfied to a great extent, i.e., if more credit is offered, then this is identical to satisfying a demand for monetary capital previously excluded: a demand that up to now was not supplied with monetary capital because it could not pay the ruling interest rate. This demand will only be attracted by a lower interest rate, and thus an additional supply of credit can only be accommodated with a reduced interest rate. The lower interest rate makes a lengthening of the roundabout production methods possible. The limitation on the length of the roundabout production methods, which until now the interest rate assured in accordance with the supply of real capital, is eliminated. One problem which we will later have to address arises here.

At the same time, however, the appearance of an expanded supply of monetary capital means something else. The new money will serve to finance roundabout production processes and will thereby be passed on to the originary factors of production that then appear with this money on the consumer goods market. If production is financed with additional money, then the question of supporting the expanded roundabout production processes will arise. Here we find a second problem which will later concern us.

Both problems—the effect of additional credit on the length of the roundabout production processes as well as its effect on the subsistence means market—appear in reversed forms with a restriction of credit. Let us assume that in a static economy part of production has been financed by credit which now is withdrawn and the money used to pay back the credit is no longer spent. Here, too, shifts in the structure of production will be observable that we will later have to discuss.

Before we go on to those questions, let us present yet another point. The analysis of the static economy we previously presented when considering the money economy started from the assumption of a rigid money supply. We assumed a given supply of money in the economy: the available money appears repeatedly in the hands of the entrepreneurs who use part of the money they receive to finance production, i.e., as capital. Additional money would have a disruptive effect, as would removing money from the economy. We must, however, deviate from this consequence if we look beyond the simple model and consider the more complex situation of the modern economy. Here the question is whether the rigid money supply is a prerequisite for the fact that from the money side no disruption in the structure of production occurs. And here we must consider certain possibilities we previously ignored. Let us imagine the case in which an economic subject saves a monetary income by singly leaving money in a box. While the saver refrains from consumption, there is a reduction in the economy’s potential supply of monetary capital that is equivalent to a restriction of credit. If under these circumstances the central bank replaces the money withdrawn from circulation with additional credit, then this increase in the amount of money will be a necessary prerequisite for the fact that those consumer goods which the hoarding “saver” passes up will be directed to the support of roundabout methods of production. On the other hand, if hoarded money again reaches the capital market without the central bank enforcing a corresponding restriction in credits, then this money would appear as additional money. Or, for example, let us think of those “obstacles” on the path of transferring monetary capital to the originary factors of production which exist in vertically structured production. It is easy to see that the introduction of new obstacles of this kind, through a progressive partitioning of production or a reduction of these obstacles by integration in the vertical structure, must go hand in hand with an increase or decrease in the circulation of money, unless the results are to occur which otherwise spring from a reduction or an expansion of credit.

These examples should suffice. They show that an elasticity in the volume of credit can be demanded without the adaptability of the money supply thereby leading to an interference of money in the structure of the roundabout methods of production. Let us again consider the previously presented model of an omniscient supervisory council which determines the interest rate. If the central bank could completely oversee the conditions which require the expansion or restriction of credit from the point of view of the “neutrality” of money, then depending on just such circumstances it could expand or limit credit. “Additional credit” that the central bank grants in order to compensate for the effects of hoarding are not “genuine additional credit,” but “compensatory credit;” and restrictions of credit by the central bank which compensate for a “dishoarding” of money are not “genuine credit restrictions” but “compensatory restrictions of credit.” However, the central bank has no reliable indicator for such a policy; there is nothing in the economy that can directly inform the central bank whether the supply of credit is greater or smaller than the supply of “real savings capital.” In the money and credit economy there is no market on which an “artificial” influencing of the supply of credit would immediately lead to a disruption. Here, the rule holds that the influence on the capital market from the side of the money supply can only be recognized by the effects which credit expansions or real credit restrictions have. Even by drawing on all of the means of modern economic observation,⁶¹ the central bank cannot arrive at that position which an omniscient institution, as we have presented it earlier, has. In practice, the central bank first sets a unilateral interest rate at which it grants credit. The magnitude of the applications which the bank receives is dependent on the height of this interest rate. If the interest rate is set at that height at which the entire supply of credit—the supply coming from the market as well as that coming from the central bank—corresponds precisely to the supply of saved capital, i.e., if each credit has the exclusive function of directing saved means of subsistence to the support of roundabout production methods, then the monetary system will work in such a way that a disturbance in the supply of capital could never come from the side of money. However, the central bank can never find a precise clue for determining this interest rate. In its discount policy it must rely on certain external indicators (reserve requirements, gold movements, the situation on the currency exchange market, etc.) As a consequence, an ideal functioning of money in the sense of a neutral money can probably never be expected—(we are ignoring that with its credit policies the central bank can also strive for another goal than the theoretical ideal of neutral money).

