PART II THE VALUE OF MONEY CHAPTER 7 THE CONCEPT OF THE VALUE OF MONEY Summary

The main task of economic theory is to explain money’s objective exchange value, or what is often called the purchasing power of money. This refers to the amount of goods that someone can obtain in the marketplace with a unit of money. This explanation in turn ultimately goes back to subjective valuations.

What sets money apart from all other goods is that money is useful (and hence valuable) to people only because of its purchasing power. In its capacity as a medium of exchange, a unit of money is only useful inasmuch as it can be used to acquire other goods and services.

When we say a particular good has objective exchange value, the term “objective” is not used to mean that this value inherently resides in the object. All market prices are ultimately determined by subjective human preferences, and therefore are subject to change whenever people’s valuations change. A typical good’s “objective” exchange value is still determined by the subjective use-values of the end user. (For example, a car manufacturer will produce cars based not on his personal whims, but on how much he can charge for them in the market. Yet these prices themselves are due to how much his customers enjoy driving the various vehicles.)

The one essential difference with money is that it has no subjective use-value, which could ultimately explain its objective exchange value. Its only value—qua money—derives from its ability to exchange for other goods in the market. This is why applying modern subjective value theory to the explanation of objective money prices is such a tricky affair. Those economists of Mises’s day who tried to explain the purchasing power of money based solely on its industrial applications, were completely evading the issue. In particular, they would be helpless to explain the purchasing power of fiat money.

Chapter Outline

1. Subjective and Objective Factors in the Theory of the Value of Money

When it comes to money, the main task of economic theory is to explain its objective exchange value, or what is often called the purchasing power of money. This refers to the amount of goods that someone can obtain in the marketplace with a unit of money. This is an objective fact: if Tom sees that a dollar bill can purchase three postage stamps, then Bill will observe the same purchasing power as well.

Even though economics focuses on the explanation of money’s objective exchange value, the explanation itself ultimately goes back to subjective valuations. For the economist grounded in the modern subjective value theory (developed by Carl Menger and his followers), all prices in the market must be explained by reference to individuals’ subjective valuations. This rule holds even for money.

What sets money apart from all other goods is that money is useful (and hence valuable) to people only because of its purchasing power. In its capacity as a medium of exchange, a unit of money is only useful inasmuch as it can be used to acquire other goods and services.

When it comes to explaining the price of, say, an original painting by Picasso, the economist starts with the fact that some people place a very high subjective value on holding such artwork. The economist has no obligation to explain why people enjoy the mere possession of a canvas covered in paint; he or she takes this preference as a given, and proceeds to explain the exchange value of the Picasso in the marketplace. Yet when it comes to money, the economist can’t explain its “price” (i.e., purchasing power) merely by saying that people enjoy acquiring and holding cash balances. Such an argument—by itself—would be circular, because the reason people want to hold cash balances is that money has purchasing power. That is why explaining the “price” of money is a much subtler task than explaining the price of a Picasso.

2. The Objective Exchange Value of Money

The objective exchange value of goods can be defined as “their objective significance in exchange” or “their capacity in given circumstances to procure a specific quantity of other goods as an equivalent in exchange.” Nowadays we might use the term market value to express the same concept as objective exchange value.

When we say a particular good has objective exchange value, the term “objective” is not used to mean that this value inherently resides in the object. (In other words, we are not using the term the same way that a good might have an objective weight or color.) All market prices are ultimately determined by subjective human preferences, and therefore are subject to change whenever people’s valuations change. But a good’s market value is still “objective” in the sense that any individual can take it as a given fact.

The objective exchange value of money refers to the possibility of obtaining a certain quantity of other goods in exchange for the money, while the price of money is this actual quantity of other goods. (The terms are not identical, but are very similar, as Mises explains on page 101.)

3. The Problems Involved in the Theory of the Value of Money

In modern economies, producers as a rule evaluate their output on the basis of subjective exchange value, rather than subjective use-value. For example, the owner of an automobile factory doesn’t order his employees to produce cars that he himself wants to drive. On the contrary, he instructs his employees to make cars that he plans on selling to others, based on what his customers want to drive. When formulating his business plans, then, he is guided by his personal, subjective valuations of the other goods he will be able to buy (houses, fancy meals, yachts, etc.) with the revenues from the sale of his cars.

In order for the owner of the automobile factory (and other producers) to accurately envision the tradeoffs of different production decisions, he needs to know the objective exchange value of the various cars he could manufacture. It’s not enough that the car producer knows that he values yachts and steak dinners; he also needs to know how much money he can raise by selling different models of his cars, and how much money he will need to spend if he wants to acquire yachts and steak dinners. Thus most production decisions involve a complex interdependence on both subjective and objective valuations.

The one essential difference with money is that it has no subjective use-value, which could ultimately explain its objective exchange value. In contrast, when it comes to the automobiles, yachts, and steak dinners, the economist ultimately could explain their relative exchange values (i.e., how many automobiles would trade for one yacht, etc.) by reference to individuals’ subjective use-values from them (i.e., how much people liked driving cars, versus piloting yachts or eating steak).

But with money, its only value—qua money—derives from its ability to exchange for other goods in the market. This is why applying modern subjective value theory to the explanation of objective money prices is such a tricky affair. Those economists of Mises’s day who tried to explain the purchasing power of money based solely on its industrial applications, were completely evading the issue. In particular, they would be helpless to explain the purchasing power of fiat money.

Technical Notes

• In the beginning of this chapter, Mises spends time placing his analysis of money within the framework of subjective value theory, as it had been developed by his Austrian predecessors (notably Menger, Böhm-Bawerk, and Wieser). Some of the terminology may appear quaint to modern economists, even those who have studied Austrian economics. But to properly explain the process by which subjective individual valuations generate objective market prices, it is necessary to distinguish between use-value and exchange value, and these concepts in turn both come with a subjective and an objective dimension. For example, the objective use-value of a pig would include the collection of bacon strips it could physically yield, while the objective use-value of a tomato seed would include the tomatoes it could physically yield. These would be empirical facts, not subject to opinion. However, a vegetarian would probably assign a lower subjective use-value to the pig than to the tomato seed, while a meat-lover might do the opposite. On the other hand, both the vegetarian and the meat-lover would agree that the objective exchange value of the pig is much higher than that of the tomato seed. For example, it would be an indisputable fact that the pig could fetch more grams of gold (or dollar bills) than the tomato seed, if both were put up for sale.

• Applying these concepts to money, Mises explains (pp. 97-98) that there are two acceptable ways of making an important point. One way is to claim that money’s subjective use-value is the same as its subjective exchange-value. (That is, the significance that a particular individual attributes to a quantity of money, must be the same significance that he or she attributes to the goods for which the money can be exchanged, because the money can’t be used to satisfy wants directly.) A different way to make the point is to say that money has no use-value at all, because any value it possesses necessarily derives from its exchange value. Mises doesn’t take a position on which of these alternate descriptions is better; he merely wants to stress the fundamental point that people consider money useful and valuable only because they expect to use it to acquire other goods. (Of course Mises is talking about money qua money. A bar of gold, for example, can still possess use-value for its industrial or ornamental applications.)

New Terminology

Exchange value: The significance of a good due to its ability to be traded for other goods. (Exchange value can be qualified as either subjective or objective.)

Market value: Synonymous with the objective exchange value of a good, typically quoted in money terms.

Objective exchange value of money: The possibility of obtaining a certain quantity of other goods in exchange for a unit of money.

Price of money: The quantity of goods (or services) that must be given up in exchange to acquire a unit of money.

Use-value: The significance of a good due to its ability to be directly used by the owner in consumption or production. (Use-value can be qualified as either subjective or objective.)

Study Questions

1. What is the central element in the economic problem of money? (p. 97)

2. Does the subjective theory of value apply to the case of money, as to all other goods? (p. 97)

3. Explain: “In the case of money, subjective use-value and subjective exchange value coincide.” (p. 97)

4. Explain: “It should be observed that even objective exchange value is not really a property of the goods themselves, bestowed on them by nature....” (p. 100)

5. If money (e.g., gold) has an industrial use as well as a monetary use, what will be the relation between its objective exchange values in those two different applications? (pp.104–05)

CHAPTER 8

THE DETERMINANTS OF THE OBJECTIVE EXCHANGE VALUE, OR PURCHASING POWER, OF MONEY

Summary>

The usefulness of money derives solely from its purchasing power. Therefore, today’s valuation of money is dependent on its purchasing power yesterday, which in turn was influenced by money’s purchasing power two days ago. Such reasoning does not lead to an infinite regress, because at some point in the past we arrive at the state of direct exchange, when goods were only valued for their direct use. This theory of the origin of money is the only one compatible with a subjectivist explanation.

