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One hundred years ago, in 1924, the Austrian economist Ludwig von Mises issued a revised German-language edition of his 1912 book Theorie des Geldes und der Unlaufsmittel. Ninety years ago, in 1934, there appeared an English-language edition under the title The Theory of Money and Credit. Over the more than a century since Mises’s book first appeared, the political and institutional circumstances of much of the world have gone through dramatic changes, yet the theoretical and policy analyses and insights of The Theory of Money and Credit have withstood the test of time.
When the first edition was published, the major countries of the world, including Mises’s Austro-Hungarian homeland, had monetary systems based on the gold standard. In 1912, two years before the beginning of the First World War, many Europeans and North Americans were still living in the afterglow of the classical-liberal epoch of the nineteenth century. Governments were still relatively limited in size and scope. Taxes were fairly low, with accompanying modest levels of government spending. Those same governments, in general, mostly respected a wide array of civil liberties and personal freedoms. Freedom of trade and enterprise was the normative standard, even if some of those governments, especially in Imperial Germany, had reintroduced various protectionist barriers and were intervening in a variety of domestic economic activities. Yet, at the same time, the far-flung British Empire was administered as a global free-trade zone welcoming buyers and sellers and investors with few if any limits based on their nationality.
The monetary system before and after World War I
The central banks of these European countries (the United States did not have a comparable national central bank in the form of the Federal Reserve System until 1914) all generally followed the “rules” of the gold standard. Bank notes and bank deposits were viewed and treated as “money substitutes,” that is, claims to the “real” money of gold and silver. Discretionary monetary manipulations by central banking authorities were generally frowned upon and not excessively practiced. If prices in general significantly rose for a period of time, it was usually due to significant increases in the world supply of gold, not the result of politically motivated paper-money inflations. However, the rationales and calls for “activist” monetary policies were increasingly for purposes of “social policy.”
When the revised second German edition of The Theory of Money and Credit appeared in 1924, the world was a radically different place from what it had been in 1912. Many of those major countries had gone through the four years of the First World War (1914–1918), and some had politically disintegrated, with the German, Russian, and Austro-Hungarian empires disappearing from the map of Europe. The prewar liberal institutions and beliefs concerning personal and economic freedom had been weakened, if not shattered. Gold redemption for paper currencies had ended among the belligerent nations in 1914 so their governments could, respectively, resort to the monetary printing presses to cover their huge war expenses.
In the immediate postwar years of the early 1920s, destructive hyperinflations were experienced in places like Germany, Austria, and Russia. Half-hearted attempts were made to restore gold-based currencies that were mere shadows of the prewar monetary system. In addition, dictatorships had come to power in the form of Marx-inspired communism in Russia under Lenin and the Bolsheviks and in the form of fascism in Italy under the leadership of Mussolini (who coined the term “totalitarianism” to express his conception of the role and power of the state). An assortment of authoritarian regimes came to power in a number of other countries.
Ten years later, in 1934, when the English-language edition of The Theory of Money and Credit was published in Great Britain, the world had changed even more. The major industrial countries were in the throes of the Great Depression following the stock market crash of October 1929, with worst of the rising unemployment and falling production experienced in the United States and Germany, though the severity of the depression was not much less felt in Great Britain and France and many other places. The gold standard had been abandoned, either de jure or de facto, virtually everywhere, with paper monies in their place as government policy tools to try to “fight” the depression.
Also, in 1933, Hitler and the Nazi Party had come to power in Germany, with dictatorial control rapidly imposed on all facets of German life and society. In the United States, Franklin Roosevelt had become president and soon imposed his own version of a fascist-like economic system on the United States in the form of New Deal centralized economic planning (which partially came to an end through a series of Supreme Court decisions in 1935 and 1936 that declared some New Deal programs to be unconstitutional).
Economic principles and the theory of money
In the preface to the 1934 English edition, Mises said that the monetary and banking institutional circumstances certainly had changed from the times when the first and second editions of his book had appeared in 1912 and 1924, respectively. But he argued:
Ten years have elapsed since the second German edition of the present book was published. During this time the external apparatus of the currency and banking problems of the world has completely altered…. [But] amid this flux, the theoretical apparatus which enables us to deal with these questions remains unaltered. In fact, the value of economics lies in its enabling us to recognize the true significance of problems, divested of their accidental trimmings. No very deep knowledge of economics is usually needed for grasping the immediate effects of a [policy] measure; but the task of economics is to foretell the remoter effects; and so to allow us to avoid such acts as attempt to remedy some present ill by sowing the seeds of a much greater ill in the future.
Economists had been intensely analyzing monetary and banking theory and policy issues since at least the middle of the eighteenth century. Some of them were among the most famous economists of their time, including David Hume, Adam Smith, David Ricardo, John Stuart Mill, and others like Jean-Baptiste Say, Henry Thornton, Nassau Senior, and John E. Cairnes, to name just a few of the prominent ones.