There is an additional point to be mentioned here. In the modern organization of credits, the central bank is not the sole source of credit. Other banks can grant additional credit—this is the case when with unchanged liabilities banks reduce their cash reserves.⁶² The central bank can never rule the money market such that it could immediately compensate for the slightest fluctuation in order to maintain the neutrality of money under all circumstances.

Thus, the problem of influencing the economy through expansion and restriction of credit results necessarily from the organization of the monetary system. The realm of the economy, however, in which we must study the effects of these disturbances in the equilibrium is the structure of production.

4. Production Under the Impact of Credit Expansion

Creating “truly” additional credit means underbidding the interest rate corresponding to the supply of saved capital. Consequently, it must lead to an excessive lengthening of roundabout production methods—to an extension of roundabout production methods beyond that limit which is justified by the economy’s supply of capital. This is the basic idea underlying the following analysis. When with various modifications we repeatedly treated the theme of the “correct” length of roundabout methods of production, we thereby answered the question regarding the effects of a credit expansion. Here we can only consider the sequence of results connected with an excessive extension of roundabout production methods in the specific form it assumes in a money and credit economy. A brief reminder regarding occurrences in the real goods economy shall again serve as a point of departure.

An excessive extension of roundabout production methods must lead to an immobilization of capital investments, to a structuring of production where free capital has been invested in such a way that a timely freeing up of this capital is not possible. If the structure of “too lengthy” roundabout production methods is carried out to an end, the result will be a complete lack of means of subsistence which could be used for the support of these methods⁶³; the economy will have to revert to production which does not use roundabout methods, i.e., to momentary production, whereby the only qualification to be made is that the available capital goods can still be used as productive aids. In any case, the lack of free capital will make it impossible to further maintain roundabout production methods. Only that which can be produced is immediately available as a finished consumer product. If, however, the economy notices in time that a further lengthening of roundabout production methods cannot lead to a good end, then with a timely shortening of the roundabout production methods it will be able to avoid a total immobilization of capital. The economy will suffer losses, the output of consumer goods will go down and continuing provisions to the previous extent will no longer be possible, but it will be possible to maintain a roundabout production method, even if its length is reduced. In anticipation of the result of the following considerations, we can say that in general the sequence of this process in a money economy will be such that this second type of consequence of an excessive extension of roundabout production methods will occur. The expansion of credit will first make a (relatively) low interest rate possible; later on, however, a rise in the interest rate will have to be expected which forces a shortening of the roundabout production methods and thus prevents a total immobilization of capital from making it necessary to revert to momentary production. However, we must begin with the first effects of an expansion of credit.

Let us begin by assuming the course of a static economy in which all prices are in equilibrium and the interest rate is at such a height that it adjusts the length of the roundabout production methods to the supply of capital, and thus simultaneously causes the freeing up of capital to just the extent necessary in order to maintain the length of the roundabout method of production, and thereby also to maintain the supply of subsistence means and the stock of capital goods.

The investment of free capital in equipment from which a freeing up of capital can only be expected at a later point in time will occur in practice (that is, in the framework of those productions in which the formation of durable capital equipment is a particularly important form of binding capital in far-reaching roundabout production processes) with regard primarily to durable capital equipment in very early production stages. Furthermore, there will be more extended production of the raw materials needed for the production of this equipment; and finally, an increase can be expected in the stock of durable equipment in production stages closely related to the production of consumer goods or even in the stage of consumer goods production itself. However, the problem of all expanded investments is the timely freeing up of capital. Hence, our question will have to be phrased as follows: Will it be possible to set free the capital needed for the continuation of this production process in time? This question is identical to another: Will the capital fund which is generated in the production of consumer goods be large enough to make the continual maintenance of all the preceding production processes possible? Or in a more generalized version: Will it be possible to achieve a renewal fund in time at each stage of production that can secure the maintenance of all preceding production processes?