The historical continuity in the value of money distinguishes it from all other commodities. People do not derive their utility from apples or oranges based on their prices, but people do evaluate the usefulness of a quantity of money based on its purchasing power.

The problem with many rival theories of the purchasing power of money—such as a simple quantity theory or “supply and demand” explanation—is that they have to take the value of money as given, and can only explain deviations from this stipulated starting point. They can’t explain the absolute level of money-prices, i.e., they can’t explain the actual exchange ratio between money and other goods at a particular time. The subjectivist, marginal-utility theory developed by Menger and his successors can explain the precise, absolute money-prices of the market today.

The exchange ratio between money and all other goods—in other words, the purchasing power of money—may be affected by changes in people’s valuations of the money side or the (other) commodities side of the ratio.

In its crudest form, the quantity theory of money is obviously wrong: It is simply not true that, say, a doubling in the quantity of money will lead to an exact doubling of all prices (quoted in money).

Modern value theory must explain the demand to hold money by starting with the subjective preferences of the individual. The community’s demand to hold money is simply the summation of the individual demands. No individual can make use of the popular “macro” approaches, which employ formulas involving “total volume of transactions” and “velocity of circulation.” Economists therefore should not use such concepts when explaining the purchasing power of money.

Money certificates are money substitutes that are fully “covered” by money proper, while fiduciary media are money substitutes that are issued above the redemption fund.

Chapter Outline

I. THE ELEMENT OF CONTINUITY IN THE OBJECTIVE EXCHANGE VALUE OF MONEY

1. The Dependence of the Subjective Valuation of Money on the Existence of Objective Exchange Value

In order for individuals to evaluate the subjective value of money, they must first consider its usefulness which is derived solely from its purchasing power. In this sense, today’s valuation of money is dependent on people’s observations of its purchasing power yesterday. And yesterday’s purchasing power, in turn, was influenced by money’s purchasing power two days ago.

Such reasoning does not lead to an infinite regress, because at some point in the past we arrive at the state of direct exchange, when goods were only valued for their direct use. At that time, goods such as gold and silver—which would become money, down the road—were valued exclusively for their industrial and ornamental purposes.

2. The Necessity for a Value Independent of the Monetary Function Before an Object can Serve as Money

The previous discussion has established that in order for individuals to place a value upon money, they must have some basis for forecasting its future purchasing power. The only way they can do this, is if the money good already has a history of objective exchange value, which the individuals can consult.

This reasoning shows the flaw in the myths about the creation of money being due to a social pact. Rather, Menger’s theory of the origin of money—in which the money commodities were originally used as ordinary commodities—is the only one compatible with a subjectivist explanation.

3. The Significance of Pre-Existing Prices in the Determination of Market Exchange Ratios

The historical continuity in the value of money distinguishes it from all other commodities. It is true that there appears to be “inertia” with respect to exchange ratios between goods; if 2 apples trade for 1 orange on Tuesday, it is unlikely that 20 apples will trade for 1 orange on Wednesday. But it is not true that Tuesday’s exchange ratio somehow influences Wednesday’s. Rather, the underlying determinants of Tuesday’s price (such as people’s subjective preferences for the two fruits) probably will not change very much by Wednesday.

In contrast, economic theory does need to rely on Tuesday’s purchasing power of money, in order to explain Wednesday’s purchasing power of money. People do not derive their utility from apples or oranges based on their prices, but people do evaluate the usefulness of a quantity of money based on its purchasing power.

4. The Applicability of the Marginal-Utility Theory to Money

The problem with many rival theories of the purchasing power of money—such as a simple quantity theory or “supply and demand” explanation—is that they have to take the value of money as given, and can only explain deviations from this stipulated starting point. For example, it is correct to say, “If a car originally has a price of $1,000, then an increase in the stock of money will, other things equal, lead to a new car price that is higher than $1,000.”

Yet this isn’t really a full explanation; why wasn’t the car’s original price $10, or $100,000? The simple “supply and demand” approach—correct as far as it goes—by itself can’t explain the absolute level of money-prices, i.e., it can’t explain the actual exchange ratio between money and other goods at a particular time.

The subjectivist, marginal-utility theory developed by Menger and his successors can explain the precise, absolute money-prices of the market today, just as it can explain the precise exchange ratios between apples and oranges.

At first it appears that money is a peculiar case that cannot be handled this way, because people’s marginal utility of money is itself derived from its objective purchasing power. But once we introduce the time element, we are not arguing in a circle. We are explaining today’s purchasing power of money by reference to yesterday’s purchasing power, and so on. We can logically follow the chain all the way back in time, until the point at which the money commodity was valued solely for its nonmonetary uses, i.e., before it became a medium of exchange.

5. “Monetary” and “Nonmonetary” Influences Affecting the Objective Exchange Value of Money

The preceding sections have established the origin of the value of money. (Namely, subjective marginal utility analysis—coupled with Menger’s explanation of the origin of money—can explain today’s absolute level of the purchasing power of money.) It is now acceptable to focus on the laws or principles governing changes in the value of money. Economists usually start at this step, even though logically they should have explained the original value of money first.

The exchange ratio between two goods can be affected by changes in the valuation for just one of the goods. For example, on Tuesday Jim may choose to drink soda over cough medicine. But on Wednesday he may reverse his preferences, and choose the medicine over the soda. This obviously needn’t be due to Jim’s sudden distaste for soda.

In the same way, the exchange ratio between money and all other goods—in other words, the purchasing power of money—may be affected by changes in people’s valuations of the money side or the (other) commodities side of the ratio.

II. FLUCTUATIONS IN THE OBJECTIVE EXCHANGE VALUE OF MONEY EVOKED BY CHANGES IN THE RATIO BETWEEN THE SUPPLY OF MONEY AND THE DEMAND FOR IT

6. The Quantity Theory

In its crudest form, the quantity theory of money is obviously wrong: It is simply not true that, say, a doubling in the quantity of money will lead to an exact doubling of all prices (quoted in money).

The germ of truth in the historical expositions of the quantity theory is that a connection exists between variations in the value of money on the one hand, and variations in the relations between the demand for money and the supply of it on the other. Throughout history, writers have noted the patterns, but the task for the modern economist is to express these truisms with the tools of modern subjective value theory.

7. The Stock of Money and the Demand for Money

Modern value theory must explain the demand to hold money by starting with the subjective preferences of the individual. The community’s demand to hold money is simply the summation of the individual demands. No individual can make use of the popular “macro” approaches, which employ formulas involving “total volume of transactions” and “velocity of circulation.” Economists therefore should not use such concepts when explaining the purchasing power of money.

In certain cases it is useful to distinguish between the individual’s demand to hold money in the broader sense versus money in the narrower sense. The former is the individual’s demand to hold both money and money substitutes (i.e., perfectly secure and immediate claims on money). The latter is the individual’s demand to hold money proper.

Money certificates are money substitutes that are fully “covered” by money proper, while fiduciary media are money substitutes that are issued above the redemption fund. For example, if a particular commercial bank accepts 1,000 ounces of gold in deposits which it keeps in the vault, but issues 1,100 paper banknotes entitling the bearer to an ounce of gold upon presentation, then 1,000 of the notes are money certificates, while 100 are fiduciary media. (In commercial practice the notes are indistinguishable, and so we can say that about 91 percent of a given note is “covered” while the remainder is “unbacked.”)

8. The Consequences of an Increase in the Quantity of Money While the Demand for Money Remains Unchanged or Does Not Increase to the Same Extent

A crude, mechanical version of the quantity theory of money holds that a doubling of the stock of money will lead to a uniform doubling of the money prices of all other goods and services. The logic behind such a view rests on the true observation that any given quantity of money can perform all the services of money for the community, with the appropriate “price level.” For example, we can imagine two economies side-by-side, which are equal in all ways except that the second community has twice the amount of money as the first. It is clear that in the second community, the prices of all goods and services have to be exactly double their values in the first community, in order to render these economies equal in all “real” respects.

Yet from this thought experiment, we cannot conclude that if we started with the first community, and then magically doubled everyone’s holding of money, that we would end up with the second community. For one thing, different individuals would respond differently to the increase in their holdings of money. Everyone would of course revise downward his or her marginal utility for a unit of money—because the stock in possession increased—but these downward movements would not be equal for all people. Because the marginal unit of money would be less valuable than before the magical increase, people would now go out and buy more goods, tending to push up prices. But different people would increase their purchases in different ways, and (in any realistic scenario) would push up the prices of some goods more than others.

Another complication is that in the real world, new influxes of money do not magically augment the cash balances of everyone in the community proportionally. Instead, new money enters the community through increased holdings of a small group of people (such as the owners of gold mines, or the customers who borrow money from a bank issuing fiduciary media). Thus the new money ripples out into the economy, as the first recipients spend the new money, then the second recipients spend it, and so on.

