Monetary Theory: Recent Episodes
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Social democrats are so desperate to cast off limits on government that they'll embrace anything that justifies their ambitions. So they invent theories of money that are very, very wrong.
Original Article: "Progressives Have Corrupted Not Only Money, but Its History as Well"
"We would not expect money to be paper, national, or under the control of any entity."
Download the slides from this lecture at Mises.org/MU22_PPT_07.
Recorded at the Mises Institute in Auburn, Alabama, on 24 July 2023.
Bob walks through a recent interview of MMT champion Warren Mosler, in which he claims that Fed rate hikes lead to larger government interest expenses and hence support economic growth and inflation. Bob presents both theoretical and empirical evidence against Mosler's claims.
Bob's Debate with Warren Mosler: Mises.org/HAP403a Bob's Review of Stephanie Kelton: Mises.org/HAP403b Bob's EconLib Article on Austerity: Mises.org/HAP403c Technical Article on Why the Treasury Can't Overdraft: Mises.org/HAP403d
Join us in Nashville on September 23rd for a no-holds-barred discussion against the regime: Mises.org/Nashville23
Mises Institute Fellow Patrick Newman joins Bob to discuss a recent tweet from Stephanie Kelton, which argued that the government's "red ink makes our black ink possible." Patrick and Bob point out that these MMT tautologies are very misleading at best. Patrick also lays out the argument in his journal article, saying that MMT's debt monetization won't cause a boom-bust cycle, but will still reduce living standards.
Per Bylund joins Bob to discuss his new paper at the QJAE, which points out several flaws in the MMT claim that money is valued in order to pay taxes.
Per's QJAE article: Mises.org/HAP398a
Can the injection of new money into the economic system enhance economic growth? Not really. Increasing (or decreasing) the money supply affects the demand for money but doesn't make us wealthier.
Original Article: "Understanding Relationships between Money Supply and Liquidity"
Monetarists believe there is an optimum growth rate of money. However, a fiat money system itself is unstable, so there is no optimum growth rate.
Original Article: "Is There an Optimum Growth Rate of Money?"
Money proper is not artifice. It is a physical "thing" of value, acquired through labor and emerging out of the needs of individuals, who through voluntary exchanges determine its value.
Original Article: "Is It Real Money or Just Artifice?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Keynesians and fellow travelers hold the Phillips curve to be sacrosanct. But because the Phillips curve cannot establish causality, it is useless as economic theory.
Original Article: "The Phillips Curve Is an Economic Fable"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Resources are scarce even when money is not.
Original Article: "A Permanent Wartime Economy"
This Audio Mises Wire is generously sponsored by Christopher Condon.
At the heart of Keynesian business cycle theory is the so-called liquidity trap. Contra Keynes, however, economies don't falter because a sudden increase in the demand for money.
Original Article: "Forget the Liquidity Trap—Loose Monetary Policies Cause Recessions"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Monetary authorities have come up with numerous clever ways of measuring money. However, they are unable even to define money, much less measure it.
Original Article: "Do Correlations Help Define Money?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Fiat money is the fuel of the modern Leviathan state. If we wish to have freedom, we must have sound money.
Original Article: "The Modern State Cannot Exist without Fiat Money"
This Audio Mises Wire is generously sponsored by Christopher Condon.
In a market economy, gold is sound money. There is no need for monetary authorities when gold rules.
Original Article: "A Short Essay on Sound Monetary Policy"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The fiat monetary system is slowly breaking down, taking the economy with it.
Original Article: "The Present Fiat Monetary System Is Breaking Down"
This Audio Mises Wire is generously sponsored by Christopher Condon.
At a time when inflation once again ravages the dollar, we recall Murray Rothbard's wisdom in his article "The Case for a Genuine Gold Dollar."
Original Article: "Rothbard on Gold"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
The current bout of inflation is the latest disaster in a string of disasters caused by government debasement of once sound money.
Original Article: "History Repeats Itself: Abandoning Sound Money Leads to Tyranny and Ruin"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
The original Monetarists (Milton Friedman), Scott Sumner, and problems with Market Monetarism.
Download the slides from this lecture at Mises.org/MU22_PPT_38.
Recorded at the Mises Institute in Auburn, Alabama, on 29 July 2022.
There are two very effective ways to destroy an economy: hyperinflation and central planning.
Recorded at the Mises Institute in Auburn, Alabama, on 28 July 2022.
Lucas Engelhardt summarizes the basics of Modern Monetary Theory.
Recorded at the Mises Institute in Auburn, Alabama, on 27 July 2022.
"We would not expect money to be paper, national, or under the control of any entity."
Download the slides from this lecture at Mises.org/MU22_PPT_05.
Recorded at the Mises Institute in Auburn, Alabama, on 25 July 2022.
Today, inflation and prices are soaring. We know that Federal Reserve monetary policy is the cause. But why didn't something similar happen after the 2008 financial crash?
Bob Murphy and professor Ross McKitrick discuss the government policies, Fed actions, and banking movements that lead up to the 2008 crisis, and why the current economic situation is different.
Ross McKitrick on inflation then versus now: Mises.org/HAP-McKitrick Bob explains how Keynesians missed the latest bout of price inflation: Mises.org/HAP347-Murphy Bob's book Understanding Money Mechanics: Mises.org/Mechanics
Money velocity's role in forcing up prices is misunderstood because today's monetary "authorities" fail to consider how new money is injected into the economy.
Original Article: "The Fed Gets It Wrong on Money Velocity, Too"
This Audio Mises Wire is generously sponsored by Christopher Condon.
In a recent episode of “The Problem With Jon Stewart,” the former Daily Show host asks former president of the Kansas City Fed Thomas Hoenig why the Fed couldn’t have bailed out homeowners, or just “quantitative ease” away the Treasury’s debt. Hoenig gives muddy answers, so Bob tries to clarify.
Mentioned in the Episode and Other Links of Interest: Jon Stewart’s full interview with Thomas HoenigJon Stewart skewers Paul KrugmanJon Stewart interviews Kelton and Gray on MMTBob’s book Understanding Money Mechanics For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on Apple Podcasts, Google Podcasts, Stitcher, Spotify, and via RSS.
Jeff and Bob discuss the mechanics—and pain—required to put an end to inflation.
Read Bob's Understanding Money Mechanics: Mises.org/Mechanics
This book provides the intelligent layperson with a concise yet comprehensive overview of the theory, history, and practice of money and banking, with a focus on the United States. Although the author considers himself an Austrian school economist, most of the material in this book is a neutral presentation of historical facts and an objective description of the mechanics of money creation in today's world.
The book is intended to be a reference for all readers, whether "Austrian" or not, and to bridge the gap by providing a crash course in the necessary theory and history while keeping the discussion tethered to current events.
— From the Introduction
Abstract: This article explains the theoretical importance of the quality of money as a factor of the demand for money and develops the composite indicator that measures the quality of money for the eurozone. The demand for money, i.e., the amount of money people keep in their balances, besides other well-known factors (e.g., interest rate, price level, and income) depends on how people subjectively perceive a particular money’s ability to serve its main functions: a medium of exchange, a store of value, and the unit of account. These properties depend not only on the instruments of monetary policy and the extent to which they are used, but also on the institutional framework of the monetary system. The article suggests that the quality of money is influenced by the institutional framework and monetary policy and that thus the quality of money is a separate channel for the transmission of money policy that works not through the usual mechanism of changing the supply of money, but through central banks affecting the demand for money. An important contribution of this article is that it develops an empirical composite indicator, which measures the quality of money in the eurozone in 1999–2019 and shows the gradual decline in the quality of the euro.
JEL Classification: E41, E52, E58, E51, E44
Vytautas Žukauskas (vytautas.zukauskas@gmail.com) is a PhD candidate in economics at the ISM University of Management and Economics and a senior policy analyst at the Lithuanian Free Market Institute. The author would like to thank Professor Guido Hülsmann and anonymous referees for their helpful and very constructive comments.
INTRODUCTION Monetary policy has an immense impact on the development of economies, and thus on the economic well-being of people. There are numerous studies investigating the channels through which central banks influence economies. How effectively certain goals may be achieved via monetary policy depends on how well we understand these channels and their relative importance. However, the recent emergence of unconventional monetary policy and vast expansion of financial markets calls for the revision of the standard view of monetary policy transmission channels.
The relationship between the demand for money balances and its determinants is a critical component in the formulation and transmission of monetary policy (Goldfeld 1994), especially because economic depressions and inflationary booms can be interpreted as caused by the disequilibrium between the supplyThroughout this text the “supply” of money will mean the available total stock of money. In cases where the argument is about the effects of the production of new money this will be indicated (e.g., “increase” or “change” in the supply of money). of and demand for money (Yeager [1956] 1997).Yeager ([1956] 1997) views the equality between the demand for money and supply of money as the equilibrium condition and identifies the disequilibrium in the money market as the primary cause of depressions and inflationary booms. Depressions occur when there is an excess demand for money, in the sense that people want to hold more money than exists. Inflationary booms occur when there is an excess supply of money, in the sense that more money exists than people want to hold.
Various factors have been proposed as the determinants of the demand for money. Yeager ([1956] 1997, 5–6) claims that the demand for money essentially depends on the volume of transactions and on the price level, with interest rates, expectations, and business conditions also playing a role:
Households and businesses demand cash balances for what are usually classified as transactions, precautionary, speculative, and investment motives. Consideration of these motives shows that the total of cash balances demanded tends to be positively associated with the physical volume of transactions paid for in money (which depends in turn on payment practices and other institutional conditions, on the human and business population, and on the level of production or real income) and with the level of prices and wages. Interest rates and expectations of future price levels and business conditions also presumably have some effect on the demand for money.
Yeager ([1956] 1997, 7) compares money to any other commodity by saying that the number of money units that people demand varies inversely with the purchasing power as the value of the unit: we want to hold more units of any good if its value is higher. And as with other goods, there is some value or purchasing power of money unit that equilibrates the amounts demanded and supplied.
According to Laidler (1971), a stable demand function is a characteristic monetarist belief and is also supported by the empirical evidence. By “stable” Laidler means that money holdings “can be explained … by functional relationships which include a relatively small number of arguments” (Laidler 1982, 39).
In practice a “small” number of arguments has meant three or four—typically including a scale variable such as income, permanent income or wealth, an opportunity cost variable such as nominal interest rate or some measure of the expected inflation rate, and, if nominal balances have been the dependent variable, the general price level. (Laidler 1982, 39–40)
The liquidity preference framework emphasized the opportunity cost as the factor of the money demand. The demand for money depends on the tradeoff between the liquidity of holding money and the opportunity cost of holding it, which is the interest rate earned on holding less liquid but interest-earning alternatives.See, e.g., Modigliani (1944); Tobin (1958). To this day authors name different factors in the demand for money balances, but the most prominent variables include the interest rate, level of income, price level, number of transactions, transaction costs, and the preferences of money holders.See, e.g., Goldfeld (1994); Serletis (2007).
In the traditional framework, monetary policy works through changes in the supply of money. One of the defining features of monetarism is a “quantity theory” approach to macroeconomics, which is “a view that fluctuations in the quantity of money are the dominant cause of fluctuations in money income” (Laidler 1982, 3). Since the demand curve for money is downward sloping,A lower interest rate means a lower opportunity cost for holding money, which increases the quantity of money demanded. an increase in the supply of money equilibrates the money market at the lower interest rate and higher quantity of money demanded.Modern monetary economics often uses the quantity theory of exchange in determining the purchasing power of money. The quantity theory of money is usually expressed with Fisher’s famous equation of exchange, MV = PY, where M is the quantity of money, V is its velocity (i.e., rate of circulation), Y is real output, and P is the price index of this output. Shifts in the supply of money, interest rate, and the amount of financial assets held by market participants in turn affect the economy (and ultimately the aggregate demand) through different transmission channels.See Mishkin (1995); Taylor (1995); and Bernanke and Gertler (1995) on the channels of conventional instruments and Gagnon et al. (2011); Campbell et al. (2012); Bauer and Rudebusch (2013); and Kuttner (2018, 126) on the unconventional instruments.
It is important that according to the traditional view the supply of money is essentially the key element through which central banks conduct the monetary policy. Monetary policy–induced changes in the supply of money are part of the transmission mechanism of monetary policy—the shifts in the demand for money are not.
This view is challenged by economists who suggest that central banks influence the demand for money through the quality of money. Hendershott (1969) claimed that the emphasis on the quantity of money and the Fisherian equation in judging the impact of monetary policy on the economy is misplaced, while its popularity stems from two factors: (1) the attractive simplicity of the naïve quantity theory and (2) historical correlations between money supply and output. Bagus (2009) argues that changes in the quality not only quantity of money are important for the demand and purchasing power of money. Quality of money is defined as the capacity of money, as perceived by economic actors, to fulfil its main functions, namely to serve as a medium of exchange, as a store of wealth, and as an accounting unit. According to Bagus and Howden (2016, 111), “As the purchasing power of money may change due only to a shift in the demand for money, the subjective valuation of money can change even with the expectation of a constant money supply.” Central banks influence characteristics of money (e.g., redemption of money and quality of the central bank’s balance sheet, conditions and stability of the banking system, organization and constitution of monetary authority), which determine actors’ preferences toward money. The quantity theory of money obscures the real problem at hand regarding the value of and demand for the monetary unit (Bagus and Howden 2016, 110).
More recently, Žukauskas and Hülsmann (2019) showed how monetary policy–induced the changes in the quality of money and shifts in the demand for money can explain the movements in the prices of financial assets. The reasoning is that the decline in the quality of money shifts the demand away from money to other assets (e.g., financial assets). They suggest a total-demand approach, which emphasizes the importance of quality of money for the reservation demand for money (demand by the holders of money). The notion of quality of money may shift the understanding of how central banks influence the economy. If it is correct, then theorists will need to accept that monetary policy works not only through the supply but also through the demand side of money.
There has been some discussion of the dimensions of monetary policy which may impact the quality of money and thus the demand for money.E.g., Bagus (2009); Bagus and Howden (2016). However, there have not been any attempts to measure this impact. The notion of the quality of money stems from the subjective value theory, in which the qualities that determine the value of objects are subjective and are hard to quantify. The absence of measurement makes it difficult to judge the importance of quality of money as a demand-side channel of monetary policy. This paper attempts to fill this gap. It will discuss the dimensions of monetary policy that are relevant for the notion of the quality of money, and it will quantify them by compiling a composite indicator of the quality of money.
The first part of the article will discuss the theory behind the subjective nature of the value and demand for money. The second part will focus on the quality of money. The third part will cover the methodological issues in compiling the composite indicator. The fourth part will present the results of the index. The fifth part will discuss the limitations and the importance of the quality of money and its measurement in the context of monetary policy.
- THE SUBJECTIVE NATURE OF THE DEMAND FOR MONEY The theory behind monetarism and the stable money demand function tends to overlook the subjective nature of the demand for money. The quantity theory of money as formulated by Fisher (1911) and restated by Friedman (1956) still dominates the way economists look at the purchasing power of money. This theory focuses on the supply of money, and it does not explicitly suggest a role for the subjective factors which determine the demand for money. “While such an analysis is not obviously incorrect, the attention the equation affords to past quantities, both of money and nominal transactions, obscures the real problem at hand regarding the value of and demand for the monetary unit.” (Bagus and Howden 2016, 110).
The qualitative (or demand-side) approach is older than the modern focus on the quantitative (supply-side) factors in the analysis of the value of money:
A long history of qualitative and demand-side analysis predates the modern attention to supply-side factors determining money’s value. Early authors such as Mariana ([1609] 1994) and Petty (1662) illustrate this long tradition of the quality theory of money. Smith ([1776] 1863) explains the origin of money by pointing to the importance of certain qualities such as a commodity’s divisibility and durability. Similar discussions of the qualities of a “good” medium of exchange are found in the classic works of Say ([1803] 1843), Mill ([1848] 1909), and Senior ([1850] 1854). Menger ([1871] 2007) explained the origin of money as a market process whereby commodities with certain marketable qualities prevail at becoming generally accepted exchange media. By the time Jevons ([1875] 1876) wrote his treatise Money and the Mechanism of Exchange, the characteristics or qualities of “good” money were generally known (and are still today summarily detailed in most introductory monetary economics texts). (Bagus and Howden 2016, 111–12)
Some economists, predominantly those in the Austrian school of economic thought, clearly recognize that the demand and value of money are subjective and that they stem from money’s ability to fulfil its functions in the market (medium of exchange, store of value, unit of account). To be properly used as money, a good must have certain characteristics. Classically, these are divisibility, fungibility (or universal want), durability, and stability of value.
Mises in the Theory of Money and Credit and Human Action explained how prices and the value of money can be explained using the same principles used to explain the prices and value of other goods in the economy. The price of money is its purchasing power, and it emerges in the market as a result of the demand for and the supply of money (the so-called money relation). It is clear that according to Mises the demand for money is subjective. Catallactics can tell us about the advantages of holding money and about the factors which may influence the demand for money, but the demand for money can never be reduced to a specific function.
But all of these objective factors always affect the matter only as motivations of the individual. They are never capable of a direct influence upon the actual amount of his demand for money. Here, as in all departments of economic life, it is the subjective valuations of the separate economic agents that alone are decisive. The store of purchasing power held by two such agents whose objective economic circumstances were identical might be quite different if the advantages and disadvantages of such a store were estimated differently by the different agents. (Mises [1934] 2012, 154)
Also,
The various actors make up their minds about what they believe the adequate height of their cash holding should be. They carry out their resolution by renouncing the purchase of commodities, securities, and interest-bearing claims, and by selling such assets or conversely by increasing their purchases. With money, things are not different from what they are with regard to all other goods and services. The demand for money is determined by the conduct of people intent upon acquiring it for their cash holding. (Mises [1949] 1998, 401)
The subjective demand for money is closely linked to the recognition that money is a good. Like any other good, money is demanded by the market participants for its valuable services. Hutt (1956) explains that money should not be considered unproductive or barren, as was claimed by many influential authors (e.g., Aristotle, Locke), who influenced modern thinkers. Keynes claimed that by choosing to hold money for convenience and security market participants are foregoing the interest that could be earned by holding other assets which bring nothing “in the shape of output” (Keynes 1936, 226). However, according to Hutt, money is productive in exactly the same sense as other goods in the economy. Money assets held provide valuable services, and they derive their value from their power to render these services. The amount of money that market participants decide to hold is determined by the marginal utility of its services. In fact, this means that money has a “prospective yield (of ‘utilities’), which invites the holding of money, as the normal return to investment” (Hutt 1956, 198). The demand for money is effectively the demand to hold. It stems from the value of being in a position to acquire other things at “the most profitable time, or at the most convenient time” (Hutt 1956, 206). Thus, holding money is not forgoing the yield which could be earned by holding other interest-bearing assets. By holding money, one earns a nonpecuniary yield in the form of money services.Also Hutt (1956, 207):The fact that we hold money assets for any period at all indicates that, although we do not want to use these assets in any other way, their services do occupy a place on our scale of preferences, just like the services of all the other capital resources which we refrain from exchanging.
The services that the owner receives from holding money are related to the uncertainty in the market economy. Rothbard ([1962, 1970] 2009, 767) recognizes that the demand for money emerges from the uncertainty that economic agents face: money’s “uses are based precisely on the fact that the individual is not certain on what he will spend his money or of the precise time that he will spend it in the future.” Although these uses are objective in the sense that every economic agent faces uncertainty, the demand for money is still subjective:
Economists have attempted mechanically to reduce the demand for money to various sources. There is no such mechanical determination, however. Each individual decides for himself by his own standards his whole demand for cash balances, and we can only trace various influences which different catallactic events may have had on demand. (Rothbard [1962, 1970] 2009, 768)
An important contribution of Rothbard is his application of total demand and stock analysis to the analysis of money and the purchasing power of money. Money is unique in the sense that people simultaneously have a reservation and exchange demand for money. As Rothbard ([1962, 1970] 2009, 757) noted, “In contrast to other commodities, everyone on the market has both an exchange demand and a reservation demand for money.” The total demand for money on the market consists of two parts: the exchange demand for money (by sellers of all other goods who wish to purchase money) and the reservation demand for money (the demand for money to hold by those who already hold it) (Rothbard, [1962, 1970] 2009, 756). Exchange demand for money is the pre-income demand, and reservation demand for money is the post-income demand. Individuals demand money that they do not yet own by offering their goods or services in return for money—this is the exchange demand for money. Individuals also demand money that they own by choosing to not spend it and keep it in their cash balances—this is the reservation demand for money.
The price level is determined by the intersection of the total demand and the total stock of money. The total-demand and stock analysis utilized by Rothbard is an elegant analytical tool which clearly shows the errors inherent in the quantity theory of money, which assumes a mechanistic relationship between the supply of money and prices. Both the exchange and reservation demand for money are subjective, thus an increase in the supply of money can produce different effects on prices depending on how people react to this change, by deciding to hold a higher or lower share of additional money in their money balances.
An important question is which one—exchange or reservation demand—is more important for the determination of prices and the purchasing power of money. According to Rothbard ([1962, 1970] 2009, 759), the reservation demand for money is more important because it is “more volatile.” The volatility of the reservation demand comes from the fact that holders of money may, for some reason (e.g., they think that the purchasing power of money will go down), want to drastically reduce their holdings of money by spending them. They cannot reduce their exchange demand for money so easily, because it is a lot easier to spend their cash balances than to turn to exchanging their goods and services for nonmonetary goods (barter) or other competing money in the market. Thus, the importance of the reservation demand for money comes from the fact that it is more volatile and thus more important in the changes in prices and the purchasing power of money. However, precisely because it is more stable, an argument can be made that exchange demand for money, i.e., the supply of goods and services, has an important influence on the purchasing prices and power of money, at least in the short run. Even if the reservation demand for money decreases significantly, the exchange demand for money can stay relatively stable and keep the prices and purchasing power of money from dropping rapidly.
Horwitz (1990) applies subjectivist principles to the demand for money as well and criticizes as oversimplified “neoclassical and Keynesian models that portray the only opportunity cost of money held as interest-bearing securities.” His approach claims that the choice to hold money depends on the utility of the most valuable alternative forgone:
When an actor is facing a decision to hold wealth in the form of money, she is deciding between a number of prospective utility streams. We can broadly categorize those streams as the utility from non-financial assets and the utility from both the availability and interest returns from non-money financial assets. (Horwitz 1990, 465)
Most importantly, the demand for money is subjective, since only the chooser can determine the utility that their choice provides. Moreover, the cost of holding money is subjective, because it is never objectively realized.
What is given up in a choice is by definition what was not chosen, so the “measure” of that cost must necessarily be the expected utility of the sacrificed alternative. Such expectations can be definitively described only by the chooser. (Horwitz 1990, 465)
The subjectivity of the demand for money brings us back to the monetary policy. If the demand for money balances has an important subjective element to it, the demand for money can be influenced, but it is not mechanically determined by such factors as income, price level, or interest rate. If this is the case, then central banks and monetary policy may not just influence the amount of money that people are willing to hold through the manipulation of the money supply and the interest rate. The subjectivist approach to the demand for money allows for the recognition that the impact of central banks on money (and prices) may be much broader. And this is exactly the claim of the recent literature on the quality of money.
- QUALITY OF MONEY AND ITS DIMENSIONS The theory of the quality of money maintains that the demand for money depends on the quality of money. Money’s quality can be defined as “the capacity of money, as perceived by actors, to fulfil all its main functions, namely to serve as a medium of exchange, as a store of wealth, and as an accounting unit” (Bagus 2009, 22–23). The quality of money is one of the important factors, along with uncertainty, financial innovations (credit cards, ATMs, money market mutual funds), frequency of payment, etc. that affect the reservation or cash balance demand for money (Žukauskas and Hülsmann 2019).
Money supply, according to this view, is just one of the factors affecting the quality of money. Existing total supply of money at any time does not matter in the sense that money can be used as a universal medium of exchange despite the amount of monetary units available (a lower amount just means a lower price level). Money supply matters for the quality of money if we add the dimensions of time and changes in the supply of money. Changes in the supply of money influence the extent of the stability of the purchasing power of money. However, there are a lot more factors or dimensions influencing the quality of money: “As the purchasing power of money may change due only to a shift in the demand for money, the subjective valuation of money can change even with the expectation of a constant money supply” (Bagus and Howden 2016, 111).
The idea behind the quality of money is that central banks, through monetary policy, influence other characteristics of money (besides money supply) that are relevant for money users. A shift in these characteristics impacts the quality and subjective value of money, and “[c]hanges in money’s quality affect the demand for money and, consequently, its purchasing power” Bagus (2015, 19).
According to Bagus, “good” monetary systems have objective qualities. The quality of a money is closely linked to the quality of the monetary regime, which can be defined as “the capacity of a monetary system to provide an institutional framework for a good medium of exchange, store of wealth, and accounting unit” (Bagus 2015, 19–20).
According to Bagus (2015), the unit of account function is fulfilled by nearly all monetary systems equally well, and it is impaired only in extreme situations. Thus it is meaningful to concentrate on the characteristics of a good medium of exchange and store of value.According to Röpke (1954), money’s functions often dissapear in a certain order. First, money ceases to be a storage of wealth. Then, money loses its function as a unit of account. The last function that is lost in a hyperinflation is the function of medium of exchange. The main requirements for money as a medium of exchange are low storage and transportation costs, easy handling, durability, divisibility, resistance to tarnish, homogeneity, and ease of recognition. However, “These properties hardly change today as paper-based fiat standards have eased the physical usability of the monetary unit, as well as the costs to provide it” (Bagus 2015, 23). Another relevant property of a medium of exchange is the number of users, because more users imply more demand for the medium of exchange. “As more people accept it in trade, the medium of exchange is more useful” (Bagus 2015, 23). Existence of ample nonmonetary demand for the money as either a consumer good or a factor of production is yet another important characteristic for a medium of exchange. However, in fiat money systems, where money is not redeemable, it does not have this property altogether.
One of the most important variables in money’s function as a store of value is the possibility of increases in its quantity. “Different monetary regimes allow for different mechanisms to increase the quantity of money, thereby influencing money’s quality. Thus, monetary systems may set strict or less strict limits for increases in the money supply” (Bagus 2015, 24). The stability of the financial system is also an important property of money and a factor in its store-of-value function.
There are monetary regimes that are more prone to generate business cycles, over-indebtedness and illiquidity than other regimes. Business cycles, over-indebtedness and illiquidity may provoke interventions and bailouts on the part of the government or monetary authorities. In the wake of the bailouts the quantity of money is often increased, or even the quality of the monetary system is diluted. (24)
The monetary regime’s independence from the government and the restrictions that it sets to eliminate or limit the government’s manipulation of money are also important to money as a store of value. “Interventions by the government often decrease the quality of money in its own favor by increases in money’s quantity or through a deterioration in the reserves backing it” (25).
To sum up, the quality of money as a store of value and a medium of exchange can essentially change in five ways (Bagus and Howden 2016, 113):
Money supply—the supply of money in existence today and in the futureRedemption ratio (in the case of commodity money systems)—the amount and value of assets or other goods that back the currency (that money can be redeemed for)Conditions and stability of the banking system—a financially troubled, illiquid banking system increases risk of bailouts, which may lead to higher quantity of money (if financed through debt monetization)Institutional framework of the monetary authority, which can mean: a. The independence of the central bank (if the central bank follows directives from the government, this increases the risk of debt monetization to finance spending)
b. Accountability and transparency—–the quality of money will improve if central bankers are accountable and responsible for their policies and if there is transparency
c. The central bank’s constitution, that is, its philosophy or objectives (e.g., price stability versus ancillary aims of full employment, increasing asset prices, and maintenance of a currency), its price inflation target, whether it has a rule-based monetary policy or simply targets asset prices
d. Staff and decision-makers at the central bank, who influence monetary policy primarily through building consensus
Quality of the central bank’s balance sheet—the quality of the reserves and assets backing the money determines the central bank’s ability to maintain and defend the currency’s value in the future Therefore, by incorporating the quality of money, it is possible to understand how the purchasing power of money can vary with a constant money stock, namely when the perceived quality of money changes. The quality of money affects the purchasing power of money by first altering the demand for money, which reflects the changed valuation of a fixed quantity of money on each person’s value scale. When the quality of money improves, the demand for money, and, consequently, money’s purchasing power, will be higher. If subjective valuation of money falls, people will reduce their cash balances and prices will increase. The subjectivity of valuation and demand for money also means that changes in the perceived quality of money can be very abrupt (which would lead to a strong and quick change in the purchasing power of money), whereas changes in the quantity of money are usually gradual.
- METHODOLOGY OF THE COMPOSITE INDICATOR Based on the framework discussed above, this section will develop an empirical composite indicator for the quality of money and apply it to the euro area. “Composite,” also known as “synthetic,” indicators are “formed when individual indicators are compiled into a single index, on the basis of an underlying model of the multi-dimensional concept that is being measured” (Nardo et al. 2005, 8). Essentially, a composite indicator consists of numerous “components” that reflect a “complex system,” making it easier to understand in full rather than by reducing it to its “spare parts” (Greco et al. 2019). The literature on composite indicators suggests a particular procedure to compile a composite indicator. We will analyze the quality of money using these steps.
Theoretical Framework
The first step in the creation of a composite indicator is the theoretical framework, which establishes what is being measured, its measurable dimensions, and eventually the indicators that constitute the composite indicator. The strength of the theoretical framework determines how meaningful the composite is. The quality of money and its measurable dimensions have already been discussed above. Here we will focus on the indicators.
The selected indicators must carry relevant information about the core components of the phenomenon being measured. Practitioners use proxy variables when direct indicators or data are not available (OECD and JRC 2008). Although the selection of indicators is vested in the theoretical framework, practitioners admit that it is a process which depends on the judgments of the researcher.According to Röpke (1954), money’s functions often dissapear in a certain order. First, money ceases to be a storage of wealth. Then, money loses its function as a unit of account. The last function that is lost in a hyperinflation is the function of medium of exchange.
The selection of the indicators for the quality of money index and the dimensions of it was heavily influenced by the existing scholarship on the quality of money, which has been discussed above. As shown in table 1, the index consists of five dimensions and eighteen indicators. The indicators in the central bank balance sheet dimension follow the suggestions of Bagus (2015) and Bagus and Howden (2016). The rest of the indicators were selected to reflect the other significant aspects of the quality of money. The choice of dimensions and indicators will be discussed below.
The Central Bank Balance Sheet
The quality of money can be measured indirectly by the assets that back the monetary base. Central bank assets serve as collateral that “backs” the currency and represents the central bank’s capability to defend the value of the currency domestically and internationally. The balance sheet will be assessed by three liquidity ratios, two international strength ratios, and one equity ratio (see table 1). The idea behind the liquidity ratios is that the higher the share of liquid and high-quality assets in the central bank’s reserves, the higher the quality of money will be. During a crisis, liquid assets can be used to support a faltering currency. International strength ratios indicate a central bank´s potential to defend the external value (i.e., the foreign exchange rate) of a currency. International strength ratios show the percentage of monetary liabilities that are backed with foreign reserves, which can be used to support the currency’s value on the foreign exchange market. The equity ratio indicates the central bank’s leverage. A higher ratio implies a more conservative situation (i.e., less leverage) and an increased quality of money.
Money Supply
Changes in the money supply is one of the factors influencing the quality of money. Existing total stock of money at any time does not matter in the sense that money can be used as a medium of exchange despite the number of monetary units available. However, changes in the money supply influence the long-term stability of the purchasing power of money. The index contains four indicators that represent different definitions of the money supply: monetary base, central bank balance sheet, and monetary aggregates M1 and M3.
Interest Rates
There is a link between money supply and interest rates. The European Central Bank (ECB) communicates its monetary policy stance by setting an interest rate target. This target is achieved primarily through open market operations—by purchasing or selling financial assets in the market and thus increasing or decreasing the monetary base. Thus, changes in the interest rates set by the central bank show how inflationary its monetary policy is. A decrease in the interest rates is achieved through an increase in the money supply, which in the long term means a lower purchasing power of money. The quality of money index contains four indicators measuring interest rates. Three of them represent three key interest rates set by the ECB: the rates on the deposit facility, the main refinancing operations (MRO), and the marginal lending facility. The fourth indicator is based on spread between the main refinancing operations rate and Taylor’s rule interest rate.
Taylor’s rule is a guideline for how central banks should change interest rates in response to changes in economic conditions. It was established to adjust and set prudent rates for the short-term stabilization of the economy while still maintaining long-term growth (Taylor 1993). Machaj (2016) admits that Taylor convincingly demonstrates that low interest rates contributed to the housing bubble and mortgage market expansion. However, Machaj (2016, 12) criticizes the Taylor rule from an Austrian perspective by saying that “any rule recommended for interest rates higher than the actual ones would have been better than that actually followed (even a rule based on astrology). Apart from that, there may be nothing specific about the Taylor rule that makes it a panacea for macroeconomic problems.” The technical problem with the Taylor rule is that it has many variants and that it cannot be applied precisely (e.g., it is difficult to measure the potential output). The fundamental problem is that following this rule does not ensure economic stability: “[T]argeting … macroeconomic variables is not a recipe for intertemporal coordination understood in the Hayekian sense: as coordination between successive stages of production” (Machaj 2014). Nevertheless, in this indicator we will use the Taylor rule as a rough guide and the basis for the evaluation of the interest rate set by the monetary authority. Following the Taylor rule does not ensure macroeconomic balance, but it is quite clear that strong deviations from it are related to macroeconomic imbalances.
Financial System Stability
The conditions and stability of the financial system matter for the quality of money, because a financially troubled, illiquid banking system increases risk of bailouts, which may lead to a higher quantity of money (if financed through debt monetization). The stability of the financial system is measured by three indicators: the Composite Indicator of Systemic Stress (CISS), the euro interbank offered rate–overnight index swap rate (Euribor—OIS) spread, and the liquidity ratio of the eurozone banking sector (for a more detailed explanation of each indicator, see table 2).
Forward Guidance
Forward guidance is central bank communication—announcements, speeches, press conferences—which aims to provide information about the likely path of future policy and interest rates (Kuttner 2018, 126). Forward guidance is an unconventional instrument of monetary policy that the ECB uses to guide the expectations of market participants about the future stance of monetary policy. Forward guidance is connected to the quality of money: expectations for prolonged periods of inflationary monetary policy mean that market participants expect the interest rates to stay low and the money supply to increase faster than otherwise. The index contains one indicator (the spread between current rate of main refinancing operations and the OIS rate) which captures the extent to which market participants expect monetary policy to remain or become inflationary (see more in table 1).
Table 1. Indicators of the quality of money index
Foreign reserve assets are assets denominated in foreign currency and include reserve position in the International Monetary Fund (IMF), special drawing rights (an international reserve asset) created by the IMF, financial derivatives, loans to nonresident nonbanks, long-term loans to an IMF Trust account, and other assets that meet the reserve assets definition.
The Euribor rates are based on the average interest rates at which a large panel of European banks borrow funds from one another.The OIS rate represents a given country’s central bank rate over the course of a certain period.
The dimensions and indicators of the index are flexible in the sense that they are mostly not specific to a particular central bank and can be applied to any currency and central bank. In this article, we will focus on the euro area and European Central Bank. To ensure maximum flexibility in using the index, it will be calculated using monthly data.If the index data is monthly, it can be easily used to calculate quarterly or yearly changes. The period for the euro analysis is the end of 1999 until the end of 2019.
One aspect not captured by the index is the institutional framework of the central bank (its independence, accountability and transparency, constitution, and staff and decision-makers) due to the lack of publicly available and quantifiable indicators. Although there are quantitative indicators of central bank independence, they are only available on an annual basis.E.g., Garriga (2016), Masciandaro and Romelli (2019). Moreover, since the evaluation of central banks’ independence does not change much over the years, it is more useful as a tool for comparing different central banks’ level of independence than for tracking the change in a particular bank’s independence. Quantitative indicators of other aspects of the institutional framework are not available, since they are heavily subjective and depend on value judgments.
Once the indicators have been established, further steps in compiling the composite indicator are normalization of the data, weighting of the indicators, and aggregating them into a composite indicator. We will go through these steps very briefly; more information on the methodology can be found in the appendix.
Normalization
Normalization converts the data of the indicators on a common scale. This is crucial for the comparability of different indicators and to combine them into a composite. The normalization method used for the quality of money index was the min-max transformation. The reasons why the min-max transformation was chosen over the other methods were primarily a) the data used in the index are time series of variables which do not have high variability or any extreme values (in the cases of extreme values, methods based on standard deviation or distance from the mean are preferred) and b) according to the theoretical framework, changes in the indicator’s value are important in the same way, regardless of the level (if this were not the case, the transformation should be concaved (log, root, exponential, or power) instead. The min-max transformation brings all the values of all the indicators onto a scale of 0 to 100, where 0 represents the lowest value and 100 represents the highest value (the formula used in the normalization can be found in the appendix).
Weighting
Composite indicator is composed of individual indicators, which may have specific weights. There are different weighting methods, but they all fall into two categories: expert/public opinion–based methods and statistical methods. The weighting procedure selected needs to reflect the object or phenomenon, and it needs to be simple in order to be able to communicate the final weighting scheme. Literature on composite indicators considers weighting based on statistical methods to be more “objective,” as statistical methods are not based on a decision-maker’s subjective valuation.See Booysen (2002); Zhou, Ang, and Poh (2007); and Decancq and Lugo (2013). Two statistical tools that are often used in weighting are correlation and multiple linear regression analysis.
The weighting of the composite indicator was decided separately at the level of the dimensions and indicators, following two steps. The first step applied regression analysis and determined the weights of the dimensions. The second step applied correlation analysis and established the weights of the individual indicators in each dimension (a detailed explanation of the two steps can be found in the appendix).
Table 2 shows the results of the first step, which used the linear regression analysis for dimension weights. After the adjustment, the coefficients of determination are not equal, but they are more balanced than in the case of equal weighting.
Table 2. Weighting adjustments in the first step (dimensions)Foreign reserve assets are assets denominated in foreign currency and include reserve position in the International Monetary Fund (IMF), special drawing rights (an international reserve asset) created by the IMF, financial derivatives, loans to nonresident nonbanks, long-term loans to an IMF Trust account, and other assets that meet the reserve assets definition.
In the second step, the equal weighting of indicators in each dimension was adjusted to avoid double counting using the correlation analysis. As explained in the appendix on methodology, the weights were distributed equally among all indicators in each dimension unless there were high levels of correlation (higher than 0.6).
Aggregation
The aggregation process combines the values of a set of indicators into one composite indicator. An important distinction of aggregation methods in the literature is between “compensatory” and “noncompensatory” approaches.See Munda (2005); and Greco et al. (2019). According to Bouyssou (1986, 151), aggregation is noncompensatory if no tradeoffs occur and is compensatory otherwise. The definition of compensation therefore presents a tradeoff. Compensatory aggregation assumes that poor performance in some indicators can be compensated for by high performance in other indicators.
Linear compensatory aggregation was chosen as the most suitable method for aggregating the quality of money index. The value of the composite index was the arithmetic average of all the indicators weighted by their respective weights. The primary reason for this choice is that the theoretical framework, which is the source of the different dimensions of the index, implicitly assumes the possibility of compensation (bad performance in one of the dimensions of quality of money can be compensated with good performance in the others). Moreover, linear compensatory aggregation is the most common method used in the creation of composite indicators (Gan et al. 2017).
- RESULTS The results of the quality of money index are presented in figure 1 below. The quality of money index suggests that over the period of the euro’s existence the quality of money overall has declined by 55 points (on a scale of 0 to 100), from 73 in December 1999 to 18 in August 2019. The rate of decline on average is 0.22 points per month, or 2.7 points per year.
Figure 1. Quality of money index
Scale: 0 to 100. We can distinguish four periods for the euro in the quality of money index. The dynamics of the quality of money were different during each of these periods, and they represent distinctive economic conditions and ECB policy environments.
The first period, from 1999 to mid-2005, marks the initial decline in the quality of money in the eurozone. The two most important drivers of the decline were the ECB’s balance sheet and interest rate policy (see Figure 2 below for the dynamics of each dimension). The quality of the balance sheet declined quite significantly during this period due to a decline in liquidity. The monetary base was growing faster than the value of gold or gold receivables, and the value of reserve assets in general was falling. Moreover, there was a drop in the value of foreign reserves and a decline in the central bank’s equity ratio. In general, the ECB’s balance sheet during this period became less liquid, and it had less foreign reserves and equity as a ratio to total assets. During the first period the ECB also significantly reduced the interest rate. The MRO rate was reduced from 4.75 in 2000 to 2 percent in 2003. The interest rate also fell below the one suggested by the Taylor rule after September 2001.
The second period lasted from about mid-2005 to mid-2008. The quality of money during this period stopped declining and stayed relatively stable. The quality of the balance sheet was still declining, but it was offset by the increased interest rates—the ECB had been transitioning out of the stimulating monetary policy and had gradually increased the MRO rate to 4.25 percent in 2008.
Figure 2. Dimension of the quality of money index
The third period, from mid-2008 to early 2013, was one of financial and economic turmoil. This period saw two very significant drops in the quality of money. The first one lasted from the second half of 2008 to the first half of 2009. There were many factors that contributed to this drop.
Firstly, the financial system’s stability declined rapidly. Financial turmoil spread to the real economy, which halted economic growth and induced the ECB to try to save the financial sector and prop up the economy by rapidly reducing the interest rates to a new record low of 1 percent. It quickly increased the growth of the money supply, and this increased expectations in the market that the central bank would continue with the inflationary monetary policy.
After the first half of 2009, the economic and financial situation in the eurozone somewhat stabilized, and the drop in the quality of money was partially offset by the increase in financial stability and reduced growth in the money supply. However, the situation worsened very quickly again in the second half of 2011, when financial markets started panicking again due to the sovereign debt crisis in some of the euro countries, primarily Greece. The stability of the financial system rapidly declined again, and the bond yields of weak euro member governments soared. This was the catalyst for ECB president Mario Draghi’s famous speech in which he said that “[w]ithin our mandate, the ECB is ready to do whatever it takes to preserve the euro.” The ECB again lowered the interest rate, increased the money supply, and started conducting quantitative easing and forward guidance. This caused the quality of the balance sheet to decline, since the new policies reduced the liquidity, reserves, and equity of the ECB. All this contributed to the significant drop in the quality of money during this period. After these measures, the stability of the financial system increased again and somewhat reversed the drop in the quality of money.
The last period started around 2013 and lasted at least until the end of 2019. During this period, the ECB continued conducting the policies of quantitative easing and forward guidance. The interest rates were reduced further until they reached 0 percent in 2016. The growth of money supply again increased and was especially high in 2013 and 2014. Quantitative easing led to the vast expansion of the central bank’s balance sheet and of the excess reserves of the commercial banks at the ECB. The ECB’s communications focused on forward guidance, assuring market participants of accommodative monetary policy in the future. All these measures convinced financial markets that the troubles are behind them, and different measures showed the gradual stabilization of the financial system. Throughout this period the quality of money declined, and financial system stability is the only dimension of the index that increased. This suggests that the policies enacted by the ECB were successful in stabilizing the financial system, but these policies caused a significant declined in the quality of money in the eurozone.
Below the limitations of the quality of money index and the importance of the quality of money—as a theoretical notion and a measurement—will be discussed briefly.
- DISCUSSION AND LIMITATIONS As mentioned previously, the framework of quality of money is based on the subjective value theory. Money as a good is valued to the extent that it fulfils the needs of market participants. In particular, money is valued when it has the properties of being a medium of exchange, a store of value, and a unit of account. However, these properties, which ones are most important, and how a particular money fulfils them are subjective value judgments. Therefore, attempts to chart the compositions of these properties cannot be thorough and objective by definition. They in themselves will be bound up in value judgments, which may be different from those of market participants. Moreover, the methodology (normalization, weighting, aggregation) of the creation of a composite index in itself requires the researcher to make subjective decisions.
Not all the dimensions that may be important to the quality of money can be easily quantified; e.g., the scholarship identifies the organization of monetary authority (the central bank’s independence, its accountability and transparency, its constitution, and its decision-makers) as one of the dimensions that is important. However, there are no quantifiable indicators to measure it. These questions are especially laden with subjective judgments. This suggests that some of the identified dimensions of the quality of money are more quantifiable than others.
Nevertheless, the composite indicator of quality of money allowed the significant decrease in the quality of the euro since its introduction to be captured. Thus, changes in the quality of money may be an important factor in the changes in the demand for money. In theory, given all the other factors (interest rate, income, prices, etc.) in the demand for money, the preference of market participants to hold money balances may change due to fluctuating quality of money. Empirical measurement has shown that changes in the quality of money over a year may be quite significant. Why is this important?
Quality of money is one more factor which needs to be incorporated into the analysis of the demand for money. This factor is quite different from the ones already accounted for in theories about the demand for money, particularly the quantity theory of money. A qualitative theory of the value of money allows the subjective judgments of market participants to be weighted. This means that the changes in the perception of value—and thus the demand for money—can be a lot more abrupt and extensive in comparison to the results of the quantitative theory of money, in which demand for money depends on more stable factors (quantity of money, level of output, etc.).
Moreover, the notions of quality of money and demand for money are intricately linked to prices. Price level is the result of the intersection of the demand for money balances and money supply. Shifts in the supply of money, as well as demand for money, result in changes in the price level. Thus, changes in the quality of money as one of the factors of money demand may cause changes in the price level. More particularly, if decreasing quality of money reduces the demand for money, the price level increases.
The application of the quality of money index to the eurozone, and the analysis of the index’s dynamics alongside the policies of the ECB, showed that the economic and financial problems of the eurozone led the monetary authority to make decisions and enact policies which led to the deterioration of the euro’s quality. Monetary policy became more inflationary. The quality of money was sacrificed in order to prop up the economy and save banks and other financial institutions.
The decreasing quality of the euro is in line with the theoretical reasoning suggested by Žukauskas and Hülsmann (2019). They claim that the quantity theory of money cannot explain why prices in the financial sector grow faster relative to prices in the nonfinancial sector and suggest a novel explanation of how monetary policy influences the prices of financial assets relative to nonfinancial assets that is based on the quality of money. A decline in the quality of money decreases the demand for money, with market participants shifting to financial assets as an alternative form of holding wealth, resulting in the increased price of financial assets.
Lastly, if quality of money, which depends on monetary policy and the overall functioning of the monetary system, is a factor in money demand, then quality of money is one of the transmission mechanisms for monetary policy. The actions of central banks influence the quality of money, which in turns affects the money demand. According to this framework, then, monetary policy not only influences the economy by changing the supply of money, but also by affecting the demand for money. Demand for money becomes (at least partly) an endogenous variable in the monetary policy.
CONCLUSIONS This article suggests that the quality of money is a concept that offers new insights on how monetary policy may influence not only the supply of money, but also the demand for it. It offers an empirical measurement of the quality of money index here applied to the euro area. The index suggests that the quality of the euro has fallen significantly since its introduction in 1999. To the extent that the demand for money subjectively depends on the quality of money, this fall has been significant enough to influence the price level in general and prices in particular (e.g., financial asset prices).
It is important to incorporate the quality of money into the analysis of the demand for money. Moreover, since central banks influence the quality of money, it is vital to treat it as one of the channels for the transmission of monetary policy. Central banks, their institutional frameworks, and their policy decisions impact the quality of money, which in turns affects the demand for money, the price level, and other variables in the economy.
APPENDIX Normalization
In cases where an indicator’s higher values represent higher values in the index,
Also, in cases where an indicator’s higher values represent higher values in the index,
, where:
is the transformed value of an indicator (a) at time t,
is the data point of an indicator (a) at time t,
min(xa) is the minimum of all data points of an indicator (a), and
max(xa) is the maximum of all data points of an indicator.
Weighting
Weighting of dimensions (subindices)
The composite index of quality of money contains five subindices, which each contain a varying number of indicators. The weight of each subindex is decided through the regression analysis of the particular subindex and the composite index. The deciding factor is the subindex’s coefficients of determination (R2) of single-variate regressions. The aim is for the coefficients of determination of each subindex to be as close as possible to each other, which means that the proportion of predictable variance in the dependent variable (composite index) due to each independent variable (subindex) should be more or less equal and not dominated by any one subindex. The procedure starts with equal weighting of all the subindices, and the weights of the subindices with the lowest coefficients of determination are increased (at the expense of subindices with high coefficients of determination) until the level of the highest possible equality is reached. There are several restrictions to this procedure. First, for reasons of simplicity and aesthetics, the increment of adjustment (up and down) is 5 percentage points. Second, each subindex should have a weight of no less than 5 percent. This is for theoretical integrity, to maintain at least minimum representation of each factor (subindex) in the composite index. Thirdly, no subindex should have a weight of more than 35 percent (roughly one-third). This is to avoid the overrepresentation of a subindex.
Weighting of individual indicators
The weighting of indicators in the subindices corresponds to the weights of the subindices, which are decided in the first step. Therefore, the general rule is that the weights of the indicators in a dimension are equal to the weight of the subindex divided by the number of indicators in it. There are two rules according to which the weights of individual indicators can be adjusted to reflect the indicators more accurately.
Some subindices have several groups of indicators, which refer to different topics or types of indicators/measurements. For example, the central bank balance sheet subindex contains for liquidity, international strength, and equity position subtopics. The first rule is that for a certain subtopic, all indicators in a subtopic are weighted equally despite the number of indicators (which means that different indicators may have different weights in the subindex depending on the number of them in the topic).The second rule for weighting the individual indicators in a subtopic is based on the correlation analysis. When indicators have a high and statistically significant correlation (judged by Pearson’s coefficient of correlation, which is higher than 0.6), they are treated as one indicator (their weights are reduced to jointly equal the weight of other indicators). Table 2 shows the results of the first step, which used the linear regression analysis to establish the weights of dimensions. After the adjustment, the coefficients of determination are not equal, but they are more balanced than in the case of equal weighting.
Abstract: This article explains the theoretical importance of the quality of money as a factor of the demand for money and develops the composite indicator that measures the quality of money for the eurozone. The demand for money, i.e., the amount of money people keep in their balances, besides other well-known factors (e.g., interest rate, price level, and income) depends on how people subjectively perceive a particular money’s ability to serve its main functions: a medium of exchange, a store of value, and the unit of account. These properties depend not only on the instruments of monetary policy and the extent to which they are used, but also on the institutional framework of the monetary system. The article suggests that the quality of money is influenced by the institutional framework and monetary policy and that thus the quality of money is a separate channel for the transmission of money policy that works not through the usual mechanism of changing the supply of money, but through central banks affecting the demand for money. An important contribution of this article is that it develops an empirical composite indicator, which measures the quality of money in the eurozone in 1999–2019 and shows the gradual decline in the quality of the euro.
JEL Classification: E41, E52, E58, E51, E44
Vytautas Žukauskas (vytautas.zukauskas@gmail.com) is a PhD candidate in economics at the ISM University of Management and Economics and a senior policy analyst at the Lithuanian Free Market Institute. The author would like to thank Professor Guido Hülsmann and anonymous referees for their helpful and very constructive comments.
INTRODUCTION Monetary policy has an immense impact on the development of economies, and thus on the economic well-being of people. There are numerous studies investigating the channels through which central banks influence economies. How effectively certain goals may be achieved via monetary policy depends on how well we understand these channels and their relative importance. However, the recent emergence of unconventional monetary policy and vast expansion of financial markets calls for the revision of the standard view of monetary policy transmission channels.
The relationship between the demand for money balances and its determinants is a critical component in the formulation and transmission of monetary policy (Goldfeld 1994), especially because economic depressions and inflationary booms can be interpreted as caused by the disequilibrium between the supplyThroughout this text the “supply” of money will mean the available total stock of money. In cases where the argument is about the effects of the production of new money this will be indicated (e.g., “increase” or “change” in the supply of money). of and demand for money (Yeager [1956] 1997).Yeager ([1956] 1997) views the equality between the demand for money and supply of money as the equilibrium condition and identifies the disequilibrium in the money market as the primary cause of depressions and inflationary booms. Depressions occur when there is an excess demand for money, in the sense that people want to hold more money than exists. Inflationary booms occur when there is an excess supply of money, in the sense that more money exists than people want to hold.
Various factors have been proposed as the determinants of the demand for money. Yeager ([1956] 1997, 5–6) claims that the demand for money essentially depends on the volume of transactions and on the price level, with interest rates, expectations, and business conditions also playing a role:
Households and businesses demand cash balances for what are usually classified as transactions, precautionary, speculative, and investment motives. Consideration of these motives shows that the total of cash balances demanded tends to be positively associated with the physical volume of transactions paid for in money (which depends in turn on payment practices and other institutional conditions, on the human and business population, and on the level of production or real income) and with the level of prices and wages. Interest rates and expectations of future price levels and business conditions also presumably have some effect on the demand for money.
Yeager ([1956] 1997, 7) compares money to any other commodity by saying that the number of money units that people demand varies inversely with the purchasing power as the value of the unit: we want to hold more units of any good if its value is higher. And as with other goods, there is some value or purchasing power of money unit that equilibrates the amounts demanded and supplied.
According to Laidler (1971), a stable demand function is a characteristic monetarist belief and is also supported by the empirical evidence. By “stable” Laidler means that money holdings “can be explained … by functional relationships which include a relatively small number of arguments” (Laidler 1982, 39).
In practice a “small” number of arguments has meant three or four—typically including a scale variable such as income, permanent income or wealth, an opportunity cost variable such as nominal interest rate or some measure of the expected inflation rate, and, if nominal balances have been the dependent variable, the general price level. (Laidler 1982, 39–40)
The liquidity preference framework emphasized the opportunity cost as the factor of the money demand. The demand for money depends on the tradeoff between the liquidity of holding money and the opportunity cost of holding it, which is the interest rate earned on holding less liquid but interest-earning alternatives.See, e.g., Modigliani (1944); Tobin (1958). To this day authors name different factors in the demand for money balances, but the most prominent variables include the interest rate, level of income, price level, number of transactions, transaction costs, and the preferences of money holders.See, e.g., Goldfeld (1994); Serletis (2007).
In the traditional framework, monetary policy works through changes in the supply of money. One of the defining features of monetarism is a “quantity theory” approach to macroeconomics, which is “a view that fluctuations in the quantity of money are the dominant cause of fluctuations in money income” (Laidler 1982, 3). Since the demand curve for money is downward sloping,A lower interest rate means a lower opportunity cost for holding money, which increases the quantity of money demanded. an increase in the supply of money equilibrates the money market at the lower interest rate and higher quantity of money demanded.Modern monetary economics often uses the quantity theory of exchange in determining the purchasing power of money. The quantity theory of money is usually expressed with Fisher’s famous equation of exchange, MV = PY, where M is the quantity of money, V is its velocity (i.e., rate of circulation), Y is real output, and P is the price index of this output. Shifts in the supply of money, interest rate, and the amount of financial assets held by market participants in turn affect the economy (and ultimately the aggregate demand) through different transmission channels.See Mishkin (1995); Taylor (1995); and Bernanke and Gertler (1995) on the channels of conventional instruments and Gagnon et al. (2011); Campbell et al. (2012); Bauer and Rudebusch (2013); and Kuttner (2018, 126) on the unconventional instruments.
It is important that according to the traditional view the supply of money is essentially the key element through which central banks conduct the monetary policy. Monetary policy–induced changes in the supply of money are part of the transmission mechanism of monetary policy—the shifts in the demand for money are not.
This view is challenged by economists who suggest that central banks influence the demand for money through the quality of money. Hendershott (1969) claimed that the emphasis on the quantity of money and the Fisherian equation in judging the impact of monetary policy on the economy is misplaced, while its popularity stems from two factors: (1) the attractive simplicity of the naïve quantity theory and (2) historical correlations between money supply and output. Bagus (2009) argues that changes in the quality not only quantity of money are important for the demand and purchasing power of money. Quality of money is defined as the capacity of money, as perceived by economic actors, to fulfil its main functions, namely to serve as a medium of exchange, as a store of wealth, and as an accounting unit. According to Bagus and Howden (2016, 111), “As the purchasing power of money may change due only to a shift in the demand for money, the subjective valuation of money can change even with the expectation of a constant money supply.” Central banks influence characteristics of money (e.g., redemption of money and quality of the central bank’s balance sheet, conditions and stability of the banking system, organization and constitution of monetary authority), which determine actors’ preferences toward money. The quantity theory of money obscures the real problem at hand regarding the value of and demand for the monetary unit (Bagus and Howden 2016, 110).
More recently, Žukauskas and Hülsmann (2019) showed how monetary policy–induced the changes in the quality of money and shifts in the demand for money can explain the movements in the prices of financial assets. The reasoning is that the decline in the quality of money shifts the demand away from money to other assets (e.g., financial assets). They suggest a total-demand approach, which emphasizes the importance of quality of money for the reservation demand for money (demand by the holders of money). The notion of quality of money may shift the understanding of how central banks influence the economy. If it is correct, then theorists will need to accept that monetary policy works not only through the supply but also through the demand side of money.
There has been some discussion of the dimensions of monetary policy which may impact the quality of money and thus the demand for money.E.g., Bagus (2009); Bagus and Howden (2016). However, there have not been any attempts to measure this impact. The notion of the quality of money stems from the subjective value theory, in which the qualities that determine the value of objects are subjective and are hard to quantify. The absence of measurement makes it difficult to judge the importance of quality of money as a demand-side channel of monetary policy. This paper attempts to fill this gap. It will discuss the dimensions of monetary policy that are relevant for the notion of the quality of money, and it will quantify them by compiling a composite indicator of the quality of money.
The first part of the article will discuss the theory behind the subjective nature of the value and demand for money. The second part will focus on the quality of money. The third part will cover the methodological issues in compiling the composite indicator. The fourth part will present the results of the index. The fifth part will discuss the limitations and the importance of the quality of money and its measurement in the context of monetary policy.
- THE SUBJECTIVE NATURE OF THE DEMAND FOR MONEY The theory behind monetarism and the stable money demand function tends to overlook the subjective nature of the demand for money. The quantity theory of money as formulated by Fisher (1911) and restated by Friedman (1956) still dominates the way economists look at the purchasing power of money. This theory focuses on the supply of money, and it does not explicitly suggest a role for the subjective factors which determine the demand for money. “While such an analysis is not obviously incorrect, the attention the equation affords to past quantities, both of money and nominal transactions, obscures the real problem at hand regarding the value of and demand for the monetary unit.” (Bagus and Howden 2016, 110).
The qualitative (or demand-side) approach is older than the modern focus on the quantitative (supply-side) factors in the analysis of the value of money:
A long history of qualitative and demand-side analysis predates the modern attention to supply-side factors determining money’s value. Early authors such as Mariana ([1609] 1994) and Petty (1662) illustrate this long tradition of the quality theory of money. Smith ([1776] 1863) explains the origin of money by pointing to the importance of certain qualities such as a commodity’s divisibility and durability. Similar discussions of the qualities of a “good” medium of exchange are found in the classic works of Say ([1803] 1843), Mill ([1848] 1909), and Senior ([1850] 1854). Menger ([1871] 2007) explained the origin of money as a market process whereby commodities with certain marketable qualities prevail at becoming generally accepted exchange media. By the time Jevons ([1875] 1876) wrote his treatise Money and the Mechanism of Exchange, the characteristics or qualities of “good” money were generally known (and are still today summarily detailed in most introductory monetary economics texts). (Bagus and Howden 2016, 111–12)
Some economists, predominantly those in the Austrian school of economic thought, clearly recognize that the demand and value of money are subjective and that they stem from money’s ability to fulfil its functions in the market (medium of exchange, store of value, unit of account). To be properly used as money, a good must have certain characteristics. Classically, these are divisibility, fungibility (or universal want), durability, and stability of value.
Mises in the Theory of Money and Credit and Human Action explained how prices and the value of money can be explained using the same principles used to explain the prices and value of other goods in the economy. The price of money is its purchasing power, and it emerges in the market as a result of the demand for and the supply of money (the so-called money relation). It is clear that according to Mises the demand for money is subjective. Catallactics can tell us about the advantages of holding money and about the factors which may influence the demand for money, but the demand for money can never be reduced to a specific function.
But all of these objective factors always affect the matter only as motivations of the individual. They are never capable of a direct influence upon the actual amount of his demand for money. Here, as in all departments of economic life, it is the subjective valuations of the separate economic agents that alone are decisive. The store of purchasing power held by two such agents whose objective economic circumstances were identical might be quite different if the advantages and disadvantages of such a store were estimated differently by the different agents. (Mises [1934] 2012, 154)
Also,
The various actors make up their minds about what they believe the adequate height of their cash holding should be. They carry out their resolution by renouncing the purchase of commodities, securities, and interest-bearing claims, and by selling such assets or conversely by increasing their purchases. With money, things are not different from what they are with regard to all other goods and services. The demand for money is determined by the conduct of people intent upon acquiring it for their cash holding. (Mises [1949] 1998, 401)
The subjective demand for money is closely linked to the recognition that money is a good. Like any other good, money is demanded by the market participants for its valuable services. Hutt (1956) explains that money should not be considered unproductive or barren, as was claimed by many influential authors (e.g., Aristotle, Locke), who influenced modern thinkers. Keynes claimed that by choosing to hold money for convenience and security market participants are foregoing the interest that could be earned by holding other assets which bring nothing “in the shape of output” (Keynes 1936, 226). However, according to Hutt, money is productive in exactly the same sense as other goods in the economy. Money assets held provide valuable services, and they derive their value from their power to render these services. The amount of money that market participants decide to hold is determined by the marginal utility of its services. In fact, this means that money has a “prospective yield (of ‘utilities’), which invites the holding of money, as the normal return to investment” (Hutt 1956, 198). The demand for money is effectively the demand to hold. It stems from the value of being in a position to acquire other things at “the most profitable time, or at the most convenient time” (Hutt 1956, 206). Thus, holding money is not forgoing the yield which could be earned by holding other interest-bearing assets. By holding money, one earns a nonpecuniary yield in the form of money services.Also Hutt (1956, 207):The fact that we hold money assets for any period at all indicates that, although we do not want to use these assets in any other way, their services do occupy a place on our scale of preferences, just like the services of all the other capital resources which we refrain from exchanging.
The services that the owner receives from holding money are related to the uncertainty in the market economy. Rothbard ([1962, 1970] 2009, 767) recognizes that the demand for money emerges from the uncertainty that economic agents face: money’s “uses are based precisely on the fact that the individual is not certain on what he will spend his money or of the precise time that he will spend it in the future.” Although these uses are objective in the sense that every economic agent faces uncertainty, the demand for money is still subjective:
Economists have attempted mechanically to reduce the demand for money to various sources. There is no such mechanical determination, however. Each individual decides for himself by his own standards his whole demand for cash balances, and we can only trace various influences which different catallactic events may have had on demand. (Rothbard [1962, 1970] 2009, 768)
An important contribution of Rothbard is his application of total demand and stock analysis to the analysis of money and the purchasing power of money. Money is unique in the sense that people simultaneously have a reservation and exchange demand for money. As Rothbard ([1962, 1970] 2009, 757) noted, “In contrast to other commodities, everyone on the market has both an exchange demand and a reservation demand for money.” The total demand for money on the market consists of two parts: the exchange demand for money (by sellers of all other goods who wish to purchase money) and the reservation demand for money (the demand for money to hold by those who already hold it) (Rothbard, [1962, 1970] 2009, 756). Exchange demand for money is the pre-income demand, and reservation demand for money is the post-income demand. Individuals demand money that they do not yet own by offering their goods or services in return for money—this is the exchange demand for money. Individuals also demand money that they own by choosing to not spend it and keep it in their cash balances—this is the reservation demand for money.
The price level is determined by the intersection of the total demand and the total stock of money. The total-demand and stock analysis utilized by Rothbard is an elegant analytical tool which clearly shows the errors inherent in the quantity theory of money, which assumes a mechanistic relationship between the supply of money and prices. Both the exchange and reservation demand for money are subjective, thus an increase in the supply of money can produce different effects on prices depending on how people react to this change, by deciding to hold a higher or lower share of additional money in their money balances.
An important question is which one—exchange or reservation demand—is more important for the determination of prices and the purchasing power of money. According to Rothbard ([1962, 1970] 2009, 759), the reservation demand for money is more important because it is “more volatile.” The volatility of the reservation demand comes from the fact that holders of money may, for some reason (e.g., they think that the purchasing power of money will go down), want to drastically reduce their holdings of money by spending them. They cannot reduce their exchange demand for money so easily, because it is a lot easier to spend their cash balances than to turn to exchanging their goods and services for nonmonetary goods (barter) or other competing money in the market. Thus, the importance of the reservation demand for money comes from the fact that it is more volatile and thus more important in the changes in prices and the purchasing power of money. However, precisely because it is more stable, an argument can be made that exchange demand for money, i.e., the supply of goods and services, has an important influence on the purchasing prices and power of money, at least in the short run. Even if the reservation demand for money decreases significantly, the exchange demand for money can stay relatively stable and keep the prices and purchasing power of money from dropping rapidly.
Horwitz (1990) applies subjectivist principles to the demand for money as well and criticizes as oversimplified “neoclassical and Keynesian models that portray the only opportunity cost of money held as interest-bearing securities.” His approach claims that the choice to hold money depends on the utility of the most valuable alternative forgone:
When an actor is facing a decision to hold wealth in the form of money, she is deciding between a number of prospective utility streams. We can broadly categorize those streams as the utility from non-financial assets and the utility from both the availability and interest returns from non-money financial assets. (Horwitz 1990, 465)
Most importantly, the demand for money is subjective, since only the chooser can determine the utility that their choice provides. Moreover, the cost of holding money is subjective, because it is never objectively realized.
What is given up in a choice is by definition what was not chosen, so the “measure” of that cost must necessarily be the expected utility of the sacrificed alternative. Such expectations can be definitively described only by the chooser. (Horwitz 1990, 465)
The subjectivity of the demand for money brings us back to the monetary policy. If the demand for money balances has an important subjective element to it, the demand for money can be influenced, but it is not mechanically determined by such factors as income, price level, or interest rate. If this is the case, then central banks and monetary policy may not just influence the amount of money that people are willing to hold through the manipulation of the money supply and the interest rate. The subjectivist approach to the demand for money allows for the recognition that the impact of central banks on money (and prices) may be much broader. And this is exactly the claim of the recent literature on the quality of money.
- QUALITY OF MONEY AND ITS DIMENSIONS The theory of the quality of money maintains that the demand for money depends on the quality of money. Money’s quality can be defined as “the capacity of money, as perceived by actors, to fulfil all its main functions, namely to serve as a medium of exchange, as a store of wealth, and as an accounting unit” (Bagus 2009, 22–23). The quality of money is one of the important factors, along with uncertainty, financial innovations (credit cards, ATMs, money market mutual funds), frequency of payment, etc. that affect the reservation or cash balance demand for money (Žukauskas and Hülsmann 2019).
Money supply, according to this view, is just one of the factors affecting the quality of money. Existing total supply of money at any time does not matter in the sense that money can be used as a universal medium of exchange despite the amount of monetary units available (a lower amount just means a lower price level). Money supply matters for the quality of money if we add the dimensions of time and changes in the supply of money. Changes in the supply of money influence the extent of the stability of the purchasing power of money. However, there are a lot more factors or dimensions influencing the quality of money: “As the purchasing power of money may change due only to a shift in the demand for money, the subjective valuation of money can change even with the expectation of a constant money supply” (Bagus and Howden 2016, 111).
The idea behind the quality of money is that central banks, through monetary policy, influence other characteristics of money (besides money supply) that are relevant for money users. A shift in these characteristics impacts the quality and subjective value of money, and “[c]hanges in money’s quality affect the demand for money and, consequently, its purchasing power” Bagus (2015, 19).
According to Bagus, “good” monetary systems have objective qualities. The quality of a money is closely linked to the quality of the monetary regime, which can be defined as “the capacity of a monetary system to provide an institutional framework for a good medium of exchange, store of wealth, and accounting unit” (Bagus 2015, 19–20).
According to Bagus (2015), the unit of account function is fulfilled by nearly all monetary systems equally well, and it is impaired only in extreme situations. Thus it is meaningful to concentrate on the characteristics of a good medium of exchange and store of value.According to Röpke (1954), money’s functions often dissapear in a certain order. First, money ceases to be a storage of wealth. Then, money loses its function as a unit of account. The last function that is lost in a hyperinflation is the function of medium of exchange. The main requirements for money as a medium of exchange are low storage and transportation costs, easy handling, durability, divisibility, resistance to tarnish, homogeneity, and ease of recognition. However, “These properties hardly change today as paper-based fiat standards have eased the physical usability of the monetary unit, as well as the costs to provide it” (Bagus 2015, 23). Another relevant property of a medium of exchange is the number of users, because more users imply more demand for the medium of exchange. “As more people accept it in trade, the medium of exchange is more useful” (Bagus 2015, 23). Existence of ample nonmonetary demand for the money as either a consumer good or a factor of production is yet another important characteristic for a medium of exchange. However, in fiat money systems, where money is not redeemable, it does not have this property altogether.
One of the most important variables in money’s function as a store of value is the possibility of increases in its quantity. “Different monetary regimes allow for different mechanisms to increase the quantity of money, thereby influencing money’s quality. Thus, monetary systems may set strict or less strict limits for increases in the money supply” (Bagus 2015, 24). The stability of the financial system is also an important property of money and a factor in its store-of-value function.
There are monetary regimes that are more prone to generate business cycles, over-indebtedness and illiquidity than other regimes. Business cycles, over-indebtedness and illiquidity may provoke interventions and bailouts on the part of the government or monetary authorities. In the wake of the bailouts the quantity of money is often increased, or even the quality of the monetary system is diluted. (24)
The monetary regime’s independence from the government and the restrictions that it sets to eliminate or limit the government’s manipulation of money are also important to money as a store of value. “Interventions by the government often decrease the quality of money in its own favor by increases in money’s quantity or through a deterioration in the reserves backing it” (25).
To sum up, the quality of money as a store of value and a medium of exchange can essentially change in five ways (Bagus and Howden 2016, 113):
Money supply—the supply of money in existence today and in the futureRedemption ratio (in the case of commodity money systems)—the amount and value of assets or other goods that back the currency (that money can be redeemed for)Conditions and stability of the banking system—a financially troubled, illiquid banking system increases risk of bailouts, which may lead to higher quantity of money (if financed through debt monetization)Institutional framework of the monetary authority, which can mean: a. The independence of the central bank (if the central bank follows directives from the government, this increases the risk of debt monetization to finance spending)
b. Accountability and transparency—–the quality of money will improve if central bankers are accountable and responsible for their policies and if there is transparency
c. The central bank’s constitution, that is, its philosophy or objectives (e.g., price stability versus ancillary aims of full employment, increasing asset prices, and maintenance of a currency), its price inflation target, whether it has a rule-based monetary policy or simply targets asset prices
d. Staff and decision-makers at the central bank, who influence monetary policy primarily through building consensus
Quality of the central bank’s balance sheet—the quality of the reserves and assets backing the money determines the central bank’s ability to maintain and defend the currency’s value in the future Therefore, by incorporating the quality of money, it is possible to understand how the purchasing power of money can vary with a constant money stock, namely when the perceived quality of money changes. The quality of money affects the purchasing power of money by first altering the demand for money, which reflects the changed valuation of a fixed quantity of money on each person’s value scale. When the quality of money improves, the demand for money, and, consequently, money’s purchasing power, will be higher. If subjective valuation of money falls, people will reduce their cash balances and prices will increase. The subjectivity of valuation and demand for money also means that changes in the perceived quality of money can be very abrupt (which would lead to a strong and quick change in the purchasing power of money), whereas changes in the quantity of money are usually gradual.
- METHODOLOGY OF THE COMPOSITE INDICATOR Based on the framework discussed above, this section will develop an empirical composite indicator for the quality of money and apply it to the euro area. “Composite,” also known as “synthetic,” indicators are “formed when individual indicators are compiled into a single index, on the basis of an underlying model of the multi-dimensional concept that is being measured” (Nardo et al. 2005, 8). Essentially, a composite indicator consists of numerous “components” that reflect a “complex system,” making it easier to understand in full rather than by reducing it to its “spare parts” (Greco et al. 2019). The literature on composite indicators suggests a particular procedure to compile a composite indicator. We will analyze the quality of money using these steps.
Theoretical Framework
The first step in the creation of a composite indicator is the theoretical framework, which establishes what is being measured, its measurable dimensions, and eventually the indicators that constitute the composite indicator. The strength of the theoretical framework determines how meaningful the composite is. The quality of money and its measurable dimensions have already been discussed above. Here we will focus on the indicators.
The selected indicators must carry relevant information about the core components of the phenomenon being measured. Practitioners use proxy variables when direct indicators or data are not available (OECD and JRC 2008). Although the selection of indicators is vested in the theoretical framework, practitioners admit that it is a process which depends on the judgments of the researcher.According to Röpke (1954), money’s functions often dissapear in a certain order. First, money ceases to be a storage of wealth. Then, money loses its function as a unit of account. The last function that is lost in a hyperinflation is the function of medium of exchange.
The selection of the indicators for the quality of money index and the dimensions of it was heavily influenced by the existing scholarship on the quality of money, which has been discussed above. As shown in table 1, the index consists of five dimensions and eighteen indicators. The indicators in the central bank balance sheet dimension follow the suggestions of Bagus (2015) and Bagus and Howden (2016). The rest of the indicators were selected to reflect the other significant aspects of the quality of money. The choice of dimensions and indicators will be discussed below.
The Central Bank Balance Sheet
The quality of money can be measured indirectly by the assets that back the monetary base. Central bank assets serve as collateral that “backs” the currency and represents the central bank’s capability to defend the value of the currency domestically and internationally. The balance sheet will be assessed by three liquidity ratios, two international strength ratios, and one equity ratio (see table 1). The idea behind the liquidity ratios is that the higher the share of liquid and high-quality assets in the central bank’s reserves, the higher the quality of money will be. During a crisis, liquid assets can be used to support a faltering currency. International strength ratios indicate a central bank´s potential to defend the external value (i.e., the foreign exchange rate) of a currency. International strength ratios show the percentage of monetary liabilities that are backed with foreign reserves, which can be used to support the currency’s value on the foreign exchange market. The equity ratio indicates the central bank’s leverage. A higher ratio implies a more conservative situation (i.e., less leverage) and an increased quality of money.
Money Supply
Changes in the money supply is one of the factors influencing the quality of money. Existing total stock of money at any time does not matter in the sense that money can be used as a medium of exchange despite the number of monetary units available. However, changes in the money supply influence the long-term stability of the purchasing power of money. The index contains four indicators that represent different definitions of the money supply: monetary base, central bank balance sheet, and monetary aggregates M1 and M3.
Interest Rates
There is a link between money supply and interest rates. The European Central Bank (ECB) communicates its monetary policy stance by setting an interest rate target. This target is achieved primarily through open market operations—by purchasing or selling financial assets in the market and thus increasing or decreasing the monetary base. Thus, changes in the interest rates set by the central bank show how inflationary its monetary policy is. A decrease in the interest rates is achieved through an increase in the money supply, which in the long term means a lower purchasing power of money. The quality of money index contains four indicators measuring interest rates. Three of them represent three key interest rates set by the ECB: the rates on the deposit facility, the main refinancing operations (MRO), and the marginal lending facility. The fourth indicator is based on spread between the main refinancing operations rate and Taylor’s rule interest rate.
Taylor’s rule is a guideline for how central banks should change interest rates in response to changes in economic conditions. It was established to adjust and set prudent rates for the short-term stabilization of the economy while still maintaining long-term growth (Taylor 1993). Machaj (2016) admits that Taylor convincingly demonstrates that low interest rates contributed to the housing bubble and mortgage market expansion. However, Machaj (2016, 12) criticizes the Taylor rule from an Austrian perspective by saying that “any rule recommended for interest rates higher than the actual ones would have been better than that actually followed (even a rule based on astrology). Apart from that, there may be nothing specific about the Taylor rule that makes it a panacea for macroeconomic problems.” The technical problem with the Taylor rule is that it has many variants and that it cannot be applied precisely (e.g., it is difficult to measure the potential output). The fundamental problem is that following this rule does not ensure economic stability: “[T]argeting … macroeconomic variables is not a recipe for intertemporal coordination understood in the Hayekian sense: as coordination between successive stages of production” (Machaj 2014). Nevertheless, in this indicator we will use the Taylor rule as a rough guide and the basis for the evaluation of the interest rate set by the monetary authority. Following the Taylor rule does not ensure macroeconomic balance, but it is quite clear that strong deviations from it are related to macroeconomic imbalances.
Financial System Stability
The conditions and stability of the financial system matter for the quality of money, because a financially troubled, illiquid banking system increases risk of bailouts, which may lead to a higher quantity of money (if financed through debt monetization). The stability of the financial system is measured by three indicators: the Composite Indicator of Systemic Stress (CISS), the euro interbank offered rate–overnight index swap rate (Euribor—OIS) spread, and the liquidity ratio of the eurozone banking sector (for a more detailed explanation of each indicator, see table 2).
Forward Guidance
Forward guidance is central bank communication—announcements, speeches, press conferences—which aims to provide information about the likely path of future policy and interest rates (Kuttner 2018, 126). Forward guidance is an unconventional instrument of monetary policy that the ECB uses to guide the expectations of market participants about the future stance of monetary policy. Forward guidance is connected to the quality of money: expectations for prolonged periods of inflationary monetary policy mean that market participants expect the interest rates to stay low and the money supply to increase faster than otherwise. The index contains one indicator (the spread between current rate of main refinancing operations and the OIS rate) which captures the extent to which market participants expect monetary policy to remain or become inflationary (see more in table 1).
Table 1. Indicators of the quality of money index
Foreign reserve assets are assets denominated in foreign currency and include reserve position in the International Monetary Fund (IMF), special drawing rights (an international reserve asset) created by the IMF, financial derivatives, loans to nonresident nonbanks, long-term loans to an IMF Trust account, and other assets that meet the reserve assets definition.
The Euribor rates are based on the average interest rates at which a large panel of European banks borrow funds from one another.The OIS rate represents a given country’s central bank rate over the course of a certain period.
The dimensions and indicators of the index are flexible in the sense that they are mostly not specific to a particular central bank and can be applied to any currency and central bank. In this article, we will focus on the euro area and European Central Bank. To ensure maximum flexibility in using the index, it will be calculated using monthly data.If the index data is monthly, it can be easily used to calculate quarterly or yearly changes. The period for the euro analysis is the end of 1999 until the end of 2019.
One aspect not captured by the index is the institutional framework of the central bank (its independence, accountability and transparency, constitution, and staff and decision-makers) due to the lack of publicly available and quantifiable indicators. Although there are quantitative indicators of central bank independence, they are only available on an annual basis.E.g., Garriga (2016), Masciandaro and Romelli (2019). Moreover, since the evaluation of central banks’ independence does not change much over the years, it is more useful as a tool for comparing different central banks’ level of independence than for tracking the change in a particular bank’s independence. Quantitative indicators of other aspects of the institutional framework are not available, since they are heavily subjective and depend on value judgments.
Once the indicators have been established, further steps in compiling the composite indicator are normalization of the data, weighting of the indicators, and aggregating them into a composite indicator. We will go through these steps very briefly; more information on the methodology can be found in the appendix.
Normalization
Normalization converts the data of the indicators on a common scale. This is crucial for the comparability of different indicators and to combine them into a composite. The normalization method used for the quality of money index was the min-max transformation. The reasons why the min-max transformation was chosen over the other methods were primarily a) the data used in the index are time series of variables which do not have high variability or any extreme values (in the cases of extreme values, methods based on standard deviation or distance from the mean are preferred) and b) according to the theoretical framework, changes in the indicator’s value are important in the same way, regardless of the level (if this were not the case, the transformation should be concaved (log, root, exponential, or power) instead. The min-max transformation brings all the values of all the indicators onto a scale of 0 to 100, where 0 represents the lowest value and 100 represents the highest value (the formula used in the normalization can be found in the appendix).
Weighting
Composite indicator is composed of individual indicators, which may have specific weights. There are different weighting methods, but they all fall into two categories: expert/public opinion–based methods and statistical methods. The weighting procedure selected needs to reflect the object or phenomenon, and it needs to be simple in order to be able to communicate the final weighting scheme. Literature on composite indicators considers weighting based on statistical methods to be more “objective,” as statistical methods are not based on a decision-maker’s subjective valuation.See Booysen (2002); Zhou, Ang, and Poh (2007); and Decancq and Lugo (2013). Two statistical tools that are often used in weighting are correlation and multiple linear regression analysis.
The weighting of the composite indicator was decided separately at the level of the dimensions and indicators, following two steps. The first step applied regression analysis and determined the weights of the dimensions. The second step applied correlation analysis and established the weights of the individual indicators in each dimension (a detailed explanation of the two steps can be found in the appendix).
Table 2 shows the results of the first step, which used the linear regression analysis for dimension weights. After the adjustment, the coefficients of determination are not equal, but they are more balanced than in the case of equal weighting.
Table 2. Weighting adjustments in the first step (dimensions)Foreign reserve assets are assets denominated in foreign currency and include reserve position in the International Monetary Fund (IMF), special drawing rights (an international reserve asset) created by the IMF, financial derivatives, loans to nonresident nonbanks, long-term loans to an IMF Trust account, and other assets that meet the reserve assets definition.
In the second step, the equal weighting of indicators in each dimension was adjusted to avoid double counting using the correlation analysis. As explained in the appendix on methodology, the weights were distributed equally among all indicators in each dimension unless there were high levels of correlation (higher than 0.6).
Aggregation
The aggregation process combines the values of a set of indicators into one composite indicator. An important distinction of aggregation methods in the literature is between “compensatory” and “noncompensatory” approaches.See Munda (2005); and Greco et al. (2019). According to Bouyssou (1986, 151), aggregation is noncompensatory if no tradeoffs occur and is compensatory otherwise. The definition of compensation therefore presents a tradeoff. Compensatory aggregation assumes that poor performance in some indicators can be compensated for by high performance in other indicators.
Linear compensatory aggregation was chosen as the most suitable method for aggregating the quality of money index. The value of the composite index was the arithmetic average of all the indicators weighted by their respective weights. The primary reason for this choice is that the theoretical framework, which is the source of the different dimensions of the index, implicitly assumes the possibility of compensation (bad performance in one of the dimensions of quality of money can be compensated with good performance in the others). Moreover, linear compensatory aggregation is the most common method used in the creation of composite indicators (Gan et al. 2017).
- RESULTS The results of the quality of money index are presented in figure 1 below. The quality of money index suggests that over the period of the euro’s existence the quality of money overall has declined by 55 points (on a scale of 0 to 100), from 73 in December 1999 to 18 in August 2019. The rate of decline on average is 0.22 points per month, or 2.7 points per year.
Figure 1. Quality of money index
Scale: 0 to 100. We can distinguish four periods for the euro in the quality of money index. The dynamics of the quality of money were different during each of these periods, and they represent distinctive economic conditions and ECB policy environments.
The first period, from 1999 to mid-2005, marks the initial decline in the quality of money in the eurozone. The two most important drivers of the decline were the ECB’s balance sheet and interest rate policy (see Figure 2 below for the dynamics of each dimension). The quality of the balance sheet declined quite significantly during this period due to a decline in liquidity. The monetary base was growing faster than the value of gold or gold receivables, and the value of reserve assets in general was falling. Moreover, there was a drop in the value of foreign reserves and a decline in the central bank’s equity ratio. In general, the ECB’s balance sheet during this period became less liquid, and it had less foreign reserves and equity as a ratio to total assets. During the first period the ECB also significantly reduced the interest rate. The MRO rate was reduced from 4.75 in 2000 to 2 percent in 2003. The interest rate also fell below the one suggested by the Taylor rule after September 2001.
The second period lasted from about mid-2005 to mid-2008. The quality of money during this period stopped declining and stayed relatively stable. The quality of the balance sheet was still declining, but it was offset by the increased interest rates—the ECB had been transitioning out of the stimulating monetary policy and had gradually increased the MRO rate to 4.25 percent in 2008.
Figure 2. Dimension of the quality of money index
The third period, from mid-2008 to early 2013, was one of financial and economic turmoil. This period saw two very significant drops in the quality of money. The first one lasted from the second half of 2008 to the first half of 2009. There were many factors that contributed to this drop.
Firstly, the financial system’s stability declined rapidly. Financial turmoil spread to the real economy, which halted economic growth and induced the ECB to try to save the financial sector and prop up the economy by rapidly reducing the interest rates to a new record low of 1 percent. It quickly increased the growth of the money supply, and this increased expectations in the market that the central bank would continue with the inflationary monetary policy.
After the first half of 2009, the economic and financial situation in the eurozone somewhat stabilized, and the drop in the quality of money was partially offset by the increase in financial stability and reduced growth in the money supply. However, the situation worsened very quickly again in the second half of 2011, when financial markets started panicking again due to the sovereign debt crisis in some of the euro countries, primarily Greece. The stability of the financial system rapidly declined again, and the bond yields of weak euro member governments soared. This was the catalyst for ECB president Mario Draghi’s famous speech in which he said that “[w]ithin our mandate, the ECB is ready to do whatever it takes to preserve the euro.” The ECB again lowered the interest rate, increased the money supply, and started conducting quantitative easing and forward guidance. This caused the quality of the balance sheet to decline, since the new policies reduced the liquidity, reserves, and equity of the ECB. All this contributed to the significant drop in the quality of money during this period. After these measures, the stability of the financial system increased again and somewhat reversed the drop in the quality of money.
The last period started around 2013 and lasted at least until the end of 2019. During this period, the ECB continued conducting the policies of quantitative easing and forward guidance. The interest rates were reduced further until they reached 0 percent in 2016. The growth of money supply again increased and was especially high in 2013 and 2014. Quantitative easing led to the vast expansion of the central bank’s balance sheet and of the excess reserves of the commercial banks at the ECB. The ECB’s communications focused on forward guidance, assuring market participants of accommodative monetary policy in the future. All these measures convinced financial markets that the troubles are behind them, and different measures showed the gradual stabilization of the financial system. Throughout this period the quality of money declined, and financial system stability is the only dimension of the index that increased. This suggests that the policies enacted by the ECB were successful in stabilizing the financial system, but these policies caused a significant declined in the quality of money in the eurozone.
Below the limitations of the quality of money index and the importance of the quality of money—as a theoretical notion and a measurement—will be discussed briefly.
- DISCUSSION AND LIMITATIONS As mentioned previously, the framework of quality of money is based on the subjective value theory. Money as a good is valued to the extent that it fulfils the needs of market participants. In particular, money is valued when it has the properties of being a medium of exchange, a store of value, and a unit of account. However, these properties, which ones are most important, and how a particular money fulfils them are subjective value judgments. Therefore, attempts to chart the compositions of these properties cannot be thorough and objective by definition. They in themselves will be bound up in value judgments, which may be different from those of market participants. Moreover, the methodology (normalization, weighting, aggregation) of the creation of a composite index in itself requires the researcher to make subjective decisions.
Not all the dimensions that may be important to the quality of money can be easily quantified; e.g., the scholarship identifies the organization of monetary authority (the central bank’s independence, its accountability and transparency, its constitution, and its decision-makers) as one of the dimensions that is important. However, there are no quantifiable indicators to measure it. These questions are especially laden with subjective judgments. This suggests that some of the identified dimensions of the quality of money are more quantifiable than others.
Nevertheless, the composite indicator of quality of money allowed the significant decrease in the quality of the euro since its introduction to be captured. Thus, changes in the quality of money may be an important factor in the changes in the demand for money. In theory, given all the other factors (interest rate, income, prices, etc.) in the demand for money, the preference of market participants to hold money balances may change due to fluctuating quality of money. Empirical measurement has shown that changes in the quality of money over a year may be quite significant. Why is this important?
Quality of money is one more factor which needs to be incorporated into the analysis of the demand for money. This factor is quite different from the ones already accounted for in theories about the demand for money, particularly the quantity theory of money. A qualitative theory of the value of money allows the subjective judgments of market participants to be weighted. This means that the changes in the perception of value—and thus the demand for money—can be a lot more abrupt and extensive in comparison to the results of the quantitative theory of money, in which demand for money depends on more stable factors (quantity of money, level of output, etc.).
Moreover, the notions of quality of money and demand for money are intricately linked to prices. Price level is the result of the intersection of the demand for money balances and money supply. Shifts in the supply of money, as well as demand for money, result in changes in the price level. Thus, changes in the quality of money as one of the factors of money demand may cause changes in the price level. More particularly, if decreasing quality of money reduces the demand for money, the price level increases.
The application of the quality of money index to the eurozone, and the analysis of the index’s dynamics alongside the policies of the ECB, showed that the economic and financial problems of the eurozone led the monetary authority to make decisions and enact policies which led to the deterioration of the euro’s quality. Monetary policy became more inflationary. The quality of money was sacrificed in order to prop up the economy and save banks and other financial institutions.
The decreasing quality of the euro is in line with the theoretical reasoning suggested by Žukauskas and Hülsmann (2019). They claim that the quantity theory of money cannot explain why prices in the financial sector grow faster relative to prices in the nonfinancial sector and suggest a novel explanation of how monetary policy influences the prices of financial assets relative to nonfinancial assets that is based on the quality of money. A decline in the quality of money decreases the demand for money, with market participants shifting to financial assets as an alternative form of holding wealth, resulting in the increased price of financial assets.
Lastly, if quality of money, which depends on monetary policy and the overall functioning of the monetary system, is a factor in money demand, then quality of money is one of the transmission mechanisms for monetary policy. The actions of central banks influence the quality of money, which in turns affects the money demand. According to this framework, then, monetary policy not only influences the economy by changing the supply of money, but also by affecting the demand for money. Demand for money becomes (at least partly) an endogenous variable in the monetary policy.
CONCLUSIONS This article suggests that the quality of money is a concept that offers new insights on how monetary policy may influence not only the supply of money, but also the demand for it. It offers an empirical measurement of the quality of money index here applied to the euro area. The index suggests that the quality of the euro has fallen significantly since its introduction in 1999. To the extent that the demand for money subjectively depends on the quality of money, this fall has been significant enough to influence the price level in general and prices in particular (e.g., financial asset prices).
It is important to incorporate the quality of money into the analysis of the demand for money. Moreover, since central banks influence the quality of money, it is vital to treat it as one of the channels for the transmission of monetary policy. Central banks, their institutional frameworks, and their policy decisions impact the quality of money, which in turns affects the demand for money, the price level, and other variables in the economy.
APPENDIX Normalization
In cases where an indicator’s higher values represent higher values in the index,
Also, in cases where an indicator’s higher values represent higher values in the index,
, where:
is the transformed value of an indicator (a) at time t,
is the data point of an indicator (a) at time t,
min(xa) is the minimum of all data points of an indicator (a), and
max(xa) is the maximum of all data points of an indicator.
Weighting
Weighting of dimensions (subindices)
The composite index of quality of money contains five subindices, which each contain a varying number of indicators. The weight of each subindex is decided through the regression analysis of the particular subindex and the composite index. The deciding factor is the subindex’s coefficients of determination (R2) of single-variate regressions. The aim is for the coefficients of determination of each subindex to be as close as possible to each other, which means that the proportion of predictable variance in the dependent variable (composite index) due to each independent variable (subindex) should be more or less equal and not dominated by any one subindex. The procedure starts with equal weighting of all the subindices, and the weights of the subindices with the lowest coefficients of determination are increased (at the expense of subindices with high coefficients of determination) until the level of the highest possible equality is reached. There are several restrictions to this procedure. First, for reasons of simplicity and aesthetics, the increment of adjustment (up and down) is 5 percentage points. Second, each subindex should have a weight of no less than 5 percent. This is for theoretical integrity, to maintain at least minimum representation of each factor (subindex) in the composite index. Thirdly, no subindex should have a weight of more than 35 percent (roughly one-third). This is to avoid the overrepresentation of a subindex.
Weighting of individual indicators
The weighting of indicators in the subindices corresponds to the weights of the subindices, which are decided in the first step. Therefore, the general rule is that the weights of the indicators in a dimension are equal to the weight of the subindex divided by the number of indicators in it. There are two rules according to which the weights of individual indicators can be adjusted to reflect the indicators more accurately.
Some subindices have several groups of indicators, which refer to different topics or types of indicators/measurements. For example, the central bank balance sheet subindex contains for liquidity, international strength, and equity position subtopics. The first rule is that for a certain subtopic, all indicators in a subtopic are weighted equally despite the number of indicators (which means that different indicators may have different weights in the subindex depending on the number of them in the topic).The second rule for weighting the individual indicators in a subtopic is based on the correlation analysis. When indicators have a high and statistically significant correlation (judged by Pearson’s coefficient of correlation, which is higher than 0.6), they are treated as one indicator (their weights are reduced to jointly equal the weight of other indicators). Table 2 shows the results of the first step, which used the linear regression analysis to establish the weights of dimensions. After the adjustment, the coefficients of determination are not equal, but they are more balanced than in the case of equal weighting.
Jeff Deist: You recently completed a series of articles for the Mises Institute, which we will publish in book form, on how money works today. Why is it important for average people to understand the mechanics of the plumbing of central and commercial banks?
Bob Murphy: There’s two main reasons. First, it’s intrinsically interesting. That’s why I went into economics. Just like the average person should know the basics about physics and chemistry and Darwin’s theory of evolution, likewise, the average person needs to know: How does money work, how do banks work? Just the raw basics of it because it’s an important part of modern society, even premodern society, in terms of money. But beyond that, because central banks certainly since 2008 and even more so in the wake of the pandemic in 2020 have done lots of things that I believe are setting the world up for a series of major financial crises, and the average person needs to know about this.
JD: Considering the monetary and fiscal machinations engaged in by governments since the pandemic, it’s as though we lost any sense of what money is. It seems unlimited. People on Twitter tell us money is just information, or energy in a system.
BM: I do know what you’re saying. On the one hand, I can’t bristle too much when outsiders, people like Eric Weinstein, come forward and they say the economists have just botched it. I get why they’re saying it, because the economists have done such a poor job. It’s hard for me to say hey, stay in your lane, leave money to the economists. But, on the other hand, you’re right. We shouldn’t jump to the conclusion that the older-school economists and the ones in the Austrian tradition don’t know anything and that there’s no point in reading them. There are lots of fallacies that intelligent people who are not conversant with the economics literature might fall prey to, just like if you go into philosophy, there are lots of detours, and you would do well to take a basic course in philosophy to avoid fallacies that plagued people centuries ago. Likewise with money, there are lots of ways you can go down the wrong path, and some of these bright people who are spouting off on Twitter are just going over stuff that was demolished by Mises in 1912. They’re just repeating those fallacies and it’s because they never heard of it before.
JD: To be fair, the average Joe or Jane might well say money is just this made-up thing government tells us to use.
BM: Exactly, and it’s interesting because there is this sense in which money is a social convention, but it’s not merely a social convention. Just like spoken language is a social convention in a sense but that doesn’t mean words can just mean whatever you want. Money is a complex topic and it is easy to think of money incorrectly and certainly to then endorse government policies that would be disastrous because you don’t really understand exactly what money is or how it functions.
JD: We’ve heard two words ad nauseam over the past sixteen months: stimulus and liquidity. One is fiscal, one is monetary. Executives, Treasury officials, legislatures, and central bankers all throwing everything but the kitchen sink at the problem. Are fiscal and monetary policy effectively merging?
BM: I think you’re right that part of what’s been happening is the traditional divide between fiscal and monetary actions has been blurred. For example, during the Obama administration (this is back when this was shocking) there were four years in a row in which the federal deficit was higher than a trillion dollars. And that was also roughly when the Federal Reserve, implementing its independent monetary policy, with no concern about the budget needs of the government, was engaged in these rounds of QE (quantitative easing). And at the time, I didn’t think that was a coincidence, just like now I don’t think it’s a coincidence that the federal government is running massive deficits right when the Fed keeps adding to its balance sheet and buying Treasurys. I don’t think that’s a coincidence.
So yes, there is this merging. Then you’ve got MMT (modern monetary theory), for example, which quite explicitly just consolidates everything. They say that when the federal government runs a deficit and buys fighter jets, the Treasury instructs the Fed to mark up the checking account balances of Northrop Grumman or Lockheed Martin, or whoever makes them. I think that’s wrong. There are still some legal issues involved, and technically the Treasury can’t just spend whatever it wants and tell the Fed, “Mark up the checking account.” Legally speaking, that’s not how it works. But you’re right, conceptually that’s the way a lot of people, even with PhDs in economics, are starting to talk about it, so it is blending together.
There are some senses in which that approach is probably correct: like I said, it was naïve for mainstream economists to act as if what the Bernanke Fed did during the Obama years was purely because they were targeting CPI (Consumer Price Index) and doing it not because they knew, the feds are issuing this much debt; if we don’t want interest rates going up on Treasurys, we have to buy a bunch of them. So, it is merging, but still, conceptually, the old-school distinctions are important if people want to understand that, for example, a government that’s in a regime of hard money can still borrow money, just like corporations or households can go borrow money and that’s not per se inflationary, whereas in the modern system, yes, if the Fed or the central bank in general is monetizing the debt, that is inflationary. It’s important to get cause and effect distinct.
JD: Give us your quintessentially fair and objective description of MMT, along with your critique.
BM: What’s funny is I’ve actually formally debated Warren Mosler. If you jump into YouTube and look at the comments, they’ll say, “Oh, Murphy agrees MMT is correct, he just doesn’t like it.” It’s a very seductive approach they have where they’re casting themselves as saying, “Look, we’re not passing judgment, we’re just saying this is modern monetary, this is the way the modern financial banking system, government money system, works, take it or leave it, and you need to know this.” But at the same time, I don’t know of any MMT proponents who want the US government to return to its constitutional duties. It seems that the MMT sort of neutral, positive as opposed to normative description of how the world works almost always goes hand in hand with prescriptions for a massive expansion in government entitlements and other types of spending programs, intervention and healthcare, because they think they’ve shown we don’t need to worry about debt.
And, just to circle back, what do they do? They’re saying, unlike private sector individuals or corporations who have to use the money but are not sovereign issuers, the monetary authorities, the US government or the Japanese government, they have monetary sovereignty. They can issue their own currency. They don’t have to pledge to redeem it in some other currency. It’s not tied to anything.
After 1971, the US dollar is not redeemable in anything. It just is what it is, it’s its own commodity unto itself, there’s no actual constraint on the US government spending more money. And so they say, if we’re talking about if we should have Medicare for all, stop saying, “How are we going to pay for it?” I think that’s the fundamental point of the MMT crowd and I’m not putting words in their mouths. Stephanie Kelton, one of the major proponents right now, that’s how she talks. And so then you say, “Okay, there’s a sense in which that’s correct, but there’s also a sense in which that’s extremely dangerous and misleading.”
So yes, it is true, if the federal government wants to fund another moon shot, wants to put a base on Mars, wants to guarantee everybody’s healthcare and that’s going to cost $20 trillion in current prices, they could go ahead and just create that money. There’s nothing legally stopping them. But to me that’s a very dangerous thing to tell the public, because it leads them to believe they can do it without any bad consequences, when in fact, I would argue, doing that’s going to raise the dollar prices of goods and services. You’re not creating extra real resources just by creating dollars. Under a gold standard, for example, everybody would agree, it’s too expensive, it’s not worth it to try to build a Mars base any time soon. By freeing the Federal Reserve from the fetters of gold, you don’t all of a sudden give us better technology. You don’t all of a sudden make more spaceships available or bases that are half built on Mars. It’s the same use of scarce resources to achieve that outcome regardless of the financing mechanism. That’s what I would say, and the MMT people will give a nod occasionally too and say, “We know prices could rise. We’re just saying that’s the constraint.” But still, that’s very misleading.
The analogy I’ve used often is to say: Imagine a couple, they’re over the kitchen table and they’re scratching their heads and say, man, these finances. We want to pay for the kids’ college, but my job only pays this, and we just can’t afford that vacation next month. And then, what if somebody gave them the insight and said, “No, stop thinking like that. You could put on a ski mask and go hold up a 7-Eleven.” And then the couple says, “Wouldn’t we go to jail or be shot by the store?” The third party would then say, “Yes, that’s true, we’re not denying that, but let’s stop talking about it in terms of we can’t afford things. Instead, the issue is do we want to go on the vacation more than we want to risk going to prison?” That’s really the tradeoff you face, and there’s a sense in which that third party giving the advice to the couple is correct, but they haven’t really helped the conversation any by making the correction that financing the vacation’s not the issue here. It’s do you want to risk going to prison if you hold up the convenience store?
That’s what the MMT people bring to the table when they say, “Let’s stop saying we can’t afford Medicare or is the public willing to tolerate higher taxes, because we can just print the money.” You’re not helping anything and in fact, you’re just dangerously leading people to believe this is some financing mechanism that actually you would never want to endorse.
JD: In the MMT conception, when Uncle Sam creates debt—public debt—that debt is private wealth.
BM: Great point and you’re right, that’s another pillar of MMT, at least about how they talk to the public and flip around your thinking about everything you’ve heard about government finance.
JD: Like deficits.
BM: Yes. That’s another sacred cow they’ll tackle. And let me be clear, I understand why so many people have become enamored with MMT, and especially Stephanie Kelton’s latest book, The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy, is provocative as well. She’s a funny writer, and I can see how someone who’s willing to go down that path can read her book and say, “This is great.” Specifically what they’ll say is, “Don’t listen to these budget hawks, who say let’s stop passing the buck to our grandkids. If you think about it from an accounting perspective, the only way the private sector can accumulate net financial assets is if the government goes deeper into debt.”
The way they’re thinking about it is: if my pension fund accumulates corporate bonds, my pension fund might have more assets, but then that means the corporation that issues those bonds now has that extra liability, so on net, those members of the private sector just cancel out. They’re saying the only way the private sector as a whole can have claims on some entity that doesn’t internally cancel out is if the entity is a non–private sector group like, oh, the US federal government. If the private sector accumulates Treasurys, stop looking at it as, Uncle Sam’s deeper in debt, how are we going to pay for this as taxpayers? Instead, look at it as, we now have many more assets, look at all these extra Treasurys we have. That’s the argument they use and I think there’s a sense in which it’s correct in terms of the accounting.
I actually think it’s not right because you could have equity. If someone starts a corporation and then people have shares of that and it’s a productive enterprise, your share price doesn’t correspond to somebody’s debit somewhere. Even on its own terms, that’s actually not correct. But even if it were correct, it still is misleading because you could just as well say, “The way that the world minus the Mises Institute gains net financial assets is the Mises Institute goes deeper into debt.” That’s also true in terms of the accounting. It’s misleading, especially when it comes to government bonds: the way we as a private sector get paid what we’re owed on those “net financial assets” is the government points guns at us, takes money, and then hands it right back to us and says, “Here’s the payment on your Treasurys, thank you.” There’s no sense in which we should view that as some asset that’s exogenous that makes the private sector wealthy.
JD: I’ll play devil’s advocate. To be fair to MMTers, in 2020 the US federal government borrowed about half of what it spent and the sky didn’t fall. And Professor Stephanie Kelton, the current face of MMT, is not nearly as odious as Krugman or some of our Keynesian friends.
BM: Right.
JD: If MMTers tend to hold left-wing political views and support big government, their retort would be that Austrians tend toward libertarian views—so our theory is just as “political.” And the idea that a sovereign issuer of currency can spend unlimited money, well you can see the enormous seductive appeal.
BM: Yes, Austrian economists stress that Austrian economics is positive, it’s not normative, and yet, in practice, very few people study Austrian economics and say, “Yes, now that I know how the business cycle works...” that’s possible. So, point well taken there. I also agree with you that Warren Mosler is a charming guy. When I debated him years ago, we were chatting before the debate and he was so charming and friendly that I realized I needed to step away, otherwise I was going to be a softie in this debate. The MMTers can say, “But regarding the issue of you right-wingers, not just the Austrians, but the Glenn Beck and Bill O’Reilly types of the world were warning since 2008, look what the Federal Reserve is doing and the dollar is going to crash. Some people were even using terms like hyperinflation, talking about the Weimar Republic and wheelbarrows. None of that happened, so how long are you guys going to continue to be wrong, talking like that?” I would say, on the one hand, yes, that’s a reason people should be careful and not throw out wild predictions, and I myself have made some predictions that turned out wrong and then I have to bear the brunt of that.
But, beyond that, if we are in an environment where the demand to hold money goes up, prices would have come down. Part of the problem is that people who had savings, they would have seen those savings having much more purchasing power than they do today. It’s really an issue of it’s a counterfactual relative to what otherwise would have happened. It still is true that by the Fed creating such and such more dollars, the purchasing power of the dollar is lower than it otherwise would have been, even though yes, measured in absolute terms, gasoline is not $20 a gallon right now. It’s also true too that by the Fed creating this money, it’s redirecting resources in the political channels.
Let’s use an analogy. If you found out your neighbor down the street was using his color printer to print out authentic-looking $100 bills, he’s been doing it for years, and that’s how he has nice cars. That’s how he goes on these vacations he’s telling you about. That’s how he can afford to dress impeccably. It would be silly for him to exonerate himself and say, “Did the economy crash, is gasoline $20? No, so stop blaming me; you can see nothing bad happened.” That wouldn’t be the issue, right? Can you understand why in that context, it’s the same thing economically? Just as I wouldn’t want my neighbor to have that ability, I don’t want Federal Reserve officials to have that ability either.
JD: Let’s talk about interest rates. Since 2008 and this period of extraordinary monetary policy, really since the Greenspan era, interest rates have been driven relentlessly lower. We’re now in a bizarro world where maybe a third of European sovereign debt is nominally negative. Nobody can make any money on a CD or simple savings account. What the hell is going on with interest rates?
BM: This is an area too where the economists have egg on their faces and I don’t just mean Austrian or conservative ones. Even Paul Krugman. They were matter- of-factly explaining: Nominal interest rates can’t go below zero because people would just switch to holding cash and that’s why once the Fed’s policy rate gets close to zero, we need to switch to other unconventional things or have deficit spending. The negative nominal interest rates shocked a lot of economists across the spectrum, because they had been teaching their students for years that it was literally impossible and then once it happened, the economists had to scratch around and say. That’s because in large institutions, to actually hold that much cash, you’d have to insure it and what are you going to do, put it in a safe deposit box? Once the impossible happens, economists are good at after the fact explaining why it happened and criticizing people who have, in their view, silly explanations.
But, it’s not that I saw negative nominal interest rates coming. I certainly think central banks have a lot to do with it, so to the people who argue to the contrary and say, “No, the Fed and ECB (European Central Bank) are just following the market down,” well, in one sense I want to say: then you should have no objection to the Fed and the ECB just liquidating their holdings and selling their assets, right? Because according to you, that’s not going to make interest rates go up. And usually they say, “No, that would make interest rates go up and that would crash everything. That would be a crazy policy to have such a restriction.” Usually when you push that they will admit yes, central banks and their policies have had something to do with lower interest rates. One of the points of QE was to lower long-term rates, because they were saying short-term rates went down to zero. Basically, that wasn’t enough, so now the Fed needs to intervene and try to push down long-term rates in order to stimulate spending, from a Keynesian perspective. Even the people pushing these things do admit, either explicitly or implicitly, the low nominal interest rates at least have something to do with massive central bank action.
Partly why it’s happened is people are so panicked. That right now, there’s such uncertainty and desire for perceived safety that people are willing to just sit on earning basically nothing with government debt. Especially if it’s from the US or the Japanese government, that’s perceived as being very safe in terms of they’re not going to default on the bond, even if they’re earning nothing or even if they’re earning slightly negative— even in nominal terms. But that’s not a natural evolution of capital. That’s not because the Chinese are saving so much. That’s because there have been these crazy business cycle swings, which, in the Austrian perspective, is because of massive central bank intervention. Ultimately, I would say it’s the central banks and their policies that have led us to this position, directly because they’re monetizing debt and pushing down interest rates and indirectly because they’ve caused the massive uncertainty that’s causing people to be so fearful that they want to have huge holdings in ostensibly safe assets.
JD: You mentioned some economists who say “Central banks don’t much matter; this trend was happening anyway.” But people like former Fed chair (now Treasury secretary) Janet Yellen also warn there are limits to monetary policy. The term is pushing on a string. There’s only so much monetary policy can do. What have these ultralow interest rates done for us?
BM: I agree that the ultralow interest rates have not done anything benign or good for us, that they present a problem. Somebody from a Yellen perspective or a Paul Krugman, what they mean when they talk like that is to say, “We can go ahead and push down interest rates, like I say, down to basically 0 percent and then we can engage in QE, even, and try to raise inflationary expectations in the future.” And the reason for doing that is to lower the real interest rate. So they’re saying once nominal rates get to zero (and yeah, they actually could go slightly negative, but they couldn’t go to –10 percent in nominal terms; even money market funds would switch to hold cash), how do you lower the real interest rate? You’ve got to raise expectations of future price inflation so that in real terms even a 0 percent nominal rate translates into –10 percent.
But, they’re coming from a Keynesian perspective when they talk like that. They think what you want to do is make people want to consume or invest now and the way you do that is you lower real interest rates. That’s the framework that they’re in and as an Austrian, I would say that that’s wrong, that interest rates have a job to do. They communicate information, if you want to use that language, and it means something. If the interest rate in the market would be 4 percent and instead it’s been pushed to zero, that’s going to screw things up. It causes the boom-bust cycle. As far as Yellen, especially now that she’s Treasury secretary, what they’re trying to get at is, there’s only so much the central bank can do. Once we’ve done all that and we’ve run out of ammo, it’s up to the fiscal policy to go ahead and run big budget deficits. So again, I think that’s totally wrong, what they’re saying, but that’s what they mean, because in their framework, what you do is you lower interest rates to stimulate spending, to fill aggregate demand. They’ve lowered interest rates, all right, and we’re still in a bad economy, so you can see how from their perspective, let’s try something else, then.
JD: Maybe it’s a political deflection on her part. But conceptually, axiomatically, we know nobody would loan you $100,000 today in exchange for a payment of $90,000 two years from now. Interest rates are supposed to be positive.
BM: Right. One way of putting it is look at the extraordinary circumstances that had to exist to explain why the Bank of Japan and maybe the ECB were considering this scenario. If you keep money on deposit with us and then you pull it out, they’re going to then charge you interest retroactively. I’m making these numbers up, but if they wanted to have a –10 percent rate and you pull out half your money, then they would actually ding the remainder that you left on deposit double that, so that you’re not gaining by pulling money out of the system. I’ve seen plans in place, I think it was in Japan, to avoid precisely that. That, if we wanted, if our policy rate were to be excessively negative in nominal terms, such that everybody would switch to holding physical currency, we’re going to set things up to ding you for that, to look at what your historical balance has been over the last five years to make it so that you don’t have the incentive to do that. They are setting that up so that they can get away with doing that, and that’s partly why there’s this push to get rid of cash, because that’s ultimately the way to protect yourself. I can hold a currency and earn zero percent in nominal terms in a safe in my house and so if they can get rid of currency so it’s all electronic, then you can’t even do that. You’re right, thinking through the logic of it in normal circumstances, why wouldn’t you just hold actual money if the banking system’s paying you negative nominal rates? There is a sense of that’s crazy and it can’t be a normal outcome.
JD: As an aside, it’s pretty remarkable how Mises’s Theory of Money and Credit from 1912 has held up. If you want to understand interest rates, go read that book.
BM: As you know, a few years ago the Mises Institute commissioned me to produce a study guide for that book. I had to reread it and sort of the old joke about when I was younger my dad was an idiot and then I grew up and I realized how much smarter he had become or wise. It was the same sort of thing—I had read it in grad school, and then having read it years later to do the study guide, I realized, Mises just has offhand remarks about all sorts of things like forex speculation and derivatives markets, and things like that, calls and puts, I think. It is interesting to see how much he really was a great financial economist. He understood modern money and banking and financial markets of his day and handled them as a brilliant theorist.
JD: There’s a lot of mainstream talk today about inflation. I wonder if that’s another concept, another term, where we have lost any agreed-upon definition.
BM: Right. Mises, famously, complained about— this was like the midcentury in terms of the US—he complained to an American audience saying how it used to be in the early 1900s, that everybody knew what inflation meant, it was an expansion of the quantity of money stock and/or the credit that the banks made available. And so, inflation had the inevitable consequence that prices quoted would go up, but inflation meant—just picture inflating something—a quantity of money would be inflated. That’s where the term came from, and he said, but now, over the decades, it has been changed—and again, he’s speaking in the 1950s— what the public thinks inflation means is rising prices. And that’s unfortunate, he said, because it’s now mistaking the symptom for the cause, and you can’t fight it if what you think the thing is is actually just a symptom. He said we have this perverse situation where the people causing the inflation are posing as the people protecting the public from inflation, which is crazy.
Since 2008, with all the massive monetary inflation that we’ve seen and with the rise of the internet and financial commentary by people outside the accepted gatekeepers, there’s been a resurgence and interest in that definition. Nowadays more people understand this huge expansion of the monetary base and look at the Fed’s balance sheet, look at all this inflation, and yes, it hasn’t shown up yet in prices at the grocery store necessarily, but look at all this inflation that’s now been pumped into the system. A lot of “regular people” who are not ideological and not steeped in the Austrian school understand that sort of language, and so we’re seeing a return to that.
But you’re right, there’s not an agreement on what does inflation mean and even in terms of looking at prices, the standard definition, it’s a very narrow basket of consumer goods. What if stock prices triple? Why isn’t that considered inflation, especially if the reason they went up is because the Fed created a bunch of money? What if real estate prices go up? People have to buy houses. It’s weird distinctions that they’re making: whereas the rental price, how much you have to pay to rent an apartment, can go into the cost of living index but if the price of a regular house goes from $200,000 to $400,000, that’s not considered that the cost of living has gone up, or at least it’s not that per se. You’d have to do implicit rental prices and whatnot. It is right that there is some disagreement, but I think it’s a healthy thing. At least, because the old consensus of two decades ago was wrong, or was harmful, at least now the fact that there’s some confusion is a sign of improvement.
JD: Just the other day Jerome Powell said that there is effectively no link between M2 and inflation. It feels like the Fed is going to do this forever. They’re going to do whatever is required to maintain at least the nominal price of equity markets. They’re going to keep interest rates low forever. They’re going to have “easy” monetary policy forever. But surely this can’t last forever?
BM: To elaborate a little bit on what you were saying with Powell, the Fed, they’ve been very slippery and so, it was true, like in 2008–09, when people like me, for example, or Peter Schiff, were warning about, look at this QE program, this is crazy. This monetary inflation will lead to price inflation. And the critics would say, “No, go look at CPI. Come on, you guys are crazy.” CPI’s just doing its thing, and then CPI starts rising and they say, “The Fed’s preferred measure is the Personal Consumption Expenditure Index, or, of course, CPI, let’s strip out the volatile food and energy price,” and they keep doing these redefinitions of things. Whether you’re looking at headlines, CPI, or even core CPI or personal, depending on each one, it’s going back ten, twenty years, and it’s the highest it’s been in thirty years. And it’s way above the Fed’s own stated target—and it’s funny, the headlines say things like, “Powell Sticks to the Script on Inflation,” like they’re not saying it as a conspiracy. I’m not saying Zero Hedge, I’m saying CNBC. The way they describe it is Powell’s got his script and he knows: Right now our position is inflation’s not a big deal. And so even though, according to their own metrics, it’s finally bouncing above what they’re saying the target is, we’re not going to tighten, because we think it’s transitory.
You’re right, they’re going to keep doing this until it’s so calamitous that even they can’t pretend that this is just a temporary blip. We’ve seen used car prices up over 50 percent year over year. They’re going to be able to blame it on the pandemic and just say, “No, that’s because of supply chains.” But eventually, you keep seeing numbers like this, they’re going to have to deal with them and at least make it look like they’re tightening. But they’ve painted themselves into a corner, like you say, now, financial markets are utterly dependent on the Fed being willing to come in and buy $50 billion plus of assets per month. The Fed needs to stop doing that because even they can’t ignore the warning signs in terms of standard prices that households face, then you’re going to have another major financial crisis.
JD: It is not just banks who are dependent on low rates, but also Congress itself. If average Treasury rates rose to historical averages, say 5 to 8 percent, debt service quickly becomes the single biggest federal budget item every year.
BM: Right, exactly. At Mises University, I had a chart in my talk recently just showing the metrics of the CBO (Congressional Budget Office)—as they describe it, the nonpartisan CBO. And they’re pretty good.
JD: Yes.
BM: I said that as if it was ironic, but no, even some of them would email me about things, areas like climate change and economics, when they were doing carbon taxes. So, yes, they want to at least be fair, or at least the people who were running it the last ten years that I’ve interacted with. But they’ll have charts of the US debt as a fraction of GDP. In the forecast, I’ll show it just going up and up and up, and that’s because, number one, you have demographic shifts, in terms of Medicare and Medicaid. You also have interest rates rising just a few percentage points, back to not even historic levels, but 1980s levels, even 2005 levels—then debt would be devastating in terms of the annual cost of servicing it, because there’s so much more outstanding nominal Treasury debt now compared to ten years ago. The reason it doesn’t feel so painful is because the yields on those Treasurys have been close to zero. And, that’s why you can get away with issuing trillions more in debt. But if those numbers go up, you’re right. If the Fed were in a position to maintain sanity in terms of purchasing power and to stop the runaway spiral in price inflation they were supposed to jack interest rates up to 8 percent; that would cripple the financial integrity of the US government. They are painting themselves into a corner where my guess is they’re going to do a little bit of both—let the dollar lose a lot of its value vis-à-vis other currencies and have the federal government’s finances get really hammered where we can pay for some of the entitlements and servicing the debt and that’s about it.
JD: We worry a lot about what Congress is doing and spending. We worry a lot about what the Fed’s doing. We worry about commercial banks responding to what the Fed’s doing. But in your forthcoming book you have an entire chapter devoted to shadow banking— carried out by nonbank lenders. What is shadow banking and should we be concerned about it?
BM: The term, as it suggests, is transactions happening in the shadows. These transactions, they serve the same economic function as traditional bank lending, but don’t operate through formal banks. If there’s any kind of private entity that raises capital and then goes around and funds ventures and things like that, that’s a way of ultimately linking savers and borrowers in a nexus that falls outside the traditional banking sector. Broadly speaking, that’s what shadow banking refers to.
The conventional reason, by the standard establishment types, they’re saying, After the 2008 crisis, we had Dodd-Frank (Dodd-Frank Wall Street Reform and Consumer Protection Act) and we can beef up the SEC (Securities and Exchange Commission). The Federal Reserve can go ahead and beef up regulations all they want, but that’s really clamping down on traditional banks. They look at investment banks, but that just pushes more people into the shadow banking sector, where we can’t regulate. So they use it as calls to have broader regulation and whatnot.
From my perspective, it is concerning because by its very nature, it’s hard to quantify this because it’s all kinds of things that don’t get reported on by the main government statisticians, and it’s hard to get data on this, but certainly those types of financing mechanisms have become more prevalent. The problem is, for example, that an institution, they owe people a bunch of money, but they’re saying, These other people owe us money. And so, those webs get pyramided on top of each other. That shows how if there’s a crisis in one area, they can all of a sudden have this domino effect elsewhere. You partly saw that in the 2008 crisis, that it wasn’t the fall in mortgages per se that caused the problem, it was the people that had put out things that would make you whole if your mortgages went down and that was even just a margin call. So, these were the chain reactions that made the mortgage-backed securities markets seize up.
That’s the concern that I have: there’s a sense in which the financial sector globally is intertwined and people are engaged in a lot more leverage, and even conventional metrics might miss some of this, and if a crisis breaks out even in one localized area, that could quickly spread, because people don’t fully realize how vulnerable the whole system is.
JD: How much off-balance-sheet debt is out there? Maybe there are trillions of dollars in exposures which don’t show up in our traditional measures of sovereign, corporate, household, or individual debt.
BM: I think that’s true. When I was doing research for the chapter you’re talking about in the book, it was surprisingly hard to pin down. I can see studies that look at this chart, but the problem was that they each had their idiosyncratic definitions as to what are we including in this metric.
JD: How much debt is in the world?
BM: If I have a $200 tab at my local bar, does that get counted? There’s lots of things like that that are more formalized, of course, but it’s ultimately how much do people think other people owe them, and there are different degrees of legality. Then who are you reporting that to? It’s not as easy to measure as how much outstanding Treasury debt is there.
What about what the federal government implicitly has promised current workers? When you retire, we owe you these benefits of social security. Well, that’s not a legally enforceable claim, but yet usually that gets counted in terms of the federal government’s liabilities, broadly considered. You’re right that there’s these different levels. Or if privately held companies have understandings with others, they could be formal contracts, but if nobody has access to that because they want to keep this secret, there could be all sorts of debt claims people hold against each other that aren’t showing up in our statistics.
And to the extent that there’s more regulation reporting requirements and there’s less privacy in the official channels, that’s made people go more underground, and especially with crypto, it’s becoming easier and easier for people to deal with each other financially in ways that do not show up in the public ledger. It’s true that these claims have grown, but by their very nature, it’s hard to quantify that. So how much? I don’t know because that’s kind of what we’re talking about; it’s in the shadows.
JD: It’s not always shadowy. Maybe the biggest nonbank lender in the United States is Quicken Loans, but we don’t think of them as nefarious. And they might seek out a political bailout from Congress if housing markets go south, but unlike commercial banks they can’t go to the Fed and get dollar reserves for their junk assets.
BM: Right.
JD: So maybe we should champion them.
BM: I use the term shadow banks just because that’s the term that’s thrown around, but you’re right. Like I said, a lot of times when you hear people discuss this, it’s from the perspective of people who don’t trust it. Unless the SEC and the Fed are involved, we can’t trust this. So, you’re right, it’s in the shadows should not be taken to mean there’s something illicit about it. I am in favor of financial transactions that are more just person to person and entity to entity and the government’s not involved. Unfortunately, though, like you said, the Fed has expanded the sorts of activities that it can dabble in, and that does mean that the bigger the sector, the more that people could argue these groups are too big to fail. Until the point at which the dollar starts really crashing, why wouldn’t the Fed come in and buy that up and rehabilitate that market?
JD: I want to finish by talking about bitcoin. You wrote Understanding Bitcoin: The Liberty Lover’s Guide to the Mechanics and Economics of Crypto-currencies in 2015. What prompted you to write that book, and have your thoughts on bitcoin changed or evolved?
BM: I want to mention my coauthor, Silas Barta. He was a person who had an early mining rig before I even understood what that term meant. He was into bitcoin and he helped in terms of the math.
JD: He’s currently filthy rich on a private island somewhere?
BM: I don’t know. I know he can pick and choose when he works, but I don’t know how much he actually held. Why I wrote the book, to answer your question, when bitcoin first came out, people were telling me about it, and I looked into it and did a lot of research. It’s a cool thing. I wasn’t into it so much at the beginning. As I got more and more into it I could see there was a group of people who knew about economic theory, monetary theory, and there was a group of people who understood public and private key encryption and Satoshi’s white paper, and there was very little overlap between those two groups. The monetary economists were talking about bitcoin in ways that were not right because the bitcoin community was saying, “No, you’re making false statements about how bitcoin works.” But then at the same time, the people who knew how bitcoin worked in terms of the mechanics of it would then say, “It’s the money right now and it’s the best currency,” and the economists would say, “No, that’s not how money works. You’re talking about money improperly.” That was the rationale for the book I wrote with Silas Barta, to give a framework. This is how bitcoin works mechanically and then in terms of how you would place this inside standard monetary theory in the Austrian tradition. This is how you would do it. I was just trying to clarify the terminology so those two groups could talk to each other and not make the other think they were idiots because they were making a basic mistake in nomenclature.
JD: Do you view bitcoin differently today? Seven years in bitcoin time is like seven hundred.
BM: Exactly. We were very careful in that book to say over and over we’re not telling you to invest and this isn’t saying it’s a good speculative asset. We are not talking about whether, measured in dollars or some other currency, bitcoin’s going to go up or down. We’re just explaining to you the mechanics of it. That was partly to make sure it wasn’t construed as investment advice, but also it was because I was more agnostic at the time.
Having seen it continue to grow, having seen massive price dips and people numerous times go, “Bitcoin’s dead, told you so,” and then it comes back and hits new highs. I now am comfortable saying in the year 2100, for example, people will still be checking the bitcoin blockchain. Some of it will be lost—people lose their private keys—and people will still know who holds it. I don’t necessarily think it will be a huge player in international commerce. It might be something akin to having big bars of gold right now, in that people know who owns them, but it’s not that those gold bars right now are the centerpiece of global transactions.
I’m not saying bitcoin is going to still be the primary cryptocurrency, but I do think people will hold it, whereas probably back when we wrote that guide I would not have been so comfortable saying that. I’ve seen enough now with the explosion of market caps and various types of cryptos to think that it is here to stay. It’s not that crypto’s going to disappear in ten years and people are going to look at that as a fad. That’s my view at the moment, and probably I’m more comfortable saying that now than I would have been back in 2015.
JD: Final question. What is the endgame? Does the US dollar get unseated in our lifetimes? How does all of this debt and monetization come to an end?
BM: I think it was Jim Rogers who said that the nineteenth century was the British century, the twentieth was the American, and the twenty-first is going to be the Chinese century, and I think that’s true. Given what they’re doing with the dollar, the only thing that’s going to make Federal Reserve officials pull back on how many dollars they’re creating is a massive crisis. Once that happens, they will be chastened, and maybe they’ll save some face, but I don’t think the dollar is going to reemerge as the global world’s reserve currency, with the prestige it had circa 1965. I don’t think that’s going to happen partly because the US’s prestige on the world stage is shrinking in many metrics and what the Fed’s been doing has been very irresponsible. It’s been coasting on its reputation.
If a South American government’s central bank had done the things the Fed has been doing, their currency would have crashed long ago. Speculators would have dumped it, saying this is reckless. The Fed gets away with it because people think, Come on, this is the Americans. They can’t be that foolish. Surely, if things start to get out of hand, they would quickly reverse course, and with what they’ve done now, that’s not going to be possible. That’s a long way of answering your question. Thirty years from now, I think the US in general is going to be a much smaller player in global affairs. There might be a basket of currencies that the IMF (International Monetary Fund) discusses, with SDRs (special drawing rights), or the World Bank, and the dollar still might be a big component of that. But in terms of is the dollar going to be viewed as the world’s reserve currency, no. In thirty years, I don’t think people will talk like that at all.
JD: Thanks very much, Bob Murphy.
BM: Thanks, Jeff.
Download the slides from this lecture at Mises.org/MU21_PPT_33. Recorded at the Mises Institute in Auburn, Alabama, on 22 July 2021.
In this lecture from 2021's Mises University, Lucas Engelhardt summarizes the basics of Modern Monetary Theory (MMT), its consequences, and the strange ideology behind it. Presented at Mises University 2021.
Download the slides from this lecture at Mises.org/MU21_PPT_06.
Recorded at the Mises Institute in Auburn, Alabama, on 19 July 2021.
Unlike the ongoing price inflation that is typically caused by central-bank expansion of the money supply, the price inflation generated by diminished supplies of goods is a one-shot affair.
Original Article: "Is There Such a Thing as Good Inflation?"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Professor Jonathan Newman joins the show for a look at America's Great Depression, Rothbard's classic explanation of a terrible period in US history. This book provides one of the best short surveys of Austrian business cycle theory, along with deep history surrounding the inflationary run-up of the 1920s and the disastrous mistakes made by the "laissez-faire" Hoover administration in the 1930s. Any serious student of booms and busts needs to read this cautionary tale, as does anyone worried about unconstrained monetary policy in the wake of Covid-19 lockdowns. It can happen here, and it can happen again, if Rothbard's counsel goes unheard.
Find the online version of the book at Mises.org/GreatDepression Receive a discount on America's Great Depression in the Mises Bookstore with code HAPOD15%
The task at hand is the study of the problems of the determination of prices and interest rates. This task requires a sharp distinction between money-certificates and fiduciary media.
Original Article: "There Is Money and Then There Are Money Substitutes"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Guido Hülsmann's The Ethics of Money Production is a masterclass both on the fundamentals of money and the disastrous moral consequences of monetary "policy." Inflation is not only an economic problem which impoverishes us materially, but a deeply corrosive force in society for individuals. There is no better work to explain the broader implications of central banking which go almost totally unremarked in the financial press.
Podcaster Stephan Livera is a big fan of the book and joins the show to explain why you need to read it.
Guido Hülsmann's The Ethics of Money Production: Mises.org/Ethics
Listen to Stephan's podcast at StephanLivera.com
Do we fund government or does government fund us? Can sovereign states issue currency at will without risk of default? Are government deficits actually a form of public wealth? And can newly issued currency (rather than taxes or bonds) be used to pay for public works, health care, college, entitlements, and guaranteed jobs? These are the arguments made by Professor Stephanie Kelton in The Deficit Myth, the latest addition to the "Modern Monetary Theory" concept. If it sounds too good to be true, it is—and Dr. Murphy joins the show to explain why.
Read Dr. Murphy's review of The Deficit Myth at mises.org/DeficitMyth
The Deficit Myth: Modern Monetary Theory and the Birth of the People's EconomyBy Stephanie KeltonNew York, 2020325 pages
Stephanie Kelton’s new book has attracted much attention, and Bob Murphy and Jeff Deist have already reviewed it, with devastating results. Why another review? The policies proposed in the book are so pernicious that further exposure of what she has in store for us is needed, and I have some new points to offer for your consideration. Besides, there are few things I enjoy more than writing a critical review.
Kelton, who teaches economics at Stony Brook University, writes clearly, though I wish she would not so frequently repeat in her endnotes passages from the text. The essence of the book is straightforward: it’s impossible for the United States, and other monetary sovereigns, to run out of money. “Today, we have a purely fiat currency. That means the government no longer promises to convert dollars into gold, which means it can issue more dollars without worrying that it could run out of gold which once backed up the dollar. With a fiat currency, it’s impossible for Uncle Sam to run out of money.”
A monetary sovereign doesn’t have to worry about how to get money to pay for the goods it wants produced. Government spending does not need to be backed by anything. There is always new money available. “Think about where the points come from when you play a card game or go to a basketball game. They don’t come from anywhere! They’re just conjured into existence by the person doing the record keeping....Uncle Sam doesn’t lose any dollars when he spends, and he doesn’t get any dollars when he taxes” (emphasis in original). When Congress votes money for a program, either new money is printed or the Fed increases credit balances. Borrowing does not change this: selling T-bills just involves more typewriter strokes.
Kelton hastens to assure us that she opposes unlimited government spending. She knows the dangers of inflation. “No one wants to live in a country where inflation gets out of hand. Inflation means a continuous rise in the price level…if prices start rising faster than most people’s incomes, it means a widespread loss of purchasing power. Left unchecked, this would mean a decline in society’s real standard of living. In extreme cases, prices can even spiral out of control, gripping a country in hyperinflation.”
She isn’t much worried by this possibility. Our problem today is not too much inflation, but too little, and if inflation ever did start to get out of hand, the government could increase taxes to end the danger. “If the government wants to boost spending on health care and education, it may need to remove some spending power from the rest of us to prevent its own more generous outlays from pushing up prices. One way to do this is by coordinating higher government spending with higher taxes so that the rest of us are forced to cut back a little to create room for additional government spending” (emphasis in original).
Here I would venture my first critical point against Kelton. Even if you accept all that she has said about modern monetary theory (MMT) and its manifold blessings—and of course you should not—why should we think that increased taxes would suffice to halt an inflation that has once begun? Taxes take time to come into effect, and what happens if inflation reaches unmanageable heights before this happens? What next—confiscation of people’s bank accounts in a perhaps futile effort to restore stability?
Kelton underestimates how rapidly inflation can get out of hand. As Mises with characteristic force remarks in Human Action, “This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.
“But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crackup boom appears. Everybody is anxious to swap his money against ‘real’ goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.”
“It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German Mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last.”
Kelton, in the grip of her theory, is willing to risk the collapse of the monetary system on the chance that the government will be able to curb inflationary pressure. If the US government did lose control, the result would be much worse than the examples of hyperinflation Mises mentions. The American dollar stands at the center of the world’s financial system, and its collapse could bring the entire world to ruin.
Why is Kelton willing to risk so much? The answer is clear. She thinks there is a great deal of “slack” in the economy and in this circumstance we need not worry about the pressure of spending on prices. I do not propose to challenge her Keynesian framework here. Rather, I wish to concentrate on a mistake she makes that leads her radically to overestimate the amount of slack.
She supports a federal jobs guarantee. “The federal government announces a wage (and benefit) package for anyone who is looking for work but unable to find suitable employment in the economy.” In defending this proposal, she makes the mistake I have in mind. She says: “Since the market price of an unemployed worker is zero—that is, no one is currently bidding on them—the government can create a market for these workers by setting the price it is willing to pay to hire them. Once it does, involuntary unemployment disappears.” Kelton has not taken account of the fact that the workers on federal jobs projects would use physical resources that must come from elsewhere in the economy. The cost of employing these workers is by no means negligible, as she wrongly says.
A federal jobs guarantee proposal to cope with unemployment during a recession thus rests on a false assumption. And it carries with it additional bad consequences, as Professor Joseph Salerno has aptly noted. Such programs, he says, “will thus siphon off labor and other resources from productive investment in the structure of production and forcibly increase the consumption/saving ratio and hence overall time preferences, reducing genuine savings and capital accumulation.
“Furthermore, as price inflation begins to rear its head, the increase in taxation aimed at ‘sopping up excess purchasing power’ by the private sector, will further increase the public’s time preferences, reduce voluntary saving and eventually cause capital consumption. Everyone will have jobs and rising money incomes and there will be a boom for government contractors so it will not look like a typical depression, but living standards will progressively decline. Also, the private sector will progressively shrink relative to the State sector because BOTH the fiscal inflation AND the later increase in taxes to offset its inflationary price effects will divert resources to the State sector. And of course the recurring increases in taxes will not arrest the inflation, because the government will continue to run fiscal deficits by financing its ever increasing spending with new money. This would be the worst of both worlds: massive inflation proceeding hand in hand with chronic depression.”
The book also contains some factual inaccuracies. Kelton deplores the fact that government welfare programs are usually not called “earned entitlement programs,” but just “entitlement programs.” Following Hendrik Hertzberg, she in part blames Robert Nozick for this change. “It was a clever move. They [Nozick and Robert Nisbet] dropped the word earned, which sounds like a good thing to most people, and emphasized the word entitlement—which by the 1970s had taken on negative connotations, as when we say that a spoiled or privileged person acts entitled” (emphasis in original). Had Kelton read Anarchy, State, and Utopia, she would not have said this. For Nozick, entitlements are good, not bad. He favors the “entitlement theory of justice.” She also wrongly calls the civil rights leader A. Philip Randolph “reverend.” He wasn’t a clergyman.
The problem with the book, though, does not lie here. Rather it is lies with Kelton’s way of looking at the world. She is fond of speaking of the Copernican turn that the MMT revolution makes possible. At any rate, it leaves my head spinning.
Download the slides from this lecture at Mises.org/MU20_PPT_21.
Recorded at the Mises Institute in Auburn, Alabama, on 15 July 2020.
Download the slides from this lecture at Mises.org/MU20_PPT_05.
Recorded at the Mises Institute in Auburn, Alabama, on 13 July 2020.
Bob wrote a lengthy review of Stephanie Kelton's new book on MMT, The Deficit Myth, for the Mises Institute. In this episode he narrates his review.
Mentioned in the Episode and Other Links of Interest: Bob’s original book review at Mises.org.Kelton’s book, The Deficit Myth. #CommissionsEarned (As an Amazon Associate I earn from qualifying purchases.)Bob’s older critique of an MMT accounting argument.Help support the Bob Murphy Show. For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
The good news is that Stephanie Kelton has written a book on MMT that is very readable and will strike many readers as persuasive and clever. The bad news is that Stephanie Kelton has written a book on MMT that is very readable and will strike many readers as persuasive and clever.
Narrated by the author.
Original Article: "A Review of Stephanie Kelton’s The Deficit Myth".
Central banks have decided that one of their main missions is to prevent deflation. But this only ends up causing the malinvestments that lead to economic busts.This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Let's Hope Deflation Is Headed Our Way"
We continue our series on Human Action with Professor Per Bylund of Oklahoma State University.
Dr. Bylund and Jeff Deist consider Part Three of the book, "Economic Calculation," considering Mises's conception of value and the folly of attempting to define a "unit of value" in a highly subjective world. They discuss socialism and the elementary theory of value and prices; inputs and outputs in barter vs. under monetary exchange; prices as exchange ratios; why change is constant and price "stabilization" efforts fail; why mathematical calculation of money prices may rival the wheel as among the most important human inventions; and why Mises thought praxeology emerged when man started thinking about monetary calculation.
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I. INTRODUCTION The economics profession has recently neglected the connections between the purchasing power and the quality of money. In order to cover this gap, I will analyze the quality of money and how its changes affect the purchasing power of money. I will argue that changes in the quality of money can be far more important for the value of money than changes in its quantity. This conclusion is in line with the subjectivist approach of the Austrian school. In fact, the quantity of money is an objective and measurable aggregate. The quantity theory of money is the heart of neoclassical monetary theory, but does not reconcile well with the Austrian approach. In contrast, the quality of money is a subjective concept and should stand at the center of a monetary theory based on human action. Money serves people in attaining their subjective ends more efficiently and it fulfills certain functions for people. The better these functions of money are fulfilled in the eyes of actors the higher they value money. The quality of money is, consequently, defined as the capacity of money, as perceived by actors, to fulfill its main functions, namely to serve as a medium of exchange, as a store of wealth, and as an accounting unit. Hence, the theory of the quality of money maintains that the demand for money does depend on the quality of money. In fact, the quality of money is one of the important factors, along with uncertainty, financial innovations (credit cards, ATM machines, MMMFs), frequency of payment, etc. that affect the reservation or cash-balance demand for money. The theory of the quality of money, thus, contrasts with a one-sided quantity theory of explaining the price level.
I will first review the treatment of the quality and quantity of money by economists. I will then analyze different properties of money influencing money’s quality and how they can change. In the process I focus on the function as a medium of exchange and as a store of value. I conclude with a summary of my findings.
II. THE THEORY OF THE QUALITY OF MONEY IN HISTORY The theory of the quality of money, even though not under this label, has a long tradition. While many authors have discussed the factors influences the quality of money, no unifying consensus has ever been established. Juan de Mariana (1609) explains that the deterioration of the quality of gold coins must be considered an (unjust) tax. Sir William Petty ([1662] 1889) considers the deterioration of the quality of coins by the government a tax. Adam Smith (1776) speaks of the origin of money and important qualities like durability and divisibility. Jean Baptiste Say ([1802] 1855) states that a good money must be divisible, of the same quality, resistant to friction, sufficiently rare, and malleable. He also analyzes the adulteration of the quality of money in historical instances as in the case of Philip I of France. Nassau William Senior ([1850] 1853) and John Stuart Mill ([1848] 1965) are two classical authors who discuss qualities of commodities that made them suitable to become money. Carl Menger (1871) explains the emergence of money as a spontaneous market process in which commodities with specific qualities prevail. Thus, the treatment of the qualities of money had been widespread before the twentieth century as William Stanley Jevons’s (1875, p. 30) passage states:
Many recent writers, such as Huskisson, MacCulloch, James Mill, Garnier, Chevalier, and Walras, have satisfactorily described the qualities which should be possessed by the material of money. Earlier writers seem, however, to have understood the subject almost as well. Harris explained these qualities with remarkable clearness in his “Essay upon Money and Coins,” published in 1757, a work which appeared before the “Wealth of Nations,” yet gave an exposition of the principles of money which can hardly be improved at the present day. Eighty years before, however, Rice Vaughan, in his excellent little “Treatise of Money,” had written a brief but satisfactory statement of the qualities requisite in money. We even find that William Stafford, the author of that remarkable dialogue of the Elizabethan age (1581), called “A Brief Conceipte of English Policy,” showed perfect insight into the subject. Of all writers, M. Chevalier, however, probably gives the most accurate and full account of the properties which money should possess, and I shall in many points to follow his views.
Austrian economists such as Mises (1953, chap. 1) and Rothbard (2004, pp. 189–93) have followed Carl Menger in their analysis of the origins of money. While Mises does not list the specific qualities that help a commodity to become money, Rothbard (2008, p. 6) mentions the “proper qualities of money”: commodity money is in heavy demand, highly divisible, portable, durable, and has a high value per unit weight.
However, Mises and Rothbard do not advance beyond this insight and do not mention—at least not explicitly—the importance of the quality of money for money’s demand. In fact, Mises neither in The Theory of Money and Credit (1953, pp. 131–37) nor in Human Action (1998) in his chapter on the demand for money (chap. 17) mentions the quality of money as a factor that influences money’s demand. As Salerno (2006, p. 39) states: “Mises (1998, pp. 398–402) provided only a very sketchy discussion of the demand for money which cannot bear the full weight of a theory of money prices.”
Rothbard (2004, p. 756) advances beyond Mises in his conceptualization of the demand for money and states: “The total demand for money on the market consists of two parts: the exchange demand for money (by sellers of all other goods that wish to purchase money) and the reservation demand for money (the demand for money to hold by those who already hold it).”
Rothbard (2008, p. 39) emphasizes that changes in the demand for money (as cash holdings) change money’s purchasing power. In chapters on the demand for money Rothbard (2008, chap. 5; 2004, chap. 11, sec. 5) like Mises does not mention the quality of money as a factor that influences the demand for money explicitly. However, Rothbard (2008, pp. 65–74) mentions two factors that are important for the quality of money: the confidence in money and inflationary and deflationary expectations.
In reviewing Mises’s and Rothbard’s contributions, one question comes to mind: Why did these authors not advance further and develop an explicit theory of the quality of money as a factor that influences money’s demand?This question is intriguing considering that Mises (1953, part II, chap. 2) and Rothbard (2004, pp. 831–42) criticize the mechanistic quantity theory of money. In fact, Mises (1953, pp. 128–30) even criticizes the quantity theory for failing to go behind supply and demand to explain what ultimately determines the value of money. By analyzing the quality of money we will, thus, build on the monetary theory of Mises and Rothbard. The answer lies most probably in their neglect of the function of money as a store of wealth. This function is essential for money’s quality and is more sensitive to changes than the medium of exchange and accounting unit functions.
In fact, Mises (1953, p. 35) follows Menger (1871, p. 278), and maintains that the store of wealth function is a derived and not a necessary function of money. Indeed, Mises (1998, p. 401) focuses even more exclusively on the exchange function of money than does Menger:
Money is the thing which serves as the generally accepted and commonly used medium of exchange. This is its only function. All the other functions which people ascribe to money are merely particular aspects of its primary and sole function, that of a medium of exchange.
Mises (1953, pp. 107, 110, 129; 1990, chap. 4) and Rothbard (2004, pp. 764–65) focus on the exchange function. Thus, they neglect important factors for the value of money. As they do not analyze in detail the store of wealth function, they neither point to the effects that changes in it or that money’s quality in general can have for money’s demand.
In contrast to the hesitant qualitative monetary analysis by the economists mentioned above, there is also a current in the economic literature that does not treat qualitative issues at all. This is the simple quantity theory of money defended by David Ricardo.For an analysis of Ricardo’s monetary theory and his version of the quantity theory see, Rist (1966), esp. chap. 3. For Ricardo it does not matter if gold coins, a chicken, a cocoa bean, a stone token or a paper note is money. Quantity is the only thing that matters. Quantitative issues explain all monetary phenomena. In fact, for Ricardo, all qualities of money are to be found within the limitation of money’s quantity.
Ricardo and the followers of the simple quantity theory strongly emphasize the exchange function of money set forth by John Law and Adam Smith for whom money is basically a voucher to buy goods. Money is simply an instrument of circulation. These quantitative theorists thereby neglect completely the function of money as a store of wealth. Ricardo also implies that there is no difference between inconvertible paper money and convertible money certificates. He, consequently, neglects the demand for money. For him convertibility is just a practical method to ensure a limitation of the quantity of money.
For the believers of this quantity theory,
the value of money is a function of its quantity, it is entirely independent of the value of the material from which coins are made and derived solely from its peculiar uses….(p. 49)
According to that theory, so long as the number of exchanges and the rapidity of the circulation of money remain the same, nothing can affect the value of the unit, and with it the level of prices, except changes in the volume of currency. (Scott 1897, p. 56)
As a consequence, quantity theorists tend to neglect the importance of the demand for money. As Carver (1934, p. 188) points out:
Most quantity theories of money are ostensibly demand and supply theories. Unfortunately, less attention has been given to the demand for than to the supply of money. In fact, some expounders of the quantity theory ignore altogether the demand for money, and proceed on the assumption that it is only the supply that counts. This ignoring of the subject of demand and concentration on the subject of supply seems to be based on the further assumption that the demand for money is, at a given time and under a given set of circumstances, fixed; that it consists exclusively in the number of commodities and services that are for sale.
The quantity theory of money continues to dominate in popular economics textbooks to this day. Some of the more widely used texts are: Mankiw (2004), Blanchard (2006), Stockman (1999), Hyman (1994), Slavin (1994), Boyed and Melvin (1994), Sachs and Larrain (1993), Ekelund and Tollison (2000), Case and Fair (1994), Dornbusch and Fischer (1990). Only a few textbook authors (Colander 1995 and Sloman 1994) mention qualities of money while Melotte and Moore (1995) claim that a good money must be divisible, portable, durable, and stable in value. The textbook by Abel, Bernanke, and Croushore (2008) does not even discuss the qualities of money at all.
Williamson (2005, p. 536) goes so far as to discuss several problems with the qualities of commodity money: First, its quality would be difficult to identify. Second, it would be costly to produce. Third, the use of the commodity as money diverts it from other uses.See also Burda and Wyplosz (2005, p. 176).
Williamson (2005) may have given the real reason why only a few lines, if any, are put forward in support of the quality of money, for it was the advent of fiat paper money that led economists to believe they found the perfect money. Thus, Lewis and Mizen (2000, p. 47) state that paper money can, in principle, do better than commodity money. They argue that paper money’s value can be better stabilized and involves lower resource costs.
A second reason for the virtual disappearance of the quality of money from economic analysis is general equilibrium analysis and mathematization in economics. In general equilibrium analysis, there is no process. With equilibrium analysis the evolution and the origin of money, which would need an analysis of the quality of money, cannot be explained. In fact, the quantity theory of money can explain neither the rise nor the demonetization of money. Moreover, the mathematization in economics and the accompanying rise of the quantity theory of money allowed for measurement. As the quantity of money is more usable for mathematics and measurements, the quality of money was disregarded.
Insights into the theory of the quality of money existed prior to the twentieth century. These insights, however, only enumerate the characteristics of what a good medium of exchange must have, neglecting to point out the importance of the characteristics for the purchasing power of money. In other words, they do not investigate the effects of changes in these characteristics on the purchasing power of money and do not set forth a unified theory of the quality of money. Money has other functions than serving as a medium of exchange. Money serves also as a store of value and a unit of account. A complete theory of the quality of money, must therefore also investigate the qualities of a money in respect to these two other functions. The function of money as a unit of account will not be dealt with. Instead the focus will be on the function of money as a medium of exchange and a store of wealth.
III. THE QUALITY OF MONEY AND ITS PURCHASING POWER The price of money is its purchasing power. As any price, the price of money is determined by its supply and demand. The demand for money is determined by its marginal utility.On a free market the supply of money, as the supply of any good, is indirectly determined by the subjective valuations of consumers. While neoclassical economists maintain that the supply of a good is determined by its historical costs of production, Austrian economists have maintained that the supply of a good is determined by alternative uses of the factors of production for the satisfaction of consumer wants and, thereby, by subjective factors. The utility of money is, in turn, determined by money’s quality, i.e., its capacity to fulfill its services. The quantity of money affects money’s marginal utility by increasing the number of monetary units. The quality of money affects money’s marginal utility by changing the position of monetary units on the value scale of actors in relation to other goods. As Salerno (2006, p. 52) summarizes the determinants of the purchasing power of money:
the stock of money is one of the immediate determinants of the structure of money prices and the purchasing power of money—in conjunction with its immediately past purchasing power, the existing stocks of goods, and the distribution of ownership and the relative rankings of goods and of money among market participants. (Italics added)
It is this relative ranking of goods and of money among market participants that is affected by the quality of money. The factors influencing the quality of money and, consequently, the relative ranking of goods and of money have been widely neglected. Their analysis is precisely the focus of this paper.
Thus, while the quantity of money is important for the purchasing power of money, it is not the only factor. As Henry Hazlitt (1978, p. 74) puts it:
The truth in the quantity theory is that changes in the quantity of money are a very important factor in determining the exchange value of a given unit of money. This is merely to say that what is true of other goods is true of money also. The market value of money, like the market value of goods in general, is determined by supply and demand. But it is determined at all times by subjective valuations, not by purely objective, quantitative, or mechanical relationships. (Italics in original)
Indeed, the quality of money is an essential factor in the process determining money’s price, i.e., its purchasing power. When the quality of money increases, money’s demand and, consequently, purchasing power will be higher than without this quality improvement. Money is, thus, no different than any other good. If the quality of a good increases, there will be more demand, and its price will be higher than without this increase of quality.
The importance of the quality of money can be seen in Eugen von Böhm-Bawerk’s analysis of price determination. Böhm-Bawerk (1884) names six individual determinants of prices in his price theory: the number of units of the goods offered; the number of units of the good demanded; the intensity with which the potential seller values the good; the intensity with which the potential seller values the monetary unit (or good of exchange); the intensity with which the potential buyers value the good; and the intensity with which the potential buyers value the monetary unit (or good of exchange).
The last four determinants can be summarized as the intensity of the valuation of money in relation to the valuation of other goods and services on the part of potential buyers and sellers. This intensity is not only influenced by the quantity of money and goods and services but also by the quality of money. The higher the quality of money is, the more buyers and sellers of money value the monetary unit in relation to other goods and services. The lower the quality of money is, the less buyers and sellers of money value the monetary unit in relation to other goods and services. This implies that the purchasing power of money can vary with a constant supply of money and of goods and services if the quality of money changes. When people start to value money higher, the purchasing power of money will be higher.
Actually, changes in the quality of money can have more abrupt and stronger effects on the price of money than changes in the quantity of money. In fact, changes in the quantity of money only have marginal effects on the value of money. Changes in the quality of money however can abruptly upset the subjective valuation of money in general. Apart from dramatic changes in the money supply, faster movements of the price of money can be expected by changes in the subjective valuation of money’s quality than by changes in its quantity.
One important ramification of the quality theory of money is that prices in general can rise or fall without a change in the quantity of money. Frank Shostak (2008) does not take into account the quality theory of money when he writes:
We know that a price of a good is the amount of money paid for the good. From this we can infer that for any given amount of goods, a general increase in prices can only take place in response to the increase or inflation of the money supply….Now, if the money stock did not increase, then consumers won’t have more money to support the general increase in prices of goods and services.
Shostak is wrong precisely because the quality of money can fall without an increase in the money supply.Subjective value theory shows that the price of pens can fall when the quality of pens decreases even with a constant supply of pens. The same is true for the price of money. The subjective valuation of money and, correspondingly, its marginal utility can fall as a result of a deterioration of money’s quality. As a consequence of the lower subjective valuation of money, money’s price falls. If my subjective valuation of money falls, I will try to reduce my cash balance. If I sold five apples for five dollars, now that the value of money is less I might sell one for five dollars. The same applies for the prices of other goods. As a result, I reduce my real cash balances.The opposite case is, of course, also possible. When people try to increase their real cash balances due to an increase in the quality of money, prices will be lower than otherwise. The effect holds independent of the quantity of money. The phenomenon of falling prices due to a generalized wish to increase cash balances has been called “cash building deflation” (Salerno 2003). See also Hülsmann (2003). Dollar prices have risen because of a change in subjective valuations and not a change in the quantity of money. This rise in prices is due to a fall in the quality of money that resulted in a fall in the demand for money. The fall in the demand for money means that money’s position on value scales relative to other goods’ positions has deteriorated.
In the following section we will discuss factors that influence the quality of money and, consequently, money’s subjective valuations. Some of the factors are related to expected increases in money’s quantity, a possibility not considered by Shostak. Other factors are completely disconnected from quantitative considerations.At this point, consider some examples provided by Carver (1934, p. 194):The desire for [money] is, in turn, made up of several elements. First, there is the fact that the Government will accept it in payments to itself; secondly, there is the fact that creditors must accept it; thirdly, there is the fact, sometimes, that the Government will give gold for it; fourthly—a resultant of the first threethere is the fact that custom has made it acceptable in private purchases. Remove any of these elements and the purchasing power of money will decrease without any increase in the quantity of money or any decrease in the number of commodities and services available for exchange.
IV. QUALITY OF MONEY AND ITS FUNCTION AS A MEDIUM OF EXCHANGE We will first look at factors or properties that influence the quality of money in its function as a medium of exchange. When these properties change the quality of money improves or deteriorates and affects the purchasing power of money.
There are several properties of a good medium of exchange. Most of them have been discussed in the literature in another context, namely in explaining the origin of money. In fact, the quality theory of money can explain the emergence and disappearance of money while the quantity theory cannot explain these phenomena.Another deficiency of the quantity theory of money is that it resorts to the socalled “velocity of circulation;” a black box used ad hoc to explain price changes unexplainable via quantity changes. Yet, an increasing “velocity of circulation” or increasing volume of exchanges in a period does not imply that prices necessarily need to rise. In fact, an increase volume of exchanges on the stock market may coincide with rising or falling stock prices. I thank José Ignacio del Castillo for bringing this point to my attention. Moreover, as a consequence of changes in the store of wealth and medium of exchange function the demand for money may change for a multitude of reasons. To explain all these phenomena by referring to the “velocity of circulation” does not clarify anything. Thus, Mises (1990, chap. 5) calls the “velocity of circulation” a “nebulous metaphor” and Rothbard (2008, p. 29) an ill-defined concept. In any case, a higher “velocity” may be the result of a deterioration in money’s quality (or of a decline in uncertainty, or of financial innovations such as credit cards, ATM machines, etc.), but not its cause. As Salerno (2006, p. 51) puts it: “the aggregate flow of money spending is determined by the value of money and not the other way around.” Salerno rightly criticizes the “vacuousness of the quantity theory.” Similarly, Carver (1934, p. 191) states that when “paper money is no longer redeemable it becomes less desirable, and therefore is spent more promptly. It loses some of its desirability—as a store of value.” In other words, a lower quality as a store of wealth may lead to increased spending independent of quantitative issues. As Carver adds, the increased spending can, however, be compensated for by a decreased eagerness to sell, because sellers also value money less than before. Then, it is not clear at all if the velocity of circulation will increase or decrease. It is, therefore, not an increase in the “velocity of circulation” but the decrease in desirability that explains the fall in purchasing power. One of the most important properties for the quality of money is the existence of a non-monetary demand in society for the money. This demand can be in the form of consumption goods or factors of production. It is important for the quality of money that its non-monetary demand plays an essential role in society—everyone wants and needs it. The money is not only demanded as a medium of exchange but also for other purposes. Thus, for money, as a good, there exist many unsatisfied wants and the intensity of the wants are relatively high and permanent (Menger 1892, p. 5). The non-monetary demand is important because it gives the money holder an “insurance.” Even if the money gets demonetized, i.e., it loses its monetary demand, there is still considerable value to it. The non-monetary demand supports its value.When gold, in 1971, became demonetized, there remained a strong industrial demand, and also as a store of wealth. The price of gold in terms of dollars even soared as the quality of dollars was reduced. The quality of dollars was reduced by suspending the redemption in gold. The price of gold in dollars rose from the conversion rate of $35 in 1971 to a yearly average of $58 in 1972, to $97 in1973, to $159 in 1974, and to $613 in 1980. The increase in the quantity of dollars was also important when the price control on gold was removed. In sum, the higher the non-monetary demand, the higher the quality of money. If, for instance, gold is money and demand for gold jewelry increases, more gold will be used for these purposes and the marginal utility of gold is raised. In other words, the marginal utility of gold may change independent of the rapidity of circulation, the number of exchanges, and the quantity of gold (Scott 1897, p. 56).Carver (1897) also emphasized that the value of money is determined by the same general laws of value as any other good and, specifically, by its metallic value independent of the number of money units. Similarly, Conant (1904) mentions the importance of the intensity of the demand for money. He shows that an increased demand for gold for use in the arts reduces its supply for monetary use.