We must be aware of the fact that the continuation of this reasoning runs into a difficulty of a particular kind which is grounded in the fact that money calculation requires the translation of actual exchange ratios into money prices. If we were satisfied here with considering a real-goods economy, then according to the explanations given up to now the answer would be a very simple one: The question regarding the support of expanded roundabout production methods has been raised whereby it is beyond any doubt that the free capital, the subsistence fund available for support, has not grown. The restructuring of production must thus lead to difficulties regarding the supply of capital. However, when considering monetary calculations we must pay attention to something else. The question is one regarding the possibility of financing expanded roundabout production methods. However, with the expansion of credit more money has been made available.

Here we could now use a helpful example. We could assume that the adoption of expanded roundabout methods of production takes place without a prior expansion of credit; that is, with the previous volume of money. This is conceivable; one would simply have to assume that as a result of errors in calculations, too lengthy roundabout production methods had been introduced. It would then immediately be clear that financial difficulties would have to arise. The freeing up of money capital in the stage of consumer-goods production would not suffice to finance all turnovers that are necessary in preceding production stages. If until now the financing of production had required a specific amount of money capital, then it will now be necessary to set aside more money capital for the financing of the expanded roundabout production methods. Since this is not the case according to our assumptions, the result must be that the supply of capital will not be sufficient to satisfy the demand for capital of preceding production stages whose satisfaction is the prerequisite for the uninterrupted continuation of production. There must be a shortage of capital and a rise in the interest rate.

This model can now be applied to the case here. The first difference is that in fact more money is available. Price increases must occur. Linked with this is probably a disruption of the prior relationships between prices. More will be said on this later. However, entirely independent of the shifts in relative prices, once the additional money is turned over in an economy, a rise in prices will occur (of many or all prices, in any case—as we will later see—a rise in the prices relevant here), which means in practice that the rise in prices will compensate for the increase in the money supply. However, a surplus of money used with correspondingly higher prices to finance the expanded roundabout methods of production has the same consequences for the extent of one’s financial possibilities as if an unchanged money supply would have been available with unchanged prices. The result is: In view of the price increases to be expected the increased supply of money basically means no expansion of financial possibilities. The application of our model made this clear.

Now we can clearly recognize the effects of an expansion of credit. The production processes will exercise an increased demand for money capital on the market. They will attempt to satisfy this demand partially from the revenues of their products insofar as they can split off a fund of money capital from these. Furthermore, they will enter the open capital market with their demand for money capital. The supply of capital must be assumed to be unchanged—for insofar as this capital represents a larger money sum, this is compensated for by the rise in prices. Demand has become greater—not only in its money expression, but also effectively, in the sense that in order to maintain the roundabout methods of production more capital will be required. The imbalance between supply and demand on the capital market must lead to a rise in the interest rate.

If we assume that additional credit can also be considered as a credit source, that is, that the central bank—for the sake of simplicity let us not speak explicitly of the other banks that engage in the creation of credit—offers additional credit, then an equilibration between supply and demand on the capital market is possible by creating more credit. Thus, the central bank can prevent a rise in the interest rate if it continues to grant additional credit. And here the question arises of which results must occur if the central bank continues the policy of expanding credit, if it thus prevents the relative shortage of money capital from leading to a rise in the money interest rate. The answer is quite obvious after what has already been said: Systematically stabilizing the interest rate must lead to a situation in which the “unjustified” lengthening of the roundabout production methods manifests itself with all its consequences; the excessive expansion of roundabout production then leads to a complete immobilization of free capital. With the expansion of credits, a restructuring of production is begun that leads to this final state. Only an increase in the interest rate can prevent the complete adjustment of production to “too low” an interest rate with all of its consequences. If the interest rate is not permitted to rise, the result will be a complete lack of consumer goods and a complete lack of a subsistence fund making the support of roundabout methods of production possible.

