The Austrian Theory of Money

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from The
Foundations of Modern Austrian Economics
, Edwin Dolan,
ed. (Kansas City: Sheed Andrews and McMeel, 1976), pp. 160–84.;
Logic of Action One: Method, Money, and the Austrian School

(Cheltenham, UK: Edward Elgar, 1997), pp. 297–320.]

The Austrian
theory of money virtually begins and ends with Ludwig von Mises’s
monumental Theory
of Money and Credit
, published in 1912.
Mises’s fundamental accomplishment was to take the theory
of marginal utility, built up by Austrian economists and other
marginalists as the explanation for consumer demand and market
price, and apply it to the demand for and the value, or the price,
of money. No longer did the theory of money need to be separated
from the general economic theory of individual action and utility,
of supply, demand, and price; no longer did monetary theory have
to suffer isolation in a context of "velocities of circulation,"
"price levels," and "equations of exchange."

In applying
the analysis of supply and demand to money, Mises used the Wicksteedian
concept: supply is the total stock of a commodity at any given
time; and demand is the total market demand to gain and hold cash
balances, built up out of the marginal-utility rankings of units
of money on the value scales of individuals on the market. The
Wicksteedian concept is particularly appropriate to money for
several reasons: first, because the supply of money is either
extremely durable in relation to current production, as under
the gold standard, or is determined exogenously to the market
by government authority; and, second and most important, because
money, uniquely among commodities desired and demanded on the
market, is acquired not to be consumed, but to be held for later
exchange. Demand-to-hold thereby becomes the appropriate concept
for analyzing the uniquely broad monetary function of being held
as stock for later sale. Mises was also able to explain the demand
for cash balances as the resultant of marginal utilities on value
scales that are strictly ordinal for each individual. In the course
of his analysis Mises built on the insight of his fellow Austrian
Franz Cuhel to develop a marginal utility that was strictly ordinal,
lexicographic, and purged of all traces of the error of assuming
the measurability of utilities.

The relative
utilities of money units as against other goods determine each
person’s demand for cash balances, that is, how much of his income
or wealth he will keep in cash balances as against how much he
will spend. Applying the law of diminishing (ordinal) marginal
utility of money and bearing in mind that money’s "use"
is to be held for future exchange, Mises arrived implicitly at
a falling demand curve for money in relation to the purchasing
power of the currency unit. The purchasing power of the money
unit, which Mises also termed the "objective exchange-value"
of money, was then determined, as in the usual supply-and-demand
analysis, by the intersection of the money stock and the demand
for cash balance schedule. We can see this visually by putting
the purchasing power of the money unit on the y-axis and the quantity
of money on the x-axis of the conventional two-dimensional diagram
corresponding to the price of any good and its quantity. Mises
wrapped up the analysis by pointing out that the total supply
of money at any given time is no more or less than the sum of
the individual cash balances at that time. No money in a society
remains unowned by someone and is therefore outside some individual’s
cash balances.

While, for
purposes of convenience, Mises’s analysis may be expressed in
the usual supply-and-demand diagram with the purchasing power
of the money unit serving as the price of money, relying solely
on such a simplified diagram falsifies the theory. For, as Mises
pointed out in a brilliant analysis whose lessons have still not
been absorbed in the mainstream of economic theory, the purchasing
power of the money unit is not simply the inverse of the so-called
price level of goods and services. In describing the advantages
of money as a general medium of exchange and how such a general
medium arose on the market, Mises pointed out that the currency
unit serves as unit of account and as a common denominator of
all other prices, but that the money commodity itself is still
in a state of barter with all other goods and services. Thus,
in the pre-money state of barter, there is no unitary "price
of eggs"; a unit of eggs (say, one dozen) will have many
different "prices": the "butter" price in
terms of pounds of butter, the "hat" price in terms
of hats, the "horse" price in terms of horses, and so
on. Every good and service will have an almost infinite array
of prices in terms of every other good and service. After one
commodity, say gold, is chosen to be the medium for all exchanges,
every other good except gold will enjoy a unitary price, so that
we know that the price of eggs is one dollar a dozen; the price
of a hat is ten dollars, and so on. But while every good and service
except gold now has a single price in terms of money, money itself
has a virtually infinite array of individual prices in terms of
every other good and service. To put it another way, the price
of any good is the same thing as its purchasing power in terms
of other goods and services. Under barter, if the price of a dozen
eggs is two pounds of butter, the purchasing power of a dozen
eggs is, interalia, two pounds of butter. The purchasing
power of a dozen eggs will also be one-tenth of a hat, and so
on. Conversely, the purchasing power of butter is its price in
terms of eggs; in this case the purchasing power of a pound of
butter is a half-dozen eggs. After the arrival of money, the purchasing
power of a dozen eggs is the same as its money price, in our example,
one dollar. The purchasing power of a pound of butter will be
fifty cents, of a hat ten dollars, and so forth.

What, then,
is the purchasing power, or the price, of a dollar? It will be
a vast array of all the goods and services that can be purchased
for a dollar, that is, of all the goods and services in the economy.
In our example, we would say that the purchasing power of a dollar
equals one dozen eggs, or two pounds of butter, or one-tenth of
a hat, and so on, for the entire economy. In short, the price,
or purchasing power, of the money unit will be an array of the
quantities of alternative goods and services that can be purchased
for a dollar. Since the array is heterogeneous and specific, it
cannot be summed up in some unitary price-level figure.

