The Theory of Money and Credit

Ludwig von Mises.
Mises, Ludwig von
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H. E. Batson, trans.
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Indianapolis, IN: Liberty Fund, Inc.
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19 of 33


Monetary Policy

1 Monetary Policy Defined*104


The economic consequences of fluctuations in the objective exchange value of money have such important bearings on the life of the community and of the individual that as soon as the state had abandoned the attempt to exploit for fiscal ends its authority in monetary matters, and as soon as the large-scale development of the modern economic community had enabled the state to exert a decisive influence on the kind of money chosen by the market, it was an obvious step to think of attaining certain sociopolitical aims by influencing these consequences in a systematic manner Modern currency policy is something essentially new; it differs fundamentally from earlier state activity in the monetary sphere. Previously, good government in monetary matters—from the point of view of the citizen—consisted in conducting the business of minting so as to furnish commerce with coins which could be accepted by everybody at their face value; and bad government in monetary matters—again from the point of view of the citizen—amounted to the betrayal by the state of the general confidence in it. But when states did debase the coinage, it was always from purely fiscal motives. The government needed financial help, that was all; it was not concerned with questions of currency policy.


Questions of currency policy are questions of the objective exchange value of money. The nature of the monetary system affects a currency policy only insofar as it involves these particular problems of the value of money; it is only insofar as they bear upon these questions that the legal and technical characteristics of money are pertinent. Measures of currency policy are intelligible only in the light of their intended influence on the objective exchange value of money. They consequently comprise the antithesis of those acts of economic policy which aim at altering the money prices of single commodities or groups of commodities.


Not every value problem connected with the objective exchange value of money is a problem of currency policy. In conflicts of currency policy there are also interests involved which are not primarily concerned with the alteration of the value of money for its own sake. In the great struggle that was involved in the demonetization of silver and the consequent movement of the relative exchange ratio of the two precious metals gold and silver, the owners of the silver mines and the other protagonists of the double standard or of the silver standard were not actuated by the same motives. While the latter wanted a change in the value of money in order that there might be a general rise in the prices of commodities, the former merely wished to raise the price of silver as a commodity by securing, or more correctly regaining, an extensive market for it. Their interests were in no way different from those of producers of iron or oil in trying to extend the market for iron or oil so as to increase the profitability of their businesses. It is true that this is a value problem, but it is a commodity-value problem—that of increasing the exchange value of the metal silver—and not a problem of the value of money.*105


But although this motive has played a part in currency controversy, it has been a very subordinate part. Even in the United States, the most important silver-producing area, it has been of significance only inasmuch as the generous practical encouragement of the silver magnates has been one of the strongest supports of the bimetallistic agitation. But most of the recruits to the silver camp were attracted, not by the prospect of an increase in the value of the mines, which was a matter of indifference to them, but by the hope of a fall in the purchasing power of money, from which they promised themselves miraculous results. If the increase in the price of silver could have been brought about in any other way than through the extension of its use as money, say by the creation of a new industrial demand, then the owners of the mines would have been just as satisfied; but the farmers and industrialists who advocated a silver currency would not have benefited from it in any way. And then they would undoubtedly have transferred their allegiance to other currency policies. Thus, in many states, paper inflationism was advocated, partly as a forerunner of bimetallism and partly in combination with it.


But even though questions of currency policy are never more than questions of the value of money, they are sometimes disguised so that their true nature is hidden from the uninitiated. Public opinion is dominated by erroneous views on the nature of money and its value, and misunderstood slogans have to take the place of clear and precise ideas. The fine and complicated mechanism of the money and credit system is wrapped in obscurity, the proceedings on the stock exchange are a mystery, the function and significance of the banks elude interpretation. So it is not surprising that the arguments brought forward in the conflict of the different interests often missed the point altogether. Counsel was darkened with cryptic phrases whose meaning was probably hidden even from those who uttered them. Americans spoke of "the dollar of our fathers" and Austrians of "our dear old gulden note"; silver, the money of the common man, was set up against gold, the money of the aristocracy. Many a tribune of the people, in many a passionate dis course, sounded the loud praises of silver, which, hidden in deep mines, lay awaiting the time when it should come forth into the light of day to ransom miserable humanity languishing in its wretchedness. And while some thus regarded gold as nothing less than the embodiment of the very principle of evil, all the more enthusiastically did others exalt the glistening yellow metal which alone was worthy to be the money of rich and mighty nations. It did not seem as if men were disputing about the distribution of economic goods; rather it was as if the precious metals were contending among themselves and against paper for the lordship of the market. All the same, it would be difficult to claim that these Olympic struggles were engendered by anything but the question of altering the purchasing power of money.

2 The Instruments of Monetary Policy


The principal instrument of monetary policy at the disposal of the state is the exploitation of its influence on the choice of the kind of money. It has been shown above that the position of the state as controller of the mint and as issuer of money substitutes has allowed it in modern times to exert a decisive influence over individuals in their choice of the common medium of exchange. If the state uses this power systematically in order to force the community to accept a particular sort of money whose employment it desires for reasons of monetary policy then it is actually carrying through a measure of monetary policy. The states which completed the transition to a gold standard a generation ago, did so from motives of monetary policy. They gave up the silver standard or the credit-money standard because they recognized that the behavior of the value of silver or of credit money was unsuited to the economic policy they were following. They adopted the gold standard because they regarded the behavior of the value of gold as relatively the most suitable for carrying out their monetary policies.


If a country has a metallic standard, then the only measure of currency policy that it can carry out by itself is to go over to another kind of money. It is otherwise with credit money and fiat money. Here the state is able to influence the movement of the objective exchange value of money by increasing or decreasing its quantity. It is true that the means is extremely crude, and that the extent of its consequences can never be foreseen. But it is easy to apply and popular on account of its drastic effects.

3 Inflationism


Inflationism is that monetary policy that seeks to increase the quantity of money.


Naive* inflationism demands an increase in the quantity of money without suspecting that this will diminish the purchasing power of the money. It wants more money because in its eyes the mere abundance of money is wealth. Fiat money! Let the state "create" money, and make the poor rich, and free them from the bonds of the capitalists! How foolish to forgo the opportunity of making everybody rich, and consequently happy, that the state's right to create money gives it! How wrong to forgo it simply because this would run counter to the interests of the rich! How wicked of the economists to assert that it is not within the power of the state to create wealth by means of the printing press!—You statesmen want to build railways, and complain of the low state of the exchequer? Well, then, do not beg loans from the capitalists and anxiously calculate whether your railways will bring in enough to enable you to pay interest and amortization on your debt. Create money, and help yourselves.*106


Other inflationists realize very well that an increase in the quantity of money reduces the purchasing power of the monetary unit. But they endeavor to secure inflation nonetheless, because of its effect on the value of money; they want depreciation, because they want to favor debtors at the expense of creditors and because they want to encourage exportation and make importation difficult. Others, again, recommend depreciation for the sake of its supposed property of stimulating production and encouraging the spirit of enterprise.


Depreciation of money can benefit debtors only when it is unforeseen. If inflationary measures and a reduction of the value of money are expected, then those who lend money will demand higher interest in order to compensate their probable loss of capital, and those who seek loans will be prepared to pay the higher interest because they have a prospect of gaining on capital account. Since, as we have shown, it is never possible to foresee the extent of monetary depreciation, creditors in individual cases may suffer losses and debtors make profits, in spite of the higher interest exacted. Nevertheless, in general it will not be possible for any inflationary policy, unless it takes effect suddenly and unexpectedly, to alter the relations between creditor and debtor in favor of the latter by increasing the quantity of money.*107 Those who lend money will feel obliged, in order to avoid losses, either to make their loans in a currency that is more stable in value than the currency of their own country, or to include in the rate of interest they ask, over and above the compensation that they reckon for the probable depreciation of money and the loss to be expected on that account, an additional premium for the risk of a less probable further depreciation. And if those who were seeking credit were inclined to refuse to pay this additional compensation, the diminution of supply in the loan market would force them to it. During the inflation after the war it was seen how savings deposits decreased because savings banks were not inclined to adjust interest rates to the altered conditions of the variations in the purchasing power of money.


It has already been shown in the preceding chapter that it is a mistake to think that the depreciation of money stimulates production. If the particular conditions of a given case of depreciation are such that wealth is transferred to the rich from the poor, then admittedly saving (and consequently capital accumulation) will be encouraged, production will consequently be stimulated, and so the welfare of posterity increased. In earlier epochs of economic history a moderate inflation may sometimes have had this effect. But the more the development of capitalism has made money loans (bank and savings-bank deposits and bonds, especially bearer bonds and mortgage bonds) the most important instruments of saving, the more has depreciation necessarily imperiled the accumulation of capital, by decreasing the motive for saving. How the depreciation of money leads to capital consumption through falsification of economic calculation, and how the appearance of a boom that it creates is an illusion, and how the depreciation of the money really reacts on foreign trade have similarly been explained already in the preceding chapter


A third group of inflationists do not deny that inflation involves serious disadvantages. Nevertheless, they think that there are higher and more important aims of economic policy than a sound monetary system. They hold that although inflation may be a great evil, yet it is not the greatest evil, and that the state might under certain circumstances find itself in a position where it would do well to oppose greater evils with the lesser evil of inflation. When the defense of the fatherland against enemies, or the rescue of the hungry from starvation is at stake, then, it is said, let the currency go to ruin whatever the cost.