It will perhaps be helpful to present this relationship in the framework of a very simple model, whereby it shall be said in advance that this model is only a highly stylized version of reality. We assume that the synchronized production stages are organized into six equal production stages; the expansion of credit would only influence the initiation of the last stage of the roundabout production method and hence, a reorganization of the production in the direction of a lengthening of the roundabout production methods would only occur here.⁶⁴ The newly started production stages would also begin to work using the lengthened roundabout production method. Thus, while until now each of the six production stages had lasted for a time (t)—that is, this amount of time had passed between the first introduction of an originary factor of production and the achievement of the finished consumer goods—from now on a roundabout method of production will have begun which only produces finished consumer goods at the end of a longer period of time (t+v). As long as the production stages which have left the length of their roundabout methods of production unchanged provide the economy with means of subsistence, no disruption will occur. However, as soon as the product of the last stage working with roundabout production methods of the previous length is used up, there will be a lack of means of subsistence, for the next stage of production has adopted a lengthened roundabout production process and thus cannot be finished in time. The lack of sellable means of subsistence also means a lack of freed-up money capital. If the interest rate had been raised earlier, then a shortening of the roundabout method of production would have been forced upon the lengthened roundabout production process. One thing is clear here: With this structuring of production processes the final consequence of a credit expansion with regard to the supply of consumer goods will not appear immediately, but only after a certain period of time. This time period is now characterized in our model by the fact that, initially, those production processes which are not changed in their structure make an even supply of the market with means of subsistence possible. It is only when supporting returns are required from those production processes which work with lengthened roundabout methods of production that a lack of means of subsistence will appear.

Let us now drop the assumption of the production process being structured in so simple a way as well as the assumption that only those production processes that are newly undertaken after the expansion of credit lengthen their roundabout method of production. It can then be clear that the lack of means of subsistence will take on a different appearance. A shortage of these will slowly arise and will assume a faster pace as the lengthening of the roundabout production method increasingly takes effect. Hence, a shortage of money capital will also gradually increase. Later we will have to take a stance concerning this relationship from a very different point of view and then arrive at a somewhat different consequence. Let one thing be said here. Since with a sequenced production structure it must be assumed that the shortage in the supply of means of subsistence (free capital) begins slowly and then will gradually increase, the possibility offered by a rise in interest rates is clear. Only an increase in interest rates can prevent an increasing shortage of means of subsistence from developing, and that in the end a complete lack of a means of subsistence emerges.

It can now be expected that in the course of the process discussed here the central bank will raise its interest rate and the expansion of credit will be discontinued before the final effects of the expansion of the roundabout production method occur. And this is so for two reasons. On the one hand, it will become apparent that the progressive expansion of credit must lead to an increasing strain on the credit system. The more the credit expansion progresses, the greater will become the share of additional credits in the overall volume of credit within the economy, while savings capital gradually loses its relative importance. Such a situation on the credit market has generally been grounds for the central bank to restrict credit. But there is a second point to be considered here. It is clear that the expansion of credit by the central bank must increase progressively if the interest rate is to be prevented from rising. For the expansion in credit simply means that a lead in the supply of money capital over the supply of real saved capital will be created. If with the continuing reduction in the supply of saved capital this lead is now to be maintained—with the consequence of making the same expanded length of the roundabout production methods possible—then the amount of additional money must grow more quickly with each price increase. The continuing price increase—that is, the devaluation of money—will make it impossible for the central bank to hold up to any parity of its currency or any reserve requirement. The strain on the credit system and an “endangering of the currency” will cause the central bank to raise its interest rate. And the increase in the interest rate will cause the roundabout production methods to be shortened.

Before we speak of this process, let us consider an entirely different relationship which must result from the expansion of credit. Here we must consider a process which can only develop in this way in a money economy and for which we find no equivalent in the real goods economy. Our starting point must be the specific function of money capital which we have discussed earlier: the support that it gives to production by financing it. So far we have studied the effects of expanding credit on the length of the time-oriented structure of roundabout production, i.e., above all on those elements of the production structure which are used in the early stages. Now our attention will be drawn to the end of the production process. If we have noticed above all a backward shifting of the means of production adopted in early production stages, then we will now have to ask whether or not shifts also occur in the stages of production close to consumption.

