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|The Economics of Ludwig von Mises: Toward a Critical Reappraisal; Edited by: Moss, Laurence S.|
14 paragraphs found.
1. In his assertion that the
only way the demand for money can be consistently incorporated into the general body of utility theory is by introducing historical prices, Mises is quite mistaken. Patinkin demonstrated how to derive a demand curve for money without resorting to past price behavior by performing what is essentially a "thought experiment" in which the individual is confronted with alternative levels of commodity prices and asked how many units of money he will demand in each case. The set of all combinations of price levels and resulting money demands constitutes the individual demand curve for cash balances. The aggregation of all individual demand curves "horizontally" at all price levels yields the market demand curve for nominal balances, and this in conjunction with the (assumed inelastic) supply of money serves to define the "market-clearing" price level. This procedure is the analogue of the familiar neoclassical supply-and-demand analysis, which serves to define the market-clearing price for particular commodities. In Patinkin's barter-money model there is no reference to past price behavior because the method of
"comparative statistics" abstracts completely from historical time.
Mises flatly denied that there was any way by which the
physical quantity of money could be increased and relative commodity prices remain unaltered. According to Mises, even if it were possible by some magically defined formula to distribute a given increase in the money supply among individuals in such a way as to
leave their relative wealth positions unaltered, demand curves still would not shift to the right by enough to raise prices proportionally. According to Mises, for this shift to occur, the marginal utility schedule of the money commodity must be a rectangular hyperbola so that, say, a doubling of the individual's cash balances lowers the marginal utility of the monetary unit by one-half. Mises dismissed this possibility by stating that it is an "absurdity" to assume that for each individual a doubling of money leads to a halving of the exchange value he ascribes to each unit.
Mises also erred when he assumed that Wicksell's "proportionality theorem"
necessarily requires that the marginal utility of the money commodity be inversely proportional to the size of the individual's nominal cash holdings. As Patinkin elegantly demonstrated for an economy where everyone's wealth position is permanently fixed, all that is required for a given increase in the money supply to lead to a proportional increase in prices is a positive excess demand for each commodity in each market
until its price has finally doubled. This condition includes the situation Mises described as a special case.
In a world where individual cash balances simply grow in size automatically (like Frank Knight's famous Crusonia Plant), the "proportionality theorem" Would have some validity, inasmuch as the new money would never change hands and hence would never give rise to a lagged process of adjustment. But in a world where the money-issuing authorities introduce the new money by buying different types of goods, services, and financial assets (and at different points in time as well), the "first round" of monetary expansion affects the cash balances of individuals differently. To dramatize this point, let us consider the existence of just one individual named Miser Joe whose demand for real balances in infinitely elastic. If new money is given to Miser Joe, the process stops dead in its tracks, despite the fact that the percentage increase in the money supply may be the same in this period as it was in the preceding period. It seems that analysis of fully anticipated inflation requires not only that the rate of growth of money remain fixed but also that the route by which the new money enters and passes through the system stay the same from one period to the next. How this assumption is at all relevant to the historical process by which new money is injected into the economy by existing governments is a point that has not received adequate attention by contemporary theorists.
THE ORIGIN OF THE AUSTRIAN THEORY OF THE BUSINESS CYCLE
In Wicksell's analysis of bank credit expansion, the commercial banks by holding the market rate of interest below the real rate of interest bring about a cumulative increase in the demand for bank loans and consequently a cumulative increase in commodity prices. The problem Wicksell raised in
Interest and Prices is whether there is an automatic "brake" on the process of bank credit expansion that would prevent the rise in prices from going on indefinitely if the bank authorities keep the market rate of interest below the natural rate and are willing to meet all demands for credit. Wicksell argued that the prices of credit expansion must come to a halt when the reserved-deposit ratio of the commercial banks falls below the legal limit or simply becomes too low for the bankers' own comfort. The banks, fearing either "fines" or a full-scale liquidity crises, raise the money rate of interest, and the inflation comes to a halt with absolute prices remaining permanently higher. In the case of a pure fiat system in which there are no required reserves or convertibility pledges to worry about, the cumulative expansion of the money supply and subsequent inflation can continue as long as the bankers keep the money rate of interest below the real rate of interest.