Sometimes this sort of conditional inflation is supported by the argument that inflation is a kind of taxation that is advisable in certain circumstances. Under some conditions, according to this argument, it is better to meet public expenditure by a fresh issue of notes than by increasing the burden of taxation or by borrowing. This was the argument put forward during the war when the expenditure on the army and navy had to be met; and this was the argument put forward in Germany and Austria after the war when a part of the population had to be provided with cheap food, the losses on the operation of the railways and other public undertakings met, and reparations payments made. The assistance of inflation is invoked whenever a government is unwilling to increase taxation or unable to raise a loan; that is the truth of the matter The next step is to inquire why the two usual methods of raising money for public purposes cannot or will not be employed.


It is only possible to levy high taxes when those who bear the burden of the taxes assent to the purpose for which the resources so raised are to be expended. It must be observed here that the greater the total burden of taxation becomes, the harder it is to deceive public opinion as to the impossibility of placing the whole burden of taxation upon the small richer class of the community. The taxation of the rich or of property affects the whole community, and its ultimate consequences for the poorer classes are often more severe than those of taxation levied throughout the community. These implications may perhaps be harder to grasp when taxation is low; but when it is high they can hardly fail to be recognized. There can, moreover, be no doubt that it is scarcely possible to carry the system of relying chiefly upon "taxation of ownership" any farther than it has been carried by the inflating countries, and that the incidence of further taxation could not have been concealed in the way necessary to guarantee continued popular support.


Who has any doubt that the belligerent peoples of Europe would have tired of war much more quickly if their governments had clearly and candidly laid before them at the time the account of their war expenditure? In no European country did the war party dare to impose taxation on the masses to any considerable extent for meeting the cost of the war. Even in England, the classical country of "sound money," the printing presses were set in motion. Inflation had the great advantage of evoking an appearance of economic prosperity and of increase of wealth, of falsifying calculations made in terms of money, and so of concealing the consumption of capital. Inflation gave rise to the pseudo-profits of the entrepreneur and capitalist which could be treated as income and have specially heavy taxes imposed upon them without the public at large—or often even the actual taxpayers themselves—seeing that portions of capital were thus being taxed away. Inflation made it possible to divert the fury of the people to "speculators" and "profiteers." Thus it proved itself an excellent psychological resource of the destructive and annihilist war policy.


What war began, revolution continued. The socialistic or semi-socialistic state needs money in order to carry on undertakings which do not pay, to support the unemployed, and to provide the people with cheap food. It also is unable to secure the necessary resources by means of taxation. It dare not tell the people the truth. The state-socialist principle of running the railways as a state institution would soon lose its popularity if it was proposed, say, to levy a special tax for covering their running losses. And the German and Austrian people would have been quicker in realizing where the resources came from that made bread cheaper if they themselves had to supply them in the form of a bread tax. In the same way, the German government that decided for the "policy of fulfillment" in opposition to the majority of the German people, was unable to provide itself with the necessary means except by printing notes. And when passive resistance in the Ruhr district gave rise to a need for enormous sums of money, these, again for political reasons, were only to be procured with the help of the printing press.


A government always finds itself obliged to resort to inflationary measures when it cannot negotiate loans and dare not levy taxes, because it has reason to fear that it will forfeit approval of the policy it is following if it reveals too soon the financial and general economic consequences of that policy. Thus inflation becomes the most important psychological resource of any economic policy whose consequences have to be concealed; and so in this sense it can be called an instrument of unpopular, that is, of antidemocratic, policy, since by misleading public opinion it makes possible the continued existence of a system of government that would have no hope of the consent of the people if the circumstances were clearly laid before them. That is the political function of inflation. It explains why inflation has always been an important resource of policies of war and revolution and why we also find it in the service of socialism. When governments do not think it necessary to accommodate their expenditure to their revenue and arrogate to themselves the right of making up the deficit by issuing notes, their ideology is merely a disguised absolutism.


The various aims pursued by inflationists demand that the inflationary measures shall be carried through in various special ways. If depreciation is wanted in order to favor the debtor at the expense of the creditor, then the problem is to strike unexpectedly at creditor interests. As we have shown, to the extent to which it could be foreseen, an expected depreciation would be incapable of altering the relations between creditors and debtors. A policy aiming at a progressive diminution of the value of money does not benefit debtors.


If, on the other hand, the depreciation is desired in order to "stimulate production" and to make exportation easier and importation more difficult in relation to other countries, then it must be borne in mind that the absolute level of the value of money—its purchasing power in terms of commodities and services and its exchange ratio against other kinds of money—is without significance for external (as for internal) trade; the variations in the objective exchange value of money have an influence on business only so long as they are in progress. The "beneficial effects" on trade of the depreciation of money only last so long as the depreciation has not affected all commodities and services. Once the adjustment is completed, then these "beneficial effects" disappear. If it is desired to retain them permanently, continual resort must be had to fresh diminutions of the purchasing power of money. It is not enough to reduce the purchasing power of money by one set of measures only, as is erroneously supposed by numerous inflationist writers; only the progressive diminution of the value of money could permanently achieve the aims which they have in view.*108 But a monetary system that corresponds to these requirements can never be actually realized.


Of course, the real difficulty does not lie in the fact that a progressive diminution of the value of money must soon reach amounts so small that they would no longer meet the requirements of commerce. Since the decimal system of calculation is customary in the majority of present-day monetary systems, even the more stupid sections of the public would find no difficulty in the new reckoning when a system of higher units was adopted. We could quite easily imagine a monetary system in which the value of money was constantly falling at the same proportionate rate. Let us assume that the purchasing power of this money, through variations in the determinants that lie on the side of money, sinks in the course of a year by one-hundredth of its amount at the beginning of the year The levels of the value of the money at each new year then constitute a diminishing geometrical series. If we put the value of the money at the beginning of the first year as equivalent to 100, then the ratio of diminution is equivalent to 0.99, and the value of money at the end of the nth year is equivalent to 100 × 0.99n-1. Such a convergent geometrical progression gives an infinite series, any member of which is always to the next following member in the ratio of 100 : 99. We could quite easily imagine a monetary system based on such a principle; perhaps even more easily still if we increased the ratio, say, to 0.995 or even 0.9975.


But however clearly we may be able to imagine such a monetary system, it certainly does not lie in our power actually to create one like it. We know the determinants of the value of money, or think we know them. But we are not in a position to bend them to our will. For we lack the most important prerequisite for this; we do not so much as know the quantitative significance of variations in the quantity of money. We cannot calculate the intensity with which definite quantitative variations in the ratio of the supply of money and the demand for it operate upon the subjective valuations of individuals and through these indirectly upon the market. This remains a matter of very great uncertainty. In employing any means to influence the value of money we run the risk of giving the wrong dose. This is all the more important since in fact it is not possible even to measure variations in the purchasing power of money. Thus even though we can roughly tell the direction in which we should work in order to obtain the desired variation, we still have nothing to tell us how far we should go, and we can never find out where we are already, what effects our intervention has had, or how these are proportioned to the effects we desire.


Now the danger involved in overdoing an arbitrary influence—a political influence; that is, one arising from the conscious intervention of human organizations—upon the value of money must by no means be underestimated, particularly in the case of a diminution of the value of money. Big variations in the value of money give rise to the danger that commerce will emancipate itself from the money which is subject to state influence and choose a special money of its own. But without matters going so far as this it is still possible for all the consequences of variations in the value of money to be eliminated if the individuals engaged in economic activity clearly recognize that the purchasing power of money is constantly sinking and act accordingly. If in all business transactions they allow for what the objective exchange value of money will probably be in the future, then all the effects on credit and commerce are finished with. In proportion as the Germans began to reckon in terms of gold, so was further depreciation rendered incapable of altering the relationship between creditor and debtor or even of influencing trade. By going over to reckoning in terms of gold, the community freed itself from the inflationary policy, and eventually even the government was obliged to acknowledge gold as a basis of reckoning.


A danger necessarily involved in all attempts to carry out an inflationary policy is that of excess. Once the principle is admitted that it is possible, permissible, and desirable, to take measures for "cheapening" money, then immediately the most violent and bitter controversy will break out as to how far this principle is to be carried. The interested parties will differ not merely about the steps still to be taken, but also about the results of the steps that have been taken already. It would be impossible for any inflationary measures to be taken without violent controversy. It would be practically impossible so much as to consider counsels of moderation. And these difficulties arise even in the case of an attempt to secure what the inflationists call the beneficial effects of a single and isolated depreciation. Even in the case, say, of assisting "production" or debtors after a serious crisis by a single depreciation of the value of money, the same problems remain to be solved. They are difficulties that have to be reckoned with by every policy aiming at a reduction of the value of money.