Lengthening the roundabout production methods must cause a change in the demand for factors of production. Here we wish to differentiate between two cases.

There could either be unemployed factors of production available on the market that can be purchased at the current price, or it could be that the employment of new factors of production is not possible or only possible at increased prices (and then probably only to a relatively small extent). In a different context we gave reasons for the existence of both of these possibilities when analyzing different market configurations for the area of the factor of production of human labor. Here it suffices to refer to these explanations; notice, though, that in the following discussion both of these possibilities are significant primarily with regard to human labor. In the first case the number of employed will increase without the wage increasing, and in the second case with an unchanged (or only slightly increased) number of employed the wage will increase. In both cases the size of the wage sum increases. This also corresponds to the situation which served as our starting point. With the expansion of credit new money capital is made available to the entrepreneur. This reaches the market of factors of production and thereby arises the possibility of expanded wage payments. Of course, the additional money can demand already available capital goods and thus drive up their prices. Insofar as this happens, the “obstacles” of which we have spoken appear on the path of money capital from the hand of the entrepreneur to originary factors of production. On the one hand, we must not overestimate the significance of these obstacles in this connection, because there is no reason to assume that the additional money will first reach the producer of consumer goods. In fact, just the opposite is to be expected. The production stages which are most directly encouraged by lowering the interest rate are those in which the reduction of costs due to a reduction in interest rates has a relatively greater significance, and this is most likely to be in the stages which precede the production of consumer goods in those stages in which the longest time passes between the investment expenditure and the production of the finished product. Then, however, it must be recognized that, even to the extent that the credit expansion first makes its effects felt on the market for capital goods, this alone does not cause the production structure to change. Production always needs originary factors of production in addition to capital goods, and only if there is a novel use of originary factors of production is there really something new in the economy, and not simply when the owner’s title to capital goods passes from one hand to another without something new having been produced. Thus, we will summarize: The credit expansion leads to an increase in the wage sum, entirely independent of whether the number of laborers increases or not. However, the increase in the wage sum means increased demand on the subsistence means market, and hence a likely expansion in the production of means of subsistence in the sense that production will strive to meet the increased demand for means of subsistence by increasing the supply as quickly as possible.

This implies that the immediate impact of the additional amount of money on prices will first be felt on the subsistence means market via a rise in the income of those who provide originary factors of production. We have seen that the additional money must not all pass directly from the hand of the entrepreneur to the originary factors of production, but that part of this money can first serve to purchase capital goods. However, these will be capital goods which in general will be used in preceding production stages, and not capital goods that already are maturing consumer goods. In the area of consumer-goods production, the additional money will thus appear less as a cost increase but rather as an increase in demand. Consequently, we can expect an expansion of production here.⁶⁵

An expansion in the production of consumer goods is equivalent to an increase in the fund of the means of subsistence. This makes the employment of more laborers at an unchanged wage or the better payment (a higher real income) of an unchanged number of laborers possible.⁶⁶However, it is of greatest importance that this increase in the means of subsistence must be linked to a consumption of capital.

Let us return again to the model of production organized into six stages we employed previously in order to consider the effect of lengthened production on the supplies of subsistence means. There we saw that lengthening the roundabout method of production in the last stage and in the newly initiated production stages would necessarily lead to a situation in which the supply of subsistence means temporarily remains constant, and a lack of these occurs only later. Now we will be able to analyze yet another change in this model. The production of subsistence means shall be increased quickly and this can only mean that capital goods which are tied up in perhaps the second or third stage of production on their way to maturing into consumer goods will be withdrawn from these stages and transformed on a shorter path into finished subsistence means. The result will be that for the following period of time an expanded supply of subsistence means may exist, but that later on there must be a greater lack of these.