Nobody would ever be so foolish as to claim that, say, a doubling of the quantity of sugar would lead to an exact halving of the exchange ratio of sugar against all other goods and services. Yet that is precisely what the crude Quantity Theorists assert when it comes to money.

9. Criticism of Some Arguments Against the Quantity Theory

Although in its crude form, the quantity theory is erroneous, even so we can defend it from some invalid objections. For example, some writers object that the quantity theory only holds ceteris paribus (i.e., when “other things are held equal”). Yet this is hardly a good objection against the quantity theory, since a critic could say the same thing about any law or principle in economic science.

Another objection people have raised against the quantity theory is that its predictions are in actual practice nullified by the behavior of “hoards.” For example, the critic of the quantity theory might say that a large influx of new money won’t have a tendency to push up prices, because some people in the community will simply expand their holdings of cash. On the other hand, say these critics, if the demand to hold money (for reasons of commerce) should suddenly increase, this won’t lead to a fall in prices (as the quantity theory would predict), because the hoards will release some of their cash into the community to satisfy the new demand.

The fundamental problem with this view is that economically, there is no distinction between the normal demand to hold cash versus “hoarding.” At any moment in time, every unit of money in the community is in someone’s cash balance; there is no such thing as money “in circulation” that could be contrasted with money “sitting idle.”

The money held by a hoarder performs the same economic function as the money held by a normal businessperson; they are both holding the money because they expect to achieve greater satisfactions from what it can buy in the future, than from what it could buy in the present. Because of uncertainty, people do not necessarily “earmark” every unit of money for a particular future purchase. Nonetheless, when we analyze why people hold money at all, we realize that there is no qualitative difference between the hoarder and the nonhoarder. All hoarding really means, is that someone carries cash balances larger than his peers’.

10. Further Applications of the Quantity Theory

Generally speaking, the demand for money increases over time, due to population increases and the intensification of the division of labor (and hence the need for exchange transactions). For this reason, it was only a theoretical curiosity for economists to try to explain what would happen if the demand for money fell, while the stock of money remained the same.

If we were to mechanically apply the quantity theory to such a situation, we would conclude that prices would rise (i.e., the purchasing power of money would fall) uniformly, in direct proportion to the drop in demand for money. However, a more satisfactory explanation needs to take into account the subjective valuations of individuals. Rather than focusing merely on crude aggregates, it is better to analyze the scenario by saying that when the demand for money falls (while the stock of it remains constant), individuals discover that they are holding larger cash balances than they desire. To improve their position, they seek to exchange some of their excess cash holdings for other goods or services. In doing so, they push up the prices of these items.

Eventually, the fall in money’s purchasing power reduces the “real” size of an individual’s cash balance until he is happy with it. If everyone in the community decides he or she is holding “too much money,” the only way to restore equilibrium is for prices to rise. If one person reduces his cash balance by spending, the seller necessarily increases his cash balance by the same amount. The given stock of money is rearranged among the people in the community; per capita cash balances have to remain the same. Even so, the rise in prices can satisfy everyone’s desire to hold smaller cash balances, because cash is held for the purpose of acquiring other goods and services. People evaluate the size of their cash holdings in terms of its purchasing power, not really by how many units of money they possess.

Although historically the demand for money itself generally grows—except perhaps for financial crises—there are cases where the demand for particular kinds of money may fall dramatically. A notable example is the demonetization of silver. As this precious metal ceased being used as a medium of exchange, and became valued solely for its industrial and ornamental applications, its exchange value fell.

III. A SPECIAL CAUSE OF VARIATIONS IN THE OBJECTIVE EXCHANGE VALUE OF MONEY ARISING FROM THE PECULIARITIES OF INDIRECT EXCHANGE

11. “Dearness of Living”

Thus far in the chapter the analysis of the objective exchange value of money has only relied on determinants that could have just as well been applied to any commodity, not just the commonly accepted medium of exchange (i.e., the money commodity). In contrast, section III examines possible changes in the objective exchange value of money that can only apply because it is a medium of exchange. The context of the discussion is the layperson’s complaint of the “dearness of living,” meaning that every generation prices seem to be higher than before.

12. Wagner’s Theory: The Influence of the Permanent Predominance of the Supply Side over the Demand Side on the Determination of Prices

Wagner explains the general rise in prices—or what is the same thing, the general fall in the purchasing power of a unit of money—by the alleged superior power of the “supply side” of the economy. The sellers of goods and services stand more to gain from price hikes than their customers stand to lose, because the price of beef (say) affects the livelihood of the butcher far more than it affects the fortunes of the average household. Wagner’s theory is flawed, however, because it cannot easily incorporate the fact that retail prices must also respond to changes in wholesale prices.

13. Wieser’s Theory: The Influence on the Value of Money Exerted by a Change in the Relations Between Natural Economy and Money Economy

Wieser attempts to explain the persistent rise in prices over time by the gradual transformation of a “Natural Economy” into a “Money Economy.” As more and more people and regions are brought into the practice of monetary exchange, Wieser argues that certain things that were previously handled through home production must now be included in the final price of goods intended for market. Wieser offers a specific example of the prices of milk and eggs rising in a rural village, once the villagers become involved with frequent trade with the much larger town. However, Wieser ignores the obvious flip-side of the development: the prices of milk and eggs will be lower in the town because of the new source of supply. The integration of the rural village into the monetary nexus gives no reason for a general rise in prices, it merely explains why the gap in prices (between the town and village) should be whittled away.

14. The Mechanism of the Market as a Force Affecting the Objective Exchange Value of Money

In direct exchange, if a potential buyer believes that the asking price of the seller is too high, the exchange will not occur. However, with the use of money, there is another possible outcome, that seems to happen in the real world. The buyer may go ahead and pay a price (in money) that he originally deemed “too high,” but will compensate by increasing the asking price for the goods that he has to sell. Thus wage earners might acquiesce in higher food prices, yet demand pay increases from their employers. The employers, in turn, might agree, knowing that they will raise prices themselves.

None of this discussion renders the basic theory of price determination invalid. It merely underscores that with the special case of money, peculiar situations can affect its valuation that simply cannot occur in the case of direct exchange.

IV. EXCURSUSES

15. The Influence of the Size of the Monetary Unit and Its Subdivisions on the Objective Exchange Value of Money

It is often asserted that the size of the monetary unit can affect its purchasing power, i.e., the general height of prices. In regard to wholesale prices, this is clearly absurd: merchants would adjust their large-scale transactions to achieve their desires, regardless of the unit.

However, there is some truth to the assertion when it comes to retail trade. For practical reasons, everyday purchases that have very low prices compared to most other goods (such as letter postage or pieces of fruit) must correspond somewhat to the lowest available denomination of the money. The use of token coinage (which can represent fractions of the standard monetary unit) and money substitutes, as well as the practice of selling multiple units of goods (e.g., a dozen eggs) as a package, can provide a wide range of flexibility, but even so it must be admitted that the size of the monetary unit does have an influence on prices quoted at the retail level.

16. A Methodological Comment

In a review of the first edition of the book, Professor Walter Lotz defended Laughlin from the critique leveled by Mises (on pages 125–28 in the present edition of the book). To review, Laughlin had tried to explain the value of paper gulden (which for a time were not redeemable in precious metal) by the prospect of their eventual redemption. Mises examined the discount investors placed on bonds issued by the same government and concluded that there must be some other factor at work, to explain the premium investors placed on the paper gulden. The answer, of course, was that the paper gulden were used as money, whereas the bonds were not. Therefore the paper gulden were valued on account of their use as media of exchange.

Lotz defends Laughlin by referring to statements from influential figures that they truly did speculate on the eventual redemption of the paper gulden. Mises points out that this entirely misses the point of his critique: Even if it is admitted that the paper gulden would eventually be redeemable for gold, that fact wouldn’t explain why the notes traded at a premium to bonds issued by the same government. More generally, Lotz approaches economic problems not through theoretical reasoning, but by appeal to historical circumstances, a procedure that Mises rejects on methodological grounds.

Important Contributions

• On page 108, Mises alludes to Menger and Böhm-Bawerk’s explanations of how prices are determined in direct exchanges (i.e., what most people call “barter”). For example, suppose people in a community own horses, and others own cows. Each person will rank various units of each animal on his own subjective scale of values. Bill might consider his first horse as the most important animal, then his first cow, and then his second horse. John, in contrast, might consider his first and then second cows to occupy the highest- and second-highest ranks in his scale of values, while his first horse comes in at the third slot. (Note that everyone exhibits diminishing marginal utility in each animal.) People will trade horses for cows so long as there are mutually beneficial trades; perhaps Bill will trade his 17th and 18th cows for John’s 6th horse, because such a trade makes both men better off in their own subjective views. (In this case, the “price” of one horse is two cows.) To understand the description Mises gives to the range of possible market prices under bilateral competition, the reader should consult the numerical example in Murray Rothbard, Man, Economy, and State (scholar’s edition, 2nd edition; Auburn, Ala.: Mises Institute, 2009, pp. 106-26).

