The Economics of Ludwig von Mises: Toward a Critical Reappraisal

Edited by: Moss, Laurence S.
(1944- )
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Collected essays, various authors. 1974 conference proceedings. Includes essays by Fritz Machlup, Israel M. Kirzner, Murray N. Rothbard, and more.

The Monetary Economics of
Ludwig von Mises
Laurence S. Moss


I wish to thank Professors Leland Yeager and Gerald O'Driscoll for reading an earlier draft of this monograph and making several valuable comments. Naturally they are in no way responsible for the interpretation I present here.


The first edition of Ludwig von Mises' Theory of Money Credit appeared in 1912, one year after the publication of Irving Fisher's Purchasing Power of Money (1911) but more than a decade before Alfred Marshall's Money, Credit, and Commerce(1922).*18 Despite the important contributions of Fisher and Marshall to the area of monetary economics, it was Mises who produced the first systematic study of the relationship among money, interest, and prices after Wicksell's celebrated Interest and Prices (1898).*19 While Wicksell's, Marshall's, and Fischer's respective contributions are ritualistically consulted by contemporary scholars, Mises' contribution is largely neglected and is no longer considered essential to a mastery of the subject matter of monetary economics. Yet the Theory of Money and Credit cannot be described as either an obscure book or one that has failed to influence the development of monetary economics. The list of scholars who have indicated at least some familiarity with Mises' monetary thought is formidable and includes men of acknowledged reputation such as Knut Wicksell, Benjamin Anderson, Lionel Robbins, John Maynard Keynes, John R. Hicks, A. W. Marget, and Don Patinkin. If to this list we add the names of several generations of veteran participants in Mises' famous monetary seminars, offered first in Vienna, then in Geneva, and later in New York, the roster must be expanded to include Friedrich Hayek, Fritz Machlup, Gottfried Haberler, Alexander Kafka, Leland Yeager, Murray Rothbard, Israel Kirzner, and myself, to name only a few.*20


What is it about this book and the arguments it contains that has kept it for nearly seventy years in limbo between virtual obscurity and academic acclaim? It is my view that Mises' Theory of Money and Credit has all the earmarks of a genuine economic classic—it touches on more of the essential problems of monetary economics than any other single work of the first quarter of the twentieth century—but it lacks an acceptable methodological framework for analyzing monetary problems. Where J. R. Hicks, Oscar Lange, and Don Patinkin harnessed the mathematical technique of "mutual determination" to the solution of the fundamental issues in monetary economics, mises operated in the world of deductive-casual models in the acknowledged tradition of Menger and Böhm-Bawerk. While orthodox monetary theory developed its essential propositions for a world without lags and troublesome distribution effects, Mises put all this at the heart of his analytic system.


I shall illustrate these points by showing how Mises' monetary economics is related to several currents of thought in the period before World War I. In section 1, I begin by critically evaluating the relation of Mises' theory of the demand for money to the work of his mentor and founder of the Austrian school, Carl Menger. I show that by confusing the demand for money with the demand for the services provided by money, Mises was forced to modify one of the basic tenets of the Austrian position in order to apply the theory of marginal utility to money. Also, I demonstrate how Mises' insistence on the relative unimportance of the speculative demand for money actually cut short a line of development in Austrian thought that would have proved useful to his own theory of business fluctuations. I conclude by summarizing the important contributions Mises made toward our understanding of the relationship between price expectations and inflation.


In section 2, I treat the influence of Wicksell and Fisher on Mises' monetary thought. More specifically I show how Wicksell's use of "cash balances" to bridge the gap between the commodity and money markets and Fisher's presentation of the quantity equation encouraged Mises (1) to carefully distinguish between accounting prices and money prices and (2) to insist on the importance of "wealth effects" in understanding the impact of changes in the money supply on the economy.


In section 3 I show how the Mises-Hayek theory of the business cycle originated in Mises' attempt to apply his theory of money to the "cumulative expansion" problem raised by Wicksell. A concluding section offers a brief statement of Mises' contribution to monetary policy.



For both Menger and Mises, the important fact about money is that it does not come into existence by community vote or governmental fiat but instead is the unintended consequence of the historical evolution of the market economy. Individuals engage in trade and commerce in order to acquire commodities capable of satisfying human wants. They willingly trade commodities only if they expect to improve their situations by doing so. There are circumstances, however, in which an individual may find it profitable to accept a commodity in exchange, not because that commodity is itself directly suited or serviceable to his personal needs but rather because he expects to be able to market that commodity at a later date for other commodities that are directly serviceable to his wants. Such a commodity acts as a medium through which exchange takes place.*21


In an exchange economy virtually all commodities are marketable, but not to the same extent. As commerce develops, individuals discover that certain commodities are acceptable on many markets; this acceptance establishes their reputation as media of exchange and further enhances their marketability. Even- tually one commodity snowballs in reputation and becomes readily acceptable on all markets. This commodity is called "money," and its essential feature is its universal marketability.


The marketability attribute of the money commodity is sometimes confused with its purchasing power, that is, its ability to command a definite quantity of another commodity in exchange. Marketability refers to the frequency with which a commodity is accepted in trade. It is true that this frequency itself must be conditioned by how many units of another commodity this first commodity may be expected to command in exchange, but it is not the extent of the purchasing power of this commodity in particular markets that is important in defining "marketability"; rather it is the fact that a commodity is capable of being traded in all markets. Stated another way, what is important about money is not that it is a "temporary abode of purchasing power" but that it is a temporary abode of purchasing power in all markets.*22


In the typical model of the barter economy there can be no a priori way of deciding which of the commodities is best suited to be money, because all commodities are assumed to be traded against one another. One cannot say that it will be the commodity with the greatest purchasing power that will serve as the medium of exchange, because at any set of relative prices one can always make the objective exchange value of a commodity look greater by redefining the units in which it is measured. According to Menger, the "most marketable commodity" is determined as the outcome of a complex historical process, which can be described in only the most general manner. The origin of money is as elusive as the origin of language itself.*23


While Menger used this historical account merely to explain that the process by which the community comes to adopt one commodity as its money is thoroughly market oriented, Mises attempted to expand the argument so as to account for the determination of the purchasing power of the monetary unit as well. According to Mises, when an individual decides what the size of his nominal, or cash, balances is to be, he consults the purchasing power of money as it appeared "yesterday" in the market. This decision on the part of all individuals about the optimal size of their nominal balances will in turn affect the purchasing power of money "today" and thereby require that individuals readjust their balances "tomorrow," until, according to Mises, an "equilibrium" position is reached.*24 In this way the past behavior of market prices affects future market outcomes.


At first sight, this appears to be a peculiar position for a member of the Austrian school to adopt. Menger and the Austrians that followed him never tired of explaining that the market process is "forward looking" and not imprisoned by the past. Commodities are valued today because they are capable of satisfying future wants, and resources are valued according to the intensity and extent of the future wants they are capable of satisfying. All market prices are ultimately derived from the marginal utilities of the commodities they help produce. In the market "bygones are forever bygones"; that is, while past historical data may guide the market participants in their plans, they never guarantee their successful outcome. Menger, Böhm-Bawerk, and Mises were in agreement that there is no greater fallacy in the entire science of economics than the pernicious doctrine that monetary costs expended on the production of commodities determine what the market prices of those commodities will be. The downfall of the English classical school was its failure to recognize that the value of resources is derived from the value of the commodities they help produce, and any coincidence between cost of production and market price simply indicates that entrepreneurs have been successful at their job of anticipating future needs.*25


It is not necessary to proceed further with this summary of the Austrian theory of value in order to indicated how heretical Mises' position on money may seem to those familiar with the position of the older Austrian school. To assert that the value of money depends on its past purchasing power is to admit that the past behavior of prices exerts an influence on future prices—the very antithesis of Menger's teachings. Let us see by what reasoning Mises came to this position.