Obviously, expanding provisions by expanding the production of consumer goods will never make it possible that the lengthened roundabout methods of production can be carried out to an end. For a prerequisite of any production using roundabout methods is, of course, the corresponding constant supply of consumer goods which can serve to support the originary factors of production. Here we are confronted on the one hand with an expanded provision of consumer goods, and on the other, with a lengthening of the roundabout production methods. Both of these movements work together in such a way that the expansion in provisions occurs at the expense of the supply of capital, i.e., that the consumption of capital only makes an expanded supply possible temporarily, but as a result of this consumption of capital a continuous provision will not be possible to the same extent. At the same time, lengthening the roundabout methods of production requires that the perpetual supply from the previous stock of capital lasts in order to be able to bridge the time span until the end of the lengthened roundabout production process. In a simple formula: Expanding the production of consumer goods by consuming capital will further increase the difficulties which must result from lengthening the roundabout methods of production.

When presenting the complicated relationships of the effects of a credit expansion one must necessarily make use of rather abstract models. We have been faced with the task of showing that in the structure of roundabout production two shifts will occur which as a rule must be differentiated. First, when consumer-goods production is expanded, capital will be consumed; and second, when roundabout methods of production are expanded there will be an increasing immobilization of capital investments. We could not make these two shifts any clearer other than by considering changes in various areas of a schematically structured production process. The economy of experience does not know any schematic organization of production processes. However, this cannot prevent the effects of an expansion in credit from manifesting themselves in both of the directions we have investigated. We have seen that the credit expansion gives the central bank which initiated it the option of either steadily making more credit available, or increasing the interest rate.⁶⁷ We have seen that preventing a rise in the interest rate must in the end lead to a total immobilization of capital, but that it can be expected that the central bank will raise its interest rate earlier in order to secure the currency and restrict the credit structure.⁶⁸ With the rise in the interest rate, however, we have a new situation.

With an increased interest rate, production processes are faced with a new basis for calculation: The prolonged roundabout production methods become unprofitable. If the interestrate increase then forces a shortening of the roundabout production methods, it thereby forces an adjustment of production to a more limited supply of capital. If the credit expansion has led to an excessive prolonging of roundabout production methods, then the halt in credit expansion leads to a liquidation of the excessive expansion of the roundabout production methods. If additional credit no longer appears on the market, then the supply of credit is identical to the supply of saved capital. Since we have no reason to assume that in this stage of credit expansion the formation of new capital by means of new saving can have any decisive impact, only the supply of capital set free in the production of consumer goods can be considered as the supply of credit. It is clear that the state of an economy depicted here only allows the freeing up of capital to a rather limited extent. Production will have to adjust to this situation. We will still have the opportunity to investigate the process of this adjustment in detail.

Let one more thing be said here. The starting point for our argument was a static economy in which a credit expansion began to take effect. Maintaining the static economy was dependent on a particular price system. The additional credit immediately caused a disruption in the price system. This disruption appeared above all in the monetary interest rate. After everything we have presented, it is clear that the interest rate in the static economic system represents a particularly important link which prevents a deviation of the various elements of this system from the path of a static course. Furthermore, we have seen that additional credits influence the relationships between the various prices by first reaching, via the originary factors of production, the consumer goods-market, forcing up the prices there. As a movement away from the static course, the expansion of consumer goods production implies consumption of capital.

Hence, increasing the supply of money by means of additional credit will not merely cause a problem of transforming one price level into another. Beyond this it will have the additional effect of disrupting the price system and distorting the structure of production.

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⁵³Here is a brief description of these conditions—thereby anticipating some matters that shall only be explained in detail later. Not only an even change in the supply of money of all money owners is necessary, and furthermore a stabilization of all creditor-debtor relations, but it would also have to be guaranteed that the structure of the supply of money capital would in no way be changed. In particular, the even change in all prices could only be reached if all economic subjects are informed of the change in the money supply and make corresponding adjustments in their behavior immediately.

⁵⁴Strictly speaking, in a static economy there is no entrepreneurial profit as a difference between expended costs and returns, but only an entrepreneur’s wage as payment for the “entrepreneur’s labor,” i.e., as part of the costs. However, since the static state is always a situation that is only reached after the adjustment to a disruption, we can define it as that state in which the entrepreneurial profit is zero, whereas in the intermediate stages of adjustment it emerges as a positive (or, depending on the circumstances, negative) magnitude. For this reason we can also speak of an entrepreneurial profit here.