Consistently and uninterruptedly continued inflation must eventually lead to collapse. The purchasing power of money will fall lower and lower, until it eventually disappears altogether. It is true that an endless process of depreciation can be imagined. We can imagine the purchasing power of money getting continually lower without ever disappearing altogether, and prices getting continually higher without it ever becoming impossible to obtain commodities in exchange for notes. Eventually this would lead to a situation in which even retail transactions were in terms of millions and billions and even higher figures; but the monetary system itself would remain.


But such an imaginary state of affairs is hardly within the bounds of possibility. In the long run, a money which continually fell in value would have no commercial utility. It could not be used as a standard of deferred payments. For all transactions in which com modities or services were not exchanged for cash, another medium would have to be sought. In fact, a money that is continually depreciating becomes useless even for cash transactions. Everybody attempts to minimize his cash reserves, which are a source of continual loss. Incoming money is spent as quickly as possible, and in the purchases that are made in order to obtain goods with a stable value in place of the depreciating money even higher prices will be agreed to than would otherwise be in accordance with market conditions at the time. When commodities that are not needed at all or at least not at the moment are purchased in order to avoid the holding of notes, then the process of extrusion of the notes from use as a general medium of exchange has already begun. It is the beginning of the "demonetization" of the notes. The process is hastened by its paniclike character. It may be possible once, twice, perhaps even three or four times, to allay the fears of the public; but eventually the affair must run its course and then there is no longer any going back. Once the depreciation is proceeding so rapidly that sellers have to reckon with considerable losses even if they buy again as quickly as is possible, then the position of the currency is hopeless.


In all countries where inflation has been rapid, it has been observed that the decrease in the value of the money has occurred faster than the increase in its quantity. If m represents the nominal amount of money present in the country before the beginning of the inflation, P the value of the monetary unit then in terms of gold, M the nominal amount of money at a given point of time during the inflation, and p the value in gold of the monetary unit at this point of time; then, as has often been shown by simple statistical investigations, mP > Mp. It has been attempted to prove from this that the money has depreciated "too rapidly" and that the level of the rate of exchange is not "justified." Many have drawn from it the conclusion that the quantity theory is obviously not true and that depreciation of money cannot be a result of an increase in its quantity. Others have conceded the truth of the quantity theory in its primitive form and argued the permissibility or even the necessity of continuing to increase the quantity of money in the country until its total gold value is restored to the level at which it stood before the beginning of the inflation, that is, until Mp = mP.


The error that is concealed in all of this is not difficult to discover. We may completely ignore the fact already referred to that the exchange rates (including the bullion rate) move in advance of the purchasing power of the money unit as expressed in the prices of commodities, so that the gold value must not be taken as a basis of operations, but purchasing power in terms of commodities, which as a rule will not have decreased to the same extent as the gold value. For this form of calculation too, in which P and p do not represent value in terms of gold but purchasing power in terms of commodities, would still as a rule give the result mP > Mp. But it must be observed that as the depreciation of money proceeds, the demand for money (that is, for the kind of money in question) gradually begins to fall. When loss of wealth is suffered in proportion to the length of time money is kept on hand, endeavors are made to reduce cash holdings as much as possible. Now if every individual, even if his circumstances are otherwise unchanged, no longer wishes to maintain his cash holding at the same level as before the beginning of the inflation, the demand for money in the whole community, which can only be the sum of the individuals' demands, decreases too. There is also the additional fact that as commerce gradually begins to use foreign money and actual gold in place of notes, individuals begin to hold part of their reserves in foreign money and in gold and no longer in notes.


An expected fall in the value of money is anticipated by speculation so that the money has a lower value in the present than would correspond to the relationship between the immediate supply of it and demand for it. Prices are asked and given that are not related to the present amount of money in circulation nor to present demands for money, but to future circumstances. The panic prices paid when the shops are crowded with buyers anxious to pick up something or other while they can, and the panic rates reached on the exchange when foreign currencies and securities that do not represent a claim to fixed sums of money rise precipitously, anticipate the march of events. But there is not enough money available to pay the prices that correspond to the presumable future supply of money and demand for it. And so it comes about that commerce suffers from a shortage of notes, that there are not enough notes on hand for fulfilling commitments that have been entered into. The mechanism of the market that adjusts the total demand and the total supply to each other by altering the exchange ratio no longer functions as far as the exchange ratio between money and other economic goods is concerned. Business suffers sensibly from a shortage of notes. This bad state of affairs, once matters have gone as far as this, can in no way be helped. Still further to increase the note issue (as many recommend) would only make matters worse. For, since this would accelerate the growth of the panic, it would also accentuate the maladjustment between depredation and circulation. Shortage of notes for transacting business is a symptom of an advanced stage of inflation; it is the reverse aspect of panic purchases and panic prices, the reflection of the "bullishness" of the public that will finally lead to catastrophe.


The emancipation of commerce from a money which is proving more and more useless in this way begins with the expulsion of the money from hoards. People begin at first to hoard other money instead so as to have marketable goods at their disposal for unforeseen future needs—perhaps precious-metal money and foreign notes, and sometimes also domestic notes of other kinds which have a higher value because they cannot be increased by the state (for example, the Romanoff ruble in Russia or the "blue" money of com munist Hungary); then ingots, precious stones, and pearls; even pictures, other objects of art, and postage stamps. A further step is the adoption of foreign currency or metallic money (that is, for all practical purposes, gold) in credit transactions. Finally, when the domestic currency ceases to be used in retail trade, wages as well have to be paid in some other way than in pieces of paper which are then no longer good for anything.


The collapse of an inflation policy carried to its extreme—as in the United States in 1781 and in France in 1796—does not destroy the monetary system, but only the credit money or fiat money of the state that has overestimated the effectiveness of its own policy. The collapse emancipates commerce from etatism and establishes metallic money again.


It is not the business of science to criticize the political aims of inflationism. Whether the favoring of the debtor at the expense of the creditor, whether the facilitation of exports and the hindrance of imports, whether the stimulation of production by transferring wealth and income to the entrepreneur, are to be recommended or not, are questions which economics cannot answer. With the instruments of monetary theory alone, these questions cannot even be elucidated as far as is possible with other parts of the apparatus of economics. But there are nevertheless three conclusions that seem to follow from our critical examination of the possibilities of inflationary policy.


In the first place, all the aims of inflationism can be secured by other sorts of intervention in economic affairs, and secured better, and without undesirable incidental effects. If it is desired to relieve debtors, moratoria may be declared or the obligation to repay loans may be removed altogether; if it is desired to encourage exportation, export premiums may be granted; if it is desired to render importation more difficult, simple prohibition may be resorted to, or import duties levied. All these measures permit discrimination between classes of people, branches of production, and districts, and this is impossible for an inflationary policy. Inflation benefits all debtors, including the rich, and injures all creditors, including the poor; adjustment of the burden of debts by special legislation allows of differentiation. Inflation encourages the exportation of all commodities and hinders all importation; premiums, duties, and prohibitions can be employed discriminatingly.


Second, there is no kind of inflationary policy the extent of whose effects can be foreseen. And finally, continued inflation must lead to a collapse.


Thus we see that, considered purely as a political instrument, inflationism is inadequate. It is, technically regarded, bad policy, because it is incapable of fully attaining its goal and because it leads to consequences that are not, or at least are not always, part of its aim. The favor it enjoys is due solely to the circumstance that it is a policy concerning whose aims and intentions public opinion can be longest deceived. Its popularity, in fact, is rooted in the difficulty of fully understanding its consequences.

4 Restrictionism or Deflationism


That policy which aims at raising the objective exchange value of money is called, after the most important means at its disposal, restrictionism or deflationism. This nomenclature does not really embrace all the policies that aim at an increase in the value of money. The aim of restrictionism may also be attained by not increasing the quantity of money when the demand for it increases, or by not increasing it enough. This method has quite often been adopted as a way of increasing the value of money in face of the problems of a depreciated credit-money standard; further increase of the quantity of money has been stopped, and the policy has been to wait for the effects on the value of money of an increasing demand for it. In the following discussion, following a widespread custom, we shall use the terms restrictionism and deflationism to refer to all policies directed to raising the value of money.


The existence and popularity of inflationism is due to the circumstance that it taps new sources of public revenue. Governments had inflated from fiscal motives long before it occurred to anybody to justify their procedure from the point of view of monetary policy. Inflationistic arguments have always been well supported by the fact that inflationary measures not only do not impose any burden on the national exchequer, but actually bring resources to it. Looked at from the fiscal point of view, inflationism is not merely the cheapest economic policy; it is also at the same time a particularly good remedy for a low state of the public finances. Restrictionism, however, demands positive sacrifices from the national exchequer when it is carried out by the withdrawal of notes from circulation (say through the issue of interest-bearing bonds or through taxation) and their cancellation; and at the least it demands from it a renunciation of potential income by forbidding the issue of notes at a time when the demand for money is increasing. This alone would suffice to explain why restrictionism has never been able to compete with inflationism.