The fallacy
of the price-level concept is further shown by Mises’s analysis
of precisely how prices rise (that is, the purchasing power of
money falls) in response to an increase in the quantity of money
(assuming, of course, that the individual demand schedules for
cash balances or, more generally, individual value scales remain
constant). In contrast to the hermetic neoclassical separation
of money and price levels from the relative prices of individual
goods and services, Mises showed that an increased supply of money
impinges differently upon different spheres of the market and
thereby ineluctably changes relative prices.

for example, that the supply of money increases by 20 percent.
The result will not be, as neoclassical economics assumes, simply
an across-the-board increase of 20 percent in all prices. Let
us assume the most favorable case — what we might call the Angel
Gabriel model — that the Angel Gabriel descends and overnight
increases everyone’s cash balance by precisely 20 percent. Now
all prices will not simply rise by 20 percent; for each individual
has a different value scale, a different ordinal ranking of utilities,
including the relative marginal utilities of dollars and of all
the other goods on his value scale. As each person’s stock of
dollars increases, his purchases of goods and services will change
in accordance with their new position on his value scale in relation
to dollars. The structure of demand will therefore change, as
will relative prices and relative incomes in production. The composition
of the array constituting the purchasing power of the dollar will

If relative
demands and prices change in the Angel Gabriel model, they will
change much more in the course of real-world increases in the
supply of money. For, as Mises showed, in the real world an inflation
of money is alluring to the inflators precisely because the injection
of new money does not follow the Angel Gabriel model. Instead,
the government or the banks create new money to be spent on specific
goods and services. The demand for these goods thereby rises,
raising these specific prices. Gradually, the new money ripples
through the economy, raising demand and prices as it goes. Income
and wealth are redistributed to those who receive the new money
early in the process, at the expense of those who receive the
new money late in the day and of those on fixed incomes who receive
no new money at all. Two types of shifts in relative prices occur
as the result of this increase in money: (1) the redistribution
from late receivers to early receivers that occurs during the
inflation process and; (2) the permanent shifts in wealth and
income that continue even after the effects of the increase in
the money supply have worked themselves out. For the new equilibrium
will reflect a changed pattern of wealth, income, and demand resulting
from the changes during the intervening inflationary process.
For example, the fixed income groups permanently lose in relative
wealth and income. [2]

If the concept
of a unitary price level is a fallacious one, still more fallacious
is any attempt to measure changes in that level. To use our previous
example, suppose that at one point in time the dollar can buy
one dozen eggs, or one-tenth of a hat, or two pounds of butter.
If, for the sake of simplicity, we restrict the available goods
and services to just these three, we are describing the purchasing
power of the dollar at that time. But suppose that at the next
point in time, perhaps because of an increase in the supply of
dollars, prices rise, so that butter costs one dollar a pound,
a hat twelve dollars, and eggs three dollars a dozen. Prices rise
but not uniformly, and all that we can now say quantitatively
about the purchasing power of the dollar is that it is four eggs,
or one-twelfth of a hat, or one pound of butter. It is impermissible
to try to group the changes in the purchasing power of the dollar
into a single average index number. Any such index conjures up
some sort of totality of goods whose relative prices remain unchanged,
so that a general averaging can arrive at a measure of changes
in the purchasing power of money itself. But we have seen that
relative prices cannot remain unchanged, much less the valuations
that individuals place upon these goods and services. [3]

Just as the
price of any good tends to be uniform, so the price, or purchasing
power of money, as Mises demonstrated, will tend to be uniform
throughout its trading area. The purchasing power of the dollar
will tend to be uniform throughout the United States. Similarly,
in the era of the gold standard, the purchasing power of a unit
of gold tended to be uniform throughout those areas where gold
was in use. Critics who point to persistent tendencies for differences
in the price of money between one location and another fail to
understand the Austrian concept of what a good or a service actually
is. A good is not defined by its technological properties but
by its homogeneity in relation to the demands and wishes of the
consumers. It is easy to explain, for example, why the price of
wheat in Kansas will not be the same as the price of wheat in
New York. From the point of view of the consumer in New York,
the wheat, while technologically identical in the two places,
is in reality two different commodities: one being "wheat
in Kansas" and the other "wheat in New York." Wheat
in New York, being closer to his use, is a more valuable commodity
than wheat in Kansas and will have a higher price on the market.
Similarly, the fact that a technologically similar apartment will
not have the same rental price in New York City as in rural Ohio
does not mean that the price of the same apartment commodity differs
persistently; for the apartment in New York enjoys a more valuable
and more desirable location and hence will be more highly priced
on the market. The "apartment in New York" is a different
and more valuable good than the "apartment in rural Ohio,"
since the respective locations are part and parcel of the good
itself. At all times, a homogeneous good must be defined in terms
of its usefulness to the consumer rather than by its technological

To extend
the analysis, the fact that the cost of living may be persistently
higher in New York than in rural Ohio does not negate the tendency
for a uniform purchasing power of the dollar throughout the country.
For the two locations constitute a different set of goods and
services, New York providing a vastly wider range of goods and
services to the consumer. The higher costs of living in New York
are the reflection of the greater locational advantages, of the
more abundant range of goods and services available. [4]

In his valuable
history of the theory of international prices, C.Y. Wu emphasized
the Mises contribution and pointed out that Mises’s explanation
was in the tradition of Ricardo and Nassau Senior, who "was
the first economist to give a clear explanation of the meaning
of the classical doctrine that the value of money was everywhere
the same and to demonstrate that differences in the prices of
goods of similar composition in different places were perfectly
reconcilable with the assumption of an equality of the value of
money." [5] Pointing out that Mises arrived
at this concept independently of Senior, Wu then developed Mises’s
application to the alleged locational differences in the cost
of living. As Wu stated, "To him [Mises] those who believe
in national differences in the value of money have left out of
account the positional factor in the nature of economic goods;
otherwise they should have understood that the alleged differences
are explicable by differences in the quality of the commodities
offered and demanded." Wu concluded with a quote from Mises’s
Theory of Money and Credit: "The exchange-ratio between
commodities and money is everywhere the same. But men and their
wants are not everywhere the same, and neither are commodities."