⁵⁵This is, of course, a thoroughly unrealistic construction—unrealistic because the consumer goods are not sold to an impersonal market and in turn resold by it, but rather those who obtain the consumer goods from the producers are traders who, on the one hand have costs they must cover in their sales price, and who on the other hand, also practice an important function in the distribution of goods. Strictly speaking, we would have to view the exchange of the finished consumer goods on the market—in particular also the turnover from wholesale trade to retail trade—as the last stage of “production,” i.e., as the last stage of that process in which the goods mature to the form in which they are taken over by consumers. This difficulty can now theoretically be bridged in such a way that we incorporate the entire trade turnover of consumer goods into our model and consider the activity of the traders as divided into that process which is the last stage of “production” and the abstractly characterized process of obtaining a product from producers and transferring it to the consumers. The merchant will receive payment for his “productive” contribution from those demanding consumer goods.

⁵⁶The following is a transposition of the model, which on pp. 21f. was developed on the basis of a numerical example, into the framework of the money economy.

⁵⁷It is clear that the simplification of reality to a model here does not consist simply in the fact that capital interest and entrepreneurial profit have been ignored. In reality, the movement of monetary capital never occurs in stages to be differentiated schematically, but there is a manifold branching out and reunification of various partial branches. We can ignore this here because we are only treating the problem that results from the existence of different stages in the turnover of monetary capital.

⁵⁸In the graph (p. 105) each arrow signifies an exchange of money (without regard to the length of the arrow). For the sake of simplicity we have allowed the stages in the exchange of money to coincide with the stages of synchronized production. This need not necessarily be the case. One could imagine, for example, that the preceding production stages I and II are integrated and in the hand of one entrepreneur. This entrepreneur will immediately pass on 50 of the 75 units of monetary capital he has received to the recipients of income and turn over only 25 to antecedent production. The amount of money which then is needed to facilitate turnovers in the construed sequence of production is now only 200. One must keep in mind, however, that the money sum of 50 which will be paid for originary factors of production in one and the same payment by the entrepreneur integrating stages I and II finances two different integrated (synchronized) production sequences. Our model could only be so simple because we have not included the exchange of durable capital goods. However, a special explanation with regard to this exchange is not necessary. Whether the capital good purchased with money is an intermediate product (a raw material) or a durable capital good, the seller receives monetary capital which—insofar as it in turn is invested—is used to purchase capital goods or as a payment for originary factors of production.

⁵⁹That a legal relationship (i.e., the purchase of a bond) may obscure an economic fact is of no importance here.

⁶⁰Until now we have only deviated from the strict assumptions of the stationary economic process where we have included new savings and the consumption of saved capital in our analysis. We have seen that in these cases, too, a reallocation of money results in a parallel change in the use of goods.

⁶¹The question should be left open whether an adjustment of economic observations to this problem—there is already the start of this in the observation of business cycles—could not change something here at least in the sense that the first symptoms of the effects of monetary stimulations on the capital market could be recognized. We will have more to say regarding these effects later. This comment should, however, in no way be understood as the policy of neutral money appearing to us as the only possible policy. This must be noted here, even though there is something to be said for just such a policy. However, our interest here in neutral money is justified purely theoretically, and it would perhaps be appropriate to present this reason explicitly: In the stationary economy, monetary influences lead to “disturbances”; hence there is a question under which circumstances these disturbances do not occur, i.e., that money is “neutral.” Here, the question regarding the neutrality of money is hence a question regarding the monetary conditions of the stationary course of a money economy.

⁶²Insofar as a bank lends available money—in particular bank notes created elsewhere—it functions as a credit agent. Insofar, however, as a bank grants a credit that can serve as payment in the form of transfers whereby the bank simultaneously debits its clients with the credited sum, a creation of credit occurs.

⁶³Insofar as “durable consumer goods” are available, their productive contributions will naturally be maintained.

⁶⁴This assumption, which we will immediately drop, is an arbitrary one. Let it also be noted that this model shall later serve in the presentation of another relationship from which the effects of a credit expansion will first be recognized in their entirety.

⁶⁵Here a credit expansion must operate in the same way as an inflation which directly serves to finance consumption—for example, to pay for state employees.