Furthermore, the more people that accept the money the better the money functions as a medium of exchange. In fact, the incorporation of new users improves the quality of the money. For instance, when people that are engaged in barter start using money its quality is increased. When the Soviet Union and China opened their economies and became a market for dollars, the quality of the dollar increased. The introduction of the euro, in ever more countries, can improve its function as a medium of exchange as more potential buyers accept it. Also legal tender laws influence the acceptance of money and, thereby its quality. As Carver (1934, p. 188) points out, it does matter for money’s purchasing power if paper money is legal-tender and accepted by the government for the payment of taxes and duties or not. By giving paper money legal privileges, the government subsidizes its quality by increasing its use in exchanges.
Other properties for money as a medium of exchange are low storage and transportation costs, easy handling, durability, divisibility, resistance to tarnish, homogeneity, and recognizability.Actually gold became useful as a world money only after advances in metallurgy made divisibility easier. See Fekete (1996, pp. 12–13). These advancements led to an increase in the quality of gold coins and to a higher purchasing power. Indeed innovations such as new melting techniques improved the quality of money (coins). Likewise innovations that decrease transportation costs, facilitate handling, resistance, recognizability or increase homogeneity, and durability also improve the quality of money. Changes in these properties affect the quality of money and thereby its purchasing power independent from money’s quantity or expectation about money’s quantity.
V. QUALITY OF MONEY AND ITS FUNCTION AS A STORE OF WEALTH One of the most important properties of good money is that it is a good store of wealth (Menger 1871, p. 277). Money is the most marketable or liquid good. Liquidity is higher or lower as the loss of value (or the loss of time) experienced in liquidating ever larger quantities of an asset is smaller or greater. The spread between bid and ask prices for a good is an increasing function of quantity. Rising spreads go along with increasing quantities offered.This does not contradict the fact, that spreads are high in some markets and lower in others. It is true that in “thin” markets spreads are high. However, when the quantities offered in “thin” markets increase, spreads also increase. When we buy and sell a book in Sanskrit we will have a high spread. When we buy and sell 1,000 books in Sanskrit, the spread tends to increase. In other markets like the stock market spreads are comparatively low. However, the stock market spreads increase with quantities offered. When we buy 1,000 shares of IBM and sell them the next second, the spread is usually very low. When we buy 100,000,000 shares of IBM and sell them the next second, the spread tends to increase. Different goods have different spreads. The speed with which spreads increase is determined by the speed with which marginal utility declines with increasing quantities.
As money is the most liquid good, people can easily store their wealth and profits from sales until needed for exchange. The stored money serves as purchasing power for the future. People can easily separate the moment of the sale of their product from the moment of the purchase of their needs. Money is, thus, a means to store wealth and preserve the value of goods and services (mainly labor) sold from price fluctuations. It is insurance against the uncertainties of the future. The store of wealth function is, consequently, crucial for the origin of money and for money’s quality. A medium of exchange that loses its storage function will also lose its exchange function.
For the purpose of our paper it is not important if the medium of exchange function or the store of wealth function is more important for the origin of money or if they are two sides of the same coin.It is true, that other goods besides money, such as commodities, serve as a store of wealth. If commodities become relatively more desirable as a store of wealth than money, money’s purchasing power decreases. The same is true for the exchange function of money. Other goods besides money, such as stocks (used as a means of payment in a buyout) or bills of exchange are used in exchanges and their desirability relative to money influences money’s purchasing power. In fact, anything may serve as a medium of exchange while not any object can serve as a store of wealth. The store of wealth function is key for the quality of money.Rist (1966, p. 329) is an example of an author that argues that the store of wealth function is more fundamental and prior to the medium of exchange function:In fact, and this point is fundamental, the function of acting as a medium of exchange, since time is necessarily involved (there is always a certain interval between the receipt of money and expenditure) presupposes the function of a store of value…[the storage and the exchange function of money are] as inseparable as the obverse and reverse of a medal. (Italics in the original) In fact, exchange always takes place in time. Production and consumption are not simultaneous.Rist (1966, pp. 107–8) emphasizes the time element. He explains the characteristics a good store of wealth must fulfill and how gold does so:it must be borne in mind that man lives in society, that social life implies exchanges of services and products, that the greater part of these exchanges can only be effects after an interval of time, and that the goods which offer the best possibility of guarding against the uncertainties of time, of taking precautions against its risks, of preserving, in order to provide against future misfortunes, the equivalent of the labour and the services provided, are precious, rare, durable and indestructible objects, such as gold….Stable money, metallic money, is the bridge between the present and the future. It is because of stable money, or, in its absence, of other stable and precious objects, that, within the economic sphere, man can wait, can reserve his choice and calculate his chances. Without that, he would be completely at a loss. (Italics in the original) Abstracting from time in economics has led to crucial errors in price theory, capital theory, etc., and it is equally misleading to abstract from time in monetary theory or exchange theory. When people sell their products they cannot, or do not, buy goods and services they need at the very same moment, but rather at a later time. A liquid good to store the wealth that does not lose in value is, hence, crucial.
There are several characteristics of a good store of wealth. One important characteristic is the hoardability or storability of a good (Fekete 2003, p. 2). A good is more storable the smaller the loss incurred when it is bought and sold in the smallest quantities—when it is possible to add and subtract small amounts from one’s store of wealth with minimal costs. It should be noted that hoardability is slightly different from liquidity. The more liquid a good is, the slower the increases of the spread between bid and ask prices with increasing quantities. Hoardability, however, refers not to the costs of selling and buying large quantities of a good but rather to the costs of selling and buying small quantities of a good. Thus, salt may be more hoardable than gold but less liquid. Hoardability is also different from divisibility. Divisibility is the ability to divide a good to make exact purchases, while hoardability refers to the economic costs of adding or subtracting from a store of wealth. Teleologically, these concepts refer to different ends, namely exchanging and storing.
Another important characteristic in relation to money’s function as a store of wealth is the possibility of changes in the quantity of money. Thus, the quality of money as a store of wealth is influenced by the possibilities of changing money’s quantity. It should be noted from the outset that the possibility of changing money’s quantity (and derived from this possibility is money’s expected quantity) is only one of several factors that influence the quality of money. Moreover, the expected quantity is relevant for human action precisely because it affects the quality of money. It is relevant because it influences money’s capacity to function as a store of wealth. The expected quantity of money is one of the important factors determining the quality of money.
Let us first look at how the quantity of money increases in free competition. Two characteristics of money production in the free market influence the quality of money as a store of wealth. First, the costs to produce the money are important. Money production costs are determined by the value that individuals place on additional money. The higher the production costs of the money in relation to its market value, the slower the quantity of money will increase. Second, the already existing stock of money in relation to potential production is important. The higher the existing stock in relation to potential production, the lower is the potential rate of increase in the money supply and the better the storage function of money is fulfilled.
We now look at the case of a monopolist money producer. When there is a monopolist producer of money an important property of the money is how its quantity is expected to change. In a fiat paper money standard with a central bank, for instance, the institutional setting of the central bank becomes relevant.The setup and the “formal” independence of the central bank can be changed, of course, and this can also be anticipated. The institutional setting of the currency, therefore, also determines money’s quality. For instance, a central bank that receives its orders directly from the government is more likely to be used to monetize government debt in order to finance spending. A formally “independent” central bank, consequently, improves the quality of the currency.In an empirical study, Spiegel (1998) argued that announcement of the independence of the Bank of England on May, 6 1997 led, on this very day, to a reduction of long-term interest rates by an average of 34 basis points, and thus a reduction of inflationary expectations. This reduction of inflationary expectations represented an increase in the quality of money. The statutes of the central bank, until they are changed, can to a certain extent limit the potential increase in the money supply. Incentives (like bonus payments for central bankers) to inflate the money supply less can also increase the quality of money. If central bankers are accountable and responsible for their policies, and if there is transparency, this can improve the quality of money.
The official goals or mandates of the central bank, as well as the minimum reserves they impose on banks, play a role in the way the quantity of money is expected to be increased and influence money’s quality. In other words, the philosophy of its monetary policy implied in the statutes of the central bank, or the philosophy of central bankers, influences the quality of money in the way that the quantity is expected to change.
A central bank, whose official policy is to stabilize consumer goods’ prices, stands for a higher quality of money than a central bank that in addition to the control of consumer goods’ prices tries to stimulate the economy, stabilize asset prices, or seek full employment.
The ideology of the central bank’s president and other central bank staff influences the quality of money. In addition, comments by central bankers and politicians can immediately alter the quality of money. For instance, when the chairman of the Federal Reserve board states that he is willing to do anything to prevent a recession, this will be interpreted as the promise of future monetary inflation. As a result, the quality of money decreases and there will be an immediate impact on prices, as the currency depreciates in terms of foreign currencies. The dollar price of all goods and services outside of the US increases. Moreover, the prices of commodities can be influenced by central bankers’ comments without a necessary change in money’s quantity. The announcement, as well as its anticipation, of a Paul Volcker or a Ben Bernanke as Federal Reserve president influences immediately the quality of money.
The integrity of the monetary unit is another important property of the quality of money. Money’s integrity, for instance, may be altered through wear and tear of metallic coins. While the nominal quantity of money remains the same, wear and tear leads to higher prices than otherwise. Coin clipping is another example. The government denigrates the quality of the monetary unit by cutting part of the coin away and replacing it with metal of an inferior value (such as copper), without changing the quantity of coins in circulation. For instance, the government can clip 10 percent of the gold coins in circulation and hoard the clipped gold or do whatever it wants with it. The quality of money may decrease independently of whether the government spends the hoarded gold or not. When people become aware of this practice it will lead to higher prices, since instead of coins of 100 percent gold, the coins are 90 percent gold and 10 percent copper.To make the point even clearer imagine that the government does not just hoard the golden ball but transports it in a ship over the ocean. The ship sinks in a storm and the gold is irretrievably lost. It is then likely that people value gold and copper, as well as other goods and services higher in relation to the currency unit than before. In this case prices do not rise because the quantity of money increases or is expected to increase but rather because the quality of the money unit’s gold content was diminished.
Another case of altering the integrity of money is a change in the redemption rate of a government-controlled commodity standard. When the US government changed the redemption rate for the dollar from 1/20.67 to 1/35 ounce of gold in 1933, the quantity of the outstanding dollars was not changed. However, the quality of the dollars changed as there was less gold backing (Carver 1934).
This leads us to the question of the backing of money in the broader sense, i.e., money proper and money-substitutes. Goods or rights of different qualities can be used to back money in the broader sense. The crucial question is, can a money-substitute be redeemed against goods or rights of higher quality? Do bank notes represent a right of redemption in specie? Are the notes just fiat paper money notes? Is the note a money-certificate that can be redeemed against assets of the banks or central banks or not?
A bank note that is a money certificate is of a higher quality than inconvertible paper money.As Carver (1934, p. 188) points out, quantity theorists erroneously must maintain that money would have the same purchasing power going off gold, provided the quantity of the paper money remains the same. This is so, because inconvertible paper money presents a claim on an indeterminate amount, while a (convertible) money certificate is a claim on a clearly defined sum. Inconvertible paper money presents a claim on something that is not specified, it fluctuates in value according to the holder’s estimation of what the inconvertible paper money will be able to buy. If this estimation is very low, the value may well fall to zero.This estimation is influenced by expected quantitative and qualitative monetary developments. Inconvertible paper money’s capacity to serve as a store of wealth is dominated by this uncertainty. Nothing of this sort happens with a (convertible) money certificate that, for instance, can be exchanged at any moment against gold. As Rist (1966, p. 200) summarizes: “In short, convertibility is not a mere device for limiting quantity; convertibility gives notes legal and economic qualities which paper money does not possess, and which are independent of quantity.”
Hence, when the redemption of bank notes in a gold standard is suspended, the quality of money, from one second to the next, is reduced (independent from what might happen to money’s quantity). Bank notes are traded at a discount in relation to gold. This discount grows when people fear redemption is less probable, while the discount shrinks when people regard redemption as imminent. Mises (1953, p. 52) points out, that the value of credit money fluctuates independently of the underlying commodity, depending on the expected probability that it will be redeemed in the future, and on the remoteness of the expected future date of redemption. An illustration is provided by the history of the greenbacks in the U.S.A similar case are the French assignats that fluctuated in value according to the opinions of the chances of redemption. See Rist (1966, p. 189). After the beginning of the American Civil War, redemption was suspended with the promise to resume redemption at some future point. As a consequence, prices rose in terms of greenbacks reflecting the deterioration in quality. During the Civil War, the purchasing power of greenbacks fluctuated with the military success of the Union, independent of quantity issues (Carver 1934, p. 203). With the resumption of specie payment in 1879, there was an expectation that the the quality of the money would increase resulting in an increase in purchasing power (Bagus 2008).
Another historical illustration of the importance of the backing of a currency is the “Bully Marks” in a German prisoners’ of war camp during World War II, as described in Radford (1945). The “Bully Marks” were backed 100 percent by food at the shop and the restaurant in the camp. When the camp was bombed, the restaurant was closed for a short while and food parcels were halved. As a consequence, it became apparent that the backing of the “Bully Marks” became insecure. “Bully Marks” lost ever more in value in relation to the more secure cigarette currency. At the end there was a flight from the “Bully Mark”—a fact, that was not caused by changes in its quantity but rather its quality.
When redemption is suspended indefinitely and there exists no hope that it will be resumed, as occurs in a fiat paper money, the assets and reserves that central banks and banks hold are still important for the quality of money. This is so, because those assets and reserves back the liabilities of the banks.
When a bank goes bankrupt, because of a bank run, the bank’s assets are taken over by the depositors and creditors. The more liquid and valuable the assets the less the money holders can lose and the better is the quality of money. For instance, consider two paper money fractional reserve banks who hold 10 percent reserves in cash and both experience a bank run leading to bankruptcy. Bank A holds foreign reserves, gold, and commercial bills as assets, allowing for a rapid sell-off and a recuperation of large amounts of the depositors’ money. Bank B holds low quality mortgages and other illiquid long-term loans that can only be sold at huge losses or cannot be sold at all. Of course, people would tend to prefer notes from Bank A to those from Bank B. Thus, changes in the assets banks hold affect the quality of their notes.
Similarly, the assets of the banking system as a whole influence the quality of money. Just imagine that Bank A or Bank B represents the aggregate balance sheet of the banking system. The assets of the central bank are especially important for the quality of money (Bagus and Schiml 2008). The assets of a central bank can be used to defend the value of a currency internally and externally. Furthermore, these assets can be used to support a collapsing banking system or a monetary reform. They back the liabilities of the central bank which is mainly the monetary base. A deterioration of the average quality of central bank assets might be called “qualitative easing.” A qualitative easing is possible without an increase in the quantity of money. For instance, a central bank may sell its gold reserves and in turn acquire loans granted to an insolvent bank or troubled government. This deterioration of the average quality of central banks assets while not affecting the quantity of money deteriorates its quality.An example is the subprime crisis. While the quantity of money did not change very much from January 2007 to August 2008, the average quality of assets that the Federal Reserve System held deteriorated substantially. Government bonds were substituted by assets of dubious quality. This process might explain part of the price inflation during the period. See Bagus and Schiml (2009). See Bagus and Howden (2009a) for an analysis of the quality of money as influenced by the actions of the European Central Bank during the financial crisis and Bagus and Howden (2009b) for a comparison of the balance sheet policies of the Federal Reserve System and the European Central Bank and the implications for the quality of the respective currencies.
A final characteristic of the quality of money as a store of wealth is the policies, the ideology, the personnel, credit, and status of government.See on this point also Hazlitt (1978, p. 76). When the fiscal condition of government improves (deteriorates), the danger that government will resort to a deterioration of the monetary standard is lower (higher) than it otherwise would have been. A deterioration of the money standard (improvement) can consist in abandoning (returning to) a commodity standard, a change in the redemption rate or in the increased (reduced) use of the printing press to finance its expenditures.
In fact, a budget deficit is like a “currency illness” and reduces the quality of money (Röpke 1954, p. 142). The amount of public debts is like a “currency cancer” and weighs on the quality of money. The condition of government actually can get very alarming and a fear arises that the government will cease to exist, e.g., the government could be overturned in a revolution or suffer defeat in a war.
In a fiat paper standard the bankruptcy or the end of the government likely means the end of the currency and renders it worthless. It is the confidence in the economy and the taxation capacities of the government that hold the value of the fiat money up. The taxation capacity is crucial, because a fiat paper money is backed by the reserves of the banking system and central bank, which are largely government debts. When government debts become worthless because of an end of government due to war or revolution, the fiat money will also lose in value and may cease to exist. An example would be greenbacks during the American Civil War. The depreciation of greenbacks in terms of gold increased after Northern defeats and was reduced by Northern victories (Studenski and Kroos, 1963, p. 147).
Another example is the development of the currency of the Philippines issued by the Japanese in World War II, as mentioned by Henry Hazlitt (1978, p. 76):
One of the most striking illustrations of the importance of the quality of the currency occurred in the Philippines late in World War II. The forces under General Douglas MacArthur had effected a landing at Leyte in the last week of October 1944. From then on, they achieved an almost uninterrupted series of successes. Wild spending broke out in the capital of Manila. In November and December 1944, prices in Manila rose to dizzy heights. Why? There was no increase in the money stock. But the inhabitants knew that as soon as the American forces were completely successful their Japanese-issued pesos would be worthless. So they hastened to get rid of them for whatever real goods they could get.
Not only wars influence the quality of money. Also economic development influences the quality of money. Anything that disturbs or disrupts development inhibits the taxation capacities of the government and, therefore, potentially the quality of a money. The importance of government policies for the quality of money implies that the government can improve the quality of money if it credibly can impose restrictions on its fiscal policies. Thus, the introduction of a new article in the constitution of a country, that makes a balanced budget mandatory, can increase the quality of money. A related example is the “Stability and Growth Pact” of the European Union. The “Stability and Growth Pact” mandates an annual budget deficit no higher than 3 percent of GDP and a national debt lower than 60 percent of GDP or approaching that value. This was instigated to raise confidence in the euro currency and give a guarantee of its quality. On the other hand, signing a treaty that will probably lead to reckless governmental policies and monetizing of debts, will decrease the quality of money. An example is the signing of the Treaty of Versailles after World War I (Bresciani-Turroni 1968, p. 54). Confidence in the future of Germany declined and a flight from the Deutsche Mark set in. Likewise, Charles Rist (1966, p. 152) emphasizes the importance of government finance for a currency:
when the convertibility of paper has to be re-establised and the exchanges stabilised, sound finance and a balanced budget count far more than limitation of the quantity of paper. The important thing in such a case is to reassure foreign holders of securities or currency as to the ultimate value of paper, and this can only be done by convincing them that the financial stability of the State has been re-established.
From all this we can infer that a fiscally irresponsible government reduces the quality of money. This is so, because by excessive taxation it destroys the productive capacities of the country, reducing the quality of existing government debts. It also increases the amount of government debts itself, which implies even higher future taxation or the monetization of debts. This implies a reduction of the quality of money. Hence, a change in the government itself, its personnel, philosophy, promises, etc., can change the quality of money without any change in money’s quantity.
VI. CONCLUSION The economic profession has largely neglected the quality theory of money concentrating mainly on money’s quantity. Changes in the quality of money are very important for the purchasing power of money and have an important explanatory power. The quality of money affects the purchasing power of money by first altering the demand for money, which reflects the changed valuation of a fixed quantity of money on the public’s value scales. The expected quantity of money is only one of many factors influencing the quality of money and derives its importance from its effects on the quality of money. Thus, an integrated theory of money must put emphasis on the quality of money and explain the importance of the expected quantity of money relating it to its effects upon money’s quality.
Money’s quality is continuously changing. The changes in the quality of money can be slow but also abrupt. Consequently, they can have stronger effects for the purchasing power of money than changes in money’s quantity, which are seldom abrupt. Actually, increases in the quantity of money are increasingly less important the higher the quality of the money is. This is so, because with a money of high quality there will be a strong demand to absorb the additional amount of money as a store of value or for industrial or consumption purposes. If its quality deteriorates or is expected to deteriorate, it can have strong effects on the purchasing power of money. Furthermore, increases in the quantity of a money of high quality such as a 100 percent gold standard do not result in a deterioration of the integrity of the money. The integrity of the previously existing gold coins is not harmed by new gold production. In contrast, increases in the quantity of a money of lower quality, i.e., a fractional reserve paper money, can cause money’s quality to deteriorate by diminishing the average backing of the previously existing monetary units.
In sum, it is time for economists to shift their focus onto the analysis of the quality of money and how it can be changed in line with the analysis in this article. For instance, the quality of different monetary and political regimes, the relevant properties of a good money, the role of expectations and the quality of media of exchange should be analyzed in more detail.
Abstract: I show evidence of Austrian boom-bust dynamics in historical data on the production structure of 28 developed economies. I employ an autoregressive distributed lag model to find that policy-induced deviations from the natural rate of interest increases roundaboutness. This could instigate an unsustainable boom. Additionally, I find that early-stage industries have higher cyclical sensitivity than late-stage industries, consistent with Austrian time-value dynamics in the structure of production.
Hayekian triangle roundaboutness monetary policy central bank business cycles JEL Classification: B53, C33, E23, E32, E43, E50 This paper is based on my MSc thesis. For valuable comments on earlier drafts of this paper including the thesis I thank Prof. Dirk J. Bezemer, Dr. Mark Skousen, Prof. Roger W. Garrison, and Prof. Lex H. Hoogduin. Last, I thank the editor and an anonymous referee for helpful suggestions that considerably improved this paper. All errors remain my own.
Mark Gertsen (markgertsen@gmail.com) is on the faculty of economics and business at the University of Groningen.
INTRODUCTION The influence of interest rates on the production structure of the economy is a key concept within the Austrian framework. In particular, interest-rate-setting central banks are deemed to be institutions distorting the market, often with a combination of artificially low interest rates and expansionary monetary policy. During the Great Moderation some economists claimed that the central banking puzzle was solved, but the 2008–09 global financial crises reignited the debate around this topic. A decade later, central banks are still dealing with the legacy of this crisis, for which the consequences are yet unclear. In this paper I provide an uncommon (to most policy-makers) though sensible view that could enrich the debate about the consequences of policy-induced monetary expansion inevitably followed by boom-bust episodes similar to the one in 2008–09. To substantiate, I attempt to quantify the difference between the natural rate of interest, defined by Wicksell ([1898] 1962) as the unobserved equilibrium price of savings and investments, and the market interest rate set by the central bank. Subsequently, I explore the effect of this interest rate gap on the production structure, or roundaboutness, of 28 OECD economies over the years 2000–14. Roundaboutness as originally pioneered by Menger (1871) and later expanded by Böhm-Bawerk (1891) explains the indirectness and lengthiness of the process in which consumption goods are created. To capture the roundaboutness of an economy, I make use of the Gross Output (GO) metric pioneered by Skousen (1990, 2015, 2018). GO measures the combined value of all stages of production in the economy.While Skousen has formalized and widely promoted the concept of GO, it is wholly based on Rothbard’s (2009, 396–403) distinction between the Keynesian “net expenditure / income approach” and the Austrian “gross expenditure / income approach”. By dividing GO by GDP, one obtains a measure which increases (decreases) with a lengthening (shortening) of the production process. Böhm-Bawerk (1891) argues that more indirect processes ceteris paribus are associated with more economic progress and increased productivity. However, expansionary monetary policy is prone to instigate an unsustainable growth path. A low-interest rate policy stimulates investments which are not profitable under the natural rate, leading to malinvestment and overconsumption, in turn leading to boom-bust dynamics (Mises [1912] 1953; Hayek 1932, 1933; Garrison 2002, 2004).
This paper contributes in three ways. First, I construct a unique data set on Gross Output for 28 OECD countries over the years 2000–14. Second, I develop a proxy measure for interest rate gaps combining the Taylor rate, the consumption-investment (CI) rate and the long-term interest (LTI) rate. Austrian theory suggests that a larger interest rate gap positively influences the roundaboutness of the economy.
Third, I explore this theoretical relation in autoregressive distributed lag (ARDL) models. There are a few studies which examine this relation for individual countries (e.g. Mulligan 2006; Carilli et al. 2008), but the present paper is the first to explore the average relation for a large number of developed economies.
The result are consistent with Austrian business cycle theory (ABCT). I find that larger interest rate gaps are indeed associated with greater roundaboutness of the economy. Additionally, I find that this effect is stronger in a subsample of the five most roundabout of 65 industries than on average (though only to prolonged gaps, of more than one year, and when using a Taylor-based proxy for the interest rate gap). In comparison, the association is three to five times weaker in a subsample of the five least roundabout industries. Also, these additional analyses are in line with Austrian business cycle theory, which implies that more roundabout, hence more capital intensive industries, should respond more to interest rate changes (Skousen, 2015, 273–304). An important qualifier of this analysis is that the results are based on average effects found in historical data—they are not forecasts, nor descriptions of individual countries. The findings do suggest that on average in 28 OECD countries during the years 2000–14, the association of empirical proxies for the interest rate gap and roundaboutness were just as suggested in Austrian business cycle theory.
Apart from the scientific contribution, the study has clear societal relevance. The effects of expansionary monetary policy are obviously of great and very topical concern. Monetary mismanagement is fundamental to macroeconomic dysfunctions in the intertemporal allocation of resources (Dobrescu et al. 2012). Policy makers as well as academics will benefit from an analysis that adds the Austrian perspective to what is primarily a mainstream debate on the direction of monetary policy.
This paper is further organized as follows. Section 2 provides a survey on the current knowledge about ABCT, both theoretical and empirical. Special attention is given to the theory and application of the Hayekian triangle. In section 3, I present an econometric model to estimate the responsiveness of (sectoral) roundaboutness to the interest rate gap and in section 4 I explain how the dataset is constructed. Section 5 provides results including model variations and a sensitivity analysis. Section 6 concludes the paper and offers some suggestions for future research.
- AUSTRIAN BUSINESS CYCLE THEORY TO DATE 1.1 Roundaboutness and Capital Theory
The conventional measure for the size of the economy is the gross domestic product (GDP). Skousen (2010, 2015, 178–85) lists the shortcomings. GDP is a net output measure of finished goods and services, which leaves out intermediate production activity and business spending in the supply chain. Each of these expenditures is the result of entrepreneurial decision making, which in turn influences the rest of the economy. Entrepreneurs do not start or expand activities based only on value added. If we are to construct an empirical proxy for ‘how the economy is doing,’ it should capture the totality of spending decisions. A gross measure, not a net measure, satisfies this criterion. Note that because of this theoretical motivation, there is no double counting problem, a common objection to the GO concept. In a system of accounts, intermediate business to business transactions are just as relevant and real as economic activity linked to final goods and services (Jorgenson et al. 2006). As Skousen (2015) puts it, “GO is the top line and GDP is the bottom line of national accounting, ….. [and both] are of equal importance” (p. xix). I will operationalize this below by using both GO and GDP in an empirical proxy of roundaboutness.
The degree of roundaboutness in an economy, a concept of central theoretical importance in Austrian theory, can be proxied by the value of GO relative to GDP. With increasing roundaboutness, increasing amounts of savings-induced capital are employed to sustainably increase the capital intensity and efficiency of the intertemporal production process. The aggregate of all these processes, with varying degrees of efficiency, forms the time structure of production of the economy. Hayek (1932) further developed the time structure of production into a schematic triangular construct, known as the Hayekian triangle. The improved version of this triangle as designed by Garrison (2002) is nowadays used to describe the successive processes of capital (goods) accruing value from the original means of production, through the resource phase, up to the final stage where they are transformed into consumption goods. Capital is heterogeneous: it moves up along the hypotenuse as working capital, which, at the final stage, is consumed (in)directly or put into use as fixed capital, aiding future working capital forward in the production process.
The concept of time is of crucial importance to capital heterogeneity and its impact on economic booms and busts. Garrison (1990) shows that the neoclassical stock-flow approach, which claims production and consumption are simultaneous, is unrealistic. The theory assumes all subjective factors in the production process as fixed through time and view the capital stock as a ‘permanent fund.’ This process may appear simultaneous, but when one refrains from the temptation to generalize capital as an attempt to formalize it, one notes that a fundamentally uncertain future by definition means the production process is subjective and not fixed through time. The subjective factors in this process are typically entrepreneurs who make decisions about how and what capital formation takes place (Mises [1949] 1998). These decisions are based on the interpretation of the economic outlook and are by no means based on clairvoyant expectations. Inherently, a fraction of the entrepreneurs always either misjudges the economic climate or is downright unfortunate, and the macroeconomic impact of these events is relatively small. However, when there is a broad central-bank-induced misconception about future demand due to misaligned—investor vs. consumer—(time) preferences, the fraction of bad decision-making significantly increases, which causes a consumption boom and a severe capital misallocation at the same time. Were it for neoclassicals, capital could easily be moved elsewhere at no cost. In reality, however, the liquidation, the adjustment and the redirection of wrongly allocated capital is a painful process.
1.2 Interest Rate Effects and Financial Sector Dominance
The main culprit for capital misallocation is the distortive effect of monetary expansion on the natural rate of interest. An excessive increase of the money supply sends conflicting signals to investors and consumers creating a wedge between the savings and investment equilibrium on the loanable funds market. The expansion lowers the interest rate and creates two virtual equilibria: (1) consumers see the lower rate as an incentive to spend more now, while (2) investors are led to believe that consumers will spend more later. This illusion of a surplus of available savings for early-stage investment purposes has been called ‘forced savings’ by Hayek (1932) and is wholly equivalent to Mises’s ([1949] 1998) malinvestment. Garrison (2004) shows graphically how these forced savings affect the structure of production leading to a ‘dueling’ production structure (Cochran 2001).
The rational expectations hypothesis is often brought up as a refutation of this theory (e.g. Wagner 1999, Cowen 1997). Evans and Baxendale (2008) nullify this argument introducing entrepreneurial heterogeneity in a prisoner’s dilemma setting based on an article by Carilli and Dempster (2001). This use of the prisoner’s dilemma illustrates the limits of rationality. Many investors may well be aware of the fact that a policy-induced credit expansion increases nominal rather than real savings. Some may even be aware of the boom-bust consequence. However, since central authorities have the sole right of issuing legal tender, investors (but even more so, banks) can externalize the cost of recessions towards (other banks and) the taxpayer (Hayek 1933). In fact, profit-maximizing investors must increase their lending or their competition will (King 2016). The incentive for the individual makes the collective system worse off. Even though investors might thus be aware of unsustainable lending practices, they are competitively forced into this behavior. In the words of Carilli and Dempster (2001), ‘banks need not be fooled or tricked into increasing lending’ (p. 324) but their customers will be fooled. The majority of customers is ignorant and just seeks the lowest price forcing banks to compete while unaware of the unsustainable system. Even the educated customer is ‘bribed’ into foolish behavior—in a macroeconomic sense—because he will otherwise get outcompeted by the ignorant ones (Garrison 1989, Block 2001). The result is that economic agents (no matter their background) are ‘pushed up’ the boom phase of the cycle towards margin lending because strategic behavior induces them to. This imposes clear restraints on the impact of rationality. The ‘search for yield’ systematically moves lenders towards riskier investments. Bloomberg (2016) writes: “Credit fund managers who, having largely sat out on the recent rally in junk-rated debts, now find themselves forced to re-enter the fray after underperforming the wider market” (emphasis mine). Additionally, Hendrickson (2017) finds that investment by firms at lower interest rates is increasingly more prone to coordination failures, adding to risk and uncertainty.
Mulligan (2013) argues that the ABCT shows resemblance with Minsky’s (1992) Financial Instability Hypothesis (FIH) in which a first mover advantage is present for lenders (borrowers) extending (taking on) more credit (debt). This means that the prisoner’s dilemma works over both the extensive and intensive margin: who is in/out, and who is first? Thus not only does excessive credit expansion lead to moral hazard, it also allows an adverse selection problem to materialize since margin lending (borrowing) lures ‘bad’ entrepreneurs and non-creditworthy borrowers into the market (Evans and Baxendale 2008). Moreover, informational cascades (or Cantillon effects) increase investor-consumer inequality due to a knowledge gap which in turn is amplified through the adhesive power of the financial sector (Howden 2010). Resource misallocation along the structure of production shifts focus and resources away from the real sector. Entrepreneurial knowledge is extracted by the financial sector leaving the real sector at a serious knowledge disadvantage on how to align consumer demands along the structure of production.
1.3 Empirical Approaches to the Structure of Production
According to Lewis and Wagner (2016) Austrian macro theory suffers from an underdevelopment in the use of empirics to support theory. Expanding on those, or developing new ways to empirically support theory would, according to the authors, make Austrian macro theory able to compete with mainstream dominance. Examples of empirical Austrian research are Mulligan (2006), Fillieule (2007), Young (2012) and Cachanosky and Lewin (2014) amongst others. Not surprisingly, they all relate to the Hayekian triangle in one way or another.
Mulligan (2006) for instance finds that lowering the interest rate below sustainable market rates provides a short-term boost to consumption and investment, but has a decreasing effect in the long run. This is in line with the ABCT. Fillieule (2007) mainly analyzes the goods-in-process structure of production and finds that a lower time preference is followed by a lengthening of the production structure in which the profitability of earlier stages relatively increases. While this provides some concrete results, he uses a formalized form of the average production structure concept of Böhm-Bawerk (1891) to counter the infinite-stages problem. Economists like Garrison (1981) argue this to be a futile attempt to quantify a series of subjective numbers into one value. An alternative approach by Cachanosky and Lewin (2014), though also based on an average production period, uses the economic value-added (EVA®) literature which allows them to ‘reframe roundaboutness and interest rate sensitivity into financial terminology’.EVA® is a registered trademark of Stern Stewart and Co. (Cachanosky and Lewin 2014). In their review of the triangle, they effectively determine that, due to its nature, empirical research is prone to subjective judgment because of the very structure of the triangular concept. The authors do endorse the approach taken by Young (2012) who qualitatively examines the impact of interest rate deviations on the aggregate roundaboutness of the Hayekian triangle rather than on specific stages. Young’s analysis of the 2002–09 US structure of production is relatively simple but elegant. He develops a ‘total industry output requirement’ (TIOR) as an indicator for roundaboutness. I will expand on his work by taking this indicator to a country level. The breadth of my dataset allows me to assess the economy-wide roundaboutness of 28 countries. This generalization, however, comes at the cost of not being able to assess individual country characteristics. Based on regression analysis, I expect similar results to match with ABCT in the sense that the production structure of an economy will expand with a larger interest rate gap.
- METHODOLOGY I use cross-country regression analysis to examine whether there are generalizable effects of a larger interest rate gap on the roundaboutness of economies. I approach roundaboutness by creating a similar metric to Young’s (2012) TIOR which I call TEOR, or, the ‘total economy’s output requirement’. The TEOR of a specific country reflects the amount of gross output required from its domestic industries both directly and indirectly to deliver a currency unit of final output.
Figure 1. A Simplified Hayekian Triangle
The TEOR is defined as the ratio of gross output to final output (excluding foreign inputs for simplicity). To illustrate, in Figure 1 I present the Hayekian triangle with intermediate and final outputs. The TEOR value is the surface of the triangle (total gross output) divided by the shaded part (final output). Formally, consider that the economy consists of an array of industries indexed by . Industries process intermediate (capital) goods yielding value added, denoted by , equal to final output (Garrison 2002). According to the Bureau of Economic Analysis, value added equals the difference between an economy’s gross output and the cost of its intermediate inputs.See https://www.bea.gov/faq/index.cfm?faq_id=1034. Industry gross output is denoted by .
Total gross output is then given by
from which the TEOR can be derived as,
By definition, a relative increase in the production of intermediate goods increases TEOR. Assuming no monetary intervention, such a situation occurs when the average relative time preference of consumers decreases. Conversely, a relative increase of final output decreases TEOR which occurs when the average relative time preference of consumers increases. This allows TEOR to function as an interpretation of roundaboutness which is an important step in the empirical analysis of ABCT.
To measure the interest rate gap, I take the difference between a country’s market interest rate (i.e. the short-term interest rate) and the natural interest rate. I proxy the latter following the original equation of Taylor (1993):
To simplify, I follow Taylor’s (1993) rule of thumb to attach 0.5 weights to and . I specify as the output gap which then yields,
where is the market interest rate that should be targeted, is the current core CPI inflation rate, is the desired inflation rate and is the estimated value of the equilibrium real interest rate. The latter’s estimations differ (Yellen, 2015) but I will follow Young (2012) and Taylor (1993) by setting it to 2 percent. A desired inflation rate of (close to) 2 percent is commonly accepted in OECD countries hence I equally standardize that rate. Natural rate estimation then follows:
(5)
Combining this with the actual market rate, the interest rate gap is calculated as:
(6)
The baseline regression then estimates the relation between the interest rate gap and roundaboutness:
(7)
where and respectively denote country and year. To recognize country heterogeneity, I control for time-invariant country characteristics in the intercept. Absolute differences between the two interest rates are useful because it allows for assessing the impact of sustained gaps. A production structure might not instantly adjust to a one-off deviation. Negative gaps ( ) pose no problems to the expected outcome since its reverse equally holds true (Rosen and Ravier, 2014).
Given the likelihood of a dynamic relationship and potential autocorrelation, I include lags of both variables and assume (trending) stationarity. Additionally, interest rates changes—often piecemeal—are subject to the Cantillon mechanism resembling distributive effects. Similarly, TEOR is also dependent on its previous values since economic growth is equally gradual. The possibility to detect the movements of both variables could be improved using quarterly or monthly data which I unfortunately do not have.
A consequence of using the ARDL model is the violation of the assumption that the dependent variable is uncorrelated with the error term—ARDL implies autocorrelation. To eliminate this, I include sufficient lags of both variables such that lagged errors can be excluded. The optimal lag amount minimizes the Akaike and Bayes information criteria. I further control for demographics since this is known to push down interest rates (Rachel and Smith, 2015; Carvalho et al., 2016). The ratio of old population (age > 65) to total population captures this effect.
To assess the elasticity of specific production stages to interest rate gaps, I follow Young (2012) and average respectively the five most roundabout (MR) and least roundabout (LR) industries into two ‘TIOR’ rates. The goal of creating these two averages is to examine the difference in cyclical sensitivity between early and late stages. Last, the CI and LTI proxy function as alternative to the Taylor proxy. Interest rate gaps are:
(8)
(9)
The CI proxy is inspired by Carilli et al. (2008) but modified following Rothbard (2009) who points out that the proportion between consumption and investment (rather than saving) reflects individual time preferences.
- DATA One of the main contributions of this paper is to construct a unique data set on Gross Output for 28 OECD countries over the years 2000–14.See Appendix A for a country overview. Underlying data has been retrieved from the World Input-Output Database (WIOD) 2016 release (Timmer et al. 2015, 2016). Specifically, I extracted annual data from 28 different National Supply and Use Tables (SUTs) corresponding to the OECD countries. The database is classified according to the ISIC Rev. 4 and its tables are based on SNA 2008. To retrieve GO per country, I use ‘total intermediate consumption’ (column labeled ‘INTC’) for GO—at basic prices—from the Use tables. This includes value added (at basic prices) plus intermediate inputs adjusted for taxes less subsidies. I calculate GDP as total value added of all industries using the same source (taxes and subsidies excluded).
Necessary data for the Taylor-rate equation are collected from several sources. The realized market interest rates per annum are retrieved from the OECD database on short term interest rates, with the exception of rates for Hungary, Japan and Slovenia which were collected from AMECO. Core CPI rates and output gaps are respectively from the OECD and AMECO database. Data on the old population ratio is from the World Bank Development Indicators (WDI). I calculated the consumption-investment interest rate proxy using data from the WDI. Specifically, I use Gross Capital Formation (as percent of GDP) and Final consumption expenditure (as percent of GDP). The long-term interest rate is proxied by OECD government bond data except for Estonia, Slovak Republic, and Slovenia, which are from the AMECO database. Some years are missing: Czech Republic (2000), Estonia (2011–14), Korea (2000), Mexico (2000, 2001), Poland (2000), Slovenia (2000, 2001).
Table 1. Descriptive Statistics Including Variable Definitions
MR and LR are calculated using underlying data from the national SUTs of the WIOD. One exception is made for Japan, where one of the five least roundabout industries, household activities, was calculated in a seemingly inconsistent way—I used the sixth least roundabout industry instead. According to Rosen and Ravier (2014), a new business cycle began around December 2000, hence I use 2001 as the base year to determine MR and LR.
The panel data are strongly balanced (N = 420). For further descriptives, see Table 1. Most variables are complete except for the LTI proxy. TEOR is relatively normally peaked but slightly skewed rightwards. MR has a few large outliers which might bias the estimators—normalizing solves some of the skewness. LR is more normally distributed but somewhat skewed to the right. The MR–LR distributional difference makes sense from a theoretical perspective. The included 65 industries roughly follow a Pareto-like distribution where MR industries are relatively more dispersed and further from the mean than LR industries. Taking the average from a sample of 10 industries to mitigate this difference barely affects LR but greatly affects MR potentially risking diluting its elasticity to the interest rate gap.
- ANALYSIS 4.1 Baseline results
I use a panel fixed effects baseline ARDL regression with clustered robust standard errors to counter heteroskedasticity in the error variance. A unit root test rejects non-stationarity. To determine the optimal lag amount for TEOR and the interest rate gap I add to both variables up to 5 lags and subject each specification to an AIC/BIC test. This suggests an ARDL(1,0) process to be optimal for modeling the relationship. A manually performed RESET test confirms that the model does not suffer from omitted variable bias. To check whether serial correlation has been eliminated, I compare the ARDL(1,0) process to eight other variations and again subject them to an information criteria test. To visualize the variations:
The model comparison shows that the ARDL(1,0) process remains to be the best fit. BIC results correcting for observation loss—due to added lags—points in the same direction. Note that it is not a certainty that autocorrelation in the error term is completely eliminated, but it is as much as possible.
Table 2. Comparison of the relationship between TEOR and the interest rate gap based on three different proxies. The dependent variable is logTEOR.
Robust standard errors in brackets * p<0.01, p<0.05, * p<0.10 To compare the Taylor-based ARDL process to the other two proxies, I run through the exact same process to determine the most optimal amount of lags for both specifications. Results suggest an ARDL(1,1) and ARDL(1,0) process for respectively the CI and LTI proxy. A comparison of the TEOR responding to all three proxies is provided in Table 2. Column 1 shows that a Taylor-based interest rate gap of 1 percent significantly results in a 0.11 percent more roundabout economy, ceteris paribus. Thus, GO increases with 0.11 percent as compared to final output, a difference in difference effect. The second column displays contradicting results and with a zero net effect does not support ABCT, whereas results in column 3 are insignificant alltogether. I want to make two additional remarks. First, I left out the control variable for the LTI proxy because demographic effects are already captured by the long term government bond interest rate (Rachel and Smith, 2015). Second, note that I included a test whether the adjusted R-squared in fact increases upon adding r_gap (and its lags) to the specification, indicating its relevance.
4.2 Cyclical Sensitivity and Country Conditions
I now substitute TEOR with MR and TR and run through the same procedure for lag and model optimization. Significant outcomes are for MR combined with the Taylor proxy and for LR combined with the CI and LTI proxy. Other variations return insignificant results. I provide the significant results in Table 3. Interestingly, the MR response to the interest rate gap is negative for the contemporaneous year but positive for its first lag. A prolonged (t>1) interest rate gap of 1 percent results in a net positive effect on roundaboutness of around 0.65 percent.
Table 3. Comparison of the average TEOR to stage-specific TIORs. DEPVAR refers to the relevant dependent variable specified below the column number.
Robust standard errors in brackets * p<0.01, p<0.05, * p<0.10 The responsiveness to an interest rate gap of the most roundabout industries is 5 times larger than that of the least roundabout industries (0.14–0.21 percent), providing the gap persists during at least two successive years. This suggests that more remote industries are as expected more elastic to interest rate changes. The CI and LTI proxy are inherently less volatile and might therefore explain the non-significant responses of MR. Conversely, the same reasoning might apply to LR estimations.
Finally, I check whether the baseline Taylor-based TEOR results are robust to specific country conditions (table not reported). In particular, I include three additional control variables on their own, and as interaction with the interest rate gap. First, I look at the growth rate of financial depth and proxy this with the growth rate of liquid liabilities as a percentage of GDP (King and Levine 1993). Second, I use R&D expenditures growth (as percent of GDP) to proxy capital intensity. Third, I use stock market capitalization growth (as percent of GDP) to determine the impact of financial sector development. A developed financial sector is generally associated with economic growth and better resource and capital allocation (Allen and Gale 2000, Levine 2002). For every addition, I re-run the lag and model optimization process to determine the most optimal ARDL specification. None of the three added control variables, nor their interactions with the interest rate gap, significantly changes the earlier results from Table 2.
- DISCUSSION AND CONCLUSION 5.1 Discussion of the Results
A positive relationship is found between TEOR and the Taylor-based interest rate gap. The outcome is both significant and economically relevant. Over the observation period, GO shows a relative growth rate of 0.11 percent to GDP for every percent increase in the interest rate gap. This translates approximately into a 0.22–0.33 percent change in GDP terms (i.e. TEOR rate* ∆GO). For a small (big) country like Belgium (United States) this means hypothetical capital misallocation of EUR 920 million (USD 34 billion) in 2014. In the upswing of a business cycle, capital misallocation accumulates over the years and pushes the economy beyond its maximally attainable production possibilities frontier until the inevitable correction sets in (Garrison 2004). A back-of-the-envelope calculation provides further color to this scenario by suggesting more capital misplacement results in deeper downturns (see Appendix B).I note two caveats here. The amounts mentioned for capital misallocation are hypothetical in the sense that it is impossible to know what share of capital is easily redirected during economic recovery and what part is plainly wasted. It is thus equally impossible to accurately determine the accumulated stock of misallocated capital the moment before a boom turns into a bust. The amounts are merely provided to give an impression of the magnitudes potentially affecting the production structure of an economy.
Figure 2. The Dueling Hayekian Triangle
Source: Garrison (2004). Policy-induced interest rates suggest an unsustainable increase in the capital-intensity of the economy potentially initiating an Austrian boom-bust cycle. Artificially low rates provide a short-term boost to both final output and gross output. ABCT predicts the latter effect to be dominant and this is indeed observable in the results. Early stage industries respond up to 5 times stronger to (prolonged) interest rate gaps than late stage industries. Early stage—more roundabout—industries act more pro-cyclical and more volatile due to time-value of money effects (Skousen 2015). Interestingly, MR industries also require a multi-lagged model suggesting they are also more sensitive to delayed interest rate effects. The fact that the average TEOR response is smaller than the lower-bound LR response may seem odd. A possible explanation for this behavior is that the average response is likely similar to a response from middle stages. In a ‘dueling’ Hayekian triangle setting, middle stages are relatively negatively affected due to misallocated capital (Cochran 2001, Garrison 2004). This results in a kink in the hypotenuse (see Figure 2). The potential relatively negative effect of the middle stages might have pulled down the economy wide average industrial response to an interest rate gap.
ABCT is particularly consistent with Minsky’s (1992) FIH which describes that extended periods of economic prosperity lead to under-evaluation of market risk inducing firms and other market participants to increase investment (Mulligan, 2013). While this process of progressive overleveraging is endogenous, the Austrian monetary expansion is exogenous. However, both mechanisms are prone to the influence that expansionary monetary pressure exerts on inflating the boom. Increasing roundaboutness due to interest rate gaps closely resembles a Minsky-like period of euphoria. Quite literally, due to misperception of risk variability and adjustment costs (i.e. price signals), entrepreneurs increasingly engage in plan revisions to further expand their business (Mulligan, 2013). This decreases productivity and leads to wasteful spending (Dobrescu et al., 2012).
5.2 Limitations and Suggestions for Future Research
Based on the constructed dataset, I put forward some suggestions I chose not to pursue in the current paper. First, different natural rate proxies could be used to calculate the interest rate gap. Labauch and Williams (2003) provide such an alternative, albeit technical, as well as Keeler (2001) who uses a term spread technique, which however should be slightly adjusted to meet the critique of Carilli et al. (2008). Second, the Taylor rate could equally be established differently. Here, both the proposition of Yellen (2015) to modify the real equilibrium interest rate or a non-generalized inflation rate to match specific countries’ past and present inflation targets could be followed.
Others interested in this topic but rather on a country level could combine the methodology of Young (2012) and the dataset of the present paper. This could yield 27 additional qualitative country-specific studies on production structures and would greatly expand the knowledge of Austrian business cycles in each of those countries. Additionally, these studies could be extended with an empirical VAR analysis including a Granger-causality check á la Carilli et al. (2008), which is quite laborious for panel data. If employing VAR, longer time series would then be desirable (e.g. by adding more years or finding quarterly or even monthly data).
Furthermore, the methodology of this paper could be used for within country panel analysis on the industrial level—each industry has its own TIOR. Data for this can be retrieved from the national SUTs of the WIOD (Timmer et al., 2015). In fact, the Young analysis could even be applied to a singly industry within or cross-country.
5.3. Conclusion
The empirical analysis of this paper confirms that Austrian boom-bust dynamics are economically relevant and do not just remain ABCT artifacts. I have employed an autoregressive distributed lag model to analyze historical data related to the production structure of 28 developed economies. I found that policy-induced deviations from the natural rate of interest increases roundaboutness and could instigate an unsustainable boom. Additionally, I found that early stage industries have higher cyclical sensitivity than late stage industries confirming the importance of time-value dynamics in the structure of production (Skousen 2015). I used three natural rate proxies the significance of which varied across the different dependent variables. The Taylor proxy applies best to average economic as well as early stage roundaboutness, while the alternative proxies are a better fit for late stage roundaboutness. Even though these differences can be explained to a certain extent, further research on these causes is warmly welcomed.
Appendix A. Overview of Countries Included in the Dataset
Source: Timmer et al. (2015). Note: I use GO/GDP ratios hence currencies play no role. Appendix B. Cross-Country Boom-Bust Statistics
Note: Capital misallocation is the cumulative sum over the years 2001 until the year before a downturn. For some countries this exceeded 1 year of negative growth in which case I also included the next year in Δ GDP during downturn. As the scatterplot shows, some countries did not experience a clear boom-bust scenario. Excluding these from the results does not change the significance of the correlation coefficient.
The Understanding Money Mechanics series by Robert P. Murphy, is a comprehensive overview of the theory, history, and practice of money and banking, with a focus on the United States.
The full book is available at the Mises Store, and free on mises.org in html and pdf versions. Also available on Amazon.
[The table of contents below is from an earlier serialized version of the book]:
TABLE OF CONTENTS Chapter 1: Introduction
Lays out the scope and purpose of the booklet, and the schedule for release.
PART I: THEORY AND HISTORY
Chapter 2: The Theory and Brief History of Money and Banking
Covers Menger’s theory of the origin of money, and briefly mentions the anthropological critique (David Graeber). Explains the attributes of a desirable commodity money. Gives a standard history of the origin and development of modern banking, including some important court rulings. Mentions the history of private mints.
Chapter 3: A Brief History of the Gold Standard, with a Focus on the United States
Explains the US dollar’s tie to the precious metals over time, and some of the major controversies such as William Jennings Bryan’s “Cross of Gold” speech. Explains the operation of the classical gold standard and how it evolved during the World Wars, Bretton Woods, and, finally, the Nixon Shock.
Chapter 4: The History and Structure of the Federal Reserve System
Explains the unusual circumstances of the Fed’s origin, and mentions “conspiracy theory” treatments. Explains how power was consolidated in DC and away from Reserve Banks under FDR, and how the Fed’s mandate again altered in 1977. Concludes with an overview of the modern organization of the Fed, including the number of member banks, how the Federal Open Market Committee (FOMC) is selected, how the chairman is picked, etc.
PART II: THE MECHANICS
Chapter 5: Standard Open Market Operations: How the Fed and Commercial Banks “Create Money”
Explains the “textbook” mechanics of the Fed buying assets to create new reserves, and then how commercial banks create new loans on top. Defines the various monetary aggregates (base, M1, M2, “Austrian true money supply,” etc.).
Chapter 6: Beyond the Fed: “Shadow Banking” and the Global Market for Dollars
Defines the concept of shadow banking and gives a brief history, plus some stats for context. Defines things like “eurodollar,” LIBOR, etc. Explains the Bank of International Settlements (BIS) and the Basel Accords. Explain the basics of the repo market and the difference between capital requirements and reserve requirements.
Chapter 7: Central Banking since the 2008 Financial Crisis
Explains the “emergency” measures that the Fed adopted (Term Auction Facility, QE rounds, interest on reserves) and negative interest rates abroad. Mentions the moves to suppress cash (tied up with negative interest rates, at least rhetorically). Explains how Maiden Lane programs are arguably illegal.
Chapter 8: The Fed’s Policies since the 2020 Coronavirus Panic
Explains some of the major changes implemented in the wake of the pandemic, such as the abolition of reserve requirements, unprecedented asset purchases, and a redefinition of M1.
PART III: APPLICATIONS
Chapter 9: Ludwig von Mises’s "Circulation Credit" Theory of the Trade Cycle
Lays out the basics of Austrian boom-bust theory. Explains that Mises developed it in The Theory of Money and Credit, in which he also said that fiat money was a theoretical possibility (!); this means that Mises clearly didn’t think that boom-bust was restricted to fiat money regimes. Using Mises’s analogy of a master builder running out of bricks, illustrates the difference between “overinvestment” and “malinvestment” theories, and also why continued pump-priming a bad idea.
Chapter 10: Monetary Inflation and Price Inflation
Starts with Friedman’s measures of money stock and (consumer price) inflation, and summarizes cases of hyperinflation (Civil War, Weimar Republic, Zimbabwe, Venezuela). Documents change in how the word “inflation” is used, and explains how “currency boards” are used by some countries to limit the ravages of inflation. Explains the famous equation of exchange (MV = PQ) and why Mises and Rothbard didn’t like it.
Chapter 11: The Inverted Yield Curve and Recession
Documents this surprisingly good forecasting tool, and then shows that it fits quite nicely within the Austrian framework.
Chapter 12: The Fed and the Housing Bubble/Bust
Shows that the textbook Austrian story fits the empirical facts of the housing boom/bust.
PART IV: CHALLENGES
Chapter 13: Does Textbook Explanation Get Money and Banking Backwards?
Is the “textbook” description (covered in chapter 5 above) actually wrong? Deals with the (relatively) recent claims—coming not just from internet critics but also a major UK institution—that bank lending is not reserve constrained. Also addresses that idea that “lending creates deposits” rather than vice versa, as the orthodox economists claim.
Chapter 14: Crying Wolf on (Hyper)Inflation?
Explains that some (including the present author) made erroneous warnings about (consumer price) inflation when QE was first implemented, and asks whether this invalidates the textbook treatment. Is it true that QE was “just an asset swap” and “wasn’t money printing”?
Chapter 15: The Keynesians on the Cause of, and Cure for, Depression
Explains the Keynesian perspective. Contrasts Austrians and Keynesians on the Great Depression. Explains the “liquidity trap” and why Keynesians think Say’s law works in the special case of “full employment” but that we need a general theory of employment, etc.
Chapter 16: The “Market Monetarists” and NGDP Targeting
Gives a brief history of the historical battles between original monetarists and Keynesians (Friedman/Phelps on the Phillips curve, the Robert Lucas critique, and rational expectations framework). Then explains how people like Scott Sumner updated Friedman’s monetarism and now offer the goal of “level targeting” of stable NGDP growth, which some Austrians argue is similar to Hayek’s approach.
Chapter 17: Bitcoin and the Theory of Money
Applies the earlier theoretical framework to Bitcoin, to answer questions such as “Is it money?” Addresses the challenge that Bitcoin violates Mises’s regression theorem.
Chapter 18: An Austrian Reaction to Modern Monetary Theory (MMT)
Reprints Murphy’s 2020 QJAE review of Stephanie Kelton’s popular book explaining MMT, The Deficit Myth.
Abstract: This paper aims to propose a non-distortionary monetary policy objective consistent with the Austrian business cycle theory. Since the price level should fall in the growing economy in the Hayekian framework, introduction of a negative inflation target combined with the Taylor rule is suggested as a non-distortionary monetary policy. To keep the money stream stable, the optimal inflation target would be equal to the opposite of the growth rate of the economy. Such policy should lead to the smoothing of the business cycle path since monetary policy could be less activist compared to the current state of the positive inflation target. Possible criticisms of this suggestion are anticipated and addressed in this paper.
central bank inflation targeting negative inflation taylor rule monetary policy business cycle JEL Classification: B53, E31, E32, E52, E58 Tomáš Frömmel (tomas.frommel@vse.cz) is a Ph.D. student in the economics department at the University of Economics, Prague.
INTRODUCTION Some economists from the Austrian school tend to criticize the existence of the central banks and suggest their abolition and transition towards a free banking system. Nonetheless, the existence of the central banks is a state that apparently cannot be changed, at least in the near future. For this reason, suggestions of the central banks’ abolition cannot be taken seriously, since they are far away from current reality. Although it may be true that the economy would develop better without the central banking system, Austrian economists might come up with some more realistic suggestions of rules for central bank policy.
The aim of this paper is, therefore, to develop a non-distortionary monetary policy objective consistent with the Austrian business cycle theory. The central bank committed to such an objective should not lower permanently the market rate of interest below the natural level, and would not distort free-market system of relative prices and trigger artificial boom-bust cycles.
The introduction of a negative inflation target combined with the Taylor rule is suggested as a satisfactory policy objective, complying with requirements presented above. Since, in the Hayekian framework, the price level should fall as the natural output of the economy grows, monetary policy could be less activist compared to the current state of positive inflation rate targeting; relative prices would not be distorted by permanent injections of new money into the economy and the course of economic development could be smoothed under the proposed rule.
There have already been some suggestions that the price level should be allowed to fall in the growing economy (e.g. Hayek 1935, Friedman 1984, Selgin 1997, or Potužák 2016). Unlike these papers, this essay respects the fact that current central banks do not target money supply and rather use interest rates as their policy instrument. Therefore, we aim to propose a non-distortionary rule prescribing how the central bank might set its interest rates. For this reason, our suggestion might be more realistic compared to the other suggestions.
The structure of the paper is as follows. The first section briefly presents monetary policy rules and especially the inflation targeting regime and the Taylor rule. The second section presents criticism of the inflation targeting from the Austrian perspective. The next section suggests the introduction of a negative inflation target and explains advantages of this policy. The last section aims to anticipate possible criticisms of the suggested policy and tries to disprove them.
- INFLATION TARGETING AND THE TAYLOR RULE Monetary policy rules are commonly seen as more convenient than discretionary policy (Sargent and Wallace 1975, Barro and Gordon 1983, or Svensson 1999). The main argument in favor of policy rules is the problem of time inconsistency of the central bank policy. A central bank committing itself to some policy rule should not adopt any policy that has not been declared in advance. Policy rules may thereby reduce entrepreneurs’ uncertainty concerning future monetary policy conditions, and the central bank becomes more predictable.
Furthermore, if arguments of the Austrian business cycle theory critics (e.g. Tullock 1988, Cowen 1997, or Wagner 1999) were right, monetary policy rules should lead to gradual smoothing of the cyclical development of the economy. If the central bank adopted and publicly communicated some policy rule, monetary policy would become more transparent and entrepreneurs would be able to understand the consequences of central bank policies more easily. Then, they would not be fooled by the monetary authority and an artificial boomThe Austrian business cycle theory (Mises 1953, Hayek 1933 and 1935, or Garrison 2001) predicts that lowering the market rate of interest below its natural level and subsequent non-uniform inflow of new money into the economy leads to investment into more roundabout production processes. Since increased investments are not accompanied by increased voluntary savings, newly created structures cannot be finished in the future. The economic boom is not sustainable for this reason, and the recession is an unavoidable result that allows re-equalization between real savings and investments. would not be triggered. To adopt a policy rule seems to be a suitable action since it limits the central bank’s ability to increase the amount of money in the economy and hereby initiates artificial boom-bust cycles.
One of the most common monetary policy rules or regimes is inflation targeting, defined by Bernanke and Mishkin (1997, 97) as “the announcement of official target ranges for the inflation rate at one or more horizons and… explicit acknowledgement that low and stable inflation is the overriding goal of monetary policy.” This regime of monetary policy is defended mostly for its high transparency and comprehensibility. A credible central bank may, by setting and publicly communicating its inflation target, simply control inflation expectations of agents in the economy and hereby control the inflation rate (Bernanke and Mishkin 1997). Furthermore, Svensson (1999) states that the inflation targeting regime helps to maintain low and stable inflation rate in the long run.
Taylor (1993) suggests a policy rule that allows the central bank to respond to the output gap and to the difference between the actual inflation rate and target for the inflation rate. The rule may be expressed by the following equation according to Mankiw’s (2009) macroeconomics textbook:Taylor (1993) assumed specific values of parameters ρ, πT, θπ and θY. Mankiw’s (2009) equation is written without any assumptions for parameters and variables.
(1)
where i denotes the central bank’s nominal rate of interest, π stands for the rate of inflation, πT is the central bank’s target for the inflation rate (set as a positive number), (yt – y*) expresses the percentage difference between current real output of the economy and its natural level, ρ is the natural rate of interest, and parameters θπ and θY express responsiveness of the central bank to changes in the inflation rate and to the deviations of real output from its natural level. Parameters πT, θπ and θY are set by the central bank. Money supply is endogenous under this rule.
The Taylor rule implies that if the rate of inflation is on the target and output does not deviate from its natural level, the central bank should set its nominal rate of interest equal to the nominal equilibrium rate of interest ρ + πt. If the rate of inflation decreases below the inflation target, the central bank should decrease its nominal rate of interest and vice versa.A sufficiently strong decrease in the central bank’s rate of interest pushes the real rate of interest downwards, below the natural level. This stimulates investments and consumption and increases the rate of inflation, which is hereby stabilized at its target.
Despite its several critics (e.g. Orphanides 2001, or Orphanides and Williams 2002), some version of the Taylor rule is used in models of new Keynesian economists (e.g. Clarida, Galí and Gertler 1998, or Svensson 2000a).
- INFLATION TARGETING: AN AUSTRIAN PERSPECTIVE Let us now assess the policy of inflation targeting from an Austrian perspective. The first problem may arise with the definition of inflation. While Austrian economists usually define inflation as an increase in the quantity of money in the circulation, mainstream economists usually speak of an increase in the aggregate price level (Bagus 2003). For purposes of this paper, let us accept the mainstream definition; inflation means a rising price level and may be measured by the consumer price index or by the GDP deflator.
Another, more serious, problem arises with targeting the positive inflation rate in the growing or stationary economy. While all central banks targeting inflation have positive inflation targets, Hayek (1928) suggests that if the quantity of money is held constant, prices must fall if the output rises and vice versa.
Hayek (1935) further argues that in the growing economy, the equality of the natural rate of interest and the market rate of interest is feasible only in case of the falling price level; price level should not be stabilized in the growing economy.Wicksell (1936) argues that the market rate of interest is equal to its natural level in case of stabilized price level. Hayek (1935) objects that this holds only in the stationary economy. Further discussion on this issue may be found in Potužák (2018).,White (1999) points out that Hayek (1976) not criticizing price level stabilization is not consistent with his previous works. Komrska and Hudík (2016) reject this alleged inconsistency. If prices are intended to rise or remain stable in such an economy, the central bank must permanently increase the amount of money in circulation, and it thereby creates permanent pressure for the reduction of the market rate of interest below its natural level.This holds regardless whether the central banks control interest rates or the money supply. An attempt to stabilize the price level in the growing economy leads to an increase in the money supply and to a decrease in the rate of interest below its natural level.
This may be simply shown using the quantity theory of money and the equation of exchange:
(2)
where M expresses the money supply, V velocity of circulation of money, P aggregate price level and Y real output. The expression MV on the right side of the equation 2 may be called nominal income of the economy.
Equation 2 implies that in case of a stable velocity of money and a stable money supply, nominal income is stable as well; then, if real output rises, the price level must fall. A permanent increase in the price level in an economy with growing natural output unambiguously implies the necessity of a permanent increase in the money supply or velocity. Targeting a positive inflation rate in the economy with growing or stationary natural output necessarily implies permanent pressure for the reduction of the market rate of interest below its natural level, which according to the Austrian business cycle theory, distorts the free market system of relative prices and triggers an artificial boom. Potužák (2018), therefore, shows that inflation targeting (or price level stabilization) is not a suitable policy in the economy with growing natural output; price level may be stabilized only in a stationary economy.
Furthermore, inflation targeting leads to the distortions in the free market system of relative prices (Cochran 2004). An increase in the price level due to an increase in the amount of money in circulation is never uniform; some prices rise and some may even fall when the central bank injects new money into the economy (Mises 1953). Selgin (1997) describes a case of a decrease in only one individual price due to a positive shift in technology while all the other prices remain unchanged. In such case, aggregate price level slightly decreases, and the central bank needs to increase the money supply to stabilize it. Thus, after a decrease in only one individual price, the central bank aiming to stabilize the price level changes all the prices in the economy. Selgin (1999) states that even Hayek realized that attempts to stabilize the price level if real output rises lead to serious dislocations of relative prices.
The last objection deals with the central bank’s alleged ability to simply control inflation expectations in the economy. This might be true; nevertheless, Murphy (2005) proposes that entrepreneurs need not care about all prices in the economy or about the aggregate price level. What matters in entrepreneurs’ decision-making are expectations about only a small set of market prices; entrepreneurs need to know only prices of their inputs and outputs. Since an increase in prices after monetary expansion is never uniform (Mises 1953), inflation expectations are different from expectations of individual price movements. All individual prices may change even in case of price level stability; hence, entrepreneurs may expect a change in a small set of prices even in case of a stabilized price level. Furthermore, some individual prices may decrease even in the case of an increasing price level. The presumed advantage of the inflation targeting regime might be hereby partly disproved from an Austrian perspective since the central bank does not possess the ability to control individual-price expectations, but only price-level expectations or inflation expectations.Inflation targeting might be probably problematic from some parts of mainstream economics (i.e. Lucas 1972) as well since it targets something that no single agent in the economy uses as his benchmark.
To sum up this section, it seems that inflation targeting suffers from several serious objections and, from an Austrian point of view, should not be evaluated as a suitable regime of the central bank policy in the growing economy. In the next section, we will introduce a rule that might be more convenient from the Austrian perspective.
- SUGGESTION OF THE NEGATIVE INFLATION TARGET There have already been some attempts to suggest a monetary policy rule that would not initiate boom-bust cycles in the growing economy. Hayek (1935) proposes that the central bank should not stabilize the price level, but rather money stream defined by the total nominal spending in the economy. Potužák (2016) explains that only keeping the money stream MV constant protects the economy against adverse effects of shocks to the velocity of money circulation that are similar to the effect of shocks to the money supply. Under Hayek’s (1935) rule,Potužák (2016) uses the term ‘Hayek MV-rule.’ money supply changes only in case of velocity changes; the central bank compensates changes in velocity of money circulation by opposite changes in the amount of money in the economy. Under such a rule, the price level would fall in the economy with growing natural output, which is consistent with the Austrian view presented in the previous section.
Nevertheless, currently central banks usually do not control the money supply but set nominal interest rates to keep the money growth within a certain interval and to fulfill their objectives. For this reason, Hayek’s proposal is not further considered as a suitable rule, but the suggestion of stabilizing money stream MV will be preserved. Some economists (e.g. Bean 1983, Hall and Mankiw 1994, West 1994, or McCallum and Nelson 1999) suggest nominal income targeting as an optimal monetary policy regime. Nominal gross domestic product would grow at a constant rate equal to the sum of the long-run average rate of growth of real output and targeted inflation rate. Nonetheless, such a policy is not significantly different from the inflation targeting. If nominal income growth is targeted, the right side of equation 2 is targeted to rise permanently. Then, the left side must grow at a stable growth rate as well, which means a permanent injection of new money into circulation. For this reason, nominal income targeting cannot be recommended as a suitable policy, since it suffers from the same problems as the inflation targeting.
As was already explained in the previous section, the Hayekian framework predicts that the aggregate price level must fall in the economy with growing natural output. Hence, introduction of the negative inflation target is suggested. The quantity theory of money and the equation of exchange is used to derive this negative inflation target. Equation 2 may be rewritten using the growth rates of all variables, obtaining the following equation:
(3)
A constant money stream MV is desired for the reasons explained above. Equality of the growth rate of the economy with the growth rate of potential output is assumed in the long run:
(4)
Hence, conclusions of Hayek (1928, 1935) combined with equations 3 and 4 imply the following formula for the optimal inflation target:
(5)
implying that in the Hayekian framework, the growth rate of the price level should be equal to the opposite to the growth rate of the potential output of the economy. The central bank could still use the Taylor rule and only use the equation 5 to set its optimal inflation target. Since the growth rate of the economy is roughly constant in the long run on the balanced-growth path (Barro and Sala-i-Martin 2004), target for inflation should be constant over time as well in such an economy.Campbell and Mankiw (1987) argue that an economic development has a stochastic trend and, thus, a growth rate of the economy is not constant over time. If this were true, the inflation target should be set as a long-term average growth rate of the economy and should be held constant for a longer time period. It would mean that monetary policy would not be completely neutral, since changes in the growth rate of the economy could cause deviations of the central bank’s inflation target from the optimal inflation target prescribed by the equation (4), but the central bank could simply control inflation expectations. Such a monetary policy regime could be acceptable for advocates of the inflation targeting (Bernanke and Mishkin 1997, or Svensson 1999) since their arguments in favor of the regime of inflation targeting might hold regardless whether the target is positive or negative. The suggestion of a negative inflation target incorporates a desired high level of transparency, trustworthiness and predictability of the central bank policy; by publicly announcing its negative inflation target, the central bank might reduce uncertainty concerning future monetary policy conditions and hereby control inflation expectations of entrepreneurs. Thus, from this perspective, inflation targeting with the positive target might not be more advantageous compared to the suggested negative inflation target policy.Nonetheless, inflation targeting proponents (Bernanke and Mishkin 1997, or Svensson 1999) broadly defend positive inflation targets. Our suggestion of negative inflation target policy would probably be criticized by them, even though the central bank would remain transparent and predictable. This objection will be discussed in the fourth section.
Nonetheless, negative inflation target policy could be more suitable than the inflation targeting with the positive target. Since, according to Hayek, the aggregate price level should gradually decrease in the economy that is going through technology-induced growth, monetary authority need not be so activist when targeting the negative inflation rate. Positive inflation rate in the economy with growing natural output must always be induced by the central bank injecting new money into the economy; on the contrary, negative inflation may be achieved per se, without any monetary authority actions.
If the central bank accepted negative inflation target policy, adjustments of the interest rate and money supply would not be needed so often and the free-market system of relative prices should be distorted less compared to targeting the positive inflation rate. Since the central bank would not permanently lower the money rate of interest below its natural level, monetary policy would not be excessively expansionary and would not initiate artificial boom and bust cycles so often. Output of the economy would be stabilized around its potential level and the course of the economic development would be smoothed.
Furthermore, since the central bank would not intervene permanently in the money markets, a free market system of relative prices would not be artificially distorted. Entrepreneurs might be able to form expectations and predictions of their prices more easily and more accurately than in case of the positive inflation target since prices would be affected only by market forces and fundamentals and not by monetary authorities (Murphy 2005).
Finally, introduction of a negative inflation target might not mean a large change in current central bank policies. Central banks setting a negative inflation target could still use some kind of the Taylor rule; the suggestion of a negative inflation target means only a change in one parameter of the monetary policy rule determined by the central bank.
- POSSIBLE CRITICISMS OF A NEGATIVE INFLATION TARGET POLICY Besides previously discussed advantages of the negative inflation target, there might be some criticisms of the suggested policy rule. This section aims to anticipate and partly disprove them.
Firstly, the suggested policy with a negative inflation target could not ensure absolute soundness of money. The central bank would have to intervene in credit markets in case of changes in the velocity of money circulation. A decrease in velocity should be accommodated by an increase in the money supply that would keep the money stream MV constant (Hayek 1935). Nevertheless, since injections of new money into the economy are not uniform and it is not ensured that new money enter exactly to the sectors with decreased velocity, free-market system of relative prices may be distorted by an inflow of new money. This monetary accommodation is, however, desirable since otherwise the economy would suffer from stronger deflation than implied by equation 5.
Moreover, the central bank would have to intervene during the business cycle since real output of the economy equals to the potential output only in the long run, and the same holds for the inflation rate and inflation target. In the short run, since the economy is hit by supply and demand shock and goes through cyclical fluctuations, the central bank committed to the negative inflation target policy would have to intervene by adjusting the rate of interest (and hence the money supply) to stabilize the inflation rate at its target and the output at its potential. If the economy is hit by a positive supply shock (i.e. due to a drop in commodity prices) and deflation deepens, the central bank, to comply with its negative inflation target, needs to lower its rate of interest to increase the amount of money in the economy. Such policy leads to a smaller decrease in the aggregate price level and the desired negative inflation rate target is met.The other possible way to conduct monetary policy in such a situation would be not to react at all and to let prices freely adjust. We treat such policy as less suitable since the rate of inflation would not be stabilized at the target and the central bank would lose control over inflation expectations. Nonetheless, the increase in prices after a monetary expansion is not uniform and the free market system of relative prices is distorted by such an attempt to override a supply-driven price development. The Austrian business cycle theory predicts that an artificial boom might be triggered by such policy. Hence, the suggested policy might not work optimally during the recessions when the inflation rate decreases below its target, which is attainable only after monetary expansion. Hence, the suggested policy might not be called non-distortionary, but rather less distortionary.
This criticism of inflation targeting, however, holds regardless of whether the inflation target is positive or negative. Nonetheless, Mises (1953) and Hayek (1933, 1935) claim that cyclical fluctuations of the economy are induced by overly expansionary policy of the monetary authority. The previous section concluded that a negative inflation target policy restricts interventions of the central bank in the credit markets and might lead to the business cycle smoothing. Then, the inflation rate should not deviate frequently from its targeted value and the frequency of central bank interventions should be lower compared to the positive inflation-target policy. From this perspective, the negative inflation target seems to be more appropriate than the positive target, although absolute neutrality of money would not be ensured.
Secondly, negative inflation target might be criticized by New Keynesians since they commonly prefer a positive inflation rate and there occurs a widespread fear from deflation (e.g. Akerlof, Dickens and Perry 1996, or Bernanke and Carey 1996). However, Borio and Filardo (2004a) distinguish three types of deflation: the good, the bad, and the ugly. Deflation implied by the proposed negative inflation target policy corresponds to the good one, caused by an increase in labor productivity and economic growth. Hence, there might be no reason for fear from this harmless deflation. Furthermore, Sargent and Wallace (1975) suggest that fully anticipated price changes should have no effect on the economic development. If the central bank with the negative inflation target were credible enough, there would be no unexpected deflation and no harmful effects on the economy.Any differences between the actual and expected rate of inflation might be avoided to prevent the deflation spiral and potentially other adverse effects of deflation. For this reason, if the central bank decided to implement the suggested negative inflation target policy, it should be implemented by gradually decreasing the inflation target accompanied by transparent communication of the central bank, so that all people may build the decreased inflation target into their inflation expectations.,Atkeson and Kehoe (2004) and Ryska (2017) showed empirically that there is no link between deflation and depression, except for the period of Great Depression. This may be another argument against fear from deflation.
Another argument in favor of the positive inflation rate claims that even fully anticipated deflation may be harmful since it leads to a reduction in consumer spending; consumers expect further decrease in prices and postpone their purchases in order to buy cheaper in the future (Krugman 1998). Potužák (2015) rejects this argument since the optimal flow of consumption over time does not depend on a ratio of present and future prices of consumption goods. The intertemporal allocation of consumption is determined by the real rate of interest. If expected deflation leads to a decrease in nominal rate of interest, real interest rate remains unaffected and optimal flow of consumption remains unaffected as well. Hence, there is no reason to be afraid of spending postponement in case of fully expected deflation.Further discussion on this issue may be found in Kovanda and Komrska (2017).
Thirdly, the proposed policy might be criticized for the problem of the zero-lower bound on nominal interest rates. Many economists (e.g. Summers 1991, McCallum 2000, Reifschneider and Williams 2000, Svensson 2000b, or Eggersson and Woodford 2003) point out that nominal interest rates cannot fall below zero. In case of the inflation rate below the target, the Taylor rule implies the necessity of lowering the central bank’s rate of interest. Because of the zero-lower bound, nominal interest rate could not be decreased below zero, which would increase real interest rate and the central bank would not be able to meet its inflation target. One might expect that the probability of the lower zero bound attainment would be increased in case of negative inflation target since equilibrium nominal interest rates would be closer to zero, compared with targeting the positive inflation rate.
Let us solve this issue. The Fisher equation expresses the following relation between the nominal and real rate of interest:
(6)
where i denotes the nominal interest rate, r stands for the real interest rate and π expresses the inflation rate. It is obvious that the negative inflation rate decreases the nominal interest rate compared to the positive target. Assuming that the inflation rate equals its target and real output is stabilized around its potential in the long run, plugging equation 5 into equation 6 implies that under the negative inflation target policy, the nominal interest rate would be given (in the long run) by the difference between the real interest rate and the growth rate of potential output of the economy:
(7)
It may be shown that the real rate of interest is higher than the growth rate of the real output if the economy is dynamically efficient (Romer 2006), hence, if the economy does not over-accumulate capital. In such an economy, the nominal interest rate is positive in the long run (Potužák 2016). Hence, even if the central bank targeted negative inflation rate, nominal interest rate would remain positive in the long run.Nominal interest rate would definitely be closer to zero than in the case of positive inflation target.
A zero lower bound might be hit in the short run since the inflation rate may fall below the target and a negative output gap may occur during the business cycle. In such a case, the Taylor rule prescribes that the central bank should lower the nominal interest rate. Since the nominal interest rate would be close to zero in the long run, there would be only limited scope for lowering the interest rates and the zero lower bound might be hit. Nonetheless, we have shown that the course of the business cycle might be smoothed under the negative inflation target policy, hence, the zero bound on nominal interest rates should not represent a serious threat under the proposed policy rule. Furthermore, since the path of economic development should be smoothed under the proposed policy, the probability of the zero-lower bound hit should be even lower than in the case of positive inflation target. The proposed negative inflation target policy might be superior to the current policies with positive inflation targets.Furthermore, Borio and Filardo (2004b) examining 14 economies in the 19th century conclude that the zero bound was never hit when the economy experienced sound deflation driven by technological progress and economic growth. This empirical result might support our theoretical conclusions, although there were no central banks in most of countries in the 19th century, while our suggestion of negative inflation target still counts with a central bank that actively sets interest rates.
Finally, New Keynesian economists (e.g. Summers 1991, Akerlof, Dickens and Perry 1996, or DeLong and Sims 1999) claim that a moderate positive inflation rate permits maximum employment and output growth in the long run because of the downward nominal-wage rigidities. For this reason, Ball (2013) even argues for an increase in inflation targets. Deflation might lead to higher than natural growth in real wages, which would increase involuntary unemployment. Nevertheless, the question is whether a decreasing profile of nominal wages would be necessary under the suggested policy. As the economy goes through the technology-induced growth, real wages grow because of the growing productivity of labor. Nominal wages might be kept constant and decreasing price level would lead to desired increase in real wages.
Let us examine this issue mathematically. Nominal wage wN is defined as a product of the real wage wR and the price level P:
(8)
Then, the growth rate of the nominal wage may be expressed by the following equation:
(9)
Neoclassical growth modelsNeoclassical growth models are explained in Barro and Sala-i-Martin (2004) or Romer (2006). predict that in the economy on the balanced growth path (steady state), the growth rate of the real wage is given by the technology growth g. Furthermore, equation 5 expresses the idea that the growth rate of the price level under the suggested negative inflation target policy equals the opposite of the growth rate of the potential output. Neoclassical growth models predict that this growth rate is given by the sum of the population growth n and the technology growth g. By plugging these growth rates into equation 9, we obtain the following formula for the growth rate of the nominal wage under the suggested policy:
(10)
We have expressed that the nominal wage growth rate would be given by the opposite of the population growth rate.Potužák (2015) comes to the same conclusion. Hence, downward rigidity of nominal wages constitutes a serious objection against the suggested negative inflation target policy if this policy were used in countries with positive population growth. In such countries with downward rigidities of nominal wages, our suggestion would lead to higher than natural growth in real wages, which would increase involuntary unemployment.
Nevertheless, Hayek (1976), Selgin (1997) and de Soto (2012) state that rigidities in nominal wages may be strengthened by the inflationary monetary policy. If real wages are rising due to technological progress and the central bank targets positive inflation rate, nominal wages must rise by a higher growth rate than the price level. This creates an environment that limits downward flexibility of nominal wages. In an environment of a stable and expected decrease in the price level, rigidities in nominal wages could be at least partly eliminated since employees could be even willing to accept a moderate decrease in their nominal wages implied by equation 10 and a falling price level would lead to an increase in their real wages.
CONCLUDING REMARKS This paper aimed to propose an objective for the central bank policy consistent with the Austrian business cycle theory. The research was motivated by the fact that many Austrian economists suggest a banking system without the central bank. Nevertheless, the existence of the central banks probably cannot be changed. Hence, Austrian economists might aim to find a non-distortionary rule for the monetary policy.
Since the price level should fall in the economy with growing natural output in the Hayekian framework, a positive inflation target is achievable only if the central bank regularly increases the amount of money in circulation. This policy is criticized from an Austrian perspective since increasing money supply pushes the money rate of interest below its natural level hereby initiates an artificial boom-bust cycle.
Introduction of a negative inflation target was suggested in this paper. Since a constant money stream is desired from the Austrian perspective, we proposed inflation targeting with the target set as the opposite number to the growth rate of the economy.
Such a policy should be superior to the positive inflation rate target since it reduces activism of the monetary authority and smooths economic development. Furthermore, all advantages of the positive inflation targeting might be kept. Possible criticisms of the suggested policy rule were anticipated and aimed to disprove, although it is not a completely non-distortionary policy.
In our view, the main challenge for future research lies in integrating the Austrian theory of capital and business cycle into the DSGE models that are one of the building blocks of modern macroeconomics. Development of the economy under the suggested negative inflation target policy could be simulated in such framework, which could help to further disprove possible criticisms of our suggestion.
Negative interest rates are now entrenched reality in Europe, and not just for buyers of sovereign or corporate debt – even retail savings accounts are affected. What does this mean for real people trying to save for retirement? And more broadly, what does it mean for Europe culturally? Not to mention America, since Alan Greenspan tells us negative rates are coming here soon?
Our guest Rahim Taghizadegan from the independent Viennese Scholarium joins the show to discuss the anti-economics of negative rates. He is co-author of a new book titled The Zero Interest Trap. He is also a co-author of Austrian School for Investors.
Saifedean Ammous explains why Austrian economics helps us understand Bitcoin, and how Bitcoin can help us understand Austrian economics.
Presented at the Libertarian Scholars Conference on 28 September 2019, at The King's College in New York City. Includes an introduction by Jeff Deist.
Bob Murphy explains some of the most important points in his new QJAE article on the fractional reserve banking debate. Bob shows why Mises thought any issuance of fiduciary media caused the boom-bust cycle, and he points out a major flaw in George Selgin’s defense of fractional reserve banking.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
In a special episode of the "Part of the Problem" podcast, Dave Smith interviews Mises Institute president Jeff Deist.
Recorded at the Mises Institute in Auburn, Alabama, on 19 July 2019.
ABSTRACT: In recent years some economists have begun to doubt the scientific standing of the standard Austrian theory of the origin of money. They seem to think that it is only one possible solution to the problem of accounting for money’s value. Of these economists, Gary North (North 2012b) has presented the most cogent counter-interpretation to how we should understand the theory of the origin of money as elaborated by Carl Menger and Ludwig von Mises. Unlike the rest of economic theory, the origin of money and Mises’s regression theorem do not partake of the character of a scientific law deduced from the basic principles of the science, but is rather, and is presented as such in the writings of Menger and Mises, what North terms “conjectural history.” In this essay we will respond to North’s challenge and to the economists who agree with him.
JEL Classification: B13, B40, B53, E40, E42 Kristoffer Hansen (kristoffer.moustenhansen@etud.univ-angers.fr) is a Ph.D. candidate at the University of Angers.
This paper originated as a presentation to the fellows’ seminar at the Mises Institute in 2017. I would like to thank Dr. Salerno and Dr. Thornton and the fellows for their helpful comments. I would also like to thank Dr. David Gordon, Dr. Guido Hülsmann, and Prof. Patrick Newman for helpful suggestions and comments. Finally, I would especially like to thank the Haag Family for sponsoring my stay at the Mises Institute in the summer of 2017, when I first presented the ideas contained herein.
Quarterly Journal of Austrian Economics 22, no. 1 (Spring 2019) full issue, click here.
- INTRODUCTION In his essay (North 2012b) for the 2012 volume in commemoration of the centennial of the publication of Mises’s Theory of Money and Credit (Hülsmann 2012b), Gary North poses a challenge to our understanding of monetary theory. Carl Menger and Ludwig von Mises, North argues, did not really integrate their theory of the origin of money into the rest of economic science. Rather, this part of the theory of money exists in the netherworld of conjectural history: it is plausible, given what money is today, that it came about the way Menger and Mises speculate, but it is by no means certain. It is simply the most convincing account to scholars in the Austrian tradition, but other accounts are possible, and given the lack of historical evidence, there is in the final analysis no way of settling the issue.
This argument is worthy of response, especially given the authority of the source, and the fact that other monetary theorists seem to agree with Dr. North in demoting the regression theorem (White et al. 2014) from the realm of pure theory. In other publications Dr. North has lucidly explained and discussed the Misesian theory of money (see North 1993, 2012a), so it might well be that he has discovered serious objections to the regression theorem and the origin of money as stated by Mises and Menger. We do not believe, however, that North’s position can be sustained and that we have to demote the regression theorem to a matter of historical conjecture. In the following we will attempt to show why.
We will proceed by first restating North’s thesis: the origin of money and the regression theorem are best understood as a historical hypothesis concerning how money could have come about. We will then examine in more detail how Menger and Mises themselves conceived of the status of the theory of the origin of money in the corpus of economic laws. Finally, we will answer North’s challenge by showing the impossibility of any other origin of the value of money than the one Mises provides and argue for the logical nature of the temporal regression by which he proves it.
- DR. NORTH’S CHALLENGE—THE ORIGIN OF MONEY AS A HISTORICAL CONJECTURE Carl Menger began his The Origins of Money by rejecting the theory that money owes its existence to law or convention. Such a law would surely have been remembered, there would be some material evidence for it—but there is no evidence, so therefore it is highly unlikely that this is how money originated (Menger 2009, 17). Gary North contends that the same is true of Menger’s own theory. Menger understands money as evolving in a process of selection from the most marketable goods to a few and finally one good that comes to be used as the most common medium of exchange. This process takes place over time as first a limited number recognizes the value of acquiring more marketable goods in exchange for less marketable and the other members of society subsequently learn from the success of these entrepreneurs. (Menger 2009, 35–37) But there is no evidence for this, or, rather, Menger provides no evidence. Writes North:
[W]e expect some historical documentation. There is none. This creates a tactical problem. A defender of the fiat dictate theory of money’s origin can invoke the same argument against Menger as he had invoked against the critic’s ideological peers. Each side declares that the origin of money was rooted in a particular institutional arrangement. What seems reasonable to one commentator does not seem reasonable to the other. (North 2012b, 170)
Menger is caught in a dilemma. He has rejected the conventional or state theory of money because of the lack of historical evidence to support it, but Menger himself provides a history of the origin of money unsupported by factual evidence. Mises’s explanation of the value of money based on the objective exchange value the monetary commodity had based on its non-monetary use before being adopted as money (Mises 1981, 130–31) runs into the same problem: there is no historical evidence for this process (North 2012b, 171). As another critic of Mises’s regression theorem wrote: “there is no unbroken sequence of uninterrupted economic causation from that far away hypothetical day to the present, in the course of which that original quantity of value has exerted its influence.” (Anderson 1917, 102) The history simply cannot be proven.Absence of evidence does not necessarily count as evidence against a given theory. There might be good reasons why we should expect no evidence and nevertheless hold to the theory. On the other hand, Menger was right to cite the absence of evidence against the state theory of money, since it is the type of historical conjecture that needs historical evidence to appear plausible. Our point in this paper is precisely that the Menger-Mises theory of money does not require historical evidence to be accepted as valid. I thank Dr. David Gordon for this point.
The origin of money, then, cannot be explained with the same apodictic certainty that Mises saw in the basic laws of economics. “[W]ith respect to the transition from value-in-use to value-in-exchange, the most we can say is that this transition was probable.” (North 2012b, 171). There is, in the very nature of the case, no evidence for the transition, since societies practicing barter were too primitive to leave any detailed inscriptions or records behind. The records we have from ancient civilizations are precisely from societies that already had highly developed monetary arrangements (North 2012b, 172). This is why we have to resort to conjectural history in order to understand how these arrangements came about.
Menger and Mises therefore resorted to what we may call a sort of conjectural history or developmentalism, following Nisbet (1969). Since there are no facts to investigate, they simply offered “a theory of how it could have happened, and more than this, how it must have happened, given the goal of individuals to improve their circumstances. Yet they stopped short of identifying their account as inherent in human action in the way that higher prices reduce the quantity demanded” (North 2012b, 174–75). This theory is reasonable and difficult to reject for an Austrian school economist, although other people, economists and non-economists alike, with a more positive view of the creative possibilities of state action, might find the story of the origin of money as a matter of royal proclamation more plausible (North 2012b, 173–74).
We must therefore conclude that the origin of money and the regression theorem as explained by Menger and Mises seem more consistent with human behavior than the state theory of money (North 2012b, 175). But this is a matter of conjecture, of developmentalism, not something we can deduce from the timeless axioms of human action.
- THE ORIGIN OF MONEY AND ITS STATUS IN THE THOUGHT OF MENGER AND MISES So much for the proposition that the origin of money is a matter of historical conjecture. But would Mises and Menger themselves recognize this interpretation of their thought? Or would they lay claim to a much stronger position?
Menger
In the case of Menger, there are some statements that would suggest that he was not opposed to the idea that the state could play a role in monetary affairs, including in introducing the common medium of exchange in the first place. In Origins, for instance, he writes that the state may not have introduced money, but that it certainly plays a role in standardizing it and perfecting goods in their monetary function (Menger 2009, 51–52). Similarly, in his Principles (Menger 2007, 262), Menger writes that “although the state is not responsible for the existence of the money-character of the good, it is responsible for a significant improvement of its money-character.”
The strongest statement Menger makes that seems to agree with North’s interpretation of the theory of the origin of money appears in his Investigations. Here he gives a précis of his theory of the origins of money, but he admits that not only can government authority serve to perfect and help smooth out the workings of the monetary system, it can even introduce the use of money through legislation (Menger 1985, 153). This is only true of modern conditions, when, e.g., a colony is formed from elements of an old culture. The primary, original way money emerged is still the same, but part of Menger’s argument for this is the absence of any evidence of state involvement in the process. Menger thus seems to agree with North that the origins of money are indeed a matter of conjectural history.
Yet this agreement is only apparent. Throughout his writings, Menger insists that he is using the same method in dealing with all the problems of economic science: “The methods for the exact understanding of the origin of the ‘organically’ created social structures and those for the solution of the main problems of exact economics are by nature identical” (Menger 1985, 159). He insists on understanding economics, including the origins of money, in terms of individuals and their actions led by their own interest:
As each economizing individual becomes increasingly more aware of his economic interest, he is led by this interest, without any agreement, without legislative compulsion, and even without regard to the public interest, to give his commodities in exchange for other, more saleable, commodities, even if he does not need them for any immediate consumption purpose (Menger 2007, 260).
All that is needed for the emergence of media of exchange is the existence of a different degree of marketability of the different goods brought to market: “The theory of money necessarily presupposes a theory of the saleableness of goods”‘Saleableness’ and ‘marketability’ are both English translations of the same German word, Absatzfähigkeit. Throughout, when not quoting, we have chosen to use the terms ‘marketable’ and ‘marketability’ exclusively. (Menger 2009, 21; cf. 2007, chap. 7). And while Menger may concede a role to the state in the modern management of money and in the introduction of money to new territories today, he is quite insistent on the organic origin and development of money as a market phenomenon: “Money has not been generated by law. In its origin it is a social, and not a state institution. Sanction by the authority of the state is a notion alien to it.” (Menger 2009, 51; cf. 2007, 261). This is not to say that Menger does not engage in historical conjectures. His account of how the precious metals came to be used as money is a hypothesis, not an historical account. But it builds on and presupposes his theory of the marketability of goods, just as he uses this theory to interpret the historical example of Mexican society at the advent of the Spanish conquerors (Menger 2007, 268–70).
Mises
If Menger can at times be interpreted in a way conformable to North’s view on the origin of money, Mises is much more adamant about the logical status of the regression theorem. Indeed, he writes (Mises 1981, 131–32) that it “provides both a refutation of those theories which derive the origin of money from a general agreement to impute fictitious value to things intrinsically valueless and a confirmation of Menger’s hypothesis concerning the origin of the use of money.” Mises also insists on the general a priori nature of monetary theory when he writes (Mises 1998, 38, 40): “In the concept of money all the theorems of monetary theory are already implied” and: “Unaided by praxeological knowledge we would never learn anything about media of exchange. […] Experience concerning money requires familiarity with the praxeological category medium of exchange.” Since he explicitly refers to his explanation as the regression theorem,Mises’s first use of the term, so far as we can see, is in Human Action, p. 406. But the argument is clearly present in Theory of Money and Credit, and Hülsmann (2007, 236) writes that the regression theorem “would become one of the pillars of his monetary thought.” it should be clear that he considered it part of the general body of economic theory, deducible from the basic axiom of human action.
To Mises, then, the origin of money follows once the conditions for it are given. In addition to an economic order based on division of labor and private property in the means of production (Mises 1981, 41), these conditions include a difference in the marketability of goods (Mises 1998, 398, 403). But once these are given, individuals will begin the process that will eventually result in the adoption of the most marketable good as money (North 2012a, chap. 1). That it must take place as a market process follows from Mises’s regression theorem: the value of a good as a medium of exchange presupposes an already existing objective exchange value which can only come from demand for it based on its use value (Mises 2016, 60).
And so it appears that neither Menger nor Mises really saw themselves as doing conjectural history. To them, the origin of money and the regression theorem are just as theoretical as the rest of economics. This is not to suggest that Menger and Mises necessarily agreed on all matters of epistemology and method, except for the fact that they were both rationalists in the broad sense of the term and wanted to explain economics on causal-realist lines. But Menger was an Aristotelian while Mises at least sounded like a Kantian.However, it has been argued persuasively that Mises was much more Aristotelian than he might at first appear. See on this point Hülsmann (2003, l–liv). However, both were agreed that economics, including monetary theory, is a science best investigated by means of deductive reasoning, and that it rested on universally valid first principles or axioms, as Mises would say, and that the conclusions deduced from these were just as valid as the axioms themselves.
Nevertheless, it is still quite possible that they were mistaken. We therefore need to move on to an examination of the theory itself.
- RESPONSE TO THE CHALLENGE: THE LOGIC OF THE TEMPORAL REGRESSION “Can a governmental authority, even if it were the most violent and the most persistent, attribute an exchange value to an object, which has no exchange value at all for the human beings that take part in the commercial life?
[…]
The government authority could declare just as well that a mountain is twice as high as it is in reality or that two pounds are actually six pounds.”(Knies 1885, 1:189; quoted and translated in Gabriel 2012, 44–45).
Gary North is not the only economist who has thought it necessary to relegate the regression theorem to the status of historical conjecture. Professor Selgin (White et al. 2014) is of the opinion that “[t]he regression theorem itself constitutes […] but one particular solution [to the question of the origin and value of money]—a solution that might now be labeled ‘backward-looking’ expectations-formation.” Even Professor Hülsmann (White et al. 2014), citing Dr. North’s essay, thinks that “[f]rom an epistemological point of view, the regression theorem does not seem to be an element of Misesian praxeology. It does not concern an a priori causal relation.” For while the subjective value of money depends on the expected future purchasing power of money (PPM), these expectations are not necessarily based on the prior PPM, or the earlier objective exchange value in Mises’s terms. We should therefore rather speak of a progression theorem, since it is the expected future prices that determine present valuations of money (Hülsmann 1996, 169, note 21). Laurence Moss (1976, 21) has even stated that Mises was quite mistaken when he thought the only way the demand for money can be consistently incorporated into the general body of utility theory was by way of introducing historical prices.However, Moss concedes (p. 28) that Mises’s use of historical prices to explain expectations-formation about future prices is “of great doctrinal importance.”
The notion that the regression theorem is not part of the corpus of theoretical economics or praxeology is thus one that seems to be gaining ground among monetary theorists. In what follows, we intend to reassert what we think is Mises’s own conception of the regression theorem as an integral and necessary part of monetary theory. Even Menger’s theory of marketability can, we contend, be shown to have universal validity, and the difference in degree of marketability to be a necessary precondition for the emergence of any media of exchange.
Before we proceed, however, we must make explicit the definitions of the concepts we are discussing. Money is simply the most commonly accepted medium of exchange. It does not matter that ‘most commonly accepted’ is an imprecise definition, since everything that is true in regards to money is true of all media of exchange (Mises 1998, 395). But it does mean that a precise definition of medium of exchange is required. Mises (ibid.) writes that
Interpersonal exchange is called indirect exchange if, between the commodities and services the reciprocal exchange of which is the ultimate end of exchanging, one or several media of exchange are interposed.
While Rothbard (2009, 189) says that
The tremendous difficulties of direct exchange can be overcome only by indirect exchange, where an individual buys a commodity in exchange, not as a consumers’ good for the direct satisfaction of his wants or for the production of a consumers’ good, but simply to exchange again for another commodity that he does desire for consumption or for production.
From these statements about the purpose of media of exchange, the following definition emerges: a medium of exchange is a good desired not for consumption or production purposes, but in order to exchange it against other economic goods.
As with ‘medium of exchange,’ marketability is a concept restricted to goods in a market economy. It has no applicability to a household economy or a socialist commonwealth. Marketability means the facility with which a good can be sold at prices that conform to the general economic situation (Menger 2007, 248), that is, without too much of a discount below expected market prices. Marketability, then, is a question of degree, of more and less marketable goods. That commodities must differ in their degree of marketability and that this fact is of importance for the emergence of media of exchange we will explain below.
The Regression Theorem
Praxeology is a science that deals with change through time. Change and temporal sequence are inseparably linked, and since action aims at change, it is in the temporal order (Mises 1998, 99). Yet most of economic theory can be elaborated without regard to time. The price of a capital good, for instance, is determined by the discounted marginal value product. While this determination looks to the future, the theoretical determination is essentially timeless, as is shown by the fact that it is elaborated under conditions where the element of uncertainty and change is assumed away (Rothbard 2009, chap. 7; cf. Mises 1998, 245–51 on the evenly rotating economy).
The regression theorem, however, and the explanation of the origin of money need to incorporate the temporal dimension. It describes a series of events that must follow one upon the other in order to establish how money came to exist and why it has the value that it has in the present moment:
The central difficulty was the interdependence between the subjective value of money (SVM) and the PPM. Money was valuable because it had purchasing power, but the purchasing power resulted from the SVM. This seemed to be an instance of circular reasoning, not of causal analysis. But Mises could solve this problem by developing an explanation which he found in Wieser: SVM and PPM did not determine one another simultaneously—which would have precluded causal analysis—but diachronically. Today’s SVM determined today’s PPM, which in turn determines tomorrow’s SVM, which determines tomorrow’s PPM, etc. (Hülsmann 2012a, 10)
Or, as Mises put it: if the history of prices of any consumer or producer good were to be wiped out, the price system would soon reestablish itself, since these prices only depend on the judgment of actors as to the good’s ability to alleviate present and future needs. But were all knowledge about the value of money to disappear, it would be impossible to reestablish the system, precisely because the use of a good as a medium of exchange is dependent on knowledge of its past purchasing power. Men would have to start over with the process of selection of the more marketable goods as media of exchange (Mises 1998, 408).
It is this temporal nature of the theory that may suggest a historical conjecture instead of logical analysis. Benjamin Anderson, whom we have already had occasion to cite, objected to Mises’s theory precisely because he wanted a logical analysis of the value of money. He thought the temporal regress, although interesting, hypothetical and abstract and not really compatible with a logical analysis of the present forces determining the value of money (Anderson 1917, 103–4). The question therefore is: can a logical argument, contra Anderson’s implication, integrate the temporal element into our understanding of the value of money?
Indeed, the laws of logic are more than capable of doing the job. We may take Aristotle for our guide in this question (Posterior Analytics 95a10–96a19, 1984, 1:157–59. The example of the house is on p. 158). In the form of a syllogism, we start with the (later) effect and want to deduce the (earlier) cause. We do this, as with all syllogisms, by connecting them by means of a middle term that persists through time from cause to effect. Aristotle gives the following example: Consider a house. We can know from the existence of the house that there must have been stones. This is so because in order to have a house, there must have been a foundation on which to build it; and before there was a foundation, there must have been stones out of which to make the foundation. From the fact of the house now we can reason to the existence of the stones earlier.
Two features of Aristotle’s argument are perhaps of special interest to our present considerations. The first is that such reasoning must proceed from effect to cause. This is so since there will be an interval of time between the existence of the cause and of the effect, and during the interval it will obviously be incorrect to say that the cause has caused the effect. The second is that the connection between cause and effect, the middle term, must be coeval with both—but cause and effect need not be coeval with each other. Now, in Aristotle’s own example, stones and house do in fact need to exist simultaneously once the house is constructed, but we can easily think of other examples where this is not the case. The clearest example is perhaps that of a child and his father: from the existence of a child now, we can infer that his father once existed, even if he does not now exist. To return to the sphere of economics, when we see a price offered for a good, we can infer that the good is subjectively valued by someone, and that this subjective value is precisely the cause that moves him to offer something in exchange for it—abstracting from speculative demand for the moment.
How does this apply to the regression theorem? It highlights, first of all, that Mises was correct in asserting that he delivered the proof for Menger’s hypothesis as to the origin of money. Beginning at one end of the chain of causation with the existence of money of a given value, Mises traced the cause of this value back through time, through the subjective estimations of future exchange value based on the objective exchange value of the moment just past, to the point when the objective exchange value was based only on the good’s use-value (Mises 1998, 406). Precisely because it is an argument proceeding from effect to cause is this certain. This is not to say that Menger’s argument did not proceed in basically the same manner. But he began in medias res, so to speak, with the cognition by the economic subjects in a barter economy of the higher marketability of some commodities, and therefore laid himself open to the criticism that his reasoning from there to the existence of money is a mere conjecture.To be clear, we think the logical structure of Menger’s argument is the same as Mises’s: he began from the fact that some goods were chosen as media of exchange and sought for the explanation in the array of market exchanges based on the difference in marketability.
The other point worth emphasizing is that cause and effect need not exist at the same time. It is enough that there is an intermediate cause, or series of causes, leading from the existence of money today back to its origin in the first demand for a good with an objective exchange value for use as a medium of exchange. The use-value that is the terminus of this series of causes need not be present throughout. Again, Mises was the first to clear up this point in the earlier theories.An economist named Oppenheim argued already in 1855 that money could continue to function as such once its original use-value has disappeared (Menger 2007, 319). So Mises may have had a forerunner in taking the theory of the value of money to its logical conclusion. Anderson (1917, 102) was quite right in doubting that an “emotion” felt 10,000 years ago could have any direct connection to the value of money today. No one claimed that it should. All the regression theorem claims is that at one point there was a good with objective exchange value based on such an “emotion” which was then gradually adopted as money. This is necessary since we need prices of goods—objective exchange value—in order to have a marginal utility of money (Rothbard 2009, 277, note 22). If we keep in mind the importance of the marketability of goods, we can see that this objective exchange value must have been a more or less constant phenomenon through space and time in order to ensure the adoption of a good as money. But as a matter of logic, as soon as a good is valued as money, its value can persist even should its use value disappear entirely. Rothbard (2009, 275) makes this point clear:
Once a medium of exchange has been established as a money, money prices continue to be set. If on day X gold loses its direct uses, there will still be previously existing money prices that had been established on day X – 1, and these prices form the basis for the marginal utility of gold on day X. Similarly, the money prices thereby determined on day X form the basis for the marginal utility of money on day X + 1. From X on, gold could be demanded for its exchange value alone, and not at all for its direct use. Therefore, while it is absolutely necessary that a money originate as a commodity with direct uses, it is not absolutely necessary that the direct uses continue after the money has been established.
The value of money, in short, has two components: its use value and its exchange value, and these are analytically distinct. Strictly speaking, only the second source of value is necessary for a money to function as such, and it is precisely its exchange value which has a temporal component (Rothbard 1988, 180–81). It relies on knowledge of past objective exchange value in order for the economic actor to form his present judgment about the subjective value to him of units of the monetary good. And this objective exchange value must at some point have originated in valuations based only on use value. But once the good is established as money, it can persist solely on the basis of its exchange value.
An argument made by Professor Kirzner in an unpublished paper can help us clarify what we are claiming for the nature of money. Kirzner correctly points out that the way out of the circularity in the explanation of the value of money is to take account of expectations in its determination. Mises’s regression theory, according to Kirzner, is just one way to do this (Kirzner n.d., 6). However, he goes on to say (ibid., 7) that
It should be observed, in any event, that insofar as potential buyers of any commodity base their price bids for it on anticipated—if speculative—possibilities of resale, these bids involve price expectations in exactly the same way as do those for money.”
With this we cannot agree. This is to collapse specifically monetary demand into a general speculative demand and to erase the distinction between monetary goods and goods simply held in anticipation of selling them in the future at a profit. Speculative demand means demand based on the expectation of future profit. Speculative demand like all entrepreneurial action is about dealing with uncertainty. As such, all action is speculative, since there is always an element of uncertainty attached to it (Mises 1998, 254; Huerta de Soto 2010, 15ff). But speculation is especially about bearing uncertainty and, in the market economy, about maximizing profits.
Monetary demand is specifically demand for a medium of exchange based on the expectation of being able to exchange it for units of the goods the actor really wants. It is about minimizing uncertainty in the actor’s future market exchanges by increasing the marketability of the goods he brings to market (Hoppe 2012). While there may at times be a particular speculative component in this demand—if, for instance, the actor adds to his cash holdings in anticipation of an expected increase in the PPM—the demand for money is sui generis and determined by the anticipated use value of the goods that can be exchanged against each unit of money and the subjective value of owning a marketable good. The yield from money held in cash balances is derived from the services it renders, i.e., from the expected future exchanges the actor expects to carry out with it (Hutt 1956, 198. Hutt recognized that part of the value of money might be speculative, but the main determinants of the value of money are still the expected future exchanges, as the speculative element is derived from this expectation). Mises at one point expresses this by saying that, in the case of money, subjective use value and subjective exchange value coincide (Mises 1981, 118). Or, rather, in order to make clear the distinction between the value of holding money and of its services, the use value of money is derived from its subjective exchange value.Salerno (2015, 74) and Edwards (1985, 53) make clear that Mises made this distinction, even if he did express himself imprecisely at times. In this case, this is due to the influence of Wieser on Mises’s thought, cf. (Hülsmann 2007, 238–39). The value of the marginal unit of money depends on what the actor expects to be able to exchange it for, and the size of the individual’s cash holding therefore depends on knowledge of the objective exchange value of money in the way Mises explained. Acquiring and holding money, then, is not in itself a speculation in future uncertainties, but an attempt to reduce the costs inherent in future exchanges by increasing the chances of quickly and easily completing one’s market transactions.
This should, we think, also answer Hülsmann’s objection. While we agree entirely that it is expected future prices that determine the present demand for money, such expectations must have a starting point. If this starting point is not based on prior exchange value, whatever array of prices the actor assumes is completely arbitrary. But the demand for money is precisely not arbitrary, so the value of money must be traced back in time to the point when acting man first demanded a given good for its services as a medium of exchange based on his appraisal of the good’s already existing objective exchange value as determined by demand based on its use value and on his judgment as to its expected higher marketability.
The Theory of Marketability
The concept of marketability might appear to depend on empirical assumptions as to the qualities of the goods exchanged in the market. Our contention is that no such assumptions are needed—goods exchanged in the market must by necessity differ in their marketability. Hoppe (2006, 182–83) suggests as much, although he does not expand on this point. For there to be any market and division of labor, there must be a plurality of goods serving different ends. Demand for these goods cannot be equal—if they were equally in demand, this could only be because they were considered equal in their services, in other words, equally good at helping man achieve his ends. But this would, as Hoppe claims, mean that they were simply units of the same type of good. The basic cause of difference in marketability, then, is unequal demand.
A few general remarks can be made about differences in marketability. Those goods demanded by more people will be more marketable than those goods that have a narrower market, i.e., goods with a ‘deeper’ market are more marketable.
Other causes also influence the degree of marketability – durability, for instance. Menger’s (2009, 29–32) detailed exposition of what influences marketability introduces various empirical assumptions, but it is still a matter of theory, not conjecture.
A Note on the Challenge of Bitcoin
Has the emergence of bitcoin and other crypto-currencies as media of exchange disproven the Mises-Menger account of the emergence of money? After all, bitcoin were intended to serve as money by its creator(s), and since it has market value now, this would seem to suggest that its value need not be based on a prior commodity value. Economists who have analyzed the issue do not think that the regression theorem has been invalidated by bitcoin. Davidson and Block (2015) argue that bitcoin is not a challenge at all, since the regression theorem only applies when money emerges out of barter; Barta and Murphy (2014) argue that since bitcoin is a medium of exchange now, it clearly cannot contradict the regression theorem; Konrad Graf (Graf 2013, 3–4) writes that “[n]o contradiction between Bitcoin and the economic-theory insights associated with the regression theorem is possible”; and, finally, Peter Surda (2012, 38–43) argues persuasively that bitcoin conforms to the regression theorem.
The reason for debate on this subject is, we think, that bitcoin and other crypto-currencies were designed to be media of exchange. It could thus seem that private individuals had simply willed a new medium into existence. But the intentions of the suppliers are completely irrelevant—the nature of a good depends on the nature of the demand for it, not what the producers had in mind when they produced the good. What is often called the first transaction where bitcoin was used as a medium of exchange shows this clearly. On May 22 2010, one person “laszlo” bought 2 pizzas paying with 10,000 bitcoins. On the surface, this may look as the first use of bitcoin as a medium of exchange. In reality, what happened was that one person, “jercos”, in search of bitcoins, bought 2 pizzas using his credit card to trade for 10,000 bitcoins because he knew someone were willing to make this trade. If any good in this exchange was used a medium of exchange, it was the pizzas, not the bitcoins. It may be very hard to find out why exactly people valued bitcoin before it was used as a medium of exchange, but it is hopefully clear that some such value is necessary in order to be able to use bitcoin and all other crypto-currencies as media of exchange. What is different in the case of bitcoin from the original emergence of money out of barter is that only one price needs to be established before bitcoin can be used as a medium of exchange—namely, their price in terms of already established money.
- IS THERE A PLACE FOR CONJECTURAL HISTORY? The regression theorem is then not a matter of conjectural history. But this does not mean that we cannot make historical conjectures about how events unfolded and institutions were established. In the field of money, however, such conjectures cannot contradict the basic theory.
The account of the emergence of money that Menger gives us can be said to be conjectural history. Based on economic theory, he suggests how and why the precious metals specifically were selected as money due to their greater marketability. There was a constant, widespread demand for these goods for use and at the same time a widespread supply of them, making it easy to bring them to market. From these broadly historical facts or assumptions, Menger describes how the monetary metals were gradually chosen as the most commonly used media of exchange in a process parallel to and dependent on the accumulation of capital goods and the intensification of the division of labor. As such, it is a highly plausible story, and one which seems to receive some confirmation from Menger’s Mexican exampleMore recent scholarship is also highly suggestive of the origin of money as a market phenomenon, completely independent of state sponsorship or interventions. See (Le Rider 2001, chap. 1).—but other conjectures are possible. It is not possible, however, to make a historical conjecture at odds with the core of the Menger-Mises theory—that the medium of exchange must have had a preexisting exchange value not based on its monetary use, and that the selection of the medium was due to its greater marketability.
Can we, then, make conjectures that concede a larger role to the political power in the origin of money? Only if the actions taken by that power in pursuit of its goal of introducing indirect exchange or influencing the choice of the money commodity conform to the laws of economics (Mises 1981, 83–94). Three broad approaches may be used by the state in its attempt to influence the choice of media of exchange:These remarks concern exclusively the influence of government on the emergence of money out of a barter economy. Mises himself discussed issues dealing with bimetallism and other monetary policies current at the time in the reference just given, while George Selgin (1994, 821–24) has applied Mises’s insights to the introduction throughout history of new fiat money. I thank Dr. Patrick Newman for this reference.
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It can try to increase the objective exchange value and increase the marketability of some goods by always being ready to buy them in the market and sell them again against the commodities the market actors wants to sell. This procedure is obviously limited by the economic resources of the state, but could possibly decide the issue between two goods of roughly the same quality competing for the role of most common medium of exchange. So the state may decide the choice between the gold standard and the silver standard, as, for instance, the US government did by demonetizing silver in the Crime of ‘73.
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It can try to confer use value on some goods and make them more suitable as media of exchange by making them legal tender for the settlement of debts. Yet forcing people in a barter economy to substitute the sovereign’s favored commodity for the one the parties to the exchange has agreed on simply disarranges all credit transactions. Credit is already very heterogeneous and probably very rare in a barter setting, and it is not conducive to the formation of money and credit markets to prevent them from operating to the profit of the market participants. Any government intervention substituting a means of payment for the one voluntarily contracted will serve to expropriate one party to the exchange to the benefit of the other. Instead of facilitating markets, this will make them cease functioning altogether.
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It can try to confer use value on some goods and make them more suitable as media of exchange by making all taxes payable in these goods.Kuznetsov’s (1997) idea about administrative goods is an example of this It could in this way make otherwise valueless things quite valuable. But another step is needed before they can become money—they must be recognized as the most marketable goods in the free estimation of the market.
These brief and by no means exhaustive remarks should be enough to make the point clear: if government intervention in the origin of money is to have any effect, it is only so long as the government conforms to the law of the market and recognizes that the choice of the monetary good is a matter of the relative marketability of the different goods. Any conjectural history of the origin of money that neglects this point is consequently inadmissible.
- CONCLUSION We have here tried to answer those economists who have begun to doubt the logic of Mises’s regression theorem. Specifically, we have dealt with the challenge raised by Dr. North to the regression theorem and Menger’s account of the origin of money. We have tried to show that these parts of monetary theory are truly praxeological laws, deduced from the basic principles of the science under the specific conditions needed for monetary exchange. Every time we come across a society using money, the value of the monetary good will have arisen in conformity to Mises’s theorem.
This is not to say that there is no room for conjectural history in describing the origin of money. We have suggested that Menger’s account of the establishment of gold and silver as money is in fact a historical conjecture—but it is based on economic theory, the theory of the marketability of goods, and only accounts so based will have any right to scientific standing.
Dr. North ends his essay with writing that he finds himself “knee-deep in developmentalism. This is not where I planned to be when I first read The Theory of Money and Credit in 1963.” Hopefully, the present essay will be a help to him and other monetary theorists who find themselves trapped in the slough of developmentalism.
In this re-broadcast of a recent Lara-Murphy Show episode, Bob Murphy and co-host Carlos Lara discuss the yield curve from an Austrian perspective. Carlos explains why a business owner who practices the Infinite Banking Concept (IBC) would want to retain ownership of the life insurance policy in his or her own name (rather than the company owning it). Their discussion is part of a series, which is tied to the upcoming seminar in Nashville, Tennessee, on May 10, 2019.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Mateusz Machaj (mateusz.machaj@uwr.edu.pl) is research fellow at the Faculty of Social and Economic Studies, Jan Evangelista Purkyne University in Usti nad Labem; and assistant professor at the Institute of Economic Sciences, the University of Wroclaw.
Quarterly Journal of Austrian Economics 21, no. 3 (Fall 2018) full issue, click here.
My comments on Karl-Friedrich Israel’s criticism (2018, p. 393) of my piece (Machaj, 2018) are not really a typical reply as I fully accept his criticism of my explanation from his thoughtful and in-depth review of the book. While being grateful for his discussion, I would like to develop the point of reproduction further, as quarrels about price-cost relations may be ambiguous.
Israel points out that “price-elasticity of demand” is essential in understanding how prices (and costs) are formed. That is certainly true, but what remains to be explained is: which price elasticity. The main point of my short discussion was to demonstrate that the price for blue shirts does not only depend on marginal utility of blue shirts (demand for them). Moreover, the prices for blue shirts may go up, because costs went up, even if absolutely nothing changed in the demand for blue shirts. The answer how this happens lies in the Böhm-Bawerkian explanation of cost formation and causal-realistic considerations of how costs go up in the first place.
Assume that blue shirt purchasers are the most eager and determined in obtaining cotton related products. Imagine a catastrophe happened to cotton industry and world production has been cut in half. The potential production of cotton related products is lower, for all cotton related products. Marginal utility of the last cotton related product goes up, because of decreased supply. Henceforth the value of that last produced cotton product is imputed back to the price of cotton as a factor of production. That implies that costs of cotton are higher as entrepreneurs are bidding more for a shrunk supply. Those increased costs of production would lead to higher prices of our considered blue shirts, provided they would still be in high demand as initially.
Consequently, even if nothing changed in the demand for blue shirts, their prices are directly related the cost of production. One may ask the question—if they were so high in (inelastic) demand, why did the price did not go higher in the first place? Because of forces of competition. The key in understanding how price formation works is the force of rivalry. Yes, producers focus on demand elasticity, but they are interested in individual demand and price elasticity for their own product. And that one is elastic even if total demand curve is inelastic, because as they raised the price for blue shirts, they would lose customers in favor of other producers, who would take advantage of lower costs and offer product with a lower price margin. Henceforth forces of competition are keeping the final price of a product in close relation to its costs. Let me emphasize that this does not mean that costs are the ultimate cause here, since they themselves are reducible to marginal utilities of all cotton products.
Böhm-Bawerk expressed that thought quite well in a similar copper example:
Again, we must not endeavor to find in the law of cost either more or less than the Austrian economists have found in it, namely, a universal law of leveling. And this is an influence which operate not merely upon certain final elements, but also at every stage of the productive process. There is a leveling or equating not merely of the final elements, labor and the disutility of labor, but also of productive goods and of utility with utility. This last takes place independent of, and ofttimes in direct opposition to the influence of the final elements. Why, in our example of the copper kettle, does the price rise from fourteen to eighteen dollars? Simply because through the common cost it can and must be leveled to the price of the other commodities produced from copper, i.e., in this case to the price of the strongly demanded copper wire. But why have prices in the entire copper business advanced? Because, and in so far as, through the increased demand for copper, the marginal utility of this material has been raised (Böhm-Bawerk, 1962, pp. 367–368).
A summary of the example could therefore be: the price for blue shirt is determined by the cost of cotton, but costs of cotton are in the final instance determined by utilities of cotton related products, represented in their final prices. In other words, when entrepreneurs are considering costs in their decisions, they are considering others’ expectations of competing marginal utilities sort of disguised as costs of production. Monetary costs of factors are a price we pay for withdrawing other projects from materializing (they simply are a form of opportunity cost).
Additionally, considering the forces of competition I would be careful with the neoclassical notion of equalizing marginal costs and marginal revenues. Such an approach does not have a typical place in the usual Austrian reasoning. It has to be very stretched and highly adjusted to make sense in real world examples. This is primarily because definition of “marginal cost” is actually quite subjective and depends on the chosen (longer or shorter) run (Rothbard, 2009, p. 695). It also wrongly suggests that fixed costs play no role in price formation and production decisions. For the real world companies they do.In general, the equation MR=MC is not really mistaken, since it may be tautological and true under the chosen assumptions. The problem lies a step back, in the assumption that costs can be easily divided into fixed and variable, and that the division can easily separate the apparently relevant from the apparently irrelevant. Only sunk costs, capitalized losses, do not play such role, but not all fixed costs are sunk.On the very significant difference between sunk and fixed costs see an underrated paper: Wang and Yang 2001. Consider the case of purchased real estate. It is a fixed cost, but usually a substantial part of it can be recovered very easily by selling it to someone else. That is why while making production and pricing decisions companies consider fixed costs in their calculations all the time (not just marginal costs). Since virtually all of the ones staying afloat do so, fixed costs are part of strategic decisions. If the consumers are backing out from purchasing a product, losses are revealed and the signal is sent that the particular real estate has an alternate employment which should be considered. Such is the process which through Internet revolutionized typical in-house stores. Many of them became closed, because a different selling channel had been created, so to stay profitable the cost of real estate would have to fall. But the cost cannot go much further down, because there are other potential renters having other marginal utilities in mind, which will justify profitable renting of the real estate. In other words, there are other marginal utilities which justify paying a higher cost. If an in-house store cannot secure a sufficient money stream for that rental price, then it means that goods sold in that place do not have sufficiently high marginal utility to the consumers. That is how all costs (not just marginal) are actually influencing and shaping entrepreneurial decisions all the time. This is a notion that comes from the Austrian version of marginalism—much stronger than a neoclassical one.
Henceforth, while I accept Israel’s blue dye point, I would state it without referencing neoclassical MC=MR rule, and with a Boehm-Bawerkian style of reasoning.Also criticized in the same book from another perspective by Newman (2018, pp. 64–67). See also Herbener (2018, pp. 161–165). Blue shirts and other shirts usually in the market will have similar prices even if they have radically different marginal utilities. They could have different prices, for example, if the price of a particular dye (blue) went up. Under those circumstances the price of a blue shirt would go up, but that increased cost would reflect higher marginal utility of alternate blue dye employment, whereas marginal utility of cotton in both blue and other shirts would be along similar lines.
Appendix On the Coinage Juan de Mariana
Translated by Hazzard Bagg
Hazzard Bagg (hbagg@lincolnschool.org) is an instructor of Latin and Greek at Lincoln School in Providence, Rhode Island. This translation constitutes pp. 268–278 of the Mainz edition of 1605 of De rege et regis institutione. Quarterly Journal of Austrian Economics 21, no. 2 (Summer 2018) full issue, click here. In order to fill a gap in the budget, which is never not a problem, especially in a sprawling empire, certain smart and clever men propose that it would be helpful in many difficult situations if something were to be pulled out of the weight of the coinage or from its quality, by debasing the metal while still retaining its original value. The prince gets to keep whatever is deducted from the quality or the weight of the currency. And what is more amazing, in the absence of harm or complaint on the part of the provincials. This wonderful technique is not a secret, but rather a useful method by which an incredible amount of gold and silver is redirected into the public treasury without the imposition of any new burden.
I have always typically thought of those men who promise to transform metals by some magical method—to make silver out of bronze and gold out of silver—as being the most untrustworthy sort, like itinerant snake oil salesmen. Now I see that metals are rendered more valuable without any effort; that they are doubled in value without any smelting, controlled merely by the edict of the prince, as if multiplied by some sacred touch or higher power; that the subjects are getting back from the economy what they had before at full value; that there is public utility in the fact that what is left over is handed over to the prince for his use. Who is so unreasonable, or, if you prefer, so insightful, that he would begrudge this happy state of affairs—especially when no innovations are being introduced?
Rather, we tread upon a road trampled by the feet of many, standing upon which great princes from every era have gotten through difficult times. Who will be able to deny that the Romans, under the pressure of the Punic War, reduced their copper coins, which were previously generous, first to two ounces of bronze, then to one ounce, and again to half an ounce... and that the government was freed from debt by this technique? That Drusus, as Tribune of the People, mixed bronze into the denarii that appeared to be made of pure silver? Plautus’s comparison of a new bawdy form of comedy to the new coinage is as wise as it is old.The reference is to Plautus’s Casina, lines 9–10: Nam nunc novae quae prodeunt cōmoediae multō sunt nequiōrēs quam nummī novī... “For the new comedies that are coming out now are much more worthless than the new coins....” Need I bring up the Jewish people, that superstitious race, who shun everyone else?Editor’s note: Mariana is not a blind supporter of the Inquisition and he defends conversos. This comment likely contains some degree of sarcasm, precisely because Mariana is using the Jews as an example of a people who are no longer fooled by monetary manipulation, unlike so many of the Christian population of Castile, who continue to be fooled by the alchemists at Court. I note that among them the temple shekel is worth twice as much as the common shekel for no other reason than that after a while it became clear to the people that half the value had been subtracted from the correct and original weight of the coinage, either all at once in a single stroke or gradually by means of all too frequent acts of deceit (which I suspect is the more likely explanation). There is no need to go on about other countries since it is common knowledge to anyone explaining the past that money has often been made worse by great kings through frequent devaluation.
Or do you suppose that it is for some other reason that solidi, which were first made of gold and then of silver, ultimately ended up as bronze for the most part, unless this was due to an assumed right to contaminate metals by adding some extraneous alloy? What should I say about our own maravedí, once gold, not so long ago silver, and now completely copper? Indeed, who is so confident that he dare criticize a practice employed by all nations at every point in time? Do we seek a higher form of praise in finding fault with institutions? Are we grasping at the empty favor of the masses?Note how Mariana says that a sound coinage is important to commoners. He is alluding to the argument that supporting such a policy is populist demagoguery. Indeed, I shall not deny (for how could I?) that the coinage has often been debased by our forebears and that the type of crisis can sometimes happen in which it is necessary to have recourse to this remedy. I will be the first to say that not everything that our forebears did was without fault.Note how Mariana says that a sound coinage is important to commoners. He is alluding to the argument that supporting such a policy is populist demagoguery. I would also maintain that deceit lies hidden behind the appearance of exceptional and accessible usefulness, that pure fakery exists, that considerable difficulties have arisen from this practice, both for governments and for individuals, and that one must not stoop to this point if we want a healthy situation.
First off, I assert that neither the portable possessions nor the land of subjects is under the legal control of the prince to the degree that he can take these things for himself at his own discretion or hand them over to someone else on a whim. Those who argue otherwise are blowhards and yes-men of the sort that are numerous in the halls of the powerful. Because of this, it is the case that he cannot order new taxes upon his nation without the consent of the people. For he should get his subjects to pay by asking openly, not by cheating them,Mariana distinguishes between lawful and unlawful taxation, contrasting a formal request for funds with the act of swindling. nor should he capriciously take a cut on a daily basis whereby they are reduced from a state of abundance and prosperity to a state of need. For that would be to behave like a tyrant who measures everything by his own desires, who takes possession of everything for himself, not a king who restrains the power that he has received from willing people with law and reason, and who does not extend his power all over the place. But I do not want to pursue any further a matter that is clearly understood and that has been discussed at greater length elsewhere.An explicit reference to the earlier, and quite controversial, commentary on tyrants and regicide found in Chapters V, VI, VII, and VIII of Book I of De rege et regis institutione. I shall only add that of the two it is the case that a king cannot debase the coinage arbitrarily and without the consent of the people. It, too, is a kind of tax by which an amount is extracted from the possessions of subjects. Who would agree to exchange gold for an equal weight of silver, or silver for an equal weight of iron? Generally speaking, why would anyone agree to accept a silver coin for a gold one or a copper coin for a silver one? This happens every time the money is debased. Indeed, it will only be permitted for the king to change the appearance of the coinage, since coinage is listed among the things that are held by royal right under imperial law, provided that the value remains inviolate in accordance with the quality of the money and pre-existing law.
The value of coinage is twofold. First, there is its natural value based upon the quality and quantity of the metal used, which can be called its “intrinsic” value. The second value is its legal and “extrinsic” one, which the prince sets by law, as he does the prices of other goods so that they are not sold for more than what the law without question has ordained. He is a fool who so separates these two values such that the subsequent legal value does not stick to its natural value. Unfair is he who commands that something that is commonly valued at five be generally sold for ten. No one should try to make this happen through effort or strictness.Elsewhere in this same chapter (most notably in the discussion of Henry VIII in the penultimate paragraph), Mariana rails against imposing a debased coinage by force. For people are influenced by a common valuation, which is based upon the quality of things and supply and demand; a prince would struggle in vain to tear up these foundations of commerce (which stand better unmoved), to deviate from the common opinion, and to bring a kind of force against their minds. What happens in the case of other commodities should also be extended to money. When assessing value by law, a prince ought to consider the actual price and weight of the metal and should not try to go beyond the small amount that can be added to the value of the metal to cover the cost of minting. For we are also not of the opinion which has hold of great scholars and famous legal experts that a prince must mint the coinage at his own expense, and that he consequently should not add anything to the true value of the metal.
As a general rule, however, if we do not want to fall into error and overturn the laws of nature, the legal value should not be discordant with the natural and intrinsic value. What a sleazy deal it would be if a prince were to keep the extra for himself—and all the more disgusting if anything is subtracted from the quality of the metal or the weight of the money! Or should he be allowed to break into the granaries of his citizens, take a portion for himself, and compensate citizens for their loss by granting the option to sell what is left for the value of the whole pile before his portion had been taken away? Who would not proclaim open robbery, the worst sort of embezzlement? The same scenario could be played out in the case of businesses, farming operations, and any moveable property, but you get the point.
In ancient times they used to exchange things without using money: a goat for a sheep, a cow for some grain. Then they figured out that it would be easier if merchandise and grain were exchanged for metals: gold, silver, and copper. Ultimately, so that it would not forever be necessary to weigh metals out for their dealings and transactions with one another (which is quite a pain), they decided that the various metals should be divided into units by public authority and that these units should be stamped according to the weight of each. This is the proper and natural way to use money that Aristotle tells us about in the first book of the Politics;Mariana draws on Aristotle’s famous discussion of money in Politics (1.9.1257a). those other ways of turning a trick to cheat the people were developed and discovered by men who could not care less about transparency and fairness. But even if the prince is not taxing the other commodities and is not laying claim to them, he often takes a cut of the currency; this does not mean that there is any less blame in doing this, nor is it any less of a subversion of, and stain upon, the laws of nature. But these mysterious, dolled-up schemes deceive most people with the result that the disease is felt less acutely.
“What harm is there,” they say, “if the prince takes a half or a quarter for himself, and if what is left over for individuals is spent at a value that is no less than the original one? Indeed, you buy clothing and food just like before. Where is the loss? For their money is used only to buy necessities.” So easily are the people tricked that they put up with the debasing of the coinage! Thus, the prince has more power over the coinage than he does over other commodities. The mints, mint officials, their operations, and the bureaucrats are completely in his power and control. Because of this, he is able to blend metals without anyone stopping him, he can introduce a new coinage in place of the old one stamped with a new mark, with no more honesty than if he were directing the other possessions of his citizens to himself with blatant force.
You might ask, what should be done when a confident enemy challenges in war? Add to that one who is aggressive because of a fresh victory and strong in troops and supplies, and when there is no money available with which a soldier might be recruited or a salary paid. Or will you suppose that he ought to surrender and that every type of misfortune should be endured so that the coinage can remain intact? I would think that every possible remedy should be tried before it should come to the extreme measure of debasing the currency. But if a major crisis is pressing and the safety of the people is in jeopardy and the affected citizens cannot be forced to enter into an agreement whereby the prince can commandeer the other possessions of his subjects to come to the aid of the country in its moment of need, only then will he be able to blend metals or snip off a portion of the weight, but with the proviso that the permission to debase should come to an end along with the war and that the blemish not be permanent, and then that the bad money that necessity forced upon them be straightaway turned in and retired, and that the proper old coinage be restored in place of that bad one for those who were holding it in good faith.
Frederick Augustus, the second of that name, was laying siege to Faenza in Flaminia during a very harsh winter. There was no money for soldiers’ pay, everywhere soldiers were slipping away, and units were being abandoned continuously. Lifting the siege was a disgraceful and serious thing, but continuing it was a difficult one. He marked money made of rawhide with the value of a gold coin, and with this conceit he got out of the tight spot. Once he had taken the city as victor, he exchanged the rawhide coins for as many gold ones as he had promised. The source is Collenutius in Book Four of his History of Naples. This example has been followed in similar crises certainly long ago but also in recent times, and coinage quite often made of hide but sometimes even out of paper has been marked without harm or rebuke. However, if a prince thinks that it is within his purview to debase the currency outside of one of these crises just to fill a deficit in his treasury, something that is more or less always a problem, I proclaim certain destruction—nor will the respite be long-lasting—as the following terrible afflictions demonstrate.
The first consequence will be the high cost of all commodities and food—doubtless not less than the amount that will have been subtracted from the quality of the currency. For people do not value a currency any more than the quality and amount of metal allows—not even if there are strict laws against doing this. Indeed, at that point the people will bemoan the fact that they have been tricked by an illusion, and they will sense that the new currency that has been substituted for the old one is not worth as much as the former currency when they need much greater resources than they used to in order to feed their families. Or are we serving up delusions rather than things that are plain to see from the accuracy of our chronicles? King Alfonso of Castile, known as “The Wise,” as soon as he gained control of the crown and possessions of the realm, substituted a bad currency, called the burgalesa, for the pepión, which was the coinage in use at the time. In order to relieve the high cost of things that immediately followed, he set the value of merchandise with a new law. This solution made matters worse since no one was willing to sell at the set price. And so, this scheme to set prices fell apart right from the start. The problem of high prices went on for a while. I conclude that damage to the coinage was the primary reason for the disaffection of the people and for his replacement by Sancho and his son before the end of his life. For since Alfonso was stubborn, in the seventh year of his reign he recalled the burgalesa and introduced a coinage that was called “black” because of the poor quality of the metal.The relative blackness of a coin indicates its poor quality by revealing its copper content. The more copper a coin contains, the blacker it will become via oxidation.
Alfonso XI, in no way chastened by the example of his great grandfather, also minted a coinage made from metal that was not of high quality that they called novenes and coronados. So that the prices of food and other items not increase, he took the sensible enough precaution that a mark—that is to say two-thirds of a pound—of silver not be worth more maravedís than it was worth previously (that is, 125). This ineffectual measure, however, turned out to be a useless precaution: inflation followed, the value of silver skyrocketed. Enrique the second, the son of this Alfonso, upon gaining the throne after the murder of his brother, King Pedro, had recourse to this solution in order to pay the salaries of his foreign provincial soldiers (to whom he owed his life and his throne) because his accounts were in a lot of trouble, since both the public and his personal treasuries had been exhausted. He struck two types of coinage, reales and cruzados, doubtless valued above the amount of metal in them. We have examined the reales of King Pedro and those of his brother Enrique; indeed, Pedro’s are of good silver of the kind that is struck in our own day in Castile; Enrique’s are blackish, evidently with a lot of copper added in. In order to alleviate the rise in the prices of things that followed (together with the dismay of people in the provinces), after a fresh appraisal, he was compelled to subtract two thirds from the value of both types of coinage. Thus, things that have been dreamed up so ingeniously to save us do frequently fall the other way. Oh, the short-sighted and blind minds of men!
That much the same thing befell Enrique’s son, King Juan, is evident from his laws. For, being out of money because of the wars that he waged, first against the Portuguese and then incessantly against the English, he struck a coinage that he called the blanca in order to send the money that he owed to the Duke of Lancaster, his rival for the throne, in accordance with the treaty that he had recently entered into with him. Presently the prices of food went up. To alleviate this problem, he soon reduced the value of the new currency by about a half. But the high prices did not let up, as he himself admitted at the Cortes at Burgos the following year in 1388. Why should I bring up the kings who followed? I find that the same collapse has developed from the same corrupt origin.
So much for high prices... Another problem flows from the first: Commercial activity that for the most part makes up both public and private wealth is slowed down by a debased coinage. The low quality of the currency clearly frightens shopkeepers and their customers; the high prices that follow on from this problem also frighten them. But if the prince were to set prices for things by fiat (as always seems to happen), instead of a cure, the problem will get much worse since there is no one who will agree to sell for that price, which is so clearly unfair and not squared with commonly recognized valuation. Once commercial activity has stopped, there is no category of problem which does not befall such a people.Mariana’s genius is his ability to synthesize and extend the ideas of his precursors. Notice how neatly he signals the greater, more global, threat to commerce that is posed by monetary manipulation. See his assertion above: “No one should try to make this happen through effort or strictness.” Certainly, the provincials will be of necessity stretched thin in two ways: first, due to the slowdown in buying and selling, the income from which the majority of the population lives will grind to a halt. These people are craftsmen for the most part and people whose hopes for a meal lie in their hands and in working every day—which is most people.Mariana emphasizes that inflation affects the poor more than it does the rich! Earlier in this same essay Mariana speculated that he could be accused of pandering to the people for criticizing debasing the coinage. Here he proudly embraces the accusation. Second, the prince will be forced either to completely withdraw the bad currency which is the cause of the problem or to issue a currency that is worse with its previous value reduced. So it happened that in the reign of King Enrique the second of Castile, in spite of this, he subtracted two thirds from the value of his new currency. Whoever found themselves holding that money suddenly discovered that, by the power of a word, what had been three hundred gold pieces had been reduced to no more than one hundred.
We seem to be kidding. Let us set aside the past. From the moment that he left the Church, Henry, the eighth king of England by that name, ran into many problems. Among these problems he debased the currency. For that which had an eleventh part of copper mixed in was gradually reduced to the point that it retained only a sixth part of silver. With a fresh decree he swept up the old money from the provincials and exchanged it for an equal number and weight of the new, debased currency. The people remained silent as long as they feared the savagery of that man, who thought of bleeding his citizens as a game. But after his death, his son Edward brought it about that the value of this coinage was decreased by half. Edward’s sister, Elizabeth, also subtracted another half from the remaining value once she gained the throne. So it was the case that those people who used to have four hundred gold pieces in that currency had it reduced to one hundred once three quarters of the value had been subtracted. And the damage did not stop there; that currency was thereupon taken out of circulation with no way to restore the loss, a scandalous mugging. Sanders, a scholar and at one time in the past a friend of mine, confirms this toward the end of Book One of his On the English Schism.
With commercial activity suspended and, as a consequence, with the provincials stretched thin, the pitiable disaster of royal taxes will come to the fore. The prince will be punished in proportion to how much he has enjoyed the profit from that currency. For it cannot be a good situation for a king to have a kingdom which is practically struggling physically; nor will the provincials be in a position to be stretched thin by paying taxes. Also, tax collectors will not bring in as much in royal taxes as they had before. I read that when King Alfonso XI of Castile was a child, royal officials were forced to submit to an audit; I have gleaned that all the royal taxes for the year came to 1,600,000 maravedíes. Those maravedíes were worth more than ours and each one was worth about as much as seventeen of ours, still an undeniably tiny and laughable amount. The writer of the history of that king describes how one of the two causes of this disastrous situation was the debasing of the coinage carried out by quite a few of the previous kings. Evidently, with commercial activity brought to a standstill, the subjects were reduced to a state of penury and were unable to bring into the treasury what they had typically brought in during normal times.
Who would not see that this is a tremendous handicap? Who would not admit this? Would you then prefer that there be a universal hatred on the part of the people that will inevitably overwhelm the prince? Is it not preferable to be loved than to be feared? In general, all public failures are blamed on the person in charge. Philip the Fair, King of France, confessed right before his death that he faced the hatred of the people for no reason other than that the coinage had been debased, and with his last words he commanded his son Louis “Hutin” to change it. The source is Robert Gaguin. I do not read anywhere about what Louis did, but it seems to be the case that the demonstrations and hatred on the part of the people did not settle down before Enguerrand de Marigny, the author of the foul scheme, was publicly executed, as the majority of the nobles urged during the proceedings and the entire population applauded. There is no need to mention the fact that the precedent set by this disaster did not discourage Hutin’s brother, Charles the Fair, nor their mutual cousin and successor, Philip of Valois, from treading on this same path of debasing the currency in France; nor need I mention the magnitude of the public reaction.Note how close these examples come to endorsing tyrannicide in response to currency debasement. Instead, let a limit be placed upon the discussion that has been begun here. I would like to give princes one last piece of advice: if you want your state to be a healthy one, do not touch the primary foundations of commerce—units of weight, measurement, and the coinage. A many-layered swindle lies hidden behind the appearance of a quick fix.
ABSTRACT: Given the importance of the School of Salamanca, economists of the Austrian School occupy a privileged position with regard to the study of literature. Specifically, they are well suited to understand a foundational text in the modern history of the novel form. Don Quijote de la Mancha (1605/1615) by Miguel de Cervantes (1547–1616) is steeped in the thinking of the School of Salamanca, especially that of the great late scholastic Juan de Mariana (1536–1624). Just as there are reasons to teach early modern economic thought in literature departments; there are reasons to teach Don Quijote in economics departments. This essay is an introduction to the philosophical, political, and economic commonalities between Cervantes and Mariana in the hopes that more classical liberals will attend to the first modern novel as a reflection of the general contours of our perspective.
KEYWORDS: Miguel de Cervantes, coinage, Don Quijote, inflation, Juan Mariana, monetary policy, scholasticism, School of Salamanca, Spain JEL CLASSIFICATION: B11, B31, N1, N43 Eric Clifford Graf (ericgraf@ufm.edu) is a professor of literature at Universidad Francisco Marroquín in Guatemala. Quarterly Journal of Austrian Economics 21, no. 2 (Summer 2018) full issue, click here. INTRODUCTION Economists from the Austrian School have long argued that the free-market mindset, which reached its peak during the classical liberal period of the eighteenth and nineteenth centuries, traces its origins back to the early modern period, especially the ideas of the late-scholastic thinkers of sixteenth and seventeenth-century Spain known as the School of Salamanca. Men like Domingo de Soto (1494–1560), Martín de Azpilcueta (1491–1586), Diego de Covarrubias (1512–1577), Luis Saravia de la Calle (1500s), Tomás de Mercado (1525–1575), Luis de Molina (1535–1600), Felipe de la Cruz Vasconcillos (1500s), and Juan de Mariana (1536–1624), were keen to define, analyze, debate, and explain topics that have always interested Austrian economists: interest rates, the prices of goods and services, the causes and effects of inflation, the advisability of different monetary policies, and the relation between supply and demand.
In the context of the importance of the School of Salamanca, economists of the Austrian School also occupy a privileged position with regard to the study of literature. Specifically, they are well suited to understand and explain a key text at the beginning of the modern history of the novel form. Don Quijote de la Mancha (1605/1615) by Miguel de Cervantes (1547–1616) is a text steeped in the thinking of the School of Salamanca. Given Thomas Piketty’s recent abuse of novels by Jane Austin, Honoré Balzac, and F. Scott Fitzgerald, Austrians ought to consider using Cervantes’s novel as a kind of riposte to the French neo-Marxist. Just as there are excellent reasons to teach early modern economic thought in literature departments; there are excellent reasons to teach Don Quijote in economics departments.
In the context of the relation between the School of Salamanca and Don Quijote, the great Jesuit thinker Juan de Mariana (1536–1624) was the most important influence. Three books by Mariana are fundamental for understanding Cervantes: 1) Historia general de España (Latin 1592, Spanish 1601), the first modern history of Spain, unsurpassed until the nineteenth century; 2) De rege et regis institutione (1598/1605), a princely advice manual written for Philip III (r. 1598–1621); and 3) De monetae mutatione (1609), the greatest and earliest response to statist inflationary monetary policy.
Now, among Cervantes specialists, consensus defines the novelist as a humanist reformer interested in the private, bourgeois form of Christianity advocated by Erasmus of Rotterdam. Cervantes himself signals this ideological orientation in Don Quijote 2.62 when his protagonist enters a printer’s shop in Barcelona and alludes to La luz del alma cristiana (1554) by the Erasmian friar Felipe de Meneses. Religious reformers like Meneses became targets of the Counterreformation, so it comes as no surprise that in the same chapter, and for the umpteenth time, Cervantes criticizes the Inquisition. The narrator reports that religious authorities order the destruction of the “enchanted head,” a device owned by Antonio Moreno, a character whose liberal values anticipate those of Voltaire, Jefferson, and Twain (all passionate readers of Don Quijote by the way). The classic works of literary criticism that established this interpretation of Cervantes are Américo Castro’s El pensamiento de Cervantes (1925), Marcel Bataillon’s Érasme et l’Espagne, recherches sur l’histoire spirituelle du XVI (1937), and Alban Forcione’s Cervantes and the Humanist Vision (1983).
Given the dominance of the Erasmian interpretation of Cervantes, especially at universities outside of Spain, we still need to demonstrate the extent to which he was influenced by the late scholastics of his own country. And given his status as the leading Salamancan at the beginning of the seventeenth century, Mariana offers the most efficient means of articulating this response. I will go further: among all the intellectuals of the early modern period, Mariana, not Erasmus, is the most useful for unraveling the major metaphorical and sociopolitical aspects of Don Quijote.
Here, then, as much for specialists in economics as for specialists in literature, I offer nine ways to understand the intellectual parallels between Mariana and Cervantes.
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AGAINST THE INQUISITION The reform-minded humanists of the Low Countries were not the only ones to rail against the Tribunal of the Holy Office. Both the first modern Spanish historian and the inventor of the modern novel rejected the institution’s politics of racial purity and its persecution of individuals like the theological poet Fray Luis de León or the reformist Archbishop Bartolomé de Carranza. In De rege, Mariana defended Jewish converts: “All those families that today shine forth with pure lineage had obscure and humble origins; if the door had been closed to plebes and converts, today we would have no nobility” (3.4). For his part, throughout his literary career, Cervantes mocked the Spanish obsession with blood purity. He does so in episodes in Don Quijote which highlight miscegenation in romantic couples like Aldonza Lorenzo and Don Quijote (1.25–26) and Zoraida and Ruy Pérez de Viedma (1.37). Similarly, he underscores the multiracial status of the Manchegan knight’s supposed lovers, such as Dulcinea (2.10) and Altisidora (2.57). This criticism also appears in so-called exemplary novels like La novela y coloquio de los perros (both c.1605) and in comical interludes like Retablo de las maravillas (p. 1615), where Cervantes questions the racial purity of a pair of talking dogs and just about any Spaniard attending the theater. And Don Quijote’s theory of lineage (2.6) echoes that of Mariana.
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AGAINST CENSORSHIP Complementing their criticisms of the Inquisition, Mariana and Cervantes were opposed to censorship. Mariana shocked many when he approved of Benito Arias Montano’s edition of the polyglot Biblia Regia (1572). In numerous episodes of Don Quijote, Cervantes links the destruction of books to the persecution of individual human beings: the burning of the mad knight’s books (1.6–7), the defense of similar books by the innkeeper Palomeque (1.32), the criticism of the Inquisition in the printer’s shop of Barcelona (2.62), Altisidora’s vision of devils torturing books in Hell (2.70), and Sancho Panza’s return home with his ass dressed in buckram as a victim of the Inquisition (2.73). Given the other connections between Mariana and Cervantes, the presence of “the Queen Doña Maguntia” in Don Quijote 2.38 likely alludes to the German city where he published the second edition of De rege. The Maguntia edition of De rege of 1605 contained a single new radical chapter on money, which would later serve as the basis for the even more polemical De monetae of 1609, which, for its part, had to be published in Cologne and caused Habsburg authorities to arrest him and put him on trial for lèse-majesté.
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RIGHT TO SELF-DEFENSE Natural law was the essential grounds for late-scholastic thinking. Thus, in De rege Mariana not only defended the right of freemen to bear arms, he argued that they must be allowed “to strengthen their bodies through military exercises” (1.5). Cervantes has Sancho embrace natural law when he rejects the laws of chivalry advocated by his master: “when it comes to defending my person, I’ll not care much about your laws, for others both divine and human allow each of us to defend himself against whomever would seek to do us harm” (1.8). In the second part of Don Quijote, a certain continuity among the characters Antonio Moreno, Claudia Jerónima, and Roque Guinart even hints at the Catalan nobility’s resistance to Habsburg efforts to outlaw a specific type of early modern shotgun (2.60–65). And there is deep irony in the fact that the peasant Sancho wins his physical confrontation with Don Quijote (2.60), because it was his own master who taught him the self-respect required to rebel against the submission demanded of him by medieval norms. Cervantes’s novel indicates that natural law, according to which no freeman deserves to be forced against his will, had subversive implications for the era’s politics, sexual relations, and institutions like feudalism and slavery.
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LIMITS ON THE POWER OF KINGS Both Mariana and Cervantes wanted checks on monarchical power. This should come as no surprise: the scholastics emphasized the popular origins of sovereignty and many of their preferred medieval sources, such as Aquinas, approved of tyrannicide. As usual, Mariana was more radical than his peers regarding this issue, not only insisting on the right to kill tyrants but broadening his definition of a tyrant to include the prince who inflates the money supply. In De rege he went so far as to argue in favor of killing kings so that these would recognize the limits of their power and the punishment that awaited them if they turned to tyranny: “It is, however, salutary for princes to be persuaded that if they oppress the realm, if they make themselves intolerable due to their vices and their crimes, then they can have their lives taken from them, not only by right but also thus earning the applause and fame of future generations” (1.6).
For his part, Cervantes establishes a similar tone in Don Quijote by quoting the refrain “beneath my cloak, I kill the king” in the first prologue and referring to “some crime of lèse-majesté” in the second. He also alludes to Calvinism in the pirates of La Rochelle (1.41), suggesting some degree of sympathy for the Monarchomachs, who embraced a Protestant version of the radical Jesuit perspective of men like Mariana.
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ARISTOTLE AND PLATO Another way to understand the mentality shared by Mariana and Cervantes is via their preference for Aristotle over Plato. This early modern polemic is often overstated, but it remains true that, when thinking about governments, the humanists followed Plato in their emphasis on cosmic idealism, abstract speculation, and a curriculum of study designed to improve the character of princes; whereas the scholastics followed Aristotle in their emphasis on realism, historical perspective, economic issues, multiple political systems, and the need for formal limits on the power of kings. For this reason, historians like Joseph Schumpeter, Murray Rothbard, and Quentin Skinner have located the origins of modern political theory in thinkers like Francisco de Vitoria (c.1483-1546), De Soto, Molina, Francisco Suárez (1548-1617), and Mariana. In Don Quijote, Cervantes articulates this same contrast through a series of allusions to Plato’s allegory of the cave, which he renders absurd by way of the Latin scholastic motto in the knight’s letter to Governor Sancho Panza: “Amicus Plato, sed magis amica veritas” (2.51), which means “Plato is a friend, but truth is a better friend.”
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NOSTALGIA FOR MEDIEVAL FUEROS AND CORTES In Don Quijote we also encounter anxiety about the lack of constitutionalism in early modern Spain. Before Governor Sancho Panza departs for the Isle of Barataria, Don Quijote gives him extensive political advice. In the end, the knight expresses horror at his squire’s inability to read or write. There is also a play on words between two senses of the term “documents” (2.42–43), which means “instructions” but also “written texts.” Sancho underscores the political importance of the second definition: “it will be necessary that they be given to me in written form.” Later, we have the chaos contained in “The Constitutions of the Great Governor Sancho Panza” (2.51), which present serious moral challenges to any reader with training in constitutional law.
It is Mariana who helps us to understand the specificity of these anticipations of modern constitutionalism in Don Quijote as well as just what all this has to do with Zaragoza, the city most mentioned in the novel. In De rege Mariana articulates tragic nostalgia for the controls on monarchical authority that were once sustained by the charters (fueros) and parliaments (Cortes) of the medieval period. He points to the investiture traditions and the local laws of the Kingdom of Aragón as model institutions and laments the brutal repression of the nobility there by Philip II in 1591. One of the great ironies of the narrative trajectory of Don Quijote is that the hidalgo would have had actual political representation in the Aragonese parliament, whereas he was excluded from the Castilian body, which never granted seats to the low nobility and which had already succumbed to the growing absolutist power of the Habsburgs.
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HISTORY VERSUS LEGEND In addition to his princely advice manual and his treatises on monetary policy, Mariana’s influence on Don Quijote can be seen in the protagonist’s tendency to conflate historical events and chivalric fantasies. The harsh realism of Historia de España appears to have caused national psychological trauma. In Mariana’s vision of Spanish History, traditional heroes like Alfonso X ‘the Wise’ and Enrique II ‘the Honorable’ and villains like Pedro I ‘the Cruel’ changed places as per the metallic content of their respective coins. The Jesuit historian discovered that Alfonso X misrepresented the value of his coins and that the coins of Pedro I were superior to those of his rival Enrique II. Don Quijote’s insanity has much to do with the ideological disorientation provoked by the long history of monetary manipulation, a theme which Mariana deployed as a desideratum of political loyalty to the kings of Spain.
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CYNICISM The baroque, disillusioned, and anti-imperialist politics shared by Mariana and Cervantes permit us to understand an overlapping metaphor found in their respective magna opera. Both writers took great interest in the classical example of Diogenes of Sinope, one of the founders of Cynic philosophy. Diogenes famously preferred the company of dogs to men and once mocked Alexander the Great by asking him to stand aside and quit blocking the philosopher’s view of the sun. In the prologue to De monetae mutatione, Mariana portrays himself as Diogenes and thus unafraid to speak out against the monetary manipulations of King Philip III and the Duke of Lerma. Similarly, in La novela y coloquio de los perros, written around 1605, coetaneous to Don Quijote, Cervantes signals that the quixotic insanity of ensign Campuzano is intimately related to the philosophy of Diogenes and then proceeds to criticize Habsburg monetary policy. Mariana could have read a manuscript version of Cervantes’s exemplary novel about talking dogs before writing the prologue to his monetary treatise addressing the same themes; or, vice versa, some parts of La novela y coloquio de los perros could have been written closer to 1609, i.e., under the influence of a version of Mariana’s controversial tract.
