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The Foundations of Modern Austrian Economics; Edited by: Dolan, Edwin G.
37 paragraphs found.
Part 2, Essay 1

Praxeology, or economic theory in particular, is thus a unique discipline within the social sciences; for, in contrast to the others, it deals not with the content of men's values, goals, and actions—not with what they have done or how they have acted or how they should act—but purely with the fact that they do have goals and act to attain them. The laws of utility, demand, supply, and price apply regardless of the type of goods and services desired or produced. As Joseph Dorfman wrote of Herbert J. Davenport's Outlines of Economic Theory (1896):

The ethical character of the desires was not a fundamental part of his inquiry. Men labored and underwent privation for "whiskey, cigars, and burglars' jimmies," he said, "as well as for food, or statuary or harvest machinery." As long as men were willing to buy and sell "foolishness and evil," the former commodities would be economic factors with market standing, for utility, as an economic term, meant merely adaptability to human desires. So long as men desired them, they satisfied a need and were motives to production. Therefore economics did not need to investigate the origin of choices. *28

Far from being opposed to history, the praxeologist, and not the supposed admirers of history, has profound respect for the irreducible and unique facts of human history. Furthermore, it is the praxeologist who acknowledges that individual human beings cannot legitimately be treated by the social scientist as if they were not men who have minds and act upon their values and expectations, but stones or molecules whose course can be scientifically tracked in alleged constants or quantitative laws. Moreover, as the crowning irony, it is the praxeologist who is truly empirical because he recognizes the unique and heterogeneous nature of historical facts; it is the self-proclaimed "empiricist" who grossly violates the facts of history by attempting to reduce them to quantitative laws. Mises wrote thus about econometricians and other forms of "quantitative economists":

There are, in the field of economics, no constant relations, and consequently no measurement is possible. If a statistician determines that a rise of 10 per cent in the supply of potatoes in Atlantis at a definite time was followed by a fall of 8 per cent in the price, he does not establish anything about what happened or may happen with a change in the supply of potatoes in another country or in another time. He has not "measured" the "elasticity of demand" of potatoes. He has established a unique and individual historical fact. No intelligent man can doubt that the behavior of men with regard to potatoes and every other commodity is variable. Different individuals value the same things in a different way, and valuations change with the same individuals with changing conditions....
The impracticability of measurement is not due to the lack of technical methods for the establishment of measure. It is due to the absence of constant relations.... Economics is not, as...positivists repeat again and again, backward because it is not "quantitative." It is not quantitative and does not measure because there are no constants. Statistical figures referring to economic events are historical data. They tell us what happened in a nonrepeatable historical case. Physical events can be interpreted on the ground of our knowledge concerning constant relations established by experiments. Historical events are not open to such an interpretation....
Experience of economic history is always experience of complex phenomena. It can never convey knowledge of the kind the experimenter abstracts from a laboratory experiment. Statistics is a method for the presentation of historical facts.... The statistics of prices is economic history. The insight that, ceteris paribus, an increase in demand must result in an increase in prices is not derived from experience. Nobody ever was or ever will be in a position to observe a change in one of the market data ceteris paribus. There is no such thing as quantitative economics. All economic quantities we know about are data of economic history.... Nobody is so bold as to maintain that a rise of a percent in the supply of any commodity must always—in every country and at any time—result in a fall of b per cent in price. But as no quantitative economist ever ventured to define precisely on the ground of statistical experience the special conditions producing a definite deviation from the ratio a:b, the futility of his endeavors is manifest. *33

Elaborating on his critique of constants Mises added:

The quantities we observe in the field of human action...are manifestly variable. Changes occurring in them plainly affect the result of our actions. Every quantity that we can observe is a historical event, a fact which cannot be fully described without specifying the time and geographical point.
The econometrician is unable to disprove this fact, which cuts the ground from under his reasoning. He cannot help admitting that there are no "behavior constants." Nonetheless, he wants to introduce some numbers, arbitrarily chosen on the basis of a historical fact, as "unknown behavior constants." The sole excuse he advances is that his hypotheses are "saying only that these unknown numbers remain reasonably constant through a period of years." *34 Now whether such a period of supposed constancy of a definite number is still lasting or whether a change in the number has already occurred can only be established later on. In retrospect it may be possible, although in rare cases only, to declare that over a (probably rather short) period an approximately stable ratio—which the econometrician chooses to call a "reasonably" constant ratio—prevailed between the numerical values of two factors. But this is something fundamentally different from the constants of physics. It is the assertion of a historical fact, not of a constant that can be resorted to in attempts to predict future events.*35 The highly praised equations are, insofar as they apply to the future, merely equations in which all quantities are unknown. *36
In the mathematical treatment of physics the distinction between constants and variables makes sense; it is essential in every instance of technological computation. In economics there are no constant relations between various magnitudes. Consequently all ascertainable data are variables, or what amounts to the same thing, historical data. The mathematical economists reiterate that the plight of mathematical economics consists in the fact that there are a great number of variables. The truth is that there are only variables and no constants. It is pointless to talk of variables where there are no invariables. *37
Part 2, Essay 3