If the tendency
of the purchasing power of money is to be everywhere the same,
what happens if one or more moneys coexist in the world? By way
of explanation, Mises developed the Ricardian analysis into what
was to be called the purchasing-power-parity theory of exchange
rates, namely, that the market exchange rate between two independent
moneys will tend to equal the ratio of their purchasing powers.
Mises showed that this analysis applies both to the exchange rate
between gold and silver — whether or not the two circulate side
by side within the same country — and to independent fiat currencies
issued by two nations. Wu explained the difference between Mises’s
theory and the unfortunately better-known version of the purchasing-power-parity
theory set forth a bit later by Gustav Cassel. The Cassel version
ignores the Austrian emphasis on locational differences in accounting
for differences in value of technologically similar goods, and
this in turn complements the broader Austrian and classical position
that the purchasing power of money is an array of specific goods.
This contrasts with Cassel and the neoclassicists, who think of
the purchasing power of money as the inverse of a unitary price
level. Thus Wu stated:

purchasing power parity theory is that the rate of exchange would
be in equilibrium when the "purchasing power of the moneys"
is equal in all trading countries. If the term purchasing power
refers to the power of purchasing commodities, which are not only
similar in technological composition, but also in the same
geographical situation, the theory becomes the classical doctrine
of comparative value of moneys in different countries and is a
sound doctrine. But unfortunately the term purchasing power in
connection with the theory sometimes implies the reciprocal of
the general price level in a country. While so interpreted the
theory becomes that the equilibrium point of the foreign exchanges
is to be found at the quotient between the price levels of the
different countries. That is …an erroneous version of the purchasing
power parity theory.

Cassel, instead of correcting the error in his concept of purchasing
power, soon abandoned the full-parity doctrine in favor of a different
and highly attenuated contention that only changes in exchange
rates reflect changes in respective purchasing power — perhaps
because of his desire to use measurement and index numbers in
applying the theory. [8]

When he set
out to apply the theory of marginal utility to the price of money,
Mises confronted the problem that was later to be called "the
Austrian circle." In short, when someone ranks eggs or beef
or shoes on his value scale, he values these goods for their direct
use in consumption. Such valuations are, of course, independent
of and prior to pricing on the market. But people demand money
to hold in their cash balances, not for eventual direct use in
consumption, but precisely in order to exchange those balances
for other goods that will be used directly. Thus, money is not
useful in itself but because it has a prior exchange value, because
it has been and therefore presumably will be exchangeable in terms
of other goods. In short, money is demanded because it has a pre-existing
purchasing power; its demand not only is not independent of its
existing price on the market but is precisely due to its already
having a price in terms of other goods and services. But if the
demand for, and hence the utility of, money depends on its pre-existing
price or purchasing power, how then can that price be explained
by the demand? It seems that any Austrian attempt to apply marginal
utility theory to money is inextricably caught in a circular trap.
For that reason mainstream economics has not been able to apply
marginal utility theory to the value of money and has therefore
gone off in multi-causal (or noncausal) Walrasian directions.

Mises, however,
succeeded in solving this problem in 1912 in developing his so-called
regression theorem. Briefly, Mises held that the demand for money,
or cash balances, at the present time — say day X — rests on the
fact that money on the previous day, day X1, had a purchasing
power. The purchasing power of money on day X is determined by
the interaction on day X of the supply of money on that day and
that day’s demand for cash balances, which in turn is determined
by the marginal utility of money for individuals on day X. But
this marginal utility, and hence this demand, has an inevitable
historical component: the fact that money has prior purchasing
power on day X 1, and that therefore individuals know that this
commodity has a monetary function and will be exchangeable on
future days for other goods and services. But what then determined
the purchasing power of money on day X1? Again, that purchasing
power was determined by the supply of, and demand for, money on
day X1, and that in turn depended on the fact that the money had
purchasing power on day X2. But are we not caught in an infinite
regression, with no escape from the circular trap and no ultimate
explanation? No. What we must do is to push the temporal regression
to that point when the money commodity was not used as a medium
of indirect exchange but was demanded purely for its own direct
consumption use. Let us go back logically to the second day that
a commodity, say gold, was used as a medium of exchange. On that
day, gold was demanded partly because it has a pre-existing purchasing
power as a money, or rather as a medium of exchange, on the first
day. But what of that first day? On that day, the demand for gold
again depended on the fact that gold had a previous purchasing
power, and so we push the analysis back to the last day of barter.
The demand for gold on the last day of barter was purely a consumption
use and had no historical component referring to any previous
day; for under barter, every commodity was demanded purely for
its current consumption use, and gold was no different. On the
first day of its use as a medium of exchange, gold began to have
two components in its demand, or utility: first, a consumption
use as had existed in barter and, second, a monetary use, or use
as a medium of exchange, which had a historical component in its
utility. In short, the demand for money can be pushed back to
the last day of barter, at which point the temporal element in
the demand for the money commodity disappears, and the causal
forces in the current demand and purchasing power of money are
fully and completely explained.