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ECONOMIC AND MONETARY POLICIES Mariana and Cervantes grasped the fundamental importance of economic freedom, both as a general moral imperative and a means of enriching the citizens of Spain. Cervantes places free-market and free-labor negotiations at the heart of key episodes. The brutality of slavery in Don Quijote’s encounter with Andrés and Haldudo and his attack on the merchants of Toledo in Don Quijote 1.4 comes full circle and is substituted by the hidalgo’s miraculous agreement to compensate Sancho for his services in 2.71 and 2.74. Then there is the fact that without intense bartering by the narrator for the missing manuscript in the marketplace of Toledo in Don Quijote 1.9, the novel as we know it would not exist.
Mariana and Cervantes considered monetary manipulation to be tyranny. For Mariana this awareness grew to fruition over the course of nearly twenty years of investigation. In his Historia de España of 1592, he examined the coins of medieval kings. In the chapter he added to the 1605 edition of De rege, he announced that Habsburg monetary manipulation was the principal basis for his political disillusionment. Finally, in 1609 he disseminated the same criticism in overwhelming fashion in De monetae. In Don Quijote, Cervantes alludes to the policy of adulterating the coins of Castile on multiple occasions. In the 1605 edition: the description of Rocinante’s hooves (1.1), the themes of robbery and adultery in the Sierra Morena episodes (1.23, 1.33, etc.), and Sancho’s slaver fantasy (1.29). In the 1615 edition: Don Quijote’s adventure with the lions (2.17), Queen Maguntia (2.38), and the first three cases adjudicated by Governor Sancho on the Isle of Barataria (2.45).
In this last context, i.e., that of the early modern relation between the novel and Habsburg monetary policy, Mariana’s chapter “De moneta” in the De rege edition of 1605 deserves far more attention than it has received. It is my thesis that some version of this essay is the most likely source for Cervantes’s attention to monetary manipulation and Habsburg tyranny in La novela y coloquio de los perros and Don Quijote, which were respectively written and published in the same year. In the appendix that follows, translated and published for the first time in English, is Mariana’s first monetary treatise, which stands as one more piece of evidence that these two intellectual giants, the inventor of the modern novel and the climactic figure of the School of Salamanca, read each other very carefully.Additional explanations for the synchronicities between Cervantes and Mariana would include the general rediscovery of Plato and Aristotle during the sixteenth century, the likelihood that Cervantes also received a Jesuit education, and the fact that both men experienced intense degrees of disillusionment with the policies of Philip II and Philip III.
ABSTRACT: This is a brief biographical sketch of the heroic late-scholastic thinker Juan de Mariana, with particular attention to his epic confrontation with Philip III and the Duke of Lerma, including a review of the list of charges against him. Around 1600, Mariana produced a series of powerful criticisms of statist monetary policy. From a broad perspective, the Jesuit’s attitude anticipates classical liberal and libertarian opposition to the shenanigans of central bankers (cf. Jefferson, Rothbard, Huerta de Soto, etc.). Furthermore, we continue to learn that Mariana’s analysis of monetary manipulation was disseminated more widely than we once thought, both within Spain and across Europe. This, in turn, supports the general thesis that the School of Salamanca had greater impact than previously believed. Deprived of their silver content, stamped with artificially inflated face values, and mass-produced by way of a hydraulic invention installed at Segovia in the 1580s, the copper billon coins allowed the Habsburgs to implement a form of taxation without consent, and Mariana dissented loudly. Many millions of citizens, from his generation to our own, have benefited from the courageous efforts of this exemplary man who defended private property and freedom against the tyrants of his day.
KEYWORDS: Juan Mariana, coinage, inflation, monetary policy, scholasticism, School of Salamanca, Spain JEL CLASSIFICATION: B11, B31, E42, N1, N43
Dr. Gabriel Calzada (gc@ufm.edu) is President of the Juan de Mariana Institute and Rector at Francisco Marroquin University in Guatemala. Quarterly Journal of Austrian Economics 21, no. 2 (Summer 2018) full issue, click here. Until September 8, 1609, Juan de Mariana did not appear to have been fully aware of just how risky it can be to participate publicly in an ideological debate, especially when one places the pillar of private property at the center of one’s political and economic theory. On that day a group of armed men headed by one Miguel de Múgica broke into the Jesuit monastery at Toledo and carried out an arrest warrant against him by order of the Bishop of the Canary Islands, Francisco de Sosa (a Franciscan), whom the King had nominated to adjudicate the controversy over the inconvenient philosopher. Three days prior, a group of officials from the Inquisition had appeared at his chamber and taken him off to make a deposition before that body’s examiners (Ballesteros, 1944, p. 222). It was then that Mariana had acknowledged being the author of his latest book, a volume of seven essays, and indicated surprise that his words had caused so much commotion.
The life of this man from Talavera had always been beset by momentous challenges. Some, such as the composition and publication of the first History of Spain, he had brought about quite consciously in order to highlight certain lacunas which he felt the society in which he lived needed to address. Others, however, were imposed upon him as a consequence of complex events which he had never intended to unleash. Seventy-three years before his arrest, towards the end of summer, a few days after his birth in Talavera de la Reina, he had to be transferred by protectors into a new home in another town, a place where the good name of his father, Juan Martínez de Mariana, the local dean of Talavera, could remain free from any dishonor.
The brilliance of Mariana’s intellect, complemented by his natural facility for languages and his portentous memory, meant that Ignacio de Loyola, always on the lookout for talent, would focus his attention on him during his first year of studying theology at Cardinal Cisneros’s Complutense University at Alcalá de Henares. The year was 1553, and he would officially enter the Jesuit Order the following January, along with other future literati like Luis de Molina and Pedro Rivadeneyra (Ballesteros, 1944, p. 18).
After his novitiate, which he fulfilled at the Castle of Simancas, and having completed his studies at Alcalá, his superiors were anxious to take full advantage of his intelligence, especially his capacity for communicating and his command of Greek and Latin, at which he continued to excel with each passing year. And so it was that Mariana was given the mission of teaching theology in the foreign capitals where the Company of Jesus sought to extend its reach. First, he was tapped to go to Rome, where in 1561 he began teaching theology at Loyola’s new Colegio Romano, attended by exceptional students, such as the future Cardinal Robert Bellarmine. Between our Talaveran and the nephew of Pope Marcellus II there arose a friendship that would last their entire lives (Ballesteros, 1944, p. 247). After four years in the Eternal City, Mariana left, first for Loreto, and two years later he packed his bags again for Sicily.
In 1569, with eight years of teaching under his belt, Mariana left Italy to begin a new phase in his life as a teacher and scholar at the Sorbonne in Paris. There he received his doctorate and became a chaired professor of theology. His courses on Thomism soon made him one of the students’ favorite professors and won him international acclaim. His great gifts as an orator and his profound knowledge of the material meant that attending his courses became a matter of punctuality, for to arrive late typically meant not being able to find a seat for the Spaniard’s lectures.Today Mariana’s name can be seen on a wall of the Parisian university, carved there in commemoration of his work.
On August 24, 1572, after more than five hundred nights of relative tranquility in Paris, Mariana likely awoke with alarm at the noise of the bells of the Church of Saint-Germain-l’Auxerrois. It was the beginning of the Saint Bartholomew’s Day massacre, which marked the bloody end to the Peace of Saint-Germain-en-Laye. Mariana was made eyewitness to the deaths of thousands of Huguenots at the hands of their Catholic rivals. The use of religion for political ends and a murderous rampage resulting in the deaths of some 2,000 citizens of the capital, and between 5,000 and 10,000 in the rest of France, must have had a profound effect on the Thomist teacher, and years later they surely influenced his political philosophy, especially his thoughts on the limits of political power and his defense of tyrannicide.
After five years teaching in Paris, Mariana presented his resignation and asked to return to Spain. The Company of Jesus accepted his petition and that same year of 1574, after thirteen years abroad, the Talaveran arrived back in his native land. His voyage took him by way of Flanders, with a stop in Amsterdam. It is possible that his return to Spain was motivated by poor health. It might also be that he had decided to seek a certain tranquility that he could not find amidst the pupils of Paris, in the hopes of recording the thoughts that had occurred to him during so many years of meticulous academic study. Perhaps these two reasons mutually reinforced each other in the decision to come home.
That same year of 1574 he would also arrive for the first time in Toledo, where he would reside for the remainder of his life. Leaving behind the bustle of two great European capitals, Mariana now had within his grasp a long desired period of rest and calm. In his request to return to Spain he had asked to be allowed to dedicate himself to his ecclesiastic vocation and to preach, and once again his wishes had been approved by Jesuit authorities. In this way, Mariana chose of his own free will to abandon the life of a university teacher.
Nevertheless, this tranquility lasted but a short while. Still in 1574, the Inquisition commissioned him, against his wishes, to be the censor of the Polyglot Bible assembled by Benito Arias Montano, who had been charged with heresy for consulting Judaic and Protestant texts for his edition. The choice of Mariana as censor was logical from the point of view of the knowledge necessary to elaborate a well-founded decision. It certainly would have been difficult to find another person with sufficient command of the theology and languages essential to the task at hand. But it also followed a certain strategic and political logic. For the fact that Mariana was a Jesuit must have made the Inquisition believe that he would harshly censor and sanction Montano in his report. In August of 1579 he finished his work, surprising all involved and society in general with an extensive and detailed study that analyzed several errors but ultimately absolved Montano. The final decision regarding the Polyglot Bible, which took Mariana more than five years to reach, not only laid out the doctrine according to which Catholic exegesis can make rightful use of rabbinical texts, but was also the first indication of an independent attitude, which, although it meant a range of inconveniences at the time for those in search of political privilege, it would also be a source of great moral support for subsequent generations and, as we shall see, for many of his contemporaries.
That intellectual independence and that demonstration of multidisciplinary knowledge which Mariana revealed in his role as censor had an unforeseen effect, one which surely did not please him. For from that moment on, and for many years to come, Mariana would be besieged with Inquisitional assignments.
During the years that the astute theologian was finishing his evaluation of the Polyglot Bible, he began to dedicate himself to researching and assembling diverse episodes for his History of Spain. He worked for seven years on this titanic project. The History of Spain was by no means the first work he had undertaken, but it was the first that he had chosen of his own volition. Mariana had decided to fill an enormous vacuum in the culture of his country, and in his chamber in Toledo he worked nonstop to make it happen. Finally, in June of 1586, he finished the initial version of the History of Spain, which for more than two and half centuries would be no less than the definitive History of Spain, with multiple editions in both Latin and Spanish.Historiae de rebus Hispaniae (1592) and its subsequent Spanish version, translated by Mariana himself and entitled A General History of Spain (Historia general de España, 1601), remained without rival in the historiography of Spain until Modesto Lafuente published his own History of Spain in 1850. Over the course of those two and a half centuries numerous editions of the Spanish version were published. Manuel Ayau, the great founder of Guatemala’s Universidad Francisco Marroquín, exhibited with great pride a Spanish edition of 1848 in his personal library.
Owing to a plodding bureaucracy that was already substantial in those days, Historiae de rebus Hispaniae, which is the title Mariana gave to the Latin edition, would not circulate for another seven years, its publication thus coinciding with the centennial of the discovery of America and the Reconquest of Granada, the very episode with which Mariana opted to end his opus.
In 1585, a year prior to finishing the History of Spain, one of his best friends, García de Loaysa, was named the personal tutor of Prince Philip, the son of Philip II. Loaysa relied upon the intellect and the independent judgment of his friend when deciding on the knowledge that he was to impart to the future King of Spain. From then on Mariana served as advisor to Loaysa, and together they maintained a running correspondence regarding the education of the Prince, allowing Mariana to perceive the outlines of a new project, the elaboration of which he undertook of his own initiative. Five years later he had copious notes that would serve him in his work on monarchy. In the summer of 1590 he spent a period in a country house in El Piélago with two friends, sharing with them, chapter by chapter, the entire book with the aim of debating it and polishing it into its final form. The following year the text was essentially finished, but Mariana did not consider it appropriate for publication until after the death of Philip II and the rise to power of the actual Prince to whom he had directed the lessons in which his own political philosophy found formal expression. Standing out among the numerous themes that he analyzed are the genesis of human society, the origin and the essence of political power, the rights of human beings, and the importance of public finance. Among the conclusions that have caused the most sensation, over the course of the more than four centuries that have passed since its writing, are topics such as the anteriority of individual rights to the birth of political power, the subordinated condition of the king, the necessity and advisability of establishing clear limits to the exercise of a constrained power located in the king’s person, the right of individuals to kill a king who has resorted to tyranny, the illegitimacy of establishing a monopoly over military power, the usurping character of laws established without the consent of the people, the importance of maintaining a balanced budget, and the unjustifiable recourse to unlawful practices even for the attainment of the most noble ends.
Coincidental to the analysis he performed in the writing of the chapter on taxation, Mariana began to be intrigued by monetary issues, in particular the relation between money and the important matter of weights and measures. This interest in arduous numismatic and pecuniary topics led him to begin to conduct research toward yet another publication. Around 1590 he commenced a search for texts with which to increase his knowledge on these subjects.
With the change in monarchs upon the death of Philip II in 1598, the Talaveran decided to brush off his book on the education of the prince and attempt its publication. At the same time, he tried to publish De ponderibus et mensuris, the work that had resulted from his investigations of weights and measures, and money in particular. The censor praised De rege et regis institutione, and that same year both De rege and De ponderibus went to press, even though neither would be distributed until 1599. The same year his friend Loaysa died, having been named Archbishop of Toledo just a year earlier and having again taken Mariana as his advisor for his new position. The publication of De ponderibus et mensuris in 1599 represented the first work by Mariana which focused on monetary issues. In all there appeared three monetary texts which would eventually conduct Mariana into the shadows of captivity. Nevertheless, the general and eminently formal approach of the first of these did not yet suggest the problems that the Jesuit scholar would suffer as a result of his later economic theory. In fact, it appears that Mariana himself never even intended to pen anything more on the money issue.
On December 31, 1596, Philip II approved a royal decree by which he attempted to raise funds and escape the consequences of the umpteenth bankruptcy of the public coffers, which had taken place earlier that same year.Prior to the bankruptcy of 1596, Spain had already experienced, during the reign of Philip II, bankruptcies in 1557, 1560, and 1575. For more details on these suspensions of payments by the Royal Treasury, see the essay by Drelichman and Voth (2009). That edict stipulated that the billon coins produced by the new hydraulic machine at Segovia were to contain no silver. The benefit this maneuver had on the Treasury was substantial. On the one hand, the King now issued coins made with the metal that had the least intrinsic value, and, on the other hand, he took advantage of the opportunity to order a recall of all billon coins previously put into circulation in order to extract their silver content and re-stamp them at Segovia with the same face value as before. The measure was not the slightest bit appreciated by the public and resulted in protests. In response to the social unrest, in 1597, the King, perhaps trying to live up to his nickname “Philip the Prudent,” decided to concede and added a grain of silver to each mark of copper in all subsequent issuances.
With the rise to power of Philip III and his advisor, the Duke of Lerma, monetary policy went down a path which we would today term “inflationary.” The five first years of his reign were characterized by a return to the minting of low-grade billon coins or coins with no silver content at all as per the late schemes of his father. In 1602, however, there was a qualitative change in this policy. On July 13, 1602, the Crown decreed the final elimination of silver and simultaneously reduced the coins to half their former size and weight. Given that the new silver-less and lower weighted billon coins maintained their previous face value, in spite of having their weight and size reduced by half, the coins minted previous to the new law suddenly and without warning saw their monetary value double. As one would expect, nobody wanted to turn over their old money in exchange for the new. Thus, on September 18, 1603, it was decreed that all coins minted previous to the new law had to be re-stamped. Accordingly, the coins with a value of two maravedís were now punched with four bars, signifying the duplication of their nominal value, and the same happened with the four maravedís coins, which had “VIII” imprinted over their previous value. In concert with these re-stampings, the treasurers subtly issued new coins officially valued at one, two, four, and eight maravedís, all of them without silver and in accordance with the new weighting system.
This measure allowed the King to collect the old maravedís coins (those with silver as well as those with relatively more copper), re-stamp them, and then pay off his suppliers and creditors using the coins with less metal. The value of the public treasury jumped by 66 percent (Ballesteros, 1944, p. 199). Some studies estimate the King’s windfall via this nifty trick at 875 million maravedís. Given the fact that the act of re-stamping does not generate any real wealth in and of itself, the proceeds that the King obtained had to result, naturally, in an equivalent diminution of the wealth of the citizenry, excepting those individuals and institutions that collaborated with the Crown in putting the new monetary policy into action and who thereby participated in the windfall.This history of monetary maneuvers is well documented at the website www.marevedis.net, especially the section on re-stampings: www.maravedis.net/resellos.html. Not even this last measure could avoid yet another suspension of payments, which took place in 1607.
The vast majority of the population was impoverished and commerce itself was adversely affected by the fiscal chaos, all of which heavily impacted the lower classes and the nation at large. Discontent spread, but the Palace walls seemed deaf to the lamentations of the people. Mariana, who always had a keen sense of morality and justice, immediately set himself to work on an explication of phenomena similar to those playing out in our own day, and he ended up denouncing the political authorities as those ultimately responsible for the situation.
What is certain is that very few people could understand as well as Mariana did the corrosive effects of suddenly changing by decree the weights and measures of money. The investigation that he had carried out while writing De ponderibus et mensuris had helped him to develop an understanding of the importance of always respecting said weights and measures. His historical knowledge offered him multiple examples from the past of the consequences provoked by similar monetary manipulations. What is more, his daily contact with commoners in the streets allowed him to directly assess the theoretical effects of such manipulations. Finally, his theological knowledge and his clear moral vision placed him in a unique position, allowing him to indicate those destructive consequences of the new monetary policy that lay in wait above and beyond its merely material effects.
And so it was that in 1603 Mariana undertook a new philological project on money. This time he focused on the causes and effects of monetary manipulations conducted by the politically powerful. This is the origin of De monetae mutatione as well as his own loss of liberty in 1609. In the words of Manuel Ballesteros Gaibrois, the events of 1602–1603 underscored “the tribune that lay dormant in the man, who converts his chamber into a jumble of written pamphlets and scientific experiments, and gradually conceives of a study—which will be entitled De mutatione monetae” (pp. 199–200).Ballesteros confuses matters slightly when he says that Mariana set about expanding the content of the chapter on money in De rege, for the latter was not published until 1605. It is not clear whether or not Mariana initially imagined this project as an independent treatise on money. If this was the case, he probably thought that the topic was of such importance that he could not wait to see it published along with the rest of the essays that he had already finished or else was in the process of finishing, all of which he had intended to release as a compilation of short meditations on diverse matters. The best indication of this urgency is the fact that the first fruits of this effort came to light well before the actual monetary essay. In effect, in 1605, only two years after the decree that mandated the re-stamping of the billon coins, and with the real consequences already plainly visible, Mariana published an early text, which already contained the heart of the argument that four years later, when published in the amplified form of a treatise, would unleash so much royal fury against his person. The opportunity that presented itself to him in 1605 was perfect. He was preparing the publication of the second edition of De rege and so he decided to insert a chapter on money just after the one dedicated to taxation. What better vehicle than a book dedicated to the education of a prince for an explanation of monetary theory? Here he could counsel against the evils caused by certain policies and try to establish the limits of political power with respect to the same issue.
Mariana began his chapter “De moneta” with an irony denoting his indignation at the policy put into action by Philip III:
Some astute and ingenious men, in order to attend to the needs that continuously overwhelm an empire, above all when it is far-flung, came up with the idea, as a useful way to overcome difficulties, of subtracting from money a certain part of its weight, such that, even if the resultant money were adulterated, it would nevertheless maintain its previous value.
Next, he explained what is concealed by these policies:
As an amount is taken from the money in terms of its weight or quality, a similar amount redounds to the benefit of the prince who mints it, which would be astonishing if it could be done without injury to his subjects.
Finally, he insinuated his own views and took the first steps toward more categorical denunciations, making it patently clear that he is referring to the King’s current policy:
In truth it would be a marvelous art, and not a secret magic but, rather, a public and laudable one, by which means great quantities of gold and silver would be accumulated in the treasury without having need to impose new tributes on the citizens. I always viewed as petulant men those who tried to transform metals, by means of certain occult skills, and make silver out of copper and gold out of silver through some chemical distillation. Now I see that these metals can change their value with no effort and no need of burners, and even multiply it, by means of a princely edict, as if by some sacred contact they were given a superior quality. The subjects will still partake of the common wealth just as much as they possessed before, and the remainder would fall to the benefit of the prince for him to apply toward the public good. Who among us has such a corrupt, or perhaps perspicacious, mindset that he would not approve of this blessing on the state? Above all if he reflects that it is nothing new. (Mariana, 1599c, pp. 339–340)
Mariana continued his exposition by presenting various historical examples of monetary manipulation, but he clarified that the fact that such policies have been carried out in the past does not justify them now. What is more, he concluded: “Under the appearance of great utility and convenience can hide a deception that produces many and worse damages both public and private, and so recourse should not be made to this extreme measure except at the experience of great duress” (p. 341).
After this thunderous introduction, our author established the foundations of his thesis and signaled private property as the principal pillar sustaining his theoretical structure. For Mariana, the point of departure is the fact that “the prince does not have any right over the private property and estates of his subjects that would allow him to take them for himself or transfer them to others,” and he affirmed that those who argue otherwise “are charlatans and flatterers, who much abound in the palaces of princes” (p. 341). Mariana maintained that taxation robs the people of their property and impoverishes them. Just in case it has not been made clear, and taking advantage of the fact that this is the very same book in which he expounds his version of the generally accepted theory of tyrannicide, he explained that to establish new taxes without the formal consent of the people makes the king a tyrant. Then he generated a parallel between inflation and taxes, argued that through the adulteration of money the king keeps for himself a part of the property of his subjects, and concluded that the king cannot devalue money without the consent of the governed.
Next, Mariana addressed the difference between intrinsic value and extrinsic value, arguing that he who would allow this difference between them to exist is a fool. The reason for this, he explained, is as follows: “Men are guided by the common value that is born out of the quality of a thing in conjunction with its abundance or scarcity, and all efforts are in vain when aimed at altering these fundamentals of commerce” (p. 343). To put it another way, men act according to their subjective evaluation of things, which is based on the properties of goods and their relative availability.In his Principles of Economics, Carl Menger, the modern founder of the Austrian School of Economics, lists four conditions that convert something into an economic good: 1) the existence of a necessity; 2) the existence of characteristics in a given thing that can causally relate to the satisfaction of that necessity; 3) awareness regarding these characteristics; and 4) awareness of that causal relation on the part of a person with control over that thing. He added that it is futile for the king to go against natural law and the monarch only has the right to a small commission for the minting of money.
Mariana went even further: he set out a range of natural economic laws and exposed the fraud involved in inflationary policy, which consists of altering the weights and measures of money and which he equates with robbery. Following Aristotle, he explained the origin of money and then turned against the principal argument in favor of inflation, namely, that since money has no other use than to provide necessary goods, what is wrong with the prince extracting his share and mandating that the remainder continue to circulate among his subjects with the same face value that it had previous to its devaluation? The answer is immediate: this policy is like robbery, because it destroys the wealth of the citizenry; and it is difficult to restrict because the king has greater control over the production of money than he has over the production of other goods. Moreover, according to the Jesuit, this policy has three obvious consequences. The first is that it will cause shortages and reduce the purchasing power of the people. He adds that the typical remedy on the part of the governing classes is to establish price controls, but that this solution only escalates the evil that it pretends to fix. Second, the debased money debilitates commerce. Price controls do not solve this problem either, because nobody will want to sell at the fixed prices and this will bring about runs on goods, stagnation, and the collapse of commerce. Third, upon the economic collapse, the taxes that the king continues to collect will provoke resentment.
Mariana concluded this new and valiant chapter by saying that he had performed his discussion of inflation in order “to admonish princes against altering those things which are the very foundations of commerce, that is, weights, measures, and currency, if they desire to have a tranquil and stable state, because under the appearance of momentary utility lies untold fraud and harm” (p. 351).
In sum, the daring Jesuit was telling the King that he should not let himself be carried away by those who were telling him that an inflationary policy was an easy solution to the problems of the public treasury, one which he had a right to employ. He explained that this is essentially a matter of property rights and that, if the King cannot make off with the goods of his vassals, neither can he alter the weights and measures of money. Inflationary policy impoverishes the people and hurts commerce, and the benefits of said policy are only superficial.
Mariana must have been conscious that many would consider his stance radical, and yet he was set on influencing the monetary policy of Philip III. For this reason it does not seem to be a coincidence that the second edition of De rege et regis institutione, in which he presented for the first time his anti-inflationary argument, was published together in a single volume with De ponderibus et mensuris, as if he had wished to add a long appendix expounding in detail on the technical foundations of the evil he was denouncing.
Meanwhile, the fiscal situation of the State continued to deteriorate and the monetary games of the King and the Duke of Lerma, the same games Mariana denounced in the chapter recently added to De rege, were ineffective in avoiding a new suspension of payments by the Treasury on November 7, 1607, only a few months after the conclusion of the re-stamping process begun in 1602. By then the Jesuit was already anticipating the publication of his treatise on the adulteration of money.According to Mariana’s own testimony at his trial, he had finished the text by 1605, making only a few minor adjustments afterward (Ballesteros 225). Towards the end of the previous year he had finished writing the seven essays that would make up his new book, in which De monetae mutatione was the fourth.The authorization by the Provincial Father for the publication of these seven treatises was issued on November 24, 1606. While the sage priest was awaiting the publication of the Latin version of the essay, he set about translating it into Spanish, once again confirming the priority that he always gave to the battle over money, which was now beginning to spill over into the intellectual world. What he surely did not anticipate was that his enemies would retreat from the public dialogue, instead leveraging political power and physical force against him with the goal of silencing his inconvenient ideas.
Around the middle of 1609 the treatise on the manipulation of money was finally published at Cologne as part of Septem tractatus, and on August 28 the King received a letter signed by one Fernando Acevedo, in which he denounced the work. The mixture of emotions that Mariana felt on September 8, when the group of armed men following the orders of Francisco de Sosa seized him and escorted him to Madrid, must have been particularly bitter. After seventy-three years dedicated to studying, teaching, certifying, and disseminating scientific ideas, the monarch responded to his independent quest for the truth in all of this work by taking away his liberty. After giving of himself to society for the better half of a century, the Government chose to persecute him, accusing him of lèse-majesté and confining him to the Basílica de San Francisco el Grande. The anger that his detailed defense of tyrannicide had failed to unleash suddenly came crashing down on him at his explication of the effects of monetary manipulation. His exposition on the causes and consequences of the inflationary phenomenon seemed more menacing to the King than the actual threat of death should he become a tyrant by not respecting the rights of his subjects.
The basic arguments of De monetae mutatione would turn out to be the same ones he had already used in his chapter on money, except that between 1605 and 1606 he had taken time to add to his historical examples, flesh out his juridical arguments, and develop his economic explications of the causes and effects of the evil that was so clearly afflicting the populace. In the prologue, in case it was not clear enough through a simple reading of the text, he underscored that the issue of monetary policy respecting billon coins was among the most important facing Spain at the time and it was what had motivated him to pen the present work. Furthermore, he implored the King to read carefully the arguments that he was going to present before condemning him for his indiscretion or deciding on whether or not he was correct. Our author made use of these initial pages to explain that the current “disorders and abuses” in the production of billon coins were making the entire populace cry out, and given that nobody dared to denounce the situation, he was taking it upon himself to do so. He even added that after so many books in which he had tried to serve His Majesty, he could think of no greater reciprocation on the part of the King and his ministers and advisors than that they should read with attention this treatise in which he had perhaps displayed an excess of missionary zeal in the denunciation of the abuses that had brought about the chaos affecting the entire country.
At the age of seventy-three, Mariana showed himself determined to rail against what he considered an injustice with grave consequences for the entire nation. He was conscious that he was inserting himself into a matter that might cause more than a few sparks to fly. Nevertheless, as he stated in another of the treatises published alongside De monetae mutatione: “the violence committed up to now will have terrorized many; but not me, for whom it only serves as a call to battle. I have proposed to establish peace between the combatants, and I am going to attempt to do so, no matter what dangers I face. It is in the most brutal and scabrous issues that one must exercise the pen.”This valiant affirmation can be found in the essay entitled “Pro editione vulgata,” the second of the treatises in Mariana’s Tractatus VII. Thus he began his treatise on money, exercising the pen in the most brutal business of them all, one that would come to be the work’s central question: Whether or not the king is the owner of the property of his subjects. For the Thomist thinker who taught at the Sorbonne, the answer was already clearly in the negative. For the septuagenarian who had developed a profound skepticism for statist solutions and a strong sympathy for the principles of individual liberty and private property, the answer could not be put more roundly, “No!” In the second edition of De rege he had already stated the case in black and white terms. The policy of continually altering the weights, values, and stamps of money, which today we would call inflationary, is a form of robbery, and he was not about to watch the same abuse take place again without decrying it.
This is how Mariana assumed for himself the voice of the people, putting the right to private property at the axis of his anti-inflationary diatribe. Having defined the core problem, he explained that the king neither has the right to establish taxes without the consent of those who will pay them nor to create monopolies, for “either way the prince appropriates part of the wealth of his vassals” (Mariana, 1861, p. 38). More still: if this is indeed the case, then “the king cannot reduce the value of money by changing its weight or its face value without the consent of the people,” and he concludes:
If the prince is not the master but, rather, the administrator of the private possessions of his subjects, then he is not allowed to take away arbitrarily any part of their possessions for this or any other reason, as occurs whenever money is debased, for then what is declared to be worth more is worth less. And if the prince is not empowered to levy taxes on unwilling subjects and cannot set up monopolies over merchandise, then neither is he empowered to make fresh profit by debasing money, because this tactic aims at the same thing, namely, robbing the people of their wealth, no matter how much it is disguised as granting more legal value to a metal than it naturally has. All of this is smoke and mirrors, and it is all doomed to the same outcome, which will be seen with more clarity in what follows. (p. 40)Regarding public consent and taxation, some might dispute whether or not Mariana was actually being contentious here. Nevertheless, it remains quite clear that the simple calling of a session of the Cortes in order to formally ratify new taxes does not satisfy him at all. In the Tratado y discurso, we can also read the following: “It is well understood that little attention is paid to what ought to happen in Spain, and here I refer to Castile, which is to drag the tax collectors before the Cortes, because the majority of them are not all that bright, since they are chosen by lot, being people who are of small minds when it comes to everything and who go about resolved to fill their pockets at any cost to the miserable public” (p. 36).
Mariana then dedicated the fourth chapter of the essay to explaining the importance of being able to count on a stable currency free from manipulations. His message was clear: political alterations of money bring about price inflation. In the author’s words, the reason for this is that “if money undershoots its legal value, all merchandise irremediably rises in price to the same degree that the value of the money drops, and all accounts are adjusted accordingly” (p. 46). Besides elevating prices, the adulteration of money alters and damages the proper functioning of commerce, because weights and measures are the foundation of all exchange. What is more, monetary interventionism is typically presented as the solution to this and other problems, and yet the sage Talaveran explained that these are “like giving drink to a sick man at the wrong time, which at first refreshes him, but in the end only makes his condition worse and increases his suffering” (p. 48). Here we have Mariana presenting an early version of the analogy between the inflationary solution and the drink used to revive an alcoholic, one which Friedrich Hayek would use roughly five centuries later.
Having analyzed the matter in depth, the philosopher detailed the disastrous effects of monetary manipulation, which, as he explained, goes against all rule, custom, reason, and natural law. In the same way that it would not be licit and nobody would approve if “the king were to break into the granaries of his subjects and take for himself half of all the wheat, and then compensate them by authorizing them to sell the remaining half at twice its previous value” (p. 68), neither is it right that the king take away half the value of the money and then attempt to satisfy its owners by declaring that what was once worth two is now worth four. And the robbery can be even greater still when the king permits or, worse still, orders that debts can be paid with the devalued money.
If injustice is the flipside of adulterated money, the face of it is inflation. Goods “will become costlier in proportion to the debasement of the money supply” (p. 69). This effect provokes popular outrage and what typically occurs is that the ruler, now caught up in the dynamic of his own interventionism, tries to fix prices. Clearly this remedy will be even worse than the disease and, as the first modern historian of Spain does well to point out, this will inevitably bring about shortages, “because nobody will want to sell” (p. 69). And if this reasoning were not remarkable enough, what followed was a compounded explication of the rise in prices in conjunction with the loss of the money’s purchasing power, the one quantitative and the other qualitative. The first phenomenon responded to the fact that, as in the case of any good, the rise in the quantity of money will diminish its value. The second, though, responded to the fact that if the quality of the money deteriorates, then people will want to exchange their goods for money only if there is an increase in the amount of money being offered for those same goods.
As Mariana had explained previously, the ruler, far from reversing course, typically ventures further down his destructive path and now attends to the symptoms, instead of the causes that he himself unleashed. Thus, the fixing of prices, as an attempt to preserve the loss of a money’s purchasing power, distorts the economy even further, bringing about general privation. In other words, shortages are not accidental but, rather, the logical consequence of fixing prices. And sooner or later, the king will be forced to acknowledge the source of the problem by lowering the official value of the money back to its intrinsic value (p. 71). The end result of all of this degradation cannot be anything other than a swelling of “collective rage,” which the prince has only brought upon himself.
If we limit ourselves to material reality, there is no doubt that the king will benefit over the short term from this kind of policy, but over the long term the dynamic effects of the strategy will have forced him to worsen his own situation, via debasement of the money and its subsequent effect on commerce (and the productivity of the nation), always as delicate as milk, “which at the slightest disturbance separates and curdles” (p. 78).
But there is more. Bad money, in this case billon, exiles good money, in this case silver. Mariana described the Spanish experience as a textbook case of Gresham’s Law. This law, popularized via the formula “bad money drives out good money,” was proclaimed in 1558 by Sir Thomas Gresham. First articulated by Nicholas Oresme, it explains the effects caused by maintaining an artificial exchange rate between two currencies despite the one being devalued and the other not.Cf. Oresme’s treatise and Selgin’s essay on Gresham’s Law. For more on Oresme, see Hülsmann, who has positioned him as the origin of the monetary theories of the Austrian School of Economics. Our Jesuit describes the phenomenon just as it was taking place between the new billon coins and the old ones, and he simultaneously denounces that in such situations the king should benefit by ordering that he be paid with money containing silver, precisely while he continues to make his bond payments and dole out salaries with money containing only copper. Finally, as Mariana does well to indicate, foreign creditors and suppliers will not accept this arrangement, and thus silver will flow in their direction (Mariana, 1861, p. 64).
For a man who has dedicated his life to reflecting on moral, political and philosophical problems, at both empirical and abstract levels, for a man who has lived abroad, written the history of Spain, and tried to assist in the education of the Prince, and for a man who has looked hard at the rights that predate the royal institution and even society itself, it is impossible not to see that the manipulation of money, with all of its attendant problems, is first and foremost a means of financing the public debt. Perhaps this is why the last chapter of his treatise is dedicated to the analysis of alternative measures that might resolve the Treasury’s problem without having to make recourse to the destabilizing and destructive “fraud” of debasing the money supply.
According to Mariana, instead of focusing on raising revenues as the way to solve the fiscal imbalance, the first thing that the King and those who govern ought to do is reduce expenditures. His second recommendation is to end subsidies, rewards, pensions, and prizes. This is because—and let us not forget—the King is administering resources that are for the most part not his own. Mariana does not hesitate to put the case simply, so that it will be understood:
Let us look at the matter clearly: If I were to send a representative to Rome and give him money for his expenses, would it be permissible for him to waste it and to give it to whomever he pleased, or for him to go about doling out another’s money in a public display of generosity? The king cannot allocate public money given to him by the citizenry with the same freedom with which a private individual spends the income derived from his own lands and other possessions. (p. 91)
Furthermore, he proposed that “unnecessary ventures and wars be avoided, that incurable cancerous limbs be amputated” (p. 91). In other words, those wars which are not absolutely necessary should cease and there should be no hesitation in allowing Flanders to secede from the Empire. Moreover, he suggested that the King dedicate more energy to keeping outlays in line with revenues, with the purpose of avoiding influence peddling and corruption. Finally, if it becomes necessary to raise taxes, Mariana proposed that these be levied on luxury items, which are purchased principally by the upper classes.
As a final point, he concluded once again that what needs to be avoided at all cost is inflationary monetary policy, because it runs contrary to both ethics and economic efficiency. For if such policy is pursued without the consent of the people, from whom part of their wealth is extracted through the encumbrance, then it is “illicit and wrong,” and even if it be done with their consent, he considered it a mistake and destructive for a variety of reasons.
Mariana was conscious of putting himself at risk by speaking so frankly and loudly, and he indicated as much in the prologue to the reader of De monetae mutatione: “I see very well that some will consider me too bold, others rash, saying that I do not consider the risk that I run. Nevertheless, I dare to speak out, an odd and retired man, against that of which so many wiser and experienced men than me have approved” (Mariana, 1861, p. 27). Even so, it must have been difficult for him to have imagined that the King and the Duke of Lerma would have unleashed their fury in such a virulent and immediate manner. He must have been thinking in such terms when they seized him at the chapter house in Toledo on September 8, 1609, by order of the Bishop of the Canary Islands.Curiously enough, ever since September 8, 1914, this day has been dedicated to celebrating the Virgen del Pino, the patron saint of the Canary Islands diocese. As he was being conducted from Toledo to San Francisco el Grande in Madrid, he would have had time to conjecture about what they were accusing him of and what would be his principal lines of defense.
Mariana was already seventy-three years old, but it was still not too late for him to learn one of the bitterest lessons of his life: if one is disposed to confront political authority in defense of individual liberty and private property, one should anticipate the likelihood that he will be abandoned by his friends and even by the institutions that he has served his entire life. This was the case, for example, with the Company of Jesus, to which Mariana had dedicated with talent and zeal his last fifty-five years. From the outset of the proceedings, the directors of the order were careful not to defend him if doing so meant compromising their interests.
The King and Lerma had been quick to detain the aged philosopher, but they would take their sweet time presenting their formal indictment. The original claim was presented by Don Fernando Acevedo on August 28. So the King waited seven days before having the Inquisition formally depose the inconvenient author and eleven more before ordering his arrest and transfer to Madrid. Nevertheless, the formal accusation would not arrive until October 27. It consisted of the following thirteen charges:
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Denying the right of the King to reform the money supply, using formulations with which he tries to discredit and reprove the monetary policy of His Majesty, such as offending ministers and defaming the nation and its customs.
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Omitting the reasons that justify the reform and using an erroneous methodology, thus making his work more a matter of libel than scientific study.Here the prosecutor accuses Mariana of using deductive logic.
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Trying to provoke and disturb the populace. In other words, trying to foment social unrest.
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Defaming Court administrators, arguing that they are inept and given to bribery.
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Maintaining that inflation is a hidden form of taxation, that the King cannot impose taxes without consent, and calling him a tyrant.
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Not considering information pertaining to the troubles of the State but, rather, inciting them by labeling as “fraudulent infamy” practices similar to those carried out in other countries.
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Classifying as inept and insolent the decisions made by ministers in the development of the national monetary policy.
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Accusing ministers of obstruction.
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Affirming that the nation is poorly governed, because public officials are corrupt.
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Insisting on the “wicked and imprudent doctrine” which claims that in matters that concern all, all may express their opinions.
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Comparing the Spanish Empire to the Roman Empire in its decadence and making fearful prognostications, in which are interwoven species of lèse-majesté.
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Accusing the King of ingratitude toward García de Loaysa, Pedro Portacerrero, and Rodrigo Vázquez.
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Finally, affirming that at that time and in that realm there coexisted the following grave evils: theft and deception among citizens; lack of honor among magistrates; robbery of public money; continuous imposition of new taxes, which end up paying for private expenditures or superficial expenditures of the Royal House, whereas the commoners cry out, oppressed by the great burden, and “pass their lives in anguish and pain no less brutal than death itself”; the existence of a great “number of poor who, without any hope and without having anything of their own, go about lashed to a stake”; the adulteration of the money supply with the harm this supposes to commerce and the shortage of all kinds of goods. (Fernández de la Mora, 1993, pp. 68–77)
At last Mariana knew the charges against which he would have to defend himself. As soon as the accusations were put before him, he requested several days to prepare his defense, which he decided to undertake personally. The final words of the prosecutor invited him to disavow the written record he had left in his book. How should he confront the situation? The alternatives were clear: either he renounced his principles and declared that he had made an error in judgment, or else he threw himself into defending his ideas at the risk of never being able to convince the tribunal that it was not true that he had committed “capital offenses,” as the prosecutor had claimed. On November 3 his choice was made clear via the thirty-five handwritten folios of exoneration that he introduced, which consisted of a series of formal arguments maintaining: that the publication of his work complied with the law from the moment it was granted the required license to be published; that in no way did it transgress the articles of his faith; and that it was “clear doctrine” that facts which are already public can be restated and that the majority of these had already been judged, referring to the abuses and corruptions that he denounced in the treatise. In addition, Mariana put forth four general arguments: 1) that he was being accused of supposed intentions that only God and he could know and which he had already disclosed in the prologue to the book; 2) that technically his book cannot be considered a defamatory libel because there is nothing surreptitious about it; 3) that it only mentions cases of corruption already punished as such; and 4) that it was printed in Cologne only because the domestic presses had been closed by royal decree and that he had obtained permission for its printing there.
Mounting his defense against the specific charges brought against him by the prosecutor, Father Mariana answered them one at a time with a combination of solid theological arguments and deft political maneuvering.This summation of Mariana’s defense is taken from Fernández de la Mora (1993, p. 83). To the first accusation he responded that he maintains his opinion that the King has no right to debase the currency without the consent of the people, for the same reasons that he had expounded in his book. To the second, he responded that he never omitted any justification for the monetary reform but, rather, that he continued to believe there is insufficient justification. To the accusation of fomenting unrest, he answered that the existence of corruption does not mean that the King knows of it and consents to it, and that he only reiterated an already public outcry. He refused to disown his affirmation with respect to the fifth accusation, according to which inflation is a tax for which the King has not obtained consent, which is therefore not legitimate, and which casts the monarch in the role of tyrant. Regarding the sixth allegation, he defended himself saying that he did not intend to incite unrest but, rather, to alert the King as to what might happen to him and what, in point of fact, has happened in other countries. Next, Mariana contested the seventh, eighth and ninth charges with a sly prestidigitation by which he tried to maintain that he was not referring to the ministers of Spain but, rather, to certain personages already condemned and to ministers in general who would establish these policies independent of consultation. He also defended himself against the incrimination that he called ministers inept and labeled their decisions insolent by alleging that “inept” means purposeless and that an “insolent” decision is merely an “extraordinary” decision, availing himself of one of the meanings that the adjective still held at the time.The argument that Mariana utilized in his defense against this charge recalls the one used several years ago by Manuel Ayau (a.k.a. “Muso”) in a famous debate at the highest institutional levels of Guatemala concerning the form that a possible stock market might take there. As told by Eduardo Mayora: “The Central Bank of Guatemala maintained its legalistic opposition to the incorporation of a fully private entity designed to underwrite a stock market. They could not imagine that such a thing could exist without passage of a special law, without the direction of the State, and, of course, without its own blessing. The proposal led to a high-level meeting with the Bank’s most powerful dignitaries, presided over by its Vice President. On the side of those favoring a stock market, there was Muso leading the charge. The Vice President of the Bank of Guatemala welcomed Muso and those in his company, following the customary protocol at that type of formal gathering, with a more or less condescending tone, after which he yielded to Muso, who, without the slightest preamble, said: ‘Well, thank you very much. Today, we are here to tell you all that you are dysfunctional....’ Every one of us froze for a few moments, which seemed like an eternity, until Muso finally added: ‘...in the sense that it is not the function of the Central Bank to regulate any stock market.’ After that we all breathed a huge sigh of relief” (personal communication, 2009). He responded to the tenth charge with an ardent declaration in defense of freedom of expression. Regarding the eleventh, he said that he had made the comparison between the two empires in order to warn about where we could all end up if the issue is not resolved. He accused the prosecutor of twisting his words in the twelfth accusation and, finally, he said that, regarding the final charge, he was merely referring to the public treasuries of all countries everywhere.
After reading the exculpatory text, the prosecutor levied a new charge against the Jesuit: alleging that the charges of the prosecutor are false. Nevertheless, the prosecutor must not have had much confidence in his accusations, because on December 2 he asked for a delay of the trial, to which Mariana objected. When the oral arguments finally took place, the accused philosopher encountered difficulties calling his seven witnesses, one of whom even refused to appear before the court. The other six defended the courage and honor of Mariana, after demonstrating their familiarity with his work. By contrast, of the ten witnesses called by the prosecutor only two were familiar with the book, but they all nevertheless denounced Mariana, displaying absolute complicity with the powers that be. Five of these went so far as to claim that the King could do as he wished with the money supply as well as the property of his subjects. Eight of the ten stated—without having read the book—that everything the book said is false.
On the day after the Day of the Magi in 1610, Mariana received a written statement of the cause against him and he responded that he will not enter into a discussion of positive laws but, rather, only natural laws. He further added that, if the prosecutor were correct, then private property would not exist, and he requested that all of the witnesses’ testimony against him be disregarded, for they have testified without citing the book in question. So the case was set for sentencing on January 9, 1610.
The King put Mariana’s feet to the fire, trying to condemn him for lèse-majesté, and meanwhile he called for his ambassadors to buy up or take possession of all the copies of the book they could find in order to burn them. Unfortunately, the ambassadors set themselves with such zeal to the task ordered by Philip III that today it is nearly impossible to find a first edition copy of Septem tractatus. Nevertheless, in spite of all the King’s efforts at getting the Vatican to back him in his persecution of the Jesuit, he never achieved an ounce of papal cooperation by which to condemn him.
In light of the impotence of the King, Mariana was freed, without any formal conclusion to the trial. As Gonzalo Fernández de la Mora (1993) does well to point out, contrary to what is usually believed, the episode “makes manifest the fact that the Monarchy’s power was not capricious but, rather, limited not only by the ethical consciences of its affiliates, but also by judicial review” (p. 99). The result of the trial ultimately supports the view advanced by, among others, Murray Rothbard in Economic Thought before Adam Smith, according to which institutional rivalry and jurisdictional overlap limited the power of the State in a relatively effective way, while the Catholic Church continued to enjoy a certain degree of power in Europe.
Juan de Mariana managed to overcome the nightmare in which he found himself all alone. At seventy-four, he returned to Toledo and never again occupied himself with monetary issues. In the years following the trial, he lived long enough to see how those who had persecuted him with their hatred fell from the pedestals to which they had risen. He also lived long enough to see how a new generation of intellectuals would defend his work, which was also attacked in France for its defense of tyrannicide. In spite of the physical disappearance of the book in which he had most clearly articulated his monetary theory, his ideas were defended by other authors, both within and beyond the borders of Spain. And so it was that so many millions of citizens, from his generation to our own, were made the welcome beneficiaries of the valiant efforts of this exemplary man who defended private property and freedom, even under the most adverse of circumstances.Among the authors who knew, defended, and disseminated some of Mariana’s ideas over the years that followed, we should note philosophical, political, economic and even literary giants ranging from Quevedo and Lope to Turgot and Locke. And as can be seen in the following essay by Professor Graf, there is a good argument to be made that Miguel de Cervantes, the author of the first modern novel, was Mariana’s greatest disciple of all.
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Quarterly Journal of Austrian Economics 20, no. 3 (Fall 2017)The Euro: How a Common Currency Threatens the Future of EuropeJoseph E. StiglitzW.W. Norton, 2016
As Joseph Stiglitz sees matters, the euro suffers from a fatal flaw. The euro is the currency of 19 European countries; and common money blocks efforts of nations that, according to Stiglitz, need to devalue their currencies. More generally, attempts to restrict government control of the economy arouse the wrath of this implacable enemy of the market.
As he explains,
When two countries (or 19 of them) join together in a single-currency union, each cedes control over their interest rate. Because they are using the same currency, there is no exchange rate, no way that by adjusting their exchange rate they can make their goods cheaper and more attractive.
Since adjustment in interest rates and exchange rates are among the most important ways that economies adjust to maintain full employment, the formation of the euro took away two of the most important instruments for insuring that.
Quarterly Journal of Austrian Economics 20, no. 3 (Fall 2017)Abstract: An open question in the Austrian business cycle theory is how labor markets across the structure of production react to broader changes in the economy. Particularly, how do labor market conditions in industries at different stages of production respond to changes in monetary policy? This paper investigates the issue by analyzing the response of employment and earnings to monetary policy shocks for ten different sectors of the economy. The results show that labor markets for each sector respond to monetary policy primarily through changes in employment rather than changes in earnings, and that there are distinct differences in the magnitude and timing of employment responses across sectors. Furthermore, these differences in sector-specific responses can be grouped according to the general stage of production that a sector is associated with.
KEYWORDS: Austrian school, business cycle, monetary policy, employment, compensationJEL CLASSIFICATION: B53, E32, E52, J2, J3
Mises wrote this book for the ages, and it remains the most spirited, thorough, and scientifically rigorous treatise on money to ever appear. It made Mises's reputation across Europe and established him as the most important economist of his age.
Narrated by Jim Vann. The full text is available online here.
Download the complete audiobook (29 MP3 files) here. This audiobook is also available on Soundcloud, Apple Podcasts, Google Podcasts, and via RSS.
Quarterly Journal of Austrian Economics 20, no. 2 (Summer 2017)The International Monetary System and the Theory of Monetary Systemsby Pascal SalinEdward Elgar, 2016
The present volume is an accomplished theoretical inquiry into the workings of the international monetary system. As the author himself explains in the introduction, the book is intended to provide readers with a good understanding of the economic principles and economic problems of international monetary economics, while drawing on sound general economic theory. Salin fully succeeds in painting a clear and concise picture of the current issues in international monetary relations, and of the theoretical discussions and proposed solutions surrounding them.
Adopting an almost exclusively theoretical point of view, Salin guides his readers in textbook-like fashion through the intricate core propositions of international monetary economics. The first two parts of the book discuss the basic statements and analyses in the field, such as the theory of exchange, the demand for money, the exchange rate, and the fundamental principles of balance of payments analysis. Part III delves into the issue of international monetary equilibrium, touching on the concepts of inflation and devaluation, the formation of international prices, and a range of exchange rate systems including fixed and flexible exchange rates. In Part IV, Salin concludes his investigations with a brief analysis of monetary policy, monetary crises, and monetary integration.
From the beginning, the building blocks of Salin’s arguments are excellently set up, and together they form an almost self-contained and complete system of thinking about monetary problems. But the strength of the book comes primarily from the fact that this system is grounded in general economic theory. While particular discussions are specialized, and thus somewhat narrow, the overall volume adds to the big picture of the workings of monetary macroeconomics, with a solid foundation in microeconomic theory. Each chapter neatly draws a conclusion on which Salin builds further arguments, but which also constitutes a valuable lesson in itself. Eventually, his analyses lead up to a refreshing overarching remark: “a surprising paradox in monetary theory: people debate about the best monetary policy, although the best solution would be not to have any monetary policy. This was the case in a pure gold standard (that is, without central banks)” (p. 245).
In relation to this welcome insight, three of the valuable lessons that Salin’s short volume offers warrant particular attention. In each case, the author sews up a competent critique of the widespread misunderstandings that surround these issues in modern literature.
First, Salin completes the discussion in Part II with a pointed analysis of the balance-of-payments—or external equilibrium—policies. He shows that such policies are “doomed to failure because [they are] based on an a priori and arbitrary definition of equilibrium and disequilibrium” (p. 100) with regard to individual cash-balance decisions. In consequence, he argues, attempting to equilibrate balance of payments accounts often leads to disequilibrium in the market, “since it is forbidding individuals to allocate their resources over time in a way which would be optimal for them” (p. 100). With regards to the disputed relationship between the balance of payments and the exchange rate, Salin also correctly points out that, contrary to popular belief, “the exchange rate is not the price of the balance of the trade balance, which would obviously be meaningless… [and since] a deficit is not a symptom of disequilibrium, it therefore has no reason to cause a change in the exchange rate” (p. 102).
Second, Salin devotes an entire chapter (chapter 12) to a detailed explanation of why inflation is a monetary phenomenon (pp. 112–118), in the case of a closed economy, as well as in an international setting with imported inflation. This discussion is not only relevant on its own, but ends up excellently supporting Salin’s subsequent analysis of the international transmission of money creation across national borders in varying currency and exchange rate regimes (ch. 16, pp. 137–149) and its congeneric impact on international monetary equilibrium (ch. 17, pp. 150–163). Third, the same chapter contains an almost taboo opinion in monetary economics, i.e. that deflation is not only unproblematic, but actually beneficial (pp. 118–119). Salin returns to this point throughout the book (pp. 41–42; 157–158; 226), reiterating the idea that “contrary to widely held ideas, deflation is preferable to inflation.”
Other similarly discerning analyses are found throughout, and towards the end of the volume, Salin offers some highly quotable turns of phrase: for example, in discussing monetary integration in Europe, he argues that “the euro is the outcome of an approach which mixes monetary nationalism, politicization of money, substitution of pseudo-independence to an external control by competition, and the use of a compulsory and constructivist process instead of a spontaneous one” (p. 241).
It should come as no surprise that this volume resonates with classical and Misesian monetary theory, and is often at odds with the great majority of modern monetary models and their conclusions. And yet, Salin’s system of monetary analysis does contain a few idiosyncrasies. Some are due to the author using his own terminology in perhaps unnecessary situations, such as substituting ‘coercion’ for ‘government intervention,’ or introducing ‘hierarchy’ in discussions of money creation (p. 102) to refer to the existence of a central bank.
Other idiosyncrasies, of greater weight, are I believe remnants of the author’s familiarity with mainstream economic analysis. One such instance is the chapter on the demand for money, which contains a discussion of the roles of money and the definition of money. Divergent views between monetary schools of thought originate from these aspects: modern analyses effectively downplay the function of money as a medium of exchange in relation to its role as a store of value or unit of account when constructing models based on a barter economy in which a numéraire is later introduced. Mises (1953, pp. 30–37), however, considered the two latter roles of money as secondary functions which can only derive from a currency’s primary function as medium of exchange, and often drew attention to the dangers of the “barter fiction” (Mises, 1998 [1949], p. 202), as he called it, for sound economic analysis.
Salin, however, is rather unconventional in his approach: while espousing the importance of money functions, he avoids differentiating between the role of money as medium of exchange and that of store of value over time. Historically, he argues, “it is likely that these roles have emerged gradually and more or less simultaneously, so that it is not possible to consider that one clearly preceded the other” (p. 30); and he suggests that theoretically, “the role of a standard of value [numéraire] is not necessary for a good to be considered currency, unlike the other two roles” (p. 30). However, this discussion is followed by a rather confusing account of how money, if introduced as only numéraire, would leave relative prices unchanged compared to a state of barter. Salin does not specify though whether this is a useful abstract exercise, or rather a fictitious assumption contrary to economic reality.
Later in the volume, this precarious analysis seems to taint the discussion on real growth and monetary growth under fixed exchange rates, for which Salin uses the example of communicating vessels (p. 162). This hydraulic view of balance-of-payments adjustment—often seen in business cycle theories as well—disregards the Cantillon effects of monetary inflation responsible for the gradual and irreversible changes in prices and wealth distribution that money creation inevitably produces in a closed or open economy. More to the point, such a view actually contradicts Salin’s overall monetary analysis in terms of individual cash-balance decisions. At best, the author’s views on these points are confusing and thus easily misunderstood; at worst, they detract from the otherwise strong case he makes against monetary and balance-of-payments policies.
These issues notwithstanding, this little volume is overall a pleasure to read. Fluent in the language of modern monetary economics, Salin makes ample use of equations and graphs in a pertinent and user-friendly way: coupled with clear and concise explanations, these mathematical elements usually provide rigor and structure to the analysis. While they may not be indispensable, they do enhance some of the arguments, and are carefully weighed not to hinder the overall flow of the narrative. Some readers may also find that Salin’s sole focus on monetary theory has perhaps deprived some of the discussions of their historical color—in particular Chapter 20, which analyzes the long-term evolution of monetary systems. Joseph Salerno’s collection of monetary essays (2010), which focuses on the history of monetary systems, the development of monetary and balance-of-payments policies, and the history of monetary thought, can be a welcome companion to Salin’s volume.
In conclusion, The International Monetary System and the Theory of Monetary Systems is replete with well-grounded arguments and thought-provoking insights. It is thus both a useful and distinctive resource for economics scholars and students, and an intellectually compelling journey into the principles of domestically sound currencies, and into how to build sound international monetary systems.
Carmen Elena Dorobăţ, Ph.D. is Assistant Professor (Lecturer) in Business at Leeds Trinity University, U.K.
Quarterly Journal of Austrian Economics 20, no. 2 (Summer 2017) ABSTRACT: The aim of this paper is to examine the non-price effects of monetary inflation. An increase in the money supply may lead to price inflation, but it may also affect the non-price parameters of goods and services, such as quality or the quantity enclosed in packaging. Based on our analysis, we claim that an expansionary monetary policy may cause a decline in quality (quantity) of produced goods and services if the rise in costs prompts the entrepreneurs not to increase nominal prices of their product but to decrease their product’s quality (quantity), increasing its effective price—price adjusted for quality (quantity). In this way, the increase in money supply may have, ceteris paribus, a negative impact on innovativeness of entrepreneurs who, instead of improving the quality of products they offer, may in fact take the opposite action in order to avoid evident nominal price increases of their products.
KEYWORDS: monetary inflation, non-price parameters of goods and services, non-price effects of monetary inflation, pricing strategy, product quality JEL CLASSIFICATION: B53, D40, E31, E51, L11 1. Introduction The influence of monetary inflationOriginally the term “inflation” stood for increase of the money supply, though nowadays this term is identified with the effects of this phenomenon: the increase of prices. Therefore, the term “monetary inflation” is used in this work and it stands for increase of money supply. “Price inflation” stands for increase of prices (Mises, 1998 [1949], pp. 419–421). on price changes has been subject to many research studies (e.g., Cantillon, 1959) [1975]; Mises, 1953 [1912]; Hayek 2008], Friedman and Schwartz, 1963). However, less attention has been paid to the analysis of the relation between monetary inflation and the changes in remaining parameters of goods and services, such as quantity (actual volume enclosed in packaging), quality, or the type and the date of delivery, etc.There is a question whether goods of different quality are still the same goods. Therefore, economists investigate the impact of monetary inflation on prices taking into account the ceteris paribus clause. However, we believe that focus on the factors economists usually abstract from can be helpful in better understanding the inflationary process and the behavior of entrepreneurs confronted with monetary inflation. There is plentiful anecdotal evidence on quality or quantity adjustments (e.g., Martin, 2008), but the academic literature on the subject is modest.
Armstrong and Chen (2009) argued that producers may use non-price (rather than price) adjustment mechanisms, if they have more information than consumers about goods’ attributes, while Snir and Levy (2011) found that producers are more likely to decrease quantities than increase nominal prices when consumers are more price attentive than quantity attentive, especially in periods of high inflation and in markets where producers face strong competition.
Imai and Watanabe (2013) examined the extent to which product downsizing occurred in Japan in 2000–2010. They found that one pricing strategy adopted among firms reluctant to raise nominal prices was to reduce the size or the weight of a product while leaving the nominal price practically unchanged, thereby raising the effective price. Importantly, the number of product downsizings has been particularly high since 2007, when firms faced substantial cost increases due to the rise in the price of oil and other imported raw materials.
Cakir, Balagtas, and Okrent (2013) analyzed the effects of package downsizing in the United States on household food-at-home consumption and expenditure in 2004–2010, while Cakir and Balagtas (2012) examined package downsizing in the Chicago ice cream market. Both studies found that producers use downsizing to implicitly increase prices in order to pass through increases in production costs.
These mainstream articles, although interesting, do not mention explicitly the link between monetary inflation and the changes in the non-price parameters of goods and services. They also tend to focus only on the package downsizing, omitting the changes in product quality.
Although Austrian economists analyze thoroughly the harmful consequences of rising money supply under the fiat monetary system and fractional-reserve banking, they are not interested in the problem of non-price effects of monetary inflation either. The only two exceptions known to us are Rothbard (2005) and Hülsmann (2008). The former (Rothbard, 2005, p. 53) assumed that consumers are more price sensitive than quality sensitive and wrote:
The general atmosphere of a “sellers’ market” will lead to a decline in the quality of goods and of service to consumers, since consumers often resist price increases less when they occur in the form of downgrading of quality.
The latter (Hülsmann, 2008, pp. 187–88) was a bit less laconic:
Then there is the fact that perennial inflation tends to deteriorate product quality. Every seller knows that it is difficult to sell the same physical product at higher prices than in previous years. But increasing money prices are unavoidable when the money supply is subject to relentless growth. So what do sellers do? In many cases the rescue comes through technological innovation, which allows a cheaper production of the product, thus neutralizing or even overcompensating the countervailing influence of inflation. This is for example the case with personal computers and other products made with large inputs of information technology. But in other industries, technological progress plays a much smaller role. Here the sellers confront the above-mentioned problem. They then fabricate an inferior product and sell it under the same name, along with the euphemisms that have become customary in commercial marketing. For example, they might offer their customers “light” coffee and “non-spicy” vegetables—which translates into thin coffee and vegetables that have lost any trace of flavor. Similar product deterioration can be observed in the construction business. Countries plagued by perennial inflation seem to have a greater share of houses and streets that are in constant need of repair than other countries.
However, neither Rothbard nor Hülsmann analyzed the above-mentioned problem in a systematic way, in contrast to our article. This limited interest in the literature is puzzling for three reasons. First, researchers have already shown that other goods’ attributes can also change depending on market conditions. Price is one of several elements that matters for consumers. Actually, in many marketplaces, adjustments in non-price attributes of products may be more important than changes in price. Thus, entrepreneurs may also compete on service quality, product quality, size or weight of a product, methods of distribution, delivery time, and so on. The non-price competition is well established in the literature (Blinder et al., 1998). Carlton (1987) even claims that markets may clear in terms of other factors than price—for example, delivery lags (Carlton, 1983). Therefore, the assumption that entrepreneurs always increase nominal prices in response to monetary inflation and rises in costs is not true.
Second, the growth of consumer prices resulting from monetary inflation is not automatic and deterministic, but depends on autonomous decisions made by entrepreneurs who, dealing with higher expenses, may or may not raise the prices of their products. Austrian economists always criticized the deterministic approaches of mainstream economics, particularly the hydraulic interpretations of the quantity theory of money, which postulate that a given increase in the money supply would lead to a proportional and mechanistic rise in the general price level (e.g., Mises, 1998 [1949], pp. 398–416). Although they are aware that increases in the money supply do not need to be revealed in increases in the consumer price level (e.g., Shostak, 2002), Austrians hardly analyze the impact of monetary inflation on non-price parameters of products.
Third, historically, until the implementation and distribution of banknotes in use, monetary inflation occurred in fact as a coin debasement—that is, a reduction in the weight or a deterioration in the quality (fineness) of coins, without changing the nominal value (Hülsmann, 2008, pp. 89–91). Therefore, economists should be aware that increases in money supply may be reflected in changes in non-price parameters of products, such as quality or weight (size).
The aim of this article is to fill the gap in the literature and thoroughly examine how the increases in money supply influence the non-price parameters of goods and services, especially how it affects the actual volume enclosed in packaging and the quality of the products. In other words, our goal is to draw a connection between monetary inflation and the non-price adjustments. Hence, we develop a theory of inflation and changes in the non-price parameters of goods and services. It turns out that neither are entrepreneurs greedy individuals who want to cheat consumers all the time, nor are downsizing and reduction in product quality always the optimal market outcome and beneficial for consumers. Our conjecture is that an expansionary monetary policy may, ceteris paribus, cause a decline in quality (quantity) of produced goods and services if the rise in costs prompts the entrepreneurs to not increase nominal prices of their products, but to decrease the products’ quality (quantity), raising rather their effective prices—prices adjusted for the volume or quality. In this way, the increase in money supply may have a negative impact on innovativeness of entrepreneurs who, instead of improving the quality of products they offer, may in fact take the opposite action in order to avoid explicit nominal price increases of their products.
The remainder of the paper is organized as follows. Section 2 analyzes the link between monetary inflation and non-price changes of goods and services. Section 3 focuses on the downsizing, and section 4 on decreasing quality. Section 5 examines the indirect effects of monetary inflation on quality of goods. Section 6 concludes.
- Monetary Inflation and Non-price Changes of the Goods and Services The starting point for our analysis is the Cantillon effect, a distributional effect and price effect resulting from the uneven increase in the money supply (Cantillon, 1959 [1755]). The new money is not evenly distributed in the economy but only runs through specific channels (Sieroń, 2015). This implies that only some entrepreneurs observe the increase in monetary demand for their products (or they observe it earlier than others). Other market actors will be confronted with a relative increase in the price of the factors of production used by them in the production process. The increase will be particularly widespread if the new money entered the economy through credit expansion (Huerta de Soto, 2006), which would lower the interest rates and, as a consequence, increase the monetary demand for raw materials and producer goods.
The rise in commodity prices was particularly strong in the 2000s (Trostle et al., 2011), when the annual percentage changes in the producer price index (PPI) were usually bigger than changes in the consumer price index (CPI), as one can see in the chart below.However, the percentage changes in the PPI were often smaller than changes in the CPI in other decades. This chart shows that producers faced significantly rising costs at that time, which could prompt them to reduce either quality or quantity of products, without adjusting nominal prices. Hence, focusing on the CPI is not sufficient in order to understand the inflationary process taking place in the economy. It cannot be ruled out that the greater increases in the PPI in the 2000s could partially have resulted from the fact that producers of consumer goods changed either the quantity or the quality of their products (and these changes were not properly reflected in statistics).
Figure 1: The percentage change from a year before in the PPI (blue line) and CPI (red line) in the 2000s
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Entrepreneurs facing the increase in costs may raise their nominal prices. However, such a solution is not always an optimal one. If the demand for a good is elastic, then an increase in price causes a decrease in revenues.It is worth mentioning that entrepreneurs always try to establish the price on the level maximizing profit, so any raising of price above the optimum value may lead to a decrease of revenue. Therefore it is not true that entrepreneurs can smoothly pass the rise in costs on to their consumers (Rothbard, 2009). Moreover, a few articles show that consumers are more sensitive to price than non-price changes due to lack of appropriate knowledge about non-price parameters or cognitive costs associated with processing information about both products’ prices and non-price parameters (Gourville and Koehler, 2004; Snir and Levy, 2011).On the other hand, Imai and Watanabe (2013) did not agree that consumers are sensitive to price changes but not to size/weight changes. Moreover, some consumers may be completely aware of an increase in an effective price (price per unit) but focus more on the nominal (absolute) price due to being short on cash.
What is more, sometimes entrepreneurs are not permitted to freely change prices. Price controls implemented by governments to keep inflation in check force them directly to change non-price attributes of products and, for example, reduce the quality or lengthen the delivery time during inflation (Carron and MacAvoy, 1981).Under the communist system, inflation was repressed. The increase in money supply led to shortages and non-price rationing—for example, in terms in time spent in lines (Kolodko and McMahon, 1987). For these reasons, entrepreneurs are forced to adjust non-price parameters of products in order to sustain their level of profitability.A similar example may be a minimum wage. The increase in the minimum wage may prompt employers to reduce fringe benefits or worsen the working conditions (Wessels, 1987).
There are many ways to deal with the rising costs. In certain sectors and at a certain point in a company’s development, the technological process plays the most important role (Hülsmann, 2008, p. 187).Please note that these efforts to deal with monetary inflation decrease the officially reported consumer inflation rate due to hedonic adjustments. However, the role and the rate of technological progress vary from one sector to another (Castellacci, 2004). For that reason, some entrepreneurs, operating in industries when the technological progress plays a much smaller role, may try to implement one of the two following major strategies (or both of them at the same time):
a) curtailing the amount of product, but keeping the nominal price unchanged (i.e., downsizing); orb) reducing costs through offering products of inferior quality.The difference between them is often very subtle as producers may use cheaper substitutes reducing quality and, for example, add water to foodstuffs in order to reduce the quantity of the primary nutrient used in the production of given goods. It seems however that it is worth distinguishing between these two methods, as the first one does not influence the quality of the products per se.
Surely, entrepreneurs may also adopt other solutions in response to monetary inflation and a surge in costs. However, we focus on the above-mentioned strategies because quantity and quality are the most important (and most general) non-price parameters of products. In particular, entrepreneurs can also increase the costs of shipping, reduce customer service, or move production to cheaper locations. They can also lower product variety because an increase in costs resulting from monetary inflation may reduce their companies’ profitability, which may lead to a narrowing of product range only to those products with the highest margin (instead of hiking prices). This is important because the literature shows that product variety enhances customers’ welfare (Dong, 2010).It is worth noting that non-price changes of a product may cause the relative underestimation of the CPI. We write about “relative” underestimation because it is difficult to determine whether there is absolutely positive or negative measurement bias in the CPI (Rossiter, 2005). However, goods substitution in the basket does not cover the loss of usability resulting from replacing more expensive goods of high quality by cheaper ones with lower quality. On the contrary, economists generally believe that substitution bias overstates the CPI.
- Downsizing Downsizing means decreasing the quantity of a product sold at the same nominal price. It seems to be a relatively new strategy, and can be either illegal or legal. The illegal one consists in placing less of the product in the packaging than was mentioned on the label, while the legal one consists in explicitly reducing the net content,The number of items or units in the packaging may also decrease, which is not easy to identify—for example, in the case of toilet paper sheets. often in a way unnoticeable for consumers, however. Although sellers are obliged to present unit price as well—that is, price per unit of weight or per product unit—the studies show that consumers are far more sensitive to changes in nominal prices than to the quantitative changes even if they both lead to the same change in effective price (Gourville, Koehler, 2004; Snir and Levy, 2011).Although this fact seems to prove that consumers do not always act rationally, it is worth mentioning that comparing both prices and quantity of different products involves additional costs in the form of time and effort (Snir and Levy, 2011). It should also be noted that unit prices are not always given, and even if they are, they are usually written with small characters. Therefore, consumers comparing only nominal prices can be considered rationally ignorant.
The nature of this phenomenon is complex. On the one hand, some argue that the above-mentioned actions show how greedy producers are and that the actions may be perceived as examples of fraud, or at least misleading packaging practices (Lawrynowicz, 2012). On the other hand, one can claim that producers almost always inform consumers about the actual quantity of the product in the packaging and indicate the unit price, whereas the consumers voluntarily make decisions on the purchase. It may also be true that some of the changes in the packaging may have an innovative character and may be an attempt to meet consumers’ needs.For example, beverages sold in tiny cans are often far more convenient though much more expensive in comparison with bigger containers when adjusted for per-unit volume.
However, it may be that downsizing is only an attempt to ensure profitability by companies facing rising costs and price-sensitive clients. This is not due to the entrepreneurs’ greed, but due to inflationary monetary policy. Because of inflation, entrepreneurs devote their time, energy, and scarce resources to producing smaller packaging in an unobvious way instead of offering products in the most appropriate form of packaging from the consumers’ point of view.
- Reduction of Quality of Goods and Services ("Cantillon Defect") Although the phenomenon of decrease in quality of some goods is a subject of research, nevertheless economists generally do not relate it to inflation policy. In this paper, we consider the reducing of quality of goods and services while keeping the same nominal price as a second non-price strategy for enterprises to adjust to monetary inflation and an increase in price of the means of production.
Reducing quality while keeping a stable nominal price, just like decreasing the quantity of the product, may turn out to be an attractive strategy aiming at increasing the effective price of goods or services as it is a parameter substantially harder to measure than price.
Two basic ways of lowering the quality are as follows: reducing durability or modifying components.Deterioration of durability may be the result of modifying components used to produce given goods. However, not every modification of components reduces durability, which is why these methods shall be discussed separately. Reducing durability of the products can be achieved mainly through the use of cheaper components of lower quality. It was recognized in the literature long ago (Swan, 1972; Gregory, 1947; Goering, 1993), but it seems this phenomenon, at least in general perception, has taken on more significance in the last several years.
The modification of components has a particular meaning in the case of non-durables, especially food. Contrary to durables, modifying components of given foodstuffs may rely on extending their durability to the detriment of nutritional values. This phenomenon is based on decreasing the content of the primary component in the product in the face of rising prices of raw materials. It may occur through replacing it with cheaper substitutesAn example of this problem is the European horse-meat affair, as the horse meat used for bovine hamburgers was cheaper (Wikipedia, 2013). (including diluting it with water), using raw materials of lower quality, or adding chemical substances (and applying production methods) that make the product more tasty or durable but harm health.One research area of particular interest is the coexistence of unprecedented monetary inflation since the 1970s (as a result of President Nixon’s definitive break from the gold standard in 1971) and the development of the world obesity epidemic, which in OECD countries dates to the 1980s (OECD, 2010; NIDDK, 2012). There are some indications that low-quality components used for production of foodstuffs, which may partly result from cheaper methods of production adopted by entrepreneurs in the inflationary environment, cause increase of obesity (Schoonover and Muller, 2006). Wiggins and Keats (2015) found that in high-income countries over the last thirty years, the cost of healthy items in the diet has risen more than that of less healthy options, thereby encouraging unhealthy diets. The reason may be that it is more difficult to cut costs associated with production of fruits and vegetables than with production of processed foods.
t is very difficult to evaluate the strategy of reducing the quality of products while keeping the same nominal price. Some will try to find reason for this in entrepreneurs’ willingness to increase sales and profits by all means, though some will defend this phenomenon and claim that clients purchase these products voluntarily. However, it should be noted that the voluntary nature of a transaction does not preclude that consumers’ utility could be higher if they were offered goods and services of better quality. Public monopoly is an example of such a situation. Clients purchase products voluntarily from the public monopoly, but their situation would be better if there were more competitors on the market.
Analyzing this phenomenon is difficult also because decreasing the quality of goods may result from many reasons, not only from expansionary monetary policy. First, it may result from monopolization of the market (Bulow, 1986). Second, government regulationWe refer in particular to price regulations, which often apply to the so-called public utility companies. Changes in the quality of services offered by public utilities due to the monetary inflation may have particular significance (Troxel, 1949). Carron and MacAvoy (1981) researched the quality of services of public utilities in the United States in the 1970s. As regulators did not give their consent to increasing prices, the quality of services and the volume of investment expen-diture decreased, while delays in delivery appeared. may influence the quality of the products. Third, the literature on the subject points to asymmetric information (Grout and Park, 2005). Finally, decreasing quality may correspond with real consumer needs. Market actors may prefer less durable goods because of lower prices, changing trends in fashion, or rapid pace of technological developments.It should also be noted that “quality” is a wider notion than “durability.” Some goods may be characterized by shorter durability, but, for example, extra conve-nience and functionality. It can therefore be reasonably concluded that though some goods were once of the higher quality, only the wealthiest people could afford them. Nowadays, thanks to lower prices, but lower quality as well, these goods are available for a wider range of consumers. From this view point, decreasing quality allows most consumers to purchase desired goods at low price. Simultaneously, there are goods of high quality on the market offered for more demanding and richer consumers.
It is notable, however, that consumers, ceteris paribus, prefer more durable goods as they “render more total service” (Rothbard, 2009, p. 16). As Reisman (1990, pp. 214–216) proved, if higher costs of producing more durable goods on the free market are less than proportionate to the product’s longer life, entrepreneurs have incentives to produce more durable products. Thus, it seems that the decreasing quality—including durability—of some goods and services may result from different government interventions, including monetary inflation, that impose higher costs on companies. Monetary inflation decreases innovation of companies, which may choose methods of production not necessarily the most innovative and favorable for consumers but that guarantee the highest rate of return in an inflationary environment.We can argue that inflation, in a sense, forces innovation by producers in cutting costs and investments that allow them to reduce the use of raw materials whose prices increase. However, it should be noted that such an allocation of resources does not have to coincide with a counterfactual free market allocation of resources. Therefore, we can state that though the inflation may, in a sense, cause innovative behavior, it would be innovation going in the wrong direction in comparison to the one that would have occurred in a reality deprived of monetary inflation.
Hence, we call the decline in quality due to monetary inflation “Cantillon defects,” as it occurs because the new money supply does not distribute itself evenly through the economy, but runs only through specific channels. Therefore, if new money enters the economy through the capital-goods and commodity sectors, entrepreneurs producing consumer goods may face rising costs that could prompt them to adjust non-price parameters of products they sell.
- Indirect Effects of Monetary Inflation on Quality of Goods and Services It is worth pointing out that reduction of the quality of goods and services offered does not have to follow directly the increase of costs of production and be the direct aim of entrepreneurs. The reduction may be only relative and occur with a delay as a result of restricting investment expenditures, including spending on research and development, in the face of inflation (Able, 1980). Moreover, monetary inflation reduces the supply of savings and increases uncertainty, negatively affecting the volume of investments (Horwitz, 2003, p. 78).
The reduction of the quality of goods and services may also result from other indirect effects of monetary inflation. First, monetary inflation decreases the real value of borrowings and thus discourages saving and prompts debtors, including consumers, to buy goods on credit. Consumers in such a situation, instead of saving for goods of higher quality, which would serve their functions for several years, may prefer to buy cheaper goods of shorter durability on credit.Encouraging borrowing would be enhanced if monetary inflation took place through credit expansion, which lowers (ceteris paribus) interest rates. The credit expansion (especially if recurrent) does not only cause a market rate below the natural level resulting from time preference, but can also lead to an increase in time preference, which encourages consumption. In other words, “easy money” policy, which leads to higher prices and higher time preference, may prompt consumers to buy cheaper, less durable goods. Consumers in such economic conditions may prefer lower expenditures in the present day, even if over the years their decision will mean higher total costs for purchasing specific goods (because of their frequent replacement). It happens so because they pay less attention to the future. Such an attitude may be supported through the possibility of buying new products thanks to reduced-interest loans. In this context, it is worth pointing out that the relatively loose monetary policy run by the Federal Reserve System contributed to the development of consumer credit in the 1920s and after the Second World War (Eichengreen and Mitchener, 2003, pp. 36–42; Huerta de Soto, 2006, pp. 487–493).
Second, monetary inflation leads to disturbances in a correctly functioning price mechanism (Horwitz, 2003). Increases in prices resulting from a higher money supply disrupt information conferred through prices, which can unbalance the structure of consumption and the allocation of production factors between goods of higher and lower quality. High price for consumers often stands for high quality (Leavitt, 1954). Therefore, consumers may interpret higher prices resulting from monetary inflation in an incorrect way as an indication of high quality. In fact, they may buy more expensive products of lower quality, which can negatively affect the profitability of companies producing goods of high quality and in this way reduce the supply of high-quality goods.
Third, an increase in prices along with lower variety and lower quality of products may stimulate individuals to self-production. What we can currently observe is the growing popularity of the movement called do-it-yourself (Wolf and McQuitty, 2011). Such a movement reduces innovation as it decreases the division of labor as well as efficiency of production.
- Conclusions In this article, we have challenged the common view that monetary inflation automatically leads to increases in prices of consumer products. Changes in prices are always a result of conscious actions of entrepreneurs who, in response to the rising prices of means of production—and according to the Cantillon effect, an increase in money supply does not affect all prices uniformly and simultaneously—may apply other strategies, consisting in decreasing the quantity of product or reducing its quality, keeping the nominal prices unchanged.
Thus, monetary inflation is a factor passed over in the literature that may be partially responsible for downsizing and decreasing quality of some products. From this perspective, the above-mentioned actions taken by entrepreneurs do not have to result from their ill will or inherent greed, but from their effort to remain in business in inflationary and competitive environment. Therefore, it seems that the Austrian theory of inflation should be extended to incorporate non-price effects of monetary inflation.
The non-price effects of increases in the money supply clearly show that the impact of monetary inflation on innovation is negative. Instead of promoting products of higher quality, entrepreneurs spend scarce resources to hide the increase in an effective price through changing packaging or reducing quality, which is detrimental to innovation. That impact does not have to be direct, but can result from cutting costs through limiting expenditures on investments.
This paper does not exhaust the subject, but it contributes to further research, perhaps of a quantitative nature. We believe that the presented considerations on non-price effects of monetary inflation have a solid foundation and contribute to the literature on inflation and business strategies adopted in an inflationary environment.
Arguments for a "rules based" Fed are gaining momentum on both the political Left and Right — and even among some libertarians. Would the adoption of ideas like NGDP targeting and the "Taylor Rule" really make the Fed less dangerous? Would they be an improvement on the Fed's current discretionary approach? Can monetary "rules" really contain booms and busts, or would Yellen and company simply break them at the first sign of the next crash? Professor Peter Klein joins Jeff for a discussion.
Read Rothbard's What Has Government Done to Our Money? here.
The great Austrian economist Friedrich Hayek celebrated a birthday earlier this week, while the prominent monetarist (and Fed historian) Allan Meltzer passed away the same day. Joining us to discuss monetarism is our friend Bob Murphy, who lays out the central tenets of the Chicago school and its godfather Milton Friedman. At its heart, Bob explains, monetarism is a cousin of Keynesianism—one advocates fiscal stimulus, the other monetary stimulus. Both go astray when it comes to money, and both fail to see the trees in the macro forest. Bob explains why in this great discussion of the differences between the Austrian and Chicago schools.
[From the Austrian Economics Newsletter, Fall 1987.]
James McGill Buchanan is the founder of the New Political Economy called Public Choice. He had devoted his 40-year career to applying the economic tools of methodological individualism and subjectivism to the study of government and political decision making. He has made important and pioneering contributions in the areas of Constitutional Economics, public deficits and debt, the subjective nature of cost, public resource allocation and political theory. In recognition of his many contributions he was awarded the 1986 Alfred Nobel Prize in Economic Science.
Professor Buchanan, currently teaching at George Mason University, received his doctorate from the University of Chicago in 1948 where he was a student of Frank Knight. In 1957, he and Prof. Warren Nutter founded the Thomas Jefferson Center for Studies in Political Economy and Social Philosophy at the University of Virginia. Buchanan and Prof. Gordon Tullock established the Center for the Study of Public Choice and the journal, Public Choice at Virginia Polytechnic Institute in Blacksburg, Virginia in 1969. In 1982, both Buchanan and the Center relocated at George Mason University in Fairfax, Virginia.
Buchahan has authored or co-authored a prodigious 23 books. The Calculus of Consent written with Gordon Tullock, formed the foundation of Public Choice theory. Cost and Choice and L.S.E. Essays on Cost (edited with G.F. Thirlby) are influential “classics” on the subjective notion of costs. His work on government deficits and debt was capped off with Democracy in Deficit: The Political Legacy of Lord Keynes written with Richard Wagner. Also to his credit are over 300 articles and contributions to books. The following interview was conducted by Austrian Economics Newsletter editors Mark Thornton and Sven Thommesen earlier this year during Professor Buchanan’s visit to Auburn University.
AEN: Professor Buchanan, congratulations on being awarded the Nobel Prize in Economics.
Buchanan: Thank you. It is an honor that I did not expect. I had heard rumors last year that I was being considered for the Prize. However, when it was awarded to Sir Richard Stone, a man who had been retired for many years, I gave up hope of ever winning the Prize.
AEN: People have often labeled your work “normative.” Could you give us your thoughts on striking the balance between truth-seeking and advocacy?
Buchanan: I have never been especially concerned about making a sharp dividing line between what is positive and what is normative. I don’t consider myself a scientist whose task is discovering a reality that somehow exists independently of me. The model of hard sciences is not at all appropriate for economics. There is an important distinction to be made between taking an ideological position and then trying to make arguments to support that position, and on the other hand, working out the consequences of ideas and coming to an ideological position.
People do sometimes interpret my work as always being in defense of liberty. But it is less a preconceived notion and more a result of my methodology. It’s analogous to an artists that only knows and uses red paint. You should not be surprised when his paintings come out in various shades of red. Methodological individualism characterizes everything that I’ve done because I simply don’t know how to proceed with anything else, as if I only had red paint. Another artist might consciously decide to create a red painting so he goes out and buys red paint. But that is an entirely different approach.
AEN: You have made several important contributions in the area of government deficit finance. What do you think of Robert Eisner’s (recently elected President of the American Economic Association) recent work on government deficits?
Buchanan: The work itself is rather confusing. What is clear, however, is that he is an unreconstructed Keynesian and starts from a position of Keynesian advocacy of government deficit financing. He argues that deficits are not really so enormous, if we use his measure. This is a very good example of how data can be manipulated to support and prove anything. And it’s also very good evidence that econometrics doesn’t mean much.
Professors Leland Yeager and Roger Garrison have pointed out that it is insidious to use inflation as a means to argue that the deficit is not very high. You can always totally eliminate the deficit by printing enough money. By confiscating the value of assets from people who hold dollar claims you could argue that inflation has lowered the “real” value of the deficit, but it seems to me just perverse and extreme to do so.
AEN: There is a wide spectrum of subjectivism from mainstream orthodoxy to Shackle and Lachmann. Where would you place yourself on the spectrum?
Buchanan: Well, I’m certainly much closer to Shackle than I am to the mainstream. I’ve been tempted to go completely along with Shackle and become a very radical subjectivist. But I recognize that if you go all the way down that road you end up with a very nihilistic position. I’m somewhere between von Mises and Yeager on the one hand and Shackle on the other. The person who comes closest to my methodological position is Jack Wiseman.
AEN: Speaking of radical subjectivism, what do you think of the prospects of hermeneutics in the realm of economics?
Buchanan: People I respect a great deal from the German tradition, who know and work in the hermeneutics literature, are very negative on what it can offer economics. I have met some very capable people in interpretive philosophy and they do have a very convincing critique of modern science and in particular economics. But in a way, it’s very much like Shackle, if you go too far you end up with nothing. It’s not a viable independent research program.
AEN: Do you consider yourself an Austrian economist?
Buchanan: I certainly have a great deal of affinity with Austrian economics and I have no objections to being called an Austrian. Hayek and Mises might consider me an Austrian but surely some of the others would not.
AEN: You have become famous by extending economic thinking into the political arena. Other economists are also now involved in some very non-traditional areas such as experimental economics and sportometrics. Is this economic imperialism, as members of other disciplines charge?
Buchanan: Economics have moved into spheres that were previously barren, analytically and intellectually. Political Science was analytically empty before we started talking about Public Choice. The criticism leveled at Public Choice is that economic motivations have been elevated to a role of primary central importance. Well, it need not be that at all. We argue that economic interest is an important consideration of everybody who participates in a choosing role. The challenge of those who critique Public Choice is to come up with another model.
AEN: You must be very excited to see the debate on monetary constitutions growing. What would you like to see the monetary constitution look like?
Buchanan: I think we need some monetary constitution, but the choice of which one in particular is less important. If you could, in fact, have a gold coin system — pure and simple — that might be best. I confess that I simply cannot understand the Yeager-Greenfield BFH System. I have tremendous respect for Leland Yeager so there must be more to it than I have understood. Some argue that we are gradually evolving towards his system right now. Given the place we are now and the difficulty of making dynamic changes, I would prefer a commodity bundle system or a constant purchasing power dollar.
AEN: What about the problem of incentives for federal bureaucrats, and the tremendous information problem involved with the constant purchasing power dollar schemes?
Buchanan: You can design an incentive structure by indexing the salaries and pensions of the members and employees of the Federal Reserve System. Fix the salaries and pensions in nominal dollars, which would prevent them from inflation and use double indexing, so that they would lose from deflation as well.
The big problem with any of these systems is credibility, and of course, that’s the big virtue of having some kind of market money like a commodity bundle or gold. It builds in predictability. However, you can still have the credibility problem because you can’t be sure if government will leave the system alone. They have always interfered in the past. That’s also a problem with Hayek’s competitive money.
AEN: What do you see as good developments in economics?
Buchanan: I think there are many very productive developments such as the new-institutional economics, law and economics, property rights, public choice, the new economic history, and the revival of Austrian economics. All of these areas are complementary and all, in a sense, can be seen as an attack on the conventional orthodoxy.
AEN: In the past you have said that modern economics is without any ultimate purpose or meaning. Has your opinion on that changes?
Buchanan: I have been quoted as saying that economics lacks passion. In the last several decades economics has taken a scientistic, econometristic, and formalistic turn. As a result, the economics profession has been attracting students who are not driven by an underlying passion to use the science of economics for anything except intellectual tools and exercise. In my generation people who went into economics had a real passion to save the world. We were all socialists, but some of us became converts or zealots of the market order, individual liberty, and libertarianism.
AEN: Who were the influential people in your intellectual life?
Buchanan: Frank Knight was very influential as a teacher, while Knut Wickesell’s Finanztheoretische Untersuchungen (A New Principle of Just Taxation), had a tremendous impact on my career. I was not as directly influenced by Mises because I was exposed to him quite late. When I was a graduate student nobody even mentioned Mises, although Hayek’s Road to Serfdom had just been published; Hayek was notorious in a sense.
I didn’t become acquainted with Mises until I wrote an article on individual choice and voting in the market in 1954. After I had finished the first draft I went back to see what Mises had said in Human Action. I found out, amazingly, that he had come closer to saying what I was trying to say than anybody else.
Quarterly Journal of Austrian Economics 19, no. 2 (Summer 2016)This ambitious new book on the foundations of money and monetary institutions, based on the the author's Ph.D. disseration defended in 2011 at the Universidad Rey Juan Carlos in Madrid, Spain (supervised by Gabriel Calzada), is an impressive interdisciplinary exercise. Part I of the book, “Metaphysics,” dwells into the nature, origin, and valuation of money. Part II, “Epistemology,” discusses what could possibly be known about monetary phenomena, and how this knowledge can best be acquired. Part III, “Ethics,” proposes a framework for a moral assessment of monetary arrangements and institutions. The last part, “Politics,” which spreads over one third of the book, addresses various issues, such as the history of fiat paper money in the USA, the optimum supply of money and credit, contemporary monetary policy and considerations about the future evolution of money. Five appendices, totaling fifty pages, detail the author’s thoughts on topics as diverse as coined money in Greece, dollarization, financial repression and even the resource curse. The book also contains a ten-page glossary and an extensive index, both of which are meant to help the reader cope with the abundant concepts and authorities to which the author refers. Capitalizing on his interdisciplinary approach, Zelmanovitz hopes to reach a large audience that goes beyond the limited circle of scholarly economists. His plan will certainly be challenged by the book’s price (in excess of hundred dollars).
Quarterly Journal of Austrian Economics 19, no. 2 (Summer 2016)In Finance Behind the Veil of Money, Eduard Braun (2014, pp. 30–36) takes the minority view that opportunity costs are not only unnecessary but even unhelpful to understanding choice.Although Braun claims that “the main arguments in [his] book do not depend on [his] approach to the cost problem”, there is no doubt that his variant of cost theory derives a distinct theory of interest which is of utmost importance in valuing financial assets, one of the main themes of his book. In doing so he follows George Reisman (1996, p. 460) who also views the “doctrine of opportunity cost” as not only unnecessary to ascertain how one makes better decisions, but that its “sole contribution is obfuscation, not perception.” Both Braun and Reisman believe that it is unnecessary to include foregone alternatives in the calculus of cost since it implies that “one must suffer by virtue of possessing the very qualities that create one’s success [i.e., better opportunities]” (Reisman, 1996, p. 460).
Such a view errs by overlooking the difference between the actor’s ex-ante expectations of an action with the ex-post results. More importantly, it mistakes what role costs in general, and opportunity costs by extension, serve in economic theory.
The Quarterly Journal of Austrian Economics
Vol. 19 | No. 2 | 200–213Summer 2016
Book Review
The Ontology and Function of Money: The Philosophical Fundamentals of Monetary Institutions
Leonidas ZelmanovitzLanham, MD: Lexington Books, 2015, xxi + 447 pp.
Nikolay GertchevNikolay Gertchev (ngertchev@gmail.com) holds a Ph.D. in economics from the University of Paris II Pantheon-Assas, and currently works for an international organization based in Brussels, Belgium.
This ambitious new book on the foundations of money and monetary institutions, based on the author’s Ph.D. dissertation defended in 2011 at the Universidad Rey Juan Carlos in Madrid, Spain (supervised by Gabriel Calzada), is an impressive interdisciplinary exercise. Part I of the book, “Metaphysics,” dwells into the nature, origin, and valuation of money. Part II, “Epistemology,” discusses what could possibly be known about monetary phenomena, and how this knowledge can best be acquired. Part III, “Ethics,” proposes a framework for a moral assessment of monetary arrangements and institutions. The last part, “Politics,” which spreads over one third of the book, addresses various issues, such as the history of fiat paper money in the USA, the optimum supply of money and credit, contemporary monetary policy and considerations about the future evolution of money. Five appendices, totaling fifty pages, detail the author’s thoughts on topics as diverse as coined money in Greece, dollarization, financial repression and even the resource curse. The book also contains a ten-page glossary and an extensive index, both of which are meant to help the reader cope with the abundant concepts and authorities to which the author refers. Capitalizing on his interdisciplinary approach, Zelmanovitz hopes to reach a large audience that goes beyond the limited circle of scholarly economists. His plan will certainly be challenged by the book’s price (in excess of hundred dollars).
The author’s research project, though immense, is striking by its clarity: a normative prescription for improving a society’s monetary institutions requires knowledge about the nature and value of money, a proper understanding of the limits of that knowledge and a realistic view about how it could be implemented practically, given the political constraints of the real world. This clarity results in a structural consistency that excites the reader’s curiosity and renders the book pleasant and engaging. The trouble with it is that, despite bringing together different views from several social disciplines, the book is not entirely convincing. Zelmanovitz possesses a vast knowledge of both authors and issues that he puts on show; but he fails to develop a step-by-step criticism-proof argument that alone could gain the reader’s endorsement. The remaining of this review will substantiate this opinion with a discussion of Zelmanovitz’s views in three areas that are foundational of his project: the moral assessment of social institutions in general, the moral justification of central banking in particular, and the theory of monetary equilibrium.
WHAT DISTINGUISHES RIGHT FROM WRONG SOCIAL ARRANGEMENTS?In the author’s intellectual framework, a proper answer to this question is essential for grasping the essence of money, because “the idea is to approach money as a social institution” (p. 1). Thus, the ethical appraisal of present-day monetary arrangements becomes encapsulated in the much broader question of the ethical assessment of social arrangements in general. Zelmanovitz’s preferred criterion for right and wrong is heavily influenced by the objectivist philosophy of Ayn Rand: “It seems difficult to think about a better criterion to define what is right and wrong with social arrangements than measuring them in light of their capacity to allow and to promote human flourishing” (pp. 167–167). The more an institution contributes to the development of the individual persona, the more appropriate it is: “Humans by nature have conscience and intelligence and the very purpose of their social arrangements is to enhance their individual opportunities to reach the limits of their potential, to flourish as individuals” (p. 4). This natural tendency of the human being to purposefully seek his own flourishing would, presumably, have the added benefit of deriving irrefutable normative statements from the very essence of beings and things. Whatever promotes individual flourishing would be right and good, and hence morally justified. This criterion would offer a solution to the alleged impossibility to derive normative claims from descriptive statements: “In the same way, that exception to the fallacy of deriving an ‘ought’ from an ‘is’ applies to what is instrumental to living beings to realize their potential” (p. 2).
As attractive as might appear this functionalist version of a naturalistic moral philosophy, it is a source of deep confusion. First of all, it lacks universality. What exactly does “human flourishing” mean, and does it have the same meaning for any single individual? Is it to be approximated by improved material welfare, longer life expectancy, more profound spiritual development, reduced frequency of military conflicts, intensified trade, etc.? The author is never explicit about his own understanding, though at some point he declares that “the more a system allows the division of labor, the better it is” (p. 14).Notice that this would imply that monastic communities, compared to worldly cities, are inferior social orders. The book somehow conveys the impression that human flourishing is to be understood as the individual pursuit of happiness, and that this would naturally result in an ever-growing division of labor. However, a systematic analysis of the practical means to achieve this very abstract goal, and of its concrete working and implications, is lacking.
Second, Zelmanovitz is conflating social with political institutions. To be more precise, he sees the latter as ordinary human organizations: “[….] because political societies are no more than groups of individuals and their institutions are no more than forms of interaction among those individuals, with everyone pursuing his or her own interest in different fields” (p. 3). This general description, while not necessarily wrong, fails to make the very important distinction between the two mutually exclusive organizational principles of groups of humans: voluntary cooperation and forceful exploitation. It would hardly be an exaggeration to state that all progress in political and moral philosophy is due to the analysis of the implications of this simple but crucial distinction. While it is hard to believe that the author might not be aware of this, he prefers to avoid a rigorous discussion of how individual cooperation restrained by rightfully acquired private property differs from centrally imposed collaboration. Rather, he prefers to confine his discourse within the framework of notions like unintended consequences and spontaneous outcomes.
An obvious problem with that approach is that it grants to the political means of acquiring wealth as much legitimacy as to the economic means, to borrow a famous distinction made by Franz Oppenheimer (1926, pp. 24–27). Spoliation of others’ production and their accumulated property, i.e. the political means, becomes as moral as the initial appropriation through one’s own labor, production and exchange, i.e. the economic means. Put differently, violence becomes legitimized in all circumstances. Such a conclusion, which incidentally empties any social political theory from its scope and meaning, could not possibly be true: a society that would admit indiscriminate violence is self-destructing by design.
The insufficient analysis of what is or is not legitimate violence implies that the very important distinction between the social class of the exploited and the social class of the exploiters is missing from the book. Hans-Hermann Hoppe has shown that these categories are crucial for understanding social evolution (Hoppe, 2001, 2012). In addition, there can be no proper understanding of the state-organized redistribution of resources, as opposed to the market-driven distribution of incomes, without recourse to this same opposition between producers and exploiters. Thus, it comes as no surprise that the author does not discuss at all state monopolies of money production in relation to their impact on wealth redistribution. Nowhere is there any mention of the well-known Cantillon effects, which have become the cornerstone of the Austrian economic and political analysis of fiat paper monies (Thornton, 2006; Dorobăt, 2014). Furthermore, had the author given a proper place to the analysis of political institutions, he would not have sought to integrate, at any cost, the catallactic with the chartalist theories of money. This endeavor, which is the core of Part I of the book, arrives at a dubious conclusion: “One must ask, can the state create value? I think that the answer to that question is undoubtedly yes and all forms of fiat money in circulation today are evidence of that” (p. 44, our emphasis). That fiat money, or for that matter any other good supplied by a monopoly, has value is no proof that its value is created by the monopoly producer. Fiat money value still springs out of its usefulness as appreciated by money users. Consequently, the determination of its purchasing power is subject to the market process, not to a decree that spells out the will of the monopoly producer. Any accommodation with the chartalist view implies a contradiction with the subjectivist theory of value, and hence great difficulties with providing a realistic account of monetary phenomena.A case in point is an extreme monetary phenomenon such as a hyperinflation. A consistent chartalist must take hyperinflations as desired and designed by the state.
IS CENTRAL BANKING LEGITIMATE?The entire chapter seven is dedicated to a discussion of the rationale for central banking. Zelmanovitz rightly discards, even though without much discussion, the most common economic justifications. The question he raises is whether a good political reason for government involvement in money production could be found. He believes he has identified such a good reason thanks to the “qualitative distinction, both legal and moral, between taxation and expropriation” (p. 197). While the book does not offer a systematic presentation of that distinction, the author’s argument is quite clear. There are emergency situations when the protection of society against enemies could not be organized efficiently without confiscating individual resources. Inflationary money printing, which is one method of resource confiscation, is therefore admitted. This is confirmed by monetary history itself, which shows that governments have monopolized money production when they needed resources for their war efforts. This fact of life proves that central banks are morally justified. Each one of these three steps of the rationalization of state monopolies in monetary affairs deserves individual scrutiny.
First, is it true that centralized confiscation of individual property is an efficient means for gathering the supposedly large pool of resources needed to defeat a foreign enemy? The author himself explicitly provides the arguments for negating centralized confiscation, but oddly enough he draws the opposite conclusion: “Therefore, if protection of life and property is of personal value for all individuals, in different circumstances, different efforts may be necessary, regardless of their individual preferences” (p. 210, our emphasis). To the extent that this confiscation is at odds with individual preferences, it is undesired and thereby revealed as reducing people’s welfare. As a matter of fact, in the absence of individual agreement, the confiscator is no longer protector; he becomes the aggressor. Consequently, centrally commanded expropriation could not logically be a means for defeating a foreign enemy. After all, an enemy is defined precisely by his assaulting on individuals’ private property! It is still possible that the author has in mind a kind of a “market failure” situation, in which for technical reasons the “public good” security could not be provided in any other way but through central planning. However, the point that the market could not provide the much needed security against foes would have needed to be substantiated much more deeply, especially in light of the argument that either there is an economic science that establishes the superiority of the competitive principle in all areas of human activity, or there is no economic science at all (Molinari, 2009). Similarly, the author could have subjected the efficiency analysis of a centrally organized war economy to the logical test of the economic calculation argument (Mises, 2008, pp. 201–232).Generally speaking, Zelmanovitz adheres to the Hayekian intellectual universe, in which the achievements of the economic science are closely linked to the deeper integration and application of such notions as subjectivity, knowledge and expectations. The author is definitely not a proponent of the Misesian approach, which is firmly anchored in the entrepreneurial market process itself and its prerequisites, one of which are the objective conditions for rational economic calculation.
Based on this premise, which we believe is contestable, the author builds up his moral case for central banking: “If a central bank is understood as a modern proxy to the monetary prerogatives of government in general, only to be used in cases of extreme emergencies, then a moral defense for its existence may be found in this work” (p. 232). Let us note first that nowhere does the author discuss the mechanisms through which monopolized money production and inflation allow the central authority to seize the resources deemed necessary. The proof of the so-called “fiscal proviso” would have been a welcome occasion to present the Cantillon effects, which we already noted are missing in this work. Moreover, given that other means for collecting resources, such as taxation or bond issuance, are also available, the superiority of inflation should have been established. As far as the argument itself is concerned, it is straightforward that even if the premise were valid, it would justify central banking exclusively in the very specific cases of presumably rare emergencies. Would not this imply that, once the emergency has been resolved, the central bank should be declared unjustified in the new circumstances, and therefore dismantled? Fearing this type of criticism, the author comes up with a really astonishing defense.
Zelmanovitz provides a condensed summary of Rothbard’s monetary history of the United States (Rothbard, 2002), in which he shows how fiat paper money and central banking became institutionalized in the context of budget deficits in need of funding. The whole point of this narrative is to convince the reader that the historical events rendered the acceptance of the “fiscal proviso” inevitable: “[….] to understand the ‘fiscal proviso’ as a mere act of force, deprived of any moral justification, even utilitarian ones, seems very unrealistic in light of the future events in the monetary history of the United States” (p. 220). In the concluding remarks to this chapter, the author becomes even more explicit: “This attitude of disregard for individual property rights is the ‘natural’ response of different governments in different historical moments. It is a ‘fact of life’“ (p. 231). In other words, the very existence of central banks, understood as the natural response of governments to somehow inevitable historical circumstances, provides a moral case in their defense.Another general feature of Zelmanovitz’s work is that practical facts often take pre-eminence over theoretical considerations. A case in point is his confession that “Ultimately, the argument in favour of a 100 percent reserve requirement that convinced me is Buchanan’s argument that once base money is no longer expensive to produce, there is no more reason to have a banking system designed to economize on it” (p. 342). But this practical argument only begs the question why, then, fractional reserve banking still persists. The answer would require a thorough theoretical study, inter alia of redistribution effects and their links to vested political and economic interests. Two objections could be spelled out. First, the argument confuses historical explanation and moral justification, which are two distinct thought processes. Were they one and the same, all things would be right by virtue of their merely being what they are. Second, and this is related to the observations from the previous section, a full-fledged theory of the government would have been needed in order to show how the progressive setting-up of a central bank as a monopolist producer of fiat paper money is, indeed, in the nature of growing governments.
Even though the author believes that he has proved a moral case for central banking, he still describes himself as an advocate for a monetary reform that would allow the individual to fully accomplish his potential. This is the last point that needs to be reviewed in some detail.
THE THEORY OF MONETARY EQUILIBRIUM AND ITS IMPLICATIONS FOR MONETARY REFORMIt is unfortunate that, in his quest for an interdisciplinary approach to money and banking, the author does not present a structured exposé of the economic analysis of money, and more specifically of an economy’s monetary equilibrium. Nevertheless, several of his comments suggest that he is a proponent of the real bills doctrine, which puts him at odds with the Austrian approach to money and banking.Zelmanovitz is heavily influenced by the monetary disequilibrium theory of Leland Yeager. However, while Yeager (1986) conceptualizes about the monetary (dis)equilibrium in real terms, Zelmanovitz’s discussion is exclusively in nominal terms. Both authors share the view that prices convey information and incentivize human action. As a result of this view about monetary equilibrium, he is advocating a reform that would ensure the flexibility of the money supply in order to accommodate changes in the demand for money, while guaranteeing the stability of money’s value. Finally, this reform would be driven by an ongoing tendency towards a higher level of abstraction and a growing dissociation between the unit of account and the medium of exchange functions. Let us elaborate on each of these points.
Zelmanovitz introduces the supply of and the demand for money in two very short paragraphs (pp. 238–239) and represents a neoclassical type of equilibrium in a chart (p. 244). He does not explain which forces actually bring about the monetary equilibrium, and what their impact on prices is. Had he done so, he would have discovered the real cash balances doctrine, according to which changes in the demand for money imply increased selling or buying of other goods against money, and hence changes in monetary prices. Whatever the stock of nominal units of money, i.e. whatever the supply of money is, price changes always guarantee that this nominal stock can satisfy any demand for real cash balances. The conclusion that changes in the purchasing power of money ensure monetary equilibrium at any time is the greatest achievement of the Austrian theory of money and banking. Building upon its foundations, Murray Rothbard declared “that there is no such thing as ‘too little’ or “too much” money, and that, whatever the social money stock, the benefits of money are always utilized to the maximum extent. An increase in the supply of money confers no social benefit whatever; it simply benefits some at the expense of others, […]” (Rothbard, 2009, p. 766, original emphasis).
The author adopts the exact opposite view, claiming that there are great social benefits to be expected from a flexible supply of money:
A relatively constant amount of money chased by a sudden increased demand will force fire sales and economic disruption. Even under relatively calm circumstances, a relatively inflexible monetary supply is not necessarily one that would adjust automatically to changes in the demand for money without somewhat important changes in money value. (p. 326)
The idea that deflationary pressures are disruptive is recurrent: “If the government keeps the supply of money constant in face of an increased demand for money, or worse, allows its contraction, it will force asset liquidations beyond the misallocations that need to be corrected, producing even bigger economic devastation, human suffering, and social unrest” (p. 242). The contraction referred to is specific to the fractional reserve banking system where loss of confidence during the downturn implies a decrease in the money supply: “[…] the banks are forced to ‘deleverage,’ that is, to call back the loans they made in order to repay the investors/depositors. Since the very essence of the system is the creation of multiple financial claims over the same amount of base money, […], that liquidation becomes problematic” (p. 207). Only an accommodative monetary policy would alleviate these alleged problems:
Therefore, while the current monetary constitution remains in place, any decision by the central bank of not providing more liquidity for the banks, and consequently forcing all economic agents, in their increased demand for cash balances, to compete for a fixed supply of money, would represent an additional effort of adaptation from society on top of the effort required to liquidate all the existing misallocations. (pp. 253–254)
There are at least three major problems with the contention that changes in the demand for money need to be matched by changes in the supply of money in order to avoid economic disruptions. First, as already pointed out, the monetary equilibrium is restored through market-driven price changes that both reflect individuals’ new preferences to hold more or less money relative to other goods and adjust the demand to hold real cash balances to the existing nominal supply of monetary units. Second, the alleged social disruptions and hardship triggered by liquidations that would go beyond those necessary to correct malinvestments are pure myths (Bagus, 2015, pp. 94–108). Should prices go below what they would have been, this would imply that those entrepreneurs that buy assets at below-equilibrium prices make profits that are explained by the corresponding losses of the selling asset-holders.Notice also that the deflationary recovery situation is fundamentally different from that of an inflationary unsustainable boom. The deflation facilitates the redistribution of existing assets from failed entrepreneurs to capitalists that consider themselves better at the art of managing assets. The deflation does not lead to waste of resources. On the contrary, the inflationary boom consists in wrong investment decisions that imply aggregate net losses and waste of resources due to the non-convertibility of some capital goods. Speculation and arbitrage would consume these possible gains until prices are restored to their equilibrium levels. From that point of view, it is even difficult to claim that there is an optimal level of liquidations corresponding to some needed adjustments, as these adjustments and liquidations are determined by the market process itself. Third, one of the book’s themes is that limitations on our individual knowledge lead to a skepticism that is “reflected in doubts about the ability to know what the quantity of money existing in society is at any given time” (p. 141). If according to the author even the supply of money cannot be known exactly, how could the authorities know what the changed demand for money is, and how could they know how to accommodate it? It seems to us that if there were knowledge limitations, they would immediately discard the very possibility for a designed policy that could do better than the natural market process.
Based on his approach to monetary equilibrium, Zelmanovitz offers a very general blue-print for monetary reform that relies on the need for a built-in flexibility of the money supply. He sees two salient features of such a reform, which he also considers historically inevitable: “The time for a monetary system in which the unit of account will be entirely abstract and all monetary merchandise will be securities is very close” (p. 318). In other words, a double dematerialization of money should occur. First, securities alone would become the most commonly used media of exchange. The author does not provide a complete explanation of why this would be so. However, one could imagine that this is the case because the issuance of securities would provide the needed flexibility for the supply of money to automatically adjust to changes in the demand for money. Second, accounting would be conducted in an independent abstract unit, so that the flexibility of the medium of exchange would not be restrained in any way whatsoever.
How realistic is this proposal for reform? Without entering into much detail, let us mention what we consider as two stumbling blocks. First, while a unit of account could exist without also being used as the unit of measure for the medium of exchange, both units are bound to be linked to each other. If that were not the case, then the function of unit of account would be overtaken by the medium of exchange itself. For instance, the French livre has been indeed a pure accounting unit. However, at any given moment, it was defined as a specific quantity of sous, deniers or francs. Even though this specific quantity has varied at different times, the link itself between the livre as a unit of account and the units of the circulating medium of exchange has been permanent. This practical example is not the result of a historical contingency; things could not have been otherwise. A completely abstract unit of account would imply that accounting itself has become abstract, i.e. disconnected from reality. This is logically impossible, as accounting has one purpose only, namely to provide the most faithful possible account of reality in monetary terms. For that account to be inter-subjectively communicable within a given community of individuals, the monetary terms in which it is expressed must be universally accepted within that community. This already implies that securities, each with its own characteristics and risks, could not become universal media of exchange, i.e. money. To the contrary, money appeared precisely as a solution to the tremendous problem of appreciating the liquidity of goods and assets with unknown marketability. To consider that securities could ever become the “monetary merchandise” implies one of two things. Either this would be a de facto return to barter, with all its implications in terms of hindered economic calculation, and hence reduced division of labor. Or this would imply that each security issuer has become an issuer of his own money. The result of this type of monetary freedom has been predicted long ago by the banker Henri Cernuschi (Mises, 2008, p. 443).
CONCLUSIONOverall, despite the weaknesses highlighted above, Zelmanovitz’s book will be appreciated by the initiated reader. It raises a very large number of relevant questions and puts together, in a thought-provoking way, a wealth of notions and concepts. However, these very same qualities that distinguish the diversified erudite are also pretext for some uneasiness, mostly related to the approach chosen.
First, the interdisciplinary approach is bound to economize on a systematic presentation of any of the specialized branches of knowledge that it exploits. This makes any such project both very difficult to understand by beginners and exposed to easy criticism by specialists. Given these unavoidable pitfalls, Zelmanovitz succeeds rather well in this delicate exercise in versatility. However, the question remains to what extent this approach deepens our knowledge of money and of monetary institutions and policy. In particular, what is its superiority to an exclusively economic study of a very specific issue that would carefully elaborate on the existing (narrow) theory?
Second, interdisciplinarity often goes hand in hand with an attempt at reconciling various epistemologies and schools of thought. This is also the case with Zelamnovitz’s book, which expresses his “convictions about the possibility in the future to recreate a consensus about good economics” (p. xxi). However, in science, truth alone is the single criterion for goodness. To the extent that concessions and compromises with the truth are needed for deriving an ecumenical position, consensus-building appears unscientific. Moreover, progress in science does not need consensus. Truth is out there to be studied and analyzed by all interested students, and arguably the discoveries of its various aspects have been consensus-breaking, rather than consensus-building. Admittedly, this is a much broader debate, which falls beyond the limited scope of this review.
REFERENCESBagus, Philipp. 2015. In Defense of Deflation. London: Springer.
Dorobăt. Carmen E. 2014. “Cantillon Effects in Contemporary Monetary Thought.” In M.V. Topan, and D.O. Jora, eds., The Cure for Crises. Bucharest: Rosetti International.
Hoppe, Hans-Hermann. 2001. Democracy, The Gold That Failed: The Economics and Politics of Monarchy, Democracy, and Natural Order. New Brunswick, N.J.: Transaction Publishers.
——. 2012. The Great Fiction. Auburn, Ala.: Ludwig von Mises Institute.
Mises, Ludwig von. 1949. Human Action: A Treatise on Economics. Auburn, Ala.: Ludwig von Mises Institute. Scholar’s Edition. 2008.
Molinari, Gustave de. 1846. The Production of Security. Auburn, Ala.: Ludwig von Mises Institute. 2nd edition, 2009.
Oppenheimer, Franz. 1914. The State: Its History and Development Viewed Sociologically. New York: Vanguard Press. 1926.
Rothbard, Murray N. 1962. Man, Economy, and State with Power and Market. Auburn, Ala.: Ludwig von Mises Institute. 2nd edition, 2009.
——. 2002. History of Money and Banking in the United States: The Colonial Era to World War II. Auburn, Ala.: Ludwig von Mises Institute.
Thornton, Mark. 2006. “Cantillon on the Cause of the Business Cycle.” Quarterly Journal of Austrian Economics 9, no. 3: 45–60.
Yeager, Leland B. 1986. “The Significance of Monetary Disequilibrium.” Cato Journal 6, no. 2: 369–399.
The Quarterly Journal of Austrian Economics
Vol. 19 | No. 2 | 178–186Summer 2016
“Finance Behind the Veil of Money”: A Rejoinder
David HowdenDavid Howden (dhowden@slu.edu) is professor of economics at Saint Louis University, Madrid Campus
In Finance Behind the Veil of Money, Eduard Braun (2014, pp. 30–36) takes the minority view that opportunity costs are not only unnecessary but even unhelpful to understanding choice.Although Braun claims that “the main arguments in [his] book do not depend on [his] approach to the cost problem”, there is no doubt that his variant of cost theory derives a distinct theory of interest which is of utmost importance in valuing financial assets, one of the main themes of his book. In doing so he follows George Reisman (1996, p. 460) who also views the “doctrine of opportunity cost” as not only unnecessary to ascertain how one makes better decisions, but that its “sole contribution is obfuscation, not perception.” Both Braun and Reisman believe that it is unnecessary to include foregone alternatives in the calculus of cost since it implies that “one must suffer by virtue of possessing the very qualities that create one’s success [i.e., better opportunities]” (Reisman, 1996, p. 460).
Such a view errs by overlooking the difference between the actor’s ex-ante expectations of an action with the ex-post results. More importantly, it mistakes what role costs in general, and opportunity costs by extension, serve in economic theory.
In his “Reply” in this issue, Braun demonstrates this misunderstanding of the ex-ante and ex-post roles of opportunity costs when he criticizes Rothbard's (1962, p. 606–607) analysis of the relationship between monetary and psychic profits.Although Reisman does not cite this example from Rothbard, he argues against several similar examples (1996, pp. 459–460). In Rothbard's example, an investor spends 5,000 gold oz. to earn 1,000 oz. net profit. The foregone alternatives are comprised of 1) 250 oz. he could have earned by investing his capital at the prevailing interest rate of 5 percent, 2) 500 oz. he could have earned by working for a competing firm, and 3) 400 oz. of lost income since he used his factory instead of renting it out. With total opportunity costs of 1,150 oz., Rothbard concludes that the “entrepreneur suffered a loss of 150 ounces over the period. If his opportunity costs had been less than 1,000, he would have gained an entrepreneurial profit” (Rothbard, 1962, p. 607).
Braun objects to Rothbard’s conclusion for two reasons. First, he finds it questionable that Rothbard constructs “arbitrary” figures to define the investor’s opportunity costs. Yet while these figures may seem arbitrary to Braun, they are an assumption by Rothbard and real to the hypothetical investor. The 1,150 oz. in foregone income is actually what the investor could have earned had he used his resources differently. The investor knows these figures through the benefit of hindsight, and from them he can determine from an ex post facto perspective the sum his foregone opportunities could have yielded.
Second, Braun objects to the conclusion that the entrepreneur made a loss. He did, after all, come out of his investment 1,000 oz. richer than he started and this is, as Braun correctly states, profit according to “traditional accounting principles.” The point of Rothbard’s example is not to show that the investor did not earn a monetary profit, but rather to show that he could have done better. The fact that he earned an entrepreneurial loss provides a signal that he must do better in the future or be forced out of the market. To forestall one objection to this conclusion, one could counter that as long as the firm earns positive monetary profits it will not risk insolvency and thus will remain in the market. Such an objection fails to realize that the firm would be forced out of the market if all other competing firms changed their activities in a way that maximized their entrepreneurial profits while one firm continued incurring entrepreneurial losses (as in this example). This is because a firm must not only earn positive (absolute) monetary profits to remain in business, but must also earn positive entrepreneurial profits relative to other firms, lest those firms undercut its business and steal market share (as in Carilli and Dempster, 2001, p. 326; Huerta de Soto, 2006, pp. 664–671). No firm can continue earning entrepreneurial losses indefinitely, and so an ex post facto assessment of the relevant opportunity costs is an essential part of the entrepreneurial process.
Constraining cost to a specific monetary expenditure instead of a general opportunity foregone does a great injustice to the decision-making process. The beauty of Rothbard's (1962, 606–607) example is that the entrepreneur now realizes he has erred. Braun places the goal of maximizing money income as primal for the entrepreneur (Braun, 2014, pp. 109, 115, 116 and passim), yet his approach leaves no method for the entrepreneur to see if he has, in fact, done so.
Although Braun focuses on this example from Rothbard, his (and Reisman’s) largest objection to the opportunity cost doctrine is that it leads to the conclusion that having more options is worse for the individual, since they believe that the more options one has, the greater will be the cost of the foregone alternative. In this regard, I will (re)address Braun's (2014, p. 32) apple example:
Let us suppose friends X and Y are on a trip in the mountains. X has two apples in his bag. Y loves apples, but has forgotten to pack one. During the first break, X permits Y to take one of the apples. Well, one could say this is a great deal for Y! However, things look differently if one takes into account opportunity cost. As soon as Y takes one of the two apples, he abstains from taking the other one. If we assume, for simplicity, that the two apples are alike, then the disadvantage in this decision is just as great as the advantage. According to opportunity-cost theory, Y is not better off at all although he has received an apple for free. His preference for one of them cost him the other one.
This case has two solutions. The first is to treat the two apples as they are in the example: alike (or, as I [Howden, 2016, p. 125fn1] have shown in more conventional terms, that X is indifferent between the two apples). I addressed previously the unconventional nature of this problem for the Austrian-school economist, not least because the assumption of indifference is not well accepted (see, e.g., Rothbard, 1956), and I provided one method to analyze this problem within an Austrian framework (Howden, 2016, p. 126).A second objection to Braun’s analysis is that Braun combines two choices into one alternative. In actuality, the hiker first has the option of choosing an apple or starving, and second he must choose between which apple to consume. I (2016, p. 125) alluded to the similarities with Buridan’s ass in the first of the two choices, and I thank Jonathan Newman for pointing out the second.
In his “Reply” in this issue, Braun relaxes the assumption that the hiker is indifferent between the two apples. His basic result is the same, which leads Braun to conclude that “[t]he purpose of the example is to show that if one takes the opportunity cost concept seriously, having options is worse and leads to less profit than having no options at all.”
On the one hand, if Braun's hiker had “no options at all,” he would starve, which is likely a worse outcome than having two apples to choose from. But there is an apparent grain of truth to the statement. The more options one has at his disposal, the more satisfying will be the “next-best alternative” the actor must forego for any course of action. While one might believe that this leads to an increase in opportunity cost for the actor a close analysis reveals this is not the case.
Assume the thirsty and hungry hiker has the following preference ranking:
Table 1: The Hiker’s Preference Ranking
Faced with the option of consuming either the red or yellow apple, the hiker chooses the more highly valued red apple and expects to earn the psychic profit from the difference in his preference between the red apple and the best foregone alternative, the yellow apple, leaving him with the expectation of psychic profit x as in Table 2.
Table 2: Revenues, Costs and Profit
Now assume that the offer of the yellow apple was retracted, and the hiker was offered the choice between only the red apple and a granola bar. Using Braun and Reisman’s logic, since the granola bar is less highly valued than the yellow apple, his foregone alternative will be less and thus his psychic profit will increase. Taking this extension to its conclusion, if the friend only offers a red apple, the foregone alternative will be death. Forgoing this lowly valued alternative would leave the hiker with the largest amount of psychic profit. It is this logic that Braun and Reisman have in mind when they consider having more options to be bad for the actor since more options seem, ceteris paribus, to reduce psychic profits.
As any hungry hiker can attest, the fact that the hiker is nourished but will only receive a seemingly small amount of psychic profit (both ex ante and ex post) must strike the reader as odd. He did, after all, forestall death by having one apple presented to him, and surely being offered either of two apples must be better yet. The reconciliation to this paradox comes from using the opportunity doctrine within its proper domain.
The first use of opportunity cost is to determine which alternative to pursue by focusing on that which foregoes the least valuable alternative. In Table 3 we can see that there are only two possible best foregone alternatives. For the 2nd through nth ranked options the best foregone alternative will be the 1st ranked alternative (i.e., the red apple). For the 1st ranked option, the best foregone alternative will be the 2nd most highly ranked alternative (i.e., the yellow apple). Since the red apple is preferred to the yellow apple, pursuing the 1st ranked alternative will result in the lowest opportunity cost.
Table 3: Opportunity Costs
Alternatively, one can see that choosing the most highly ranked option will also result in the highest amount of expected psychic profit. The first ranked alternative will be the only one that incurs an opportunity cost valued less highly than it is. Thus only the first ranked alternative can create a positive amount of expected psychic profit, as in Table 4.
Table 4: Psychic Profit
Note that adding more options does not change this analysis. The hiker will still choose the red apple even if we add a new alternative (except if the new alternative is more highly ranked than the existing red apple). Braun is incorrect in stating that “having options is worse and leads to less profit than having no options at all.” Adding a new option to the actor’s preference ranking will either: 1) create a new negative expected psychic profit (which is of no relevance since the option will not be pursued), if the alternative is ranked 2nd or lower on the preference rank, or 2) increase the expected psychic profit if the newly introduced option takes the 1st place on the preference rank.
The second use of opportunity costs is an ex post facto assessment to determine if the chosen option was the correct one. It is this use that Braun and Reisman invoke often, though to illustrate (incorrectly) buyer’s remorse.Strangely, Reisman does not use this ex post role of opportunity costs in “ascertaining how one might do better” (1996, p. 460). In a similar way, Braun does not realize that when he laments that the opportunity cost doctrine “neglects costs when they actually arise—in action” that it is this ex-post facto assessment that allows the actor to use opportunity costs with the benefit of the hindsight that his action allows for (Braun, 2014, p. 33). (I deal with this latter objection by Braun in Howden (2015, pp. 579–580).) While the previous ex ante role of opportunity cost rests on expectations of both revenues and profits, in the ex post role we actually know how events did turn out. Of course it could be that we chose wrong, e.g., the red apple might have been rotten. With this new knowledge we can revise our preference ranking, perhaps shifting the red apple lower in the expectation that other similar apples may also be rotten. In this way, we partake in a trial-and-error process that improves our decisions in light of newly revealed information concerning the nature and relationship of expected psychic revenues and resultant opportunity costs. Buyer’s remorse is not a sign that the use of opportunity costs is deficient, but that our estimations of what those costs could have been differed from their actual realization.
Braun insists that all costs be treated as historical money costs. Of course it is one of the great advantages of the price system that money prices provide a common denominator in which all values can be distilled to and compared with. The common denominator of money is thus essential to compare different foregone alternatives on an even footing, so Braun is half right when he focuses on money costs. He errs, however, to the extent that money revenues comprise only some of the opportunities foregone.
In the simplest example used by every Principles of Economics instructor, the cost for the student to pursue a university degree is four years of tuition plus four years of time foregone. Four years of tuition is easily valued and (before discounts and scholarships) equal for all students (e.g., four years at $40,000 per year). The time foregone can only be compared with this monetary cost if it is valued in money terms. Since the particular monetary value on time will differ depending on one’s opportunities the easiest method to value these four “lost” years is with wages foregone. If one could have worked at a job for $20,000 per year, the value of these four years will be $80,000. Taken together, the total opportunity cost of a university education is $240,000, of which $160,000 will be an actual money outlay and the remainder lost wages. The student will register for university if he values the four-year degree more than the value of the foregone alternatives, $240,000.
Braun wants to throw the baby out with the bathwater in ignoring the lost wages, since they are not a historically incurred monetary cost. This would set the bar much lower for students to decide to go to university (among other decisions) since, e.g., in the above example only two thirds of the foregone alternatives were in a historically incurred monetary form. It is trivial to state the importance of the value of the non-monetary foregone alternatives since they can, in many cases, make the monetary costs negligible.I would venture that the vast majority of our decisions have no monetary component, and can only be decided on by comparing expected psychic revenues. My decision to watch Real Madrid play soccer instead of FC Barcelona can be explained with tables 1 through 4 by substituting watching Real Madrid as my most preferred alternative and FC Barcelona as my second ranked option. No money changes hands, but only one choice will have a positive expected psychic profit. Braun could counter that he focuses on business decisions, which generally have a money component. This would only beg the question as to why a different decision-making process is necessary for businesses than individuals.
I will close by asking how Braun would solve the following question without resorting to non-historically incurred monetary costs.
Students A and B value a university education the same, and also must pay the same tuition rate. A has few opportunities in life and the best foregone use of the four years is a minimum wage job (i.e., $80,000). B has an offer to play basketball for the Cleveland Cavaliers for $13 mn. for the first three years, with an option to play a fourth year for $6 mn. B opts to not go to university, while A registers in an undergraduate economics program.
Given that the preferences and historically incurred monetary costs are identical, how does Braun propose to explain the difference in choice?The interested reader can find the correct answer in Howden (2016b).
REFERENCESBraun, Eduard. 2014. Finance behind the Veil of Money: An Essay on the Economics of Capital, Interest, and the Financial Market. Liberty.Me.
Carilli, Anthony M., and Gregory M. Dempster. 2001. “Expectations in Austrian Business Cycle Theory: An Application of the Prisoner’s Dilemma,” Review of Austrian Economics 14, no. 4: 319–330.
Howden, David. 2015. Review of “Finance Behind the Veil of Money: An Essay on the Economics of Capital, Interest, and the Financial Market, by Eduard Braun,” Quarterly Journal of Austrian Economics 18, no. 4: 578–583.
——. 2016a. “Finance Behind the Veil of Money: Response to Dr. Braun’s Comment,” Quarterly Journal of Austrian Economics 19, no. 1: 124–128.
——. 2016b. “On Opportunity Costs.” Working paper.
Huerta de Soto, Jesús. 2006. Money, Bank Credit, and Economic Cycles, trans. Melinda A. Stroup. Auburn, Ala.: Ludwig von Mises Institute.
Reisman, George. 1996. Capitalism. A Treatise on Economics. Ottawa, Ill.: Jameson Books.
Rothbard, Murray N. 1956. “Toward a Reconstruction of Utility and Welfare Economics.” In The Logic of Action, vol. 1. Cheltenham, U.K.: Edward Elgar, 1997.
Rothbard, Murray N. 1962. Man, Economy and State, Scholars ed. Auburn, Ala.: Ludwig von Mises Institute, 2007.
The Quarterly Journal of Austrian Economics
Vol. 19 | No. 2 | 173–177Summer 2016
Reply to Dr. Howden on Opportunity Costs
Eduard BraunDr. Eduard Braun (eduard.braun@tu-clausthal.de) holds a postdoctoral position at the Clausthal University of Technology.
INTRODUCTIONHowden (2016) dedicates a large part of his response to criticizing my way of dealing with and classifying the concept of opportunity costs in my book (Braun, 2014). I must start by saying that the main arguments in my book do not depend on my approach to the cost problem. The main reason why I considered it necessary to abandon the opportunity cost concept is that I found it impossible to apply it to the analysis of human action in the passing of time. For this purpose, the concept of costs as employed in business life, where profits are traditionally not calculated on the basis of opportunity costs but as historically incurred monetary expenses,Though government intervention has partly changed this in recent years (see Huerta de Soto, 2012, pp. xxiv–xxix). are much more useful. It appeared to me that if “the interest rate expresses itself in the difference between income and costs at each stage” (Huerta de Soto, 2012, p. 557), the costs must not be understood as foregone opportunities but as historical outlays.
CRITICAL REFLECTIONS ON THE OPPORTUNITY COST DOCTRINEMost Austrians agree that costs are a praxeological phenomenon. Each action implies the incurrence of costs. In the terminology of Rothbard (1962, p. 104; see also Mises, 1949, p. 97), the objective of human action, i.e., psychic profit, can be expressed as follows:
psychic profit = psychic revenues - psychic costs
When it comes to analyzing the actions of entrepreneurs the term “psychic” is substituted by the term “monetary” as it is the purpose of business enterprises to generate monetary, not psychic income. We therefore get:
monetary profit = monetary revenues - monetary costs
These statements are uncontroversial. The disagreement between Howden and myself consists in that I do not define the costs in these formulas in the same way as do most Austrian economists or, for that matter, mainstream economists. They consider all costs to be opportunity costs. Opportunity costs are usually defined as the evaluation placed on the most highly valued alternative or opportunity that was rejected in a choice among alternatives. In the following, I will point out what I consider to be the rather questionable implications of the opportunity cost doctrine.
In his discussion of market calculation, Rothbard (1962, pp. 606ff.) provides an example of an entrepreneur who has invested 5,000 ounces of gold in his business and therefrom earns a net income of 1,000 ounces over a one-year period. According to traditional accounting principles, these 1,000 ounces are profit. Rothbard (1962, p. 607) however argues that the entrepreneur still has to deduct from this net income “his implicit expenses, i.e., his opportunities forgone by engaging in the business.” Only then has the entrepreneur arrived at a figure that denotes his profit or loss. Rothbard gives the following (hypothetical) numbers for these “opportunities foregone”: The entrepreneur could have earned 250 ounces of interest if he had not invested his 5,000 ounces in his business; he could have earned 500 ounces in wages if he had sold his labor on the market; and 400 ounces if he had rented out his land instead of using it in the business. Together, he could have made 1,150 ounces if he had not engaged in the business. Therefore, Rothbard (ibid.) argues, “the entrepreneur suffered a loss of 150 ounces over the period.”
In short, although our entrepreneur has earned 1,000 ounces, Rothbard claims that he has made a loss of 150 ounces because the entrepreneur could have earned 150 ounces more if he had invested his resources outside of his business — in other words, because his opportunity costs were higher than his revenues.
I am not the only one who considers this kind of reasoning to be questionable. Reisman (1996, p. 460) gives an analogy to Rothbard’s procedure: “One gains ten pounds, but might have gained twenty pounds. This is then taken to mean that one has lost ten pounds.” Reisman (ibid.) then goes on to state the implications of the opportunity cost doctrine as propagated not only by Rothbard, but by most economists:
It follows from the opportunity-cost doctrine that precisely to the degree that one is confronted with profitable ways to invest one’s capital, and precisely to the degree that one’s services are in great demand, one’s income must be less—in a word, that one must suffer by virtue of possessing the very qualities that create one’s success.
In my book, I drew on Reisman’s critique and formulated my reservations in the following way: According to the opportunity cost concept, “the possibility of choosing between several alternatives—a possibility that one would think to be beneficial from the point of view of the person choosing—appears to be something bad, even destructive” (Braun, 2014, p. 32). The better the alternatives among which one can choose, the smaller the resultant profits.
It is in the context of this argument that I provide the example of the two friends and their apples that Howden (2016) discusses at length. The point of this example is that according to the opportunity cost doctrine there is a great difference between the case where friend A is allowed to choose which one of the two apples of his friend B he prefers and the case where A simply gets one of B’s apples without being asked to choose. If A is allowed to choose between the two apples, the apple he does not pick constitutes the opportunity costs of his decision. If the apples should happen to be very similar, the revenues of A (the apple he chooses) would almost be matched by his costs (the apple he does not choose) and his psychic profit would be minimal. As opposed to that, if A simply received an apple without having to choose, his profit would be much greater because his revenue would not be matched by any offsetting costs.Howden (2016) objects to this example on the grounds that I have assumed (in my book) that both apples are alike, which in his point of view implies that it is impossible to choose between them. In order to show that this assumption is unnecessary, I have dropped it in the above rendition.
The purpose of the example is to show that if one takes the opportunity cost concept seriously, having options is worse and leads to less profit than having no options at all. This is the reason why both Reisman and I do not find it helpful.
Reisman’s and my criticism of the said doctrine does not imply that we question that the prices of production factors are influenced by the value of the alternative uses to which they might be put (for the following, see Reisman, 1996, p. 461). The price of the quantity of wheat that is employed in the production of bread is not only influenced by the demand for bread, but also by the demand for other products this input, wheat, could have been employed to produce. The money price of wheat emanates from the demand for all the different products which it helps or might help to produce. Alternative uses actually matter, and the choices of consumers between different consumer goods actually determine the market prices of these goods and of the producer goods that help to produce them. But to say that choices and alternative uses matter does not imply that alternative uses constitute costs. Reisman’s (1996, p. 461) summary of his argument is well worth reading:
The supporters of the opportunity-cost doctrine generally recognize the process by which money costs are determined, then confuse the alternative opportunities whose competition in bidding gives rise to the money costs with the phenomenon of cost itself, and thereafter ignore the necessity of a money outlay actually being present. In other words, they identify a cause of the determination of money costs, confuse the cause with the effect, and proceed to ignore the effect, which is nonetheless essential.
Alternative uses do matter, of course, and it is important to any decision-maker to be aware of the options he has before choosing a certain alternative and rejecting others. But it leads to confusion if these alternative uses are called costs. Particularly, as I said above, it becomes difficult to discuss the role of time in human action if costs are supposed to relate to choices. Choices are instantaneous, timeless. Only actions have a time dimension; and in action, costs must be understood as historical costs. As I show in my book, this approach to costs and action allows for a praxeological explanation of originary interest that avoids the shortcomings of the traditional Austrian analysis of this topic pointed out by Hülsmann (2002).
REFERENCESBraun, Eduard. 2014. Finance behind the Veil of Money: An Essay on the Economics of Capital, Interest, and the Financial Market. Liberty.Me.
Braun, Eduard. 2016. “A Comment on Dr. Howden’s Review of Finance behind the Veil of Money,” Quarterly Journal of Austrian Economics 19, no. 1: 121–123.
Howden, David. 2016. “Response to Dr. Braun’s Comment,” Quarterly Journal of Austrian Economics 19, no. 1: 124–128.
Huerta de Soto, Jesús. 2012. Money, Bank Credit, and Economic Cycles. 3rd edition, trans. Melinda A. Stroup. Auburn, Ala., Ludwig von Mises Institute.
Hülsmann, Jörg Guido. 2002. “A Theory of Interest,” Quarterly Journal of Austrian Economics 5, no. 4: 77–110.
Mises, Ludwig. 1949. Human Action. A Treatise on Economics. New Haven, Conn.: Yale University Press.
Reisman, George. 1996. Capitalism. A Treatise on Economics. Ottawa, Ill.: Jameson Books.
Rothbard, Murray. 1962. Man, Economy, and State with Power and Market. 2nd edition. Auburn, Ala.: Ludwig von Mises Institute, 2009.
Quarterly Journal of Austrian Economics 19, no. 2 (Summer 2016)
Howden (2016) dedicates a large part of his response to criticizing my way of dealing with and classifying the concept of opportunity costs in my book (Braun, 2014). I must start by saying that the main arguments in my book do not depend on my approach to the cost problem. The main reason why I considered it necessary to abandon the opportunity cost concept is that I found it impossible to apply it to the analysis of human action in the passing of time. For this purpose, the concept of costs as employed in business life, where profits are traditionally not calculated on the basis of opportunity costs but as historically incurred monetary expenses, are much more useful. It appeared to me that if “the interest rate expresses itself in the difference between income and costs at each stage” (Huerta de Soto, 2012, p. 557), the costs must not be understood as foregone opportunities but as historical outlays.
Concrete Economics: The Hamilton Approach to Economic Growth and PolicyStephen S. Cohen and J. Bradford DeLongHarvard Business Press Review, 2016xi + 223 pages
Cohen and DeLong are well-known economists, but they indict their fellow economists for an overemphasis on theory. Away with models that have little relation to reality, our authors say. Instead, we need to graph a simple lesson about the source of America's prosperous economy.
What is this simple lesson? “In successful economies, economic policy has been pragmatic, not ideological. And so it has been in the United States. From its very beginning, the United States again and again enacted policies to shift its economy onto a new growth direction. … These redirections have been big. And they have been collective choices. … Government signaled the direction, cleared the way, set up the path, and, where needed, provided the means. And then the entrepreneurs rushed in, innovated, took risks, profited, and expanded that new direction in ways that had not and could not have been foreseen.”
The heroic leaders include, first and foremost, Alexander Hamilton; Hamilton’s nineteenth-century successors, who continued his high tariff policies; Teddy Roosevelt and FDR; and Dwight Eisenhower. Hamilton, a “major economic theorist,” favored “high tariffs, high spending on infrastructure, assumption of the states’ debts by the federal government [and] a central bank.” The rationale for this ambitious program was to reshape the economy “to promote industry … the aim was not to shift the new and fragile economy to its comparative advantage, but rather to shift that comparative advantage.”
Hamilton’s policy is open to an obvious objection, but Cohen and DeLong stand ready with an answer. The objection is that free trade benefits everyone engaged in it. If, by contrast, the government picks “winners,” such as industries it wishes to support, there will be losers as well. If so, do we not have here a case in which the value preferences of the policymakers have been substituted for the freely expressed wishes of the consumers?
The authors answer in this way: “The textbooks tell us that the operations of a free trade system produce a positive sum game: all sides gain. But in industries of substantial economies of scale, of learning and spillovers, there is a major zero-sum element to the outcome. Few governments, if any, place the welfare of the rest of the world above that of their own citizens — my gain can well be your loss. … In terms of the structure of production and employment, the gain of one side comes at the expense of the other side, unless … the other side (in this case, the United States) can move its resources and people into still higher-value-added activities, industries of the high-value future.”
This response blatantly begs the question. Of course, they are right that if an industry subsidized by the government drives out of business a competing industry from another country, the subsidized industry benefits and the losing industry suffers. It hardly follows from this, though, that a free trade policy puts the welfare of the world above that of its own citizens. Why do the losses to the unprotected industry outweigh the gains of consumers in one’s own country now able to buy products more cheaply from the foreign firm? Of course, if one assumes that a prosperous economy must be heavily industrialized, our question can be answered; but this is just what is at issue. Why not let the balance between industry and non-industrial products be settled by the freely expressed wishes of consumers?
Cohen and DeLong cannot yet be forced from the field of battle. They say about the “East Asian Model,” “The objective was to steer investment into industries that would pay off over the long run. It is not to direct resources into industries that earn the largest immediate profits for businesses at some set of [Adam] Smithian free-market prices. The object is to direct resources to industries that will pay off in terms of economic development.”
Is not the far-seeing state able to see into the future better than businessmen, heedless of the long run out of avidity for current profits? Readers more skeptical of the state than the authors will be pardoned for doubting the matter, all the more so when the authors themselves acknowledge problems with their scheme: “Can such policies go wrong? Yes. Can such policies produce horrible economic disasters? In many cases they have.”
Further, even if the state spotters of future trends “get it right,” from the viewpoint of the industrial policy our authors favor, the fundamental question recurs. Why should the balance between current production and production for the future be set by anything other than the decisions of the consumers? Why is a greater emphasis on the future than consumers wish somehow “better”? The authors suggest that if the economy grows fast enough, sacrifices of present consumption will be repaid by higher consumption in the future. Even if they are right, though, who are they to say that the sacrifices are worth it? Once more, Cohen and DeLong substitute without basis their own value judgments for those of the free-market consumers.
I suspect that the authors, if they deigned to read these remarks, would respond with derision: “Raise all the free-market purist points you want. What we propose works!” They say, “What we do know is that since the days of Hamilton, it is a fact that America’s successful economic policy has been pragmatic, not ideological. It has been concrete, not abstract.”
America, under the high tariff pro-industrial policy the authors support, became the most prosperous economy in the world; and the success of state-directed economies in China and East Asia adds further evidence. Is it not simply obstinate to deny this?
This argument is vulnerable at two points. The first of these will be familiar to any reader of Bastiat and Hazlitt. Granted that the American economy has attained great prosperity, how do we know that prosperity would not have been even greater under the laissez-faire regime our authors disdain? Must we not examine “what is unseen,” as well as “what is seen,” as Bastiat long ago noted?
Have we been too hasty in this response? The authors might be taken to answer us in this way: “The United States had every chance of sharing what W. Arthur Lewis called the economies of temperate European settlement. These other countries — Australia, Argentina, Canada, and even the Ukraine — became in the nineteenth century great granaries and ranches for industrial Europe. But none of these developed the industrial base to become fully first-class balanced economies in the late nineteenth century. … When commodity price trends turned against them, they lost relative ground. By contrast, the twentieth century became an American century precisely because America by 1880 was not a gigantic Australia.”
Here once more our authors have begged the question. They assume that, in the absence of “industrial policy,” the United States would have been a largely agricultural country. Why think this?
The doubt here is more than an abstract possibility, of the sort Cohen and DeLong view with contempt; and this raises the second line of attack that may be directed against their “it works” argument. There is little reason to think that Hamiltonian policies led to American prosperity. True enough, tariffs were often high, and nineteenth-century governments favored internal improvements. But tariffs were virtually the only source of government revenue, and the size and scope of government was minuscule in comparison to today’s bloated state. Why not ascribe the success of the American economy to the relative freedom of the economy rather than to industrial policy? Appeal to the “concrete” avails nothing; facts without theory are blind. The question becomes all the more pressing when one considers that the authors count as a case of successful state intervention the government’s making land available through the Homestead Act of 1862. The fact that the government made it very easy to acquire title, rather than selling land by auction to the highest bidder, is somehow counted as a triumph for state policy. If one is going to call a way of privatizing land an instance of state oversight of the economy, the case for state control of the economy is readily made. To readers who do not share the biases of Cohen and DeLong, though, their procedure will seem akin to calling white black.
David Gordon is Senior Fellow at the Mises Institute, and editor of The Mises Review. Contact: email.
The Austrian Economics Core Curriculum course lays out the fundamentals of Austrian Economics. Drawing on the tradition of Mises and Rothbard, the course begins with Praxeology, the study of human action, from which economic principles are deduced. An exposition of subjective value and the division of labor follow, providing the requirements for exchange and markets. From there, the concepts of money’s origin and value are explored, with the interest rate coordination of consumer preferences and the structure of production and business cycles. Finally, the crucial role of the entrepreneur in the market economy and economic calculation are explained.
Featuring lectures by David Gordon, Jörg Guido Hülsmann, Jeffrey M. Herbener, Lucas M. Engelhardt , Roger W. Garridon, Joseph T. Salerno, and Peter G. Klein.
Students that complete this course will earn a certificate of completion.
Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 116–120
The most recent financial crisis has engendered various actions by institutions aiming—or at least pretending to aim—to end the crisis and to stabilize the economy in general and the banking sector in particular. Not only have central banks flooded the markets with cheap money, but governments have also introduced new regulations intended to prevent the banking sector and, consequently, the entire economy from blundering into another crisis. These initiatives will in fact make everything worse, or are—at best—pointless. Apart from revised rules for banking supervision (“Basel III”), laws concerning the restructuring or formal liquidation of banks were passed in several countries. In Germany, the government created a Banking Restructuring Act (“Gesetz zur Reorganisation von Kreditinstituten”) aiming at 1) the successful restructuring of (especially) so-called “systemic” banks without affecting the stability of the banking system as a whole and 2) the involvement of both equity and debt holders in solving a bank’s crisis rather than the taxpayer.
While the German Banking Restructuring Act has been the subject of thorough jurisprudential research, David Rapp was the first to analyze the Banking Restructuring Act from a business economics perspective, based upon Austrian insights.
Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 121–123
Dr. Howden (2015) has done me the honor of reviewing my recent book "Finance behind the Veil of Money" (Braun, 2014) in this journal. Many of the points he raises are very helpful to the potential reader. He is probably correct in stating that the book is not an easy read. Its origin as a doctoral thesis explains why no theoretical obstacles were avoided, even those that might be cumbersome for the general reader. When Dr. Howden takes issue with my analyses of the opportunity cost concept and the time preference theory of interest, he also touches points that are of interest to potential readers. In both cases, I elaborate on minority positions within the Austrian School—I follow Dr. Reisman on opportunity cost and Dr. Hülsmann on interest theory. I expected that my discussion of these topics would arouse opposition, or better, I had the desire that it would because, in my opinion, they are yet to be satisfactorily resolved.
Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 101–111
[The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression by Scott Sumner]
The Midas Paradox is an impressive piece of scholarship, representing the magnum opus of economist Scott Sumner. What makes the book so unique is Sumner’s use of real-time financial data and press accounts in order to explain not just broad issues—such as, “What caused the Great Depression?”—but to offer commentary on the precise zigs-and-zags of the economy during the 1930s.
Sumner rejects the standard Friedmanite monetarist “long and variable lags” approach, and argues that financial markets respond virtually instantly to new information, including announcements and events that would change expectations about the future path of monetary policy. Both because of his methodological innovations and his painstaking research, Sumner’s book is an invaluable resource to economists and historians interested in the Great Depression and the operation of the classical gold standard.
Although I admire much of the book, I must reject its central thesis. Indeed, the very title The Midas Paradox is an allusion to the disaster that comes from an obsession with gold. Sumner agrees with standard Austrian critiques of the New Deal and its crippling effects on labor markets, but he also thinks a large portion of the blame for the Great Depression lies with the unfortunate fact that policymakers’ hands (and currencies) were tied to gold. Even though economists back in the 1930s thought that central banks were “pushing on a string” with their low interest rate policies, Sumner thinks it is now well established that it was unwittingly tight money that made this depression “Great.”
Furthermore, Sumner draws lessons for today, believing that economists are wrong to focus on low nominal interest rates and even the huge expansions in monetary bases that the world’s major central banks have delivered since the 2008 crash. Instead, with his “Market Monetarist” framework, Sumner believes that central banks have foisted enormously tight monetary policy on the world, and that this largely explains the horrible crash and then sluggish recoveries of Western nations in the last decade.
In Sumner’s view, only by adopting a more useful criterion for assessing monetary policy can economists explain past crises and help policymakers avoid future ones. As Sumner concludes his introductory chapter: “The events of the past five years should make us all a bit more forgiving of those interwar policy experts who failed to correctly diagnose the problem in real time. When aggregate demand collapses, it looks to almost everyone as if the symptoms of the fall in aggregate demand are the causes. That was true in the 1930s and it is equally true today” (p. 32).
Although I could spend the rest of this review noting the areas on which I agree with Sumner, the best contribution I can make is to point out why I think his thesis ultimately fails. To that end, I will first show that the single most important relationship he charts in the book—and it is Sumner himself who christens it as such—is just as consistent with the Rothbardian (1963) explanation of the Depression as it is with a Market Monetarist one. Then I will show that Sumner’s emphasis on gold—which is the reason for the book’s title, after all—is misplaced; it cannot fulfill the criterion that Sumner himself says it must.
I will conclude that Sumner’s book, excellent though it is in many respects, fails in its purpose. Austrians who subscribe to the Rothbardian explanation (which in turn was an elaboration of the Misesian theory of the business cycle) may collect some interesting nuances and a wealth of data from Sumner’s book, but they have no reason to abandon their basic framework.
Evidence that Fits Both Frameworks: The Connection between Real Wages and OutputIn his introductory chapter Sumner declares, “If I were asked to give a talk on the Great Depression and allowed just one slide, it would undoubtedly be Figure 1.2” (p. 20). We have reproduced that crucial chart below.
Figure 1.2: The Relationship between Detrended Industrial Production and Detrended (Inverted) Real Wages, 1929–1939, MonthlyIn Sumner’s figure, the gray line shows the logarithm of industrial production, meaning that straight lines indicate steady percentage rates of growth (or shrinkage). The dark black line is the logarithm of the inverse of the real (i.e. price-level-adjusted) wage rate.
The figure shows quite clearly that during the 1930s, as real wages increased, industrial production fell. On the other hand, increases in industrial production went hand-in-hand with declines in real wages.
As it happens, I am perfectly happy with Sumner’s graph. In fact, I will go further and enthusiastically endorse just about all of Sumner’s interpretation of it as well:
[A] sharp fall in output could be caused by either a rise in nominal wages or a fall in the price level. It so happens that both factors played an important role in the Great Depression….
During the 1930s, the biggest supply shocks were New Deal programs aimed at artificially raising nominal wages. There were five big wage shocks, each of which tended to abort otherwise promising recoveries in industrial production. These wage shocks thus tended to make real wages more countercyclical—higher wages led to lower output.
…
But what about the demand shocks, which were the major cause of the Great Contraction? Recall that the real wage is the nominal wage divided by the price level…. Wholesale prices fell sharply during the 1929–1933 and 1937–38 contractions and rose sharply after the dollar was devalued in April 1933. Because nominal wages tend to be sticky, or slow to adjust, sudden changes in the WPI tend to show up inversely as changes in the real wage rate…. If prices fall much faster than wages, then profits decline and companies lay off workers. Real wages actually rose sharply during the early 1930s for those lucky enough to maintain full-time jobs. (Sumner, pp. 20–22, emphasis added.)
Perhaps surprisingly, in the above quotation, Sumner has provided the same basic explanation of the high (and persistent) unemployment rate that I myself gave, in my decidedly Rothbardian treatment in Murphy (2009). Sumner and I agree that during the 1930s, unemployment shot up whenever real wages were increasing and (perversely) made labor more expensive relative to other commodities.
However, where Sumner and I disagree concerns the blame for this state of affairs. If the general price level falls, while nominal wage rates do not fall nearly as much, then Sumner ultimately blames the monetary authorities for letting the purchasing power of money increase so rapidly. In contrast, I blame the other interventions of the federal government (in conjunction with labor unions) for making wages so much “stickier” than they had been in previous depressions.
In particular, we can compare the behavior of nominal wages and prices of the early 1930s with the experience from the 1920–1921 depression. Here we rely on the statistics and analysis from Gallaway and Vedder (1987). First we reproduce one of their tables:
Table 4: Rate and Indexes of Consumer Prices, Money Wages, Productivity, and Productivity-Adjusted Real WagesAs the final column from the table shows, real wages for hourly workers—especially if we further factor in productivity—grew substantially over the years of the Great Contraction, reaching almost 20 percent higher by 1933 (when the unemployment rate was almost 25 percent). For another amazing fact, note that nominal (money) wage rates for hourly workers in 1931 were only 5.6 percent lower than they had been in 1929, even though consumer prices by that point had fallen 11.4 percent. During this year, unemployment was already at a devastating 15.9 percent.
Even the table above does not shed light on the policies that might have contributed to the problem. After all, Sumner could take these data from Gallaway and Vedder in stride, showing the disastrous consequences of the Fed’s (allegedly) tight monetary stance in the early 1930s amidst “sticky nominal wages.”
Yet here is where the comparison with the 1920–1921 episode is decisive. After producing the above table, Gallaway and Vedder explain:
The issue is whether the Hoover recipe delayed the onset of money wage adjustments sufficiently to exacerbate the disequlibrium and increase the severity of the Great Depression. The evidence is persuasive that this is the case…. [A] monthly wage index compiled by the Federal Reserve Bank of New York (reported by Lionel Robbins) shows almost no movement in money wage rates from the fourth quarter of 1929 through the second quarter of 1930.
Contrast this pattern with that of the 1920–21 downturn. In both cycles, industrial production peaked at midsummer before the onset of the decline. In both cycles, the decline was precipitous, 27.5 percent from July 1920 to July 1921 and 21.3 percent from June 1929 to July 1930. However, as noted earlier, in the 1920-21 case, money wage rates fell by 13 percent, setting the stage for the sharp recovery that began in August 1921. One of the factors cited by Benjamin Anderson in explaining this recovery is “a drastic reduction in the costs of production.” How these costs were reduced is clear—money wage rates were cut, something that did not occur in the early days of the Great Depression. For example, according to data compiled by the National Industrial Conference Board, hourly wage rates for unskilled male labor fell more between 1920 and 1921 than they declined throughout the Great Depression.
The clear implication seems to be that the money wage rate adjustment process was distinctly different during the Great Depression compared to the 1920–21 decline in business activity. Apparently, Herbert Hoover’s goal of maintaining levels of money wage rates was achieved, at least temporarily. (Gallaway and Vedder, 1987, p. 46, emphasis added, endnotes removed.)
Much more recently, Lee Ohanian (2009) develops a formal neoclassical model and concludes that Herbert Hoover’s policies—which asked large firms to maintain nominal wage rates in exchange for keeping out unions—are ultimately to blame for the Great Depression. He writes in his abstract: “The theory also can reconcile why deflation/low nominal spending apparently had such large real effects during the 1930s, but not during other periods of significant deflation.”
In summary, regarding the “one slide” that Sumner would use if he had to choose just one, he and I are in agreement: The key to understanding the massive unemployment of the 1930s is real wage rates. Sumner and I agree that during an economic downturn, the last thing in the world we want is for labor to become artificially more expensive as prices fall faster than wage rates.
Yet rather than ask (ask Sumner does) why policymakers at the Federal Reserve allowed such a deadly fall in prices, instead I would ask why policymakers in the federal government hindered the fall in (nominal) wages that had been the norm in previous depressions (or “panics”).