We begin by developing Mises' notion of "pure fiat money." As is well known, the commodity that the community adopts as its money generally possesses certain physical characteristics that make it capable of satisfying a variety of nonmonetary wants. For example, gold coins can be melted down to make jewelry, and paper money can be used to wallpaper a room. According to Mises, these other uses of the money commodity outside the sphere of exchange must be considered of secondary importance to a general theory of money. A pure theory of money must yield thorems that apply to all forms of money regardless of the material out of which it is made. Mises explained how the historical evolution of monetary and banking institutions (for example, the development of the clearing system and the introduction of a variety of paper monies into the exchange economy) demonstrates that no fact about money essential to the determination of its purchasing power depends on the stuff out of which the money is made.*26 Thus it is necessary at the outset of any investigation into the pure theory of money to abstract completely from the real-world fact that money is often made of valuable materials that are themselves capable of satisfying nonmonetary wants. The reader may find it useful to think of the entire stock of money as consisting of paper money, with the paper of so poor a quality that it has no alternative use outside the monetary sphere. From now on our use of the term money refers to these disembodied units of purchasing power. In Hicks' felicitous phrase, money is the "ghost of gold."*27 The problem then is to explain how individuals decide how many units of money to hold, that is, how they determine the size of their cash balances.


Inasmuch as individuals do find it necessary to hold money and expend part of their wealth in order to acquire money, this disembodied object must satisfy some want. Furthermore, the stock of money in the possession of each individual is capable of variation, as individuals are constantly faced with the choice of building up or reducing their existing cash balances, that is, they are compelled to arrive at an estimate of the marginal utility of money. According to Mises, the marginal utility of money is derived from the marginal utility of the commodities money is capable of purchasing, or, stated another way, the use value of money coincides exactly with its exchange value.*28 It would seem, therefore, that if the demand for money depends entirely on the exchange value of money, individuals must have some idea of what the purchasing power of money is prior to determining the size of their cash balances. But how can individuals have any idea the purchasing power of money when it depends in large part on the size of the cash balances individuals are willing to hold? Thus we seem to have come full circle in our attempt to explain the purchasing power of money by means of utility theory. What we have arrived at is the infamous "circularity problem," which was one of the leading problems in monetary theory at the time Mises wrote.*29


It will be instructive at this point if we try to understand why this same problem does not arise in an analysis of the exchange value of a nonmonetary commodity such as bread. The marginal utility of bread depends on the physical characteristics of bread that make it serviceable to men's wants and the hierarchy of wants themselves. According to Mises, both sets of conditions do not belong to the "economic at all but are partly of a technological and partly of a psychological nature.*30 Having described the demand conditions for bread, it is in principle possible to determine the exchange value of bread. But with money the situation is altogether different because "the subjective value of money is conditioned by its [purchasing power] i.e., by a characteristic that falls within the scope of economics."*31 In the case of money it is not possible (even "in principle") to conceive of its having value without making reference to its past purchasing power.


We may question whether this distinction between money and other commodities is not a bit overdrawn. There are many commodities that individuals demand partly for their want-satisfying characteristics and partly because they are capable of being exchanged at a later date for other commodities. We need not restrict our examples to rare coins and antiques, inasmuch as all commodities that shed their services over extended periods are capable of being resold during their lifetime in highly developed resale markets. In cases such as these would not the exchange value of the commodity itself affect the market demand? Certainly Mises would be prepared to admit that in a highly developed economy, all commodities, insofar as they yield any liquidity services, could also serve as "assets."


While Mises did not deny the obvious possibility that in an advanced money economy individuals may acquire nonmonetary commodities for the express purpose of being able to exchange them at a later date for other commodities directly serviceable to their needs, he insisted that this practice only becomes widespread during exceptional times, that is, when the existing monetary order is headed for a complete breakdown as during the course of hyperinflation. According to Mises, "Under present organization of the market, which leaves a deep gulf between the marketability of money on the one hand and of other economic goods on the other hand, nothing but money enters into consideration at all as a medium of exchange. Only in exceptional circumstances is any other economic good pressed into this service."*32 Thus when Mises insisted that the marginal utility of commodities is determined by nonmarket considerations and the marginal utility of money is derived entirely from its exchange value, we must interpret this as pertaining to a money economy operating under what Mises described as "ordinary circumstances."


In such economy individuals find it necessary to hold cash balances because they need to maintain a fund of instant purchasing power. The number of units of money they demand depends on the efficiency of the monetary unit in acquiring commodities, and this in turn depends on the past array of market prices. When planning their cash requirements on a particular market day, individuals have no basis for evaluating the purchasing power of money other than its past "track record." Thus while all other market plans are essentially forward looking in the sense described earlier, the demand for money is necessarily "backward looking." Mises explained that to "demand of a theory of the value of money that it should explain the exchange-ratio between money and [other] commodities solely with reference to the monetary function, and without the assistance of the element of historical continuity in the value of money, is to make demands of it that run quite contrary to its nature and its proper task."*33


It will be helpful to distinguish between the two following propositions:

Since money qua money is desired because it is a medium of exchange (and not because of the physical characteristics of the materials out of which it is made), it is impossible to derive a theory of the demand for money consistent with the utility theory of value, which does not make reference to the past behavior of market prices.
Individuals when planning the size of their cash balances form expectations about future price behavior on the basis of past price experience.


Both propositions are part of Mises' Theory of Money and Credit, but while the first asserts something about the character of analytic constructs in monetary theory, the second is a bold empirical hypothesis of the way individuals behave in a market economy. I shall evaluate Mises' claim about the logical structure of monetary theory first and then return to the use he makes of his empirical hypothesis in his description of the inflationary process.


1. In his assertion that the only way the demand for money can be consistently incorporated into the general body of utility theory is by introducing historical prices, Mises is quite mistaken. Patinkin demonstrated how to derive a demand curve for money without resorting to past price behavior by performing what is essentially a "thought experiment" in which the individual is confronted with alternative levels of commodity prices and asked how many units of money he will demand in each case. The set of all combinations of price levels and resulting money demands constitutes the individual demand curve for cash balances. The aggregation of all individual demand curves "horizontally" at all price levels yields the market demand curve for nominal balances, and this in conjunction with the (assumed inelastic) supply of money serves to define the "market-clearing" price level. This procedure is the analogue of the familiar neoclassical supply-and-demand analysis, which serves to define the market-clearing price for particular commodities. In Patinkin's barter-money model there is no reference to past price behavior because the method of "comparative statistics" abstracts completely from historical time.*34


It is interesting to notice, however, that Patinkin and Mises agreed that the individual cannot decide the extent of his monetary needs (i.e., the size of his cash balances) without knowledge of the array of market prices. Both writers assumed that the demand for a certain number of units of the money commodity is really a disguised demand for a definite quantity of reserve purchasing power. The individual has no way of determining how many units of money he will require unless he has some knowledge of the absolute effectiveness of each unit in acquiring other commodities in the market. What enters into each individual's utility function is not the demand for a certain quantity of money but the demand for a certain fund of ready purchasing power, what Patinkin appropriately called "real balances."*35


The introduction of "real balances" as a factor in the utility function is quite congenial to the spirit of Mises' analysis. Mises argued at great length that the money commodity is desired only because of the nonmonetary commodities it is capable of purchasing. Individuals continually adjust the size of their cash balances so that the number of units of money they hold provides them with a certain quantity of purchasing power. If an individual perceives that his cash balances are providing him with a greater amount of purchasing power than he desires, he will buy either interest-bearing securities or commodities in an effort to "dispose of the superfluous stock of money that lies useless on his hands." In the opposite case, where cash balances are too small, the individual will "take steps to reach the desired level of reserve purchasing power by suitable behavior in making sales and purchases."*36


Having decided that Mises' demand for money is really a demand for a certain quantity of real cash balances, we ask what determines the size of real cash balances individuals desire to hold? The basic reason for holding money is the lack of simultaneity between payments and receipts and the need to hold transaction balances in order to bridge the gap between the two. Mises reasoned that since money enters into most transactions, in a grow- ing economy, as the number of transactions per person increases, the individual is required to hold larger stocks of real cash balances.*37


According to Mises, however, the largest part of the real balances held by individuals is used to provide for unplanned expenses that may arise in the future. A sudden illness or an unanticipated breakdown in plant machinery makes it necessary for economic agents to hold a certain quantity of reserve purchasing power as a type of insurance. Mises explained that this precautionary demand for real cash balances, unlike the transactions demand, tends to fall as the market economy develops highly liquid forms of interest-bearing property. The individual holds a precautionary stock of real balances because the transaction costs of moving out of nonmonetary assets into money are too great to effectively meet emergency payments. With the development of resale markets for certain types of securities these costs decline substantially, and individuals are thereby able to maintain a certain level of liquidity by substituting securities for real cash balances.*38


It would seem then that the "premium" the individual pays for the marginal dollar of precautionary balances is measured by the interest forgone by not purchasing a dollar's worth of "highly liquid" securities. But Mises denied this implication by stating that to regard "interest as compensation for the temporary relinquishing of money [is a view of] insurpassable naivety."*39 Elsewhere Mises was even more explicit about this matter when he denied that the demand for real cash balances is in any way interest elastic: he wrote that there is no direct connection between the rate of interest and the amount of money held by the individuals who participate in the transactions of the market.*40 Thus while Mises did describe something approximating a liquidity-preference demand for real cash balances, he insisted (without argument) that there is no regular functional relationship between the interest rate and the demand for such balances.