• The first sections of this chapter lay out Mises’s famous regression theorem, which successfully applies subjective value theory to the case of money. Earlier economists had been unable to accomplish this feat, because they thought the approach would lead to a circular argument in the case of money. (How can we explain the objective purchasing power of money by reference to subjective valuations, when those subjective valuations in turn are completely dependent on money’s objective purchasing power? It seemed to Mises’s predecessors that this approach said, “Money is valuable because money is valuable.”) Mises broke out of the circularity by introducing the time element: People are willing to sell other goods and services for money today because they expect that same money to command purchasing power tomorrow. (This explains money’s purchasing power today.) But people’s expectations about the future purchasing power of money are formed by their observations of the recent past, i.e., their observations of money’s purchasing power yesterday. We can push the explanation all the way back until the point at which (commodity) money had an objective exchange value due entirely to its use in nonmonetary applications.

• On page 160 Mises gives a simple illustration (involving a pear, lemonade, etc.) of how an individual’s scale of values can be transformed with the possibility of market exchange.

New Terminology

Quantity theory of money: An old doctrine explaining changes in the purchasing power of money by reference to the quantity of money and the demand to hold it. (There are many versions of the quantity theory, with the more mechanical ones—which posit that a doubling of the money stock will lead to a doubling of all prices—being obviously wrong.)

Money certificates: Money substitutes that are fully backed by money (in the narrower sense).

Fiduciary media: Money substitutes issued over and above the money (in the narrower sense) held in the redemption fund. Fiduciary media are “unbacked.”

Hoards (noun): People who accumulate large cash balances in certain circumstances, allegedly counteracting the predictions of a naïve quantity theory of money.

Regression Theorem: Mises’s argument that the current purchasing power of money is influenced by people’s memory of yesterday’s purchasing power. The causality is traced back in time, until the point at which the money good was valued as a regular commodity in direct exchange.

Study Questions

1. Explain: “The subjective value of money must be measured by the marginal utility of the goods for which the money can be exchanged.” (p. 109)

2. If all types of money must have originally had a nonmonetary source of valuation, how can Mises explain fiat money? (pp. 110–11)

3. If the “past value of money is taken over by the present,” does that mean current conditions and expectations have no influence on the value of money today? (p. 111)

4. Explain: “If all the exchange ratios of the past were erased from human memory, the process of market-price-determination might certainly become more difficult ... but it would not become impossible.” (p. 113)

5. Explain: “[A] mechanical theory of price-determination was arrived at—a doctrine of Supply and Demand.... It is correct or incorrect, according to the content given to the words Supply and Demand.” (pp. 128-29)

CHAPTER 9

THE PROBLEM OF THE EXISTENCE OF LOCAL DIFFERENCES IN THE OBJECTIVE EXCHANGE VALUE OF MONEY

Chapter Outline

1. Interlocal Price Relations

Money can perform its services from virtually any location. Gold stored in the cellars of the Bank of England can be used as a common medium of exchange anywhere in the world, through the use of banknotes, checks, and clearing systems. In contrast, physical location is a crucial feature of other economic goods. “Coffee in Brazil” is not the same good as “coffee in England,” from the perspective of English consumers.

If we completely disregard the possible (but small) influence of the position of money on its valuation, then we can derive the law that every economic good that is ready for consumption, has a subjective use-value qua consumption good at the place where it is, and qua production good at those places to which it may be transported for consumption. Therefore, the money-price of any commodity in any place must be the same as the money-price at any other place, once we adjust for the money-cost of transportation, unless there are institutional limits restricting exchange. (In the real world, there are possible costs of the transport of money, the need to re-coin it, and so on, that would affect the foreign-exchange rate such as the cable rate. These complications do not arise if we assume the money itself stays put.)

2. Alleged Local Differences in the Purchasing Power of Money

Despite the arguments put forward in the previous section, many people still cling to the belief that one’s money “goes further” in some regions compared to others. However, this erroneous view neglects the fact that the same physical item is a different good, economically speaking, depending on its location. A cocktail in a bar in Manhattan is a different good from the “same drink” in a bar in Boise, so their different money-prices cannot lead us to conclude that the “value of money” is higher in Boise than in Manhattan. On the contrary, the purchasing power of money will tend to be equalized in all regions where it is used, and any apparent discrepancies are due to differences on the commodity side.

3. Alleged Local Differences in the Cost of Living

Closely related to the fallacy that the purchasing power of money can vary from region to region, is the claim that the “cost of living” is higher in one area versus another. Here too we need to consider the subjective valuations of individuals, rather than the physical attributes of goods and services. An apartment carries a higher rental price in a resort town near a popular beach, versus a rural area with no special attractions, precisely because people value the proximity to the beach, the local night life, etc. It is simply not true that the same lifestyle can be obtained more cheaply in the rural town than in the resort town. If the “cost of living” really were higher in one location, people would move out of the area until its prices had fallen enough to eliminate the discrepancy.

Technical Notes

• Mises says on page 171 that the money-price of a commodity must be the same in all places, due account being made for the money-cost of transport, and disregarding “the time taken in transit.” This caveat is necessary because the time dimension affects the subjective valuation of goods. For an extreme example, if it takes one year to ship a new computer to a colony on Mars, the manufacturer would insist on a higher retail price (obtainable in one year) than the current spot price on Earth, even after adding in explicit shipping expenses. This is because the computer manufacturer could receive revenues from Earth-based customers immediately, which is more valuable than having to wait a year to receive the same amount of money from Martian consumers.

• Mises concedes on pages 176–77 that there is a limited sense in which a region’s higher “cost of living” is both valid theoretically and important in practice. Namely, for those workers who move to a region and do not subjectively value its amenities, the high money-prices for rent, parking, food, and so on must be compensated by an appropriate increase in their money-wages or salaries. For example, a hospital located in a resort beach town may need to offer a higher salary to attract (say) a qualified brain surgeon, if there happen to be no brain surgeons eager to live near the beach and who are therefore willing to accept the “normal” salary in the face of above-average prices for housing in the resort town.

New Terminology

Clearing systems: Arrangements that cancel out or “clear” reciprocal financial claims, so that only net claims need be settled through the actual transfer of money.

Foreign-exchange rate: The exchange ratio between a domestic and foreign currency.

Cable rate: Slang used by foreign-exchange traders to denote the exchange rate between the U.S. dollar and British pound sterling.

Study Questions

1. What complementary good is necessary to turn the production good “coffee in Brazil” into the consumption good “coffee in Europe”? (p. 171)

2. Explain: “To what absurd conclusions should we not come if we regarded goods lying in bond in a customs or excise warehouse and goods of the same technological species on which the duty or tax had already been paid as belonging to the same species of goods in the economic sense?” (pp.172–73)

3. Explain: “It is hardly possible to agree with these arguments [put forward by Wieser], which smack a little too much of the cost-of-production theory of value and are certainly not to be reconciled with the principles of the subjective theory.” (p. 174)

4. Can government restrictions on the movement of commodities and workers explain differences in retail prices? (p. 175)

5. What does Mises intend with his example of a hotel on the peaks and valleys of the Alps? (p. 176)

CHAPTER 10

THE EXCHANGE RATIO BETWEEN MONEY OF DIFFERENT KINDS

Chapter Outline

1. The Two-fold Possibility of the Coexistence of Different Kinds of Money

If the inhabitants of one country exclusively use a certain money (such as gold) for their domestic purchases, while a second country uses a different money (such as silver) for their domestic purchases, and the two countries are closely tied economically through trade, then it is incorrect to say that gold is the only common medium of exchange in the first country, and silver the only one in the second country. On the contrary, because merchants from one country can only trade goods with the other country’s merchants through the use of the other domestic money, it is clear that both monies are media of exchange among people in both countries.

2. The Static or Natural Exchange Ratio between Different Kinds of Money

Whether two different monies operate side by side in the same country under a parallel standard, or whether one money is used exclusively for domestic trade in one country while the other money is likewise used in a second country, the same principle operates to regulate the exchange ratio (or what nowadays would be called the exchange rate) between the two monies. The theory of purchasing power parity says that the exchange ratio between two monies is determined by the respective exchange ratios of each money and other goods and services.