Even Henry of Langenstein (1325-83), who of all the Scholastics was the most hostile to the free market and advocated government fixing of the just price on the basis of status and cost, developed the subjective factor of utility as well as scarcity in his analysis of price. But it was the sixteenth-century Spanish Scholastics who developed the purely subjective and profree-market theory of value. Thus, Luis Saravia de la Calle (c. 1544) denied any role to cost in the determination of price; instead the market price, which is the just price, is determined by the forces of supply and demand, which in turn are the result of the common estimation of consumers on the market. Saravia wrote that, "excluding all deceit and malice, the just price of a thing is the price which it commonly fetches at the time and place of the deal." He went on to point out that the price of a thing will change in accordance with its abundance or scarcity. He proceeded to attack the cost-of-production theory of just price:

Those who measure the just price by the labour, costs, and risk incurred by the person who deals in the merchandise or produces it, or by the cost of transport or the expense of travelling...or by what he has to pay the factors for their industry, risk, and labour, are greatly in error, and still more so are those who allow a certain profit of a fifth or a tenth. For the just price arises from the abundance or scarcity of goods, merchants, and money...and not from costs, labour, and risk. If we had to consider labour and risk in order to assess the just price, no merchant would ever suffer loss, nor would abundance or scarcity of goods and money enter into the question. Prices are not commonly fixed on the basis of costs. Why should a bale of linen brought overland from Brittany at great expense be worth more than one which is transported cheaply by sea?...Why should a book written out by hand be worth more than one which is printed, when the latter is better though it costs less to produce?...The just price is found not by counting the cost but by the common estimation. *60

Similarly the Spanish Scholastic Diego de Covarrubias y Leiva (1512-77) a distinguished expert on Roman law and a theologian at the University of Salamanca, wrote that the "value of an article" depends "on the estimation of men, even if that estimation be foolish." Wheat is more expensive in the Indies than in Spain "because men esteem it more highly, though the nature of the wheat is the same in both places." The just price should be considered not at all with reference to its original or labor cost but only with reference to the common market value where the good is sold, a value, Covarrubias pointed out, that will fall when buyers are few and goods are abundant and that will rise under opposite conditions. *61


The Spanish Scholastics also anticipated the Austrian school in applying value theory to money, thus beginning the integration of money into general value theory. It is generally believed, for example, that in 1568 Jean Bodin inaugurated what is unfortunately called "the quantity theory of money" but which would more accurately be called the application of supply-and-demand analysis to money. Yet he was anticipated twelve years earlier by the Salamanca theologian the Dominican Martin de Azpilcueta Navarro (1493-1587), who was inspired to explain the inflation brought about by the importation of gold and silver by the Spaniards from the New World. Citing previous Scholastics, Azpilcueta declared that "money is worth more where it is scarce than where it is abundant." Why? Because "all merchandise becomes dearer when it is in great demand and short supply, and that money, in so far as it may be sold, bartered, or exchanged by some other form of contract, is merchandise and therefore also becomes dearer when it is in great demand and short supply." Azpilcueta noted that "we see by experience that in France, where money is scarcer than in Spain, bread, wine, cloth, and labour are worth much less. And even in Spain, in times when money was scarcer, saleable goods and labour were given for very much less than after the discovery of the Indies, which flooded the country with gold and silver. The reason for this is that money is worth more where and when it is scarce than where and when it is abundant." *63


