Ludwig von Mises (1881-1973) made a major contribution to the theory of money with the publication of his book, The Theory of Money and Credit (1912). He was 31 years old. It was translated into English in 1924. It was updated in 1934. The 1934 edition was reprinted, without changes except for an appendix, in 1953 by Yale University Press. It had previously been published in England.
He followed this path-breaking book with what has proven to be one of the most important essays in the history of economic theory: “Economic Calculation in the Socialist Commonwealth” (1920). In it, he argued that without capital markets based on private ownership, socialist central planners are economically blind. They cannot know either the economic value or the price of capital goods. Therefore, they cannot know which resources should be allocated to meet the desires of consumers, including the State itself. He expanded this essay into a book, Socialism: An Economic and Sociological Analysis (1922). A second German edition appeared in 1932, the year before Hitler became Chancellor of Germany. This was the edition used to translate the English-language edition, published in 1951 by Yale University Press. Mises added an Epilogue, which began with these words: “Nothing is more unpopular today than the free market economy, i.e., capitalism.” It ended with these words: “Not mythical ‘material forces’, but reason and ideas determine the course of human affairs. What is needed to stop the trend towards socialism and despotism is common sense and moral courage.”
More than any other economist, it was Mises who offered the most detailed theoretical critique of socialism. But, as it turned out, it was not sound ideas, but the economic irrationality of socialist economic planning that finally undermined the envy-driven, power-loving, statist religion of socialism. Socialism by 1989 had bankrupted its most powerful incarnation, the Soviet Union. When it fell, socialist economists found themselves with few followers. Overnight, socialism had become a joke. Books on “what Marx really meant” filled the “books for a buck” bins in college-town bookstores. Socialist professors never had a plausible economic theory; they had only tenure. As the pro-socialist and millionaire economics textbook author Robert Heilbroner finally admitted in The New Yorker in 1990, “Mises was right.” Heilbroner’s ideological academic peers have not been equally honest.
Mises’s last major book was Human Action: A Treatise on Economics (Yale University Press, 1949; 3rd edition, Regnery, 1966: the edition I used for this study). Human Action presented a comprehensive theory of the free market on the one hand and economic interventionism by civil government on the other.
Mises wrote many books and articles. His main writings have been in English since 1949, when Human Action appeared, but hardly anyone has read all of them, including members of the comparatively small band of disciples who call themselves Misesians. The timing of the publication of Human Action could not have been worse. It was the year after the publication of Paul Samuelson’s textbook, Economics, which went on to sell three million copies and shape economics students’ thinking without significant opposition for almost two decades. It is still in print. By 1949, the Keynesian revolution was in full operation in American classrooms outside of Chicago. In contrast, Mises was a little-known Austrian immigrant whose major theoretical contributions to economics were long forgotten, relics of an ante-bellum, pre-Keynesian world. He was teaching in an academically peripheral university that did not even bother to pay him out of its own funds. His salary was paid by a handful of supporters, most notably Lawrence Fertig. There Mises taught his graduate seminars until 1966, when he retired at age 85. He died in 1973, making him ineligible for the Nobel Prize in economic science. The next year, his former disciple, F. A. Hayek, shared the Nobel Prize with socialist Gunnar Myrdal. (It was said at the time that Hayek never expected to win it, and Myrdal never expected to share it.) Hayek won on the basis of his theory of the business cycle, developed in the 1930’s, which was based almost entirely on Mises’s Theory of Money and Credit, and also for his theory of the free market as a transmitter of accurate information, a theory developed originally by Mises in Socialism, which had converted Hayek from his youthful socialist leanings, as he later said publicly. But Hayek had used a few charts in the 1930’s. Mises never did. Hayek was clearly scientific; Mises clearly wasn’t. Thus is academic performance rewarded by the economics profession.