For example, if the price of a barrel of crude oil, measured in American dollars, is $100, while the price of a barrel of crude oil quoted in Japan is ¥8,000, then the exchange rate between the two currencies must be $1 for ¥80. If the exchange rate were different, there would be arbitrage opportunities for buying oil with one currency and selling it for the other. For example, suppose the exchange rate were $1 for ¥90 (rather than the equilibrium price of $1 for ¥80). In that case, a Japanese investor could take ¥8,000 and buy a barrel of crude oil. Then he could sell the oil to an American for $100. Finally he could go to the foreign exchange market and trade his $100 for ¥9,000. Thus the Japanese investor would have taken advantage of the existing price ratios to effortlessly turn his original ¥8,000 into ¥9,000. (His efforts to profit from this arbitrage opportunity would eventually eliminate it, since he would be acting to push up the yen-price of oil, push down the dollar-price of oil, and push down the yen-price of a dollar bill.)

If we first imagine a unified region using a single money, with no institutional obstacles to trade among its inhabitants, then it is clear that all commodities, including money, will be distributed among the population in accordance with marginal utility. If some people end up holding an above-average amount of (say) blankets, it is because their demand for this good is higher than average. By the same token, if some people acquire larger cash balances than others, it is because their demand to hold money is larger. There is no question of a dangerous “trade deficit” that could cause a “drain of money” from some people to others.

The same principles hold for nations. The aggregate figures of imports and exports are simply the summation of the trading activities between the individuals in each country. An accumulation of money in one country versus another can only be sustainable if the demand to hold money increases in the first country relative to the second. A trade deficit not accompanied by such a shift in the demand for money will be quickly self-reversing, as the prices in the country accumulating money will rise and the prices in the country losing money will fall.

Technical Notes

• Mises argues on pages 179–80 that even in cases where the consumers in two different countries use different monies in everyday transactions, nonetheless if the regions are closely bound by international trade, then “from the economic point of view both [monies] must be regarded as money for each area.” Updating to our times, what Mises has in mind is that the American businessman who wants to import cars from Japan, must at some point in the transaction exchange dollars for yen or vice versa. In that respect, the yen is a medium of exchange that is accepted in trade by the American businessman, in addition to all of the Japanese. However, it is still not obvious that this should mean that the yen is money even in the United States, because the definition of money is “a commonly accepted medium of exchange.” To be sure, the yen is commonly accepted among Americans doing business with Japan, but it is not commonly accepted in the United States per se. However, the important point is not whether we say that the yen is money in the United States, but rather that we understand Mises’s point that international trade requires businesspeople to accept the monies used in foreign lands.

• On page 182 Mises writes, “[Classical political economy] demonstrated that international movements of money are not consequences of the state of trade; that they constitute not the effect, but the cause, of a favourable or unfavourable trade-balance.” He has in mind the following contrast in analysis: Suppose the English spend one million gold ounces importing wine from France, while the French spend only 900,000 gold ounces importing sweaters from England. An English mercantilist would probably bemoan the fact that his countrymen were importing more than they were exporting, and that this “unfavorable trade balance” was unwittingly losing 100,000 ounces of gold to the dastardly French. However, the classical economists such as Hume, Smith, and Ricardo could point out that the French (in the aggregate) apparently desired to increase their holdings of gold, while the English apparently desired to reduce their holdings. In that case, the only way to satisfy these shifts in money demand would be for the French to ship the English 100,000 gold ounces worth of goods, for which the English would not ship any (nonmonetary) goods in return.

New Terminology

Parallel Standard: A monetary system in which two different goods both serve as monies. (For example, gold and silver might both serve as money under a Parallel Standard.)

Exchange rate: The ratio at which one currency trades against another in the foreign-exchange market.

Purchasing Power Parity: The theory stating that the exchange ratio between two monies is determined by the respective exchange ratios of each money and other goods and services.

Study Questions

1. When England operated on a gold standard, while Germany operated on a silver standard, does Mises think that silver should have been considered as money even in England? (pp. 179–80)

2. How does the doctrine of purchasing power parity explain the exchange ratio between gold and silver in the example of cloth and wheat? (p. 181)

3. Explain: “If no other relations than those of barter exist between the inhabitants of two areas, then balances in favor of one party or the other cannot arise.” (p. 182)

4. What was the train of thought that Mises says “dealt the Mercantilist Theory its death-blow”? (p. 182)

5. Explain: “[I]nternational movements of money, so far as they are not of a transient nature and consequently soon rendered ineffective by movements in the contrary direction, are always called forth by variations in the demand for money.” (p. 185)

CHAPTER 11

THE PROBLEM OF MEASURING THE OBJECTIVE EXCHANGE VALUE OF MONEY AND VARIATIONS IN IT

Chapter Outline

1. The History of the Problem

Some of the greatest minds in economics have devoted themselves to the development of indexes that would provide an objective measurement of the change in the purchasing power of money. However, such statistical techniques have never lived up to their promises, as even their own creators often admitted.

2. The Nature of the Problem

Just as we can express the price of any commodity by reference to how many units of money it takes to purchase one unit of the commodity, the opposite approach can yield the “price” of a unit of money in terms of the commodity. However, this technique yields as many “prices” of money as there are commodities. What economists desire is a method for combining all of this information into a single measurement of “the” purchasing power of money. Then, a second task is to ask of any particular commodity’s price change, how much can be attributed to forces arising from the side of money (in contrast to a change in the relative scarcity of the good which would also make its price rise).

3. Methods of Calculating Index Numbers

Nearly all attempts at measuring the objective exchange value of money have relied on the assumption that if a large enough collection of goods are included in the “basket” to be measured, then changes in the relative scarcities of the goods themselves will largely cancel out. Thus the average or net change in the prices of all the goods (as quoted in money) will demonstrate whether the purchasing power of money has risen or fallen. Unfortunately, in practice it is only possible to carry out such calculations by making ad hoc assumptions about the relative importance of various factors. In the end, the economic theorist does not gain much from studying the various statistics of price movements that he could not obtain from deductive reasoning about the nature of exchange and money.

4. Wieser’s Refinement of the Methods of Calculating Index Numbers

Wieser devised the most careful and satisfactory approach to measuring the objective exchange value of money, with a technique involving the contrast between nominal and real income. However, even Wieser’s approach had several fatal flaws. For example, over large stretches of time, the types of income people could earn become incommensurable, robbing Wieser’s technique of its desired precision.

5. The Practical Utility of Index Numbers

The criticisms leveled against various techniques for calculating index numbers refer to the problems of economic theory. In practical use for government policy, these techniques provide a rough guide to changes in the purchasing power of money.

Technical Notes

• On page 189 Mises writes, “Invariability in respect of the property to be measured ... is a sine qua non of all measurement.” For example, if a person is using a meter stick to measure length, then he must be assuming that the meter stick’s length is itself invariable. Yet when economists try to measure changes in the objective exchange value of money (i.e., in the purchasing power of money), they run into the problem that there are no such invariable benchmarks. If the exchange ratio between money and any other commodity changes, it is not clear whether the change originates from the side of money or the commodity.

• Some numerical examples may clarify Mises’s observations on index numbers (pp. 188–90). If the price of oil increases from $90 to $100, while the price of a television falls from $100 to $90, it is possible that these changes have nothing to do with the purchasing power of money, and merely reflect a shift in demand away from televisions and into oil. On the other hand, if all prices (quoted in money) in the community increased exactly by 10 percent in one year, then it would be clear that the purchasing power of money had fallen and was the driver of the price increases. But in the real world, things are never so clear-cut. Typically some prices rise while others fall, and the price movements are not in the same percentages across commodities. There is no nonarbitrary way to determine how much of a given good’s change in price is due to changes in its relative value (with respect to other commodities) versus a change in the purchasing power of money.

Study Questions

1. Explain: “Only by letting fall morsels of statistics is it possible for the economic theorist to maintain his prestige in the face of questions of this sort.” (p. 188)

2. Explain: “He who cares to go to the trouble of demonstrating the uselessness of index numbers for monetary theory and the concrete tasks of monetary policy will be able to select a good proportion of his weapons from the writings of the very men who invented them.” (p. 188)

3. Why are index numbers not very important for the “extension of the theory of the nature and value of money”? (pp. 189–90)

4. Even if we grant for the sake of argument that a loaf of bread possesses a constant utility in the objective sense of food value, why is this approach unhelpful when it comes to the use of index numbers in monetary theory? (p. 193)

5. Does Mises think that index numbers are completely useless? (p. 194 )

CHAPTER 12

THE SOCIAL CONSEQUENCES OF VARIATIONS IN THE OBJECTIVE EXCHANGE VALUE OF MONEY

Chapter Outline

1. The Exchange of Present Goods for Future Goods

People often exchange present goods for future goods, for example by lending money today (a present good) in exchange for a promise of repayment of future principal plus interest, or by agreeing today to exchange goods against money in the future. Although businesspeople take great caution regarding changes in the prices of particular commodities, they typically do not take into account the possible fall in the objective value of money itself. To the extent that people do protect themselves in contracts from possible changes in the value of a currency, it is only a paper currency the value of which might fall relative to a currency backed by gold. Hardly anyone (at the time of Mises’s writing) realizes that the exchange value of gold itself could change during the length of a contract.