⁶⁶Let us briefly discuss a frequently observed situation.

1. In the case of the employment of more laborers at an unchanged wage, as long as an expansion in the production of consumer goods has not occurred, the increased wage sum will not correspond to an expanded subsistence fund. If this is the situation, we have a case of “forced saving.” Hence an unchanged subsistence fund makes it possible, as a result of its higher “virulence” (reduction in the rations in which it is consumed), to lengthen the roundabout methods of production. (This would occur “at the expense” of the laborers whose wage would be less than the marginal product.) However, this relationship does not, under any circumstances, justify the possibility of a lasting “support” of expanded roundabout production methods, because it cannot be anything more than a friction. In the end, the increased wage sum will lead to an expanded production of consumer goods, lest the costs of production for consumer goods were to grow at least in the same proportion as the size of the money demand for means of subsistence. This cannot, however, be assumed because—as we have shown—it must be assumed that those capital goods which will first show the price increase will not be those which are intermediate products maturing into consumer goods. However, if the quick increase in the production of consumer goods is only possible through an increase in prices, the subsistence fund must grow more slowly than the size of the wage sum. If one wishes, one can also speak of forced saving here. However, certain further effects appear to us to be more important, namely, that—as we will now show—in this connection even the smallest expansion in the production of consumer goods means consuming capital. In the other case, where a limited supply of laborers at the current wage rate lets the wages rise, the just presented idea can be applied without difficulty. Raising the monetary wage must result in a rise in real wages since the supply of means of subsistence grows. However, insofar as the prices of consumer goods increase, this rise in the real wage will not occur to the same extent as the increase in monetary wages.

2. A “forced saving” has also been derived from another connection. Wherever monetary income remains unchanged, a price increase forces consumers to refrain from consumption. One must, however, use caution in applying this rule. If, for instance, the recipient of a monetary pension is forced to refrain from consumption by a price increase, then on the opposite side there is an alleviation of a real burden on the debtor. Saving will only take place if the debtor refrains from increased consumption. However, this is in no way forced, but rather perfectly normal “voluntary” saving. (By the way, it might have its justification if one assures that the recipient of a pension will often be less inclined to save than he who becomes a debtor in order to gain larger economic successes with borrowed money. The problem, however, lies entirely in the realm of the voluntary saving.) Analogous here is the situation when contrasting the reduction in the “purchasing power” of the income of, for example, civil servants and the relief for the taxpayer. We need no longer concern ourselves here with these questions.

⁶⁷It is not necessary to point out that a central bank’s rationing of credit without raising the interest rate must essentially have the same results as increasing the interest rate. In both cases, the extension of credit will be limited. In one case, those who are able to pay the highest interest receive credit; in the other case, some other selection principle will be decisive for the distribution of credit. Insofar, however, as a forced-down interest rate satisfies credit seekers who could not pay a higher interest, while it simultaneously excludes credit seekers who could pay a higher interest rate, a rationing of credit counteracts a distribution of credit according to economic efficiency. Besides, in view of the circumstance that in addition to the central bank other sources of credit exist, the rationing of credit will imply a lower interest only for those economic subjects whose credit demand is directly satisfied by the central bank, while elsewhere on the capital market the interest cannot be kept down unless one subjects the entire capital market to detailed restrictions with all of their ensuing consequences (which are of no interest here, however).

⁶⁸There are only a few comments to be made regarding what would have to be expected if the central bank refrained from raising the interest rate and continued to expand credit. The progressive lack of subsistence means would lead to an emergency in the economy which would find expression in a rapid increase in prices. For reasons we have already mentioned, the volume of credit would also always increase at a faster rate. In this situation the economy would cease calculating with inflation money. However, since it is only available in a limited amount, all other money would only be obtainable on the credit market at a higher interest rate. With this, an interest rate corresponding to the supply of saved capital would take effect. During periods of great inflation, the “depreciation” of inflated money has been frequently delayed by the state’s freezing prices in order to create a market in which only this inflated money could be used. In spite of this, a transition towards calculating in other currencies has often been made. In addition, when forming the interest rate for inflated money, the depreciation of money has often been accounted for by means of a corresponding rise in the interest rate.