Nevertheless, the unpopularity of restrictionism has other causes as well. Attempts to raise the objective exchange value of money, in the circumstances that have existed, have necessarily been limited either to single states or to a few states and at the best have had only a very small prospect of simultaneous realization throughout the whole world. Now as soon as a single country or a few countries go over to a money with a rising purchasing power, while the other countries retain a money with a falling or stationary exchange value, or one which although it may be rising in value is not rising to the same extent, then, as has been demonstrated above, the conditions of international trade are modified. In the country whose money is rising in value, exportation becomes more difficult and importation easier. But the increased difficulty of exportation and the increased facility of importation, in brief the deterioration of the balance of trade, have usually been regarded as an unfavorable situation and consequently been avoided. This alone would provide an adequate explanation of the unpopularity of measures intended to raise the purchasing power of money.


But furthermore, quite apart from any consideration of foreign trade, an increase in the value of money has not been to the advantage of the ruling classes. Those who get an immediate benefit from such an increase are all those who are entitled to receive fixed sums of money. Creditors gain at the expense of debtors. Taxation, it is true, becomes more burdensome as the value of money rises; but the greater part of the advantage of this is secured, not by the state, but by its creditors. Now policies favoring creditors at the expense of debtors have never been popular. Lenders of money have been held in odium, at all times and among all peoples.*109


Generally speaking, the class of persons who draw their income exclusively or largely from the interest on capital lent to others has not been particularly numerous or influential at any time in any country. A not insignificant part of the total income from the lending of capital is received by persons whose incomes chiefly arise from other sources, and in whose budgets it plays only a subordinate part. This is the case, for instance, not only of the laborers, peasants, small industrialists, and civil servants, who possess savings that are invested in savings deposits or in bonds, but also of the numerous big industrialists, wholesalers, or shareholders, who also own large amounts of bonds. The interests of all of these as lenders of money are subordinate to their interests as landowners, merchants, manufacturers, or employees. No wonder, then, that they are not very enthusiastic about attempts to raise the level of interest.*110


Restrictionistic ideas have never met with any measure of popular sympathy except after a time of monetary depreciation when it has been necessary to decide what should take the place of the abandoned inflationary policy. They have hardly ever been seriously entertained except as part of the alternative: "Stabilization of money at the present value or revaluation at the level that it had before the inflation."


When the question arises in this form, the reasons that are given for the restoration of the old metal parity start from the assumption that notes are essentially promises to pay so much metallic money. Credit money has always originated in a suspension of the convertibility into cash of Treasury notes or banknotes (sometimes the suspension was even extended to token coins or to bank deposits) that were previously convertible at any time on the demand of the bearer and were already in circulation. Now whether the original obligation of immediate conversion was expressly laid down by the law or merely founded on custom, the suspension of conversion has always taken on the appearance of a breach of the law that could perhaps be excused, but not justified; for the coins or notes that became credit money through the suspension of cash payment could never have been put into circulation otherwise than as money substitutes, as secure claims to a sum of commodity money payable on demand. Consequently, the suspension of immediate convertibility has always been decreed as a merely temporary measure, and a prospect held out of its future rescission. But if credit money is thought of only as a promise to pay, "devaluation" cannot be regarded as anything but a breach of the law, or as meaning anything less than national bankruptcy.


Yet credit money is not merely an acknowledgment of indebtedness and a promise to pay. As money, it has a different standing in the transactions of the market. It is true that it could not have become a money-substitute unless it had constituted a claim. Nevertheless, at the moment when it became actual money—credit money—(even if through a breach of the law), it ceased to be valued with regard to the more or less uncertain prospect of its future full conversion and began to be valued for the sake of the monetary function that it performed. Its far lower value as an uncertain claim to a future cash payment has no significance so long as its higher value as a common medium of exchange is taken into account.


It is therefore quite beside the point to interpret devaluation as national bankruptcy. The stabilization of the value of money at its present—lower—level is, even when regarded merely with a view to its effects on existing debt relations, something other than this; it is both more and less than national bankruptcy. It is more, for it affects not merely public debts, but also all private debts; it is less, for one thing because it also affects those claims of the state that are in terms of credit money while not affecting such of its obligations as are in terms of cash (metallic money) or foreign currency, and for another thing because it involves no modification of the relations of the parties to any contract of indebtedness in terms of credit money made at a time when the currency stood at a low level, without the parties having reckoned on an increase of the value of money. When the value of money is increased, then those are enriched who at the time possess credit money or claims to credit money. Their enrichment must be paid for by debtors, among them the state (that is, the taxpayers). Yet those who are enriched by the increase in the value of money are not the same as those who were injured by the depreciation of money in the course of the inflation; and those who must bear the cost of the policy of raising the value of money are not the same as those who benefited by its depreciation. To carry out a deflationary policy is not to do away with the consequences of inflation. You cannot make good an old breach of the law by committing a new one. And as far as debtors are concerned, restriction is a breach of the law.


If it is desired to make good the injury which has been suffered by creditors during the inflation, this can certainly not be done by restriction. In the simpler circumstances of an undeveloped credit system, the attempt has been made to find a way out of the difficulty by conversion of the debts contracted before and during the period of inflation, every debt being recalculated in the devaluated money according to the value of the credit money in terms of metallic money on the day of origin. Supposing, for instance, that the metallic money had been depreciated to one-fifth of its former value, a borrower of 100 gulden before the inflation would have to pay back after the stabilization, not 100 gulden, but 500, together with interest on the 500; and a borrower of 100 gulden at a time when the credit money had already sunk to half of its nominal value, would have to pay interest on and pay back 250 gulden.*111 This, however, only covers debt obligations which are still current; the debts which have already been settled in the depreciated money are not affected. No notice is taken of sales and purchases of bonds and other claims to fixed sums of money; and, in an age of bearer bonds, this is a quite particularly serious shortcoming. Finally, this sort of regulation is inapplicable to current-account transactions.


It is not our business here to discuss whether something better than this could have been thought of. In fact, if it is possible to make any sort of reparation of the damage suffered by creditors at all, it must clearly be sought by way of some such methods of recalculation. But in any case, increasing the purchasing power of money is not a suitable means to this end.


Considerations of credit policy also are adduced in favor of increasing the value of money to the metal parity that prevailed before the beginning of the period of inflation. A country that has injured its creditors through depreciation brought about by inflation, it is said, cannot restore the shattered confidence in its credit otherwise than by a return to the old level of prices. In this way alone can those from whom it wishes to obtain new loans be satisfied as to the future security of their claims; the bondholders will be able to assume that any possible fresh inflation would not ultimately reduce their claims, because after the inflation was over the original metal parity would presumably be returned to. This argument has a peculiar significance*112 for England, among whose most important sources of income is the position of the city of London as the world's banker. All those who availed themselves of the English banking system, it is said, ought to be satisfied as to the future security of the English deposits, in order that the English banking business should not be diminished by mistrust in the future of the English currency. As always in the case of considerations of credit policy like this, a good deal of rather dubious psychology is assumed in this argument. It may be there are more effectual ways of restoring confidence in the future than by measures that do not benefit some of the injured creditors at all—those who have already disposed of their claims—and do benefit many creditors who have not suffered any injury—those who acquired their claims after the depreciation began.


In general, therefore, it is impossible to regard as decisive the reasons that are given in favor of restoring the value of money at the level that it had before the commencement of the inflationary policy, especially as consideration of the way in which trade is affected by a rise in the value of money suggests a need for caution. Only where and so far as prices are not yet completely adjusted to the relationship between the stock of money and the demand for it which has resulted from the increase in the quantity of money, is it possible to proceed to a restoration of the old parity without encountering a too violent opposition.

5 Invariability of the Objective Exchange Value of Money as the Aim of Monetary Policy


Thus, endeavors to increase or decrease the objective exchange value of money prove impracticable. A rise in the value of money leads to consequences which as a rule seem to be desired by only a small section of the community; a policy with this aim is contrary to interests which are too great for it to be able to hold its own against them in the long run. The kinds of intervention which aim at decreasing the value of money seem more popular; but their goal can be more easily and more satisfactorily reached in other ways, while their execution meets with quite insuperable difficulties.


Thus nothing remains but to reject both the augmentation and the diminution of the objective exchange value of money. This suggests the ideal of a money with an invariable exchange value, so far as the monetary influences on its value are concerned. But, this is the ideal money of enlightened statesmen and economists, not that of the multitude. The latter thinks in far too confused a manner to be able to grasp the problems here involved. (It must be confessed that they are the most difficult in economics.) For most people (so far as they do not incline to inflationistic ideas), that money seems to be the best whose objective exchange value is not subject to any variation at all, whether originating on the monetary side or on the commodity side.