Not only
does the Mises regression theorem fully explain the current demand
for money and integrate the theory of money with the theory of
marginal utility, but it also shows that money must have originated
in this fashion — on the market — with individuals on the market
gradually beginning to use some previously valuable commodity
as a medium of exchange. No money could have originated either
by a social compact to consider some previously valueless thing
as a "money" or by sudden governmental fiat. For in
those cases, the money commodity could not have a previous purchasing
power, which could be taken into account in the individual’s demands
for money. In this way, Mises demonstrated that Carl Menger’s
historical insight into the way in which money arose on the market
was not simply a historical summary but a theoretical necessity.
On the other hand, while money had to originate as a directly
useful commodity, for example, gold, there is no reason, in the
light of the regression theorem, why such direct uses must continue
afterward for the commodity to be used as money. Once established
as a money, gold or gold substitutes can lose or be deprived of
their direct use function and still continue as money; for the
historical reference to a previous day’s purchasing power will
already have been established.

In his comprehensive
1949 treatise, Human
, Mises successfully refuted earlier criticisms
of the regression theorem by Anderson and Ellis.
Subsequently criticisms were leveled at the theory by
J.C. Gilbert and Don Patinkin. Gilbert asserted that the theory
fails to explain how a new paper money can be introduced when
the previous monetary system breaks down. Presumably he was referring
to such examples as the German Rentenmark after the runaway
inflation of 1923. But the point is that the new paper was not
introduced de novo; gold and foreign currencies had existed
previously, and the Rentenmark could and did undergo exchange
in terms of these previously existing moneys; furthermore, it
was introduced at a fixed relation to the previous, extremely
depreciated mark. [11]

criticized Mises for allegedly claiming that the marginal utility
of money refers to the marginal utility of the goods for which
money is exchanged rather than the marginal utility of holding
money itself; he also charged Mises with inconsistently holding
the latter view in the other parts of The Theory of Money and
Credit. But Patinkin was mistaken; Mises’s concept of the
marginal utility of money always refers to the utility of holding
money. Mises’s point in the regression theorem is a different
one, namely, that the marginal utility-to-hold is itself based
on the prior fact that money can be exchanged for goods, that
is, on the prior purchasing power of money in terms of goods.
In short, money prices of goods, the purchasing power of money,
has first to exist in order for money to have a marginal utility
to hold, hence the need for the regression theorem to break out
of the circularity.

Modern orthodox
economics has abandoned the quest for causal explanation in behalf
of a Walrasian world of "mutual determination" suitable
for the current fashion of mathematical economics. Patinkin himself
feebly accepted the circular trap by stating that in analyzing
the market ("market experiment") he began with utility
while in analyzing utility he began with prices ("individual
experiment"). With characteristic arrogance, Samuelson and
Stigler each attacked the Austrian concern with escaping circularity
in order to analyze causal relations. Samuelson fell back on Walras,
who developed the idea of "general equilibrium in which all
magnitudes are simultaneously determined by efficacious interdependent
relations," which he contrasted to the "fears of literary
writers" (that is, economists who write in English) about
circular reasoning.

Stigler dismissed
Bhm-Bawerk for his "failure to understand some of the most
essential elements of modern economic theory, the concepts of
mutual determination and equilibrium (developed by the use of
the theory of simultaneous equations). Mutual determination ..
. is spurned for the older concept of cause and effect."
Stigler added the snide note that "Bhm-Bawerk was not trained
in mathematics." [14] Thus, orthodox economists
reflect the unfortunate influence of the mathematical method in
economics. The idea of mutual functional determination — so adaptable
in mathematical presentation — is appropriate in physics, which
tries to explain the unmotivated motions of physical matter. But
in praxeology, the study of human action, of which economics is
the best elaborated part, the cause is known: individual purpose.
In economics, therefore, the proper method is to proceed from
the causing action to its consequent effects.

In Human
Action, Mises advanced the Austrian theory of money by delivering
a shattering blow to the very concept of Walrasian general equilibrium.
To arrive at that equilibrium, the basic data of the economy —
values, technology, and resources — must all be frozen and understood
by every participant in the market to be frozen indefinitely.
Given such a magical freeze, the economy would sooner or later
settle into an endless round of constant prices and productions,
with each firm earning a uniform rate of interest (or, in some
construction, a zero rate of interest). The idea of certainty
and fixity in what Mises called "the evenly rotating economy"
is absurd, but what Mises went on to show is that in such a world
of fixity and certainty no one would hold cash balances. For since
everyone would have perfect foresight and knowledge of his future
sales and purchases, there would be no point in holding any cash
balance at all. Thus, the man who knew he would be spending $5,000
on 1 January 1977 would lend out all his money to be returned
at precisely that date. As Mises stated:

individual knows precisely what amount of money he will need at
any future date. He is therefore in a position to lend all the
funds he receives in such a way that the loans fall due on the
date he will need them… When the equilibrium of the evenly rotating
economy is finally reached, there are no more cash holdings. [15]

But if no
one holds cash and the demand for cash balances falls to zero,
all prices rise to infinity, and the entire general equilibrium
system of the market, which implies the continuing existence of
monetary exchange, falls apart. As Mises concluded:

the imaginary construction of an evenly rotating economy, indirect
exchange and the use of money are tacitly implied…. Where there
is no uncertainty concerning the future, there is no need for
any cash holding. As money must necessarily be kept by people
in their cash holdings, there cannot be any money.. .. But the
very notion of a market economy without money is self-contradictory. [16]

The very
notion of a Walrasian general equilibrium is not simply totally
unrealistic, it is conceptually impossible, since money and monetary
exchange cannot be sustained in that kind of system. Another corollary
contribution of Mises in this analysis was to demonstrate that,
far from being only one of many "motives" for holding
cash balances, uncertainty is crucial to the holding of any cash
at all.