Sumner's Misplaced Emphasis on GoldIn the previous section, I argued that the Rothbardian interpretation of the Great Depression could easily incorporate the single most important graphical relationship of Sumner’s book. Namely, a Rothbardian could agree that the immediate driver of unemployment was the real wage rate, but the Rothbardian would lay the blame on government measures that interfered with nominal wage adjustments, rather than with deflationary monetary policy.
In this section, I question Sumner’s emphasis on money—and in particular, the operation of the gold standard—as a key component of the Great Depression. Here again we will reproduce a key chart from Sumner’s book, namely Figure 2.1 (p. 44), which plots the inverse of the “gold ratio” against industrial production:
Figure 2.1: Industrial Production and 12-Month Change in C/G RatioTo understand the significance of this figure, we first must explain the “inverted gold ratio.” Sumner had earlier (p. 28) defined the gold reserve ratio as “the ratio of the monetary gold stock and the currency stock.” Now under the rules of the classical gold standard, “countries were supposed to adjust their currency stock in proportion to their changes in their monetary gold stock,” and thus if a country did not do so, then such “[v]ariations in the gold reserve ratio can be seen as an indicator of discretionary monetary policy” (p. 29).
Returning to the figure above, we now see how it apparently endorses the Sumnerian framework. If the currency/gold ratio (the dark black line) falls, it means that the outstanding stock of currency has fallen relative to the amount of gold held for monetary purposes. It is discretionary monetary policy tightening, in the context of the classical gold standard. And since the dark black line goes hand-in-hand with industrial production (the gray line), Sumner believes that this chart is consistent with his central thesis.
However, even at this stage, there are problems. First, note that from January 1929 up until the fateful month of October 1929, the 12-month change in the currency/gold ratio is (slightly) negative. Even so, industrial output rises through the summer. Moreover, the particular zigs and zags do not coincide with each other; there is a relative tightening (i.e. falling dark black line) from April through June, while industrial production rises during this stretch. Furthermore, there is a spike in the black line going into October 1929, which (to repeat) represents a relative loosening of monetary policy in Sumner’s framework.
To be sure, eventually both lines collapse, but it is hardly clear that the movements in the black line are causing reactions in the gray line. Indeed, consider that as of January 1930, the height of the black line has returned to the same position it held back in April 1929. That means that the (modest) 12-month decline in the inverted gold ratio by January 1930 was no larger than that same change had been in April 1929. And yet, this monetary tightening coincided with growing industrial output back in April, while by January industrial production was in free-fall.
Now, when it comes to explaining the stock market crash of October 1929, what really matters is not the mechanical policy of that moment but rather the expectations of investors. Perhaps the Federal Reserve signaled in some way the sharp tightening of monetary policy that would eventually come, and investors realized how much things had changed as fall 1929 unfolded.
As a staunch proponent of the Efficient Market Hypothesis (EMH), this is indeed the approach Sumner adopts. Space constraints do not allow me to summarize his case, but I think it is fair to say that he presents no smoking guns. In fact, Sumner himself implicitly admits that he has failed in the task he set for himself, when he (no doubt subconsciously) moves the goalposts.
Specifically, on page 40 Sumner tells us his strategy (consistent with the EMH):
Before we throw up our hands and accept the “bubble” explanation, we should first see whether there is an alternative explanation that allows for sensible investors to have been highly optimistic in September 1929 and much more pessimistic in November 1929. (Sumner, p. 40, emphasis added.)
To reiterate, for Sumner’s book to “work,” he must now show us what tangible actions (which could have been in the form of remarks made to the press) the Federal Reserve made in a two-month window from September to October 1929, which involved the handling of the gold standard and which made both the stock market valuations of early September and late October 1929 “rational.” Were there any such actions that would have altered expectations in such a drastic way?
I submit that Sumner gives us nothing that fits the bill. He himself seems to acknowledge this when, twenty-one (unconvincing) pages later, Sumner writes:
At the beginning of this chapter, I suggested that in order to understand the October [1929] crash, one needed to explain why it would have been sensible for investors to be highly optimistic in September 1929, and somewhat pessimistic in November 1929. Is there an explanation for such a dramatic change in sentiment? (Sumner, pp. 60–61, emphasis added.)
Note the subtle movement of the goalposts (again, I believe innocent enough); on page 40 he had sought something that would make investors “much more pessimistic” two months later, while on page 61 he has lowered the bar to “somewhat pessimistic.” (Would a mere change to “somewhat pessimistic” explain back-to-back drops of almost 13 percent and then 12 percent, which is what happened in the market on October 28 and 29?) Sumner knows he doesn’t have it. Indeed, later on this page Sumner writes, “This makes it almost impossible to establish a clear link between monetary policy and the 1929 crash” (p. 61).
Now in fairness, Sumner might respond that his book does not need to explain how monetary tightening—due to the constraints of the gold standard—led to the 1929 stock market crash. This is because one of the ways Sumner departs from conventional analyses is that he thinks market crashes do not necessarily coincide with “real” downturns; his best counterexample is the 1987 market crash, which was bigger than the 1929 one and obviously didn’t spawn a decade-long depression.
Even so, it sure seems as if the 1929 stock market crash had an awful lot to do with the onset of the Great Depression. Just look again at the final chart above, taken from Sumner: the big drop in industrial production clearly began with the market crash. The fact that Sumner admits his framework can’t really explain this sharp turnaround is (in my opinion) key evidence that his focus on gold—and denial of the existence of asset bubbles—is fundamentally mistaken.
ConclusionIn truth, no economic historian can explain the precise timing of every movement in the financial markets and broader economy, for the simple reason that humans have free will. Even so, using the very criteria Sumner himself embraces, we can conclude that his book—though superb in several dimensions—does not achieve its stated purpose.
Putting aside the detailed statistics, I will end this review with a simple question: How can it be that the classical gold standard is largely responsible for the Great Depression, when the classical gold standard was operating during several previous financial panics and depressions (small “d”)? To blame the Great Depression on the gold standard is akin to blaming a particular plane crash on gravity.
In contrast, the Rothbardian analysis at least has a shot at being satisfactory. After all, Herbert Hoover in his memoirs tried to defend his legacy by assuring his readers (truthfully) that his administration had taken unprecedented measures in battling the Depression, meddling in the economy in ways that no president during peacetime had done before. That’s the place to start, when we ponder why Herbert Hoover suffered from a worse downturn than any president before.
Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 65–84
ABSTRACT: Central banks have embarked on a transition from relative secrecy to relative transparency over the last two decades. This has led researchers to investigate the ramifications of transparency on important economic outcomes. By and large, the results reported have been favorable, favorable with qualifications, or ambiguous. This paper examines the communications of officials from the Federal Reserve during 2007, the year between the end of the housing bubble and the beginning of the financial crisis. In contrast to previous findings, these communications are indicative of either deception, incompetence, or a combination of both.
KEYWORDS: Federal Reserve, transparency, monetary policy, policy objectives and coordination JEL CLASSIFICATION: E52, E58, E61, E65, Z18
“There are several reasons to believe that this concern about burst bubbles may be overstated.”– Fred Mishkin, Feb. 17, 2007
Introduction Central banks have become more “transparent” over the last quarter-century. By communicating their actions, intentions, and philosophy they give the appearance of public-spiritedness and justify their independence from the political process. By examining this greater transparency with regards to monetary policy, economists have found that it has led capital markets and interest rates to react more efficiently and be more efficient.The drive for increased transparency began in the 1990s. In 1994 the Federal Open Market Committee (FOMC) started announcing its target for the federal funds rate. In 1999, the FOMC began announcing its “bias” for future changes in monetary policy as well as issuing more details statements when it was not changing rates. A few years later it began announcing FOMC votes after each meeting. In 2005, the FOMC began releasing the minutes of its meeting prior to the subsequent FOMC meeting. In 2007, the Fed has increased the frequency and content of its publicly-released forecasts. Similar trends towards central bank transparency have occurred at the Bank of England, European Central Bank, the Norges Bank, Sveriges Riksbank (the central bank of Sweden) and the Reserve Bank of New Zealand. (Blinder et al., 2008, p. 3)
In contrast, the economic theory of regulation (Stigler, 1971) holds that regulators such as central banks will be “captured” and act in the private interests of the industries that they regulate. Evidence is presented here regarding the Federal Reserve’s role in regulation and financial oversight that supports this theory by showing that communications from the central bank have a tendency to support the Federal Reserve and the financial industry’s interests, rather than the public interest. The fact that the large banks were bailed out during the crisis confirms this conjecture about the nature of the relationship between the Federal Reserve and the financial industry.
This paper contends that central bank communications can indeed mislead market participants. Previous studies that rely on numerical market data have concluded that transparency has been generally beneficial. In contrast, public speeches by members of the FOMC on financial innovation and Federal Reserve oversight of financial institutions and financial products, such as mortgage-backed securities are examined here for their transparency. These communications are drawn from a critical period between the end of the housing bubble in 2006 and the financial crisis, which began in 2007. Rather than being transparent and helping markets equilibrate, these communications were effectively deceptive in an apparent attempt at maintain undo confidence in financial markets.
Central Bank Transparency The issue of central bank transparency or lack thereof is important under a discretionary monetary regime. For example, Koppl (2002) shows that the central bank is a “big player” and market participants must expend resources and bear risk because the central banker has discretion and disproportionate impact on market outcomes. Likewise, Goodfriend (1999) in examining the role of the regional Federal Reserve banks, concludes that market expectations could be fractured if decision making over monetary policy were centralized in the hands of a “dictator” and that centralized decision making could be more easily captured by special interests. Crowe and Meade (2008) and McGregor (2007) have analyzed how much transparency has really changed and whether to expect more or less transparency in the future.
Prior to 1990, monetary policy was largely shrouded in mystery. Under the gold standard and in the Bretton Woods system, monetary policy was less arbitrary than today because it had a relatively fixed anchor. Because money had no anchor after Bretton Woods, policy makers felt a need for secrecy and a fear that lack of secrecy would undermine markets. Those fears gradually receded and were replaced with the notion that better communications by central bankers would help to manage expectations in financial markets and lead to improved economic results.
The Federal Open Market Committee (FOMC) began to announce its federal funds rate target in February of 1994. In May of 1999, the FOMC began publishing statements regarding its “bias” towards future rate changes. In 2002, it began to release the votes of the FOMC immediately after meetings. The Fed has continued its transition to greater transparency and more timely communication of its monetary policy. Forward-looking policy guidance was added in 2003.The release of FOMC minutes was shortened to three weeks after each meeting in 2005. Numerical forecasts with an extended three-year time horizon were added in 2007. Meeting transcripts for an entire year are now publicly released with a five-year lag. The financial crisis that began in 2008 has led the Fed to extend its transparency further into the future, e.g. rates will remain low for the foreseeable future.
Blinder (2008) reports that the central banks of England, New Zealand, Norway, Sweden, elsewhere in Europe, and other nations have adopted the philosophy of greater transparency and in many cases explicit inflation-targeting regimes. According to Blinder (2008, p. 3), “the view that monetary policy is, at least in part, about managing expectations is by now standard fare both in academia and in central banking circles. It is no exaggeration to call this a revolution in thinking.”
There has been a great deal of research on this new paradigm of monetary policy and while better communication is generally lauded as a good thing, it is not yet considered a panacea. For example, there is the ultimate constraint that central banks will know more about their own views and actions than will the general public and financial markets. Therefore, there cannot be complete transparency. In addition, Bernanke (2004) admits that no system is known in which central banks can be completely self-constrained when changing conditions and surprises dictate deviations from previous central bank communications and inflation targets. Therefore central banks cannot provide 100 percent certainty about the information they share regarding the future.
The general appeal of transparency is that better communications by central banks help to manage or stabilize expectations and stable expectations help central bankers to implement more effective monetary policy, even though it may have less “influence” in the short run. Donald L. Kohn and Brian Sack (2004) contend that individuals place special authority on the communications of central banks based on the central banks’ records of forecasting. While empirical studies support this view, it is not surprising, given the large amount of resources allocated by central banks to forecasting and by market participants to analyzing central bank communications.
Blinder (2008) shows that there is an extensive empirical literature that examines the impact of central bank communications on measurable movements in interest rates and events in stock markets. The general conclusion of these studies is that such central bank communications can and do positively impact these markets, but not necessarily as completely as central banks wish.
This paper does not argue with this conclusion. Rather, it relies on these types of results: central bank communications do impact behavior in a relatively effective manner. Additionally, this paper builds on the suggestion in the literature that central bank communications could also be welfare reducing, a minority view. For example, Amato, Morris, and Shin (2002) contend that central bank communications could move markets away from fundamentals if market participants give too much weight to central bank communications relative to market-generated data.
Are Central Banks Captured? What are the implications of Amato, Morris, and Shin’s (2002) contrarian stance? Most of the literature on transparency implicitly or explicitly assumes central bankers are motivated by concern for the public interest. This literature produces a great deal of evidence that this is indeed the case. However, if we were to re-examine this literature from a private-interest approach we might even find that Amato, Morris and Shin (2002) was not the exception, but the rule. Perhaps the evidence that transparency facilitates such things as stabilization of interest rates and inflation expectation could also be viewed as in the interest of central banks and money center banks as well as the public interest.
George Stigler (1971) presents an economic theory of regulation that suggests that special interests have an economic incentive to have agencies regulate their industries to create a cartel-like environment that will produce economic rents for members of the industry. Stigler’s approach is closely aligned with the capture theory of regulation. This theory holds that interest groups with high stakes in both the form and the enforcement of a regulation or set of regulations will devote resources to capture the legislative process, commissions, and regulatory staffs. This allows the industry to control and benefit from the regulatory process. The outcomes are most often worse than if there were no regulation at all. Hamilton (2013) shows that when regulatory officials are not elected (as in the case of the central bank of the United States) and when democratically elected officials face insignificant competition, private-interest outcomes will dominate public-interest outcomes. More specifically Rothbard (1984) has demonstrated that the Federal Reserve System was intended as and acts as a cartelizing device for large banks’ interests. Broz (1997) argues that the Federal Reserve was a joint product consisting of a public good, i.e., a reduction in bank panics, and a private good, i.e., benefits to the large New York City banks, as suggested above.
An additional motivation for this research is an important paper by White (2005). He found that the Federal Reserve is highly influential in the business of publishing academic research in monetary economics. In his sample of the Journal of Monetary Economics and the Journal of Money, Credit and Banking, 80 percent and 75 percent of the articles had at least one coauthor with a Federal Reserve affiliation and 82 percent and 87 percent of the editorial board members had Federal Reserve affiliations. At the very least, this influence would tend to have a “crowding out” effect on research on alternative monetary regimes, such as the gold standard and free banking. White (2005, pp. 343–344) concludes that:
an academic economist who values the option to someday receive an offer from the Fed, either to become a staff economist, or a visiting scholar, faces a subtle disincentive to do regime-challenging research. To repeat Fettig’s (1993) characterization of Milton Friedman’s view: “if you want to advance in the field of monetary research… you would be disinclined to criticize the major employer in the field.”
Central Bank Deception? “Indeed, U.S. financial markets have proved to be notably robust during some significant recent shocks.”– Donald L. Kohn, Feb. 21, 2007
Thornton (2004) suggests that one should not listen to Federal Reserve chairman Alan Greenspan’s testimony and speeches. Delete it from your mind like spam emails. Watch what he has done and what he is doing, but deeply discount anything you read about his testimony. Note that Greenspan’s speeches and testimony as well other central bankers is often considered obfuscation rather than true deception.
Central banking is a confidence game. The Federal Reserve runs a monetary system where money has no traditional backing, such as gold or silver. It runs a banking system that has, until the housing bubble-financial crisis, had no reserves to back deposits, other than drawer money. The central bank certainly has its own tools to give us confidence in the system, such as the discount window, which serves as Federal Reserve role as a lender of last resort. Other institutions such as legal tender laws and deposit insurance also provide confidence by acting as security for the value of the dollar and insuring bank accounts against bank failure. Although central bankers would not accept the notion that central banking is a “confidence game,” they regularly speak of investors’ confidence, consumers’ confidence, policy expectations, and economic uncertainty.A confidence game (also known as a bunko, con, flimflam, hustle, scam, scheme, or swindle) is defined as an attempt to defraud a person or group by gaining their confidence. The victim is known as the mark, the trickster is called a confidence man, con man, or con artist, and any accomplices are known as shills. Confidence men exploit human characteristics such as greed, vanity, honesty, compassion, credulity, and naïveté. The common factor is that the mark relies on the good faith of the con artist.
The Federal Reserve seeks to maintain our confidence in its system and to encourage people to not take proper precautions against the negative effects of its policies. Printing up money and lowering the value of dollar-denominated assets while simultaneously providing benefits to special interest groups is a deception that is a major part of the confidence game.
The basic focus here will be on the Federal Reserve’s mission to instill confidence in us about the economy while simultaneously instilling confidence in us about the abilities of the Fed itself. The first mission is easy to see because Federal Reserve officials are almost always publicly bullish and hardly ever publicly bearish about the economy. According to the central bank, the economy always looks good, if not great. If this message fails to have its intended effect, the central bank will proclaim that the economy is better than it appears and that there are signs of recovery and economic growth. If there are some problems, please do not worry, the Federal Reserve says: it will come to the rescue with truckloads of money, lower interest rates, and easy credit. If things were to get worse, which they won’t, the Federal Reserve would be able to respond with monetary weapons of mass stimulation. Of course this perspective is consistent with the viewpoint of mainstream economists. They see the business cycle as caused by psychological problems, random technological shocks, or market failures. In fact, the business cycle can be attributed to the divide between interest rates set by the Federal Reserve and those indicated by market forces.
The evidence presented here comes from public speeches by leading officials of the Federal Reserve during the year 2007. This is the period between the ending of the housing bubble in 2006 and the onset of the financial crisis, which began in earnest in 2008. Predictably, their testimony and speeches are highly nuanced and hedged. The quotes taken from these communications typically represent concluding or summary remarks. Note that this evidence is qualitative in nature rather than quantitative and therefore not of the species used by mainstream economists.
Ben Bernanke
Let us begin at the beginning of 2007 with the chairman of the Fed, Ben Bernanke. The former economics professor from Princeton gave an address to the annual meeting of the American Economic Association. (Bernanke, 2007) Bernanke was the first chairman of the Fed from academia since Arthur Burns, and it was Burns who helped take us off the gold standard.
In addressing his fellow mainstream academic economists, Bernanke was unusually bold in describing the Federal Reserve’s access to and ability to use data concerning financial markets. This knowledge and expertise includes the market for derivatives and securitized assets. He describes the Federal Reserve as a type of superhero for financial markets. In discussing the Federal Reserve’s role as chief regulator of financial markets he makes powerful claims concerning the Federal Reserve’s ability to identify risks, anticipate financial crises, and effectively respond to any financial challenge.
Many large banking organizations are sophisticated participants in financial markets, including the markets for derivatives and securitized assets. In monitoring and analyzing the activities of these banks, the Fed obtains valuable information about trends and current developments in these markets. Together with the knowledge it obtains through its monetary policy and payments activity, information the Fed gains through its supervisory activities gives the Fed an exceptionally broad and deep understanding of developments in financial markets and financial institutions.
In its capacity as a bank supervisor, the Fed can obtain detailed information from these institutions about their operations and risk-management practices and can take action as needed to address risks and deficiencies. The Fed is also either the direct or umbrella supervisor of several large commercial banks that are critical to the payments system through their clearing and settlement activities. (Bernanke, 2007)
In other words, according to the Federal Reserve, it knows everything about financial markets. In truth, the banks and the Federal Reserve apparently had no idea about the looming dangers concerning derivatives, securitized assets, and risk management practices. But it gets worse:
In my view, however, the greatest external benefits of the Fed’s supervisory activities are those related to the institution’s role in preventing and managing financial crises.See Thornton (2010). https://mises.org/daily/4177/The-Federal-Reserve-as-a-Confidence-Game-What-They-Were-Saying-in-2007#_ftn1.
In other words, the Federal Reserve can prevent most crises and manage the ones that do occur. Given that we are more than seven years into this serious economic downturn, that banks are even bigger and more susceptible to systemic risk, and that the national debt and the Fed’s balance sheet have exploded upward in size, his statement is clearly in doubt.
Finally, the wide scope of the Fed’s activities in financial markets—including not only bank supervision and its roles in the payments system but also the interaction with primary dealers and the monitoring of capital markets associated with the making of monetary policy—has given the Fed a uniquely broad expertise in evaluating and responding to emerging financial strains. (Bernanke, 2007)
In other words, the Federal Reserve is an experienced, forward-looking preventer of financial crises. This is a strong claim given Bernanke’s own abysmal record of forecasting near-term events during and after the housing bubble. As financial strains did emerge, it would be hard to judge Bernanke’s evaluation and response as even marginally satisfactory unless one takes the perspective of the large banks and financial institutions.
Bernanke is infamous on the Internet because of the YouTube video that chronicles his rosy view of the developing crisis from 2005 to 2007. He denied in 2005 that there was a housing bubble. Bernanke in 2006 denied that housing prices could decrease substantially. He said that if they were to fall it would not affect the real economy and employment. He first denied and then tried to calm fears about the subprime-mortgage market. He stated in 2007 that he expected reasonable growth and strength in the economy, and that the problem in the subprime market (which had then become apparent) would not impact the overall mortgage market or the economy in general. In mid-2007 he declared the global economy strong and predicted a quick return to normal growth in the United States. Remember, Austrians were writing about the housing bubble, its cause, and the probable outcomes as early as 2003.See the compilation by MarcellusCMarcellus, “Ben Bernanke Was Wrong,” at https://www.youtube.com/watch?v=9QpD64GUoXw.
Possibly the worst of Bernanke’s statements occurred in 2006, near the zenith of the housing bubble and at a time when all the exotic mortgage manipulations were in their “prime.” This was the era of the subprime mortgage, the interest-only mortgage, the no-documentation loan, and the heyday of mortgage-backed securities. The new Federal Reserve chairman admitted the possibility of “slower growth in house prices,” but confidently declared that if this did happen he would just lower interest rates.
Bernanke also stated in 2006 that he believed that the mortgage market was more stable than in the past. He noted in particular that “our examiners tell us that lending standards are generally sound and are not comparable to the standards that contributed to broad problems in the banking industry two decades ago. In particular, real estate appraisal practices have improved.”
Bernanke is considered a top mainstream economist with the best credentials and extensive service in academia and government. The chairman of the Federal Reserve has enormous resources at his disposal including a virtually unlimited budget, thousands of economists and consultants, and every piece of economic data, including detailed information concerning every major financial firm. With those resources at his disposal he consistently issued wrong answers over an extended period of time. The plausible explanations for this pattern of misinformation include; 1) Modern mainstream economics is inadequate with respect to using monetary policy to control macroeconomic outcomes, 2) Monetary policy is something beyond the capabilities of bureaucratic management, or that 3) Bernanke was issuing statements that were in the private interests of either the Federal Reserve, the banking and nonbanking financial industries, or both. These three possibilities are not mutually exclusive.
Fred Mishkin
Less than two weeks after Bernanke’s address to the American Economic Association, fellow academic Fred Mishkin, a governor of the Federal Reserve Board, took the stage at the Forecaster’s Club of New York. (Mishkin, 2007) Mishkin is a leading mainstream economist and expert on money and banking, and the author of the best-selling college textbook on money and banking. Mishkin addressed the group on the topic of enterprise risk management and mortgage lending.
He begins,
Over the past ten years, we have seen extraordinary run-ups in house prices … but … it is extremely hard to say whether they are above their fundamental value.… Nevertheless, when asset prices increase explosively, concern always arises that a bubble may be developing and that its bursting might lead to a sharp fall in prices that could severely damage the economy.…
The issue here is the same one that applies to how central banks should respond to potential bubbles in asset prices in general: Because subsequent collapses of these asset prices might be highly damaging to the economy … should the monetary authority try to prick, or at least slow the growth of, developing bubbles?
I view the answer as no. (Mishkin, 2007)
In other words, if the Federal Reserve is not worried enough to change policy and address bubbles, you should not be worried either. He continues:
There is no question that asset price bubbles have potential negative effects on the economy. The departure of asset prices from fundamentals can lead to inappropriate investments that decrease the efficiency of the economy. (Mishkin, 2007)
In other words, there are some potential problems with bubbles. But Mishkin has a theory that says there can be no such thing as significant bubbles.
If the central bank has no informational advantage, and if it knows that a bubble has developed, the market will know this too, and the bubble will burst. Thus, any bubble that could be identified with certainty by the central bank would be unlikely ever to develop much further. (Mishkin, 2007)
He then tells his listeners that in the unlikely event of a housing bubble, it really would not be a problem for several reasons:
Asset price crashes can sometimes lead to severe episodes of financial instability.… Yet there are several reasons to believe that this concern about burst bubbles may be overstated.
To begin with, the bursting of asset price bubbles often does not lead to financial instability.…
There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability. House prices are far less volatile than stock prices, outright declines after a run-up are not the norm, and declines that do occur are typically relatively small.… Hence, declines in home prices are far less likely to cause losses to financial institutions, default rates on residential mortgages typically are low, and recovery rates on foreclosures are high. Not surprisingly, declines in home prices generally have not led to financial instability. The financial instability that many countries experienced in the 1990s, including Japan, was caused by bad loans that resulted from declines in commercial property prices and not declines in home prices. (Mishkin, 2007)
Everything he just said turned out to be completely untrue. As the leading expert on these subjects, he should have known that all of the statements in this quote were either not true or were at least far from certain. He clearly appears to be using this communication to quell rising fear and to instill confidence and it all turned out to be not true. But he continues to dig his hole deeper and his deception wider:
My discussion so far indicates that central banks should not put a special emphasis on prices of houses or other assets in the conduct of monetary policy. This does not mean that central banks should stand by idly when such prices climb steeply.…
Large run-ups in prices of assets such as houses present serious challenges to central bankers. I have argued that central banks should not give a special role to house prices in the conduct of monetary policy but should respond to them only to the extent that they have foreseeable effects on inflation and employment. Nevertheless, central banks can take measures to prepare for possible sharp reversals in the prices of homes or other assets to ensure that they will not do serious harm to the economy. (Mishkin, 2007)
In other words, the Federal Reserve understands bubbles, but it is not going to stop a possible housing bubble. In fact, if prices did start to decline noticeably and present any danger to employment or to raise the specter of deflation, Mishkin says the Federal Reserve is prepared to protect us from the bursting of the bubble and prevent housing prices from falling. Mishkin was in effect issuing a blanket insurance policy on housing prices.
Donald Kohn
Federal Reserve vice chairman Donald L. Kohn significantly downplayed the possibility of a crisis, but said:
In such a world [of financial crisis], it would be imprudent to rule out sharp movements in asset prices and deterioration in market liquidity that would test the resiliency of market infrastructure and financial institutions.
While these factors have stimulated interest in both crisis deterrence and crisis management, the development of financial markets has also increased the resiliency of the financial system. Indeed, U.S. financial markets have proved to be notably robust during some significant recent shocks. (Kohn, 2007)
He is in effect telling his listeners—mostly high-level employees in banking, finance and regulatory agencies—that financial markets are stable in the face of shocks, but despite this stability the Federal Reserve is working further to deter economic crisis and learning and doing more to be ready to manage future crises.
The Federal Reserve, in its roles as a central bank, a bank supervisor, and a participant in the payments system, has been working in various ways and with other supervisors to deter financial crises. As the central bank, we strive to foster economic stability. As a bank supervisor, we are working with others to improve risk management and market discipline. And in the payments and settlement area, we have been active in managing our risk and encouraging others to manage theirs. (Kohn, 2007)
In other words, the Federal Reserve will deter any crisis and is working with other regulators to prevent financial crises, to provide economic stability, improved risk management, and market discipline.
The first line of defense against financial crises is to try to prevent them. A number of our current efforts to encourage sound risk-taking practices and to enhance market discipline are a continuation of the response to the banking and thrift institution crises of the 1980s and early 1990s.…
Identifying risk and encouraging management responses are also at the heart of our efforts to encourage enterprise wide risk-management practices at financial firms. Essential to those practices is the stress testing of portfolios for extreme, or “tail,” events. Stress testing per se is not new, but it has become much more important. The evolution of financial markets and instruments and the increased importance of market liquidity for managing risks have made risk managers in both the public and private sectors acutely aware of the need to ensure that financial firms’ risk-measurement and management systems are taking sufficient account of stresses that might not have been threatening ten or twenty years ago. (Kohn, 2007)
In other words, the Federal Reserve’s number-one job is to prevent “extreme” events. Kohn is essentially telling his audience that the Federal Reserve is aware of black swans and that the Federal Reserve tests financial firms so that if such an event were to take place financial markets could withstand extreme changes in the economy.
A second core reform that emerged from past crises was the need to limit the moral hazard of the safety net extended to insured depository institutions—a safety net that is required to help maintain financial stability. Moral hazard refers to the heightened incentive to take risk that can be created by an insurance system. Private insurance companies attempt to control moral hazard by, for example, charging risk-based premiums and imposing deductibles. In the public sector, things are often more complicated. (Kohn, 2007)
Well, he did get that one right. Things are more complicated in the public sector. The Federal Reserve’s bureaucratic approach does need the element of deposit insurance, provided by the FDIC, to instill confidence in the system of fractional-reserve banking. However, the Federal Reserve’s own record of bailouts over the period of the so-called Great Moderation created a moral hazard for financial firms that ended up overwhelming the deposit insurance system. And now for the pièce de résistance: “The systemic-risk exception has never been invoked, and efforts are currently underway to lower the chances that it ever will be.” (Kohn, 2007)
This record of resisting the systemic-risk exception has now been shattered. What does that tell about the status of moral hazard in financial markets and what might transpire in the next crisis?
Randall Kroszner
Fed governor Randall S. Kroszner was the Federal Reserve’s number-one official in terms of regulation of financial markets. He was the point man in preventing things like systemic risk, but he considered all the new financial “innovation” and “engineering” to be a good thing:
Credit markets have been evolving very rapidly in recent years. New instruments for transferring credit risk have been introduced and loan markets have become more liquid.… Taken together, these changes have transformed the process through which credit demands are met and credit risks are allocated and managed.… I believe these developments generally have enhanced the efficiency and the stability of the credit markets and the broader financial system by making credit markets more transparent and liquid, by creating new instruments for unbundling and managing credit risks, and by dispersing credit risks more broadly.…
The new instruments, markets, and participants I just described have brought some important benefits to credit markets. I will touch on three of these benefits: enhanced liquidity and transparency, the availability of new tools for managing credit risk, and a greater dispersion of credit risk. (Kroszner, 2007a)
What he then goes on to discuss are “recent developments” such as credit default swaps (CDS), of which the “fastest growing and most liquid” are credit-derivative indexes involving such things as packages of subprime residential mortgages. He says that “among the more complex credit derivatives, the credit index tranches stand out as an important development.”
He believes that, historically, secondary markets were illiquid and nontransparent because banks held their own loans and that this was a problem. Now because of these new financial vehicles liquidity has improved and transparency has improved. This promotes better risk management, as risk is measured and priced better because market participants have better tools to manage risk. The result has been a “wider dispersion of risk.”
On its face, a wider dispersion of credit risk would seem to enhance the stability of the financial system by reducing the likelihood that credit defaults will weaken any one financial institution or class of financial institutions. (Kroszner, 2007a)
According to Kroszner, yes, there are some concerns here, but most of these concerns are “based on questionable assumptions.” Yes, there is risk, but it is the risk that has been out there all along; now we can trade this risk among ourselves. There is “nothing fundamentally new to investors … credit derivative indexes simply replicate the sort of credit exposures that have always existed.” Plus, remember that this risk is greatly diminished because lenders require borrowers to put up collateral.
What Kroszner seems to have failed to realize is that by allowing institutions to disperse their risk, the regulators encouraged and allowed for a huge increase in the aggregate amount of risk. When banks kept their own loans on their own books, they were careful to make prudent loans, but with nearly free money available from the Federal Reserve, they wanted to make more loans, and the only way to do that is to make riskier loans. They did not want to hold the risky loans, so they “dispersed” them.
Kroszner told his audience that the market already experienced a surprise in May of 2005, but that since that time much energy has been expended by market participants and the Federal Reserve to improve risk management.
We do not have to worry, Kroszner tells us, because Gerald Corrigan is in charge of making sure nothing goes wrong. Corrigan—a former president of the New York Federal Reserve and a managing director in the Office of the Chairman of Goldman Sachs—has been in charge of a private-sector group that controls “counterparty risk management policy” for the financial industry.
Cooperative initiatives, such as [this one led by Corrigan] can contribute greatly to ensuring that those challenges are met successfully by identifying effective risk-management practices and by stimulating collective action when it is necessary.… The recent success of such initiatives strengthens my confidence that future innovations in the market will serve to enhance market efficiency and stability, notwithstanding the challenges that inevitably accompany change. (Kroszner, 2007a)
Checking ahead, we find Kroszner still bullish later that same year.
Looking further ahead, the current stance of monetary policy should help the economy get through the rough patch during the next year, with growth then likely to return to its longer-run sustainable rate. As conditions in mortgage markets gradually normalize, home sales should pick up, and homebuilders are likely to make progress in reducing their inventory overhang. With the drag from the housing sector waning, the growth of employment and income should pick up and support somewhat larger increases in consumer spending. And as long as demand from domestic consumers and our export partners expand, increases in business investment would be expected to broadly keep pace with the rise in consumption. (Kroszner, 2007b)
Over the next year, the Dow would lose 6,000 points; by 2010 the amount of unemployment increased by seven million. Consumer confidence had hit a 27-year low, and sales of new homes hit the lowest level in a half a century—the lowest level in recorded history!
Conclusion We can see that the Federal Reserve plays a confidence game. Its officials’ public pronouncements, while heavily nuanced and hedged, uniformly present the American people and the leading figures in banking and finance with a rosy scenario of the economy, the future, and the ability of the Federal Reserve to manage the market. Ben Bernanke and his successor, Janet Yellen have continued to spin a positive story of economic recovery dating back to the spring of 2008.
These are the people who said that there was no housing bubble, that there was no danger of financial crisis, and that a financial crisis would not impact the real economy. These are the same people who said they needed a multitrillion-dollar bailout of the financial industry, or else we would get severe trouble in the economy. They got their bailout, and we got the severe trouble anyway. Is it not time to bring this game, this confidence game, to an end for the sake of economic stability?
However, all this evidence does not rule out the other explanations for their behavior. They could be just incompetent; they could genuinely think they are acting in the public interest, or it might not be humanly possible to run such a monetary system and they were just hoping that unwarranted confidence could save all of us from a genuine disaster.
Recorded during the Authors Forum at the 2016 Austrian Economics Research Conference, Leonidas Zelmanovitz (Liberty Fund), discusses his recent book, The Ontology and Function of Money: The Philosophical Fundamentals of Monetary Institutions (Lexington Books, 2015). Includes an introduction by Mark Thornton.
Quarterly Journal of Austrian Economics 18, no. 4 (Winter 2015): 578–583
Based on his doctoral thesis directed by Jörg Guido Hülsmann (who also wrote the foreword to the book), German economist Eduard Braun's Finance Behind the Veil of Money aims to show how money affects our financial decisions. The reader will notice that Braun approaches this goal from a different angle of most Austrian-school economists. Instead of looking at how money and credit affect interest rates and propagate an Austrian business cycle, Braun focuses on the “subsistence fund.” Largely jettisoned from modern Austrian business cycle theory, in a way Finance Behind the Veil of Money picks up where Richard Strigl left off with his Capital and Production (1934).
In expounding an updated theory of the definition and role of the subsistence fund, Braun rewards the reader for the time dedicated to reading the book. This time is not insubstantial. At 342 pages, the book is neither concise nor easy reading. It is heavy, dense, technical and littered with citations. The publisher’s exclusive use of endnotes makes the going tougher yet, as the reader constantly finds himself flipping pages to find out to whom Braun is attributing a concept, to what era the idea belongs or, indeed, since Braun uncovers the changing thoughts of several authors over their lifetimes, to what specific work of an author he is referring.
Dr. Mark Thornton on the View Point radio program. Interviewed by host Joey Clark, Mark discusses the Austrian view of economics and how it differs from the mainstream perspective. Topics include: malinvestment, prices, deflation, recessions, central banks, interest rates, and the 'Skyscraper Curse'.
According to the National Bureau of Economic Research (NBER), a recession is defined as a “significant decline in economic activity spread across the economy, lasting more than a few months.” Often, this is understood as two consecutive quarters of negative economic growth as measured by a country’s GDP.
Public opinion is generally quite simple in regard to recession: upswings are generally welcomed, recessions are to be avoided. The “Austrians” are however at odds with this general consensus — we regard recessions as healthy and necessary. Economic downturns only correct the aberrations and excesses of a boom. The benefits of recessions include:
Sclerotic structures in the labor market are broken up and labor costs decline.Productivity and competitiveness increase.Misallocations are corrected and unprofitable investments abandoned, written off, or liquidated.Government mismanagement of the economy is exposed.Investors and entrepreneurs who were taking too great risks suffer losses and prices adjust to reflect consumer preferences.Recessions also allow a restructuring of production processes.At the end of the corrective process, the foundation for a renewed upswing is more stable and healthy. We thus see deflationary corrections as a precondition for growth in prosperity that is sustainable in the long term. Ludwig von Mises understood this when he observed:
The return to monetary stability does not generate a crisis. It only brings to light the malinvestments and other mistakes that were made under the hallucination of the illusory prosperity created by the easy money.
Can the Government Save Face?However, in addition to leading to true temporary hardship for the malinvestment-affected areas of the economy, an economic recession in the near future would represent a harsh loss of face for central bankers. Their controversial monetary policy measures were justified as an appropriate means to nurse the economy back to health. That is, their efforts to end or avoid helpful recessions were claimed to contribute to the eagerly awaited self-sustaining recovery.
But the attempt to combat a crisis that was triggered by too loose monetary policy by the very same means will not lead to sustainable prosperity. It will only delay the crucial adjustment processes of a deflationary phase. The longer they are delayed and the more the central bankers and politicians attempt to keep them at bay, the more uncomfortable this adjustment will become.
Politics Trumps EconomicsIn general, there is the tendency in every democratic system to prevent too-painful adjustment processes as its nature of short-term bitterness and long-term benefits conflicts with the result scheme politicians are reelected for. No democratic government that is presented with the bill for the obvious successes and failures of its administration at the next election, will voluntarily allow a deep recession to occur — even if it were to agree that the adjustment was necessary.
Hence, inflationary policy is always a welcome method of impoverishing the population by decree and thereby pushing through a real adjustment of prices by force. The debasement of money as a rule always hits a society’s most underprivileged the hardest, as rich people can more easily avoid a devaluation of their wealth.
Concern from Outside the Austrian CampNonetheless, representatives of the Austrian school are no longer alone in warning about the fatal long-term consequences of the zero interest rate policy. Even the Bank for International Settlements, often referred to as the “central bank of central banks,” understands that endless attempts at avoiding recessions can have truly negative effects.
The BIS’s 2014 report warns of overly euphoric financial markets which, according to The Financial Times are “out of step with reality.”
The BIS explains:
Particularly for countries in the late stages of financial booms, the trade-off is now between the risk of bringing forward the downward leg of the cycle and that of suffering a bigger bust later on.
New debt serves primarily to keep the fragile edifice of debt from collapsing; it doesn’t lead to new investment activity. In this respect, the BIS sees parallels between Western industrialized nations today and Japan in the 1990s. These policies, the BIS contends “destabilises the banking sector directly but also acts as a drag on the supply of credit and leads to its misallocation.”
This year, the ECB, which as the successor of the German Bundesbank has long kept the flag of inflation reservation flying, finally capitulated and began betting on increased monetary stimulus — in keeping with the motto: “It isn’t working, so let’s do more of it!”
Nevertheless, according to F.A. Hayek, these united global crisis defense mechanisms only postpone the crisis which will take place at any rate, only later and much more severely:
To combat a depression by a forced credit expansion, is akin to the attempt to fight an evil by its own causes; because we suffer from a misdirection of production, we want even more misdirection — an approach that necessarily leads to an even more serious crisis once the credit expansion comes to an end.
Philip Mirowski, known for his book More Heat than Light: Economics as Social Physics, Physics as Nature’s Economics in which he criticizes neoclassical economics for adopting methods from the natural sciences, recently published a book on neoliberalism and the economics profession during the financial crisis. In Never Let a Serious Crisis Go to Waste: How Neoliberalism Survived the Financial Meltdown, his main thesis is that the economics profession utterly failed in predicting and explaining the financial crisis. Nevertheless mainstream economists did not suffer any negative consequences but continue with business as usual.
In Mirowski’s view, neoclassical economics, neoliberalism, and the political right came out of the crisis stronger thanks to a complicated propaganda effort and an intricate lobbying machine headed by the Mont Pelerin Society (MPS). According to Mirowski, the Mont Pelerin Society functions at the heart of a complex web of conservative and free-market think tanks and the neoliberal academics that controls politics.
Mirowski’s analysis is interesting even though it comes from a far left and egalitarian perspective. Especially pertinent is his analysis and critique of neoclassical economics.
The Lamentable State of the Mainstream Economics ProfessionThe neoclassical mainstream profession was unable to predict the Great Recession. As neoclassical economists believed in a new age of macroeconomic stability, dubbed the Great Moderation, in which central banks had basically abolished harsh recessions, they were taken by surprise by the immense problems the financial system and the world economy started to experience in 2008.
Mirowski explains this failure as the result of a methodological dead end. The neoclassical profession was unable to predict the Great Recession with their methodological instruments such as the infamous dynamic stochastic equilibrium models (DSGE). Since in the DSGE there is basically no room for crises, neoclassical economists were not only unable to predict the financial crisis, they are also unable to explain it in retrospect.
Mirowski diagnoses a cognitive dissonance in the neoclassical camp. As neoclassical theories are unable to explain the financial crisis, there is a gap between the accepted theory and reality. To bridge this gap neoclassicals have, according to Mirowski, reacted in accommodating (or distorting) the empirical evidence to fit their theories somewhat. Instead of recognizing that a paradigmatic change is necessary in mainstream economics, the economics profession stubbornly sticks to their mathematical models.
Mirowski describes accurately the inertia of mainstream orthodoxy. Sunk costs of intellectual capital investments for neoclassical economists are enormous. The profession remains without orientation and vision, stumbles, and stagnates in mediocrity. Indoctrination propagates the orthodoxy. Students are socialized with economics textbooks using an incoherent potpourri of theories. They are made to read short-lived articles published in highly ranked journals using mainstream methodology. In this context, Mirowski points to the fact that journals in general have stopped publishing articles on methodology and economic history in favor of mathematical and statistical articles. Mirowski correctly connects the mathematization with the incorporation of natural scientists into economics and regards this development as one reason for the financial crisis.
The Methodology ProblemMirowski criticizes neoclassical methodology arguing that economists envy the physical sciences. Due to this envy, economists started to imitate the method and models of physics. It was the mathematical approach used in physics that made neoclassical economists unable to foresee the crisis. Mirowski’s critique does not shy away from leftist neoclassical economists. Consistent in his approach he not only chides Greenspan and Bernanke, but also Stiglitz and Krugman. While there may be ideological differences between them, they all employ DSGE models in which a representative agent maximizes utility functions.
According to Mirowski it was the DSGE model that allowed for the unification of economics again after microeconomics had been separated from macroeconomics due to the Keynesian revolution. DSGE models allowed employing the mathematical approach of microeconomics in the macrosphere by introducing utility maximizing agents and high aggregation. Mirowski goes so far as to say that without DSGE, neoclassical economics disappears.
While Mirowski calls for a reset of economics and the end of the neoclassical paradigm, he fails to provide an alternative, and he does not seem to be aware of the praxeological approach of the Austrian school. The realistic alternative Mirowski calls for already exists. He is also unaware that due to their realistic approach, Austrian economists were not surprised at all by the financial crisis, which was predicted by some of them. Unfortunately, the ignorance of Mirowski concerning the Austrian school is immense as we will see in his interpretation of Hayek and his complete neglect of the works of Ludwig von Mises and Murray Rothbard; not to speak of his neglect of contemporary Austrians.
Mirowski’s Confusion About Schools of ThoughtThe main problem of Mirowski is his confusion when it comes to the Austrian school and libertarianism. Mirowski regards most neoclassical economists as neoliberals (with some exceptions on the left such as Stiglitz or Krugman). Implicitly he also incorporates the Austrian school in the neoliberal camp. He even writes about “Hayekian neoliberals.” Yet, Austrians are neither neoclassical nor can many be considered to be neoliberal.
It is true that in some parts of his book Mirowski distinguishes between neoliberal versus libertarian, and neoclassical versus Austrian, but he does not apply this distinction consistently. This lack of consistency produces curious results.
For instance, he argues that Chicago’s efficient market hypothesis (EMH) formalizes Hayek’s theory of knowledge. This seems to imply that Hayek, or other Austrians, share the method of neoclassical economists, and belong to one and the same neoliberal camp.
Nothing could be further from the truth. Hayek’s theory of subjective knowledge treats knowledge as being tacit, private, subjective, and decentralized. Hayek’s treatment of subjective knowledge is fundamentally opposed to any mathematical or formalized treatment of information. More specifically, the creative nature of entrepreneurial knowledge in the Austrian tradition contrasts with the objective and given type of information of the EMH.
The EMH states that market prices are efficient as they incorporate all relevant information and assumes an objective kind of information that can be bought and sold on the market place. Yet, what is important is not the objective and given information, but rather the subjective interpretation thereof and the creation of new entrepreneurial knowledge in a dynamic process. Past prices are just historical exchange relationships that serve market participants to create new information. Mirowski distorts Hayek by stating that according to Hayek the market transmits the knowledge of what we need to know. Instead Hayek pointed out that market prices allow us to use the subjective knowledge of other market participants. The market does not automatically transmit the knowledge that we need to know, rather market participants need to discover and create what they need to achieve their ends.
There are additional problems with Mirowski’s mixing of subjectivism and Hayek’s theory of knowledge with EMH, CAPM, and the Black-Scholes model. There is nothing subjectivist in an equilibrium construct such as the EMH, the CAPM; or Black-Scholes. In all these mathematical models all relevant information is already given. They are static. Mirowski simply misses Hayek’s main point that entrepreneurs in a competitive market process discover new information. As the market is a process, the market is never perfect. Market participants may err or fall prey to illusion; Mirowski’s whole book is a prime example for that.
Another curious result from Mirowski’s failure to distinguish clearly between the Austrian school and neoliberals comes when he deals with constructivism. Mirowski regards neoliberals as constructivist. At the same time Mirowski includes Hayek in the group of neoliberals (and one might wonder the whole Austrian school) and tries to reconcile Hayek’s criticism of constructivism with neoliberalism. But how can Hayek, who has fought most vigorously against scientism and constructivism in the twentieth century, be a constructivist?
Austrians vs. ChicagoansThe implicit mixing of the Austrian and Chicago schools is especially problematic. Mirowski claims that neoliberals subscribe to the concept of the spontaneous order. Yet, the spontaneous order is a concept employed mainly by Hayek and other Austrians. In contrast, neoliberals of the Chicago school use the equilibrium construct as an analytical tool. Yet, equilibrium analysis is fundamentally opposed to the Austrian school’s analysis of the dynamic market process. In short, neoliberals of the Chicago school do not employ the concept of spontaneous order consistently.
Writers such as Mark Skousen (2006) have tried to bridge the gap between the Chicago school and the Austrian school. Yet, this endeavor is an impossible undertaking. The main and fundamental difference between the two schools of thought is their methodological approach. Austrians in the Misesian tradition logically derive a priori economic laws from the axiom of human action with the help of some general presuppositions. Instead of making experiments and looking into the outside world, they look inside using introspection to find truth.
In contrast, Chicago school economists following Milton Friedman (1953) employ a positivist methodology. While Austrians maintain that one needs a theory first in order to understand history, followers of the Chicago school try to derive economic laws from history; sometimes applying econometric analysis. While scholars in the tradition of the Austrian school view reality as a dynamic process of human interaction, Chicago scholars employ equilibrium models, in which entrepreneurship and creativity are absent by definition and the dynamic market process is frozen. While Austrian economists regard the aim of an economist to understand and to explain the laws that govern the dynamic market process, Friedman’s aim is to make correct predictions. While Austrian economists aim at a realistic explanation of the market process, for Friedman realism of the assumptions is irrelevant. Only the predictive power of a theory counts.
In his book, Mirowski criticizes Friedman’s approach stating that model building for predictions has been a disastrous failure, an assessment many Austrians would share. Unfortunately, Mirowski fails to mention Austrian methodology in his book and seems to be unaware of this alternative defended by many members of the “neoliberal” MPS.
Directly related to these methodological differences between Vienna and Chicago is the opposed view on competition. While Chicago scholars tend to support and devise antitrust laws in order to bring reality closer to their model of perfect competition, Austrian scholars oppose the intervention of the government into the dynamic market process in the form of antitrust laws.
The high aggregation required by model building and mathematization has also lead to directly opposed views on capital by both schools. Capital, which is presented by the letter “K” in Chicagoite models, is viewed as a homogenous, permanent fund that synchronously and automatically produces income. The view of capital as a homogenous fund and production as instantaneous is a direct consequence of the mathematization and formalization of the Chicago school.
The Austrian view on capital is fundamentally opposed to the neoclassical one. Indeed, there was an intense debate between Chicago and Vienna on the concept of capital. Friedrich Hayek (1936) and Fritz Machlup (1935) criticized Frank Knight for the meaningless concept of capital as a homogenous, automatically self-maintaining fund. Austrian capital theory and the view of production as a time consuming process allowed Austrian economists to develop a theory of intertemporal distortions in the structure of production induced by credit expansion unbacked by real savings. Austrian business cycle theory is commonly not understood by the Chicago school as neoclassical economists lack the necessary theoretical instruments; instruments they are unable to develop with their methodological approach.
Explaining Booms and BustsConsequently, the interpretations of the Great Depression (and the Great Recession) by Austrians and Chicagoites differ widely. The Chicago school, following Milton Friedman and Ana J. Schwartz, maintains that the severity of the Great Depression was due to errors committed by the Federal Reserve. More precisely, the Federal Reserve according to Friedman and Schwartz did not expand the monetary base fast enough during the early 1930s. Following the Chicago interpretation, Ben Bernanke (2002) promised Milton Friedman not to commit the same mistake again, which explains the Federal Reserve’s reaction to the Great Recession in the form of Quantitative Easing.
In contrast, Austrian business cycle theory explains the Great Depression by the extraordinary credit expansion of the 1920s. Reinflating the money supply, in the Austrian view, disturbs the necessary readjustment as it stabilizes artificially old malinvestments and stimulates additional ones. Austrians explain the severity of the Great Depression by the size of the credit expansion in the 1920s and the concomitant malinvestments as well as the government interventions introduced in the 1930s such as the Smoot-Hawley Tariff Act or the New Deal in general.
Austrian economists were not blinded by the apparent price stability in the early 2000s. In fact, Mises and Hayek warned against policies of general price level stabilization hailed by Fisher and other monetarists. In times of economic growth such policies require the continuous injection of new money which is the source of intertemporal distortions. Due to their business cycle theory, Austrians were not taken by surprise by the financial crisis in contrast to Chicago economists. The same is true for the years leading to the Great Recession. Thus, Mirowski is just plain wrong with his sweeping statement that the (whole) economics profession did not foresee the financial crisis. It is true that neoclassical economists due to their methodological approach could not develop the theoretical tools necessary to understand the problems of the ongoing credit expansion of the early 2000s. In contrast, Austrian economists had those tools.
Unsurprisingly, another main area of disagreement between Chicago and Vienna, which Mirowski does not explain, is on monetary policy. Most Austrians favor the abolition of central banks and the introduction of a free market money, such as a 100 percent gold standard. Chicago school economists generally do not want to entrust the money supply to the market but are in favor of a central bank issuing fiat money. Central planning in money is not seen as a problem, but as a solution to crisis in the banking sector by defenders of the Chicago school.
Mirowski does not touch upon all these fundamental differences. He is correct, when he points to the central bank correctly as a neoliberal institution. Yet, he also claims that the Tea Party in the US is basically a neoliberal group. Later in the book he states that Ron Paul wants to abolish the Federal Reserve. Mirowski also mentions that Ron Paul is in the tradition of Hayek who is in favor of free banking. However, Ron Paul is regarded to be close to the Tea Party. The reader remains confused. Why would a hero (Ron Paul) of a neoliberal group (Tea Party) want to abolish a neoliberal institution (Federal Reserve)?
We are faced with another apparent contradiction caused by not distinguishing clearly between Austrians and Chicagoites or neoliberals and libertarians. If Mirowski had explained that Ron Paul is a follower of the Austrian school, it would have been no surprise to the reader that he opposed the Federal Reserve. But Mirowski just states that Bernanke sides with the neoliberal position of Milton Friedman. He simply fails to understand that Chicagoites and Austrians are diametrically opposed on fundamental questions and that it is a fallacy to consider them as ideologically and methodologically close.
The Origins of Mirowski’s ConfusionWhere does Mirowski’s confusion stem from? Why does he not clearly differentiate between the Chicago and the Austrian school?
There are basically three reasons that may have contributed to this confusion. First, the Austrian school and the Chicago school share many free market ideas. Members of both schools generally oppose price controls, product regulation, and the public provision of education services. Yet, as we have pointed out above, differences abound. The Chicago school supports central banking and antitrust, while the Austrian school does not. If Mirowski had looked into the libertarian positions many Austrians hold, he would have recognized that most Austrians are wide apart from the neoliberal positions of Chicago.
Second, Hayek became a professor at the Univeristy of Chicago in 1950. Yet, the location of Hayek at Chicago does not imply that he was close to Chicago school ideas. In fact, Hayek became professor at the Committee of Social Thought in Chicago, because Chicago economists had opposed his appointment at the economics department. This is understandable as Hayek was very critical of the positivistic approach that Chicago economists followed.
Third, the most likely cause of confusion stems from Mirowski’s treatment of the Mont Pelerin Society where Austrians and Chicagoites often meet together. From the very beginning, starting with the 1947 founding meeting of the Mont Pelerin Society, there were three main schools of thought that were represented: the Austrian school, the Ordoliberalism, and the Chicago school. Mises and Hayek from the Austrian school, Walter Eucken and Wilhelm Röpke were Ordoliberals, and George Stigler, Frank Knight, and Milton Friedman from the Chicago school.
Both the Chicago school and the Ordoliberal school can be classified as neoliberal. They oppose socialism, but also Manchesterism, i.e., they oppose the laissez-faire approach of classical liberalism. Both Ordoliberals, mainly located in German speaking countries, and the Chicago school favor a strong state to set the framework for the market and direct economic life in certain directions. They also want the state to provide some social security.
There has been tension from almost the very beginning between Austrians and neoliberals within the Mont Pelerin Society. As Mises wrote in the 1950s: “I have more and more doubts whether it is possible to cooperate with Ordo-interventionism in the Mont Pelerin Society.”
In retrospect and from the point of view of the Austrian school, it may be regarded indeed as a strategic error to found an alliance with the Chicago school and other neoliberals within the Mont Pelerin Society. As Austrians and neoliberals are united in the Mont Pelerin Society, authors like Mirowski tend to conflate neoliberalism with libertarianism and Chicago positions with Austrian ones. Instead of treating neoliberals as friends with a common cause, Austrians could have fared better by regarding neoliberals as enemies of their enemies; namely of full-blown socialism. Austrians could have made their ideological and methodological differences much clearer in a Mont Pelerin Society dominated by themselves and excluding Chicagoites and other neoliberals. Most of the attacks from Mirowski against the economics profession per se or against liberalism would have lost credibility. Then Mirowski would have had to direct his criticism only against the Chicago school and neoliberals.
This article was adapted from Philipp Bagus’s article “Why Mirowski Is Wrong About Neoliberlaism and the Austrian School.”
Quarterly Journal of Austrian Economics 18, no. 3 (Fall 2015) ABSTRACT: A recent controversy has brewed over whether or not the emergence of bitcoin, as a new medium of exchange, is in accordance with Mises’s regression theorem. The main question in the debate seems to be, is bitcoin valued in direct use? The present paper contends that with respect to the regression theorem, this issue has no bearing on bitcoin’s genesis, because it is relevant only when a new medium of exchange arises out of a pure barter economy. The debate is therefore predicated on a misinterpretation of the theorem. However, the issue of bitcoin’s direct-use value, if it has one, does have relevance in assessing the likelihood it will become a generally-accepted medium of exchange—i.e., money.
KEYWORDS: money, bitcoin, regression theorem, Mises JEL CLASSIFICATION: E59 I. Introduction In the last couple of years, there has been much debate online, particularly in Austro-libertarian circles, concerning the economic nature of crypto-currencies, and in particular the origin and potential future of the first crypto-currency to emerge; namely, bitcoin. There are two areas in which this debate has been focused. The first asks: “is bitcoin money? And if not, does it have the potential to become money?” The second question is: “does bitcoin have a direct-use value, and if not, does its obvious emergence as a medium of exchange therefore not refute Mises’s regression theorem?” To that end, the commentators have been either searching for this value or criticizing the theorem, depending on which side they take. A subsidiary issue is whether or not it matters if bitcoin’s direct-use value, if it has one, is intangible.
Most commentators agree that bitcoin is a medium of exchange—that is to say, there are at present market actors who willingly accept bitcoins in exchange for real goods and services, and then use them to buy other goods—but that bitcoin is not money, at least not yet, insofar as money is usually defined. This requires that the item be a general medium of exchange, acceptable to most people for purchases and sales, and at least as of 2015, bitcoin has not (yet?) achieved that status. Of course, there is a clear praxeological distinctionOn praxeology, see Block (1973), Hoppe (1991, 1995), Hülsmann (1999), Mises (1969, 1998), Polleit (2008, 2011), Rothbard (1951, 1957), Selgin (1988). to be made between goods that are valued as media of exchange, and those that are valued only for their direct use. Thus, we must draw a clear distinction also between an economy where individuals rely on indirect exchange in some capacity, and one where they rely solely on barter.
However, there is no praxeological difference between a medium of exchange and money. For the difference here boils down merely to one of how one defines the word “money,” and to what extent the medium in question is accepted in the market in order to meet the definition. Menger (2009, p. 11) defines money as the “universal medium of exchange,” meaning it must be accepted by everyone, while Mises (1998, p. 398) more reasonably maintains it must be “generally-accepted and commonly-used,” leaving some room for the possibility that not everyone need be willing to accept it. But no matter which definitional version one chooses, it seems fairly clear that bitcoin has not yet reached the threshold of either of them.
Whether it can reach that tipping point at some point in the future is not a praxeological question, and is something that will be discussed in a later section. First, in Section II we turn to the issue of bitcoin and the regression theorem. Section III considers in further detail Mises’s regression theorem. Section IV asks whether bitcoin violates the regression theorem, and Section V asks whether bitcoin can become money. Section VI is devoted to a hypothetical: suppose bitcoin evolved directly from barter; would this then constitute a violation of the regression theorem? We conclude in Section VII.
II. The Present Debate Concerning Bitcoin and the Regression Theorem The debate has been framed by most commentators in the following way: the regression theorem refers to the emergence of a medium of exchange, where a good that was once valued only for its services in some direct use (either in consumption or production) becomes valued for its function in indirect exchange. According to these authors, bitcoin fits within the broad category of a medium of exchange. So its presence in the market must either refute the theorem on the grounds that it has never been valued directly, and certainly not as a tangible commodity like gold; or, the theorem is intact. And this can come about in one of two ways: (a) because bitcoin did indeed have some value prior to its becoming a medium of exchange, and (b) because the theory allows this value to involve an intangible good.A smaller number of commentators maintain that the regression theorem refers to the emergence of money rather than a mere medium of exchange, and because bitcoin is not yet money, they claim it is not necessary to reconcile bitcoin’s presence in the market with the theory. Indeed, say these authors, the theory proves bitcoin never will become money. However, as Murphy (2013b) points out, this argument overlooks the fact that the regression theorem is a praxeological theory, which does not concern itself with the question of why or when a medium of exchange becomes money. The transition to money is a process governed solely by the liquidity of the good in question and the psychological response of the actors, and the point at which it occurs is determined arbitrarily according to a defined standard. In effect, the move from an exchange medium to a money occupies a continuum. See on this Block and Barnett (2008).
For example, Graf (2013a, 2013b) sets out to demonstrate that bitcoin does not violate the regression theorem on the grounds that it does indeed have a prior direct-use value. Graf lists the reasons why he thinks actors might have valued bitcoin prior to it becoming a medium of exchange; for example, as a digital object for use in testing the network, or for a game, or simply because it was seen as advancing a cause. He contends there is no economic reason why a medium of exchange has to start out as a physical material as opposed to an intangible good. While Menger maintains that money has to originate as a commodity—implying that the good must be tangible—in the modern age we should consider all goods to be contenders for becoming a media of exchange, whether or not they possess any physical attributes, says Graf.
In the same vein, Tucker (2014) also searches for bitcoin’s non-monetary value, noting it has an independent direct use as a payment system, this attribute of bitcoin being contained within the network and the blockchain.“A blockchain is a transaction database shared by all nodes participating in a system based on the bitcoin protocol. A full copy of a currency’s blockchain contains every transaction ever executed in the currency.” From https://en.bitcoin.it/wiki/Block_chain. As a result of this value, Tucker is also of the opinion that bitcoin does not invalidate the theorem.
Surda (2012, 2014) contends that if one denies that bitcoin complies with the regression theorem, one denies the a priori character of the theorem itself, “shooting oneself in the foot in the process.” As an a priori argument this is incontrovertible. Since the theorem implies a medium of exchange must start out as a commodity, and it is undeniable that bitcoin is a medium of exchange, it must necessarily be the case that bitcoin was valued as a commodity prior to it being used in indirect exchange. The fact that we might remain oblivious to the motivations of the original actors, or the properties that were (or are) valued by them, has no bearing on the issue.
Faggart (2014a, 2014b, 2014c) also supports the notion that bitcoin must be reconciled with the regression theorem. He observes nevertheless that Surda’s argument is circular: Even though the theorem is apodictic, we cannot simply assume the chains of reasoning used to deduce the theory are correct. Because bitcoin was designed from the ground up to be money, and therefore did not appear to have a clearly identifiable original direct use, it is necessary to respond to critics who question the theorem, and we must do so by providing some kind of empirical evidence. To satisfy them, says Faggart (2014c), we must examine the history to identify when bitcoin went from being a “consumer good” to being used in indirect exchange.
Murphy (2013a, 2013b, 2014) maintains that if one wishes to square Misesean theory with bitcoin, it is quite possible to do so by envisaging that the first actors to acquire the crypto-currency did so for ideological reasons. We can compare this to the kind of value people derive from contributing to a cause or to a charity. Because of such motivations, people had a framework for evaluating its purchasing power, says Murphy. He asks if it might be possible for a medium of exchange to emerge on the market without having any direct use at all. For example, says Murphy, consider a person who is willing to be the first to give up something of market value in order to acquire a completely new good—such as a bitcoin—simply because it has the potential for becoming a medium of exchange. This alone could establish its price, and thus set the stage for its actual emergence as a medium of exchange. This assumes, of course, that the good in question has attributes that make it especially suitable for that purpose. In this case, the new medium of exchange, assuming it becomes one, would never be valued for anything other than its use in indirect exchange. Murphy then declares that if this is the case, there must be a “loophole” in Mises’s argument.
Suede (2011) also embraces the idea that an object need not necessarily be valued directly before its emergence as a medium of exchange. Therefore, it is not necessary for us to look for bitcoin’s value as such, or for the point in time at which it transitions from a commodity to a medium of exchange. The argument that market participants always have to experience a good in some direct way before they can use it as a medium of exchange is not true. All that is needed is for them to perceive the benefits of indirect exchange in order to invent the necessary medium. According to Suede, the indirect exchange properties of gold alone would give it value even if it never had any other use. In a similar vein, bitcoin could emerge as a medium of exchange without any direct-exchange value, and do so even in the absence of an existing price network. As a consequence of these observations, Suede suggests that Mises’s whole approach to the origin of money is erroneous.
However, what the arguments above all have in common is that they misinterpret Mises’s regression theorem. Indeed, the question of whether or not bitcoin can be reconciled with the regression theorem misses the point entirely. While some of the claims raised by these commentators are very cogent, the debate has been framed in entirely the wrong terms. In order to understand why, a review of the regression theorem is appropriate.
III. Mises's Regression Theorem Before The Theory of Money and Credit was published in 1912, no one had been able to employ the lessons learnt during the marginal revolution, concerning subjective value and marginal utility theory, and apply it to money. Goods other than money had marginal utility, which could explain their demand and supply schedules in terms of money, but money itself could not have marginal utility—or so it was thought. How could it, asked the economists of the time? If marginal utility were applicable to money, its demand schedule could only be explained by analyzing it in terms of all the other goods on the market. But if all these goods are valued in terms of money, and yet money is valued in terms of them, then clearly this is a circular argument, they said. Accordingly, money was separated from praxeological theory, and from individual action.
Mises’s accomplishment was to show, without introducing a circular argument, that the demand schedule for money can be explained using marginal utility theory, and that it has a downward sloping curve like any other good. In addition, he demonstrated that the demand for money is to hold for future exchanges. It is comprised of an exchange demand by those who wish to obtain money and a reservation demand by those who already possess it. Mises was able to avoid the circularity problem by introducing a time element into the argument as follows: Money is subjectively evaluated (in terms of other goods) not by simultaneously, and subjectively, assessing the prices of other goods (in terms of money), but rather by employing the objective prices that already exist. Put another way, the subjective exchange value of money (to hold) today takes place using as a starting point the objective exchange values of yesterday. This is the crux of the theorem. Menger had laid the groundwork for establishing the technical features of money, but Menger’s contribution did not explain how money derived its (subjective) value. As Mises ([1912] 1953, p. 116) states,
Neither Menger, nor any of the many investigators who have tried to follow him, have even so much as attempted to solve the fundamental problem of the value of money. Broadly speaking, they have occupied themselves with checking and developing the traditional views and here and there expounding them more correctly and precisely, but they have not provided an answer to the question: What are the determinants of the objective exchange-value of money?
In The Theory of Money and Credit, Mises (1912) ably disposed of all the previous erroneous notions concerning the value of money: that its value was tied to the cost of production, that it was dependent on money income versus real income, or that it could be reduced to mathematical formulae, using equations of exchange and untenable variables such as the velocity of circulation.See Rothbard (2004, pp. 831–842) and (2011, pp. 685–708) for a criticism of the equation of exchange and the notion of the velocity of money.
But there remained a problem, claimed the critics, for if the value of money is determined in part by the array of prices that existed yesterday, and yet those prices were derived by using a value of money that was based upon the prices extant the day before, then does this not lead to an infinite regress? No, said Mises, for if taken back far enough, there comes a point at which money first emerges as a medium of exchange out of a pure barter economy. Prior to this, it is valued only for its non-monetary uses as a commodity. The demand for money is therefore pushed back to the last day of barter, where goods are traded only in direct exchange, and where the temporal element of the regression theorem ends. It is in this way that all charges of circularity are obviated.
The regression theorem is first and foremost an argument based on praxeological deductions. It can be seen, however, that the theorem involves two distinct elements. The first part is a causal-realist explanation of the marginal utility of money, while the second is a causal-genetic explication that deals with the origin of money. The second element explains why there is not an infinite regress, and how an economy transitions from a state in which there is only direct exchange—a state of barter—to one where indirect exchange is present.
With reference to this second element, Mises ([1912] 1953, p. 110) states:
If the objective exchange-value of money must always be linked with a pre-existing market exchange-ratio between money and other economic goods (since otherwise individuals would not be in a position to estimate the value of the money), it follows that an object cannot be used as money unless, at the moment when its use as money begins, it already possesses an objective exchange-value based on some other use.
It is important to emphasize that what Mises refers to in this passage is the origin of a new money—de novo—i.e. from a pure state of barter, where there are no existing money prices. To that end, the second part of the regression theorem only explains the genesis of a new money where none existed before. It explicates how a barter economy—where all economic calculation is conducted ordinally—becomes a monetary economy in which calculation is performed cardinally. It should not be interpreted to mean that once a calculational framework in terms of money prices is established, that all future media of exchange (or monies) within that economy must arise from having a prior non-monetary use. The theory therefore is not an explanation for the origin of all monies or all media of exchange.
Indeed, Mises fully recognized that a new medium, such as a fiat currency, can piggyback onto any existing price framework, and that in this case, the new currency need never have been valued directly as a commodity itself. The only requirement is that the paper money’s exchange value can be traced back in time, sequentially, to when only a commodity money existed, and ultimately to the point when that commodity was last used solely in barter.
From a historical perspective, fiat currencies and other paper currencies, such as “credit money,” have come into existence by being redeemable for the commodity money. In this way, confidence is created in the public that the new medium will be accepted in exchange. It then becomes a money. But as Mises makes clear, a paper currency can continue its monetary function even when it is no longer redeemable, provided the public continues to have confidence in its acceptability.
But there is an important point to make here. The regression theorem has nothing to say about the question of why subsequent currencies become established, why they continue to be accepted, or why they displace existing ones. Nor does it have anything to say about the rate at which a new currency is exchanged with the old.
Certainly, in the case of an emergent fiat currency, its redeemability at a fixed rate for the prior currency (or commodity money) is mandated by law, initially. And it might appear that this is a necessary requirement for its adoption. Moreover, it might seem that once its connection to the prior monetary system is dropped, and it becomes a true paper currency, it can do so only through the enforcement of legal-tender laws. But, empirically, we can observe that the initial legal requirement for redemption and rate-fixity is not a necessary condition for a new money to piggyback onto an existing one. Credit money,See Mises (1912) pp. 61–62. for example, can arise without any statutory stipulations whatsoever; the redemption that it initially possesses may be based upon a contractual agreement only. Moreover, since it arises as a credit instrument, its initial redemptory feature is certainly not instantaneous, and not at a fixed rate. And yet despite this, and without the benefit of any legal-tender laws, it emerges as standalone currency and continues to do so, even when all connections to the previous monetary regime are severed.
How is this possible? To ask this is to ask a psychological question, because ultimately any money’s acceptability, as an exchange medium, is determined solely by the psychological impulses of those using it. Credit money is possible only because individuals have enough confidence that others will accept it in exchange, once they have done so themselves. The question of why the first person accepted it as such can be answered only by delving into his mind. But even the acceptability of a fiat currency is determined by the psychology of individual actors. One need look no further than past hyperinflations to see that legal-tender laws are no guarantee that fiat money always continues to function.
The acceptability of any new currency is not a praxeological issue. Redeemability may give market participants the confidence that the new currency will be accepted by others such that they will demand it for themselves, and legal tender laws give added impetus to these beliefs, but these notions are not related to any praxeological phenomena that govern the genesis of money. Nor is it deducible from the logic of action that once this confidence has been established, the fiat currency can continue to function as money after the redeemability has been eliminated. Historically, these sequences of events have certainly occurred, but because they are dependent on the confidence of the public, they are merely psychological phenomena.
What praxeology has to say, and what matters as far as the regression theorem is concerned, is that it is logically impossible for any new money to emerge unless there is some sort of existing price structure in place. Without prior prices present in some form, actors cannot calculate using the new money. And, therefore, if no price ratios have been established monetarily between the various goods and services, they can only be obtained through a process of direct exchange in the barter economy. This is the crux of the regression theorem. But there is no praxeological necessity for the new money to be redeemable for the old in law, or to trade at a fixed rate with it. Praxeology has nothing to say on the sequence of events during the transition. It merely prohibits the adoption of a new money without a calculatory framework.
After The Theory of Money and Credit was published, a number of economists criticized Mises on the grounds that the theory failed to explain how entirely new paper currencies can replace existing fiat monetary regimes. An example is the German Rentenmark, which was introduced to replace the paper mark in 1923 as a result of the hyperinflation that Germany experienced during the early 1920s. Clearly, this new currency neither possessed an objective-exchange value based on some other use, nor even a previous exchange value based on a commodity money. But these criticisms of Mises were misplaced, because they were founded on a misinterpretation of the regression theorem. That theorem does not contend that a new or subsequent money must arise out of a state of barter. Nor does it attempt to explain why new monies that have not arisen from barter replace existing ones. It merely implies that in order for the new money to be used in economic calculation, there must be an existing price system in place upon which the new money can be superimposed, which was clearly the case with the Rentenmark.
However, the establishment of the Rentenmark is an interesting example of how the psychological factors come into play when a new currency replaces an existing one.
As Bresciani-Turoni (1968, p. 347) explains,
In October and in the first half of November [of 1923] lack of confidence in the German legal currency was such that, as Luther wrote, ‘any piece of paper, however problematical its guarantee, on which was written “constant value” was accepted more willingly than the paper mark.’ …But on the basis of the simple fact that the [Rentenmark] had a different name from the old, the public thought it was something different from the paper mark, believed in the efficacy of the mortgage guarantee and had confidence.
The reason the Rentenmark could be used for economic calculation was because the memory of a price structure still existed under the paper mark, despite the latter’s hyperinflation; it was this previous structure that enabled the Rentenmark to serve as a unit of account, entirely in accordance with the regression theorem. But the reason it was accepted, and thus came into general circulation, was purely psychological.
As Parsson (2009, pp. 11–12) states, “The Rentenmark was placed in circulation beside the devalued Reichsmark and carried no real value of its own but the naked avowal that there would be only so many Rentenmarks and no more.”
A more recent example of paper money supplanting paper money is the euro, which superseded a number of existing national fiat currencies beginning in 1992. The regression theorem implies that without a price structure under the old system, it would have been impossible for the euro to become money. However, beyond this fact, the reason the euro was accepted by individuals as money was due to its anticipated acceptability in exchange. This involved various psychological factors, created in the minds of the public, by legal tender laws, by various assurances of the government, and by its redeemability (for a while) against older currencies, that gave rise to the necessary confidence.Also, governments announced that they would only accept this new currency for tax purposes. For example, initially, the exchange rates of the national monies were locked at fixed rates against each other, and then at an arbitrary rate against the new euro.
It might be objected that these examples are not sufficient to demonstrate why bitcoin does not violate the regression theorem. It might be argued, for example, that bitcoin has not been established with the aid of legal tender laws or at a fixed rate with the prior currency. But it would be a mistake to think that because other currencies have been established through fiat, that the praxeological argument with respect to bitcoin is unconvincing. Praxeological arguments can neither be proven nor disproven using empirical data. The examples we give above are merely illustrations; and the intent is only to contrast the psychological factors that can come into play with the praxeological ones. The important point to make is that psychological factors have no bearing as far as the regression theorem is concerned.
IV. Does Bitcoin Violate the Regression Theorem? There are no clearly definable psychological requirements for a medium of exchange to arise. This is in contrast to the praxeological necessities dictated by the regression theorem. From a praxeological perspective, it is clear from the foregoing discussion there are two separate circumstances in which a new medium of exchange can start to function as a means of calculation and unit of account: (1) The new medium emerges from a pure barter economy, in which case it must have some previous direct-use value, or (2) it emerges when there is an existing money-price structure in place, or at least the memory of one.
In this case, the new medium, whether tangible or intangible—need not have any value as a commodity in direct use, need not necessarily be “backed” by or redeemable for anything, and need not be established at a fixed rate. None of this violates or invalidates the regression theorem. Historically it is true that new media have often incorporated some of these features as a means of creating the necessary psychological reaction to induce its acceptance, but they are not a praxeological necessity from the perspective of economic calculation. As long as prices exist in terms of the old money, this is all that is required to satisfy Mises’s theorem.
What does this mean for bitcoin? Clearly, this quasi money emerged onto the scene in the presence of an existing monetary regime. Therefore, to ask whether or not it had any value in direct use prior to its becoming a medium of exchange is irrelevant as far as the regression theorem is concerned. If it was (or is) a commodity that had (or has) a non-monetary value, then to fret over whether this good is intangible or not, is also of no consequence to the theory. Since an existing price structure was in place, the regression theorem has nothing more to say on the matter. And it is not incumbent upon advocates of the regression theorem to explain how the price of bitcoin in terms of the existing currency was established in the absence of any legally-imposed conversion process, when the theorem has nothing to say on the matter. Beyond this, what was the critical element that bitcoin needed in order to emerge as a medium of exchange? It was for at least some actors to have enough confidence that when it was first obtained by them for goods they wished to sell, it could be spent for items they wished to buy. It may well be the case that the reason they had this confidence was because bitcoin did indeed have a prior non-monetary value. But analyzing the actors’ motivations, and the factors that induced their confidence is beyond the scope of the regression theorem or any praxeological discussion. It is nevertheless an interesting question, because if bitcoin ultimately becomes money—i.e. a generally-accepted medium of exchange—then it would be the first non-commodity money to succeed in the absence of legal-tender laws, government assurances, or some kind of institutional backing.Almost the very opposite is true. Bitcoin faces actual government opposition. See https://www.google.ca/?gfe_rd=cr&ei=EXk7VIS8Is2GoQT8xoHQDQ&gws_rd=ssl#q=government+opposes+bitcoin.
It would not, however, be the first non-fiat medium of exchange to arise this way. For example, in Argentina during the recession and financial crisis of the early 2000s, privately-issued media of exchange circulated widely as a means of facilitating commercial interaction. According to Colacelli and Blackburn (2005), approximately 7 percent of the country’s population traded with the so-called “Credito” during 2002. It should be pointed out this medium of exchange did not arise out of barter itself; in other words, it had no direct-use value at all. Rather, the Credito was issued by private clubs in the form of a paper chit. Even though it was initially pegged at a nominal fixed rate to the existing fiat currency, it was not redeemable for that currency. It was therefore not a money substitute, but rather a separate monetary implement. It succeeded, at least for a time, because users had enough confidence that it would generally be accepted within the orbit of the particular clubs that issued it. The Credito ultimately failed, however, as a result of counterfeiting and inflation, and because government actions to shore up the Peso led to a greater confidence in the regular fiat money. The Credito never had the attributes necessary to overcome the legal protections of the Peso, or the optimum technical properties to become a new money. It nevertheless demonstrated, before the advent of bitcoin, that privately-issued paper media of exchange can emerge in the presence of an existing currency. This example showed that it can do so without any governmental backing or promises of redeemability by the issuer; even in the face of government opposition. The question of whether or not bitcoin can progress to being money is discussed next.
V. Can Bitcoin Become Money? Carl Menger laid out the necessary attributes a good must possess in order to succeed as money; that is, to become a universal medium of exchange. It should be noted that his argument was not praxeological, in that it did not examine money on the basis of its marginal utility. Nor did it trace the genesis of a medium of exchange backward in time, via the kind of analysis Mises would later provide in the regression theorem. Rather, Menger’s contribution was to provide an empirical and historical analysis of the origin of money, specifically when it arises from a pure barter economy.
To that end, Menger concludes that the most fundamental attribute a good must have before it can become a medium of exchange—and ultimately the dominant medium and hence money—is its degree of saleableness (market liquidity, marketability) in direct exchange. Market liquidity, it will be noted, is subjective. It is not measurable. It has no praxeological explanation, because it is a psychological phenomenon. Liquidity depends upon several factors, according to Menger: First, upon the intensity of the demand for the commodity in question; second, upon the purchasing power of those who demand it; third, upon the availability of its supply; fourth, upon the divisibility of the commodity; fifth, upon the development of the market, in particular the level of speculation. And finally, upon the type and number of political or social restrictions that may imposed upon it. Menger then lays out the spatial and temporal limits on its liquidity, which include the distribution and permanence of its demand, its transportability, its durability, and its storage costs, etc. Other important technical aspects are its homogeneity, its recognizability, and stability in price in terms of other goods.Menger was certainly not the first to discuss the necessary attributes of money, in general, or the precious metals in particular. For example, Aristotle in Politics, Book I, Section IX discusses how money should be transportable, divisible, and “intrinsically useful” (having a direct use). He says, “When the inhabitants of one country became more dependent on those of another, and they imported what they needed, and exported what they had too much of, money necessarily came into use.” Adam Smith in his Wealth of Nations discusses how durability and divisibility are important characteristics of money. According to Smith ([1776] 2005, p. 26) “Metals can not only be kept with as little loss as any other commodity, scarce any thing being less perishable than they are, but they can likewise, without any loss, be divided into any number of parts, as by fusion those parts can easily be re-united again; a quality which no other equally durable commodities possess, and which, more than any other quality, renders them fit to be the instruments of commerce and circulation.” With respect to precious metals, Jean Baptiste Say ([1821] 1971, p. 222) lists many of the same features: Precious metals are divisible, homogenous, resistant to friction (i.e. durable), sufficiently rare, and capable of being stamped. John Stuart Mill ([1848] 2009, p. 338) says that the reasons precious metals became money were that they “pleased everyone to posses,” they are transportable, easily hidden, divisible, homogeneous, and “their purity may be ascertained and certified.” And Jevons ([1875] 1898, pp. 30–39) lists the necessary attributes of good money as follows: utility and value, portability, indestructibility, homogeneity, divisibility, stability of value, and cognizability.
The greater the number and intensity of these attributes, the more likely a good will be used in indirect exchange. When a less liquid good is brought to market, the seller will seek to exchange it not just for the good which he requires directly, but if this is not possible, for the most marketable commodity he can use indirectly. This presupposes that the actor has sufficient knowledge and confidence that the commodity in question, which is not necessarily valued by him in its direct use, can be resold. It is this information and assurance regarding a particular good’s liquidity, among an increasing number of actors over time, that results in the good emerging as the most commonly-used medium. As Menger ([1892] 2009, p. 45) states,
The reason why the precious metals have become the generally current medium of exchange ... is because their saleableness is far and away superior to that of all other commodities, and at the same time because they are found to be specially qualified for the concomitant and subsidiary functions of money.
Of course, Menger’s analysis does not refer to the emergence of paper money from a commodity money, or paper from paper. In the case of a fiat currency, where government mandates the money’s acceptability and hence its liquidity through legal tender laws, the currency clearly has no direct use, even though many of the technical factors, such as divisibility, durability, transportability, and consistency, are still desirable.
But what about a non-fiat, non-commodity money? As discussed in the previous section, there is no praxeological necessity for any new medium of exchange to have a direct use unless it emerges from pure barter, and then only because there is no existing monetary price structure in place. But if a new medium of exchange, such as bitcoin, is set to emerge in the presence of an existing currency, then having some non-monetary uses undoubtedly increases its liquidity, which can aid in its emergence, and hasten its transition to money. Saleability inspires confidence that the new money will be accepted by others, and that the person who purchases it as a medium of exchange will not be left holding the bag at the end of the day. Once the new medium of exchange becomes established, and demand for its monetary use increases, then demand in direct use becomes less important, but at least in the beginning, non-monetary demand surely provides an important boost.
Prior to it becoming a medium of exchange, bitcoin’s non-monetary demand was clearly rather limited, but it must have had utility in some form—perhaps as a digital object, a game, a cause, a badge of membership etc.—because it began to be exchanged for fiat currency during 2009. Then, on October 5, 2009, the first exchange rate with the U.S. dollar was published. This step, and the advent of bitcoin exchanges such as Mt. Gox, demonstrated that bitcoin could be sold for the most liquid of all goods, the extant currency, and was therefore gaining in liquidity itself, even though there is no record of it being used as a medium of exchange at this point. However, given that bitcoin was designed from the ground up to be money, with all the technical features normally associated with a functional money (and many more besides) it was not too long before it started to be used in indirect exchange. According to Surda (2014), the first such documented case occurred on May 22, 2010, when Laszlo Hanyecz purchased two pizzas for 10,000 bitcoins. Obviously, at this stage, the purchasing power of bitcoin was relatively low, but as more and more people recognized its liquidity, and the possibility that it might one day become money, demand increased, primarily from speculation.
Speculation in bitcoin has at times raised its purchasing power and its exchange rate with the dollar, and given rise to the view that the “greater fool theory” is at play. Many expect that the market for bitcoin represents a bubble that will ultimately crash. North (2013) even argues that the creation of bitcoin is something akin to a Ponzi scheme. But as Rothbard ([1962] 2004, pp. 130–136) points out, speculation does not necessarily indicate economic error. To the contrary, economic agents engaging in this type of behavior might well be correct in their predictions, in which case their actions can be viewed as beneficial, for they hasten the adjustment of the commodity toward its equilibrium price. The question therefore is this: Is the increased speculative demand for bitcoin justified? No one can say for sure.This is basically an entrepreneurial issue, not one of praxeological economics. But while bitcoin’s initial liquidity was not particularly impressive before it became a medium of exchange, it nevertheless possesses some truly unique features that should enhance its utility, and possibly its marketability now that it is a medium of exchange.
Graf (2013b) outlines some of the monetary attributes of bitcoin; it is infinitely durable, it has a finite supply, it has very small transaction costs, it cannot be counterfeited, it is apolitical, and it has no cross-border limitations. It also has no weight and is easier to transact with than gold. Suede (2011a) mentions that this quasi money cannot be confiscated since the files in which it resides can be replicated and hidden. Political restrictions might pose a problem, but the fact that it is peer-to-peer means the government would have to shut down the web to stop it; an unlikely prospect. Another feature is that when it is exchanged, it is done so over a network and transmitted electronically, but it is not a bitcoin substitute that is sent; rather, it is these very coins themselves. This, and the fact that bitcoin obviates the need for commercial banks, means there would be no need for money substitutes, and fiduciary media might no longer be able to be produced. Coupled with bitcoin’s finite stock, it is possible that an added benefit would be the permanent termination of the business cycle,For the Austrian business cycle theory that supports this contention, see Hayek (1931), Mises (1998), Rothbard (1993). provided of course bitcoin became universally used, and displaced all fiat and commodity monies. See also (Surda (2012) on this issue.
The truly unique functions of bitcoin, as detailed by Surda (2014), are non-monetary, and include the following: It it can act as an effective means of notarization, it can act as “smart property,”Smart property is where an ownership title is contained within the blockchain. The title could be for a house, car, stocks, etc. Titles held in this way can be traded or used as collateral with very low probability of fraud. It was first proposed by Nick Szabo (1997). it can perform conditional transfers,Any transfer that is conditional on some action or event occurring. e.g. stock options, futures, gambling. it eliminates the need for intermediaries, particularly in multi-party transactions, it can act as a form of stock ownership eliminating the need for separate stock exchanges, it can record transactions for auditing purposes, etc. etc. These factors are of course closely associated with (but not the same as) the monetary function. This raises the interesting possibility that as bitcoin becomes more widely exchanged, and not just hoarded for speculative purposes, these unique features will become more apparent to more users, thereby increasing the demand even further, in a virtuous circle where demand and liquidity reinforce each other.
Casey (2011) takes the view that because bitcoin is not backed by anything, it will ultimately fail. His comments are fairly typical of those who view the market as a bubble: “bitcoins are just an electronic abstraction. They can’t be used for anything else, nor are they made of something that can be used for anything else....”
Now it is true historically that commodity monies such as gold and silver have had a direct use as jewelry, etc. But as Mises makes clear, once a medium becomes generally accepted by the public, and hence money, the underlying direct use can disappear entirely, even though the commodity still continues to function as money. Liquidity gives rise to more liquidity as confidence in the new money increases. Thus, the cause of the original liquidity—its direct use—becomes less and less important. Moreover, money always functions only as long as people have confidence in it, and this is true even if it does have a concurrent direct use. Even if gold were once again to become the universally accepted medium of exchange, it would not be “backed” by something of equal value. This is because, ceteris paribus, when a commodity becomes money, the increased exchange demand causes its price (in terms of other goods) to become higher—typically orders of magnitude higher—than the price it would be if used as a commodity only. Since the increased exchange demand can be said to represent people’s confidence, anticipation, expectation etc., that it will continue to be universally accepted in indirect exchange, it must be the case that if people’s confidence were to fail, its price would fall. If gold’s ability to perform its function as money suddenly evaporated in the minds of market participants—let us say another money were discovered that was generally recognized as being superior—gold money users would soon find their money was “backed” by relatively little.But not nothing. This metal would still be useful for jewelry, false teeth, etc. This of course is true also of a fiat currency, where initial confidence is provided by government guarantees and maintained by legal tender laws and tax policy. If all confidence in the government is lost, the underlying true very limited or non-existent value of the paper is soon revealed.
VI. A Hypothetical Posit that bitcoin evolved as money directly from barter; would this then constitute a violation of the regression theorem? Before
we attempt to answer this question, we note that this supposition is patently false. Bitcoin is a product of the twenty-first century, quite distant from the time in which barter was the generally accepted way of facilitating trade, if it ever even existed. Moreover, it is highly doubtful that a digital object requiring an extremely complex infrastructure, such as the internet, could ever develop in a pure barter economy, where the division of labor is almost non-existent.
Why make this query then? We step out of reality in this manner so as to make an important economic distinction. Economists do not have controlled experiments at their disposal, and thus must be excused for engaging in contrary to fact conditionals.
So assume bitcoin has arisen, de novo, from a pure barter economy. If the regression theorem says that money can only arise out of a commodity, and “commodity” means tangible good, then that theorem is wrong. Assuming bitcoin is a money (it is not yet generally accepted, although one day it might be) the regression theorem is wrong because bitcoin is not, and was never, a commodity. On the other hand, if the regression theorem says that money must arise out of something that is of value, then the regression theorem is correct. Bitcoins were something “of value” to at least some people even at their inception. So what does the regression theorem actually say?
How does the analysis of those analyzing the regression theorem stack up against this criterion? Most speak of it in terms of a commodity, not something of value.
For example, Rothbard clarifies (1963; emphasis added by present authors):
This process: the cumulative development of a medium of exchange on the free market—is the only way money can become established. Money cannot originate in any other way, neither by everyone suddenly deciding to create money out of useless material, nor by government calling bits of paper “money.” For embedded in the demand for money is knowledge of the money-prices of the immediate past; in contrast to directly-used consumers’ or producers’ goods, money must have preexisting prices on which to ground a demand. But the only way this can happen is by beginning with a useful commodity under barter, and then adding demand for a medium for exchange to the previous demand for direct use (e.g., for ornaments, in the case of gold). Thus, government is powerless to create money for the economy; it can only be developed by the processes of the free market.
And in the view of Mises (1912; emphasis added):
The unsatisfactory results offered by the subjective theory of value might seem to justify the opinion that this doctrine and especially its proposition concerning the significance of marginal utility must necessarily fall short as a means of dealing with the problem of money. According to his argument, the objective exchange value of money is not determined at all by the processes of the market in which money and the other economic goods are exchanged. If the money price of a single commodity or group of commodities is wrongly assessed in the market, then the resulting maladjustments of the supply and demand and the production and consumption of this commodity or group of commodities will sooner or later bring about the necessary correction. If, on the other hand, all commodity prices, or the average price level, should for any reason be raised or lowered, there is no factor in the circumstances of the commodity market that could bring about a reaction. Consequently, if there is to be any reaction at all against a price assessment that is either too high or too low it must in some way or other originate outside the commodity market.
When Mises and Rothbard penned these words, there were no digital goods in existence. For these economists, intangible goods (in the broadest sense) were labor services, trademarks, goodwill, etc., and various financial assets such as insurance policies, stocks and bonds.
Now it is very difficult to explain how intangible goods like these could ever become media of exchange, let alone money. For example, suppose Smith sells a cow to Jones, in exchange for 20 hours of Jones’s labor, and then Smith, instead of asking Jones to work for him, exchanges this labor (or some portion of it) with Green to buy, say, a bushel of wheat. It is true that Jones’s labor is being used by Smith in an indirect way to sell his cow and buy a bushel of wheat from Green. But it is certainly very doubtful that Jones’s labor could ever become money. One immediate problem is that Jones cannot be everywhere, and therefore there would have to be multiple Jones’s, all agreeing to use their labor as media of exchange. But labor is never completely nonspecific, so there would be no homogeneity. It could never serve as a unit of account. This lack of homogeneity is true for all other (non-digital) intangible assets. Therefore, it would never have occurred to Mises and Rothbard that intangible goods could ever be used as money. It seems absurd. It would not be unreasonable for them to assert that de novo money must arise from a tangible good.
However, for the modern economist, the digital age changes the notion of an intangible good. Intangible digital goods can be replicated to create identical units; they can be completely homogeneous. In an important sense, they can be even more homogenous than any physical good can ever be. Moreover, they can be instantly transportable over the internet, and almost infinitely divisible and durable. Until the development of bitcoin, digital goods would not have made a good money. However, bitcoin combines the features of an algorithm that limits supply, with a method of verifying transactions (in the blockchain) that limits double spending, and employs asymmetric cryptography that uses elliptic curve functions with no solution. In this way digital objects can be made to be extremely secure, with a supply that cannot be counterfeited or inflated.Inflated beyond a finite amount; in the case of bitcoin, 21 million units. In short, there now exist intangible goods that can have all the characteristics of money.
Let us assume that by using the word “commodity,” Mises and Rothbard meant a tangible commodity, like gold, and not an intangible one. If so, were they in error when they said that money that arises from barter must be a “commodity?” Would it have been more correct to say that it must have direct-use “value,” thereby encompassing all goods, not merely tangible ones? It seems a bit harsh to say they were wrong, knowing what we now know about digital goods, and positing an almost impossible world where digital objects like bitcoin emerge in a pure barter economy. But strictly speaking, in order to account for all possibilities, even unlikely ones, it would indeed be more complete to say that the regression theorem should imply that when money first emerges from a pure state of barter—and a cardinal calculational framework is created for the first time—the good in question must have prior value in direct use.
VII. Conclusion Mises’s regression theorem is a praxeological analysis of the marginal utility of money. It states that the subjective money prices used in calculation, today, are based in part on the objective money prices of yesterday. For any good to be used as a medium of exchange, an objective framework of prices must already be in existence. Because the very first medium of exchange to emerge must have done so when there were no money prices, it follows that this good must originally have been valued, and bartered, in direct exchange. The regression theorem does not say that all subsequent media of exchange must have been exchanged directly or have a direct-use value.
Menger’s earlier discussion on the origin of money is an empirical and historical analysis. It says that because money—the generally-accepted medium of exchange—is the most liquid good, it follows that items with a high degree of liquidity in direct exchange are the most likely to emerge as money in indirect exchange. But there is no praxeological necessity that money must have a direct use in order to be salable. The marketability of money depends on the confidence of market participants. Liquidity is a psychological phenomenon.
Those who seek to determine if bitcoin violates the regression theorem, by asking whether or not it has been valued directly, are barking up the wrong tree. Bitcoin does not need to have a direct-use value in order to be a medium of exchange, because it did not emerge from a pure barter economy. This medium of exchange therefore does not violate the theorem. Clearly, it does have such a value, because it was directly exchanged for other goods, including the U.S. dollar. This provided the initial liquidity, which helped it to become a medium of exchange. Will bitcoin ever become liquid enough to become generally accepted, and hence money? It is unique among all previous media of exchangeFor example, Hayek’s (1978) “ducat.” For a critique, see Rothbard (1992). in that it incorporates numerous novel features, many of which offer up their services only when it is used as a medium of exchange. This means that as it becomes more widely adopted, it is probable its liquidity will increase, not just because more people will accept it for its monetary uses, but also because more people recognize the advantages of its non-monetary uses. Whether or not it can ever become money remains to be seen.
[First published in Inquiry, November 12, 1979.]
A half-century ago, America — and then the world — was rocked by a mighty stock-market crash that soon turned into the steepest and longest-lasting depression of all time.
It was not only the sharpness and depth of the depression that stunned the world and changed the face of modern history: it was the length, the chronic economic morass persisting throughout the 1930s, that caused intellectuals and the general public to despair of the market economy and the capitalist system.
Previous depressions, no matter how sharp, generally lasted no more than a year or two. But now, for over a decade, poverty, unemployment, and hopelessness led millions to seek some new economic system that would cure the depression and avoid a repetition of it.
Political solutions and panaceas differed. For some it was Marxian socialism — for others, one or another form of fascism. In the United States the accepted solution was a Keynesian mixed-economy or welfare-warfare state. Harvard was the focus of Keynesian economics in the United States, and Seymour Harris, a prominent Keynesian teaching there, titled one of his many books Saving American Capitalism. That title encapsulated the spirit of the New Deal reformers of the '30s and '40s. By the massive use of state power and government spending, capitalism was going to be saved from the challenges of communism and fascism.
One common guiding assumption characterized the Keynesians, socialists, and fascists of the 1930s: that laissez-faire, free-market capitalism had been the touchstone of the US economy during the 1920s, and that this old-fashioned form of capitalism had manifestly failed us by generating, or at least allowing, the most catastrophic depression in history to strike at the United States and the entire Western world.
Well, weren't the 1920s, with their burgeoning optimism, their speculation, their enshrinement of big business in politics, their Republican dominance, their individualism, their hedonistic cultural decadence, weren't these years indeed the heyday of laissez-faire? Certainly the decade looked that way to most observers, and hence it was natural that the free market should take the blame for the consequences of unbridled capitalism in 1929 and after.
Unfortunately for the course of history, the common interpretation was dead wrong: there was very little laissez-faire capitalism in the 1920s. Indeed the opposite was true: significant parts of the economy were infused with proto–New Deal statism, a statism that plunged us into the Great Depression and prolonged this miasma for more than a decade.
In the first place, everyone forgot that the Republicans had never been the laissez-faire party. On the contrary, it was the Democrats who had always championed free markets and minimal government, while the Republicans had crusaded for a protective tariff that would shield domestic industry from efficient competition, for huge land grants and other subsidies to railroads, and for inflation and cheap credit to stimulate purchasing power and apparent prosperity.
It was the Republicans who championed paternalistic big government and the partnership of business and government while the Democrats sought free trade and free competition, denounced the tariff as the "mother of trusts," and argued for the gold standard and the separation of government and banking as the only way to guard against inflation and the destruction of people's savings. At least that was the policy of the Democrats before Bryan and Wilson at the start of the 20th century, when the party shifted to a position not very far from its ancient Republican rivals.
The Republicans never shifted, and their reign in the 1920s brought the federal government to its greatest intensity of peacetime spending and hiked the tariff to new, stratospheric levels. A minority of old-fashioned "Cleveland" Democrats continued to hammer away at Republican extravagance and big government during the Coolidge and Hoover eras. Those included Governor Albert Ritchie of Maryland, Senator James Reed of Missouri, and former Solicitor General James M. Beck, who wrote two characteristic books in this era: The Vanishing Rights of the States and Our Wonderland of Bureaucracy.
But most important in terms of the depression was the new statism that the Republicans, following on the Wilson administration, brought to the vital but arcane field of money and banking. How many Americans know or care anything about banking? Yet it was in this neglected but crucial area that the seeds of 1929 were sown and cultivated by the American government.
The United States was the last major country to enjoy, or be saddled with, a central bank. All the major European countries had adopted central banks during the 18th and 19th centuries, which enabled governments to control and dominate commercial banks, to bail out banking firms whenever they got into trouble, and to inflate money and credit in ways controlled and regulated by the government. Only the United States, as a result of Democratic agitation during the Jacksonian era, had had the courage to extend the doctrine of classical liberalism to the banking system, thereby separating government from money and banking.
Having deposed the central bank in the 1830s, the United States enjoyed a freely competitive banking system — and hence a relatively "hard" and noninflated money — until the Civil War. During that catastrophe, the Republicans used their one-party dominance to push through their interventionist economic program. It included a protective tariff and land grants to railroads, as well as inflationary paper money and a "national banking system" that in effect crippled state-chartered banks and paved the way for the later central bank.
The United States adopted its central bank, the Federal Reserve System, in 1913, backed by a consensus of Democrats and Republicans. This virtual nationalization of the banking system was unopposed by the big banks; in fact, Wall Street and the other large banks had actively sought such a central system for many years. The result was the cartelization of banking under federal control, with the government standing ready to bail out banks in trouble, and also ready to inflate money and credit to whatever extent the banks felt was necessary.
Without a functioning Federal Reserve System available to inflate the money supply, the United States could not have financed its participation in World War I: that war was fueled by heavy government deficits and by the creation of new money to pay for swollen federal expenditures.
One point is undisputed: the autocratic ruler of the Federal Reserve System, from its inception in 1914 to his death in 1928, was Benjamin Strong, a New York banker who had been named governor of the Federal Reserve Bank of New York. Strong consistently and repeatedly used his power to force an inflationary increase of money and bank credit in the American economy, thereby driving prices higher than they would have been and stimulating disastrous booms in the stock and real-estate markets. In 1927, Strong gaily told a French central banker that he was going to give "a little coup de whiskey to the stock market." What was the point? Why did Strong pursue a policy that now can seem only heedless, dangerous, and recklessly extravagant?
Once the government has assumed absolute control of the money-creating machinery in society, it benefits — as would any other group — by using that power. Anyone would benefit, at least in the short run, by printing or creating new money for his own use or for the use of his economic or political allies.
Strong had several motives for supporting an inflationary boom in the 1920s. One was to stimulate foreign loans and foreign exports. The Republican party was committed to a policy of partnership of government and industry, and to subsidizing domestic and export firms. A protective tariff aided inefficient domestic producers by keeping out foreign competition. But if foreigners were shut out of our markets, how in the world were they going to buy our exports? The Republican administration thought it had solved this dilemma by stimulating American loans to foreigners so that they could buy our products.
A fine solution in the short run, but how were these loans to be kept up, and, more important, how were they to be repaid? The banking community was also confronted with the curious and ultimately self-defeating policy of preventing foreigners from selling us their products, and then lending them the money to keep buying ours. Benjamin Strong's inflationary policy meant repeated doses of cheap credit to stimulate this foreign lending. It should also be noted that this policy subsidized American investment banks in making foreign loans.
Among the exports stimulated by cheap credit and foreign loans were farm products. American agriculture, overstimulated by the swollen demands of warring European nations during World War I, was a chronically sick industry during the 1920s. It had awakened after the resumption of peace to find that farm prices had fallen and that European demand was down. Rather than adjusting to postwar realities, however, American farmers preferred to organize and agitate to force taxpayers and consumers to keep them in the style to which they had become accustomed during the palmy "parity" years of the war. One way for the federal government to bow to this political pressure was to stimulate foreign loans and hence to encourage foreign purchases of American farm products.
The "farm bloc," it should be noted, included not only farmers; more indirect and considerably less rustic interests were also busily at work. The postwar farm bloc gained strong support from George N. Peek and General Hugh S. Johnson; both, later prominent in the New Deal, were heads of the Moline Plow Company, a major manufacturer of farm machinery that stood to benefit handsomely from government subsidies to farmers. When Herbert Hoover, in one of his first acts as president — considerably before the crash — established the Federal Farm Board to raise farm prices, he installed as head of the FFB Alexander Legge, chairman of International Harvester, the nation's leading producer of farm machinery. Such was the Republican devotion to "laissez faire."
But a more indirect and ultimately more important motivation for Benjamin Strong's inflationary credit policies in the 1920s was his view that it was vitally important to "help England," even at American expense. Thus, in the spring of 1928, his assistant noted Strong's displeasure at the American public's outcry against the "speculative excesses" of the stock market.
The public didn't realize, Strong thought, that "we were now paying the penalty for the decision which was reached early in 1924 to help the rest of the world back to a sound financial and monetary basis." An unexceptionable statement, provided that we clear up some euphemisms. For the "decision" was taken by Strong in camera, without the knowledge or participation of the American people; the decision was to inflate money and credit, and it was done not to help the "rest of the world" but to help sustain Britain's unsound and inflationary policies.
Before the World War, all the major nations were on the gold standard, which meant that the various currencies — the dollar, pound, mark, franc, etc. — were redeemable in fixed weights of gold. This gold requirement ensured that governments were strictly limited in the amount of scrip they could print and pour into circulation, whether by spending to finance government deficits or by lending to favored economic or political groups. Consequently, inflation had been kept in check throughout the 19th century when this system was in force.
But world war ruptured all that, just as it destroyed so many other aspects of the classical-liberal polity. The major warring powers spent heavily on the war effort, creating new money in bushel baskets to pay the expense. Inflation was consequently rampant during and after World War I and, since there were far more pounds, marks, and francs in circulation than could possibly be redeemed in gold, the warring countries were forced to go off the gold standard and to fall back on paper currencies — all, that is, except for the United States, which was embroiled in the war for a relatively short time and could therefore afford to remain on the gold standard.
After the war, the nations faced a world currency breakdown with rampant inflation and chaotically falling exchange rates. What was to be done? There was a general consensus on the need to go back to gold, and thereby to eliminate inflation and frantically fluctuating exchange rates. But how to go back? That is, what should be the relations between gold and the various currencies?
Specifically, Britain had been the world's financial center for a century before the war, and the British pound and the dollar had been fixed all that time in terms of gold so that the pound would always be worth $4.86. But during and after the war the pound had been inflated relatively far more than the dollar, and thus had fallen to about $3.50 on the foreign-exchange market. But Britain was adamant about returning the pound, not to the realistic level of $3.50, but rather to the old prewar par of $4.86.
Why the stubborn insistence on going back to gold at the obsolete prewar par? Part of the reason was a stubborn and mindless concentration on saving face and British honor, on showing that the old lion was just as strong and tough as before the war. Partly, it was a shrewd realization by British bankers that if the pound were devalued from prewar levels England would lose its financial preeminence, perhaps to the United States, which had been able to retain its gold status.
So, under the spell of its bankers, England made the fateful decision to go back to gold at $4.86. But this meant that Britain's exports were now made artificially expensive and its imports cheaper, and since England lived by selling coal, textiles, and other products, while importing food, the resulting chronic depression in its export industries had serious consequences for the British economy. Unemployment remained high in Britain, especially in its export industries, throughout the boom of the 1920s.
To make this leap backward to $4.86 viable, Britain would have had to deflate its economy so as to bring about lower prices and wages and make its exports once again inexpensive abroad. But it wasn't willing to deflate since that would have meant a bitter confrontation with Britain's now-powerful unions. Ever since the imposition of an extensive unemployment-insurance system, wages in Britain were no longer flexible downward as they had been before the war. In fact, rather than deflate, the British government wanted the freedom to keep inflating, in order to raise prices, do an end run around union wage rates, and ensure cheap credit for business.
The British authorities had boxed themselves in: They insisted on several axioms. One was to go back to gold at the old prewar par of $4.86. This would have made deflation necessary, except that a second axiom was that the British continue to pursue a cheap credit, inflationary policy rather than deflation. How to square the circle? What the British tried was political pressure and arm-twisting on other countries, to try to induce or force them to inflate too. If other countries would also inflate, the pound would remain stable in relation to other currencies; Britain would not keep losing gold to other nations, which endangered its own jerry-built monetary structure.
On the defeated and small new countries of Europe, Britain's pressure was notably successful. Using their dominance in the League of Nations and especially in its Financial Committee, the British forced country after country not only to return to gold, but to do so at overvalued rates, thereby endangering those nations' exports and stimulating imports from Britain. And the British also flummoxed these countries into adopting a new form of gold "exchange" standard, in which they kept their reserves not in gold, as before, but in sterling balances in London.
In this way, the British could continue to inflate; and pounds, instead of being redeemed in gold, were used by other countries as reserves on which to pyramid their own paper inflation. The only stubborn resistance to the new order came from France, which had a hard-money policy into the late 1920s. It was French resistance to the new British monetary order that was ultimately fatal to the house of cards the British attempted to construct in the 1920s.
The United States was a different situation altogether. Britain could not coerce the United States into inflating in order to save the misbegotten pound, but it could cajole and persuade. In particular, it had a staunch ally in Benjamin Strong, who could always be relied on to be a willing servitor of British interests. By repeatedly agreeing to inflate the dollar at British urging, Benjamin Strong won the plaudits of the British financial press as the best friend of Great Britain since Ambassador Walter Hines Page, who had played a key role in inducing the United States to enter the war on the British side.
Why did Strong do it? We know that he formed a close friendship with British financial autocrat Montagu Norman, longtime head of the Bank of England. Norman would make secret visits to the United States, checking in at a Saratoga Springs resort under an assumed name, and Strong would join him there for the weekend, also incognito, there to agree on yet another inflationary coup de whiskey to the market.
Surely this Strong–Norman tie was crucial, but what was its basic nature? Some writers have improbably speculated on a homosexual liaison to explain the otherwise mysterious subservience of Strong to Norman's wishes. But there was another, and more concrete and provable, tie that bound these two financial autocrats together.
That tie involved the Morgan banking interests. Benjamin Strong had lived his life in the Morgan ambit. Before being named head of the Federal Reserve, Strong had risen to head of the Bankers Trust Company, a creature of the Morgan bank. When asked to be head of the Fed, he was persuaded to take the job by two of his best friends, Henry P. Davison and Dwight Morrow, both partners of J.P. Morgan & Co.
The Federal Reserve System arrived at a good time for the Morgans. It was needed to finance America's participation in World War I, a participation strongly supported by the Morgans, who played a major role in bringing the Wilson administration into the war. The Morgans, heavily invested in rail securities, had been caught short by the boom in industrial stocks that emerged at the turn of the century. Consequently, much of their position in investment-banking was being eroded by Kuhn, Loeb & Co., which had been faster off the mark on investment in industrial securities.
World War I meant economic boom or collapse for the Morgans. The House of Morgan was the fiscal agent for the Bank of England: it had the underwriting concession for all sales of British and French bonds in the United States during the war, and it helped finance US arms and munitions sales to Britain and France. The House of Morgan had a very heavy investment in an Anglo-French victory and a German-Austrian defeat. Kuhn, Loeb, on the other hand, was pro-German, and therefore was tied more to the fate of the Central Powers.
The cement binding Strong and Norman was the Morgan connection. Not only was the House of Morgan intimately wrapped up in British finance, but Norman himself — as well as his grandfather — in earlier days had worked in New York for the powerful investment banking firm of Brown Brothers, and hence had developed close personal ties with the New York banking community. For Benjamin Strong, helping Britain meant helping the House of Morgan to shore up the internally contradictory monetary structure it had constructed for the postwar world.
The result was inflationary credit, a speculative boom that could not last, and the Great Crash whose 50th anniversary we observe this year. After Strong's death in late 1928, the new Federal Reserve authorities, while confused on many issues, were no longer consistent servitors of Britain and the Morgans. The deliberate and consistent policy of inflation came to an end, and a corrective depression soon arrived.
There are two mysteries about the Great Depression, mysteries having two separate and distinct solutions. One is, why the crash? Why the sudden crash and depression in the midst of boom and seemingly permanent prosperity? We have seen the answer: inflationary credit expansion propelled by the Federal Reserve System in the service of various motives, including helping Britain and the House of Morgan.
But there is another vital and very different problem. Given the crash, why did the recovery take so long? Usually, when a crash or financial panic strikes, the economic and financial depression, be it slight or severe, is over in a few months or a year or two at the most. After that, economic recovery will have arrived. The crucial difference between earlier depressions and that of 1929 was that the 1929 crash became chronic and seemed permanent.
What is seldom realized is that depressions, despite their evident hardship on so many, perform an important corrective function. They serve to eliminate the distortions introduced into the economy by an inflationary boom. When the boom is over, the many distortions that have entered the system become clear: prices and wage rates have been driven too high, and much unsound investment has taken place, particularly in capital-goods industries.
The recession or depression serves to lower the swollen prices and to liquidate the unsound and uneconomic investments; it directs resources into those areas and industries that will most-effectively serve consumer demands — and were not allowed to do so during the artificial boom. Workers previously misdirected into uneconomic production, unstable at best, will, as the economy corrects itself, end up in more secure and productive employment.
The recession must be allowed to perform its work of liquidation and restoration as quickly as possible, so that the economy can be allowed to recover from boom and depression and get back to a healthy footing. Before 1929, this hands-off policy was precisely what all US governments had followed, and hence depressions, however sharp, would disappear after a year or so.
But when the Great Crash hit, America had recently elected a new kind of president. Until the past decade, historians have regarded Herbert Clark Hoover as the last of the laissez-faire presidents. Instead, he was the first New Dealer.
Hoover had his bipartisan aura, and was devoted to corporatist cartelization under the aegis of big government; indeed, he originated the New Deal farm-price-support program. His New Deal specifically centered on his program for fighting depressions. Before he assumed office, Hoover determined that should a depression strike during his term of office, he would use the massive powers of the federal government to combat it. No more would the government, as in the past, pursue a hands-off policy.
As Hoover himself recalled the crash and its aftermath,
The primary question at once arose as to whether the President and the federal government should undertake to investigate and remedy the evils. … No President before had ever believed that there was a governmental responsibility in such cases. … Presidents steadfastly had maintained that the federal government was apart from such eruptions … therefore, we had to pioneer a new field.
In his acceptance speech for the presidential renomination in 1932, Herbert Hoover summed it up:
We might have done nothing. … Instead, we met the situation with proposals to private business and to Congress of the most gigantic program of economic defense and counterattack ever evolved in the history of the Republic. We put it into action. … No government in Washington has hitherto considered that it held so broad a responsibility for leadership in such times.
The massive Hoover program was, indeed, a characteristically New Deal one: vigorous action to keep up wage rates and prices, to expand public works and government deficits, to lend money to failing businesses to try to keep them afloat, and to inflate the supply of money and credit to try to stimulate purchasing power and recovery. Herbert Hoover during the 1920s had pioneered the proto-Keynesian idea that high wages are necessary to assure sufficient purchasing power and a healthy economy. The notion led him to artificially raising wages — and consequently to aggravating the unemployment problem — during the depression.
As soon as the stock market crashed, Hoover called in all the leading industrialists in the country for a series of White House conferences in which he successfully bludgeoned the industrialists, under the threat of coercive government action, into propping up wage rates — and hence causing massive unemployment — while prices were falling sharply. After Hoover's term, Franklin D. Roosevelt simply continued and expanded Hoover's policies across the board, adding considerably more coercion along the way. Between them, the two New Deal presidents managed the unprecedented feat of making the depression last a decade, until we were lifted out of it by our entry into World War II.
If Benjamin Strong got us into a depression and Herbert Hoover and Franklin D. Roosevelt kept us in it, what was the role in all this of the nation's economists, watchdogs of our economic health? Unsurprisingly, most economists, during the depression and ever since, have been much more part of the problem than of the solution. During the 1920s, establishment economists, led by Professor Irving Fisher of Yale, hailed the 20s as the start of a "New Era," one in which the new Federal Reserve System would ensure permanently stable prices, avoiding either booms or busts.
Unfortunately, the Fisherites, in their quest for stability, failed to realize that the trend of the free and unhampered market is always toward lower prices as productivity rises and mass markets develop for particular products. Keeping the price level stable in an era of rising productivity, as in the 1920s, requires a massive artificial expansion of money and credit. Focusing only on wholesale prices, Strong and the economists of the 1920s were willing to engender artificial booms in real estate and stocks, as well as malinvestments in capital goods, so long as the wholesale price level remained constant.
As a result, Irving Fisher and the leading economists of the 1920s failed to recognize that a dangerous inflationary boom was taking place. When the crash came, Fisher and his disciples of the Chicago School again pinned the blame on the wrong culprit. Instead of realizing that the depression process should be left alone to work itself out as rapidly as possible, Fisher and his colleagues laid the blame on the deflation after the crash and demanded a reinflation (or "reflation") back to 1929 levels.
In this way, even before Keynes, the leading economists of the day managed to miss the problem of inflation and cheap credit and to demand policies that only prolonged the depression and made it worse. After all, Keynesianism did not spring forth full-blown with the publication of Keynes's General Theory in 1936.
We are still pursuing the policies of the 1920s that led to eventual disaster. The Federal Reserve is still inflating the money supply and inflates it even further with the merest hint that a recession is in the offing. The Fed is still trying to fuel a perpetual boom while avoiding a correction on the one hand or a great deal of inflation on the other.
In a sense, things have gotten worse. For while the hard-money economists of the 1920s and 1930s wished to retain and tighten up the gold standard, the "hard-money" monetarists of today scorn gold, are happy to rely on paper currency, and feel that they are boldly courageous for proposing not to stop the inflation of money altogether, but to limit the expansion to a supposedly fixed amount.
Those who ignore the lessons of history are doomed to repeat it — except that now, with gold abandoned and each nation able to print currency ad lib, we are likely to wind up, not with a repeat of 1929, but with something far worse: the holocaust of runaway inflation that ravaged Germany in 1923 and many other countries during World War II. To avoid such a catastrophe we must have the resolve and the will to cease the inflationary expansion of credit, and to force the Federal Reserve System to stop purchasing assets, and thereby to stop its continued generation of chronic, accelerating inflation.
Presented at Mises Boot Camp, a one-day seminar for anyone seeking to learn the fundamentals of the Austrian school. Download the Syllabus.
Recorded at the Mises Institute in Auburn, Alabama, on 25 July 2015.
The ECB is now two months into its bond buying binge but the European Central Bank (ECB) never clearly explained the goal and purpose of its own version of quantitative easing. The deflation bogeyman was never a serious threat, nor was it based on any solid theoretical foundation.
A possible justification may have been to make the 1 percent much wealthier so that their extravagant lifestyles trickled benefits down to the average working stiff. Another possible reason may have been to lower the value of the euro to benefit exporters at the expense of the rest of European consumers, the middle class, and the poor. This would be a violation of the unwritten rule that monetary policy should not be targeting the value of the currency directly.
Of course, when the rule maker breaks his own rules, it reduces the importance of all rules. The commitment not to print to finance government spending has gone to the same graveyard as the 60 percent debt-to-GDP rule or the under-3 percent budget deficit rule. Meanwhile, the ECB’s current actions are making a mockery of the alleged independence of central banking.
Central Banks Are Buying Up Government DebtUnder normal conditions, economists take it for granted that interest rates cannot drop below zero. Instead of paying someone to borrow your money, you could just as easily stuff the money in your mattress. So why is so much of European government debt actively trading at negative rates? Why would you take money out of your mattress and pay 1,060 euros for something that will only get 1,000 euros in a year?
The answer is simple: buying government debt can make sense if you have no intention of holding the debt to maturity and think you can find a “greater fool” who will buy the debt from you. That greater fool is often the European Central Bank which, like many other central banks around the globe, is buying up government debt to keep debt-financed programs alive for another day.
And now, faced with very low or even negative interest rates on government debt, governments have been rushing to issue even more debt before announcing, in all likelihood, more vote-getting government expenditures. So, let’s not be fooled by the ECB’s charade that its actions are not indirectly financing new government expenditures.
Why Aren’t Banks Lending More?What about bank lending? Isn’t the ECB’s quantitative easing and negative-interest-rate policy spurring a Europe wide surge in borrowing? After all, negative interest rates are supposed to have the effect of discouraging saving and encouraging movement away from presumably safe government debt into other types of borrowing.
You can lead a horse to water, but you cannot make him drink, so the fact that interest rates are at rock bottom levels is not necessarily enough to spur a frenzy of borrowing by businesses in the face of an uncertain economic future.
Banks also face new hurdles. Not surprisingly, the ECB’s current actions are, in reality, being somewhat defeated by its previous monetary policy. Banks, as financial intermediaries, make money between deposit rates and lending rates. They borrow short term and lend long term.
By setting negative rates on reserves, however, and by inducing negative interest rates on government bonds, the ECB has created a significant compression in yields. This has reduced bank profits. Banks must now charge customers for deposits. Large customers such as hedge funds and mutual funds have been withdrawing funds, further drawing down bank profits.
For example, several large pension funds in Switzerland have recently rediscovered the advantages of the mattress. As Pater Tenebrarum noted,
One fund manager showed that for every CHF 10 million in pension money, his fund would save CHF 25,000 — in spite of the costs involved in vault rent, cash transportation and other expenses.
Furthermore, Basel III forces banks to hold more risk-free assets. Banks have been forced to load up on government debt at negative rates. This also has been squeezing profits. Does anyone really expect European banks to lend more in such an economic environment?
What’s the Endgame?The real objective of the ECB’s current money printing is essentially to kick the can down the road. It won’t solve Europe’s deep-seated structural problems. It will only postpone the inevitable and will also make the final reckoning much, much worse. Printing intrinsically worthless paper will not solve Europe’s fundamental problem of supply being misaligned with demand — a misalignment created by government’s incessant interference with the workings of the price system.
With this new phase of monetary expansion, Europe is slowly walking down the same slippery slope toward hyperinflation that is the inevitable endgame of all fiat currency systems.
In this, Germany missed an opportunity to set the ship straight. It should have made it crystal clear that any purchase of government bonds by the ECB (which violates European law) would have meant Germany’s leaving the currency union and reestablishing the deutschmark under German control. But then again, the German government is not the German people. Such quantitative easing makes it much easier to finance government spending, and the resulting inflation will lower the real value of the government’s existing debt. Of course, this is all for short-term benefits to the government, with long-term costs to everyone else.
ThroughoutJ. Patrick Rhamey is assistant professor in the Department of International Studies and Political Science at Virginia Military Institute in Lexington, Virginia. I was a summer fellow in 2007 and 2008. During these experiences, under the advice and support of Dr. Salerno, I developed a passion for the field of international conflict. Furthermore, Dr. Salerno instilled in me the importance of thinking strategically regarding interdisciplinary theorizing and the importance of interdisciplinary work to the future of the social sciences. his career, Dr. Salerno has sought to expand the influence of Misesian scholarship, not only through his own research, but also classroom engagement, graduate student mentorship, and the education of the general public. His impressive body of work represents a true educator whose interest is fundamentally the advancement of human knowledge. It is in this spirit that this chapter seeks to provide an initial blueprint for the interdisciplinary expansion of Austrian principles to the political science realm, specifically the subfield of international relations theory. While international relations theory has strong shared origins in classical liberal approaches (Van de Haar 2009), recent theoretical evolution across the dominant paradigms has increased the potential for an expansion of Austrian ideas. Many theories within the subfield of international relations have begun to experience something of an “individualist shift” both methodologically and theoretically.This trend originates in the renewed emphasis on domestic politics as a source of foreign policy behavior and extends to recent research examining the underlying causes of individual decision-making (Putnam 1988) and the relationship between the preferences of individual decision-makers and foreign policy selection (Bueno de Mesquita 1999). For these reasons, if approached correctly, international relations research is a field ripe for future interdisciplinary engagement.
Notably, there does not exist an absence of political science research by Austrians, though these contributions remain beyond mainstream political science discourse. Perhaps the best examples are Murray Rothbard’s Power and Market and the concluding chapter of Man, Economy, and State which explicitly engage the effects of coercion, or politics, on human behavior.Indeed, the clarity of analysis from one volume to the other highlights the artificial and unnecessary division of the two works by the initial publisher. The foundation of the argument focuses primarily on the voluntary interactions of individuals in the absence of violence (economics), and yet concludes by engaging the reality that coercion (politics) is nearly always and everywhere present and “economic analysis must be extended to the nature and consequences of violent actions and interrelations in society” (Rothbard [1962] 2004, p. 875). In essence, the fields of economics and political science are highly complementary if not inherently intertwined. Unfortunately this early clear intersection of the two fields of inquiry did not occur more broadly, as political science, the younger of the two, developed from a combination of European legal and historical approaches (Carr 1939; Morgenthau 1948) and early American behavioralist research (Merriam 1924; Key 1934; Key 1966).While some influence from economics is present in contemporary political science research, it is primarily of the positivist variant, to which there has been a significant backlash in the form of “post-positivist” theoreticians (e.g., Peterson 2004; Tickner 2005). However, unlike economics where certain biases may exist, Austrian ideas surrounding political organization, coercion, and the state are somewhat accepted. For example, James C. Scott’s The Art of Not Being Governed: An Anarchist History of Upland Southeast Asia and Charles Tilly’s “War Making and State Making as Organized Crime” share many commonalities with Rothbardian analysis of the state and are standard reading in undergraduate comparative politics courses.
This chapter proceeds by outlining the evolution of international relations theory over the past two decades with specific attention to the progression of theoretical development toward a greater focus on human action. While most research is heavily positivist in its construction, theoretical development over the course of the past two decades has led, steadily, away from the abstractions of traditional neorealist (Waltz 1979) and liberal institutionalist (Keohane and Martin 1995) paradigms that have dominated international relations research. New theoretical approaches that offer greater recognition to human agency, as well as new methodological challenges in qualitative research, provide an opportunity for Austrian engagement. Following a discussion of these theoretical approaches, I conclude with suggested strategies for continued expansion of Austrian ideas to the social sciences outside economics.
The Current State of the International Relations LiteratureI first introduce through a simple illustration the relative position of the dominant international relations theoretical perspectives in the context of two fundamental criteria in Figure 1. The theories are organized according to their assumptions concerning the effect of anarchy on preferences, and thereby behaviors (y-axis), and the assumed level of analysis determining the type of actor under study (x-axis). Organizing each perspective by their nuanced conceptualizations on these two particular subjects provides an effective means of discussing their unique attributes within the context of their overarching similarities. (See Figure 1 on the following page.Immediately the reader will notice the placement of constructivism. While I do not discuss constructivism at length in this chapter, constructivism is unique given its assumption of an endogenous relationship between levels of analysis. As examples, the key systemic features which frame state’s conceptions of world politics such as state sovereignty (Treaty of Westphalia) and anarchy are not universal truths, but social constructions by the states themselves (Wendt 1992, 1995). It is this endogenous relationship between society, state, and system the graphical portrayal is intended to illustrate.)
Notably, either abstraction presents potential problems for future Austrian interdisciplinary analysis. In particular, the level and corresponding relevant unit of analysis being anything beyond the individual is an inherently hostile assumption, as praxeological analysis recognizes accurately that only individuals are capable of action. For example, neorealists may assume for theoretical purposes that all states are rational unitary actors, but such an assumption is ineffective in generating common sense explanations of real world phenomena, given “there are no such things as ends of or actions by “groups,” “collectives,” or “states,” which do not take place as actions by various specific individuals (Rothbard [1962] 2004, p. 2). However, in the theoretical space that minimizes such abstractions, specifically the liberal and neoclassical realist conceptual spaces, the possibility for the development of an interdisciplinary Austrian discourse is quite plausible. Driving this evolution toward the individual over the past two decades of international relations research is in part the desire of applied research to understand real world outcomes, leading to what J. David Singer (1961) termed “vertical drift” wherein theories built on such abstractions as “state behavior” become applied to explaining foreign policy choices by individuals.
For much of international relations, anarchy defines contextual constraints, where expected behavior follows from the strength of the anarchy assumption (Powell 1994). Implied for many authors, particularly in the realist tradition, is that given anarchy and human depravity, conflict will ensue. Even neoliberal institutionalists acknowledge the anarchy assumption of neorealism, resigning themselves to searching for those conditions in which “cooperation under anarchy” is a possibility (Axelrod and Keohane 1985). If anarchy is as salient a political problem as neorealists suggest, then actors seek nothing more than power, as apart from coercive government their security is impossible to guarantee (hence Waltz’s characterization of the system as “self-help”). However, if anarchy is merely an environmental condition suggesting the absence of a single coercive entity, rather than being a constraint that determines behavior, then gains are not inherently zero-sum and cooperation is not only possible, but likely the dominant strategy within the anarchic context.This distinction between anarchy as a defining characteristic that causes states to behave a certain way, as is the assumption by neorealists, versus anarchy as merely a systemic condition that describes the absence of a single coercive entity, as is the assumption by liberal researchers in international relations, has dramatic consequences for expectations of state behavior. Flowing from the neorealist assumption that anarchy causes behaviors are the assumptions that all states pursue self-help strategies, all gains are relative and mutually exclusive, and thereby this systemic condition leads inevitably to conflict. However, if anarchy is merely a descriptive characterization of the international system as the absence of government, which through liberal logic may be a systemic condition that expands possible behaviors rather than constrains as realists would claim, it cannot be assumed anarchy inherently leads to competition over relative gains and conflict. The “strength” of the anarchy assumption in international relations theory is thereby the degree to which the condition of anarchy forces states to behave in a specific manner.
On the right side of the horizontal axis are the predominantly system-focused explanations of international politics, depicting states as unitary actors. In this context, simplistically, the relationship of anarchy is perceived as either an aspect of the environment (English school) or the prime determinant of state preferences (Neorealism). On the left hand side of the graph reside those theories of international politics which focus on a sub-state unit of analysis, each providing an explanation of state behavior as a determinant of either group or individual action. The “Effect of Anarchy” in this context is parallel to the underlying discussion of the “state of nature” in much of political philosophy.It is worth noting that the conceptions of “anarchy” in international relations theory are not entirely identical in classical realism and neorealism (or lower horizontal pairings) as the graph may suggest, as Morgenthau did not share Waltz’s view that the international system is inherently conflictual due to the effect of anarchy (see Morgenthau 1948, pp. 39–40). However, Morgenthau does share the Hobbesian view of human nature which is an abstraction based upon the Hobbesian view of the state of nature, or anarchy. Morgenthau’s conception of human nature, the basis for his description of statesmen and justification for the primacy of the state, exists as an extension of the idea of man’s nature under conditions of anarchy, even if he does not agree anarchy exists in the reality of international politics. Perhaps a more appropriate title for the y-axis would be “conception of human nature” ranging from good to bad. However, I expect in that case a footnote would be necessary explaining the nuances of the systemic level. The point here, however, is simple: philosophically the effects of anarchy on behaviors and human nature are directly related. Toward the top of the y-axis, anarchy has a powerful effect on human behavior, wherein man cares only for his self-preservation resulting in a Hobbesian existence that can only be described as “nasty, brutish, and short.” Alternatively, toward the bottom of the vertical axis, the state of nature, or anarchy, does not imply chaos. Intrinsic to anarchy in this Lockean conception is the principle of natural law endowed to the individual, wherein everyone is entitled to “life, liberty, and property.” In this context, human nature is not so negatively viewed, as individuals are capable of organizing themselves. Government, thereby, is either only necessary to protect person and property against those occasional individuals who seek to violate the principles of natural law, or alternatively is entirely unnecessary if individuals are capable of interaction absent a monopolizing coercive force (Rothbard 2002a). The vertical axis across both levels of analysis can also be described as the degree to which cooperation is possible in the absence of a centralized government in international politics.
Given the existing landscape of international relations theory, Moravcsik’s (1997) conception of liberalism, designated simply as “liberalism” in the illustration, provides the clearest potential avenue for the application of Austrian ideas. Recognizing the failures of systemic, state focused neorealism to account for domestic sources of state behavior (notably the collapse of the Soviet Union), Moravcsik (1997) presents a reframed variant of liberalism in international relations to fully account for the dynamics of policy formation. As both economists and political scientists are well aware, the term liberalism has been construed to mean a myriad of things, both within and beyond international relations research. Moravcsik’s articulation of a liberal theory of international relations is an attempt at salvaging liberalism’s “self-inflicted” condition. However, as the author makes clear, he is providing a “restatement” of liberal theory built squarely on classical liberal foundations.Notably this restatement is not neoliberal institutionalism, which unfortunately dominated the term liberalism until very recently. In terms of assumptions, neoliberal institutionalism shares the entirety of the neorealist core (including the states as rational actors abstraction) while moderately relaxing the implications of anarchy on state preferences. Given this relation, Keohane’s (1993) statement that neoliberal institutionalism “borrows as much from realism as from liberalism” is disingenuous. Institutionalism borrows entirely from realism, while only moderately co-opting liberalism’s focus on the human progressivity (Zacher and Matthews 1995). To use the example of cooperation, it occurs despite systemic conditions of anarchy because actors determine that by doing so they can improve their condition (e.g., Axelrod and Keohane 1985). The core assumptions regarding states as rational unitary actors and the system organization as anarchic are identical. Neoliberal institutionalism appears to remain ambivalent to the historical emphasis of classical liberalism on the individual and the promotion of human freedom, leaving preferences as exogenously determined. I’ll refrain from delving further into the nuances of neoliberal institutionalism and neorealism, as the neo-neo debate has been thoroughly explored elsewhere (Jervis 2003; Baldwin 1993; Powell 1994). Liberalism as defined by Moravcsik thereby is explicitly a theory of preference formation, and it is in this particular conceptualization of liberalism that the most fruitful possibilities of interdisciplinary theorizing with Austrian researchers lies.
Moravcsik makes a series of core assumptions emphasizing preference formation and the evolution of interests within domestic society. First, the fundamental actor in international relations is the individual. Decisions are made by individuals acting in response to an environment to satisfy subjective goals determined by subjective sets of values. Already, we have dramatically complicated the study of international relations away from systemic theories. Second, and by extension, the state is a subset of individuals in society reacting to the preferences of individuals in the society at large. Actors in government, like actors in domestic society, have their own sets of values and preferences and exist in a particular institutional context, be it democratic or authoritarian. This environmental constraint shapes the availability and perceived values of the policy options available to state actors, but individuals remain the only entity capable of action. Finally, preferences across potential behaviors, and the resulting causal processes in policy choice, are constrained further by the international environment of interacting individual preferences and material capabilities (or opportunity to achieve some end).
Moravcsik (1997) essentially constructs a “bottom-up” view of international politics, tracing the source of state behaviors to the initial development of preferences by individuals within societies. What individuals within states want “is the primary determinant of what they do,” not the nature of the system as anarchic (Moravcsik 1997, p. 521), opening the door to understanding political phenomenon as they actually happen rather than under a predefined set of unrealistic abstractions. However, to employ liberalism to better understand outcomes we must have some means of logically deducing the source of preferences, of which Moravcsik lists three: ideational, commercial, and republican. The ideational components capture particular political, national, and socioeconomic cleavages and are manifest in normative explanations of the democratic peace (Dixon 1994), ethnicity based explanations of foreign policy behaviors (Davis and Moore 1997), and liberal economic preferences (Mousseau 2003). Commercial incentives are driven by motivations for some subjectively defined economic gain. These may take the form of trade and investment behaviors, but also may manifest themselves through preferences for resource access and even coercive seizure (e.g., Snyder 1991). Finally, republican sources of preferences are rooted in the political institution’s method of filtering the preferences articulated by the domestic populace. Likely the best examples are provided by the institutional democratic peace literature, but more specifically selectorate theory (Bueno de Mesquita et al. 1999). Indeed, selectorate theory, may provide the best illustration of the bottom-up preference formation process presented by liberalism while retaining a focus on individual action.
The implication of this articulation of liberal theory is a complete reformulation of how we conduct international relations research to refocus not on states, but upon the individual within society. Neorealism, restricted to the system level and states as actors, fails to independently account for state preferences, and so a focus on human action is the logical transition. However, a focus on individuals does not eliminate the systemic realm, in so far as the system is defined through the behaviors of other individuals engaging in their own series of actions within and between political systems.See the conceptual discussion of interactions in Bueno de Mesquita et al. (1999). Furthermore, given the necessity of such a transition toward the individual and human action, there has been something of a convergence in international relations theory. For example, Jack Snyder’s (1991) work on empires, if one was ignorant of his self-identification as a “realist,” is indistinguishable from the theoretical processes outlined by Moravcsik. Specifically, Snyder discusses the logrolling interests of domestic actors, ideational preferences, and political institutional configurations all contributing to the propensity and rate at which empires historically over-expand — an outcome that is impossible to explain under any framework where states are rational unitary actors.
This international relations shift toward liberalism seems intuitively obvious, occurring quite broadly in mid-range topical analysis (see Oneal 2012): individuals have values for ends and employ means to achieve those ends. However, understanding, operationalizing, and incorporating the preferences of actors, determining their relative importance, and then interacting those aggregate preferences with state structures and the preferences of others individuals outside the state is a daunting task, and attempts to do so do not debunk clearly deduced theory as the burden of properly specifying such empirical analysis is exponentially greater than traditional state-level studies. However, with advancements in technology, the ability to conduct econometric tests of liberal ideas are more accessible and plausible, providing a means to mathematically sort out myriad coinciding human behaviors. In particular, the recent availability of multilevel modeling to political scientists is intuitively appropriate for testing liberal hypotheses, which employ indicators from across arenas of political interaction (e.g., actors both within and between states). Indeed, progress for the field entails “an increasing ability to explain and connect complex phenomenon” both theoretically and methodologically (Dryzek 1986, p. 301).
Liberalism in international relations theory is not the only path that has evolved to grant greater attentiveness toward the inherent basis of social science research in human action. Neoclassical realism possesses many of liberalism’s strengths while attempting to maintain many of classical realism’s fundamental Machiavellian assumptions. Like liberalism, neoclassical realism “explicitly incorporates both external and internal variables.” However, “the scope and ambition of a country’s foreign policy are driven first and foremost by its place in the system and specifically by its relative material power capabilities … the impact of such power capabilities on foreign policy is indirect and complex … translated through intervening variables at the unit level” (Rose 1998, p. 146). Though political preferences are influenced by the actor’s position in the power hierarchy relative to all other actors in the system, human action still is the fundamental phenomenon of interest. Indeed, there are close parallels evident in not only the analysis, but also the conclusions, of neoclassical realists and Austrians on the topic of war and empire. For example, both Snyder (1991) and Salerno (1995) engage in similar discussions of the relationship between inflation and imperial expansion, as well as highlighting it as a catalyst of further international conflict and long run unsustainability.Snyder’s Myths of Empire is both an excellent example of neoclassical realism and source of many parallels with existing Austrian perspectives, including coalition behavior in democracies leading to warlike behaviors, the pervasiveness of certain “myths” of external threat exploited by politicians to justify conflicts, and the inevitable destructive consequences of imperial overexpansion. Another possible example is that of Robert Higgs (1987) “ratchet effect” and the “phoenix factor” discussed by Organski and Kugler (1977). Distinctly, while liberalism is a theory of preferences from the bottom up, neoclassical realism is a theory of preferences from the bottom down. Though liberalism as discussed is perhaps more amenable to Austrian engagement, both approaches, however, attempt to integrate individual behaviors into a general theory of international relations, albeit with different emphases on the relative importance societal influences.
Perhaps neoclassical realism and liberalism constitute different roads leading to the same destination. Both take seriously the need to incorporate greater complexity into our theories to better account for political phenomenon. Encouraging for practitioners of international relations, and the potential for interdisciplinary engagement with the Austrian school, is the drifting of paradigms not further apart, but closer together. These two latest iterations of realism and liberalism are perhaps more theoretically compatible than ever before in the past, constituting, in Lakatosian terms, progress in the field. In conjunction with rising methodological interest in deductive theory development and qualitative analysis (see Goertz 2005), a fruitful cross discipline dialogue incorporating the Austrian school as a next necessary step to this theoretical evolution in international relations is now possible.
Strategies for Future Interdisciplinary EngagementIn order for such a debate to both occur and be fruitful, not only must the theoretical components be compatible and international relations researchers amenable to an Austrian turn, as I argue they now are, but the presentation of the ideas must be done in a thoughtful and effective manner. Just as in the presentation of any argument or position, the negative aspects of the method by which it is presented, or the individual doing the presenting, affect audience receptivity. For this reason, it is necessary for those engaging mainstream IR theory in advocacy of an Austrian perspective to be somewhat strategic, or at least minimally thoughtful, in the method and context of that interaction. While international relations as a field may be ready for interdisciplinary engagement, there are, in my opinion, three broad strategic impediments currently limiting the persuasiveness of the Austrian school to the social sciences (and the general public) that must first be addressed.
Strategy 1: Comprehension Before EngagementOne great pitfall to any interdisciplinary engagement is a failing to fully understand the core theories, methods, and even discipline specific jargon of the field you seek to engage.Perhaps the best example is the term “institution” which possesses numerous definitions dependent upon the field and context within which it is used. Comprehension is a necessary condition to effective engagement, and in its absence, attempts at an intellectual exchange may be dismissed or misunderstood, harming future discourse. As one example, there is a frequent and unfortunately persistent mischaracterization in Austrian circles of democratic peace theory, often inappropriately conflated with neoconservative foreign policy prescriptions. As but one example, a recent discussion by Hans Hoppe (2013) on the democratic peace grossly mischaracterizes the theory as including the claims “In order to create lasting peace, the entire world must be made democratic” and “war must be waged on those states to convert them to democracy and thus create lasting peace.” Such a claim about democratic peace is a complete invention, as there is not a single piece of democratic peace research in international relations that states either. Indeed, the original conceptualization of the democratic peace in modern political science empirical research was labelled the “libertarian peace” and focused on libertarian normative values (Rummel 1983). Such claims are completely absent in both the normative (Dixon 1994) and institutionalist (Bueno de Mesquita et al. 1999) explanations of the empirical finding, which has been described as “the closest thing we have to an empirical law in the study of international relations” (Levy 1989, p. 88). Indeed, the empirical record even suggests that newly created, unstable democracies are the most violent states in the system (see Mansfield and Snyder 2002). Dr. Hoppe appears to confuse the democratic peace, which originates as a deductive theory about domestic influence on the polity by Immanuel Kant ([1795] 1991, p. 113) and/or the rise of capitalist preferences by Joseph Schumpeter (1950; 1955), with neoconservative foreign policy recommendations (e.g., Kagan 2012) and the idealist policy prescriptions of Woodrow Wilson.Notably, Kagan and many neocons operate out of the field of history. There are no significant neoconservative international relations scholars, due both to the absence of any clear logic behind such an approach as well as a dearth of empirical evidence for such policies’ effectiveness. Wilsonian idealism, likewise, is generally absent in contemporary research, and the term exists in the present typically as a pejorative used by neorealists in describing liberal theorists (e.g., Mearsheimer 1995).
While the criticism of such neoconservative policies that follows in Hoppe’s analysis is well crafted and would be predominantly shared by most democratic peace theorists, the failure to properly engage the enormous extant literature and demonstrate a basic knowledge of the theory as it currently exists in international relations fosters and supports divisions between the two social science fields rather than providing interesting political science insights from an Austrian perspective. Research in coercive hierarchical power relationships and the dissemination of democracy (Organski 1968; Rasler and Thompson 1994), the causal development of clear individual preferences within democratic (and non-democratic) institutional frameworks (Mousseau 2003; Peceny and Butler 2004; Gartzke 2007), and the relationship of foreign policy behaviors to institutional coercive strength (Rhamey 2012) all go ignored through this failing to engage international relations scholarship. Such a dialogue between these systemic and liberal approaches with Austrian scholarship has enormous potential for better understanding human action in the political context.For an introduction to the democratic peace in international relations, see Russett et al. (1995).
Strategy 2: Engage and Incorporate MathematicsIf a priori science is a valuable approach, and we cannot knowingly observe the underlying motivations of actors, then generalizable and observable patterns of behavior should no doubt be present throughout a cadre of relevant historical events. While exploration of a single event may require a potentially dangerous divination of motivation in order to sensibly explain an historical episode, as well as any relevance to praxeological theories, econometric large-N analysis possesses the virtue of mathematically organizing possible relationships between events to uncover generally present correlations. A relationship between observable phenomena that are generalizably present in coincidence with an outcome of interest should correspond with any reasonably developed praxeologically deduced theorem, and certain types of statistical analysis may heavily complement Austrian research.Importantly, there is an intuitively plausible potential relationship between the praxeological approach and Bayesian empirical analysis that requires additional future attention by social scientists. Bayesian analysis recognizes the inherent uncertainty underlying observable events, obvious when observing real world phenomenon, as we cannot understand the complexity of motivations inherent in individual decision-making. However, rather than the explicitly inductive process of Bayesian updating, conceivably our priors may be updated instead by the deductive expression of a praxeologically based theory, permitting a more effective and appropriate large-N test. In other words, the logical posterior for an Austrian Bayesian model is the deductively generated theoretical information where probabilistic analysis is conditional on common sense claims. While the idiosyncrasies of a single case may make for difficult historical illustration, laws of human behavior capable of explaining real world occurrences, in a Mengerian sense, should be observably evident in a statistically significant fashion across a relevant population in a properly specified model.“Properly specified model” is simply one that accurately manages the nature of the data (e.g clustering, time series, hierarchical data structure) while also organizing the data to logically fit deduced theoretical priors. Generally, the problem in social sciences is not the models, but poor application and interpretation. While the failure to demonstrate expected empirical relationships that can be deduced from a praxeological approach does not, by definition, disprove the theory, it can serve the quite important purpose of highlighting deficiencies or logical fallacies within a deduced theorem. Theories are not apodictically true simply by labeling themselves a priorist, and a failing to observe generally present historical relationships that should coincide with the theory in a properly constructed econometric model is potentially an indication of a failing in the theory’s initial deductive logic. Furthermore, formal modeling, such as that often employed in applications of selectorate theory (see Bueno de Mesquita et al. 2008), can be a helpful means of organizing information regarding causal processes arrived at through clearly deduced theories.
Austrians often criticize econometric analysis as promulgating poorly developed or even illogical theories through the manipulation of algorithms to provide corroborating mathematical relationships. However, such a cautionary note surrounding statistical analysis is made by any serious approach to the social sciences, even in the most positivist corners, and an emphasis on theory prior to econometric testing is taught in every mainstream graduate research design course.Such criticisms are present in the most frequently used texts for such courses in political science and sociology doctoral programs, such as those by Shively (1974), King et al. (1994), Goertz (2005), and Ragin (2008). This attack on econometrics, then, is something of a straw man caricature of econometric research as such inductive, hyper-positivist work is not the standard in mainstream social science. Instead, the hostility toward mathematics is more likely an indication of mathematical ignorance of underlying statistical algorithms, a confusion regarding statistical claims surrounding causality, or simply an attempt to promulgate a bad, illogical theory when confronted with a lack of, or even contradictory, empirical evidence. While properly developed social science theory is not dependent on empirical “proof,” an absence of such is typically a sound indication that something in the theory’s logic has gone awry. This is not to suggest that historical method of careful logical argumentation on a case by case basis is without merit (e.g., Rothbard 2002b). However, such qualitative approaches, while interesting, may not provide the most effective social science illustrations regarding generalizable theories. Econometric knowledge is neither the foundation nor the end goal of social science research, but if done well, it is an important tool in the arsenal of the social scientist and should be embraced.
Strategy 3: Focus on Academic EngagementThe ideas of the Austrian school have the potential to contribute greatly to the social sciences, but perceptions of those ideas, and thereby their dissemination, may be marred, however unfairly, by an unclear union between the intellectual development of theory building and libertarian political activism. As such, scholars should promote a clear distinction between Austrian research and political activism, not allowing scholarly work to be shrouded by irrelevant, and sometimes counterproductive or contradictory, agendas. This strategic concern is particularly applicable to interdisciplinary expansion to political science and international relations, fields already highly sensitive to the politicizing of social science research. In these fields, new research programs viewed as pandering to particular ideological perspectives or political groups, regardless of whether they are left, right, or libertarian, are likely to be quickly dismissed. For this reason, the community of Austrian scholars should promote a clear distinction between Austrian research and political activism.
In part due to the efforts of scholars such as Dr. Salerno, the Austrian school has grown in prominence and exposure by leaps and bounds in the academic community, both within economics and beyond. However, the growth of the Austrian school as a heterodox approach may also tend to attract elements that seek to exploit rising interest for personal profit, or those attracted to the community not necessarily by its ideas, but its distinctiveness from the existing status quo. Such groups may include racists, fear-mongers, or simply those advocating apophenic views contradictory to empirical reality. Clearly, as an intellectual enterprise that not only values the development of thoughtful theoretical and empirical research, but also one with a deep dedication to principles of human liberty, the scholarly community must act to quickly condemn any such groups that may attempt to associate themselves with the Austrian school for no other reason than its rising popularity. Organizations or individuals whose mission is contrary to that of advancing sound social scientific thought and human liberty central to the Austrian school should be immediately and quickly dismissed. Obviously most Austrian scholars are quick to condemn these types of groups or individuals, but a more active, vocal, and immediate stance is necessary within the scholarly community in opposition to such detrimental associations to prevent negative perceptions by broader academe and to preserve the school’s intellectual integrity. In addition to being clearly opposed to principles of human liberty and Austrian thought, such negative associations would also be highly detrimental to the advancement of interdisciplinary opportunities across the social sciences.
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After Joey Rothbard’s death, I flew to New York to organize the disposal of Murray and Joey’s goods according to their wills. Books and papers went to the Mises Institute, of course, where they are the center of our library and archives. But my strongest memory, aside from ineffable sadness, was the printed document on the small table next to Murray’s reading chair in the living room. It was Joe Salerno’s doctoral dissertation.
To me, that has always symbolized Murray’s relationship with Joe, whom he praised as a wonderful economist, and — perhaps almost as important in our times — as a brave fighter against error and sellout.
Joe has been a strong intellectual influence on the Mises Institute since our founding. How appropriate that he is also Murray’s successor as our academic vice president.
Joe influences so much. The Mises University, the Austrian Economics Research Conference, and the Summer Fellows Program are all under his aegis, and much the better for it. Not only is Joe an important scholar, he is a teacher of the sort we would all have loved to have had. No one could be more patient, rigorous, detailed, and loving. Forget Mr. Chips. We’ve got Joe Salerno.
AMatthew McCaffrey is an assistant professor of enterprise at the University of Manchester, Manchester, United Kingdom. I was a summer research fellow from 2008–2013. Professor Salerno served on my master’s thesis committee in 2010, and we have since collaborated on several research projects. This essay was inspired by our work on the history and theory of entrepreneurship, for which Professor Salerno was an invaluable mentor. serious interest in the entrepreneur is often considered a defining characteristic of the Austrian school. This attention is evident in its prehistory, in the writings of Richard Cantillon, Jean-Baptiste Say, and others (Hébert 1985; Hébert and Link 1988), and also in Carl Menger’s foundational Principles of Economics (1871). Entrepreneurship plays a central role in the work of Ludwig von Mises as well, who often referred to it as the “driving force of the market.” However, despite the universal importance assigned to the entrepreneur among Austrian economists, there is still much discussion about what exactly entrepreneurs do, and their precise function in the market economy. The questions involved are often complex and cover a wide range of problems, such as the determination of profit and loss, the role of uncertainty and speculation in the market, and the equilibrating properties of arbitrage, to name only a few. As a result, the various theories of entrepreneurship that have appeared in the Austrian tradition, each of which has its own fundamental assumptions and goals, have been the source of disagreements about economic theory and policy.
One controversial problem that remains to be thoroughly examined is the relationship between entrepreneurial theory and public policy. The relevant questions are: does economic policy have a direct effect on entrepreneurial behavior, and if so, can the study of entrepreneurship inform economists regarding the welfare outcomes of intervention into the market process? Thus far, the conventional wisdom on this subject (and on entrepreneurship in general) has been largely informed by the writings of Israel Kirzner, which have proved quite influential among recent generations of Austrian economists. Kirzner argues that policy interventions remove the incentive provided by pure profits, thereby hampering entrepreneurs’ ability to discover beneficial opportunities in the market. This in turn implies that opportunities for mutually beneficial market exchange are passed over, and interference with entrepreneurial alertness therefore undermines the welfare-increasing properties of the market process, which normally encourages entrepreneurial alertness and discovery.
Given that Austrian economists are often critical of the various economic arguments in support of regulation, it should not come as a surprise that an entrepreneurial theory linking intervention to welfare losses would be readily accepted. However, I argue that the view of entrepreneurship advanced by Professor Kirzner faces serious difficulties when it tries to explain the effects of public policy on entrepreneurship. I suggest that more satisfactory answers to questions of policy can be found by considering intervention through the framework of entrepreneurial calculation and judgment. This approach was pioneered mainly by Ludwig von Mises, especially in his famous dispute over the feasibility of socialism. Mises’s work has in turn been expanded and elaborated by later economists, especially Joseph Salerno, whose contributions to our knowledge of the entrepreneur’s distinct role cannot be overstated (1990a, 1990b, 1993, 2008). The work of economists like Mises and Salerno clearly demonstrates that the calculation-judgment theory is applicable to a wide range of policy problems, and firmly establishes the dangers of economic intervention for the market process.
Entrepreneurial Incentives and Economic PolicyThis section explores the relation between alertness theory and economic policy. The framework for Kirzner’s policy analysis is found in his theory of “entrepreneurial incentives,” developed primarily in his book Discovery and the Capitalist Process (1985).A thorough review of the theory of entrepreneurial incentives is beyond the scope of this paper, which deals only with its application to economic policy. For a more complete exposition, cf. McCaffrey (2014). Entrepreneurial incentives are a way to explain the roots of alertness and their role in promoting opportunity discovery. This is necessary because for Kirzner discovery falls outside the conventional economic presentation of incentives, as I will now explain. A consistent theme in Kirzner’s writings is the contrast between what he calls “Robbinsian maximizing” and entrepreneurial alertness. Robbinsian maximizing is a textbook description of how individuals engage in the weighing of alternatives, perform cost-benefit analysis, and maximize utility.It has been argued that Kirzner interprets Lionel Robbins too narrowly, mistakenly concluding that he is simply an early proponent of the conventional economic approach to utility maximization (Salerno 2009). In other words, Robbinsian maximizing involves individuals perceiving and reacting to incentives in the usual economic sense. However, “ordinary” incentives cannot be used to explain entrepreneurs’ discovery of opportunities, Kirzner argues, because incentives must be known to an actor in order to be incorporated into standard utility calculus. But pure profit opportunities are unknown; they are waiting to be discovered, and therefore cannot consciously play into the cost-benefit analysis of individuals. Alertness to opportunities must therefore be explained by factors other than conventional economic incentives.
Kirzner calls these factors “entrepreneurial incentives.” Entrepreneurial incentives are contained in previously-unforeseen profit opportunities. Unlike ordinary incentives, pure profit opportunities attract the attention of entrepreneurs because it is in the entrepreneur’s interest to notice them (1985, pp. 28–29). Previously-unseen profit opportunities represent potential gains for entrepreneurs, who will be alert to them provided the opportunity is valuable enough. Entrepreneurial incentives are therefore another way of saying that opportunities cause their own discovery. Kirzner calls this conclusion a “paradox,” because it is unclear how such causation could occur:
How, one must surely ask, can an enhancement of the desirability of a particular course of action which by the very definition of this kind of incentive has not yet been noticed inspire its discovery? How can an unnoticed potential outcome, no matter how attractive, affect behavior? How can the attractiveness of an unknown opportunity that awaits one around the corner possibly inspire one to peer around that corner? (1985, pp. 108–09; emphasis in original)
Unfortunately, Kirzner does not resolve the paradox. Instead, he suggests that, although the foundations of alertness require serious investigation, the tendency of opportunities to cause their own discovery is a part of our basic factual knowledge of the economy (1985, p. 109).
Kirzner’s views on the foundations of alertness have already received critical attention (Hülsmann 1997; Foss and Klein 2010; Friedman and Evans 2011), and it has been argued that the opportunity paradox places the alertness theory on insufficient foundations (McCaffrey 2014). Because potential entrepreneurs are prevented by definition from knowing of the existence of an opportunity, and even of searching for it, the causal explanation of alertness must come from some other source, specifically the opportunity itself, and the “open-ended” environment it resides in. The problem pointed out by the critics is that it is logically unsatisfactory to think of unknown opportunities as causing alertness, or helping to “[switch] on the entrepreneurial antennae” (1985, p. 109). Opportunities are not acting agents, and without this key connection between opportunities and discovery, alertness theory runs into difficulty, almost anthropomorphizing opportunities in order to explain how they inspire discovery.