Furthermore, the Spanish Scholastics went on to anticipate the classical-Mises-Cassel purchasing-power parity theory of exchange rates by proceeding logically to apply the supply-and-demand theory to foreign exchanges, an institution that was highly developed by the early modern period. The influx of specie into Spain depreciated the Spanish escudo in foreign exchange, as well as raised prices within Spain, and the Scholastics had to deal with this startling phenomenon. It was the eminent Salamanca theologian the Dominican Domingo de Soto (1495-1560) who in 1553 first fully applied the supply-and-demand analysis to foreign exchange rates. De Soto noted that "the more plentiful money is in Medina the more unfavourable are the terms of exchange, and the higher the price that must be paid by whoever wishes to send money from Spain to Flanders, since the demand for money is smaller in Spain than in Flanders. And the scarcer money is in Medina the less he need pay there, because more people want money in Medina than are sending it to Flanders." *64 What de Soto was saying is that as the stock of money increases, the utility of each unit of money to the population declines and vice versa; in short, only the great stumbling block of failing to specify the concept of the marginal unit prevented him from arriving at the doctrine of the diminishing marginal utility of money. Azpilcueta, in the passage quoted above, applied the de Soto analysis of the influence of the supply of money on exchange rates, at the same time that he set forth a theory of supply and demand in determining the purchasing power of money within a country.


De Roover then discussed the sixteenth-century Spanish Scholastics, centered at the University of Salamanca, the queen of the Spanish universities of the period. From Salamanca the influence of this school of Scholastics spread to Portugal, Italy, and the Low Countries. In addition to summarizing Grice-Hutchinson's contribution and adding to her bibliography, de Roover noted that both de Soto and Molina denounced as "fallacious" the notion of the late thirteenth-century Scholastic John Duns Scotus (1266-1308) that the just price is the cost of production plus a reasonable profit; instead that price is the common estimation, the interaction of supply and demand, on the market. Molina further introduced the concept of competition by stating that competition among buyers will drive prices up, while a scarcity of purchasers will pull them down. *69


The cost-of-production theory of just price held by the Scotists was trenchantly attacked by the later Scholastics. San Bernardino of Siena, de Roover pointed out, declared that the market price is fair regardless of whether the producer gains or loses, or whether it is above or below cost. The great early sixteenth-century jurist Francisco de Victoria (c. 1480-1546), founder of the school of Salamanca, as well as his followers insisted that the just price is set by supply and demand regardless of labor costs or expenses; inefficient producers or inept speculators must bear the consequences of their incompetence and poor forecasting. Furthermore, de Roover made clear that the general Scholastic emphasis on the justice of "common estimation" ( communis aestimatio) is identical to "market valuation" ( aestimatio fori), since the Scholastics used these two Latin expressions interchangeably. *71


Wages were treated by the two Italian friars as equivalent to the prices of goods. For San Bernardino, "The same rules which apply to the prices of goods also apply to the price of services with the consequence that the just wage will also be determined by the forces operating in the market or, in other words, by the demand for labor and the available supply." An architect is paid more than a ditchdigger, asserted Bernardino, because "the former's job requires more intelligence, greater ability, and longer training and that, consequently, fewer qualify.... Wage differentials are thus to be explained by scarcity because skilled workers are less numerous than unskilled and high positions require even a very unusual combination of skills and abilities." *81 And Sant' Antonino concluded that the wage of a laborer is a price which, like any other, is properly determined by the common estimation of the market in the absence of fraud.


Finally, the Jevons-Walras mathematical method necessarily deals with "functions of interdependent phenomena," whereas, for Menger and the Austrians, economic laws are genetic and causal, proceeding from the utility and the action of the consumer to the market result. As Kauder put it:

For Marshall, value and cost, supply and demand are interdependent factors whose functional connection can be explained in an equation or a geometrical figure. For Wieser, Menger, and especially for Böhm-Bawerk the wants of the consumer are the beginning and the end of the causal nexus. The purpose and the cause of economic action are identical. There is no difference between causality and teleology, claims Böhm-Bawerk. He knew the Aristotelian origin of his argument. *93
Part 3, Essay 1

In our classrooms we draw the Marshallian cross to depict competitive supply and demand, and then go on to explain how the market is cleared only at the price corresponding to the intersection of the curves. Often the explanation of market price determination proceeds no further—almost implying that the only possible price is the market-clearing price. Sometimes we address the question of how we can be confident that there is any tendency at all for the intersection price to be attained. The discussion is then usually carried on in terms of the Walrasian version of the equilibration process. Suppose, we say, the price happens to be above the intersection level. If so, the amount of the good people are prepared to supply is in the aggregate larger than the total amount people are prepared to buy. There will be unsold inventories, thereby depressing price. On the other hand, if price is below the intersection level, there will be excess demand, "forcing" price up. Thus, we explain, there will be a tendency for price to gravitate toward the equilibrium level at which quantity demanded equals quantity supplied.