That such
problems are now troubling mainstream economics is revealed by
F.H. Hahn’s demonstration that Patinkin’s well-known model of
general equilibrium can only establish the existence of a demand
for money by appealing to such notions as an alleged uncertainty
of the exact moments of future sales and purchases, and to "imperfections"
in the credit market — neither of which, as Hahn pointed out,
is consistent with the concept of general equilibrium. [17]

With respect
to the supply of money, Mises returned to the basic Ricardian
insight that an increase in the supply of money never confers
any general benefit upon society. For money is fundamentally different
from consumers’ and producers’ goods in at least one vital respect.
Other things being equal, an increase in the supply of consumers’
goods benefits society since one or more consumers will be better
off. The same is true of an increase in the supply of producers’
goods, which will be eventually transformed into an increased
supply of consumers’ goods; for production itself is the process
of transforming natural resources into new forms and locations
desired by consumers for direct use. But money is very different:
money is not used directly in consumption or production but is
exchanged for such directly usable goods. Yet, once any commodity
or object is established as a money, it performs the maximum exchange
work of which it is capable. An increase in the supply of money
causes no increase whatever in the exchange service of money;
all that happens is that the purchasing power of each unit of
money is diluted by the increased supply of units. Hence there
is never a social need for increasing the supply of money, either
because of an increased supply of goods or because of an increase
in population. People can acquire an increased proportion of cash
balances with a fixed supply of money by spending less and thereby
increasing the purchasing power of their cash balances, thus raising
their real cash balances overall. As Mises wrote:

services money renders are conditioned by the height of its purchasing
power. Nobody wants to have in his cash holding a definite number
of pieces of money or a definite weight of money; he wants to
keep a cash holding of a definite amount of purchasing power.
As the operation of the market tends to determine the final state
of money’s purchasing power at a height at which the supply of
and the demand for money coincide, there can never be an excess
or a deficiency of money. Each individual and all individuals
together always enjoy fully the advantages which they can derive
from indirect exchange and the use of money, no matter whether
the total quantity of money is great or small. Changes in money’s
purchasing power generate changes in the disposition of wealth
among the various members of society. From the point of view of
people eager to be enriched by such changes, the supply of money
may be called insufficient or excessive, and the appetite for
such gains may result in policies designed to bring about cash-induced
alterations in purchasing power. However, the services which money
renders can be neither improved nor impaired by changing the supply
of money…. The quantity of money available in the whole economy
is always sufficient to secure for everybody all that money does
and can do. [18]

A world of
constant money supply would be one similar to that of much of
the eighteenth and nineteenth centuries, marked by the successful
flowering of the Industrial Revolution with increased capital
investment increasing the supply of goods and with falling prices
for those goods as well as falling costs of production.
As demonstrated by the notable Austrian theory of the
business cycle, even an inflationary expansion of money and credit
merely offsetting the secular fall in prices will create the distortions
of production that bring about the business cycle.

In the face
of overwhelming arguments against inflationary expansion of the
money supply (including those not detailed here), what accounts
for the persistence of the inflationary trend in the modern world?
The answer lies in the way new money is injected into the economy,
in the fact that it is most definitely not done according to the
Angel Gabriel model. For example, a government does not multiply
the money supply tenfold across the board by issuing a decree
adding another zero to every monetary number in the economy. In
any economy not on a one-hundred-percent commodity standard, the
money supply is under the control of government, the central bank,
and the controlled banking system. These institutions issue new
money and inject it into the economy by spending it or lending
it out to favored debtors. As we have seen, an increase in the
supply of money benefits the early receivers, that is, the government,
the banks, and their favored debtors or contractors, at the expense
of the relatively fixed income groups that receive the new money
late or not at all and suffer a loss in real income and wealth.
In short, monetary inflation is a method by which the government,
its controlled banking system, and favored political groups are
able to partially expropriate the wealth of other groups in society.
Those empowered to control the money supply issue new money to
their own economic advantage and at the expense of the remainder
of the population. Yield to government the monopoly over the issue
and supply of money, and government will inflate that supply to
its own advantage and to the detriment of the politically powerless.
Once we adopt the distinctively Austrian approach of "methodological
individualism," once we realize that government is not a
superhuman institution dedicated to the common good and the general
welfare, but a group of individuals devoted to furthering their
economic interests, then the reason for the inherent inflationism
of government as money monopolist becomes crystal clear.

As the Austrian
analysis of money shows, however, the process of generated inflation
cannot last indefinitely, for the government cannot in the final
analysis control the pace of monetary deterioration and the loss
of purchasing power. The ultimate result of a policy of persistent
inflation is runaway inflation and the total collapse of the currency.
As Mises analyzed the course of runaway inflation (both before
and after the first example of such a collapse in an industrialized
country, in post-World War I Germany), such inflation generally
proceeds as follows: At first the government’s increase of the
money supply and the subsequent rise in prices are regarded by
the public as temporary. Since, as was true in Germany during
World War I, the onset of inflation is often occasioned by the
extraordinary expenses of a war, the public assumes that after
the war conditions including prices will return to the pre-inflation
norm. Hence the public’s demand for cash balances rises as it
awaits the anticipated lowering of prices. As a result, prices
rise less than proportionately and often substantially less than
the money supply, and the monetary authorities become bolder.
As in the case of the assignats during the French Revolution,
here is a magical panacea for the difficulties of government:
pump more money into the economy, and prices will rise only a
little! Encouraged by the seeming success, the authorities apply
more of what has worked so well, and the monetary inflation proceeds
apace. In time, however, the public’s expectations and views of
the economic present and future undergo a vitally important change.
They begin to see that there will be no return to the pre-war
norm, that the new norm is a continuing price inflation — that
prices will continue to go up rather than down. Phase two of the
inflationary process ensues, with a continuing fall in the demand
for cash balances based on this analysis: "I’d better spend
my money on X, Y, and Z now, because I know full well that next
year prices will be higher." Prices begin to rise more than
the increase in the supply of money. The critical turning point
has arrived.

