PART I THE NATURE OF MONEY CHAPTER I THE FUNCTION OF MONEY Summary

Money is necessary in a society based on private property and the division of labor. The function of money is to facilitate these trades: Money is a commonly used medium of exchange.

In a direct exchange, people accept goods in trade that they intend to personally use, whether for consumption or production. There is no medium of exchange involved in the transaction.

In an indirect exchange, at least one person in the transaction accepts a good that he intends to trade away in the future for something else. The item that is accepted in the first trade is a medium of exchange.

Even before the use of money, traders would have quickly discovered the benefits of indirect exchanges, and the use of media of exchange to facilitate them. Some goods would have had a far broader market than others. A trader who came to market with an unmarketable good would place himself in a more advantageous bargaining position if he engaged in an indirect exchange, by trading his good for something that was more marketable.

Because every trader would act in this fashion, those goods that were initially more marketable, would see their marketability enhanced even further. Over time, a community would gravitate to one or a few commodities that would be acceptable to everyone in trade. This is how money emerged from an initial state of barter. Historically the market has often chosen gold and silver as money.

Although other writers outline other “functions” of money—such as a standard of deferred payments or a store of value—these all flow from its definition: money is a commonly accepted medium of exchange.

Chapter Outline

1. The General Economic Conditions for the Use of Money

A person living by himself on a tropical island would not need money. Several people living in the same household would not need money either, so long as they produced everything they needed within the household. Even an entire community—consisting of thousands or millions of households, each of which specialized in producing different goods and services—could get by without the use of money, assuming there were a central group or person who acted as a “planner” and told everyone what to make, and decided which portion of the total output each person would get to consume.

However, in a society based on the division of labor, and where private individuals own both consumption goods (TVs, radios, Big Macs) and producer goods (tractors, factories, copper mines), money is essential. In such a society, there is no one person or group who decides how scarce resources will be deployed. Each individual must make his or her own plans, which usually require exchanging property for other people’s property. The function of money is to facilitate these trades: Money is a commonly used medium of exchange.

2. The Origin of Money

In a direct exchange, people accept goods in trade that they intend to personally use, whether for consumption or production. For example, suppose Alan has a muffin but he is really hungry for fish. Bill, on the other hand, has a net (which can be used to catch fish) that he doesn’t really want, but he thinks Alan’s muffin looks delicious. If Alan trades his muffin for Bill’s net, this is a direct exchange. There is no medium of exchange involved in the transaction.

In an indirect exchange, at least one person in the transaction accepts a good that he doesn’t intend to consume or use himself in production. Rather, the person accepts a good because he plans on trading it away again in the future. For example, suppose there is a woman who has knitted a quilt, and she wants to exchange it for a certain parakeet. Unfortunately, the man who owns the parakeet doesn’t want a quilt, but is instead interested in obtaining a new radio. The owner of the radio, however, hates birds, but is very cold at night. The woman with the quilt, unfortunately, is very hard of hearing and has no use for a radio.

In this scenario, no direct exchange is possible. However, the woman could trade away her quilt for the radio—even though she personally has no use for it—and then trade the radio in turn for the parakeet. These two successive trades would make all three people happier. In this example, the radio would be a medium of exchange.

Logically, there must have been a time when people had goods and traded with each other, but before money had arisen. Even before the use of money, traders would have quickly discovered the benefits of indirect exchanges—and the use of media of exchange to facilitate them.

Some goods (eggs, milk, leather) would have had a far broader market than others (telescopes, philosophy books, machinery). A trader who came to market with an unmarketable good such as a telescope probably wouldn’t be able to quickly find someone who (a) had the items that the first trader hoped to acquire and (b) wanted a telescope. In this case, the trader could improve his bargaining position by trading away his telescope for something more marketable, such as eggs, even if the trader had no desire to eat the eggs.

Because every trader would act in this fashion, those goods that were initially more marketable, would see their marketability enhanced even further: They would be demanded not only by people intending to use them directly, but also by people intending to use them as media of exchange. In any particular indirect exchange, a trader would naturally prefer to sell his own wares in exchange for the most marketable medium of exchange, because this would place him in the most advantageous position as he continued looking for the goods he ultimately desired. Over time, a community would gravitate to one or a few commodities that would be acceptable to everyone in trade. A commonly accepted medium of exchange is money.

Historically, gold and silver have been the two commodities most frequently employed as money. They have very similar properties and are both excellent media of exchange.