The Marshallian explanation of the equilibrating process—not usually introduced into classroom discussion—is similar to the Walrasian but uses quantity rather than price as the principal decision variable. *5 Instead of drawing horizontal price lines on the demand-supply diagram to show excess supply or unmet demand, the Marshallian procedure uses vertical lines to mark off the demand prices and the supply prices for given quantities. With this procedure the ordinate of a point on the demand curve indicates the maximum price at which a quantity (represented by the abscissa of the point) will be sold. If this price is greater than the corresponding supply price (the minimum price at which the same quantity will be offered for sale), larger quantities will be offered for sale. The reverse takes place when supply price exceeds demand price. In this way a tendency toward equilibrium is allegedly demonstrated to exist.


This procedure also assumes too much. It takes for granted that the market already knows when the demand price of the quantity now available exceeds the supply price. But disequilibrium occurs precisely because market participants do not know what the market-clearing price is. In disequilibrium "the" quantity is not generally known nor is the highest (lowest) price at which this quantity can be sold (coaxed from suppliers). Thus it is not clear how the fact that the quantity on the market is less than the equilibrium quantity assures the decisions of market participants to be so modified as to increase it.


Advertising, a pervasive feature of the market economy, is widely misunderstood and often condemned as wasteful, inefficient, inimical to competition, and generally destructive of consumer sovereignty. In recent years there has been somewhat of a rehabilitation of advertising in economic literature, along the lines of the economics of information. According to this view advertising messages beamed at prospective consumers are quantities of needed knowledge, for which they are prepared to pay a price. The right quantity of information is produced and delivered by the advertising industry in response to consumer desires. For reasons having to do with cost economy, it is most efficient for this information to be produced by those for whom such production is easiest, namely, by the producers of the products about which information is needed. There is much of value in this approach to an understanding of the economics of advertising, but it does not explain everything. The economics-of-information approach tries to account for the phenomena of advertising entirely in terms of the demand for and supply of nonentrepreneurial knowledge, information that can be bought and sold and even packaged. But such an approach does not go beyond a world of Robbinsian maximizers and fails to comprehend the true role of advertising in the market process.


By viewing advertising as an entrepreneurial device, we are able to understand why Chamberlin's distinction between fabrication costs and selling costs is invalid. *10 Fabrication (or production) costs are supposedly incurred for producing a product, as distinguished from selling costs incurred to get buyers to buy the product. Selling costs allegedly shift the demand curve for the product, while the costs of fabrication (production) affect the supply curve only. The distinction has been criticized on the grounds that most selling costs turn out to be disguised fabrication costs of one type or another. *11 Our perspective permits us to view the issue from a more general framework, which embodies the insight that all fabrication costs are at once selling costs as well. If the producer had a guaranteed market in which he could sell all he wanted of his product at a certain price, then his fabrication costs might be only fabrication costs and include no sum for coaxing consumers to buy it. But there never is a guaranteed market. The producer's decisions about what product to produce and of what quality are invariably a reflection of what he believes he will be able to sell at a worthwhile price. It is invariably an entrepreneurial choice. The costs he incurs are those that in his estimation he must in order to sell what he produces at the anticipated price. Every improvement in the product is introduced to make it more attractive to consumers, and certainly the product itself is produced for precisely the same reasons. All costs are in the last analysis selling costs.

Part 3, Essay 2

What keeps the market process in perpetual motion? Why does it never end, denoting the final state of equilibrium of our system? If Austrian economists answered by saying, "Something unexpected always happens," they would be accused of vagueness and reminded that only perpetual "changes in data" could have this effect. An attempt to show that continuous autonomous changes in demand or supply do account for the permanent character of the market process would involve a drawn-out discussion of the effects of ever-changing patterns of knowledge on the conduct of consumers and producers, a discussion in which Austrian economists would be at a serious disadvantage without prior elucidation of the term knowledge.