Consequently, this problem carries over to Kirzner’s analysis of economic policy as well, in that the alertness approach does not provide a framework for real-world analysis of the welfare effects of government intervention. Kirzner’s research in entrepreneurship is generally intended to demonstrate the equilibrating and welfare-enhancing properties of the market process, with policy considerations playing a secondary role. Nevertheless, thinking in terms of entrepreneurial incentives is supposed to shed new light on economic policy prescriptions too, explaining how hampering the market process produces inferior welfare outcomes, thus adding vital support to more conventional analysis.
Although economists have developed numerous ways to analyze public policy, many of these are framed in terms of the effects of regulation on ordinary incentives. Kirzner, however, argues that there is danger in thinking only in these terms, to the neglect of the welfare implications of entrepreneurial incentives (Kirzner 1984; 1985, pp. 132–33). This is because changes to entrepreneurial incentives affect the market process in a special way. Specifically, economic regulations hamper entrepreneurial alertness, and prevent the discovery of new opportunities, resulting in welfare losses. This assessment depends on the paradox of alertness discussed above.
Kirzner’s view of economic policy is a straightforward application of his incentive theory, and he describes the connection between regulation and entrepreneurial incentives as “intuitively obvious” (Kirzner 2009). Specifically, economic policy poses a threat to human welfare when it reduces or eliminates entrepreneurial incentives. When economic policy eliminates a profit opportunity or renders it less remunerative, it becomes less attractive to entrepreneurs. Because it is no longer in an entrepreneur’s interest to notice the opportunity, it tends not to be noticed. By reducing the rewards (in terms of pure profit) attached to alertness, regulation therefore decreases the likelihood that entrepreneurs will be successful discoverers:
[D]irect controls by government on prices, quantities, or qualities of output production or input employment may unintentionally block activities which have, as yet, not been specifically envisaged by anyone. Where these blocked activities turn out to be entrepreneurially profitable activities (perhaps as a result of unforeseen changes in data), the likelihood of their being discovered is then sharply diminished. Without necessarily intending it, the spontaneous discovery process of the free market has thus been, to some extent, stifled or distorted. (Kirzner 1982)
Intervention eliminates new and unknown opportunities, preventing entrepreneurs from being drawn to them, and ultimately preventing welfare-enhancing market coordination. How precisely does regulation affect alertness? The answer seems to be that,
To announce in advance to potential entrepreneurs that [for example] “lucky” profits will be taxed away is to convert open-ended situations into situations more and more approximating those of a given, closed character. The complete taxing away of pure entrepreneurial profit can, it is clear, succeed only in removing from potential entrepreneurs all incentive for paying attention to anything but the already known. (Kirzner 1985, p. 111, emphasis in original)The last sentence seems to imply that entrepreneurs can pay attention to the unknown. Unfortunately, Kirzner does not explain exactly what this might entail.
Kirzner seems to be arguing that entrepreneurs possess a general knowledge of “where to look,” such that if this general field becomes less profitable, they will be less likely to notice specific opportunities in it. Yet if opportunities are discovered without ordinary incentives (such as those involved in search efforts), it is not clear how giving entrepreneurs general information would aid or hamper discovery. Would not information about where to look simply affect ordinary, known incentives? If expressed in these terms, the thrust of Kirzner’s argument would be unobjectionable. It would imply that when government announces a certain kind of production is no longer profitable, entrepreneurs acknowledge this change, alter their calculations accordingly, and shift their resources to more remunerative forms of production. Yet this view of entrepreneurship and regulation relies on the conventional approach to incentives: the open-ended-vs.-closed distinction is most plausible if entrepreneurs can act and search for opportunities, or, even better, exercise judgment about how to use resources. But if we try to apply the specific notion of entrepreneurial incentives to policy analysis, the causal problem of alertness appears again.
Consider an example. Suppose there are two industries, auto manufacturing and software engineering. In each of these industries entrepreneurs are earning the same returns, and as far as all potential entrepreneurs are concerned, both industries are equally attractive. Let us then suppose the government announces that a new tax will be levied on the profits of the auto industry, while the software industry will be left unhampered. According to Kirzner, opportunities in auto production have been eliminated, and potential entrepreneurs will now perceive the industry as closed, which in turn means relatively few profit opportunities will be discovered there. There are two ways to explain this result. First, entrepreneurs might acknowledge the new policy, ignore the auto industry, and focus their attention elsewhere. This would involve action and search, however, and is not consistent with Kirzner’s theory of alertness. The second possibility is that entrepreneurs do not act differently in response to the new tax policy, but instead the lack of profitability in auto manufacturing unconsciously steers them away from that industry and toward others. This seems more in keeping with Kirzner’s theory, but it returns us once again to the question of causation.
A potential entrepreneur’s knowledge of the tax could certainly influence his deliberate search efforts and decisions about production. But how could it influence the passive state Kirzner uses as a starting point? If a profitable opportunity cannot, by itself, cause its own discovery, how can we be sure that an unprofitable opportunity will have the opposite effect, and tend to remain unnoticed? If an entrepreneur does not know that an opportunity exists, how can a policy that decreases the profitability of that opportunity change the likelihood of his noticing it? In order to answer these questions, it seems we must incorporate other kinds of behavior, such as search or judgment.
I will not add to this criticism other than to point out that if entrepreneurial incentives cannot be integrated into a theory of unhampered markets, then the implications for restricted markets are ambiguous. If one believes there is no necessary tendency for entrepreneurs to notice opportunities (or even that opportunity discovery is not the best basis for a theory of entrepreneurship), then the above policy analysis loses its force; regulation might just as well hamper erroneous incentives or errors as prevent entrepreneurial success.Also, regulation need not simply inhibit the discovery of profitable opportunities: it might also produce new opportunities for rent-seeking or other forms of destructive entrepreneurship (Foss and Klein 2010). Based on the above discussion, it should be clear that policy analysis poses a problem for alertness theory.
In addition to typical policy questions, the opportunity-causation problem also has implications for the debate over the feasibility of central planning, a system of organization Kirzner argues is subject to a lack of proper entrepreneurial incentives (1982). Using the entrepreneurial-incentives approach, however, the case against central planning might actually be weakened:
It is true in a trivial sense that entrepreneurs can be defined as those who are “alert to profit opportunities,” but we wonder why agents of the central planning board could not be equally alert. The real issue is not alertness, but the magical property that Kirzner attributes to those who are alert: the property of thereby finding what they are looking for (a profit opportunity) and knowing what to do about it. If mere alertness — activated by “the profit motive” … — were all it took to produce the requisite knowledge, one could incentivize central planners with the same motive or an even stronger one, such as the death penalty … (Evans and Friedman 2011)
There is then a difficulty in explaining how entrepreneurial alertness differs in market versus non-market (e.g., socialist) settings. If alertness is a universal phenomenon, as Kirzner believes, then it is unclear how or why government agencies do not also possess some degree of alertness — or why they could not be motivated to alertness. Once again, the necessary links between opportunity and alertness — and between decreased opportunity and non-alertness — are missing. Without them it does not seem possible to apply Kirzner’s alertness theory to economic policy, at least in the manner he suggests. The solution, I argue that we can solve this problem by relying on the concept of entrepreneurial calculation using money prices.
As mentioned above, Kirzner recognizes the problem involved in not explaining opportunity causation, yet still draws theoretical and policy conclusions as if the paradox had been resolved. It is difficult to escape the feeling that Kirzner accepts it as a matter of course that the market process produces beneficial welfare outcomes, and further, that this is the direct result of entrepreneurs tending to discover profitable opportunities. As he himself puts it, “there can be no doubt that such inspiration [i.e., entrepreneurial alertness] has been of enormous importance throughout recorded human history” (1985, p. 109). But this is a conclusion to be reached by careful reasoning, not a fundamental assumption. And until we clarify these assumptions and more clearly explain the foundations of entrepreneurial theory, economic policy is bound to remain a controversial subject. While this is far from an exhaustive discussion, I hope it is sufficient to demonstrate the need for careful scrutiny of the alertness hypothesis in economic policy, and moreover, to spark economists’ interest in alternative theories of entrepreneurship that more easily explain the effects of regulation on entrepreneurial behavior.
Entrepreneurial Calculation and JudgmentThe problems of the alertness approach do not mean that entrepreneurial theory must give up any hope of policy relevance. However, they do require us to more carefully consider the basic elements of theory, and how they relate to real-world human behavior. To this end, I suggest that instead of a theory of entrepreneurial alertness, what is needed is a theory of entrepreneurial judgment. The judgment approach to entrepreneurship has a long history within the Austrian school, and can be traced back at least as far as Menger’s writings. Menger did not write extensively on the entrepreneur, but he did describe a number of different ways entrepreneurship can occur (1994, pp. 159–61). Two forms of entrepreneurship that are relevant for judgment are “the act of will by which goods of higher order … are assigned to a particular production process” and the “supervision of the particular production process” (Menger 1994, p. 160; emphases in original). Both of these aspects of entrepreneurship point to the idea of a capital-owning, decision-making entrepreneur (Salerno 2008).
The judgment approach flourished in the works of Menger’s disciples, especially in the writings of Böhm-Bawerk (McCaffrey and Salerno 2014), Frank Fetter (McCaffrey unpublished), and Ludwig von Mises. Of these economists, Mises’s writings have received the most attention, and are the subject of controversy. Yet a careful study of his writings shows that his work falls within the judgment tradition. This thread of Mises’s thought begins with early writings such as The Theory of Money and Credit (McCaffrey 2013), and continues on through his more systematic exposition of entrepreneurship in Human Action (Salerno 2008; Foss and Klein 2010). The judgment view was further elaborated by Murray Rothbard, who placed his own discussion in the midst of an extended treatment of production theory (2004, pp. 509–55).Rothbard also drew attention to the Austrian heritage in entrepreneurship and pointed out several confusions about this legacy (1985; 1987). Among more recent generations of economists, the judgment theory has been developed by Joseph Salerno (2008) and has crystallized in such works as Foss and Klein (2012). This approach to entrepreneurship is therefore well-established within the Austrian school, and in fact represents a dominant trend in historical Austrian thinking on the subject.
The judgment approach views entrepreneurship as the function of residual decision making about the use of heterogeneous capital goods in production. In other words, the entrepreneur is the individual or group ultimately responsible for the direction of an enterprise, and this entails the ownership of capital and the direction of the factors of production. Because production takes time, arranging the structure of production implies that entrepreneurs make speculative judgments about the future state of the market. Eventually, consumer demand will reveal whether particular uses of capital were justified. If his initial judgments were correct, the entrepreneur earns profits, and if not, he incurs losses. The entrepreneur therefore bears the uncertainty of the future in exchange for the chance to reap profits. The key point, however, is that in order to do this entrepreneurs must exercise judgment about the allocation of resources.
However, when making decisions entrepreneurs first require some method of comparing the costs and benefits of each alternative use of scarce resources in order to determine which combinations of the factors will serve the most urgent needs of consumers. Entrepreneurs find this means of evaluation in monetary calculation. Calculation consists in entrepreneurs appraising the future prices of the factors of production through their “‘experience’ of past prices and … their ‘understanding’ of what transformations will take place in the present configuration of the qualitative economic data” (Salerno 1990a, p. 60). Once these mental estimates have been formed, entrepreneurs are in a position to gauge the relative merits of alternative arrangements of the factors. But their experience and understanding must be expressed in terms of a common denominator, namely money prices:
[A]s Mises points out, economic calculation involves arithmetic computation and … it is for this reason that economic calculation can only be calculation in terms of money prices. … As the only possible tool of calculable action, money prices do not merely permit people to utilize their individual “knowledge of particular circumstances of time and place” to enhance the efficiency with which goods are produced in society, prices render possible the very existence of social production processes. (Salerno 1990b)
Calculation therefore provides the “indispensable mental tool for choosing the optimum among the vast array of intricately-related production plans that are available for employing the factors of production within the framework of the social division of labor” (Salerno 1990a, p. 52). In other words, calculation provides, among other things, a basis for entrepreneurs’ judgment regarding the direction of the factors. More profoundly, calculation is actually the fundamental characteristic of a rational economic system, which is simply impossible in its absence, as in the case of socialist societies (Mises 1998 [1949]; Salerno 1990a; 1990b; 1993).
The distinct traits of calculation and judgment are all absent in the alertness view. This is a necessary result of Kirzner’s distinction between Robbinsian maximizing and entrepreneurial discovery, which excludes capital ownership, uncertainty bearing, and monetary losses from the start. Yet this exclusion is precisely why alertness theory stumbles when it confronts policy analysis. Because Kirzner cannot incorporate ordinary economic decision making into entrepreneurship, he instead explains it by appealing to variables outside the sphere of action, i.e., the existence of pure profit opportunities, which in turn leads to the problems discussed above. However, a capital-owning, uncertainty-bearing entrepreneur who earns monetary profits or losses can play an integral role in policy analysis.
The Policy Implications of EntrepreneurshipWith the ideas of entrepreneurial calculation and judgment in mind, we can now make sense of the link between public policy and entrepreneurial theory. One distinct advantage of the calculation-judgment theory is that it is easily integrated into policy analysis; the causal connections between policy and entrepreneurship are not metaphorical or paradoxical, but can be analyzed using fairly straightforward economic tools. What is more, by showing how policy interventions interfere with the process of economic calculation and judgment, we can more clearly determine the welfare implications of such interference.
Ownership and Political EntrepreneurshipThe application of judgment theory begins with the idea of ultimate or residual control over an enterprise. By determining where the locus of control and decision making lies, we can determine the scope and extent of entrepreneurial calculation, and also see how it might be hampered. More importantly, by discovering which individuals ultimately own and allocate resources, we can see how entrepreneurial behavior is different across institutional and policy contexts. The most obvious examples to contrast are entrepreneurial behavior in the market and in the political realm.
We have already said something about entrepreneurial calculation in the market. In sharp contrast is the element of “entrepreneurship” that occurs within government. Although decision making within government is often complex, it is clear that within any given state there is some form of ultimate authority over resource allocation. The exercise of this control may be termed “political entrepreneurship” (McCaffrey and Salerno 2011). Political entrepreneurship is distinct from market entrepreneurship in at least two important ways: first, it occurs outside the sphere of economic calculation, and second, it is financed through coercive redistribution as opposed to voluntary exchange.Note that Kirzner’s entrepreneur does not possess resources in either a political or a market setting. Therefore, market entrepreneurship cannot easily be distinguished from political entrepreneurship based on this difference or on considerations of the entrepreneur’s methods of finance. The non-voluntary nature of public finance means that no matter how decisions are made, they will conflict with the current preferences of the public at large, while the absence of calculation means decisions lack rational direction. Political entrepreneurship — i.e., government decisions about the allocation of resources—therefore diverts the stream of spending away from the path it would have taken in an unregulated market, and also distorts the structure of production (Rothbard 2004, pp. 1151–55, 1167–68; McCaffrey 2011). Political entrepreneurship cannot therefore produce the same welfare-enhancing effects as market entrepreneurship, and the absence of entrepreneurial calculation within government means that it never could.
Entrepreneurship and the Institutional FrameworkThe judgment approach also allows us to see how policy shifts the entrepreneurial function from one individual or group to another, and how this shift affects welfare outcomes. Changes in the entrepreneurial function are most relevant in a system of economic intervention. Under interventionism, ownership is systematically shared between government and private individuals, or in other words, there is a forcible separation of the ownership and control of the means of production. One way to describe this situation is “institutionalised uninvited co-ownership” (Hülsmann 2006; emphasis in original). For instance, when a government nationalizes an auto manufacturer or even the auto industry, entrepreneurs in these firms surrender their decision making ability, and the entrepreneurial function is shifted from the market to the political sphere. Even if entrepreneurs nominally retain ownership of the firm, they are little more than the managers of the enterprise — they can ultimately be replaced by the political entrepreneurs, who retain residual control. A system of government intervention, because it alters the pattern of ownership of the factors, also involves a systematic transfer of decision-making authority over them. Intervention therefore changes the pattern of entrepreneurship in society, by shifting the entrepreneurial function from some individuals to other more favored groups, be they rent-seeking firms or political entrepreneurs themselves.
“Institutionalized uninvited co-ownership,” is also closely tied to the incentive problem known as “moral hazard,” defined as, “the incentive of a person A to use more resources than he otherwise would have used, because he knows, or believes he knows, that someone else B will provide some or all of these resources” (Hülsmann 2006). When ownership and control are forcibly separated, a wide range of “perverse” incentives — such as moral hazard, adverse selection, and the tragedy of the commons — are brought into play. Under a system of free contracting, entrepreneurs (principals) must use judgment to arrange incentives within the firm, thereby mitigating moral hazard. However, when ownership is forcibly shared, the scope for calculation and judgment are reduced, prolonging or even institutionalizing incentive problems.
Moral hazard is not the only aspect of government intervention that can be viewed in an entrepreneurial light though. A closely related subject is the problem of “regime uncertainty.” This term was coined by Higgs (1997) as a way to explain the conditions which led to the long-term decline in private investment during the Great Depression. Higgs argues that entrepreneurs were reluctant to invest in a political environment hostile to their profit-seeking interests. In particular, widespread fear existed among businessmen that under the New Deal regime, industries would be nationalized, while taxes and other regulations would severely curtail profitability. What is more, the ideological stance of the Roosevelt administration was decidedly anti-business, creating an environment in which the viability of the fundamental institutions of the market economy was thrown into question. The uncertainty produced by the regime thus resulted in depressed investment and significantly delayed recovery.
Yet if the task of the entrepreneur is to allocate resources in the face of uncertainty, why would regime uncertainty pose a special problem? Regime uncertainty is relevant for judgment because it represents uncertainty about the institutional environment in which entrepreneurs make decisions; in a way, it tears the canvas on which entrepreneurs are trying to paint. One way to express this idea is to say that regime uncertainty occurs at a different institutional “level” than entrepreneurs are used to dealing with (Bylund and McCaffrey unpublished). That is, when regimes create fear about the security of the very system of private enterprise — in practice, the security of property rights and profits — they throw the “rules of the game” into question. Entrepreneurial judgment, on the other hand, usually takes place at the level of the “play of the game,” with certain institutional constraints taken for granted.
One result is that regime uncertainty undermines judgment by threatening its raison d’être. In a regime that is considered friendly to private enterprise, entrepreneurs constantly strive to earn profits and avoid losses. When regime uncertainty appears, however, entrepreneurs cannot be sure of the link between successful judgment and monetary rewards, and they therefore restrict their profit-seeking behavior (Bylund and McCaffrey unpublished). Reduced activity by entrepreneurs implies reduced effort to calculate in the economy, and ultimately, decreases in consumer satisfaction. There is then a reasonable chain of causation running from policy (actual or threatened), to entrepreneurs’ perceptions of monetary incentives, to a decline in entrepreneurial activity, and finally, to resulting welfare losses.Note that these links would be absent if entrepreneurs were unaware of the existence of monetary incentives. Judgment therefore provides a substantive connection between regime uncertainty and welfare.
This is one way the conventional effects of regime uncertainty can be expressed in entrepreneurial terms. We can also imagine the reverse of regime uncertainty, when entrepreneurs believe returns will be guaranteed no matter the quality of their judgment. Of course, guarantees of profitability and security are not found in the market; they are, however, often made by government in its negotiations with rent-seeking firms. When guarantees are made, profit-seeking activities increase because entrepreneurs believe they will be protected (e.g., through grants of monopoly privilege or bailouts), whether their investments are wise or not. Entrepreneurs are more likely to engage in risky and unprofitable production when convinced they will not ultimately bear the uncertainty of their decisions. This again hints at moral hazard.
ConclusionThe theory of the entrepreneur is one of the most important components of economic science. But although it is vital for economists to understand the driving force of the market, it is equally important know how public policy hampers this force. The most obvious obstacle to economic progress is government intervention in the market economy, which inevitably involves interference with the decisions of the entrepreneur. Yet how we think of the entrepreneurial function matters greatly for our conclusions about exactly how economic policy changes the entrepreneurial process and the welfare outcomes of the market economy. If, following Kirzner, we view the entrepreneur as a resource-less and inactive agent awaiting the serendipitous discovery of profit opportunities, policy analysis becomes effectively impossible. Because the existence of profit opportunities does not explain a tendency toward entrepreneurial success, it likewise does not show how changes to the policy environment tend negatively to impact discovery and the welfare of market participants. The alertness theory does not then provide a substantial foundation on which to build a distinctly entrepreneurial approach to policy analysis.
However, once we take into account the vital roles of calculation and judgment, it is easy to see that economic policy distorts and changes entrepreneurs’ behavior. Judgment theory relies on the concrete notions of capital ownership, calculation in terms of money prices, and decision making about the use of the factors, all of which can be seen at work in the real world. Intervention shifts the pattern of ownership and therefore also falsifies the money prices entrepreneurs use to appraise the factors of production. Intervention also directly abrogates the judgment of entrepreneurs by diverting the structure of production from the course it would have taken in an unregulated market. The direction and scope of entrepreneurial decision making are thus altered, and consumer welfare is reduced. Moreover, public policy can drastically affect the business environment in which entrepreneurs act, threatening the fundamental institutions of the market economy on which entrepreneurs rely. This depresses entrepreneurial activity, resulting in a general loss of welfare.
Judgment, through its connections to economic calculation, provides a concrete reference point from which to analyze the effects of policy. Calculation is mass to judgment’s velocity, and together they form the driving force of the market. This view of the entrepreneur not only has a long history within the Austrian school, but has already been applied to numerous problems in theory and policy, and will no doubt serve as a useful tool for analyzing many more. It therefore represents a positive way forward for scholars in economics and public policy.
As a final thought, let me add that while the future is bright, so too is the past; in other words, it is vital to recognize that many of the most important advances in Austrian economics have emerged from careful reflection on the foundations laid by the giants of the tradition, whose insights must never be taken for granted. As our thinking on entrepreneurship moves forward, it too should be mindful of its roots in the Austrian school, and always take care to appreciate the contributions of previous generations. With that in mind, it is safe to say that as this tradition grows and thrives in the coming years, it will owe no small debt to Joseph Salerno.
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——. 2008. “The Entrepreneur: Real and Imagined.” Quarterly Journal of Austrian Economics 11(3): 188–207.
——. 1993. “Mises and Hayek Dehomogenized.” Review of Austrian Economics 6(2): 113–46.
——. 1990a. “Postscript: Why a Socialist Economy is ‘Impossible’.” In Economic Calculation in the Socialist Commonwealth. Auburn, Ala.: Mises Institute.
——. 1990b. “Ludwig von Mises as Social Rationalist.” Review of Austrian Economics 4(1): 26–54.
InXavier Méra holds a PhD in economics from the University of Angers and teaches at IÉSEG School of Management in Paris, France. I was a Mises Institute research fellow in 2009, 2010 and 2011, and would like to thank Professor Salerno, my fellow research fellows and the Institute staff and faculty for making these experiences enjoyable and intellectually rich. I am especially indebted to the Institute’s and research program’s donors, without whom none of this would have been possible. This chapter is an extension of a paper originally developed with the help and encouragement of Professor Salerno while a summer fellow. Thanks to Simon Bilo and Per Bylund for their thoughtful comments on a previous version. 2009, I had for the first time the opportunity of participating in the Mises Institute summer fellowship program under the guidance of Professor Salerno. On this occasion, I worked on an article touching upon the theme of monopoly price theory, a shared research interest of ours (Salerno 2003, 2004). My goal was to focus on how the pricing of factors of production is affected when their products are sold at monopoly prices (Méra 2010).
Now, the very nature of the issue at hand required to take a “long run” perspective since it concerns the production decision point, a decision which must be made by some capitalist-entrepreneur in anticipation of its future returns. Because of this focus, I noticed in the course of my research that Ludwig von Mises and Murray Rothbard tend to emphasize the same requirement for a monopoly price to emerge, as far as the demand schedule for the monopolized good is concerned, in the long run and in the “immediate run” (when the good is already available).
This is problematic because, as I intend to explain below, their criterion of a seller or a cartel of sellers facing an “inelastic demand” above the “competitive price” (Mises) or the “free-market price” (Rothbard) is only required in the immediate run. This has consequences in regard to the question of the limits to monopoly pricing, a question that Rothbard (1962, pp. 680–81) briefly but explicitly deals with in his “A World of Monopoly Prices?” section when he asks “Can all selling prices be monopoly prices?” He also provides insights outside of this section which also have direct implications for that question. Most notably, he explains that the very concept of a monopoly price makes sense only as a byproduct of interventionism, arguably an improvement over Mises’s theory. Nonetheless, Rothbard’s take, as well as Mises’s, suffers from this issue of the inelastic demand criterion and related weaknesses that I intend to highlight and repair below. Since these shortcomings happened not to be decisive for the article I worked on under Professor Salerno’s supervision, I had left them at that.In Méra (2010), my remarks in relation to the issue of the inelastic demand criterion are confined to footnotes. The present article essentially elaborates on these remarks. It seems appropriate then to deal with them here.
I begin with a brief summary of Rothbard’s view of monopoly prices as a hampered market phenomenon only. I interpret this modification of Mises’s monopoly price theory in the following way: the limits to monopoly pricing are shown to be narrower than what Mises thought. In other words, there is less room for monopoly prices to emerge in a market economy than Rothbard’s mentor considered.
Then I explain how, on the other hand, the ambiguous treatment of the inelasticity of demand criterion in Mises and Rothbard’s analysis leaves less room for monopoly prices than there really is. Although in contrast the modern neoclassical theory’s treatment of monopoly avoids the same ambiguity and its consequences, I show that the reason is accidental and that this should not be mistaken as a sign that it provides a superior alternative.
Finally, the main theory and policy implications of our findings are stressed: if there can be monopoly prices without inelastic demand schedules above free market prices, the price distortion potential of monopolistic privileges is more important than what Rothbard envisages. It becomes then all the more urgent to refrain from granting them if one wants to spare the bulk of consumers from the effects of factor misallocation.
Re-Thinking the Limits to Monopoly Pricing: Rothbard’s ContributionIn relation to Mises’s exposition of monopoly price theory, Rothbard’s central contribution is to show that the dichotomy between a competitive and a monopoly price is illusory in a free market framework. The movement from a competitive price to a monopoly price and the movement from a sub-competitive price to a competitive price are indistinguishable, for instance. The most fundamental reason is that the seller is in the same position vis-à-vis the demand schedule, whatever case one considers. All that we know based on Mises’s praxeology is that, nonmonetary factors aside, the seller will try to obtain a price above which the demand schedule is elastic. This is true when he can obtain a monopoly price. But this is true as well as when he can only charge a competitive price. Otherwise, he would charge a higher price. In other words, both prices appear to be distinguishable only if one arbitrarily postulates that a certain price is competitive so that a higher price can be considered as a monopoly price if the seller can increase his monetary income or net revenue by selling the good at this higher price. Absent an independent criterion to conceive of this competitive price, the whole dichotomy fades away (Rothbard 1962, pp. 687–98). If one cannot distinguish between two things, they are essentially the same.O’Driscoll (1982, pp. 190–91) argues that “a distinctively Austrian theory of monopoly remains to be written” and more specifically that “Murray Rothbard and Dominic Armentano, present a distinctive theory with roots deep in the history of economics and with strong affinity to the common-law treatment of monopoly. Their theory is not, however, the outcome or development of any particular Austrian insight.” However one might argue that Rothbard’s take is distinctly Austrian in its realization that the usual dichotomy of a competitive and a monopoly price in a free market is an anomaly in the context of Mengerian price theory (as developed by Mises). After all, Rothbard’s point is that the competitive price benchmark in a free market cannot be derived from the fundamentals of action. As a consequence, it appears as a foreign element forced into the theoretical edifice.
On the contrary, there is an identifiable criterion providing the basis for such a distinction once one contrasts actions occurring in a free market framework with actions occurring while some potential sellers are excluded from the market under threats of or outright aggression. As Rothbard (1962, p. 904) puts it:
We have seen above that on the free market, every demand curve to a firm is elastic above the free-market price; otherwise the firm would have an incentive to raise its price and increase its revenue. But the grant of monopoly privilege renders the consumer demand curve less elastic, for the consumer is deprived of substitute products from other potential competitors. Whether this lowering of elasticity will be sufficient to make the demand curve to the firm inelastic (so that gross revenue will be greater at a price higher than the free market price) depends on the concrete historical data of the case and is not for economic analysis to determine.
In other words, one can conceive of a monopoly price, as compared to a free market price, because the demand schedules that remaining sellers face are altered. These sellers are then not in the same position vis-à-vis these demand schedules than they would be when anyone has the right to compete with them. They will then be able to charge a monopoly price if the demand schedules they now face, independently or together as a cartel, are inelastic above the free market price, which is only possible if the market demand schedule is inelastic above the free market price (Rothbard 1962, p. 674).If the grant of privilege is given to one seller only, then the demand schedule he now faces is the market demand schedule.
Now, these simple yet profound insights mean the following, in relation to the question of the limits to monopoly pricing. If Mises and all the writers who have claimed that monopoly prices could arise in a free market framework have been mistaken here about their nature, they have underestimated the limits to monopoly pricing in society. Rothbard’s contribution — recasting the theory of monopoly price as part of a theory of interventionism — implies the claim that the scope for monopoly prices is narrower than what Mises thought.It was quite narrow already as compared to the views of some of Mises’ predecessors (Salerno 2003, pp. 60–62). Indeed there was no doubt for Mises that government is by far the main source of monopoly prices (Mises 1949, p. 363).
The Overlooked Case of Monopoly Prices with Elastic Demand SchedulesEven if one endorses Rothbard’s contribution, one might nevertheless argue that there is more room for monopoly prices than he thought. To understand this, one must focus on some condition required for a monopoly price to emerge that both Rothbard and Mises have repeatedly stressed in their writings on the topic. The above quote displays this condition. The demand schedule that the holder of a monopolistic privilege faces must be such that above the free market price (or the competitive price, for Mises), one or several prices bring in more revenue. This is the “inelasticity of demand” criterion. The implication is that monopoly pricing in society is limited to the extent that demand schedules are elastic in the relevant ranges. For Rothbard then, the less goods there are for which people are eager to increase their expenses on above their free market prices, the less room there is for monopoly pricing, no matter how effective the grants of privilege are at hampering competition.
There can be no quarrel with this as long as one takes an immediate run perspective in which the goods to be sold or withheld from the market are readily available. Matters are different however once one focuses on the production decision points, when people try to maximize net income and not necessarily gross income. Increasing one’s net income by restricting one’s production of a good is possible even if one faces an elastic demand schedule above the free market price, provided that one’s average production expenses fall at a high enough pace (or rise slowly enough). All that is really required is that total expenses fall more than total income. The decisive consideration is not inelasticity of demand. If it remains of course a factor of emergence of monopoly prices, it is not a necessary criterion anymore. The limits to monopoly pricing are not as narrow as what Rothbard suggests.
Mises and Rothbard’s Conflation of the Immediate Run and the Long RunNow the reader familiar with Mises and Rothbard’s writings might ponder. These authors did not forget to take production expenses into account in their discussions of monopoly prices, did they? To be sure, they did not. The point is however that Mises (1944), Mises (1949) and Rothbard (1962) never explicitly recognize that the inelasticity of demand criterion needs to be qualified once production is taken into account. In these expositions, they tend to jump from an immediate run to a long run perspective and vice versa without saying so. As a consequence, inelasticity of demand for the product appears to be a required criterion even when the analysis focuses on the production decision point.
For instance, in the paragraph following the above quote, Rothbard (1962, p. 904) mentions the restriction on production and the inelasticity criterion in the same breath, as if maximizing gross income still was the relevant consideration for the monopolist at the production decision point:
When the demand curve to the firm remains elastic (so that gross revenue will be lower at a higher-than-free-market price), the monopolist will not reap any monopoly gain from his grant. Consumers and competitors will still be injured because their trade is prevented, but the monopolist will not gain, because his price and income will be no higher than before. On the other hand, if his demand curve is inelastic, then he institutes a monopoly price so as to maximize his revenue. His production has to be restricted in order to command the higher price. The restriction of production and higher price for the product both injure the consumers.
Here the restriction of production comes as an afterthought, once one has considered which price would maximize gross income. Or, earlier, Rothbard (1962, p. 672) introduces the theory of monopoly price by quoting a passage of Human Action in which Mises focuses on the production decision point:
If conditions are such that the monopolist can secure higher net proceeds by selling a smaller quantity of his product at a higher price than by selling a greater quantity of his supply at a lower price, there emerges a monopoly price higher than the potential market price would have been in the absence of monopoly.
This is compatible with an elastic demand. And yet, Rothbard immediately adds, as if it was no different:
The monopoly price doctrine may be summed up as follows: A certain quantity of a good, when produced and sold, yields a competitive price on the market. A monopolist or a cartel of firms can, if the demand curve is inelastic at the competitive-price point, restrict sales and raise the price, to arrive at the point of maximum returns. If, on the other hand, the demand curve as it presents itself to the monopolist or cartel is elastic at the competitive-price point, the monopolist will not restrict sales to attain a higher price. [Emphasis in the original]It is not without justification then, that Armentano’s summary of Rothbard’s position conflates the immediate run and the long run: “It has been common, of course, to speak of monopoly price as that price accomplished when output is restricted under conditions of inelastic demand, thus increasing the net income of the supplier.” (Armentano 1978, p. 103). See also Armentano (1999, p. 48) and Armentano (1988, p. 8). See also Costea (2003, pp. 47–48) and Costea (2006, p. 45) describing Mises’s position in the same way.
Similarly, in Human Action, the required condition of the inelastic demand for a monopoly price to emerge is defended, and then production considerations are added with no qualification of the criterion. The initial requirement reads as follows:
The reaction of the buying public to the rise in prices beyond the potential competitive price, the fall in demand, is not such-as to render the proceeds resulting from total sales at any price exceeding the competitive price smaller than total proceeds resulting from total sales at the competitive price. (Mises 1949, p. 355)
Then he starts discussing the problem of resource allocation and production expenses. As a consequence, “net proceeds” (Mises 1949, pp. 357, 358, 359, 374) now become the relevant consideration, as they should. And yet, no mention is made of the fact that the previously stated requirement is not strictly valid anymore when he later refers to a “propitious configuration of demand” (Mises 1949, p. 370).
In Mises (1944), the same ambiguity is to be found in an even more pronounced way because Mises shifts back and forth from the immediate run to the long run perspective. First, Mises (1944, p. 2) posits the inelasticity of demand criterion with a numerical example. Given an existing stock of a good, the monopolist does not restrict his sales because demand is such that the total proceeds diminish at any higher price than the competitive one: “If a rise of the price above the competitive price results in a more-than-proportional restriction of the quantity bought by the public, the total proceeds of the seller would drop.” In the next paragraph, he switches to the long run perspective by considering the problem of the allocation of factors and then explains that,
… if some special barriers prevent other people from competing with the monopolistic sellers, a restriction of the production of copper or shoes that does not comply with the demands of the consumers becomes possible. Although the consumers are ready to pay for additional quantities of copper or shoes at prices which would render an expansion of production profitable on a competitive market, the sellers, sheltered by monopoly, do not expand production if they are better off under a state of affairs which results in a higher income for them with curtailment of production. (Mises 1944, p. 2)
Notice how Mises speaks here of mere “income” and not “net proceeds,” despite the fact that he is considering the production decision point. And on the next page, he comes back to the immediate run inelasticity of demand requirement. Both the immediate and long run perspectives are in effect conflated.Klein (2008, p. 177) has noticed that in his general discussion of price determination, “Rothbard (1962) is somewhat imprecise in distinguishing among equilibrium constructs.” We might add that this is true of Mises too, at least in the context of monopoly price theory, as illustrated above. On the distinctions between a “plain state of rest” (PSR), a “final state of rest” (FSR), the intermediate “Wicksteedian state of rest” (WSR) coined by Salerno (1994), and an “evenly rotating economy,” as a complete set of precise equilibrium constructs, see Klein (2008, pp. 172–83). Rothbard’s “immediate run” (PSR) and “long run” equilibriums (FSR) that we have been using here are sufficient for our present purpose however. It does not fundamentally alter Rothbard’s discussion and our analysis here if one interprets them in terms of WSR and FSR instead, since the PSR and the WSR are both about decisions to be made regarding some already produced goods. As one consequently fails to consider the case of a monopoly price with an elastic demand schedule, one narrows the limits to monopoly pricing too much (beyond Rothbard’s reduction to cases of interventions).
Surprisingly enough, given the evidence of conflation that we have shown, it turns out that in one instance Mises has implicitly considered the case of a monopoly price with an elastic demand. Mises (1944, p. 7) draws a table with hypothetical figures showing slightly decreasing average expenses as production expands. There are four prices considered, 5, 6, 7 and 8 monetary units per unit of product and a higher price always implies lower proceeds: the demand is elastic on whatever range we consider above 5, which Mises declares to be the competitive price. According to the inelasticity criterion, there is therefore no room for a monopoly price. But Mises writes that “the monopoly price most favorable to the monopolist is 7” (6, 7 and 8 are monopoly prices)! The reason of course is that, given the figures he chooses, the expenses required diminish more than the proceeds when one reduces the scale of production. Nevertheless, he does not mention explicitly that this is a case of a monopoly price with an elastic demand while, as shown above, he conflates the relevant required criteria for the immediate and the long run perspectives in the same article.
Rothbard too implicitly recognizes the case of a monopoly price with an elastic demand somewhere. In Power & Market, he reproduces an extract from Man, Economy, and State which claimed that an inelastic demand schedule is required for a monopoly price to arise. It is repeated word for word except for one added qualification: “The monopolist, as a receiver of a monopoly privilege, will be able to achieve a monopoly price for the product if his demand curve is inelastic, or sufficiently less elastic, above the free-market price” (Rothbard 1970, p. 44, emphasis added). Inelasticity is not a necessary requirement anymore. He does not explain the addition of the “sufficiently less elastic” criterion but one can certainly see that it makes perfect sense, in light of Mises’ example above and our comments.
To avoid conflation, one can explicitly refer to the two decisions points and thereby disentangle the two required criteria. Kirzner’s exposition comes closer to this than Mises’ and Rothbard’s (Kirzner 1963, pp. 265–96) and is arguably superior in this regard. Another is to call the immediate run and the long run monopoly prices differently. This is, as Salerno (2003, p. 31) notices, what Fetter (1915, pp. 80–81) does, writing of a “crude monopoly price” when the sale of an already produced stock of a good is considered, and of a mere “monopoly price” for a good when its production is considered. Then it can be easily grasped that a crude monopoly price requires an inelastic demand schedule above the free market price, whereas a mere monopoly price does not.
The Trouble with Rothbard’s Falling Costs ProvisoThe lack of a clear-cut explicit distinction in Mises and Rothbard’s analysis between the immediate run and the long run can lead to some further confusion. If one ignores the case of a monopoly price with an elastic demand, it is difficult to make sense of Rothbard’s proviso, according to which a monopoly price will arise when one is striving for maximum net proceeds, “whatever the actual configuration of money costs, unless, indeed, average money costs are falling rapidly enough in this region to make the “competitive point” the most remunerative after all” (Rothbard 1962, p. 674).
The reason is the following. For the “competitive point”Rothbard speaks of a competitive point instead of a “free market point” because the context is his discussion of Mises’ theory. The reader must not get confused by this. This discussion is relevant in Rothbard’s framework once the theory is fixed and depicts how a monopoly price actually contrasts with a free market price instead of a “competitive” price. As Rothbard (1962, p. 903) puts it in his chapter on interventionism and socialism: “In chapter 10 we buried the theory of monopoly price; we must now resurrect it. The theory of monopoly price, as developed there, is illusory when applied to the free market, but it applies fully in the case of monopoly and quasi-monopoly grants.” to yield a higher net return than the restrictive alternative with an inelastic demand, it would be necessary that expenses fall in absolute terms when one increases production, not merely on average, since gross income falls when one expands until the free market point (by definition of the inelasticity of the relevant range of the demand schedule). But this is impossible. Average expenses might fall when production is increased, because of the indivisibility of some factors of production. Total expenses cannot. If the producer-seller will face an inelastic demand for his product in the future, restriction must pay whatever the configuration of expenses is. And believing that a proviso is required here amounts once again to an unjustifiably narrow view of the limits to monopoly pricing.
The proviso makes sense only once one recognizes the possibility of a monopoly price with an elastic demand. In general, the higher the average expenses become as production expands, the more likely it is that cutting production below the free market level pays. Hence the case of a monopoly price with an elastic demand, provided that average expenses become low enough when one reduces production below the free market level (“low enough” meaning that total expenses fall at a faster pace than total receipts in order for net proceeds to rise). In other words, the more they rise instead, or fall at a slow pace, the less likely it is that net proceeds will be higher at a lower level of production, the more chances there are that the free market level of production is the most remunerative. But this possibility arises only when the demand is elastic above the free market price. When doing less brings in more gross revenue, restriction in the monopolized industry always pays. Any other conclusion unduly narrows down the limits to monopoly pricing.
The Current Textbook Treatment as a Superior Alternative?It could be argued that the orthodox take on monopoly as found in Arnold (pp. 223–58) or any microeconomics textbook is superior to Mises and Rothbard’s in at least one respect: there is no risk of the sort of conflation we have pointed out here because there is no immediate run analysis to conflate with a long run perspective in its treatment of the issue. In that neoclassical approach, the sellers are producers too, even in the short run. There is no question of what to do with an available stock of a good. There is no reason then for inelasticity of demand to be a distinguishing criterion since monetary profit maximization — and therefore money costs — are relevant considerations in all cases.
Apart from the fact that getting rid of the immediate run is per se problematic since the useful and realistic concept of a crude monopoly price disappears from the picture, the most fundamental reason why inelasticity has no decisive role in that approach is that it is based on different categories with different criteria than the older monopoly price theory. As Caplan (1997) puts it, in modern neoclassical theory,
there is always some degree of monopolistic distortion unless firms face a horizontal demand curve. For unless firms face a horizontal demand curve, a profit-maximizing firm sets its price above its marginal cost. In the absence of perfect price discrimination, this means that there is a “deadweight loss” — or unrealized gains to trade.
In other words, the fundamental distinction here is between “pure and perfect competition” with perfectly elastic demand schedules and “imperfect” or “monopolistic competition” with downward sloping demand curves (“monopoly” being the extreme case in which only one seller would face the market demand schedule).
Turning toward this approach as an apparently more rigorous alternative brings in its whole theoretical apparatus with its weaknesses that Mises and Rothbard have identified. For although Caplan (1997) claims that he affords “all too little attention to the modern neoclassical theory,” Rothbard (1962, pp. 720–22) actually demonstrates that perfect elasticity is impossible since it is not compatible with the always holding law of marginal utility. As a consequence downward sloping demand curves for individual sellers and the corresponding “failure” to equate price and marginal cost are no signs of monopolistic distortion and the marginal cost pricing criterion cannot serve as a realistic criterion to conceive of a competitive price.
It should be kept in mind that the older monopoly price theory does not depend on the benchmark of “pure and perfect competition,” which explains why Mises and Rothbard found something of value in it whereas they entirely dismissed the newer view (Mises 1949, pp. 356–57; Rothbard 1962, pp. 720–38).
Conclusion: Theory and PolicyIs there more to say about the maximum limits to monopoly pricing than the fact that in the immediate run, elastic demand schedules deprive monopolistic privilege holders of opportunities to charge “crude” monopoly prices? Or that demand schedules which are too elastic in relation to average production expenses deprive monopolistic privilege holders of opportunities to charge monopoly prices for their products? According to Rothbard (1962, p. 681), in the aforementioned “A World of Monopoly Prices?” section of Man, Economy, and State, “monopoly prices could not be established in more than approximately half of the economy’s industries,” among other reasons because it is impossible for every industry to face an inelastic demand schedule since buyers cannot spend more in every industry.
Now, as explained above, the inelasticity of demand criterion is only required in the immediate run perspective of deciding what to do with an available stock of a good. As a consequence, if at most half of the economy’s industries could face inelastic demands above their free market prices, there could still be other monopolized industries able to charge monopoly prices provided that their total expenses fall at a rapid enough pace when they reduce production. More than half of an economy’s industries might then charge monopoly prices. The limits to monopoly pricing are then larger when one focuses on the production decision points. In light of our explanations, Rothbard’s neglect of this insight is attributable to his and Mises’s tendency to conflate the immediate and long run perspectives in their expositions.
The implications are straightforward. As far as pure theory is concerned, Rothbard underestimated the impact of granting monopoly privileges on price formation. If monopoly prices can arise without inelastic demand schedules, factor allocation is correspondingly altered to the detriment of the bulk of consumers, beyond the already recognized alteration occurring under the condition of inelastic demand schedules. As far as policy is concerned, it becomes all the more urgent to abolish monopoly privileges, or to refrain from enacting them in the first place, if one wants to minimize factor misallocation.
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InMarek Hudík is postdoctoral fellow at the Center for Theoretical Study at Charles University in Prague, Prague, Czech Republic. I was a summer research fellow at the Mises Institute in 2009. Throughout the fellowship, I greatly benefited from Professor Salerno’s kind help and constant encouragement. his introduction to the second edition of Rothbard’s Man, Economy, and State, Professor Salerno (2004) argues that Rothbard’s purpose in writing his treatise was not to develop a heterodox school of economics and break with the prevailing body of thought. On the contrary, Rothbard examined contemporary literature and attempted to integrate this literature with his own views. As Salerno shows, Rothbard believed that his treatise could draw other economists to the ideas that used to be part of the mainstream in the not-so-distant-past. We now know that Rothbard did not succeed in this and that as of today, there still is a communication gap between the Austrians and the rest of economic profession. This paper argues that the gap could be narrowed if the Austrian economics becomes more mathematized.By “mathematization of economics” I mean the “use of mathematical techniques … in economic arguments” (Backhouse 1998, p. 1848). An alternative definition of the term can be found in Beed and Kane (1991, p. 581), who understand it as the “increasing emphasis given to mathematical economics.” For a discussion of the concepts of mathematization, formalization, axiomatization, and abstraction, see e.g., Weintraub (1998) and Backhouse (1998).
At a first glance, mathematization of Austrian economics may seem to be contradiction in terms. Yet, at a closer inspection, the idea turns out to be not paradoxical at all: note for instance, that the “literary” character of Austrian economics is typically not included among its defining characteristics (Machlup 1982; Leeson and Boettke 2006; O’Driscoll, Jr., and Rizzo 2002); in a similar vein, Vaughn (1998, p. 2) sees the Austrian aversion to mathematics as a “superficial identifying characteristic,” and Backhouse (2000, p. 40) points out that, to the best of his knowledge, no Austrian has “ever explained why mathematics cannot be used alongside natural-language explanations”; on top of that, Moorhouse (1993, p. 71) reviewing Mises’s views on mathematical economics concludes that there is “no major methodological gulf between praxeology and neoclassical mathematical economics.”
Admittedly, Rothbard, as well as some other Austrians, raised objections against mathematization; but his demonstrated preferences speak otherwise: he sometimes expresses his ideas formally or semi-formally (e.g., Rothbard 2004, pp. 120–121, 152–153, 234). In addition, there is a long line of authors whom we may count as Austrian or Austrian-inspired who occasionally use mathematics in their economic writings. These include Wicksteed (1910), Fetter (1915), Hayek (1941), Haberler (1950), Machlup (1939), Morgenstern (von Neumann and Morgenstern 1953), McCulloch (1977), Garrison (1978), Murphy (2005), Leeson (2010), etc.
Some of these authors even explicitly claim that mathematization of economics is, at least to a certain extent, methodologically acceptable or even desirable. For example, Hayek (1952, p. 214) sees mathematization as “absolutely indispensable to describe certain types of structural relationships”; Machlup (1991) roots for “polylinguistic scholarship” characterized by coexistence of mathematical and non-mathematical language; in Boettke’s (1996) view, formal models are “fine” when constrained by an understandability criterion; and according to Morgenstern (1963, p. 19), an outright supporter of mathematization of economics, the laws of society will be written in the language of mathematics, just like the laws of nature.
This paper acknowledges that mathematization has costs and benefits. At the same time, it admits that it is probably impossible to determine the range of levels of mathematization for which benefits outweigh costs. Given this limitation, the aim of this paper is thus rather modest: it merely attempts to show that the optimal level of mathematization is not zero. More specifically, this paper points out the benefits of mathematization that seem to have been overlooked by some Austrian authors and it shows that most of Austrian criticisms which supposedly challenge mathematization, in fact point to different issues.
Benefits of MathematizationMises (1996; 2003; 1977) and Rothbard (2004; 1997a; 1997b) claim that formalization adds nothing to our knowledge as it only involves translation of verbal statements into symbols.This claim seems uncontroversial: it is put forward by both critics of mathematization (e.g., Novick 1954) and its advocates (e.g., Samuelson 1952). However, see Dennis (1982a; 1982b) for criticism of this view; see also Weintraub (1998, p. 1844) who posits the view of mathematics as an engine of discovery as an alternative to mathematics as a language. According to Rothbard (1997a, p. 61; 2004, p. 325), benefits of formalization are none, and therefore formalization should be cut through the principle of Occam’s razor.This Rothbard’s claim is problematic: if true, how would we explain that mathematics itself (or any other discipline) became formalized? Indeed, until the Renaissance, there was basically only “literary mathematics”: for instance the symbols “+” and “—” first appeared in the late fifteenth century and “=” was introduced only in the early sixteenth century (Cooke 2005, p. 432). Mises (1996, p. 333) suggests that if there is any benefit to formalization at all, it is pedagogical: diagrammatic exposition can be helpful to students of economics. Mises thus indirectly admits that mathematics (in a diagrammatic form) contributes to clarity of exposition. But why restrict this benefit only to students? Should not economists always communicate with their colleagues in the clearest possible way, especially when presenting new ideas?
Clarity of exposition achieved through diagrammatic representation is but one (and perhaps even not the most important) benefit of the use of mathematics in economics. I propose that mathematics offers also the following three benefits: First, mathematics is nowadays a common language of most economists and other researchers across disciplines — it is thus necessary to communicate ideas; Second, mathematics is less ambiguous than verbal language as it forces one to define precisely the meanings of concepts; and Third, mathematics is generally more efficient than verbal language, both for “producers” and “consumers” of economic ideas. These three benefits of mathematization are now discussed in turn.
Mathematics as a Common LanguageIf the great majority of economists use mathematics, it pays for each individual economist to use mathematics too; this is simply a coordination problem. The use of verbal language may lead to misunderstanding by the rest of the profession. When an Austrian and another economist speak of marginal utility or time preference, for example, do they in fact mean the same things?For a discussion of different definitions of marginal utility, see Hudík (2014a). On the ambiguity of time preference definition, see Potužák (2014).
There are numerous examples in the history of economic thought when translation into the language of mathematics helped to clarify the differences between competing approaches.Admittedly, there are also instances when mathematization contributed to ambiguity of economic concepts (Stigler 1950). In this context, it should also be noted that there usually is more than one way of formalizing a theory and this further complicates the issue (Beed and Kane 1991). For instance, Marshall’s (1982) translation of Ricardo’s theory of price formation into mathematics allowed for distinguishing between the classical and marginalist theories and facilitated the latter’s acceptance. Similarly, mathematics in the hands of Hicks (1937) and some others helped to detect the differences between “Keynes and the classics” on macroeconomic issues and contributed to the creation of the “neoclassical synthesis.” According to one observer:
Keynes was impressed by the help given by mathematics when numerous economists (Harrod, Hicks, Samuelson, Bryce) cleared up confusions in his General Theory and also presented his system neatly with the help of mathematics. (Harris 1954, p. 384)
Several decades later, formalized language of mathematics revealed that the dispute between “monetarists” and “Keynesians” was not about a general theoretical framework but about different empirical assessment of the value of parameters of the same model (e.g., Modigliani 1977; Mayer 1995). To plunge into more heterodox waters, Roemer (1982; 1988) is one of several economists who formalized Marxian economics and thus helped readers to compare the similarities and differences between Marxism and other mathematized approaches.
With respect to Austrian economics it is interesting to note that according to Chipman (1954, p. 364), “it is hard to find in mathematical economics any discussions more abstruse and difficult to follow than the great verbal debates between the Austrian and American schools on capital theory.” Fortunately for Chipman and others, several attempts to formalize Böhm-Bawerk’s theory have emerged (e.g., Dorfman 1959; 1995; 2001; Potužák 2014) and helped to clarify the debate. Very helpful in this respect is also Garrison’s (1978; 2000) partly formalized treatment of Austrian macroeconomics.
Mathematization is of course not the only way of dealing with the “language-coordination problem.” For instance, one may ignore the majority of economists and choose to “play the game” only with those who use his (i.e., verbal) language. However, this would in effect amount to creating a closed school of thought whose members are able to communicate only with each other but would not be able to interact with the rest of the discipline.Interestingly, until the first half of the twentieth century, i.e., before mathematical methods spread through the discipline, mathematical economics was considered to constitute such closed group. See e.g., Clark (1947). Closed schools of thought are analogous to closed economies: they protect their cherished ideas from competition. As in the case of trade, such a state of affairs benefits “producers” of ideas but hurts the “consumers” who receive products of inferior quality. Rothbard (1987) seems to have been aware of these adverse effects of isolated groups and perhaps that is also why he chose to communicate with the mainstream.Similar attitude was adopted by many Austrians before and after Rothbard, including Böhm-Bawerk, Mises, and Hayek.
Another possibility of approaching the “language-coordination problem” is to stick to verbal language with the proselytizing aim of persuading the rest of the profession to use it, too. In other words, one may be trying to change the language convention, and achieve a switch from a “mathematized equilibrium” to a “verbal equilibrium” of the “language coordination game.” Nevertheless, success of such an attempt seems unlikely, all the more for the fact that the “mathematized equilibrium” is — as I argue below — superior.
Mathematics as a More Precise LanguageOne of the benefits of mathematization is that it forces us to formulate our ideas precisely (e.g., Klein 1954; Tinbergen 1954; Chiang 1984; Clower 1995). It is sometimes correctly argued that verbal language can be made as precise as the language of mathematics (e.g., Menger 1973; Beed and Kane 1991). In reality, however, this opportunity very often goes unexploited: unless one is forced to express ideas formally, one is perhaps not even aware that the language is ambiguous. Perhaps the best example of increased clarity due to formalization is the creation of the supply and demand model. As Schumpeter (1994, p. 602) points out:
the sponsors of supply and demand [of the 19th century], again with the unnoticed exception of Cournot (and very few others, such as C. Ellet and D. Lardner), even experienced difficulty in setting on its feet the very supply-and-demand apparatus, the claims of which to a place in economic theory they tried to assert. They talked of desires or desires backed by purchasing power, of “extent” of demand and “intensity” of demand, of quantities and prices, and did not quite know how to relate these things to one another. The concepts, so familiar to every beginner of our own days, of demand schedules or curves of willingness to buy (under certain general conditions) specified quantities of a commodity at specified prices, and of supply schedules or curves of willingness to sell (under certain general conditions) specified quantities of a commodity at specified prices, proved unbelievably hard to discover and to distinguish from the concepts—quantity demanded and quantity supplied.
Precision of mathematics also helps to derive implications of one’s assumptions and to demonstrate possible inconsistencies (e.g., Dorfman 1954; Clower 1995). For instance, Samuelson (1957), by formulating Marxian model of wages and interest discovered an error in Marx’s theory that went unnoticed for 90 years (Brems 1975). Mathematics may also help to discover inconsistencies in the Austrian economics: Austrian economists work with preference scales; at the same time, they sometimes criticize the transitivity assumption used by other economists (Block and Barnett 2012). Yet, it is straightforward to show formally that an ability to rank alternatives on a single scale corresponds to the assumptions of completeness and transitivity of the preference relation. In other words, whenever a preference scale is introduced, completeness and transitivity of preferences are implicitly assumed (Hudík 2012). To use a different example, with the help of some simple mathematics it can be demonstrated that, contrary to Rothbard’s (2004, p. 240) claim, the principle of diminishing marginal utility does not necessarily imply a downward-sloping demand curve (Hudík 2011a).
Interestingly, Rothbard sees the ambiguity of the verbal language as an advantage. He quotes Bruno Leoni and Eugenio Frola:
the lack of mathematical precision in ordinary language reflects precisely the behavior of individual human beings in the real world. ... We might suspect that translation into mathematical language by itself implies a suggested transformation of human economic operators into virtual robots. (Rothbard 1997a, p. 62)
This argument is unpersuasive on several grounds: First, it is not at all clear why researchers should use imprecise language just because their researched subjects are imprecise; one can (and, indeed, should) talk precisely even about imprecision. Second, Leoni and Frola’s argument seems to imply that economists should not describe human behavior by concepts which are not used by the acting individuals themselves. However, this requirement imposes unnecessary constraint on economic theories. For instance, economists would be barred from referring to the law of marginal utility merely because people are generally unaware of this law. Finally, Leoni and Frola neglect the fact that economics mostly deals with an order which emerges as an unintended consequence of human actions (Hudík 2011b) where their argument is inapplicable. Consider, for example, activities of speculators which inadvertently contribute to efficient allocation of resources. I assume that we want to be able to describe these consequences even though speculators themselves are unaware of them.
Mathematics as a More Efficient LanguageMathematics is often more efficient than verbal language for both “producers” and “consumers” of economic ideas. From the perspective of the “producers”, mathematics economizes on effort: laborious thought processes are “embodied” in simple rules for manipulation of mathematical symbols (Whitehead 1911, p. 41). In this context Duesenberry (1954) understands mathematics as a “capital good” increasing productivity of economist’s “labor.” On the one hand, Duesenberry admits that it may be true that one cannot do anything with mathematics which cannot be done with verbal language; on the other hand, however, he claims that verbal language is much less efficient; according to his analogy, “[o]ne probably cannot do anything with power shovels that cannot be done with picks and hand shovels” (Duesenberry 1954, p. 361). Analogously, Chiang (1984, p. 5) thinks of mathematics as a “mode of transportation.”This metaphor seems to have been used for the first time by Fisher (2007); for similar metaphors, see e.g., Pareto (1897), Champernowne (1954), Tinbergen (1954), Menger (1973) and McCloskey (1994).
Chiang (1984, p. 4) mentions another aspect of the efficiency of mathematization of economics: there exists a large number of mathematical theorems at economists’ disposal. Consequently, we do not have to rediscover these theorems whenever they arise in a new context (Dorfman 1954, p. 376). Thus, for instance, in order to prove his theorem of the existence of (“Nash”) equilibrium in strategic games, Nash applied first Brouwer’s and later Kakutani’s fixed point theorems (Kuhn and Nasar 2002). Half a century before Nash, Euler’s theorem was applied to address the “adding-up problem” in the theory of distribution (Stigler 1994).For more examples of mathematical theorems that were directly applied in economics, see Debreu (1984).
As for “consumers” of economic ideas, mathematics often allows them to economize on their time and attention: as Klein (1954, p. 360) puts it, “[t]here is a real merit in condensing wordy volumes or manuscripts into a few understandable pages.” Nash may again be used as an example here: his famous dissertation thesis that earned him the Nobel Prize has only twenty seven pages; his paper on the existence of Nash equilibrium takes up only one page (Nash 1950a), while his ground-breaking paper on the bargaining problem is eight pages long (Nash 1950b). It is safe to assume that without formalization Nash’s papers would have to be considerably longer.As usual, there is a dissenting view, this time it is Marshall’s: The chief use of pure mathematics in economic questions seems to be in helping a person to write down quickly, shortly and exactly, some of his thoughts for his own use … It seems doubtful whether anyone spends his time well in reading lengthy translations of economic doctrines into mathematics, that have not been made by himself. (Marshall 1982, p. ix)
Costs of MathematizationMathematization does, naturally, have its costs. As pointed out by Morgenstern (1963, p. 2), when evaluating costs of mathematization, one has to distinguish among (i) criticism of inappropriate use of mathematics, (ii) criticism of the underlying economic model which happens to be analyzed mathematically, and (iii) criticism of mathematization.
In the first category we find criticisms of Bourbakism in economics (McCloskey 1994), of the use of calculus (Boulding 1948; Rothbard 1977), or of applying the mathematics of nineteenth-century mechanics to economics in general (Mirowski 1989). Likewise, criticisms of failed attempts to mathematize phenomena which seem to be impossible to address with known mathematics belong to this category (Beed and Kane 1991; Wutscher et al. 2010), as do also criticisms of misinterpreting quantitative economics (Mises 1996, pp. 55–56)It should be added that Mises criticized the use of quantitative methods to test theories; there is no argument in Mises’s writings against using quantitative methods in applied research. See also Leeson and Boettke (2006). and measurement (Rothbard 1977). None of these or similar criticisms, justifiable or not, represent arguments against the use of mathematics in economics as such.
Type (ii) criticisms are also not arguments against mathematization. They include criticism of unrealistic assumptions (e.g., Keynes 1964; Leontief 1971; Beed and Kane 1991; Wutscher et al. 2010) or criticism of particular concepts that happen to be used by mathematical economics, such as equilibrium (Wutscher et al. 2010). It is important to repeat that most mathematization is simply a translation of verbal statements into symbols; hence, the problem must be with theories themselves, not mathematics (Backhouse 1998; 2000). One may interject that the use of certain branches of mathematics (e.g., calculus) requires some additional assumptions such as continuity and differentiability (Menger 1973); but again, this criticism concerns only the application of a particular branch of mathematics to particular economic problem and is consequently not a general argument against mathematization. Furthermore, technical assumptions used by mathematical economics are often harmless: for instance, it is well-known that all important conclusions of standard demand theory can be obtained without the assumption of continuous and differentiable utility functions. Yet, continuous and differentiable functions are often used for the sake of convenience.
Actual costs of mathematization are identified by type (iii) criticisms. What are these costs? I identify three: first, tendency to downplay factors which are difficult to formalize; second, tendency to lose touch with reality; third, decrease of intelligibility for lay people. Note, that the first two costs are not inherent to mathematization per se; they are rather incidental to it and can perhaps be avoided. More importantly, though, none of these costs constitutes by its nature an argument for avoiding the use of mathematics altogether.
Downplaying Factors Not Amenable To FormalizationA tendency to neglect everything that cannot be easily formalized is a drawback of mathematization acknowledged by mathematical economists themselves (e.g., Debreu 1986). For instance, Krugman (1996; quoted in Backhouse 1998) argues that economists ignored important models for spatial economics just because these models could not be formalized.
Sometimes economists go so far as to demand that theories must refer only to quantifiable magnitudes. In his Nobel lecture Hayek (1975, p. 434) points out that
while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated important which happens to be accessible to measurement.
He gives an example of quantifiable relationship between aggregate demand and total unemployment on one hand, and relationship between unemployment and the structure of relative prices and wages on the other. The former is accepted as “scientific,” while the latter is neglected as not testable because we never know what the equilibrium prices and wages are.
Other phenomena that are difficult to treat mathematically and are often mentioned by the Austrians are subjectivism and Knightian uncertainty. Again, these can be argued to receive insufficient attention by economists.For the debate on formalization of Knightian uncertainty, see Caplan (1999) and Wutscher et al. (2010); for an attempt to formalize subjectivism in games, see Hudík (2014b). Still, one may wonder if perhaps the limits of mathematization, whether in this particular case or in general, do not often coincide with the limits of scientific investigation: are currently non-mathematizable phenomena amenable to science at all?
I suggest that the way to deal with the phenomena which are currently difficult to mathematize is not only a careful use of known mathematic tools but also development of new tools. For example, before von Neumann and Morgenstern (1953) mathematical economics (and, as a matter of fact, any branch of economics) was unable to deal with strategic decision problems. Hence, von Neumann and Morgenstern constructed a completely new branch of mathematics to deal with strategic issues. As this example illustrates, the limits of mathematization are not given but constantly evolve.
Losing Touch with RealityIt is often argued that mathematization leads to a loss of contact with reality (e.g., Boulding 1948; Champernowne 1954; Novick 1954; Šímová and Šíma 2012).On the other hand, Brems (1975) provides the following counter-example of verbal treatment leading to focus on imaginary problems: investment in the Keynesian theory was considered a function of the rate of interest instead of the change of the rate of interest, only because verbal economics was unable to handle difference or differential equations. This can have several reasons: In Debreu’s (1986, p. 1268) view, the power of mathematics is such that the “seductiveness of [mathematical] form becomes almost irresistible” and researchers thus tend to forget economic content. Still, Debreu argues that separation of models and reality can sometimes be an advantage. For instance, it is said to bring economics closer to the ideology-free ideal (see Düppe 2010).Morgenstern praised mathematical economics for exactly the same reason. See Leonard (2010).
According to Duesenberry (1954, p. 362), loss of touch with the real world is simply given by the job description of an economic theorist: the aim of the theorist is not to explain a particular set of observations but to show general consequences of a set of premises. To this argument we may add that a theorist also aims at universalization: she also attempts to show that two or several seemingly separate theories are merely different manifestations of the same principle. Hence, theoretical research is necessarily often disconnected from reality as it focuses on logical consistency of theories. From this perspective, criticism of the separation of mathematical models from reality could be interpreted as a criticism of theoretical research as such and as a plea for focusing on applied research. I hasten to add that the debate on optimal allocation of resources between theoretical and applied research is extremely important (see e.g., Šťastný 2010); yet, it is a different debate than the one on costs and benefits of mathematization.
IntelligibilityIt is probably true that the more formalized a model is, the less intelligible it is to lay people. Should economists worry about this trade-off? On the affirmative side stands the consideration that economic literacy is low which in turn has substantial negative externalities as citizens and voters are called upon to form opinions on many economic issues (e.g., Becker 2000; Šťastný 2010). On the other side stands the argument that, as in any other science, researchers should write primarily for other researchers and educating lay people should be left to popularizers: as individual economists differ in their skills and talents, there are benefits from specialization.Steven Levitt is an exception that may in fact prove the rule: his pop-economics books are co-authored with the journalist Stephen Dubner. Trading off benefits of formalization for intelligibility of academic writing to the general public thus seems inefficient. A different question is whether economists have sufficient incentives to be popularizers; but that is again for another debate.
ConclusionExamination of benefits and costs of mathematization suggests that the issue is not whether to use mathematics in economics or not; instead, the issue is what kind of mathematics is appropriate and how it should be used (cf. Backhouse 2000; Rosser 2003). It should be stressed that mathematization by no means is in conflict with the Austrian methodology, although some aspects of Austrian economics may be difficult to formalize at the present state of knowledge. This limitation, however, does not imply that we should give up on pushing the limits of mathematization further. Given that spreading ideas among the bulk of modern economists requires the use of mathematical language, one may only hope to see more and more mathematized Austrian economics in the future. For as they say: b(m) - c(m) > 0, for some m > 0.
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ScholarsAmadeus Gabriel is assistant professor in the Department of Finance and Economics at the La Rochelle Business School, France. I was a summer fellow at the Ludwig von Mises Institute as an undergraduate student in 2006, and later as a graduate student in 2011. of the Austrian tradition are particularly known for their important work in the field of monetary economics. They analyze the dynamics of fiat money and its impact on the real economy. However, empirical attempts to support the theoretical claims are relatively rare. In this chapter, I sketch an empirical strategy to test whether a change in the monetary regime has significantly impacted the accumulation of public debt and government deficits in the United States. Government deficits appear to be significantly lower under the gold standard regime and significantly higher under a regime of fiat money after controlling for other explaining factors such as, for instance military expenses or interest charges.
This chapter is structured as follows. Section 2 gives an overview about the nature of money to understand the dynamics of fiat money. Section 3 outlines why the introduction of a fiat money regime potentially increases the accumulation of public debt. Section 4 outlines the econometric model to account for the effects of different monetary regimes on public debt. Furthermore, potential lines of research are provided to improve the explanatory power and robustness of the model. Section 5 concludes.
Monetary Mechanisms and Monetary PolicyAs Mises repeatedly stresses, money is the fruit of indirect exchange (Mises 1980, p. 45). Thus, the emergence of money is spontaneous and becomes necessary as the division of labor increases and wants become more refined (Mises 1980, p. 5). Individuals only choose to have recourse to indirect exchange when the goods they can acquire are more marketable than those which they surrender.
As a result, the most marketable commodities will become common media of exchange and their position is strengthened as their relative marketability increases in comparison to other commodities (Mises 1980, p. 6). The main function of money according to Mises is its universal employment as a general medium of exchange (Mises 1980, p. 7).
Hülsmann (2008) introduces a further distinction between natural and forced monies. Natural money corresponds to money that arose through voluntary actions of individuals which circulates until it is displaced by an external pressure. Alterations to the former type of natural money are defined as forced money. In this case, money no longer complies with individual preferences, but is the result of a welfare reducing imposition. As a consequence, forced monies are per definitionem less socially beneficial than natural monies, as they only exist due to the violations of individual rights. Based on this distinction, it is possible to introduce a further division between credit money and paper money. As Hülsmann (2008) points out, the value of credit money (a claim to money in the future) is based on the trust that the respective sum of money is eventually refunded in the future.
Paper money or fiat money owes its existence to legal privileges. Hülsmann (2008) emphasizes that paper money has never spontaneously emerged as a result of the voluntary actions of individuals. Legal tender laws impose the use of a lower quality paper money at the expense of the natural money. The bad money, i.e., the overvalued paper money, drives the good money, i.e., the undervalued natural money out of the market as their legal equivalence is only due to imposed laws and do not reflect the economic reality. This process is known as Gresham’s law, named after Thomas Gresham (Hülsmann 2008, p. 127). Naturally, this leads to inflation of the overvalued money, “because this money is produced and held in greater quantities than would be the case in the absence of the price control” (Hülsmann 2008, p. 127). The natural limit in money production is distorted as the full consequences are not borne by the money producer. Legally established values are not altered and constraining competitive processes are suspended under legal tender laws. Moreover, Cantillon effects, named after the French economist Richard CantillonSee Richard Cantillon, La nature du commerce en général (Paris: Institute national d’études démographiques, 1997). enforce the enrichment of money producers under the regime of legal tender. As Hülsmann (2008, p. 44) points out, there can be no simultaneous increase of all prices as newly created money enters the market. The first users of the new money have the privilege to use it on goods priced according to the quantity of money that existed before the increase in the money supply. However, the newly acquired purchasing power does not remain unnoticed and spreads out through the economy. Prices eventually adjust upward due to the increased demand of the initial users. The last receivers have not benefited from the new money. To the contrary, they suffer a deteriorated quality of the money and higher price levels.
As Hülsmann (2008, p. 89) argues, debasement was traditionally the way to inflate the money supply. The nominal value of a coin was modified not reflecting the metal content any longer or the content of metal was reduced without an according change in the nominal value. However, debasement reached a whole new level with the emergence of fractional-reserve banking, i.e., the issuance of coins or bank notes which are not fully covered by the available reserves. This significantly reduced the cost of money production. According to Hülsmann (2008, p. 93), there are three main reasons that led to this phenomenon.
In the first place, the warehousing institutions, the original function of banks to the late 1700s, have been perverted. Second, credit banking has been perverted as banks use deposits for loans. Lastly, it was a natural response to the threat of government expropriation. As banks feared that their holdings would be eventually confiscated, they preferred to lend out the funds. However, as individuals eventually find out about the debased monies, it is necessary to guarantee a continual demand through legal tender laws. This privilege is the ultimate explanatory link for all other monetary advantages.
In addition to the outlined factors, the twentieth century witnessed the development of maturity mismatching in the banking sector (Bagus and Howden, 2009), i.e., borrow short and lend long. Nowadays, this is considered as one of the main functions of banks. For instance, Freixas and Rochet (2008) point out that “modern banks can be seen as transforming securities with short maturities, offered to depositors, into securities with long maturities, which borrowers desire.” Necessarily, this implies a certain “risk” for banks if the credits are not covered by corresponding savings of depositors. If depositors require their funds, banks can have recourse to derivatives (such as swaps or futures) or engage into interbank lending to limit this “liquidity risk.” However, this type of risk management is very costly. In a competitive environment where the success of a bank’s business is based on its ability to gain confidence of depositors, the constant mismatching of maturities must be relatively limited. Depositors are not likely to give their money to banks that accumulate negative working capital and struggle to refinance their debt.
To recapitulate, money evolved spontaneously in the market. Historically, gold and silver were chosen as the common medium of exchange for their practical purposes. For reasons of convenience, warehouses arose to store these metals and certificates were issued. As a consequence, certificates were traded in everyday business and rarely redeemed into gold. Unfortunately, this created a temptation to engage into fractional-reserve banking and to issue certificates in excess of the actual gold reserves. At some point, governments entered into the game and monopolized the minting of coins and established legal tenders laws. Under the classical gold standard from 1815–1914, a fractional gold standard was institutionalized and guaranteed by the respective states. As already outlined above, fractional-reserve banking diminishes the cost of money production and increases the profitability of banks. As a consequence, there is a tendency to threaten the financial stability of banks as the continual issuance of credits in excess of savings is eventually discovered by depositors and creditors. Bank runs and the liquidation of assets are naturally the cause as people lose confidence.
The drawbacks of this business model must be resolved by some external institution that guarantees the liquidity of banks. This is the role of central banks (Bagus 2012). Central banks are lenders of last resort for commercial banks. Banks can now refinance their debt through short-term credits and liquidity problems can be limited as the production of money is coordinated by the central bank. However, under the gold standard, even coordinated money expansion was limited by the fear of redemption in a crisis. By the 1970s the burden of the gold standard was removed and the doors were further opened for the lucrative business of money creation.
Monetary Policy Since the 1970s in the United StatesThe abolition of the gold standard on August 15, 1971, led to the establishment of a regime of paper monies for most of the national currencies. Before this date all national currencies were linked to the gold standard via the US dollar. As the US decided to go off gold altogether, the fractional-reserve gold certificates basically became paper money (Hülsmann 2008, p. 223). The new fiat money standard magnified moral hazard at a large scale. Fiat money allows producers of money to “create ex nihilo virtually any amount of money” (Hülsmann 2006, p. 10). The growth of the money supply increased significantly after the decision to go off the gold window. The M3 monetary aggregate grew by 12.42 percent in 1972 in the US, although the average growth rate was about 6.76 percent in the decade before.
Under the regime of William McChesney Martin from 1951 to 1970, monetary policy was relatively conservative. Growth rates of the CPI were below three percent during the early 1960s (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 23). As Martin points out in testimony to the Joint Economic Committee: “the Fed has a responsibility to use the powers it possesses over economic events to dampen excesses in economic activity by keeping the use of credit in line with resources available for production of goods and services.Martin’s testimony to the Joint Economic Committee, February 5, 1957. Cited by (Bremner 2004, p. 123). In 1964, Martin expressed his concerns about increasing inflation as federal spending increased a lot during the second half of the 1960s. Bremner (2004, p. 191) cites a quote by Martin which summarizes his worries: “I think we’re heading toward an inflationary mess that we won’t be able to pull ourselves out of.” Martin expressed in his last press conference that he had “feelings of failure for not having controlled inflation” (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 26). By 1970, Martin was replaced by Arthur F. Burns. He commenced a period of high inflation and very low real interest rates, a byproduct of loose money now simplified by the full fiat money standard. However, even before the suspension of payment by the Fed in 1971, the federal funds rate was already lowered from 8.02 percent during the first quarter in 1970 to 4.12 percent by the fourth quarter of the same year (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 26). What are the implications of low or even negative real interest rates? They reduce the incentives for people to save money and at the same time the cost of debt is significantly reduced. Even though federal funds rates were eventually raised during the following years, they never kept up with the running inflation rates and real interest would only be over 2 percent in the second quarter of 1976 (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 26). Thus, during his tenure until 1978, real interest rates were only above 2 percent for three quarters. The Per Jacobsson Lecture on “The Anguish of Central Banking” (Burns 1979) summarizes his views on monetary policy and central banking relatively well. Basically, the upward pressures on prices by interest groups are the real reason for the inflationary policy by the Fed. According to him, the Fed does not have enough power to effectively fight against inflation “as it is illusory to expect central banks to put an end to the inflation that now afflicts the industrial democracies” (Burns 1979, p. 21). After a short intermezzo by Miller whose tenure ended into an emergency sale of US gold and borrowings from the International Monetary Fund (IMF) (Dowd and Hutchinson 2010, p. 251), President Carter moved Miller to the Treasury department and appointed Paul Volcker as the chairman of the Fed.
As a consequence, the federal funds rates increased significantly from 2 percent to 12 percent (Dowd and Hutchinson 2010, p. 251) and real interest rates remained high during the 1980s. Just as Burns, he was also invited to give the Per Jacobsson Lecture, but concluded that inflation had been defeated under his regime. However, as the problem of inflation was apparently controlled, another chairman, Alan Greenspan was appointed. He supported the deregulation of the banking sector under Reagan (Dowd and Hutchinson 2010, p. 252). Greenspan emphasized that inflation must be kept low during his confirmation hearings (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 32), however it took only a few months until this plan was scrapped. Greenspan responded to the stock market crash of October 1987 by cutting interest rates and by declaring that the Fed is disposed to provide “liquidity” in such a case (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 32). Later, interest rates were kept low, even as inflation reached 6 percent during 1989–1990. The policy of low interest rates continued until 1994, where the Federal funds yield reached the lowest levels since the 1960s. As a reaction to this inflation scare, interest rates doubled, although Greenspan was reluctant to take this action initially.Board of Governors FOMC Transcripts, February 3–4, 1994, p. 55. However, this led to big losses for many entities that were betting on low interest rates. Most notoriously California’s Orange County defaulted on its debt by speculating with derivatives on low interest rates (Dowd and Hutchinson 2010, p. 53).
By February 1995, Greenspan announced that his policy of increasing rates is over.Testimony to the House Banking Committee, February 22, 1995). Effectively, the money supply growth was 2.6 percent higher than nominal GDP during this tenure. The failure of Long-Term Capital Management in 1998 (Lowenstein 2001) illustrated perfectly the approach which was taken by the Fed by now. Not only was a bailout organized, but under Greenspan interest rates were subsequently cut three times to calm down financial markets. This low-interest policy basically allowed the financial sector to maintain more activity of unsustainable trading activities. Ultimately, this policy fueled the dotcom bubble during which stocks were even more overevaluated than during 1929 (Garrison and Callahan 2003). As a consequence, interest rate raises followed in the year 1999 and 2000 which eventually triggered the bust of the stock market. However, already by 2001, the federal funds rate was lowered again to fight the ongoing recession. Together with the occurrence of the 9/11 terrorist attacks and fiscal policy under the newly elected President Bush, interest rates attained the lowest level since 1961 by the year 2002. From 2002 to his retirement in January 2006, Greenspan kept interest low below 3 percent. This period also witnessed the housing bubble and the closely tied structured finance crisis. The burst of this bubble finally led to the current financial crisis. The following “non-moderate” recession is accompanied by nominal interest rates which are currently approaching zero, while real interest rates are simply negative. The development of the federal funds rate can be depicted as follows in figure 1.
To summarize, ever since the fight on inflation of the early 1980s under Volcker, interest rates have been declining. The most substantial reductions happened in the post-era of the dotcom bubble and as a response to the terrorist attacks of 2001. Likewise, federal funds rate have been lowered to an all-time low to fight the current recession. Monetary policy of the last thirty years substantially reduced the cost of debt and consequently eased the issuance of debt securities in the financial market.
Fiat Money and Public DebtFiat money and legal privileges reduce the natural barriers to the creation of credits. Debts are an easy way to increase the expenses of governments. Furthermore, debts are by far more popular than the alternative, i.e., taxes. However, governments are special debtors as they can have recourse to means of financial repression: “Financial repression occurs when governments implement policies to channel to themselves funds that in a deregulated market environment would go elsewhere” Reinhart, Kirkegaard, and Sbrancia (2011).
There are several measures that increase artificially the demand of sovereign bonds, however the main measure of financial repression is to keep nominal interest rates low through loose monetary policy. It reduces the interest expenses for governments and high inflation reduces the cost of debt at the expense of the creditors. Similarly, traditional investors are more likely to put their money into government bonds as savings accounts are not profitable enough. In the case of negative real interest rates, as witnessed 1945–1980 and since 2007 (Reinhart, Kirkegaard, and Sbrancia 2011), it even becomes a supplementary tax in addition to the redistributive consequences of inflation. Figure 2 shows the evolution of government debt during the phase of positive real interest rates and a sharp increase since 2007 when real interest rates were negative again.
Empirical ImplicationsBuilding upon the theoretical arguments of this paper, it is manifest to test whether public debt and government deficits have, ceteris paribus, significantly increased under a full fiat money standard.
Yoon (2012) shows, using a new recursive method for unit root testing, that the U.S. public debt–GDP ratio was explosive in nature during the sample period. This is an interesting result as a standard unit root test such as an augmented Dickey-Fuller test shows that this series contains an unit root and is therefore stationary (Bohn 2008). As a result, there is no concluding evidence about the properties of public debt in the United States during this period.
Figure 4 suggest that wars played a major role for the accumulation of debt. As Figure 3, Yoon (2012) points out “The War of Independence, Spanish–American War, the Civil War, World War I, and World War II — explain the high debt–GDP ratio in 1791 and the sharp increases in 1812–16, 1861–66, 1916–19, and 1941–46.” By way of contrast, the debt–GDP ratio has generally declined during peacetime periods, with the exception of the Great Depression/New Deal era (1929–39), the 1980s, and the post-1921 period.” Furthermore, the author interprets the exceptional period from the 1980s onwards as a result of the Cold War and the “post-2001 war on terror.”
There might be a potential endogeneity bias for the decision to adopt (or leave) the gold standard or a fiat money standard, which could likely lead to spurious results for our analysis. Basically, this would mean that some underlying factor accounted for both the choice of the monetary regime and the differences in the level of public debt. For example, war times and a suspended gold standard have been highly correlated in history for obvious reasons. However, as Bernanke (2004, p. 16) outlines, those decisions are highly influenced by internal and external political factors so that it is very unlikely to be an issue for our analysis.
Empirical StrategyOne potential empirical strategy has been outlined in Gabriel (2014). As outlined above, there is conflicting evidence about the stationarity of public debt. To overcome this problem, I analyze GDP deficits as the dependent variable for the sample period from 1800 to 2012 (Bohn 2008). In this paper, I use a VAR(2) model which controls for several factors such as military spending to capture the war periods or interest charges to capture the cost of debt.Refer to Gabriel (2014) for the details of the model, where several tests, such as e.g., autocorrelation in error terms, to account for a potential downward bias are provided. The model allows us to make interesting forecasts of how the dependent variable should have evolved during the period of the full fiat money standard (1971 to the present) after controlling for the outlined variables. Figure 4 summarizes the findings of Gabriel (2014).
The red line describes actual data on GDP deficits for the specified period. As described before, the VAR(2) model is applied to the dataset from 1800–1970 to generate a forecast of the how the values should have evolved based on the specified framework. This is the blue line. Finally, the green area corresponds to the confidence interval for the forecast of the VAR(2) model. This graph shows that actual deficits are in general higher (except for the year 2000) than they should be. Thus, the interpretation of this period by Yoon (2012) as a result of the Cold war is not supported by this analysis. The noteworthy GDP deficit figures must be explained otherwise. The theoretical arguments in this chapter make a case that the dynamics of fiat money are a plausible explanation for this observation.
ConclusionAustrian scholars in monetary economics are not tired of pointing out the dynamics of fiat money and their impact on the economy. This chapter attempted to complement their theoretical arguments by providing a short historical overview of monetary policy in the United States. A preliminary empirical assessment provides evidence that the switch to the current monetary regime possibly explains higher GDP deficits after controlling for other factors such as military expenses or interest charges. A more detailed analysis on this issue is left for future research.
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ModernPer Bylund is John F. Baugh Center Research Professor in the Department of Entrepreneurship at Baylor University in Waco, Texas. I had the great pleasure and privilege of being a summer research fellow in 2009 and 2010, and a postdoctoral research fellow in 2012. This chapter is an extension of the theoretical perspective developed in my dissertation at the University of Missouri, which was originally developed while a summer fellow at the Mises Institute and with the help and encouragement of Professor Salerno. economic theory tends to treat production, the process of generating valued consumption in a market, as a function carried out within firms and so out of reach for the general market (Coase 1937). Firms are seen as “black box” generators of output from inputs in accordance with a calculable and formalized “production function,” and both inputs and outputs are exchanged at competitive money prices in market transactions. The market, consequently, is seen as simply a means for efficiently allocating resources through the price mechanism. The development and production of the specific goods and services that are directly valued by consumers is considered of much lesser import.
In contrast, Austrians emphasize the causal processes in the economy and therefore pay much attention to production — the way value is created through consumer wants satisfaction — and capital theory — how factors are utilized to support production. Austrians recognize that the specialized market process consists of and is dependent on an intricate structure of productive resources. This structure supports roundabout production processes that exploit productivity-enhancing uses of non-permanent intermediate (produced) goods. Such an advanced production apparatus is dependent on the specific uses of capital goods that facilitate taking factors of production through stages aimed at eventually satisfying consumer wants.
This distinctly Austrian perspective on the market as a process of production is the subject for this chapter, with specific emphasis on how changes to the economy’s production apparatus or capital structure are brought about. The aim is to elaborate on the implications of the market’s capital and production structure and thereby illustrate a specific theoretical problem that is conspicuously missing in the Austrian analysis. I draft a solution to this problem by addressing potential remedies made available by market actors exercising productive entrepreneurship. In this sense, the essay elucidates a realm for entrepreneurship within production and capital theory.
Production and Capital StructureCapital goods can be defined as “the produced goods that must be combined still further with other factors in order to provide the consumers’ good” (Rothbard 2004 [1962], p. 299). These intermediate or “produced” goods that can only indirectly satisfy consumer wants are “a necessary way station to increased consumption” (Rothbard 2004 [1962], p. 966; emphasis in original). Seen as a whole, they compose “an intricate, delicate, interweaving structure of capital goods” (Rothbard 2004 [1962], p. 967; Lachmann 1978 [1956]), a production structure that in its current length and form is configured to satisfy wants already anticipated by entrepreneurs.
A production structure is composed of specific capital goods, themselves a combination of other capital goods and original factors. It is assembled and configured in a specific way for a specific purpose (Lachmann 1978 [1956]) and operated by specialized labor. Production is temporally dependent since it must be carried out in time. Carrying out a production process with already existing, supporting capital goods takes time, as does the production of the capital goods used in the process. The existent production structure was brought together and configured in the past, and is used and operated in the present to produce consumers’ goods available in the future.
Time, therefore, is both a limitation and a factor of production: due to its irreversibility, it “puts the future services of certain resources beyond our reach in the present and so makes it impossible to anticipate their use” (Hayek 1941, p. 52). In other words, we cannot conceive of specialized production without capital. Even acknowledging that there is a capital structure supporting production in multiple stages ultimately appears insufficient for us to fully understand the production process. For this reason, a theory of production is of limited use without a capital theory that also includes action and so explains the structure’s dynamic: how and why the production structure has taken a certain shape and how and why the structure changes over time. As we will see, the Austrian conception of production subject to the heterogeneous structure of productive capital indicates a problem related to the structure of tasks in an economy’s production apparatus. This problem does not exist for Robinson Crusoe but is potentially crippling in a specialized market, and it requires entrepreneurship and integration to be solved.
Roundabout Production Without Existing CapitalImagine that a person P, in a world without existent capital, decides to manufacture a product A with the intention of making it available for consumers in the open market. To the extent the production process requires (or is more productive with) capital, these capital goods must first be produced. Regardless of the complexity of the specific production process, the only possible way of realizing production of A is to first produce the necessary intermediate goods such as tools and machinery, and then, at a later time and using the intermediate goods, produce A. To make this happen, P therefore accumulates the resources necessary, gets busy creating the means to carry out the production process, and then produces the end product.
Due to P’s productive endeavor to establish the necessary structure for their envisioned production process, the world now has capital. This capital gives P a competitive advantage in the market by creating a unique production capability (Barney 1995; 1991), which increases in the overall valuable output in the economy. The direct effect of the “advancing capital structure increases the marginal productivity of labor” without requiring an increase in “the labor energy expended” (Rothbard 2004 [1962], p. 578). The capital created is essentially an extension of and therefore facilitates more productive uses of labor. In this sense, the investment creating “non-permanent resources enables us [the market] to maintain production permanently at a higher level than would be possible without them” (Hayek 1941, p. 54, emphasis in original). Overall, P’s endeavor has brought about a situation where the original factors — land and labor — are used more efficiently toward satisfying consumer wants than was the case before. Production has become more roundabout.
The value of this better use of original factors is measured by the subjective valuations of consumers who benefit from this production. As Austrians have known since Menger (2007 [1871]), the market value of the capital produced is derived from consumer benefits. This means the value cannot be established until consumer valuation of the end product has been revealed through market action (purchases of the product). The market value of the produced capital — the indirect means to satisfy consumer wants — is equal to their contribution to the value consumers ultimately place in the consumption good produced (Mises 1951 [1936]; Rothbard 1987).
The temporal sequence of actions within the production process is then exactly the opposite of how its value is derived. Production begins with the extraction of the highest-order goods from their natural state and the production of intermediate or capital goods, and continues through the stages to eventually produce the lowest-order good offered to consumers. Upon consumers’ decision to purchase the lowest-order good at a certain price, the market value of capital goods is established by imputation “upstream” through the higher orders to the highest order and original factors (Menger 2007 [1871]). There can be no capital that is not preceded by production, and there can be no specialized, roundabout production without the existence of capital.
Roundabout Production In the Specialized MarketLet us now turn to analyzing a specialized market economy with existing advanced production structures, as does e.g. Rothbard (2004 [1962]) and Coase (1937). We assume a market with highly specialized production with a capital structure that is well configured to satisfy consumer wants. As capital is heterogeneous, by which is meant that it “is not an amorphous mass but possesses a definite structure [and] is organised in a definite way” (Hayek 1941, p. 6), the capital structure entails both productivity gains and high costs of adjustment. As the market data change, the existing capital structure will be misaligned to real consumer wants. In this sense, the specialized market place is very fragile to (unanticipated) changes.
This problem is partly recognized in the Austrian business cycle theory, but it is scarcely elaborated. Rather, it is acknowledged that the realignment process of the market’s capital structure, from the anticipated and prepared-for market situation to the new and revealed situation, takes time. This is undoubtedly true, and this process is carried out by entrepreneurs (broadly defined), who are “eager to earn profits, appear as bidders at an auction, as it were, in which the owners of the factors of production put up for sale land, capital goods, and labor” (Mises 1998 [1949], p. 335). Time-consuming and costly realignment follows (cf. Williamson 1985, pp. 21–22).
Yet this problem does not arise only when the market process is affected by abrupt and/or unanticipated exogenous change such as the expansion of credit by banks and the subsequent distortion of market prices. In fact, any reconfiguration, elaboration, or expansion of the capital structure, whether as a reaction to changing consumer preferences or as a means toward increased productivity and economic growth, is subject to what we can describe as a “specialization deadlock”: production structure based inertia to which both market actions and actors are subject.
A specialized market consists of production processes that encompass many stages and where the stages are carried out separately by specialized labor operating specialized capital structures configured to facilitate this particular (and perhaps similar) stage. While there may be several uses for specialized capital, each of the uses tends to be highly specific and the capital goods are therefore very limitedly substitutable in the market. To the degree capital traded in the market has undergone a particular transformation by being irreversibly combined into a non-decomposable unique (or uniquely aligned) capital good, there is no existent market for the produced means of production. New capital goods exist in a non-salable state to the degree their uses have no or very limited substitutability and lack obvious substitute uses. Whether or not a market for specialized capital goods emerges depends on the competitive discovery process (Hayek 1978) as entrepreneurs imitate and attempt to surpass the original entrepreneur’s successful production achievement (Bylund forthcoming; 2011).
While the uniqueness of particular capital goods in specialized production may severely limit their markets (both in terms of demand and supply), this may not constitute more than a temporary problem. The problem emerges as specialized capital is utilized in roundabout production processes under intensive division of labor. Assuming a market with entrepreneurs alert to and ready to adjust errors and misalignment through arbitrage (Kirzner 1973), and therefore an equilibrating market process, the market should soon approach stasis.
Entrepreneurs, eager for profit, will bid for capital and labor factors that they perceive to be undervalued or in otherwise suboptimal use. Provided entrepreneurs do not commit more errors than successful adjustments, and provided consumer preferences do not frequently, radically, and unexpectedly change, a market without innovation has limited opportunity for growth and productivity increase. In fact, even allowing for innovation of capital goods, which can be usefully thought of as finding new productive combinations of land factors and existing capital (Schumpeter 1934 [1911]), will not facilitate economic growth through productivity increases unless there is also a corresponding intensification in the division of labor. As Mises (1998[1949], p. 164) notes,
The division of labor splits the various processes of production into minute tasks, many of which can be performed by mechanical devices. It is this fact that made the use of machinery possible and brought about the amazing improvements in technical methods of production. Mechanization is the fruit of the division of labor, its most beneficial achievement, not its motive and fountain spring.
The truthfulness of the temporally dependent order in Mises’s claim can easily be shown, as we shall see in the next section.
The Specialization DeadlockConsider the specialized market in the previous section. Assuming the market is minimally regulated and therefore without artificial barriers of entry, we can assume with Rothbard (2004 [1962], p. 369, fig. 41) that the rate of interest income for capitalist investments in each production stage will be approximately the same. Entrepreneurial arbitrage will see to it that this holds true within one production process as well as across parallel, competing processes. Alert entrepreneurs will discover and correct through arbitrage any “errors” revealed by above-normal returns in any process or stage. Profitable (successful) undertakings tend to be imitated and loss-generating (unsuccessful) are abandoned by entrepreneurs eager to earn profits, which suggests an equilibrating process consisting of continuous adjustment through correction (Shane 2003). This, in turn, suggests that markets are effectively created for specific capital goods utilized in production processes as entrepreneurs set out to imitate and emulate processes that earn profits (Stigler 1951; Bylund 2015). The economy in this sense functions as a continuous “discovery process” where competition for profit is the driving force toward better alignment between the totality of the production structure and consumer wants (Hayek 1978).
Along the lines of this reasoning one can develop a theory of strategic management based on the resources used within the firm, as has been done by Barney (1986; 1991) and others. The incentive of any firm (or rather, its owners and management) is here to strive for including and utilizing as rare and unsubstitutable resources as possible that are still valuable in production. The rarer and less substitutable (and imitable) the resources, the longer a firm can stay ahead of its competition and earn above-normal profits — competitors are simply unable to emulate the capital recipe of success. But it should be noted that while this competitive advantage may last for some time due to the unavailability of necessary resources for competitors, it will eventually be undermined by the discovery of better processes or alternative implementations of the same process.
The reason for this is that capital goods are produced and non-permanent. Even in situations where a certain capital good cannot be imitated or emulated (however unlikely this scenario is), it must be reproduced when it is used up or expired. The serviceability of capital can be extended through investments in maintenance, upkeep, and repairs. Still, capital is ultimately consumed during the production process, which means the owner of a unique capital good used in profitable production must at some point invest to extend its productive life. In a specialized market economy, any such reproduction must to some degree depend on the availability of market for materials, parts, etc., — the higher-order goods used in production of the capital good. It is therefore an impossibility that a certain resource combination — a particular capital good — is non-reproducible over time.
But even so, as Mises shows in the quote above, capital is ultimately dependent on division of labor preceding its development and use. Only through the splitting of tasks can capital goods be (1) innovated and (2) utilized in new processes. The former holds true simply because new specializations (that is, a more intensive division of labor) are necessary in order to produce a new type of capital good, at the very least in the tasks of combining factors or configuring an existing capital good. The latter is illustrated by Mises’s example of mechanization of the minute tasks that are made into separate tasks only through the splitting of existing, more broadly defined, tasks.
Consider a production process in our previously assumed specialized market that is dedicated to the production of bread. It consists of the following division of labor: a farmer produces wheat, a miller produces flour, and a baker produces and sells the bread. Each stage uses capital: the farmer uses a plow in the spring and sickle in the late summer, the miller uses milling stones, and the baker uses an oven. One can imagine making this process more roundabout through the innovation of new capital goods to support either of the stages, e.g. a tractor for the farmer or a blender for the baker (Böhm-Bawerk 1959 [1889]). But no such capital can be made available for the farmer or baker without an innovative entrepreneur figuring out the full production process for that specific capital good. This amounts to a much greater undertaking than the error-correction type of arbitrage provided by Kirznerian entrepreneurs (Kirzner 1973; 2009).
An alternative is to make the bread-producing process itself more roundabout through the insertion of more narrowly specialized labor: splitting a task into several (Smith 1976 [1776]; Bylund forthcoming). The splitting of a task is different from simply “adding” labor power. The farmer can “hire” labor workers to carry out the same tasks as he is already carrying out, which increases output through increasing the volume of labor being used in the process. As these workers need to be paid — and likely monitored (Alchian and Demsetz 1972; Williamson 1993) — it is not obvious that this is a profitable investment for the farmer. Where an increase in the number of workers leads to diminishing returns, the farmer is likely to make a loss on invested funds.
The alternative is to engage in intensifying the division of labor, which, as suggested in the Mises quote above, entails taking an existing task and dividing it into a number of more narrowly defined tasks. In the case of the bread production process, this amounts to replacing one of the existing stages with several new and separate tasks in the same way a hypothetical original production process was split from self-sufficiency toward specializations in farming, milling, and baking.
Where a market stage already consists of easily separable tasks, such as the plowing, sowing, watering, and harvesting of farming, specialization may not be more than a minor change. For instance, a farmer having hired labor workers may assign specific tasks to different workers and thereby simplify specialization. This must be preceded by increased density of labor factors (Durkheim 1933 [1892]) and can be facilitated by coordination through centralized ownership (Stigler 1951). As this type of “marginal” or incremental specialization can be rather easily brought about, it may not constitute an economic problem of production. In fact, such productivity-increasing measures should be easily discernible for the actors themselves: we know that “work performed under the division of labor is more productive than isolated work and that man’s reason is capable of recognizing this truth” (Mises 1998 [1949], p. 144; emphasis added). This is not a division of labor as much as it is a rational (re)allocation of labor input across already existing chores. But this means it also cannot constitute a problem for competing farmers, who as (or even more) easily can institute this type of division of labor by imitation or emulation. So we may, for the sake of simplicity, assume that such comparatively simple opportunities have already been exploited. Indeed, we can think of the inefficient use of laborers on the farm as an “error” to be corrected by the alert farmer.
This leaves the type of disruptive specializing that suggests a new production sub-process to replace a commonplace and standardized task carried out by market actors. We can now begin to discern the problem, since all the “low-hanging fruits” in terms of productivity-increasing allocative measures are easily exploitable and so should tend to already be exploited. What remains is the unintuitive or highly coordinative task-splitting that requires foresight, investment, and perhaps development of new types of capital goods to be realized. Add to this situation how within-stage (horizontal) competition should tend to standardize the procedures used and therefore effectively produce market standards around best practices. This is the process through which markets are created, which was explained by Stigler (1951). While the market may not reach a general equilibrium, it can easily be seen how its competitive process brings about standardizing at the production possibilities frontier. At this point, further specializing should seem unattainable if at all advantageous — much like splitting the task of “driving a taxi” into the more specialized tasks of driving straight, driving around corners, and going in reverse.
Further advances in productivity requires the adoption of a more intensive division of labor — the further splitting of existent tasks — and the use of (new) capital to replace labor with automatic execution of newly identified and separated “minute tasks.” The market, in other words, finds a state of rest in the sense of a highly restricting inertia — if not impossibility — of adopting further productivity-increasing measures. Specialization cannot go further through incremental adoption of better utilizations of labor. Whether or not market actors have exhausted all opportunities for further incremental improvements to production processes, the market is in a specialization deadlock.
Breaking Free From the Specialization DeadlockSo far we have considered production in the market: while not all actions necessarily take place independently and under the price mechanism, we noted how markets are generated as new production structures are imitated by competitors (Stigler 1951; Bylund 2011; forthcoming). For all tasks carried out in an economy’s production apparatus, therefore, there is semi-standardization within the limits of substitutability where the price mechanism is applicable. In other words, there is a tendency toward standardization of best practices through competition as improvements are all but universally implemented through profit-induced imitation in the open market.
So far we have not made any assumptions about who brings about or profits from the adjustments made in the market. The reason for this is that opportunities for incremental changes to the production structure are neither difficult to discover nor to implement or observe /imitate. This suggests the function of adjustment can be carried out by most or all market actors and without much foresight, coordination or investment. Indeed, the farmer who hires labor workers and assigns different responsibilities to them is engaging in (a weak form of) specialization and division of labor, but in such a mundane fashion that it is of little analytical importance. These tasks were already carried out — they may even have been identified as separate such — and the increased density due to increased volume of available labor facilitated an “obvious” opportunity for “specializing.” Rather than each labor worker switching between the same or similar tasks, each worker could save time and energy by streamlining their work and so focusing on a single or only a few tasks serially divided among them (Smith 1976 [1776]). This type of improvement in productivity is, indeed, within the limits of man’s capability of reason. In fact, we might expect the common worker, knowledgeable of the production process as well as the “particular circumstances of time and place” (Hayek 1945, p. 521), to identify and act to implement such productivity-increasing measures.
But this only augments our perception that the specialization deadlock is an economic problem. It should furthermore be an increasing problem as a market becomes more intensely specialized, since specializing increases heterogeneity and therefore lowers the overall density of workers carrying out similar tasks in the market place. As opportunities for specializing are exploited, taking specialization even further may necessitate much less obvious changes — and coordination. So far in our discussion, we have not included more than minimal coordination in the market place, primarily through the price mechanism and simple agreements.
Consider the case of the tractor noted above. In order to provide a tractor in this market, actors need to break free from the specialization deadlock. This is a problem of innovation, coordination, and capital investment, since it includes the insertion of a new productive sub-process to produce a higher-order good (the tractor) to be used in farming. This sub-process requires its own division of labor to carry out tasks specific to tractor production. In this case, this is a novel process the tasks of which may not have been more than limitedly known. But this need not be the case: we can easily imagine splitting the existing tasks into several independent subtasks. The solution is however found to be the same: innovation, coordination, and capital investment are necessary for the implementation and thus realization of the new tasks and thereby the more roundabout production structure.
It is not within the scope of this chapter’s discussion to specify the exact nature of implementing such improvements to the production structure. This has been done elsewhere (Bylund 2011; 2015; forthcoming), so it should therefore be sufficient to point out that this is the role of the innovative and imaginative entrepreneur. But it should also be noted that there can be no blueprint for the implementation (realization) of such novel production processes that introduce a radically intensified division of labor since their functioning is strictly unknowable — detailed information about the intricate workings of a previously unseen sub-process is revealed only through its implementation process. For this reason, the entrepreneur can only guide the project and must rely on the decentralized problem-solving or proxy-entrepreneurship of employed workers (Foss, Foss and Klein 2007). This appears to require an integrated production structure, which is commonly referred to as a firm.
Implications for Economic TheoryWhat has been drafted above suggests that production theory is incomplete without both capital theory and entrepreneurship. This may appear obvious to Austrians, but the entrepreneurship aspect appears often missing or lacking in discussions on capital theory. Rothbard’s discussion on production theory in Man, Economy and State can serve as an illustrative example.
Rothbard here provides a groundbreaking discussion on production theory, but his discussion on the effect of saving on the economy’s production stages is severely lacking. Increased saving, states Rothbard, shifts “investment further up the ladder to the higher-order production stages.” And further: “Simple investigation will reveal that the only way that so much investment can be shifted from the lower to the higher stages … is to increase the number of productive stages in the economy, i.e. to lengthen the structure of production” (Rothbard 2004 [1962], p. 519, emphasis in original). Perhaps this is a necessary conclusion, but as we have seen in this chapter, increasing the number of production stages implies the splitting of tasks and, essentially, breaking free from the specialization deadlock of the existent capital structure. We can hardly assume that this process is automatic or immediate (and it is of course unlikely that Rothbard would rely on such an assumption).
But even if we allow this process to be time-consuming, any production process must already encompass a full-length process with stages covering the production distance from virgin land to consumer. A more roundabout production process does not add stages to the “top,” but must split a stage into several or insert a new sub-process in-between or to assist existing stages. This has implications for the income accruing to factors and capitalists involved in each stage, since a “local” intensification of the division of labor by splitting one stage into many necessarily disrupts production.
Rothbard seems to assume a preexisting market for each production stage, which suggests standardization and substitutability throughout the market and thus somewhat accurately determined market prices. From the perspective of Rothbard’s discussion, it may not be limiting but useful to rely on analytical aggregates and talk of “readjustment.” But “readjusting” the production structure to new levels of saving is a much messier process than the type of arbitrage-like allocative adjustment we discuss above — and much messier than is shown in Rothbard’s analysis. Changes to the length of the production structure means the structure is disrupted by an imaginative entrepreneur, which has implications throughout the “intricate, delicate, interweaving structure of capital goods” (Rothbard 2004 [1962], p. 967). It is insufficient and potentially misleading to assume changes in the savings rate reallocates “capital” within the production process (and therefore across the production apparatus’ existing stages). More realistically, productive investments can fundamentally change production processes by splitting or inserting stages, and this can bring about important changes to the economy’s capital structure.
It is furthermore insufficient to treat the entrepreneur as simply the discoverer of price discrepancies who then acts to shift factors from one production process to another to better account for their “real” value (Rothbard 2004 [1962], p. 511; cf. Kirzner 1973; Sautet 2000). As Rothbard (2004 [1962], pp. 858–59) puts it:
to view entrepreneurship as simply the founding of new firms is completely invalid. Entrepreneurship is not just the founding of new firms, it is not merely innovation; it is adjustment: adjustment to the uncertain, changing conditions of the future. This adjustment takes place, perforce, all the time and is not exhausted in any single act of investment.
But as we saw above, while adjustment takes place “all the time” it can and does take place within the limits of the existing division of labor intensity; “adjustment” is unable to deal with the specialization deadlock and therefore excludes disruptive innovation. In other words, it does not include “breaking free” from the deadlock through revolutionizing the production structure, which necessitates realizing an innovative splitting of tasks — which in turn requires integration (a firm) (Bylund 2015). Entrepreneurial adjustment ensues upon and as a consequence of disruption, but it is limited to corrections given the existing production or capital structure and incremental improvements to it.
In this sense, we have drafted a scope for entrepreneurship with the help of capital and production theory that both confirms and challenges Rothbard’s analysis. It confirms Rothbard’s focus on adjustments, which are carried out “all the time” through the market’s competitive discovery process and “is not exhausted in any single act of investment.” This can potentially be seen as a “Kirznerian” type of entrepreneurship (Kirzner 1973; 1979; 1999; 2009). Yet Rothbard, by not including the type of disruptive entrepreneurship that can be found in e.g. Schumpeter (1934 [1911]), sees no significance in organization or its function in the market. He therefore does not recognize the causal relationship between the division of labor and the creation of capital that Mises notes and that we here found to suggest a solution to the interlocking compatibilities of the production structure that we refer to as the “specialization deadlock.”
In fact, it appears Rothbard in Man, Economy and State fails to recognize the great importance of the division of labor for production and capital theory as well as for the evolution of society. This chapter attempts to show, in line with Mises’s view (Mises 1998 [1949]; Salerno 1990) as well as Rothbard’s later and more astute understanding (Rothbard 1991), how the importance of the division of labor hardly can be exaggerated, but that it in fact can be used to explain the process of capital creation.
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TheEduard Braun holds a postdoctoral position to the chair of economics at Clausthal University of Technology, Clausthal-Zellerfeld, Germany. I attended the Mises University in 2007 and was a summer research fellow in 2008. The present chapter is an outflow of my introduction to and study of German economic thought between 1800 and 1950, which I became interested in while a summer fellow at the Mises Institute under the direction of Professor Salerno. Historical school of economics does not enjoy the best reputation among present-day economists, but especially the Austrian school appears to be out of sorts with its former adversary in the Methodenstreit. It seems fair to say that David Gordon’s (1996, p. 7ff.) account, according to which the members of the Historical school bluntly rejected economic laws like the principle of supply and demand, is generally accepted among Austrian scholars today. In the English-speaking world, Friedrich von Hayek, Joseph Schumpeter, and Ludwig von Mises are mainly responsible for this state of affairs (Hodgson 2010, p. 296; Grimmer-Solem and Romani 1998, p. 268).
I do not try, in this chapter, to overturn this negative judgment. However, I would like to point out that there are some elements in the body of Austrian Economics that definitely stem from the Historical school. Surprisingly, the Historical school acts as the model for Mises’s capital concept and, by implication, for his economic calculation argument against socialism. Mises’s discussion of the fundamental difference between capitalism and socialism does not, or not only, rest upon praxeological reasoning. In fact, the same praxeological laws apply in both capitalism and socialism. In order to make his case, Mises has to presuppose several historical institutions that only exist in developed and monetized market economies. In this context, he draws on concepts developed by the Historical school. It was not necessary for him to acknowledge his debt to this school — and possibly he was not even aware of it — because he could act on the authority of Carl Menger, at least regarding the capital concept they both employed. Carl Menger himself, however, derived the capital concept on which Mises would later rely directly from Richard Hildebrand, a member of the Historical school. Like in monetary theory (see Gabriel 2012, p. 41), the influence of the Historical school on Mises concerning capital theory was an indirect one — via Menger.
The present chapter starts, in section 2, with a short presentation of how Menger, in 1888, changed his point of view on capital, and continues, in section 3, with the demonstration that Menger, in adopting the new and different view, made a step toward the Historical school. Section 4 traces this historical point of view on capital in Ludwig von Mises’s writings. It cannot be said that section 5 demonstrates, once and for all, that Mises implicitly admitted that economics is, in some sense, a historical science. But it tries to indicate the difference he made between praxeology and economics. The former he calls the general theory of human action, but the latter he does not consider to be entirely free from historical preconditions. Finally, section 6 contains a short discussion of Albert Schäffle’s analysis of economic calculation as a central institution of capitalism. Apparently, Mises argument against the feasibility of socialism was at least foreshadowed by a member of the often ridiculed Historical school.
Carl Menger on CapitalCarl Menger changed his point of view on capital theory considerably between 1871 and 1888 (Schumpeter 1997, p. 187; Braun 2014). He did not discuss capital very deeply in his Principles (Stigler 1937, p. 248), but to the extent he did, he advocated a capital theory that is concerned with production. His capital theory was connected to his vision of the production process as divided into several successive stages, where consumer goods result from the successive processing of combinations of higher-order goods to lower-order goods. Menger (1871, p. 155) says that one possesses capital if one “already has command of quantities of economic goods of higher order … in the present for future periods of time.” By adding this aspect to production theory and associating it with capital theory, he laid the groundwork for Austrian capital theory as developed by Böhm-Bawerk (1930), Friedrich von Hayek (1941), and Ludwig Lachmann (1978).
It is seldom recognized that by 1888 Menger had changed his view. In a long article on the subject — Zur Theorie des Kapitals (A Contribution to the theory of capital) — Menger proposed a radically different vision of the scope of capital theory. Streissler (2008, p. 371) is of the opinion that, by writing his article, Menger only made a prepublication attempt to refute the theory of Böhm-Bawerk. However, it seems more probable that Menger turned against all capital theories — including his own one — which have been developed by economists in disregard of everyday language use and established business practices. At the very outset, he declares that it is
a mistake that cannot be disapproved of enough when a science … denotes completely new concepts by words that, in common parlance, already describe a fundamentally different category of phenomena — a category that is also important for the respective discipline — correctly and properly (Menger 1888, 2).
It could be suggested that he was referring mainly to Böhm-Bawerk’s theory in this quote. However, there is every indication that Menger also implicitly revoked his earlier point of view. For the common parlance concept of capital is not identical with his own one from the Principles at all. In Menger’s (1888, p. 37; emphasis added) words, the common parlance view has nothing to do with the production process or the different orders of goods:
When businessmen and lawyers speak about capital, they do mean neither raw materials, nor auxiliary materials, nor articles of commerce, machines, buildings and other goods like this. Wherever the terminology of the Smithian school has not already penetrated common parlance, only sums of money are denoted by the above word.
He hastens to add that capital only embraces sums of money that are dedicated to the acquisition of income, and that “sums of money” not only refers to plain money, but to the monetary value of all kinds of business assets in economic calculation.
Menger thus switched sides in a debate that seems to be as old as economics itself. Does the term “capital” refer to a production factor or does it refer to the organization of the market economy by calculating entrepreneurs who maximize the monetary yield on their financial capital? At a first glance, the distinction between these two viewpoints does not seem to create a great problem. To give an example, even Mises (1949, p. 260 ff.) contains traces of both concepts of capital. He reserved the plain term “capital” for the economic calculation of entrepreneurs but, for lack of a better term, he referred to the produced goods of higher orders as “capital goods.” The next section will demonstrate, however, that the two sides of the term capital do not fit together harmoniously; rather they roughly correspond to the two sides of the Methodenstreit between the Austrian and the Historical school of economics. Menger’s earlier concept was elaborated to Austrian capital theory, whereas his concept of 1888 turns out to be the one endorsed by the Historical school.
The Historical School as the Source of Menger’s Later Viewpoint on CapitalThe first thing that must be mentioned is that Gustav Schmoller, Menger’s principal opponent in the Methodenstreit, was quite happy with Menger’s later standpoint on capital theory. In his Grundriß der allgemeinen Volks-wirtschaftslehre, Schmoller (1904, p. 180; emphasis added) appreciated Menger’s step toward the common parlance concept of capital:
Where one has provisions of goods in mind that technically serve further production, one may also use the term capital; often it will be better to say acquisitional wealth. All in all it seems to me to be the right thing to return, with C. Menger, to the capital notion as established in business life.
In fact, it can hardly surprise that Schmoller welcomed Menger’s shift of opinion. In his 1888 article, Menger clearly adopted the viewpoint of the Historical school of economics.
It is easy to demonstrate this point. When Karl Rodbertus (1843, p. 23ff.) made, probably for the first time in the history of economic thought (Jacoby 1908, p. 27), the distinction between social and private capital — between capital as a production factor and capital as a means of acquisition and calculation denominated in money — he ascribed each term to a distinctive problem area. For him, social (or real) capital is a universal, absolute, and pure concept that can be defined independently of time and place. It is the capital concept that he thought is apt for economic science. Private capital, on the other hand, only has relative importance. It results “from the arbitrary ingredients of a historical state of affairs. It would disappear if profit-yielding property disappeared” (Rodbertus 1843, p. 24, n.; emphasis added).
In other words, the capital concept which Menger used in his Principles and which later Austrians like Böhm-Bawerk, Hayek, and Lachmann adopted (and which relates to Mises’s “capital goods”) can be found in any economic system and in any time period. Individuals in isolation, like Robinson Crusoe, employ higher order goods in the same way as a socialistic and a capitalistic society does. It is a general theoretical concept and independent of historical factors. Monetary calculation, on the other hand, which is the background of Menger’s later (1888) capital concept, is only a historical phenomenon. It is neither part of Robinson’s island nor of a socialist society. It only appears in a developed and monetized market economy where property rights to the means of production are enforced. Later on, German economists like Adolph Wagner generally referred to this concept of capital as the historical-legal one (Jacoby 1908, p. 28).
That Carl Menger adopted the viewpoint of the Historical school becomes even more obvious when one compares his 1888 article with what Richard Hildebrand had written five years earlier. Hildebrand, a member of the Historical school teaching in Graz, Austria (Schulak and Unterköfler 2011, p. 25), had written a book on monetary theory that contained one chapter on capital. There, he clearly foreshadowed Menger’s later position. First of all, like Menger (1888), he rejected the efforts of economists to create capital concepts that deviate from common parlance. Hildebrand (1883, p. 72, n. 35) counters the
idea that the capital concept is open to arbitrary terminology at all, or that science, in a way, has to create or invent the concept in the first place. To the contrary, the concept of capital … is a fact that is already given by economic life.
Second, Hildebrand’s positive view of the common parlance concept unsurprisingly coincides with Menger’s. He (1883, p. 74, n. 35) states that “capital indeed can only be thought of or imagined as a certain sum of money,” and, like Menger, he immediately adds that capital also comprises real assets in so far as they have or represent monetary value.
Ludwig von Mises on CapitalAs opposed to nearly all other Austrian economists to the present day, Ludwig von Mises did not follow Menger’s discussion of capital as contained in the latter’s Principles, but was oriented toward the 1888 article on capital theory. This shines through, for the first time, in his treatise on Socialism where he explicitly refers to Menger (1888) and states:
[W]e must first ask what significance is attached to the term [capital] in business practice. … The concept of capital is derived from economic calculation. Its true home is accountancy — the chief instrument of commercial rationality. Calculation in terms of money is an essential element of the concept of capital. (Mises 1951, p. 123)
In his Human Action, Mises went a step further and not only stuck to the monetary notion of capital, but explicitly rejected the social (or real) capital concept. He (1949, p. 262) called it a confusion to argue, as some economists do,
that “capital” is a category of all human production, that it is present in every thinkable system of the conduct of production processes — i.e., no less in Robinson Crusoe’s involuntary hermitage than in a socialist society — and that it does not depend upon the practice of monetary calculation.
So in fact, without admitting it though, Mises adhered to the capital concept developed and called for by the Historical school of economics. He did not follow the early Menger or Böhm-Bawerk, who had assigned capital theory to the analysis of the production process; he rather built upon Menger’s later article which was, as shown above, a concession to the Historical school.
The Historical Character of Economics — According to Ludwig von MisesWhy did Mises rely on the historical-legal capital concept? After all, Mises argued that economics is a part of the more universal science praxeology, and that praxeology is the science of every kind of human action (Mises 1949, p. 3). According to this classification, no historical relativity is involved in economics, and therefore the real capital concept, which can easily be reconciled with every individual human action like it is done in Crusoe economics, seems to suggest itself. However, it is often overlooked that economics is not identical with praxeology, even in Mises’s own thinking.
Whereas praxeology, the general theory of human action, “can be precisely defined and circumscribed” (Mises 1949, p. 235), the scope of economics can not so easily be demarcated. Its relationship to praxeology is not a simple one, and especially its area of application is not easy to determine.
The specifically economic problems, the problems of economic action in the narrower sense, can only by and large be disengaged from the comprehensive body of praxeological theory. (Mises 1949, p. 235; emphasis added)
And here comes the main point. Other than praxeology, which is general and absolute, economics is bound to special preconditions and, consequently, is not a general theory in the same way as praxeology. This claim is emphasized by Mises himself when he adds that “in this disengagement [of economics from praxeology], historical and conventional aspects cannot be ignored” (1940, p. 226; emphasis added).I quote from Mises’s Nationalökonomie because the same passage in Human Action does not seem to make sense: “Accidental facts of the history of science and conventions play a role in all attempts to provide a definition of the scope of ‘genuine’ economics” (Mises 1949, p. 235). The same is true for the third edition. The historical relativity of economics, which Mises admits in these few words, manifests itself a few lines further where he says that economics and catallactics are “the analysis of those actions which are conducted on the basis of monetary calculation,” and that the analysis of socialism, where monetary calculation does not exist, “is possible only through the study of catallactics, the elucidation of a system in which there are money prices and economic calculation” (Mises 1949, p. 235).
In short, economics itself does not deal with all human actions in all kind of societies, but only with human actions that are directly or indirectly connected to money prices and economic calculation. It is true: in order to do this adequately, economics presupposes a general theory of human action — praxeology — but it is not identical with it.Joseph Salerno comes to a similar conclusion concerning another important economic concept: The entrepreneur-promoter does not exist under all circumstances, either. The entrepreneur-promoter “cannot be defined with praxeological rigor; it can only be identified by a historical judgment” (Salerno 2008, p. 195).
It should be remembered that Mises’s (1951) famous argument according to which a collectively planned society is not feasible is also based on historical institutions. Without exchange between money and producers’ goods, he argued, prices of these goods cannot be determined and consequently economic calculation becomes impossible in socialism. This argument is not based on praxeology alone, but it presupposes, for the market economy which serves as benchmark, the existence of money, monetary calculation, and property rights to the means of production. It was this aspect of capitalism that Mises focused on, and from this perspective it becomes clear why he adhered to the historical-legal capital concept. This kind of capital does not exist in socialism, and therefore it could help to distinguish capitalism from any other economic system.
The Economic Calculation Argument as Found in Albert Schäffle’s WorkThat Mises’s use of the capital concept endorsed by the Historical school is no coincidence is apparent when reading the approach of earlier members of this school to the question of economic calculation. In this regard, especially Menger’s predecessor on the chair of economics in Vienna, Albert Schäffle (1823 — 1903), must be mentioned. It has been noted before that Schäffle at least hinted at the difficulties a socialist society would face when allocating the available resources to the myriads of different uses. Schäffle is cited for having argued, in Hodgson’s (2010, p. 300) words,
that a system based on calculations concerning labour time faced intractable problems, including the heterogeneity of labour and the inaccessibility of relevant data, and would undermine individual incentives.
Apparently, Schäffle had at least a sense of the calculation problem of socialism, although, according to Hodgson at least, he primarily seems to have aimed at the well-known incentive problem. Huerta de Soto (2010, p. 100) goes a step further and imputes to Schäffle the demonstration
that, without imitating the system of price determination found in market processes, it would be inconceivable that a central planning agency could efficiently, in terms of both quantity and quality, allocate society’s resources.
However, neither Hodgson nor Huerta de Soto argues that Schäffle has anticipated Mises’s argument in the proper sense. They merely concede him to have sensed the difficulties of organizing production without the help of economic calculation.
It does not become clear, in their short remarks, how close Schäffle actually came to deal with questions that later became central for the Austrian school. In his Kapitalismus and Socialismus, a book which Hodgson and Huerta de Soto do not analyze and which has not been translated into English, Schäffle demonstrates that he was well aware of the problem that has to be solved by any economic order. In this, he partly anticipated Leonard Read’s famous story I, pencil where it is shown that even in the production of such a simple thing as a pencil more or less the whole world participates.
The social character of the human economy shows that everyone, from morning to night, depends on the work of the whole humanity. I wake up in the morning and put on a dressing gown: the wool it consists of has been grown, years ago, in Australia; it has been shipped to Trieste by Dalmatians, freighted to Moravia by Italian workers and the staff of the Austrian railways, spun and woven there with the help of English machines, and dyed with African colors. (Schäffle 1870, p. 103)
Confronting the complicated relationships of the modern production process, Schäffle (1870, p. 105; emphasis added) uttered the question: “The economic miracle of the much discussed division of labor — by which means is it accomplished?”
So he clearly posed the question that Mises would answer in his discussion of the possibility of economic calculation under socialism. Furthermore, he was well aware of the fact that the socialist authors had either not realized that socialism has to solve this problem or had provided merely superficial solutions. This becomes clear in the second edition of Kapitalismus und Socialismus which was part of a larger work on the social sciences. First, Schäffle pointed out that socialism must think of something that could substitute private entrepreneuship:
With the abolition of private capital as the profit-oriented director of the economy, the difficulty occurs to achieve productivity, which was aspired by private capital in its own interest, in the same or even a larger and progressing measure, so that the fairer distribution of the created wealth does not end up with less to distribute than the present-day market. (Schäffle 1881, p. 317; emphasis removed)
Therefore, he continued, socialism must find a means of minimizing costs. But “[h]ow are the [socialist] managers of the production process supposed to determine the ‘socially required’ amount of costs?” (Schäffle 1881, p. 317). This would be a very difficult task, he noted, as the ‘socially required’ amount of costs depends on numerous and variable factors. Socialist theorists deceive themselves as long as they ignore this problem:
In my opinion, socialism exposes itself to a fateful and economically cardinal calculation error as long as it does not try to contrive ways and means which guarantee, in a better way than the current competition among capitalists does, that no arbitrary measure of “socially required” amount of labor is found and asserted for the determination of exchange value, but the one that is as low as possible from a social and evolutionary point of view. (Schäffle 1881, p. 318)
How deep Schäffle actually analyzed the whole question of economic calculation in socialism is difficult to tell. He wrote several books, like The Quintessence of Socialism and The Impossibility of Social Democracy, touching on this topic. Hodgson (2010), who analyzed them, has not found a systematic treatment of the issue. Kapitalismus und Socialismus, from which I have quoted above, is a treatise of more than 700 pages and consists of public lectures Schäffle had given in Vienna. Therefore, it does not contain a systematic line of argument. Schäffle neither comes up with a proposal for the organization of the production process under socialism nor does he outrightly deny its possibility. He rather seems to advocate a mixed economy as he does in his other books (Hodgson 2010, p. 311). However, a profound judgment can only be made after a thorough study of all of his works which include, next to his lengthy monographs on socialism, several multi-volume textbooks on economics and sociology.
At this place it suffices to register that Albert Schäffle, a member of the Historical school, came close to seeing the problem of economic calculation under socialism. Whether he analyzed it satisfactorily is not top priority. One must not forget that, unlike Mises and Hayek, Schäffle wrote decades before the Bolshevik Revolution and had no real-world example of socialism to consider. Furthermore, he mainly wrote before the neoclassical revolution, thus lacking the apparatus necessary for the dismantling of Marxist theory (Hodgson 2010, p. 306). At any rate, Schäffle and the Historical school can be shown to have points of contact with Austrian Economics, whatever the methodological differences may be. Whether these links are worth a closer inspection and whether modern Austrians can profit from it cannot be foretold. For my part, I believe that the comprehensive rejection of a whole school of thought will rarely be justified.
ConclusionStreissler (1990, p. 31) has called it a myth that the early members of the Austrian school elaborated their novel insights independently of and in contrast to German economics of their day. I would not go so far as to maintain that the fundamental opposition between the Austrian and the Historical school is also a myth. At any rate, I tried to show in this chapter that at least some caveats must be made. Although he did not stress this point, even Ludwig von Mises, the father of the general theory of human action, in some of his theoretical arguments presupposes the existence of historical conditions and institutions. The connection to the Historical school can best be seen in the fact that both Menger and Mises employed its capital concept. Mises’s argument on the impossibility of economic calculation under socialism is based on it, and it even seems that the argument naturally flows from it. At least one member of the Historical school, Albert Schäffle, was led to similar, though less elaborated and precise views concerning the role of economic calculation in capitalism and socialism.
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WeMateusz Machaj is assistant professor at the Institute of Economic Sciences at the University of Wroclaw, Wroclaw, Poland. I would like to thank to Professor Joseph Salerno for many years of his invaluable help. This article is an outcome achieved due to indispensable long-term academic guidance of Professor Salerno. My intellectual development would have not been possible without his personal support, and without the study of his masterful works on monetary theory and general economic theory. understand knowledge as an acquaintance with various facts and natures of objects in the real world. By studying and investigating aspects of our lives we get to “know” certain things and we classify these inquiries into disciplines. We can widen knowledge in total by different methods. In order to achieve progress in gained knowledge we use dissimilar frameworks to learn mathematics, physics, economics, social relations, characters of our friends, or languages. It is also important that we can learn some of these things through different methods, especially different methods for different people, or different methods for the same people over time. One term “knowledge” is being used to deliberate in general about all those disciplines, yet this should not cloud first and foremost feature of knowledge: its heterogeneity.
The Austrian school has been mostly successful in economic theorizing because it realistically emphasizes heterogeneous nature of the world. Whereas various neoclassical schools, or their siblings, tend to homogenize economic phenomena, the Austrians tend to do the opposite. The prime example of the case is theory of capital, which in the Austrian version is built on the notion that capital goods do not have a common physical denominator (which could theoretically express its aggregated “amount”). Starting from such basic observation the Austrians were able to build their own theory of socialism and theory of the business cycle. As Roger Garrison notes (1992, p. 171, emphasis added),
If capital goods were wholly non-specific, if the collection of them were fully homogeneous such that any one capital good is a perfect substitute for any other, then production processes could proceed as if time ran both ways. A half-finished performance hall could be completed — with no effects on cost or construction time—as a bowling alley; the production process that yields musical instruments could — with an eleventh-hour change of mind — yield bowling pins and bowling balls instead.
Under homogeneous circumstances the issue of proper allocations would never have to arise, since every process would already be fully integrated and properly coordinated. The problem of the trade cycle would be nonexistent, since any inconsistency in the various diverse stages of production would be absent. Similarly any socialist economy would not fail at the basic problem of equilibrating the capital goods market, because optimal allocations of them would have already been chosen.Mises notes (1966, pp. 206–07) that under perfect substitutability of capital goods would imply that “all means of production ... would be as if only one kind of means — one kind of economic goods of a higher order existed.” Therefore in a socialist economy one could calculate according to the usage of the one universal higher order good (e.g., kilograms of such good), and avoid the problem of valuation of heterogeneous factors of production (non-perfect substitutability of capital goods).
Other important Austrian contributions are also more or less related to the issue of heterogeneity. For this reason it could even be seen as a typical feature of the modern Austrian economist’s toolbox. Austrians are different, because Austrians heterogenize.
The same approach to heterogeneity applies for different types of “knowledge.” A typical model breakthrough comes from Hayek’s example of a breakaway from the neoclassical approach. Hayek’s famous contribution comes from the analysis on how knowledge is “used in society” (Hayek 1945). Yet even though this analysis of complexity of economic phenomena is fruitful and worth of deeper studying, it (along with others) created a lot of side debates about the “knowledge” problem under hypothetical socialist order. We will attempt to refrain from settling those debates here. Our goal is to follow Hayek’s footsteps and to try to distinguish several types of knowledge. The goal can allow us to settle the definitional importance of knowledge for Mises’s argument about the impossibility of the rational allocation of resources under socialism.
Here we offer our (arbitrary) classification of knowledge, which, though not very rigorous, helps to navigate through the usages of the term in the calculation debate. It is important to keep in mind that we don’t want to completely classify various types of knowledge, but to envision how it relates to the socialist puzzle.
Objective “Technological” KnowledgeAlthough other types below could also be seen as objectively existing.The word “objective” seems suitable, because the main feature lies in the interpersonal aspect of this knowledge, which can be simply transmitted from one person to another. It is knowledge which is coded in textbooks and countless publications.During the socialist calculation debate the term “technological” knowledge was used (see Mises 1966, p. 699). Due to its specific “objectivity” it can be communicated between the people with the use of alphabet, algebra and other symbols. Without those symbols there would be no abstract thinking, and consequently man would still live in caves (Cassirer 1944, pp. 46–47). Objectivity is here to be understood as the possibility to be (potentially) universally recognized by any intelligent being, no matter what place and time one lives in. Due to language and objectivity of those statements knowledge can be transmitted (sometimes through the painful process of learning) between all intelligent (and sufficiently capable) individuals.
Such knowledge can include statements from all developed sciences be they empirical or non-empirical; mathematics and logic, physics and chemistry, climatology and biology, economics and sociology, politics and history, etc. Even though all those disciplines differ and use radically dissimilar methods, they can be grouped into one big family of objective Science. There are multiple examples of that knowledge such as (geology) “earth is not flat,” (biology) “spiders eat flies,” (physics) “the speed of light is constant,” (mathematics) “In Euclidean geometry parallel lines do not intersect,” (climatology) “Earth is warmer than it was 40 years ago,” (economics) “minimum wage leads to higher unemployment,” (history) “Julius Cesar did not invent the caesar salad,” and so forth.
The important fact is that none of those statements has to do with distinct characteristics of the particular being who is proposing them. They are as general as possible and can be presented by a male teenager in Africa, a female doctor in Germany, or retired astronaut in the Moon. Also they are conditioned by the concept of Wertfreiheit. They are value-free. Their most important feature is correctness or incorrectness, no matter the values, opinions and views of the person proposing them. During the socialist calculation debate such knowledge was seen as easily obtainable and possessed by socialist bureaucrats.
Hayekian KnowledgeHuman knowledge does not end with such universal and communicative observations. Not all the data can be effortlessly gathered in objectified and interpersonal form. Some information is hard or costly to transfer, so perhaps it seems sensible to use the name “transfer problem.” There exist two main reasons causing the transfer problem to arise. The first one is a subjective nature of individually “witnessed” data, which become a part of “tacit knowing.” Hayekian knowledge is perceived by an individual. At the same time it is being used by the individual even though she or he cannot formulate it explicitly and communicate it to another person. Tacit information is beyond textbooks and often beyond personal recognition of it (Polanyi 1966, p. xviii). Since personal boundaries are difficult to overcome such knowledge remains hidden behind individual barriers of the mind (Huerta de Soto 2010, pp. 27–28).
The second reason for the transfer problem is decentralized nature of Hayekian knowledge. At first it may seem that the reason is no different from the first one. Nevertheless the difference is important, because in the first case barriers have more to do with individual’s limits. In the second case scantiness of the data is an objective fact important for practical reasons. Because countless individuals are working with complex data, it is practically impossible for any isolated individual to gather their knowledge and unify it into one objective formula (even without admitting the “tacit” element of it). Hayek wrote extensively about its economic importance (see his illustrations in Hayek 1945, p. 522). He also made it an important part of the argument against market socialism model (Hayek 1940, pp. 192–93).
The examples of that knowledge could be “John knows unspoken local customs,” “Jack is the only one who knows how to talk to Mary,” “Martin knows how to start that machine,” etc.
Misesian KnowledgeAn important question that arises with the title of the section is: why make a difference between “Hayekian” and “Misesian” knowledge? We are inclined to do so, because Mises emphasized the role of prices in the economy, whereas Hayek attempted to go further and focus on something underneath prices: production functions. For the former, prices per se were of interest. For the latter something more substantial had to be hidden behind those prices. Hence local conditions and knowledge about them was named by us as “Hayekian.” In the case of Mises, all aspects associated with calculation and prices will be seen by us as “Misesian” knowledge.
Therefore Misesian knowledge is strictly associated with monetary prices, and has three interrelated features in different time dimensions:
- past prices and praxeological recapitalizations undertaken in the past,2. current price offers,3. “current allocation activities” (Salernian “social appraisement process”On the appraisement process see Salerno (1990, p. 42; 1994a, p. 120). It is of course debatable to call activities as “knowledge.” But, as we explain below, we will stretch a little bit and name them “knowledge,” because from a certain perspective this is what the central planners would need to “know” — the actions of private owners — in order to act efficiently.).
Strictly speaking prices are ratios of exchange between sovereign owners in a realized transaction. In that sense they are phenomena of the past. Currently existing, though not yet realized, price offers are also often seen as “prices” of the present circumstances. Competing and cooperating owners of the factors of production establish a nexus of contracts that allows them to create the price structure. The phenomena of price activities arise in all instances of economic calculation — realized past prices , past actions undertaken to correct them, current price offers, and current actions based on calculation outcomes and expectations about future prices. Clearly, at every point in time part of the existing Misesian knowledge is objective and known, but part of it is always beyond human recognition, because it will be determined in the future: allocation activities undertaken after the acquaintance with price offers. That is why entrepreneurship consists of a combination of knowledge and ignorance.
Past prices can be observed and expressed in the form of statistics, therefore they belong also to our first category of knowledge (as we emphasized in the beginning we are not searching for fully non-overlapping definitions). Nevertheless past prices are only the beginnings of calculation, since they only reflect past choices conditioned by outdated anticipations (see Mises 1966, p. 330). The next constituents are price offers, which in the Misesian sense are not yet “prices.” They are offers formed today under current market conditions, which are different from the conditions under which past prices had been formed. Therefore in contrast to realized prices they convey some form of current information and views about the future. If someone theorizes about prices as information signals, currently available price offers perform this function (they are not strictly speaking prices as exchange ratios).They also include current understandings of past trends in prices. The information on past prices visioned as valuable is being reflected in the current appraisal.
Price offers and past prices close the category only of existing Misesian knowledge. Economic calculation involves economic activity under uncertainty, what results in changes of economic conditions and unexpected outcomes (with price changes). It is one thing to know past prices and current price offers, but it is another to act upon those prices. Past prices inform entrepreneurs about past events. Current price offers inform entrepreneurs about today’s conditions and expectations about the future. Potential, not realized, prices “transmit” correct and incorrect entrepreneurial anticipations about possible marginal valuations of resources they own. That is why they do not transmit strictly Hayekian “knowledge,” but can include entrepreneurial perspectives on Hayekian knowledge.
All knowledge associated with various past and present instances of monetary calculation is not sufficient for the market process to happen. The driving forces for it are allocation activities (part of yet non-realized Misesian knowledge of what would private entrepreneurs do). These are actions undertaken by entrepreneurs after recognition of current price offers (with considerations on past prices and recapitalizations). The central owner under socialism has precisely the following problem: he cannot know allocation activities based on current price offers.At some point Hayek suggested this is not the main problem, because “price expectations and even the knowledge of current prices are only a very small section of the problem of knowledge” (Hayek 1937, p. 51). In the other paper he suggested otherwise. See Hayek (1984, pp. 57–58). He is not in a position to recognize what private owners would do, and how they would exclude each other from the market process. He is able to gather data on past prices, or even price offers right before the complete nationalization of resources, but he cannot know which allocation activities would have been performed under private property. Even if he or she knew all the relevant Hayekian knowledge, it would not suffice to solve allocation problems under socialism, since all of the Misesian knowledge would have to be known. The activity of entrepreneurs is something which cannot be implicit in the informational parameters of any system of equations, or any prices based on past or current data (see Salerno 1994, p. 120).
Three distinctive examples of Misesian knowledge could be: (1) “Lemons sold for 3 dollars per kilogram yesterday,” (2) “This flat is for sale for a million dollars,” (3) “Martin decided to produce 30 uniquely designed cars and price them at $3 million per car.”
“Full” Economic KnowledgeComplete economic knowledge is not anything “real,” but it is one of the assumptions in the possible “mathematical” solution to the calculation problem (which was never consequently defended by anyone). It boils down to knowledge of all possible “production functions” available to human beings. Hayek had this type of knowledge in mind when he theorized about allocation problems after postulating many ifs; if we possess all relevant information, all preferences, all knowledge of available means, then the problem of allocation is “purely one of logic” (Hayek 1945, p. 519).
In the neoclassical analysis, production functions are very simple (they have to be) and easily subjected to mathematical formulation. They use only a few variables as factors of production. Their coefficients are given and their influence on production is established and well known. At the same time, since the equations are simple and use few variables, “marginal rates of substitutions” can be inferred from those equations. They can become sorts of shadow prices, which could in theory substitute real world monetary prices and entrepreneurial assessments.Stigler and Becker (1977, p. 77) use the term “shadow price” to label a valuation for a good, which is not sold or purchased in the market. They use it for a different type of a discussion, but the idea to use the concept of “shadow price” is similar as in here. A “shadow price” is something which is to be inferred from subjective valuations and can substitute market pricing. Yeager uses “shadow price” in the analogous sense (Yeager 1994, p. 101). Those substitution levels can demonstrate, for example, “how much more is being produced when x amount of factor A is substituted for y amount of factor B?” Such contingent tradeoffs could be used for rational allocation.From the equations we can know how much of an additional amount of one factor of production is needed to replace decreased amount of the other factor if one wishes to maintain the level of output. These types of rate can be known only if production function is simple and known.
In reality such full economic “knowledge” cannot be achieved for two main reasons. Firstly, as Austrian economists have emphasized, production functionsActually the word “function” is a doubtful name, but it is a topic for another discussion. There is not much typically “functional” about production processes. are complex and each one of them is extremely specific. Production functions consist of many factors of production, which cannot be constricted and grouped into such macroeconomic (or microeconomic) variables as “K” (capital goods) and “L” (labor), or additionally “H” (human capital) and “A” (technology, or “total factor productivity”). Real world production functions have many more variables and their coefficients are not stable numbers. Due to complexity of those functions, simultaneous equations of production functions cannot in fact be “solved” even in “theory.” Walrasian equations can surely be solved, because they are simple and have as many equations as unknowns with known coefficients (Walras 1954, p. 238).Walras later on (when he deals with progress) allows for adjustable coefficients, but still the system contains “as many equations as there are unknowns to be determined” (p. 384). They appear to be mathematical tasks. By assuming such a trivial world of flat production functions, one is assuming away essential problems of complex economic reality.
The second reason for the lack of such “full” knowledge of the real world is uncertainty and human creativity. However precise the production functions are, they are never accurate, because people are never in a position to fully determine the future. They cannot “close” production functions and make them “complete,” because they would have to include all possibilities about the future.This is why a neglected Barone stated that “it is frankly inconceivable that the economic determination of the technical coefficients can be made a priori” (Barone 1908, p. 287). Ironically he later became to be quoted for having “solved” the problem of economic calculation under socialism, even though he did not believe so and actually argued the opposite. Assumptions about the knowledge of those functions implicitly embrace the notion that future is largely foreseen, and that man can anticipate what he or she will learn in the future. Human beings are not omniscient and the future is purely uncertain (in the Knightian sense). It cannot even be subjected to calculus of class probabilities, because in the course of economic events case probability prevails. By assuming away the uncertainty of the future, the fundamental problems of entrepreneurship are also assumed away. Change implies necessity for economic decision making (Mises 1966, p. 212).As Hayek (1945, p. 94) notes “economic problems arise always and only in consequence of change.” With full knowledge of the future, human beings do not face the problem of proper judgments, since all of them are optimal and efficient. Henceforth “full” economic knowledge (which would allow “shadow prices” instead of monetary prices) is impossible to be achieved, because production functions are too complex and because people can never have a complete list of “correct” functions (which would include information about future events).
The last few sentences seem too trivial and obvious to be mentioned, but there is an interesting consequence of them for the Hayekian concept of knowledge. The complete full economic knowledge is not split up and partitioned between the individuals, therefore it does not become “Hayekian knowledge” when decentralized. If we somehow summed up all the Hayekian knowledge we would still not achieve “full knowledge.” In referring to the hypothetical concept of full economic knowledge Mises writes “no single man can ever master all the possibilities of production, innumerable as they are,” and so the entrepreneurs are divided between their tasks in the environment of monetary calculation (Mises 1990, p. 17). Hayek has a footnote to that Mises’s passage when he refers to the “division of knowledge” (Hayek 1937, p. 50). Yet this is not what Mises had in mind, since clearly full economic knowledge, “all the possibilities of production, innumerable as they are,” cannot be either known or divided between individuals just as infinity cannot be divided into finite numbers. Mises’s point was that “full knowledge” can never be achieved, not that it is in some way divided between the people (compare with Horwitz 1998, p. 430).
As we see, full economic knowledge is unachievable because of the “complexity” and “indeterminacy” of what we sometimes call “production functions.” Indeterminacy problems were to be avoided only if man could turn into a sort of “Laplace’s demon” — entity capable of gaining knowledge about “everything,” meta-knowledge, which would allow the possessor of it to project reality in any way he or she wanted. Fortunately we deal in this article with humans, not gods; henceforth we can set such issues aside for philosophers and theologians. The theoretical economic system can never be “complete” in such sense.
Knowing, Guessing and the Market ProcessPerfect Laplacian knowledge leads to perfect forecast. All-knowing man possessing features of the Laplacian “demon” could notice and understand the position of any molecule (even a social “molecule”) in the (social) universe. Such recognition would allow for the planning of every future step ahead and effectively adjust actions to any desirable and possible state of affairs. No mistakes would be committed and the equilibrated Utopian dream could be realized. Any step away from such perfect knowledge results in uncertainty. In order to cope with uncertainty people try to forecast future events.
Beyond the point of perfect knowledge the strict connection between knowledge and forecast breaks. At the extreme, perfect knowledge allows for perfect forecast.“It may be added that knowledge, in the sense in which the term is here used, is identical with foresight only in the sense in which all knowledge is capacity to predict” (Hayek 1937, p. 51). It might be stated that we need calculation, because we can never possess enough knowledge. Once we move away from perfect knowledge we also move away from perfect foresight. Moreover, under the circumstances of uncertainty more knowledge does not always mean better forecasts. It may be truer for cases of natural sciences. The more we know about physics, or chemistry, the better we can forecast “behavior” of the matter. It is slightly different with knowledge of social sciences, where knowledge to some extent improves our understanding of the social world (not necessarily forecasting abilities). More Hayekian, or more current Misesian knowledge, does not necessarily lead to a better economic forecast.
Portions of social knowledge do not guarantee that foreseeing will be in a better shape. Entrepreneurs might be equipped with Hayekian knowledge, but this does not guarantee their success. They can gain a lot of Hayekian knowledge in the market, but still these gains will not automatically transform themselves into entrepreneurial successes. Even the elements of Misesian knowledge do not assure that. Entrepreneurs can acquaint themselves with past prices (realized exchanges) and price offers (currently existing ratios). Knowledge of those is not a formula for commercial accomplishments. When the entrepreneur starts to gather all the price data and gets to know current and previous price offers, it is still not enough to bring him good foresight. Moreover, it is almost nothing. The entrepreneur can gather all that knowledge, and still lose money.
Additionally, gains in knowledge per se do not reap entrepreneurial gains. The effective entrepreneur is not someone who knows “more” than others. There are many entrepreneurs who accomplish a lot even though they were less knowledgeable than their rivals. Especially in the light of the fact that many huge entrepreneurial successes work like in the romantic Schumpeterian story of the entrepreneurs, who break the existing social structures. Sources of triumphs for any entrepreneur do not lie in the typical knowledge build-up, but often in envisioning what is unseen and most likely cannot be seen. All those actions are subjected to revisions and to praxeological recapitalizations in the form of losses and profits, as well as changing asset ownership. Good choices are indicated by correct monetary imputation, and do not have to be correlated with gains in information, or any type of “knowledge” acquisition (Salerno 1990a, pp. 59–60; 1990, pp. 42–43).
Naturally, it does not follow that “knowledge” has nothing to do with forecasts and entrepreneurship. Nevertheless, the entrepreneurs are not spreading Hayekian “knowledge” in their calculations. First of all, in the case of the unfortunate word “transmission,” they are transmitting some things, but these are not Hayekian knowledge and not in the form of prices. Entrepreneurs are transmitting their judgments, and they do it mostly in the form of price offers conveying this information. Whether correct or incorrect, price offers given by sellers of goods and services inform us about how market conditions are currently perceived. The yet to be successful entrepreneur is the one who is capable of “spotting” false prices, a discrepancy between current price offers for factors of production and prices for consumer goods which will be created in the future. “Spotting” is a metaphor, since technically we can only “spot” what already exists. “False prices” do not exist yet. They shall only materialize once the future becomes present. Hence the reason why Kirznerian “profit opportunities” are blurred by clouds of uncertainty and they do not exist yet. Current price offers inform us how entrepreneurs envision today future market conditions. Precisely that kind of “information” is hidden behind prices, not information about proper ways of adjusting “production functions.”
In the neoclassical framework entrepreneurial choice is given by the intersection of the marginal revenue curve and marginal cost curve. The main oversimplification in such an apparatus comes from the coincidence of the two and presupposed incidental existence. In reality one can get to know marginal cost curves by searching for price offers (more or less). Nevertheless the marginal revenue curve does not exist; it cannot be spotted and properly acted upon. We cannot be alert to the marginal revenue curve because it is not there yet. Instead of one marginal revenue curve there is virtually unlimited number of potential non-realized marginal revenue curves. Each of them has case probability assigned to it, thus strictly speaking it has no numerical probability at all. Whoever is more successful in picking the “proper” curve, wins. The “proper” solution is offered with the future being realized. In order to foresee the demand, one does not need to “know more” than others. One needs to make a proper judgment (Hülsmann 1997, p. 35). The “selection” mechanism cannot be reduced to gains in any mentioned type of knowledge.
In other words, the market process is not driven by entrepreneurs who know more, but by entrepreneurs who deliberately select arbitrary types of information and act upon them. A real world forecast is based on those selections of information. Information is interpreted, understood and used.As Kirzner points “possessing all this information is not the same as having assimilated it” (Kirzner 1996, p. 150). In this sense “assimilation” process is always subjective (both for the entrepreneur and hypothetical central owner under socialism). What types of information are available to various entrepreneurs? As we saw in the process of economic calculation there is lots of it: realized transactions, which inform us about habits; and recapitalizations, which inform us about the extent of past mistakes. On top of that there are current price offers, which inform us about competitive potential in the market e.g., in which field we can be outcompeted by others and in which fields can we rely on the division of labor. Finally, there are undertaken actions and reallocations by other owners. All this Misesian type of knowledge is generated by the market, based on praxis, and can be referred to as the social appraisement process.
Not only is the world and its information heterogeneous, but so too are individuals. Each entrepreneur is different and has his unique entrepreneurial vision, which can be expressed through the use of property. Entrepreneurs differ in their judgments and disagree on what is economical, and what is not (Lavoie 1985, p. 123). Whoever performs well enough in this task outcompetes his rivals in the market process.
Let us take the case of an entrepreneur producing machines with the use of steel. He can notice past prices for finished products (machines) and past prices of steel. They can inform him about past exchanges and demonstrate past market conditions. He can evaluate them and engage in Verstehen. Any information he gets by contemplation can be useful for current price considerations. Equally useful are “present prices,” price offers for steel. (The entrepreneur also tries to anticipate future prices of the machines). Steel prices inform the entrepreneur how steel is being valued by sellers and by his competitors, other entrepreneurs who alternatively employ steel (to produce something else or similar). Henceforth current prices (offers and transactions from the immediate past) at least inform the entrepreneur of how valuable alternative employments for various factors are, or how other market participants envision the markets of goods produced with steel (compare with Yeager 1994, pp. 95–96). This notification of how much factors are expected to be worth, is a relevant part of the market process and entrepreneurial division of labor.
Accurate anticipation of future prices based on individual understanding of selected information leads to profits. In everyday life we notice how new information changes the prices and actions of market participants. The person acquiring new knowledge cannot be sure that its spread should change prices in a particular way. In some cases we can be almost close to certainty what the effect should be. But it can never be “fully” known in advance. If new fields of oil are discovered, the anticipation is that the price of oil should go down. Nevertheless it need not to, and we can envision scenarios in which the opposite happens. Successful entrepreneur is the one who can “interpret the information” correctly, but only in the ex post sense. He acts very often against the tide and the rest of the market.
The crucial side of the competitive process is its legal aspect. The mechanism of entrepreneurial selection is based on property shifts, which result from monetary calculation. This works despite psychological motivations of the participants, or their “knowledge,” or their “ignorance.” It does not matter what entrepreneurs’ incentives are, or what kind of information they possess. They can know a lot, or little, they can be motivated in their actions by their personal skills, or act upon an ideological bias. Whatever they know, and whatever their incentives are, as economists we do know that those who satisfy consumers most survive in the market. We do not even have to assume that entrepreneurs are interested in “maximizing” profits (Alchian 1950, pp. 212–13).Actually “maximization” is also an improper word, since it would imply we have a particular “function” to be maximized. In reality, entrepreneurs choose between various rates of profits and case probabilities associated with them. Their personal interests and motivations are not important. Profits are the link between consumer satisfaction and entrepreneurial decisions acknowledging them. That is why the market process “works” — because calculation has consequences for allocations.
In the economic analysis of socialism we can assume many things. If we assume that planners have “full knowledge,” then we “solve” the problem with an unrealistic assumption. In the real world planners can only gain other types of knowledge. They can possess all the necessary technological knowledge, and even the more specific Hayekian knowledge of time and place. We can even add that planners could possess scatters of Misesian knowledge: they could accurately know past prices and price offers right before the imposition of the socialist order. Yet even this knowledge does not solve the main socialist deficiency: the central owner does not know what are, or would be, the allocations of private owners. He cannot substitute them, or even hire them as bureaucrats, because tangible entrepreneurial skills are manifested in the realms of praxeological boundaries conditioned by asset ownership. When the central owner nationalizes the resources, all entrepreneurial skills are outlawed and simply lost.Mises (1990, p. 38) brilliantly emphasized this in his initial article: “Unfortunately ‘commercial-mindedness’ is not something external, which can be arbitrarily transferred. … The entrepreneur’s commercial attitude and activity arises from his position in the economic process and is lost with its disappearance.” They cannot be recovered by any bureaucratic structure, because there is no real world competition set in the property regime.
ConclusionsAs we have seen, in economics “knowledge” can have many different meanings. In assessing economic systems one has to be careful in making particular assumptions about “knowledge,” because any discussion may turn out to be blurred by definitional barriers. Depending on what we exactly mean by the term “knowledge” various conclusions about its possession or non-possession can be reached. It all comes down to what exactly we understand by this term.
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TextbookGuillaume Vuillemey is a PhD student in economics at Sciences Po, Department of Economics, Paris, France. I was a summer research fellow at the Mises Institute in 2009, under the guidance of Professor Joseph Salerno. descriptions of financial markets draw a clear and seemingly unambiguous distinction between spot and future transactions. Whereas future transactions are often confined to derivatives markets, everyday trades on stocks, bonds or other assets are said to be spot. Furthermore, common descriptions of spot transactions usually do not distinguish between (i) the time a trade is agreed upon and (ii) the time it is paid for and delivered, as both are assumed, by definition, to take place virtually at the same point in time.
This chapter provides a theoretical investigation of high-frequency trading (HFT), which arises from the lag existing — even for seemingly spot transactions — between steps (i) and (ii). To this end, I shall redefine the dichotomy between spot and future transactions when the settlement of trades does not occur in real time but with a lag, and when this lag can be exploited by algorithms, computerized techniques or human decisions.
High-frequency trading consists of trade exposures opened and closed between settlement dates by market participants ensuring that their net open exposure at the settlement time is zero (implying that none of the trades performed intraday are either paid for or delivered). HFT transactions are not akin, for conceptual understanding, to usual trades that would merely be executed “faster” or to positions being liquidated after a shorter period of time. One distinguishing characteristic of HFT activities is that they can be performed with virtually zero cash or securities’ holdings in the first place, as the trader ensures a zero net position at the settlement date.
This chapter investigates two questions. First, does HFT imply that intraday buy and sell trades are performed using temporarily ex nihilo created fiat money? Second, can the case where securities are agreed-upon but never delivered create multiple (therefore conflicting) but valid property rights on particular assets? The issue at hand resembles those raised by fractional reserve banking. Importantly, this chapter does not comment on the status of high-frequency trading under various legal systems or jurisdictions — this is left for future research — and instead focuses only on the theoretical conditions under which the above-mentioned consequences may occur.
If the above questions are to be given a positive answer, then serious consequences follow as regards intraday liquidity management in payment and settlement systems. An example is that of “failures to deliver” arising from high-frequency trading from naked short selling, whereby a trading institution is not able to deliver at settlement date securities it has been selling during the day.On the extent of failures to deliver in the United States, see SEC Fails-to-Deliver Data. Other consequences may relate to intraday collateral management, for instance in the case where securities are bought and delivered as collateral before the settlement of the initial purchase. Besides economics, ethical and legal issues raised by the potential over-issuance of property rights through high-frequency trading activities are akin to those raised by Mises (1996) or Huerta de Soto (2011) in the case of fractional reserve banking. An overview of Mises’s views on fractional reserve banking and monetary theory can be found in Salerno (1994).