3. The “Secondary” Functions of Money

Money is, by definition, a common medium of exchange, which therefore serves to facilitate the exchange of goods and services. In a market economy, this is a crucial “function” and we see money’s importance by focusing on it. Although other writers outline other “functions” of money—such as a standard of deferred payments, or a facilitator of credit transactions, or a store of value through time—these all flow from its use as a common medium of exchange.

Important Contributions

• Mises references Carl Menger, whose 1871 Grundsätze (translated as Principles of Economics) is the founding work of what is called “Austrian” economics. Among his other contributions, Menger is credited in the annals of the history of economic thought with giving the first satisfactory explanation of the origin of money. Rather than assuming that money must have been created by an edict issued by a powerful king or wise tribal leader, Menger showed that step-by-step evolution from an initial state of barter to a monetary economy, where each person only seeks to improve his own position at each step in the process.

• Even in modern textbooks, writers will list several “functions” of money. This can be confusing, because it makes it hard to pin down exactly what money is and why it so important. Menger’s approach—followed by Mises—is refreshingly clear: Money is defined as a commonly accepted medium of exchange, and this characteristic enables all of the other “functions” attributed to it.

New Terminology

Direct exchange: An exchange in which both parties intend to directly use the received good, either in consumption or production.

Indirect exchange: An exchange in which at least one party intends to hold the received good, in order to trade it away in the future for something else.

Division of labor: The situation in which people specialize in particular occupations, producing far more than they personally can consume, and trade away their surplus to receive some of the surplus created by others.

Medium of exchange: A good that is accepted in exchange, with the intention of trading it away to acquire something else in the future.

Money: A medium of exchange that is generally accepted in the community. Money typically stands on one side of virtually every exchange.

Study Questions

1. Would a society based on total central planning in both production and consumption need money? Why or why not? (p. 29)

2. Why doesn’t a direct exchange involve the use of a medium of exchange? (p.30)

3. Can you think of reasons that traders eventually gravitated toward gold and silver as money, as opposed to other items such as cattle or aluminum?

4. Did media of exchange exist before the existence of money? (pp. 30–32)

5. For the various secondary functions of money listed by Mises, explain how each is related to money’s role as a commonly accepted medium of exchange. (pp. 34–36)

CHAPTER 2

ON THE MEASUREMENT OF VALUE

Summary

The classical economists relied on an objective theory of value, and naturally thought that money was a measuring rod of this objective value. Modern economics is based on a subjective theory of value, which traces the source of value to the mind of the individual actor. Value is the significance given to a particular good by a person.

Subjective value is bound up with the idea of exchange. Each party to a voluntary trade gives up an item that is lower on his value ranking (or scale of values), in exchange for an item that is higher on his ranking. Exchanges will occur until there are no more mutually beneficial trades. Individuals’ subjective valuations give rise to objective exchange ratios or prices.

The law of diminishing marginal utility states that the value of the last unit of a commodity decreases as the person acquires a greater quantity of the commodity. The various schemes to define an objective measurement of satisfaction—a “util”—cannot get around the fact that value scales involve a ranking (1st, 2nd, 3rd, etc.) and not a measurement of the intensity of value. It is impossible to perform arithmetical operations on the marginal utilities of various units in order to compute the “total utility” or total value of the entire stock of the good. If someone says, “Diamonds are more valuable than water,” what he means is that if forced to give up one diamond or one gallon of water, he would choose to give up the latter.

Knowledge of objective money prices causes people to revise their subjective value scales. Objective money prices provide a “common denominator” for the market exchange values of all the various goods and services available.

However, money prices themselves are constantly changing. That is why Mises and Menger prefer to say that money is an index (not a measurement) of prices, since it is less liable to confusion.

Chapter Outline

1. The Immeasurability of Subjective Use-Values

The classical economists (such as Adam Smith) relied on an objective theory of value, which held that the value of a commodity was based on an objective criterion (such as the amount of labor required for its production). In this mindset, it was natural to view money as a measuring rod of this objective value. Just as a thermometer shows a higher reading on a hot day than on a cold day—reflecting the objectively warmer temperature—so too did the classical economists think that a higher price tag indicated that a more expensive good had a higher objective value than a cheaper good.

However, modern economics is based on a subjective theory of value, which traces the source of value to the mind of the individual actor. In modern economics, value doesn’t reside in physical things per se, but instead is an attribute ascribed to physical things by subjective preferences. Value is the significance given to a particular good by a person, who can imagine ways to use the good to become more satisfied.