At this point,
the economy is regarded as suffering from a money shortage as
evidenced by the outstripping of monetary expansion by the rise
in prices. What is now called a liquidity crunch occurs on a broad
scale, and a clamor arises for greater increases in the supply
of money. As the Austrian school economist Bresciani-Turroni wrote
in his definitive study of the German hyperinflation:

The rise
of prices caused an intense demand for the circulating medium
to arise, because the existing quantity was not sufficient for
the volume of transactions. At the same time the State’s need
of money increased rapidly… the eyes of all were turned to
the Reichsbank. The pressure exercised on it became more and
more insistent and the increase of issues, from the central
bank, appeared as a remedy….

The authorities
therefore had not the courage to resist the pressure of those
who demanded ever greater quantities of paper money, and to
face boldly the crisis which … would be, undeniably, the result
of a stoppage of the issue of notes. They preferred to continue
the convenient method of continually increasing the issues of
notes, thus making the continuation of business possible, but
at the same time prolonging the pathological state of the German
economy. The Government increased salaries in proportion to
the depreciation of the mark, and employers in their turn granted
continual increases in wages, to avoid disputes, on the condition
that they could raise the prices of their products….

Thus was
the vicious circle established; the exchange depreciated; internal
prices rose; note-issues were increased; the increase of the
quantity of paper money lowered once more the value of the mark
in terms of gold; prices rose once more; and so on…

For a long
time the Reichsbank — having adopted the fatalistic idea that
the increase in the note-issues was the inevitable consequence
of the depreciation of the mark — considered as its principal
task, not the regulation of the circulation, but the preparation
for the German economy of the continually increasing quantities
of paper money, which the rise in prices required. It devoted
itself especially to the organization, on a large scale, of
the production of paper marks. [20]

The sort
of thinking that gripped the German monetary authorities at the
height of the hyperinflation may be gauged from this statement
by the president of the Reichsbank, Rudolf Havenstein:

The wholly
extraordinary depreciation of the mark has naturally created
a rapidly increasing demand for additional currency, which the
Reichsbank has not always been able fully to satisfy. A simplified
production of notes of large denominations enabled us to bring
ever greater amounts into circulation. But these enormous sums
are barely adequate to cover the vastly increased demand for
the means of payment, which has just recently attained an absolutely
fantastic level….

The running
of the Reichsbank’s note-printing organization, which has become
absolutely enormous, is making the most extreme demands on our
personnel. [21]

The United
States seems to be entering phase two of inflation (1975), and
it is noteworthy that economists such as Walter Heller have already
raised the cry that the supply of money must be expanded in order
to restore the real cash balances of the public, in effect to
alleviate the shortage of real balances. As in Germany in the
early 1920s, the argument is being employed that the quantity
of money cannot be the culprit for inflation since prices are
rising at a greater rate than the supply of money.

Phase three
of the inflation is the ultimate runaway stage: the collapse of
the currency. The public takes panicky flight from the money into
real values, into any commodity whatever. The public’s psychology
is not simply to buy now rather than later but to buy anything
immediately. The public’s demand for cash balances hurtles toward

The reason
for the enthusiasm of Mises and other Austrian economists for
the gold standard, the purer and less diluted the better, should
now be crystal clear. It is not that this "barbaric relic"
has any fetishistic attraction. The reason is that a money under
the control of the government and its banking system is subject
to inexorable pressures toward continuing monetary inflation.
In contrast, the supply of gold cannot be manufactured ad libitum
by the monetary authorities; it must be extracted from the ground,
by the same costly process as governs the supply of any other
commodities on the market. Essentially the choice is: gold or
government. The choice of gold rather than other market commodities
is the historical experience of centuries that gold (as well as
silver) is uniquely suitable as a monetary commodity — for reasons
once set forth in the first chapter of every money-and-banking

The criticism
might be made that gold, too, can increase in quantity, and that
this rise in supply, however limited, would also confer no benefit
upon society. Apart from the gold versus government choice, however,
there is another important consideration: an increase in the supply
of gold improved its availability for nonmonetary uses, an advantage
scarcely conferred by the fiat currencies of government or the
deposits of the banking system. In contrast to the Misesian "monetary
overinvestment" theory of business cycles, on which considerable
work has been done by F.A. Hayek and other Austrian economists,
almost nothing has been done on the theory of money proper except
by Mises himself. There are three cloudy and interrelated areas
that need further elaboration. One is the route by which money
can be released from government control. Of primary importance
would be the return to a pure gold standard. To do so would involve,
first, raising the "price of gold" (actually, lowering
the definition of the weight of the dollar) drastically above
the current pseudo-price of $42.22 an ounce and, second, a deflationary
transformation of current bank deposits into nonmonetary savings
certificates or certificates of deposit. What the precise price
or the precise mix should be is a matter for research. Initially,
the Mises proposal for a return to gold at a market price and
the proposal of such Austrian monetary theorists as Jacques Rueff
and Michael Heilperin for a return at a deliberately doubled price
of $70 an ounce seemed far apart. But the current (1975) market
price of approximately $160 an ounce brings the routes of a deliberately
higher price and the market price much closer together. [23]

