5. International Monetary Theory

CHAPTER 5

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International Monetary Theory

Austrian analysis of the balance of payments and the exchange rate originated in Ludwig von Mises’s Theory of Money and Credit,¹ first published in German in 1912. In formulating his theories, Mises built on the analysis of the monetary adjustment process under a specie standard pioneered by eighteenth-century writers, most notably David Hume and Richard Cantillon, and on the extensions of their analysis to the case of an inconvertible paper money by the British bullionists of the early nineteenth century, especially David Ricardo. Important elaborations and applications of Mises’s theoretical framework were subsequently undertaken by Mises² himself, writing during the German hyperinflation, and, later, by his student F.A. Hayek³ and other economists associated with the London School of Economics during the 1930s, notably Lionel Robbins⁴ and Frank Paish.⁵

Among Continental economists, the Polish-born Michael A. Heilperin, who was Mises’s colleague at the Geneva Institute of International Studies in the 1930s, is especially noteworthy for following a basically Austrian approach in his writings on a broad range of international monetary issues.⁶ In German-language publications of the 1920s and 1930s, Misesian monetary theorists such as the early Fritz Machlup,⁷ the early Gottfried Haberler⁸ and Wilhelm Röpke⁹ developed the implications of the Austrian approach for the solution of the so-called “transfer problem” of unilateral payments and capital movements. More recently, Murray N. Rothbard¹⁰ has criticized the case for fluctuating exchange rates and analysed twentieth-century international monetary experience, particularly the workings of the gold exchange standard, from an Austrian perspective; and Joseph T. Salerno¹¹ has restated the Austrian analysis in the light of the modern monetary approach and used it to evaluate the performance of the classical gold standard.

Austrian analysis of the balance of payments begins with the insight that disequilibria in payments balances between exchanging parties can never arise in a system of barter and that money in its role as the general medium of exchange is therefore the active element that determines the balance of payments. Money does not merely move to and fro in passive response to discrepancies that arise in the trade of commodities, services, and assets.¹² Balance-of-payments phenomena are thus treated, as they were by Cantillon, Hume, and the bullionists, as an integral part of the market process by which the purchasing power of money and its distribution among regions and nations sharing a common currency are adjusted to variations in the relationship between the demand for and supply of money. For example, under an international gold standard, an increase in the supply of money in a gold-mining nation that disrupts a pre-existing monetary equilibrium by furnishing some residents with excess cash balances leads to excess demands in goods and asset markets, and this results—sooner or later, depending on the concrete data of the case—in a net outflow of money through the nation’s current and capital accounts and, hence, a deficit in its “money account” or overall balance of payments. When residents have succeeded in ridding themselves of their excess cash, equilibrium is restored in the domestic “money market” and subsequently in the balance of payments as the net outflow of money ceases.

In thus analyzing the balance of payments as a phase in the monetary adjustment process, the Austrian theory focuses on the actions of individual money holders linked to one another in a sequence of monetary exchanges. The steps in this sequential adjustment process are then accounted for by examining the causes and effects of the decisions to equilibrate their cash balance positions undertaken by individuals who constitute different links in the macroeconomic income and spending chains that reach back to the originating cause of the monetary disequilibrium. As Hayek¹³ and Salerno¹⁴ in particular have shown, it is therefore the interrelated variations in the complex of individual cash balances, incomes, and prices—and not brute up-and-down movements in national money supplies, nominal GDPs, and price levels—that drive this equilibrating process.

One of the more significant implications of this analysis is that a balance of payments adjustment under a common international money such as gold does not require or promote monetary inflation and deflation, as it is commonly said to do in the textbook characterization of the “price-specie-flow mechanism.”¹⁵ Under the international gold standard, the transfer of money from one nation to the rest of the world as a result of, say, a decline in world demand for that nation’s exports, will be quickly reversed unless, as is likely to happen, it is accompanied by a relative decrease in the demand for cash balances on the part of workers and entrepreneurs experiencing falling real incomes in the contracting export industry. And even if demand for cash balances does fall the reduction in the nation’s money supply does not represent a “deflation,” properly defined as a reduction in the money supply of a closed system or “currency area,” but merely the same type of redistribution of cash balances between individuals, industries and regions that regularly occurs when demand shifts from the product of one domestic industry to that of another within, for example, the present-day U.S. fiat dollar area.