Subjective value is bound up with the idea of exchange. If a man values a piece of iron more than a piece of bread, it means that he would choose the former if faced with a choice between the two. Even Robinson Crusoe, alone on his desert island, reveals his valuations by his “exchanges” with nature. For example, he may value satisfying his hunger more than he values satisfying his desire to lounge on the beach, and that is why he “exchanges” his leisure time for coconuts (by climbing trees).

With more than one person, valuation guides exchanges made in the marketplace. Each party to a voluntary trade gives up an item that is lower on his value ranking (or scale of values), in exchange for an item that is higher on his ranking. This apparent contradiction—where each person gives up something “less valuable” in exchange for something “more valuable”—is perfectly sensible because value is in the eye of the beholder, i.e., value is subjective.

In the market, exchanges will occur until there are no more mutually beneficial trades. The underlying subjective valuations driving acts of exchange do not involve a “measurement” of value. (For an analogy, someone can rank his friends in order of importance, without implying that there is an objective unit of friendship that the person measures in each person before constructing the ranking. Someone can report, “Jim is my best friend and Sally is my second-best friend” without being able to say, “Jim is a 24 percent better friend than Sally.”) All that is necessary is that a person be able to look at any two possibilities, and decide which he prefers.

Even though market exchanges are driven by subjective valuations that are themselves nonquantifiable, nonetheless these exchanges in turn give rise to objective exchange ratios or prices. For example, suppose Alice has three pears while Bob has two apples, and that on her value scale Alice ranks “two apples” more highly than “three pears,” whereas Bob has the opposite ranking. These subjective valuations—which do not involve any measurement of the amount of value or utility residing in each combination of fruit—mean that the two people can gain from trading the three pears for the two apples. This mutually beneficial trade then establishes that the objective price of an apple is 1.5 pears, and that the price of a pear is two-thirds of an apple. Thus Alice and Bob’s subjective rankings of apples and pears, allowed for the formation of an objective market price reflected in their exchange. But it would be nonsensical to describe this scenario as one in which “an apple gives 50 percent more value to people than a pear.”

The law of diminishing marginal utility states that the value of the last unit of a commodity (in someone’s possession) decreases as the person acquires a greater quantity of the commodity. This follows from the observation that a person will necessarily assign subsequent units of a commodity to those purposes that he deems less and less significant. For example, if a person has only one gallon of water, he will attach a great significance to it, because it is necessary to stave off thirst.

As a person’s access to water becomes greater, however, the last (or marginal) gallon of water becomes less significant. The 25th gallon, perhaps, will be devoted to cooking, and is not nearly as important as the 1st through 24th gallons, which were devoted to drinking. And the 1,000th gallon might be used to wash the car, a relatively unimportant goal.

The various schemes to define an objective measurement of satisfaction—a “util”—cannot get around the fact that value scales involve a ranking (1st, 2nd, 3rd, etc.) and not a measurement of the intensity of value. The renowned Chicago School economist Irving Fisher, for example, devised a clever argument by which he equated the utility of the 100th loaf of bread with the utility derived from the last and second-last units of fuel oil. At the same time, the utility of the 150th loaf of bread was equal to the utility of only the last unit of fuel oil. Fisher concludes that the 150th loaf of bread must have only one-half the utility of the 100th loaf. But this assumes away diminishing marginal utility in the fuel oil.

2. Total Value

If it is impossible to measure the value in a single unit of a good, it is obviously impossible to perform arithmetical operations on the marginal utilities of various units in order to compute the “total utility” or total value of the entire stock of the good. One problem with this approach is that a free good (such as air) would end up with a total value of zero, since the marginal utility of one cubic meter of air is zero in most circumstances.

It must be repeated that utility or value is a concept related to the acts of choice that a particular individual contemplates. If someone says, “Diamonds are more valuable than water,” what he means is that if forced to give up one diamond or one gallon of water, he would choose to give up the latter. But if an individual had to choose between all the water in the world, or all the diamonds, then he would choose to retain the water (at least if he wanted to live longer than a few days). Only in this contrived case can we meaningfully speak of the “total value” of the entire stock of water, because in this situation the “total value” and the “marginal value” are the same; the unit under consideration is all the water in the world.

3. Money as a Price Index

At this point, it should be clear that money cannot serve as a measuring rod of subjective value. There is a sense in which money is a measure of objective market exchange value, however. For example, if a car trades for $20,000 while a motorcycle trades for $10,000, then the car has twice as much exchange value. Someone bringing a car to market can obtain “twice as many goods and services” for it, where the amount is measured in money prices.