Mises found Wicksell's analysis of the problem unsatisfactory, and in the third part of his
Theory of Money and Credit he tried to explain why the cumulative expansion process must come to an end
even under a pure fiat system. According to Mises, when the commercial banks encourage additional borrowing by lowering the market rate below its natural level, entrepreneurs are encouraged to make more long-term investments, that is, to lengthen the "period of production."
With the newly issued bank money entrepreneurs bid resources out of the production of consumption goods into the production of capital goods despite the fact that no additional planned savings has taken place. Consumer prices must rise to generate the "forced savings" required to make the increased
capital goods construction possible. Finding wages and resource costs higher than expected, the entrepreneurs turn to the banks to demand a larger quantity of money than before. Mises believed that the size of the money supply would increase not only absolutely but proportionately as well, so that the Wicksellian cumulative expansion process could not go on indefinitely without a collapse of the monetary order under the strains of hyperinflation.
The only alternative to the destruction of the monetary order is for the banks to restore equality between the money rate of interest and the natural rate of interest, in which case the sudden cutoff of entrepreneurial loans will require the liquidation of partly completed projects and the transfer of resources to other parts of the economy.
By using 'yesterday's" prices to explain the current demand for money and thereby "today's" prices, Mises is open to the charge of explaining prices by means of prices and hence arguing in a circle. Mises, aware of this objection, developed what he termed the "regression theorem" to explain how past values could be consistently introduced into a theory of the value of money without arguing in a circle. Mises explained that when we regress and explain "today's" prices by "yesterday's" and "yesterday's" by the "day-before-yesterday's," and so on, we ultimately come to a point in the past when the earliest form of the money commodity emerged. At this time, money took the form of a marketable commodity valued entirely for its nonmonetary uses. Here its market (objective) value was the outcome of the interaction between its supply and the hierarchy of human wants. At this point the historical regression stopped because in principle past price behavior is not needed to determine the market value of this commodity since it has not emerged as "money." Thus Mises' regression theorem states that any object presently used as money is ultimately linked to some commodity that was originally directly serviceable to men's wants, and furthermore, if this link did not exist, society (the collection of valuing minds) would have no epistemological basis for estimating the exchange value of money. The obvious implication of this theorem is that government, no matter how powerful, cannot introduce an object as money unless it first defines that object in terms either of a money already existing or of a commodity whose market value is already established. Once defined in this way, the value of the money commodity eventually (over time) comes to be governed by the behavior of historical prices, and its nonmonetary uses take on a subordinate and sometimes insignificant role (Mises,
Theory of Money, pp. 120-23). On the circulatrity problem, see Patinkin,
Money, Interest, pp. 114-16, 573-75. Cf. Mises' discussion of pre-World War I literature in
Theory of Money, pp. 114-22.
It is usual to credit Irving Fisher and not Mises with the "price anticipation effect"; see, for example, John T. Boorman and Thomas M. Havrilesky,
Money Supply, Money Demand, and Macroeconomic Models (Boston: Allyn & Bacon, 1972), pp. 208-9. Certainly Fisher's
Purchasing Power of Money and his
Rate of Interest (New York: Macmillan Co., 1907) predated Mises'
Theory of Money. It seems to me that Mises' discussion of price expectations and how they affect the decision to hold cash balances is sufficiently different from Fisher's discussion to warrant some academic recognition. Edmund Phelps credited Mises, rather than Fisher, in "Money Wage Dynamics and Labour Market Equilibrium," in
Microeconomic Foundations, p. 129.
Ibid. Mises dated the "proportionality theorem" to Hume and Mill (
Theory of Money, pp. 139-40). The doctrine, however, can be located in the sixteenth-century writings of Jean Bodin and the Spanish Scholastics. What disturbed Mises was that while the general theory of price had advanced beyond the naive notion that price is
proportional to the ratio between demand and supply, monetary theory had not (cf. Mises,
Theory of Money, pp. 128-30).
Patinkin wrote that "a doubling of the quantity of money can in general be expected to affect both equilibrium relative prices and the rate of interest. Specifically, the relative prices of those commodities favored by debtors will rise, while those favored by creditors will fall. Similarly, the (real) interest rate will rise or fall, depending on which of two countervailing forces is stronger: the decrease in the demand for bonds, caused by the worsened real position of creditors; or the decrease in the supply of bonds, caused by the improved real position of debtors" (
Money, Interest, p. 74).