The ideal of a money with an exchange value that is not subject to variations due to changes in the ratio between the supply of money and the need for it—that is, a money with an invariable innere objektive Tauschwert*113—demands the intervention of a regulating authority in the determination of the value of money; and its continued intervention. But here immediately most serious doubts arise from the circumstance, already referred to, that we have no useful knowledge of the quantitative significance of given measures intended to influence the value of money. More serious still is the circumstance that we are by no means in a position to determine with precision whether variations have occurred in the exchange value of money from any cause whatever, and if so to what extent, quite apart from the question of whether such changes have been effected by influences working from the monetary side. Attempts to stabilize the exchange value of money in this sense must therefore be frustrated at the outset by the fact that both their goal and the road to it are obscured by a darkness that human knowledge will never be able to penetrate. But the uncertainty that would exist as to whether there was any need for intervention to maintain the stability of the exchange value of money, and as to the necessary extent of such intervention, would inevitably give full license again to the conflicting interests of the inflationists and restrictionists. Once the principle is so much as admitted that the state may and should influence the value of money, even if it were only to guarantee the stability of its value, the danger of mistakes and excesses immediately arises again.


These possibilities, and the remembrance of very recent experiments in public finance and inflation, have subordinated the unrealizable ideal of a money with an invariable exchange value to the demand that the state should at least refrain from exerting any sort of influence on the value of money. A metallic money, the augmentation or diminution of the quantity of metal available for which is independent of deliberate human intervention, is becoming the modern monetary ideal.


The significance of adherence to a metallic-money system lies in the freedom of the value of money from state influence that such a system guarantees. Beyond doubt, considerable disadvantages are involved in the fact that not only fluctuations in the ratio of the supply of money and the demand for it, but also fluctuations in the conditions of production of the metal and variations in the industrial demand for it, exert an influence on the determination of the value of money. It is true that these effects, in the case of gold (and even in the case of silver), are not immoderately great, and these are the only two monetary metals that need be considered in modern times. But even if the effects were greater, such a money would still deserve preference over one subject to state intervention, since the latter sort of money would be subject to still greater fluctuations.


6 The Limits of Monetary Policy


The results of our investigation into the development and significance of monetary policy should not surprise us. That the state, after having for a period used the power which it nowadays has of influencing to some extent the determination of the objective exchange value of money in order to affect the distribution of income, should have to abandon its further exercise, will not appear strange to those who have a proper appreciation of the economic function of the state in that social order which rests upon private property in the means of production. The state does not govern the market; in the market in which products are exchanged it may quite possibly be a powerful party, but nevertheless it is only one party of many, nothing more than that. All its attempts to transform the exchange ratios between economic goods that are determined in the market can only be undertaken with the instruments of the market. It can never foresee exactly what the result of any particular intervention will be. It cannot bring about a desired result in the degree that it wishes, because the means that the influencing of demand and supply place at its disposal only affect the pricing process through the medium of the subjective valuations of individuals; but no judgment as to the intensity of the resulting transformation of these valuations can be made except when the intervention is a small one, limited to one or a few groups of commodities of lesser importance, and even in such a case only approximately. All monetary policies encounter the difficulty that the effects of any measures taken in order to influence the fluctuations of the objective exchange value of money can neither be foreseen in advance, nor their nature and magnitude be determined even after they have already occurred.


Now the renunciation of intervention on grounds of monetary policy that is involved in the retention of a metallic commodity currency is not complete. In the regulation of the issue of fiduciary media there is still another possibility of influencing the objective exchange value of money. The problem that this gives rise to must be investigated (in the following part) before we can discuss certain plans that have recently been announced for the establishment of a monetary system under which the value of money would be more stable than that of a gold currency.

7 Excursus: The Concepts Inflation and Deflation


Observant readers may perhaps be struck by the fact that in this book no precise definition is given of the terms inflation and deflation (or restriction or contraction); that they are in fact hardly employed at all, and then only in places where nothing in particular depends upon their precision. Only inflationism and deflationism (or restrictionism) are spoken of, and an exact definition is given of the concepts implied by these expressions.*114 Obviously this procedure demands special justification.


I am by no means in agreement with those unusually influential voices that have been raised against the employment of the expression inflation altogether.*115 But I do think that it is an expression that it is possible to do without, and that it would be highly dangerous, on account of a serious difference between its meaning in the pure economic theory of money and banking and its meaning in everyday discussions of currency policy, to make use of it where a sharp scientific precision of the words employed is desirable.


In theoretical investigation there is only one meaning that can rationally be attached to the expression inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange value of money must occur Again, deflation (or restriction, or contraction) signifies a diminution of the quantity of money (in the broader sense) which is not offset by a corresponding diminution of the demand for money (in the broader sense), so that an increase in the objective exchange value of money must occur If we so define these concepts, it follows that either inflation or deflation is constantly going on, for a situation in which the objective exchange value of money did not alter could hardly ever exist for very long. The theoretical value of our definition is not in the least reduced by the fact that we are not able to measure the fluctuations in the objective exchange value of money, or even by the fact that we are not able to discern them at all except when they are large.


If the variations in the objective exchange value of money that result from these causes are so great that they can no longer remain unobserved, it is usual in discussions of economic policy to speak of inflation and deflation (or restriction, or contraction). Now in these discussions, whose practical significance is extraordinarily great, it would be very little to the purpose to use those precise concepts which alone come up to a strictly scientific standard. It would be ridiculous pedantry to attempt to provide an economist's contribution to the controversy as to whether in this or the other country inflation has occurred since 1914 by saying: "Excuse me, there has probably been inflation throughout the whole world since 1896, although on a small scale." In politics, the question of degree is sometimes the whole point, not, as in theory, the question of principle.


But once the economist has acknowledged that it is not entirely nonsensical to use the expressions inflation and deflation to indicate such variations in the quantity of money as evoke big changes in the objective exchange value of money, he must renounce the employment of these expressions in pure theory. For the point at which a change in the exchange ratio begins to deserve to be called big is a question for political judgment, not for scientific investigation.


It is incontrovertible that ideas are bound up with the popular usage of the terms inflation and deflation that must be combated as altogether inappropriate when they creep into economic investigation. In everyday usage, these expressions are based upon an entirely untenable idea of the stability of the value of money, and often also on conceptions that ascribe to a monetary system in which the quantity of money increases and decreases pari passu with the increase and decrease of the quantity of commodities the property of maintaining the value of money stable. Yet however worthy of condemnation this mistake may be, it cannot be denied that the first concern of those who wish to combat popular errors with regard to the causes of the recent tremendous variations in prices should not so much be the dissemination of correct views on the problems of the nature of money in general, as the contradiction of those fundamental errors which, if they continue to be believed, must lead to catastrophic consequences. Those who in the years 1914-24 contested the balance-of-payments theory in Germany in order to oppose the continuation of the policy of inflation may claim the indulgence of their contemporaries and successors if they were not always quite strictly scientific in their use of the word inflation. In fact, it is this very indulgence that we are bound to exercise toward the pamphlets and articles dealing with monetary problems that obliges us to refrain from using these misleading expressions in scientific discussion.

Notes for this chapter

[The author uses the term Geldwertpolitik in the technical sense defined in the above section. I have reserved the term monetary policy for this special meaning. Currency policy is the term I have used to translate Währungspolitik. H.E.B.]
Similar interests, say those of the printers, lithographers, and the like, may play a part in the production of paper money also. Perhaps such motives had something to do with Benjamin Franklin's recommendation of an increase of paper money in his first political writing, which was published (anonymously) in Philadelphia in 1729: "A Modest Inquiry into the Nature and Necessity of a Paper Currency" (in The Works of Benjamin Franklin, ed. Sparks [Chicago, 1882], vol. 2, pp. 253-77). Shortly before—as he relates in his autobiography (ibid., vol. 1, p. 73)—he had printed the notes for New Jersey, and when his pamphlet led to the decision to issue more notes in Pennsylvania, despite the opposition of the "rich men," he got the order to print the notes. He remarks on this in his autobiography: "A very profitable job, and a great help to me. This was another advantage gained by me being able to write" (ibid., p. 92).
[Printed Liberty Fund edition mistakenly reads "Native"—Econlib Ed.]
On the naive inflationary proposals that have been made in recent years by the motor-car manufacturer Henry Ford, the famous inventor Edison, and the American senator Ladd, see Yves Guyot, Les problèmes de la déflation (Paris, 1923), pp. 281 f.
This had been urged as early as 1740 by William Douglass in his anonymous writing A Discourse Concerning the Currencies in the British Plantations in America (Boston, 1740). See also Fisher, The Rate of Interest, p. 356.
See Hertzka, Währung und Handel (Vienna, 1876), p. 42.
See Bentham, Defense of Usury, 2d ed. (London, 1790), pp. 102 ff.
See Wright and Harlow, The Gemini Letters (London, 1844), pp. 51 ff.
See Hofmann, "Die Devalvierung des österreichischen Papiergeldes im Jahre 1811," Schriften des Vereins für Sozialpolitik 165, Part I.
[It should be remembered that the German edition from which the present version is translated was published in 1926. See, however, the discussion of British policy, pp. 23-26 above. H.E.B.]
[See p. 146 n above.]
Cp. pp. 251 and 262-63 above.
Esp. Pigou, The Economics of Welfare (London, 1921), pp. 665 ff.