Knowledge of objective money prices causes people to revise their subjective value scales. Someone who despises smoking and loves vegetables may nonetheless place a higher value on an unopened carton of cigarettes than on a tomato, because she can sell the carton for money, and then use the money to buy a tomato as well as many other items. In this way, objective money prices provide a “common denominator” for the market exchange values of all the various goods and services available.

However, because money prices themselves are determined by the underlying subjective valuations of the traders, they are constantly changing. The various combinations of goods that one motorcycle can “buy” today, may be different tomorrow, not only because the price (quoted in money) of the motorcycle can change, but also because the prices (quoted in money) of all others goods can change. That is why Mises and Menger prefer to say that money is an index (not a measurement) of prices, since it is less liable to confusion.

Important Contributions

• The replacement of the classical economists’ labor (or cost) theory of value, with subjective value theory, was a true revolution in economic theory. The classical theory explained the price of a good by the amount of labor or (more generally) the cost of producing the good. Although such an approach explained the fact that prices and production costs tended to be similar, there were many problems. For example, it was clear that the actual day-to-day prices of goods were not determined by production costs, so at best the cost theory explained long-run tendencies, not the determinants of actual market prices. Worse still, “costs” are themselves prices, and so to explain the price of a good by the costs of producing it, only pushes the problem back one step. By explaining the prices of consumer goods through the interaction of subjective valuations in the market—and then using these consumer prices to explain the prices of the producer goods needed to make them—the subjective value theorists resolved these problems. Although other economists participated in the Subjectivist/Marginal Revolution, it was the Austrian economists who worked out the logical foundations of the new approach, as Mises’s frequent references to Menger, Böhm-Bawerk, and Wieser testify.

• Irving Fisher was an incredibly influential economist from the Chicago School, and arguably one of the founders of modern, mainstream economics. Although economists paid lip service to the subjectivist revolution in value theory, nonetheless they often fell back into the old habit of viewing utility as a cardinal, measurable substance. Mises’s critique of Fisher is a good illustration of this tendency. Modern Austrian economists also chide their mainstream peers for relying on mathematical models of “utility functions” that can easily lead the economist into forgetting that modern price theory only assumes that individuals can rank various combinations of goods from best to worst. There is no need to assume that a consumer has an intensity of preference for various goods that could be measured by units of utility.

New Terminology

Free good: A good that has a price of zero, because it is not scarce. There is enough of the good to satisfy all human wants that it can technically fulfill.

Law of diminishing marginal utility: The rule, deducible from the nature of economizing action, that each additional unit of a good or service will have a lower value, because a person will allocate successive units to satisfying ends that are less and less important.

Objective theory of value: An explanation of value that relies on the objective properties of a good, such as its cost of production or the amount of labor that went into its construction. (The classical economists, such as Adam Smith and David Ricardo, held an objective theory of value.)

Prices: The market exchange ratios between various goods and services. In a monetary economy, prices are typically quoted in terms of the money good.

Scale of values: An analytical tool by which the economist interprets the actions of an individual, who subjectively ranks particular units of goods and services in order from most to least important.

Subjective theory of value: An explanation of value that relies on individuals’ subjective rankings of particular units of goods and services. (The so-called Marginal Revolution of the early 1870s—spearheaded by Carl Menger, William Stanley Jevons, and Léon Walras—overturned the objective theory of value and ushered in the subjective theory.)

Value: The importance that an individual places on a particular unit of a good or service.

Study Questions

1. Explain: “In the older political economy, the search for a principle governing the measurement of value was to a certain extent justifiable.” (p. 38)

2. Why would an isolated individual still need to engage in a “comparison of values” before taking action with respect to scarce goods? (p. 38)

3. Why does an exchange of two items require that the people making the exchange place the items in reverse order on their value scales? (p. 39)

4. Explain: “The untenability of [Wieser’s] argument is shown by the fact that it would prove that the total stock of a free good must always be worth nothing.” (p. 45)

5. How does money aid the entrepreneur? (pp. 48–49)

CHAPTER 3

THE VARIOUS KINDS OF MONEY

Summary

A money substitute is a perfectly secure and immediate claim on money. Because the claims themselves can facilitate indirect exchange, they become a “substitute” for the original commodity money.

The definition of money should serve the purposes of economic theory, the most important being the explanation of the purchasing power of money. For economics, what matters is the actual practices and expectations of individuals in the market, rather than legal formalities.

Commodity money is a common medium of exchange that is also an economic good in its own right. For example, gold, silver, and even tobacco have historically been used as money, and yet people also valued and traded these commodities for other reasons.