Knowledge then is an elusive concept wholly refractory to neoclassical methods. It cannot be quantified, has no location in space, and defies insertion into any complex of functional relationships. Though it varies in time, it is no variable, either dependent or independent. As soon as we permit time to elapse, we mustpermit knowledge to change, and knowledge cannot be regarded as a function of anything else. The state of knowledge of a society cannot be the same at two successive points of time, and time cannot elapse without demand and supply shifting. The stream of knowledge produces ever new disequilibrium situations, and entrepreneurs continually manage to find new price-cost differences to exploit. When one is eliminated by strenuous competition, the stream of knowledge throws up another. Profit is a permanent income from ever-changing sources.


What we have here is a difference of opinion on the nature of the market process. For one view the market process is propelled by a mechanism of given and known forces of demand and supply. The outcome of the interaction of these forces, namely, equilibrium, is in principle predictable. But outside forces in the form of autonomous changes in demand and supply continually impinge on the system and prevent equilibrium from being reached. The system is ever moving in the direction of an equilibrium, but it never gets there. The competitive action of entrepreneurs tending to wipe out price-cost differences is regarded as "equilibrating"; for in equilibrium no such differences could exist.

Part 3, Essay 5

Even if such a coherent long-run equilibrium price system did exist and could be known, it would not last. Its data would not remain the same for long. The steady flow of knowledge will tomorrow produce a pattern of knowledge different from today's, and apparent changes in demand and supply will entail a new set of equilibrium prices. Not without reason are we compelled to look for a paradigm to replace the general-equilibrium model.


The difference between the commodity market and the securities market is instructive. Today's potato price may not be consistent with today's prices for other vegetables. If so, equilibrating forces that require time will come into operation. But today's market equilibrium price may also be inconsistent with the long-run supply and demand for potatoes. The equilibrating forces released by the second disparity may impede or reinforce those released by the first. Certainly they require a different time dimension to be fully deployed. And the longer the time required by any force, the greater the probability that it will be affected by unexpected change. To opt for the market process against general equilibrium means to accept the implication that a fully coherent price system providing a basis for consistent aggregation can never exist.

Part 3, Essay 6

Part 3, Essay 6
The Austrian Theory of Money
by Murray N. Rothbard

The Austrian theory of money virtually begins and ends with Ludwig von Mises's monumental Theory of Money and Credit, published in 1912. *45 Mises's fundamental accomplishment was to take the theory of marginal utility, built up by Austrian economists and other marginalists as the explanation for consumer demand and market price, and apply it to the demand for and the value, or the price, of money. No longer did the theory of money need to be separated from the general economic theory of individual action and utility, of supply, demand, and price; no longer did monetary theory have to suffer isolation in a context of "velocities of circulation," "price levels," and "equations of exchange."


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


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


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


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


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


If relative demands and prices change in the Angel Gabriel model, they will change much more in the course of real-world increases in the supply of money. For, as Mises showed, in the real world an inflation of money is alluring to the inflators precisely because the injection of new money does not follow the Angel Gabriel model. Instead, the government or the banks create new money to be spent on specific goods and services. The demand for these goods thereby rises, raising these specific prices. Gradually, the new money ripples through the economy, raising demand and prices as it goes. Income and wealth are redistributed to those who receive the new money early in the process, at the expense of those who receive the new money late in the day and of those on fixed incomes who receive no new money at all. Two types of shifts in relative prices occur as the result of this increase in money: (1) the redistribution from late receivers to early receivers that occurs during the inflation process and (2) the permanent shifts in wealth and income that continue even after the effects of the increase in the money supply have worked themselves out. For the new equilibrium will reflect a changed pattern of wealth, income, and demand resulting from the changes during the intervening inflationary process. For example, the fixed income groups permanently lose in relative wealth and income. *46