In the war of ideas against monetary debasement and then socialism, Mises served as the lone Marine who led the initial assaults against the statists’ machine gun nests in academia. He did it from outside academia’s walls. The University of Vienna never hired its most distinguished economics graduate. Hayek was part of the second wave: Mises’s early disciples, who began volunteering for duty in the early 1920’s. These included Lionel Robbins, Wilhelm Röpke, and several world-famous economists who by 1940 had left “military service” to become part of the “diplomatic corps,” seeking a cease-fire with the enemy. For this, they were rewarded well by the enemy: major publishing houses, academic tenure, and the honorary presidency of at least one regional economics association. Yet at age 85, Mises was still tossing grenades at the enemy’s bunkers. (Hayek also remained on duty in the field, but he was always more of a sniper.)
In summarizing Mises’s theory of money, I draw heavily on his two major works that dealt with monetary theory, The Theory of Money and Credit and Human Action, plus a few minor books. I cover five themes: the definition of money; the optimum quantity of money, and how to achieve it; the myth of neutral money and its corollary, stable prices; fractional reserve banking, and how to inhibit it; and the monetary theory of the business cycle. They are closely interrelated. Mises’s system was a system.
I refer repeatedly to the Web site of the Liberty Fund, which has posted all of The Theory of Money and Credit. Warning: anyone who can actually read the Table of Contents on this site is doing better than I.
The book’s pages are not numbered on the Web edition. Usually, several chapters are included in each bloc of text from the book. If you want to locate any word or phrase in the text, I suggest that you read the text on-screen. Then use the Google Toolbar. This is a highly useful tool that I use daily. It highlights any word or phrase in HTML, allowing you to locate any word in a few seconds: a rapid scrolling until you see the yellow highlighted word. Download the program at www.google.com/about.html. It is on the left-hand side of the screen. (It works only with Internet Explorer.)
A suggestion: do not surrender to the temptation to skip over block quotations from Mises. To understand what Mises believed, you must read Mises carefully. Do not rely on my comments, which are there only to help you identify and better understand the most important themes in Mises’s exposition on money.
A warning: you may think you know what Mises taught about money and banking. Unless you have read the relevant material more than once, you probably have confused Mises’s ideas with something you read in a hard-money newsletter, now defunct, back in 1981.
I MONEY: A MARKET-GENERATED PHENOMENON
Mises began his presentation in Part I, Chapter I of The Theory of Money and Credit with a discussion of voluntary exchange. In a society without exchange, money is unnecessary. Mises said specifically in the book’s first paragraph that money is also not needed in theory in a pure socialist commonwealth (p. 29). By contrast, in a private property order, “The function of money is to facilitate the business of the market by acting as a common medium of exchange” (p. 29).
Direct exchange is barter. Barter is associated with a low division of labor. Participants expect to consume whatever it is that they receive in exchange. But in a more developed system of indirect exchange, participants exchange their goods and services for goods that can be exchanged for additional goods and services. Mises then explained why certain commodities become the widely accepted means of exchange, i.e., money. He distinguished between two kinds of goods. This conceptual distinction is fundamental to his theory of money.
Now all goods are not equally marketable. While there is only a limited and occasional demand for certain goods, that for others is more general and constant. Consequently, those who bring goods of the first kind to market in order to exchange them for goods that they need themselves have as a rule a smaller prospect of success than those who offer goods of the second kind. If, however, they exchange their relatively unmarketable goods for such as are more marketable, they will get a step nearer to their goal and may hope to reach it more surely and economically than if they had restricted themselves to direct exchange. It was in this way that those goods that were originally the most marketable became common media of exchange; that is, goods into which all sellers of other goods first converted their wares and which it paid every would-be buyer of any other commodity to acquire first. And as soon as those commodities that were relatively most marketable had become common media of exchange, there was an increase in the difference between their marketability and that of all other commodities, and this in its turn further strengthened and broadened their position as media of exchange (p. 32). . . . This stage of development in the use of media of exchange, the exclusive employment of a single economic good, is not yet completely attained. In quite early times, sooner in some places than in others, the extension of indirect exchange led to the employment of the two precious metals gold and silver as common media of exchange. But then there was a long interruption in the steady contraction of the group of goods employed for that purpose. For hundreds, even thousands, of years the choice of mankind has wavered undecided between gold and silver (p. 33).
Mises made his point unmistakably clear: “It was in this way that those goods that were originally the most marketable became common media of exchange.” Mises therefore defined money as the most marketable commodity. “It is the most marketable good which people accept because they want to offer it in later acts of impersonal exchange” (Human Action, p. 401.).