But virtually all of them built their ideas on the “classical” labor theory of value, that is, that the value of any good — including a commodity such as gold or silver — ultimately derived its long-run value in the marketplace based on its costs of production, reducible to a quantity of labor time and effort that had gone into the extraction of resources and the manufacture of the finished good.
After the emergence of the subjective theory of value, especially with the publication of Carl Menger’s Principles of Economics (1871) and its elaboration by his “Austrian” followers, Friedrich von Wieser and Eugen von Böhm-Bawerk in the 1880s and 1890s, the labor theory of value was replaced by the theory of (marginal) subjective value. Ultimately, the value of any good was derived from its “utility” or usefulness in satisfying a human want or desire. The “utility” of any particular unit of a specific quantity of a good was based on the wants it satisfied in descending order of importance.
The means of production (land, resources, labor, capital) received their value from their “indirect” usefulness in enabling a desired finished good to be manufactured into the final form that resulted in the desired consumption satisfaction. In turn, the marginal value of any specific unit of such means of production was derived from the value of the marginal unit of the final good produced relative to its utility to being used in some alternative line of production.
Menger had explained the origin of money as a medium of exchange in his Principles of Economics (1871) and in his Investigations into the Methods of the Social Sciences (1883). He demonstrated that money was not a creature or a creation of the State; it emerged “spontaneously” over a long period of time as people attempted to overcome the difficulties of direct barter exchange. In his famous monograph on “Money” (1892), Menger extended his analysis to trying to analyze the demand to hold money based on its marginal valuation in acts of exchange.
The origin of money and its value through time
But it really was not until Mises’s Theory of Money and Credit that there was an especially thorough and satisfying exposition of the demand for money and its purchasing power, or value, in the marketplace. Mises adopted Menger’s theory of the origin of money: individuals in search of opportunities for gains from trade may discover that while Sam has what Bill wants, Bill does not possess what Sam would take in trade to give up what is in his possession. Even if there is what economists have come to call a double coincidence of wants (each has what the other desires in a trade), the characteristics of the goods in question may preclude their division into relative amounts reflecting a set of agreed upon terms of trade without one or both of these goods losing their desired qualities (for example, dividing a horse in half ends its usefulness for riding or pulling a wagon).
Over time, individuals discover that some goods are more valuable in terms of the fairly wide demand for them or their relative ease of divisibility without losing their desired qualities, or their convenience in being transported to where trades may occur, or the durability of their qualities and useful characteristics over time. Historically, those goods that have demonstrated the greatest combinations of such attributes have tended to be more frequently utilized as a media of exchange, until only one or two have become the ones most widely used for money.
Money, increasingly, therefore, is on one side of every exchange. People trade the good they possess for a sum of the money, and then turn around and use that money to purchase all the other goods they desire from all the other individuals participating in the expanding social system of division of labor. As a result, again over time, the good used as money derives its market value from two sources: from its original usefulness as some good used for consumption or production and its now additional usefulness as a medium of exchange. As time passes, its usefulness and value for as a medium of exchange may overshadow and perhaps finally completely supersede its usefulness and value as a consumption or production good.
Then its primary or even singular value is simply as a market-chosen means of exchange. Its continued use is now based on its social institutionalization as money and people’s estimates of its value in market transactions based upon its observed value for exchange purposes. The link in following money’s value backwards would be traceable to the day when that good was first also used as money, the day before which it simply was considered useful and valuable as a consumption or production good. While money’s historicity explains how and why it had a value for exchange purposes in the past, its value is determined by people’s subjective (marginal) valuations concerning its anticipated usefulness and value in the exchange opportunities today and in the future. Mises’s analysis of the value of money through and back in time became known as the Regression Theorem.
The meaning of the value of money and economic calculation
Another particular quality of the money-good in the marketplace is that unlike other goods bought and sold, money has no single price. With money on one side of every exchange, all traded goods and services tend to have one price, their respective money price. That is, how many units of money to buy or sell a hat, or purchase a house, or pay for a particular meal in a restaurant. Money becomes the unit of account, with the relative values of all goods expressed in the single common denominator of their respective money prices. This makes possible and facilitates the ease of “economic calculation,” the valuation and appraisement of the relative values of individual goods and combination of goods for purposes of determining “more expensive” and “less expensive,” and of profit or loss.
However, due to money’s unique place in the nexus of exchange, money has as many prices as goods against which it trades. This is precisely because money remains as the only good that directly trades for everything else offered on the market. Money may be thought of as the hub of a wheel of exchange, with each of the spokes being the individual goods against which money is being traded, with all the spokes connected by the same unit of exchange. If we then ask, what is the value, or general purchasing power, of money, the answer is the array, or set, or network of relative prices between money and all the other goods against which it is trading at any moment in time.