According to Austrian theory, the monetary and balance of payments equilibrium that the market is continually driving towards can be described as one in which the purchasing power of money (the “PPM” for short) is everywhere absolutely equal. Interspatial equalization of the PPM is not taken to mean, however, that national price indexes ever tend towards equality. Indeed, Austrians eschew the use of such statistical constructs when they theorize about changes in the PPM, using them only to obtain rough historical estimates of variations in the PPM.¹⁶ For Austrian theorists the phrase “geographical equalization of the value of money” refers to an equilibration of the unaveraged and heterogeneous array of alternative quantities of goods that are exchangeable for a unit of money.

Thus conceived, equilibration of money’s purchasing power array cannot be expected to yield equality between the prices of physically identical goods available in different locations, let alone between the arbitrarily selected and weighted price indexes of different nations or regions. The reason is to be found in Mises’s subjectivist insight that the situation of a good in space may affect its perceived usefulness and thus its subjective value in satisfying human wants.¹⁷ For example, coffee in Brazil is evaluated by coffee drinkers in New York City as a capital good which must be combined with additional labor and complementary capital goods—, that is, the means of transportation—before it can attain the (higher) subjective value of the consumption good, coffee in New York. Indeed, an important respect in which the money commodity differs from non-monetary commodities is that money’s position in space is a matter of indifference to economic agents. The reason is that there exist “money substitutes” such as checkable deposits and bank notes which are routinely accepted as substitutes for the money commodity in exchange. With the use of clearing systems, money substitutes are virtually costless to transfer. Thus stocks of money, wherever they may be situated within the unitary market area, for all practical purposes constitute parts of a supply of a perfectly fungible commodity, subject to the operation of the Jevonian Law of Indifference, also known as the Law of One Price.

But the Austrian insight regarding the influence of the spatial element on the quality of (non-monetary) goods does not embrace merely the pure distance between the location of the consumer and the location of the capital good, but also the consumer’s positive or negative psychic response to the very site of purchase or consumption. For example, even in equilibrium, the same brand of men’s shirt may simultaneously sell for different prices at a mall boutique and at a downtown clothing store, because, at the margin, consumers are prepared to offer a higher price for the shirt purchasable at the mall location, which is perceived to be more easily accessible and more pleasant. Or consider that a glass of beer consumed in a restaurant situated on top of a skyscraper and offering a breathtaking view of Manhattan commands a much higher price than a glass of the same beer imbibed in a pub a few blocks away at street-level. Surely we do not expect would-be bar patrons at the former establishment to react to knowledge of such a price discrepancy by a mad scramble to the elevators, precisely because such a discrepancy does not represent a genuine interlocal disequilibrium in the PPM. Taking into account their spatial quality components, the two glasses of beer represent different goods. This is not to deny, of course, that, whenever consumers are neutral with respect to alternative locations of stocks of a technologically identical good ready for consumption or purchase, the spatial equilibration of the PPM implies the complete eradication of interlocal price differences.

Thus, from the Austrian point of view, the equilibration of the PPM is accomplished as part of the same macroeconomic process that gives rise to the structure of relative prices. As Phillip H. Wicksteed¹⁸ has shown us, this process culminates in a state in which, barring further change in the data, no mutual gains can be obtained from further exchange between any two market participants, because the ordinal value rankings of equal-sized units of each of the various goods and of money are identical for all those possessing them. This state also reflects the absolute equalization of the objective exchange value of money between any two locations, because it implies that interlocal differences between prices of physically homogeneous goods exactly equal their costs of transportation (abstracting from time in transit) between their consumption and production centers and, more generally, that no individual can achieve a more desirable outcome, that is, an increase in total utility, from the exchange process by diminishing his expenditures on consumer goods available at one location and substituting expenditures on goods, whether physically homogeneous or not, offered at alternative locations.