Money facilitates credit transactions. What are credit transactions? “Credit transactions are in fact nothing but the exchange of present goods against future goods” (TM&C, p. 35).
We now have Mises’s definitions of money (the most marketable commodity) and credit (the exchange of present goods for hoped-for future goods).
Money serves as a transmitter of value through time because certain goods serve as media of exchange. Why do they so serve? Because of “the special suitability of goods for hoarding” (p. 35). This economic function of money also involves the transport of value through space. It is not that money circulates that makes it money. Lots of goods circulate. It is that money is hoarded — is in someone’s possession as a cash balance — that is crucial for its service as a medium of exchange. He wrote that “it must be recognized that from the economic point of view there is no such thing as money lying idle” (p. 147). In other words, “all money must be regarded at rest in the cash reserve of some individual or other.”
What is called storing money is a way of using wealth. The uncertainty of the future makes it seem advisable to hold a larger or smaller part of one’s possessions in a form that will facilitate a change from one way of using wealth to another, or transition from the ownership of one good to that of another, in order to preserve the opportunity of being able without difficulty to satisfy urgent demands that may possibly arise in the future for goods that will have to be obtained by exchange (p. 147).
Because we live in ignorance about an uncertain future, we hold money: the most marketable commodity. Because it is highly marketable, it provides us with the most options, no matter what happens. If we had better knowledge of the future, we would hold whatever good is most likely to be most in demand in the new conditions, in order to maximize our profits. But we do not know, so we settle for holding money. We gain a lower rate of profit, but we gain much greater security in preserving exchange value.
MONEY IS NOT A MEASURE OF VALUE
Money transmits value, Mises taught, but money does not measure value. This distinction is fundamental in Mises’s theory of money. “Money is neither an abstract numéraire nor a standard of value or prices. It is necessarily an economic good and as such it is valued and appraised on its own merits, i.e., the services which a man expects from holding cash. On the market there is [sic] always change and movement. Only because there are fluctuations is there money” (Human Action, p. 418).
Any economic theory that teaches that money measures economic value, or that any civil government should establish policies that preserve the value of money because money is a measure of value, is anti-Misesian. You must understand this conclusion if the remainder of this study is to make any sense at all. The call for government-induced stable purchasing power, with or without a government-licensed monopolistic central bank, is an anti-Misesian call for government intervention into the economy. Mises was opposed to government intervention into the economy, including the monetary system.
Mises was adamant: there is no measure of economic value. He was a disciple of Carl Menger. Menger was a proponent of a strictly subjective theory of economic value. Mises insisted that there is no objective way to measure subjective value. He began Chapter 2, “On the Measurement of Value,” with these words: “Although it is usual to speak of money as a measure of value and prices, the notion is entirely fallacious. So long as the subjective theory of value is accepted, this question of measurement cannot arise” (TM&C, p. 38). Subjective valuation “arranges commodities in order of their significance; it does not measure its significance” (p. 39). It ranks significance; it does not measure it. This is the theme of Chapter 2.
If it is impossible to measure subjective use-value, it follows directly that it is impracticable to ascribe ‘quantity’ to it. We may say, the value of this commodity is greater than the value of that; but it is not permissible for us to assert, this commodity is worth so much. Such a way of speaking necessarily implies a definite unit. It really amounts to stating how many times a given unit is contained in the quantity to be defined. But this kind of calculation is quite inapplicable to processes of valuation (p. 45).
The fact that money does not measure value is a crucially important aspect of Mises’s theory of money. Perhaps this analogy will help clarify his reasoning.
DO YOU LOVE ME?
A wife asks: “Do you love me?” Her husband dutifully answers: “Of course I do.” She presses the issue: “How much do you love me?” He answers: “A lot.” She continues: “Do you love me more than you used to love your ex-girlfriend?” He replies: “Yes, I do.” So far, we are still in the realm of subjective value.