In the end Mises viewed real cash balances as something individuals must hold because of the structure of the payments mechanism and the uncertain nature of the world in which they live. While the size of an individual's real balances is a subjective matter determined by his own appraisal of his economic situation and subject to revision from time to time, the individual views these balances as sort of the dues he must pay in order to successfully participate in the market economy.*41 Certainly they provide the individual with utility but only in the same way that the legal order provides individuals with utility—real balances are merely part of the framework within which market action takes place.


Thus Mises' writing reveal a tendency to view the individual's desired level of real balances as something relatively constant and determined by the structure of the world in which he operates and the way he perceives that world. This approach is actually a retrogression from Menger's concept of the demand for money. In his late writings Menger argued that the bulk of the cash balances are held by individuals for speculative purposes. For Menger, market prices are subject to wide dispersion over both time and place; consequently, individuals hold money balances in search of "bargain prices." For example, an individual seeking to purchase a "used" typewriter must have the ready cash to move into the market for typewriters without delay as soon as he spies a machine being offered on favorable terms. In this way, Menger called attention to the speculative demand for money that applies to all markets wherever future prices are uncertain.*42


Although the holding of speculative balances means forgoing the opportunity of purchasing an interest-bearing asset, this loss promises to be offset by the marginal capital gain of buying a commodity on more favorable terms than would otherwise be possible. Clearly, a lowering of the market rate of interest must encourage an increased holding of real balances for speculative purposes, and hence the liquidity-preference approach is entirely consistent with Menger's treatment of the demand for money. In Menger's view, the speculative balances held by individuals are a rational response to a world of uncertain prices, and balances held for this purpose are actually a type of investment, the rate of return on which can be measured by the expected capital gain of the individual.


Without explanation Mises simply rejected the Mengerian notion of an investment demand for money except during the exceptional times of monetary crisis. Mises agreed with Menger that during the long evolutionary period before a single money came into existence the competing media of exchange had to be marketable over both time and place. However, with the appearance of highly developed markets for the resale of interest-bearing property, this store-of-value function of money loses importance, as few will demand real cash balances for investment purposes when they can own interest-bearing assets instead. Here Mises simply failed to recognize that from the economic point of view speculative balances are not "barren" but perform a valuable service for the individual.*43


If it were possible to measure the amount of price variation that characterizes each market in the economy, the resulting "coefficients of price variation" would come out lowest for those markets in which standardized commodities like bread, milk, and other articles of final consumption are sold and highest for the markets in which the industrial ovens for baking bread and the machinery needed to process the milk are sold. What I have in mind here is that capital goods transactions as well as all other transactions that involve other highly specialized goods may offer an opportunity for speculative behavior that does not exist in markets closer to the consumer. If this is true, a lowering of the market rate of interest will produce not only an increased demand for speculative balances but also an increased trade in markets for what Menger called "higher order" goods. This may result in a deepening of the capital structure, something that both Mises and later Hayek described as characteristic of the boom period of the business cycle, when banks encourage borrowing by lowering the market rate of interest. It is unfortunate that Mises overlooked Menger's speculative demand for money and the implied interest elasticity of the demand for real balances, because it really opens a line of investigation that might have proved quite congenial to his own work on the business cycle.*44


To summarize: Mises explained the individual's demand for real cash balances in terms of both the transactions and precautionary motives, motives that depend on "the organization of the whole social apparatus of production and exchange" and not on either the interest rate or the individual's own wealth position. Thus while real cash balances enter into the individual's utility function (as they must since they are the object of purposive market action), they enter into it as a fixed magnitude. The individual forms no estimate of the marginal utility of real cash balances but only of the marginal utility of the monetary unit so that he may decide how many units of the money commodity he must hold in order to have some already decided fund of real purchasing power. Patinkin's formulation of the demand for (real) cash balances, which emphasized the substitution effect between real balances and other forms of nonmonetary wealth, applies the marginal utility theory directly to the question of what level of real balances is optimal and hence is a more general development of the strand of marginal utility analysis Mises pioneered.*45


Why did Mises apply the marginal utility theory to the demand for the money commodity rather than to the demand for real balances, which the money commodity only represents? I believe the answer has to do with Mises' unwillingness to include anything but goods of final consumption in the individual's untility function.*46 This explains why Mises emphasized that the marginal utility of money must be defined in terms of the marginal utility of the commodities that money is exchanged for in the market. But in other places he mentioned the twin services money provides as a bridge between payments and receipts and as a fund of real purchasing power against future unforeseen contingencies. Yet it is not enough that real cash balances are serviceable to wants because they satisfy them in a manner different from all other commodities. Mises explained that, when an individual destroys, say, one dollar's worth of milk, the (real) national product falls, but when that same individual burns a dollar's worth of the money commodity, the (real) national product remains unchanged.*47 Let us elaborate on the relationships involved here in more detail. The immediate impact of the destruction of a dollar's worth of money is to lower the in- dividual's real cash balances by one dollar. If the individual seeks to reestablish his level of real purchasing power, he must consume fewer commodities in the market. This brings about a tendency for market prices to fall just a little, and everyone else's real cash balances to rise just a little. As the other individuals increase their consumption in order to reduce their real cash balances to their desired level, the essentially release the money the first individual is looking for. In equilibrium once again, the stock of money has fallen by one dollar, the price level is a bit lower, but all real magnitudes are left unchanged, including each individual's real cash balances, which have returned to the original level.*48


Certainly, this suggests that the marginal utility of the money commodity must be zero, since the loss of one unit ultimately results in the loss of nothing real. Mises may well have been troubled by this conclusion, because it implies that individuals seek to acquire something which in the aggregate they really do not want—a position that strikes a sour note among economists who view man as a purposive agent. Had Mises realized that the marginal utility theory should be applied to the services provided by real cash balances and not to the money commodity itself, a great deal of obscurity in his discussion might have disappeared. But the year was 1911, and there was much more that had to be said before J. R. Hicks could at last clarify the distinction between the demand for money and the demand for the services provided by money in his famous 1935 article.*49


Thus we have seen that Mises' statements about the form the utility theory must take when applied to the demand for money are largely incorrect and result from a failure to distinguish adequately between the "utility of money" and the "utility of the services provided by money." Patinkin's technique of counting real balances as a part of the individual's wealth, and thereby incorporating real balances directly into the individual's utility function, permits the development of a theory of the demand for money that is not related to historical prices. But while Patinkin's approach offers much in the way of generality, something is also lost. In the Patinkin barter-money model the money commodity can be any of the many commodities available, since all commodities are assumed to be freely tradable in all markets. The barter economy is transformed into a money economy by the deceptively simple assumption that "the nth commodity is money." In the Mises formulation, however, the whole point of the analysis is to explain the exchange value of a commodity that is different from all others because it is freely tradable on all markets. Whether the gains in historical realism offered by Mises' approach are worth the sacrifice of the theoretical compactness of Patinkin's approach and whether the two approaches can be combined are questions worth discussing, especially in light of Clower's criticisms of the barter-model approach.*50 I shall not stop to consider this problem here.