Answering the above questions requires a careful analysis of the consequences of the lag between the time trades are agreed and the time they are paid for and delivered. I will show that, when clearing and settlement do not occur in real time, trades that are usually — theoretically and/or legally — described as spot must be treated as futures if a careful economic analysis is to be conducted. I also provide a criterion to distinguish between spot and future trades. Finally, I show that the over-issuance of property rights arising from HFT exists when transactions which should be treated as futures are legally or factually treated as spot.
The remainder of the chapter is structured as follows. First, high-frequency trading is described and is shown to be merely the exploitation of the lag between the time trades are agreed upon and the time they are settled. Its fundamental difference with other (“usual”) trading activities is also highlighted. Then, the distinction between spot and future transactions is refined. Trades on financial markets where settlement is delayed are shown to be meaningfully understood as futures. Finally, I define the conditions under which certain legal treatments of high-frequency trades as spot or as future transactions may lead to the over-issuance of property rights, thus give rise to liquidity risk in payment and settlement systems.
High-Frequency Trading as the Exploitation of Delayed SettlementI shall start by examining the nature of high-frequency trading and the conditions under which it arises. High-frequency trading on an exchange platform consists of trades usually performed by computer algorithms so as to benefit from private information regarding the order flow or from small price variations over short horizons (ranging from a few milliseconds to a few hours). The major characteristic of high-frequency trading algorithms is that they ensure a virtually zero net open exposure at the end of each trading day, so that no cash or securities have to be physically delivered. High-frequency trading has recently become a sizeable phenomenon on financial markets, as it represents up to 70 percent of all trades on some organized stock exchanges (see Swinburne 2010).
I do not propose an extensive review of the literature (which can be found in Gomber et al., 2011). Most of the academic work revolves around the consequences of high-frequency trading on particular aspects of the price system, typically on the price formation mechanisms (bid-ask spreads, “price discovery” mechanisms, etc.).Another issue regarding high-frequency, which has been less dealt with in the literature, is the extent to which it is akin to insider trading, as some high-frequency traders benefit from their technological superiority to get market information (on incoming buy and sell orders especially) ahead of other market participants. This issue is not addressed in the present chapter. For instance, one oft-mentioned concern relates to the fact that high-frequency trading may amplify price volatility to the extent of triggering “flash crashes.”The most prominent example of so-called “flash crash” occurred on May 6, 2010, when the Dow Jones Industrial Average plunged by about 9 percent before recovering in a few minutes. High-frequency trading algorithms have been shown to play a role in the amplification of the drop (see SEC, 2010). Among the main findings documented in the empirical literature are a reduction in trading costs and bid-ask spreads (see Brogaard 2010; Hasbrouck and Saar 2010) and a decline in short-term volatility (see Jarnecic and Snape 2014 or Brogaard 2011). Contrasting with the existing literature, this chapter focuses on an issue of a completely different order, largely neglected up to now. I do not focus on the empirical or theoretical consequences of high-frequency trading on particular aspects of the price system, but instead provide a theoretical analysis of high-frequency trading as regards property rights on cash and on traded securities. More precisely, do HFT activities lead to the over-issuance of property rights or to the ex nihilo creation of money?
An essential preliminary to be mentioned is a key institutional feature of present-day financial systems, namely the lag that exists on financial markets between the time trades are agreed (prices and quantities are decided upon) and the time payment and delivery actually take place. Whereas trade orders can be executed at any point in time during the trading day, clearing and settlement occur at one point only during the day, usually at the end of the trading session or up to T+72 hours. It is of utmost importance to highlight that such a time lag for so-called spot transactions is essentially institutional, i.e., that it does not primarily exist as a consequence of any physical or operational constraint. With the advent of computerized technologies at all stages of post-trade processing, real-time settlement (or quasi real-time settlement, as several actors have to be coordinated) could be a perfectly valid and implementable contractual or legal framework. For instance, real-time gross settlement systems (abbreviated RTGSA comprehensive overview of RTGS payment systems is provided by the Bank of International Settlements (1997).) exist for interbank payments — such as Fedwire in the United States and TARGET2 in Europe.
As a preliminary, I shall examine the extent to which high-frequency trades differ from other (“usual”) trades and show that high-frequency trading primarily exists as a consequence of delayed settlement. One key theoretical question for my purposes is actually whether high-frequency trades are akin to “usual” trades that are performed faster (an asset being bought at some date and sold a short moment — from microseconds to several hours — later), i.e., trades that could be fully described in theoretical terms by the canonical description of exchange phenomena (see Mises, 1996, for example). I aim to show that high-frequency buy-and-sell trades cannot be understood theoretically as a combination of spot buy and sell transactions.
I shall begin with a mere description of the steps involved in any combination of spot buy and sell transactions. For trader A, a usual buy-and-sell transaction amounts to (i) agreeing with B on prices and quantities, (ii) paying the agreed-upon monetary units to B in exchange for the agreed-upon good, and at a later date (iii) agreeing with C on prices and quantities and finally (iv) delivering the agreed-upon good to C in exchange for the agreed-upon monetary units.
On the contrary, high-frequency buy-and-sell operations do not imply, at any time, either any disbursement of cash or any physical delivery of a security or good. This is due to the fact that steps (i) and (iii) occur between two settlement dates, so that the buy and sell transactions never have to be paid for or delivered. If a buy-and-sell operation is performed within a few seconds, or even within a few hours, it will never have to be physically settled. One characteristic of high-frequency trading is indeed that investment positions are held for short periods of time so that net exposures are virtually zero at the end of each trading day, when clearing and settlement occur. As a result, high-frequency trading activities can virtually be performed with zero initial cash and zero initial securities (neglecting trading fees or initial cash balances to be maintained at the exchange platform). One may thus move in and out of investment positions thousands of times a day without having either to pay for the securities it buys or to physically deliver the securities it sells. A trader who consistently ensures a zero net open exposure at the end of the trading day can perform his activities without any holding of either cash or securities in the first place.
It must be clear at this stage that the latter feature — the absence of any physical payment or delivery — exists only because of the delayed settlement of all trades. If trades were to be cleared and settled in real time, or in approximately real time, then high-frequency trading would essentially disappear as it would become impossible to trade without virtually any cash or securities initial endowment. What would remain would eventually be buy-and-sell trades that are executed “quickly,” but not high-frequency trades. In order to further understand high-frequency trading, the legal consequences of delayed settlement have to be clearly grasped.
Spot vs. Futures and the Status of Financial TradesGiven delayed settlement, can trades on financial markets be regarded as spot transactions? A clear understanding of the distinction between spot and future transactions is of utmost importance for my purposes, as each of these transactions implies different consequences regarding the property rights at stake. What is usually referred to as a spot transaction is a transaction where both (i) the agreement between two parties on prices and quantities and (ii) the payment on one side, the delivery of the agreed-upon goods on the other side (or clearing and settlement) occur virtually at the same time, meaning that the time span between steps (i) and (ii) is insignificant for human action and for economic theory. One can see that what is crucial to the definition of a spot transaction is whether settlement is delayed or not.
The dichotomy, however, is not as clear-cut as it seems. Strictly speaking, agreement on prices and quantities on one side, and payment and delivery on the other side, are very unlikely to occur at the exact same time in everyday exchanges. Think of a baker who gives a piece of bread to a customer and receives cash only a few seconds after both parties agreed on prices and quantities. Clearly, considering physical time, there is a lag between the agreement between the parties and the process of payment and delivery. Does this imply that this transaction should not be considered as spot but as future? Considering physical constraints, what lag is low enough so that a transaction can be considered spot and not future? One hour? Ten seconds? One microsecond? Phrased this way, the question is misleading and the distinction between spot and future transactions has to be rephrased. The relevant time to be considered is not the physical time but the time of human action. More precisely, one is faced with the problem of continuums in human action and economic behavior. Rothbard (2001, pp. 264–65) argues:
The human being cannot see the infinitely small step; it therefore has no meaning to him and no relevance to his action. Thus, if one ounce of a good is the smallest unit that human beings will bother distinguishing, then the ounce is the basic unit. … If it is a matter of indifference for a man whether he uses 5.1 or 5.2 oz. of butter, for example, because the unit is too small for him to take into consideration, then there will be no occasion for him to act on this alternative.
Similarly, if the lag between the time a trade is agreed and the time it is paid for and delivered has no relevance for human action, then it does not make sense to label as future a transaction where such lag is, say, of 10 seconds. Asserting that it is irrelevant for human action means that the buyer of the agreed-upon good does not and cannot engage in any other transaction or operation involving property rights on the good between the time prices and quantities are decided upon and the time payment and delivery take place. For example, the good bought cannot be pledged as collateral once its purchase is agreed but before it has actually been received. What fundamentally distinguishes a spot from a future transaction is not the physical time lag that virtually always exists (even if very short) between the time a trade is agreed and the time it is paid for and delivered, but whether this time lag is relevant and meaningful for human action. A similar argument has recently been made by Bagus and Howden (2012), who distinguish between demand and term deposits in the debate on fractional reserve banking.
Consider a trading platform with a low level of computerized automation, a relatively low speed of order execution (as compared to present-day speeds) and an end-of-day clearing and settlement. This is roughly akin to what used to exist about fifteen years ago before the tremendous technological improvements underwent by trading platforms. On such an exchange, a lag between clearing and settlement exists but it is essentially irrelevant for human action, as it cannot be exploited — or possibly very marginally. Thus, everyday transactions on such a platform can, without any major theoretical difficulty,In a world where the automation of stock exchanges through computer systems is low or inexistent, i.e., where high-frequency trading or multiple intraday transactions on the same security are virtually not possible, treating as spot a transaction that is technically future (with a maturity of a few hours up to 24 hours) may only matter in case of bankruptcy — for example, if bankruptcy is declared between the time a trade was agreed and the time it was supposed to be paid for and delivered. be treated legally and conceptually as spot.
The whole picture changes with technological improvements when high-frequency trading arises, i.e., when the lag between the time trades are agreed upon and the time they are paid for and settled can be meaningfully exploited. More precisely, a security that has been bought at some point during the day can then be re-sold before being first physically received. Faced with the above-outlined continuum problem, I explained that the distinction between spot and future transactions is to be expressed not in terms of the physical time between agreement and settlement but in terms of time meaningful for human action. Therefore, if high-frequency trades are to be understood as trades that are agreed upon but never paid for and delivered, they can no longer be understood as spot transactions and can conceptually be defined more meaningfully as future transactions. Future transactions differ from spot transactions in that they are agreed in the present but paid for and delivered at a future date, so that the time lag between the agreement on prices and quantities on one side, and the clearing and settlement on the other, is no longer irrelevant for economic and legal theory. In terms of property rights, spot and future transactions are different in esse. Spot transactions are the exchange of property rights over present goods, whereas future transactions are the exchange of claims on property rights on future goods.
If it is clear that high-frequency trades are to be considered as futures, what about trading positions that are kept open until the settlement date, i.e., transactions that will indeed be paid for and delivered? An important issue to highlight is that nothing makes it possible to distinguish ex ante a high-frequency trade from any other trade. When a buy or sell order is executed on the market (“execution” here referring not to the fact that a trade is paid for and delivered, but merely to the fact that a buyer is matched with a seller, i.e., that an agreement on prices and quantities is reached), nothing makes it possible to identify trades of two different types as there cannot exist prescience, at least for an external observer, about whether the position will be liquidated or not before the settlement date. All trades are potentially high-frequency trades ex ante. When there is no real-time settlement, all trades must therefore be regarded as futures in the first place, so as to account for the institutional lag between the time of order execution and the time of clearing and settlement. Indeed, the possibility that a particular trade be high-frequency always exists before the settlement time. In this context, trading positions that are left open over at least one settlement date can be considered similar to future contracts that are kept until maturity, whereas trading positions that are liquidated before settlement date are akin to future contracts that are never delivered.
Legal Treatment and Consequences for Property RightsAll transactions that are usually regarded as spot in economic analysis have been shown to be better understood as futures. Moreover, I explained how different are the implications of spot and future transactions in terms of property rights. Following the above analysis, one needs now to investigate how various legal or contractual arrangements may result or not in the over-issuance of property rights or in the ex nihilo creation of fiat money. Can one think of cases where such over-issuances from high-frequency trades exist because of the lag between the time trades are agreed and the time they are cleared and settled?
First, if all trades on financial markets are to be seen as futures, it must be emphasized that future transactions do not entail any over-issuance of property rights. When one sells at some date a security to be delivered in the future, it does not matter at all whether he actually owns the security in the first place. To understand this, the distinction between a present good and a future good must be restated. What is exchanged in a future transaction is a claim on a future good against a claim on future money. One must emphasize that only claims are exchanged, so that no property rights on present money or securities are exchanged (or involved in any way). Therefore a future transaction, if properly dealt with contractually and legally, is not and cannot imply any over-issuance of property rights. The only point in time where property rights on actual physical securities and on money matter is at the maturity date, i.e., when the future transaction has to be settled. The same reasoning applies for any trade (including high-frequency trades) correctly understood as a future trade. When a security “is bought” during a trading session, what is actually bought is a claim on a future security to be delivered at the settlement time (say, the end of the trading day). Similarly, what is sold in such a transaction is not present money but a claim on future money. If all trades on financial markets are to be treated legally and contractually as future transactions in this precise sense, then high frequency trading does not imply any over-issuance of property rights. A high-frequency trader would then be perfectly akinOne slight difference is that one party usually has to pay a present premium in order to enter a future transaction. This, however, is not a necessary element of a future contract. The only payment that a high-frequency trader has to make — like any other trader — is the trading fee to the exchange platform. to a trader on futures markets who buys and sells contracts on oil, currencies or whatever securities but consistently unwinds his positions before the maturity date (i.e., never gets delivered with the underlying assets nor pays for any of these assets). Such traders consistently trade claims on future goods but never wait for the maturity of the future contract. This cannot lead to the over-issuance of property rights. In such a case, it is likely beneficial to market liquidity, similar to dealers in futures markets providing liquidity to end-user investors.
Alternative theoretical cases shall nevertheless be considered. Up to now, I have explained without further explanation that high frequency trading does not imply the over-issuance of property rights if trades are “treated legally and contractually as future transactions.” Such a proviso is of the utmost importance. Confusion may indeed come from the fact that what has been here described as future transactions is usually, in textbook explanations of the phenomenon, described as spot transactions. What if trades that are factually futures (as they are paid for and delivered only at an end-of-day settlement date) were to be treated legally and contractually as spot? Or, in other terms, what if an inconsistency in the legal framework exists, so that delayed settlement is the norm for transactions legally treated as spot? Once again, I shall make clear that the issue whether trades are treated as future or as spot under various legal systems or jurisdictions is complex and is not discussed in the present chapter, as my focus is on economic theory only.
In this case, a high-frequency trader buying a security during the day (to be delivered at the end of the trading day) could possibly engage in other operations involving property rights on a present security — not only claims on property rights on future securities — for example by pledging this security as collateral. Until either the settlement date or the date the position is liquidated, there would be two seemingly legitimate owners of the exact same security. This case would clearly result in an over-issuance of property rights that are not backed by actual physical securities. This is reminiscent of “circulation credit” or “inflation” in Mises’s sense (Mises 1981; Salerno 2000). Similarly, assume that a seller is able to use intraday the cash he is supposed to be delivered only at the settlement date — for example to repay a maturing debt — then such cash must be considered as ex nihilo created fiat money, as no one renounced yet to this quantity of money in the present. Once again, this would merely be an over-issuance of fiat money, which may have serious implications for liquidity risk in payment and settlement systems in a stressed environment.
ConclusionThis chapter provided a theoretical examination of high-frequency trading, focusing on whether it creates either additional property rights that are not backed by physical securities or ex nihilo created money. This is likely to occur as high-frequency traders can buy and sell large amounts of securities without virtually any cash or securities endowment in the first place. One key feature for a theoretical understanding of high-frequency trading is that it exploits the lag between the time trades are agreed and the time they are paid for and settled. In turn, high-frequency trading as it is currently practiced would essentially disappear if clearing and settlement were to be implemented in real time.
Whereas the time lag between the execution of a trade (i.e., the matching of a buyer and a seller) and its settlement has long been virtually irrelevant for human action as it could not be exploited — or only to a very limited extent — the advent of electronic trading platforms and of computerized trading algorithms enabled exploiting this lag to a greater extent. What used to be considered as spot transactions without any major conceptual difficulty can no longer fit the stylized description of a spot transaction, i.e., a transaction where payment and delivery occur virtually at the same time as the agreement on prices and quantities. Given that powerful computer techniques enable exploiting smaller and smaller lags (nowadays a few microseconds), the dichotomy between spot and future transactions has to be re-thought. Faced with the continuum problem, I argue that the distinctive criterion which ultimately matters is not the physical time lag that almost necessarily exists between trade agreement and delivery, but whether this lag is meaningful for human action — or, eventually, for algorithms executing models designed by humans. In that regard, all transactions usually regarded as spot have to be treated conceptually as futures with the advent of high-frequency trading techniques (of course, as long as the institutional lag between trade execution and delivery is maintained).
Turning to a legal analysis of high-frequency trading, I show that — in a system where settlement is delayed — the issue whether an over-issuance of property rights exists ultimately depends on whether it is treated legally as spot or future. If high-frequency trades are properly dealt with as futures — i.e., not as an exchange of property rights on goods, but as claims on property rights on goods — then no such consequences follow. This implies, for example, that traded securities cannot be pledged as collateral before they are physically delivered. On the contrary, if high-frequency trades are treated legally, contractually or factually as spot, then there exists over-issuance of property rights, even though it is for short time periods. This gives rise to liquidity risk in payment and settlement systems.
Following the above analysis, two research directions are to be outlined for future work. First, I set a theoretical framework indicating under which legal arrangements high-frequency trading may or not lead to the over-issuance of property rights. A survey of the existing legal frameworks in the United States or in Europe would be highly valuable as a complement. Second, from a theoretical perspective, the framework set out above could be extended to the study of another controversial market practice, namely naked short-selling. Naked short-selling occurs when a security is shorted before being first borrowed or located. A legal issue therefore is whether it is fraudulent in that one is selling something he does not own in the first place. This practice could be fruitfully analyzed not as the shorting of a security but as the shorting of a claim on a security, therefore as a future.
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Brogaard, J. 2010. “High-Fraquency Trading and its Impact on Market Quality.” Northwestern University Working Paper.
——. 2011. “High-Frequency Trading and Volatility.” Northwestern University Working Paper.
Gomber, P., Arndt, B., Lutat, M., Uhle, T. 2011. High-Frequency Trading. Goethe Universität.
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Mises, Ludwig von. 1981. The Theory of Money and Credit. Indianapolis: Liberty Classics.
——. 1996. Human Action. Fox & Wilkes, San Francisco.
Rothbard, Murray N. 2001. Man, Economy and State. Auburn, Ala.: Mises Institute.
Salerno, Joseph T. 1994. “Ludwig von Mises’s Monetary Theory in Light of Modern Monetary Thought.” Review of Austrian Economics 8(1): 71–115.
——. 2000. “Inflation and Money: A Reply to Timberlake.” Money, Sound and Unsound, chap. 17. Auburn, Ala.: Mises Institute, 2010.
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AustrianSimon Bilo is assistant professor of economics at Allegheny College, Meadville, Pennsylvania. This paper is a revised version of selected sections of my 2006 M.A. thesis. I would like to thank Peter Boettke, Per Bylund, Gene Callahan, Jan Havel, Marek Hudík, Juraj Karpiš, Shruti Rajagopalan, Walter Stover, Lawrence White, and participants of the Graduate Student Paper Workshop at GMU for their valuable comments and suggestions during earlier drafts of this paper. A draft of the paper was also presented at the Austrian Scholars Conference in 2009. I gratefully acknowledge the financial help that I received from the Mercatus Center at George Mason University while working on this project. All the usual caveats apply. I have known Joseph Salerno for about ten years. These were ten formative years for me — I was an undergraduate student in Prague back then; now I am teaching economics myself. Salerno played an important role in this journey of mine: he was my adviser in the summer of 2005 at the Mises Institute, he kindly agreed to write letters of recommendation for me when I was applying for graduate school, and we would see each other when the two of us were attending the Colloquium on Market Institutions and Economic Processes at New York University. economists have not ventured into the field of international economics very often and most of the exceptions wrote their work a long time ago. This is the case with the work on money and credit by Mises (1953 [1924], esp. pp. 170–86), Hayek’s discussion of monetary nationalism (1999 [1937], esp. pp. 61–73), Machlup’s (1939, 1940) and Haberler’s (1950) contributions, and Rothbard’s brief discussion in Man, Economy, and State (2004 [1962], esp. pp. 828ff.).
Of the few recent contributions made to this field, two authored by Salerno (1994a; 1994b) highlight the subjectivist perspective that Mises (1953 [1924]) holds about the determinants of the purchasing power of money in geographically separate locations. Physically identical goods in different locations are different economic goods even if we assume away all transportation costs. Because people often value separate economic goods differently, prices of physically identical goods in different locations might vary even in general equilibrium.
The insight that there can be an equilibrium with different prices between physically identical goods in different locations is important from the perspective of the absolute purchasing power parity theory, which is one of the models that tries to explain foreign exchange rates. This theory assumes the law of one price and implies that equilibrium exchange rate must equalize prices of physically identical goods across different currency areas when the prices of the goods are converted into same currency. Currently available data, however, bring this idea of absolute purchasing power parity into question: the general consensus is that in spite of high variability of foreign exchange rates, it takes a number of years at best before the exchange rate adjusts to a deviation from parity (Rogoff 1996; Taylor and Taylor 2004). It is this “purchasing power parity puzzle” (Rogoff 1996) that Mises’s subjectivist view on purchasing power of money can explain: if physically identical goods in different locations are different economic goods, it is not surprising that they have different price tags when the prices are expressed in the same currency and that absolute purchasing power parity does not hold. Yet, at the same time, there can still be a tendency toward equilibrium in the exchange rate between two currencies. The equilibrium exchange rate, however, does not reflect the purchasing power parity condition but rather the subjective valuations of goods in each currency area, given the prices of those goods in their respective domestic currencies.
In what follows, I develop the argument from the previous paragraph. I first review the insights of Mises and Salerno on the subjectivist theory of the purchasing power of money and then look at how these insights apply in the setting of two currency areas with a floating foreign exchange rate. In conclusion, I formulate the underlying subjectivist theory of foreign exchange rates.
Subjective Valuation Differentiates Purchasing Power of Money Across SpaceIn the section on “Alleged Local Differences in the Cost of Living,” Mises (1953, pp. 175–78) stresses the importance of the position of goods in space when considering the valuation of those goods and their relative prices. He illustrates how important the location of goods is by comparing the prices in Karlsbad, a desired spa destination, and prices in other cities. While the same type of good costs more in Karlsbad than in other cities, the price difference is justified because goods in Karlsbad are perceived as different types of goods. In other words, “[i]f [person] has to pay more in Karlsbad for the same quantity of satisfactions, this is due to the fact that by paying for them he is also paying the price of being able to enjoy them in the immediate neighborhood of the medicinal springs” (Mises 1953, pp. 176–77).
To generalize the previous example, one can say that the position of a good in space matters — geographic location is an important characteristic of an economic good that can change one’s perception of this good, and consequently its value and price. Physically identical goods in different locations can then be priced differently even in equilibrium (Mises 1953, pp. 177–78; Salerno 1994b, pp. 251–52).
Arbitrage Does Not Equalize Purchasing Power of Money Across SpaceOne can object that while the demand for goods might differ by location, the difference at least does not apply in the case of tradable goods, which can be easily transported from one place to another. The demand for apples in the city of Meadville in Northwestern Pennsylvania, for example, might be lower than the demand for apples in Manhattan, incentivizing suppliers to distribute apples accordingly and eventually equalize the prices of apples in both places. If the existing relative supply of apples in these two places results in lower relative price of apples in Meadville, this incentivizes entrepreneurs to ship apples from Meadville to Manhattan to equalize the profits from selling apples in the two different places. Assuming perfect competition and zero transportation costs, one might say that profits equalize when the price of apples in Meadville is the same as the price of apples in Manhattan.
However, since tradable goods are usually bundled with non-tradable complements as Rogoff (1996, pp. 649–50) and Taylor and Taylor (2004, pp. 136–37) briefly note, location also affects the prices of tradable goods. Shelf-space, for example, is one such non-tradable complement: returning to the apple parable, a sufficient lack of shelf-space in Manhattan may fail to incentivize shop-keepers to supply enough apples to equalize prices between Meadville and Manhattan. In this case, the opportunity cost of supplying so many apples is too high; Manhattan shop-keepers would rather use the scarce shelf-space to offer other products while keeping the price of apples relatively high.
To generalize the example, one can say that tradable goods often need to be bundled with non-tradable complements when sold in specific geographic locations. Since these complements might be subjectively valued and priced differently across locations, opportunities to arbitrage price differentials across space are limited. This limitation might then lead to price differentials between physically identical goods sold in different geographic locations.
Subjective Valuation Differentiates Purchasing Power of Money also Across Currency AreasThe conclusion that physically identical goods can vary in equilibrium prices between different locations also applies to the case of two separate currency areas. This application suggests that foreign exchange rates do not necessarily correspond to the absolute purchasing power parity of the respective currencies. To illustrate this point, I will use a modified version of the previous section’s apple parable.
Assume that there are only two places in the world: Manhattan and London. Each city has its own independent fiat currency so that people in Manhattan use the dollar ($) and people in London use the pound (₤). Let’s assume an equilibrium where an apple in Manhattan costs $6 and where a physically identical apple located in London sells for ₤2. Assuming away transportation costs, the absolute purchasing power parity theory says that the equilibrium exchange rate between dollars and pounds is $6 per ₤2, i.e., $3/₤1. If the foreign exchange rate was different, the purchasing power parity theory suggests that this would create a state of disequilibrium with associated arbitrage opportunities that buyers and sellers will exploit until the exchange rate $/₤ is equal to the ratio of the price of apple expressed in dollars over the price of apple expressed in pounds.
However, the subjectivist insight proposed by Mises (1953) and emphasized by Salerno (1994a; 1994b) suggests a very different conclusion about the equilibrium exchange rate. Following the example, even if $6 and ₤2 are the equilibrium prices of apple in Manhattan and London respectively, the two prices tell us little about the equilibrium foreign exchange rate between dollars and pounds. The difference in geographic location means that apple in Manhattan and apple in London represent two different economic goods. The difference means that while $6 is the price of an apple in Manhattan, we cannot necessarily infer from this that in equilibrium people are willing to pay the pound equivalent of $6 for an apple in London. People might be paying more or less for an apple in London than its dollar equivalent, depending both on the demand for apples in London and on the prices and subjective values of complementary non-tradable goods necessary to sell apples in London. Assuming that the equilibrium price of an apple in London is ₤2, this implies the exchange rate $/₤ can be below or above the absolute purchasing power parity of $3/₤1.
Purchasing power of money is therefore unequal across currency areas in the same way it is unequal across different geographic locations within the same currency area. Goods with identical physical characteristics but different locations are different economic goods (Salerno 1994a, p. 107). In equilibrium, such goods can have different prices when their respective prices are converted into the same currency unit. As a result, equilibrium foreign exchange rate does not have to equalize the prices of goods across currency areas and therefore does not have to adhere to the absolute purchasing power parity condition.
Foreign Currency is Valued Subjectively as a Means Toward Goods in Its Currency Area/p>If absolute purchasing power parity is not the equilibrium condition for the foreign exchange rate between two currencies, what are the equilibrium conditions? It is important to realize in this regard that people demand money because it is medium of exchange (Mises 1953, pp. 30ff.) — a medium of directly purchasing goods in its corresponding currency area. Assuming that money does not have non-monetary uses, people value different currencies against each other depending on the economic goods they can procure with those respective currencies (Mises 1953, pp. 180–81).
The foreign exchange rate of a currency thus depends on the prices that people expect to pay for goods using the currency. If expected prices increase in one currency, demand for that currency drops at the foreign exchange market and its exchange rate becomes less favorable; if the expected prices decrease, the demand for the currency increases and its exchange rate becomes more favorable. In contrast to the absolute purchasing power parity theory, however, the relationship between the foreign exchange rate between two currencies and the prices of goods that people using each currency can buy is qualitative and does not follow a pre-determined mechanical formula. The numerical imprecision of the law explaining determinants of foreign exchange rates is a necessary consequence of the fact that most of the goods that people buy with each currency are different economic goods that people value subjectively. People’s subjective valuations therefore act as a filter for every price change of a good expressed in that currency: people ultimately decide to what extent the price change has an effect on their demand for the currency in question.
Conclusion: Subjectivism and International EconomicsIn his 1994a and 1994b articles, Salerno restored attention regarding Mises’s subjectivist approach to monetary theory and international economics. This approach helps us to understand why economists have been struggling to empirically confirm the absolute version of the purchasing power parity theory. They have been unsuccessful because the theory assumes the law of one price for goods that have identical physical characteristics but which differ in location. Because the difference in location means that these goods are in reality different economic goods, the law of one price does not have to hold and the absolute purchasing power parity can be violated even in equilibrium. The subjectivist approach to international economics thereby gives us yet another illustration of the importance of subjectivism in economics that was emphasized by Hayek (1952, p. 31).
ReferencesHaberler, Gottfried. 1950. The Theory of International Trade. William Hodge & Company.
Hayek, Friedrich A. von. 1952. The Counter-Revolution of Science. Glencoe, Ill.: Free Press.
——. 1999 [1937]. “Monetary Nationalism and International Stability.” In Stephan Kresge, ed., The Collected Works of F. A. Hayek, Vol. 6: Good Money Part II: The Standard, pp. 37–100. London: University of Chicago Press and Rutledge.
Machlup, Fritz. 1939. “The Theory of Foreign Exchanges.” Economica, n.s. 6(24): 375–97.
Machlup, Fritz. 1940. “The Theory of Foreign Exchanges.” Economica, n.s. 7(25): 23–59.
Mises, Ludwig von. 1953 [1924]. The Theory of Money and Credit. New Haven, Conn.: Yale University Press.
Rogoff, Kenneth. 1996. “The Purchasing Power Parity Puzzle.” Journal of Economic Literature 34(2): 647–68.
Rothbard, Murray N. 2004 [1962]. Man, Economy, and State with Power and Market. Scholar’s Edition. Auburn, Ala.: Mises Institute.
Salerno, Joseph T. 1994a. “Ludwig von Mises’s Monetary Theory in Light of Modern Monetary Thought.” Review of Austrian Economics 8(1): 71–116.
——. 1994b. “International Monetary Theory.” In Peter Boettke, ed., The Elgar Companion to Austrian Economics, pp. 249–57. Aldershot, Hants, England and Brookfield, Vermont: Edward Elgar.
Taylor, Alan M., and Mark P. Taylor. 2004. “The Purchasing Power Parity Debate.” Journal of Economic Perspectives 18(4): 135–58.
Ten years ago Joe Salerno inherited the Mises Institute’s summer fellowship program from his predecessor, Jörg Guido Hülsmann. Generously funded by Peg Rowley, summer fellows are given time to study Austrian economics firsthand with some of the current masters. Not only is a sense of camaraderie inculcated amongst the participants, but they are also given access to the world’s best Austrian economics library and other resources. Frequent visits by friends of the Institute give these young scholars the ability to ask questions about the theory and history of the movement, and give them an ability to become a part of its ongoing evolution.
Central to this fellowship is the mentorship of Professor Salerno himself. Under his stewardship the program has brought 138 students to the Institute’s facility in Auburn, Alabama, from 2005 to 2013. These students have produced magnificent works central to Austrian economics during their summers in Auburn, and have gone on to take active roles in both the academic community and with private industry.
Perhaps more important than the careers that these young scholars have gone on to live is the enlightenment that they have shared with others through their daily lives. Using their argumentation skills fomented during their stays at the Mises Institute, these scholars have had their reach extended to others in subsequent encounters. We are all the better off for it.
The contributors to the present volume come from the ranks of PhD students, post-doctoral researchers and university professors. They have reached out to others in a bid to have the truth of their studies heard by the widest audience possible. Professor Salerno’s work in fostering debate and encouraging students during their summer in Auburn has no doubt been influential in spurring on this activism.
The present book is divided into three sections: money, policy and what we can refer to as mundane economics, the study of the basic, yet vital topics of the science. Each section represents an important area of Professor Salerno’s own research and his imprint on each chapter should be apparent to the reader. Suffice to say, a brief overview of his contributions will assist the reader in seeing his impact on the development of these young Austrian scholars in particular, and on Austrian economics in general.
Influence on Mundane EconomicsProfessor Salerno is one of the leading contemporary theorists in the Austrian tradition. A former colleague of Murray Rothbard’s, Professor Salerno has made his unfading mark on the theoretical Austrian literature through several influential as well as highly provocative articles. He has also changed the landscape for Austrian theorizing and the self-perception of Austrians.
His perhaps most debated contribution is “Mises and Hayek Dehomogenized” (1993), an article that essentially rewrote the history and sociology of the Austrian school. Professor Salerno here argues that “the Mengerian tradition was developed in very different directions by his brilliant followers, Eugen von Böhm-Bawerk and Friedrich von Wieser, and by their own students and followers” (1993, p. 114). In fact, Professor Salerno argues, these directions constitute “very different paradigms.” The former focuses on monetary calculation and resource allocation using actual market prices and comprises the social rationalism of Mises (Salerno 1990) and the judgmental entrepreneur (Salerno 2008b); one may also add the distinctly Austrian method of praxeology (see e.g., Rothbard 1951a; 1951b). The latter, in contrast, is a “general equilibrium tradition” (Salerno 2002) focused on the problem of coordination due to dispersed and tacit knowledge (see Hayek 1937; 1945) and much more inclined to quantitative analyses.
While only one of many influential contributions, the “dehomogenized” article represents Professor Salerno’s contributions to Austrian theory well. His contributions to “mundane” theory are primarily in the form of integrating existing theories and prospective theoretical perspectives by offering reinterpreting and contextualizing commentary, comparisons, and theoretical extensions. While perhaps not as glamorous as producing thousand-page treatises, this important integrative work is what produces a consistent body of theory that defines and furthers a tradition or school of thought.
Salerno’s work has strengthened the Austrian theoretical tradition and helped identify precursors and “proto-Austrians.” His work stretches beyond publishing in specifically Austrian journals and discussing exclusively Austrian theorists. Much thanks to Professor Salerno’s work, we are able to trace the philosophical origins of Austrian thought centuries if not millennia back in time and can identify kinship with other traditions. To exemplify, Professor Salerno has pursued illuminating commentary on the legacies of Carl Menger (Salerno 2004; 2010a), Eugen von Böhm-Bawerk (Salerno 2008), Ludwig von Mises (Salerno 1995a; 1999; 2012), Murray N. Rothbard (Salerno 2006), as well as of the French Liberal school’s Jean-Baptiste Say and Frédéric Bastiat (Salerno 1978; 1985; 1988; 1998; 2001), and has addressed the theoretical origins and shortcomings of opponents and competing traditions (Salerno 1992). Professor Salerno has also addressed traditions in monetary theory (Salerno 1991), but this work has come to be overshadowed by his important theoretical advances related to macroeconomics and money, especially monetary policy, business cycle theory (Salerno 1989; 2012b), and the calculation problem (Salerno 1990b; 1994b; 1996a).
Money and PolicyBesides his work on the more mundane aspects of economics, Professor Salerno has pushed forward the development of the one topic, besides method, that most separates neoclassical from Austrian economists: business cycle theory. This focus stems from the fact that the
Austrian theory [of the business cycle] embodies all the distinctive Austrian traits: the theory of heterogeneous capital, the structure of production, the passage of time, sequential analysis of monetary interventionism, the market origins and function of the interest rate, and more. (Salerno 1996b)
While this focus on business cycle theory has most recently been summarized in Salerno (2012), the bulk of his work on the topic has fallen into monetary theory and history. (Understandably so, as manipulations to the money supply as the root of economic disturbances remain the bulwark of the Austrian theory.) As the title of his most comprehensive book alludes to (Salerno 2010b), the undercurrent of his life’s work can be summed up in two words: “sound money.” In this agenda, Professor Salerno can be included in a long line of great economists championing a solid currency for the economy to be built upon, starting with the Spanish scholastics in the sixteenth century, expanded upon by David Ricardo and his fellow “bullionists” in the early nineteenth century, and most forcefully and completely argued by Ludwig von Mises in the early twentieth century. According to Mises (1971, pp. 414–16),
the sound money principle has two aspects. It is affirmative in approving the market’s choice of a commonly used medium of exchange. It is negative in obstructing the government’s propensity to meddle with the currency system. … Sound money meant a metallic standard. … The excellence of the gold standard is to be seen in the fact that it renders the determination of the monetary unit’s purchasing power independent of governments and political parties.
Professor Salerno has made available to his professional colleagues, students and laymen alike the true historical role and functioning of the “gold standard” (in its myriad forms). His work (Salerno 1983) on defining what a true gold standard entails has been instrumental in recognizing red-herring gold standards, imperfectly designed as they were, and which are commonly used to denigrate the usefulness of the “barbarous” monetary relic. His most comprehensive work on the topic (Salerno 1984), shows that the international gold standard is an oft-misunderstood beast because of the aggregative tactic the profession chooses to look at economic phenomena. Taking a more disaggregated approach to monetary and balance-of-payments theory allows one to see the true equilibrating mechanisms promoted by a healthily functioning gold standard.
Nor have these historical insights been merely apparent, allowing one to gain an understanding of a past disconnected from the future. In “War and the Money Machine: Concealing the Costs of War beneath the Veil of Inflation,” Professor Salerno lays out a theory of war finance, showing that monetary inflation obscures the cost of war and contributes to the capital decumulation and wealth destruction that ultimately ensues. That war-time inflation paves the way to “economic fascism” should be more than apparent to the reader who considers the socialization of large swaths of the American economy that have taken place over the past fifteen years in the wake of the ongoing “War on Terror,” an insidious undertaking with an enormous price tag. With some estimates of the total cost of this war as high as $5.5 trillion (nearly $20,000 per American citizen) the role of inflation in financing this broad-reaching undertaking cannot be overstated (Eisenhower Study Group 2011).
Professor Salerno has been instrumental in demonstrating that Ludwig von Mises’s contributions to the theory of money in the early twentieth century not only predated and were ignored by many mainstream economist, but is also far superior (Salerno 1994a). In light of this, it is to his credit that he has not ignored mainstream monetary theory completely. In Salerno (2006) he gives a “Rothbardian” analysis of the familiar equation of exchange. His insights allow the reader to see clearly and in a way that is not possible via the vacuous quantity theory that
the Quantity Theory of Money as expounded in terms of the Quantity Equation gets matters exactly wrong: it is not the flow of spending that determines the price level, given a level of output that is exogenously determined in some separate and mysterious real process. Rather the money prices and quantities of goods exchanged, which are codetermined in the overall market process, are the causal determinants of the spending flow. (Salerno 2006, p. 51)
Never content to rest on the laurels of his forebears, he has striven to improve upon the great works they have achieved. Salerno (1987) provides a better measure of the “true” money supply. Unsatisfied with the existing “M”s expounded with near unanimity by the rest of the profession, Professor Salerno builds off Rothbard (1963, pp. 83–86; 1978; 1983, pp. 254–62) to provide a better answer to a seemingly simple question: how much money is floating around out there? Not only is the exercise admirable for its clarity, it also shows a dedication to truth seeking and an undogmatic approach to economic analysis. Though clearly following in the footsteps of Rothbard, Professor Salerno does not hesitate to correct the dean of the Austrian school in his previous attempts to define the money supply.
To the Next GenerationThe contributions to economic science discussed above, although formidable, will not be Professor Salerno’s greatest professional achievement. The thirteen contributors to the present volume have all learned from him, and there can be no doubt as to the influence he has had on their intellectual development. Just as Professor Salerno very clearly is influenced by the Menger-Mises-Rothbard tradition of the Austrian school, each of these thirteen authors (as well as the other summer fellows under his tutelage, and the thousands of people who have listened to his lectures and read his works) can be considered an intellectual descendant of his. To introduce the adjective, we are all “Salernians” in some way.
Professor Salerno was not only present for the rebirth and revival of Austrian economics in the mid-1960s, he has been an important focal point of its continual growth over the ensuing decades. With this book, we present to him the evidence that the discipline is in good hands, and that his reach and influence has not only been wide, but also strong, ensuring its promulgation for another generation. It is with this contribution that his most lasting influence has been made, and continues to grow with each passing year. Thanks, Joe.
ReferencesEisenhower Study Group. 2011. “Cost of Iraq, Afghanistan, and Anti-Terrorism Operations.” Watson Institute for International Studies, Brown University. Accessed 27 August 2014.
Hayek, F. A. v. 1937. “Economics and Knowledge.” Economica 4(13): 33–54.
——. 1945. “The Use of Knowledge in Society.” American Economic Review 35(4): 519–30.
Mises, Ludwig von. 1971. The Theory of Money and Credit, 2nd ed. Irvington-on-Hudson, N.Y.: Foundation for Economic Education
Rothbard, Murray N. 1951a. “Mises ‘Human Action’: Comment.” The American Economic Review 41(1): 181–85.
——. 1951b. “Praxeology: Reply to Mr. Schuller.” The American Economic Review 41(5): 943–46.
——. 1963. America´s Great Depression. Princeton, N.J.: Van Nostrand.
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EconomistsDavid Howden is professor of economics and chair of the Department of Business and Economics at St. Louis University, at their Madrid campus, Madrid Spain. beyond a certain age will recall a simple mnemonic when listing money’s main functions: “Money is a matter of functions four, a medium, a measure, a standard, a store.” The four functions of the categorization of money are known today as the, (1) medium of account, (2) measure (or unit) of value, (3) standard of deferred payments, and (4) store of value. The rhyme alludes to the fact that economists thought that money served a somewhat broader role once upon a time than it does today.
The mnemonic also makes clear that money has several well-defined uses, unlike other economic concepts, like “goods” which have innumerable uses subjectively determined by their users, or a “price” which is the unique objective embodiment of these uses. In this way, money is special.
Due to good luck endued in him by his parents, Joe Salerno is of the age necessary to be included in the group of economists who cut their teeth in monetary economics by learning this rhyme. Unfortunately, he may well be old enough to have forgotten it, as well as where he left his glasses, his wife’s birthday, their anniversary, and all sorts of other things important to his life!Amongst other things important to his life, I will take the liberty to include the first time Joe met me. By my “young” mind’s recollection, this was at a dinner at a taco house in Auburn, Alabama, some balmy early June evening in 2008. This was the first of two summers I would spend at the Ludwig von Mises Institute as a summer fellow under the guidance of Joe. Thank you, Joe, for your intellectual encouragement, mentoring and, of course, friendship, over these past six years.
In this chapter I will revisit the use of this simple mnemonic to underscore what money is. I will then use these insights to augment Salerno’s (1987) work on the “true money supply.”
Money is as Money DoesIn an unsettling way, the old adage that “money is as money does” has a ring of truth to it. When defined, as it commonly is in introductory economics textbooks, as “the generally accepted medium of exchange,” money can be a variety of goods, provided they meet three criteria: (1) that the good is used to settle exchanges, (2) that the good is the final means of settlement, i.e., not credit, and (3) that the economic community generally accepts such a good to settle exchanges. Economists then move on to a discussion of whether a “good” is a candidate for inclusion in the definition of the money supply when it satisfies all three of these conditions. The result is any of the common “M” measures of money.
While it is trivially true that money is as money does, there must be a better way to approach the problem. The old trusty mnemonic hints at how we can proceed.
In the common story of the origin and evolution of money, one central aspect is the reduction of transaction costs (i.e., Menger 1871, chap. 8, 1892). In a moneyless world there is a double-coincidence of wants problem, as elaborated by Jevons (1875, p. 3). As the scope of trades is limited and the costs associated with setting an agreeable price once trading partners do meet is high, there is an incentive for traders to use specific goods that are widely demanded to settle their transactions. As more individuals use these few specific goods to settle their exchanges, they gain a value for exchange purposes in addition to the value they possess for direct use. The process ends when one (or very few) goods begin to be traded solely for exchange purposes, and their acceptance is due to the knowledge that they can be easily traded with, and accepted by, another individual. Money is the outcome of this process, and it is also clear that whatever good is functioning as money will also be the generally accepted medium of exchange as a result.
Money’s use during its evolutionary process is clearly for exchange purposes but there is also an additional role of great importance. Mises (1949, pp. 244–51) sheds light on this by way of his equilibrium construct of the “evenly rotating economy” to demonstrate when money is not necessary. Only in a world of full certainty — one where all expenditures are known in advance, both in magnitude and timing — would money not be necessary. The reason comes from a simple opportunity cost analysis.Confusions suffered while interpreting the results of Mises’ evenly rotating economy commonly center on misunderstandings of what role money is embodying within it. Specifically, it is not necessary for money to circulate as a medium of exchange but it is of importance that it exists to denominate prices (Howden 2009, 8 n.8).
Since money functions as the final means of settlement, it is also always and everywhere a present good. Indeed, money functions as the present good par excellence and as such yields no interest payment. Holding money will always force an individual to incur a cost in terms of the yield on whatever other best but foregone option is available to him. Rather than forego an opportunity by holding money, if the individual knew in advance what his monetary demands would be he would either lend his money at interest until it was needed, or would turn to the futures market to settle his future transactions at some discounted value in the present.
Depart from the perfectly certain world, however, and one runs into the intractable problem of how to best meet his future needs. As Mises (1949, pp. 14, 249) shows, money serves as a security hedge to guard against these uncertain situations. The key problem is that “[u]ncertain of what, when, where or the amount of future expenditures, individuals demand to hold an amount of money to safeguard against this uncertain future” (Bagus and Howden 2013, p. 236).
Of course, other highly liquid money substitutes can also serve this role to some degree. Rothbard (1962, p. 713) refers to these as goods as a type of “quasi money,” but to the extent that they are not perfectly liquid assets or the final means of settlement, they cannot function as “money.”
Thus, while a highly liquid very short-term bond may substitute for money in some ways, the fact that it is never the final means of settlement and is itself open to some degree (however small) of default risk forever trap it in the category of quasi moneys and stop it from claiming a monetary status. Chief among these quasi moneys in today’s economy are money market mutual funds (currently amounting to about $2.7 trillion) and liquid assets used as collateral by the shadow banking industry.Notoriously difficult to define or measure, some estimates place the size of the shadow banking system in the United States at $19 trillion as at year-end 2011 (Singh 2012). By way of comparison, the True Money Supply figure, defined in Salerno (1987) and elaborated on below, was substantially smaller at the end of 2011 — $7.3 trillion.
In this brief discussion of the evolution and use of money there are several roles taking place concurrently. The most obvious one is the medium of exchange — a unit to transfer in settlement of pecuniary obligations. There is also the role of money in mitigating our felt uncertainty, however. In order to function accordingly, we must identify what the relevant uncertainties are that the individual will face.
Having already commented on the unknowledge of what, how much or when we will need purchasing power in the future, we can now comment on why money is held as a hedge against these expectations. After all, most individuals can and do hold a variety of liquid non-money financial assets to assist them with their future expenses, e.g., equities, short-term bonds or certificates of deposit. All of these non-money financial assets have a risk inherent in them which the money holder must overcome.
It is useful to think about financial assets in terms of two characteristics — when are they available, and what value they will have at that moment when they are used. The first criterion can be divided into two categories. A good is either a present good, i.e., it can be used at any time, or it is a future good, i.e., its value cannot be realized until some point in the future. The values in question also come in two distinct forms. A financial asset either trades at par or market value, with the latter fluctuating as per supply-demand conditions in the market. All financial assets can be classified according to these characteristics, as in Figure 1.
In the scope of financial assets, money is unique. It is the only good that is available at a moment’s notice and at par value. The par value nature of a financial asset comes from the fact that its payout is defined in terms of itself. One dollar held as currency or on deposit equals one dollar of purchasing power. Likewise, bonds are denominated in terms of money units (e.g., dollars), such that the purchaser receives a set nominal amount of said currency units upon maturity. In contrast, financial assets that trade at market value are purchased in terms of “shares” (or a claim to shares in the case of a future), with each share deriving its value from an underlying asset, whether it exists in the present or the future. When an individual buys a share in a company, the value is defined as a percentage of the company’s future earnings stream, discounted to the present at an appropriate discount rate.
Equities and money are both present goods in the sense that their respective values, or purchasing powers, are unleashed at a moment’s notice. The owner of equity is forever unsure of the value he will receive for the sale of his shares, however, as it is dependent on market conditions at the time of sale. The owner of a bond is assured the value of his asset, but only if he waits until maturity to sell it. (He can, of course, sell at any moment though the value he receives will be dependent on supply-demand conditions at the time, i.e., he will receive the market value at that moment in time, effectively making the bond an equity investment ex post.)
In a superficial sense, money is demanded because it is highly liquid. Yet this cannot be the sole reason money is demanded, as other financial assets such as equities and heavily traded debt securities are also highly liquid. Money is also demanded because its nominal purchasing power is guaranteed, as it is with bonds if we abstract from default risk. Thus, in some ways money exhibits features of equity securities (e.g., high liquidity) and other features more common in debt (e.g., par value redemption).
More to the point, money is demanded because of its uniqueness. Money is the only asset that is able to combine both features — par value and on demand availability — into one package. It is this combination that makes money such an exceptional, and also essential, part of a portfolio of financial assets.
Money as Medium of Exchange and Unit of Account, Present and FutureThus far I have been able to establish some characteristics of money without making reference to its specific functions. Actually, the causality runs the other way ‘round. There are some specific roles needed to be filled in the economy, and money (broadly defined for the moment) is the good that emerges to serve these roles. To understand why, consider two of the common functions of money in our introductory mnemonic. To jog the younger reader’s mind (as well as Joe’s): “Money is a matter of functions four: a medium, a unit, a standard, a store.”
The obvious two functions that correspond to what any introductory economics course teaches us are those of the unit of account and medium of exchange. In one very important way, these two roles share a common link. They both perform their role in the present. Money serving as a numéraire to express prices allows for value comparisons in the here and now, and when we exchange money we settle our transactional obligations instantly. Thus, the unit of account and medium of exchange are both present functions of money.
Although we commonly think of money in terms of these present functions, is it also possible for money to have future functions? Again, returning to our mnemonic we see that the other two roles — the store of value and standard of deferred payments — are important roles that money is expected to perform at some future date. Whether money will prove itself to be a useful store of value will not be known until the future is revealed. Long-dated contracts can be defined in terms different than the common unit of account by the standard of deferred payments.A weight of gold served this purpose for most of history, even when a different currency unit was used in exchange for more short-term oriented pricing. This changed in the United States starting with the Legal Tender Act of 1862 (which, despite a tumultuous start was finally ruled constitutional in the 1884 case of Juilliard v. Greenman, 110 U.S. 421). Despite contracting for settlement in a different good than was commonly used as the medium of exchange, legal tender laws effectively make the standard of deferred payments (as well as the other monetary functions) the same as the preferred money of the state. Since payment must be accepted if rendered in the legal tender, even a pre-agreed alternative cannot be upheld in a court of law.
Each of money’s four roles has a temporal dimension, but they also have a common connection by the general category of use that they are satisfying. Generally speaking money is either used to price a good for sale (if one is the seller) or exchange for the good to complete the transaction (if one is the buyer). Figure 2 shows how money’s four roles dovetail with the two criteria defining their demand. Money, by serving in any of these four functions, is demanded to set prices or exchange for goods, either now or in the future.
As previously alluded to, one monetary good need not serve all of these roles simultaneously. Historically, many goods have served as pricing units without also being exchanged to settle transactions. Although gold and other precious metals have commonly served as pricing units in recent history, accounts abound of other, less common goods, performing the same role. Cigarettes in POW camps (Radford 1945), large circular Rai stones on the South Pacific islands of Palau and Yap (Bryan 2004) and even slave women (cumal) in Early Medieval Ireland (Nolan 1926) are well-known (and well-used) examples provided by economists.
Likewise media of exchange are varied over history, though much less so than with the units of account. The reason for this is straightforward. As per Menger’s theory of the evolution of money, for money to achieve the status of the “generally accepted medium of exchange,” it must be broadly demanded throughout the economy. Together with some of the objective properties of precious metals (e.g., divisibility, durability, difficulty to counterfeit, etc.), metallic goods were used because of the assuredness that the recipient would accept them.
Pricing units need not be chosen mindful of this constraint. Instead they have been selected for criteria that include general knowledge of their value, constancy of value of time (or, at least, a non-volatility of value compared to the values of other goods), and ease of recognition. Divisibility has never been an issue for pricing units, as fractions of any unit can express value as well as any whole number. Fractions of women were used to define fines in ancient Ireland, though these prices were not paid with the aid of a steady-handed surgeon. Instead they were settled with another good functioning as a medium of exchange, at the going exchange rate of that good for women.Although using fractions of women to pay fines could lead to more accurate convictions and judicious verdicts, as with King Solomon’s ruling to “split the baby,” as recounted in 1 Kings 3: 16–28.
Money’s four roles are a direct outgrowth of the fact that what we call “money” is actually the combination of several functions commonly embodied in one good. Denominating the prices of all goods in terms of one good brings great computational ease when comparing the opportunity costs of alternatives. Not only is the calculation provided by money prices “a device for lowering transaction costs relevant to deliberate search,” it is also the embodiment of a social arrangement allowing for spontaneous learners to easily recognize overlooked opportunities (Kirzner 1979, p. 150).
As an example, a simple economy consisting of ten goods to exchange against each other would have 45 “prices” if there was not a single good used to express their value with a common denominator.An economy with n goods will result in (1/2)(n-1)(n) direct exchange ratios. Using one of these ten goods to express all other prices results in only nine prices (with the price of the good in terms of itself, one, making an additional tenth “price”). In the modern economy, the number of goods is many orders of magnitude greater than this example. The average car, to take one small component of the vast number of goods produced in the American economy, has upwards of 15,000 separate parts. If these individual parts were transacted without a common pricing unit, there would be over 112 million separate exchange ratios! Since the automotive industry is less than 2.5 percent of the whole American economy, I leave it to the reader to consider the number of “prices” that could exist across the United States lacking a common denominator through the unit of account. Needless to say it is doubtful that such computational complexity resulting from direct exchange ratios would allow for anything more than a simplistic, nearly autarkic, economy.Confusions around the origin and emergence of money commonly treat the unit and account and medium of exchange interchangeably. David Graeber (2011) is unconvinced by Menger’s evolutionary theory, relying on anthropological data that seems to suggest there was never a time when direct exchange existed, an important first step in the path to a money emerging as a form of indirect exchange. As proof, Graeber points to the lack of pricing boards showing prices expressed in terms of multiple goods. In this criticism, Graeber asks too much and too little. Too much because he extends what is really an example of a lack of multiple units of account as means to express prices to conclude that there was never a time with multiple goods functioning as media of exchange. On the other hand he asks too little by expecting there to be evidence of a primitive society expressing prices in terms of all, or many, other goods. Given the computational problems discussed above for a small economy not using a common unit of account, I would expect that this monetary function was eclipsed by one, or a very small number of, goods in anything more advanced than a very primitive society, thus explaining the lack of anthropological evidence from very early human developments.
Money may be a present good, but the people who use it are always future oriented. Thus there will be a necessary forward-looking perspective on each of money’s two roles, in addition to their demands in the present.
The store of value, being the future extension of the medium of exchange role, is probably the simplest future-oriented function to understand. Money is demanded in the present to settle current debt and transactional obligations. However, due to the uncertainty inherent in the future, there will need to be a medium of exchange demanded today to fulfill requirements in the future. The exact dates and magnitudes of these expenses are as yet unknown, but the money saved today must retain its value, or purchasing power, until that unknown future date.
Thus, the store of value function is the other side of the medium of exchange coin. Economists often couch their discussion of the store of value function as if it was a way to transmit wealth to the future. Such an understanding of the role obfuscates the issue. Money is not demanded to transmit wealth into the future, although it can certainly perform this role. Almost no one holds a sum of money today because he is preserving his “wealth” for the future. After all, there is an opportunity cost to using money for this role given its lack of interest return. In its place, investment vehicles commonly perform this task.
Money serving as a store of value is more correctly thought of as the property whereby money will only be demanded today based on its expected purchasing power in the future. This future purchasing power will be determined by how well the medium of exchange preserves its value, i.e., functions as a store of value. Note that this is quite different from more typical discussions of storing wealth for the future in the general sense, something which is not unique to the monetary asset. We are here concerned with money’s ability to preserve its value to be used in the future for monetary needs, which are, incidentally, the same category of needs that money is demanded for in the present as a medium of exchange.
The standard of deferred payments functions as the reverse side of the unit of account coin. It is the ability of a good to express the value of other goods, but over a longer time horizon than the standard unit of account. As an example of this distinction today, despite having lost 98 percent of its purchasing power over the last 100 years, the U.S. dollar has managed to do so with constancy. Each year prices increase by around 3 percent on average, notwithstanding some outlying periods. On a year-to-year basis the U.S. dollar performs well as a unit of account, and, e.g., a clothing shop, can take comfort in knowing the price tag made in one year will suffice for the following year as well; menu costs are minimal. Over longer periods the dollar has performed terribly and lacking an alternative good to use as the standard of deferred payments, Americans have had to suffer the costs of hedging their bets on long-term contracts denominated in dollars.
When using the term “money,” what economists have in mind is actually any of the four specific roles performed by money. In this way, one reason that monetary economics has become so confused is that the very adjective in its title is ill-defined. Furthermore, with the exception of select works in the now well-aged “New Monetary Economics” literature (Black 1970; Hall 1982a, b; Greenfield and Yeager 1983), very few serious attempts have been made to look at money’s individual roles in isolation of their shared embodiment in a single good. General equilibrium models are at a loss to incorporate money since they have no scope for a medium of exchange. It has been difficult to integrate money into basic utility analysis since money confers no direct utility, unlike other goods. (And since utility analysis forms the bedrock of microeconomics, the economics profession has long grappled unsuccessfully at providing “microfoundations” for monetary economics.) In short, much has been lost by using one word — money — to describe four different functions.
Multiple or a Unique “Monetary” Good?The source of the muddled state of present monetary economics stems, at least in part, from the simple fact that for the better part of a century, one good has served all four monetary roles. This is understandable given that the enforcement of legal tender laws effectively forces one good (i.e., the legal tender) to serve all roles simultaneously. Before the passage of such laws in the mid-nineteenth century, an American could purchase a home with a mortgage denominated in ounces of gold and furnish it with goods priced in U.S. dollars. Neither dollars nor gold would be needed to pay for either transaction, as silver could be exchanged at the market rate. With the advent of legal tender laws, prices could still be struck in any good, but the payer would always be able to use U.S. dollars in settlement. As a result, U.S. dollars became the dominant pricing unit, both for current and long-dated contracts.
Yet there is still another reason why one good would assume all roles concurrently. Consider the origin of the demand for money. Mise’s use of the evenly rotating economy illustrates that it is only the existence of uncertainty that makes money a necessity. Money need not exist as a medium of exchange, not in any abstract sense anyhow, since any contract can be settled with a future if its magnitude and timing are known in advance (or an option if not even the timing is known).
Money is held to mitigate the holder from the uncertainty concerning his future transactions needs. In this way, one may get the impression that money’s key role is the store of value —the ability for it to unleash purchasing power in the future. Such thinking is also erroneous, as there are several assets that can provide more-or-less good stores of value over time. (It is often recollected that one ounce of gold has purchased a good men’s suit for hundreds, if not thousands, of years.)
The way that money insures the holder from uncertainty stems from its unique properties as a financial asset, as in Figure 1. It is the unique good that is redeemable at par value at a moment’s notice. From this simple fact we can derive three important insights about what money is.
The first is that a good only functions as “money” when its two general functions coincide. Specifically, if a good is used as the pricing unit and is also exchanged to settle transactions, it will by necessity trade at par value. At the same time, since money is the generally accepted medium of exchange it will also be available on demand since the timing of future transactions cannot be estimated, evenly probabilistically, in the present. This is important to the extent that we can see why money takes on its specific role in the schema of financial assets, a position attributable to the specific monetary demands by individuals.
The second insight is that we can better explain what is not money. In short, any asset not trading at par value and available on demand cannot be so categorized. The reason is that it would negate the original reason why money is held — to mitigate uncertainty. Holding an asset as “money” even though it is not available on demand (e.g., a future or a bond) entails a degree of risk since there is no guarantee that the purchasing power will be available at that moment when the holder demands it. What good is a 30-year bond to the holder as money if he requires funds in ten years’ time?
On the other hand, holding a good that trades at market value (e.g., equities) will give the holder no assurance that its value will be retained, either in whole or in part, at that moment when the holder needs it. Holding Enron shares may have seemed to satisfy an individual’s demand for money superficially, but when it turned out that his shares were worthless, he moved on to satisfy this monetary role by means of another good.
Thus only goods available on demand and at par value can survive as money, and these two criteria are only fulfilled when a good is used as a pricing unit and as a medium of exchange simultaneously.
Finally, we gain some insight into better defining what the money supply is. Currency obviously fits the bill, but what of bank accounts? To the extent that they are guaranteed to be paid on demand and at par value, demand deposits also comprise an important component of the money supply. Herein lays two important caveats. Fractional-reserve banks do not necessarily come with either of these assurances. As recent events in Cyprus have made clear, fractional-reserve deposits are effectively equity holdings masquerading as money. When bank assets lost sufficient value to render them illiquid, depositors were paid out a corresponding fraction of their account’s value, an event akin to receiving the market value of a number of shares. Alternatively, some fractional-reserve banks honor the par value redemption of their deposits, but only after the depositor incurs a waiting period to receive his funds. Such a condition is imposed in nearly all banking systems on redemption requests above a certain amount.
Historically, a similar condition was used liberally on fractional-reserve deposit accounts under the guise of the “option clause.”Checkland (1975, p. 85) describes the Scottish free-banking period as one of “continuous partial suspension of payments.” This has since been heralded as a stabilizing force of free-banking systems lacking a guarantor such as a central bank to function as a lender of last resort (White 1984, pp. 28–29; Selgin 1988, pp. 161–62; Selgin and White 1994, pp. 17–26). Such advocacy gets the problem of stabilizing the monetary system exactly backwards. Solving the problem of banking instability by removing the on demand criterion, even if for only a short while, removes one-half of the key features making money so unique. It also removes one-half of the reasons why money is demanded.
Thus, deposits held in fractional-reserve bank deposits are a tenuous component of the money supply. Provided that the issuing bank can maintain on demand and par value redemption, there is no significant problem. Changing either of these aspects effectively removes the asset from the upper-left quadrant in Figure 1, and relegates the former “money” to some other financial role.
(Re)defining the Money SupplyDefining the money supply is tricky business. This is so not least because of what criteria define monetary assets, but also because some of those assets are not capable of performing their jobs without serious caveats. I will close with some brief and sundry comments on Salerno’s (1987) definition of the “true money supply.”
In writing this pithy article, Salerno builds from the theoretical framework of Rothbard (1963, pp. 83–86; 1978; 1983, pp. 265–62) used to accurately define the money supply. In doing so Salerno diverges from Rothbard by excluding life insurance net policy reserves, owing to the fact that very few, if anyone, considers them to be part of the money supply. Since the supply in question is concerned with the “generally accepted” medium of exchange, Salerno excludes this component due the lack of perception that it is money on the part of money holders.
While this exclusion is warranted if one is concerned with money as the “generally accepted medium of exchange,” it is unwarranted if one defines “money” under a different set of criteria. As money is demonstrated herein to be defined as “the unique financial asset that is available at par value, on demand,” the inclusion of life insurance policy reserves is not only warranted, but necessary. Indeed, some works, e.g., Nash (2009), Lara and Murphy (2010), point to the use of life insurance policies as a bank account, and thus implicitly include these reserves in the money supply.
Salerno also excludes money market mutual funds (MMMF) because they are not instantly redeemable, nor are they par value claims to cash. While they may look like this at first glance, a MMMF is an equity claim to a managed investment portfolio of short-term, high-grade financial assets. Cases where these funds have “broke the buck,” i.e., the net asset value of the underlying portfolio drops below the value of MMMF claims to the assets, have historically resulted in either the owners receiving less than the par value of their holdings, or a capital infusion from the fund’s sponsors. Likewise, Salerno excludes short-term time deposits on the grounds that they are not available on demand.
More common attempts to define the money supply have suffered from an ad hoc approach, as is the case with the common “M” measures.Alternative measures of the quantity of money run into similar difficulties. The “Divisia” monetary aggregates developed by Barnett (1980) use what are essentially the same types of money and money substitutes as in the more common M measures, though weighted by their expenditure share instead of evenly. Austrian economists have made great strides by realizing that the money supply can be defined by the two main reasons that money is demanded, whether to facilitate payments or to provide an uncertainty hedge. Most notably this approach follows Rothbard (1962, pp. 756–62) in defining the reservation demand to hold money separately from its exchange demand (Howden 2013, p. 21).
Ultimately, definitions of the money supply are tricky because they grapple with four problems at once. These four problems allude to money’s four roles, as listed in the opening mnemonic. I will end this chapter with one approach to measure money, and draw one implication.
In one way, money defines prices that will need to be paid for with the medium of exchange. The stock of exchange media available to settle these prices is one “money supply.” For simplicity I suggest we call this “exchange supply of money,” Mx.
Money as used to price goods comes with one complication. At any given time there is a set of obligations priced in terms of the money unit that require the medium of exchange to settle (e.g., debts coming due). To this set we can include those goods desired (but not obliged) to be purchased, which are priced in the money unit and which the medium of exchange will be required to settle (e.g., consumers and producers goods). The sum of these prices, or units of exchange, comprises what we can call the “pricing supply of money,” Mp. There is also a known amount of units of account that will arise at a future date, due to existing debt contracts yet to be fulfilled. The standard of deferred payments, thus, can also be defined with some degree of certainty in the present and we can call this the “future pricing supply of money,” Mp´.
This approach to defining the money supply gives rise to several distinct quantities, only one of which has any bearing to the more commonly given measures. While the Mx supply is easily understood, both Mp and Mp´ are determined not by any monetary factor, but instead by the demand of individuals to purchase goods and services (whether on the current spot market or on some futures market in the past). Readers will see an affinity between this approach and Salerno (2006), whereby prices are not the result of the demand for money per se (as is commonly extrapolated from the quantity theory of money), but are rather the result of the demands for goods and services which in turn create the pricing money supplies, Mp and Mp´.
One implication of, and benefit from, using several “money” supplies is that it allows for an alternative method to look at how the purchasing power of the medium of exchange fluctuates over time. If, e.g., Mx < Mp, the value of the medium of exchange must rise to clear the market. Since some of the prices that comprise the supply of pricing units of money, Mp, are fixed at a pre-defined value (e.g., those resulting from a previous debt contract), either the prices of goods contained in Mp will fall, or the real value of the supply of the medium of exchange, Mx, will rise. Of course, these implications are just two sides of the same coin.
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InMateusz Benedyk is a PhD Candidate at the Faculty of Social Sciences, University of Wrocław and the President of Ludwig von Mises Institute Poland. The author would like to thank Mateusz Machaj and David Howden for their helpful comments. I was a summer research fellow in 2012. This chapter was inspired by Professor Salerno’s many contributions in the field of history of the Austrian school of economics and his investigations regarding the monetary theory. recent decades we have witnessed several debates on the legacy of Friedrich von Hayek in the realm of monetary policy. His writings have been both endorsed and attacked by economists from opposing branches of Austrian economics.For example Hayek was attacked for not seeing the merits of fractional reserve banking by Lawrence H. White, “Why Didn’t Hayek Favor Laissez Faire in Banking?” History of Political Economy 31, no. 4 (1999): 753–69; and for not blaming fractional reserve bankers for business cycles by Walter Block, Kenneth M.Garschina, “Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process,” Review of Austrian Economics 9, no. 1 (1996): 77–94. Part of the problem is that Hayek partially changed his mind throughout his life and gave different policy prescriptions in the 1970s than he did in 1930s.For the discussion of Hayek’s writings in 1970s and 1980s see G. R. Steele, “Hayek’s Theory of Money and Cycles: Retrospective and Reappraisal,” Quarterly Journal of Austrian Economics 8, no. 1 (2005): 3–14. Here we will deal primarily with the earlier works of Hayek. But even the interpretation of his major works on money, banking and business cycle from 1920s and 1930s poses some problems.
We would like to shed some light on the Hayekian analysis of different monetary institutions. Specifically, we want to clarify what the economic consequences of such institutions: fractional and one-hundred percent reserve banking; and various monetary policy norms of central banks.This list does not pretend to exhaust all of the Hayek’s insights in the field of money. It includes only the problems that created numerous controversies and rivalrous interpretations in the literature. More comprehensive study should include e.g., effects of various international monetary systems and the differences between central and free banking or between token and commodity money. Special attention will be given to the differences between constructs of pure money and business cycle theories as opposed to policy prescriptions. The first section discusses the relation between fractional-reserve banking and the business cycle. It also deals with Hayek’s opinions on one hundred percent reserve banking. In the second section we debate the claim of Hayek endorsing the monetary policy of stabilizing the level of nominal spending. Several concluding remarks are offered in the last section.
Fractional and One-Hundred Percent Reserve BankingIn Hayek’s view the contemporary organization of the banking sector was responsible for the cyclical fluctuations of the economy. He devoted the whole chapter of the Monetary Theory and the Trade Cycle to show that the expansion of credit by fractional-reserve banks must necessarily lead to unsustainable boom even if there is no central bank.Friedrich A. Hayek, “Monetary Theory and the Trade Cycle,” In: idem, Prices and Production and Other Works, ed. Joseph Salerno, Auburn 2008, pp. 73–103.
According to Hayek the magnitude of the bank’s credit expansion depends on its cash reserves. The crucial point is “that the ratio of reserves to deposits does not represent a constant magnitude, but, as experience shows, is itself variable.”Ibid., p. 91. If, for whatever reason, economic conditions improve and banks consider their cash reserve to be excessive, they will grant additional credit to their customers. “[F]or reasons of competition ... the bank that first feels the effect of an increased demand for credit cannot afford to reply by putting up its interest charges; for it would risk losing its best customers to other banks that had not yet experienced a similarly increased demand for credit.”Ibid., p. 93.
This expansion of credit occurres without corresponding growth of savings. Other banks cannot distinguish between deposits created out of new savings and the ones created without it. They will join the credit expansion, as money from other banks will be deposited in their company, and lower their growing reserve ratio. The effect of the process is that the money rate of interest is for the time being lower than the natural rate.
Only so long as the volume of circulating media is increasing can the money rate of interest be kept below the equilibrium rate; once it has ceased to increase, the money rate must … rise again to its natural level and thus render unprofitable … those investments which were created with the aid of additional credit.Ibid., p. 94.
Since fractional reserve banking is in Hayek’s view responsible for the business cycle, it’s hardly a surprise that he mentioned on several occasions the idea of one-hundred percent reserve banking. As early as 1925 he discussed the idea shortly in a review of Federal Reserve monetary policy after the crisis of 1920. Hayek wrote the following:
The older English theorists of the Currency School, who, as we already pointed out, understood the nature of cyclic fluctuations better than most of the economists who came after them, also hoped that cyclic swings could be prevented by their proposals for the regulation of note issues. … If the basic idea underlying the Peel’s Act were consistently implemented and a 100 per cent gold coverage were required for bank deposits as well as for bank notes, the problem of preventing depressions would be resolved in a drastic manner.Friedrich A. Hayek, “Monetary Policy in the United States after the Recovery from the Crisis of 1920,” In: Idem, Good Money. Part I, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 5, Indianapolis 2008, p. 111, n. 37.
A monetary system without business cycle seems like a desirable goal, but Hayek was not eager to advocate the idea of abolishment of fractional reserves. In Monetary Theory and the Trade Cycle Hayek stated clearly that in case of one hundred percent reserve banking:
[t]he stability of the economic system would be oFriedrich A. Hayek, Monetary Theory…, p. 103.btained at the price of curbing economic progress. The rate of interest would be constantly above the level maintained under the existing system. … The utilization of new inventions and the “realization of new combinations” would be made more difficult, and thus there would disappear a psychological incentive toward progress.
Hayek didn’t elaborate further on this point. It therefore seems unconvincing: why would capitalists earning a higher rate of interest on their capital be discouraged to innovate and invest? Shouldn’t a system where entrepreneurs make mistakes on a regular basis (malinvest during the business cycle) be more disruptive for innovators?On this point see: Joseph Salerno, “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Quarterly Journal of Austrian Economics 15, no. 1 (2012): 22–23, 37–38. Jesús Huerta de Soto thinks that “maybe it would be wiser to interpret the assertions Hayek made in 1929 (in Monetary Theory and the Trade Cycle) in the context of the lecture given before the Verein für Sozialpolitik. ... Hayek’s speech was subject to a rigorous examination by professors who were little inclined to accept conclusions they viewed as too original or revolutionary.”Jesús Huerta de Soto, Money, Bank Credit and Economic Cycles, translated by Melinda A. Stroup, Auburn 2006, pp. 470–71, n. 74.
Hayek returned to the idea of one hundred percent reserve banking in 1937 in the series of lectures published as Monetary Nationalism and International Stability. In the fifth lecture he reviewed briefly “The Chicago Plan of Banking Reform.”Friedrich A. Hayek, "Monetary Nationalism and International Stability," In: Idem, Prices and Production and Other Works, pp. 410–13. This time Hayek’s objections to the abolishment of fractional reserve banking were completely different:
The most serious question which it raises, however, is whether by abolishing deposit banking as we know it we would effectively prevent the principle on which it rests from manifesting itself in other forms. … [T]he question is whether, when we prevent it from appearing in its traditional form, we will not just drive it into other and less easily controllable forms. … The [Peel’s Banking] Act of 1844 was designed to control what then seemed to be the only important substitute for gold as a widely used medium of exchange and yet failed completely in its intention because of the rapid growth of bank deposits. Is it not possible that if similar restrictions to those placed on bank notes were now placed on the expansion of bank deposits, new forms of money substitutes would rapidly spring up or existing ones would assume increasing importance?Ibid., pp. 411–12.
This analysis does not mention any economic deficiencies connected with the system of one hundred percent reserve banking. The obstacle is of a practical nature — whether we will be able to stop the creation of new money substitutes that will take the place of bank notes and deposits.A description of these obstacles is a major part of Hayek’s discussion of the Chicago Plan. It’s therefore an overstatement to say that “in Monetary Nationalism and International Stability, [Hayek] changed his mind, proposed a constant money supply and advocated the demand for a 100-percent reserve requirement in banking” — Jesús Huerta de Soto, Money…, p. 470, n. 74. We may conclude here that Hayek saw the merits of advocating for an end of fractional-reserve banking — a seed of the business cycle in the contemporary economy — but never fully endorsed the program of one hundred percent reserve banking, pointing to problems of both a theoretical and practical nature.
Central Bank’s Policy PrescriptionsThe greatest controversies regarding Hayek’s stance on monetary theory arise from the central bank’s policy norms that Hayek allegedly proposed. Since we live (as Hayek did as well) in a world of central banks managing the fractional-reserve banking system, we may ask if there is something the monetary authorities can do to mitigate the business cycle.We have already discussed the possibility of central banks requiring banks to hold one hundred percent reserves on deposits, so we won’t mention the subject in this section. Recently Lawrence White stated:
Hayek’s business cycle theory led him to the conclusion that intertemporal price equilibrium is best maintained in a monetary economy by constancy of “the total money stream,” or in Fisherian terms, the money stock times its velocity of circulation, MV. Hayek was clear about his policy recommendations: the money stock M should vary to offset changes in the velocity of money V, but should be constant in the absence of changes in V.Lawrence H. White, “Did Hayek and Robbins Deepen the Great Depression?” Journal of Money, Credit and Banking 40, no. 4 (2008): 754–55, emphasis added.
White’s bold statements led Marius Gustavson to propose a ‘Hayek Rule’ — understood as keeping MV constant — as a norm for Federal Reserve’s policy in the 21st century.Marius Gustavson, The Hayek Rule: A New Monetary Policy Framework for the 21st Century, Reason Foundation Policy Study 389 (2010). Gustavson’s study includes references to White’s 2008 paper. Two questions arise:
(1) Did Hayek endorse such a policy?
(2) Does Hayek’s business cycle theory provide a justification for “Hayek Rule”?
To properly answer these questions it’s useful to consider the theoretical context of Hayek’s business cycle investigations. For Hayek the main puzzle was how to integrate the theory of business cycle into the general equilibrium theory.In Hayek’s words: “By ‘equilibrium theory’ we here primarily understand the modern theory of the general interdependence of all economic quantities, which has been most perfectly expressed by the Lausanne School of theoretical economics.” — Friedrich A. Hayek, Monetary Theory…, p. 19, n. 15. In other words: how it is possible that forces leading markets to clear fail to coordinate consumers’ preferences and producers’ decisions during the business cycle? Hayek’s view was that we should focus on the active role money plays in the economy. The introduction of money breaks the clear process of price formation in barter and makes it possible that “real” factors responsible for price formation will be for some time hindered by monetary factors.
Beginning in mid-1920s Hayek struggled to describe the active role money plays in price formation in a more detailed fashion.Between 1925–1929 Hayek was preparing a book on the subject titled Geldtheoretische Untersuchungen, which he never completed. Two articles Hayek published at the time were excerpts from the book: Intertemporal Price Equilibrium and Movements in the Value of Money (originally appeared in German in 1928) published in Good Money. Part I; The Paradox of Saving (published in German in 1929) published inter alia in Prices and Production and Other Works. The English translation of the unfinished manuscript of the Geldtheoretische Untersuchungen has been recently published as Investigations into Monetary Theory, first chapter of: Friedrich A. Hayek, Business Cycles. Part II, ed. Hansjoerg Klausinger, The Collected Works of F.A. Hayek, vol. 8, Chicago 2012. He came up with the idea of “neutral money” — a set of conditions needed for the money to be neutral toward prices. His first idea was that the supply of money must be constant in order to be neutral. In the 1930s he changed his mind and advocated the idea that money may be neutral when the effective money stream (MV) is constant.This evolution of Hayek’s thought is well documented in another paper of Lawrence H. White, “Hayek’s Monetary Theory and Policy: A Critical Reconstruction,” Journal of Money, Credit and Banking 31, no. 1 (1999): 109–20. Does it follow that Hayek advocated the monetary policy of stabilizing MV? Not necessarily.
In the second edition of Hayek’s Prices and ProductionFriedrich A. Hayek, Prices and Production, [In:] Idem, Prices and Production and Other Works, pp. 301–04. and in a paper from 1933 titled On ‘Neutral’ MoneyFriedrich A. Hayek, On ‘Neutral’ Money, [In:] Idem, Good Money. Part I, pp. 228–31. we find some clarifications as to the proper relation between the theoretical concept of neutral money and the prescribed monetary policy. In the latter Hayek wrote: “The concept of neutral money was designed to serve as an instrument for theoretical analysis, and should not in any way be set up as a norm for monetary policy, at least in the first instance.”Ibid., p. 228. Hayek stressed the monetary policy can have different goals than getting close to the state of neutral money. He also mentioned the stable MV is not the sufficient condition for money to be neutral.
It is quite conceivable that a distortion of relative prices and a misdirection of production by monetary influences could only be avoided if, first, the total money stream remained constant, and second, all prices were completely flexible, and, third, all long term contracts were based on a correct anticipation of future price movements. This would mean that, if the second and third conditions are not given, the ideal could not be realized by any kind of monetary policy.Friedrich A. Hayek, Prices and Production, p. 304. Almost identical statement in: Friedrich A. Hayek, On ‘Neutral’ Money, p. 230.
Lack of perfect foresight regarding the future value of money and any degree of price stickiness make neutral money an impossibility. One could argue that even though we cannot reach perfection, it is still a good idea to pursue the ideal. But Hayek saw other problems with stabilizing the level of nominal expenditures. In Prices and Production he briefly discussed the problems with changing money velocity due to hoarding, dishoarding, changes in business organization etc.
For, in order to eliminate all monetary influences on the formation of prices and the structure of production, it would not be sufficient merely quantitatively to adapt the supply of money to these changes in demand, it would be necessary also to see that it came into the hands of those who actually require it, i.e., to that part of the system where that change in business organization or the habits of payment had taken place. It is conceivable that this could be managed in the case of an increase of demand. It is clear that it would be still more difficult in the case of a reduction. But quite apart from this particular difficulty which, from the point of view of pure theory, may not prove insuperable, it should be clear that only to satisfy the legitimate demand for money in this sense, and otherwise to leave the amount of the circulation unchanged, can never be a practical maxim of currency policy.Friedrich A. Hayek, Prices and Production, p. 297.
For Hayek it was clear that pumping money in any place in the economy as a reaction for increased demand for money in another place would not suffice to get closer to money neutrality. The money would have to be given to exactly those persons whose demand has increased. Hayek understood well that giving more money to a single person will result in a series of small adjustments of incomes and spending habits of many individuals cooperating with the agent, who got the money in the first place.Example of such an analysis can be found in: Friedrich A. Hayek, Monetary Nationalism…, pp. 353–59. Increasing the quantity of money in places where the demand for money remained unchangedFor example when central bank buys large quantities of securities in a Quantitative Easing program. would entail another round of necessary adjustments of incomes and spending patterns without accommodating the original change in money velocity.
Apart from abstract arguments about problems with implementation of stable MV policy Hayek specifically argued against monetary policy measures to combat deflation during the Great Depression as late as 1932. In a preface to English translation of Monetary Theory and the Trade Cycle Hayek wrote:
[The existence of deflationary process] does not, by any means, necessarily mean that the deflation is the original cause of our difficulties or that we could overcome these difficulties by compensating for the deflationary tendencies, at present operative in our economic system, by forcing more money into circulation. … To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection — a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end.Friedrich A. Hayek, Monetary Theory…, pp. 5, 6–7.
Not only did Hayek differentiate between theoretical concepts and policy norms, find practical problems in stabilizing MV and explicitly rejected fighting the recession with money creation, but he actually proposed another policy norm in the writings on money neutrality and constant flow of spending. In Prices and Production he mentions only that “Hence the only practical maxim for monetary policy to be derived from our considerations is probably the negative one that the simple fact of an increase of production and trade forms no justification for an expansion of credit, and that—save in an acute crisis—bankers need not be afraid to harm production by over-caution.”Friedrich A. Hayek, Prices and Production, p. 298. In On ‘Neutral’ Money Hayek dared to propose a more specific solution:
[I]t seems to me that the stabilization of some average of the prices of the original factors of production would probably provide the most practicable norm for a conscious regulation of the quantity of money.Friedrich A. Hayek, On ‘Neutral’ Money, p. 231.
In light of these passagesInterestingly White quoted the same passage from “On ‘Neutral Money’” in Lawrence H. White, Hayek’s Monetary Theory…, p. 117. it seems that White’s statement about Hayek’s clear policy recommendation of stabilizing the level of nominal spending is unfounded — Hayek explicitly endorsed another rule and found problems with implementing targeted nominal spending rule.
There are big differences between stabilizing MV and stabilizing the prices of factors of production. Proponents of stabilizing MV claim that a shrinking nominal GDP is an indication that the central bank should increase the money supply (we need to remember that NGDP is only an approximation of the level of spending, since GDP excludes transactions of goods that are not final. If we want to measure the level of spending properly we should include all money transactions). A proponent of stabilizing MV could argue that even if money expenditures rose during the boom phase, it would be unwise to let it shrink to the pre-boom level. Therefore Quantitative Easing I in the USA would be justified since NGDP was falling between Q3 2008 and Q2 2009.According to “The Economist”: “Hayek believed the central bank should aim to stabilise nominal incomes. On that basis Mr [Lawrence] White thinks the Fed was right to pursue the first round of quantitative easing, since nominal GDP was falling, but wrong to pursue a second round with activity recovering.”
A proponent of stabilizing the prices of the factors of production could argue that it’s unwise to maintain prices at the inflated boom level. Lower input prices would actually stimulate the demand by entrepreneurs to start investing again. Hence, if we look at the level of factors of production prices we see a different story. Let’s take for example Producer Price Index. At the end of the previous recession — in 2002 the index (1982=100) stood at around 100 points. At the bottom of recession in February 2009 it stood at around 160 points, so it would indicate that monetary policy was extremely accommodative.All the data is taken from Federal Reserve Bank of St. Louis.
There is also another “Hayekian” problem connected with advocating QE: can the central bank actually gather and process all the information needed to fight the shrinking money expenditures in the same manner as private banks would do.For the discussion see: William N. Butos, “Monetary Orders and Institutions: A Hayekian Perspective,” Quarterly Journal of Austrian Economics 15, no. 3 (2012): 259–76.
ConclusionsFriedrich von Hayek rarely stated clearly his monetary policy proposals. He was mostly interested in the field of pure monetary theory (at least in the 1930s). It seems to us that his theories of money and business cycle can give good arguments for people advocating one hundred percent reserve banking. When it comes to monetary policy of the central bank Hayek briefly proposed the idea of stabilizing the prices of factors of production, but did not elaborate on why this should be the best policy.
Perhaps it is unfortunate Hayek used the framework of general equilibrium theory to investigate the problem of the business cycle.For other problems associated with Hayek’s methodological choices see: Joseph Salerno, "Mises and Hayek Dehomogenized," Review of Austrian Economics 6, No. 2 (1993), pp. 113–46. This might lead many to confuse the highly abstract and unrealistic conditions of general equilibrium with the desired state of monetary affairs, whereas occurrence of these conditions would actually mean that money is not needed in the economy at all.Ludwig von Mises, Human Action. A Treatise on Economics, Auburn 1998, pp. 250–51. Only late in his life Hayek managed to incorporate his more dynamic view on economy regarding competition and entrepreneurial discoveries into the money and the area of business cycles. In Denationalization of MoneyFriedrich A. Hayek, The Denationalization of Money: An Analysis of the Theory and Practice of Concurrent Currencies, [In:] Idem, Good Money. Part II, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 6, Indianapolis 2008, pp. 128–229. he finally proposed the idea of opening the sphere of money and banking to the competition instead of leaving it to the plans of bureaucrats.
In a lecture from October 1977 Hayek stated:
The interesting fact is that what I have called the monopoly of government of issuing money has not only deprived us of good money but has also deprived us of the only process by which we can find out what would be good money. We do not even quite know what exact qualities we want because in the two thousand years in which we have used coins and other money, we have never been allowed to experiment with it, we have never been given a chance to find out what the best kind of money would be.Friedrich A. Hayek, Toward a Free Market Monetary System, [In:] Idem, Good Money. Part II, p. 234.
This call for a competition in the field of money seems to me the best example of a truly Hayekian monetary policy.
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In this article IPhilipp Bagus is professor of economics in the Department of Applied Economics I at Universidad Rey Juan Carlos, Madrid, Spain. Professor Bagus was a summer research fellow in 2006 and 2009. This chapter is an extension of the theoretical perspective developed in the article “The Quality of Money,” for which the he received very valuable comments by Professor Salerno. The author wishes to thank David Howden for excellent comments on the present article. Joseph T. Salerno has not only been a very important mentor and friend for me. With his humor, positive attitude, and generous support he is a precious asset for Mises Institute summer fellows such as I was for two years. Thank you, Joe. With his articulate, intransigent and courageous support of sound money, he is an invaluable asset for the Austrian school. He not only always stands up to defend the theoretical advances of Mises and Rothbard, he also has added to the corpus of Austrian theory. would like to continue in the tradition of Mises, Rothbard, and Salerno to analyze how sound monetary regimes affect the quality of money. The value of money, as of any other good, depends on its usefulness or quality in the eye of its user. Money’s quality can be defined as “the capacity of money, as perceived by actors, to fulfill its main functions, namely to serve as a medium of exchange, as a store of wealth, and as an accounting unit” (Bagus 2009, pp. 22–23). Changes in money’s quality affect the demand for money and, consequently, its purchasing power. The quality of a monetary regime, in turn, may be defined as the capacity of a monetary system to provide an institutional framework for a good medium of exchange, store of wealth, and accounting unit.
While the quality of a monetary system or regime is perceived subjectively by actors, there are several objective characteristics that tend to influence this perception. In a trial and error process actors normally do not base their perceptions of their institutional framework on poor whims, as they suffer the consequences of poor judgment. Guided by the objective qualities of monetary systems, actors tend to benefit as they can hedge against depreciation or gain from appreciation of the currency. They can protect their monetary wealth more efficiently. In this article we will analyze these objective qualities of “good” monetary systems.
Connection Between the Quality of Monetary Regimes and Money’s Purchasing PowerThe quality of monetary systems has been neglected in the literature.Bagus (2009) discusses the quality of money in general. Bagus and Schiml (2009, 2010) and Bagus and Howden (2009a, 2009b) analyze the quality of the currency unit through the central bank’s balance sheet. Bagus and Howden (2011) point out that Iceland’s central bank adopted an explicit lender of last resort function that deteriorated the quality of Iceland’s monetary regime. Comparative analyses of monetary systems from an institutional perspective are rare.The mainstream focuses narrowly on the aspect of central bank independence and mostly neglects all other aspects. Neither do textbooks delve into the qualities of monetary systems, an exception being White (1999). Rather, monetary policies within the setting of our current fiat money systems are analyzed, sometimes enriched by a narrative of the evolution of some historical monetary regimes, yet without providing a comparison of them. The neglect of a comparison might be caused by the belief that we have found the best monetary system. Fiat monetary systems are controlled by a central bank and can be manipulated to provide a supposedly perfect money fulfilling its functions as a medium of exchange, store of value, and unit of account. Moreover, qualities of monetary regimes are hardly measurable or usable in econometric analysis which makes the question unattractive for modern econometric research. Recently, the financial crisis has led to doubts about the set up of the financial system and the monetary system in particular, which makes a comparative analysis of the monetary system timely.
The quality of monetary systems influences the demand for money and, thereby, money’s purchasing power. While much emphasis has been put on the quantity of money and its influences on money’s purchasing power, money’s quality, and the quality of monetary systems are equally important for money’s price, if not more so. In fact, money’s quantity may be interpreted as one of several characteristics that determine money’s quality and the likelihood and capacity of monetary regimes to increase or decrease money’s quantity is one of the important characteristics of the quality of a monetary regime.
Changes in monetary systems may lead to sudden changes in money’s quality and purchasing power. More specifically, a change in the monetary regime may lead to a pronounced change in the valuation of money in relation to other goods. Imagine that actors regard the new monetary system as a worse provider of a medium of exchange, store of wealth, and accounting unit than the preceding system. Actors value money less intensely with respect to other goods. This may be illustrated by an example of an individual’s value scale before and after the regime changes.
Value scale before regime change...20th 5th $10 bill21st Hamburger meal22nd 6th $10 bill23rd cheeseburger24th 7th $10 bill25th Bottle red wine26th Bottle white wine
In our example our person having seven $10 bills in his pocket would not buy wine priced at $10. However, she would give up one $10 bill for a cheeseburger that she values higher than the 7th bill she owns. She would also spend the 6th bill for the hamburger meal valued higher. Let us look at the value scale of the regime change by which the perception of money’s quality falls. The new monetary regime is in the eyes of actors providing a worse medium of exchange, store of value, and unit of account than the preceding regime.
Value scale after regime change...20th Hamburger meal21st Cheeseburger22nd Bottle red win23rd 5th $1024th Bottle white wine 25th6th $1026th 7th $10
We see that goods tend now to be ranked higher on the value scale relative to money units than before.Salerno (2006, p. 52) refers in this context to “the relative rankings of goods and of money among market participants.” This relative ranking is immediately and potentially strongly affected by changes in monetary regimes. After the change, the person would give $10 for a bottle of white wine. She would also buy red wine, cheeseburger, or a hamburger meal with $10. The prices of these good would tend to increase. Without any increase in the quantity of money, money is valued less in comparison to goods due to the qualitative deterioration of the monetary regime. Money’s purchasing power decreases. Brisk changes in purchasing power may be caused by a change in monetary regime. This gives us reason to analyze the quality of different monetary regimes and how changes to them influence their quality.
Qualities of Monetary RegimesMonetary regimes provide a framework within which money fulfills its functions. As the unit of account function is fulfilled by nearly all monetary systems equally well and it is impaired only in extreme situations, we will concentrate of the characteristics of good medium of exchange and store of value.As Röpke states, referring to the German 1922–1923 hyperinflation (1954, p. 121), money’s functions often disappear in a certain order. First, money ceases to be used as storage of wealth, when actors start to think that it continuously will lose value. Second, when the fluctuations of the value of money increase and money loses its value faster, money loses its function as a unit of account. People started to calculate in other units. In 1923, they started to calculate in gold and even the German government calculated its taxes in gold mark. The last function that is lost in a hyperinflation is the function as medium of exchange. People progressively started to use foreign exchange to transact (Bresciani-Turroni 1968, p. 89). In November 1923, the mark was completely abandoned as a medium of exchange.
We will begin with the characteristics of a good medium of exchange and the influence on it by a monetary regime. A good medium of exchange has low storage and transportation costs. Other properties are easy handling, durability, divisibility, resistance to tarnish, homogeneity, and ease in recognition. These properties hardly change today as paper-based fiat standards have eased the physical usability of the monetary unit, as well as the costs to provide it. In commodity standards these qualities may change when society switches from one commodity to the other. For instance, a change from a silver to a gold standard may imply an increase in the quality of money as gold is more durable than silver, which suffers from oxidization. A more relevant property of a medium of exchange is the number of users. More users imply more demand for the medium of exchange. As more people accept it in trade, the medium of exchange is more useful. Changes in monetary systems may increase the number of users and thereby the quality of the money. For instance, at the end of the nineteenth century ever more countries left their silver standards to adopt the gold standard. The increased use of gold as a currency increased its quality as money. Similarly a switch from Germany’s Deutsche mark to the more widely used Euro or from national fiat currencies to a world fiat money increases the quality of money as a medium of exchange. The tendency of an increase in the quality of money as a medium of exchange is, however, counteracted by possible decreases in its functionality as a store of value.
Ironically, maybe the most important characteristic for a medium of exchange is the existence of ample non-monetary demand for the money as either a consumer good or a factor of production. The demand for other, non-monetary purposes assures that there exist unsatisfied wants which are intense and permanent (Menger 1892, p. 5). The non-monetary demand serves as “insurance” for the money holder as it stabilizes its value due the constant demand.The main disadvantage of Bitcoin is that it virtually lacks such an “insurance.” If the money is demonetized, in the worst case scenario, by the government or because people turn to another medium of exchange, it will still retain its use value. A money with a very low or no non-monetary demand loses almost all its value in a demonetization. Its value is totally dependent on the monetary demand for the good and the confidence in it. Its value tends to be more volatile than the value of a money that has a stabilizing non-monetary demand. If the insurance breaks away even without any change or expected change in money’s quantity, its quality is reduced, leading to a tendency for its purchasing power to decrease. This is so, because the risk of demonetization and a complete loss of value for money holders without a non-monetary demand insurance is greater than for a monetary unit with a use value. Without this insurance, the demand for money tends to fall, leading to a fall in purchasing power. Therefore, if there is a switch from a monetary regime with ample non-monetary demand such as a gold standard to a monetary regime without a relevant non-monetary demand such as a fiat money standard, the quality of the money regime is reduced, independent of (expected) quantity changes.
The store of value function is another important function of money. There are several characteristics of a good store of wealth.
One of its most important characteristics is the possibility of increases in its quantity. Different monetary regimes allow for different mechanisms to increase the quantity of money, thereby influencing money’s quality. Thus, monetary systems may set strict and less strict limits for increases in the money supply. A switch from a monetary system that strictly limits the quantity of money and its possible increases to a monetary system that makes increases in the money supply more likely and less predictable implies a deterioration of the quality of money.
For the quality of the monetary regime the stability of the financial system it fosters is also important. There are monetary regimes that are more prone to generate business cycles, over-indebtedness and illiquidity than other regimes. Business cycles, over-indebtedness and illiquidity may provoke interventions and bailouts on part of the government or monetary authorities. In the wake of the bailouts the quantity of money is often increased, or even the quality of the monetary system is diluted. For instance, redemption into specie might be suspended or a new monetary order may emerge (e.g., the introduction of a world fiat money). Consequently, money’s quality is affected negatively by a change toward a more instable monetary system.
The probability of demonetization is a related factor influencing money’s quality. Some monetary systems are more prone to demonetization than others. Systems that come along with an instable financial sector may lead to collapse or public bailouts that endanger the confidence in the monetary unit. Another factor that affects money as a store of value is the potential for general manipulation by the government. Interventions by the government often decrease the quality of money in its own favor by increases in money’s quantity or through a deterioration in the reserves backing it. A government could, for instance, confiscate the gold reserves of its fiat currency to pay for expenditures thereby decreasing the quality of money. Some systems are less prone to government intervention than others where the government has a stronger foothold in the system.Herbener (2002, p. 11) points out that the government is likely to use those footholds to switch to ever more interventionary monetary regimes: Given any foothold in monetary affairs, the state would always move step by step to an inflationary monetary regime, the exercise of which would eventually cripple, if not destroy, the market itself. Given the power to coin gold, the state would come to suppress the coinage of private mints by waiving its mintage fee. Once securely dominant as a money producer, it would make its coins legal tender, leading to the possibility of seigniorage from debasement. Likewise, if the state had the power to issue money substitutes, it would suppress the issue by private banks by waiving the printing or accounting fees. Once securely dominant as a money substitute producer, the state would rescind redemption to capture the revenue from inflating the stock of its, now, fiat paper money. The more independent a monetary regime is from the government, the higher is the quality of the currency. A switch to a monetary system more dependent or open to interventions by a government means a deterioration of money’s quality.
A 100 Percent and Free Gold StandardI will now analyze the quality of money in different monetary regimes.For an analysis of the devolution of monetary systems see also Hoppe’s (1994) analysis. Hoppe shows how money and credit deteriorates as a result of government intervention. Rittershausen (1962, p. 334) and Veit (1969, p. 88) offer classifications of monetary regimes. Rittershausen focuses on the legal tender and emphasizes that systems were beside specie also bank liabilities are legal tender diminish the quality of the currency. His classification is similar to mine. I will start with the highest quality monetary regime and work my way downward to systems of lower quality. In a 100 percent gold standard, only gold (or 100 percent backed gold certificates) is money and banks hold 100 percent reserves for their demand deposits. The following analysis applies mutatis mutandis to other 100 percent commodity standards such as a 100 percent silver standard.Similary, gold and silver may be in use simultaneously. I picked the example of gold out for two reasons: the historic importance of the gold standard and its unique qualities.
A 100 percent and free gold standard offers all the qualities of good money. Gold has a relatively high value in a small size, thus reducing storage and transportation costs. It is easy to handle in exchange and easily divisible. It is homogenous. Its grade is easy recognizable and it is resistant to tarnish. There exists a tremendous non-monetary demand for gold all over the world. Gold is also relatively hoardable as it can be bought and sold in large amounts without losses. Moreover, the production costs of gold are very high, as is the existing gold stock. Anyone can mint coins; the government has no foothold in the monetary system. Gold is, thus, difficult to manipulate by governments. Only by outright coin clipping or by changing the monetary regime itself can the government manipulate gold. Furthermore, these two kinds of gold manipulations can face strong resistance, as they are highly visible when gold is in the hands of the citizenry.
In addition, in a 100 percent gold standard there is unlimited and unconditional redemption. The banking system is per definitionem liquid; it cannot be brought down by a bank run, as there are 100 percent reserves. The economy and the government are less likely to have negative effects on the quality of money than in other regimes. This is so, because a 100 percent gold standard strengthens the economy and puts limits on the spending of government. As there is by definition no credit expansion and no artificial reduction of interest rates, there is no credit created business cycle. And as taxation is unpopular and government debt cannot be monetized but has to be paid out of taxes, government has to be fiscally more responsible. The tendency toward slowly falling prices in such a system when economic growth exceeds increases in gold production makes debts less attractive.For an analysis of growth deflation see Salerno (2003). Overindebtedness is therefore quite unlikely.
In a free 100 percent gold standard there exists also monetary competition. No one imposes gold as money and other monies can compete freely with it. The competition in the production of money ensures the quality of money. Bad money is pushed out of the market by good money (Hayek 1978, pp. 1–3).For the advantages of currency competition see Klein (1974) and Vaubel (1977, 1988). Only the money that best fulfills and keeps fulfilling the function as unit of account, storage of wealth and a medium of exchange prevails under free competition. There is no central bank, no monetary monopoly or legal tender laws. Hence, there will be a discovery process for the best currency. Different issuers in a trial and error process compete in offering currencies to their customers. Inefficient producers of money disappear. Only the efficient producers of money that produce money in a quantity and quality fitting consumers’ wishes best will survive. As money users usually prefer a stable currency, there will be a competitive process toward stable currencies.
Lastly, the monetary system tends to be stable. 100 percent reserves on demand deposits ensure that no bank runs on demand deposits will lead to a banking crisis. Moreover, there are harsh limits to other types of maturity mismatching, i.e., borrowing short and lending long (Bagus 2010; Bagus and Howden 2010). Borrowing short and lending long is a very risky business. Competitors, by assuming short-term debts and not rolling over the debt, might drive banks into bankruptcy. Speculators may also short bank stocks and try to instigate a run on the short-term liabilities of banks. Customers will attend those banks that limit this risky behavior. In short, in a free market maturity mismatching is strictly limited and there is no reason why banks would systematically err about the amount of short-term renewable savings. More importantly, the promoters of excessive maturity mismatching such as government guarantees for banks are limited, or absent, as there is no central bank that could roll over short-term debts nor credit expansion increasing constantly the money supply making a roll-over of short-term debts easier. The financial system in a 100 percent gold standard is, therefore, very stable. The chance that governments will be tempted to bailout the financial system diluting the value of money or the monetary regime is reduced.
Fractional Gold StandardsI will now analyze fractional reserve gold standards with different properties. I will not explore every theoretical possibility but will concentrate on the historical monetary regimes. The first fractional reserve standard is a gold coin standard.Again, the analysis applies mutatis mutandis to other fractional reserve commodity standards. In a gold coin standard banks hold fractional reserves and gold coins are in circulation. A gold coin standard contains the same properties in regard to its functions as a medium of exchange as a 100 percent gold standard. Gold is not perishable, homogeneous, has a great value in a small bulk, etc.
The main difference concerning the quality of the money, though, comes with money’s function as a store of wealth. In a gold coin standard, money is easier to manipulate for governments than in a 100 percent gold standard, as the government typically holds the monopoly of the mint. In addition, banks are allowed to produce fiduciary media, i.e., money substitutes not backed by gold. The banking system does not necessarily have to hold 100 percent reserves, as credit expansion is possible. Credit expansion, by causing business cycles, weakens the economy and helps to monetize government debts. In a recession, there is the danger of government bailouts diluting money’s value. Recessions may also be used as a pretext to increase government’s foothold in the economy, for instance by installing a central bank. If a central bank is installed, the quality of money falls even more, as this agency is a foothold of the government into the monetary system that is likely to reduce the quality of money further.
Moreover, credit expansion serves as a promoter of maturity mismatching, i.e., borrowing short and lending long. In the case of roll over problems of short-term debts, banks may use their own deposits as a substitute for financing. In addition, credit expansion tends to increase the money supply which reduces the risk of maturity mismatching. The financial system becomes more unstable by the tendency for excessive maturity mismatching. This makes a government bailout implying a deterioration of the money standard more likely.
Furthermore, an important difference of a fractional gold standard and a 100 percent gold standard is the effect of increases in the quantity of money on its quality. When in a 100 percent gold standard new gold is mined, this gold naturally is of the same quality as the old money. The quality does not deteriorate. Yet, when in a fractional gold standard, the amount of fiduciary media, i.e., paper money, increases, the quality of the currency decreases, as there are less gold reserves per monetary unit. The reserve ratio shrinks and the average backing of the currency deteriorates.
Gold Bullion StandardThe gold bullion standard tends to emerge from a gold coin standard. When in a gold coin standard, credit expansion creates recurrent banking crisis, and banks tend to press for the installation of a lender of last resort, the central bank. At the same time, banks are interested in a reduction of coins in circulation which is realized in a gold bullion standard, where the government does not mint coins. Typically, the gold reserves are centralized in a central bank. The currency is backed by gold bullion and the reserves centralized in a central bank. The currency can be exchanged against bullion at a fixed rate. Gold coins likely disappear from circulation.
In such a system the quality of money is reduced vis-à-vis a gold coin standard. It is more difficult to hoard gold as only bullion can be exchanged against currency. Due to the difficulties of redeeming and transporting bullion, less currency will be redeemed into gold and gold will practically disappear from day-to-day transactions. Consequently, banks can reduce their gold reserves. This allows for greater credit expansion, which, via business cycles, weakens the economy and helps to monetize government debt. As banks tend to reduce their reserves, they become more illiquid. Greater credit expansion and the introduction of a central bank reduce also the risk of maturity mismatching. Excessive maturity mismatching adds to the instability of the financial system. The higher probability of bailouts and further denigration of the regime deteriorates the quality of the currency.
As there is a lower amount of gold in the hands of the public it is easier for the government to suspend redemption altogether without leading to a double standard and facing the resistance of people to hand over their gold. Thus, the government can manipulate the money and deteriorate the money standard easier.
Gold Exchange StandardThe next step down in the quality of monetary standards is a gold exchange standard. A gold exchange standard is a fixed exchange rate system like the Bretton Woods system. Currencies are pegged at a fixed rate with a main currency that can be redeemed into gold bullion. Only central banks can redeem one currency into gold bullion through the main central bank which was the case during the Bretton Woods era with the Federal Reserve System.
A gold exchange standard leads to a further centralization of gold reserves and allows the banking system outside the main country to expand credit on top of the main currency. The main banking system also is likely to use its privileged position in order to expand credit. The system sows the seeds of its own collapse if the main country expands credit, thus imposing a cost on the rest. The exploitation of this position will then meet the resistance of the other countries who start to demand redemption as happened in the case of Bretton Woods, when the French government demanded payment in gold.
As a consequence of a higher capacity for credit expansion, business cycles will become more volatile, harming the economy. In addition, monetization of debt on a larger scale becomes possible. Maturity mismatching increases and the financial system grows more unstable increasing the chance of diluting bailouts. The tendency toward price inflation also increases, which in turn incentivizes people to take on debts. The population’s day-to-day connection with gold becomes looser and less resistance will be felt when the connection is cut by the government altogether.
It should be pointed out that becoming the main currency in a gold exchange standard may in some sense increase the quality of this main currency. It is very profitable to be an international reserve central bank (Rittershausen 1962, p. 408). Other central banks hold reserves of the main currency at very low interest rates. Other central banks must fear devaluations that would imply losses in their assets. When a currency becomes the main currency it implies therefore an increase in its quality. Other economic agents are more likely to accept and hold this currency.
Within these fractional reserve standards we may distinguish between systems where the unit of account and medium of exchange are separated and those where they coincide. In systems where unit of account and medium of exchange are separated, people calculate in a currency such as gold but pay also with another medium of exchange such as bank notes or deposits. These notes and deposits may have a discount in relation to payments in specie. Therefore, a credit expansion may lead to a higher discount leaving unharmed the integrity of the gold currency. Prices denominated in bank notes increase but not denominated in specie. If, on the other hand, bank notes and deposits have to be accepted at par due to legal tender laws, the quality of the system decreases. Credit expansion in this case cannot lead to a discount anymore but deteriorates the quality of specie as prices denominated in gold increase.
Fiat Paper Money StandardA brisk change in the quality of the monetary regime occurs when redemption is finally suspended altogether leading to a fiat paper currency. In a fiat paper money standard as the world has been on since 1971, not even central banks are able to redeem the currency against bullion. There is no guarantee anymore to receive any specific amount of gold for the currency. Hence, the quality of the money has declined.The fall in the quality of money helps to explain historical price inflations. When the U.S. went off the gold standard in March 1933, wholesale price soared 14 percent over 1933 and 31 percent by 1937. When the U.S. went off the gold reserve standard (the Bretton Woods system) in August 1971, wholesale price increased 4.35 percent during the rest of the year, more than 13 percent between 1972 and 1973, and over 34 percent between 1972 and 1974 (Hazlitt 1978, p. 76).
There is a wide divide between redeemable claims to gold as in the gold standards discussed above and unredeemable paper money. Unredeemable paper money presents a claim on something that is not specified. Fiat paper money fluctuates in value according to the holder’s belief of what the fiat money will be able to purchase. This estimation may fall very low and easily to zero. It is completely dependent on trust. If trust evaporates its value may well fall to zero, without dramatic changes in the money’s quantity.
The capacity of irredeemable paper money to serve as a store of wealth is dominated by this uncertainty. Nothing of this sort happens with a (convertible) money certificate that, for instance, can be exchanged at any moment against gold. As Rist (1966, p. 200) summarizes: “In short, convertibility is not a mere device for limiting quantity; convertibility gives notes legal and economic qualities which paper money does not possess, and which are independent of quantity.” Therefore, when the redemption of bank notes and deposits in a gold standard is suspended, the quality of money, from one second to the next, is reduced (independently from what might happen to money’s quantity).
Once redemption is suspended, there is no safety net for the value of the currency to fall back to. Money is not connected any longer with the industrial demand for gold. The “insurance” of a strong industrial demand for the money holder is gone.One might argue that “de facto” redemption, i.e., interventions of the central bank selling its assets are an insurance. However, there is no legal insurance or security whatsoever that central banks will intervene at the point of time the money holder wants.
Production costs of new paper money are very low, increasing the likelihood of increases in the money supply. Moreover, as redemption is suspended, the last control against government manipulation is gone. The floodgates for governmental manipulation of the money supply are open. Now the only restriction for government is its own will to put a limit on the production of additional money. These limits are typically formalized through the statutes and mandates of the central bank.
As a central bank can print an unlimited amount of money and bail out banks, moral hazard ensues. Maturity mismatching increases and reserve ratios are reduced. Credit expansion leads to more volatile business cycles harming the economy. The monetization of government debts by using the printing press has become easier. The financial system becomes even more fragile than before. Government bailouts become more likely and deteriorate the quality of money. As a consequence, money practically loses its function as a good store of wealth. Price inflation becomes a feature of everyday life. As people become accustomed to increasing prices, they start to incur more debt. Both the indebtedness and fragility of the economy increase. Thus, at the instant the monetary system is deteriorated to fiat paper money system, the quality of money declines sharply.
Switching Monetary Regimes and Money’s Purchasing PowerChanges in the quality of money can be made within a certain monetary regime and by changing the monetary regime. Any move up the qualitative ladder explained above from the bottom to the top, i.e., from a fiat paper money, to a gold exchange standard, to a gold bullion standard, to a gold coin standard to a 100 percent free gold standard implies a substantial improvement in quality. Any move down the qualitative ladder implies a deterioration of the quality of money and a tendency for price inflation. Downward movements have been more common in history. Especially in preparation of or during war efforts, monetary regimes were often changed for the worse (Rittershausen 1962, p. 366).
Improvements in monetary regimes have occurred in history. For instance, resumptions of specie payments, i.e., a change from a fiat paper money to some variant of a gold standard have occurred in history at various times; especially when specie payment was suspended during war and later resumed. Examples are the resumption of specie payment in Great Britain after the Napoleonic Wars and after World War I, as well as the resumption of specie payment after the U.S. Civil War in 1879. When it is expected that specie payment will be resumed, people expect the quality of money to increase and money’s price can rise immediately. This is probably one cause of the price deflation in the U.S. before the resumption of specie payment in 1879 (Bagus 2015). Another example is Peel’s Bank Act of 1844 which prohibited the issue of unbacked bank notes. The failure of Peel’s Bank Act was to not include bank deposits in the provision. The introduction of a 100 percent reserve ratio for demand deposits as well, would have increased the quality of the monetary regime strongly.
In general, however, the evolution has been downward from gold standards of a higher quality to gold standards of a lower quality and finally to fiat money standards. In fact, once we step down from a 100 percent gold standard, the seeds are sown for a progressive deterioration of the money regime. Government gets a foothold in the monetary system. Credit expansion by the central bank lead to excessive maturity mismatching, overindebtedness, and financial instability. In the crisis caused by these monetary regimes, bailouts tend to occur leading to higher government debts which are later monetized. In theses crises the regime is also often denigrated. For instance, redemption of specie payments may be suspended in a banking crisis.
ConclusionBeside money’s quantity also its quality influences its purchasing power. In this paper we have analyzed the quality of monetary regimes which consists in providing an institutional framework for a good medium of exchange, store of value and medium of account. Changes in monetary regimes may lead to substantial changes in money’s quality and thereby affect money’s demand and purchasing power. The highest quality regime contains a 100 percent gold standard. Fractional-reserve gold standards contain the seeds of their own deterioration, leading via credit expansion to economic and banking crisis. Via progressive government intervention and centralization of reserves a gold coin standard deteriorates into a gold bullion standard and a gold exchange standard.
The switch from a gold exchange standard to a fiat paper standard is a watershed. There is no non-monetary demand for the money unit anymore. Its value is solely maintained by trust and confidence while the insurance of an ample non-monetary demand has vanished. Government and central banking control monetary affairs totally. Recurrent recessions and bailouts of the financial system become likely, deteriorating the quality of money. Future research may focus more on the qualities of different monetary regimes and how their switch affects the quality of money and also economic growth. A switch to a higher quality regime of money in a recession may positively affect confidence and economic growth.
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——. 2006. “A Simple Model of the Theory of Money Prices.” Quarterly Journal of Austrian Economics 9(4): 39–55.
——. 2010. Money, Sound and Unsound. Auburn, Ala.: Mises Institute.
Vaubel, R. 1977. “Free Currency Competition.” Review of World Economics 113 (3): 435–61.
Vaubel, R. 1986. “Currency Competition vs. Government Money Monopolies.” Cato Journal 5(3): 927–47.
Veit, Otto. 1969. Grundriß der Währungspolitik. 3rd ed. Frankfurt am Main: Fritz Knapp.
White, Lawrence H. 1999. The Theory of Monetary Institutions. Malden, Mass.: Blackwell.
The Next Generation of Austrian Economics: Essays in Honor Joseph T. Salerno is a celebratory volume honoring the work of a respected and beloved teacher. It signifies a flourishing career of significant achievement, and also the gratitude and well-wishes of his students.
Dr. Salerno, longtime Professor of Economics at Pace University and Academic Vice President of the Mises Institute, is honored in these pages by the very students whose lives and careers he influenced. His important work in monetary theory and policy, not to mention his great exposition of Austrian school sociology, are addressed here by contributors such as Dr. Philip Bagus, Dr. David Howden, Dr. Per Bylund, Dr. Mateusz Machaj, Dr. Matthew McCaffrey, Dr. Peter Klein, and others.
Salerno stands at the head of what may be termed the “5th generation” of Austrian economists, having been both a friend and close associate of the late Murray Rothbard (not to mention a young attendee at the famed 1974 South Royalton conference). But as this volume illustrates, Joe is also a great friend, mentor, and godfather to an emergent new generation of formidable Austrian economists.
Austrian economists are justifiably proud of the rich heritage handed down by Carl Menger, Eugen von Böhm-Bawerk, Ludwig von Mises, Murray Rothbard, and their contemporaries, and Austrians are keenly interested in the origin and development of their ideas. An appreciation for history has led some modern economists, mistakenly, to see the Austrian tradition as static, rigid, and backward-looking, focused on the achievements of the past rather than discoveries and new developments.
As the contributions to this volume attest, nothing could be further from the truth. Austrian economics is a vibrant, healthy, growing tradition, confident in its core propositions while filled with lively debates and exciting new advances. These authors of the essays collected here build upon, refine, extend, and challenge the contributions of their teachers, just as previous generations have done, all the way back to Menger.
Joseph Salerno’s own work is a vibrant illustration of this pattern. Salerno has made seminal contributions to the development and application of Austrian economics, while remaining within the broad, causal-realist tradition pioneered by Menger and refined by Böhm-Bawerk, Mises, and Rothbard. Salerno’s early work was in monetary economics and the history of economic thought. His doctoral dissertation (Salerno 1980) offered a novel interpretation of the “bullionist controversy” and subsequent developments in British monetary theory and policy. He also published a number of important papers on the largely-neglected French liberal school of Say, Destutt de Tracy, Dunoyer, Bastiat, and Molinari, among others, and their important predecessor (and proto-Austrian) Cantillon (Salerno 1978; 1983; 1988). Along with Rothbard he developed a distinctly Austrian approach to measuring the money supply (Rothbard 1978; Salerno 1987), one consistent with Austrian concepts of the nature and role of money.
It was his work on money that led Salerno to a significant breakthrough in the interpretation of Mises’s economics. It had long been recognized, inside and outside the Austrian school, that Mises’s great accomplishment in his Theory of Money and Credit (1912) was an integration of monetary theory into the general, subjectivist, marginalist understanding of value, prices, and markets shared by the Austrian, Walrasian, and Marshallian schools. Prior to Mises, prices were typically analyzed as exchange ratios between goods, not ratios between goods and a monetary unit. Money was a “veil,” overlaying (or obscuring) underlying economic relationships. Mises showed that economic actors evaluate units of money the same way they evaluate discrete units of other goods and services, namely in terms of marginal utility, and that the general theory of economic value also explains the value of money. In a perceptive Postscript to a reprint of Mises’s 1920 essay on socialist calculation, Salerno (1990a) highlighted the degree to which Mises’s analysis of socialism flowed from his analysis of money. As Salerno (1990a, p. 35) put it:
Mises’s pathbreaking and central insight is that monetary calculation is the indispensable mental tool for choosing the optimum among the vast array of intricately-related production plans that are available for employing the factors of production within the framework of the social division of labor. Without recourse to calculating and comparing the benefits and costs of production using the structure of monetary prices determined at each moment on the market, the human mind is only capable of surveying, evaluating, and directing production processes whose scope is drastically restricted to the compass of the primitive household economy.
In other words, what Mises means by “economic calculation” is monetary calculation. The core problem facing the government planner is not that he lacks the “knowledge of particular circumstances of time and place,” as Hayek (1945) famously put it, but that he lacks the real-world monetary prices needed to weigh alternative benefits and costs, to estimate rates of return on investment, and hence to allocate resources rationally in a complex world.
This insight led to a profound revaluation of Mises’s contributions and the role of Mises’s work in the history of economic thought. By the 1980s Hayek’s profound and influential social theory, which emphasized the challenges of economic organization under dispersed knowledge and limited understanding, and was deeply wary of attempts to reconstruct society according to some “rational” plan, was embraced by most Austrian economists. Even today, Hayek’s pithy line from The Fatal Conceit (1988, p. 76) — “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design” — adorns many an email signature line and blog masthead. But, as Salerno carefully demonstrated, this anti-rationalist, incrementalist, evolutionary, “English” approach to economics, law, and social theory was particular to Hayek, and not at all shared by Mises.
In “Ludwig von Mises as Social Rationalist” (1990b) and “Mises and Hayek De-Homogenized,” (1993), Salerno offered a different interpretation of Mises and Mises’s place within the Austrian tradition. Salerno argued that Menger’s younger colleagues Böhm-Bawerk and Weiser extended Menger’s approach along distinct, sometimes contradictory, paths. What we might call a Wieser-Hayek-Kirzner strand of Austrian economics emphasizes disequilibrium, the informational role of prices, and profit-seeking behavior as an equilibrating force. In contrast, the Böhm-Bawerk-Mises–Rothbard strand emphasizes monetary calculation and the entrepreneur as a purposeful, forward-looking agent. In my own work on the entrepreneur (Klein 2008a; Foss and Klein 2012; Klein and Bylund 2014) I have highlighted two distinct Austrian interpretations of the entrepreneurial role. In Kirzner’s (1973) influential formulation, the entrepreneur is a largely passive “discoverer” of profit opportunities created by disequilibrium “gaps” in the current structure of market prices. As I read Mises — largely influenced by Salerno’s interpretation — the entrepreneur plays a different role in Mises’s system, namely deliberate, active, purposeful action in the face of uncertainty in pursuit of economic gain. In the former approach, the market does the work, and the entrepreneur need not be “rational,” only alert to preexisting opportunities. In the latter, the entrepreneur makes use of monetary calculation to plan and act to bring about an improvement in market conditions. I view my own work here as largely an extension of Salerno’s interpretation of Mises.
While some of Salerno’s contemporaries such as Israel Kirzner and Leland Yeager challenged Salerno’s “two Austrian traditions” thesis (Yeager 1994; Kirzner 1999), Salerno’s intellectual mentor, Murray Rothbard, embraced it. Indeed, Rothbard hailed Salerno’s work on calculation and knowledge as a major advance in the Austrian tradition, and an improvement on his own understanding. Rothbard (1989) described Salerno’s “Social Rationalist” paper as “a wonderful, superb advance and breakthrough, not only in the history of economic thought, but also in economic theory itself. ... In a sense, this sort of breakthrough experience is something like the joy of an intellectual conversion.” Rothbard went on to note that while he had harbored reservations about Hayek’s emphasis on the division of knowledge and coordination of plans, he had never quite been able to articulate why he felt uncomfortable about Hayek’s approach to the calculation problem. “Even though steeped in Mises, I had never really paid enough attention to his society-as-division-of-labor theme, and the crucial rationalism there.” Rothbard also described Salerno’s “Mises and Hayek De-Homogenized” as “a magnificent achievement.”
Most important, Rothbard (1989) saw Salerno’s contributions as exemplifying the general pattern of advance and development within the Austrian school:
Your article also points up an important point for the history of thought generally and for Austrian economics in particular. People have bitterly accused me of resisting all change in Austrian economics and of denouncing any differing opinions. Not true: I welcome change and advances in Austrian theory provided that they are true, i.e., that they work from within the basic Misesian paradigm. So just as I think I have advanced beyond Mises in developing the Misesian paradigm, people like Hans Hoppe and yourself have advanced the paradigm still further, and great!
Like the contributors to the present volume, I hope to make my own incremental advances to the Austrian tradition by building on Salerno’s work, just as Salerno built on Rothbard, Rothbard built on Mises, and so on.
Another of Salerno’s important contributions is his reinterpretation of the rise, decline, and rebirth of the Austrian tradition itself. Most accounts of the Austrian school trace its demise to the 1930s and 1940s, as Austrian capital theory was attacked by Knight and Sraffa and Austrian monetary and business-cycle theory was attacked by Keynes and his followers. The rise of positivism and mathematical formalism rendered the Austrians’ causal, verbal style obsolete anyway. Then — according to the typical account (e.g., Vaughn 1994) — the Austrian school experienced a dramatic revival following the South Royalton conference and Hayek’s Nobel Prize, both of which occurred in 1974.
Salerno offers two important corrections to this story. First, he argues that the core of the Austrian system as it developed in the late nineteenth and early twentieth centuries was not its distinct approach to money and the business cycle, but Menger’s causal, realistic account of price formation (Salerno, 1999). Austrian economics was not — as even some contemporary Austrian economists seem to believe — verbal Walrasian or Marshallian microeconomics plus capital-based macroeconomics (and spontaneous order and plan coordination and the knowledge problem as additional glosses). Instead, Austrian economics was a different kind of microeconomics. As Salerno demonstrated, Mengerian price theory peaked before 1920 following the contributions of Böhm-Bawerk and a few European Mengerians, and the particularly important work of the English economist Philip Wicksteed and the Americans John Bates Clark, Frank Fetter, and Herbert Davenport. Unfortunately, during this time most younger European, British, and American economists were adopting Marshall’s eclectic, mechanistic approach, and interest in Menger faded. More important, the “fourth” generation of the Austrian school, led by Hayek and including Morgenstern, Haberler, and Machlup, were heavily influenced by Schumpeter, who had introduced Walrasian price theory to the German-speaking world. In other words, by 1920 most economists, including the younger Austrian economists, had abandoned the causal, realistic approach to value, prices, and markets offered by Menger and Böhm-Bawerk.
The importance of Mises’s Human Action (1949) is not, in this interpretation, simply that it provided an overview of Mises’s mature thinking on a variety of economic topics — a sort of advanced Austrian textbook. As Salerno (1994; 1999) argues, Mises’s treatise offered no less than a rehabilitation and restatement of Mengerian price theory, one further developed by Rothbard in his Man, Economy, and State (also widely mistaken for a textbook). Salerno is himself a major contributor to this revival of Austrian price theory, in particular by highlighting and developing the various equilibrium constructs used by Mises and Rothbard (e.g., the “plain state of rest,” the “final state of rest,” and the “evenly rotating economy,” and what Salerno (1994, p. 99) calls the “Wicksteedian state of rest,” a concept implicitly, but not explicitly, analyzed by Mises and Rothbard).
Second, Salerno (2002) argues that the Austrian revival should be dated not from 1974, starting with the South Royalton Conference, but from 1962–63, when Rothbard published Man, Economy, and State (1962), America’s Great Depression (1963), and What Has Government Done to Our Money? (1963), the works that sparked the younger South Royalton participants’ interest in Austrian economics. Interestingly, these works all deal with what I have called “mundane Austrian economics” (Klein 2008b) — the analysis of value, prices, markets, money, capital, and government intervention — and not the more esoteric philosophical, methodological, and political topics that interest so many Austrians today. Salerno’s introduction to the 2009 edition of Man, Economy, and State is a major contribution to doctrinal history in its own right, pointing out Rothbard’s many advances beyond Mises, particularly in the areas of capital theory and monopoly theory.
In all these revisionist essays, Salerno demonstrates a keen grasp of the underlying theoretical and doctrinal issues, bringing out nuances and subtleties overlooked by other writers. Indeed, many Austrian writings on the Austrian school paint a somewhat tedious and even maudlin picture in which the major thinkers and writers agree on fundamental issues and are united in a desperate battle against socialists, Keynesians, and interventionists. As Salerno points out, the truth is far more interesting. While the early and later Austrians shared many core constructs, theories, and doctrines, there was a tremendous variety of ideas and approaches within the Austrian school, as there continues to be today. The Austrian tradition from its inception was a living, breathing, and lively intellectual movement, filled with internal as well as external controversy. This variety continues to the present, and it is important to review, analyze, sometimes synthesize, and other times disentangle the different theories and methods. Far from indicating weaknesses within Austrian economics, these controversies demonstrate its strength. Vive les différences!
To summarize, Salerno’s contributions range across a variety of subjects (money, price theory, comparative economic systems, doctrinal history, and more) and employ a variety of methods, while remaining squarely in the causal-realist tradition established by Menger, Böhm-Bawerk, the Anglo-American Austrians, Mises, and Rothbard. He is an exceptionally clear thinker and an excellent writer, witty and erudite as well as thoughtful and informative.
I met Joe Salerno in 1989 at an early edition of the Mises Institute summer instructional conference (later expanded into today’s “Mises University”). He was already a rising star in the Austrian movement, but came across then — as he does now — as a regular guy, a wisecracking, sharp-tongued, unpretentious, rough-hewn fellow from New Jersey. He remains one of the funniest people I’ve ever met, and I can’t recall how many hours I’ve spent laughing with him (and his charming wife Helen). I’ve lectured, along with Joe, at the Mises University for the last twenty years, and he is enormously popular with students, for his humor as well as his knowledge.
Joe took over for Guido Hülsmann as director of the Mises Summer Fellows Program in 2004, and it has been a joy to watch him embrace the role of mentor for dozens of younger scholars, many of whom have contributed to the present volume. Besides having a huge influence on his contemporaries, Joe has become the leader of the Austrian movement to its younger practitioners. Speaking for my fellow Austrians, I can say, with pleasure, that we are all Salernians now.
ReferencesFoss, Nicolai J., and Peter G. Klein. 2012. Organizing Entrepreneurial Judgment: A New Approach to the Firm. Cambridge: Cambridge University Press.
Hayek, F. A. 1945. “The Use of Knowledge in Society.” American Economic Review 35: 519–30.
——. 1988. The Fatal Conceit: The Errors of Socialism. In W. W. Bartley III, ed., The Collected Works of F. A. Hayek. Chicago: University of Chicago Press.
Kirzner, Israel M. 1973. Competition and Entrepreneurship. Chicago: University of Chicago Press.
——. 1999. “Mises and His Understanding of the Capitalist System.” Cato Journal 19: 215–32.
Klein, Peter G. 2008a. “Opportunity Discovery, Entrepreneurial Action, and Economic Organization.” Strategic Entrepreneurship Journal 2: 175–90.
——. 2008b. “The Mundane Economics of the Austrian School.” Quarterly Journal of Austrian Economics 11: 165–87.
Klein, Peter G., and Per L. Bylund. 2014. “The Place of Austrian Economics in Contemporary Entrepreneurship Research.” Review of Austrian Economics 27: 259–79.
Rothbard, Murray N. 1978. “Austrian Definitions of the Supply of Money.” In Louis M. Spadaro, ed., New Directions in Austrian Economics, pp. 143–56. Kansas City: Sheed Andrews & McMeel.
——. 1989. Letter to Joseph T. Salerno, March 28.
Salerno, Joseph T. 1978. “Comment on the French Liberal School.” Journal of Libertarian Studies 2: 65–68.
——. 1980. “The Doctrinal Antecedents of the Monetary Approach to the Balance of Payments.” PhD Dissertation, Department of Economics, Rutgers University.
——. 1983. “The Influence of Cantillon’s Essai on the Methodology of J.B. Say: A Comment on Liggio.” Journal of Libertarian Studies 7: 305–16.
——. 1987. “The ‘True’ Money Supply: A Measure of the Supply of the Medium of Exchange in the US Economy.” Austrian Economics Newsletter 6: 1–6.
——. 1988. “The Neglect of the French Liberal School in Anglo-Saxon Economics: A Critique of Received Explanations.” Review of Austrian Economics 2: 113–56.
——. 1990a. “Postscript: Why a Socialist Economy is ‘Impossible.’” In Ludwig von Mises, Economic Calculation in the Socialist Commonwealth. Auburn, Ala.: Mises Institute, 1990, pp. 34–46.
——. 1990b. “Ludwig von Mises as Social Rationalist.” Review of Austrian Economics 4: 26–54.
——. 1993. “Mises and Hayek Dehomogenized.” Review of Austrian Economics 6: 113–46.
——. 1994. “Ludwig von Mises’s Monetary Theory in the Light of Modern Monetary Thought.” Review of Austrian Economics 8: 71–115.
——. 1999. “The Place of Mises’s Human Action in the Development of Modern Economic Thought.” Quarterly Journal of Austrian Economics 2: 35–65.
——. 2002. “The Rebirth of Austrian Economics — in Light of Austrian Economics.” Quarterly Journal of Austrian Economics 5: 111–28.
——. 2009. “The Ambition of Rothbard’s Treatise.” In Murray N. Rothbard, Man, Economy, and State with Power and Market, Scholar’s Edition. pp. xix–l. Auburn, Ala.: Mises Institute.
Vaughn, Karen I. 1994. Austrian Economics in America: The Migration of a Tradition. Cambridge: Cambridge University Press.
Yeager, Leland B. 1994. “Mises and Hayek on Calculation and Knowledge.” Review of Austrian Economics 7: 93–109.
In this interview, Mark Thornton talks to host Scott Horton about how we are much better off without the fed, and how QE monetary policy is causing the global economy to contract.
The announcement of the euro-QE was not the start of Europe’s monetary Dark Age. That started many years ago with Chancellor Kohl’s undermining of the “hard deutsche mark Bundesbank” in the late 1980s. The darkness further descended when the newly created European Central Bank (ECB) implemented monetary frameworks which essentially tied Europe into a global 2-percent-inflation standard, following the US Federal Reserve.
The darkness continues unabated with the ECB’s decision in January to pursue its own version of the “Great Monetary Experiment” (GME), launched first by Obama’s architect-in-chief Professor Ben Bernanke and his fellow travelers in the Federal Open Market Committee (FOMC). One would have thought that before this could happen there would have been exhaustive hearings both within the ECB and the German and French parliaments about just how successful, or not, the GME had been. They should also have looked at the record of Abenomics in Japan. And even as the final hour approached, with the die all but cast, no one at the ECB press conference asked the question:
Signore Draghi, why are we in Europe embarking on a monetary experiment which has already failed in the US and Japan? I mean by failure, the fact that this is the weakest economic expansion ever following a Great Recession in the US. And we are already witnessing the bursting of a huge oil and commodity bubble with, yet unknown but almost certainly, severe consequences, whilst in Japan there has been a second recession, not economic renaissance as Prime Minister Shinzo Abe promised.
The Easy-Money Enthusiasts are EmboldenedBut no, there was none of that. Instead on the eve of the launch, even more monetary nonsense was to emerge. First, from Rome there was socialist Prime Minister Renzi calling for the euro to make its smooth descent to parity against the US dollar — its “natural level.” And then, ex-ECB board member Professor Lorenzo Bini-Smaghi, in an editorial for London’s leading Keynesian financial newspaper, The Financial Times (January 20), admired how the ECB was about to repudiate political interference from Berlin in defense of “price stability” (meaning 2 percent inflation). The ECB was establishing its “independence,” Bini-Smaghi wrote, just as the Bundesbank had done against Chancellor Adenauer in raising rates by 2 percentage points when he had demanded no rise at all. In the monetary cult, 2 percent inflation forever and a recurrent deadly plague of market irrationality (what Keynesians describe as “animal spirits”) represents the ideal resting place.
Now that the monetary barbarians have finally sacked Frankfurt, with the incredible cooperation of Chancellor Merkel, it is not too early to ask when a system based on stable money might return. The answer is: don’t look to Rome! Although both improbable and risky, one option is a political earthquake in Germany which would lay waste to the current system, and thrust that country out of the European Monetary Union and toward the resurrection of the “hard deutsche mark.”
Are Central Banks Too Weak?But let’s take one step back and review Kenneth Rogoff's recent comments from Davos. In spite of himself, Rogoff managed to utter some truth about the likely future for long-term inflation. In a January 21 Bloomberg TV interview with Tom Keene, Rogoff gave a gloomy warning, though it’s unclear whether or not he would view it as gloomy. The long-term bond markets are now assuming that central banks in the US, Europe, and Japan will be unsuccessful in achieving their 2 percent inflation targets, and that inflation will remain well below that level, even in the long-run. That is foolhardy. The central banks may seem weak for now, but do not underestimate their power to achieve inflation in the long-run! Professor Rogoff did not go into details about how this ability might return, but in technical terms we could say that will happen when the neutral level of interest rate rises — whether (optimistically) due to blossoming of investment opportunity or (pessimistically) due to growing capital shortage (in the worst cases triggered by war or other disasters). At that stage, the massive excess reserves now in the various monetary systems would feed a wider monetary and lending boom.
That is how the failed Roosevelt QE policies of 1934–36 ended — after the Crash and Great Recession of 1937–38 came the war and high inflation. Let’s hope the sequel to Obama-Merkel-Abe QE is different.
Image source: iStockphoto.
Savings has nothing to do with money. For instance, if a baker produces ten loaves of bread and consumes one loaf, his savings is nine loaves of bread. In other words, the “savings” in this case is the baker’s real income (his production of bread) minus the amount of bread that the baker consumed. The baker’s savings now permits him to secure other goods and services.
For instance, the baker can now exchange his saved bread for a pair of shoes with a shoemaker. Observe that the baker’s savings is his real means of payments — he pays for the shoes with the saved bread. Likewise, the shoemaker pays for the nine loaves of bread with the shoes that are his real savings.
What Is Savings?The introduction of money doesn’t alter what we have so far said. When a baker sells his bread for money to a shoemaker, he has supplied the shoemaker with his saved, unconsumed bread. The supplied bread sustains the shoemaker and allows him to continue making shoes. Note that the money received by the baker is fully backed by his unconsumed production of bread.
Yet without the medium of exchange, i.e., money, no market economy, and hence, the division of labor, could take place. Money enables the goods of one specialist to be exchanged for the goods of another specialist. In short, by means of money, people can channel real savings, which in turn permits the widening of the process of real wealth generation.
Also, in a world without money it would be impossible to save various final goods like perishable goods for a long period of time. So the introduction of money solves this problem. Instead of storing his bread, the baker can now exchange his bread for money.
In other words, his unconsumed production of bread is now “stored,” so to speak, in money. There is, however, one proviso in all of this: that the flow of the production of goods and services continues unabated. This means that whenever a holder of money decides to exchange some money for goods, these goods are there for him.
Having Money Is Not the Same as Having SavingsThus when a baker exchanges his money for apples, the baker has already paid for them with the bread produced and saved prior to this exchange.
Now what about the case where money is used to buy unprocessed material — is the unprocessed material real savings? The answer is no. The raw material must be processed and then converted into a piece of equipment, which in turn can be employed in the production of final goods and services that are ready for human consumption. In this sense, the buyer of unprocessed material transfers his claims on real savings to the seller of material in return for the prospect that the transformed material, some time in the future, will generate benefits far in excess of the cost incurred.
Furthermore, the buyer of the material also buys time (i.e., by having the material readily available, he can proceed immediately with the stages of making the final tool). If the material weren’t available he would have to extract it himself, which of course would delay the making of the final tool.
Once real savings are exchanged for money, the recipient of the money can exercise his demand for money in a variety of ways. This, however, will not have any effect on the existent pool of real savings.
An individual can exercise his demand for money either by holding it in his pocket, or in his house, or by placing it in the custody of a bank in a demand deposit, or even in a safe deposit box.
Also, whether he uses it immediately in exchange for other goods, or lends it out, or puts it under the mattress, it does not alter the given pool of real savings. Thus by putting the money under the mattress, an individual doesn’t engage in the act of saving. He is just exercising a demand for money. What individuals do with money cannot alter the fact that real savings are already funding a particular activity. Whether individuals decide to hold onto the money, or lend it out alters their demand for money, but this has nothing to do with savings.
Whenever an individual lends some of his money he in fact transfers his claims on real goods to a borrower. By lending money, the individual has in fact lowered the demand for it. Note that the act of lending money (i.e., the transferring of the claim) doesn’t alter the existent pool of real savings. Likewise, if the owner of money decides to buy a financial asset like a bond or a stock he simply transfers his claims on real savings to the seller of financial assets. No present real savings are affected as a result of these transactions.
How Does Money-Supply Expansion Affect Savings?Now let us examine the effect of monetary expansion on the pool of real savings. Since the expanded money supply was never earned, goods and services therefore do not back it up, so to speak. When such money is exchanged for goods it, in fact, amounts to consumption that is not supported by production. Consequently a holder of honest money (i.e., an individual who has produced real wealth), that wants to exercise his claim over goods discovers that he cannot get back all the goods he previously produced and exchanged for money.
In short, he discovers that the purchasing power of his money has fallen — he has in fact been robbed by means of loose monetary policy. The printing of money therefore cannot result in more savings as suggested by mainstream economists, but rather to its redistribution. This, in the process, undermines wealth generators, thereby weakening over time the pool of real savings. So any so-called economic growth, in the framework of a loose monetary policy, can only be on account of a private sector that manages to grow the pool of real savings despite the negative effects of the loose money policy.
We can thus conclude that savings is not about money as such, but about final goods and services that support various individuals that are engaged in various stages of production. It is not money that funds economic activity but the flow of final consumer goods and services. The existence of money only facilitates the flow of the real stuff.
Image source: iStockphoto.
Volume 17, No. 4 (Winter 2014)Steve Forbes and Elizabeth AmesNew York: McGraw Hill, 2014, xvii + 249 pages Money is an odd book. Its odd character can be brought out through an analogy. Imagine that someone wrote an eloquent book about price and wage controls. The book showed how attempts to control prices led to economic disaster. Faced with an abundance of incontrovertible evidence that demonstrated the bad effects of these measures, an informed policymaker would find only one rational choice available to him. He should not impose comprehensive price controls but rather should use controls in moderation.
Would it not be obvious what had gone wrong with our imagined book? If price controls do not work, they should be done away with altogether. “Moderation” in the use of a bad measure is no virtue. If cyanide is poison, “drink in small doses” is not the appropriate response.
Money falls exactly into the bad pattern just described. Forbes and Ames write with insight about the dangers of inflation and easy money. In response, they propose that the monetary system should be based on gold. What could be better? Unfortunately, they do not favor a genuine gold standard: instead, their plan calls for limiting monetary expansion by tying the dollar to gold at a fixed rate. In sum, monetary expansion is bad, so we ought to reduce the extent to which the Fed may engage in it.
Forbes and Ames aptly quote Ron Paul on the fundamental fallacy of inflationism: “If governments or central banks really can create wealth simply by creating money, why does poverty exist anywhere on earth?“ (p. 81, quoting Ron Paul)The same page mentions that ”noted economic historian” Murray Rothbard said that inflation favors the first recipients of new money, but Rothbard’s name does not appear in the book’s index. (See p. 81 and the note on p. 219, citing “What Has Government Done to Our Money?” (1963). Money is valuable because we can use it to purchase goods and services: increasing the number of monetary units does not add new goods or services to those already produced.An exception must be made for non-monetary uses of a monetary commodity. An increased supply of gold, e.g., makes more gold available for jewelry.
The point seems obvious once stated; why do so many ignore it? As Forbes and Ames point out, many nations favor inflation because it will increase exports and reduce imports. Foreign buyers, so long as the money of their own nation has not also expanded at as fast a rate, will find that they can purchase more goods for the same nominal amount of their money; and importers will find that, with their inflated money, they can purchase less.
In this view, exports are good and imports are bad; but why should we accept this? “Trade deficits and surpluses have historically reflected little about the health of an economy. Neo-mercantilists overlook the fact that the United States has had a merchandise trade deficit for roughly 350 out of the last 400 years.... The fact that the United States buys products and services from other nations doesn’t mean it is weak; it means that the U.S. economy is strong and has the wealth and resources to buy what others are selling.” (p. 55)
The authors strike forcefully at the Keynesian claim that inflation is needed to combat unemployment. “According to [William] Phillips and his fellow Keynesians, vigorous growth corresponded to price increases, while lower inflation correlated with higher jobless levels. In other words, there was a trade-off between inflation and employment.” (p. 79)
As the “stagflation” of the 1970s showed, the Keynesian claim is false. Inflation and unemployment “don’t move the way Keynesians would have you believe. In the inflationary boom/bust era of the 1970s and early 1980s, unemployment reached higher levels than during the financial crisis.” (p. 80)
Broadening their critical assault, Forbes and Ames show the deleterious moral effects of inflation. “Weak, unstable money inflames perceptions of unfairness. People with fixed incomes struggling with rising prices in an uncertain economy become enraged when they see others appear to get rich through speculation or crony capitalism, not honest effort.” (p. 102)Wilhelm Röpke, Welfare, Freedom, and Inflation (1964), is an outstanding analysis of the moral effects of inflation.
The natural conclusion from all this criticism of inflation is that the government ought to refrain entirely from monetary expansion; but a theoretical error blocks the authors from seeing this. The error is that money is a measure of value that must be kept constant. “Money is a standard of measurement, like a ruler or a clock, but instead of measuring inches or time, it measures what something is worth.... Just as we need to be sure of the number of inches in a foot or the minutes in an hour, people in the economy must be certain that their money is an accurate measure of worth.” (p. 26)
What is wrong with this? When you pay $25,000 for a car, you are not measuring the value of the car. Rather, you are showing that you prefer the car to the money: the person who sells you the car has the reverse valuation. Without this difference in preferences, no exchange would take place. If, as Forbes and Ames imagine, money measures value, both you and the car seller would arrive at the same “measure” of the car’s value. We would have no account at all of why an exchange takes place.
We can trace further the source of the authors’ mistake. They rightly note that money “originated in the marketplace as a solution to a problem. It arose spontaneously, like the spoon or the personal computer, in response to a need.” (p. 37). With money, it is much easier to achieve the “double coincidence of wants” required for an exchange than without it. But they miss why this is so. The reason is that practically everyone is willing to accept money in an exchange; it is a commodity that everyone wants. Instead, Forbes and Ames identify the need as “for a stable unit of value to facilitate trade.” (p. 37)
This fundamental error leads them to recommend inadequate policies. Their plan leaves plenty of room for monetary expansion. Their “gold standard allows the money supply to expand naturally in a vibrant economy. Remember that gold, a measuring rod, is stable in value. It does not restrict the supply of dollars any more than a foot with twelve inches restricts the number of rulers being used in the economy.” (p. 128) Money needs to expand if the economy is growing, because without the expansion, prices would fall; and then, horribile dictu, money would cease to be a constant measuring rod. Further, if a “major financial panic” demanded “an emergency injection of liquidity,” the Fed would be able to act as a lender of last resort. (pp. 158–159)
How is the goal of stable money to be achieved? “The twenty-first century gold standard would fix the dollar to gold at a particular price.... The Federal Reserve would use its tools, primarily open market operations, to keep the value of the dollar tied at that rate of gold.” (p. 152) In this etiolated gold standard, only the United States would need to fix its money to gold in the fashion just mentioned. “If the United States went to gold, other countries would likely fix their money to the dollar, if only for convenience…. Of course, if a country wanted to attach its currency directly to gold instead of the gold-backed dollar, it could do so.” (p. 155)
An obvious objection to this proposal is that “setting a fixed dollar/gold ratio is price fixing and therefore anti-free market.” To this, the authors incredibly answer: “Having fixed weights and measures is essential for fair and free markets. We don’t let markets each day determine how many ounces there are in a pound or how many inches there are in a foot.... Money, similarly, is a measure of value.”(p. 161) They fail to grasp that economic value is subjective: there are no fixed units of value that correspond to units of measurement of physical objects.
Their proposal, as they readily acknowledge, revives the interwar gold exchange standard and the post-World War II Bretton Woods arrangement. For them, this is no objection: those were excellent monetary systems. True enough, there are a few “gold standard purists” who argue that the policy of credit expansion pursued by the Fed in the 1920s under the gold exchange standard “produced the disaster of 1929.” These purists are wrong. “The cause of the Depression was the U.S. enactment of the Smoot-Hawley Tariff.” (pp. 148–149) So much for Mises, Hayek, and Rothbard! Readers in search of a deeper analysis of monetary policy should put aside this superficial book and turn instead to the works of these great Austrian theorists. A good beginning would be America'rs Great Depression by “noted economic historian” Murray Rothbard.I have benefited greatly from Joseph T. Salerno, “Will Gold-Plating the Fed Provide a Sound Dollar?” (Salerno, 2014).
Volume 17, No. 4 (Winter 2014) KEYWORDS: monetary policy, Mariana, Jefferson, Cervantes, Don Quixote, Austrian School, School of Salamanca, Philip II, Philip III, libertarianism, liberty, slavery, regicide, billon coins, Constitutionalism, Aragon, Euclid, Ron Paul, Paul KrugmanJEL CLASSIFICATION: B1, B2, B3, N1, N4What will I say about our own maravedí, which was first of gold, then silver, and now is entirely of copper? And who would be so bold as to dare to censure a custom allowed in all times and all places?
Juan de Mariana, La dignidad real y la educación del rey (341)All translations are the author’s own, unless otherwise indicated.
‘What do you mean “forced people?”’ asked Don Quijote. ‘Is it possible that the King uses force against anyone?’
Miguel de Cervantes, Don Quijote de la Mancha (1.22.199)
INTRODUCTIONStriking parallels exist between the work of Juan de Mariana (1536–1624) and modern political opposition to the advisability of central banking in the United States. I claim that said parallels can, and indeed should, be viewed as a matter of ideas passed down both directly and indirectly from late Renaissance Spain, ideas that were expressed in response to historical circumstances remarkably similar to our own. To quote Mariana: “What has happened will happen. Previous events are very influential: They convince us that what sets out on the same path will reach the same conclusion” (Mariana, [1609] 2007, p. 279).
Modern monetary theory first arose at the University of Salamanca during the second half of the sixteenth century through the combined efforts of Neo-Scholastic thinkers like Martín de Azpilcueta, Diego de Covarrubias, Tomás de Mercado, González de Cellorigo, and Luis de Molina.As Luis Beltrán points out, the School of Salamanca’s “boundaries are blurry,” and not all of the thinkers that we associate with it actually attended the university or taught there, including Mariana. Still, it was the source of the intellectual atmosphere of late Renaissance Spain. For detailed presentations of the School of Salamanca, see the monograph by Marjorie Grice-Hutchinson and the edited volume by Grabill. On the one hand, motivated by their philosophical interest in medieval and classical knowledge on the subject and, on the other hand, by the social and economic turmoil brought about by the importation to Spain of massive amounts of gold and silver from the New World, these men penned treatises expounding variously on the origins, functions, and effects of money. At the turn of the sixteenth century, however, a more critical and political incentive for monetary analysis arose when the Habsburg kings Philip II, Philip III, and Philip IV embraced a policy of debasement to cope with the massive costs incurred by the Spanish Empire, not the least among which were expenditures associated with courtly extravagance, bureaucratic graft, and multiple wars both domestic and foreign, especially in the Low Countries of northern Europe. Thus, the infamous Spanish billon copper coin, in the end entirely denuded of its silver content and transformed into one of the most worthless currencies of the modern era.
Figure 1. A vellón coin of Philip IV with a nominal value of sixteen maravedíes.
The great Jesuit thinker Juan de Mariana is the major voice of this last phase of the School of Salamanca’s monetary theory. Extending the ideas of his precursors, his principal legacy in the field of economics is De monetae mutatione (A Treatise on the Alteration of Money), published in 1609, which is a brilliantly articulated condemnation of the inflationary policies of King Philip III and his advisor the Duke of Lerma, and for which Mariana was promptly arrested and charged with lèse-majesté. His confrontation with Habsburg authorities over their fiscal shenanigans suggests another important facet of his thought: his radical advocacy of regicide. In his equally provocative princely advice manual, De rege et regis institutione (The King and the Education of the King), published in 1599, Mariana lays out the case for killing kings who abuse their power. And thanks to the second edition of this manual, published in 1605, which contains an early version of De monetae mutatione in the guise of its sole additional chapter, “De moneta” (“On Money”), Mariana’s aggressive economic analysis remains forever linked to his scandalous endorsement of assassination as a vital check to monarchical tyranny.
Both the monetary concerns and the anti-authoritarian animus of the modern libertarian wing of American conservatism are heavily bound to the ideas of the Austrian School of economics, which includes such luminaries as Carl Menger (its founder), Ludwig von Mises, Friedrich Hayek, Murray Rothbard, Walter Williams, Hans-Hermann Hoppe, and Jesús Huerta de Soto. They also echo the economic and political views expressed by Thomas Jefferson during the early years of the Republic. The Austrian School’s debts to Salamanca have already been pointed out. But given Jefferson’s own documented attention to Mariana’sHistory of Spain (Historiae de rebus Hispaniae, [1592] 1854),3 In the references, this is listed as Historia general de España. These are the same work. First Latin (1592), then a Spanish translation by Mariana himself (1601), and finally the first English translation appears to be 1699. It is likely, although impossible to tell, that Jefferson himself had English translations in his libraries and that he sent the same book to Madison, but he could also have sent Madison a Latin or a Spanish version. The problem is compounded by the fact that the 1699 English translation is entitled The General History of Spain, whereas Jefferson refers to it as History of Spain (as do many modern English-speaking experts on Mariana). as well as his profound admiration for the works of John Locke and Miguel de Cervantes—arguably two of Mariana’s most significant readers—it is well-nigh time to recognize that substantial aspects of American libertarianism are doubly reinforced projections of the great Jesuit scholar’s menacingly cynical stances against the policies of the Spanish Habsburgs. In short, Mariana’s unique formulation of the politics of money stands as one of the most profound connections between the baroque world and our own.In addition to Grice-Hutchinson, Murray Rothbard should be credited with having emphasized the depth of the legacy of the School of Salamanca for Austrian economics. He made a good circumstantial case for Mariana’s influence as well (2006, pp. 117–122, passim). In political terms, he also pointed out that Mariana was “positively ‘pre-Lockean’ in his insistence on the right of the people to resume the rights of sovereignty they had previously delegated to the king. While Locke developed libertarian natural rights thought more fully than his predecessors, it was still squarely embedded in the scholastic natural law tradition” (p. 314).
MONETARY THEORY, DEFICIT SPENDING, AND ECONOMIC CRISISIn the wake of the worldwide economic crisis of 2008, we have witnessed an ongoing debate over the decisions by political authorities, Americans and Europeans in particular, to debase their respective currencies.Of course, American and European authorities are not alone. The Chinese have long been accused, by American politicians in particular, of maintaining an artificially devalued yuan; Japan recently declared all-out war on deflation by vowing to print as many yen as it takes; Latin American countries like Argentina and Venezuela are notorious for periodic monetary collapses; and then there are the classic apocalyptic currencies of Zimbabwe and Weimar Germany. The authorities of ancient Rome and Greece were no different. The earliest known text to refer to a debased currency is generally held to be Aristophanes’s play The Frogs (718–782), which dates from 405 B.C. This boils down to a difference of opinion regarding the advisability of interfering with the economy by injecting money into it in order to rescue those who bet wrong prior to the crisis—i.e., institutions and individuals who might otherwise be left holding worthless property, especially real estate and the stocks of failed corporations, such as banks, car companies, etc. The interventionists reason that with more money chasing the same amount of assets, goods, and services, people will shrug off the urge to save because their net worth will appear to stabilize, or else they will feel obliged to spend as the rate of return on their savings plummets in concert with the lowering of interest rates due to the increased availability of money. Furthermore, deficit spending by governments is viewed as the necessary complement to monetary expansion. Mainstream economists and politicians argue that the crisis will worsen without the continuation or increase of government outlays in the form of infrastructure projects or wealth transfer payments in the form of social services and welfare.
Central bankers as well as officials in favor of more government debt, then, would have us believe that their efforts will bring about a general “stimulation” of commercial activities, thereby staving off economic ruin. The libertarian response is that such policies are destructive and unethical because they distort the “market” value of things by changing relative prices. Likewise, the Neo-Scholastics of Salamanca argued that said policies are unadvisable and unjust because they distort the “natural” value of things. Libertarians and Salamancans tend to link morality to economics since, on the one hand, they oppose those who are employed by the government or else are the beneficiaries of its largesse and, on the other hand, they believe that the longer term consequences of economic interventionism hurt people more than whatever dubious short term benefits it may have.In an effort to spare readers a much more detailed economics lesson, I oversimplify the important Austrian corollary that inflation ultimately leads to the destruction of malinvested capital and, therefore, higher unemployment, lower wages, and generally less production of wealth and, therefore, less improvement of the human condition than would otherwise have occurred according to the natural conditions of an admittedly harsh free market economy. This longer term view is perhaps best understood as a combination of Joseph Schumpeter’s relatively pessimistic notion of the “creative destruction” of capitalism and Friedrich Hayek’s more optimistic notion of its “extended order,” both of which would seem to have been at least in part intuited by the Salamancans (cf. Schumpeter [1942] and Hayek [1988]). Market strategists like Jim Rogers, James Grant, and Meredith Whitney, along with a minority of academic economists, such as Nassim Taleb, Mark Thornton, and Niall Ferguson, all make similar points when they rail against deficit spending and monetary debasement.