End of Notes

20 of 33


The Monetary Policy of Etatism

1 The Monetary Theory of Etatism


Etatism, as a theory, is the doctrine of the omnipotence of the Estate, and, as a policy, the attempt to regulate all mundane affairs by authoritative commandment and prohibition. The ideal society of etatism is a particular sort of socialistic community; it is usual in discussions involving this ideal society to speak of state socialism, or, in some connections, of Christian socialism. Superficially regarded, the etatistic ideal society does not differ very greatly from the outward form assumed by the capitalistic organization of society. Etatism by no means aims at the formal transformation of all ownership of the means of production into state ownership by a complete overthrow of the established legal system. Only the biggest industrial, mining, and transport enterprises are to be nationalized; in agriculture, and in medium- and small-scale industry, private property is nominally to continue. Nevertheless, all enterprises are to become state undertakings in fact. Owners are to be left the title and dignity of ownership, it is true, and to be given a right to the receipt of a "reasonable" income, "in accordance with their position"; but, in fact, every business is to be changed into a government office and every livelihood into an official profession. There is no room at all for independent enterprise under any variety of state socialism. Prices are to be regulated authoritatively; authority is to fix what is to be produced, and how, and in what quantities. There is to be no speculation, no "excessive" profit, no loss. There is to be no innovation unless it be decreed by authority. The official is to direct and supervise everything.*116


It is one of the peculiarities of etatism that it is unable to conceive of human beings living together in society otherwise than in accordance with its own particular socialistic ideal. The superficial similarity that exists between the socialist state that is its ideal and pattern and the social order based upon private property in the means of production causes it to overlook the fundamental differences that separate the two. Everything that contradicts the assumption that the two kinds of social order are similar is regarded by the etatist as a transient anomaly and a culpable transgression of authoritative decrees, as evidence that the state has let slip the reins of government and only needs to take them more firmly in hand for everything to be beautifully in order again. That the social life of human beings is subject to definite limitations; that it is governed by a set of laws that are comparable with those of Nature; these are notions that are unknown to the etatist. For the etatist, everything is a question of Macht—power, force, might. And his conception of Macht is crudely materialistic.


Every word of etatistic thought is contradicted by the doctrines of sociology and economics; this is why etatists endeavor to prove that these sciences do not exist. In their opinion, social affairs are shaped by the state. To the law, all things are possible; and there is no sphere in which state intervention is not omnipotent.


For a long time the modern etatists shrank from an explicit application of their principles to the theory of money. It is true that some, Adolf Wagner and Lexis in particular, expressed views on the domestic and foreign value of money and on the influence of the balance of payments on the condition of the exchanges that contained all the elements of an etatistic theory of money; but always with great caution and reserve. The first to attempt an explicit application of etatistic principles in the sphere of monetary doctrine, was Knapp.


The policy of etatism had its heyday during the period of the world war, which itself was the inevitable consequence of the dominance of etatistic ideology. In the "war economy" the postulates of etatism were realized.*117 The war economy and the transition economy showed what etatism is worth and what the policy of etatism is able to achieve.


An examination of etatistic monetary doctrine and monetary policy has a significance that is not limited to the history of ideas. For in spite of all its ill success, etatism is still the ruling doctrine, at least on the continent of Europe. It is, at any rate, the doctrine of the rulers; its ideas prevail in monetary policy. However convinced we may be that it is scientifically valueless, it will not do for us nowadays to ignore it.*118

2 National Prestige and the Rate of Exchange


For the etatist, money is a creature of the state, and the esteem in which money is held is the economic expression of the respect or prestige enjoyed by the state. The more powerful and the richer the state, the better its money. Thus, during the war, it was asserted that "the monetary standard of the victors" would ultimately be the best money. Yet victory and defeat on the battlefield can exercise only an indirect influence on the value of money. Generally speaking, a victorious state is more likely than a conquered one to be able to renounce the aid of the printing press, for it is likely to find it easier to limit its expenditure on the one hand and to obtain credit on the other hand. But the same considerations suggest that increasing prospects of peace will lead to a more favorable estimation of the currency even of the defeated country. In October 1918 the mark and the krone rose; it was believed that even in Germany and Austria a cessation of inflation might be counted upon—an expectation which admittedly was not fulfilled.


History likewise shows that sometimes the "monetary standard of the victors" can prove to be very bad. There have seldom been more brilliant victories than those eventually achieved by the American insurgents under Washington against the English troops. But the American "continental" dollar did not benefit from them. The more proudly the star-spangled banner rose on high, the lower did the exchange rate fall, until, at the very moment when the victory of the rebels was secured, the dollar became entirely valueless. The course of events was no different not long afterward in France. In spite of the victories of the revolutionary army, the metal premium rose continually, until at last in 1796 the value of money touched zero point. In both cases the victorious state had carried inflation to its extreme.


Neither has the wealth of a country any bearing on the valuation of its money. Nothing is more erroneous than the widespread habit of regarding the monetary standard as something in the nature of the shares of the state or the community. When the German mark was quoted at ten centimes in Zurich, bankers said: "Now is the time to buy marks. The German community is indeed poorer nowadays than before the war, so that a low valuation of the mark is justified. Nevertheless, the wealth of Germany is certainly not reduced to a twelfth of what it was before the war; so the mark is bound to rise." And when the Polish mark had sunk to five centimes in Zurich, other bankers said: "This low level is inexplicable. Poland is a rich country; it has a flourishing agriculture, it has wood, coal and oil; so its rate of exchange ought to be incomparably higher."*119 Such observers fail to recognize that the valuation of the monetary unit depends not upon the wealth of the country, but upon the ratio between the quantity of money and the demand for it, so that even the richest country may have a bad currency and the poorest country a good one.

3 The Regulation of Prices by Authoritative Decree


The oldest and most popular instrument of etatistic monetary policy is the official fixing of maximum prices. High prices, thinks the etatist, are not a consequence of an increase in the quantity of money but a consequence of reprehensible activity on the part of "bulls" and "profiteers"; it will suffice to suppress their machinations in order to ensure the cessation of the rise of prices. Thus it is made a punishable offense to demand, or even to pay; "excessive" prices.


Like most other governments, the Austrian government during the war began this kind of criminal-law contest with price raising on the same day that it put the printing press in motion in the service of the national finances. Let us suppose that it had at first been successful in this. Let us completely disregard the fact that the war had also diminished the supply of commodities, and suppose that there had been no forces at work on the commodity side to alter the exchange ratio between commodities and money. We must further disregard the fact that the war, by increasing the period of time necessary for transporting money, and by limiting the operation of the clearing system, and also in other ways, had increased the demand for money of individual economic agents. Let us merely discuss the question, what consequences would necessarily follow if, ceteris paribus, with an increasing quantity of money, prices were restricted to the old level by official compulsion?


An increase in the quantity of money leads to the appearance in the market of new desire to purchase, which had previously not existed; "new purchasing power," it is usual to say, has been created. If the new would-be purchasers compete with those that are already in the market, then, so long as it is not permissible to raise prices, only part of the total purchasing power can be exercised. This means that there are would-be purchasers who leave the market without having effected their object although they were ready to agree to the price demanded, would-be purchasers who return home with the money with which they set out in order to purchase. Whether or not a would-be purchaser who is prepared to pay the official price gets the commodity that he desires depends upon all sorts of circumstances, which are, from the point of view of the market, quite inessential; for example, upon whether he was on the spot in time, or has personal relations with the seller, or other similar accidents. The mechanism of the market no longer works to make a distinction between the would-be purchasers who are still able to buy and those who are not; it no longer brings about a coincidence between supply and demand through variations in price. Supply lags behind demand. The play of the market loses its meaning; other forces have to take its place.


But the government that puts the newly created notes in circulation does so because it wishes to draw commodities and services out of their previous avenues in order to direct them into some other desired employment. It wishes to buy these commodities and services; not, as is also a quite conceivable procedure, to commandeer them by force. It must, therefore, desire that everything should be obtainable for money and for money alone. It is not to the advantage of the government that a situation should arise in the market that makes some of the would-be purchasers withdraw without having effected their object. The government desires to purchase; it desires to use the market, not to disorganize it. But the officially fixed price does disorganize the market in which commodities and services are bought and sold for money. Commerce, so far as it is able, seeks relief in other ways. It redevelops a system of direct exchange, in which commodities and services are exchanged without the instrumentality of money. Those who are forced to dispose of commodities and services at the fixed prices do not dispose of them to everybody, but merely to those to whom they wish to do a favor Would-be purchasers wait in long queues in order to snap up what they can get before it is too late; they race breathlessly from shop to shop, hoping to find one that is not yet sold out.