2. One of the principal contributions of the Theory of Money and Credit is the consistency with which Mises explored the implications of the fact that individuals consult the past behavior of market prices when planning the current size of their cash balances. Here historical prices are used to develop a bold empirical hypothesis about the way expectations about future prices are formed. In this area I consider Mises' contributions to be of great doctrinal importance.


Mises employed the hypothesis that the past behavior of prices affects current planned cash holdings to explain why, in countries where inflation has been most rapid, "the decrease in the value of the money has occurred faster than the increase in its quantity."*51 What happens, according to Mises, is that people come to expect the inflation to continue well into the future and, rather than have the purchasing power of their cash balances steadily erode, take actions to reduce their real cash reserves. This causes the inflation to accelerate as large numbers of individuals go about substituting commodities and securities for cash. It remained for later economists to develop a theory of the "optimal" demand for real cash balances at each level of inflation, but Mises was certainly one of the early developers of this line of thought.*52


Mises was also one of the earliest to explain why during prolonged inflations individuals experience a definite "shortage of money" when it is actually an "abundance of money" that is causing the inflation in the first place. What happens is that the individuals (anticipating an increase in the rate of inflation) allow their real cash balances temporarily to fall below their (long-run) desired level. In such circumstances the prices being asked and bid for most commodities are no longer related to the present quantity of money in circulation but to the future expected quantity of money. Individuals allow their cash balances to fall dangerously low in the expectation that their future money incomes will rise by enough to allow them to restore their cash balances to the desired level. If the monetary authorities suddenly lower the growth rate of the money supply, money incomes will not increase quickly enough to restore cash balances, and individuals will experience a definite shortage of money. They will complain to the monetary authorities about a lack of liquidity and will insist that all would be well if the monetary authorities would pursue a less restrictive policy. The inability of bankers to understand the causes of this shortage-of-money phenomenon soon leads them down the perilous path of stepping up the growth rate of the money supply.*53


Mises also applied his price-expectations hypothesis to the problem of "sellers inflation" and sketched an argument that is especially interesting in light of the current economic confrontations of a cartelized world economy. Mises explained that the modern economy is characterized by a wide variety of markets in which cartels, trusts, monopolies, and state-regulated prices predominate. Ordinarily, the profit-maximizing monopolist discovers the maximum price he can charge by raising his price and watching what happens to his sales. If sales fall off by enough to lower total receipts, the monopolist knows that he has gone too far. But during a prolonged inflation the buyers find it more economical to pay the higher price asked than to abstain and chance paying a still higher price later. In Mises' words, buyers pay the high prices in the hope of "screwing up" the prices of the goods they sell by enough to offset the difference. Thus the result is that market demand curves become more inelastic, and cash balances are reduced to raise the extra revenues. Thus the inflation indirectly leads to an increase in the monopoly power of existing cartels and creates the incentives for other cartels to be formed. This argument is an interesting one and may explain why the cartelization of industry and prolonged inflation are not separate events coincidently occurring at the same point in time but rather interconnected phenomena.*54


While the tendency among economists of Mises' day was to link the demand for cash balances to the current level of economic activity and then bring price expectations in as a sort of afterthought, Mises placed the past behavior of prices at the very heart of his conception of money. The hypothesis that the past behavior of price is the basis on which market participants form their expectations about future price behavior has proved extremely valuable in the econometric investigation of the demand for money, especially during severe inflations.*55 I do not think that Mises has been given adequate credit for having pioneered this approach.*56



There is an affinity between Wicksell's Interest and Prices and Mises' Theory of Money and Credit because both economists attempted to put the quantity theory on a firm basis by reconciling it with the then-recent marginal utility theory of value.*57 According to Wicksell, the marginal utility theory explains the structure of relative commodity prices but not the absolute level level of the prices themselves. The quantity theory, on the other hand, specifies the price level that is consistent with a given stock of money, volume of output, and "velocity of circulation," but does not explain the mechanism by which changes in the supply of money bring about changes in the level of prices. Wicksell resolved these difficulties by emphasizing the pivotal role cash balances play in linking the money and commodity markets. Every individual is required to hold a certain quantity of (real) money balances in order to conduct his ordinary economic affairs, and when his existing cash balances exceed (or fall short of) this required level, he must expand (or contract) his commodity purchases accordingly. This same behavior carried out simultaneously by large numbers of economic agents results in movements in the absolute level of commodity prices. In the event the money supply increases and (real) cash balances are larger than individuals desire them to be, the increased spending in the commodity market will raise the level of prices and lower real balances until the community is willing to hold the expanded stock of money. When actual (real) cash balances are once again equal to desired (real) cash balances for all individuals, the equilibrium level of prices has been attained.*58


There can be little doubt that Mises' own presentation of the cash-balance mechanism owed much to Wicksell. However, what disturbed Mises most about Wicksell's presentation of the cash-balance mechanism was his conclusion that the price level generally changes in direct proportion to changes in the quantity of money. What we shall call the "proportionality theorem" is based on the following reasoning: Since, in equilibrium, relative commodity prices are equivalent to the relative marginal utilities of the commodities whose prices are being compared, changes in the size of individual cash balances cannot affect relative prices unless they in some way alter the underlying marginal utilities for the goods in question. Furthermore, the marginal utility of commodities depends entirely on the relationship among the physical characteristics of commodities, their supply, and the hierarchy of human needs, and so alterations in cash holding that do not affect these underlying real magnitudes must leave relative marginal utilities unaltered. Thus when a monetary disturbance has finally worked itself out, all relative prices must be at their original values, which implies that if prices have changed, they must have changed in the same proportion. Said another way, Wicksell argued that changes in the quantity of money have a neutral impact on relative commodity prices.*59


Mises flatly denied that there was any way by which the physical quantity of money could be increased and relative commodity prices remain unaltered. According to Mises, even if it were possible by some magically defined formula to distribute a given increase in the money supply among individuals in such a way as to leave their relative wealth positions unaltered, demand curves still would not shift to the right by enough to raise prices proportionally. According to Mises, for this shift to occur, the marginal utility schedule of the money commodity must be a rectangular hyperbola so that, say, a doubling of the individual's cash balances lowers the marginal utility of the monetary unit by one-half. Mises dismissed this possibility by stating that it is an "absurdity" to assume that for each individual a doubling of money leads to a halving of the exchange value he ascribes to each unit.*60


What Mises evidently failed to realize is that this allegedly absurd assumption is implicit in his own account of the demand for money. If the individual demands a certain fund of real purchasing power and continually adjusts his nominal cash balances with this object in mind, then a doubling of his nominal balances will result in a halving of the marginal utility of the monetary unit. To escape this conclusion Mises would have to assume that the individual's demand for real cash balances is itself a variable subject to utility calculations. Then a doubling of the individual's nominal money balances would have the immediate effect of making him wealthier, which probably would increase his demand for real balances and prevent the marginal utility of the money commodity from falling by a full one-half.*61 But this approach requires that we include real balances within the individual's utility function, something that, as we have seen, Mises was not willing to do.