Mises was critical of the now common attempts to “measure” the value of money through the construction of price indices, such as the Consumer Price Index (CPI). Every such index involves creating a selected “basket” of goods considered representative of the purchasing habits of some “average” household or buying unit to which are assigned “weights” to the various goods in the basket (that is, the relative amounts of each purchased on a regular basis), and which is then tracked to determine the cost of buying that “basket” over a given period of time. If the cost of the basket has increased (decreased) over that period, it is said that the value of the monetary unit has decreased (increased) by a certain percentage and that the society has experienced price inflation (price deflation) to that degree over that time period.
Understanding the reason for Mises’s critical view of index-number methods for trying to measure changes in the value or purchasing power of money gets us to a crucial and central aspect of his whole
theory of how monetary changes
influence the market process. The focus on a single price index number for an averaged and summarized set of individual goods and their prices in that “basket” easily creates the impression that changes in the purchasing power of money occur uniformly and seemingly simultaneously.
Mises was an adherent of what is generally referred to as the quantity theory of money. That is, all other things held the same, any general rise or fall in the value or purchasing power of money has its basis in either a change in the total quantity of money in the economy or in a change in people’s willingness to hold a certain average monetary cash balance to facilitate their desired transactions over a period of time (often referred to as money’s “velocity,” that is, the number of times a given quantity of money “turns over” to facilitate a given number of transactions over a period of time).
Mises argued that if prices, in fact, increased (decreased) simultaneously and proportionally, that is, at the same time and by the same percentage, monetary changes would have no or few “real” effects on the relative price, wage, production, and output relationships in the market. For instance, suppose the price of a pair of shoes was $10 and the price of a hat was $20; then their relative price relationship would be two pairs of shoes traded for one hat in the marketplace. If now a 10 percent increase in the quantity of money resulted in a proportional rise the price of shoes to $11 and the price of a hat to $22, the relative price relationship between shoes and hats would still be two pairs of shoes for one hat, even though in absolute terms the price of both was now higher. Monetary changes would be “neutral” in their effects on the “real” relationships between prices and goods in the marketplace.
The nonneutrality of monetary changes
However, this was and is not the way changes in the quantity of money impact and influence prices or the relative supplies of goods in the market process, Mises insisted. Money, instead, was “nonneutral” in its effects. Mises, of course, was not the first economist to point this out. Richard Cantillon (1680–1734) drew attention to it in his Essay on the Nature of Commerce in General (1755), as did David Hume (1711–1776) in his famous essay “Of Money” (1752). An especially detailed analysis of money’s nonneutral effects was given by John E. Cairnes (1823–1875) in his essays on the impact of the Australian gold discoveries in the 1840s on global prices over time in his Essays in Political Economy (1873).
But Mises made the nonneutrality of money a centerpiece of his analysis in The Theory of Money and Credit and in his later expositions in Monetary Stabilization and Cyclical Policy (1928) and in Human Action, A Treatise on Economics (1949). There is no such thing as “helicopter money” that falls from the sky and reaches the pockets of each member of the society at the same time and in the same amount. New or additional quantities of money are introduced or “injected” into the market at some particular point(s) as additional cash holdings now available, first, to some individuals before others.
Suppose there is an increase in the gold supply, as Cairnes analyzed in the case of the Australian gold discoveries. The newly mined gold appeared first in the pockets of the prospectors who brought that gold to the coastal towns of Australia. It was used to increase the demand for the variety of particular goods and services these miners wished to buy, with the prices of these goods rising first in the face of an increased monetary demand for them.
To meet the new demand, a portion of the newly discovered gold was exported to Great Britain and other European countries in exchange for increased supplies of manufactured goods now wanted in those Australian towns, with European prices rising, in turn, in a particular sequence. To expand production for those export goods and the greater consumer demands of the European exporters who now had the financial wherewithal to increase their own demands for desired goods, some of the additional gold in the hands of Europeans was exported to other parts of the world in exchange for greater supplies of resources and raw materials in an attempt to increase the supply of manufactured goods. Resource and raw material and goods prices began to rise in a certain sequence in other parts of the world to meet the new demand.
Slowly but surely, the gold discoveries in Australia affected global prices, first in the Australian coastal areas, then in various parts of Europe, followed by rising prices in other corners of the world. Many, if not all, prices were eventually impacted throughout the world, Cairnes argued, but in a particular temporal sequence reflecting who had the new supplies of gold first, second, and third and the patterned effect this had on relative prices, wages, profits, and productions. The final effect of this process was a generally higher “level” of prices in the world economy, but this had come about neither simultaneously nor proportionally.