For once the commodities have been sold that were already on the market when their price was authoritatively fixed at a level below that demanded by the situation of the market, then the emptied storerooms are not filled again. Charging more than a certain price is prohibited, but producing and selling have not been made compulsory. There are no longer any sellers. The market ceases to function. But this means that economic organization based on division of labor becomes impossible. The level of money prices cannot be fixed without overthrowing the system of social division of labor


Thus official fixing of prices, which is intended to establish them and wages generally below the level that they would attain in a free market, is completely impracticable. If the prices of individual kinds of commodities and services are subjected to such restrictions, then disturbances occur that are settled again by the capacity for adjustment possessed by the economic order based on private property sufficiently to make the continuance of the system possible. If such regulations are made general and really put into force, then their incompatibility with the existence of a social order based upon private property becomes obvious. The attempt to restrain prices within limits has to be given up. A government that sets out to abolish market prices is inevitably driven toward the abolition of private property; it has to recognize that there is no middle way between the system of private property in the means of production combined with free contract, and the system of common ownership of the means of production, or socialism. It is gradually forced toward compulsory production, universal obligation to labor, rationing of consumption, and, finally, official regulation of the whole of production and consumption.


This is the road that was taken by economic policy during the war. The etatist, who had jubilantly proclaimed the state's ability to d o everything it wanted to do, discovered that the economists had nevertheless been quite right and that it was not possible to manage with price regulation alone. Since they wished to eliminate the play of the market, they had to go farther than they had originally intended. The first step was the rationing of the most important necessaries; but soon compulsory labor had to be resorted to and eventually the subordination of the whole of production and consumption to the direction of the state. Private property existed in name only; in fact, it had been abolished.


The collapse of militarism was the end of wartime socialism also. Yet no better understanding of the economic problem was shown under the revolution than under the old regime. All the same experiences had to be gone through again.


The attempts that were made with the aid of the police and the criminal law to prevent a rise of prices did not come to grief because officials did not act severely enough or because people found ways of avoiding the regulations. They did not suffer shipwreck because the entrepreneurs were not public spirited, as the socialist-etatistic legend has it. They were bound to fail because the economic organization based upon division of labor and private property in the means of production can function only so long as price determination in the market is free. If the regulation of prices had been successful, it would have paralyzed the whole economic organism. They only thing that made possible the continued functioning of the social apparatus of production was the incomplete enforcement of the regulations that was due to the paralysis of the efforts of those who ought to have executed them.


During thousands of years, in all parts of the inhabited earth, innumerable sacrifices have been made to the chimera of just and reasonable prices. Those who have offended against the laws regulating prices have been heavily punished; their property has been confiscated, they themselves have been incarcerated, tortured, put to death. The agents of etatism have certainly not been lacking in zeal and energy. But, for all this, economic affairs cannot be kept going by magistrates and policemen.

4 The Balance-of-Payments Theory as a Basis of Currency Policy


According to the current view, the maintenance of sound monetary conditions is only possible with a "credit balance of payments." A country with a "debit balance of payments" is supposed to be unable permanently to stabilize the value of its money; the depreciation of the currency is supposed to have an organic basis and to be irremediable except by the removal of the organic defects.


The confutation of this and related objections is implicit in the quantity theory and in Gresham's law. The quantity theory shows that money can never permanently flow abroad from a country in which only metallic money is used (the "purely metallic currency" of the currency principle). The tightness in the domestic market called forth by the efflux of part of the stock of money reduces the prices of commodities, and so restricts importation and encourages exportation, until there is once more enough money at home. The precious metals which perform the function of money are distributed among individuals, and consequently among separate countries, according to the extent and intensity of the demand of each for money. State intervention to assure to the community the necessary quantity of money by regulating its international movements is supererogatory. An undesired efflux of money can never be anything but a result of state intervention endowing money of different values with the same legal tender All that the state need do, and can do, in order to preserve the monetary system undisturbed, is to refrain from such intervention. That is the essence of the monetary theory of the Classical economists and their immediate successors, the Currency School. It is possible to refine and amplify this doctrine with the aid of the modern subjective theory; but it is impossible to overthrow it, and impossible to put anything else in its place. Those who are able to forget it only show that they are unable to think as economists.


When a country has substituted credit money or fiat money for metallic money because the legal equating of the overissued paper and the metallic money sets in motion the mechanism described by Gresham's law, it is often asserted that the balance of payments determines the rate of exchange. But this also is a quite inadequate explanation. The rate of exchange is determined by the purchasing power possessed by a unit of each kind of money; it must be determined at such a level that it makes no difference whether commodities are purchased directly with the one kind of money or indirectly, through money of the other kind. If the rate of exchange moves away from the position that is determined by the purchasing-power parity, which we call the natural or equilibrium rate, then certain sorts of transaction would become profitable. It would become lucrative to purchase commodities with the money that was undervalued by the rate of exchange as compared with the ratio given by its purchasing power, and to sell them for the money that was overvalued in the rate of exchange in comparison with its purchasing power And because there were such opportunities of profit, there would be a demand on the foreign-exchange market for the money that was undervalued by the exchanges and this would raise the rate of exchange until it attained its equilibrium position. Rates of exchange vary because the quantity of money varies and the prices of commodities vary. As has already been remarked, it is solely owing to market technique that this basic relationship is not actually expressed in the temporal sequence of events. In fact, the determination of foreign-exchange rates, under the influence of speculation, anticipates the expected variations in the prices of commodities.


The balance-of-payments theory forgets that the volume of foreign trade is completely dependent upon prices; that neither exportation nor importation can occur if there are no differences in prices to make trade profitable. The theory clings to the superficial aspects of the phenomena it deals with. It cannot be doubted that if we simply look at the daily or hourly fluctuations on the exchanges we shall only be able to discover that the state of the balance of payments at any moment does determine the supply and the de exmand in the foreign-exchange market. But this is a mere beginning of a proper investigation into the determinants of the rate of exchange. The next question is, What determines the state of the balance of payments at any moment? And there is no other possible answer to this than that it is the price level and the purchases and sales induced by the price margins that determine the balance of payments. Foreign commodities can be imported, at a time when the rate of exchange is rising, only if they are able to find purchasers despite their high prices.


One variety of the balance-of-payments theory attempts to distinguish between the importation of necessaries and the importation of articles that can be dispensed with. Necessaries, it is said, have to be bought whatever their price is, simply because they cannot be done without. Consequently there must be a continual depreciation in the currency of a country that is obliged to import necessaries from abroad and itself is able to export only relatively dispensable articles. To argue thus is to forget that the greater or less necessity or dispensability of individual goods is fully expressed in the intensity and extent of the demand for them in the market, and thus in the amount of money which is paid for them. However strong the desire of the Austrians for foreign bread, meat, coal, or sugar may be, they can only get these things if they are able to pay for them. If they wish to import more, they must export more; if they cannot export manufactured and semimanufactured goods, then they must export shares, bonds, and securities of various kinds. If the note circulation were not increased, then the prices of the objects that were offered for sale would have to decrease if the demand for import goods and hence their prices were to rise. Or else the upward movement of the prices of necessaries would have to be opposed by a fall in the price of the dispensable articles the purchase of which was restricted so as to permit the purchase of the necessaries. There could be no question of a general rise of prices. And the balance of payments would be brought into equilibrium, either by the export of securities and the like, or by an increased export of dispensable goods. It is only when the above assumption does not hold good, only when the quantity of notes in circulation is increased, that foreign commodities can still be imported in the same quantities in spite of a rise in the foreign exchange; it is only because this assumption does not hold good that the rise in the foreign exchange does not throttle importation and encourage exportation until there is again a credit balance of payments.


Ancient Mercantilist error therefore involved a specter of which we need not be afraid. No country, not even the poorest, need abandon the hope of sound currency conditions. It is not the poverty of individuals and the community, not indebtedness to foreign nations, not the unfavorableness of the conditions of production, that force up the rate of exchange, but inflation.


It follows that all the means that are employed for hindering a rise in the exchange rate are useless. If the inflationary policy continues, they remain ineffective; if there is no inflationary policy, then they are superfluous. The most important of these methods is the prohibition or limitation of the importation of certain goods that are deemed dispensable, or at least less indispensable than others. This causes the sums of domestic money that would have been used for the purchase of these commodities to be used for other purchases and naturally the only goods here concerned are those that would otherwise have been sold abroad. These will now be purchased at home for prices that are higher than those offered for them abroad. Thus the reduction of imports and so of the demand for foreign exchange is balanced on the other side by an equal reduction of exports and so of the supply of foreign exchange. Imports are in fact paid for by exports and not by money, as Neo-Mercantilist dilettantism still continues to believe. If it is really desired to dam up the demand for foreign exchange, then the amount of money to the extent of which it is desired to stop importation must be taken away from those at home—say by taxation—and kept out of circulation altogether; that is, not used for state purposes, but destroyed. That is to say, a deflationary policy must be followed. Instead of the importation of chocolate, wine, and lemonade being limited, the members of the community must be deprived of the money that they would otherwise spend on these commodities. Then they must limit their consumption either of these or of some other commodities. In the former case, less foreign exchange will be wanted, in the latter more foreign exchange offered, than previously.

