6 The Theory of Money and Credit

After completing the two essays on the bank’s foreign-exchange policy, I intended to proceed with work on my theory of money and credit. I had barely written the first pages when, in early January 1909, I was called to special military duty. The so-called “annexation crisis” had caused the government to take extraordinary measures and speed up the modernization of the artillery. I returned to Vienna in February, and on April 1, entered the Viennese Handelskammer. I found no time for scientific work during the first months on the new job; it was not until the fall that I was able to begin. The finished manuscript was in the hands of the publisher early in 1912.

The greatest difficulty I faced in preparing the book was that I had intended to deal with only a portion of the broad scope of economic problems. But economics must necessarily be a closed, unified system. One cannot extract bits and pieces and study them independently. In economics, there is no such thing as specialization. Whoever deals with a part must do so on the basis of a theory that encompasses all problems. Gratitude is due the old masters, but I was finding that I could not use any of the existing theories. I was advancing further down the path they had discovered. The system of Menger and Böhm-Bawerk was no longer fully satisfying to me. In fact, I was displeased by their treatment of the problems with which monetary theory must begin.

The reigning notion at the time stated that the theory of money could be neatly separated from the broader structure of economic problems—that it did not, in fact, actually belong within the field of economics, and was to a certain extent a discipline unto itself. In accordance with this notion, universities in Anglo-Saxon countries created special professorships for currency and banking. But the notion was false; it was my intention to reveal its untenability and return the theory of money to the study of economics.

I had already begun writing my theory of direct exchange, and would have included it in the first volume along with the theory of indirect exchange had I been able to take my time and work in peace. But I knew that we were standing on the eve of a great war, and there was not much time available to me. I wanted to complete my book before the war’s outbreak. Thus I made the decision to go beyond the narrow structure of monetary theory by a few points only, postponing a more comprehensive work. I believe the task was done justice.

I want to emphasize expressly that any quarrels I had with the works of Menger and Böhm-Bawerk had rather more to do with what they did not say than with what they did. I regretted their not having replaced John Stuart Mill’s inadequate delineation of the field of economics with a more satisfactory one. I disapproved of their lack of sharp criticism concerning the even more inadequate use of mathematical economics, as well as their failure to elaborate more clearly on their own point of view. Above all, I found that Böhm, in his discussion with Wieser, had neglected to touch upon topics that were of decisive importance.

The problems of assumed measurement of value, and the related problem of total value were points within the theory of money that I could not silently ignore, despite their belonging to general value theory. That there existed such a thing as “value calculation” or even “value measurement—that “value” of a total supply could be calculated from the known “value” of a part, and, inversely, that the “value” of a part could be obtained from the “value” of a whole—were notions that needed to be refuted if a theory of money was to be developed. One had to actually eliminate hypostasis of “value,” and demonstrate that there is an activity of valuing and there are acts of valuation, but that the term “value” is permissible only when limited to denoting an individually valued object, or to designating the result of a valuation process.

I disposed of these problems in the first few sections of my book, and in so doing, refuted the fallacies of Schumpeter and Irving Fischer. Cuhel’s book¹ proved useful to me in all of this. The author is forgotten today and his book is outdated; but I do not doubt that he, in the end, will hold the place of honor due to him in the history of our science.

The theories on determination and changes of the purchasing power of money take Menger’s theory of cash holding as a starting point. All further theories I had to construct anew. It is not my intention to present an excerpt from my book within these pages. I wish merely to remark on my method and its relevance.

Throughout my book I use the “step-by-step” method, a method being rediscovered today under the designations period analysis or process analysis. It is the only acceptable method. It renders the argument between short-run and long-run economics superfluous, and even the distinction between statics and dynamics becomes dispensable. If no condition is considered “normal”—if one is aware that the idea of “static equilibrium” has nothing to do with the life and action we study and is merely a mental image that is used in order to conceptualize human action through a state of nonaction—then one must recognize that it is always motion we are studying, but never a state of equilibrium. All of mathematical economics, with its beautiful curves and equations, is idle flirtation. The setting up of equations and the drawing of curves must be preceded by nonmathematical considerations; the setting up of equations does not broaden our understanding. Mechanical equations can be used to solve practical problems through the introduction of empirically acquired constants and data; but equations of mathematical catallactics cannot in the same way be of service to practical problems in the area of human action where constant relations do not exist.

In my book on money I made no use of polemics directed against the mathematical school. I presented the correct doctrine and refrained from attacking the method of mathematicians. I even withstood the temptation to unravel the vacuous term “velocity.” The death knell for mathematical economics was sounded when I proved that the money supply and spending power of the monetary unit are not inversely proportional. The proof demonstrated that the only constant relationship that was believed to have been found between “economic quantities” is in fact a variable determined by the data in each individual case. It also rendered Irving Fisher and Gustav Cassel’s equations of exchange obsolete.