Fiat money is accepted as a common medium of exchange not because of its technological properties, but because of a special legal designation provided by the appropriate authority. For example, in the current United States “green rectangular pieces of paper” become money when certain ink patterns are placed on them.

Credit money occurs when a claim on a physical or legal person, falling due in the future, is itself used as a medium of exchange.

Some theorists explain the value of money as due to State commands. But the government cannot force people to adopt a particular item as the commonly accepted medium of exchange, let alone to accept it with a particular purchasing power. The government can use its tremendous power to make it more likely that people will adopt a particular item (such as green pieces of paper with certain ink patterns) as money, but economically something is money because of its usage by people in the market. A government edict per se cannot transform it into money.

Chapter Outline

1. Money and Money Substitutes

A money substitute is a perfectly secure and immediate claim on money. For example, suppose the commonly accepted medium of exchange is gold, and a reputable bank issues a paper ticket entitling the bearer to one ounce of gold. So long as people in the community are certain that they will be paid in physical gold whenever they present the ticket to a branch of the bank, then such tickets are money substitutes and may change hands during purchases the same way physical gold would.

In the market economy, people can issue perfectly secure and immediate claims (i.e., redemption tickets) to all sorts of goods, not just money. But the crucial feature of such claims on money is that the claims themselves can facilitate indirect exchange, and so become a “substitute” for the original commodity money. In other words, pieces of paper entitling the owner to an ounce of gold can circulate in the market the same way actual 1 oz. gold coins would (so long as everyone is assured of immediate redemption). In principle merchants might never actually turn the tickets in, to receive the physical gold. In contrast, people might trade paper claims guaranteeing the owner to a loaf of bread, but they would eventually redeem them. Such tickets could never become “bread-substitutes” because the paper couldn’t serve the same function as actual bread.

For economists—as opposed to legal theorists or the businessperson—the definition of money should serve the purposes of economic theory. The central task of the economic analysis of money is to explain the exchange ratios between money and all other goods, i.e., to explain the purchasing power of money.

In Mises’s judgment, the most fruitful classification scheme distinguishes between the underlying “money in the narrower sense” versus perfectly secure and immediate claims to such money, i.e., money substitutes. He concedes that it would be logically consistent to include money substitutes in the definition of money itself, but believes his preferred distinction (i.e., between money and money substitutes) will make it easier to explain other phenomena (such as the purchasing power of money, as well as the boom-bust cycle) more clearly in later chapters. (See the Appendix B on page 231 for a diagram outlining Mises’s classification scheme for various items that are often included in the concept of money.)

2. The Peculiarities of Money Substitutes

In the economic analysis of money, what matters is the actual practices and expectations of individuals in the market. For example, whether or not legislation declares that token coins are legally binding claims on money, if in practice the holder of a token can easily exchange it for the “equivalent” amount of actual money, then economically speaking the token is a money substitute.

The same principle applies to banknotes. For example, conventional accounts say that Austria-Hungary from 1900 to 1914 possessed a paper standard, because legally the Austro-Hungarian Bank had no obligation to redeem its paper notes for commodity money, and in fact the notes were declared legal tender. Yet in practice during this period, the Austro-Hungarian Bank would voluntarily cash its paper notes for gold upon request, and so economically speaking Austria-Hungary was on a gold standard.

3. Commodity Money, Credit Money, and Fiat Money

Commodity money is a common medium of exchange that is also an economic good in its own right. For example, gold, silver, and even tobacco have historically been used as money, and yet people also valued and traded these commodities for other reasons.

Fiat money is accepted as a common medium of exchange not because of its technological properties, but because of a special legal designation provided by the appropriate authority. For example, in the current United States “green rectangular pieces of paper” are not money per se. They only become money when they are cut to exact size and printed with the correct designs by the U.S. Treasury. Thus the green pieces of paper appear to become money by “fiat” (i.e., command) of the U.S. government. However, in economics the definition of money is a commonly accepted medium of exchange. The government can only use its powers to encourage people to use a particular class of items—for example, green pieces of paper with the appropriate ink patterns—as a common medium of exchange; the mere legal declaration isn’t what makes them money, economically speaking.