The reference to Wicksteed suggests why Austrian balance of payments theorists, like their bullionist forerunners, consider monetary equilibrium to be relatively rapidly established. Wicksteed¹⁹ begins his analysis by assuming that consumer value scales and the stocks of all goods (including money) remain constant over the course of a logically stipulated “market day” that dawns in disequilibrium and terminates in a pure exchange equilibrium. This procedure permits him to analyze the short-run arbitrage and speculative processes that lead to the equilibrium structure of relative prices (the inverse of the equilibrium PPM array) in isolation from the complex phenomena of entrepreneurship and production. It also serves to emphasize the point that the geographical equalization of the PPM is a pure exchange phenomenon which is constantly being approximated by real-world market processes and does not await the time-consuming adjustment of the production structure that characterizes the longrun equilibration of the overall economy. Austrians are thus inclined to speak of ‘the’ purchasing power of money only a little less confidently than they and other economists refer to “the” market prices of oil, steel, wheat and other broadly traded commodities.

Austrian analysis of the determination of the exchange rate between two independent moneys is based on the purchasing power parity (PPP) theory as it was first formulated by Mises in 1912,²⁰ four years before Gustav Cassel published the first of his many statements of it. In Mises’s version of the theory—which, unlike Cassel’s later version, is “absolute” and exclusively monetary—the long-run equilibrium or “final” exchange rate between two currencies is always exactly equal to the inverse of the ratio between the purchasing powers of the two currencies. This implies that a given depreciation of the overall purchasing power of currency A relative to that of currency B brings about an increase of the final price of B in terms of A in precisely the same proportion, regardless of the inevitable changes in relative prices that are produced by the nonneutral depreciation process.

The marked differences between the Misesian and Casselian versions of the PPP theory can be traced back to Mises’s analytical coup in perceiving the artificiality of the distinction long maintained in classical monetary theory between the case of a parallel standard, that is, two different moneys circulating side by side in domestic use, and the case in which there is only one kind of money employed in domestic transactions while another kind is in use abroad.²¹ According to Mises, as long as exchange relations exist between two different currency areas, economically, the money of one area necessarily functions as the money of the other area, since both moneys must be utilized in effecting an exchange between the two areas.

Most importantly, in the Misesian version of the theory the exchange rate between two different national currencies is not determined, as it is for Cassel, by the “quotient between the general levels of prices in the two countries.” National price indexes, which generally include purely domestic goods, for example the “houses and haircuts” of textbook fame, whose spatial quality components render their prices interlocally and, a fortiori, internationally incommensurable, are wholly irrelevant to the issue, because there is no longer a reason to distinguish between internationally “tradeable” goods and domestically produced and consumed “non-tradeable” goods. As in the case of domestically coexisting parallel currencies, all goods entering into the exchange nexus, (and here we distinguish between spatially differentiated goods) find expression in the purchasing power array of each of the two national currencies, because all goods are potential objects of international trade, even though many may be “immovable” or “non-transportable.” Certainly, one of the lessons learned from the exchange rate gyrations of the 1980s was that American real estate and consumer services, when rendered sufficiently cheap by a depreciated dollar, are purchasable by foreign speculators and tourists.