Mises also erred when he assumed that Wicksell's "proportionality theorem" necessarily requires that the marginal utility of the money commodity be inversely proportional to the size of the individual's nominal cash holdings. As Patinkin elegantly demonstrated for an economy where everyone's wealth position is permanently fixed, all that is required for a given increase in the money supply to lead to a proportional increase in prices is a positive excess demand for each commodity in each market until its price has finally doubled. This condition includes the situation Mises described as a special case.*62


Mises was on more solid ground when he argued that as a practical matter an increase in the physical quantity of money alters the ex- isting distribution of community wealth and hence cannot have the neutral effect on relative commodity prices that Wicksell and other advocates of the proportionality theorem supposed it would. In this context Mises criticized Irving Fisher for basing part of his defense of the proportionality theorem on a subtle confusion between a change in the physical quantity of money and a change in the accounting definition of the money unit. As Fisher explained in Purchasing Power of Money, when the government changes the denomination of money so that what was previously called a "half dollar" is now called a "dollar," all market prices change in the same proportion. Fisher claimed that this is an instance where a doubling of the nominal quantity of money is accompanied by a doubling of all money prices.*63 Mises explained, however, that only the accounting definition of the monetary unit has been changed, not the actual quantity of money. If tomorrow the Bureau of Weights and Measures decrees that all one-inch units are to be renamed "one foot," and all twelve-inch rulers renamed "four yards," and so on, only a fool would insist that the absolute size of all real objects has increased. Changes in the accounting definition of money are of a purely legal, or stipulative, nature and do not necessitate a process of market adjustment.*64


In Mises' view, every increase in the physical quantity of the money commodity must manifest itself as an increase in the cash balances of one or more economic agents in the market. For this reason, a successful reformulation of the quantity theory must begin with the brute fact that an injection of new money into the economy always results in an increase in the cash balances of certain individuals and never in the cash balances of everyone at once. According to Mises, the economic consequences of this phenomenon necessarily give rise to a redistribution of wealth and hence to an alteration in relative commodity prices. Suppose (under a fiat standard) the monetary authorities print a new batch of money to pay for the completion of a highway project. The members of society directly involved in the highway project find their cash balances greater than they expected and go out to spend the new money on commodities and various financial assets.*65 This increased expenditure brings about a tendency for prices to rise, especially the prices of products favored by the recipients of the new money. However, the money that is spent shows up as an increase in the cash balances of other individuals, and the rise in prices spreads to other commodities. This inflationary process continues and reduces the real balances of individuals but not to the same extent. Individuals "weigh" the impact of a change in relative prices differently, and hence some individuals will judge the decline in the purchasing power of money to be very great, while others may view it as being quite small. The more heterogeneous the consumption patterns of individuals (i.e., the wider the currency area), the less reliable will be any single "price index" as a measure of the decline in the purchasing power of the money commodity.*66 When a new equilibrium "price level" is finally attained, the now larger stock of money will be distributed among the market agents in such a way that each is holding his desired level of real purchasing power in the form of cash balances once again. In this new equilibrium position those individuals who were the first to receive the new money (i.e., the highway people) will probably find their wealth positions increased, and those who were the last to receive the new money will probably find their wealth positions worsened. What has happened is that the increase in the quantity of money has given rise to a process of market adjustment that has altered the relative wealth positions of individuals.*67


It may happen that when relative and absolute prices change so as to make all economic agents once again content with the size of their cash balances, the shift in wealth ends up favoring those individuals with high propensities to save. Secondary effects will be promoting the accumulation of capital, lowering the "natural" rate of interest, and augmenting the productive capacity of the nation. In this way an increase in the quantity of money brings about an increase in production—the well-known phenomenon of "forced savings." But it is just as likely that the increase in the quantity of money could result in "forced consumption" and the destruction of productive capacity. Mises contended that in most cases the phenomena involved are too complex for the monetary authorities to know in advance which tendency will prevail. The only thing that may be said for certain is that some redistribution will occur.*68


Mises correctly pointed out that the fundamental cause of these elusive "distribution effects" is the lack of simultaneity among various price changes. Those individuals who find their revenues increasing more quickly than their expenses are made wealthier while those in the reverse situation are made poorer. Mises explained (citing Fisher and Knies) that, if it were possible to fully anticipate the extent of the future decrease in the purchasing power of money, these wealth effects could be mitigated by altering contractual interest rates to include an "extra" compensation for the decline in the purchasing power of money. According to Mises, this does happen over short periods as the market rate of interest is observed to move upward during inflations.*69 Over a long period, however, it is difficult if not impossible for individuals to anticipate what impact changes in the purchasing power of money will have on personal standards of welfare.


It is worth mentioning that contemporary discussions of "real in-indebtedness effects" support Mises' contention that "once-and-for-all" type increases in the quantity of money will have nonneutral effects on the money economy. In a world where it is possible to convert transitory gains into permanent gains by buying and selling bonds, an increase in the quantity of money will not only alter relative commodity prices but will change the real rate of return on capital as well.*70 The "proportionality theorem" still has a place in contemporary monetary theory as a long-run proposition about the relationship between money and prices during prolonged, and therefore anticipated, inflations. Consider the situation where the money supply grows during each period by a certain fixed percentage. According to the standard analysis, after a transitional period during which desired real balances are reduced and long-term contracts "indexed," prices will rise continuously at the same rate as the money supply. The "new" money flows through the economy augmenting individual cash balances by enough to keep their real value constant, and the inflationary revenue that the money-issuing authorities receive is equal to the nominal value of the new money issued.*71 Much discussion has centered on the question of whether the benefits of inflationary finance exceed the burdens imposed on the economic community, but little discussion has focused on the problem Mises raised of the mechanism of market adjustment that these long-run consequences are supposed to follow.


In a world where individual cash balances simply grow in size automatically (like Frank Knight's famous Crusonia Plant), the "proportionality theorem" Would have some validity, inasmuch as the new money would never change hands and hence would never give rise to a lagged process of adjustment. But in a world where the money-issuing authorities introduce the new money by buying different types of goods, services, and financial assets (and at different points in time as well), the "first round" of monetary expansion affects the cash balances of individuals differently. To dramatize this point, let us consider the existence of just one individual named Miser Joe whose demand for real balances in infinitely elastic. If new money is given to Miser Joe, the process stops dead in its tracks, despite the fact that the percentage increase in the money supply may be the same in this period as it was in the preceding period. It seems that analysis of fully anticipated inflation requires not only that the rate of growth of money remain fixed but also that the route by which the new money enters and passes through the system stay the same from one period to the next. How this assumption is at all relevant to the historical process by which new money is injected into the economy by existing governments is a point that has not received adequate attention by contemporary theorists.



We have seen that the essence of Mises' approach to monetary economics consists of the view that not only the size of the increase in the money supply but also the route by which the new money enters and makes its way through the economic system affect the final market outcome. It was in applying this method of analysis to a problem raised by Wicksell's famous theory of cumulative expansion that Mises laid the foundations of the Austrian theory of the trade cycle.


In Wicksell's analysis of bank credit expansion, the commercial banks by holding the market rate of interest below the real rate of interest bring about a cumulative increase in the demand for bank loans and consequently a cumulative increase in commodity prices. The problem Wicksell raised in Interest and Prices is whether there is an automatic "brake" on the process of bank credit expansion that would prevent the rise in prices from going on indefinitely if the bank authorities keep the market rate of interest below the natural rate and are willing to meet all demands for credit. Wicksell argued that the prices of credit expansion must come to a halt when the reserved-deposit ratio of the commercial banks falls below the legal limit or simply becomes too low for the bankers' own comfort. The banks, fearing either "fines" or a full-scale liquidity crises, raise the money rate of interest, and the inflation comes to a halt with absolute prices remaining permanently higher. In the case of a pure fiat system in which there are no required reserves or convertibility pledges to worry about, the cumulative expansion of the money supply and subsequent inflation can continue as long as the bankers keep the money rate of interest below the real rate of interest.*72


Mises found Wicksell's analysis of the problem unsatisfactory, and in the third part of his Theory of Money and Credit he tried to explain why the cumulative expansion process must come to an end even under a pure fiat system.*73 According to Mises, when the commercial banks encourage additional borrowing by lowering the market rate below its natural level, entrepreneurs are encouraged to make more long-term investments, that is, to lengthen the "period of production."*74 With the newly issued bank money entrepreneurs bid resources out of the production of consumption goods into the production of capital goods despite the fact that no additional planned savings has taken place. Consumer prices must rise to generate the "forced savings" required to make the increased capital goods construction possible. Finding wages and resource costs higher than expected, the entrepreneurs turn to the banks to demand a larger quantity of money than before. Mises believed that the size of the money supply would increase not only absolutely but proportionately as well, so that the Wicksellian cumulative expansion process could not go on indefinitely without a collapse of the monetary order under the strains of hyperinflation.*75 The only alternative to the destruction of the monetary order is for the banks to restore equality between the money rate of interest and the natural rate of interest, in which case the sudden cutoff of entrepreneurial loans will require the liquidation of partly completed projects and the transfer of resources to other parts of the economy.*76


The details of the theory are sketchy, and Mises failed to prove that the rate of growth of the money supply must necessarily accelerate when the market rate is held below the natural rate. It remained for Mises' student F. A. Hayek to develop Mises' idea into a full-fledged theory of the modern trade cycle.*77 The Mises Hayek theory of the business cycle centers around the idea that the route by which newly created money enters the economy is essential in determining its impact on the monetary order. The analysis treats increases in the quantity of money as necessarily involving changes in relative prices and transfers in wealth among individuals. If present-day monetary economics seems far removed from the concerns of Mises and Hayek, the only reason is that it treats all increases in the quantity of money as being essentially alike and disregards the question of the "transmission mechanism" by which the new money makes its impact felt on the money economy by assuming relative prices are (after a brief transition period) left unchanged.