A second
area for research is the matter of free banking as against one-hundred-percent
reserve requirements for bank deposits in relation to gold. Mises’s
Theory of Money and Credit was one of the first works to
develop systematically the way in which the banks create money
through an expansion of credit. It was followed by Austrian economist
C.A. Phillips’s famous distinction between the expansionary powers
of individual banks and those of the banking system as a whole.
However, one of Mises’s arguments has remained neglected: that
under a regime of free banking, that is, where banks are unregulated
but held strictly to account for honoring their obligations to
redeem notes or deposits in standard money, the operations of
the market check monetary expansion by the banks. The threat of
bank runs, combined with the impossibility of one bank’s expanding
more than a competitor, keeps credit expansion at a minimum. Perhaps
Mises underestimated the possibility of a successful bank cartel
for the promotion of credit expansion; it seems clear, however,
that there is less chance for bank-credit expansion in the absence
of a central bank to supply reserves and to be a lender of last
resort. [24]

there is the related question, which Mises did not develop fully,
of the proper definition of the crucial concept of the money supply.
In current mainstream economics, there are at least four competing
definitions, ranging from M1 to M4. Of one point an Austrian is
certain: the definition must rest on the inner essence of the
concept itself and not on the currently fashionable but question-begging
methodology of statistical correlation with national income. Leland
Yeager was trenchantly critical of such an approach:

familiar approach to the definition of money scorns any supposedly
a priori line between money and near-moneys. Instead, it
seeks the definition that works best with statistics. One strand
of that approach … seeks the narrowly or broadly defined quantity
that correlates most closely with income in equations fitted to
historical data …. But it would be awkward if the definition
of money accordingly had to change from time to time and country
to country. Furthermore, even if money defined to include certain
near-moneys does correlate somewhat more closely with income than
money narrowly defined, that fact does not necessarily impose
the broad definition. Perhaps the amount of these near-moneys
depends on the level of money-income and in turn on the amount
of medium of exchange…. More generally, it is not obvious why
the magnitude with which some other magnitude correlates most
closely deserves overriding attention…. The number of bathers
at a beach may correlate more closely with the number of cars
parked there than with either the temperature or the price of
admission, yet the former correlation may be less interesting
or useful than either of the latter. The correlation with national
income might be closer for either consumption or investment than
for the quantity of money. [25]

Money is
the medium of exchange, the asset for which all other goods and
services are traded on the market. If a thing functions as such
a medium, as final payment for other things on the market, then
it serves as part of the money supply. In his Theory of Money
and Credit, Mises distinguished between standard money (money
in the narrow sense) and money substitutes, such as bank notes
and demand deposits, which function as an additional money supply.
It should be noted, for example, that in Irving Fisher’s non-Austrian
classic, The Purchasing Power of Money, written at about
the same time (1913), M consisted of standard money only, while
M1 consisted of money substitutes in the form of bank demand deposits
redeemable in standard at par. Today no economist would think
of excluding demand deposits from the definition of money. But
if we ponder the problem, we see that if a bank begins to fail,
its deposits are no longer equivalent to money; they no longer
serve as money on the market. They are only money until a bank’s
imminent collapse.

in the same way that M1 (currency plus demand deposits) is broader
than the narrowest definition, we can establish even broader definitions
by including savings deposits of commercial banks, and cash surrender
values of life insurance companies, which are all redeemable on
demand at par in standard money, and therefore all serve as money
substitutes and as part of the money supply until the public begins
to doubt that they are redeemable. Partisans of M1 argue that
commercial banks are uniquely powerful in creating deposits and,
further, that their deposits circulate more actively than the
deposits of other banks. Let us suppose, however, that in a gold-standard
country, a man has some gold coins in his bureau and others locked
in a bank vault. His stock of gold coins at home will circulate
actively and the ones in his vault sluggishly, but surely both
are part of his stock of cash. And, if it also be objected that
the deposits of savings banks and similar institutions pyramid
on top of commercial bank deposits, it should also be noted that
the latter in turn pyramid on top of reserves and standard money.

Another example
will serve to answer the common objection that a savings bank
deposit is not money because it cannot be used directly as a medium
of exchange but must be redeemed in that medium. (This is apart
from the fact that savings banks are increasingly being empowered
to issue checks and open up checking accounts.) Suppose that,
through some cultural quirk, everyone in the country decided not
to use five-dollar bills in actual exchange. They would only use
ten-dollar and one-dollar bills, and keep their longer-term cash
balances in five-dollar bills. As a result, five-dollar bills
would tend to circulate far more slowly than the other bills.
If a man wanted to spend some of his cash balance, he could not
spend a five-dollar bill directly; instead, he would go to a bank
and exchange it for five one-dollar bills for use in trade. In
this hypothetical situation, the status of the five-dollar bill
would be the same as that of the savings deposit today. But while
the holder of the five-dollar bill would have to go to a bank
and exchange it for dollar bills before spending it, surely no
one would say that his five-dollar bills were not part of his
cash balance or of the money supply.

A broad definition
of the money supply, however, excludes assets not redeemable on
demand at par in standard money, that is, any form of genuine
time liability, such as savings certificates, certificates of
deposit whether negotiable or nonnegotiable, and government bonds.
Savings bonds, redeemable at par, are money substitutes and hence
are part of the total supply of money. Finally, just as commercial
bank reserves are properly excluded from the outstanding supply
of money, so those demand deposits that in turn function as reserves
for the deposits of these other financial institutions would have
to be excluded as well. It would be double counting to include
both the base and the multiple of any of the inverted money pyramids
in the economy.


[1] Ludwig von Mises, Theorie des Geldes und der
Umlaufsmittel (1912); see the third English edition, The
Theory of Money and Credit (New Haven, Conn.: Yale University
Press, 1953).