She presses the issue. “You used to be wild about her. I remember. You don’t act very wild about me. Do you love me more now than you loved her back then?” This raises the question of the permanence of value scales over time. The problem is, these scales of value change. Also, we forget what they were, and how intensely they registered with us. A truth-telling husband may reply: “I just don’t remember.” Or he may say, “I love you more now than I loved her back then,” mentally defining “love” to make the statement true. But how can he be sure what he felt back then? His memory has faded, along with his passion. This is the philosophical problem of subjective valuation through time. No one on earth possesses a permanent subjective value scale that measures changes in one’s temporal subjective value scale.
Next, she moves to objective value. “Exactly how much more do you love me than you used to love her?” Now he faces a dilemma, both personal and epistemological. She has moved from a consideration of his subjective scale of values to an objective measure of subjective value. Here is his epistemological dilemma: there is no objective measure of subjective value. A subjective value scale is ordinal — first, second, third — rather than cardinal, i.e., “exactly this much more.” Subjective values are ranked, not measured.
A wise husband with a knowledge of the Bible might try to end the discussion by saying, “I love you more than rubies.” Solomon said something like this. “Who can find a virtuous woman for her price is far above rubies?” (Proverbs 31:10). But even Solomon did not say exactly how much above rubies her price is.
There is no objective measure of subjective values. A diamond may be forever; it does not measure subjective value. Nothing on earth does.
COMPARE, YES; MEASURE, NO
Mises said that every economic act involves a comparison of values (TM&C, p. 38). A person chooses among several commodities (p. 38). He exchanges one commodity for another. “For this reason it has been said that every economic act may be regarded as a kind of exchange” (p. 39). Mises in Human Action made central this idea of human action as exchange: an exchange of conditions. “Action is an attempt to substitute a more satisfactory state of affairs for a less satisfactory one. We call such a wilfully induced alteration an exchange. A less desirable condition is bartered for a more desirable.” (Human Action, Chapter IV, Sect. 4: “Action as an Exchange.”)
Nevertheless, the exchange is not based on someone’s measure of value, merely his comparison of value: more vs. less. As he says, “The judgement, ‘Commodity a is worth more to me than commodity b‘ no more presupposes a measure of economic value than the judgement ‘A is dearer to me — more highly esteemed — than B‘ presupposes a measure of friendship” (TM&C, pp. 44-45). This means that “There is no such thing as abstract value” (p. 47). There are only specific acts of valuation. Money does measure objective prices (ratios of exchange). “If in this sense we wish to attribute to money the function of being a measure of prices, there is no reason why we should not do so” (p. 49). Admitting that money measures objective prices is not the same as saying that money is a measure of value, which is subjective. Money does not measure value. Mises was quite clear: “What has been said should have made sufficiently plain the unscientific nature of the practice of attributing to money the function of acting as a measure of price or even of value. Subjective value is not measured, but graded. The problem of the measurement of objective use-value is not an economic problem at all” (p. 47).
I emphasize this because we hear, over and over, such phrases as this:
“There is nothing more important that the government can provide individual producers than a reliable standard of value, a unit of account that retains its constancy as a measuring device.”
This statement is completely contrary to Mises’s theory of subjective economic value, on which his theory of money rests. It is contrary to Mises’s theory of civil government. It is contrary to the concept of free market money, as Mises described it. In short, it is contrary to Misesian economics. Forewarned is forearmed.
FOUR KINDS OF MONEY
Mises said that there are four kinds of money: token (base metal) coins, commodity money, credit money, and fiat money (pp. 59-62). Commodity money is what the free market has determined is the most marketable commodity, and therefore the medium of exchange. It is “a commercial commodity.”
We may give the name commodity money to that sort of money that is at the same time a commercial commodity; and the name fiat money to money that comprises things with a special legal qualification. A third category may be called credit money, this being that sort of money which constitutes a claim against any physical or legal person. But these claims must not be both payable on demand and absolutely secure; if they were, there could be no difference between their value and that of the sum of money to which they referred, and they could not be subjected to an independent process of valuation on the part of those who dealt with them. In some way or other the maturity of these claims must be postponed to some future time (p. 61).