A contemporary American version of this debate was recently broadcast on Bloomberg TV between Congressman Ron Paul and Nobel Prize winner and New York Times pundit Paul Krugman. Paul stands for fiscal conservatism, debt reduction, and smaller government; Krugman argues for economic management, monetary intervention, and deficit spending. First, Paul:
I believe in very small government. I emphasize personal liberties. I don’t like a managed economy, whether it’s through central economic planning or monetary policy or, or even Congress doing it. So it’s a completely different, uh, philosophy that markets are supposed to work, you know, in a natural way. I want a natural rate of interest. I don’t want the government or the Federal Reserve fixing the rate of interest. That’s a price fixing. And wage and price controls never work, so pricing the cost of money, uh, doesn’t work either. And this idea that somebody or some group might know what the proper amount of money should be or what the proper rate of interest should be is sort of presumptuous. You know, I don’t, I don’t know where they get this knowledge, and uh, Hayek called it a “pretense of knowledge.” They pretend they know, but they really don’t... Governments aren’t supposed to run the economy; the people are supposed to run the economy.
Then, Krugman:
You can’t leave the government out of monetary policy. If you try to think, you know, we’re, we’re gonna just let it set itself, it doesn’t happen. The government is actually always, uh, the, the Federal Reserve, the Central Bank, is always going to be in the business of managing monetary policy. If you think that, that... you can avoid that..., um, you’re living in some... you’re living in a world as it was a hundred and fifty years ago. Right? We have an economy in which money is not just pieces of green paper with, uh, with, uh, faces of dead presidents on them. Money is, is, uh, is the result of the financial system. It includes a variety of assets. We’re not even quite sure where the line between money and non-money is. It’s kind of a, a continuum. And look, history tells us that, in fact, an un... a completely unmanaged economy is subject to extreme volatility, is subject to extreme downturns. I know there’s this legend... that the Great Depression was somehow caused by the government, caused by the Federal Reserve, but it’s not true. The reality is that was a market economy run amuck, which happens, happened repeatedly over, over the past couple of centuries... There are limits. You do need the government to step in to stabilize...
Finally, Paul responds to Krugman’s idea that inflation is necessary to get things going again:
Inflation is theft. You’re stealing value from people who save money. So, if you have a 2% or a 10%, the value of the currency is lost. And it really destroys an important feature of the economy, and that is saving. Savings tells us something, and it tells us that capital is available. This notion that capital can come out of the expansion of the money supply is remote. Now, uh, Professor Krugman indicates that we just want to go back a hundred years or so..., but he wants to go back a thousand years, or two thousand years, just as the Romans and the Greeks and all other countries debased their currency... (Paul, 2012)
We should note that this debate is, and always has been, very much a matter of perception and perspective. Austrians and libertarians claim to see what others cannot or will not see, namely, that currency manipulation and deficit spending only create an illusion of wealth. In reality government officials are “monetizing” the debt created by their expenditures and foisting the costs onto future generations. More generally, in an unjust sleight of hand, they are transferring debt to creditors: debasing the currency allows debtors to more easily pay off what they borrowed back when the currency had relatively more value. Unwitting citizens, then, are forced to share in government debt as well as the losses of companies bailed out by said government. Even John Maynard Keynes, the most famous apologist for this dual strategy, noted its secretive and sinister nature: “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose” (1920, p. 236). Mariana saw just as much: “the prince…, if he repeatedly debases the value of the currency,… does not avoid committing an offence, with obvious infraction of the laws of nature, and in truth he is deceiving many with means meticulously devised so that they will not grasp the damage that he causes them” (La dignidad real [1605] 1981, p. 344).
Objections to Keynesianism are not exclusive to the United States. In Paradigm Lost: The Euro Crisis, Uri Dadush and Vera Eidelman argue that restoring the natural value of things and reducing the size of government are the only ways to bring about economic recovery in the same country that over four hundred years ago gave us Mariana. Note the historical irony that the Habsburg policy of currency devaluation is now off the table because the Spanish have embraced the euro, which is regulated by the European Central Bank headquartered in Frankfurt and controlled by bodies like the European Commission in Brussels and Luxemburg:
Spain has to effect a profound structural transformation and cannot look to a cyclical recovery to reignite growth and reduce its mass unemployment. It must instead unwind distortions that were built up over more than a decade, restore its competitiveness, and reallocate resources to manufacturing and other growing tradable sectors. With currency devaluation not an option, these reforms will only happen if unit labor costs, house prices, and the price of services decline relative to its European partners. A smaller government sector and other far-reaching reforms must kick-start this process. (Dadush and Eidelman, 2010, p. 65)
Of course, the fact that Spain has relinquished control of its currency does not mean that its citizens will not suffer the consequences of increases in the money supply enacted by European institutions. While there may be differences in degree, both the European Central Bank and the Federal Reserve Bank in the United States have opted for monetary expansion, the inflationary effects of which might take time to occur and might be difficult to perceive as they arise at different rates across different sectors of the economy, but will in the long run be no less destructive of each currency’s purchasing power.
Mariana made all of these observations as early as his chapter on money in the 1605 edition of De rege, where he objected on moral as well as economic grounds to the Habsburgs’ debasement of the billon coins (“monedas de vellón” in Spanish). He understood that their policy was an illegitimate form of taxation designed to pay for excessive government expenditures, that it robbed citizens of their personal wealth, and that it would cause shortages and price inflation and have dire consequences for the nation as a whole:
In the first place, it is necessary to affirm that the prince does not have any right over the private property and estates of his subjects that would allow him to take them for himself or transfer them to others.
This adulteration is a form of tribute by which is subtracted some amount of the wealth of the citizens.
Would it be licit to force open the granary of a subject and steal from him part of his grain and then compensate him for the damage by granting him the power to sell that which remained in his granary at the same value that it had when it was full and we had not taken any part of it? Who would not say that this was robbery?
First, this abuse will necessarily be followed by a dearth of foodstuffs in direct proportion to the value that is removed from the currency, for men do not value money by anything other than its quality and solidity, even when severe penalties are decreed to forestall shortages. What is more, the people will feel tricked and will not stop protesting against this debased currency which has come to substitute the old but which lacks its value, calculating that now they will need much more money to meet their basic needs.
The merchant and the buyer withdraw at the first sign of adulteration and the shortages that it causes. And if the prince fixes the price of goods, as is oftentimes desired, instead of achieving the remedy that is intended, he will aggravate the problem, because nobody will want to sell at a price which is considered unjust and unfair when it is compared with the common estimation. Once commerce is ruined in this fashion, there will be no limit to the ills that will befall the people, and the inhabitants of that country will lose wealth right up until their last breath. (La dignidad real [1605] 1981, pp. 341–343, 346, 348–349)
The temporal inflection that Mariana gives to this last statement is crucial. Inflation only makes matters worse in the future. His prediction took a few years to come about, but the history of the value of the billon coins confirms his prescience. As one researcher at the Federal Reserve Bank of Chicago put it: “The Spanish experience unleashed unprecedented manmade inflation, which made the Price Revolution of the sixteenth century (price level increases due to the inflow of American gold and silver) look tame” (Velde, 1998, p. 11). Note how well the graph of the market value of the billon quarter coin resetting to its intrinsic value (Figure 2) corresponds to the fall of the Spanish Empire, the end of which is traditionally marked by the Treaty of Westphalia in 1649.
Figure 2. Market and intrinsic values of a vellón cuarto coin, 1597–1659.
Arguments about the government’s right to grow itself through debt and then print money in order to pay for it amount to more than an economic policy dispute. As Paul has consistently pointed out, since these issues concern federal officials’ ability to redistribute the wealth of citizens, they are ultimately constitutional in nature. In an editorial piece for The Washington Times, Warren L. Dean, Jr. objected in similar terms to the logic that a failure on the part of Congress to increase the federal debt limit would bring about a national default that was “unconstitutional”:
It seems that the “me” generation thinks it has a constitutional right to continue to spend money it does not have. Without much doubt, its theory has to be among the most stupid—and most childish—constitutional arguments that ever have been put forward in Washington.
It is putting our constitutional system of government in hock and mortgaging the liberty of future generations of Americans. For a nation that, until now, has lived by the philosophy that it would hand the next generation a brighter future than the last, it is quite a reversal.
The liberal left prefers to spend the money of future generations. That is easier because the unborn don’t have a say in the matter. They don’t have the right to vote and cannot object.
In fact, the Constitution is quite clear in this area. It should be. It was built on the foundation of a rebellion that was, in turn, inspired by a tax revolt. That is one reason why Article I of the Constitution firmly vests the power of the purse in the elected representatives of the people in Congress. The power to tax, spend and, yes, even to borrow are all vested in Congress, which shall have the power “To borrow money on the credit of the United States.” Pretty clear, you might think. Neither the executive nor the judiciary has that power. In fact, it is unconstitutional for the executive to spend money not appropriated by Congress. (Dean, 2012)
Similar clashes are arising in Europe. Not only has there been extensive debate in Mediterranean states like Greece and Spain regarding the legality of ceding control of their domestic economies to Brussels, we now see a corresponding debate in the Federal Republic of Germany over the legality of “restructuring” the debt of said states on the backs of Germans: “The German Constitutional Court must now decide whether the European Central Bank’s policy of buying bonds contravenes the conditions under which Germany joined the European Union” (Raisbeck, 2013).
Here again, with respect to both the United States and the European Union, Mariana’s thinking about fiscal matters can seem prophetic because the laws of economics that he perceived are applicable regardless of time and space. His complaints about the policies of the Habsburgs are the same ones we hear today against central banks and governments. And not only did Mariana articulate them in moral and economic terms, he did so on formalistic, or what today we would call “constitutional” grounds. He complains loudly in book one, chapter eight of De rege that tradition had been abandoned by granting excessive power to the head of state, what we would call the “executive branch.” This is the essential reason behind his constant appeals to the Kingdom of Aragon, which unlike his native Kingdom of Castile, had clung tenaciously to its jurisdictional independence from Habsburg authority right up until the 1590s:
According to Aristotle, among the Greeks, the Lacedaemonians only conferred authority on their kings when it came to the direction of warfare and the care and administration of sacred things. In more recent days, in Spain, the Aragonese thought similarly, being so zealous in the defense of their liberty that they believe all liberties are diminished at the slightest concession. And thus, the Aragonese established an intermediate body between the king and the people, similar to that of the tribunes, popularly known as the Justice of Aragon, which, armed with the laws and the authority of the people, would keep royal power within certain limits... Among those people and others nobody doubts that the authority of the people is greater than the authority of the king. Otherwise, how would it be possible to resist the power and the will of kings?
Requiring that the decisions of the king be ratified by the community at large (a right which, in spite of everything, is still maintained among the Aragonese) has been suppressed...
Our own ancestors, being wise men, foresaw this danger and instituted numerous and most farsighted measures so that kings would be constrained within the limits of moderation and sobriety and would not be able to exercise an excessive power that might harm the public. Among other things, with great prudence they established that no important business should be resolved without consulting the lords and the commoners, to which end there were to be convened parliamentary Cortes in the realm to be attended by elected representatives from all branches, that is, the prelates with full jurisdiction, the lords, and the conservators of the townships. This custom is still maintained in Aragon and other provinces, and God grant that our princes would restore it! Why have our traditional Cortes been so disfigured by the exclusion of the lords and the bishops, rendering impossible that common consent wherein resides public well-being, such that public and private business is now resolved at the arbitrary whim of the king and the will of the few? (Mariana, [1599] 1981, pp. 93–94, 98, 101)
THE ANIMUS OF AUSTRIAN ECONOMICS: MARIANA AND HABSBURG TYRANNYA fascinating aspect of Mariana’s career is that he gradually concludes that one way, if not the very best way, to judge history itself is in terms of monetary policy. In this he represents the logical extension of the School of Salamanca, which left a philological record of deepening interest in economic matters. In 1550, for example, Diego de Covarrubias produces the school’s first full treatise on money, Veterum collatio numismatum (An Examination of Ancient Coins), in which chapters five and six deal with the historical currencies of Spain ([1550] 1775, pp. 168–252). Covarrubias notes passively that the practice of debasement dates as far back as the reign of King Alfonso X (1252–1584), also known as “el Sabio” ‘the Wise.’ In a preliminary note to his 1775 edition of Covarrubias’s study, Josef Berní y Catalá indicates that the version published at León in 1558 contains these two chapters translated into Spanish, while the rest remain in Latin ([1550] 1775, pp. 309–311). Some of this divergence owes to simple nationalism, but it also reveals a desire to place highly technical and controversial information about the history of Spanish money before a reading public no longer versed in Latin.
For his part, Mariana’s interest in things monetary dates at least from his investigations for his epic Historia general de España (Latin, 1592; Spanish, 1601), a text in which he also mentions, and in fact condemns, Alfonso X’s recourse to debasement ([1592] 1854, 13.9.382–383). A few chapters on he declares that Alfonso’s policy lent enormous support to his son Sancho’s rebellion (14.5.407). Later, he pauses to qualify the triumph of Enrique II (1366–1367, 1369–1379), the first of the great Trastámara line that begat the Catholic Monarchs Ferdinand and Isabella, by indicating that this king too had to turn to debasement to finance his wars against Pedro I (1350–1366, 1367–1369). Mariana even says that Enrique only got away with it because he was so handsome, and because he was generally regarded as the embodiment of gentlemanliness (“por excelencia le llamaban el Caballero”), whereas his rival was utterly cruel (17.14.520). From then on Mariana displayed ever-increasing urgency in regard to this theme, with each book granting more attention to monetary matters, allowing them to emerge as the primary focus of his life’s work. In 1599, he published a study of weights and measures, De ponderibus et mensuris (On Weights and Measures), topics that relate to debasement because authorities manipulate currencies by changing precisely these parameters. After seeing to the Spanish translation ofHistory of Spain, with its clear critiques of Alfonso X and Enrique II, he then focused on adding “De moneta” to the 1605 edition of De rege. As Gabriel Calzada points out, Mariana inserted this new, highly contentious chapter on money into book three, precisely after the chapter on tribute, or what we would today call “taxation.” Moreover, “the second edition of De rege et regis institutione, in which he presented for the first time his anti-inflationary argument, was published together in a single volume with De ponderibus et mensuris, as if he had wished to add a long appendix expounding in detail on the technical foundations of the evil he was denouncing” (pp. 86, 88–89). The concluding words of “De moneta” underscore this link: “we wanted to admonish princes against altering those things which are the very foundations of commerce, that is, weights, measures, and currency, if they desire to have a tranquil and stable state, because under the appearance of momentary utility lies untold fraud and harm” ([1605] 1981, p. 351). In 1609, the topic reached critical mass in Mariana’s astonishing De monetae mutatione, which he quickly translated into Spanish for circulation in manuscript form, a clear sign of the gravity with which he now viewed the explication of monetary theory. The fact that Spanish authorities responded to this final sally by arresting him and charging him with lèse-majestéindicates that he was by no means alone in this regard.
What we are witnessing, then, from Covarrubias through Mariana, is the early modern birth of monetary theory, and by extension economics itself, as a discrete field of inquiry.Grice-Hutchinson: “It is clear that the monetary theory of the School of Salamanca spread through many countries during the earlier decades of the seventeenth century” ([1952] 2009, p. 74). For a look at the way modern fields of scientific study took shape through a kind of introspective precipitation of the modern intellect, all with a serious nod to early modern Spaniards like Velázquez and Cervantes, see Michel Foucault’s The Order of Things. What is more, we are watching its coincidental politicization. Mariana lays the groundwork for all this by way of historical analysis. As we have seen, as early as 1592 he had already indicated the ineptitude with which Alfonso X “the Wise” chose to dilute his coins with copper. In the “De moneta” chapter of the 1605 edition of De rege, he reiterated his view that this was, in fact, the main reason for the chaos that threatened Alfonso’s reign. This time he does so in the first person:
I believe that the poor quality of the new money was the principal cause of the people’s exasperated spirits, so much so that during the life of King Alfonso they switched allegiance to Don Sancho and his sons. Don Alfonso was so stubborn and capricious that in the seventh year of his reign he tired of the money called the burgalesa and changed it for yet another, which was called the negra because the metal was so bad. ([1605] 1981, p. 347)
Mariana continues his monetary disenchantment with Spanish history, first dispensing with Alfonso XI (1312–1350), who evidently ignored the lessons to be learned from his great-grandfather, before turning once again to the civil wars between Pedro I and Enrique II. Striking here is the casual frankness with which he flips the traditional roles played by Enrique, the founder of the House of Trastámara, and Pedro “el Cruel” ‘the Cruel,’ the last king of the moribund House of Burgundy. All pretense vanishes, reputations are irrelevant, and the archeological record unveils the truth:
We have been able to inspect the reales of Don Enrique and Don Pedro. Those of the latter were truly of good silver, equal to that still used in our day in Castile; those of Don Enrique were rather blackened through much mixing with the copper they contained. And at the advent of a shortage of all goods of primary necessity, he found himself obliged to reduce the value of the currency by two thirds. Such often happens, for what is believed to be most useful and ingenious comes to be most harmful through lack of foresight and because the judgment of men is blind. ([1605] 1981, pp. 347–348)
For more than fifteen years before his open attack in 1609 on Philip III and the Duke of Lerma in De monetae mutatione, Mariana had been putting a lot of ink to paper against two of the most iconic kings of Spanish history, and precisely according to their willingness to debase their currencies.
It is his historically inflected politicization of monetary policy that makes Mariana such a giant. He may have accessed Nicholas Oresme’s work, he surely read Salamancan Neo-Scholastics like Covarrubias and Molina, and in chapter three of De monetae mutatione he cites René Budel’s De monetis et re numaria (On Money and Monetary Things, 1591), which means he knew the substance of many other publications on the subject (Laures, 1928, p. 163). He grasped Gresham’s Law, whereby bad money drives out good in the context of an artificial exchange rate; he perceived the subjectivist theory of value, anticipating what today we would call “marginal utility”; he understood both the quantitative and the qualitative theories of inflation; and he warned of the disastrous effects inflation has on commerce and society. But the specifics of his thoughts on these matters are rarely original. His intellectual power is one of synthesis; his work, in essence, is a bitter preview of the cynicism of the Austrian economists, who regard much of recorded history as a series of misguided economic interventions arising from, and leading to, all sorts of travail and misery. To put it another way, Mariana’s true genius, his most original discovery of all, is that statist monetary policy and authoritarianism are one and the same. And he brought a massive dose of moral courage to giving the issue its public due, turning up the volume of his insight and aiming it straight at the powers that be.For a thorough discussion of the nefariousness of interventionist monetary policy, see Rothbard ([1963] 2008).
This is also what makes the 1605 version of his essay on money so important; for it is here that he first establishes the lateral connections between currency debasement and two other wicked regal practices: tyranny and slavery. This is merely a matter of the transitive property of equality in the fields of logic and mathematics, whereby if a = b and b = c, then a = c. Euclid’s “first common notion” from book one of his Elements, which by the way was translated into Spanish in 1576 by Rodrigo Zamorano, states it thusly: “Things which are equal to the same thing are also equal to one another” (2). In book one, chapter five of the first edition of De rege, Mariana had already defined a good king as one who treats his subjects as if they were his own progeny, as opposed to tyrants, who enslave them: “Thus it comes about that he rules his subjects not like slaves, as the tyrants do, but he is over them as if they were his children” ([1599] 1948, p. 136). A few pages later he had tied tyranny to slavery again:
It is unavoidable that the tyrant be afraid of those whom he puts in a state of dread; and must diligently take care, by removing all their means of protection and by taking their weapons away, not leaving them even their personal arms, that those whom he holds as slaves get no opportunity to engage in any of the liberal arts, worthy of a freeman, or strengthen their bodily robustness and their spiritual confidence by military activities. ([1599] 1948, p. 140)The Second Amendment to the US Constitution addresses this same issue.
In 1605, when he adds “De moneta” to what is otherwise the exact same text, Mariana defines monetary manipulation as illegitimate taxation and, therefore, another form of tyranny:
The prince cannot impose new tributes without first obtaining the formal consent of the people. Let him request them, certainly, but he is not to despoil his subjects by taking something each day according to his fancy and little by little reducing to misery those who until recently were rich and happy. To proceed in this manner would be to act like a tyrant, who measures all according to his greed and arrogates all powers to himself, not like a king, who should moderate the authority which he received from those who accepted him as such according to reason and law, and not extend it further. ([1605] 1981, pp. 341–342)
What we have, then, in the 1605 edition of De rege, is a triple equivalency between tyranny, monetary debasement, and slavery. And here again, because he appeals to transcendental moral laws, Mariana’s line of reasoning can seem prescient. Forcing citizens to assume the payment of debts unlawfully incurred by the government is to enslave them. Americans should recognize a slogan from the Revolutionary period lurking in this construct: “taxation without representation is tyranny.” The only difference is that Mariana goes a step further by exposing monetary manipulation which finances government debt as an illegal form of taxation. In other words: “debasement is taxation without representation, which is tyranny.” In his editorial piece for The Washington Times, Dean (2012) makes essentially the same argument:
But while we are looking at the question of the constitutional implications of fiscal irresponsibility, it might be more instructive to consider the other, far simpler, post-Civil War amendment to the Constitution. The 13th Amendment elegantly states, “Neither slavery nor involuntary servitude, except as punishment of a crime whereof the party shall have been duly convicted, shall exist within the United States.” Involuntary servitude includes indentured service and peonage—in other words, compulsory service in payment of a debt.
Here we might ask, what is the proper response to tyrannical leaders who enslave their citizens? Mariana’s answer is one from which many contemporary readers will recoil, but it was accepted doctrine at the time: when monarchs become tyrants, they may be killed.In the classical tradition Cicero and Plutarch had supported tyrannicide. John of Salisbury had argued for assassination of tyrants in his Policraticus. Thomas Aquinas endorsed the right to resist tyrants in Summa Theologica and elsewhere, although he thought fear of tyrannicide drove princes to even worse behavior and so he preferred the examples of those martyred by Nero and Diocletian. In early modern Spain, the emphasis on natural law by the Neo-Scholastics at Salamanca led down this road as well, especially among the Jesuits, and the thought of Juan de Mariana is perhaps the most notorious example. For a detailed survey and fuller discussion, see Brincat (2008). In book one, chapter six of De rege, just after the chapter in which he lays out his definition of tyranny, the Jesuit thinker clearly endorses political assassination as a necessary check to kings who transgress the limits of their power:
If circumstances require, and the commonwealth is not able otherwise to protect itself, it is right, by the same law of defense and even by an authority more potent and explicit, to declare the prince a public enemy and put him to the sword. Let the same means be available to any individual, who, having given up the hope of escaping punishment and with disregard for his personal safety, wishes to make the attempt to aid the commonwealth.
It is a salutary reflection that the princes have been persuaded that if they oppress the state, if they are unbearable on account of their vices and foulness, their position is such that they can be killed not only justly but with praise and glory. Perhaps this fear will give some pause lest they deliver themselves up to be deeply corrupted by vice and flattery; it will put reins on madness. ([1599] 1948, pp. 148, 149)
In an important moral qualification, Mariana has argued here that a political assassin is only justified if she is willing to die in the attempt. Although he never deigned to personally take up arms against the king, with his pen Mariana was certainly willing to put his life on the line for what he believed. When he proclaimed the illegitimacy of Philip III’s monetary policy in De monetae mutatione, he knew full well that he risked a charge of lèse-majesté, the penalty for which was death:
At a time when some are restrained by fear, others held, as it were, in bondage by ambition, and a few are losing their tongues and stopping their mouths because of gold and gifts, this pamphlet will achieve at least one goal: All will understand that there is someone among the people who defends the truth in his retirement, and points out the public threat of dangers and evils if they are not confronted with dispatch. Finally, like Diogenes, I will appear in public, I will rattle my barrel; I will openly assert what I think—whatever the final outcome. ([1609] 2007, p. 252)
To the degree that adherents to the Austrian School of economics look to Mariana for the roots of their political and economic thinking, they are taking inspiration from ideas that the valiant Jesuit theorist formulated in response to Habsburg tyranny. In her magnificent monograph on the School of Salamanca, Marjorie Grice-Hutchinson drew the direct lines of influence that the Spanish Neo-Scholastics had on the evolution of economics, from seventeenth-century thinkers like Grotius, Pufendorf, and Hutcheson to philosophes like Galiani, Condillac, and Turgot ([1952] 2009, pp. 59–78), which all allows for a multi-pronged impact on classical English economists like Locke, Smith, and Ricardo. Moreover, by any number of these routes, modern nineteenth-century economists like Jevons, Walras, and Menger are also their inevitable heirs. The problem with situating Mariana in this trajectory has always been that, owing to the fact that both De rege and De monetae mutatione were collected and burned with such zeal by Catholic as well as Protestant authorities, the recognition of his influence has remained speculative. Still, it is difficult to imagine that near contemporaries like Grotius, Scaccia, and Jesuits like Lessius, Salas, and Lugo, all intermediate figures cited by Grice-Hutchinson, would not have laid their hands on Mariana’s controversial work. The recent discovery by Calzada of a copy of De ponderibus et mensuris in Locke’s library is, I believe, an excellent indication that Mariana’s influence was likely far broader and more tangible than previously imagined.
In the last two sections of this essay, I want to point out that Mariana’s modern legacy has also taken two additional, relatively unrecognized paths, namely via Cervantes and Jefferson. First, let us summarize that we are contemplating highly politicized arguments that are both economic and constitutional in nature: Mariana’s objection to monetary tyranny is part and parcel of his objection to the Habsburgs’ political usurpation of the medieval traditions of Spain’s local legal codes (fueros), the last remaining vestiges of which were in Aragon at the time of his writing. With these facts in mind, I find it noteworthy that Cervantes read Mariana and that Jefferson read both Cervantes and Mariana. Ironically, Grice-Hutchinson cites Cervantes only as a warning against “the sin of reading our own ideas into the work of older writers” ([1952] 2009, p. ix). I want to embrace this sin and consider that certain reflections on the meaning of money and the struggle for liberty found in the writings of the inventor of the modern novel and the author of the American Declaration of Independence may owe some degree of their inspiration to Mariana.
MARIANA AND CERVANTESIf Mariana’s genius lies in his discovery of the politics of money and his subsequent radical opposition to monetary adulteration as one of the most nefarious examples of monarchical tyranny, in a curious twist, the most immediate consequence of his work was its influence on the history of the novel.For indications of the deep impact that Mariana’s work had on Cervantes, see Fernández-Morera (2009), Liu (2007), and Graf (2011, 2013). Readers of Cervantes’s Don Quijote (part one, 1605; part two, 1615)—first published the same year as Mariana’s second edition of De rege, with its added “De moneta” chapter—will be familiar with the protagonist’s difficulties regarding which heroes he should emulate. Substantial passages involve the knight’s perplexing decisions to fashion himself after a shifting series of fictional and quasi-historical champions: Palmerín de Inglaterra, Amadís de Gaula, Bernardo del Carpio, “El Cid” Rodrigo Díaz de Vivar, Reinaldos de Montalbán, Abindarráez, the Marqués de Mantua, the Caballero del Febo, etc. One scholar describes Don Quijote’s neurotic indecision as reflecting his society’s “crisis of exemplarity,” the end result of a process by which classical models of humanist virtue lost their persuasiveness over the course of the sixteenth century (Hampton). Readers of Mariana, however, can see how specifically this crisis coincides with the Jesuit’s own scientific demolitions of the myths of Spanish history. With Alfonso X “the Wise,” Enrique II of Trastámara, and now both Philip II and Philip III all unveiled as adulterating tyrants, is it any wonder that Don Quijote turns to fiction before wandering out on an impoverished Castilian landscape in an elusive quest for justice?
Beyond Don Quijote’s identity crisis, we also find Mariana’s thoughts on money and politics insinuating themselves into the most intricate ironies of Cervantes’s novel. From the outset, as the aging hidalgo proceeds to sell off his estate to finance his consumption of militant fantasy literature, his household management might be said to resemble that of the Spanish Empire. The fact that a full three quarters of his income goes to food suggests that price inflation is now chipping away at any benefit he enjoys via his tax-exempt status (1.1). Leaving home, he remains in utter denial of economic reality. The first innkeeper actually has to inform him that adventures require money (1.3). In his first act as a “caballero,” he intervenes in a labor dispute that has all the markings of an allegory about the effect of the Habsburg’s new monetary policy upon future generations (1.4). Don Quijote finds Juan Haldudo brutally whipping Andrés, and when he orders him to fork over the youth’s back pay, the farmer sarcastically says that he will happily do so, with interest even. The mad knight responds that he will waive the interest so long as he pays the salary he owes him in reales—i.e., good silver coins instead of adulterated copper ones. A few chapters later, the second narrator’s determined haggling with Moriscos over the lost manuscript, which he finds in a heap of papers destined to feed silkworms, twice highlights the subjective theory of value, with the added irony that Spain’s silk industry is about to be destroyed by the government’s expulsion of these same people (1.9). Later still, Don Quijote’s dismissals, or dissembling postponements, of Sancho’s repeated requests for a salary again make manifest an elitist disregard for the rules of the modern market economy (1.18, 1.20, 1.46, 2.7, etc.).For the tragic irony of the silk industry and the Toledo manuscript as well as more on the drama of Sancho’s salary in Don Quijote, see the wonderful book by Carroll B. Johnson (2007). I believe that Johnson misfires by reading Cervantes as a critic of the free market per se rather than as an ironic observer of the dangers of governmental interference therein.
Even more intriguing, Don Quijote contains numerous ironic allusions to Gresham’s Law. The novel’s first explicit pun involves just such an allusion. The description of Rocinante—“he had more quarters than a piece of eight”—refers to cracks in a horse’s hoof owing to poor care, improper shoeing, injury, or any number of diseases; but it also plays off the decay of the Spanish money supply, which is taking place from the ground up, so to speak, via the Habsburgs’ devaluations of the vellón cuarto coin (1.1). Despite the official exchange rate of sixty-eight cuartos per real, it now took more quarters to buy a piece of eight as people responded to the new policy by spending copper and saving silver. Toward the heart of the novel, Sancho’s fortuitous discovery of one hundred gold pieces hidden inside a suitcase in the Sierra Morena hints at the same practice—i.e., good money is being secreted away in response to the Habsburgs’ adulterations and mandated exchange rates (1.23). Indeed, throughout the Sierra Morena episodes, Cervantes appears to riff off the two senses of “adultery,” the one having to do with sexual infidelity, the other with falsifying coinage. Again, when the squire fantasizes about getting rich by importing black slaves from the Kingdom of Micomicón to Spain, his racialist metaphor, “as black as they be, I will turn them back into white or yellow,” overtly references the darker, oxidized copper coins that are now pushing out silver and gold (1.29). The phrase also wryly acknowledges the counterfeit billon industry that sprang up on Spain’s borders in response to the artificial rise in the price of copper caused by the Habsburg policy (Lea, 1906, pp. 560–566). And in part two, when Ricote offers to pay Sancho two hundred gold pieces to assist him in recovering his treasure, we can read Cervantes drawing an astonishingly complex and critical parallel between the exile of the Moriscos and the outflow of good money from Spain: mutually reinforcing socially immoral and economically unwise policies (2.54).For more on the Ricote episode and the gold standard, see Liu (2007).
With Sancho’s and Ricote’s monetary evasions and Mariana’s denunciations of the Habsburg policy in mind, it is difficult to avoid a deeper, truly bourgeois understanding of gold permeating Cervantes’s masterpiece. As ambassador Warren Randolph Burgess once explained, gold puts natural limits on the powers of government, making it “historically one of the best protections of the value of money against the inroads of political spending.” And as Austrian economist Joseph Schumpeter pointed out, this is precisely “why it was so popular in the bourgeois era. It imposes restrictions upon governments or bureaucracies that are much more powerful than is parliamentary criticism. It is both the badge and the guarantee of bourgeois freedom—of freedom not simply of the bourgeoisinterest, but of freedom in the bourgeois sense” (quoted by Woods, 2009, pp. 114–116). The ironies of Don Quijote’s attitudes toward gold accentuate his romantic, tragicomic status: early on, he can be a meddling, oppressive bully; other times, especially in the second part, he rises to the role of defender of justice. In his famous “Golden Age” speech the knight clearly understands that the difficulty of mining gold makes it a store of value, but his nostalgia for some sort of prehistoric Platonic communism that would obviate private property leaves much to be desired (1.11).For different views of Don Quijote’s “Golden Age” speech, see Geoffrey Stagg (1985) and Francisco Pérez de Antón (2003). Stagg details the philological history of the trope and Pérez de Antón assesses the same as a trans-historical delusion also found at the roots of both Marxism and liberation theology. Like Pérez de Antón, in her recent book, Susan Byrne holds that Cervantes himself is here being critical of private property, endorsing the knight’s nostalgia for Platonic communism (2012, p. 42). I hold that a more Marianan-inspired irony is at play and that Don Quijote is rhetorically abusing the hospitality of his hosts. In the lion episode, however, which elicits the Morisco narrator Cide Hamete’s most effusive praise, the hero symbolically defies not just a royal beast but also what fellow hidalgo Diego de Miranda at first thinks must be a wagon bearing “the King’s money” (2.17). Sancho’s tip of two gold pieces to the driver and the lion keeper, followed by the latter’s promise to relate the knight’s challenge to “the very King himself when he appears at Court,” conclude the episode with flippant gestures in the direction of Philip III. Later, it is hard not to see a related slap at the same monarch when Governor Sancho, who reigns according to Don Quijote’s princely advice, metaphorically contravenes the policy of inflation by finding ten gold pieces hidden in a cane, thereby exposing a debtor’s illicit attempt to avoid paying his creditor (2.45). Viewed this way, the novel contains a whole slew of loaded phrases that bring Mariana’s protests to mind, such as Don Quijote’s quip at the beginning of part two that “historians who avail themselves of lies ought to be burned like those who counterfeit money” (2.3), or the subtly misallocated Latin phrase in the first prologue, “Non bene pro toto libertas venditur auro” ‘There is not sufficient gold to buy back the loss of liberty.’
If politicized allusions to money are not enough to indicate Mariana’s importance for Cervantes, Don Quijote also contains, particularly in part two, a consistent critique of the decadence of the courtly governing classes, and even insinuations of the Jesuit’s constitutional nostalgia for Aragon. Critics often marvel at the burst of Solomonic and Platonic wisdom that Sancho displays when he finally gets his island. His perceptive ruling in favor of the creditor strikes me as a case in point. But some of the final decrees in “The Constitutions of the Great Governor Sancho Panza” are ironically flawed from both Salamancan and Austrian perspectives. When he fixes the price of shoes, we know that this gesture obviates much of what was good about his reign, for he has effectively lowered the quality and the quantity of footwear available to the fictional citizens of Barataria (2.51). Similarly, his prohibition against hoarding is bound to have disastrous effects. And what are we to make of the fact that Governor Sancho accepts two hundred gold pieces from the malicious Duke while refusing to take the same sum from Ricote to assist him in the recovery of his fortune? After retiring from Barataria, Sancho repeatedly claims to have governed beyond reproach—“I have governed like an angel”—but the bias he subsequently displays against his Morisco neighbor suggests that a more sinister chain of command has taken hold in the real world (2.53-54).In the context of the connections between Cervantes and Jefferson that I will soon discuss, it is quite difficult not to see a parallel between Sancho’s “angelic” defense of his art of governing and James Madison’s famous lines from Federalist No. 51: “If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself.” (1788)
The other dreadful irony at the heart of the novel’s second part is the fact that Zaragoza, the constantly named objective that remains just out of Don Quijote’s reach, was also the site of an Aragonese Cortes tradition in which, unlike the tripartite Castilian tradition, hidalgos actually had political representation as a fourth estate. All remnants of said tradition were put to the sword by Philip II when he invaded Aragon in 1591, and just like Mariana, Cervantes appears chagrined by that outcome. Scholar Quentin Skinner once noted that the collapse of late medieval republicanism in Western Europe, which coincided with the rise of the early modern authoritarian super states, was marked by an intellectual return of the tradition of educating princes by guiding them toward the light of reason via utopian curriculums (“Political Philosophy” 441–452). But libraries have been burned, allegorical caves remain dark dreamscapes, and no Platonic island paradise awaits us at the end of Don Quijote. Another of Cervantes’s recourses to Latin, which is found in Don Quijote’s last letter to Governor Sancho, “Plato amicus, sed magis amica veritas” ‘Plato is a friend, but a greater friend is the truth,” harmonizes perfectly with the anti-monarchical neo-Aristotelian melancholy of late Scholastics like Mariana. Which is to say that there is something not just “curiously impertinent” about Don Quijote, but that, as per so many of its aspects, such as the lion episode, the aborted nostalgia for Aragon, and the consistent pro-Morisco theme, there is in fact something downright tyrannicidal about the novel. I submit that Cervantes announced his angry political sentiment as early as the first prologue of 1605 when he made recourse to an old Spanish proverb: “debajo de mi manto, al rey mato” ‘beneath my cloak, I kill the king.’For a more detailed look at the political tension between Plato and Aristotle in part two of Don Quijote, see Graf (2013). For a thorough look at the epic struggle between utopian thinking and limited constitutional government, see Levin (2012).
Don Quijote is massive and complex, on the order of the entirety of Shakespeare’s tragedies, but if I had to pick one coetaneous writer who sheds the most light on the novel, it would be Mariana, who not only articulated the intellectual thrust of Cervantes’s bitter bourgeois irony but who directly confronted the same Habsburg tyrants against whom the novelist consistently tilts. In my view, like Mariana, Cervantes defends liberty in a materialist sense, i.e.—Don Quijote is not just about the abstract right to “dream the impossible dream” but, rather, the tangible right to live free of the monetary, legal, religious and even military oppressions directed by an imperious State hell bent on the daily mugging, enslaving, exiling, and killing of its citizens.
JEFFERSON, CERVANTES, AND MARIANAThe two aspects of Thomas Jefferson’s thought that have most influenced modern American libertarianism are his emphasis on the vitality of revolution and his opposition to central banking. In the case of the latter, Jefferson was so wary of institutional promissory notes that his censure extended to banking in general—i.e., beyond his well-known alliance with James Madison in opposition to Alexander Hamilton’s plan for a national bank. It would be difficult to exaggerate the radicality of his views on these issues, which are found in oft-cited letters containing hyperbolic expressions of love for political violence and hatred of government-backed fractional lending and deficit spending by both federal authorities and private institutions:
The spirit of resistance to government is so valuable on certain occasions, that I wish it to be always kept alive. It will often be exercised when wrong, but better so than not to be exercised at all. I like a little rebellion now and then. It is like a storm in the Atmosphere. (“Letter to Abigail Adams, February 22, 1787,” in Capon, 1987, p. 172)
And what country can preserve its liberties, if its rulers are not warned from time to time, that this people preserve the spirit of resistance? Let them take arms. The remedy is to set them right as to the facts, pardon and pacify them. What signify a few lives lost in a century or two? The tree of liberty must be refreshed from time to time, with the blood of patriots and tyrants. It is its natural manure. (“Letter to William Stephens Smith, November 13, 1787,” in Boyd, 1955, p. 356)
My own affections have been deeply wounded by some of the martyrs to the cause, but rather than it should have failed, I would have seen half the earth desolated. Were there but an Adam & Eve left in every country, & left free, it would be better than as it now is. (“Letter to William Short, January 3, 1793,” in Peterson, 1984, p. 1004)
Bank-paper must be suppressed, and the circulating medium must be restored to the nation to whom it belongs. (“Letter to John Wayles Eppes, 11 September 1813,” in Looney, 2010, p. 494)
I sincerely believe, with you, that banking establishments are more dangerous than standing armies; and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale. (“Letter to John Taylor, 28 May 1816,” in Ford, 2010, p. 533)
Jefferson’s lifelong interest in Cervantes is evidenced in a number of letters in which he recommends the Spaniard’s great novel to friends and family alike. Quite simply, as Alison P. Weber puts it, “the Quixote was one of the books Jefferson could not live without” (2009, p. 407). Furthermore, his statements suggest “that Jefferson interpreted Cervantes’ attitude toward his protagonist as critical yet not entirely unsympathetic” (p. 403). In other words, Jefferson understood the author Cervantes as essentially skeptical of authority and the character Don Quijote as the target of his satire, but not exclusively so—i.e., he saw the knight as an overreaching menace, but he also noticed that he was not always off the mark. Weber assures us that Jefferson did not read Cervantes as did the Romantics, by which she means that he did not take him to be a disillusioned fatalist in the spirit of Heine or Schelling (pp. 404–405). Nevertheless, as many of the extreme quotes that we have seen here from Jefferson as well as Mariana attest, the “gentle reasonableness” of Enlightenment thinkers can be as overstated as that of their Renaissance forebears. Jefferson may not have had time for literary analysis, but that does not mean that he did not intuit and perhaps even internalize the deeply radical aspects of Don Quijote. His respect for Cervantes’s achievement strikes me as tantalizingly in tune with his hatred of authoritarian government and central banking, and perhaps even indicative of some deeper tragic sense of his own weaknesses.American philosopher Leo Strauss struggled to advance a Socratic vision of American liberalism as a broadly defined hybrid creature he called “aristocratic democracy,” which would be constantly reassessing its own values as a way of avoiding the pitfalls of socialist populism. Interestingly, he cites Jefferson’s idea of the best government as that which allows for “a pure selection of natural aristoi into offices” (1989, p. 55), but his view of Don Quijote is decidedly more tragic, comparing his role to that of Socrates in Aristophanes’s Clouds: “Socrates owes his downfall to a man who seeks light in the most literal sense, to a kind of Sancho Panza, to a rustic who has lost his bearings or has gone astray. It will do no great harm if this comparison suggests a similarity between Aristophanes’ Socrates and Don Quixote” (p. 119).
Of greater interest might be Jefferson’s connection to Mariana. There is no evidence that he was familiar with Mariana’s confrontations with the Habsburgs inDe rege or De monetae mutatione, which might lead us to resign ourselves to the Jesuit’s indirect influence on the Virginian’s political and monetary views by way of Cervantes, Locke, and so many others. But as it turns out, we are free to go much further, for Jefferson had a copy of Mariana’s Historia de España in his personal library (Sowerby, 1952–1959, 1.79). In fact, according to a letter by Jefferson dated September 1, 1785, after an unsuccessful quest for a certain tantalizing “collection of tracts on the economies of different nations,” he did manage to secure and ship an English translation of Mariana’s history from Paris to his dear friend and fellow revolutionary Madison (Jefferson, [1785] 2013). This book could only have reinforced Jefferson’s animus against bank paper and, for this academic at least, it is exciting to imagine the legendary hard-money attitude of the author of the Declaration of Independence gaining significant momentum from Mariana’s running commentary against the monetary manipulations of the most beloved Spanish kings. And who knows? It is just possible that prior to his letter to Madison, Jefferson had spent the summer of 1785 searching for an unknown volume of economic treatises that would have contained a copy of Mariana’s De monetae mutatione.
The Free Market 32, no. 12 (December 2014) Throughout the existence of the Fed, its officers and intellectual supporters understandably asserted that the government’s movement toward central banking was a most beneficial evolution. In a 1948 issue of The Federal Reserve Bulletin, for example, Fed Chairman Thomas B. McCabe asserted that money production could not manage itself, so we need a central bank such as the Fed that acts for the public interest. Nearly three decades later, the venerable Arthur Burns claimed that the basic assets of the Fed are concern for the general welfare, moral integrity, respect for tested knowledge, and independence of thought.
The alleged benefits from a Fed-managed elastic money stock became the standard justification for the Fed in later propaganda. Again in 1948, Fed Chairman McCabe asserted that a lack of a central bank caused a continual threat of financial panic, but the Fed put an end to this danger — a rather cheeky claim to make only a few years after the Great Depression. Subsequent Fed Chairman William McChesney Martin claimed that the Fed was designed to minimize panics and crises due to irregularities in flow of money supply and make the monetary system function more smoothly, but that a gold standard was too rigid.
In 2013, Chairman Ben Bernanke likewise told college students that “financial stability concerns were a major reason why Congress decided to try to create a central bank in the beginning of the 20th century.”
Alas, from the beginning, reality diverged from Fed rhetoric. What the Fed claimed it did and would do sharply differed from what it actually did and from the consequences of its actions. Instead of preventing and ameliorating crises, it caused and aggravated them. Instead of fighting inflation, it was inflation’s fountainhead. Instead of remaining politically independent, it served politicians.
While it was originally claimed that the Fed would make financial and economic crises impossible by supplying an elastic money stock, in reality, from the beginning the Federal Reserve System was deliberately designed as an engine of inflation to be controlled and kept uniform by the central bank.
Federal Reserve Reality U.S. economic history clearly refutes the notion that the Fed merely maintained an elastic currency to satisfy only the needs of commerce. If that were so, one would expect no necessary long-term trend toward increasing inflation, yet that is what we see. The rate of annual increase of the monetary base has increased with each inflation-enhancing institutional change in our monetary system. From 1918 through 1933, the year Roosevelt took us off the domestic gold standard, the monetary base increased at an average annual rate of approximately 2.2%. From 1933 to 1971, when Nixon took the dollar off the last vestiges of the international gold standard, the monetary base increased at an average annual rate of 6.4%. After we left gold for good, the Fed increased the monetary base at an average annual rate of 9.8%.
The money stock followed suit. Since the advent of the Fed, M2 money stock increased by $10,006.4 billion in 2012. That is over a 452% increase during the life of the Fed.
As one might expect as the money supply increased continually over the past century, the purchasing power of the dollar collapsed relative to what it was the century before the Fed. The consumer price index was 22.8 times higher in June 2013 than in January of 1913.
From 1800 to about 1895, the purchasing power of the dollar roughly doubled. Then, as prices began their long march up after the advent of the Fed, the dollar’s purchasing power began its long slide downward, culminating in a PPM (purchasing power of the monetary unit) of approximately 8 cents in 2009 compared to the dollar of 1800. So much for maintaining the value of the dollar, stable price, and manipulating the money supply only for the needs of commerce.
In light of the historical record, concerns about price deflation should be laughable. Noticeable price deflation has occurred only three times over the past one hundred years. The Fed allowed for price deflation in the wake of the 1920–21 recession, which is why it was over so quickly. It was ineffective in stopping monetary and price deflation in 1931–33 even though it was not for lack of trying.
The Fed Fails to Prevent Crises The financial meltdown of 2008 is merely the most recent economic debacle fostered by the Fed. Less than eight years after its origin, a Fed induced inflationary boom set in motion the recession of 1920–22. Fed inflation in the mid-to-late 1920s ushered in the recession that turned into the Great Depression. After World War II the Fed oversaw inflation and recession during the 1950s. By 1963 Fed-backed inflation so far outstripped the U.S. stock of gold that it was nowhere near large enough to cover our obligations under the Bretton Woods system. The situation was so bad, in fact, that the U.S. Treasury was compelled to borrow abroad in money other than dollars because of foreign lack of confidence in U.S. currency. The Fed prevented neither the stock market crash of 1987 nor the collapse of the hedge fund Long Term Capital Management. Immediately after the great stock market crash of 1987, then new Federal Reserve Chairman Greenspan, assured investors that the Fed stood ready to provide whatever liquidity was necessary to keep the markets afloat. The Fed’s solution to the 1990s recession and Mexican Peso crisis was more of the same — monetary inflation via credit expansion.
Investors flush with new cash were looking for opportunities and became hip to the next big thing: technology and the internet. Fed inflation in the 1990s led to the tech-stock bubble and subsequent recession of 2000. The Fed again responded by doing what it does best: assuring investors, expanding credit and increasing the money supply and repeated its “accommodation” after the 9/11 terrorist attacks. Many investors, bitten by the tech crash and induced by various lending regulations, directed their new money into real estate and then mortgage backed securities and financial derivatives based on these securities. Capital was malinvested again resulting in the Great Recession and the worst of crony capitalism.
Economic history demonstrates that not only has the Fed not provided economic stability, again and again it has introduced instability and economic destruction through its inflationary credit expansion and interest rate manipulation.
Conclusion For 100 years the Fed has proclaimed its econonomic indispensibility. The picture it paints of a world without the Fed is a dystopian one in which society is left lurching from recession to recession, alternately experiencing runaway inflation and high unemployment. Thanks to the Fed, it is claimed, we instead enjoy sound money, fewer recessions, high employment, stable prices, and increased standards of living. In other words, the Fed is absolutely necessary for full-orbed macroeconomic stability.
Economic reality teaches a vastly different lesson, however, because the laws of economics have a way of impinging on statist rhetoric. The history of the Fed has been one of monetary inflation, higher overall prices, diminished purchasing power, economic depressions, and lost decades. In 1913 the state sowed the inflationist wind and for a hundred years we have been reaping the economic whirlwind.
[This article is excerpted from the December issue of The Free Market, and is adapted from the fifth chapter of 2014's The Fed at One Hundred, edited by David Howden and Joseph Salerno.]
Throughout the existence of the Fed, its officers and intellectual supporters understandably asserted that the government’s movement toward central banking was a most beneficial evolution. In a 1948 issue of The Federal Reserve Bulletin, for example, Fed Chairman Thomas B. McCabe asserted that money production could not manage itself, so we need a central bank such as the Fed that acts for the public interest. Nearly three decades later, the venerable Arthur Burns claimed that the basic assets of the Fed are concern for the general welfare, moral integrity, respect for tested knowledge, and independence of thought.
The alleged benefits from a Fed-managed elastic money stock became the standard justification for the Fed in later propaganda. Again in 1948, Fed Chairman McCabe asserted that a lack of a central bank caused a continual threat of financial panic, but the Fed put an end to this danger — a rather cheeky claim to make only a few years after the Great Depression. Subsequent Fed Chairman William McChesney Martin claimed that the Fed was designed to minimize panics and crises due to irregularities in flow of money supply and make the monetary system function more smoothly, but that a gold standard was too rigid.
In 2013, Chairman Ben Bernanke likewise told college students that “financial stability concerns were a major reason why Congress decided to try to create a central bank in the beginning of the 20th century.”
Alas, from the beginning, reality diverged from Fed rhetoric. What the Fed claimed it did and would do sharply differed from what it actually did and from the consequences of its actions. Instead of preventing and ameliorating crises, it caused and aggravated them. Instead of fighting inflation, it was inflation’s fountainhead. Instead of remaining politically independent, it served politicians.
While it was originally claimed that the Fed would make financial and economic crises impossible by supplying an elastic money stock, in reality, from the beginning the Federal Reserve System was deliberately designed as an engine of inflation to be controlled and kept uniform by the central bank.
Federal Reserve RealityU.S. economic history clearly refutes the notion that the Fed merely maintained an elastic currency to satisfy only the needs of commerce. If that were so, one would expect no necessary long-term trend toward increasing inflation, yet that is what we see. The rate of annual increase of the monetary base has increased with each inflation-enhancing institutional change in our monetary system. From 1918 through 1933, the year Roosevelt took us off the domestic gold standard, the monetary base increased at an average annual rate of approximately 2.2%. From 1933 to 1971, when Nixon took the dollar off the last vestiges of the international gold standard, the monetary base increased at an average annual rate of 6.4%. After we left gold for good, the Fed increased the monetary base at an average annual rate of 9.8%.
The money stock followed suit. Since the advent of the Fed, M2 money stock increased by $10,006.4 billion in 2012. That is over a 452% increase during the life of the Fed.
As one might expect as the money supply increased continually over the past century, the purchasing power of the dollar collapsed relative to what it was the century before the Fed. The consumer price index was 22.8 times higher in June 2013 than in January of 1913.
From 1800 to about 1895, the purchasing power of the dollar roughly doubled. Then, as prices began their long march up after the advent of the Fed, the dollar’s purchasing power began its long slide downward, culminating in a PPM (purchasing power of the monetary unit) of approximately 8 cents in 2009 compared to the dollar of 1800. So much for maintaining the value of the dollar, stable price, and manipulating the money supply only for the needs of commerce.
In light of the historical record, concerns about price deflation should be laughable. Noticeable price deflation has occurred only three times over the past one hundred years. The Fed allowed for price deflation in the wake of the 1920–21 recession, which is why it was over so quickly. It was ineffective in stopping monetary and price deflation in 1931–33 even though it was not for lack of trying.
The Fed Fails to Prevent CrisesThe financial meltdown of 2008 is merely the most recent economic debacle fostered by the Fed. Less than eight years after its origin, a Fed induced inflationary boom set in motion the recession of 1920–22. Fed inflation in the mid-to-late 1920s ushered in the recession that turned into the Great Depression. After World War II the Fed oversaw inflation and recession during the 1950s. By 1963 Fed-backed inflation so far outstripped the U.S. stock of gold that it was nowhere near large enough to cover our obligations under the Bretton Woods system. The situation was so bad, in fact, that the U.S. Treasury was compelled to borrow abroad in money other than dollars because of foreign lack of confidence in U.S. currency. The Fed prevented neither the stock market crash of 1987 nor the collapse of the hedge fund Long Term Capital Management. Immediately after the great stock market crash of 1987, then new Federal Reserve Chairman Greenspan, assured investors that the Fed stood ready to provide whatever liquidity was necessary to keep the markets afloat. The Fed’s solution to the 1990s recession and Mexican Peso crisis was more of the same — monetary inflation via credit expansion.
Investors flush with new cash were looking for opportunities and became hip to the next big thing: technology and the internet. Fed inflation in the 1990s led to the tech-stock bubble and subsequent recession of 2000. The Fed again responded by doing what it does best: assuring investors, expanding credit and increasing the money supply and repeated its “accommodation” after the 9/11 terrorist attacks. Many investors, bitten by the tech crash and induced by various lending regulations, directed their new money into real estate and then mortgage backed securities and financial derivatives based on these securities. Capital was malinvested again resulting in the Great Recession and the worst of crony capitalism.
Economic history demonstrates that not only has the Fed not provided economic stability, again and again it has introduced instability and economic destruction through its inflationary credit expansion and interest rate manipulation.
ConclusionFor 100 years the Fed has proclaimed its econonomic indispensibility. The picture it paints of a world without the Fed is a dystopian one in which society is left lurching from recession to recession, alternately experiencing runaway inflation and high unemployment. Thanks to the Fed, it is claimed, we instead enjoy sound money, fewer recessions, high employment, stable prices, and increased standards of living. In other words, the Fed is absolutely necessary for full-orbed macroeconomic stability.
Economic reality teaches a vastly different lesson, however, because the laws of economics have a way of impinging on statist rhetoric. The history of the Fed has been one of monetary inflation, higher overall prices, diminished purchasing power, economic depressions, and lost decades. In 1913 the state sowed the inflationist wind and for a hundred years we have been reaping the economic whirlwind.
Cantillon defines wealth as the consumption goods produced by land and labor. This contrasted with the Mercantilists who thought money was wealth.
From Part 1: "Production, Distribution, and Consumption". Narrated by Millian Quinteros.
Zimbabwe hit the headlines in the 2000s due to its extraordinary inflation rate, peaking at a monthly rate of 79.6 billion percent in November 2008. The hyperinflation was a result of Robert Mugabe’s government’s printing of excess money in order to finance government corruption as well as involvement in the Democratic Republic of Congo.
As one would expect, Zimbabwe was a point of interest for monetary economists due to its extraordinary rate of inflation. However, more recently, Zimbabwe has become a fascinating example of an economy operating with concurrent currencies, but has received little to no attention from academic economists.
A Mixture of MoniesThe monetary situation in Zimbabwe is quite complex and appears even more peculiar when we find that the state has not one but nine legally-recognized forms of legal tender, with its own currency failing to place on the list.
Initially the currencies of choice were the US dollar and the South African rand; however, the Botswana pula, the British pound, and the euro have also enjoyed some popularity. All five currencies eventually became legal tender. Furthermore, the Zimbabwean government recently made an additional four currencies legal tender; namely the Australian dollar, Chinese yuan, Japanese yen, and Indian rupee.
Although this is hardly the ideal monetary system envisaged by Austrian school economists, it is a captivating scenario. The creation of legal tender in the past has often proved to be an impediment to competition between monies, but in this respect, the monetary regime in Zimbabwe is, in many ways, unique in recent history.
To illustrate this further, we need to make two critical considerations: network effects and Gresham’s Law.
Network EffectsMoney is the perfect example of a good exhibiting network effects. A network effect occurs when the desirability of an item depends upon the amount of others using it. Since money is demanded due to its acceptability among others for future payment, money is said to exhibit network effects.
Absent legal tender laws, the greater the number of an individual’s trading partners using a particular medium of exchange, the easier it is to transact with that currency. Furthermore, the easier it is to transact with a particular money, the more desirable that money becomes to individuals.
In other words, accepting a particular currency increases its desirability and thereby encourages others to accept it, further increasing its desirability. This is essentially the view Carl Menger discusses when he describes the emergence of money from a barter system.
Once a particular currency gains widespread acceptance, the above process results in a weak form of path dependency or lock-in — that is, once a currency is established, the system tends to favor the incumbent money over potential alternatives. Thus, in the context of the network effects of money, money users are concerned with the size and location of a particular network, and money is accepted with these variables in mind. Under such circumstances, a seemingly superior alternative may fail to supplant a currency already enjoying widespread circulation.
Nevertheless, the problem that network effects entail for alternative currencies no longer exists when the alternative money has obtained the status of legal tender. Legal tenders must be, by definition, accepted if offered in payment of debt. Consequently, if a new alternative currency is legal tender, individuals will have no (or at least lesser) concern about the size or location of its network, allowing it to take the place of the older alternative that does not enjoy legal tender status. However, in addition to network effects, it is also important to consider Gresham’s Law when speaking of concurrent currencies.
Gresham’s LawGresham’s Law tells us that bad money drives out good money. In its purest form, Gresham’s Law is inapplicable to the case of Zimbabwe. The reason for this is that, contrary to what occurred in previous centuries around the globe, the Zimbabwean regime has not set fixed exchange rates between the various currencies. Rather, cashiers are to check market exchange rates on a daily basis.
However, with some slight adjustments to the original theory, a form of Gresham’s Law can be constructed to apply to Zimbabwe. Moreover, the consequences of this modified theory are similar to the original law. A currency experiencing more inflation than substitute currencies would be used in trade as often as possible. This would serve dual purposes. First, the owner of the substandard currency would prefer to use it in trade in order to keep their more stable and more robust currency in hand. Second, an individual in possession of the value-losing currency would rush to exchange it in order to obtain goods losing value less rapidly than the said currency.
It is nevertheless important to note that the currency would only be seen as substandard so long as it is decreasing in value relative to other monies in the economy. Additionally, if it were to continuously decrease in value, its destructive effect on the economy would eventually cease, as it would ultimately become a nearly worthless currency, limiting its use to minute transactions.
Legal Tender Impedes CompetitionHowever, when we model an economy using both legal tender laws and Gresham’s Law we create a new problem. No new currency is likely to usurp an incumbent currency unless the incumbent has suffered such a large decrease in value that larger transactions in that currency have become impossible. This is because Gresham’s Laws ensures that inferior currencies will be the first to be traded, and legal tender laws oblige people to accept any currency with the legal tender status.
Nevertheless, even in cases where the most popular currency used to trade does suffer a massive decline in value, it will not be replaced with the most robust currency. It will be replaced with the next worst.
Moreover, Zimbabwe offers yet another twist which will favor inferior currencies. A peculiar fact about Zimbabwe — and a fact that will have important consequences to a Zimbabwean’s choice of currency — is that trade has been hindered in Zimbabwe due to the relatively high value of even the lowest denominated notes of their legal tenders.
There is a shortage of coins in Zimbabwe due to their high shipping costs. When using US dollars for example, the $1 bill is the most popular note due to budget constraints. For the average Zimbabwean, $1 is a lot of money, and due to the dearth of coins, people are often forced to buy more goods than are wanted or needed. Ironically, inferior currencies may actually be favored for convenience.
ConclusionWhile the more slowly depreciating currencies will be favored for savings, Zimbabwe’s monetary system favors less stable currencies for daily transactions. While legal tender laws remove the problem of network effects they create a new problem, namely a situation that allows inferior currencies to dominate trade.
Image source: iStockphoto.
Jeff Deist and Peter St. Onge discuss some of the fundamental questions about money in this electronic age. What do Menger and Mises tell us about the origins of money? How do we define it? What's the difference between "money" and a "medium of exchange"? And, was Hayek right about degrees of "moneyness"?
Market prices are determined by the bargaining between suppliers and demanders. Price determination by supply and demand is illustrated with a thought experiment that uses a fixed quantity of a perishable product (i.e., green peas) and known maximum valuations of consumers.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
In addition to training and the forces of supply and demand, workers with higher quality skills, risky jobs, or jobs which require trustworthy employees will receive higher wages. This is now known as the theory of compensating differentials that is often attributed to Adam Smith.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
Wherever a government establishes its capital, the city will grow in size because the additional spending attracts labor and businesses to service the government and its employees and thus, it becomes a commercial center for the nation as well.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
The opportunity cost of becoming a skilled worker includes both the direct expenses as well as the foregone labor during the training period or apprenticeship. As a result, skilled workers must be paid higher wages than unskilled workers.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
The interest rate is determined by the supply and demand for loanable funds, not the supply of money. Savings and frugality decrease the interest rate while lavish spending increases it. War increases the interest rate, peace decreases it. Paying off the national debt decreases the interest rate. A positive balance of trade decreases the interest rate, but the government cannot effectively lower the interest by a usury law. The interest rate is a critical factor in the valuation of assets such as land.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
Rural France was impoverished because commodities had to be sent to the capital and major cities to pay taxes to the state and rents to the property owners living there. It is argued here that if factories were permitted in rural areas, basic commodities could be turned into goods, which could then be sent to the cities at a much lower transport cost. This would save resources in transportation and benefit both rural populations and property owners.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
All human societies are based on a system of property rights. The distribution of rights will necessarily be unequal, and the use to which property is put will be dependent on the tastes of the owners.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
In this first of four chapters on economic geography and location theory, Cantillon explains that settlements are based on the requirements of production, especially the quantity of labor, and the extent of the specialization and division of labor.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
Here the circular-flow economy is extended to international trade. Instead of barter or exchange with money, Cantillon explains how international trade takes place on the basis of bills of exchange. He showsthat a state which accumulates money will enjoy a temporary gain in international trade, but that states where manufacturing industries develop will enjoy a higher standard of living. The only clear exception Cantillon makes to free trade is his famous endorsement of the English Navigation Acts, where domestic shipping is protected, not in its own right, but to provide ships and sailors during wartime.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
There is an expense associated with transporting money based on the distance, risks, and other transaction costs. Bills of Exchange are a type of contract that can reduce this cost by avoiding shipments that are offsetting between two locations. When money must be sent, bankers charge a fee for arranging the shipment and providing their customers with a bill of exchange, or check, that can be drawn or cashed at a correspondent bank where the money is sent. When the exchange rate is above par, it indicates a balance of payments deficit, and when the exchange rate is below par, it indicates a balance of payments surplus.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
Cities form at sites where large property owners have decided to live. Specialization of labor expands to meet the demands of the wealthy. Cities grow even larger when manufacturing industries produce for export, and whose workers are essentially supported by the production of foreign lands. Cantillon placed a great deal of emphasis on transportation costs. He found that property owners who lived far from their lands would experience a reduction in income proportional to the cost of transporting their production to market.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
The wealth of a nation depends on putting the labor force to work. Those who are unnecessary for farming can be employed in making higher quality products and manufactured goods, particularly durable goods made from metal. Saving is the key determinant of wealth and gold is a particularly useful form of savings because it can purchase all things, even in time of war. The prince and property owners determine how people will be employed by their consumption choices, while the Catholic Church reduces the resources available to materially sustain the people.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
When there is an increase in the quantity of money, prices will increase depending on how the new money holders decide to spend their money. The price changes will also be affected by such things as regulations on trade and the perishability of the products that are traded. In other words the simple quantity theory of money is naïve in proposing that a doubling of the quantity of money would double all prices equally. Changes in the quantity of money will change relative prices and have real effects on the economy, a phenomenon now known as the Cantillon Effects.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
Fractional-reserve banking is a system where the banks lend some of their deposits and earn interest. This increases the amount of money in circulation compared to warehouse or 100% reserve banking. This utility of banking comes at the risk of being unable to withdraw your deposits. The amount that can be lent into circulation depends on the type of bank and the needs of the depositors. There are goldsmith-bankers, the typical banker who issues banknotes, and the national bank.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
Here Cantillon uses his price-specie flow mechanism to analyze some of the effects of inflation. Increasing the supply of money by mining hurtssome people and benefits others because certain prices and incomes rise faster than others. However, if the new money is accumulated and saved by those who successfully export goods, either because of superior quality or more efficient transportation, it will lead to higher standards of living.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
Increases in the supply of money from a balance of trade eventually causes prices to rise. This in turn puts pressure on domestic producers and increases imports. The result is that the balance of trade is reduced and eventually is negative. This is Cantillon’s price specie-flow mechanism which demonstrates the reasons for the tendency for equilibrium in international monetary flows. The balance of trade can result in economic power, but this also causes the economy to lapse into luxury and decline.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
Interest is established in the market by lenders and borrowers and the interest rate on a particular loan is determined by the risk of default. A loan is repaid from the income generated from capital investments and the interest paid is equivalent to the profits of fully capitalized enterprises. Small entrepreneurs pay high rates whether they borrow cash or purchase goods to be paid at a later date, based on risk and their propensity to spend beyond their means.Thereby, interest rates on loans are connected with an individual’s time preference.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
When the government’s national bank inflates the money supply by increasing the supply of banknotes, it reduces the rate of interest and can increase the price of stocks. This is a corrupt process and when the notes are redeemed, the price of stocks falls and can result in bank runs and economic chaos. This is now known as the business cycle.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
Gold and silver were highly valued before they were used as money. They hold many advantages over other goods such as durability, divisibility, transportability, and homogeneity. These are the reasons which led gold, silver, and copper to be chosen as money, not “fancy” or common consent. When princes debase money or issue imaginary money, they hurt the economy.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
National Banks are of little utility and can be the source of economic chaos. The increase in the supply of money that they provide is relatively small and offers the same disadvantages as increases in real money. They are therefore unnecessary and potentially very harmful, as in the cases of the Bank of Venice and the Bank of London. The roles of legal tender laws, fractional reserve banking, and regional trade fairs are described.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
Large transactions can be accomplished with the use of bills of exchange or barter, which reduces the demand for money. Ordinary transactions by people require actual coin money in circulation. A variety of factors, therefore, affect the flow of money in circulation and this in turn affects the amount of money in circulation.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
Exchange rates are explained as a function of the balance of trade and other factors. A trade deficit can cause your money to exchange below par, while a trade surplus will cause it to exchange above par. In fact, the exchange rate, above and below par, is an indicator of the general balance of trade in a country. An attempt to prohibit the export of gold necessary to pay for deficits only hurts the economy.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
Cantillon develops a circular-flow model of the economy that shows the distribution of farm production between property owners, farmers, and workers. Farm production is exchanged for the goods and services produced in the cities by entrepreneurs and artisans. While the property owners are “independent,” the model demonstrates the mutual interdependence between all the classes of people that Adam Smith dubbed the “invisible hand” in The Theory of Moral Sentiments (1759).
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
Cantillon constructs a model of the isolated estate or closed economy where the choices of property owners determine outputs and prices, regardless if they manage the isolated estate or lease it to farmers. Mistakes of the farmers or changes in demand by the property owners cause changes in prices, profits and losses, which drive the economy back to equilibrium. The result is that the price system directs resources to the same outcome as that provided by the direct management of the estate owner, ala Adam Smith’s use of the “invisible hand” in the Wealth of Nations.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
Because the opportunity cost of a good cannot be fixed, it is impossible to know the proper exchange ratios for barter. This problem is overcome in the market by using commodities that have marketable characteristics, such as transportability, durability, and a recognized economic value, to serve as a medium of exchange. Prices of goods do not strictly follow the quantity theory of money.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
Entrepreneurs establish markets in centrally located villages which provide the necessary conditions under which prices are established between supply and demand. The size of the market town depends on the size of the economy it serves.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
Intrinsic value can be measured by the quantity of land and laborers, taking into account the quality of land and labor. Some goods are produced almost entirely with land, others solely from labor. In the garden example, intrinsic value is both the direct expenses of the garden and the foregone value of land. Intrinsic value of a choice never changes, but market prices vary according to demand. Cantillon’s construction of “intrinsic value” should therefore be understood as the concept of opportunity cost, not the essential nature of a thing.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
William Petty set off the search for a par value between land and labor. Cantillon provides a theoretical answer (referenced in Adam Smith’s Wealth of Nations) that property owners must provide their labor with the production of at least twice the land necessary to sustain the worker in order that enough children are raised to maintain the workforce over time. The amount of land will actually vary from job to job, person to person, and among different countries and societies. Therefore, the practical circumstances of the world dictate that there is no such “par” value between land and labor, only money— a “most certain measure”—can be used for income measurements and comparisons.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
Farm production produces three rents, one of which sustains the farm workers, while the other two can be sold at wholesale to entrepreneurs who in turn provide property owners and farmers with goods and merchandise. This is the circular flow model of the economy. Money facilitates the flow and timing of rent payments (i.e., “velocity”) and the rate of the monetary flow determines the ratio between the quantity of money and the value of annual production. This model is then used to explain the implications of international trade.
From Part 2: Money and Interest. Narrated by Millian Quinteros.
The price of gold and silver and the ratio between them is determined by markets and is also based on their usefulness, cost of production, and transportation costs. When government mints establish a fixed ratio between gold and silver money that is not based on market prices, the overvalued metal will be driven from circulation. This is commonly referred to as “Gresham’s Law” where bad money drives out good money.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
Population is based on the tastes and choices of property owners. Early versions of the Malthusian approach to population growth—that it follows some mathematical formula—are criticized. This chapter also shows that the opulence and lavish spending of the prince and absentee landlords living far from their lands was responsible for the poverty and declining population of France, which ultimately led to the French Revolution.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
The supply of workers adjusts itself to the demand for labor, across all professions, via wage rates, migration, and changes in population. Prosperity cannot be created by subsidizing job training.
From Part 1: Production, Distribution, and Consumption. Narrated by Millian Quinteros.
Raising and lowering the nominal value of money is shown not to undermine the theory of the value of money. In contrast, such measures are shown to be methods by which the prince acquires resources by deceiving individuals about the value of money. The process causes chaos in the market.
From Part 3: International Trade and Business Cycles. Narrated by Millian Quinteros.
From The Review of Austrian Economics Vol. 1, No. 4, 1987.
From the first, the Austrians entertained a wish ... to apply their marginal utility theory to the case of money—which both the enemies of this theory and some of its foremost sponsors . . . declared to be impossible.
—Joseph A. SchumpeterSchumpeter, 1954, 1089.
The current epoch of inflation over much of the world has emphasized yet again the acute relationship between the quantity of national moneys and domestic price levels. Inflation has also underscored the inadequacy of the Keynesian model in dealing with money-price level relationships. Keynes for the most part disposed of price level movements by assuming prices constant. His focus was on employment and interest rates (Keynes, 1936). Keynesianism swept the economics profession at a time when inflation was not a problem. Therefore, economists who embraced Keynesian doctrine as a general theory have had a less-than-satisfactory framework for treating price level changes.
The current epoch of inflation over much of the world has emphasized yet again the acute relationship between the quantity of national moneys and domestic price levels. Inflation has also underscored the inadequacy of the Keynesian model in dealing with money-price level relationships. Keynes for the most part disposed of price level movements by assuming prices constant. His focus was on employment and interest rates (Keynes, 1936). Keynesianism swept the economics profession at a time when inflation was not a problem. Therefore, economists who embraced Keynesian doctrine as a general theory have had a less-than-satisfactory framework for treating price level changes.
Keynes’s great intellectual victory in the middle half of the twentieth century has obscured at least two major doctrines that dealt specifically and directly with the quantity of money and prices. One was early monetarist theory, then known as the quantity theory of money. This doctrine was developed by Irving Fisher, E.W. Kemmerer, and others in the United States. In Britain, similar analysis resulted from the works of Edwin Cannan, A.C. Pigou, and economists of the Cambridge school, who were beneficiaries of the earlier classical works of John Stuart Mill, Henry Thornton, and David Ricardo. The other development was the Austrian theory of money initiated by Carl Menger, and continued and enlarged upon by Ludwig von Mises, Friedrich Hayek, Murray Rothbard, and other economists in the Austro-German tradition. These two doctrines shared important similarities and registered some differences, but both were fundamentally distinct from the Keynesian theory that has eclipsed them. Neglect of these doctrines has left economics less rich than it otherwise would be, and the doctrines themselves have had less impact on current theory and policy than they would have had if they had focused their attention on points of agreement and come to terms with their differences.
This article explores the fundamental operational concepts in monetarist and Austrian theories that bear on the utility and value of money, in order to determine where they are compatible and to assess the logic and significance of their differences.
Money evolved from commodities that were not money. Self-sufficient households, when they began to specialize, first bartered goods and services directly. They then learned to barter indirectly for items they did not want, but which they knew they could use subsequently in other exchanges for things they did want. These indirect bartering devices became media of exchange.
Primitive commodity moneys were varied and innovative (Jevons, 1898, 20-28). The more widely a given commodity money circulated, the more utility it had as a money and the more valuable it tended to become in terms of other goods. Carl Menger observed that, “Money commodities came to have utility as money beyond their utilities as commodities because they brought people closer to their ultimate goals of getting the goods and services they wanted” (1981, 262). This evolution is so inferentially logical that it hardly needs empirical substantiation. If it had not occurred, any historian could have invented it.
In the course of time, however, even the most refined commodity moneys gave way to token representations in order to economize their costs as media of exchange; and finally—if “finally” is now—the commodity itself has faded from the scene. Economic systems have been left with only paper and bookkeeping representations that are initiated and accepted under the coercive authority of the state.
The concept of subjective utility in economic analysis was introduced by Carl Menger, and, contemporaneously, by the English economist William Stanley Jevons and the French economist Leon Walras in the great triple coincidence of economic thought (Schumpeter, 1954, 825-29, 1055, passim). Menger developed a table showing assumed cardinal values for the declining marginal utilities often economic goods as envisioned by some economic man. However, he did not defend the simplifying assumption of cardinality for the utility schedule, nor did he include either an income constraint or a utility schedule for money (Menger, 1981, 125-28).
The inability to discriminate conceptually between commodity utility and monetary utility is evident in all the works on money in this period. Jevons, for example, wrote correctly:
Since money has to be exchanged for valuable goods, it should itself possess value, and it must therefore have utility as the basis of value. Money ... is only received to be passed on. The utility of the substance for other purposes must have been the prior condition for its employment as money. ... It is doubtful whether the most powerful government could oblige its subjects to accept and circulate as money a worthless substance which they had no other motive for receiving (1898, 31).
Jevons’s statement shows how difficult it was to penetrate the veil of the commodity in order to perceive the special utility of money. This analytic difficulty often led to the observation: “Money itself has no marginal utility, since it is not intended for consumption” (Wicksell, 1935, 20).
Ludwig von Mises came closer than any other economist of the time to a valid interpretation of the utility of money. He first wrote: “The subjective value [utility] of money is conditioned by its objective exchange value (emphasis added).” So far so good. However, he then restated the conventional error:
Money has no utility other than that arising from the possibility of obtaining other economic goods for it. . . . This peculiarity of the value of money can also be expressed by saying that, as far as the individual is concerned, money has no use-value [utility] at all, but only subjective exchange value (1980, 118, 130).
Von Mises’s statement acknowledged the necessity for money to have utility—that it is an economic item to be brought into the panorama of market evaluation. But since its perceived utility was locked into its purchasing power for buying other things, the contradiction followed that money has no utility of its own.
Three factors probably contributed to this widely accepted view. First, at the time this issue came into economists’ thinking, almost all money was commodity money, or pretended to be. Since some commodity first gave monetary life to any commodity money, the supposition followed that money without its redemptive commodity could not have value of its own and certainly could not have utility. Second, the awareness that the nominal quantity of money units could change without changing the real value of the total stock of money seemed to discourage the notion that the total stock is real capital, regardless of the fact that the size of the nominal stock is irrelevant to the value of the real stock. Third, since money “only” existed to be exchanged for something else, its utility had to be something akin to an imaginary number. It was derived from the utilities of the things it could buy. To their everlasting credit, the Austrians insisted on bringing money into the general theory of value by emphasizing a demand function for money, but they lacked a utility theory of money qua money with which to complete the analysis.
Schumpeter correctly interpreted the Austrian view to mean that the exchange value of money—what it will buy—must be known before the individual can assign any utility to a unit of money: “It is therefore impossible to do in the case of money what can be done in every other case, namely, to deduce its exchange value from . . . schedules of marginal utility: to attempt to do so seems to spell circular reasoning” (1954, 1090). Indeed, this “problem” came to be known as the “Austrian circle” (Rothbard, 1976, 167).
Von Mises recognized and accepted the sequence of thought that led into the Austrian circle, and he tried to break out of it with his “regression theorem.” He argued that money’s value and utility today could be traced back incrementally day-by-day, year-by-year, decade-by-decade “in temporal regression” to the time when the money was a commodity money; then, as summarized by Murray Rothbard, “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.”Cf. Jevons’s statement earlier in this article Rothbard claims that this theorem “fully explains the current demand for money and integrates the theory of money with the theory of marginal utility” (Rothbard, 1976, 167-69, emphasis added; von Mises, 1980, 131-36).
Don Patinkin rejected the circularity argument by noting that it does not distinguish between “demand” as a schedule of alternative quantities, and “demand” as an amount demanded:
It is true that the amount demanded of money [by an individual or by all individuals}—as well as of any other good—depends upon prices. Nevertheless, it is also true that the equilibrium prices depend upon the demand functions. The “circularity charge” is simply a denial of this elementary distinction (1965, 116).While Patinkin rejects the Austrian circle and, therefore, von Mises’s regression theorem, he nonetheless gives full credit to von Mises’s contribution
Patinkin’s observation does not quite hit the mark. Von Mises did not confuse “demand” and “quantity demanded.” Nonetheless, this paradox is an illusion and the regression theorem is an awkward and useless contrivance which does nothing more than reargue the origin of commodity money. All these “problems” result from not recognizing money’s utility as money, and from a confusion of utility and value. Money does not have utility “only” to buy other things. It has the utility of being the exclusive vehicle for allocating expenditures of income over time. This role should be analyzed as one factor contributing to the terms on which money is exchanged for goods and services (that is, its value). If fiat paper money were dumped into a primitive barter economy and forced into acceptance by the impress of legal tender, its price would be established in terms of other things because of the monetary function it fulfilled and because its quantity was limited. Note that the coercive authority that would force acceptance of the money by means of the legal tender power cannot fix the terms on which the money is exchanged. The price level and the corresponding “price” of money—expressed by the inversion of the price level—are determined by the number of money units imposed on the economy, the efficacy of the payments system as a means of metering payments over time (that is, on the monetary utility of money), the stability of the economic environment, the productivity of enterprise, et hoc genus omne.
A memorable article that dealt definitively with this issue was written by W.H. Hutt in 1954. Hutt first reviewed the state of utility theory with respect to money and found it wanting, even though he, too, thought von Mises had come the closest to a correct interpretation. Money has utility, Hutt explained, because it is a “wealth-unit ready to be activated.” It also has the property of being the most easily adjusted asset in case an excess quantity accumulates. It yields service, and therefore an implicit rate of return to its owners. Adam Smith, Hutt observed, had written that money was unproductive because it was like a highway (Hutt, 1954, 217). “But Mises,” Hutt declared, “would insist that a highway is productive” (von Mises, 1980, 170). He cited a passage from von Mises that is notable both for its insight and also because it contradicts von Mises’s previous assertion that “money has no use-value at all (Hutt, 1954, 218).” Wrote von Mises:
It must be recognized that from the economic point of view there is no such thing as money being idle. All money, whether in reserves or literally in circulation, ... is devoted in exactly the same way to the performance of a monetary function. ... All money . . . lies in some individual’s stock ready for eventual use. . . . What is called storing money is a way of using wealth (von Mises, 1980, 170).
Hutt contributed important details to the utility argument. Money does not do its work by circulating, he stated.
If the work of money is circulation, then money is always “idle” because transactions are quasi-instantaneous. . . . The transfer [of money] itself occupies a mere moment whilst the services which flow from the possession of money are continuous over time. The essence of all these services is availability.
Real money units are thus like a real piano, which has utility because it is ready to be played even when it is silent. Money assets, Hutt emphasized, are “subject to the same laws of value as other scarce things [and] are equally productive in all intelligible senses (1954, 218-20).
Irving Fisher was as ambivalent as von Mises with respect to the utility of money. In The Purchasing Power of Money, published just the year before von Mises’s Theory of Money and Credit, Fisher wrote that marginal utilities, unlike prices, are “not only impossible to measure, but are unequal and vary unequally among individuals.” He recognized that money has marginal utility, which would vary directly with the purchasing power of money “if all prices and all money incomes change in the same ratio” (1911, 220).
Fisher, similar to von Mises, fell into the error of not allowing money to have its own utility because he (of all people) neglected money’s real value when analyzing its utility. “The quantity theory of money . . . rests,” he wrote, “. . . upon the fundamental peculiarity which money alone of all goods possesses—the fact that it has no power to satisfy human wants except a power to purchase things which do have such power” (1911, 32).
What Fisher, von Mises, and others did not recognize explicitly was that this “exception” to money’s “uselessness” was all important. It can be brought into focus most meaningfully by changing the statement, “Money can only be used to buy other things,” to, “Money is the exclusive means for buying other things.” These statements are similar; but one describes money’s function with the bemeaning adverb “only,” while the other uses the elite adjective “exclusive.”
In his Rate of Interest written in 1907, Fisher offered a view of money’s utility very similar to von Mises’s more profound expression:
The most salable of all properties is, of course, money and as Carl Menger pointed out, it is precisely this salability which makes it money. The convenience of surely being able, without any previous preparation, to dispose of it for any exchange ... is itself a sufficient return upon the capital which a man seems to keep idle in money form. This liquidity of our cash balance takes the place of any rate of interest in the ordinary sense of the word (1907, 212; also cited in Patinkin, 1965, 580; emphasis added).
Fisher’s notion of an implicit return on money held is identical to Hutt’s “yield.” Patinkin noted the ambiguity in the two passages from Fisher and the fact that Fisher wrote the meaningful interpretation of monetary utility in 1907, and the conventionally incorrect view four years later in 1911.
All this emphasis on the utility of money in the late nineteenth and early twentieth centuries should have culminated in an epic work on the subject. However, if the “culmination” of monetary economics was Keynes’s General Theory, the marginal utility of money is conspicuous by its absence. It appeared in only one paragraph in which Keynes treated the general properties of money. Besides the fact that the supply of money is completely inelastic under a fiat paper money system, Keynes wrote, the demand for money has an elasticity of substitution of zero,
which means that as the exchange value of money rises [the price level falls] there is no tendency to substitute some other factor for it. . . . This [inelasticity] follows from the peculiarity of money that its utility is solely derived from its exchange-value, so that the two rise and fall pari passu, with the result that as the exchange-value of money rises there is no motive or tendency ... to substitute some other factor for it (1936, 231).
This treatment has money held in a portfolio of interest-earning assets, and not as an exchange medium appreciating to the point where it would be too valuable to be held any longer and would be “sold.”
The fallacy in Keynes’s argument lies in the clause, “its utility is solely derived from its purchasing power” (emphasis added). The utility schedule of money is indeed proportional to money’s purchasing power. However, money does not “derive” its utility from its purchasing power. Its utility is derived from its effectiveness as a rationing device for household and business income over time—as Keynes himself recognized at one point. “One reason for holding cash,” he observed without any particular emphasis, “is to bridge the interval between the receipt of income and its disbursement” (1936, 195).
Keynes did not redeem himself with another passage in which he explicitly recognized the utility of money held, as did Fisher and von Mises. While he saw that the marginal utility schedule of money was geared to the exchange-value of the money unit, he did not notice that this linkage would permit money to be entered into a marginal utility calculus for establishing spending equilibrium between money and other economic wealth. (See appendix.) In Keynes’s world, a falling price level that increased the exchange-value of the money unit generated no behavioral reaction that would stabilize general disequilibrium conditions, but only further acquisitions of the wealth-item that was appreciating. This oversight is consistent with his inability to derive a real balance effect that would get the economy into “full employment” equilibrium.
A resolution of the value-utility argument over money requires some reassessment of money. Much of the confusion and error in characterizing money has resulted from concentrating on the nominal quantity rather than on the real quantity. In the absence of expectations, the real quantity is largely independent of the nominal quantity. A nominal unit of money loses utility during an inflation in proportion to the rise in prices. But a real unit of money— the nominal unit adjusted for changes in the value of the money unit—loses no utility until it no longer performs in its usual way as a disburser of income between payment periods. As in all other determinations of real value, money’s utility is a feature that contributes to its demand, and the real income of money users is a second conventional determinant. However, the quantity of nominal money units is as irrelevant to the real value of the money stock as is the calibration of apples in bushels or pounds to the real value of apples.
Utility and value are not on the same plane. Utility precedes value and is parallel to scarcity. To label the utility of money “subjective value” as von Mises did is to foster a contradiction in terms. Money has subjective utility and objective value, regardless of whether a price index (inverted) measures its value accurately or not.
This correction does not deny the principle that consumption guides production. Nonetheless, the scarcity of resources used in getting the supply of anything to market is essential for setting the terms on which the demand is satisfied.
Both Fisher and von Mises emphasized the impossibility of measuring subjective utilities. Both saw utility as a force operating in markets, and also as a force whose magnitude marginally declines. To Fisher, its unmeasurability was a reason to use an objective measure—a price index—as a guide to “corrections in a monetary standard” (Fisher, 1911, 22). He did not mean to throw out the gold standard. He simply recommended periodic modifications to the fixed official price of gold because the production of gold was so great at the time that he feared a gold inflation (!) (Fisher, 1911, 248-50).
His prescription in practice called for only an occasional change in the mint price of gold to adjust for severe changes in its real price that were associated with a chronically rising or falling level of money prices. “Our ideal, he wrote “is not primarily constancy of the dollar but rather dependability. Fluctuations which can be foreseen and allowed for are not evils. ... [No one] should expect the monetary unit to insure him against every wind that blows” (1911, 223; emphasis added).
Fisher’s mathematical and statistical training undoubtedly led to his confidence in the use of a price index as a vehicle to measure the value of the money unit. Without such a construction, the common general confusion between relative prices and the price level could never be resolved, so changes in money prices were not likely to be distinguished from changes in real prices. “Individual prices,” he wrote, “cannot be fully determined by supply and demand, money cost of production, etc., without surreptitiously introducing the price level itself” (1911, 175). He recognized that the price level when inverted is the only conceptual means for expressing the price of money, and that a price index is the only practical means for estimating the price level.
Von Mises argued that since money prices (“objective exchange values”) were the result of subjective utilities, their general level was not explicitly measurable. Money prices he saw as indispensable means for valuing economic goods and services, but, paradoxically, the value of money itself was unquantifiable (von Mises, 1980, 62).
Von Mises here derived what can be labeled the Austrian principle of money: “Every variation in the quantity of money introduces a dynamic factor into the static economic system” (von Mises, 1980, 168). When the stock of money—even if money is gold—changes, the circumstances of the change (where and how the money comes into the system, and who first gets it) inevitably result in relative price changes. In addition, the distribution of wealth and income also change (von Mises, 1978, 81). Thus far, von Mises’s analysis and Fisher’s had much in common: Money in practice is not neutral in the short run.
Statistically speaking, von Mises noted, these changes in relative prices and real incomes change the “scaling factors” that weight the prices computed in any index. Statistical doctrine cannot provide an accurate means for weight changes. Therefore, “the idea that change in the purchasing power of money may be measured is scientifically untenable” (von Mises, 1978, 99). On the other hand, “any index method is good enough to make a rough statement about the extremely severe depreciation of the value of a monetary unit, [but it] is not necessarily either scientifically correct or applicable in practice” (von Mises, 1978, 89; also 1980, 216-22). Since monetary changes alter relative prices, von Mises argued, a policy to stabilize the price level would have to fix all relative prices and would result in severe distortions to the economic allocation of resources.
The difference between the two schools over this issue is both conceptual and practical. Both recognized that the purchasing power of money is a reflection of money prices inverted. Von Mises even stated that the ‘’fictitious” concept of a “price level” enables the observer “to distinguish and determine whether changes in exchange relationship between money and other commodities arise on the money side or the commodity side. . . . This distinction is urgently needed” (1978, 85). Fisher developed much the same argument (Fisher, 1911, 174-79). However, Fisher also believed that the price index, with all of its imperfections, was statistically valid and operationally useful. Since money prices are measurable data, a price index is “an ascertainable magnitude with a meaning common to all men” (Fisher, 1911, 220).
The conceptual validity of a price index seems logical. Imagine an economy in which the purchase and sale of one commodity dominates all exchanges. The market price of that commodity in terms of the money unit when inverted would also be the market price of the money unit in terms of that commodity. If the number of commodities exchanged for money were to increase, the conceptual means of evaluating the money unit would not change. It would still be the value of the money unit in terms of some aggregate of goods. Indeed, the value of the money unit cannot be measured in any other way. The validity of the concept cannot be denied because of the imperfection of the method used to measure it.
The propriety of using index numbers to measure prices, and hence the value of the money unit, is another story. It depends ultimately on the statistical reliability of the method for deriving the index, and is essentially an empirical issue. For example, given two periods, one of reasonably stable prices and one of pronounced inflation, do relative prices change significantly more in the inflationary period than they do in the stable period? If so, von Mises’s rejection of indexes would have some practical weight.
The Austrian view of the value of money, as set out by von Mises, argued correctly that money must be analyzed in a general theory of value. The value of money is determined in all markets where money is exchanged, he wrote. “To explain its determination is the task of the theory of the value of money” (von Mises, 1980, 141). Very properly, he applied an implicit real balance effect to show how an adjustment of prices resulted from a change in the quantity of money:
An increase in a community’s stock of money [alters] the ratio between the demand for money and the stock of it . . .; [people] have a relative superfluity of money and a relative shortage of other economic goods. The immediate consequence of both circumstances is that the marginal utility to them of the monetary unit diminishes. This necessarily influences their behavior in the market. They are in a stronger position as buyers. . . . They are able to offer more money for the commodities that they wish to acquire. It will be the obvious result of the [circumstances] that the prices of the goods concerned will rise. . . . Thus the increase of prices continues, having a diminishing effect until all commodities . . . are reached by it (von Mises, 1980, 160-61).
No quantity theorist or monetarist could describe the adjustment to an excess supply of money more effectively. Following this passage, however, von Mises made a substantive criticism of the “mechanical version” of the quantity theory of money: “A thorough comprehension of the means by which money changes prices makes [the quantity theorists’] point of view untenable” (1980, 161). Consequently, “no fixed relationship can be established between the changes in the quantity of money and those of the [money] unit’s purchasing power” (von Mises, 1978, 91).
To von Mises, Fisher’s manipulations with “neutral” money seemed impossibly mechanistic. The quantity theory assumes an exogenous quantity of money and employs a velocity of circulation and a total output of goods and services—variables outside the decision-making volition of human beings. In his view, therefore, it could not reflect subjective valuations of individuals, (von Mises, 1980, 153-54).
This charge is understandable and has long been a criticism of the quantity theory. Another criticism of some moment is that the quantity theory sublimates the real balance effect implicit in its workings, and hides the utility of money. Von Mises’s use of the real balance effect, and his simultaneous criticism of the quantity theory, imply that he, too, saw the quantity theory in this light. He recognized Fisher as one who “takes his stand upon the subjective theory of value,” but who is “unable to show the way subjective valuations are affected by variations in the ratio between the stock of money and the demand for money” (von Mises, 1980, 158).By the “demand for money,” von Mises indicated that he meant “volume of transactions [divided by] velocity of circulation.” Using the algebra of the equation of exchange,
T/V =M/P, and M/M
in contemporary parlance is the real value of the total stock of money (von Mises, 1980, 158).
If Fisher oversold his price index thesis because of his faith in statistical measurement, von Mises’s arguments were often whimsical. He had the habit of acknowledging that economic concepts have magnitudes, and he would use these devices analytically; but then he would argue that assigning any precise values to these variables by statistical measurement was improper.
All index-number systems are based upon the idea of measuring the utility of a certain quantity of moneyNot “utility,” but value. And not “subjective significance” in the next sentence but objective value as registered by markets. . . . . Their purpose is the determination of the subjective significance of the quantity of money in question. For this, recourse must be had to the quite nebulous and illegitimate fiction of an eternal human with invariable valuations (von Mises, 1980, 221).
Recognition of the quantity theory’s defects as an engine of analysis was expressed by A.C. Pigou when he wrote that he favored the form of the cash balance (or “Cambridge”) equation to the quantity theory because the cash balance approach
focuses attention on the proportion of their resources that people choose to keep in the form of [money] instead of focusing it on “velocity of circulation.” . . . [The cash balance method] brings us at once into relation with volition—an ultimate cause of demand—instead of something that seems at first sight accidental and arbitrary (1951, 174).
D.H. Robertson made a similar distinction. The cash balance equation, he wrote, “is the more useful for enabling us to understand the underlying forces determining the value of money; while the [quantity theory] is the more useful for equipping us to watch with understanding the actual processes by which in real life the prices of goods and services change” (1948, 38-39). The cash balance equation thus lent itself to the construction of a demand for money that answered von Mises’s criticisms of the quantity theory and, as well, provided a vehicle for understanding the true utility of money.
In most important respects, Austrian and monetarist monetary doctrines employ similar constructions and similar methods to analyze money’s impact on the economy. Both imply an awareness of the utility of money as money. Both develop demands for money that are methodologically consistent with demand constructions for all other goods and services. Both emphasize the necessity and importance of markets for specifying prices as guides to economic decision making. Both see the value of money in its classical garb as an inversion of money prices. Both make use of the real balance effect. Both deny the short-run neutrality of money; and both deplore the misbehavior of “managed” monetary systems. Wherein then lie their differences?
Most of the disagreements are either methodological misunderstandings or questions of empirical fact. One lingering difference between the two, in contrast to their many common principles, is in the validity each assigns to the statistical measurement of prices. Austrians incongruously deny validity of indexes yet continuously make use of the concept. In this day and age of statistical refinement—never mind the many misuses of statistics—this intellectual position is untenable. Just because a device is not perfect does not mean that it is useless. It should be used, however, with caution and with an understanding of its frailties. The Austrian criticism is a well-considered caveat if it limits itself to this point.
Fisher seems to have leaned too far in the other direction by assigning too deterministic a role to index numbers and by emphasizing too literally the influence of money on prices. Schumpeter hazards the guess that Fisher’s vested interest in a “piece of social engineering—the compensated-dollar plan—pushed aside all other considerations” (Schumpeter, 1954, 1103).
Another methodological issue is the Austrian contentiousness for insisting that utility can only be measured ordinally and not cardinally. Utility is a force that has magnitude and direction, as the Austrians know better than anyone else. Therefore, it can be treated as if its values are specific (as, indeed, Menger did). In fact, the only necessary condition for determining market equilibrium between money and goods is that all marginal utility schedules decline (Patinkin, 1965, 95). When people then give up money to get other wealth, they run themselves up the utility schedules of money and down the utility schedules of other wealth, until they reach a new equilibrium. (See appendix.)
Austrian doctrine also objects to the assumption of fixed utility schedules for other wealth when only a change in money disturbs some previous equilibrium. This issue is also methodological rather than substantive. Since the nonneutrality of money and the heterogeneity of individuals’ utility schedules do not violate in any way the conclusion that changes in the quantity of money significantly affect prices, the assumption of monetary neutrality and the specification of cardinal utilities are simplifications that clarify the analysis by showing it unadorned. The argument, in short, is not over a question of fact but over the efficacy of method.
Austrian doctrine on price indexes and utilities has some substantive basis, and is very useful in limiting enthusiasm for authoritarian tampering with the monetary system. However, the concept of circularity in the utility, value, and demand for money is an illusion, and the regression theorem therefore is a pointless contrivance. If a paradox is imaginary, the “solution” to it is worthless.
All professional specialists tend to culture their intellectual rent factors or vested interests, and economists are not exceptions. When this practice is carried on so intensively over minor details that it produces what appear to be ideological differences, it becomes counterproductive to the momentum of valid first principles. All of which is to say that, as allies, monetarists and Austrians both would better serve their common interests.
Appendix:The Equilibrium Value for the Marginal Utility of MoneyAssume declining marginal utility schedules for money, M, and all other goods and services, R. Money exchanges for these goods and services at market prices until a typical individual maximizes his utilities for money and goods relative to their prices. That is, in equilibrium (ephemeral as it might be) the marginal utility of money relative to the price of money equals the marginal utility of goods relative to the price of goods.
MUm = mur
Pm Pr
(1)
The price of goods, PR, is some construction of the general price level, and the price of money, pM, is 1/PR. Therefore, equation 1 can be reduced to three terms:
MUm _ MUr
(2)
and
MUm _ MUr Pr2
(3)
This last equation states that the marginal utility of the nth money unit in equilibrium is equal to the marginal utility of goods divided by the price level squared.
To visualize this explanation, let the original equilibrium in equation 1 occur when PR and pM are both 1. In this case, MUm would also equal MUR Now let a monetary inflation, say, triple the price level by a threefold increase in the stock of money. The new equilibrium, assuming no expectations of further price change, occurs when
MUm = MUr, and
(1/3) 3
(4)
the new equilibrium marginal utility of money is
mum = mur /9
(5)
When the money stock and the price level triple, the marginal utility of the nth dollar in equilibrium is one-ninth what it was originally. This value is explained by noting that the whole schedule of monetary utility for nominal money units must be scaled down to one-third of its former value, and in addition everyone must hold three times the former number of money units. Equilibrium, therefore, occurs on a utility schedule that has been reduced by a factor of 3 at a point three times as far out on the money axis.
Eighty years ago, Mises's The Theory of Money and Credit first appeared in English. It remains one of the most important books on money and inflation penned in the twentieth century, and it still offers the clearest analysis and understanding of booms and busts, inflations and depressions, writes Richard Ebeling.
This audio Mises Daily is narrated by Robert Hale.
Volume 17, No. 3 (Fall 2014)ABSTRACT: Keynes’s theory of Aggregate Expenditures from the General Theory is examined and criticized. Keynes suggested numerous reasons why his marginal propensity to consume (MPC) might vary across individuals, over different time periods, and might be fundamentally heterogeneous in other respects, but assumed a constant MPC for tractability. He also argued that saving was a leakage (1920, pp. 19–20; 1936, pp. 81–85), but ignored the role of financial intermediation, which makes savings available to finance additional expenditure. More importantly, he ignored the injection of newly-created money which boosts both consumption and investment expenditure but does not depend on saving (Mises, 1949, pp. 567–573). When the amount of saving available to finance consumption and investment expenditure is correctly acknowledged, the effective multiplier is greatly increased, computed now as m = ∆Y/∆AE = 1/(MPS)RRR = 1/((1-MPC)RRR). However, it should be kept in mind that, like the money multiplier, the Keynesian multiplier is merely an upper limit which can only be approached asymptotically and over time. In light of this caveat, the multiplier becomes a relatively unimportant concept. Because the required reserve ratio appears in the corrected multiplier, the significance and potential impact of 100 percent reserve banking reforms are also addressed.
KEYWORDS: Keynesianism, aggregate expenditure, stabilization policy, fiscal stimulus, multiplier effectJEL CLASSIFICATION: B31, E21, E22, E61, 0431. INTRODUCTIONIs Keynesian stimulus policy in any sense justifiable or warranted? And has it ever been? Substantial literature argues that it is and has been effective, and will continue to be needed in the future, though it has repeatedly been proven ineffective both empirically and as policy. Nevertheless, it remains the cornerstone of economic policy followed by the U.S. and virtually all advanced economies, and recommended by intergovernmental development lenders, if not actually forced by them on developing nations. This paper will demonstrate that the Keynesian expenditure multiplier is not a positive policy guide, and that Keynesian stabilization policy should be abandoned.
Though not the only economist to advocate counter-cyclical macroeconomic stabilization, Keynes remains strongly identified with all variants of such policy approaches, and they are appropriately characterized as Keynesian (Hansen, 1953; Lerner, 1944; Patinkin, 1963, pp. 343–348; Clarke, 1988; Dimand, 1988; Salant, 1989; and Backhouse, 1995; among many others). Although a distinction can be drawn between theories and policies explicitly proposed by Keynes during his life and in his writings, and those proposed by his many followers (Leijonhufvud, 1968, pp. 6-35), among them Hansen (1932, pp. 305–313 [ch. 20]; 1941, pp. 261–289 [chs. 12 and 13]; 1949, pp. 115–142; 1953, pp. 86–114; 1960, pp. 140–150; 1951, pp. 629–674 [chs. 33–35]; 1964, pp. 11–39, 43–55), Lerner (1936, 1944, pp. 296–312; 1951, pp. 245–258), Meade (1951), Robinson (1953; 1956, pp. 208–221; 1962, pp. 63–69; 1969, pp. 15–39, 91–97), Samuelson (1954), and Salant (1989), the strong common thread of counter-cyclical fiscal activism which Keynesian economics shares with Keynesianism more broadly considered, cannot be denied. Lucas and Sargent (1978) concluded that Keynesian economics had to be abandoned, yet the U.S., like most advanced economies, never really superseded deficit finance except for a brief period in the late 1990s, and returned to it in response to the 2007–2009 recession and its aftermath. Keynesian models never seem to die, notwithstanding clear analytical limitations (Backhouse and Laidler, 2004; De Vroey and Hoover, 2004). The thesis of this paper is that Keynesian stabilization policy is not justified by its purported theoretic foundations in the aggregate expenditures multiplier and the marginal propensity to consume.
The Keynesian Resurgence which started in 2008 is currently scheduled to last until the Second Coming. Perhaps longer. In the eventuality, all but inconceivable to Keynesian-inspired policy-makers and their cheerleaders, that the continued and persistent failure of Keynesian policy leads to it becoming once again widely discredited, new resurgences can be anticipated whenever capitalism fails once and for all, as it had utterly and inexorably during the financial crisis of 2007. This rendered private property obsolete and necessitated a progressive socialism directed by an “elite” of pretentious intellectuals and dirigiste technocrats. Never mind that the elite inspired and presided over the unsustainable expansion which led to the collapse. Predictably, the proposed remedy for failed financial regulation is always expanded, more encompassing, and ideologically triumphalist regulation.
Keynesian policy today is inspired less by serious contemporary economics, whether fallacious or not, than the aspirations of policy makers whose economic impact is aptly described by analogy to navigators who persistently run their ship aground whenever the rising tide threatens to float it free. Some Keynesian proponents acknowledge the recovery attained under the Resurgence has thus far been lackluster, but attribute this to the inadequacy of the stimulus and bailout spending. This in a financial environment where the U.S. has nearly quadrupled the monetary base over a four-year period. Among others, former chair of the Council of Economic Advisors Christine Romer (2011) calls for continued monetary and fiscal stimulus to facilitate continued recovery. She deplores the “theorists” ruled by an arbitrary religious faith that monetary expansion leads to inflation. In her view, policy should be formulated by hard-headed “empiricists” like herself, who can correctly observe that after an unprecedented expansion of base money and increasing money in circulation by over 20 percent since the start of the recession, consumer price index (CPI) inflation has not risen too much above pre-recession levels. In addition to ignoring actual prices actual consumers have actually been paying for actual groceries and gasoline, she also ignores the statistical impact on the CPI of weighting housing costs, which have fallen markedly since the start of the recession, at their higher, pre-recession levels. This makes the CPI understate inflation by overstating the impact of falling rental and real estate markets. Housing prices have fallen the most in the urban markets where they were most overvalued before the speculative bubble burst, which are the only markets captured in the CPI.
Interestingly, Romer’s own empirical research finds that tax cuts are more effective in stimulating the economy than fiscal spending or monetary expansion (Romer and Romer, 2010). The unhelpful and uninformative division of the profession into virtuous and pragmatic “empiricists,” who can formulate effective policy responses, and bad, dogmatic “theorists,” who are mired in non-Keynesian rhetoric, is about as helpful as reviving the division of the profession into “salt-water” and “fresh-water” economists (Krugman, 2009). Salt-water economists were orthodox Keynesians at Eastern Establishment schools and Berkeley. Fresh-water economists were monetarists and New Classicals near the Great Lakes. Where, for example, does the Austrian school fit in these spurious intellectual taxonomies? Keep in mind these are no more than ad hoc rhetorical devices, intended to be abandoned or superseded as convenient. It may be an admirable distinction for the Austrian school to pass under the radar of the economic ideologues, who remain as uniformed about economic reality as they are insistent on asserting their mistaken views in the realm of public policy.
The great moderation, the protracted though clearly unsustainable policy-induced economic expansion of 1982–2007, was a period during which the business cycle was considered as obsolete as Keynesian stabilization policy had previously rendered it during the 1960s. This multiparadigm period was marked by an informal division of labor, with Keynesian and post-Keynesian theorists dominating long-run economic analysis, and new classical economists dominating analysis of short-run phenomena. The Keynesian perspective is that an increase in saving reduces aggregate income in the short run, but somewhat schizophrenically, according to uncontroversial views of long run economic growth typified by the Solow growth model, also contributes to sustainable growth (Welfens, 2011, p. 109).
The remainder of this paper is organized as follows. First, the historical evolution of the theory of the consumption function is developed in section 2, focusing on its implications for the marginal propensities to consume and save. The familiar Keynesian multiplier is derived in section 3. Then, Keynes’s treatment of saving as a leakage is criticized and corrected to account for financial intermediation in section 4. The possibility of accelerated intermediation is discussed in section 5. Implications of 100 percent reserve banking are discussed in section 6, and the impact of hyperbolic time discounting is developed in section 7. Concluding comments are presented as section 8.
- THEORYKeynes framed what is now called the absolute income hypothesis defining the traditional or naïve Keynesian consumption function: C = C0 + MPC(Y), whereC0 is autonomous consumption and MPC is the marginal propensity to consume (Keynes 1936, pp. 113–119). Thus consumption expenditure C becomes a function of current income Y. A more sophisticated variant may substitute disposable income Yd which takes into account taxes, transfers, and other sources of income. D’Orlando and Sanfilippo (2010) argued that many results deriving from this naïve model of consumption were both well-grounded on behavioral economics and enjoyed sound empirical support.
Duesenberry (1949) next proposed the relative income hypothesis, arguing that consumption was determined less by current absolute income, but by individuals’ income relative to others in society. He proposed a consumption function in terms of the average propensity to consume C/Y,
Ct/Yt = a – b(Yt/Y0),
where the greater an individual’s consumption Yt exceeded the average Y0, the lower would be their average propensity to consume. Thus, even in very poor and rich societies, the richest will consume less of current income than the poorest, who will consume all or nearly all of their income.
Modigliani and Brumberg (1954) later framed the life-cycle hypothesis, arguing that consumers seek to maximize the intertemporal utility from a stream of consumption expenditure. They demonstrated it was optimal for consumers to smooth consumption even if their income was erratic or varied over the course of their career. This accorded with the observation that typical income patterns tend to rise as a worker gains experience and seniority, peaking just prior to retirement, and then being zero or significantly lower during retirement. Rather than severely restrict consumption early in their careers and during retirement, workers would generally benefit both from borrowing against future expected income to finance higher consumption early in their career, especially if they have high time preference, and later on by saving for retirement.
Modigliani and Brumberg’s life cycle consumption function depended on both accumulated wealth W and current income Y, expressed as
C = aW + bY,
where a is the marginal propensity to consume as a fraction of wealth, and b is the conventional Keynesian MPC. This function can be subsumed into the Keynesian absolute income hypothesis if aW is conflated with Keynes’ C0, autonomous consumption, merely implying the plausible interpretation that C0 rises with higher W. Dividing both sides by current income gives
C/Y = b + a(W/Y),
which gives the relationship between the average propensity to consume (APC, = C/Y) and the ratio of accumulated wealth to current income.
One implication of the life-cycle hypothesis was that worker saving would be determined by the average growth rate of GDP. High growth would reward savers more, and furthermore would encourage additional saving which would be required to enjoy an average standard of living in retirement. Increases in life expectancy or lowering of the retirement age would also encourage greater saving, as workers would have to save for a longer retirement period. Modigliani and Brumberg were able to show that in a steady-state economy, working savers would transfer wealth to retired dissavers as these retired workers used up the wealth they had accumulated earlier. If the population grew over time, there would be relatively more workers and fewer retirees, lowering the burden on the working savers while increasing the benefit to the average retiree, but for a shrinking or aging population, this outcome would be reversed, perhaps unsustainably. Increasing productivity would increase income over time, which would tend to encourage additional saving and increase the stock of wealth, both acting to increase the balance of net saving by workers over dissaving by retirees.
Two problems were raised with the life-cycle hypothesis: 1) empirically, younger workers apparently refrain from borrowing against future expected income in the amount that would maximize their utility given the model’s assumptions; and 2) similarly, it was also observed that retirees generally consume less than is strictly consistent with their actual life expectancy. The failure of younger workers to borrow enough may result from ignoring debt aversion in relatively naïve intertemporal utility functions, and when student debt is considered, today’s young workers do borrow against future expected income, more so than ever before. Today the level of student loan debt for many consumers is comparable to mortgage borrowing. Three explanations were proposed to explain retirees’ failure to consume in accordance with their life expectancy: 1) retirees may overoptimistically estimate their life expectancy; 2) retirees are highly risk averse and cannot easily reenter the workforce except at significantly diminished wages, so they have a precautionary motive to retain substantial savings to cover unforeseen financial contingencies, such as market reversals or medical expenses; and 3) retirees may retain some unconsumed wealth to bequeath to their descendants.
To address perceived shortcomings of earlier consumption theories, Friedman (1957) proposed the permanent income hypothesis. Although his refinement of Modigliani and Brumberg is equivalent to merely extending individual life expectancy to infinity, in terms of interpretation, Friedman distinguished between permanent and temporary income. Extending life expectancy to infinity incorporates a bequest motive. Permanent income includes interest income on accumulated assets, regularly-occurring asset appreciation, and the non-variable component of current income, e.g., that part of attributable to accumulated human capital, as long as worker skills do not become obsolete rapidly. For many salaried workers, the permanent component of their wages is basically the whole amount, as long as workers perceive strong job security. For workers in less secure positions, it would be only the opportunity cost of the next best wage they could receive if they lost their current job. It would not include variable overtime demands or sales commissions, but recurring seasonal variations would average out. Temporary income, the variable component, or income perceived by workers as temporary, does not support much consumption spending—Friedman suggested this component should be saved and only the interest spent on additional current consumption, because then any interest on permanent additions to capital would be an addition to permanent income. It could be argued that low time preference individuals save temporary income to boost their asset stock and therefore increase their permanent income, but that individuals with higher time preference are more prone to spend temporary income immediately.
Both the life-cycle and permanent income hypotheses predict individuals act to smooth consumption over their lifetimes, as that is a utility maximizing strategy in these models. Younger workers with relatively low current incomes should borrow against higher expected future incomes and retirees should dissave (Thaler, 1990, p. 195), though empirically workers either do not typically do this at all, or do so less than the two hypotheses predict (Hall, 1978; Flavin, 1981, 1983; Hall and Mishkin, 1982; Wilcox, 1989; Zeldes, 1989; Singleton, 1990; Campbell and Mankiw, 1990; Carroll, 1994; Shea, 1995; Souleles, 2002; Stephens, 2003). In particular, young workers seem either to pessimistically under-appraise either their own future income stream or overall economy-wide growth, or both (Courant, Granmlich, and Laitner, 1984). Retirees also avoid consuming all remaining wealth as their life expectancy diminishes, perhaps due to bequest motives, or because consuming the whole stock of accumulated assets prior to death would be financially catastrophic, or both. Tests of the permanent income and life cycle hypotheses are highly sensitive to the method for segmenting income and consumption into permanent and transitory components. For example, Shirvani and Wilbratte (2009), using multivariate stochastic detrending, found that permanent consumption is determined by permanent income, but that the transitory component of consumption was not related to either permanent income or transitory income. Zeldes (1989) found that poor household consumption was constrained by current income, but rich household consumption was not.
The persistent failure of any compact single-parameter consumption function to adequately explain real-world consumption behavior led to new efforts to capture additional determinants of consumption behavior. Real-world consumers enjoy consumption, but also desire the security—and perhaps the status—offered by accumulated saving. For example, in his celebrated Diary, Samuel Pepys repeatedly expresses delight in the size of his increasing savings, though perhaps equally so in specific acts of consumption.Pepys (1893, vol. 1, pp. 34, 56, 155, 158–159, 194–195, 219, 234, 253, 274, 283, 292, 322; vol. 2, pp. 39, 93, 152, 231, 235, 254, 276, 303, 327, 351, 380, 400, 405; vol. 3, pp. 74, 94, 142, 173, 175, 216, 272, 303, 338, 370; vol. 4, pp. 88, 116, 137, 161, 191, 217, 261, 278, 398, 323, 328, 341, 361, 378, 398; vol. 5, pp. 2, 33, 42, 57, 173, 225, 246, 265, 285, 331, 362; vol. 6, pp. 42, 112, 190). He also expresses significant discomfort the one time his net worth declined (vol. 1, p. 253), but to be quite accurate, his delight in consuming food, wine, entertainment, etc. is just as well documented and equally noteworthy. The need for a more realistic and encompassing theory of consumption, combined with the empirical failure of earlier naïve theories, led to a more sophisticated multidimensional approach.
The behavioral life-cycle hypothesis (D’Orlando and Sanfillipo 2010) proposes segregating income and wealth into different categories with different MPCs: current income, savings (current assets), and future income. They note that empirically, consumers demonstrate different responses to changes in different categories of wealth and income, a behavior called mental budgeting. D’Orlando and Sanfillipo credit Keynes with the seminal identification of most of the basic underlying factors explaining consumption behavior: utility maximization based on foresight and calculation, preference for procrastination (high time preference), cognitive scarcity, imitation, status quo bias, short time horizon, prodigality (which may also come from high time preference), mental budgeting (where different accounts are kept for different classes of income, including permanent and transitory, as well as different classes of wealth-bearing assets), risk aversion, ambiguity aversion, and debt aversion.
Consumers characteristically have different MPCs for wealth derived from different sources, from assets which are earning different returns—whether from interest/dividend income or asset appreciation—and for physical assets in different locations, as well as for financial assets with varying degrees of liquidity, or different exposure to various kinds of risk, e.g., foreign-denominated assets exposed to exchange-rate risk, etc. (Thaler, 1994, p. 188). It has also been found that MPCs are magnitude-inconsistent—MPCs for small changes in income and/or wealth are significantly higher than for larger changes (Thaler, 1990; Heath and Soll, 1996; Souleles, 2002).
MPCs also vary with time horizon, that is, they are time-inconsistent in that long-term preferences deviate from the short-term preference for immediate gratification (Rabin, 1998, p. 38), which incidentally explains Pepys’s behavior. Consumers make very patient, low-time-preference tradeoffs between costs and benefits far in the future, but still desire immediate gratification (Ho et al., 2006, p. 21). Behaviorally, consumers also employ imitative or habitual heuristics to avoid the deliberation costs of processing available information or of collecting that information in the first place (Stigler and Becker, 1977, p. 82; Pingle, 2006, pp. 340–342). It has also been suggested that retirees spend less because they can spend more time in leisure activities like food preparation or bargain hunting, and thus their consumption is closer to what the life cycle and permanent income hypotheses predict, though their expenditure is lower (Becker, 1965; Aguiar and Hurst, 2005). Small changes in income are more likely to be perceived and treated as temporary, while sufficiently large changes are likely to be perceived as permanent, resulting in correspondingly large adjustments in consumption spending and living standard. However, this would not explain the behavior of younger workers.
Time preference ensures consumers prefer current to future satisfaction, but their actual behavior suggests an even higher preference for current consumption, such as might be explained by the more distant future appearing less certain, and consumers are increasingly risk averse for decisions which extend over longer time periods (Feldstein, 1985), and are thus exposed to more risk, for a longer period, and of a less definable character. One reason consumers may care less about the future is the uncertainty regarding future consumption opportunities, as well as how their preferences may change between now and then (Thaler et al., 1997, p. 648; Pesteau and Possen, 2006, p. 4). Debt aversion offers an additional reason young workers do not consume more (Thaler, 1992, p. 10), but that may be offset in the data by the massive student loan debt many young workers now accumulate.
One feature of behavioral life cycle models is that consumers do not know if a change in income will be permanent, but to some extent act as if they were, more that the level of uncertainty suggests (Shirvani and Wilbraitte, 2009, p. 59). Consumers behave as if they keep separate mental accounts (Prelec and Lowenstein, 1998), which are subjective rather than precise, and distinguish among current disposable income, with a very high MPC, and current assets, with a much lower or even near-zero MPC (Heath and Soll, 1996, p. 41). Unsurprisingly, future income and assets both have very low MPCs. Welfens (2011, p. 126) suggests high time preference by either consumers or policy makers, perhaps driven by poor institutional arrangements, should influence policy makers to adopt short-run Keynesian policies, because economic growth is not possible unless institutions are changed to favor it.
Seventy years of investigations into Keynesian-inspired consumption theory and a variety of appealingly parsimonious hypotheses have led to the general conclusion that consumer behavior is not so simple after all. And if the MPC cannot be averaged over a whole economy and is not time invariant, there can be no multiplier effect, as the next several sections will demonstrate.
- DERIVATION OF THE MULTIPLIERThe Keynesian multiplier is derived as follows (Keynes, 1936, ch. 10, pp. 113–131). Y represents income and output, and AE is aggregate expenditures, all measured in dollar terms. Any increase in income and output is decomposed into an infinite stream of increases in expenditure:
∆Y = ∆AE0 + ∆AE1 + ∆AE2 + ∆AE3 + … + ∆AEn + …
Each element in this infinite sum is related to the immediately preceding element by the marginal propensity to consume (MPC). Keynes also defines the marginal propensity to save (MPS). Any change in disposable income is divided between consumption and saving, so the marginal propensities to save and consume add to one: 1 = MPC + MPS. Although the MPC may vary across individuals, in Keynes’s construction there is one overall average MPC for the economy at any point in time, so the MPC is assumed to have a constant value less than 1.00 and usually greater than 0.50:
∆Y = ∆AE0 + (MPC)∆AE0 + (MPC)∆AE1 + (MPC)∆AE2 + … + ∆AEn + …
Because the MPC relates each element in the series to the one preceding, the series can be expressed exclusively in terms of the initial increase in expenditure and progressively higher orders of the MPC:
∆Y = ∆AE0 + (MPC)∆AE0 + (MPC)2∆AE0 + (MPC)3∆AE0 + … + (MPC)n∆AE0 + …
Note, however, that MPC heterogeneity derived from time and magnitude inconsistency breaks down the logic of this derivation in a way that mere aggregation over heterogeneous agents does not. Given the implicit assumption that the aggregate or economy-wide MPC is time invariant over the period it takes to arrive at the final change in income ∆Y, this is equivalent to the infinite convergent series:
∆Y = (MPC)0∆AE0 + (MPC)1∆AE0 + (MPC)2∆AE0 + (MPC)3∆AE0 + … + (MPC)n∆AE0 + …
which can be expressed as:
∆Y = ∑i=0,∞(MPC)n∆AE0 = ∆AE0∑i=0,∞(MPC)n
Finally, for infinite convergent sums, and dividing ∆Y by the initial ∆AE to define the multiplier, we have:
m = ∆Y/∆AE = 1/(1 – MPC) = 1/MPS
It is important that the MPC be strictly less than one for the infinite sum to converge. Although some individuals could conceivably spend more than their whole income through borrowing, transfers, confidence fraud, etc., the economy-wide average cannot exceed one. Even when institutionalized under government sponsorship, confidence fraud does not increase aggregate wealth or income.
For agents with high time preference, the MPC is very high in the short run, but diminishes as additional rounds of consumption occur. For agents with low time preference, the MPC is initially low and remains low for later rounds of expenditure.This points to the efficacy of hyperbolic, rather than standard exponential, discounting, which has been explored in the behavioral economics literature (Strotz, 1956; Phelps and Pollak, 1967; Laibson, 1997; Angeltos, 2001, p. 50, n. 13; Frederick et al., 2002, p. 360; Ho et al., 2006, p. 21; D’Orlando and Sanfilippo, 2010). The great sin in Keynes’s view is having too low an MPC, and therefore too high an MPS (Keynes, 1920, p. 20; 1936, pp. 81–85, 116–119). This view ignores the possibility of financial intermediation, not to mention monetary injection.
- THE MULTIPLIER WITH FINANCIAL INTERMEDIATIONWe start as before, with a hypothesized increase in total income and output being arrived at as the infinite sum of a series of increases in expenditure:
∆Y = ∆AE0 + ∆AE1 + ∆AE2 + ∆AE3 + … + ∆AEn + …
Some part of each increment of income received as expenditure, measured by the MPC, is immediately spent on consumption goods. At the outset however, we differ from Keynes by observing that the part not spent on consumption, measured by the MPS, does not simply disappear, as Keynes assumed, but is placed in the hands of financial intermediariesBanks and other financial intermediaries act solely as middlemen when they lend person A’s deposits to person B. In principle, A could lend to B directly, so the bank is nothing more than a middleman in this case. However, most bank intermediation today relies on credit creation by banks—when the bank lends A’s deposits to B, A can still spend their demand deposits or withdraw their time deposits, and now so can B. Here, banks are not purely middlemen, but increase the amount of money in circulation by creating additional credit. Credit created by private banks is sometimes called intermediated credit. Monetary expansion by the central bank encourages credit creation by increasing private bank lending, while making additional funds available for that purpose, increasing the multiplier as described in this section. To distinguish credit created through fractional reserve banking (intermediated credit) from credit which results from an expansionary money supply, the latter is sometimes called injected credit (Cochrane, Call, and Glahe, 1999). The distinction is significant but has no bearing on the present discussion. I am greatly indebted to an anonymous reviewer for pointing out this distinction as a potential source of confusion. who lend a good part of this portion to finance investment expenditures. The amount of each increment of expenditure loaned out by the financial intermediaries to finance investment is given by MPS(1 – (RRR), where RRR is the required reserve ratio.The RRR is formally a regulatory constraint set by the central bank or other authority, but banks typically hold non-zero excess reserves in addition. The actual amount of unloaned deposits banks hold is determined by their effective reserve ratio. Although in reality, this varies with banks’ risk tolerance, awareness of actual risk exposure, and differences in the kinds of lending particular institutions specialize in, etc. these real-world variations can be ignored for the present discussion. The effective reserve ratio for demand deposits is directly analogous to the loan loss reserve ratio held on saving or time deposits. Thus the presentation applies equally well to all deposits. RRR is conventionally thought of as being arbitrarily set by regulatory authorities, currently approximately 10 percent for the U.S. In practice, this quantity can be thought of as the actual bank intermediation rate, which captures not only banks’ required reserves, but excess reserves they hold voluntarily hold over and above the amount dictated by the reserve requirement, as well as loan loss reserves on time deposits not subject to the reserve requirement. For expository convenience and simplicity, all deposits are treated the same.
In Keynes’s formulation, each element in the expenditure series was related to the preceding by the MPC, but in adapting Keynes’s multiplier scheme to account for financial intermediation, we can see that each element is related to the preceding by MPC + MPS(1 – RRR). Since MPC + MPS = 1, we can rewrite this constant as 1 – MPS + MPS – MPS(RRR) or 1 – MPS(RRR). Thus, each increment of expenditure is reduced from the preceding one by a far smaller amount:
∆Y = ∆AE0 + (1-MPS(RRR))∆AE0 + (1-MPS(RRR))∆AE1 + (1-MPS(RRR))∆AE2 + … + ∆AEn + …
Following the standard derivation, each increment of expenditure can be expressed in terms of the initial one:
∆Y = ∆AE0 + (1-MPS(RRR))∆AE0 + (1-MPS(RRR))2∆AE0 + (1-MPS(RRR))3∆AE0 + … + (1-MPS(RRR))n∆AE0 + …
And the whole series can be expressed as higher orders of (1-MPS(RRR)):
∆Y = (1-MPS(RRR))0∆AE0 + (1-MPS(RRR))1∆AE0 + (1-MPS(RRR))2∆AE0 + (1-MPS(RRR))3∆AE0 + … + (1-MPS(RRR))n∆AE0 + …
This can be expressed as:
∆Y = ∑i=0,∞(1-MPS(RRR))n∆AE0 = ∆AE0∑i=0,∞(1-MPS(RRR))n
And for infinite convergent sums, we can now write the multiplier as:
m = ∆Y/∆AE = 1/(MPS(RRR)) = 1/((1-MPC)(RRR))
Table 1. Modified Keynesian Multipliers as a Function of the Effective Reserve Ratio
Note particularly that even with very high reserve requirements, the multipliers adjusted for intermediation are much higher than Keynes suggested. One consequence of this finding is that, far from being a drag on the economy or a leakage out of current expenditure, the amount of income saved boosts the multiplier substantially. If the reserve requirement is ten percent, each dollar saved results in ten times as many dollars of additional income as Keynes suggested, irrespective of how the MPC may vary throughout the economy.
Keynes introduced the now-familiar, though quite obviously wrong, idea that saving represents a drag on output in The Economic Consequences of the Peace (Keynes, 1920, pp. 19–20). In the Treatise on Money (Keynes, 1930 I, p. 279) he attributes recessions to a mistaken tendency for agents to save in excess of investment, rather than for investment to exceed saving. Apparently here he was referring to the economy after a collapse of aggregate expenditure, rather than during the unsustainable expansion which would have to precede a recession. According to the Treatise on Money, too much saving causes recessions (Keynes 1930 I, pp. 172–179), but by the time of the General Theory, saving and investment are always equal by definition (Keynes, 1936, pp. 74–85), though saving remains a necessary evil.Robinson (1969, pp. 95–97) makes the more sophisticated observation that saving is necessarily neither good nor bad. Its contribution to economic growth depends on whether it is invested and how productive those investment goods turn out to be. This comes close to approaching the Austrian school’s doctrine of capital multispecificity (Lachmann, 1956, pp. 2–3).
- THE AGGREGATE EXPENDITURE MULTIPLIER AND THE MONEY MULTIPLIERThe derivation presented in section 3 above makes the relatively reasonable assumption that each round of additional investment expenditure simultaneously accompanies each additional round of lending by the financial intermediaries. But what if financial intermediation happens significantly faster? Clearly, under appropriate circumstances, banks can lend money more rapidly than borrowers can spend it on consumption, and indeed, until the funds are spent on consumption, they are saved. Except for the small fraction held as bank reserves, these unspent funds are available to be loaned out.
This section presents a derivation of the multiplier with instantaneous, or at least, very rapid, financial intermediation. Now each element in the summation is related to the one preceding not by MPC + MPS(1 – RRR), but by the much greater quantity MPC + MPS(1 – RRR)/RRR. Here the amount of additional income which is spent on consumption is the same as in Keynes’s original multiplier, but now, instead of the remainder being a leakage, the unspent portion is loaned out in successive rounds of lending determined by the money multiplier. Therefore the second term in the constant is multiplied by m = 1/RRR, assuming that deposit expansion occurs instantaneously, or at least, before the next round of additional expenditure. The constant relating different rounds of expenditure can be rewritten as
1 – MPS + MPS/RRR – MPS = 1 – 2MPS + MPS/RRR = 1 – [2MPS – MPS/RRR].
This quantity is greater than one for any values of the MPS, MPC, or any non-zero reserve requirement, and thus the multiplier cannot be derived, because the summation never converges. If we could perform financial intermediation quickly and efficiently enough, income and expenditure could expand without limit. In this situation, the reserve requirement is not adequate by itself to limit the amount of income, even if it can limit the money supply.
- IMPLICATIONS FOR THE MULTIPLIER UNDER 100 PERCENT RESERVE BANKINGUnder 100 percent reserve banking, the reserve requirement becomes 100 percent, so the multiplier would reduce to its familiar Keynesian form given in the General Theory:
m = ∆Y/∆AE = 1/(MPS)RRR = 1/(1-MPC)RRR = 1/(MPS) = 1/(1-MPC)
However, under 100 percent reserve banking, the 100 percent reserve requirement would apply to demand deposits and other deposit instruments commonly available today. It appears highly likely that the financial services industry would respond to the imposition of 100 percent reserve banking by introducing innovative products to facilitate intermediation while rewarding depositors with higher returns. No one has claimed that implementation of 100 percent reserve banking would result in immediate and permanent disintermediation, or that this would be a desirable outcome. If savings go predominantly into instruments for which the 100 percent reserve requirement is inapplicable, the multiplier would be jointly determined by the MPS, the MPC, and the bank intermediation rate or effective reserve ratio, just as described in section 3 above.
- THE MULTIPLIER WITH HYPERBOLIC DISCOUNTINGGiven Keynes’s implicit assumption that the MPC is time invariant, it becomes interesting to see how relaxing this assumption changes the multiplier. Recall the familiar infinite convergent series:
∆Y = (MPC)0∆AE0 + (MPC)1∆AE0 + (MPC)2∆AE0 + (MPC)3∆AE0 + … + (MPC)n∆AE0 + …
This formulation assumes the more familiar exponential discounting. If the MPC diminishes over time, this can be modeled with hyperbolic discounting. Far from being an arbitrary counterfactual, hyperbolic discounting is well established in the behavioral economics literature (Strotz, 1956; Phelps and Pollak, 1967; Laibson, 1997; Angeltos, 2001, p. 50, n. 13; Frederick et al., 2002, p. 360; Ho et al., 2006, p. 21; D’Orlando and Sanfilippo, 2010). The original exponentially-convergent series can be replaced by an expression which diminishes for subsequent rounds of additional expenditure, such as
MPC’ = MPC/(1+n)
This changes the infinite series to
∆Y = (MPC)0∆AE0 + (1/2)(MPC)1∆AE0 + (1/3)(MPC)2∆AE0 + (1/4)(MPC)3∆AE0 + … + (1/1+n)(MPC)n∆AE0 + …
Which can be expressed as:
∆Y = ∑i=0,∞(1/1+n)(MPC)n∆AE0 = ∆AE0∑i=0,∞(MPC)n/(1+n)
Because each item in the summation is smaller than for the Keynesian multiplier, this series converges more rapidly, so unambiguously m’ << m, or in other words:
m’ = ∆Y/∆AE << 1/(1 – MPC) = 1/MPS
An even more extreme, though fortunately more tractable and intuitive approach is to assume future discounting is so extreme that all future consumption is ignored beyond one time period. Then the infinite sum is replaced with:
∆Y = (MPC)0∆AE0 + (MPC)1∆AE0 = ∆AE0(1 + MPC)
The multiplier is then derived as:
m = ∆Y/∆AE = 1 + MPC = 2 – MPS
This preserves the Keynesian conclusion that the higher the MPC and the lower the MPS, the higher the multiplier. The upper bound of two it suggests happens to accord well with empirical findings (Bodkin and Eckstein, 1985, Romer and Romer, 2010), however this has to be taken with a grain of salt. Many empirical estimates of the multiplier are less than one, (e.g., Barro and Redlick, 2010), implying both a negative MPC and an MPS greater than one. The deceptively simple concept of the MPC having a single, constant, time-invariant, time-consistent, and economy-wide value has to be abandoned, and Keynesian stimulus and stabilization policy along with it.
- CONCLUSIONKeynesian stabilization policy has informed and inspired government responses to the 2007 financial crisis and the 2008–2010 recession. Keynesian economics does not attempt to address the unsustainable expansions which render recessions inevitable. In fact, credit expansion and artificially low interest rates were policy choices pursued aggressively and almost unwaveringly from 1982 to the present. It is difficult for any objective observer to conclude that Keynesian economics offers plausible or especially enlightening explanations for this experience. The Keynesian resurgence is not in any way a resurgence of Keynesian economics, or in any way an intellectual resurgence of ideas that were thoroughly discredited by the stagflation in the 1970s. What we are seeing is merely a resurgence of Keynesian rhetoric in the realm of public policy, trotted out once again to justify a blatantly ineffective and indefensible expansionary policy. Credit expansion got us into this hole, and more credit expansion should not be expected to dig us out.
Sustainable economic growth depends on individual producers’ freedom to divide their income into consumption and saving in accordance with their own preferences, not the preferences assumed for them by politicians and bureaucrats. It is a bizarre delusion to argue that a sustainable outcome which reflects agent preferences can be improved by manipulating interest rates or credit markets. At best, such manipulations can only increase short-term production through inflation. As repeated experience has demonstrated, they can also bring about speculative bubbles and recurrent recessions which make welfare-maximizing consumption smoothing impossible. Monetary expansion and deficit financing should hardly be promoted as welfare-enhancing policy measures, the Keynesian resurgence notwithstanding.
Eighty years ago, in the autumn of 1934, Ludwig von Mises’s The Theory of Money and Credit first appeared in English. It remains one of the most important books on money and inflation penned in the twentieth century, and even eight decades later, it still offers the clearest analysis and understanding of booms and busts, inflations, and depressions.
Mises insisted that the economic rollercoaster of the business cycle was not caused by any inherent weaknesses or contradictions within the free market capitalist system. Rather, inflationary booms followed by the bust of economic depression or recession had its origin in the control and mismanagement by governments of the monetary and banking system.
Money Emerges from Markets, Not GovernmentBuilding on Carl Menger’s earlier work, Mises demonstrated that money is not the creature or the creation of the State. Money is a market-based and market-generated social institution that spontaneously emerges out of the interactions of people attempting to overcome the hindrances and difficulties of direct barter exchange.
People discover that certain commodities possess combinations of useful qualities and characteristics that make them more marketable than others, and therefore more easily traded away for various goods that someone might wish to acquire in exchange with potential trading partners.
Historically, gold and silver were found through time to have those attributes most desirable for use as a medium of exchange to facilitate the ever-growing network of complex market transactions that enabled the development of an ever-more productive system of division of labor.
Money and the Savings-Investment ProcessMoney not only facilitates the exchange of goods and services in the present — currently-available apples for currently-available bananas — but also makes easier and possible the exchange and transfer of goods and their uses over and across time.
Willing investors can borrow from willing savers sums of money set aside out of earned income to then use to purchase and hire various quantities of productive resources — including capital equipment, workers for hire, and useful resources and raw materials — to employ them in production activities that will finally result in potentially marketable and profitable finished consumer goods at some point in the future.
Out of earned revenues from such sales, the investor pays back the borrowed savings with any agreed-upon interest payment, which reflects the time preference of the savers for having been willing to defer the use of a part of their own income for the period of time covered by the loan.
Under a commodity monetary system such as a market-based gold standard, there is a fairly close and closed connection between income earned and consumer spending, and savings set aside and savings borrowed for investment purposes.
Suppose that $1,000 represents the money income earned by people during a given period of time. And suppose that these income earners decide to spend $750 on desired consumer goods and to save the remaining $250 of their earned income.
That $250 of saved income can be lent out at interest to those wishing to undertake future-oriented investment projects. The real resources — capital, labor services, raw materials — that the $250 of purchasing power represents are transferred from the savers to the investors. The remaining real resources of the society represented by the $750 of buying power that income earners choose to spend in the present are directed to the manufacture and marketing of more immediately available consumer goods.
Thus, the scarce and valuable resources of the society are effectively coordinated between their two general uses — producing goods closer to the present (such as a currently existing oven being combined with labor and raw materials to bake the daily bread that people wish to consume), or being used to manufacture goods that will be available and of use at some point later in time (such as the production of new ovens to replace the existing ones that eventually wear out or to add to the number of existing ovens so bread production can be increased in the future).
Like all other prices on the market, the rates of interest on loans coordinate the choices of savers with the decisions of borrowers so to keep supplies in balance with demands for either consumer goods or future-oriented investment goods.
In principle, there is nothing to suggest that within the free market economy itself, there are forces likely to bring about imbalance or discoordination between the choices and decisions of those trading in the marketplace. This remains true either for consumer goods in the present, or for savings in the present in exchange for more and better goods in the future through informed and successful investment by profit-oriented entrepreneurs.
Central Banks as the Cause of the Business CycleBut what Ludwig von Mises showed in The Theory of Money and Credit and then in even greater detail in his master work, Human Action, was how the harmony and coordination of the competitive, free market can be thrown out of balance through the monetary central planning of governments and central banks.
First under a weakened gold standard and then under systems of purely government-controlled paper monies, central banks have the ability to create the illusion that there is more savings available in the economy to sustain investment-oriented uses of scarce resources in the society than is actually the case.
For example, in the United States, the Federal Reserve has the authority and power to buy up government securities and other “assets” such as mortgaged-backed securities, and pay for them by creating money “out of thin air” that then adds to the loanable funds available to the banking system for lending purposes.
People may be still consuming and saving in the same proportions out of their earned income as they have in the past, but now financial institutions have artificially created bank credit to offer to potential borrowers, and at below what would otherwise be market-generated rates of interest to make investment borrowing more attractive to undertake.
To use our previous example, suppose that people are still spending $750 of their $1,000 of earn income on desired consumer goods and saving the remaining $250. But suppose that the central bank has increased available loanable funds in the banking system by an additional $250.
Investment borrowers, attracted by the lower rates of interest, borrow a total of $500 from banks — $250 of “real savings” and $250 of artificially created credit. They attempt to draw $500 worth of the society’s scarce and real resources into future-oriented investment activities that would not increase output in the economy until sometime later.
But income earners are still spending $750 of their originally earned income on desired consumer goods. This results in the limited and scarce capital, labor and raw materials in the society being “pulled” in two incompatible directions at once — into the manufacture of $750 worth of consumer goods and $500 worth of investment goods, when to begin with there were only $1,000 worth of such real and scarce means of production.
Price Inflation and Misdirection of ResourcesThis will inevitably tend to push up prices in general in the economy above where they would otherwise have been if not for the central bank’s expansion of the money supply in the initial form of new bank credit, as consumers and investors bid against each other to attract into their direction the goods and services they, respectively, are attempting to buy. Thus, such monetary manipulation always carries the seed of future price inflation within it.
At the same time, Mises argued, the fact that the newly created money first enters the economy through the banking system through investment loans brings about a malinvestment of capital and misallocation of labor and other resources as investment borrowers attempt to employ (as in our example) the equivalent of 50 percent of the society’s resources into future-oriented investment activities ($500), while income earners wish only to save the equivalent of 25 percent of their income ($250).
Even though price inflation will push up the dollar amount of money income earned, the unsustainable imbalance between savings and investment brought about by central bank monetary policy will be reflected in any discoordination between the percentage amount of income (and the real resources they represent) that people wish to set aside for purposes of savings and the amount of money investment borrowers attempt to undertake as a percentage of the real resources available in the society, due to central bank money creation.
Recession Correction Follows the Inflationary MisdirectionThis misdirection of capital, labor and raw materials away from that allocation and use consistent with people’s actual decisions to consume and to save, means that every monetary-induced inflationary boom carries within it the seeds of an eventual and inescapable economic downturn.
Why? Because once the monetary expansion either slows down or is ended, interest rates will begin to more correctly reflect real available savings to sustain investments in the economy. At which point, it will start to be discovered that capital and labor have been drawn into investment uses and employments that cannot be completed or maintained in a, now, non-monetary inflationary environment.
An economic recession, therefore, is the discovery period of misallocations of scarce resources in the economy that requires a rebalancing and a recoordination of supplies and demands for a return to market- and competitively-determined harmony in the society’s economic activities for long-run growth, employment, and improved standards of living.
The current boom-bust cycle through which the U.S. and the world economy has been passing for over a decade now, has shown the real world application and logic of what Mises demonstrated in The Theory of Money and Credit decades ago, and why reading and learning from this true classic of monetary theory and policy still offers an invaluable guide for ending the business cycles of our own time.
Image source: Sean MacEntee flickr/photos/smemon
Reprinted from Mises.ca
Anyone who knows him personally would attest that David Gordon is a troublemaker. He lived up to this label with a recent review of the new book by Steve Forbes and Elizabeth Ames. Gordon took them to task for referring to money as a measure of value, analogous to a ruler or clock; Gordon cited the authority of Ludwig von Mises while rejecting such a view. In a previous post at Mises Canada, I then defended Gordon from the reply of John Tamny. Yet now I see that economist Marc Miles has jumped in the fray, also thinking that Gordon is ignorant of basic economics.
Let me be clear: Gordon (and Mises) are right; money is not a “measuring rod” of value. However, the reason Tamny and Miles are astounded by Gordon’s position is that they think he is denying the (obvious) fact that people acquire money merely as a means to a further end. In the present post, let me try to clear up all of this confusion that the mischievous Gordon stirred up. As we’ll see, it’s precisely because people use money as a means to a further end, that it is NOT analogous to a ruler or clock or scale.
Voluntary Trades and Implications for “Value”For a full-blown discussion of these matters–particularly as they were developed in the hands of the fathers of the Austrian School–see Dan Sanchez’s meticulous post. But for our purposes, we can hit the main points quickly: When two people engage in a voluntary trade, it must be the case that each person subjectively values the item received more than the item given up. Otherwise, there would be no reason for them to trade.
For example, if Joe’s mom packed him an apple for lunch, while Sally’s dad packed her a banana, then if the two kids trade, it must mean that (1) Joe values a banana more than an apple and (2) Sally values an apple more than a banana. (Let’s assume the kids are trading based on the items, and not, say, because Joe wants to ask Sally to the dance and is buttering her up.)
Notice that this inequality in valuations must exist for the trade to happen. Far from “measuring” the value in each piece of fruit and then declaring them to be equal, Joe and Sally compare the fruits and come to OPPOSITE conclusions. This is not possible with physical properties, such as the mass of each piece of fruit, or the amount of calories. In other words, it would not be possible for both students to walk away with “the heavier” piece of fruit. But it is possible for each student to walk away with “the more valuable” piece of fruit–that’s the beauty of voluntary exchange. It is a win-win proposition.
The same is true if one of the kids has money. For example, if Joe has a $1 bill, while Sally has a banana, and they still engage in a trade, then it must be true that Joe subjectively values the banana more than the marginal $1 bill, while Sally values that additional $1 bill more than her banana. Again, there is no “measurement” going on here; each child sees an inequality of values.
However, it is true that we might say, “The exchange demonstrated that the objective market value of the banana was $1 at that moment.” But even here, there is nothing analogous to measuring length with a ruler, or weight with a scale. We’ll explain why in the next section.
Why Expressing “Market Value” In Units of Money Is NOT Like Using a RulerWhen you measure length with a ruler, you are assuming that there is an objective property of an object called its length, and that you can use an object (namely a ruler) possessing a standardized amount of this property in order to determine the magnitude that adheres to the specific object. So by convention we call a certain object a “ruler that is one foot in length,” and then we count up how many times we lay that thing end-to-end to measure the length of a fence (say). To say the fence is 18 feet long means that it possesses a magnitude of length that is 18 times as great as the length of one standard ruler.
There is absolutely nothing like this going on when people buy and sell goods in the market. This is the case, even when we take the (correct) view of Tamny and Miles into account, who realize that money is a means to a further end. For example, if a boy sells an hour of his labor (cutting the lawn) to his neighbor for $10, and then spends that $10 at the arcade, we can ultimately explain these actions by saying, “The boy valued his enjoyment at the arcade more than the hour of leisure he gave up cutting the neighbor’s lawn.” There is nothing analogous to physical length here, which the boy “measured” with his judgments or actions.
Why Mises Liked the Gold StandardIt is true that Ludwig von Mises, as well as plenty of other economists in the classical liberal tradition, was very fond of the classical gold standard. This is because it tied the government’s hands, preventing large and sporadic monetary inflation. Entrepreneurs could better plan their activities knowing that the purchasing power of money would not be subject to wild fluctuations caused by political whims.
However, to acknowledge all of this is NOT to admit that money tied to gold (for example) therefore has a “fixed” value and provides an objective unit of measurement. This is because the value of a unit of gold itself can change.
For example, suppose the government follows Forbes and Ames’ advice, and pegs the dollar-price of an ounce of gold. Then a few years later, an asteroid containing 170,000 tons of gold lands on the earth, effectively doubling the amount of gold held by humans in just a few weeks. If the U.S. government did nothing, the dollar-price of gold would crash. To maintain the peg, therefore, the government would flood the world with new dollars, causing the dollar-price of everything BUT gold to skyrocket. Do Tamny and Miles deny that this would sure seem like “inflation” in the eyes of the general public, and that the objective “ruler” now seemed to have a malleable length after all?
ConclusionAs Ludwig von Mises explained more thoroughly than any other economist, the new subjective theory of value ushered in during the early 1870s forever exploded the notion of money as an objective “measuring rod” of value. Nonetheless, Mises favored the classical gold standard as a way of minimizing the political influence on the quantity of money. There is nothing contradictory in these positions.
Image source: Wiki Commons
Scotland’s vote for independence resulted in a negative. There won’t be, for now, further discussions about what Scotland should do with its monetary institutions. Still, there is one more issue that I would like to discuss, because it transcends the particular case of Scotland, had independence been the result of the vote.
There is a widespread belief that a sound banking system requires a central bank to act as a lender of last resort. In a nutshell, the argument goes as follows: there are inherent potential instabilities in the banking system, to avoid a serious crisis and to interrupt means of payment, a central bank that is “external” to market forces should behave as a lender of last resort.
There are two problems with this line of reasoning. First, it takes as given that the banking system is inherently unstable. This is not as obvious as it is sometimes believed. Second, it is assumed that to have a lender of “last resort,” means having a central bank.
Let us say that Scotland voted for independence and unilaterally decided to keep using the British pound (note that a unilateral decision gives the country more flexibility than a bilateral agreement to change the currency if the British pound proved to be a bad choice). In the case of such a unilateral choice, in principle, Scottish banks won’t be able to turn to the Bank of England as a lender of last resort. But this doesn’t mean that the banks fall short on lenders to go to. In fact, they have the financial markets of the whole world to find lenders willing to extend them credit.
It is not, then, that banks don’t have access to lenders absent a central bank. The issue is whether the “lender of last resort” should extend credit to banks under any circumstances or only to banks that are illiquid but solvent. If the central bank, as a lender of last resort, is just going to mimic the market, what’s the point of having one? And if the central bank is not going to behave like the market, namely, easily extend credit to insolvent banks, then it does not only add moral hazard problems to the banking market, but it also fails to add efficiency to the market. A financial market with insolvent banks that are able to subsist thanks to the lender of last resort is less efficient and stable than a market where insolvent banks need to become solvent or discontinue business (like in any other market).
Banking Crises Reward Efficient BanksThe crisis of 1890 in free-banking Australia is telling. While insolvent banks were having problems and losing reserves, more efficient banks were increasing their reserves rather than losing them, contrary to what one would expect from the “inherently unstable” argument. The market share was shifting from inefficient to efficient banks. The banking system wasn’t unstable. It was, in fact, government interference introduced to “control” the crisis that made things worse. A mandatory banking holiday blurred the difference between solvent and insolvent banks; the market did not have a clear signal of which banks should and should not be trusted. Also, the government intervention allowed bankrupt banks to re-open for business without having to pay their old debts. Those banks that managed their reserves and deposits efficiently were now in a worse situation than the banks that got a free pass to ignore their financial obligations. Efficient banks started to lose reserves in favor of formerly inefficient banks now free of their debts.
Another historical case is the Ayr Bank during the Scottish free banking period. The Ayr Bank did what it was not supposed to do: it over-issued convertible banknotes. Not surprisingly, the bank failed. This case is sometimes mentioned as an example of how a bank failure can drag other banks down because Ayr Bank’s bankruptcy negatively affected many small banks. This, however, was limited in its extent because the banks that failed where those investing and exposing themselves to the Ayr Bank. That is, the banks that failed where the Ayr Bank itself, which did not manage its reserves efficiently, and those banks that imprudently invested in Ayr Bank.
Freedom and Flexibility Are the AnswerOther free banks that knew better were not affected by the crisis, and the crisis provides just another historical example of the market working in the money and banking market where market actors are able to separate between efficient and inefficient banks. Moreover, as is common in the banking sector, the accounts of a failing bank can be acquired by banks in good standing, which means that a bank failure does not necessary imply that their customers lose their deposits. Just as the bankruptcy of a firm is not a market failure, but a market correction, the same interpretation should apply when inefficient banks fail, increasing the market share of efficient banks (like in any other market).
Scotland, had it voted for independence, was highly unlikely to opt for free banking. An alternative for Scotland (or any other newly-independent country) might be to use the Euro (or any other currency) rather than the British pound. Which currency would be best, however, would be up to the local population to decide, and which currency is most advantageous is best discovered through market processes.
The need of a lender of last resort is not a strong argument for having a central bank. It might, actually, be an argument against having a central bank.
Image source: iStockphoto.
Money: How the Destruction of the Dollar Threatens the Global Economy — and What We Can Do About It, by Steve Forbes and Elizabeth Ames, McGrawHill, 2014
Money is an odd book. Its odd character can be brought out through an analogy. Imagine that someone wrote an eloquent book about price and wage controls. The book showed how attempts to control prices led to economic disaster. Faced with an abundance of incontrovertible evidence that demonstrated the bad effects of these measures, an informed policymaker would find only one rational choice available to him. He should not impose comprehensive price controls but rather should use controls in moderation.
Would it not be obvious what had gone wrong with our imagined book? If price controls do not work, they should be done away with altogether. “Moderation” in the use of a bad measure is no virtue. If cyanide is poison, “drink in small doses” is not the appropriate response.
Money falls exactly into the bad pattern just described. Forbes and Ames write with insight about the dangers of inflation and easy money. In response, they propose that the monetary system should be based on gold. What could be better? Unfortunately, they do not favor a genuine gold standard: instead, their plan calls for limiting monetary expansion by tying the dollar to gold at a fixed rate. In sum, monetary expansion is bad, so we ought to reduce the extent to which the Fed may engage in it.
Forbes and Ames aptly quote Ron Paul on the fundamental fallacy of inflationism: “If governments or central banks really can create wealth simply by creating money, why does poverty exist anywhere on earth?”P. 81, quoting Ron Paul. The same page mentions “noted economic historian” Murray Rothbard but Rothbard’s name does not appear in the book’s index. Money is valuable because we can use it to purchase goods and services: increasing the number of monetary units does not add new goods or services to those already produced. (An exception must be made for non-monetary uses of a monetary commodity, such as jewelry.
The point seems obvious once stated; why do so many ignore it? As Forbes and Ames point out, many nations favor inflation because it will increase exports and reduce imports. Foreign buyers, so long as the money of their own nation has not also expanded as quickly, will find that they can purchase more goods for the same nominal amount of their money; and importers will find that, with their inflated money, they can purchase less.
In this view, exports are good and imports are bad; but why should we accept this? “Trade deficits and surpluses have historically reflected little about the health of an economy. Neo-mercantilists overlook the fact that the United States has had a merchandise trade deficit for roughly 350 out of the last 400 years. ... The fact that the United States buys products and services from other nations doesn’t mean it is weak; it means that the U.S. economy is strong and has the wealth and resources to buy what others are selling.”
The authors strike forcefully at the Keynesian claim that inflation is needed to combat unemployment. “According to [William] Phillips and his fellow Keynesians, vigorous growth corresponded to price increases, while lower inflation correlated with higher jobless levels. In other words, there was a trade-off between inflation and employment.” As the “stagflation” of the 1970s showed, the Keynesian claim is false. Inflation and unemployment “don’t move the way Keynesians would have you believe. In the inflationary boom/bust era of the 1970s and early 1980s, unemployment reached higher levels than during the financial crisis.”
Broadening their critical assault, Forbes and Ames show the deleterious moral effects of inflation. “Weak, unstable money inflames perceptions of unfairness. People with fixed incomes struggling with rising prices in an uncertain economy become enraged when they see others appear to get rich through speculation or crony capitalism, not honest effort.” (For more on this, see Wilhelm Röpke’s, Welfare, Freedom, and Inflation).
The natural conclusion from all this criticism of inflation is that the government ought to refrain entirely from monetary expansion; but a theoretical error blocks the authors from seeing this. The error is that money is a measure of value that must be kept constant. “Money is a standard of measurement, like a ruler or a clock, but instead of measuring inches or time, it measures what something is worth. ... Just as we need to be sure of the number of inches in a foot or the minutes in an hour, people in the economy must be certain that their money is an accurate measure of worth.”
What is wrong with this? When you pay $25,000 for a car, you are not measuring the value of the car. Rather, you are showing that you prefer the car to the money: the person who sells you the car has the reverse valuation. Without this difference in preferences, no exchange would take place. If, as Forbes and Ames imagine, money measures value, both you and the car seller would arrive at the same “measure” of the car’s value. We would have no account at all of why an exchange takes place.
We can trace further the source of the authors’ mistake. They rightly note that money “originated in the marketplace as a solution to a problem. It arose spontaneously, like the spoon or the personal computer, in response to a need.” With money, it is much easier to achieve the “double coincidence of wants” required for an exchange than without it. But they miss why this is so. The reason is that practically everyone is willing to accept money in an exchange; it is a commodity that everyone wants. Instead, Forbes and Ames identify the need as “for a stable unit of value to facilitate trade.”
This fundamental error leads them to recommend inadequate policies. Their plan leaves plenty of room for monetary expansion. Their “gold standard allows the money supply to expand naturally in a vibrant economy. Remember that gold, a measuring rod, is stable in value. It does not restrict the supply of dollars any more than a foot with twelve inches restricts the number of rulers being used in the economy.” Money needs to expand if the economy is growing, because without the expansion, prices would fall; and then, horribile dictu, money would cease to be a constant measuring rod. Further, if a “major financial panic” demanded “an emergency injection of liquidity,” the Fed would be able to act as a lender of last resort.
How is the goal of stable money to be achieved? “The twenty-first century gold standard would fix the dollar to gold at a particular price. ... The Federal Reserve would use its tools, primarily open market operations, to keep the value of the dollar tied at that rate of gold.” In this etiolated gold standard, only the United States would need to fix its money to gold in the fashion just mentioned. “If the United States went to gold, other countries would likely fix their money to the dollar, if only for convenience. ... Of course, if a country wanted to attach its currency directly to gold instead of the gold-backed dollar, it could do so.”
An obvious objection to this proposal is that “setting a fixed dollar/gold ratio is price fixing and therefore anti-free market.” To this, the authors incredibly answer: “Having fixed weights and measures is essential for fair and free markets. We don’t let markets each day determine how many ounces there are in a pound or how many inches there are in a foot. ... Money, similarly, is a measure of value.” They fail to grasp that economic value is subjective: there are no fixed units of value that correspond to units of measurement of physical objects.
Their proposal, as they readily acknowledge, revives the interwar gold exchange standard and the post-World War II Bretton Woods arrangement. For them, this is no objection: those were excellent monetary systems. True enough, there are a few “gold standard purists” who argue that the policy of credit expansion pursued by the Fed in the 1920s under the gold exchange standard “produced the disaster of 1929.” These purists are wrong. “The cause of the Depression was the U.S. enactment of the Smoot-Hawley Tariff.” So much for Mises, Hayek, and Rothbard! Readers in search of a deeper analysis of monetary policy should put aside this superficial book and turn instead to the works of these great Austrian theorists. A good beginning would be America’s Great Depression by “noted economic historian” Murray Rothbard.