[2] On the changes in relative prices attendant on
an increase in the money supply, see Mises, Theory of Money
and Credit, pp. 139–45.

[3] For more on the fallacies of measurement and index
numbers, see Mises, Theory of Money and Credit, pp. 187–94;
idem, Human Action: A Treatise on Economics (New Haven,
Conn: Yale University Press, 1949), pp. 221–24; Murray N. Rothbard,
Economy, and State
(Princeton, N.J.: D. Van Nostrand,
1962), 2:737–40; Bassett Jones, Horses and Applies: A Study
of Index Numbers (New York: John Day, 1934); and Oskar Morgenstern,
the Accuracy of Economic Observations
, 2nd
rev. ed. (Princeton University Press, 1963).

[4] See Mises, Theory of Money and Credit,
pp. 170–78.

[5] Chi-Yuen Wu, An
Outline of International Price Theories
(London: George
Routledge and Sons, 1939), p. 126.

[6] Ibid., p. 234; Mises, Theory of Money and Credit,
p. 178. Mises’s development of the theory was independent of Senior’s
because the latter was only published in 1928 in Industrial
Efficiency and Social Economy
(New York, 1928), pp. 55–56;
see Wu, Outline of International Price Theories, p. 127

[7] Ibid., 250; Mises’s formulation is in Theory
of Money and Credit, pp. 17988.

[8] See Wu, Outline of International Price Theories,
pp. 251–60.

[9] Miss’s regression theorem may be found in Theory
of Money and Credit, pp. 97–123. For an explanation and a
diagrammatic representation of the regression theorem, see Rothbard,
Man, Economy, and State, pp. 231–37. Menger’s insight into
the origin of money on the market maybe found in Carl Menger,
of Economics
(Glencoe, Ill.: The Free Press, 1950), pp.
257–62. On the relationship between Menger’s approach and the
regression theorem, see Mises, Human Action, pp. 402–4.

[10] Mises, Human Action, pp. 405–7. The regression
analysis was either adopted by or arrived at independently by
William A Scott in Money
and Banking
, 6th ed., (New York: Henry Holt,
1926), pp. 54–55.

[11] J.C. Gilbert, "The Demand for Money: The
Development of an Economic Concept," Journal of Political
Economy 61 (April 1953):149.

[12] Don Patinkin, Money,
Interest, and Prices
(Evanston, Ill: Row, Peterson, 1956),
pp. 71–72, 414.

[13] Paul A. Samuelson, Foundations
of Economic Analysis
(Cambridge, MA: Harvard University
Press, 1947), pp. 117–18.

[14] George Stigler, Production
and Distribution Theories: The Formative Period
(New York:
MacMillan, 1946), p. 181; also see the similar, if more polite,
attack on Menger by Frank H. Knight, "Introduction,"
in Menger, Principles, p. 23. For a contrasting discussion
by the mathematical economist son of Menger, Karl Menger, see
"Austrian Marginalism and Mathematical Economics," in
Carl Menger and the Austrian School of Economics, John
R. Hicks and Wilhelm Weber, eds. (Oxford: Clarendon Press, 1973),
pp. 54–60.

[15] Mises, Human Action, p. 250.

[16] Ibid., pp. 249–50, 414.

[17] F.H. Hahn, "On Some Problems of Proving
the Existence of an Equilibrium in a Monetary Economy," in
The Theory of Interest Rates, F.H. Han and F.P.R., Breckling,
eds. (London: Macmillan, 1956), pp. 128–32.

[18] Mises, Human Action, p. 418.

[19] On the advantages of a secularly falling price
"level," see C.A. Phillips, T.F. McManus, and R.W. Nelson,
Banking and the Business Cycle (New York: Macmillan, 1937),
pp. 186–88, 203–7.

[20] Costantino Bresciani-Turroni, The
Economics of Inflation
(London: George Allen & Unwin,
1937), pp. 80–82; also see Frank D. Graham, Exchange,
Prices, and Production in Hyper-inflation: Germany 1920–23

(New York: Russell and Russell, 1930), pp. 104–7. For an analysis
of hyperinflation see Mises, Theory of Money and Credit,
pp. 227–30; and idem, Human Action, pp. 423–25.

[21] Rudolf Havenstein, Address to the Executive
Committee of the Reichsbank, 25 August 1923, translated in The
German Inflation of 1923
, Fritz K. Ringer, ed., (New York:
Oxford University Press, 1969), p. 96.

[22] See Denis S. Karnofsky, "Real Money Balances:
A Misleading Indicator of Monetary Actions," Federal Reserve
Bank of St. Louis Review 56 (February 1974): 2–10.

[23] Mises’s proposal is in Theory of Money and
Credit, pp. 448–57; also see Michael A. Heilperin, Aspects
of the Pathology of Money (Geneva: Michael Joseph, 1968);
and Jacques Rueff, The Monetary Sin of the West (New York:
Macmillan, 1972).

[24] See Miss, Human Action, pp. 431–45.

[25] Leland B. Yeager, "Essential Properties
of the Medium of Exchange," Kyklos (1968), reprinted
in Monetary
, R.W. Clower, ed. (London: Penguin Books, 1969),
p. 38.

N. Rothbard (1926–1995), the founder of modern libertarianism
and the dean of the Austrian School of economics, was the author
of The
Ethics of Liberty
and For
a New Liberty
and many
other books and articles
. He was also academic vice president
of the Ludwig von Mises Institute and the Center for Libertarian
Studies, and the editor – with Lew Rockwell – of The
Rothbard-Rockwell Report

Rothbard Archives


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