Having come to the end of my survey of the monetary economics of Ludwig von Mises, I would like to say a few words about his con- tribution to the theory of economic policy. Mises favored an international monetary mechanism that would constrain the money-issuing proclivities of modern governments. He recognized that one of the great threats to the liberal ideal of a free, mobile, and prospering world economy is the tendency on the part of government to increase state coffers by using the "printing press' rather than by borrowing or issuing new taxes. For Mises the guaranteed consequence of this policy, which he termed "inflationism," is the wholesale redistribution of the wealth and property of individual citizens. This redistribution is accomplished, not by the method of parliamentary debate and legislative action, but by haphazard and cruel method that leave the poorest and most disadvantaged segments of the population worse off than before. In Mises' view the great threat to the survival of democratic ideals and the organization of modern industrial life is a hyperinflation that would ravage the world economy like an angry fire, destroying the property and aspirations of the masses and creating conditions for military takeover and total state control.*78


As a practical matter, Mises favored commodity gold standard whereby each government would have to maintain the convertibility of money in terms of gold. Any policy of inflationism would be short lived in the wake of declining gold reserves, or the state would suffer the diplomatic embarrassment of having to redefine its currency unit in terms of gold. Mises, of course, realized that the resource costs of such a monetary arrangement are high, and the system itself is never totally insured against sudden and sometimes massive changes in the quantity of money that originate from, say, technological innovations in the processing of gold or new mine discoveries.*79 But the virtue of the arrangement is not that it makes it too costly for the size and growth of the money supply to become an object of government policy. Mises preferred the impersonal mechanisms of the market, no matter how imperfect, to the whims and gluttonous excesses of power-hungry politicians. In Mises' view, the strategy that is currently favored in liberal quarters, that of moving toward a less expensive fiat currency system while urging the monetary authorities to pass parliamentary decrees limiting their own appetities, is as idealistic as expecting a child not to eat candy placed in his hand.


Following Wicksell, Mises called attention to the fact that commercial banks issue deposits that act as a substitute for currency in the cash balances of individuals.*80 According to Mises, the specific way by which banks create money under fractional reserve arrangements and the manner in which they introduce the new money into the economic system necessarily bring about an overinvestment of resources in capital goods production and the need for subsequent business readjustments. For this reason, Mises paired his advocacy of the gold standard with a system of free (competitive) banking in order to eliminate the possibility of severe business downturns.*81


By modern-day standards Mises must be termed a "monetarist," for he surely believed that changes in the quantity of money are the primary cause of aggregate instability. In one respect, however, Mises was even more radical in his monetarism than traditional advocates of the quantity theory, such as Wicksell, Fisher, and Friedman; for he refused to consider the "proportionality theorem" as being at all relevant to the experiences of modern money economies. The proportionality theorem suggests that there are circumstances in which changes in the quantity of money can lead to changes in the absolute level of commodity prices but level all real economic magnitudes (i.e., relative prices) unchanged. For Mises there are no circumstances in which the modern technology of money creation permits it to have a neutral impact on the money economy. In short, not only does money matter, but it matters all the time!

Notes for this chapter

The first edition of Ludwig von Mises' Theory of Money and Credit appeared in German in 1912 under the title Theorie des Geldes und der Umlaufsmittel. The second German edition appeared in 1924 and included two previously published articles, one on the classification of monetary theories and the other on the policy of postwar (World War I) deflation. In 1934 the second German edition was translated into English by H. E. Batson and published under the title The Theory of Money and Credit,with an introduction by Lionel Robbins (London: Jonathan Cape, 1934). In 1953 a new English edition included an essay "Monetary Reconstruction" (New Haven: Yale University Press, 1953). Mises' writings on Monetary theory, inflation, and the trade cycle appeared in a number of other places as well; see Bettina Bien [Greaves], The Works of Ludwig von Mises (Irvington-on-Hudson, N. Y.: Foundation for Economic Education, 1969), esp. p. 57. Three important monographs by Mises on monetary questions written between 1923 and 1931 are in the process of being translated. The first monograph, entitled Geldwertstabilisierung und Konjunkturpolitik (Jena: Gustav Fischer, 1928), is of special interest because here Mises elaborated on the process by which bank credit expansion distorts relative prices and brings about the conditions of economic crisis. This mechanism is only touched on in his Theory of Money and Credit (see my discussion, section 3). The second monograph, Die Ursachen der Wirtschaftskrise: Ein Vortag (Tübingen: J. C. B. Mohr, 1931), criticized the antidepression policies at the time of the Great Depression. The third monograph, Die Geldtheoretische Seite des Stabilisierungsproblems (Leipzig: Duncker & Humblot, 1923), applied the theory of monetary inflation to the events leading up to the collapse of the German mark. With these exceptions and another regarding his theory of interest (see note 57 below), Mises did not alter his position or significantly change his formulation of any of the main topics discussed in this paper, so that his entire monetary economics was essentially intact in the 1912 volume. All references in this paper are to the 1953 English edition.

Irving Fisher's Purchasing Power of Money first appeared in New York in 1911, and this is the edition to which Mises referred. I shall cite the revised edition of Fisher's book; it appeared in 1913 and was reprinted (New York: Augustus Kelley, 1963). Alfred Marshall's Money, Credit and Commerce appeared in London in 1923 and was reprinted (New York: Augustus Kelley, 1965).