Image source: iStockphoto
This article is also available as an Audio Mises DailyAt the time of this writing, Argentina is a few days away from formally defaulting on its debts.How could this happen three times in just twenty-eight years?
Following the 2001 default, Argentina offered a debt swap (a restructuring of debt) to its creditors in 2005. Many bondholders accepted the Argentine offer, but some of them did not. Those who did not accept the debt swap are called the “holdouts.” When Argentina started to pay the new bonds to those who entered the debt swap (the “holdins”), the holdouts took Argentina to court under New York law, the jurisdiction under which the Argentine debt has been issued. After the US Supreme Court refused to hear the Argentine case a few weeks ago, Judge Griesa’s ruling became final.
The ruling requires Argentina to pay 100 percent of its debt to the holdouts at the same time Argentina pays the restructured bonds to the “holdins.” Argentina is not allowed, under Griesa’s ruling, to pay some creditors but not others. The payment date was June 30. Because Argentina missed its payment, it is now under a 30-day grace period. If Argentina does not pay by the end of July it will, again, be formally in default.
This is a complex case that has produced different, if not opposite, interpretations by analysts and policy makers. Some of these interpretations, however, are not well-founded.
How Argentina Became a Bad DebtorAn understanding of the Argentine situation requires historical context.
At the beginning of the 1990s, Argentina implemented the Convertibility Law as a measure to restrain the central bank and put an end to the hyperinflation that took place in the late 1980s. This law set the exchange rate at one peso per US dollar and stated that the central bank could only issue pesos in fixed relation to the amount of US dollars that entered the country. The Convertibility Law was, then, more than just a fixed-exchange rate scheme. It was legislation that made the central bank a currency board where pesos were convertible to dollars at a “one to one” ratio. However, because the central bank had some flexibility to issue pesos with respect to the inflow of US dollars, it is better described as a “heterodox” rather than “orthodox,” currency board.
Still, under this scheme, Argentina could not monetize its deficit as it did in the 1980s under the government of Ricardo Alfonsín. It was the monetization of debt that produced the high inflation that ended in hyperinflation. Due to the Convertibility Law during the 1990s, Carlos Menem’s government could not finance the fiscal deficit with newly created money. So, rather than reduce the deficit, Menem changed the way it was financed from a money-issuance scheme to a foreign-debt scheme. The foreign debt was in US dollars and this allowed the central bank to issue the corresponding pesos.
The debt issued during the 1990s took place in an Argentina that had already defaulted on its debt six times since its independence from Spain in 1816 (arguably, one-third of Argentine history has taken place in a state of default), while Argentina also exhibited questionable institutional protection of contracts and property rights. With domestic savings destroyed after years of high inflation in the 1980s (and previous decades), Argentina had to turn to international funds to finance its deficit. And because of the lack of creditworthiness, Argentina had to “import” legal credibility by issuing its bonds under New York jurisdiction. Should there be a dispute with creditors, Argentina stated it would accept the ruling of New York courts.
Many opponents of the ruling today claim that Argentina’s creditors have conspired to take away Argentine sovereignty, but the responsibility lies with the Argentine government itself, which has established a long record of unreliability in paying its debts.
The Road to the Latest DefaultThese New York-issued bonds of the 1990s had two other important features besides being issued under New York legal jurisdiction. The incorporation of the paripassu clause and the absence of the collective action clause. The paripassu clause holds that Argentina agrees to treat all creditors on equal terms (especially regarding payments of coupons and capital). The collective action clause states that in the case of a debt restructuring, if a certain percentage of creditors accept the debt swap, then creditors who turn down the offer (the “holdouts”) automatically must accept the new bonds. However, when Argentina defaulted on its bonds at the end of 2001, it did so with bonds that included the paripassu clause but which did not require collective action by creditors.
Under the contract that Argentina itself offered to its creditors, which did not include the collective action clause, any creditor is entitled to receive 100 percent of the bonus even if 99.9 percent of the creditors decided to enter a debt swap. And this is precisely what happened with the 2001 default. When Argentina offered new bonds to its creditors following the default, the “holdouts” let Argentina know that under the contract of Argentine bonds, they still have the right to receive 100 percent of the bonds under “equality of conditions” (paripassu) with those who accepted the restructuring. That is, Argentina cannot pay the “holdins” without paying the “holdouts” according to the terms of the debt.
The governments of Nestor Kirchner and Cristina Kirchner, however, in another sign of their contempt for institutions, decided to ignore the holdouts to the point of erasing them as creditors in their official reports (one of the reasons for which the level of debt on GDP looks lower in official statistics than is truly the case).
It could be said that Judge Griesa had to do little more than read the contract that Argentina offered its creditors. In spite of this, much has been said in Argentina (and abroad) about how Judge Griesa’s ruling damages the legal security of sovereign bonds and debt restructuring.
The problem is not Judge Griesa’s ruling. The problem is that Argentina had decided to once again prefer deficits and unrestrained government spending to paying its obligations. Griesa’s ruling suggests that a default cannot be used as a political tool to ignore contracts at politician’s convenience. In fact, countries with emerging economies should thank Judge Griesa’s ruling since this allows them to borrow at lower rates given that many of these countries are either unable or unwilling to offer credible legal protection to their own creditors. A ruling favorable to Argentina’s government would have allowed a government to violate its own contracts, making it even harder for poor countries to access capital.
We can simplify the case to an analogy on a smaller scale. Try to explain to your bank that since it was you who squandered your earnings for more than a decade,you have the right to not pay the mortgage with which you purchased your home. When the bank takes you to court for not paying your mortgage, explain to the judge that you are a poor victim of evil money vultures and that you have the right to ignore creditors because you couldn’t be bothered with changing your unsustainable spending habits. When the judge rules against you, try to explain to the world in international newspapers how the decision of the judge is an injustice that endangers the international banking market (as the Argentine government has been doing recently). Try now to justify the position of the Argentine government.
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According to mainstream economics textbooks, one of the primary functions of money is to measure the value of goods and services exchanged on the market. A typical statement of this view is given by Frederic Mishkin in his textbook on money and banking. “[M]oney ... is used to measure value in the economy,” he claims. “We measure the value of goods and services in terms of money, just as we measure weight in terms of pounds and distance in terms of miles.”
When money is conceived as a measure of value, the policy implication is that one of the primary objectives of the central bank should be to maintain a stable price level. This supposedly will remove inflationary noise from the economy and ensure that any changes in money prices that do occur tend to reflect a change in the relative values of goods and services to consumers. Thus, for mainstream economists, stabilizing a price index based on a basket of arbitrarily selected and weighted consumer goods, e.g., the CPI, the core CPI, the Personal Consumption Expenditure (CPE), etc., is a prerequisite for rendering money a more or less fixed yardstick for measuring value.
This idea — that a series of acts involving interpersonal exchange of certain sums of money for quantities of various goods by diverse agents over a given period of time somehow yields a measure of value — is another ancient fallacy that can be traced back to John Law. Law repeatedly referred to money as “the measure by which goods are valued.” This fallacy has been refuted elsewhere and rests on the assumption that the act of measurement involves the comparison of one thing to another thing that has an objective existence, and whose relevant physical dimensions and causal relationships with other physical phenomena are absolutely fixed and invariant to the passage of time, like a yardstick or a column of mercury.
In fact, the value an individual attaches to a given sum of money or to any kind of good is based on a subjective judgment and is without physical dimensions. As such the value of money varies from moment to moment and between different individuals. The price paid for a good in a concrete act of exchange does not measure the good’s value; rather it expresses the fact that the buyer and the seller value the money and the price paid in inverse order. For this reason neither money nor any other good can ever serve as a measure of value.
Unfortunately, advocates of a gold-price target wholeheartedly embrace this mainstream doctrine while giving it an odd twist. They begin with the wholly unsupported assumption that one commodity, gold, is stable in value and that, therefore it can serve as the lone guiding star — or “The Monetary Polaris” as Nathan Lewis terms it — for Fed monetary policy. According to Steve Forbes, writing in the introduction to Lewis’s Gold: The Monetary Polaris, real gold standards have one thing in common: “They use gold as a measuring rod to keep the value of money stable. Why? Because the yellow metal keeps its intrinsic value better than anything on the planet.”
Louis Woodhill, in a Forbes column, writes in a similar vein, explaining that “[t]he fundamental validity of the gold standard rests upon the premise that the real value of gold remains constant over time. ... The most fundamental thing about a unit of measure is that it be constant. ... Gold is not money, and it should not be money. However we can and should use gold to define the value of the dollar.” These passages reflect an almost mystical belief that the “intrinsic” or “real” value of gold is, for all practical purposes, eternally unchanging, unaffected by the continual flux of human valuations, stocks of resources (including gold itself ), technology, and entrepreneurial judgments that define the essence of the dynamic market economy. Furthermore no definition is ever given of what exactly the concept of “intrinsic value” means or in what units it is expressed.
Historical experience clearly shows that the value of gold vis-à-vis other commodities has fluctuated over the centuries, even when gold has served as the monetary standard. This was certainly the case, for example, when the US returned to the gold standard after the Civil War. From 1880 to 1896, US wholesale prices fell by about 30 percent. From 1897 to 1914 wholesale prices rose by about 2.5 percent per year or by nearly 50 percent. This rise came about mainly as the result of a nearly doubling of the global stock of gold between 1890 and 1914 due to discoveries of new gold deposits in Alaska, Colorado, and South Africa, and improvements in the technology of mining and refining gold.
Proponents of gold-price targeting thus seem to ignore both theory and history in assuming that once the dollar price of gold has been fixed, the value of money itself becomes forever stable and immune to the influence of market forces of supply and demand. Inflation and deflation are, therefore, ipso facto banished from the economy. This implies that any changes occurring in the quantity of money under a fixed-gold price regime are to be construed as benign and stabilizing adjustments of the supply of money to changes in the demand for money. Steve Forbes writes: “The fact that a foot has 12 inches doesn’t restrict the number of square feet you have in a house. The fact that a pound has 16 ounces doesn’t restrict your weight, alas — it’s a simple measurement. ... The virtue of a properly constructed gold standard is that it’s both stable and flexible—stable in value and flexible in meeting the marketplace’s natural need for money. If an economy is growing rapidly such a gold-based system would allow for rapid expansion of the money supply.”
In other words Forbes’s “stable and flexible” gold standard would facilitate and camouflage an inflationary expansion of the money supply that would, according to Austrians, distort capital markets and lead to asset bubbles. The motto of our current gold-price fixers seems to be: “We want sound money — and plenty of it.”
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This transcript is adapted from an interview with Mark Thornton and David Morgan at The Morgan Report. Mark Thornton is available for media interviews. Contact him here.
David Morgan: Could you give us your personal assessment on the current economic landscape?
Mark Thornton: Well, I guess we’re at the point in history that I always thought was going to occur. Ever since I was a young man, very young man, I realized through study that going off the gold standard was a big mistake. That was really my first interest in economics and it just expanded outward from there and I found the Austrian School and got involved with the Mises Institute and went on and got my graduate degree.
I have been studying this issue ever since. The only thing that has really surprised me about this is that it has taken so long to get to this place in time and by this place, I mean a world in which fiat money is the sole circulating means of exchange and where central banks are engaged in a world currency war, trying to manipulate the value of their currencies downward in a simultaneous battle across the globe. But in particular the United States, the European Central Bank, Japan, and China and then of course many other countries engaged in the war in a defensive status where countries like Switzerland and Norway are pumping up their money supplies and engaged in quantitative easing in order to stabilize the exchange value of their currency.
So here in the United States, the ramifications of that are fairly easy to see that the Federal Reserve has manipulated markets to an extreme and to a level that I never thought they were going to be willing to go to. But they’ve manipulated stock markets and bond markets have created bubbles throughout the economy in the US in terms of, of course, the stock market reaching all-time high levels, bond markets reaching all-time high levels, junk bond yields down to historically low levels, rising real estate prices, rising art prices.
It’s truly remarkable to the extent that they’ve been able to engineer this. They’ve taken so many unprecedented measures. I really never thought that central bankers would go to this extreme but they’ve done it. So right now, what we’re looking at is a worldwide currency war. We’re looking at real estate housing bubbles all around the planet, whether it’s Canada, in Asia, in Manhattan, in Washington DC.
There are these housing bubbles and real estate bubbles rising to the extreme. Then one of the things that I like to follow as an indicator is the Skyscraper Index. The Skyscraper Curse is the eerie correlation of the building of record setting skyscrapers and world economic crises.
Basically going around the planet, we see all sorts of huge skyscrapers being built and even more recently, China and Saudi Arabia have announced plans to build worldwide record-setting skyscrapers. So that’s the way I view it, that we’re in unprecedented territory at this point and time in terms of markets.
DM: The way I see it, all debts are either paid, defaulted upon, or partially paid off. But at some point in time, there is a reconciliation of the monetary system.
You’re either going to default outright saying that we cannot pay back the debt or you’re going to default on a currency, which means that you’re going to continue to print money until the currency becomes worth less, worth less, and then it’s worthless.
Can we default outright? Can we default via currency default, or do we have a combination? What are your thoughts?
MT: Well, David, it’s a very good question and it’s a very, very important question. As you say, all debts are ultimately paid. The question is, “By whom?” Is it going to be the borrower or is it going to be some other party that ends up footing the bill for those debts?
The governments of the world have built up huge national debts and obligations going forward that are unsustainable and that in my view cannot be paid off in a rational way which is using part of your revenues to pay off or pay down those debts.
Right now, we’re living in a world where governments are able to borrow money very inexpensively at low interest rates. But if and when interest rates were to rise primarily through an inflation premium, the interest burden of those debts would be very difficult and put enormous pressures both on the treasury as well as the economy itself. Both would be burdened of those higher interest rates.
So the question becomes, as you suggest, “Are you going to try to pay off those debts in a rational way or are you going to use, resort to inflation in the printing press to pay off those debts?”
The problem with fiat money is that it always leads policy makers and politicians to the second answer which is using the printing press to pay it off because that’s more politically acceptable in the short run. But in the long run of course, it eventually causes the economy and the government to fall into a vortex where they’re required to print up ever increasing quantities of money to keep that system going.
So generally speaking, of course it’s better not to go into debt unless you’re buying productive assets that are going to be able to pay off those debts. The government is clearly not doing that. The second best alternative is to either pay off or default outright on those debts. This is something that governments and central banks are also loath to do, although that imposes the least economic burden on society across the board.
So the more likely, the most likely alternative and one that looks increasingly obvious to me is that they will continue to use the printing press. They can pull back at anytime but the pain, the political pain and the economic pain in the short run is so difficult for them to accept, that it’s likely that they’re going to go down the path of printing up ever-increasing quantities of money, engaging in quantitative easing and so forth.
The people that they brought in to engineer this process are PhD economists, and PhD economists are some of the most dangerous people in the world in terms of economic policy. Right now we have a world in which many of the financial and even some of the political institutions are controlled by PhD economists, mainstream economics, Keynesian economists, many of them MIT economists.
We shouldn’t forget for example that Mario Draghi who is in charge of the European Central Bank was officemates with Ben Bernanke at MIT when they were in graduate school. So they’re out of the same exact mindset where the professional economist can engineer an economy, can manipulate policy in such a way, in the same way a child plays with a toy.
In my estimation, it’s a very dangerous situation. I don’t think the world has ever been in a more dangerous economic situation than it is today.
We just had some photographs taken of our summer research fellows who are graduate students from around the world who come here for the summer to study.
We were doing this photo shoot and one of my bosses came in and said, “OK. Which one of these geniuses is going to be the next billionaire?” I thought to myself, “All of these people could be billionaires in the very short run, just as soon as hyperinflation is ignited in the economy.”
It’s a very short path to where the standard of wealth has jumped from being a millionaire to a multi-millionaire, now to a billionaire, multi-billionaire. But when the hyperinflation, when that process is sped up tremendously, and then you will be looking at people who are trillionaires and multi-trillionaires because the value of the currency can very rapidly deflate when faced with the enormous increase in the money supply which has so far been pent up on the balance sheets of central banks, on the balance sheets of treasuries, and on the balance sheets of the large money central banks.
So it’s not directly flowing to consumers and so if consumers don’t have the money, it doesn’t show up in the consumer price index. But it has shown up in terms of stock market values and bond values because all that money has been funneled in that direction.
But money doesn’t stay put forever and any safe outcome would rely on the completely unfeasible idea that somehow central banks are going to be able to wiggle their way out of this process.
DM: I get a call for a consultation and Mr. X says, “I had a big real estate portfolio and now it has declined 30 percent. I can’t borrow against it even anymore, even though I have great equity still. You advocate precious metals as a protection, David. They really haven’t done much the last three years. I have good liquidity. I have good cash flow. What do I do now? I don’t know if we’re having the inflationary blow-off or if we’re actually going into a deflation as Robert Prechter states.” What do you say?
MT: Well, of course the inflation-deflation debate is very important and it has been muddled by mainstream economists. The traditional notion of inflation was that inflation was the government increasing the money supply and deflation was a decrease in the money supply.
Mainstream economists have flipped that on its head so that inflation is a rise in general prices and deflation is a decrease in general prices. So, the traditional version was cause and effect where it focused in on the cause which was government increasing the money supply rather than the effect, which is an overall increase in prices.
So with that muddled definition, we entered this era of central bank manipulation to an extreme and therefore you’ve gotten this somewhat confused debate about inflation and deflation.
The way I view it is that in a policy sense, the government is going to continue to engage in a monetary inflation, but one of the deflation scenarios that I see is a deflation in asset prices because the economy is always trying to work to correct the errors that occur because of the central bank’s manipulation of interest rates and central banks have been manipulating interest rates downward. This has caused entrepreneurs to make investments in capital goods, in companies. That’s what has pushed the prices up and that’s what has pushed prices up in particular industries.
So there are a lot of hot industries, the internet stocks, although they’ve come down; the social media stocks, although they’ve been hit a little bit. It has forced things like gold stock prices down until very recently.
So the way I look at it is we’re going to see a continuation of monetary inflation by central banks that will ultimately be confronted by an asset price deflation, caused by markets, realizing that there has been so many investment errors in the economy and miscalculations as to the value of companies.
So you can have those things occurring simultaneously or contemporaneously because there are really two different phenomena. One is the central banks trying to manipulate the economy with more money and artificially low interest rates and the other is the economy trying to correct the errors that the central bank is creating and that would see lower stock prices, lower bond prices, and even lower real estate prices and lower land prices.
So it’s just a battle between those two forces of central banks versus economic reality.
DM: In theory, the US dollar could be saved. What do you think of a chance of some major reform in the near future on the US dollar?
MT: Well, it doesn’t look like there’s much chance. But there has been a small ideological revolution that has taken place over the last several years and that’s the key to it. Don’t expect any policy reforms to come out of Washington DC, or Tokyo, or Brussels.
The reform is not going to come from there. It’s going to come from the hearts and the minds of people across the country and I think that to a large extent, Americans are now disillusioned with their political system that the Fed in particular is seen as arrogant and more as the cause than the solution.
Historically, the Fed has always been able to paint themselves as the solution to our problems rather than the cause of our problems. I think the percentage of people who view the Fed as the cause of our problems has risen, continues to rise, and will likely continue to rise even further.
I see more and more people both around me and around the country and around the world trying to put themselves as much as possible on their own personal gold standards, so that they’re transferring their wealth from US dollar denominated assets into either productive assets or into precious metals.
So if you transfer your cash wealth from dollar denominated deposits in banks to gold denominated accounts or physical gold, paper gold, then you’re moving yourself personally to the gold standard. So it’s impossible to predict how and when there will be a return to the gold standard. But I think that the probabilities are actually much higher than most people would predict or admit.
There has always been this long train of beliefs that the US dollar is as good as gold, that the dollar is the world reserve currency, that the dollar is the international trade currency and things like that. That the central bank of the United States is the most powerful institution and there are a lot of cracks in the Fed’s edifice and the dollar’s invincibility and you see that in the actions of other central banks, and you see that in the actions of Americans and Chinese people and Indian people and people around the globe.
They’re saying there’s a possibility which seems to be increasing that these central banks are going to be willing to depreciate the value of currencies by a significant amount, and that they don’t show any tendency over the last several years to either admit their mistakes or to let up on the pedal of monetary inflation and quantitative easing.
So I think that the probability of a return to the gold standard is relatively high but it’s only going to be the result of two things happening. One, the Fed continues to cause economic destruction of our wealth and two, is the ideological change where more and more people accept the Austrian position on economic policy and they don’t have to necessarily understand all of the details. They just need to accept the ideas that private property is the foundation of a strong economy, that free markets are the way to allocate resources and to produce the greatest consumer satisfaction and standard of living and that that is possible only under a system of sound money, which means basically gold and silver coins.
Here at the Mises Institute we are planning the Mises University, where we bring in 150 college students. Then of course we broadcast it to tons of other people on the internet.
We show them step by step the science, the economic science behind these propositions, most of these kids are not going to go out and necessarily become professional economists or teach economics at the university.
But once you go through the process of seeing the implications of free markets and seeing how free-market prices emerge and how entrepreneurs’ savings cause economic growth, how sound money produces a stable economy, providing another foundation for economic growth and prosperity, once you see the science behind all that, you don’t necessarily have to remember it all.
What you remember is the judgment that Austrian economics entails and therefore you accept the Austrian position with respect to how economic policy should be established. So I think that’s the way that things are ultimately going to turn out. When I started down this journey, there was nobody really who believed or taught Austrian economics.
Fast forward about 35 years and Austrian economics is being taught at universities around the world. Here in the United States, many, many young people, young adults, teenagers, college students, and college graduates consider themselves libertarian whereas 35 years ago, nobody knew what a libertarian was or had ever heard of the term.
Now Austrian economics is a very, very popular topic among these young people. While it’s not necessarily a majority of these young people, it is the case that the people who have already studied this and have accepted this and are advocates for Austrian economics, they are really the leaders of the future. These are the people who are going to take on leadership positions in society whether that’s in business, finance, whether they’re entrepreneurs or educators or media, journalists, so on and so forth.
So in the long run, I think you’ve got to be incredibly optimistic about where we’re heading today. It’s just that that road is fraught with a lot of dangers at the same time, economic dangers.
DM: I want your take on why gold has had a significant premium over silver especially in the last hundred years.
This follow-up question is, “Any thoughts on why Asia is accumulating gold at a rate that has really leaving silver as a secondary role, knowing that China was the last to come off the silver standard?”
MT: Well, David, that is a great question and all of the interviews I’ve done, that is the most under-asked question of them all. I think it’s really one of the most important questions in terms of a general outlook of where things are and where they’re likely to go.
I love silver. I think silver is the natural money for the last millennium and likely to go forward for the next millennium. Historically if you go back further in time, you have copper being a prominent medium of exchange, silver being a prominent medium of exchange.
But gold really wasn’t a commonly used medium of exchange throughout most of history. Generally speaking, Austrians recommend it — they talk about the gold standard but what they’re really talking about is a gold-silver-copper standard where there’s no fixed ratios of prices between one and the other.
They all would float independently and exist in markets that they were most well-suited for and so as we move into a gold reform era, where we go back to the gold standard, I think what you’re seeing right now is that people are reacting to fiat currency by investing heavily in gold because it’s the easiest commodity money to store.
The storage cost of gold, the transport cost of gold are very, very low and so you can transmit and store a huge value in terms of gold so that if you were to use gold to buy a house or buy a car, it’s very easy to transport that and also to store that, whereas if you were to try to buy a house in silver, it would be much more difficult.
On the other hand, it’s easy to make transactions in terms of silver and copper coins because of their relatively lesser value compared to gold. So I think that the type of money that would exist in hand to hand transactions would be very little in terms of gold but much more in terms of silver and copper.
So if we were to return to a commodity coin standard, I think you would see the ratio of gold to silver values return to their historical norms.
Now the only thing that would act against that is of course how we can store our gold and silver and we could theoretically store our gold and silver in bank accounts, and draw on those bank accounts in terms of checks and in terms of debit cards and so forth.
There wouldn’t be as much of a demand necessarily for silver. But I think as we do reform the monetary system, that there would be an increase in the demand for silver relative to the increase in the demand for gold.
Another reason why gold has done so well relative to silver is that the Chinese population, in particular the Indian population — of course it’s also the Thai population — have historically been more favorable toward gold and holding gold in the form of jewelry, in ornaments. They built up their wealth by acquiring gold ornaments, jewelry, etc., rather than silver.
So there’s a higher cultural demand in those areas for gold relative to silver. So there’s a cultural effect there and of course that has been compounded by the fact that the increase in relative income in China and India has been enormous in Asia, relative to the real decline in income in the US and other Western economies.
So there have been definite reasons why gold is outpaced in almost a very abnormal way. The price increase of silver, because of those factors like storage cost, transport cost — it’s also because the demand has come from countries that have historically had higher demand for gold, and their incomes are rising.
DM: Very good. I’m not going to try to lead you on this, although I might sound that way. But what I want to get a further comment on is gold really is mainstream. I mean even though Wall Street pooh-poohs it and you don’t hear it on the mainstream financial channels, etc., look, central banks still have a gold balance sheet. The Bank for International Settlements used to only settle only in gold. They quit doing it sometime ago.
So really gold is pretty much an establishment metal relative to silver. There are no central bank hordes of silver anywhere. No one in the establishment considers silver as money. So do you think that has something to do with the silver to gold ratio as well?
MT: Oh, yeah, there’s no doubt. I mean when you go from a world where people are actually exchanging gold and silver coins to where the commodity money is all horded by central banks, they’re certainly going to the central banks that left a gold standard rather than a gold and silver standard. So the central banks are the largest holders of commodity money and that’s gold. So that certainly plays into it because you have a world that went off a gold standard where central banks were the largest holder of gold. But when they disgorge themselves of that gold, that puts tremendous downward pressure on gold prices as well, so the relative value of gold versus silver would also adjust back toward historical norms.
DM: What are your thoughts on the US dollar as a reserve currency of the world going forward?
MT: I’ve written about this on mises.org as well. Barry Eichengreen came out with a book that tried to address this whole question of the dollar as the world’s reserve currency.
He basically came to the conclusion that the world had no choice. There were no competitors for the US dollar as world reserve currencies. I openly challenge that whole idea that there were no alternatives and therefore everybody would be stuck with the US dollar. I think events before that book came out and then after that book came out indicate that Barry was wrong and that there are potential and existing alternatives for central bank reserves. That would include of course gold and silver, and central banks have been purchasing gold.
It also would include other currencies and so the other currencies of the world, the British pound, the euro, the Japanese yen, and the Chinese renminbi are all potentially world reserve currencies, and of course China is actively trying to achieve that. They’re using more gold in their central banks. India is using more gold.
So a lot of central banks have already turned toward gold in other currencies, but there’s a lot of uncertainty for them. So the dollar hasn’t been completely removed. It has only been partially removed but it’s no longer the case that the dollar makes up 90 percent of the central bank’s balance sheets.
The figure is much less than that today and declining. So I think the status, the monopoly status of the US dollar as a reserve currency has already been broken and I see that trend continuing.
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This article is also available as an Audio Mises DailyThe Federal Reserve System of central banking was a response to the financial panics of 1903 and 1907 that rocked the US financial system. One of the key objectives, if not the only real one, was to counterbalance the nefarious nature of fractional reserve banking. We now have experienced a century of living with a central bank and we must only conclude that it has failed as a counterbalance while making fractional reserve banking an even bigger, more nefarious master. The evidence is clear and reform of the system is not the answer. Only the abolition of this institution will begin to set our economic system on the right path.
The central bank should never have been created as a “lender of last resort,” which may sound like a good or beneficial thing, but it is just the opposite.
Having a “lender of last resort” simply ensures that banks win at everyone else’s expense. With such a system in place, banks are more willing to leverage their deposits (commit more fraud) and increase the riskiness of their lending. If a person with a gambling problem has a rich uncle ready to bail him out, is he more or less likely to get into trouble by taking bigger and riskier bets?
By taking away some of the risks of a bank run, the central bank also took away the fear that supported sound lending practices. The fear of bank runs is, of course, a beneficial aspect of bank runs, because bank runs prune out the deadwood in the banking system. When we use central banks to ensure that some banks are too big to fail, we have seriously distorted the profit and loss aspect of the banking system, and consequently, much of the capitalist system.
Some economists claim that the Fed’s dual mandate was a mistake and minor reforms (such as limiting the mandate to inflation) could set monetary policy on the right path. Americans only have to look across the pond to Europe to see that such reform would simply set monetary policy on a different wrong path.
The European Central Bank (ECB) is just as guilty as the Fed of creating the housing bubbles at the beginning of this century. Yet, the ECB was legally structured to be much more conservative than the Fed. The Germans accepted the concept of the euro as the price for reuniting with East Germany but required that the structure of the central bank resemble essentially a larger carbon copy of the Bundesbank.Some of the concepts are drawn from Dr. Philipp Bagus’s excellent book, The Tragedy of the Euro. The ECB’s sole objective was price stability and its mandate clearly made financing government debt a no-no. Its main building is in Frankfurt so as to press home the point that it would be a German (i.e., harder money) style of central bank.
However, even with such a conservative structure, it has been making essentially the same mistakes as the Fed.
The first problem with the ECB’s monetary policy is that it defines price stability as a flat consumer price index (CPI). The original quantity theory of money related money with the price of transactions, not just real gross domestic product (GDP). When inflation is defined as the CPI, instead of the price of everything money can buy (including asset prices), monetary policy is focused on a healthy group of trees while the rest of the forest is diseased. Moreover, zero inflation may actually be reflecting an overly aggressive monetary policy if average prices should have been dropping.
The second problem is the way ECB monetary policy is currently structured. It is a bubble-creating machine. The ECB provides liquidity on collateral; the higher the quality of the collateral, the greater the liquidity. European banks quickly realized that the best collateral was government bonds in the Euro zone since the bonds were all given AAA ratings by the ratings agencies. The assumption, of course, is that governments never default.
With a large demand for government bonds, interest rates quickly fell Euro-wide to levels that only Germany experienced before the creation of the euro. By lowering the cost of borrowing, countries such as Greece or Italy had a much greater incentive to borrow to pay for vote-getting public expenditures (especially increases in public sector wages). Governments issued an excessive amount of bonds, which led to an excessive amount of liquidity and credit and led to the massive housing bubbles and malinvestments experienced between 1999 and 2007 throughout the Euro zone. Without such a monetary policy structure, Greece, Spain, and Italy would never have been able to get into this much debt trouble. The bubble in government bonds can be directly attributed to the ECB’s liquidity-granting structure. What is unbelievable is that this system is still in place, and the ECB seems totally unaware of what it has done and continues to do. European banks are currently up to their eyeballs in government debt, but the ECB seems oblivious to its role in this massive charade.
The ECB recently implemented negative deposit rates, and is considering a form of QE. It would be wiser to make it impossible to use government bonds as collateral for cheap ECB loans while adopting clear and immediate restraints (including outright abolition) on the ability to create money, borrow, and tax, whether through direct taxation or borrowing by states, fractional reserve private banking, or the actions of a central bank.
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This article is also available as an Audio Mises Daily
Today every central bank on the planet is printing money by the bucket loads in an attempt to stimulate their economies to escape velocity and a sustainable recovery. They are following Keynesian dogma that increasing aggregate demand will spur an increase in employment and production. So far all that these central banks have managed to do is inflate their own balance sheets and saddle their governments with debt. But make no mistake, central banks are not about to cease their confidence in the concept of insufficient aggregate demand. In fact, European Central Bank (ECB) President Mario Draghi is considering imposing negative interest rates to force money out of savings accounts and into the spending stream. Such an action is fully consistent with Keynesian dogma, so other central bankers will be impelled by the failure of their previous actions to follow suit.
Violating Say’s LawKeynes’s dogma, as stated in his magnum opus, The General Theory of Employment, Interest and Money, attempts to refute Say’s Law, also known as the Law of Markets. J.B. Say explained that money is a conduit or agent for facilitating the exchange of goods and services of real value. Thus, the farmer does not necessarily buy his car with dollars but with corn, wheat, soybeans, hogs, and beef. Likewise, the baker buys shoes with his bread. Notice that the farmer and the baker could purchase a car and shoes respectively only after producing something that others valued. The value placed on the farmer’s agricultural products and the baker’s bread is determined by the market. If the farmer’s crops failed or the baker’s bread failed to rise, they would not be able to consume because they had nothing that others valued with which to obtain money first. But Keynes tried to prove that production followed demand and not the other way around. He famously stated that governments should pay people to dig holes and then fill them back up in order to put money into the hands of the unemployed, who then would spend it and stimulate production. But notice that the hole diggers did not produce a good or service that was demanded by the market. Keynesian aggregate demand theory is nothing more than a justification for counterfeiting. It is a theory of capital consumption and ignores the irrefutable fact that production is required prior to consumption.
Central bank credit expansion is the best example of the Keynesian disregard for the inevitable consequences of violating Say’s Law. Money certificates are cheap to produce. Book entry credit is manufactured at the click of a computer mouse and is, therefore, essentially costless. So, receivers of new money get something for nothing. The consequence of this violation of Say’s Law is capital malinvestment, the opposite of the central bank’s goal of economic stimulus. Central bank economists make the crucial error of confusing GDP spending frenzy with sustainable economic activity. They are measuring capital consumption, not production.
Two Paths of Capital DestructionThe credit expansion causes capital consumption in two ways. Some of the increased credit made available to banks will be lent to businesses that could never turn a profit regardless of the level of interest rates. This is old-fashioned entrepreneurial error on the part of both bankers and borrowers. There is always a modicum of such losses, due to market uncertainty and the impossibility to foresee with precision the future condition of the market. But the bubble frenzy fools both bankers and overly optimistic entrepreneurs into believing that a new economic paradigm has arrived. They are fooled by the phony market conditions, so bold entrepreneurs and go-go bankers replace their more cautious predecessors. The longer the bubble lasts, the more of these unwise projects we get.
Another chunk of increased credit goes to businesses that could make a profit if there really were sufficient resources available for the completion of what now appears to be profitable long term projects. These are projects for which the cost of borrowing is a major factor in the entrepreneur's forecasts. Driving down the interest rate encourages even the most cautious entrepreneurs and bankers to re-evaluate these shelved projects. Many years will transpire before these projects are completed, so an accurate forecast of future costs is critical. These cost estimates assume that enough real capital is available and that sufficient resources exist to prevent costs from rising over the years. But such is not the case. Austrian business cycle theory explains that absent an increase in real savings that frees resources for their long term projects, costs will rise and reveal these projects to be unprofitable. Austrian economists explain that a declining interest rate caused by fiat money credit expansion does not reflect a change in societal time preference — that is, society's desire for current goods over future goods. Society is not saving enough to prevent a rise in the cost of resources that long term projects require. Despite central bank interest rate intervention, societal time preference will reassert itself and suck these resources back to the production of current goods, where a profit can be made, and away from the production of future goods.
No Escape from Say’s LawNo array of bank regulation can prevent the destruction of capital that becomes apparent to the public through an increase in bank loan losses, which may reach levels by which major banks become insolvent. Bank regulators believe that their empirical research into the dynamics of previous bank crises reveals lessons that can be used to avoid another banking crisis. They believe that banker stupidity or even criminal culpability were the underlying causes of previous crises. But this is a contradiction in logic. We must remember that the very purpose of central bank credit expansion is to trigger an increase in lending in order to stimulate the economy to a self-sustaining recovery. But this is impossible. At any one time there is only so much real capital available in society, and real capital cannot be produced by the click of a central bank computer mouse. As my friend Robert Blumen says, a central bank can print money but it cannot print software engineers or even cups of Starbucks coffee to keep them awake and working. Furthermore, requiring banks to hold more capital — which is the goal of the latest round of negotiations in Basel, Switzerland — is nothing more than requiring stronger locks on the barn door, while leaving the door wide open. Closing the door tightly after the horse is gone still means the loss of the horse. Why would an investor purchase new bank stock offerings just to see his money evaporate in another round of loan losses?
ConclusionThe governments and central banks of the world are engaged in a futile effort to stimulate economic recovery through an expansion of fiat money credit. They will fail due to their ignorance or purposeful blindness to Say’s Law that tells us that money is the agent for exchanging goods that must already exist. New fiat money cannot conjure goods out of thin air, the way central banks conjure money out of thin air. This violation of Say’s Law is reflected in loan losses, which cannot be prevented by any array of regulation or higher capital requirements. In fact rather than stimulate the economy to greater output, bank credit expansion causes capital destruction and a lower standard of living in the future than would have been the case otherwise. Governments and central bankers should concentrate on restoring economic freedom and sound money respectively. This means abandoning market interventions of all kinds, declaring unilateral free trade, cutting wasteful spending, and subjecting money to normal commercial law, which would recognize that fiat money expansion by either the central bank or commercial banks is nothing more than outright fraud. The role of government would revert to its primary, liberal purpose of protecting life, liberty, and property and little more.
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Volume 3, No. 3 (Fall 2000)There seems to be a lot less disagreement between Rothbard and Rashid than meets the latter’s eye. The biggest issue on which there is a gap separating Rashid from Rothbard (and Mises) is in the necessity of money originating from a commodity. Here I believe the regression theorem makes clear why Rothbard is correct and Rashid is incorrect. On other issues, either there is agreement to be found between the two in other works of Rothbard than that “lucid monograph” What Has Government Done to Our Money?, or the disagreements come from looking at the issues at different levels, so that differences are not contradictory.
Volume 8, No. 2 (Summer 2005)Selgin and White commence their defense of monetary systems with fractional-reserve banking, provided they are based on gold specie money. They argue that such systems are both ethically and economically defensible. With respect to the economics of the matter, they address several issues. We consider them in the following order: instability; resource costs savings;feasibility; and, mismatching of maturities. We conclude with a discussion of the possible conflation of time and demand deposits. If Selgin and White are correct that fiduciary media could exist in an otherwise free market, we would have truly reached the promised land.
Volume 8, No. 4 (Winter 2005)The present work is a doctoral dissertation written at the University of Hamburg. It deals with Mises’s work on monetary economics and business cycle theory. After an introductory chapter, the author starts with a short presentation of Mises’s life and work and gives an overview of the Austrian School and German monetary thought at the eve of the twentieth century. He then analyzes the first German-language edition of Theory of Money and Credit and subsequent developments in Mises’s monetary thought, in particular in the context of the Keynesian revolution. In the fifth chapter, the author reviews the development of Mises’s political ideas, and of his ideas on monetary policy in particular (p. 64). He then considers the ways in which contemporary monetary theory and policy reflects Misesian themes and summarizes his findings in a concluding chapter 7.
The Fed and the Treasury are betting on the fact that the dollar will remain the world’s reserve currency forever, and that the US can inflate without consequences indefinitely. The international victims of the scheme, however, are looking for a way out, writes Dante Bayona. This audio Mises Daily is narrated by Allan Davis.
Volume 8, No. 3 (Fall 2005)The aim of this paper is to criticize the foundation and the relevance of the insulation argument. In what follows, I will attempt to show that: (1) The favor flexible exchange rates enjoy in the literature is in part a result of the confusion between devaluation and free exchange rates; (2) Asymmetric shocks cannot provide a basis for the insulation argument, for their meaning is either a definitional truism or simply absurd; (3) Devaluation cannot offset the impact of foreign trade shifts on the domestic structure of production, and it instead produces additional problems; (4) A policy of monetary nationalism cannot prevent foreign-engineered business cycles from affecting domestic economic conditions, even if this is the only (but neglected) instance when a case for insulation could be rightly made.
Elizabeth Warren outlines 11 Commandments of Progressivism and each requires coercion and politics to succeed, writes William Anderson. This audio Mises Daily is narrated by Allan Davis.
Volume 9, No. 4 (Winter 2006)Austrians frequently lament the absence of an Austrian undergraduate money-macro curriculum, especially at the intermediate level. This is ironic in that a large body of work currently exists, both from “the masters” and more recent researchers that provides the essential theoretical underpinnings and historical and empirical analysis from which to mount a coherent Austrian macro course suitable for second or third year students. Unfortunately, that literature generally presupposes significant background knowledge in Austrian economics and thus does not ordinarily serve as a suitable platform upon which to build an intermediate money-macro course. Butos suggests all the components for such a course are in hand save one: an intermediate macro text appropriate for classroom use.
Volume 12, Number 4 (2009)
Much has been written about the quantity of money and its effects on money’s purchasing power. However, changes in the quality of money have been widely neglected. This paper analyzes changes in the quality of money and its influence on the purchasing power of money.
Volume 13, No. 3 (Fall 2010)
Recognizing different types of savings allows for a more fruitful analysis of the business cycle. Sustainable investment activities must be financed by an equivalent amount of savings, both in length of availability and quantity. Upward-sloping yield curves are a feature of the unhampered loanable funds market. Interest rates differ along this curve depending on the investment community’s demand for funds. While free market maturity mismatching can be successful and advance intermediation, the existence of either a central bank or a fractional reserve banking system skew the yield curve, resulting in malinvestment fueled boom-bust cycles. Credit expansion alone fails to explain the full extent of these cycles. Additional causes of the business cycle are found via excessive maturity mismatched borrowing driven by three banking sector interventions: credit expansion, the provision of a lender of last resort, and government bailout guarantees.
Volume 16, Number 2; Summer 2013
Don Bellante and Roger W. Garrison (1988) compared two alternative explanations of monetary dynamics: those based on a vertical long-run Phillips curve and those derived from analysis of Hayekian triangles. The authors concluded that the only factor differentiating the two models is the “process” whereby the initial cause is converted into the final “neutral” effect. This article refutes that conclusion. To do so, it suffices to demonstrate that the long-term effect of monetary policy is never neutral. While it is true that after the boom and bust the economy returns to the natural rate of unemployment, the crucial point is that the “natural rate” at the end of the cycle is quite different from the one evident at the start. This requires an “Austrian” Phillips curve with a positive slope.
Volume 6, No. 4 (Winter 2003)As Paul Samuelson once put it: Adam Smith is dead and Keynes is dead; well—and Mises is dead, too. But Keynesianism is alive and well and back with a vengeance. Built on solid neoclassical foundations, this “new” Keynesianism, which features the effects of nominal rigidities in the presence of economic shocks and the existence of involuntary unemployment, represents the theoretical core of modern monetary policy. This article gives a short overview of the new Keynesian theory of optimal monetary policy. The concept of inflation targeting represents the core of this theory. It will be illustrated with the help of Walsh’s simple model of inflation targeting (Walsh 2001b). On the basis of this model, the implications of the theory of optimal monetary policy for practical monetary policy will be demonstrated.
Volume 6, No. 4 (Winter 2003)Mainstream writings on monetary policy typically focus on the goals that are assumed to be the goals of monetary policy makers. Inflation targeting, employment, equilibration of the balance of payments, growth targets for monetary aggregates, the stabilization of exchange rates, GDP, or asset prices—these and similar goals for monetary policy are discussed in more or less detail in present-day textbooks. When it comes to the means by which these ends are to be reached, the discussion stops altogether and gives way to a description of the technicalities of open market policies, discount rates, reserve requirements, and so on.
In the present article, we will neglect these technicalities of monetary policy and focus on ultimate means and ends. The rationale for this procedure is twofold.
On the one hand, ends such as inflation targeting and growth rates of monetary aggregates are not ultimate, but intermediate ends. The tacit understanding is that they are more or less closely related to the attainment of the ultimate end—the reduction of scarcity (increase of “prosperity” or “wealth”). Our approach allows us to sidestep the discussion of the validity of this tacit understanding. We will directly address the more fundamental question to what extent monetary policy can and does affect the wealth of the community of money users at all.
On the other hand, the focus on ultimate means allows us to study monetary policy from a far more general point of view than is usually done. In particular, it allows us to interpret the institutional framework of money production as one of the means of monetary policy, and to compare different institutional set-ups. Our approach takes it for granted that central banks, the IMF, the World Bank, and other national and international monetary organizations are not ultimate givens, but creatures of the human will. They are means of monetary policy in the fundamental sense in which we understand this word. And as mere means to an end, rather than ends in themselves, they can be compared to other institutional arrangements that are supposed to attain the same ultimate end of reducing scarcity.
Accordingly, we will first study money production on an unhampered market. Then we will turn to the question whether politically induced changes in the money supply are suitable to bring about a further reduction of scarcity as compared with the free market. We will conclude that this is not the case. Quite the contrary, such changes actually aggravate the situation. Therefore the only logical alternative of politically induced changes in the money supply, namely, laissez-faire, is the optimal monetary policy.
It might be objected from the very outset that this approach cannot possibly warrant the conclusion it is supposed to yield, because the focus on the production of money is far too narrow to do justice to the complex issues involved in monetary policymaking. But this objection would miss the mark. The production of money is the essential means of monetary policy, even if we understand monetary policy in the conventional sense of “decision-making by monetary authorities.” Nobody contests the importance of the money supply for monetary policy in this sense. Admittedly it can be a tricky task to define monetary aggregates that are most relevant from a political point of view. But this does not alter the fact that manipulating the money supply is the main vehicle of conventional monetary policy. Indeed, quite irrespective of the goals of monetary policy, there are only two types of means available to the policy maker.
The first type of means is monetary interventionism—in particular, price controls in the form of domestic price caps or of foreign exchange controls. It is well-known that these means are abortive. Just as price controls in any other market, they do not solve the problem they purport to solve, but merely stifle the market process and the ability of the members of society to adapt to changing circumstances (Mises 1998, chaps. 30–31; Rothbard 1993, chap. 12). We therefore do not have to deal with them now.
The second type of means consists in changing the money supply. This is most obviously the case when the policy of the monetary authority consists in targeting a certain money aggregate (money supply growth rules). But it is also the case when the authority targets a certain inflation rate, or a certain interest rate, and so on. The simple but important truth is that, whenever monetary policy does not command the other market participants to behave in a certain way (interventionism), it has no other means but to change the money supply.We use the term “interventionism” in the narrow sense in which Ludwig von Mises (1977, p. 20) has used it. Murray Rothbard used the term in a larger sense, which includes the government production of money. See for example Rothbard (1977). In short, noninterventionist monetary policy in all cases boils down to changing the money supply. The main reason why this fact is usually not perceived with the necessary clarity is the somewhat exaggerated emphasis that professional monetary economists place on discussing the various possible ends of monetary policy, as well as the various techniques used to change the money supply (open market operations, bank reserve requirements, discount policy, and so on).
Our focus on the production of money is therefore hardly inappropriate to answer the question whether laissez-faire is the best monetary policy. Notice that the present study differs from previous works not only through its focus on the production of money. We also take the case of money competition—parallel production and use of several monies—to be the rule rather than an exception on the free market.In this way we go beyond our own previous study on money competition, in which we had espoused the conventional approach of first analyzing the use of only one kind of money—monopoly money, or “standard” money as it is commonly called—and only in a second step introduced the use of other monies (Hülsmann 1996). In the light of the present study it will appear that the conventional approach makes a comparatively weak case for monetary laissez-faire. Notice that, while other studies of Austrian inspiration (White, Dowd, Selgin, and others) also purported to deal with “currency competition,” these works did not deal with our present subject, the production of money, but with the production of money substitutes. On the important differences between money and any substitution, see Mises (1980, pp. 63ff.). This approach will prove to be very useful in analyzing “hard cases” such as deflation and the flight from money.
The Production of Money on the Free MarketIn order to put our analysis into proper perspective, it is useful to first study the main characteristics of unhampered money production. The unhampered market economy is defined by the absence of legal restrictions that prevent the citizens from using their property to produce money or money substitutes. On a free market, each market participant freely chooses to enter, or not to enter, the money production business. Everybody may try to mint and coin precious metals, and everybody may try to produce and offer other things for employment in indirect exchange.
The production of commodity money such as gold is then determined by the same facts that constrain the production of any other good. Gold money will be produced to the extent that this production yields a sufficient return, that is, to the extent that there is a sufficient spread between the quantity of product (in ounces of gold) and the quantity of gold expenditure (in ounces of gold) on the factors of production, in particular, on labor services. Now this spread is in turn determined by the demand for all other goods. Suppose that consumers spend more money on shoes and that there is therefore an incentive to increase the production of shoes. The shoe producer can increase production only if he bids labor and other factors of production away from other businesses, such as the production of gold coins. The shoe producer can offer higher prices for these factors because his selling receipts increase, and as a consequence the other firms will have to cut back production.
In short, on a free market the production of money is constrained within the limits set through voluntary cooperation between the members of society. No other considerations come into play. In particular, for purely technical reasons there is no such thing as monetary policy in the conventional sense. The quantity of paper money can be profitably increased at the whim of its producer, because he produces at virtually zero cost. By contrast, increasing the quantity of commodity money entails significant costs and is therefore much more limited. Additional quantities will be produced only if consumers can be expected to patronize this increase more than increased quantities of the other goods that could also be produced with the same factors of production.
Although on a free market, any person could try to produce paper money, there are compelling reasons to assume that the production of money on a free market would in practice boil down to the mining and coining of precious metals, the physical characteristics of which make them more suitable as media of exchange than all other commodities. Theoretical analysis and historical experience both tell us that this will be the case. Paper money is unsuited to withstand the competition of the precious metals. The essential reason for its inferiority is that it does not attract a non-monetary demand (Hülsmann 1996, pp. 293–99, 307; 2000, pp. 428–30).
Although on a free market, any person could try to produce paper money, there are compelling reasons to assume that the production of money on a free market would in practice boil down to the mining and coining of precious metals, the physical characteristics of which make them more suitable as media of exchange than all other commodities. Theoretical analysis and historical experience both tell us that this will be the case. Paper money is unsuited to withstand the competition of the precious metals. The essential reason for its inferiority is that it does not attract a non-monetary demand (Hülsmann 1996, pp. 293–99, 307; 2000, pp. 428–30).
Currency competition on a free market would thus be confined to the competition between precious metals. Here the relative scarcities of the various known metals play an important role in conjunction with certain technological constraints. Suppose that the entire economy uses gold coins for its monetary exchanges, and that silver and copper are used only for ornamental purposes. Now suppose further that the economy grows and that as a consequence the purchasing power of gold constantly increases. There will come a point at which it is no longer convenient to produce and use gold coins that are sufficiently small to be used as payment in small transactions, such as paying for a cup of coffee or for a hair cut.
One solution to overcome this difficulty is the use of gold substitutes, such as tokens. We can for example imagine that a firm issues paper notes, or coins made out of plate, or some other type of signs made out of cheap material, to represent very small quantities of gold—too small to be handled in the form of gold coins. The issuer holds the corresponding quantities of gold, and he will surrender gold upon presentation of those tokens once a sufficiently great number of them are presented for redemption. Such systems have proven their expediency in many historical cases, for example, in U.S. mining towns in the nineteenth and twentieth century. Still the use of token money is expedient only within fairly narrow limits, because of two disadvantages: it invites counterfeiting, both by the issuer himself and by other people, and it entails the additional costs of token production.
Another solution is to use a different metal, the purchasing power per weight unit of which makes it expedient to use coins made out of this metal for buying and selling those goods that can no longer be conveniently exchanged for gold. Let us therefore assume that some market participants start using silver coins in small transactions, and that other market participants imitate this successful behavior. As a consequence, our economy would use two monies—gold and silver—that freely circulate in parallel and overlapping networks. At least at the beginning, the gold network would probably be much larger, and silver coins would be used only in those less frequent cases in which neither gold tokens nor gold coins would be convenient.
If economic growth continues, the substitution process would replicate itself, both in the higher and in the lower echelon of money prices. Thus, at one point silver too might have such a high purchasing power that small transactions could no longer be made in silver coins. The market participants then might decide to use copper coins for these small transactions, thus layering a network of copper exchanges over the already existing networks of gold and silver exchanges. Meanwhile, gold coins could have such a high purchasing power that they might be unsuitable for most daily transactions. In this case, silver coins will replace them as the most widely circulating medium of exchange; the gold coins would be used only in transactions involving very expensive goods; and copper coins would be used predominantly in transactions involving goods of a very small value.
This is how the growth and decline of the economy determine the competition between different monies. And a similar role accrues of course to the production of additional quantities of these monies. On the one hand, in our above example, the production of additional quantities of gold would delay the substitution process, and so would the production of additional quantities of silver and copper. On the other hand, the production of additional quantities might reach such an extent that the metal would be unsuitable to be used in indirect exchanges. If gold were as common as iron, so that a wagonload would be needed to pay for a suit, it would not be used as a medium of exchange. Long before this happens, some other precious metal would replace it.
But however many currencies would be used on a free market, in any case the production of each of them would be narrowly circumscribed, as we have said, within the limits given through consumer preferences. The production of money, and the use of money, would be subject to the very same laws that apply to the production and use of all other goods. On a free market, consumers are the ultimate arbiters of all investment decisions. By buying and by abstaining from buying, they determine the profitability of each line of production. Capitalists would therefore produce any kind of money up to the point at which they expect it to no longer be profitable, and then invest all further resources into the production of other goods. And people would use any kind of money—that is, own it—so as to maximize the subjective value of their portfolios. If they found they owned too much gold, they would sell the superfluous gold for other things that for them have a higher value (for example, they would sell it for other kinds of money, or for other “real” goods and services). Thus the use of money follows the same principle that governs the use of all other goods: we only own it to the extent that it does not prevent us from owning other goods that for us are more important.
The Nonutilitarian Case for Monetary Laissez-FaireSo far we have described how money would be produced on a free market. We were only concerned with the purely factual description of how the system works. In particular, we left out all questions pertaining to the political evaluation of its workings, that is, to the question of whether monetary laissez-faire is a good or a bad thing. To this question we now turn. In the present section, we will briefly deal with the nonutilitarian case for laissez-faire in the production of money. The remainder of our study will then take on the utilitarian considerations that here come into play.
The first thing to notice is that the political evaluation of monetary order must be cast in terms of alternatives. It would for example be pointless to argue that monetary laissez-faire was deficient from some absolute point of view, if we lacked a better alternative system that we could put in its place. The relevant consideration is how the free-market production of money compares to other monetary regimes.
A second preliminary observation concerns the choice of the standard of comparison. What should be the criterion in the light of which the comparison should be made? More importantly, who should decide what the criterion should be? The usual approach is to take the judgments of the members of society as an ultimate arbiter. But if we follow this approach, we very quickly reach insurmountable limits because of the ubiquity of conflicts of interest. For example, it is one thing to state that the production of additional quantities of gold delays the substitution of gold by silver. It is quite a different thing to conclude that the production of additional quantities of gold is a good thing. We might grant that the present users of gold coins are interested in maintaining a large network of gold exchanges. But they are also interested in maintaining the purchasing power of their present cash balances, and further gold production would reduce this purchasing power below the level it would otherwise have reached. Moreover, one must not ignore the silver producers and silver coin users. These people could be said to have an interest in a more limited production of gold, because in a growing economy this would speed up the substitution of silver for gold, thus enlarging the network of silver exchanges and increasing the purchasing power of their present cash holdings.
Economic science cannot settle the conflicts of interest between these different individuals and groups. There is no common denominator of all individual interests that would allow us to make judgments about aggregate welfare, to the effect that, for example, it would be better to have a larger rather than a smaller quantity of gold or silver or any other medium of exchange. The fundamental problem of trying to make economic reasoning the arbiter in such conflicts is that we would have to weigh and add and subtract individual values. But this approach has no scientific basis at all.
Many Austrians therefore adopt a different approach to tackle policy questions in a context of conflicting interests. They hold that the only defendable welfare criterion is the respect of property rights, because this criterion alone can be justified without self-contradiction.See Hoppe (1989, 1987). See also Rothbard (1998, 1997). Rothbard’s early work on welfare economics followed a different approach, arguing that the market process is inherently optimal because all parties engaged in exchanges “demonstrate,” by the very fact that they exchange, their preferences. See Rothbard (1956). But this argument does not hold water because Rothbard merely assumes that only the use of one’s property “counts” in demonstrating one’s preferences. The point is to prove the pertinence of this assumption; it cannot be simply taken for granted. If we apply this criterion to the production of money, then the number of monies spontaneously chosen by the market participants, whatever this number may be, is the optimal number, because the market economy is defined as the totality of social interaction premised on the respect of private property rights. For the same reason, whatever the quantity produced of any of these monies in a free market is the optimal quantity.
The optimality of monetary laissez-faire in the above sense must not be confused with the question whether individuals can produce or hold too much, or not enough, money. Market participants can err and do err when using money, just as they commit errors when using any other good. Notice however that each market participant has strong incentives to avoid error and to produce and use the optimal number of monies. These incentives are lacking when money production is under political control.For a general discussion of the comparatively superior ability of the market process to bring ex ante plans in line with ex post realities, see Rothbard (1977, chap. 2).
The Utilitarian Case for Monetary Laissez-FaireWhat we have said so far coincides with the conclusions reached in the best treatises on monetary economics, which approach our problem from a utilitarian perspective. Economists from David Hume onward have emphasized that the quantity of money is irrelevant for the wealth of a nation. It is true, however, that Hume and most other economists have defended this proposition with all sorts of qualifications. Only a handful of economists including John Wheatley, Ludwig von Mises (in his mature works) and Murray Rothbard have defended it categorically and consistently.See Wheatley (1807, chaps. II and III, esp. pp. 35–48). The first chapter of this neglected book contains a brilliant critique of the monetary thought of David Hume, Adam Smith, and James Steuart. For an overview of some of the fallacious monetary arguments that plagued classical economic thought, see Gertchev in the present issue. Today the fundamental insight that the nominal size of the money supply is irrelevant for aggregate wealth lives on in the tradition inspired by Mises. See, for example, Salin (1990, 1991), Reisman (1996), and Huerta de Soto (1998). Says Mises: “The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do (Mises 1998, p. 418).”In his Theory of Money and Credit, Mises had taken certain exceptions to the principle that the money supply is irrelevant. Thus he argued that decreases of the price level were likely to entail “convulsions” (1980, p. 359) and unnecessary production of commodity money (p. 333). He also argued that fiduciary media could spur the accumulation of capital (p. 388). Even more so than Mises, Rothbard recognized the central importance of this point, which made it in fact an axiom of the theory of money. In Rothbard’s words: “One of the most important economic laws, therefore, is: Every supply of money is always utilized to its maximum extent, and hence no social utility can be conferred by increasing the supply of money” (Rothbard 1993, p. 671; 1990, p. 34; 1983, p. 45). In Rothbard’s eyes, the free-market production of money conveyed no monetary benefits, but it served the nonmonetary demand for the metals used as money. Therefore, he concluded, the free-market production of commodity money was always optimal.Rothbard (1990) says:We conclude, therefore, that determining the supply of money, like all other goods, is best left to the free market. Aside from the general moral and economic advantages of freedom over coercion, no dictated quantity of money will do the work better, and the free market will set the production of gold in accordance with its relative ability to satisfy the needs of consumers, as compared with all other productive goods. (pp. 34–35)
We have seen that this argumentation is slightly incorrect because technological constraints (convenient coin size) determine currency competition too. But to the extent that we may abstract from these physical constraints, the Rothbardian position is unassailable. A higher money supply goes in hand with higher money prices, whereas a lower quantity goes in hand with lower prices. But the level of money prices has absolutely no impact on aggregate production. At a higher level, entrepreneurs enjoy higher selling prices, but their buying prices are higher too. And similarly, at a lower level of money prices, both selling and buying prices are low and therefore do not affect the economic success of production.Jean-Baptiste Say has illustrated this point with a famous mental experiment that still serves its pedagogical purpose: Imagine two market economies that are exactly alike, with the sole exception of the quantity of money that is being used. And assume that economy A uses twice as much money as economy B. In this case, Say argued, the money prices in A will be exactly twice as high as the money prices in B. Now, the point is that this does not affect the wealth of the nation, and it does not even affect the relative economic status of each individual. Whether we have more money or less is ultimately irrelevant (Say 1841, p. 248). See also Wheatley (1807, p. 37). Increases and decreases of the quantity of money do affect the wealth position of individuals and groups relative to one another. But they do not cause an increase of aggregate wealth and of aggregate production beyond the level it would otherwise have reached.
Hence, if we disregard the technological constraints of coin production, changes in the quantity of money do not alleviate scarcity within society. And neither do such changes aggravate scarcity. To facilitate monetary exchange, there is no reason to prefer any one money supply to another. A constant money supply is not superior, nor inferior to an increasing or to a decreasing money supply.For a refutation of the view that increases in the money supply, per se, entail business cycles, see Hülsmann (1998).
And if we do take account of the technological constraints of coin production, as we have done above, the conclusion remains the same. To facilitate indirect exchange, it is not necessary to violate the property rights of the market participants through legal tender laws and other institutions, in order to produce a different quantity of money from the one that would have been produced on the free market. Any such policy does not facilitate indirect exchange. At the very best, it boosts the use of one type of money at the expense of other types of money. And it always entails a distribution of resources that differs from the one that would have resulted from the voluntary interaction of the members of society.
To sum up, money production is subject to the same constraints as all other branches of production, constraints that ultimately spring from the value scales of the individual market participants, who consent or do not consent to cooperate. From this point of view, the free market production of money is inherently optimal, irrespective of the number of monies and of their relative quantities. The relevant question is therefore not: How much money should be produced? The question is: Are there any legal restrictions that hamper the competitive production of money? And as stated above, there seems to be no economic reason for the establishment or maintenance of such restrictions. Any number of monies spontaneously chosen by the market participants is, at any rate from an ex ante point of view, the optimal number, and any quantity produced of any of these monies in a free market is the optimal quantity.
Let us now examine the utilitarian considerations that are typically brought forward against monetary laissez-faire. The problem we have to deal with boils down to the following question: Are there any benefits to be derived from a political manipulation of the production of money? In other words: To what extent could it be expedient to violate individual property rights, in order to bring about changes in the money supply that differ from those that would have been obtained on a free market? If we find that such infringements of property rights merely benefit one group of individuals at the expense of other individuals or groups, we will have to deny any overall benefits. Such benefits could be said to exist only if politically induced changes in the money supply do in fact reduce scarcity.Historically, the most important institutions designed to induce political changes of the money supply were (1) paper money (protected by legal tender laws and other monopolistic charters) and (2) fraudulent fractional reserve banking (protected by chartered central banks, legalized suspensions of payments, and paper money).
Space limitations compel us to deal only with the main arguments leveled against our tenet that all quantities of money produced in a free-market context are equally optimal. We will first examine the question whether politically induced changes in the quantity of money do have any direct benefits, and then turn to their alleged indirect benefits.
Does printing more paper money reduce, by itself, the scarcity of resources? To raise the question is to answer it. Printing more paper tickets does not make us richer than we otherwise would be, because our welfare does not depend on the quantity of money we use, but on the quantities of real goods that can be purchased with this money. The simple fact is that printing money is not identical with producing goods that can be purchased with this money. Additional money does not make the nation of money users better off than it would otherwise have been. If it were otherwise, we would long since have reached Nirvana. The incontestable fact is that printing more paper money is not the same thing as producing more of the nonmonetary goods that are offered in exchange for money. It follows that the production of money is in any case not a direct cause of those other goods.
Thus the only question is whether there are any indirect causal relationships between these two magnitudes. The remainder of our study will examine this question in some detail. Let us notice from the outset that the utilitarian rationale for monetary policy ultimately hinges on an affirmative answer to it. If changes of the money supply cannot even indirectly be of any benefit for society, then there is no use for monetary policy at all, and we would do well getting rid of the institutions in charge of monetary policy as quickly as possible.
Before we proceed, let us, only for the sake of completeness, raise the question of whether monetary policy could be justified in terms of purely accidental causal relationships. The answer to this question is patent. If changes of the money supply brought about positive consequences by mere accident, so that negative consequences were as likely to follow from the policy of changing the money supply, it would be meaningless to speak of monetary policy at all, and central banks and other authorities in charge of it should be abolished at once.
The Beneficial-Distribution FallacyOur analysis of money production on a free market led us to the conclusion that any quantity of money that comes into existence without infringement of other people’s property rights is the optimal quantity under given circumstances. Now let us hasten to point out that this statement must not be confused with the claim that free-market money would be optimal in the sense of being somehow “neutral” with regard to the market process. Changes in the money supply always and everywhere have a permanent impact on the real economy, irrespective of whether those changes result from the market process itself or are politically induced.
In short, changes in the money supply have a real impact, both in the short run and in the long run, and this impact exists quite independent of whether the market participants are smart enough to anticipate the ongoing changes in the quantity of money. This is so because changes of the money supply modify the distribution of wealth within society.Notice that this is a common feature of all changes in society. Any change in the quantity of any good affects the relative wealth positions of all individual market participants. The man who produces and sells new chairs thereby increases his money income relative to the money incomes of all other market participants. The payments he receives are deflected from the payments other market participants could have received for their products. The latter are now forced to sell at lower prices than they otherwise could have realized, that is, which they could have realized in the absence of the new chair production. An increase of the quantity of money benefits the individuals who receive the new money units first, because their monetary income increases relative to that of their fellow citizens. In their capacity as consumers and entrepreneurs, they can now bid away consumers’ goods and factors of production from other members of society. Those who are last in line in this process are impoverished relative to the wealth they would have had without the increase of the quantity of money. And similarly, a decrease of the quantity of money harms those who first suffer from this decrease, because their monetary income diminishes relative to that of the other market participants.The first economist to stress these distributive issues related to changes in the money supply was Richard Cantillon (2001). Subsequent authors such as David Hume, J.S. Mill, and J.E. Cairnes noticed that new quantities of money spread throughout the economy in a time-consuming process, but they tended to downplay or ignore the permanent changes induced by this process. In their view, changes in the quantity of money had no long-run real effects. It was Ludwig von Mises (1912, pp. 222ff.) who rediscovered Cantillon’s important insight.
Now it is conceivable that the money-induced redistribution process will turn out to benefit the best entrepreneurs of the nation. This possibility has been stressed in the doctrine of forced savings.Advocates of the doctrine were, among many others, Mises (in the Theory of Money and Credit, not in Human Action), Josef Schumpeter, and Friedrich A. Hayek. For the history of this doctrine, see Hayek (1939). Mises (1998, pp. 548f.) seems to use the term in a slightly different meaning. If the redistribution works out to the advantage of those who are best at investing the available resources, then their decisions will have greater weight than they otherwise would have had. Inversely, the decisions of all other people, who are comparatively poor investors, would have less weight than otherwise. Thus the increase of the money supply has a positive net impact.
However, there is no such thing as a mechanism according to which a money-induced redistribution process automatically benefits the best entrepreneurs. There is no reason why an increase of the money supply, as such, should not entail exactly the opposite result, namely, benefiting the less competent at the expense of the more competent entrepreneurs. Inflation-induced forced savings are therefore nothing but a pleasant accident of history. It is a fallacy to elevate the merely accidental connection between inflation and increased production into a principle of monetary policy. The distribution effects of money alleviate scarcity only accidentally.
If anything, we have good reasons to assume that the money-induced redistribution process would usually benefit the less competent at the expense of the more competent entrepreneurs. This is so especially when the production of money is under political control, such as in a central banking system. There is an overwhelming incentive for paper money producers to finance the welfare state and the warfare state with the printing press. After all, it owes its monopoly privileges to the very state that calls on it in times of financial distress. Similarly, which entrepreneurs are more likely to depend on a paper money producer to finance their ventures—competent or incompetent entrepreneurs? The answer seems to be obvious. For highly profitable firms it is easy to attract sufficient support from capitalists. Only firms operating at a loss, or ventures that offer a very unlikely promise of future profits, truly need redistribution in their favor through the printing press. Hence, there are compelling reasons to believe that the political control of the money supply will tend to benefit the incompetent rather than the competent members of the nation.
The Motivation FallacyAccording to this argument, market participants will work more and/or harder when motivated through rising selling prices. Because paper money producers can very easily bring about such an increase by printing more money tickets, they can stimulate aggregate production. This holds true at least in the short run, that is, in the period during which the additional money spreads through the economy. Luminaries such as David Hume (1985, pp. 286f.) have endorsed this argument. But it is liable to fundamental objections.
In virtually all cases, the additional money is first sold to only a part of the market participants. We may grant that these people will be enthusiastic to obtain higher prices for the goods they sell, and thus set out to produce even more. They buy more factors of production and produce greater quantities than before. However, this comes necessarily at the expense of other entrepreneurs, who can no longer compete with the former on the factor markets and who will therefore produce less and who will—on equal psychological grounds—be discouraged. In short, the additional money would destroy as much motivation and labor on the one hand, as it would entail on the other hand.
Assume now for the sake of argument that all market participants simultaneously receive an aliquot share of the increased money supply, in the form of increased prices for their products. In this case, all factor prices would be bid up instantaneously, and again no increase of aggregate production would take place. One could argue that the increased nominal demand would attract certain quantities of “idle” resources that would not otherwise have been offered for sale. However, this would be the case only if the owners of these resources underestimated the decrease in purchasing power of money that results from the increase of the money supply.Notice that even in this case the attraction of the “idle” resources into production does not mean that production has been stimulated or increased from any overall point of view. There is after all a reason why these resources lay “idle,” namely, that from the long-term point of view of their owners, the present use of these resources seemed to be inexpedient. In short, they were not idle at all, but were used as a reserve for later periods, and it is probably not necessary to prove that this reservation demand has a very important social function. Consuming one’s reserves in the present is, by any meaningful standard, not a reduction of scarcity, but an impoverishment. See on this problem Salin (1991). If they overestimated it, more resources would lay “idle” as a consequence of the increase of the money supply than would otherwise have been the case. In short, there is again no systematic causation at stake—only accidental causation, which, as we have observed, is irrelevant for the justification of monetary policy.
A motivation theorist à la Hume could still argue as follows: Granted that the increased selling prices would not allow our entrepreneurs to buy more factors of production. But would this price increase not at the very least prompt them to work more and/or harder than before?
There are three difficulties with this argument. First, it is not at all plausible that entrepreneurs should delight in contemplating the mere level of their selling prices, without relating them to buying prices. Why should an entrepreneur be more motivated than otherwise, just because his selling prices increase, even though the prices of his factors of production increase on equal footing? Second, it is not the case that the profit motive needs to be switched on through the printing press. Entrepreneurs are always seeking profits. They do not need bureaucrats sitting on a printing press to motivate them. Third, we have to consider again that the higher nominal receipts do not reflect a higher purchasing power. Why should entrepreneurs be willing to work more, thus forgoing leisure, for a mere nominal compensation?
The Numéraire FallacyAccording to this argument, a system of competing currencies lacks a common numéraire or standard of value for economic calculation and is therefore from an economic point of view inferior to a system endowed with such a common standard. As a consequence, it could be argued, the introduction of a fiat currency could provide significant net benefits. It would not just entail political redistribution, but also contribute to reducing scarcity in society.
This argument is premised on a wrong conception of economic calculation. It overstates the similarities between economic calculation on the one hand, and technological weights and measures on the other hand. The purpose of the latter is to provide the terms in which we subdivide things of the material world. By contrast, the purpose of economic calculation is to provide a common denominator for the comparison of different courses of action. It is a decision-making tool in a much more narrow sense than weights and measures.
The central device of economic calculation is the profitability calculus, which divides total selling receipts by total cost expenditure for each alternative course of action. Physically heterogeneous choice alternatives are thus rendered comparable in common terms, namely, in terms of percentages. This essential service of economic calculation in no way depends on other people calculating in terms of the same unit.
It could be argued that things are not really different as far as the use of physical weights and measures are concerned. Here too each individual could calculate in terms of self-defined units without thereby changing the result of the calculus. However, technological calculations do greatly benefit from common weights and measures, because this commonality facilitates communication among the different members of society. By contrast, economic calculation is not primarily a means of communication—in fact, entrepreneurs often take great pains to hide the result of their economic calculations from other people. And even to the extent that they do communicate these results, the relevant information is contained, not in any absolute numbers, but in the bottom-line rates of return on investment. And these rates (percentages) can be compared irrespective of the kind of money used.
One might object that the use of different kinds of money entails more uncertainty for the validity of one’s economic calculation than would be the case if only one kind of money were used. This is so because there would be fluctuating exchange rates between the different monies.
While this observation is correct, it does not lend itself to the conclusion that a homogenization of the monetary system would be beneficial. The point is that any differences between products, firms, places, and times are sources of uncertainty. If such differences subsist on a free market, then we have good reason to assume that the package greater-heterogeneity-plus-uncertainty ranks higher on individual value scales than a reduction of uncertainty by greater homogeneity. We have already pointed out that, on an unhampered market, everyone may attempt to establish a homogeneous paper money. If he cannot bring the other market participants to accept his product, we may conclude that the citizens prefer the greater variety, and the greater uncertainty, of a heterogeneous monetary system to the increased certainty under a unified system.
The Sticky-Prices FallacyAccording to this argument, inflation is a suitable means to increase the spread between selling prices and buying prices, thus making businesses profitable in those situations when they cannot bid down buying prices far enough to allow for continued production. The main application of the argument is to overcome rigidities in the labor market. Inflation, so the argument goes, reduces real wage rates to the equilibrium level so that full employment is restored and all productive resources (in particular, labor forces) of society can be used.
Ever since the 1920s, this argument has played a prominent role in monetary policy debates, and after World War II it rose to the status of a dogma. But it is a fallacy. It assumes independence between monetary policy and the institutions governing the pricing processes on the other markets, whereas these two realms are not in fact independent of one another. Contractual techniques such as the indexing of labor contracts might be rather imperfect vehicles, but in any case they show that market participants try to anticipate changes in the money supply. In many cases labor unions overestimate the future loss of money’s purchasing power. The result is even more unemployment than before—a good illustration is given by the evolution of the German, French, and Spanish labor markets since the 1970s. Considering these incontestable facts, economists are well advised to start seeing labor-market rigidities again as a dependent variable, rather than as something outside of human control.
The Adjustment Fallacy I: Supply of and Demand for Cash HoldingsMost errors about the optimal quantity of money are variants of a basic confusion that we may call the “adjustment fallacy.” This fallacy consists in the belief that the nominal quantity of money needs to be adjusted to prevailing economic conditions, lest a disequilibrium situation would occur. We can distinguish two main variants of this fallacy.
The first variant stresses that the quantity of money available for cash holdings must be adjusted to the demand for cash holdings (stocks). The second variant of the fallacy stresses that the supply of and demand for money in market exchanges must be adjusted—the nominal quantity of money offered for sale against other goods must be adjusted to the demand for money in the form of the quantities of commodities offered on the market (flows). In what follows we will deal with the first variant, and in the next section we then turn to the second variant.
The Supply of Cash Holdings
As far as the supply of cash holdings is concerned, we must point out that this supply is, at any point of time, identical with the aggregate quantity of money under the control of the individual market participants. The expressions “supply of cash holdings” and “quantity of money” are therefore synonymous to the extent that all units are liable to be acted upon at all, rather than for example buried at the bottom of an ocean.
Notice that all units of money are held, that is, to the extent that they are under the control of some one at all, are part of the individuals’ cash holdings. In other words, there is no such thing as “money in circulation” that can meaningfully be distinguished from “money held.” Money does not circulate in the sense that it would at some point of time not belong to any person. In exchange, money units are transferred from one person to another, but even in this case each single unit at each single point of time belongs to someone.We can meaningfully distinguish “money in circulation” from those money units that are not under control of any member of society, for example, money units buried on the sea bed after a shipwreck. But in this case too all units of money in circulation are held at all points of time, and there is no difference between, on the one hand, money in circulation in the stated sense and, on the other hand, money held in individual cash balances.
The Demand for Cash Holdings
Why do we seek to own money at all? The essential service of money is in reducing the problem of the double coincidence of wants. This problem is greatest in a system of direct or barter exchanges. A partial solution is to abandon direct exchange and adopt indirect exchange—with money as an intermediary. In developed economies, virtually all indirect exchanges are performed with but one medium of exchange, or at any rate with a very small number of media of exchange. Media of exchange that are used in a great number of transactions are monies.
The services of any given sum of money depend on the quantities of other goods that can be exchanged for it. In 1960, $500 could buy more things than $550 in the year 2000 because the purchasing power of the dollar had considerably decreased in between these two years. Thus the exchange services of money have nothing to do with its nominal quantity, but only with its purchasing power.
But money’s services not only depend on general conditions such as its purchasing power and alternative investment opportunities, but also on strictly personal factors that vary from one individual to another (Mises 1980, chap. 8). A sum of money provides its service not only at the moment when the money owner sells it to purchase any goods he desires, but it serves during the entire period in which its owner keeps it in his cash balance. At each point of time, acting man balances the amount of money he holds against his holdings of all other economic goods. We cannot say on a priori grounds how much money any given market participant will choose to hold. But we can say that he will sell money if he thereby acquires what he values more than the sum of money he abandons, and that he will buy money if he prefers this additional quantity to the price he had to pay. Each man’s portfolio reflects not only his individual station in life, but also the other aspects of his personality: his virtues and his vices. The spendthrift has ever too much money in his hands, and not enough consumers’ goods. The neurotic coward sits on mountains of cash. The adventurous entrepreneur places all money into investments, whereas the prudent businessman keeps a large cash reserve. In short, there are no general rules to determine how much money a man will hold. But this does not alter the fact that each man faces the everlasting trade-off imposed by scarcity: The more money he holds, the more he must forgo the services he could have derived from other goods, and vice versa.
Adjustment of Demand and Supply?
Now back to the problem that was our point of departure. According to a widely held opinion, monetary equilibrium in the sense of equality between the supply of and demand for cash holdings requires that changes in demand be matched by corresponding changes in the nominal supply. An increased demand requires that the supply increase too, and vice versa. But the supply of commodity monies such as gold and silver can only catch up very slowly with such changes and, due to technical limitations, gold and silver production might not deliver the required absolute quantities at all. Thus there seems to be a case for the government to impose a paper money, any quantities of which can be produced at virtually zero cost.One way of refuting this argument is to point out that it relies on a misinterpretation of the laws of demand and supply. It is meaningless to speak about demand for and supply of one commodity without reference to the demand for and supply of alternative goods, that is, without reference to market prices. And because market prices can change, demand and supply can be adjusted to one another at any point of time.
Another way of countering the above case for paper money is to highlight its underlying assumption that the supply of cash holdings is independent of the demand for cash holdings (Hülsmann 2000, pp. 435, 438–40). Such independence does indeed exist in the case of most other goods, and the reason is that in most other cases the amount of services to be derived from the good in question essentially depends on the good’s physical characteristics. For example, the services typically delivered by a telephone do not depend at all on the demand for this telephone, or on the demand for telephones of this type. Whether market participants hold the telephone in high or low esteem, whether they pay high or low prices for it, has no impact whatever on the amount of services to be derived from a telephone of this type. But in the case of cash holdings, supply and demand are not independent because here demand does depend on supply, and supply does depend on demand.
If the quantity of money is increased, the purchasing power of each unit will decrease below the level it would otherwise have attained. This means that the services that can be derived from each money unit have decreased, and since money owners are only interested in the amount of these services, rather than in the nominal quantities in which these services are embodied, their demand for nominal quantities of money will be higher than it otherwise would have been.Edwin Cannan points out that it would be more appropriate to say, like Sidgwick, that the increased money supply induces an “extension” rather than an increase of the demand for money. Cannan offers a charming illustration of the principle of extension of demand: “People will take the additional currency as they take additional whiskey when it is watered down and offered to them at a lower rate, but that does not show that, in the absence of increase of demand in the narrower sense, they will take additional whiskey or additional currency at the old rate” (Cannan 1951, p. 10).
Similarly, if the demand for money held increases, the supply of monetary services increases automatically—that is, without any change in the nominal supply of money. An increase of the demand for money held means that the individual under consideration (1) exchanges the money he owns only at lower money prices than otherwise, and/or (2) that he buys additional money units at higher prices (in terms of his labor and other parts of his property).See Say (1841, pp. 243f.). Notice that Say here spells out the meaning of Adam Smith’s concept of “effective demand.” Notice also that we will deal with the impact of sticky prices on the automatic adjustment of demand and supply at the end of the present paper. In both cases the increased demand ipso facto increases the supply of services of each money unit, because the increased demand means an increased purchasing power of money.
Notice that in the light of these facts it is not only superfluous, but also quite nonsensical to “adjust” the supply of money to be held to changes in demand. An increased nominal supply, far from offsetting the increased demand it was meant to offset, only causes a further increase of the demand for cash holdings. Far from equilibrating the supply of and demand for cash holdings, nominal supply changes merely elicit an additional nominal demand.
The Adjustment Fallacy II: Monetary ExchangesLet us now turn to the other variant of the adjustment argument. In this variant, monetary policy is needed to adjust the supply of money—this time understood in the sense of the “flow” of money units offered for sale against other goods—to match the demand for money, defined as the quantities of these other goods offered for sale against money. Without monetary policy in place to do the adjustment job, there might be more or less serious mismatches (disequilibria) between the supply of and demand for money, and as a consequence there would be economic crises, most notably when the supply of money proves to be insufficient to buy all the products offered for sale.
Before we set out to examine this argument case by case, it might be useful to point out that the argument is squarely based on what could be called the “correspondence theory” or the “representation theory” or the “assignment theory” of money.This theory had important champions in John Law, Montesquieu, Simmel, Wieser, Schumpeter, and many others. For a critique of Schumpeter’s assignment theory, see Mises (1980, pp. 512ff.). According to this theory, the money in some way “represents” the other goods, and the smooth operation of a monetary economy depends on how well the supply of money “corresponds to” the supplies of the other goods. If there is too much money around, inflation sets in and entails various negative consequences. If there is not enough money in the market, there will be more or less serious disruptions of economic activity. The task of monetary policy is therefore to ensure correspondence between money and the other goods, and it pursues this goal by modifying the quantity of money.
This theory is probably the one monetary fallacy that has done the greatest harm in the history of the West.Not surprisingly the fallacy arose at the end of the seventeenth century, which had witnessed the emergence of bank note currencies and of those privileged banks that should later become “central banks” (Sweden, England). Monetary theory was then still in its infancy and some of the theoreticians were led into wild speculations. They noticed that, in deposit banking, there is a correspondence between the quantity of money substitutes (in particular the bank notes) and the quantity of money proper (gold, silver, etc.), which these substitutes represent by contract between the bankers and their customers. John Law and others started seeing representations everywhere and postulated that not only was there to be correspondence between money substitutes and money proper, but also between money and the other goods. Before we turn to our case-by-case examination, let us emphasize from the outset that money does not represent or correspond to anything but itself. It is meaningless to assert such correspondence as far as market exchanges are concerned because the quantities that allegedly “correspond” to one another are identified only through the market process. Only if there were a nonmonetary unit of value that could serve as a tertium comparationis apart from market exchanges would it be conceivable that the money supply could be said to correspond to the supplies of other goods. But no such unit of value exists.
The Case of a Growing Economy
In a growing economy, ever more goods are offered on the market for sale against money. In such a case, an adjustment theorist could argue, one also needs more money to buy these greater quantities of goods, lest money prices would drop and strangle production.
The main problem with this argument is that it is premised on a much too static notion of entrepreneurship. Businessmen do not behave like robots that mechanically react to changes in their environment. They are entrepreneurs, who seek to anticipate relevant future changes. In an environment of decreasing prices, therefore, entrepreneurs can run a profitable business by bidding down buying prices or, if this is not possible, by abstaining from investment altogether. And successful entrepreneurs will do precisely that. The difference between successful businessmen and incompetent spendthrifts is that the former do base their actions on a correct estimate of future price changes. At any point of time, an entrepreneur can protect himself against the future impact of falling selling prices by either bidding down in the present the payments for his factors of production, or abstaining from investment altogether. The latter strategy is the wise course of action whenever he cannot bid down his factor prices, which is usually the case when he is more or less alone in anticipating the future drop of prices, whereas other entrepreneurs do not diminish their offers. If he cannot cut his costs he will not invest at all, but wait until his competitors, who paid the factor prices he believed were too high, eventually go bankrupt. Then he will step in and get the buying prices he needs for a profitable operation, and he might even buy the production facilities of some of the failed competitors.
Those businessmen who merely react to changes in market prices will of course be negatively surprised when they have to confront the growth-induced drop of the price level. They have bought their factors of production at prices that were not justified in the light of this subsequent event, and thus their profits are considerably reduced and more than often they will even incur losses to the point of bankruptcy. Now the point to stress is that there would be nothing wrong with these bad entrepreneurs going out of business.
Suppose that (a) their firms could operate profitably at the lower (possibly further decreasing) price level, and they only go bankrupt because they went into debt at the previous higher price level; in this case, the former owners—who turned out to be bad entrepreneurs—would be replaced by new owners, usually the former creditors, who could then go on to run the business profitably and produce for the market.
Or suppose that (b) these firms could no longer operate profitably at the lower (decreasing) prices level;This could be the case, for example, because the growth process went in hand with a different distribution of wealth within society, which in turn changed the aggregate demand for the various types of products to the detriment of our firm, and to the advantage of other firms. then our firms are unprofitable because other entrepreneurs can employ the factors of production that these firms need at even greater profit—thus they bid up the prices to such an extent that our firms become unprofitable. Yet in this case, it would be all right and good to close shop and make the factors of production available for other firms.
Because our assumptions (a) and (b) cover all possible cases, we can conclude that growth-induced declines of the price level do not entail any disadvantages for society as a whole.Monetarist scholars have illustrated this economic law through empirical studies of growing economies with a shrinking price level. Two important cases are Germany and the U.S. in the last quarter of the nineteenth century—a period that is often misleadingly called a “depression.” See Nocken (1993, pp. 157–89); Friedman and Schwarz (1963); Bordo and Redish (2003). There is no rationale for offsetting economic growth with a parallel increase of the money supply. Such a policy would affect the distribution of wealth within society, and only accidentally have a positive impact on aggregate production. Moreover, it would encourage entrepreneurial recklessness, because it rewards businessmen who speculate precisely on such a policy bailing them out in the future; and it punishes the prudent and self-reliant entrepreneurs who anticipate growth-induced declines of prices and therefore do not invest as much as they would have otherwise invested, thus making factors of production available for other lines of production.
The Case of a Shrinking Economy
In a shrinking economy, ever less goods are offered on the market for sale against money, and as a consequence money prices rise. What would be the policy implications from the point of view of the adjustment fallacy? Probably an adjustment theorist would argue that the increasing price level would somehow be harmful to society. But increasing prices are not more harmful than declining prices.
Below, we will even go beyond this proposition and argue that the same thing holds true for decreases or increases of the money supply. In a market economy, there are strong incentives for the market participants to minimize the negative impact that changes of the quantity of money may have on production. As soon as these changes become excessive, profit opportunities arise that make it expedient to use other monies in lieu of the volatile one.
The Case of “Hoarding”
“Hoarding” is a pejorative expression for an increase in the demand for real cash balances. Let us first remind ourselves that all quantities of money are “hoarded” because each single money unit is held in the “hoard”—that is, in the cash balance—of some individual. Therefore it is impossible to hold money more intensely than it otherwise would have been held. Money held is money held is money held.
So what is the emotional prejudice, evident in the expression “hoarding,” ultimately all about? As we have said, it is about the resentment that some people feel against other people’s increased demand for real cash balances. The essential reason for this resentment is that “hoarding” brings about a decline of the money price level. It therefore threatens all business ventures that are based on the expectation of higher prices.
Above we have explained what an increased demand for cash balances means: the money owner parts with his money only at lower prices than he would otherwise have had to pay, and he is ready to offer more goods than otherwise in exchange for additional quantities of money. In both cases, all money units are held or “hoarded” as they are always held or hoarded. The difference is that the money owners value themhigher than before.
We have already explained that such increases in the demand for real cash balances cannot be offset through a countervailing increase of the nominal money supply. Any such neutralizing policy would intensify the problem it was meant to solve. The additional money dilutes the purchasing power of all money units, thus prompting a further increase in the demand for money.It might be argued that this policy does at least stabilize the level of purchasing power at which the demand for and supply of money equilibrate. In this case the argument no longer turns around adjustment per se, but around the old ideal of a stable purchasing power of money. For a critique of the attempts to measure and stabilize the purchasing power of money see Rothbard (1993, chap. 11).
It is true however that a paper money supply can also be increased at such a rate that a deterrent effect sets in. If the market participants anticipate a steady absolute decline of the purchasing power of money, they will decrease their demand for real cash balances even though their nominal cash holdings increase. In such cases, the nominal supply of money often grows at breathtaking rates, while at the same time the aggregate purchasing power of the money supply declines.This phenomenon has been observed especially in the later stages of a hyperinflation, such as in the German hyperinflation of 1923. It follows that a paper money producer determined to fight “hoarding” at any cost may indeed succeed in this endeavor. The question is of course whether the attainment of this goal was worth sacrificing the currency—for nothing else but a collapse or at least a near collapse of monetary exchanges is usually involved.
Even more fundamentally, we need to raise the question of whether there is anything bad about hoarding. It is certain that “hoarding” will produce winners and losers—all changes in society do that. But hoarding will not necessarily disrupt production, because it can be anticipated. And even to the extent that it does disrupt the business of those entrepreneurs who did not so anticipate it, there is, as we have explained above, no rationale for bailing out these bad entrepreneurs, rather than letting the creditors take over their firms, or letting other firms take over the factors of production that hitherto were employed in these firms.
The Case of Inflation
So far we have studied the impact nonmonetary changes have on the relation between the demand for and supply of money. We now turn to changes emanating from the side of money—increases and decreases of the money supply, which for the purposes of our analysis we may call “inflation” and “deflation” respectively.
First of all it could be argued that the production of money could be excessive in comparison to the growth of the “goods side.” We have already discussed the main fallacies involved in this argument. The services of monetary exchange do not depend on how the money supply changes relative to the supplies of the goods that are exchanged against money. An increased production of money entails higher money prices than would otherwise have been paid on the market. Under certain conditions, such increased money production will also lead to an absolute increase of money prices. But neither the absolute nor the relative increase of money prices (relative to the level they would have attained in the absence of the inflation) does, per se, imply any insurmountable negative consequences for the economy.
It is conceivable that on the free market the supply of a precious metal increases at such a rate that it becomes inexpedient to use it as a medium of exchange. Imagine for instance that somebody would suddenly find a mine containing more than a million times the quantity of gold in existence. As a consequence, gold might no longer be used as a medium of exchange. Other commodities would then replace it in this role. But as this example clearly shows, on a free market the money users can contain the damage done by unwarranted increases of any precious metal within fairly narrow limits. After all, to have a free market means that nobody is prevented from trying out supposedly beneficial alternatives. This is why inflation in a paper money system, in which only the authorities may experiment with alternatives, tends to be much more harmful, especially when we consider the fact that paper money producers have actually many incentives to spur inflation, rather than to reduce it.
But quite apart from the incentive issue, paper money entails several severely negative consequences that would not exist on a free market. For example, paper money producers have an almost unlimited ability to bail out any market participant. This entails the problem known as “moral hazard”—market participants with good personal and professional connections to the paper money producer invest in excessively risky ventures. When these investments turn sour, the paper money producer bails them out, that is, he rescues them at the expense of the other money users. This is one reason why paper money entails more waste than free-market money and thus creates more scarcity than would have existed on the free market.
Another reason why paper money inflation is qualitatively different from increases of the supply of commodity money is that it allows governments to finance all kinds of wasteful projects through debt. In particular, welfare and warfare are much larger and much more wasteful under government control of money production than on an unhampered market. They are presently so wasteful that it is completely out of the question to ever pay back the debts used to finance them. Why, then, can governments always find new creditors for more debts? Because all market participants know that these debts are backed up by the printing press of the government-controlled (often government-owned) paper money producer.
A third reason why paper money creates more scarcity of goods and services than would have existed on the free market is that the virtually costless production of paper money allows for arbitrary and huge increases of the money supply. It is virtually impossible for the market participants to adapt quickly enough to these changes. There is the very real danger that the interest rate on the loan market will drop belowits equilibrium level. This would entail the boom-bust cycle that we know from theMisesian business cycle theory.
To sum up, increases in the supply of any money are not liable to be more harmful, per se, than a decreasing or stable money supply. The traditional focus of monetary economists on changes of quantifiable aggregates such as the money supply proves to be very inappropriate in this case, as in many other cases. The negative consequences that are commonly associated with inflation—in particular, the waste of resources due to adjustment problems—do not primarily spring from increases of the quantity of money, but from the lack of currency competition. And as we have seen, the very existence of a (government-protected) paper money entails problems that are unknown on a free market. Alas, for the same reason it is comparatively easy to handle these problems, at any rate from a purely technical point of view. All that is necessary is to abolish the monopoly privileges of the paper money producers, who would then quickly be driven out of business.
The Case of Deflation
Next to hoarding, deflation is the great scapegoat of monetary economics. The fight against deflation is today widely considered to be the most basic mission of monetary authorities, the bare minimum of economic statesmanship. It is the prima facie justification of inflationist monetary policy and of the institutions designed to apply it—in particular, monopolistic paper money producers.
But surprisingly this rationale does not stand on stronger ground than the other theories justifying present-day monetary institutions. The case for preventing deflation is not so much based on argument, but on a long tradition of demonizing it.It is a revealing fact that there is virtually no literature on deflation in modern economics. A recent exception is Kumar et al. (2003). While this work has the merit to finally bestow some attention to the phenomenon of deflation, it does little more than restate the untenable commonplaces that form the present-day mythology of deflation. We therefore need to deal with this rationale in more detail than the other arguments.
We have already shown that the anti-deflation argument is untenable insofar as deflation is meant to mean a drop of the price level. The remaining question is whether the fight against deflation in a slightly different definition—a decrease of the money supply in the wider sense—has any better foundations. As we shall see, it is true that deflation in the latter sense entails a more or less dramatic fall of the price level. But it is unwarranted to jump from this fact to the conclusion that deflation destroys the division of labor, or that it can be offset through an inflationist policy.
What does it mean concretely when we say that the “money supply decreases”? Four forms of deflation can be distinguished and we will deal with them in turn.
- Free Market Deflation
Deflation can mean that some market participants, for whatever reason, decide to destroy their money holdings, or at least parts thereof. This physical-destruction scenario has of course no practical significance; it has never led to a large-scale deflation of the sort that would cause sleepless nights to policymakers.
- Confiscatory Deflation
Much more relevant in practice is deflation in the form of a confiscation of money holdings through the government. Confiscatory deflation has a long tradition. It is usually part and parcel of monetary reforms, for example, in Germany 1948, Brazil 1990, Russia 1990, and Argentina 2001. And fighting it is of course no problem for a government, because all it would have to do is not to confiscate the money of its subjects.
- Credit Money Deflation
Historically, deflation often occurred when monetary authorities redeemed credit money without neutralizing these redemptions through new issues, or when they destroyed paper money received as taxes. The usual purpose of these deflations was to bring inflated credit money back to parity, in particular, after wars. Such deflations took place in Britain after the publication of the Bullion Report, in the U.S. after the Civil War (the driving force was Secretary of the Treasury, Hugh McCulloch), and in Britain, Sweden, Holland, the U.S., and other countries after World War I.
As in the case of confiscatory deflation, it is very easy for governments to “fight” credit money deflation by simply not engaging in it or, better still, by never having created inflationary credit money in the first place. Still we might raise the question of whether the decrease in the quantity of money would, per se, have any negative consequences for aggregate production. The answer is in the negative. Decreases in the quantity of money have very much the same effect as increased hoarding, and businessmen and other market participants can adjust to them. Successful entrepreneurs will anticipate both the deflation itself and its impact on the price system. They will profit from their superior forecasting abilities at the expense of other entrepreneurs, who fail to bid down the prices of their factors of production in time to provide for a sufficient spread between these expenditures and their future selling proceeds. Again, there is no reason why this redistribution should have negative consequences for overall production. If anything, it can be expected to have a positive impact because it weeds out the less efficient entrepreneurs.
One might argue that credit money deflation entails more complications than increased hoardings. In particular, this form of deflation might provoke spiraling bearish expectations. When prices have dropped for a while, more and more people might assume that there is some sort of automatism in this trend and start increasing their demand for money. This will decrease prices even further, thus reinforcing the bearishness of these people, who then increase their demand for money even more, and so on.
Notice that such bearish expectation spirals can be very beneficial if they merely speed up the process whereby the market participants correctly anticipate the rock bottom provided by the minimum money supply at which the deflation stops. It is however possible that an expectation spiral overshoots. People might panic and hold on to their money even when prices have reached such a low level that it would be worthwhile to start spending money again. This can conceivably lead to a situation in which indirect exchanges with the deflationary money become impossible for technical reasons. The decreasing prices would require ever-smaller money units, but these cannot be produced in time (with the printing press) or cannot be handled at all in daily transactions (for example, microscopically small gold coins). In other words, great credit money deflations can raise the spectre of monetary disintegration, especially in the absence of entrepreneurial leadership.
How does the free market handle this problem? The solution is the same one that usually comes to be applied in the case of the inverse problem of hyperinflation. The name of the solution is money competition. As soon as the bearishness of the market participants on behalf of the deflationary money becomes excessive—that is, as soon as there is disequilibrium—other means of exchange are used in substitution of that money. The simple reason is that disequilibrium is tantamount to profit opportunities. Excessive deflations are therefore usually accompanied by the spontaneous adoption of other monies. The market participants would still find it profitable to engage in indirect exchange, and they could do this because they still have real assets to offer, most notably their labor services and other tangibles. As a consequence, they would start using other things as media of exchange, in particular, foreign paper monies and money substitutes provided by sound banks, but also commodity money such as gold and silver coins. The spontaneous adoption of currencies has been observed again and again in historical deflation processes, although government intervention usually prevented it from running its full course. Of course such processes go in hand with a substantial redistribution of wealth within society, but, as we have argued in some detail, this is not per se detrimental from an overall point of view.
- Price-Control Deflation
In many historical cases, deflation set in when governments imposed price controls on the exchange rates between monies used in parallel circuits, most notably in bimetallist regimes. Economists know that these price controls activate Gresham’s law—the bad (undervalued) money drives out the good (overvalued) money. The bad money continues to be used in monetary exchanges, while the good money is either completely withheld from the market or sold to residents of places where the price control does not apply. This disappearance of the good money means nothing else than that the overall quantity of money has been reduced in the territory subject to the price control.
Again, it is obviously very easy for governments to fight this form of deflation. And let us also repeat that interventionist deflations are condemnable, not because they entail a reduction of the quantity of money per se, or because certain market participants might not be able to successfully pursue their productive activities in this deflationary environment, but because they result from the violation of property rights.
Flight From Money
One of the most haunting emergency scenarios—for monetary policy makers at any rate—does not feature any physical disappearance or destruction of existing money units, but the loss of their monetary nature. Two main cases must be distinguished.
In the first case, money substitutes (for example demand deposits held at commercial banks) lose their status as money substitutes because no market participant wishes to buy them anymore. This is usually the case when the issuer of these money substitutes (the bank) is unable to redeem them against money (for example, against the paper bank notes issued by a “central bank”—that is, by a paper money producer).
In the second case, a paper money loses its status as money because no market participant wishes to buy it anymore. This usually happens in the terminal stage of a hyperinflation. But it could also happen, even without any previous period of price increases, if our present-day fiat money producers were stripped of their monopoly status and had to compete with “natural monies” such as gold and silver on equal legal footing. In any case, the resolution of the market participants not to use the paper money as a means of exchange makes it lose all of its value. The formerly cherished tickets become wastepaper.
In both cases the flight from money sets in as a reaction to a previous inflation. It does not drop out of the clouds as an entirely uncaused plague, but is the natural consequence of a previous regime of more or less extended inflation. It follows that the conventional bias against it gets things exactly upside down. The truth is that the flight from money is a great force of liberty. It destroys the institutional embodiments of inflation: fractional reserve banking and paper money. It stops inflation and thereby puts an end to the rechanneling of income in favor of the happy few with good connections to the politico-monetary establishment, and to the detriment of the politically unconnected rest of society. This consideration alone would be reason enough to welcome it.
The flight from money involves a disruption of the division of labor that cannot be prevented through entrepreneurial anticipations of the event. Quite to the contrary, such anticipations have the character of a self-fulfilling prophecy. If the market participants expect a future run on the fractional reserve banks, they will withdraw their money in time. But this very preventive action reduces the cash balances of the banks (the so-called “reserves”) and thus precipitates a run in the present. Similarly, if the market participants expect the future evaporation of a presently existing paper money, they will as far as possible stop using it now. But this will reinforce the increase of the price level in terms of that money, and other people might therefore also be induced to abandon its use. Hence, a cumulative process involving an ever-lower purchasing power of this paper money might set in and ultimately lead to its complete abandonment.
Another reason why the flight from money always involves disruptions is that, under paper money and fractional reserve banking, the division of labor is to a more or less large extent geared toward satisfying the needs of the groups in control of the inflation. Yet let us hasten to point out that, for this very reason, those disruptions seem to be rather unobjectionable. They resemble the disruptions shaking a former slave economy after the institution of slavery is abolished, or the disruption of a totalitarian society once the despot has been dethroned. Like any other large-scale change, a flight from money destroys the value of certain factors of production, and it makes other factors of production valuable. Economic theory does not provide any grounds on which we could prefer the use of the former production factors to the use of the latter. Notice however that the new values reflect the preferences of free men (or at least: of men who are more free than they were before), whereas the old values gave much more prominence to the preferences of the ruling classes.
So far we have argued that the traditional emotional bias against the flight from money has no rational foundation. There is nothing wrong with it, lest one were to assume that the interests of the happy few who thrive on the perpetuation of the inflationary regime were identical with the interests of all members of society. The next question is: How would the free market handle such situations? On a free market, nobody would be coerced into accepting monies or money substitutes he does not wish to own. As a consequence, a flight from money would run its course, eradicating fractional-reserve notes and deposits, and evaporating paper monies.
How long will this process last? Does it entail long-winding depressions and unemployment? Not necessarily. There is no reason that would make it impossible, for example, that people adjust to the new circumstances instantaneously. If the market participants, at the very onset of the flight from money, anticipated how much each price would eventually drop, they would reach “rock bottom” in a second. Fractional-reserve notes and paper monies would disappear instantaneously from circulation, and everyone would be aware of the new prices of all existing goods in terms of the other monies. This is of course an unlikely scenario, but notice that it is not a physical impossibility that prevents instantaneous adjustment. The bottleneck is anticipations. Some businessmen are very good at anticipating future states of affairs that are radically different from the present ones, and these persons will turn their ability into profit during the flight from money (just as they reap profits in inflationary periods, for the same reason). But the great majority of market participants lack this ability, and therefore a flight from money is a time-consuming process that not only brings about a redistribution of resources, but also certain other problems.
Among these problems, unemployment is usually cited in the first place. But it is not an essential aspect of this process. Workers and entrepreneurs certainly can find wage-rate agreements that make the continued operation of the firm possible. This is so even if neither the entrepreneurs nor the workers correctly anticipate the end of the process.
Can monetary policy successfully counteract a flight from money? Again, the easiest way to do this is by not letting it come to inflation in the first place. The secure road around the flight from money is to abolish inflation here and now. But once this flight has set in, it cannot be prevented with the conventional means of monetary policy. Increasing the money supply would only pour fuel on the flames, because the new money units merely amplify the very reason why the money is abandoned—its absolute loss of purchasing power. On the other hand, a policy of decreasing the money supply on a massive scale might conceivably prevent the money from being completely abandoned. But this policy would require that the monetary authority seize major parts of the cash holdings of the citizens. Such situations have often led to a change of the monetary constitution. Banks then usually are granted the privilege to refuse redemption, thus turning their tickets into paper money. In other cases, the money threatened by extinction has been replaced by a new currency as in Germany in 1923 and 1948. More recently, currency boards have played a similar role (Gertchev 2002). The offshoot of all of this is that flights from money are times of dramatic changes. But if radical policy shifts are necessary anyway, why not liberalize the production of money right away?
ConclusionThe competitive production of money can work and, we might add, has worked well in all known historical cases. We have shown that from a normative point of view that stresses the integrity of private property, it is superior to its logical alternative: government control of the money supply. And we have argued at some length that there is no tenable utilitarian case to be made for modifying the free-market production of money through political means. Conventional monetary policy and its institutional underpinnings in the form of central banks and similar monetary organizations are therefore useless at best, and should be abandoned. Politically induced changes in the money supply—the very essence of noninterventionist monetary policy—do not alleviate the problem of scarcity. Their main effect is to enrich some groups at the expense of other groups, and to create several grave problems that are unknown in the market economy.
Our analysis has also shown the importance of a competitive production of money. It is an error to equate the free market in money with the prevalence of commodity money. The late-nineteenth-century gold standard was a fiat standard! Problems start as soon as any type of money enjoys the legal privilege of being the “standard” money, and thus is immunized from competition. We have shown that competition is essential for the smooth replacement of one (technologically inferior) money by other commodity monies. It is equally essential for a fast adjustment process in times of hyperinflation or deflationary spirals. In the light of this, the nineteenth century standardization movement appears as one of the burdensome legaciesof classical liberalism.
Volume 7, No.1 (Spring 2004)It is pretty well established within Austrian economics that the optimum quantity of money is whatever level is established at any given time. The logical implication of this claim is that any amount of the commodity that intermediates trade will do as well as any other in acquitting this task. This being the case, there is no social or even private gain to be obtained by anyone adding to the money stock. The present paper challenges this view, but from within the praxeological tradition. That is, we shall argue that although prominent Austrian economists have indeed made this argument, they are incorrect from their own basic perspective, which is shared in full by the present authors. Our thesis, in contrast to theirs, is that “more is better,” or, more strictly speaking, at the very least it is possible that additional stocks of money can make a positive contribution to economic welfare.
Volume 6, No. 4 (Winter 2003)In my opinion there is a reason why Austrian monetary policy views are largely not shared by the mainstream. It is not due to a grand conspiracy against Austrian scholars but due to their monocausal,often ideological-driven economic reasoning. In this context I want to follow Laidler (2003, p. 13): “This is not the place to embark on a detailed critique of the Austrian cycle theory. Suffice it to suggest that its exponents took logical possibilities . . . and treated them as logical necessities.” Be that as it may—one thing is for sure: possibly, no single currency regime is best for all countries and for all times (Bordo 2003, p. 33) as Austrians want us to believe.
Volume 6, No. 4 (Winter 2003)The fundamental question we have to confront in the theory of monetary policy is therefore not whether money affects the real economy—yes it does, both in the short run and in the long run—but whether changes of the money supply can make society better off in the aggregate. Austrian economists who follow the approach of Mises and Rothbard believe that it cannot. By contrast, the intellectual edifice of Keynesianism—both old and new—rests squarely on the notion that money does alleviate the problem of scarcity for society as a whole. The entire case for monetary policy is based on the idea that “a decrease of inflation is followed by temporary output losses” (Zimmermann 2003, p. 6). At least in the short run, there is a trade-off between inflation and unemployment. But why should we believe that such a trade-off is more than an accident of history—that is, why should we not believe that a decrease in inflation could with equal probability lead to temporary output gains?
Volume 3, No. 3 (Fall 2000)In 1998 I presented a paper which argued that no theory of money was possible—in the sense of there being a stable relationship between a few explanatory variables. I was told that a theory was possible on Austrian premises and that Murray Rothbard had provided such a theory. As I am much indebted to Murray Rothbard for having supported my critique of Adam Smith, I thought this a powerful rebuke. What follows is my attempt to show why Rothbard does not really contradict my position and how my position is actually a refinement of Austrian premises.
Volume 15, No. 3 (Fall 2012)
An adaptive systems approach is used to compare a free banking system and a central banking regime with respect to their respective capacities to use and generate relevant knowledge. Monetary equilibrium, as a byproduct of a free banking system, has also been proposed as a norm for central bank policy. Differences in the way each system functions are found to cast doubt on that claim. The central problem identified is the difficulty of exporting results from one institutional setting (free banking)to a qualitatively different one (central banking).
Volume 3, No. 4 (Winter 2000) According to mainstream economics, the validity of various definitions of money can be ascertained by means of a statistical test. What determines whether money M1, M2, and the other Ms are valid definitions is how well they correlate with national income. Most economists hold that, since the early 1980s, correlations between various definitions of money and national income have broken down. The reason for this breakdown, it is held, is that financial deregulation has made the demand for money unstable. In short, the nature of financial markets has changed; consequently, past definitions of money no longer hold.
WHY THE MAINSTREAM APPROACH IS FLAWED Observe that, for the mainstream, the definition of money is established through an arbitrary mixing of various liquid assets and then correlating this mixture with another dubious statistic labeled national income. In other words, any mixture of liquid assets will be classified as money as long as this mixture passes the correlation test. Now, if any mixture of liquidity is accepted, why not include retail good inventories? After all, these inventories might be as liquid as stocks or bonds. Yet, no one would consider these inventories as part of the money supply (Rothbard 1978, p. 149).
But no definition can be established by means of a correlation. The purpose of a definition is to present the essence, the distinguishing characteristic of the subject we are trying to identify. A definition is to tell us what the fundamentals of a particular entity are. No statistical correlation could ever provide this. According to Salerno,
Measures of the U.S. money stock in current use in economic and business forecasting and in applied economics and historical research are flawed precisely because they are not based on an explicit and coherent theoretical conception of the essential nature of money. Given the all-pervasive role of money in the modern market economy, existing money-supply measures therefore tend to impede, rather than to facilitate, a clear understanding of the past or future development of actual economic events. (1987, p. 1)
To establish the definition of money we have to ascertain how the money economy came about. Money emerged because barter could not support the market economy. A butcher who wanted to exchange his meat for fruit might not have been able to find a fruit farmer who wanted his meat, while the fruit farmer who wanted to exchange his fruit for shoes might not have been able to find a shoemaker who wanted his fruit.
The distinguishing characteristic of money is that it is the general medium of exchange. It has evolved from the most marketable commodity. On this Mises wrote,
There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money. (1980, p. 45)
Similarly, Rothbard wrote that,
Just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media—in almost all exchanges—and these are called money.(1981, p. 3)
Since the general medium of exchange was emerged from a wide range of commodities, money must be such a commodity. According to Rothbard, “Money is not an abstract unit of account, divorceable from a concrete good; it is not a useless token only good for exchanging; it is not a ‘claim on society’; it is not a guarantee of a fixed price level. It is simply a commodity” (ibid., p. 4).
Moreover, “an object cannot be used as money unless, at the moment when its use as money begins, it already possesses an objective exchange value based on some other use” (Mises 1980, p. 131) .
Why?
In contrast to directly used consumers’ or producers’ goods, money must have pre-existing prices on which to ground a demand. But the only way this can happen is by beginning with a useful commodity under barter, and then adding demand for a medium to the previous demand for direct use (e.g., for ornaments, in the case of gold). (Rothbard 1981, pp. 3–4 )
In short, money is that for which all other goods and services are traded. This fundamental characteristic of money must be contrasted with those of other goods. For instance, food supplies the necessary energy to human beings, while capital goods permit the expansion of infrastructure that in turn permits the production of a larger quantity of goods and services.
Contrary to mainstream thinking, the essence of money has nothing to do with financial deregulation—the essence of money will remain intact in even the most deregulated of markets.
Some commentators maintain that money’s main function is to act as a means of savings. Others argue that its main role is to provide services of a unit of account and to function as a store of value. While these roles are important, they are not fundamental. The fundamental role, the essence of money, is that of a general medium of exchange. Because of this, all other functions emerge. The fact that an entity becomes the medium of exchange gives rise to these other functions.
THE DEFINITION OF MONEY Through an ongoing selection process over thousands of years, people have settled on gold as money. In other words, gold served as the standard money. In today’s monetary system, the core of the money supply is no longer gold but coins and notes issued by the government and the central bank.It is not the intent of this article to discuss how paper money displaced gold. Consequently, coins and notes constitute the standard money, known as cash, that is employed in transactions. In other words, goods and services are sold for cash.
At any point in time part of the stock of cash is stored, that is, deposited in banks. Once an individual places his money in a bank’s warehouse he is in fact engaging in a claim transaction. In depositing his money, he never relinquishes his ownership. No one else is expected to make use of it. When Joe stores his money with a bank, he continues to have an unlimited claim against it and is entitled to take charge of it at any time. Consequently, these deposits, labeled demand deposits, are part of money.
Thus, if in an economy people hold $10,000 in cash, we would say that the money supply of this economy is $10,000. But, if some individuals have stored$2,000 in demand deposits, the total money supply will remain $10,000: $8,000 cash and $2,000 in demand deposits—that is, $2,000 cash is stored in bank warehouses. Finally, if individuals deposit their entire stock of cash, the total money supply will remain $10,000, all of it in demand deposits.
This must be contrasted with a credit transaction, in which the lender of money relinquishes his claim over the money for the duration of the loan. Credit always involves a creditor’s purchase of a future good in exchange for a present good. As a result, in a credit transaction, money is transferred from a lender to a borrower.
The distinction between a credit and a claim transaction serves as an important means of identifying the amount of money in an economy. Following this approach, one could easily note that, notwithstanding popular practice, money invested with money market mutual funds (MMMF) must be excluded from the money supply definition. Investment in a money market mutual fund is in fact an investment in various money-market instruments. The quantity of money is not altered as a result of this investment; only the ownership of money has temporarily changed. Including investment in MMMFs in the money definition will only lead to a double-counting thereof. If Joe invests $1,000 with an MMMF, the overall amount of money in the economy will not change as a result of this transaction. To incorporate the $1,000 invested with the MMMF into the definition of money would therefore amount to double-counting.
The fact that mutual funds offer their clients check facilities has prompted some analysts to suggest that deposits with mutual funds are similar to bank demand deposits. According to Haymond,
If Joe sees an asset he wants to purchase, say a new car, he will not be the least concerned with whether his original money is loaned out somewhere else: he will simply open his MMMF checkbook and write the check. (2000, p.60)
However, when an individual writes a check against his account with the money market fund, he in fact instructs them to sell some of his money market certificates for cash. The buyer of these certificates parts with his money, which is then transferred to the holder of the check; money changes hands, but no new money is created.
Furthermore, the fact that MMMF checks are employed in payments does not mean that they are money. Checks are a particular way of employing existing money in transactions.
The crux in identifying what must be included in the money supply definition is to adhere to the distinction between a claim transaction and a credit transaction. Following this principle, it is questionable whether savings deposits should be part of the money supply.
According to popular thinking, the inclusion of savings deposits into the money supply definition is justified on the grounds that money deposited in saving accounts can always be withdrawn on demand. But the same logic should also be applied to money placed with an MMMF. The nub, however, is that savings deposits do not confer an unlimited claim. The bank could always insist on a waiting period of thirty days during which the deposited money could not be withdrawn. Savings deposits should therefore be considered credit transactions with depositors relinquishing ownership for at least thirty days. This fact is not altered just because the depositor could withdraw his money on demand. When the bank accommodates this demand, it sells other assets for cash. Buyers of assets part with their cash, which in turn is transferred to the holder of the savings deposit. The same logic is applicable to fixed-term deposits like CDs, which are credit transactions.
Recently, mainstream economists have introduced a new definition of money—labeled money of zero maturity (MZM). This definition comprises all monetary instruments that have zero maturity and that are therefore redeemable at par on demand. Included in MZM are currency, demand deposits, traveler’s checks, savings deposits, and deposits with MMMFs. This definition, however, suffers from the fact that it fails to distinguish between a claim and a credit transaction.
Though traveler’s checks are considered an integral part of the money supply, they should not be. Traveler’s checks are receipts for investment in the companies that issue them. As such, they result from a credit transaction, and therefore are not part of the money definition. Cashing a traveler’s check means that AMEX or VISA will transfer money from their deposits to the holder of the check, which will not change the amount of money in the economy .
Mainstream thinking currently excludes from the money supply government deposits held in banks and the central bank. Consequently, if the government taxes people by one billion dollars, money is transferred from their deposits to the government’s deposit. This is viewed just as if the money supply fell by one billion dollars. In reality, however, the money is now available for government expenditure, meaning that money held in government deposits should be part of the definition of money.
Incorporating all the above arguments, the money supply is defined as follows:
Cash+demand deposits with commercial banks and thrift institutions+government deposits with banks and the central bank.
This definition shows clearly that any expansion in money supply results solely from central bank injections of cash and commercial banks’ fractional reserve banking.
SHOULD DEMAND DEPOSITS BE PART OF MONEY? Although demand deposits result from claim transactions, banks are legally permitted to regard them as the outcome of credit transactions. The legal precedent for this was set in 1811 in England with Carr v. Carr. The court had to decide whether the term “debts,” mentioned in a will, included a cash balance in a bank deposit account. The judge, Sir William Grant, ruled that it did. Grant ruled that since the money had been paid generally into the bank and was not earmarked in a sealed bag, it had become a loan to the bank (Rothbard 1983, p. 93). So, if demand deposits are legally considered credit, how can we regard them as part of the money supply?
On this, Mises wrote,
It is usual to reckon the acceptance of a deposit which can be drawn upon at any time by means of notes or checks as a type of credit transaction and juristically this view is, of course, justified; but economically, the case is not one of a credit transaction. If credit in the economic sense means the exchange of a present good or a present service against a future good or a future service, then it is hardly possible to include the transactions in question under the conception of credit. A depositor of a sum of money who ac-quires in exchange for it a claim convertible into money at any time which will perform exactly the same service for him as the sum it refers to, has exchanged no present good for a future good. The claim that he has acquired by his deposit is also a present good for him. The depositing of money in no way means that he has renounced immediate disposal over the utility that it commands. (1980, pp. 300–01)
Similarly, Rothbard argued,
In this sense, a demand deposit, while legally designated as credit, is actually a present good—a warehouse claim to a present good that is similar to a bailment transaction, in which the warehouse pledges to redeem the ticket at any time on demand. (1978, p. 148)
In short, when a depositor places his money in a savings or fixed-term deposit, he temporarily relinquishes his ownership. This, however, is not the case with demand deposits. As long as the bank does not use the money in demand deposits, it is backed one-hundred-percent by the deposited cash. Whenever banks lend part of the deposited money, they create new demand deposits that do not have any cash backing. Since the created deposits can masquerade as proper representatives of cash, they should be included as part of the money supply.
A case, could be made, however, that people who place their money in demand deposits do not mind banks using their money—which would mean that we are dealing with a credit transaction. How, then, are we to decide what money is? As long as people trade, there will always be a demand for money, which will be held either in cash or in bank deposits. Consequently, regardless of people’s attitudes, once banks use deposited money, an expansion of money that is not backed by money proper is set in motion.
But one could also argue that the acceptance of checks written against demand deposits as money is conditioned upon the perceived solvency of the bank that issued them. It is true that, once the public becomes suspicious about a particular bank, bankruptcy could occur because of a “run” on the bank. This does not alter the fact that demand deposits are part of money though. All that would happen in such a case of bankruptcy is that deposits not backed by cash would disappear. Deposited cash, however, cannot disappear as long as the physical stock of money is not destroyed.
ELECTRONIC MONEY, SWEEP TRANSACTIONS, AND THEIR EFFECT ON THE DEFINITION OF MONEY The recent introduction of electronic money seems to cast doubt on our definition of money. It would appear that deregulated financial markets create various forms of new money. Notwithstanding, various forms of electronic money, or e-money, like digital currency, are effectively claims against banks. They don’t have a “life of their own.” Similar to demand deposits, digital currency can function as long as individuals know that they can obtain cash on demand. According to Mises’s regression theorem, the historical link between paper currency and gold is what holds the present monetary system together. Various financial innovations do not create new forms of money, but rather new ways of employing existing money in transactions (White 1996). Regardless of these financial innovations, the nature of money will never change. It will always be the thing that all other goods and services are traded for.
Since January 1994, banks and other depository financial institutions have initiated sweep programs to lower statutory reserve requirements on demand deposits. In a sweep program, banks “sweep” funds from demand deposits into money market deposit accounts (MMDA), personal savings deposits under the Federal Reserve’s Regulation D, that have a zero statutory reserve requirement ratio. By means of a sweep, banks reduce the required reserves they hold against demand deposits. As a result of the sweep program one could argue that the money definition outlined above will not cover the total money supply. This criticism, however, is misplaced, for it has nothing to do with the definition as such, but with the difficulties of measuring money, which was transferred out of demand deposits by banks without the depositors’ consent. (The Federal Reserve of St. Louis provides a monthly estimate of the amount of money swept.)
CONCLUSION As we have shown, the validity of various definitions of money cannot be ascertained by means of a statistical correlation with national income. A valid definition can be established by following the essentialist approach—that is, by focusing on the distinguishing characteristics of an entity. Contrary to mainstream thinking, we have shown that the money supply definition remains intact, notwithstanding the deregulation of financial markets and the introduction of electronic means of payments.
Volume 19, Number 3 (Fall 1999)An Interview with Frank ShostakFrank Shostak is chief economist at Ord Minnett Jardine Fleming, Sydney, Australia, one of the largest brokerage houses in that country, and serves on the editorial board of The Quarterly Journal of Austrian Economics. He received his bachelor's degree from Hebrew University, master's degree from Witwatersrand University and PhD from Rands Afrikaanse University, and has taught at the University of Pretoria and the Graduate Business School at Witwatersrand University. He is a frequent contributor to the Asian Wall Street Journal, among many other popular and scholarly venues. His email address is fshostak@ords.com.au
AEN: Do you find Austrian economics useful in your day-to-day work?
SHOSTAK: I think it's important that clients understand the rationale behind your thinking. The Austrian School makes that possible. Clients relate to it very easily, and there's plenty of available literature with which they can follow up. On the other hand, most businessmen cannot understand econometrics, even if they sometimes pretend to because they don't want to appear stupid. But the really smart ones want to know why you think the way you do. You can't just say: "that's what the model says." Serious businessmen won't buy that. Neither will they be tricked into thinking their advisers are oracles. I never pretend to predict the future but only to suggest possibilities based on real events and realistic theory.
AEN: The job of chief economist for a major investment firm usually involves mathematical wizardry.
SHOSTAK: I was trained as a mathematical economist. My dissertation topic was "An Econometric Inquiry into the Monetary Transmission Mechanism in South Africa." After my PhD, I went to work as the head of the econometrics department for the major Johannesburg bank. While there, I built one of the first large macroeconomic models in South Africa. I visited the Wharton School of Business, showing it off and impressing all the math jocks. After working ten years on the project, I began to have doubts, and those doubts grew.
At some point, I decided to throw myself back into thinking about the basis of economic theory. I eventually read Murray Rothbard's Man, Economy, and State, and it permanently changed the way I thought about economics. He began with human beings as they are and as they act and as they choose-points that macroeconomic models cannot take account of. It became clear to me that most of what I was doing was based on the wrong foundation.
The big problem in economics is not that it lacks technical sophistication; the problem is that it lacks philosophical sophistication. When economists do attempt to give the science a philosophical justification, the results are unimpressive. It usually comes down to a defense of patently incorrect assumptions about the world.
But why should we assume things that are incorrect? The answer used to be that you can know good models by their predictive power. Today, few believe that, so the defense of implausible assumptions now comes down to this: they are necessary to create models. This is just a vicious circle, when the starting point and the ending point are the same. This is just a con-job.
From a Rothbardian point of view, economic theory must stand on its own. It doesn't require a mathematical proof but a logical one. It is valid in all space and time because it deals with unchanging laws of cause and effect that emanate from choice.
This is not captured in mathematical functions. If you say y is a function of x, you are trying to dispense with causality and you imply that relations between facts are brought about apart from choice. But in the end, human beings decide how much to spend, whether and how much to invest, and so on. If you throw this idea out, you can create elegant models of anything you want, but they have no bearing on reality.
AEN: While in South Africa, did you know Ludwig Lachmann?
SHOSTAK: I attended his private seminar, which he ran out of his house. What aroused my attention was his attack on quantitative economics. I remember thinking: there must be something wrong with this guy. But he invited me to join his seminar, and I always found him interesting. He lectured and we heard papers by others, and I presented some.
Even in those days, Lachmann emphasized uncertainty and the unknowability of the future. Much of it was sound, but he tended toward nihilism, the assertion that we can never know anything. I must say it wasn't until Hans Hoppe's article on that subject in the old Review of Austrian Economics that these issues were clarified for me.
In any case, in one seminar, he mentioned the debate between Keynes and Mises. I wondered who this Mises guy was, and I became very curious. Lachmann let me photocopy his copy of the first edition of Human Action, and I read the whole thing. I must admit that I couldn't understand a word of it. I was very upset because I thought of myself as a top economist, a member of an elite corps of econometricians. For my own sake, I remember hoping that Mises was just writing rubbish.
After that, I read Henry Hazlitt, whose work I found comprehensible but childish, intriguing but not rigorous-or so I thought. Later I changed my mind. In any case, Hazlitt footnoted Rothbard, and finally I found the economist who could, for me, make the case for the Austrian School.
In my opinion, Man, Economy, and State is better organized, more precise, and more focused than Human Action. Rothbard writes for the mainstream economist and in a language he can understand. Part of the difficulty of becoming an Austrian economist is that it requires a different vocabulary. Rothbard makes the transition much easier.
In fact, I attribute the rise of the Austrian School in our times, whether in academia or the financial world, to Rothbard's writings. They have had far more influence than is usually admitted, even by Austrians themselves. That so many claim that their primary influence is Lachmann or Mises or Hayek is due to the natural tendency to rally around thinkers who speak more obscurely as a way of congratulating oneself on one's interpretive capacities. It is Rothbard who has taught the world of today Austrian economics.
AEN: Was Lachmann a classical liberal?
SHOSTAK: Yes, he was, but he also had a great deal of admiration for Keynes. I asked him about Mises, and he said that Mises was a very stubborn person who didn't make enough of an effort to understand Keynes. If he had made more of an effort, he wouldn't be as negative toward Keynes. He also regarded Mises as arrogant, abrasive, and uncompromising.
I didn't tell him this at the time, but it is clear why Mises didn't compromise. He had strong disagreements with his colleagues. He wasn't interested in making incorrect assumptions about the world. He wanted to describe reality. Of course this led him to be an outcast after the entire profession had decided that it is perfectly fine to assume such things as all people are identical, knowledge is perfect, and output is given.
AEN: What about Lachmann's influence in the Austrian movement?
SHOSTAK: There is a long-running tendency among Austrians who have discovered the fallacies of mainstream thought to reject not just bad theory, but theory altogether. They conclude from the failure of one formal system of thought that all formal systems of thought must go. They rally around the work of Lachmann and G.L.S. Shackle and end up rejecting the existence of the law of demand, for example.
This is an enormous error. The problem with mainstream economics is not that it is theoretical and formal but that it is based on the wrong foundation and therefore generates crazy conclusions. The right response is to start from the right foundations. If a bridge collapses, you shouldn't reject the possibility of scientific geometry; you should try to figure out what went wrong with the bridge engineering plan.
Lachmann's key contribution to Austrian theory was said to be his theory of expectations. He said we live in a kaleidic world that is shaped mainly by what we believe about it and what others believe about our beliefs, etc. But Mises pointed out in the 1940s that expectations are a black box to an economist; they belong in the category, not of praxeology, but of thymology: knowledge concerning internal human valuations. We cannot make any fixed assumptions about such valuations. We cannot say they are perfect or that they are never correct about the future. We just do not know. Praxeology provides certain knowledge about unchanging facts.
AEN: How does this apply in the context of business cycle theory?
SHOSTAK: Writing in Economica in 1943, Lachmann criticized Mises's theory of the business cycle on grounds that expectations could prevent it from taking place. The idea is that businesses expect the bust and refrain from investment expansion, thereby muting the impact of new money coming into the economy. Hence, the business cycle is recast as an information- coordination problem rather than a theory about cause and effect.
The incorrect assumption here is that bad expectations are somehow the cause of the business cycle. The actual cause is the introduction of counterfeit money, which redistributes wealth and leads businesses to make calculation errors. You can have any kind of expectations you want but they will not and cannot obviate past events. This new money is an economic error which must work itself through the economy in some way.
You cannot use psychology to explain the consequence of real events. What people believe about the future cannot change the reality of cause and effect. The business cycle is a consequence of a real act of damage that, once set in motion, cannot be undone. Guido Hlsmann prefers to recast the business cycle theory into a general theory of error cycles, which gets to the core of the issue at hand: government intervention leading to bad decisions.
AEN: Which aggregate money supply statistic do you think is the most reliable?
SHOSTAK: I like the one spelled out by Rothbard in the late 1970s: money that permits instant conversion at no loss. Today this is covered by such aggregates as M2 and Money of Zero Maturity, or MZM. You need to make small modifications-removing short-term savings deposits-and you need to make allowance for institutional money.
Using this measure, it's clear that the money supply has been bouncing back since about 1992, and in the first quarter of 1999, money growth reached as high as eleven percent. This suggests to me that America's economy is very unbalanced. When and how it will tip the other way can't be known, but it will happen. Most people, including people at the Fed, are focusing on whether inflation will return. But that is not the issue. The issue is exaggerated levels of investment, particularly in the stock market, that cannot be sustained.
When the bust hits, you can bet that there will be more cries for the Fed to inflate. This will be a direct result of Milton Friedman's claim that the depression in the 1930s would have been prevented if the Fed had inflated. But he has it exactly backwards: it was the early credit expansion that created the conditions that led first to the boom and then to the bust. It was the first round of money printing that destroyed the pool of funding.
AEN: What do you mean by pool of funding?
SHOSTAK: Essentially, the pool of funding is the quantity of goods available in an economy to support future production. In the simplest of terms: a lone man on an island is able to pick 25 apples an hour. With the aid of a picking tool, he is able to raise his output to 50 apples an hour.
Making the tool, however, takes time. During the time he is busy making the tool, the man will not be able to pick any apples. In order to have the tool, therefore, he must first have enough apples to sustain himself while he is busy making it. His pool of funding is his means of sustenance for this period-the quantity of apples he has saved for this purpose.
The size of this pool determines whether or not more sophisticated means of production can be introduced. If it requires one year of work, for instance, for the man to build his tool, but he has only enough apples saved to sustain him for one month, then the tool will not be built-and the man will not be able to increase his productivity.
The island scenario is complicated by the introduction of multiple individuals who trade with each other and use money. The essence, however, remains the same: the size of the pool of funding sets a brake on the implementation of more productive-but longer-stages of production.
Trouble erupts whenever the banking system makes it appear the pool of funding is larger than it is in reality. When a central bank expands the money stock, it does not enlarge the pool of funding. It gives rise to the consumption of goods which is not preceded by production. It leads to less means of sustenance for the production structure.
As long as the pool of funding continues to expand, loose monetary policies give the impression of boosting economic activity. That this is not the case becomes apparent as soon as the pool of funding begins to stagnate or shrink. Once this happens, the economy begins its downward plunge. At this point, the central bank's monetary policy becomes ineffective. The most aggressive loosening of money will not reverse the plunge. Paper money cannot replace apples.
AEN: What do you make of the many companies that are attracting funding without actually showing profits or earnings?
SHOSTAK: In a free market with sound money, stock prices would function very much like other prices on the market. They would change relative to each other and pay an average return tending toward the normal rate of profit, with due qualifications owing to the good judgment of investors. What we see today, however, is roughly akin to a hyperinflation in financial assets. This is no different from the debasement we see in the value of money in a normal inflation.
Most economists believe that if the stock market is going up, the economy is being revived. But altering the valuation of stocks does not change reality. It is only a manifestation of what people think about the real world. And if you print money, you corrupt the signals that lead people to make rational decisions. Right now, people are being led to form false perceptions about reality. That doesn't mean that people cannot make money in stocks, but it does mean that the present rise of the stock market cannot be sustained.
In the real world, there is no way a company with no earnings can be properly valued at half a trillion dollars. And yet that is what we are seeing. Someone may say: but these companies may produce something someday. Sure, but there are limits. A new Volkswagen is a good car, and it may have a surprisingly high price due to popularity. But when the car sells for a million dollars, something has gone very wrong. It doesn't matter how spectacular the new technology is. Resources are being misallocated.
Even aside from these absurd prices, you can know that malinvestment is taking place by looking at the money-supply figures. They have been growing for years, and every time a crash or a recession is threatened, the Federal Reserve intervenes to save the day. When will all this end? There is no way to know. But the fund is not unlimited, and when the means of sustenance are not there, the growth cannot continue. The music will stop at some point, and, when it does, all the new credit in the world will not revive the economy. The new money can pour in but people will not use it to invest.
AEN: This sounds something like a Keynesian liquidity trap.
SHOSTAK: There is a superficial commonality. There is such a thing as pushing on string. What Keynes describes, however, he does not explain. Only the Austrian cycle theory can do that. A good example can be found in the Asian crisis. Paul Krugman says that Japan fell into a liquidity trap. Why? He doesn't know. He just describes it as an unfortunate state of mind adopted by the citizens, one that can only be cured by printing money.
But there is no need to resort to psychological explanations for why the Japanese are reluctant to borrow. It is clear that the pool of funding was unable to support the level of investment that had been subsidized by excess credit creation, averaging 9 percent per year prior to the crisis. When the central bank raised interest rates, the bubble burst and all the misallocation-which is to say the robbery-was revealed.
How do you recover from a crisis? The Japanese government continues to inflate and spend money. This is incredibly wrongheaded. To create more money is merely to replicate the error that brought about the problem in the first place. And yet, virtually every economist, from Keynesian to monetarist, recommends this disastrous path as the way out of recessions. The only path to recovery is to allow the bad investments to wash out of the economic structure and allow the pool of funding to be replenished.
AEN: Why is inflation still considered the preferred path of economic recovery?
SHOSTAK: It represents a complete misunderstanding of the purpose of money. The purpose of money is to facilitate exchange. It cannot create or sustain economic growth. It is no substitute for productivity. No matter how powerful a central bank is, it cannot revive an economy that is suffering from a credit-generated bust.
Also, mainstream economists have a hard time understanding the theoretical basis of a misallocation of resources. This is due to their economic method. Misallocation cannot be put on a graph and it cannot be represented in a mathematical equation. It has to be understood in light of market theory, which mainstream economists only embrace to the extent it can be modeled.
Think about the statistic Gross Domestic Product (GDP), from which most all economic indicators are derived. What is it? The value of goods and services produced expressed in terms of money, with the real GDP arrived at by dividing it by some meaningless deflator. If you print more money, you spend more money and GDP goes up.
But this does not reflect economic reality. Neither does the GDP deal with stages of production. It should be clear, then, that the GDP is not a reliable indicator of economic growth. It does not reflect malinvestment and, moreover, it is subject to manipulation depending on monetary policy.
AEN: Austrians are sometimes said to regard recessions as the "good" part of the cycle.
SHOSTAK: This is because recessions reveal an underlying reality. They expose a lie that has been generated by credit creation. In Malaysia, for example, the government had been trying to build an Asian version of Silicon Valley, to compete with the US. They had massive structures and companies and plans. But none of it amounted to anything. It was no more valuable than an Egyptian pyramid. The virtue of a recession is that it reveals the truth.
But this truth is difficult for people to face. Economists spend an enormous amount of energy inventing policies to keep the truth from being revealed in recessions. This is what accounts for the hysterical fear of deflation, which is considered to be the worst thing an economy can face. Instead they recommend more inflation. In fact, in an inflated economy, a deflation is exactly what is needed.
The International Monetary Fund (IMF) has improved its understanding of the importance of recessions. In Japan, for example, its economists said that banking and the industrial sector need to be cleaned up. At the same time, the IMF is still pro-credit creation. In Indonesia, with the IMF's blessing, money expansions were running 60 percent and more. In South Korea, the rates were at 35 percent.
What does this accomplish? Nothing but further economic destruction. You cannot eat money. To get the economy back on a sound footing, you need to store up a new pool of funding-the real stuff-so the capital stock can be replenished. That requires sacrifice in the short term.
I fully expect Asia to crumble again. Last year's major crisis was a result of bad fiscal and monetary policies, and those haven't changed. Neither has the economy adjusted.
AEN: What about the currency board option?
SHOSTAK: It produces a better result than the present system because it defangs the central bank. To that extent, it is a good step. But it creates problems of its own. The currency board must choose some existing currency on which to base its system. Doing so makes the currency-board country monetarily and politically beholden to the host country, whether it be Germany or the United States.
The best solution in these countries is to stop printing money and adopt a pure gold standard, defining their own currency in terms of gold. No country is too small to make this feasible. Such a country might be opposed by the US, but it would become a magnet for investment. It would not be vulnerable to outside shocks or outside political manipulation. A country with a gold standard wouldn't have to pay any attention to Alan Greenspan. Most importantly, its productive sector would be built on a solid financial foundation.
Of course central banks are working to undermine gold right now, just as they have for most of this century. Their recent sales of gold suggest that they would like to get rid of gold completely. Even from their own point of view, this is crazy. The current monetary system is completely unstable, and unloading gold can only destabilize the system further.
AEN: How regulated is the financial sector in Australia?
SHOSTAK: About as regulated as the US, which is to say partially so. In the early 1980s, we had what is called financial deregulation, but this phrase is a misnomer. Because money is unsound and the central bank still has the power to inflate and provide guarantees against financial failure, deregulation unleashes financial institutions to conduct business unchecked by genuine market forces.
This is what happened in the savings and loan crisis, an experience that foreshadowed the financial crisis throughout Asia. It was this very deregulation that opened the spigots, and brought about the huge boom-bust cycle.
The lesson is that you cannot have financial deregulation and also have a central bank. The two are incompatible. The whole point of a central bank is to make the banking system unaccountable to market forces. Whenever the banks are in trouble, there is a lender of last resort. No other business entity enjoys such a privilege.
AEN: How powerful is the Fed in your part of the world?
SHOSTAK: Its power to do evil is enormous. Its bureaucrats exercise the dominant influence at all G7 meetings, as well as the Organization for Economic Cooperation and Development (OECD) and the World Bank. It works to coordinate world policies to prevent anyone from getting out of line. The Fed's ideal is a world monetary system that it manages completely, but, for political reasons, it is unable to achieve this.
So in the meantime, its main goal now is what it has always been: to provide a safe and profitable working environment for its member banks via monetary policy, which is to say, credit expansion. This is what is behind the Fed's attempted bailouts of Mexico and Asia. It was acting to protect the assets of its member banks' portfolios.
More generally, the Fed's actions generate inflation and the business cycle, and create artificial uncertainty in the market. It cannot be known in advance what policies the Fed will adopt, and neither can you know the precise timing of the effects. Just speculating on the Fed's actions swings markets in wild and unpredictable ways. I have to laugh every time the Fed demands that the portfolios of foreign central banks become more "transparent." No institution is more clouded in secrecy and obfuscation than the Fed. We can only guess at what it has done or is doing.
AEN: This is one reason you don't accept the Efficient Markets Hypothesis (EMH).
SHOSTAK: It's not only the Fed; uncertainty is built into the core of the market itself. The whole theory of the EMH is ridiculous. They are saying there is no reason for market analysis. All that can be known is known and reflected in the market price. If this were true, there would be no profits. There would be no business cycle.
EMH is another error that stems from a misapplication of mathematical techniques to human action. They examine past behaviors and develop probability distributions based on them, as if past behavior can somehow be a guide to future behavior. But the science of probability breaks down insofar as human choice is involved. There is no normal distribution in human affairs. In some ways, the EMH represents the opposite error of Lachmann. It goes from believing that nothing about the future can be known to assuming that everything about the future can be known. The whole question is mistaken. It is not a question of whether or how much knowledge is out there. It is a question of whether people have understood the information and acted upon it. Plenty of knowledge that is available may not be reflected in the price. The price only reflects knowledge that market participants believe is relevant to market conditions and have thereby acted upon. The market does not have a life of its own and it is not a god; neither is the market random, blind, and aimless.
The market is made up of human beings who are radically different from each other. We have different goals, different kinds and levels of information, and face different environments. Discovering how this works itself out in voluntary exchange is the task of market analysis. Economics is a qualitative, not quantitative, science. It's amazing how many errors in economic theory stem from the failure to understand this.
AEN: You don't find the recent critics of the Austrian School very compelling?
SHOSTAK: Take a look at Brian Caplan's article in the Southern Economic Journal. It is an apologia for fudging one's scientific standards. It's true, he says, that utility is not cardinal but ordinal, but there's nothing wrong with indifference curves even though they assume cardinality. Why? Because it's easy and nothing important is compromised. But he's wrong. The assumption that people's utility functions can be compared mathematically opens up a Pandora's Box of economic and social planning.
He further defends the idea of indifference on grounds that such a state of mind is actually possible. But economists don't care about psychology; they care about action and choice. Indifference is not an economic category. The whole point of economic theory is to explain the implications of choice. People must set priorities and act on them. Economic theory consists of elucidating causal relations between actions and events, not speculating on states of mind or weaving tales through graphs and equations.
Caplan further notes that Rothbard criticizes the continuous function assumption behind smooth curves, preferring to deal only in discreet units. He then claims that Rothbard himself dispensed with his critique in order to draw demand and supply curves. In the first place, Rothbard was merely using the curves for illustrative and not theoretical purposes, and he put them in context in a way which neoclassicals do not. Rothbard's graphs illustrate but do not determine the theory, and there's a huge difference.
But there's a more fundamental point: Caplan never rebuts Rothbard's criticism of the continuous function assumption. Again, Caplan seems to be suggesting that he might have been correct, but then claims it doesn't matter. But of course it matters, if we care about getting the theory right. As scientists, we should not adhere to theoretical assumptions about the world that are false.
But mainstream economists do this all the time, just so they can use mathematics. If some point doesn't fit into a graph or equation, it is just thrown out. That is why most economists today end up doing nothing but analyzing various nonsensical states of equilibrium. Their priorities are wrong. Our purpose should not be to do math but to arrive at true theory.
AEN: Apart from business cycle theory, what aspects of Austrian economics are useful to you?
SHOSTAK: I use the foundational issues of choice and human action on a daily basis. But the great gift that Austrian economics gives practitioners is the ability to think logically about all aspects of economic life. There are so many investment fads out there. They come and go every season. With Austrian economics, you can easily spot the fallacies in these new theories and stay rooted in reality. Over the long-term, this is the best survival mechanism I know.
Volume 12, Number 3 (Summer 1991)AEN: Throughout your career as an economist, you have shown interest in social ethics.
YEAGER: I don't see anything peculiar about economists being interested in ethics. The two fields overlap. Both are concerned with how people can function together in society without central direction. Somehow, they pursue their own interests and serve those of others at the same time.
AEN: And your interest is utilitarianism.
YEAGER: That's right. Among many classical liberals, utilitarianism is considered a bad word. But I don't think many understand what it means. There are different varieties of utilitarianism. Mises and Hazlitt, both utilitarians, are on the same wave length, as was David Hume, who inspired F.A. Hayek.
Remember that no sensible version of utilitarianism makes interpersonal comparisons of utility. Hume, Mises, Hazlitt, and Hayek did not engage in interpersonal comparisons of utility.
Bentham, I suppose, wrote as if he imagined that it were possible. The same can be said of the mathematical psychics of Edgeworth. He seem to conceive--either as an expository device or even seriously--of the possibility by drawing up his aggregate utility functions as if it were possible.
AEN: But how can utilitarianism protect the minority against the majority?
YEAGER: It is a standard caricature that it cannot. Murray Rothbard takes this position all the time. But if we go back to Chapter 5 in Mill, the one dealing with justice, we find that justice is a name for that set of rules and principles that would guide our institutions and behavior which are of utmost importance toward human happiness. If we set aside justice to give a thrill to Rothbard's majority--the people who get their kicks from torturing red heads--then we are setting aside rules and principles that are important for a decent society and therefore to human happiness.
But this notion of overriding minority rights for the sack of amusement of the majority is a caricature version of utilitarianism. Respect for minority rights is essential to a decent society. Any reasonable version of utilitarianism takes a longer view, considering how a good society can be sustained. It is not concerned with the pleasures of the moment.
In my pessimistic moments, I decide not to write anything more about this since Hazlitt has already said everything.
AEN: What's wrong with natural rights theory?
YEAGER: Nothing. I consider myself a consistent champion of the kind of rights that are mentioned in the Declaration of Independence and the Bill of Rights. But it is wrong to start with some conception of rights and then try to derive everything from that. The importance of respecting human rights is a result of our coming to realize how important they are to a good society and human cooperation.
I get the impression from libertarian rights theorists--like Tibor Machan--that they want to just posit human rights. The good guys see them, the bad guys don't, and that's that. They must think it somehow demeaning to human rights to argue for them.
My objection to rights theory--as it is presented by those who want to distinguish themselves from utilitarianism--is the basis on which they enunciate rights. Rothbard's rights are peculiar for being so narrow--body and property--but most "rights" just amount to claims without obligations.
Furthermore, to invoke rights in a discussion is to use heavy artillery that is contrary to the peaceful discourse. A rights advocate will says, morality requires that my policy be adhered to and anybody who disagrees or denies the rights that I have announced is an enemy of morality. And that's the end of discussion. This is not scholarship at its best.
AEN: But you want to hold on to a notion of rights.
YEAGER: Not as the starting point, but as concepts that arise within the field of ethics. The following definition of rights works in practically all contexts in which the word is used:
Rights are entitlements to behavior on the part of others which are binding with a particularly strong degree of moral force.
Rights to life, liberty, and property means that it is particularly binding on others that they do not invade our own lives, bodies, and freedom.
AEN: But in popular discussion, the terms "rights" is most often used to mean the opposite of your definition.
YEAGER: True. Civil rights are valid, but people try to sell contrary policies under its name. The so-called civil rights bill, which increases opportunities for anybody who has a grievance to sue the employer, is a bad idea. It's disingenuous to deny that such bills are not important in setting up de facto quotas. If the best way to protect yourself from suits is to have the statistically correct mixed of groups, you're being prodded to do it that way.
Many good intentions are vaguely written into the law only bring opportunities for nasty and litigious types to exploit the law in other ways.
AEN: Do you wish more economists were interested in ethics?
YEAGER: We can't expect all economists to be interested in the same things. But the tradition of economists interested in ethics goes way back and carries up to the present. Smith, Hume, Mill, Keynes, Mises, Hayek all were. And ethics does indeed seem to be becoming more important to economics discussion these days. The typical economic journal does not deal with the subject, since it is supposed to be on the frontiers and cannot be concerned with the great bulk of accepted doctrine.
AEN: What role has the mathematization of the profession had in pushing aside ethical discussion?
YEAGER: It has played a role in pushing aside the overlaps between economics and ethics, because it isn't too obvious how one puts ethics into equations. But I don't want to condemn mathematics, since doing so would be engaging in a particular type of methodology. I don't much admire laying down methodological taboos, telling your colleagues the right way to go about things.
AEN: Are you uncomfortable with Mises's views on the use of mathematics, that they have a limited use in doing history but not in economic theory?
YEAGER: I have always been a bit dismayed at Mises's a stern line against mathematics in economics. How can one be so far sighted to see that nothing good can come out of the application of mathematics to economics?
In general, I think people ought to be more modest in their methodological sermonizing. Just because one theorists doesn't apply certain methods doesn't mean they should be taboo.
Mathematics can be a good way of conveying some ideas. With some concepts, you have to keep hammering at them to get them across to your students. The idea of maximizing utility under constraints should be done with words, graphs, and mathematics.
Three ways are always better than one. To really understand these topics, you've got to go over them several times while using a variety of techniques. That the basis of my forthcoming article, "The Curse of Methodology."
AEN: You speak about Austrian taboos, but aren't there taboos in the mainstream?
YEAGER: There are plenty of methodological taboos which are never even discussed. And sometimes the tacit methodologizing is even worse than the explicit methodologizing. If people are explicit, they are laying out their message for inspection. An implicit assumption of the mainstream is that if economic reasoning is to be rigorous, it must present a formal model cast in the form of maximization of utility, profit, or present value.
AEN: Is any particular school guilty of this?
YEAGER: The New Classicists are my particular bugabear. They are always telling us that we must suppose that markets are always clearing, that we've got to interpret the business cycle as if markets are always clearing, that we've got to see unemployment as voluntary withholding of labor from the market. But this notion that all markets are clearing, or are close enough to clearing so that we are required to do our reasoning as if they were clearing, has no more merit than a methodology which hardly gets explicitly discussed.
I am skeptical about all such postulates. The postulates which are legitimate depend on what you are studying. For example, if you are doing an exercise in microeconomics to find the long-run equilibrium consequences on the price and output of a product because of a specified tax or change in technology, then it only clutters up the argument to focus on the transition from the present state of affairs to the future equilibrium state of affairs. We have no particular reason to be interested in the disequilibrated markets before prices have fully adjusted. The proper question is: what is the tendency of the specified change in the data.
But if we are doing macroeconomics--which is concerned with lapses from full coordination, and what accounts for the greater or lesser degree of full coordination in the economy--then these transitional obstacles are the center of the topic. What might be merely a fringe complication set aside in a micro analysis are moved to the very center when we are doing macroeconomics. Yet New Classical economists dismisses all concerns with lapses of coordination and the failure of market so clear completely. It simply wipes away the problem.
AEN: Are you, then, a methodological pragmatist?
YEAGER: I am a methodological libertine. I am not saying that anything goes, or that whatever one comes up with is automatically valid. Divine inspiration is not as good as looking at the facts. But let people work with whatever method works for them, and fits with their talents and inclinations. After all, their work is open for public inspection.
AEN: Donald McCloskey has been persuasive in this regard. What do you think of his work?
YEAGER: I agree with him at many points when he is speaking independently. I really haven't read some of the people that he cites--those associated with deconstructionism and hermeneutics--but I am not too impressed with them.
Hermeneutics, of course, was a flash in the pan, but it is an example of what happens quite often in economics. Economists will latch onto an idea out of some other field in hopes of making a splash in your own. They'll dip into engineering, psychology, or mathematics and try to make a reputation. This way they can look catholic and widely read.
AEN: And what of your view toward Shackle and Lachmann, the radical subjectivists?
YEAGER: They advanced of a kind of subjectivism I reject. In short, they advanced nihilism. I know they don't call it that, but that is the way it comes across to me. If the extreme subjectivists like Lachmann and Shackle take themselves seriously--that we cannot know anything about the future, that expectations are subjective, that the future is being freely invented--why would they pose as professors of economics? Why do they set out to do anything? Lachmann was a dear man, but his entire doctrine was negative and trying to pull down economic rationality. But today's students do not waste time on the ideas of the radical subjectivists.
AEN: How do you see your own role in the Austrian school?
YEAGER: I don't know whether I am considered a critic of Austrian economics or not. I have criticized their business cycle theory and the methodological work of Austrians. But I am basically sympathetic to it and have had a long-term respectful interest in the Austrians.
I first came across some books by Mises when I was at Overland College shortly after the war. I believe they were Omnipotent Government and Bureaucracy. I was favorably impressed and learned a lot. In fact, I had the bad judgment of including some of his insights to an answer in a final exam in an anti-trust class. I received a "C" for including Misesian insights where they weren't appropriate.
While I was visiting Princeton library, I read Nationalökonomie before Human Action, the English version, even appeared. I had already read some Hayek material out of Individualism and Economic Order.
But mostly I was very excited about Mises's doctrine of calculation under socialism. I gave a faculty seminar on that topic when I was teaching for one year at Texas A&M in 1949. I even thought about exploring some related topic for my PhD dissertation.
AEN: What themes in Austrian economics do you like?
YEAGER: I like the concern with the big picture. The Austrians have shown how the activities of millions of separate people can be coordinated into a system that has a semblance of logic and structure even without a central planner. And I also like the Austrian tradition's concern with institutions. Unlike the mainstream, which gets bogged down in questions like decision-making in the firm, Austrians are concerned with the relation between interdependent units in the economy.
AEN: And what don't you like?
YEAGER: I am not a card-carrying Austrian. I don't like the way the business cycle theory gets repeated without any new evidence or logic. And on capital theory, I find myself disagreeing with Austrians.
Briefly, my view is that if you put together Boehm-Bawerk, Cassel, and Fisher, and make the proper selection and combination of their doctrines, you have the essence of good capital theory.
That is, the interest rate is determined by an interaction between the productivity of roundaboutness and time preference.
But I don't know why this should be considered anti-Austrian. Boehm-Bawerk and Hayek explicitly recognized both time and productivity as factors in the forming of interest. I cannot quite understand how the pure subjectivist, or pure time preference, theory of interest came to be regarded as a key part of Austrian doctrine. I only have a hunch. Maybe people thought that since subjectivism is good, the more you have the better.
AEN: You don't regard Austrian economics as separate school within economics?
YEAGER: It certainly shouldn't separate itself and take on the mission of doing battle with the mainstream. All of us economists have some idea we hope to contribute to our fellow economists.
The Austrian tradition is distinctive in having a favored set of topics and perhaps a method. But Austrians should be trying to influence the general understanding of how the economy works.
AEN: What can formal Austrian theory add to the body of mainstream thought?
YEAGER: The emphasis on the dispersion of knowledge in society, and the need to organize it through market means, is an important message that needs to be incorporated into the mainstream. And the emphasis on legal institutions and their role in the coordination of economic activity is also a fruitful framework for study.
Hayek often gets credit for this, but one can find a knowledge problem implicit in Mises. The planners don't know how to combine the factors of production, even supposing they know what they want to produce. Mises's emphasis on meaningful markets displays his interest in gathering this knowledge in the price system, a point upon which Hayek elaborated.
AEN: What about the role of entrepreneurship as a unique Austrian contribution?
YEAGER: It does need to be hammered home, but I think by now the mainstream has got the message. If we can find an economist who hasn't got it, then Austrians should continue. The problem is that entrepreneurship is an idea that is difficult to model. So working in this area doesn't provide much opportunity to demonstrate technical ability. That may be why it doesn't show up as much as it should.
I do think that there has been too much discussion about whether entrepreneurship is equilibrating or disequilibrating. It is clearly both.
AEN: Any thoughts on the anti-socialist revolution in Eastern Europe?
YEAGER: Sure. It overwhelmingly demonstrates that economies that try to be centrally directed do not work. It was a very decisive experiment. The advocates of socialism will no longer come from the ranks of the economists. It is no longer intellectually respectable.
AEN: But it doesn't necessarily follow that just because totalitarian socialism fell, free markets will take their place. We could end up with lots of little social democracies.
YEAGER: But the only option to socialism is markets. Those are the only two models around. There are no other methods of economic coordination out there. Social democracy just means a heavy welfare state, but Swedish-type economies are essentially capitalist economies. It is not a third type.
There is, of course, a question of how far one can go with taxation before one ruins the economy, and I don't know the answer. But social democracy still qualifies as a market. I don't think we are faced with an all or nothing choice about laissez-faire economics.
AEN: When can we criticize the interventionism of a social democracy?
YEAGER: When it impairs incentives to produce. How much intervention we can have without hurting incentives is a subject for more research.
Volume 3, Number 3 (Summer 1982)John B. Egger and Leland B. Yeager review William H. Hutt's book, The Keynesian Episode.