Mises’s definition of credit money distinguishes credit money from a receipt for money. Credit money is not “both payable on demand and absolutely secure.” It is not the same as that which we can call warehouse receipts for commodity money, in which case “there could be no difference between their value and that of the sum of money to which they referred.” In Human Action, he defined a warehouse receipt for money metal coins a money-certificate. “If the debtor — the government or a bank — keeps against the whole amount of money-substitutes a 100% reserve of money proper, we call the money-substitute a money-certificate” (p. 433). A money-certificate is both payable on demand and secure. It is not a promise to pay at some date in the future. It is a promise to pay immediately on demand, a promise that can be fulfilled in all cases because there is money metal on reserve to meet all of the receipts even if they were presented for redemption on the same day. Money-certificates function as money because they are the equivalent of the commodity money that they represent. For each money-certificate issued, the equivalent weight of coins is withdrawn from circulation. “Changes in the quantity of money-certificates therefore do not alter the supply of money and the money relation. They do not play a role in the determination of the purchasing power of money” (p. 433).
Credit money is money that has less than a 100% reserve in coins. “If the money reserve kept by the debtor against the money-substitute issued is less than the total amount of such substitutes, we call the amount of substitutes which exceeds the reserve fiduciary media. As a rule it is not possible to ascertain whether a concrete specimen of money-substitutes is a money-certificate or a fiduciary medium.” Fiduciary media increase the amount of money in circulation. “The issue of fiduciary media enlarges the bank’s funds available for lending beyond these limits” (p. 433).
Money is a commodity, Mises insisted. It is not a promise to pay. Fiduciary media is a promise to pay. It is a promise that cannot be fulfilled at the same time to everyone who has been issued fiduciary media.
The value of a coin is based on the weight and fineness of its metal.
Nevertheless, in defiance of all official regulations and prohibitions and fixing of prices and threats of punishment, commercial practice has always insisted that what has to be considered in valuing coins is not their face value but their value as metal. The value of a coin has always been determined, not by the image and superscription it bears nor by the proclamation of the mint and market authorities, but by its metal content (TM&C, p. 65).
FREE COINAGE, NOT STATE MONOPOLY
Civil governments in the past have issued coins or ingots with a stamp on them that certifies their weight and fineness. In the short run, at least, this was a benefit to market participants: it reduced their search costs for reliable coinage. “But in the hands of liberal governments the character of this state monopoly was completely altered. The ideas which considered it an instrument of interventionist policies were discarded. No longer was it used for fiscal purposes or for favoring some groups of the people at the expense of other groups” (Human Action, p. 782). But, he goes on to say, “On the other hand, individuals were entitled to bring bullion to the mint and to have it transformed into standard coins either free of charge or against payments of a seigniorage [fee] generally not surpassing the actual expenses of the process.”
Stamping coins is not part of the provision of civil justice, which alone justifies a State monopoly, according to his utilitarian democratic political theory (pp. 149-50). This is the only case I know in all of Mises’s writings where he identified as beneficial to society a zero-fee, monopolistic service offered by civil government to citizens, despite the fact that stamping coins is not part of what he regarded as civil government’s legitimate monopoly of law enforcement by violence. He did not say that he recommended this practice. He said only that liberal governments for a time did not abuse their declared monopoly over coin stamping.
In Mises’s theory of money, money is not what the State says it is — what he calls the “nominalist” theory of money. Money is what the free market says it is: the most marketable commodity. He ended Chapter 3 of Theory of Money and Credit with a call for free coinage: a denial of the State’s monopoly over money. He rejected nominalism and affirmed free coinage. Nominalism leads to the State’s establishment of its own monopolistic money substitutes, which State officials insist are money, but which are of less value, according to the free market’s assessment.