Credit money occurs when a claim on a physical or legal person (e.g., a corporation or government agency), falling due in the future, is itself used as a medium of exchange. To distinguish credit money from mere credit, it is necessary that people are generally willing to accept the claim in trade not because they want to wait and receive the underlying payment (to which the claim entitles them), but because they expect to be able to easily trade away the claim itself for other goods. For example, suppose a government originally promised to redeem its paper notes immediately upon demand for commodity money (such as gold). But during a war, the government suspends convertibility, so that the paper notes are now not legally binding claims on anything. However, if the public expects that at some point in the future, redeemability will be restored, then the notes would circulate as credit money (not fiat money) because they would be claims to gold falling due in the future (at an uncertain date). So long as the paper notes are considered so liquid that virtually everyone is willing to accept them in trade, they are a common medium of exchange and hence money.

4. The Commodity Money of the Past and of the Present

Some theorists explain the value of money as due to State commands. For example, “The monetary unit of the United States is the dollar, because the U.S. government has passed a law.” But this is a very inadequate reading of history, because governments cannot simply force a particular good to command a particular purchasing power in the market. For example, a king can collect taxes in the form of silver coins, and then debase them by melting them down and minting a greater number of coins with less silver content per coin. But the market will react by raising prices (quoted in terms of the coins), and even if the king resorts to price controls with draconian penalties, he will cause shortages in accordance with economic law.

Technical Notes

• On pages 56–57, Mises argues that token coinage is not an independent economic concept, but rather a special type of money substitute. Token coinage was developed to facilitate small transactions. For example, in a country using gold as its commodity money, it would be awkward to purchase an item with a price of th of an ounce of gold, if customers had to use the physical gold itself. The government might therefore produce a limited number of small discs (perhaps made of copper or nickel) that were stamped with, “Legal Tender, th oz. of gold.” Even though the actual metal content of the tokens would be less, they would nonetheless trade at their face value so long as everyone believed that the government would faithfully exchange one ounce of physical gold for 100 tokens. The important point is not whether such redemption were a legal requirement, but merely whether in practice people expected the option to be available upon demand. (Also note that the “coins” Mises discusses on pages 50–51 are not token coins, but coins consisting of the commodity money. In other words, such coins are valued because they actually consist of a recognized weight in gold or silver, not because the holders expect to be able to redeem them for gold or silver.)

• In the Misesian scheme, credit money is not the same as a money substitute because the claims constituting credit money are not due immediately, whereas they must be for a true money substitute. Money substitutes are valued the same as the underlying money to which they are claims; a banknote entitling the bearer to one ounce of gold, upon request, will have the same purchasing power as one ounce of gold. However, a corporate bond promising the bearer one ounce of gold in 30 years, if it is to become a credit money and circulate as a common medium of exchange, will be subject to an independent valuation, depending not merely on the reliability of the claim and the wait involved, but also on the liquidity of the bond. (See p. 61.)

New Terminology

Banknotes: Paper notes issued by banks, typically entitling the bearer to a specified amount of the money good.

Cash (verb): To redeem a claim (such as a banknote) by paying the specified amount of the money good.

Commodity money: A common medium of exchange that is an economic good in its own right, valued for nonmonetary reasons.

Credit money: A common medium of exchange that is a claim on a person or legal person (such as a corporation or government agency), not falling due until a (possibly uncertain) future date.

Debase: To dilute the value of the money, for example when a ruler introduces “base” metals into the coinage, reducing their precious-metal content.

Fiat money: A common medium of exchange accepted not because of its technological properties, but because of a special legal designation provided by the appropriate authority. Fiat money is not “backed up” by anything else.

Gold standard: The arrangement by which a nation’s money (such as the U.S. dollar or the British pound) can be redeemed for a definite weight of gold.

Legal tender: An item that the government declares to be valid for the payment of debts denominated in money, at par value.

Liquid (adjective): The ability of being sold for the full market price with a very short search time. (For example, a share of corporate stock is much more liquid than a house.)

Money in the narrower sense: The actual money good (whether commodity, fiat, or credit money), not including money substitutes.

Money in the broader sense: The actual money good (whether commodity, fiat, or credit money), plus money substitutes.

Money substitute: A perfectly secure and instantly redeemable claim on money, which itself circulates as money (in the broader sense) because it fulfills the functions of money.

Paper standard: The arrangement by which the government does not redeem paper notes for a precious metal. (A paper standard stands in contrast to a gold standard.)

Price controls: Government decrees threatening fines or other punishment for people trading at prices that are either too high (in the case of a price ceiling) or too low (in the case of a price floor).

Purchasing power: The amount of goods and services that a unit of money can command because of the various prices in the market.

Token coins: Coins that serve as representatives of money (usually in very small denominations), even though they do not contain the full weight of metal in the case of a commodity money.