The step-by-step analysis must take into account the passage of time. The time lag between cause and effect becomes a multiplicity of time differences between single, successive consequences. Upon examining these lags in time, one is led to a precise theory of the social consequences of change in the purchasing power of money.

In order to shed some light on the objections I raised earlier concerning the teachings of Menger and Böhm-Bawerk and to give some concrete examples that illustrate the difference between the older and the younger Austrian schools, I must address Böhm-Bawerk’s reaction to my theory. Both Menger and Böhm-Bawerk tacitly assumed the neutrality of money. They had developed the theory of direct exchange and held to the opinion that all problems of economic theory could be solved without the imaginary notion of money-free market exchanges. This teaching was now made untenable by my theory of the inevitable non-neutrality of money. But Böhm refused to admit this. He raised no objections to the cogency of my step-by-step analysis; he did not deny its results—namely, that changes in purchasing power of money cause prices of different commodities and services to change neither simultaneously nor evenly, and that it is incorrect to maintain that changes in the quantity of money, yield simultaneous and proportional changes in the “level” of prices. But he did maintain that this was a “friction phenomenon.” The old doctrine was correct “in principle,” according to Böhm. It would retain its full significance for an analysis of “purely economic action.” Reality presents resistance and friction, however, which would cause the result to deviate from that which would have been arrived at theoretically. I tried in vain to convince Böhm of the inadmissibility of the use of metaphors borrowed from mechanics. One can see in his twofold arrangement of the tasks of the price theory that Böhm was heavily influenced by the ideas of John Stuart Mill.² I could have convinced him had only I been clear about the basic problems. But I myself was still operating under the influence of Mill. It was only years later that I would be able to refute Böhm-Bawerk’s doctrine of “direct exchange advantage.”³ Writing the essay devoted to a critique of the doctrines of Menger and Böhm, I believe, was a way of erecting a lasting memorial to the two masters.

In the chapter dealing with the structuring of exchange ratios between different kinds of money I sought to restate Ricardo’s irrefutable doctrine, which had been suppressed by the “balance of payment” theory. Soon thereafter, Gustav Cassel presented Ricardo’s doctrine in inexpedient form and designated it the “purchasing power parity theory.” During the 1920s it was called one of two things: Cassel’s theory, if one agreed with it, and Mises’s theory, if one rejected it. But I repeat: it is Ricardo’s theory.

The second large problem with which my book dealt was that of fiduciary media. I had to create this new term in order to overcome the prevailing confusion surrounding the use of the term “credit.” If no distinction is made between the terms “commodity credit”⁴ and “fiduciary credit,”⁵ (Machlup offers the clever translations transfer credit and created credit), useful results can never be achieved. It is only by first making this distinction that the foundation can be laid for a correct critique of the doctrine of “elasticity” of bank media of payment; with this distinction the way is made free for the monetary theory of business cycle phenomena. I was given the honor of naming it the Austrian Trade Cycle Theory.

In the last section of my book, my concern was to discuss items that were of general interest at the time, namely, currency and banking problems. In concluding my book, I pointed out that prevailing notions on banking would soon lead to catastrophic events.

As could be expected, my book was rejected by German scientific journals in a most precipitous manner. I paid this little attention. I knew that my views would soon take hold. I saw with horror the catastrophe which I had predicted standing before the door.

New books that are “destroyed” by critics are lasting and valuable. He who only says what others want to hear is better off remaining silent. Knapp, Benedix, Liefmann, Diehl, Adolf Wagner, and Bortkiewicz, all celebrated “monetary theorists” in Germany at the time, have been forgotten.

The first economist to give my work any credit was B.M. Anderson in his book, The Value of Money, which appeared in 1919. Because Austria was at war with the United States, it was two years later that I first caught a glimpse of it.

John Maynard Keynes reviewed my book in the first issue of the Economics Journal that appeared after the outbreak of the war.⁶ Mr. Keynes gave the book some praise: “the book is not to be denied considerable merits... the book is enlightened in the highest degree possible.” But on the whole, Mr. Keynes was greatly disappointed.

My book seemed to him “not constructive” and “not original;” there is “no lift in the book.” And he added, “One closes the book, therefore, with a feeling of disappointment that an author so intelligent, so candid and so widely read should, after all, help one so little to a clear understanding of the fundamentals of his subject.” Sixteen years later,⁷ Keynes admitted that his knowledge of the German language was lacking. “In German,” he said, “I can only understand what I know already—so that new ideas are apt to be veiled from me by the difficulties of the language.” It was not my fault that Keynes found my book neither original nor constructive, and that it could not bring him to a clear understanding of the problems.