Mises, however, succeeded in solving this problem in 1912 in developing his so-called regression theorem. Briefly, Mises held that the demand for money, or cash balances, at the present time—say day X—rests on the fact that money on the previous day, day X-1, had a purchasing power. The purchasing power of money on day X is determined by the interaction on day X of the supply of money on that day and that day's demand for cash balances, which in turn is determined by the marginal utility of money for individuals on day X. But this marginal utility, and hence this demand, has an inevitable historical component: the fact that money had prior purchasing power on day X-1, and that therefore individuals know that this commodity has a monetary function and will be exchangeable on future days for other goods and services. But what then determined the purchasing power of money on day X-1? Again, that purchasing power was determined by the supply of, and demand for, money on day X-1, and that in turn depended on the fact that the money had had purchasing power on day X-2. But are we not caught in an infinite regression, with no escape from the circular trap and no ultimate explanation? No. What we must do is to push the temporal regression to that point when the money commodity was not used as a medium of indirect exchange but was demanded purely for its own direct consumption use. Let us go back logically to the second day that a commodity, say gold, was used as a medium of exchange. On that day, gold was demanded partly because it had a preexisting purchasing power as a money, or rather as a medium of exchange, on the first day. But what of that first day? On that day, the demand for gold again depended on the fact that gold had had a previous purchasing power, and so we push the analysis back to the last day of barter. The demand for gold on the last day of barter was purely a consumption use and had no historical component referring to any previous day; for under barter, every commodity was demanded purely for its current consumption use, and gold was no different. On the first day of its use as a medium of exchange, gold began to have two components in its demand, or utility: first, a consumption use as had existed in barter and, second, a monetary use, or use as a medium of exchange, which had a historical component in its utility. In short, the demand for money can be pushed back to the last day of barter, at which point the temporal element in the demand for the money commodity disappears, and the causal forces in the current demand and purchasing power of money are fully and completely explained.


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

The services money renders are conditioned by the height of its purchasing power. Nobody wants to have in his cash holding a definite number of pieces of money or a definite weight of money; he wants to keep a cash holding of a definite amount of purchasing power. As the operation of the market tends to determine the final state of money's purchasing power at a height at which the supply of and the demand for money coincide, there can never be an excess or a deficiency of money. Each individual and all individuals together always enjoy fully the advantages which they can derive from indirect exchange and the use of money, no matter whether the total quantity of money is great or small. Changes in money's purchasing power generate changes in the disposition of wealth among the various members of society. From the point of view of people eager to be enriched by such changes, the supply of money may be called insufficient or excessive, and the appetite for such gains may result in policies designed to bring about cash-induced alterations in purchasing power. However, the services which money renders can be neither improved nor impaired by changing the supply of money.... The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do. *62

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


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

The rise of prices caused an intense demand for the circulating medium to arise, because the existing quantity was not sufficient for the volume of transactions. At the same time the State's need of money increased rapidly...the eyes of all were turned to the Reichsbank. The pressure exercised on it became more and more insistent and the increase of issues, from the central bank, appeared as a remedy....
The authorities therefore had not the courage to resist the pressure of those who demanded ever greater quantities of paper money, and to face boldly the crisis which...would be, undeniably, the result of a stoppage of the issue of notes. They preferred to continue the convenient method of continually increasing the issues of notes, thus making the continuation of business possible, but at the same time prolonging the pathological state of the German economy. The Government increased salaries in proportion to the depreciation of the mark, and employers in their turn granted continual increases in wages, to avoid disputes, on the condition that they could raise the prices of their products....
Thus was the vicious circle established; the exchange depreciated; internal prices rose; note-issues were increased; the increase of the quantity of paper money lowered once more the value of the mark in terms of gold; prices rose once more; and so on....
For a long time the Reichsbank—having adopted the fatalistic idea that the increase in the note-issues was the inevitable consequence of the depreciation of the mark—considered as its principal task, not the regulation of the circulation, but the preparation for the German economy of the continually increasing quantities of paper money, which the rise in prices required. It devoted itself especially to the organization, on a large scale, of the production of paper marks. *64

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


Furthermore, in the same way that M1 (currency plus demand deposits) is broader than the narrowest definition, we can establish even broader definitions by including savings deposits of commercial banks, savings bank deposits, shares of savings and loan banks, and cash surrender values of life insurance companies, which are all redeemable on demand at par in standard money, and therefore all serve as money substitutes and as part of the money supply until the public begins to doubt that they are redeemable. Partisans of M 1 argue that commercial banks are uniquely powerful in creating deposits and, further, that their deposits circulate more actively than the deposits of other banks. Let us suppose, however, that in a gold-standard country, a man has some gold coins in his bureau and others locked in a bank vault. His stock of gold coins at home will circulate actively and the ones in his vault sluggishly, but surely both are part of his stock of cash. And, if it also be objected that the deposits of savings banks and similar institutions pyramid on top of commercial bank deposits, it should also be noted that the latter in turn pyramid on top of reserves and standard money.