If changes in the purchasing power of money could be anticipated, then their impact could be offset by altering the terms of credit transactions. If both lenders and borrowers expect a weaker currency in the future (i.e., rising prices of most goods and services quoted in the currency), then lenders will insist on charging a higher interest rate and borrowers will be willing to pay it, because loans will be repaid in weaker currency.

2. Economic Calculation and Accountancy

Accountancy is imperfect in several respects. For example, it relies on subjective estimates of uncertain factors, such as the value of inventory (which is dependent on future demand) and the likelihood of default by the issuers of bonds. Yet another major flaw is that accountants use monetary figures as if they were akin to measures of length and weight. But since the purchasing power of money itself can change, accountancy is analogous to an architect designing blueprints in a world where rulers have variable lengths. Monetary depreciation can cause businesspeople to overestimate their profits and unwittingly engage in capital consumption.

3. Social Consequences of Variations in the Value of Money When Only One Kind of Money is Employed

If the quantity of a commodity such as coal is suddenly and unexpectedly increased, it will cause its price to drop. This will hurt those people who were holding large amounts of coal (such as the owners of coal mines and wholesalers) at the moment of the price drop, and it will help the consumers of coal (such as the owners of railroads and power plants). However, the gains will exceed the losses for the community as a whole, because the greater quantity of coal can yield more goods and services.

Things are different with the money commodity. Insofar as its monetary services are concerned, additional quantities confer no net benefits on the community. When new quantities of money enter the economy (from a new gold mine, for example), it spreads unevenly throughout the system. The chief beneficiaries are the original owners, then those upon whom they first spend the new money, and so on. The losers are those whose incomes (measured in money) do not rise even as they see prices going up in the things that they buy. Wealth is redistributed from some groups to others, but the community as a whole is not made richer by the influx of new money (except possibly indirectly if the beneficiaries of the inflation make more productive use of their redistributed wealth than the former owners).

4. The Consequences of Variations in the Exchange Ratio Between Two Kinds of Money

The uneven increase in prices due to an influx of new money (either from gold discoveries or from the issuance of more paper money and fiduciary media) can lead to redistribution even among groups using different currencies. For a modern example, suppose initially that one U.S. dollar trades for one euro, and that the price of a bushel of wheat initially is $5 and also €5. Then the Federal Reserve promises to sharply increase the quantity of dollars over the next few months, so that speculators on the foreign exchange market push down the value of the dollar so that it now trades for only one-half of a euro.

In this situation, the price of U.S. wheat would be €2.50 from the perspective of European millers, while wheat purchased from European farmers would be the original €5. The demand for American exported wheat would increase, while the American demand for European wheat would collapse. The prices of wheat in the two currencies would quickly adjust until balance had been restored, with U.S. wheat selling for (say) $8 and European wheat selling for €4. But even after this quick adjustment, there would be a lasting advantage given to American wheat exporters, because they could sell wheat for $8 instead of $5, even though their expenses (on labor, tractors, etc.) had not yet risen proportionally. European millers and consumers of bread would also benefit, because from their perspective the price of wheat would have fallen from €5 to €4 per bushel, even while their money incomes stayed the same. Two large groups of losers would be U.S. consumers and European wheat farmers. Only after all U.S. domestic prices had adjusted to the new quantity of dollars would the redistribution cease.

Technical Notes

• On pages 195–96, Mises writes, “When anybody buys (or sells) corn, cotton, or sugar futures . . . he is well aware of the risks that are involved in the transaction. He will carefully weigh the chances of future variations in prices, and often take steps, by means of insurance or hedging transactions ... to reduce the aleatory factor in his dealings.” His purpose in this passage is to contrast the businessman’s wariness concerning individual price changes over time, with the businessman’s (at that time) ignorance of changes in the purchasing power of money over time. However, Mises’s description is difficult to explain to a novice, because normally economists would describe the use of futures contracts as themselves “insurance” or “hedging” operations. For example, if a farmer knows he will have a large harvest of wheat to sell in six months, and his ability to make his mortgage payments and pay other expenses depends critically on the price of wheat, the farmer may want to “lock in” the price by selling futures contracts in wheat. On the other side of the transaction, a large operation that makes bread may itself want to lock in the price of one of its major inputs, so that a sudden price spike won’t cripple operations. The bread producer would thus gladly buy the futures contracts issued by the farmer. This is a mutually beneficial arrangement in which no money changes hands in the present, but the two parties today lock in the price at which they will exchange wheat for money in the future. (Technically we have described a forward contract, which is economically very similar to a futures contract.) The use of futures contracts and other derivatives can allow market participants to hedge away their exposure to particular price swings, where they forfeit the potential benefits of a favorable move while avoiding the downside of an unfavorable move. This is the sense in which such contracts can serve as insurance.

• Mises warns (pp. 204–06) that a depreciating currency can lead to capital consumption. For a simple example, suppose a man spends $100,000 on a machine that lasts for ten years. If prices are stable (and disregarding interest), the man needs to earn at least $10,000 each year in sales revenue over and above labor and other expenses, in order to account for the depreciation on his machine. If inflation causes him to earn far more than he originally anticipated over the years from the sale of his goods, after setting aside $10,000 each year the man might spend the remaining “profit” on fancy dinners and vacation cruises. However, after ten years (with $100,000 in hand, disregarding interest) the man may discover that because of the fall in the purchasing power of money, a new machine has a price of $200,000. Thus the man unwittingly consumed half of his capital over the decade: he started with one new machine and ended up with the means to buy only half of a new machine. The man realizes that his fancy dinners and cruises were funded not out of profits but by eating away at his business assets.

New Terminology

Capital consumption: A metaphor denoting the reduction in capital because of a failure to reinvest enough out of current output.

Futures contract: A standardized contract, traded on an organized exchange, where two parties agree to exchange a good at a specified price (the futures price) at a specified future date (the delivery date). As conditions change and alter the futures price pertaining to the delivery date, the exchange will credit or debit the accounts of the buyer and seller of the original futures contract on a daily basis to reflect the change. (If the futures price goes up, the buyer gains and the seller loses, etc.) These daily episodes of marking-to-market restore the market value of the futures contract itself to zero. Upon delivery, the seller of the futures contract delivers the good, while the buyer pays the current spot price for that date, not the futures price as originally specified.

Forward contract: Similar to a futures contract, though a forward contract is not standardized. Furthermore, there is no daily marking-to-market. On the delivery date, the buyer pays the forward price as originally specified in the contract. Thus the forward contract can achieve a positive or negative market value, as conditions change and cause the actual spot price (on the delivery date) to move above or below the originally specified forward price.

Hedging transaction: A financial transaction in which an individual attempts to reduce his or her exposure to a market outcome. For example, someone who believes that Stock XYZ will outperform most other stocks might “go long” by purchasing several thousand shares of it. But to hedge himself against a general fall in the market, he might also “go short” an index fund holding all the stocks in the S&P 500. Thus, even if XYZ falls in price, the investor will still make money, so long as Stock XYZ drops by a smaller amount than most other stocks.

Aleatory: Dependent on chance, luck, or an uncertain outcome.

Study Questions

1. Relate the following comment to Mises’s earlier discussion (p. 61) of the hypothetical possibility of fiat money: “Lenders and borrowers are not in the habit of allowing for possible future fluctuations in the objective exchange value of money.” (p. 195)

2. If the purchasing power of money unexpectedly falls, who is hurt—creditors or debtors? (p. 200)

3. What is necessary to eliminate the undesirable consequences of “unlimited inflationary policy”? (p. 203)

^*4. Mises writes, “If the objective exchange value of all the stocks of money in the world could be instantaneously and in equal proportion increased or decreased, [and] if all at once the money-prices of all goods and services could rise or fall uniformly, the relative wealth of individual economic agents would not be affected” (p. 207). Does Mises’s argument assume that everyone holds the same fraction of his or wealth in the form of cash balances, or does it also work if some people hold (say) large amounts of real estate, while others hold mostly cash? (Keep in mind that for this argument Mises has assumed away the problem of contracts for future goods.)