Study Questions

1. What is “peculiar” about the fact that people may use claims on money, rather than money itself? How is this peculiarity “explained by reference to the special characteristics of money”? (p. 50)

2. What does Mises think of the treatment economists had given to money, before his own contribution? (p. 51)

3. What is the task of economic theory, regarding money? (p.51)

4. Explain: “[W]hereas it is impossible to satisfy an increase in the demand, say, for bread by issuing more bread-tickets ... it is perfectly possible to satisfy an increased demand for money by just such a process as this.” (p. 53)

5. Would Mises be surprised at the world’s current monetary system? (p. 61)

CHAPTER 4

MONEY AND THE STATE

Summary

Unless it resorts to outright socialism, the State must conform to the market. Its actions in the market are governed by the Laws of Price. In this respect, the State has more influence than any other entity, but this is due to the State’s enormous budget.

In economics, money is a common medium of exchange. But from the legal point of view, money is a common medium of payment or debt settlement. Money can only serve this function (as a medium of debt settlement) because it is a medium of exchange. This is clear when we consider cases where a contract cannot be fulfilled as written, and so the court specifies a monetary payment instead.

Government cannot force people to attribute a certain exchange value to a good. The legal system can certainly allow debtors to “satisfy” their contractual liabilities by paying with items at a face value higher than what the creditors actually believe they are worth, but this merely means a partial repudiation of the debt.

Originally the State’s only role in the monetary sphere was to supply recognizable coins that were hard to counterfeit and that were very similar in appearance, weight, and fineness. By producing suitable coins, the State was merely facilitating commerce, because merchants wouldn’t need chemical tests and scales to evaluate the gold or silver their customers presented in payment.

The State’s influence in the monetary sphere has grown because its size has grown, but also because of its control of the mint: The State can withdraw coins of one metal and replace them with coins of a different metal. The State also influences the monetary sphere through its ability to suspend the immediate redemption of money substitutes, converting them into credit money or even fiat money.

Chapter Outline

1. The Position of the State in the Market

Although it commands a large influence because of its power to tax, ultimately the State must conform to the market. Unless it completely abolishes private property and forms a socialist State, the government can only successfully change market prices through its own decisions to buy and sell. The same is true of money: mere government edicts cannot explain the purchasing power of a common medium of exchange.

2. The Legal Concept of Money

In economics, money is a common medium of exchange. But from the legal point of view, money is a common medium of payment or debt settlement. If a contract calls for one party to pay back a loan of “100 ounces of gold, plus 5 ounces in interest” in one year, the legal system must specify what types of goods are acceptable to satisfy the contract. (For example, must it be done in physical gold, or can a banknote or a check written on a bank account—denominated in gold—satisfy the debt? What about token coins that can be exchanged for gold?) However, money can only serve this function (as a medium of debt settlement) because it is a medium of exchange. This is clear when we consider cases where a contract cannot be fulfilled as written, and so the court specifies a monetary payment instead.

Government cannot force people to attribute a certain exchange value to a good. The legal system can certainly allow debtors to “satisfy” their contractual liabilities by paying with items at a face value higher than what the creditors actually believe they are worth, but this merely means a partial repudiation of the debt.

3. The Influence of the State on the Monetary System

Originally the State’s only role in the monetary sphere was to supply coins of the greatest possible degree of similarity in appearance, weight, and fineness. Furthermore, to do its task well the State would manufacture coins that were hard to counterfeit, and that bore a recognizable stamp. In this regard, the State wasn’t defining money, but was instead merely taking what the market had chosen as the money—for example, gold—and then producing hunks of the money in convenient shapes. By producing suitable coins, the State was merely facilitating commerce: if everyone recognized the State’s one-ounce gold coin, and knew that it was genuine, then merchants wouldn’t have to resort to chemical tests and scales to evaluate the yellow metal their customers presented in payment.

The State’s influence in the monetary sphere has grown because its size (relative to the economy) has grown, but also because of its control of the mint. The State can exert great power over what its subjects choose as the common medium of exchange, since it can (for example) withdraw coins of one metal and replace them with coins of a different metal. Even so, the State cannot avoid the laws of economics. The failed attempts at bimetallist legislation—where the government established a fixed ratio between the value of gold and silver—showed the operation of Gresham’s Law. That is, when the actual market values of gold and silver deviated from the legal ratio, people would hoard the undervalued metal and try to spend the overvalued metal.

The State also influences the monetary sphere through its ability to suspend the immediate redemption of money substitutes, converting them into credit money or even fiat money.