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

Part 3, Essay 7

However, two ominous symptoms of underlying structural distortions then appeared: annual rates of price increases sharply accelerated, running in most developed countries well into two-digit figures, and rates of increase in output began to slacken. Unemployment percentages, at historic lows since the late forties, started an upward climb, and every attempt to reduce the rate of price increase brought fresh upward jumps in unemployment and excess industrial capacity. Forecasts of the Organization for Economic Cooperation and Development described the price situation as "worrying" and reported that, although price inflation continued at historically high rates (in excess of 12 percent per annum in early 1974), growth continued to decelerate (that is, aggregate demand fell in relation to aggregate supply). "Over the last few years unemployment seems to have risen in relation to demand pressures," and the "unemployment rate at the peak of the boom is higher than at earlier peaks." *73


Consumption demand begins to increase as a result of the increased money incomes that factor owners have been receiving as a consequence of the increase in bank money. By hypothesis there has been no change in the rate of saving out of income. As these incomes are spent, the increased consumption expenditure meets an attenuated supply of consumer goods. Prices of consumer goods now, at this later stage, begin to rise relative to the prices of unfinished products, especially those farthest away from the final consumption stage. The process described earlier is now reversed: returns rise in stages nearer consumption, while returns decline in stages farthest from consumption. Nonspecific resources are once more drawn back into the production of consumer goods. All those capital goods intended for a different production structure have now to be readapted, to fit another, less capitalistic structure, with concomitant losses and unemployment. These losses are particularly heavy on those capital goods most suited only to a more capitalistic structure. Capital goods that are profitable to produce only at the lower rates of interest have been overproduced. They have been overproduced because the price signals generated by the hypothesized monetary policy have resulted in the production of inappropriate combinations of capital goods. Capital goods appropriate to the real factors (including transactors' time preferences or propensity to consume out of income) have been under-produced. In summary, the attempted extension of the production structure cannot be completed for lack of resources.


If many contemporary economists refer to recessions or depressions today, it is almost invariably to their purely monetary aspects. Thus Friedman argued that "the American economy is depression-proof": a drastic monetary decline on the lines of 1930-33 is now impossible because of deposit insurance and banking and fiscal changes. *110 Paul W. McCracken concurred that economic management "can probably avert a major and a generalized depression"—financial collapse on the 1930s scale has been so rare that it would be premature to anticipate something similar. (However, he sternly warned companies and financial institutions against the risks of unwise financing policies.) *111 Harry G. Johnson stated that it is a "virtual certainty that nations will never again allow a massive world recession to develop" since "their economists would know better than to accept disaster as inevitable or inexplicable." *112 Haberler entitled the foreword to the 1964 edition of his Prosperity and Depression "Why Depressions Are Extinct." He cited the strength of the United States financial structure, deposit insurance, refusal to tolerate a wholesale deflation, and the powerful built-in stabilizer of the government budget. By preventing a decline in expenditure, this policy has "proved to be a very powerful brake on deflationary spirals and has been a major factor in keeping depressions mild." Outlining the main features of business cycles, he stated:

A very significant fact is that the wholesale price level almost always rises during the upswing and falls during the downswing, and the money values—payrolls, aggregate profits etc.—always go with the cycle. This proves that changes in effective demand, rather than changes in supply, are the proximate cause of the cyclical movement in real output and employment. *113

In either case, it is the investment goods industries farthest from the production of consumer goods that feel the pinch first. If the monetary expansion continues steadily with the relative increase in consumer goods prices, firms nearer consumption bid away nonspecific resources from these industries, which now find that their costs rise faster than their selling prices. If the expansion slows down, there is an unambiguous decline in monetary demand for the investment projects begun at the lower interest rates. But even while unemployment and malinvested excess capacity appear in stages farthest from consumption, the incomes generated in the expansion are still working through the system. Consumer goods industries will maintain and even increase their demand for factor services: whereas at the beginning of the expansion these industries were outbid for factor services, they now face both an increase in demand and an increasing supply of nonspecific factors, as these are released by firms farther from consumption. Consumer prices may well continue to rise, but much depends on how rapidly output can be increased in these industries and nonspecific resources shifted back into consumer goods production. Mitigation of the level of employment also depends on both these elements.