Thus the apparent problem for the PPP theory that is raised by the existence of goods having a fixed position in space is easily solved by taking the spatial dimension of quality into account. For example, if the final or PPP exchange rate between the U.S. dollar and the British pound is two to one, then the pound price of a house located in London must be exactly one-half the dollar price of this same house. Of course, owing to consumer perceptions of the difference in quality between the two cities as residential locations, the final price in dollars (pounds) of an identically constructed house situated in Manhattan may be three times the price of the London house also expressed in dollars (pounds). To maintain purchasing power parity, therefore, it is not necessary that technologically identical but immovable goods available in different locations maintain equal prices in the same currency, but only that the ratio of the prices in two different currencies of an immovable good in the same location equal the inverse of the exchange rate between these two currencies. If the ratio of currency prices for any given commodity diverges from the prevailing exchange rate, equilibrium has not yet been attained and profit opportunities will exist for selling the good for the relatively overvalued currency, employing the sale receipts to purchase the undervalued currency, and then using the latter to repurchase the original good. These arbitrage operations will drive the exchange rate and the ratio of currency purchasing powers towards a mutual and final adjustment.²²

For the Austrian, then, the problems arising from “fixed” or “pegged” exchange rates between national fiat currencies are the same as the problems confronting a domestic bimetallic standard. Gresham’s Law, which, as Mises²³ first recognized, is merely the application of the general theory of price controls to the monetary sphere, operates to cause a chronic shortage on foreign exchange markets or disappearance from domestic monetary circulation of the artificially undervalued national currency or metal.

Another feature which significantly distinguishes Mises’s formulation of the PPP theory from Cassel’s involves the question of whether the exchange rate is exclusively a monetary phenomenon or whether changes in the real data via movements in relative prices are capable of bringing about a permanent departure of the equilibrium exchange rate from the rate which maintains strict PPP between the two currencies. Like Cassel, especially in his later writings, most modern writers pursue what might be termed an “inclusive” approach to exchange rate determination, that is, one which includes references to non-monetary factors as codeterminants of the exchange rate. They therefore reject the absolute version of the PPP theory, on the grounds that it cannot account for the influence on the equilibrium exchange rate of variations in the nation’s “real terms of trade,” that is, the relative price between the nation’s imports and exports.

Whatever the validity of this criticism against the PPP theory expressed in terms of relative national price levels, it has no bearing whatever on a theory referring to the relative purchasing powers of parallel currencies coexisting in a unitary market area. The Misesian version of the PPP theory remains intact in its absolute and exclusively monetary formulation. To illustrate, let us consider the case of a monopolistically induced increase in the price of oil, the U.S. import, relative to the U.S. export, wheat. While the terms of trade turn against the USA, ceteris paribus, that is, in the (unlikely) absence of any induced changes in the monetary data, there will be no long-run depreciation of the U.S. dollar against the Saudi riyal, because both currencies experience an equal reduction of their purchasing powers in terms of oil and, assuming the demand for oil is inelastic along the relevant segment of the global demand curve, equal increases of their purchasing powers in terms of wheat. Of course, this is not to deny that short-run and self-reversing fluctuations in the exchange rate may accompany the market’s adjustment to the alteration in relative prices. Thus U.S. consumers may initially respond to the increased price of oil with increased expenditures on oil without a corresponding reduction in their spending on wheat, allowing their cash balances to run down temporarily. This response implies a planned “overabsorption” of output relative to their shrunken real income by U.S. residents, creating an excess demand for riyals in the foreign exchange market and necessitating a temporary rise in the exchange rate and a depreciation of the dollar. The movement in the exchange rate will thus assist in clearing excess demands in output markets and adjusting the terms of trade to prevent overabsorption and preserve balance of payments equilibrium, but only until U.S. residents’ expenditures adjust, cash balances are re-established at their former equilibrium levels, and the exchange rate floats back down to its unchanged PPP level.

Moreover, other things are not likely to remain equal. In particular, the redistribution of income and wealth from U.S. entrepreneurs and laborers to their Saudi counterparts can be expected to result in a change in the relative demands for the two currencies and a depreciation of the dollar in the long run. But it is the relative decline in the cash balance demand for the dollar and therefore in its purchasing power vis-à-vis the riyal, and not the deterioration of the U.S. terms of trade, which is the direct cause of the change in the final exchange rate.

