Free Trade, Monetary Stabilization, and Cyclical Policy

Mises was reluctant to become involved in any organized political campaign. In a November 1924 letter, he declined an honorary executive position in an Austrian free-trade association, stating, “As a matter of principle, I do not belong to any political or economic-political organizations.”³⁵ This attitude changed over the next couple of years, as he enjoyed the early successes of the European free-trade movement. But his original apprehensions proved correct and his involvement, while intense and high profile, was also short-lived. Among his international associates in the movement, he saw political maneuvering, nepotism, and other forms of questionable behavior at the expense of the free-trade cause. Mises waited for the right opportunity to take his leave.

The opportunity came when the International Committee of the Europäischer Zoll-Verein—the European free trade organization of which Mises had founded the Austrian chapter— campaigned against Austria's annexation to the German Reich (the Anschluss question). Neither Mises nor his Austrian colleagues could afford to be associated with either side of the dispute, and when the committee ignored Mises's urging to withdraw from its campaign, Mises left the organization in February 1929.

Disillusioned with the official free-trade movement, Mises returned his focus to the battle of ideas.

At the height of his involvement with the Europäischer Zoll-Verein, Mises had written an update of his theory of money in light of more recent developments, to take account in particular of the workings of the gold-exchange standard.

In February 1928, he published a concise presentation of the main events in the modern history of money for a more general public.³⁶ A few weeks after this publication, he was in the process of completing a monograph on monetary stabilization and economic policy designed to combat business cycles. On March 17, he offered the manuscript to Gustav Fischer. Mises emphasized that the time was right for such a book, both because of the increased general interest in business cycles and because the Verein für Sozialpolitik would deal with these problems at their annual meeting in the fall.³⁷ Fischer was convinced. Geldwertstabilisierung und Konjunkturpolitik (Monetary Stabilization and Cyclical Policy) was sent to bookstores on May 22.³⁸

In the book, Mises delivered a systematic critique of Irving Fisher's views on monetary reform, which had gained great support in the world of academic economists. It had prompted men such as John Maynard Keynes and Gustav Cassel to endorse similar schemes. According to Fisher, the deficiency of commodity money—such as gold and silver coins—was that it did not provide a standard of constant purchasing power. As a consequence, long-term investment and contracts for deferred payments involved excessive risk. His proposed solution was to replace the gold standard with a currency of stable purchasing power as defined by a price index.

Mises pointed out that stability of the purchasing power of money was not a requisite of capital-intensive production. Market participants could very well take account of expected changes in the purchasing power of money when they made any long-term investments or contracts. Moreover, because the purchasing power of money could not be defined without arbitrary assumptions, Fisher's index-number standard would not be different in essence from the prevailing commodity standards. In terms of an arbitrary index number it might be stable, but no price index could possibly represent the relevant purchases of all market participants. So any single index number would necessarily fail to stabilize purchasing power for many market participants. Fisher's scheme could not possibly establish money of stable value, but only a transfer of value other than that which would occur on the free market.

The crucial issue from Mises's point of view was not value stability but distribution. While it was certainly true that the gold standard did not produce stable purchasing power, its virtue was that its distribution effects were free from political interference. Any artificial currency such as paper money would constantly invite political manipulation and thus lead to a redistribution of resources based on political bargaining power rather than the will of consumers.

Fisher had completely overlooked this problem. Like all those who endorsed price stabilization, he focused exclusively on redistribution resulting from variations of the price level. But as Mises showed, this problem was already addressed in the market and expressed as “price premiums” in the gross interest rate. But there was no such counterbalance for the redistribution that resulted from “Cantillon effects”—new money reaching different market participants at different times. Fisher's diagnosis did not cover this problem and his scheme for monetary reform ignored it.

In the second part of the book, Mises presented a revised version of his business-cycle theory. He introduced the distinction between two types of inflation: inflation of fiduciary media and inflation of money proper. Mises argued that the recurrence of the business cycle—its cyclical nature—resulted exclusively from the inflation of fiduciary media. Increases of the money supply were more or less one-time shots. They could entail malinvestment, but this was only one time for all. In contrast, there was a tendency to repeat experiments with fiduciary media, because businessmen and politicians believed that the issuance of additional fiduciary media was a suitable way to reduce interest rates.³⁹ With this explanation Mises complemented his previous analyses of the business cycle, which had focused on the process linking boom and bust, but which had not yet included an explanation of the recurrence of cycles.

Mises also radicalized his praise for free banking. In the second edition of his treatise on money he had said that future money reformers would be well advised to reconsider the case for free banking. Now he added that, historically, fiduciary media have become a large-scale problem only because the state had gotten involved in banking. Governments privileged certain banks with a monopoly on note issuance; they also intervened to bail out these banks when the fractional-reserve scheme collapsed in bank runs. As a consequence, the crises of fractional-reserve banking had reached far greater proportions than they would have in a free market. And the cooperation between (fractional-reserve) central banks—which had been reinforced in the wake of the 1922 Genoa conference and which had become standard practice under the gold-exchange standard— only further increased the dimensions of the problem.

Free banking would have minimized these crises. But Mises did not believe that it was possible to overcome the political resistance against the establishment of this system. He hoped that monetary policymakers would be wiser in the future and heed the teachings of his business-cycle theory.⁴⁰