The nominalists assert that the monetary unit, in modern countries at any rate, is not a concrete commodity unit that can be defined in suitable technical terms, but a nominal quantity of value about which nothing can be said except that it is created by law. Without touching upon the vague and nebulous nature of this phraseology, which will not sustain a moment’s criticism from the point of view of the theory of value, let us simply ask: What, then, were the mark, the franc, and the pound before 1914? Obviously, they were nothing but certain weights of gold. Is it not mere quibbling to assert that Germany had not a gold standard but a mark standard? According to the letter of the law, Germany was on a gold standard, and the mark was simply the unit of account, the designation of 1/2790 kg. of refined gold. This is in no way affected by the fact that nobody was bound in private dealings to accept gold ingots or foreign gold coins, for the whole aim and intent of state intervention in the monetary sphere is simply to release individuals from the necessity of testing the weight and fineness of the gold they receive, a task which can only be undertaken by experts and which involves very elaborate precautionary measures. The narrowness of the limits within which the weight and fineness of the coins are legally allowed to vary at the time of minting, and the establishment of a further limit to the permissible loss by wear of those in circulation, are much better means of securing the integrity of the coinage than the use of scales and nitric acid on the part of all who have commercial dealings. Again, the right of free coinage, one of the basic principles of modern monetary law, is a protection in the opposite direction against the emergence of a difference in value between the coined and uncoined metal (pp. 66-67). . . . The role played by ingots in the gold reserves of the banks is a proof that the monetary standard consists in the precious metal, and not in the proclamation of the authorities (p. 67).
In Chapter 4, “Money and the State,” Mises made clear that the State does not establish economic laws of exchange. It is subordinate to these laws. Mises even capitalized this phrase: Laws of Price. (The editor of the Web-based edition removed these capitals. He also removed the capital S from State.)
The position of the state in the market differs in no way from that of any other parties to commercial transactions. Like these others, the state exchanges commodities and money on terms which are governed by the laws of price. It exercises its sovereign rights over its subjects to levy compulsory contributions from them; but in all other respects it adapts itself like everybody else to the commercial organization of society. As a buyer or seller the state has to conform to the conditions of the market. If it wishes to alter any of the exchange ratios established in the market, it can only do this through the market’s own mechanism. As a rule it will be able to act more effectively than anyone else, thanks to the resources at its command outside the market (p. 68). . . .
The concept of money as a creature of law and the state is clearly untenable. It is not justified by a single phenomenon of the market. To ascribe to the state the power of dictating the laws of exchange, is to ignore the fundamental principles of money-using society (p. 69).
The State passes laws and enforces them, but this does not change the laws of value. It merely produces results that are in conformity to the laws of value. For example, consider the free market’s establishment of two forms of money, gold and silver coins. The State stamps metal coins as being of a particular weight and fineness. The specified weight and fineness are not specified on each coin, but by law, the coins must meet a specified standard. Mises called this coinage system a “parallel standard.” The free market establishes their value based on the value of their metals. “This stage was reached without further State influence” (p. 72).
At some point, the State intervenes by establishing a legal exchange rate between the parallel systems of coinage, despite the fact that for thousands of years the systems have flourished in the free market (p. 75). As soon as the free market’s price for each metal deviates from the State’s legal parity — a system of price controls — Gresham’s law takes over. This was the observation by Queen Elizabeth’s royal factor in Antwerp, Sir Thomas Gresham, that “bad money drives out good money.” Mises clarified Gresham’s law in Human Action. “It would be more correct to say that the money which the government’s decree has undervalued disappears from the market and the money which the decree has overvalued remains” (p. 450). Consumers hoard the undervalued coins, or use them in illegal black market exchanges at ratios that deviate from the law’s fixed ratios, or send them abroad, where the coins purchase goods of equal market value. People then spend the overvalued coins in public.
The result of this government price-setting is always a monometallic standard in the legal markets of the nation: either gold or silver. This is the free market’s response to price controls on the two metals. This result may not have been the policy-makers’ intention.
The primary result of this was a decision, for a little while at least, between the two precious metals. Not that this was what the state had intended. On the contrary, the state had no thought whatever of deciding in favor of the use of one or the other metal; it had hoped to secure the circulation of both. But the official regulation, which in declaring the reciprocal substitutability of gold and silver money overestimated the market ratio of the one in terms of the other, merely succeeded in differentiating the utility of the two for monetary purposes. The consequence was the increased employment of one of the metals and the disappearance of the other. The legislative and judicial intervention of the state had completely failed. It had been demonstrated, in striking fashion, that the state alone could not make a commodity into a common medium of exchange, that is, into money, but that this could be done only by the common action of all the individuals engaged in business (pp. 75-76).