The foregoing analysis, of course, implies that Austrians conceive purchasing power parity between currencies as a condition which fully holds only in equilibrium, and they recognize that real factors do play a role, albeit subordinate and transient, in the determination of the spot exchange rate that is actually realized at each moment on the foreign exchange markets. With regard to the spot exchange rate, Austrians, taking their cue from Mises,²⁴ also emphasize its responsiveness to expectations of future variations in currency purchasing powers and in national money supplies. In recognizing that movements of the exchange rate generally anticipate adjustments forthcoming on the domestic money market, however, the Austrian approach must be distinguished from the rational expectations approach. While adherents of both approaches view the foreign exchange market as an asset market characterized by instantaneous market clearing and the participants’ orientation to new information, Austrian theorists do not accept the “efficient market hypothesis” as a realistic description of the operation of this market. Rather, they consider the behavior of the exchange rate to be governed by the conflicting forecasts of ever-shifting aggregations of bears and bulls, who differ in their experiences and market situations and in their abilities to predict future market conditions.

Bibliography

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Rothbard, Murray N. 1975. “Gold vs. Fluctuating Fiat Exchange Rates.” In Gold Is Money, Hans F. Sennholz, ed., pp. 24–40. Westport, Conn.: Greenwood Press.

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____. 1994. “The Gold Exchange Standard in the Interwar Years.” In Money and the Nation States, Kevin Dowd and Richard Timberlake, eds. Oakland, Calif.: Independent Institute.

Salerno, Joseph T. 1982. “Ludwig von Mises and the Monetary Approach to the Balance of Payments: Comment on Yeager.” In Method, Process, and Austrian Economics: Essays in honor of Ludwig von Mises, Israel M. Kirzner, ed., pp. 247–56. Lexington, Mass.: D.C. Heath.

____. 1984. “The International Gold Standard: A New Perspective.” Eastern Economic Journal 10, October/December: pp. 488–98.

____. 1992. “Gold and the International Monetary System: The Contribution of Michael A. Heilperin.” In The Gold Standard: Perspectives in the Austrian School, Llewellyn H. Rockwell, Jr., ed., pp. 81–111. Auburn, Ala.: Ludwig von Mises Institute.

Wicksteed, Phillip H. [1932] 1967. The Common Sense of Political Economy and Selected Papers and Reviews on Economic Theory, 2 vols., Lionel Robbins, ed. New York: Augustus M. Kelley.

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From: “International Monetary Theory,” in The Edward Elgar Companion to Austrian Economics, ed. Peter J. Boettke (Brookfield, Vt.: Edward Elgar, 1994), pp. 249–57.

¹ Ludwig von Mises, The Theory of Money and Credit, 3rd ed. (Indianapolis: Liberty Classics, [1953] 1981), pp. 195–213.

² Ludwig von Mises, On the Manipulation of Money and Credit, ed. Percy L. Greaves, Jr., trans. Bettina Bien Greaves (Dobbs Ferry, N.Y.: Free Market Books, 1978), pp. 1–55.

³ F.A. Hayek, Monetary Nationalism and International Stability (New York: Augustus M. Kelley, [1937] 1971).

⁴ Lionel Charles Robbins, Economic Planning and International Order (London: Macmillan, 1937); idem, Money, Trade and International Relations (London: Macmillan, 1971).

⁵ Frank W. Paish, “Causes of Changes in Gold Supply,” in The Post-War Financial Problem and Other Essays (London: Macmillan, 1950): pp. 149–86; idem, “Banking Policy and the Balance of International Payments,” in Readings in the Theory of International Trade, eds. Howard S. Ellis and Lloyd A. Metzler (Homewood, Ill.: Richard D. Irwin, [1936] 1966): pp. 35–55.

⁶ Joseph T. Salerno, “Gold and the International Monetary System: The Contribution of Michael A. Heilperin,” in The Gold Standard: Perspectives in the Austrian School, ed. Llewellyn H. Rockwell (Auburn, Ala.: Ludwig von Mises Institute, 1992), pp. 81–111; Michael A. Heilperin, Aspects of the Pathology of Money: Monetary Essays from Four Decades (London: Michael Joseph, 1968); idem, International Monetary Economics (Philadephia: Porcupine Press, 1978).