I take for my theme in discussing the Moss paper, Mises' emphasis on adjustment processes in the marketplace. Mises throughout his work was interested in how markets adjust to changing data, how information is transmitted, and how expectations are formed. This preoccupation is especially evident (and especially complementary to accepted doctrine) in two points discussed by Moss. The first is the treatment of Mises' theory of how optimal cash balances are arrived at and how they are related to price levels. According to Moss, the problem Mises was trying to solve was the following: the optimum level of individuals' cash balances depends upon the price level, but the price level depends in part on the level of cash balances people choose to hold. How,
then, can people arrive at their optimum cash balance without knowing the price level, which can only be determined after people decide how much cash to hold? Moss referred to this as the famous "circularity problem" that troubled early twentieth-century economic theory. Moss credited Patinkin with showing that the problem is eliminated once we realize that the optimum level of cash balances can be determined by the intersection of the supply curve for money and the demand curve derived by a hypothetical comparison of various price levels and the resulting level of cash balances desired, yet he congratulated Mises for developing a "bold empirical hypothesis" about how expectations are formed. Here is, I think, a perfect example of the importance of Mises' approach to economics as a supplement to neoclassical theory. Mises could not divorce the problem of the acquisition of knowledge and the formation of expectations from the problem of how equilibrium states are reached. While Patinkin was interested in defining an equilibrium condition, Mises was much more interested in explaining how human actions lead toward that equilibrium. In that light, Mises' hypothesis—that individuals determine their cash balances on the basis of yesterday's prices, which in turn affect today's prices, until expectations about prices and the actual price level converge to an equilibrium price is where the supply and demand curves intersect; justs from one equilibrium to another. Individual economic actors only know when the system is out of equilibrium, when reality does not meet their expectations (yet their expectations will have some influence on the reality that occurs), and it is this lack of realization of their plans that conveys the knowledge to them that they must revise their plans. It is this process that Mises was describing. We all tell our undergraduates that it is not enough to say that equilibrium price is where the supply and demand curves intersect; one must explain how that equilibrium is achieved and how the market adjusts to new equilibria. If we recognize that Patinkin told us what the equilibrium conditions are, it is Mises who was trying to explain how we get there.
The circularity problem was one that bothered many economists sixty years ago; that was before they fully comprehended the idea of mutual determination or interdependence. How could one explain general movements of prices by changes in the supply of, and demand for, money if one were blocked from grasping that the demand for money was in turn to be understood as a function of prices? We no longer see any difficulty with this type of interdependence, whether it be formulated in terms of a set of simultaneous equations or in terms of a sequence analysis of equilibrium positions. No doubt in 1911 the charge of circularity had to be taken seriously. That is the reason Mises resorted to a sequence analysis but interpreted it as a "historical link" between yesterday's prices and today's decisions. The term
historical was a bit misleading, but the main thing was that the association of experience with expectations was established in the student's mind.
Of even greater significance was what Mises said about "abnormal situations," in which expectation of future price increases may not be formed just by the experiences with yesterday's prices but also by announcements an expectations of governmental fiscal and monetary policies. If prices are expected to increase—not because they have risen in the past, but because of announcements, reports, authoritative interpretations, rumors, or what not—the resulting decline in the demand for money may well lead to an actual rate of price increase far in excess of what could be explained by the ongoing increase in the supply of money. Indeed the resulting decline in aggregate real balances may provide a good description of what goes on during a galloping price inflation.
In Rothbard's paper on economic calculation under socialism, I was especially intrigued by his statement that the central Planning Board in its decision making—without market prices to aid its calculation—is in the same position as a big business firm or any organization that is vertically integrated to such a large degree that markets disappear or market prices can be disregarded. This is an issue that I have tried to sell in several of my publications (the first time in a book that appeared in 1934 and most recently in a paper on international integration,
) but unfortunately not with sufficient success. Whenever a firm (or concern) supplies the output of one of its departments as an input to another of its departments instead of selling it in a competitive market at a price established by supply and demand, the problem of artificial transfer prices or off jumbled cost-and-revenue figures arises. There may still be calculations, but not according to the economic principle—or what Mises termed "economic calculations."