5 The Suppression of Speculation


It is not easy to determine whether there are any who still adhere in good faith to the doctrine that traces back the depreciation of money to the activity of speculators. The doctrine is an indispensable instrument of the lowest form of demagogy; it is the resource of governments in search of a scapegoat. There are scarcely any independent writers nowadays who defend it; those who support it are paid to do so. Nevertheless, a-few words must be devoted to it, for the monetary policy of the present day is based largely upon it.


Speculation does not determine prices; it has to accept the prices that are determined in the market. Its efforts are directed to correctly estimating future price situations, and to acting accordingly. The influence of speculation cannot alter the average level of prices over a given period; what it can do is to diminish the gap between the highest and the lowest prices. Price fluctuations are reduced by speculation, not aggravated, as the popular legend has it.


It is true that the speculator may happen to go astray in his estimate of future prices. What is usually overlooked in considering this possibility is that under the given conditions it is far beyond the capacities of most people to foresee the future any more correctly. If this were not so, the opposing group of buyers or sellers would have got the upper hand in the market. The fact that the opinion accepted by the market has later proved to be false is lamented by nobody with more genuine sorrow than by the speculators who held it. They do not err of malice prepense; after all, their object is to make profits, not losses.


Even prices that are established under the influence of speculation result from the cooperation of two parties, the bulls and the bears. Each of the two parties is always equal to the other in strength and in the extent of its commitments. Each has an equal responsibility for the determination of prices. Nobody is from the outset and for all time bull or bear; a dealer becomes a bull or a bear only on the basis of a summing up of the market situation, or, more correctly, on the basis of the dealings that follow on such a summing up. Anybody can change his role at any moment. The price is determined at that level at which the two parties counterbalance each other. The fluctuations of the foreign-exchange rate are not determined solely by bears selling but just as much by bulls buying.


The etatistic view traces back the rise in the price of foreign currencies to the machinations of enemies of the state at home and abroad. These enemies, it is asserted, dispose of the national currency with a speculative intent and purchase foreign currencies with a speculative intent. Two cases are conceivable. Either these enemies are actuated in their dealings by the hope of making a profit, when the same is true of them as of all other speculators. Or they wish to damage the reputation of the state of which they are enemies by depressing the value of its currency, even though they themselves are injured by the operations that lead to this end. To consider the possibility of such enterprises is to forget that they are hardly practicable. The sales of the bears, if they ran against the feeling of the market, would immediately start a contrary movement; the sums disposed of would be taken up by the bulls in expectation of a coming reaction without any effect on the rate of exchange worth mentioning.


In truth, these self-sacrificing bear maneuvers that are undertaken, not to make a profit, but to damage the reputation of the state, belong to the realm of fables. It is true that operations may well be undertaken on foreign-exchange markets that have as their aim, not the securing of a profit, but the creation and maintenance of a rate that does not correspond to market conditions. But this sort of intervention always proceeds from governments, who hold themselves responsible for the currency and always have in view the establishment and maintenance of a rate of exchange above the equilibrium rate. These are artificial bull, not bear, maneuvers. Of course, such intervention also must remain ineffective in the long run. In fact, there is only one way in the last resort to prevent a further fall in the value of money—ceasing to increase the note circulation; and only one way of raising the value of money—reducing the note circulation. Any intervention, such as that of the German Reichsbank in the spring of 1923, in which only a small part of the increasing note expansion was recovered by the banks through the sale of foreign bills, would necessarily be unsuccessful.


Led by the idea of opposing speculation, inflationistic governments have allowed themselves to become involved in measures whose meaning is hardly intelligible. Thus at one time the importation of notes, then their exportation, then again both their exportation and importation, have been prohibited. Exporters have been forbidden to sell for their own country's notes, importers to buy with them. All trade in terms of foreign money and precious metals has been declared a state monopoly. The quotation of rates for foreign money on home exchanges has been forbidden, and the communication of information concerning the rates determined at home outside the exchanges and the rates negotiated on foreign exchanges made severely punishable. All these measures have proved useless and would probably have been more quickly set aside than actually was the case if there had not been important factors in favor of their retention. Quite apart from the political significance already referred to attaching to the maintenance of the proposition that the fall in the value of money was only to be ascribed to wicked speculators, it must not be forgotten that every restriction of trade creates vested interests that are from then onward opposed to its removal.


An attempt is sometimes made to demonstrate the desirability of measures directed against speculation by reference to the fact that there are times when there is nobody in opposition to the bears in the foreign-exchange market so that they alone are able to determine the rate of exchange. That, of course, is not correct. Yet it must be noticed that speculation has a peculiar effect in the case of a currency whose progressive depreciation is to be expected while it is impossible to foresee when the depreciation will stop, if at all. While, in general, speculation reduces the gap between the highest and lowest prices without altering the average price level, here, where the movement will presumably continue in the same direction, this naturally cannot be the case. The effect of speculation here is to permit the fluctuation, which would otherwise proceed more uniformly, to proceed by fits and starts with the interposition of pauses. If foreign-exchange rates begin to rise, then, to those speculators who buy in accordance with their own view of the circumstances, are added large numbers of outsiders. These camp followers strengthen the movement started by the few that trust to an independent opinion and send it farther than it would have gone under the influence of the expert professional speculators alone. For the reaction cannot set in so quickly and effectively as usual. Of course, it is the general assumption that the depreciation of money will go still farther But eventually sellers of foreign money must make an appearance, and then the rising movement of the exchanges comes to a standstill; perhaps even a backward movement sets in for a time. Then, after a period of "stable money," the whole thing begins again.


The reaction admittedly begins late, but it must begin as soon as rates of exchange have run too far ahead of commodity prices. If the gap between the equilibrium rate of exchange and the market rate is big enough to give play for profitable commodity transactions, then there will also arise a speculative demand for the domestic paper money. Not until the scope for such transactions has again disappeared owing to a rise in commodity prices will a new rise in the price of foreign exchange set in.


Etatism eventually comes to regard the possession of foreign money, balances as such, and foreign bills, as behavior reprehensible in itself. From this point of view, it is the duty of citizens—not that this is asserted in so many words, but it is the tone of all official declarations—to put up with the harmful consequences of the depreciation of money to their private property and to make no attempt to avoid this by acquiring such possessions as are not eaten up by the depreciation of money. From the point of view of the individual, they declare, it may indeed appear profitable for him to save himself from impoverishment by a flight from the mark, but from the point of view of the community this is harmful and therefore to be condemned. This demand really comes to a cool request on the part of those who enjoy the benefits of the inflation that everybody else should render up his wealth for sacrifice to the destructive policy of the state. In this case, as in all others in which similar assertions are made, it is not true that there exists an opposition between the interests of the individual and the interests of the community. The national capital is composed of the capital of the individual members of the state, and when the latter is consumed nothing remains of the former either. The individual who takes steps to invest his property in such a way that it cannot be eaten up by the depreciation of money does not injure the community; on the contrary, in taking steps to preserve his private property from destruction he also preserves some of the property of the community from destruction. If he surrendered it without opposition to the effects of the inflation all he would do would be to further the destruction of part of the national wealth and enrich those to whom the inflationary policy brings profit.


It is true that not inconsiderable sections of the best classes of the German people have given credit to the asseverations of the inflationists and their press. Many thought that they were doing a patriotic act when they did not get rid of their marks or kronen and mark or kronen securities, but retained them. By so doing, they did not serve the fatherland. That they and their families have as a consequence sunk into poverty only means that some of the members of those classes of the German people from which the cultural reconstruction of the nation was to be expected are reduced to a condition in which they are able to help neither the community nor themselves.

Notes for this chapter

On this, see my book, Die Gemeinwirtschaft, 2d ed., (Jena, 1922), pp. 211 ff.
See my book, Nation, Staat und Wirtschaft (Vienna, 1919), pp. 108 ff.
Cassel rightly says: "A perfectly clear understanding of the monetary problem, brought about by the world war, can never be attained until officialdom's interpretation of affairs has been disproved point by point, and full light thrown on all the delusions with which the authorities attempted as long as possible to obsess the public mind" (Cassel, Money and Foreign Exchange After 1914 [London, 1922], pp. 7 ff.). See Gregory's criticism of the most important etatistic arguments in his Foreign Exchange Before, During and After the War (London, 1921), esp. pp. 65 ff.
A leader of the Hungarian Soviet republic said to the author in the spring of 1919: "The paper money issued by the Soviet republic ought really to have the highest exchange rate next to the Russian money, for, through the socialization of the private property of all Hungarians, the Hungarian state has become next to Russia the richest state in the world, and consequently the most deserving of credit."

End of Notes

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