If one follows the “microeconomics” of the “macroeconomic” effect of changes in the quantity of money, there is no way that prices in general can be rising other than through the sequential process by which new quantities of money are introduced into the hands and demands of one group of people, then another group of people, followed by another and another. It is only then that through the rising demands for first some goods, then other goods, and, then, still other goods that, cumulatively, prices in general will have gone up in some uneven and sequential pattern.
The monetary injection points and their nonneutral impact
Mises emphasized that there is no rigid and mechanical process about all this because it all depends upon the historical and institutional circumstances of how the change in the quantity of money is introduced. The sequence outlined above with an increase in gold supplies “injected” into the global economy via, at first, the spending patterns of Australian gold miners, will be different from a fiat-money system in which paper currency is printed and used by a government to cover, say, war expenses.
As Mises explained, in this alternative scenario, the new money enters the economy as a greater government demand for military armaments and accompanying war material. The demands for and the prices of war manufactures will tend to rise first. Their profit margins increase at the start, followed by the wages and resource prices of the factors of production they increase to satisfy the government’s greater demands for the means needed for war. The higher relative revenues and incomes of those working in and drawn into war-related productions in the economy now increase their money demands for other desired goods, bringing about rises in another set of prices and demands for the things they wish to buy. And so on, until, again, prices in general in the economy may now be higher, but it will have been brought about in its own particular nonneutral temporal sequence of rising prices and wages and changes in the relative productions of various goods and services.
Another element in this non-neutral monetary process, Mises argued, was an inescapable modification and redistribution of income and wealth. The very fact that some demands and prices and wages rise before others necessarily improves the real relative income positions of some in the society and reduces the real relative incomes of others. Those who experience higher prices and wages for their goods and services earlier in this temporal sequence have higher money incomes to spend before many of the prices of the goods they want to demand have increased in price. Hence, they have more money to spend for goods whose prices have not yet increased or not by as much as their own. This represents a real increase in income for as long as the prices they receive from the goods and services they sell continue to rise more and before the prices the goods and services they buy.
Others in society do not do as well. Given the temporal sequence in which the demands and prices of various goods are rising during the monetary expansion, those individuals and groups who experience higher and rising prices for the goods and services they regularly buy before the prices and wages for the goods and services they sell rise equally or more experience a decline in their real relative incomes. These latter members of society lose during the monetary inflationary process, while those in the earlier groups and sectors of the economy gain from the on-going inflation. Those on fixed incomes or pensions are, clearly, the most obvious victims of monetary inflations.
Monetary deflations are equally nonneutral in their effects
Mises was equally clear that monetary contractions, or “deflationary” processes, were just as nonneutral in their effects on prices, wages, profits, and incomes. As he explained in The Theory of Money and Credit:
Monetary appreciation [falling prices], like monetary depreciation [rising prices] does not occur suddenly and uniformly throughout a whole community, but as a rule starts from single classes and spreads gradually…. The first of those who have to content themselves with lower prices than before for the commodities they sell, while they still have to pay the older higher prices for the commodities they buy, are those who are injured by the increase in the value of money. Those, however, who are the last to have to reduce the prices of the commodities they sell and have meanwhile been able to take advantage of the fall in prices of other things, are those who profit from the change.
This is why Mises considered it futile and counterproductive to try to compensate for the effects of a prior monetary inflation by following it by a monetary deflation. The deflation merely brings in its wake its own nonneutral effects different from and in no way compensating for the loses that particular individuals may have suffered during the monetary inflation. Or as Mises expressed it in a later essay on “The Non-Neutrality of Money” (1938):
[Some] suggest methods to undo changes in the purchasing power of money; if there has been an inflation they wish to deflate to the same extent and vice versa. They do not realize that by this procedure they do not undo the social consequences of the first change, but simply add to it the social consequences of a new change. If a man has been hurt by being run over by an automobile, it is no remedy to let the car go back over him in the opposite direction.
Mises emphasized, as we saw, that how monetary expansions (or contractions) work their way through the marketplace depends on the particular institutional and historical circumstances in which the monetary change occurs. But, in fact, the monetary and banking institutional setting when Mises published and revised The Theory of Money and Credit and wrote his later expositions, as in Human Action, remained fairly much the same, and remains so today. That is, monetary and credit expansions occur through banking systems overseen and fundamentally controlled by central banks.
Given this institutional arrangement of modern monetary and banking systems, Mises applied his theory of the nonneutrality of money to understand and analyze the processes through which inflations and recessions, the booms and busts of the business cycle, are brought about. And, furthermore, what institutional changes would have to be introduced if the causes and consequences of the business cycle were to be eliminated or at least greatly reduced.
This article was originally published in the March 2024 edition of Future of Freedom.