Knut Wicksell, Geldzins und Guterpreise (Jena: Gustav Fischer, 1898) trans. R. F. Kahn, with an introduction by Bertil Ohlin, under the title Interest and Prices: A Study of the Causes Regulating the Value of Money (London: Royal Economic Society, 1936). The 1936 translation also contains a reprint of Wicksell's 1907 lecture"The Enigma of Business Cycles," translated by Carl Uhr. All references in this paper are to the reprint of the 1936 edition of Interest and Prices (new York: Augustus Kelley, 1962).
From 1934 until 1940, when he immigrated to the United States, Mises served as professor of international economic relations at the Institut Universitaire de Hautes Études Internationales in Geneva, Switzerland. In 1945 Mises was named visiting professor at the Graduate School of Business Administration of New York University; he remained there until his retirement in 1969. For additional biographical information, see my introduction.
Cf. Carl Menger, Principles of Economics, trans. James Dingwell and Bert F. Hoselitz, with introduction by Frank H. Knight (Glencoe, III.: Free Press, 1950), pp. 226-85; and Mises, Theory of Money, pp. 30-37.
The Austrians themselves were not always clear about the distinction between "purchasing power" and "marketability"; see, for example, Menger, Principles, pp. 241-42. the importance of this distinction was argued by R. W. Clower in "A Reconsideration of the Microfoundations of Monetary Theory," Western Economic Journal 10 (December 1967): 1-8.
Menger, Principles, pp. 357-71. Cf. Friedrich A. Hayek, The Counter-Revolution of Science: Studies on the Abuse of Reason (Glencoe, Ill.: Free Press, 1955), pp. 82-83.
Mises, Theory of Money, pp. 111-14. Cf. Wicksell's contribution discussed in section 2.
See, for example, Menger, Principles, pp. 145-48, 157-61; see also Mises, "Remarks on the Fundamental Problem of the Subjective Theory of Value," Epistemological Problems of Economics (Princeton: D. Van Nostrand, 1960), pp. 167-82.
Mises distinguished between the juristic and the economic points of view and insisted that demand deposits and bank notes are money because they perform the economic function of money regardless of whether or not they have commodity backing (Theory of Money, pp. 275-77). On the evolution of banking practices and the substitution of "fiat" for commodity money, see Theory of Money, pp. 297-338. Cf. Wicksell, Interest and Prices, pp. 62-80.
Hicks introduced this phrase in order to ridicule the Misesian concept of money because it tried to offer a historical explanation for the value of the money commodity (see discussion below); for our purposes, however, Hicks's phrase may be used to dramatize how advanced Mises' notion of money actually was for its time (J. R. Hicks, "A Suggestion for Simplifying the Theory of Money," Economica 2nd. Ser., 2 February 1935: 1-19; reprinted in Friedrich a. Lutz and Lloyd W. Mints Reading in Monetary Theory [Homewood, Ill.:1951] pp. 14., Cf. Mises' criticism of Wicksell's cumulative process, section 3 below.
See, for example, Mises, Theory of Money, pp. 109, 119.
By using 'yesterday's" prices to explain the current demand for money and thereby "today's" prices, Mises is open to the charge of explaining prices by means of prices and hence arguing in a circle. Mises, aware of this objection, developed what he termed the "regression theorem" to explain how past values could be consistently introduced into a theory of the value of money without arguing in a circle. Mises explained that when we regress and explain "today's" prices by "yesterday's" and "yesterday's" by the "day-before-yesterday's," and so on, we ultimately come to a point in the past when the earliest form of the money commodity emerged. At this time, money took the form of a marketable commodity valued entirely for its nonmonetary uses. Here its market (objective) value was the outcome of the interaction between its supply and the hierarchy of human wants. At this point the historical regression stopped because in principle past price behavior is not needed to determine the market value of this commodity since it has not emerged as "money." Thus Mises' regression theorem states that any object presently used as money is ultimately linked to some commodity that was originally directly serviceable to men's wants, and furthermore, if this link did not exist, society (the collection of valuing minds) would have no epistemological basis for estimating the exchange value of money. The obvious implication of this theorem is that government, no matter how powerful, cannot introduce an object as money unless it first defines that object in terms either of a money already existing or of a commodity whose market value is already established. Once defined in this way, the value of the money commodity eventually (over time) comes to be governed by the behavior of historical prices, and its nonmonetary uses take on a subordinate and sometimes insignificant role (Mises, Theory of Money, pp. 120-23). On the circulatrity problem, see Patinkin, Money, Interest, pp. 114-16, 573-75. Cf. Mises' discussion of pre-World War I literature in Theory of Money, pp. 114-22.
Mises, Theory of Money, p. 97.
Ibid, p. 135. Cf. Menger's discussion of commodities as assets (Principles, pp. 241-56).
Mises, Theory of Money, p. 120.
Patinkin, Money, Interest, pp. 3-43.
Ibid, p. 17.
Mises, Theory of Money, pp. 134-35. Cf. Wicksell, Interest and Prices, pp. 39-40; and Patinkin's remark on the significance of this passage in Money, Interest, pp. 581-82.
Mises explained how, with the development of deposit banking, the larger part of these transaction balances is held in the form of checking accounts (Theory of Money, pp. 132, 302-5). On the historical increase in transactions demand for money, Mises wrote, "The characteristic feature of the development of the demand for money is its intensification; the growth of division of labour and consequently of exchange transactions, which have constantly become more and more indirect and dependent on the use of money..." (ibid. p. 151). Mises criticized those who maintain that the transactions demand for money is proportional to the volume of transactions, anticipating Baumol's inventory model by many years.
"Every economic agent is obliged to hold a stock of the common medium of exchange sufficient to cover his probable business and personal requirements" (Mises, Theory of Money, p. 132). Later Mises wrote, "The uncertainty of the future makes it seem advisable to hold a larger or smaller part of one's possessions in a form that will facilitate a change from one way of using wealth to another, or transition from the ownership of one good to that of another, in order to preserve the opportunity of being able without difficulty to satisfy urgent demands that may possibly arise in the future for goods that will have to be obtained by way of exchange. So long as the market has not reached a stage of development in which all, or at least certain, economic goods can be sold (i.e. turned into money) at any time under conditions that are not too unfavourable, this aim can be achieved only by holding a stock of money of suitable size" (ibid., pp. 147-48).
Ibid., p. 353. In an accompanying note Mises identified Law, Cieszhowski, Proudhon, and Macleod as subscribing to this view. According to Hicks, the liquidity preference theory is original with Keynes (A Treatise on Money, 2 vols. [London: Macmillan & Co., 1930]) and is the essence of Hicks own suggestion for simplifying the theory of the demand for money (A Suggestion, p. 16). Hicks overlooked Menger's contribution to the subject; see my discussion in section 1.
Mises, Theory of Money, p. 346; see also pp. 148, 350. In these passages Mises referred to the "natural rate" of interest or the real rate of return on capital. At another point in his discussion he admitted that, as bond prices rise, individuals may increase their demand for cash balances, which is equivalent to saying that there is an inverse relationship between the money rate of interest and desired cash balances (ibid., p. 143). What Mises apparently wished to say is that while a temporary change in the demand for cash balances could lead to a change in the money rate of interest, an interest-elastic demand for money could not exist in the long run because there are automatic market forces that will bring the money rate into line with the natural rate (see section 3). There could, however, be an indirect relationship between money and interest through the creation (or destruction) of capital (see section 2).
Mises nowhere stated this exactly; but the notion that an individual continually reassesses his need for real cash balances in light of day-to-day-changes in market conditions seems alien to Mises' discussion. He did at one point, however, hint that the demand for real balances may be partly dependent on the individual's wealth position, which does suggest a modern view of the subject. Mises wrote, "Every separate economic agent maintains a stock of money that corresponds to the extent and intensity with which he is able to express his demand for it in the market" (Theory of Money, p. 207). See also discussion, ibid., p. 150.
For this interpretation of Menger, I am indebted to Erich W. Streissler, "Menger's Theories of Money and Uncertainty—A Modern Interpretation," in Carl Menger and the Austrian School of Economics, ed. J. R. Hicks and W. Weber (Oxford: Clarendon Press, 1973), pp. 164-89. Streissler's discussion of Menger's view on the speculative demand for money was based on an article entitled "Geld," which Menger contributed to Handwörterbuch der Staatswissenschaften; it was reprinted in The Collected Works of Carl Menger, ed. Friedrich A. Hayek (London: London School of Economics and Political Science, 1936) 4: 1-124. The article went through several editions between 1891 and 1909, the time when Mises was attending the University of Vienna, yet, apparently, Mises did not notice the argument.
Mises wrote that "hoarding cash as a form of investment no great part in our present stage of economic development, its place having been taken by the purchase of interest-bearing property" (Theory of Money, p. 35).
