Exchange Rate Determination: Purchasing Power Theory

Mises also took a position at odds with the mainstream view on another important issue: the factors determining the exchange rate between two monies. To do so, he revived an older doctrine that had been displaced by the prevailing veil-of-money myth.

Because mainstream economists conceived of the value of money as a mere reflection of the value of underlying real commodities, it was only natural for them to stipulate that exchange rates too were merely a reflection of some real state of affairs. Thus the balance-of-payments theory enjoyed a virtual monopoly in higher economic education and guided the policies of the German and Austro-Hungarian central banks.⁶⁵ According to this theory, international monetary movements (and thus the exchange rate between different national currencies) tended to equal whatever rate equilibrated the relative weight of imports and exports of commodities and services, and of foreign credit and foreign debts. These real factors were the independent variables, whereas international monetary payments and the exchange rate were dependent variables. The political implication was that, when faced with an undesired depreciation in the exchange rate, governments had to act on those real factors to prevent their expression in monetary flows: they had to curtail imports through tariffs, import quotas, and other measures.

Mises had already rebelled against this orthodoxy in his first publication on monetary policy, his 1907 article on the motives behind the Austro-Hungarian Bank's regulation of exchange rates. There he asserted that the theory of the value of money was not yet sufficiently developed, and the relationship between the quantity of money and the exchange rate was unknown.⁶⁶ Five years later, the theory of the value of money was sufficiently well developed in his mind. He demonstrated that the balance-of-payments theorists had turned the real chain of causation on its head. The volume of imports and exports, and of foreign liabilities and credits was not independent of the exchange rate, but entirely dependent on it.

The balance-of-payments theory forgets that the volume of foreign trade is completely dependent upon prices; that neither exportation nor importation can occur if there are no differences in prices to make trade profitable.⁶⁷

He went on to explain the root of the error:

It cannot be doubted that if we simply look at the daily or hourly fluctuations on the exchanges we shall only be able to discover that the state of the balance of payments at any moment does determine the supply and the demand in the foreign-exchange market. But this is a mere beginning of a proper investigation into the determinants of the rate of exchange. The next question is, What determines the state of the balance of payments at any moment? And there is no other possible answer to this than that it is the price level and the purchases and sales induced by the price margins that determine the balance of payments. Foreign commodities can be imported, at a time when the rate of exchange is rising, only if they are able to find purchasers despite their high prices.⁶⁸

Mises points out that it was Ricardo who had first developed the correct view of exchange rate determination. The exchange rate between two monies depended exclusively on the relative purchasing power of each. In a free market, exchange rates would tend to make it irrelevant which money is used to buy a non-monetary commodity:

The different kinds of money are exchanged in a ratio corresponding to the exchange ratios existing between each of them and the other economic goods. If 1 kg of gold is exchanged for m kg of a particular sort of commodity, and 1 kg of silver for m/15¹/₂ kg of the same sort of commodity then the exchange ratio between gold and silver will be established at 15¹/₂. If some disturbance tends to alter this ratio between the two sorts of money, which we shall call the static or natural ratio, then automatic forces will be set in motion that will tend to re-establish it.⁶⁹

The political implications of this analysis are diametrically opposed to the ones suggested by the balance-of-payments doctrine. There is in fact no need to prevent a depreciation of the exchange rate through government intervention, because sooner or later the falling exchange rate would equilibrate the purchasing powers of the two monies, preventing a further fall.

As Mises later acknowledged, this idea was essentially contained already in the classical quantity theory of money, as well as Gresham's Law and the doctrine of the British Currency School. His analysis, which was based on the modern theory of subjective value, had refined these older views and restated them in a more nuanced manner, but the practical conclusion had remained the same. Mises said in retrospect:

Governmental interventions that seek to regulate international monetary flows to provide the “necessary” quantities of money for the economy are superfluous. In all cases, the undesired outflow of money can only be the result of a governmental intervention that endows differently valued monies with the same legal purchasing power. All that the government must do not to destroy the monetary order, and all that it can do, is to avoid any such interventions. That is the nub of the monetary theory of Classical Economics and of its immediate successors, the theoreticians of the Currency School.⁷⁰ It was possible to refine and develop this doctrine with the modern subjective theory, but it was impossible to overhaul it and put something else at its place.⁷¹

His exposition would eventually have an impact on central-bank policy, but at first it was dismissed, and its application prevented. One of the most vituperative dismissals came from a certain Kurt Singer, a follower of Knapp, who had attacked Mises for lack of logic.⁷² Years later, Mises commented on Singer in a letter to Emil Lederer:

I myself regret it very much today that history has proved me right rather than the champions of inflation. My income would be substantially higher if Knapp and his disciples had turned out to be right.⁷³

Mises felt it was necessary to return to the subject of exchange-rate determination after World War I because the continued prevalence of the balance-of-payment doctrine had Austria well on its way to hyperinflation. In the feverish days of 1919, he wrote a paper on “Zahlungsbilanz und Wechselkurse” (Balance of Payments and Exchange Rates), which proved to be influential in turning Austrian monetary policy away from the path of hyperinflation before it was too late.

Some years after Mises's book had come out, the Swedish economist Gustav Cassel, who would play an important role in interwar economic science in Germany, developed a variant of the same theory without referring to his contemporary Austrian predecessor.⁷⁴ Cassel's exposition had a great deal more success, which was probably due to the fact that he had coined the popular new phrase “purchasing power parity” to describe the equilibrium exchange rate and also because he was less vitriolic than Mises, who had denounced the champions of the balance-of-payments doctrine as dilettantes and called their analysis superficial—which in fact it was. During the 1920s, then, Ricardo's theory “was called Cassel's theory if one agreed; and Mises's theory if one disagreed.”⁷⁵