But what the state fails to achieve through legislative means may be to a certain degree within its power as controller of the mint. It was in the latter capacity that the state intervened when the alternative standard was replaced by permanent monometallism. This happened in various ways. The transition was quite simple and easy when the action of the state consisted in preventing a return to the temporarily undervalued metal in one of the alternating monometallic periods by rescinding the fight of free coinage. The matter was even simpler in those countries where one or the other metal had gained the upper hand before the state had reached the stage necessary for the modern type of regulation, so that all that remained for the law to do was to sanction a situation that was already established (p. 76).
In other cases, the transition was deliberate. But the free market’s laws of price always governed the transition. This was especially true of the State’s attempted establishment of economic parity between credit money and money metal coinage. Gresham’s law still rules.
The exaggeration of the importance in monetary policy of the power at the disposal of the state in its legislative capacity can only be attributed to superficial observation of the processes involved in the transition from commodity money to credit money. This transition has normally been achieved by means of a state declaration that inconvertible claims to money were as good means of payment as money itself. As a rule, it has not been the object of such a declaration to carry out a change of standard and substitute credit money for commodity money. In the great majority of cases, the state has taken such measures merely with certain fiscal ends in view. It has aimed to increase its own resources by the creation of credit money. In the pursuit of such a plan as this, the diminution of the money’s purchasing power could hardly seem desirable. And yet it has always been this depreciation in value which, through the coming into play of Gresham’s law, has caused the change of monetary standard. It would be quite out of harmony with the facts to assert that cash payments had ever been stopped; that is, that the permanent convertability of the notes had been suspended, with the intention of effecting a transition to a credit standard. This result has always come to pass against the will of the state, not in accordance with it (p. 77).
In order to effect the acceptance of fiat money or credit money, the State adopts a policy of the abolition of its previous contractual obligations. What was previously a legal right of full convertability into either gold or silver coins is abolished by a new law. The State removes the individual’s legal right to exchange the State’s paper notes for gold or silver coins. It then declares that the new, inconvertible fiat paper money or bank credit money is equal in value to the older redeemable notes, meaning equal to the value of the actual coins previously obtainable through redemption. But the free market determines otherwise. The two forms of money are not equal in value in the judgment of the market’s individual participants. Gresham’s law is still obeyed.
Business usage alone can transform a commodity into a common medium of exchange. It is not the state, but the common practice of all those who have dealings in the market, that creates money. It follows that state regulation attributing general power of debt liquidation to a commodity is unable of itself to make that commodity into money. If the state creates credit money — and this is naturally true in a still greater degree of fiat money — it can do so only by taking things that are already in circulation as money substitutes (that is, as perfectly secure and immediately convertible claims to money) and isolating them for purposes of valuation by depriving them of their essential characteristic of permanent convertability. Commerce would always protect itself against any other method of introducing a government credit currency. The attempt to put credit money into circulation has never been successful, except when the coins or notes in question have already been in circulation as money substitutes (pp. 77-78).
According to Mises, money is the most marketable commodity. Historically, money has been gold and silver. Money-certificates are receipts for money metals that are backed 100% by these metals. They function as money because they are exchangeable for specified quantities of money metal at any time without restriction. There are three other kinds of money: credit money (money-certificates that are not 100% backed by money metals), low-denomination token coins made of base metals, and fiat money (certificates designated by the State as money, but not backed by anything — no promise to pay anything).
The State can set legal prices, meaning exchange ratios, between the various kinds of money. The effects of such fixed exchange rates are identical to the effects of any other kind of price control: gluts and shortages. The artificially overvalued money (glut) replaces the artificially undervalued money (shortage). This cause-and-effect relationship is called Gresham’s law.
The free market establishes free coinage. The State in the past has stamped certain coins or ingots with its identifying mark, as a means of validating the weight and fineness of these money metal objects. But when the State establishes a monopoly over money, it has violated the free market’s principle of private ownership and exchange.
The free market establishes the quantity of money in circulation, just as it supplies the quantity of consumer goods and capital goods. This raises an important question. Is money a consumer good or a capital good? Or is it neither? I cover this in the Part II: “The Optimum Quantity of Money.”
January 21, 2002
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