5. Explain: “Europe had exported ships and rails, metal goods and textiles, furniture and machines, for gold which it little needed or did not need at all, for what it had already was enough for all its monetary transactions.” (p. 211)

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^*Questions with an asterisk signify the question is a particularly difficult one.

CHAPTER 13

MONETARY POLICY

Summary

Originally, citizens judged the success of monetary policy by the soundness of the coinage it maintained in circulation. In modern times monetary policy refers to government (or central bank) efforts to alter the purchasing power of money. The chief instrument through which the State carries out monetary policy is its strong influence on the kind of money used by the citizenry.

Inflationism is that monetary policy that seeks to increase the quantity of money. Naïve inflationism believes that money constitutes wealth, and that creating more money will turn poor into rich. A second group of inflationists understands that printing more money will cause prices to rise, but endorses the policy because they want to help debtors or achieve some other goal. A third group of inflationists understands that the policy in general will wreak economic havoc, but they support it too because they believe some essential government programs sometimes must be paid for through an “inflation tax.” Economics can say, without making any value judgments, that inflationism is a very poor policy for achieving its stated objectives.

Restrictionism or deflationism is policy that aims at raising the objective exchange value of money. It is unpopular for various reasons.

Because neither inflationism nor deflationism is capable of achieving its stated objectives, the only sensible monetary policy is one that aims at eliminating all government interference with the purchasing power of money. In practice, this means a rigid adherence to a commodity standard, which in modern times means either the gold or silver standard.

In technical economic theory, the only coherent definition for inflation is an increase in the quantity of money (in the broader sense of the term) that is not offset by a corresponding increase in the demand for money (in the broader sense of the term), with the necessary result being a fall in the purchasing power of money. Deflation is the opposite, namely a reduction in the quantity of money that is not offset by a fall in the demand for it, such that prices tend to fall. The economist who wishes to influence public policy and avert disaster shouldn’t lecture others on their sloppy use of terminology, but instead should expose the errors of inflationism.

Chapter Outline

1. Monetary Policy Defined

Originally, citizens judged the success of monetary policy by the soundness of the coinage it maintained in circulation. If and when governments violated that trust by debasing the coinage, it was for fiscal (i.e., budgetary) ends: the authorities needed more money and so turned to inflation.

In modern times, however, governments use monetary policy to achieve other socio-political aims. Although particular factions may favor one monetary policy versus another because of the specific advantages they expect to derive—for example, the owners of gold mines favoring a return to the gold standard—in general monetary policy nowadays refers to government (or central bank) efforts to alter the purchasing power of money.

2. The Instruments of Monetary Policy

The chief instrument through which the State carries out monetary policy is its strong influence on the kind of money used by the citizenry. As controller of the mint and sole issuer of money substitutes, the modern State has wide discretion in this “choice” by its subjects. If the State decides to remain on a metallic standard (such as gold or silver), then it still must choose which precious metal. More generally, if the State opts for a credit or fiat money, then the State has the further option of altering the quantity of money at will, to achieve its objectives regarding the purchasing power of money.

3. Inflationism

Inflationism is that monetary policy that seeks to increase the quantity of money. Naïve inflationism believes that money constitutes wealth, and that creating more money will turn poor into rich. A second group of inflationists understands that printing more money will cause prices to rise (an elementary fact that the first group fails to see). Yet even so this second group endorses the policy, because they want to help debtors, or achieve some other goal, by raising prices. Finally, a third group of inflationists understands that the policy in general will wreak economic havoc, but they support it too because they believe some government programs (such as defense from foreign invaders) are absolutely essential, and sometimes must be paid for through an “inflation tax.”

This third defense of inflation underscores the anti-democratic nature of the policy. Its proponents candidly admit that the public would never support certain programs (such as major wars) if they were forced to explicitly bear the full financial burden through taxation or government deficits financed by genuine savings. But when the programs are funded (partially) through the printing press, it is not clear to the average voter what is causing prices to rise and his standard of living to fall. He blames unions or currency speculators, not government spending.

Ironically, if the public anticipates a sharp future decline in the purchasing power of money because of an influx of new notes (printed by the government), then prices in the present can rise in expectation. Yet until the new notes physically exist, there may appear a shortage of notes. Thus the public and academics may clamor for more inflation, in order to satisfy the apparent “needs of commerce.” Yet it is inflationism itself that has caused the problem, and further bouts will only exacerbate the situation.

Economic science cannot judge the policy objectives of inflationism; it cannot say whether it is proper to (say) help debtors or exporters at the expense of others. But what economics cansay, without making any value judgments, is that inflationism is a very poor policy for achieving its stated objectives. Each of its alleged goals (helping debtors, helping exporters, etc.) can be achieved much more directly by other interventions besides a general debasement of the monetary unit. In this sense economics can criticize inflationism.

4. Restrictionism or Deflationism

Restrictionism or deflationism is policy that aims at raising the objective exchange value of money. It is unpopular for various reasons. First, governments do not benefit from it because they must sacrifice potential spending in order to (say) retire some of the notes collected through taxation. Second, a nation with an appreciating currency would see a “deteriorating” trade balance in the eyes of the public, which is also unpopular. Finally, the primary beneficiaries of deflationism are creditors, who generally speaking are a small and unpopular group.

The only time deflationism is politically viable occurs after a period of inflationism, either for matters of prestige or to assure international creditors to continue using a certain country’s financial institutions. Yet even here, a policy of deflationism does not simply reverse the harms of the prior inflation, but instead causes many new harms of its own. For example, many of the creditors who will be helped by the current round of deflation were not the same people harmed during the inflation. In general it must be concluded that deflationism is a poor method for achieving the specific aims of its proponents.

5. Invariability of the Objective Exchange Value of Money as the Aim of Monetary Policy

If neither inflationism nor deflationism is capable of achieving its stated objectives, the only sensible monetary policy is one that aims at eliminating all government interference with the purchasing power of money. In practice, this means a rigid adherence to a commodity standard, which in modern times means either the gold or silver standard.

6. The Limits of Monetary Policy

As all government efforts to influence the purchasing power of money must ultimately work through the subjective valuations of individuals, in this realm as in others the government’s power is limited. The authorities cannot anticipate the precise, long-run effects of their efforts to manipulate the currency, and this is one of the strongest arguments against such manipulation in the first place.

7. Excursus: The Concepts Inflation and Deflation

In technical economic theory, the only coherent definition for inflation is an increase in the quantity of money (in the broader sense of the term) that is not offset by a corresponding increase in the demand for money (in the broader sense of the term), with the necessary result being a fall in the purchasing power of money. Deflation is the opposite, namely a reduction in the quantity of money that is not offset by a fall in the demand for it, such that prices tend to fall. However, outside the realm of technical economics, the terms inflation and deflation have certain connotations. The economist who wishes to influence public policy and avert disaster shouldn’t lecture others on their sloppy use of terminology, but instead should expose the errors of inflationism.

Technical Notes

• On page 219 Mises writes, “If a country has a metallic standard, then the only measure of currency policy that it can carry out by itself is to go over to another kind of money.” What Mises has in mind—and this is borne out by the important phrase “by itself”—is that the classical gold standard placed strict limits on each of the participating countries. In the period before the first World War, for example, the United States government pegged the dollar to 23.22 grains of gold (working out to around $20.67 per ounce), while the British government pegged its own currency at the rate of £4.25 to an ounce of gold. Thus the exchange rate between the dollar and British pound was fixed at $4.86 to a pound. If the United States government began printing up excessive amounts of new dollars, this would tend to cause domestic prices (quoted in dollars) to rise faster than they did (quoted in pounds) in Great Britain. Americans would start importing more from (cheaper) British producers, and the resulting trade deficit would allow the British to accumulate more and more dollars. This in turn would put pressure on the foreign exchange rate, which would (under a fiat standard) simply cause the dollar to depreciate against the British pound. But since both currencies were tied to gold at fixed rates, the falling dollar would open up an arbitrage opportunity for speculators to turn their dollars into the U.S. authorities in exchange for gold. Thus, as its gold reserves began to dwindle, the U.S. would have to abandon its inflationary path. Thus a metallic standard keeps sharp limits on the inflationary policies of any single country.

•On page 227 Mises writes, “In all countries where inflation has been rapid, it has been observed that the decrease in the value of the money has occurred faster than the increase in its quantity.” On the following page he explains that the value of money is influenced by both supply and demand. For a modern example, suppose that the Chairman of the Federal Reserve announced that he would cause the quantity of U.S. dollars to rise by a factor of 1,000 in the course of a week. Even ignoring the step-by-step process of inflation, the end result would not simply be a general 1,000–fold rise in prices. Instead, prices (quoted in U.S. dollars) would rise by much more than that, because Americans would no longer want to hold dollars. They would no longer view the dollar as a safe currency, and would seek to replace their dollar holdings with either other currencies or perhaps the precious metals. In order to restore equilibrium, then, prices would have to rise not merely on account of the extra quantity of dollars, but also because of the sharp drop in the subjective desire to hold them.