⁷ Fritz Machlup, “Foreign Debts, Reparations, and the Transfer Problem,” in International Payments, Debts and Gold: Collected Essays by Fritz Machlup (New York: Charles Scribner’s Sons, 1964a), pp. 396–416; idem, “Transfer and Price Effects,” in International Payments, Debts, and Gold: Collected Essays by Fritz Machlup (New York: Charles Scribner’s Sons, 1964b), pp. 417–24.

⁸ Gottfried Haberler, “Transfer and Price Movements,” in Selected Essays of Gottfried Haberler, ed. Anthony Y.C. Woo (Cambridge, Mass.: MIT Press, 1985), pp. 133–42.

⁹ Wilhelm Röpke, “On the Transfer Problem in International Capital Movements,” in Against the Tide, trans. Elizabeth Henderson (Chicago: Henry Regnery, [1930] 1969), pp. 1–23.

¹⁰ Murray N. Rothbard, “Gold vs. Fluctuating Fiat Exchange Rates,” in Gold Is Money, ed. Hans F. Sennholz (Westport, Conn.: Greenwood Press, 1975), pp. 24–40; idem, What Has Government Done to Our Money?, 4th ed. (Auburn, Ala.: Praxeology Press, 1990); idem, “The Gold Exchange Standard in the Interwar Years,” in Money and the Nation States, eds. Devin Dowd and Richard Timberlake (Oakland, Calif.: Independent Institute, 1994).

¹¹ Joseph T. Salerno, “Ludwig von Mises and the Monetary Approach to the Balance of Payments: Comment on Yeager,” in Method, Process, and Austrian Economics: Essays in Honor of Ludwig von Mises, ed. Israel M. Kirzner (Lexington, Mass.: D.C. Heath, 1982), pp. 247–56 [reprinted here as Chapter 6]; idem, “The International Gold Standard: A New Perspective,” Eastern Economic Journal 10 (October/December): pp. 488–98 [reprinted here as Chapter 15].

¹² Mises, The Theory of Money and Credit, p. 208; Salerno, “Monetary Approach to the Balance of Payments,” p. 248.

¹³ Hayek, Monetary Nationalism and International Stability, pp. 19–24.

¹⁴ Salerno, “Monetary Approach to the Balance of Payments,” pp. 490–91.

¹⁵ Robbins, Economic Planning and International Order, pp. 280–90; Salerno, “Monetary Approach to the Balance of Payments,” pp. 491–92.

¹⁶ Ludwig von Mises, The Theory of Money and Credit, 2nd ed. (Irvington-on-Hudson, N.Y.: Foundation for Economic Education, [1953] 1971), pp. 187–94; Heilperin, International Monetary Economics, pp. 259–69.

¹⁷ Mises, The Theory of Money and Credit, 3rd ed., pp. 195–203.

¹⁸ Phillip H. Wicksteed, The Common Sense of Political Economy and Selected Papers and Reviews on Economic Theory, 2 vols., ed. Lionel Robbins (New York: Augustus M. Kelley, [1932] 1967), vol. 1, pp. 140–45.

¹⁹ Wicksteed, The Common Sense of Political Economy, vol. 1, pp. 218–28.

²⁰ Mises, Theory of Money and Credit, 3rd ed., pp. 205–13; Chi-Yuen Wu, An Outline of International Price Theories (London: George Routledge & Sons, 1939), pp. 115–16, 233–35.

²¹ Mises, Theory of Money and Credit, 3rd ed., pp. 206–07; Lord Lionel Robbins, Money, Trade and International Relations (London: Macmillan, 1971), p. 22.

²² Rothbard, “What Has Government Done to Our Money,” p. 42.

²³ Mises, Theory of Money and Credit, 3rd ed., pp. 90–93, 282–86.

²⁴ Mises, Theory of Money and Credit, 3rd ed., pp. 27–28, 51.