Menger denied the relevance of an "equilibrium market price" completely; see Streissler, "Menger's Theories of Money," p. 169. I think it more in keeping with later Austrian thought to deny its relevance to "capital goods" type transactions: see ibid., pp. 171-89. Cf. Donald A. Nichols, "Market Clearing for Heterogeneous Capital Goods," Micreocomomic Foundations of Employment and Interest Theory, ed. Edmund S. Phelps et al. (New York: W. W. Norton & Co., 1970), pp, 394-410.
Patinkin, Money, Interest, pp. 78-116; and esp. pp. 574-75.
see discussion in Mises, Theory of Money, pp. 79-90.
Mises wrote somewhat mysteriously, "The laws which govern the value of money are different from those which govern the value of consumption goods. All that these have in common is their general underlying principle, the fundamental Economic Law of Value" (ibid., p. 86).
Our analysis has conveniently ignored "distribution effects," which Mises claimed accompany all monetary disturbances of any magnitude: see section 2. Cf. Milton Friedman, The Optimum Quantity of Money and Other Essays (Chicago: Aldine Publishing Co., 1969), pp. 14-15.
See note 10 above.
See note 5 above for reference to Clower's work.
Mises, Theory of Money, p. 227.
Mises believed that "a money which continually fell in value would have no commercial utility," that is, the money would cease to be money (ibid). This position is false on both empirical and theoretical grounds. Consider a constant decrease in the value of money of, say, 10 percent a year. The individual would not reduce his real cash balances continually but only until the marginal benefit from a unit of real balances was equal to the (now expanded) cost of holding money. See Friedman, The Optimum, pp. 8-14.
See Mises' discussion of 'panic prices' in Theory of Money, pp. 228-29.
Ibid., pp. 162-65.
Philip Cagen, "The Monetary Dynamics of Hyperinflation," in Studies in the Quantity theory of Money, ed. M. Freidman (Chicago, 1958), pp. 25-117.
It is usual to credit Irving Fisher and not Mises with the "price anticipation effect"; see, for example, John T. Boorman and Thomas M. Havrilesky, Money Supply, Money Demand, and Macroeconomic Models (Boston: Allyn & Bacon, 1972), pp. 208-9. Certainly Fisher's Purchasing Power of Money and his Rate of Interest (New York: Macmillan Co., 1907) predated Mises' Theory of Money. It seems to me that Mises' discussion of price expectations and how they affect the decision to hold cash balances is sufficiently different from Fisher's discussion to warrant some academic recognition. Edmund Phelps credited Mises, rather than Fisher, in "Money Wage Dynamics and Labour Market Equilibrium," in Microeconomic Foundations, p. 129.
An important thesis of this paper is that Mises (like Wicksell) was an admirer of the quantity theory but critical of Fisher's mechanical version of that theory, which tends to ignore the role individual cash balances play in linking the commodity and money markets. On Mises as an adherent of the quantity theory, see Theory of Money, pp. 130, 146-54. On Wicksell as a supporter of the quantity theory, see Patinkin, Money, Interest, p. 587, for references to Wicksell's writings. I wish to emphasize that I am concerned here with Mises' monetary economics and their relationship to Wicksell's early monetary theories. Thus, I make no attempt to trace the evolution of Wicksell's own ideas or to discuss his debate with Mises, which occurred after the publication of the Theory of Money and Credit. Wicksell's later views on money are in his Lectures on Political Economy 2 (London: Routledge & Kegan Paul, 1935); see also Carl G. Uhr, Economic doctrines of Knut Wicksell (Berkeley: University of California Press, 1960), pp. 198-327.
Wicksell, Interest and Prices, pp. 18-28.
Ibid. Mises dated the "proportionality theorem" to Hume and Mill (Theory of Money, pp. 139-40). The doctrine, however, can be located in the sixteenth-century writings of Jean Bodin and the Spanish Scholastics. What disturbed Mises was that while the general theory of price had advanced beyond the naive notion that price is proportional to the ratio between demand and supply, monetary theory had not (cf. Mises, Theory of Money, pp. 128-30).
Ibid., pp. 141-42.
See Patinkin's distinction between an "individual demand curve for money" and a "market equilibrium" curve in Money, Interest, pp. 24-31.
Ibid., pp. 50-59.
Fisher, Purchasing Power, pp. 29-30.
Mises, Theory of Money, pp. 143-45.
Compare this treatment of the consequences of an increase in the quantity of money with the gold-discovery example offered by Mises in Theory of Money, pp. 137-45.
Cf. Mises' criticism of "price averages" in Theory of Money, pp. 188-94.
When prices start on an upward course, the first recipients of the new money may find that their real balances have fallen and that they must now resell some of the nonmonetary commodities that they originally purchased with the new money. If transactions costs are large enough, they may find that their final wealth position is lower than before they received the new money. Thus the rule that the first recipients of the new money are gainers need not necessarily be true. The reason governments gain by issuing new money is that they generally find themselves in a "debtor" position and the inflation reduces the real value of their liabilities (ibid., p. 139).
See Mises' discussion of "forced savings" in Theory of Money, pp. 346-52.
Mises credited Karl G. A. Knies Geld und Kredit (Berlin: Weidmann, 1876) and Fisher's Rate of Interest (New York: Macmillan Co., 1907) for explanations of the impact of price expectations on interest rates (Theory of Money, pp. 200, 454). In more recent literature the rise in interest rates during prolonged inflation is sometimes termed the "Gibson paradox." This phenomenon was correctly understood by Mises.
Patinkin wrote that "a doubling of the quantity of money can in general be expected to affect both equilibrium relative prices and the rate of interest. Specifically, the relative prices of those commodities favored by debtors will rise, while those favored by creditors will fall. Similarly, the (real) interest rate will rise or fall, depending on which of two countervailing forces is stronger: the decrease in the demand for bonds, caused by the worsened real position of creditors; or the decrease in the supply of bonds, caused by the improved real position of debtors" (Money, Interest, p. 74).
See, for example, Friedman, The Optimum, pp. 16-21.
See Don Patinkin, "Wicksell's Cumulative Process, "Economic Journal 62 (1952): 835-47; reprinted in Patinkin, Money, Interest, pp. 588-97.
Mises, Theory of Money, pp. 355-57.
In the preface to the second German edition of the Theory of Money (see note 1 above), Mises explained that he was adopting Böhm-Bawerk's terminology because it was best known to his readers, but he stated that his own views on the determination of the (natural) rate of interest were now (i.e., 1924) different. His criticisms of Böhm-Bawerk finally appeared in. Nationalökonomie (Geneva, Switzerland: Editions Union, 1940), pp. 439-44. An English translation of these passages was completed by Bettina Bien Greaves and Percy L. Greaves, Jr., in Mises Made Easier: A Glossary for Ludwig von Mises' Human Action (New York: Free Market Books, 1974), pp.150-57. See also Ludwig von Mises, Human Action: A Treatise on Economics (Chicago: Henry Regnery, 1966), p. 488n. For Mises' own "time preference" theory of interest, see ibid., pp. 479—90. It so happens, however, that Mises' particular explanation of why Wicksell's cumulative process must end was not affected by his subsequent position on the nature and determination of interest.
We have seen that Mises did not consider the possibility of a continuous and fully anticipated price inflation of, say, 10 percent accompanied by an equivalent increase in the quantity of money with all distribution effects eliminated by appropriate "index clauses" in all contracts. Mises believed that in such circumstances individuals would continually reduce their desired cash balances propelling the economic system toward hyperinflation (see note 35 above). However, the argument used here with regard to bank credit expansion is a bit more subtle. Apparently, the initial lowering of the money rate below the natural rate alters relative prices making the prices of higher-order goods (i.e., capital goods) rise relative to lower-order goods (i.e., consumer goods). As consumer goods prices rise (because of the introduction of new money into the economy), capital goods prices must rise faster to maintain the ratio dictated by the lower interest rate. But consumer prices in the next period will rise still faster, and the system is propelled toward hyperinflation, which is intensified by the reduction of (real) cash balances mentioned above. Mises developed the mechanisms sketched here in more detail in his 1928 monograph Geldwertstabilisierung und Konjunkturpolitik.
This process of readjustment is, of course, a business depression. Mises claimed as much (Theory of Money, pp. 365-66).
See esp. Friedrich A. Hayek's early writings, such as Prices and Production (London: George Routledge & Sons, 1935), pp. 148-52; and Hayek, "Capital and Industrial Fluctuations," Econometrica 2 (April 1934): 152-67.
Mises, Theory of Money, pp. 435-57.
Ibid., pp. 138, 416-17; see also Mises, Human Action, pp. 471-76.
Though Wicksell did not include demand deposits in his definition of "money," he realized that an increase in deposits acts like money in raising prices. The purpose of his "cumulative process" discussion was to augment the quantity theory by describing the mechanism by which increases in bank reserves increase prices; cf. Patinkin, Money, Interest, p. 588. Mises was more "modern" than Wicksell because he defined "money" in a broader sense so as to include bank deposits (Theory of Money, pp. 278-96). See also translator's remarks, ibid., pp. 482-83.
Such an arrangement would not, according to Mises, encourage bank credit expansion but would actually retard it. Competition among the note-issuing banks would raise the reserve-deposit ratio. Any single group of banks found unable to meet their payments obligations would be declared "bankrupt" and their owners held libel under the usual arrangements of business law. Cf. Mises, Human Action, pp. 444-48.

Ludwig von Mises and The Theory of Capital and Interest, by Israel M. Kirzner

End of Notes

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