New Terminology

Monetary policy: Government or central bank efforts to alter the purchasing power of money.

Inflationism: Monetary policy that seeks to increase the quantity of money.

Naïve inflationism: Inflationism supported by the belief that money constitutes wealth.

Inflation tax: The redistribution of wealth from the citizenry to the government (or its designated beneficiaries) through inflation.

Restrictionism/Deflationism: Monetary policy that aims at raising the objective exchange value of money.

Inflation: An increase in the quantity of money (in the broader sense of the term) that is not offset by a corresponding increase in the demand for money (in the broader sense of the term), with the necessary result being a fall in the purchasing power of money. (Note that this is a technical economic definition, not necessarily having the connotations of “inflation” in popular discussions.)

Deflation: A reduction in the quantity of money that is not offset by a fall in the demand for it, such that prices tend to fall. (Note that this is a technical economic definition, not necessarily having the connotations of “deflation” in popular discussions.)

Study Questions

1. What unflattering possibility does Mises suggest regarding Ben Franklin’s support of paper money early in his career? (p. 217)

2. Why does “naïve inflationism” recommend an increase in the quantity of money? (pp. 219–20)

3. Is it possible for someone to support inflationism, even if he understands that it will have grave economic consequences? (pp. 221–22)

4. Explain: “[I]nflation becomes the most important psychological resource of any economic policy whose consequences have to be concealed; and so in this sense it can be called an instrument of unpopular, i.e., of anti-democratic, policy, since by misleading public opinion it makes possible the continued existence of a system of government that would have no hope of the consent of the people if the circumstances were clearly laid before them.” (pp. 223–24)

5. Would Mises have been surprised by the second half of the twentieth century, since he writes, “In the long run, a money which continually fell in value would have no commercial utility. It could not be used as a standard of deferred payments” (p. 227)?

CHAPTER 14

THE MONETARY POLICY OF ÉTATISM

Summary

Étatism as a theory is the doctrine of the omnipotence of the State. As a policy, étatism is the attempt to regulate all social and economic affairs by authoritative commandment and prohibition.

The étatist views money as a creature of the State, and hence (erroneously) believes that a powerful and rich State should have a correspondingly “good” money. But history is full of cases where even the victors in a war saw the collapse of their currency, or where a wealthy country had a very weak currency.

Often the authorities will try to mitigate the consequences of inflationism by imposing price controls. If the controls are applied to a small number of items, then shortages will develop because the producers of these items will see other prices rise but will not be able to charge appropriate prices for the items in question. The authorities must then either abandon their policy or intervene further still, controlling more prices and possibly compelling people to work against their will.

A popular view holds that a country experiencing a debit balance of payments cannot stabilize the value of its money, until the underlying defects are rectified. However, if a country uses purely metallic money, then a debit balance of payments will eventually reverse itself automatically, because the outflow of metal will lead to falling domestic prices. For countries on credit or fiat money, a similar principle holds. A debit balance of payments per se cannot unilaterally cause a nation’s currency to depreciate, because the debit balance itself is caused by inflation. No matter the foreign trade situation, a country can always choose sound money.

If the government wishes to avoid having its currency “attacked” by speculators, it need only abandon inflationist policies.

Chapter Outline

1. The Monetary Theory of Étatism

Étatism as a theory is the doctrine of the omnipotence of the State. As a policy, étatism is the attempt to regulate all social and economic affairs by authoritative commandment and prohibition. Although the outward appearances of private property and entrepreneurship may be left intact, in practice étatism can only be realized as State Socialism. Because sociology and economics detail the limits on what sheer might can achieve in attempting to redesign human society, étatists seek to discredit these fields.

2. National Prestige and the Rate of Exchange

The étatist views money as a creature of the State, and hence (erroneously) believes that a powerful and rich State should have a correspondingly “good” money (i.e., money with a high exchange rate). But history is full of cases where even the victors in a war saw the collapse of their currency, or where a wealthy country had a very weak currency.

3. The Regulation of Prices by Authoritative Decree

Often the authorities will try to mitigate the consequences of inflationism by imposing price controls, in which people are punished by fines or prison sentences for asking (or even paying) prices above the legal ceiling. If the controls are applied to a small number of items, then shortages will develop because the producers of these items will see other prices rise but will not be able to charge appropriate prices for the items in question. This outcome is the opposite of what the authorities intended; they had imposed the price controls to keep the items accessible to the public, not to eradicate them from the store shelves. At this point, the authorities must either abandon their policy or intervene further still, controlling more prices and possibly compelling people to work against their will.

4. The Balance of Payments Theory as a Basis of Currency Policy

A popular view holds that a country experiencing a debit balance of payments cannot stabilize the value of its money, until the underlying defects are rectified. However, the classical economists and later the Currency School demonstrated the flaws in this view. If a country uses purely metallic money, then a debit balance of payments will eventually reverse itself automatically, because the outflow of metal (such as gold) will lead to falling domestic prices. Eventually, residents will prefer to buy from domestic producers rather than foreigners, and foreign purchasers will prefer to buy more cheaply from them as well. Thus the debit balance will turn into a credit balance of payments, and the monetary metal will tend to flow back into the country that originally experienced the drain.

For countries on credit or fiat money, a similar principle holds. A debit balance of payments per se cannot unilaterally cause a nation’s currency to depreciate, because the debit balance itself is caused by inflation. No matter the foreign trade situation, a country can always choose sound money.

5. The Suppression of Speculation

When inflationist policies lead to a depreciation of a country’s money against other currencies, government officials will often denounce foreign speculators for “attacking the currency.” Yet in general, speculators cannot alter the average price of a good (including money), they simply smooth out the ups and downs. The speculator tries to buy low and sell high (or vice versa). By buying undervalued currencies, the speculator pushes up the price toward its long-run level, and by selling overvalued currencies, the speculator pushes them down toward the “correct” level. If the government wishes to avoid having its currency “attacked” by speculators, it need only abandon inflationist policies.

Important Contributions

• On pages 246–48, Mises explains the process by which limited interventions lead to undesirable consequences, even from the point of view of the authorities. These in turn lead to further interventions, in an attempt to counteract the bad consequences. The process continues until the authorities either abandon their program or reach full-blown socialism. Although economists before Mises understood the undesirable effects of price ceilings, this broader dynamic was something that Mises stressed throughout his career. Mises contrasted the virtues of a free market versus outright socialism, precisely because he thought it was a mirage to endorse a “mixed economy” that avoided either extreme. In fact in 1950 he would deliver a speech entitled, “Middle of the Road Policy Leads to Socialism.”

• On pages 249–52, Mises showcases his numerous talents as an economist. He demonstrates a command of pure economic theory, the history of economic thought, and the day-to-day activities in the actual foreign exchange market. It is only because of his mastery of all three areas that he can so confidently explain the errors in rival doctrines, and why the businessman is fooled by correlations that do not represent actual causality when it comes to trade flows and exchange rates.

New Terminology

Étatism (as theory): The doctrine of the omnipotence of the State.

Étatism (as policy): The attempt to regulate all social and economic affairs by authoritative commandment and prohibition.

Mixed economy: An economy possessing aspects of both capitalism and socialism, in which private individuals retain nominal ownership of the means of production, but the government extensively regulates their use of this property, including wages, interest rates, and other prices set on the market.

Debit balance of payments: The situation occurring when the people of a country collectively spend more on foreign goods and assets than vice versa. It is settled by an outflow of money from the country.

Credit balance of payments: The situation occurring when the people of a country collectively spend less on foreign goods and assets than vice versa. It is settled by an inflow of money to the country.

Shortages: A shortfall in the quantity of goods offered for sale, compared to the amount consumers wish to purchase. Shortages are caused when a price ceiling holds the price below the market-clearing level.

Study Questions

1. Why does economic science pose a threat to étatism? (p. 243)

2. After a price ceiling is imposed, what happens once the stocks of goods that were already on the shelves have been sold off? (p. 247)

3. Explain: “If the regulation of prices had been successful, it would have paralyzed the whole economic organism. The only thing that made possible the continued functioning of the social apparatus of production was the incomplete enforcement of the regulations that was due to the paralysis of the efforts of those who ought to have executed them.” (p. 248)

4. Explain: “Price fluctuations are reduced by speculation, not aggravated, as the popular legend has it.” (p. 253)

5. Explain: “The fluctuations of the foreign-exchange rate are not determined solely by bears selling but just as much by bulls buying.” (p. 253)