Important Contributions

• Carl Menger’s explanation of the origin of money (laid out in chapter 1) offers a satisfactory rebuttal to the “State theory of money” offered by Knapp and other theorists. (p. 73) If an Austrian economist disputes the theory that money derives its value from the State, the argument is more compelling if the Austrian can show—using Menger’s approach—how money arose spontaneously on the market.

• In this chapter we already see the benefit of Mises’s fastidious classification scheme regarding money. Armed with his categories of money substitutes, commodity money, and credit money, Mises can explain exactly how a State influences the money used by its subjects. While many others place great importance on State legislation regarding tax payments and debt contracts, Mises instead looks at the State’s role in minting coins and its power to change money substitutes into credit money (by suspending immediate redemption of the claims to money). (pp. 77–78)

New Terminology

Bimetallist legislation: Efforts by the government to establish a fixed conversion ratio between gold and silver. For example, the government might require that merchants who post a price in gold ounces, also accept payment in silver ounces at a fixed multiple of the gold price.

Gresham’s Law: Popularly summarized as “bad money drives out good,” the phenomenon by which people will hold money that is undervalued by legislation, and will spend the money that is overvalued by legislation. For example, if bimetallist legislation requires that merchants accept silver and gold at the ratio of 16–to–1, when in fact the actual market exchange rate is 20–to–1, then everyone will try to buy with silver, and no one will use gold for making purchases. Gold will seem to disappear, and only silver will be used in commerce. For a different example, if the government passes legal tender laws on all government-stamped coins, then coins with low metal value (such as U.S. quarters minted in the year 2000) will circulate in trade, whereas coins with high metal content (such as U.S. quarters minted in the year 1950) will be hoarded by people who recognize the value of the silver.

Study Questions

1. Explain: “When notes that are appraised commercially at only half their face-value are proclaimed legal tender, this amounts fundamentally to the same thing as granting debtors legal relief from half of their liabilities.” (p. 71)

2. Explain: “State declarations of legal tender affect only those monetary obligations that have already been contracted.” (p. 71)

3. What are the two mechanisms through which the “State’s influence on commercial usage, both potential and actual, has increased”? (pp. 72–73)

4. Explain: “A country that wishes to persuade its subjects to go over from one precious-metal standard to another cannot rest content with expressing this aspiration in appropriate provisions of the civil and fiscal law.” (p. 74)

5. Explain: “The parallel standard was thus turned, not into a double standard, as the legislators had intended, but into an alternative standard.” (p. 75)

CHAPTER 5

MONEY AS AN ECONOMIC GOOD

Chapter Outline

1. Money Neither a Production Good nor a Consumption Good

Traditionally, economic goods were divided into consumption goods (what Menger called goods of the first order) and production goods (what Menger called goods of higher orders). Consumption goods directly satisfied human desires, whereas production goods only satisfied them indirectly. (For example, an apple might be a consumption good to a hungry man, while an apple seed would be a production good.) If we insist on a two-fold scheme, then money must be a production good, since it is clearly not a consumption good. Yet this is problematic too, because money is very different from other types of production goods.

A solution is to adopt a three-fold system, consisting of consumption goods, production goods, and media of exchange. This makes sense, because money is not a “commercial tool” in the same way that account books are. Although in a certain sense money “facilitates commerce” just as boats and railroads do, they differ in a crucial way: Increasing the supply of money does not make the community richer, whereas having more boats, railroads, and other production goods allows for the greater satisfaction of human desires. This is why money should be classified in a separate category, namely media of exchange.

2. Money as Part of Private Capital

Private capital can be defined as the aggregate of the products that serve as a means to the acquisition of goods. Money should clearly be included in this category, and in fact historically an interest-bearing sum of money was the starting point of the concept of “capital.”

Over time, theorists realized that money was “barren” and did not directly yield its “fruits” the way physical seeds or human labor could. To explain why people would be willing to pay interest on money loans, we must recognize that money can be exchanged for other, productive goods. This observation reinforces the decision to classify money as a medium of exchange, rather than a production good: the only way to salvage the inclusion of money as a part of private capital, is to distinguish it from other production goods and recognize its special ability to be exchanged for them.

3. Money Not a Part of Social Capital

Social (or productive) capital can be defined as the aggregate of the products intended for employment in further production. If we deny that money is a production good, then obviously it cannot be a part of social (or productive) capital.

Important Contributions

• Mises’s summaries of various debates (on whether money is a production good, or whether it is part of social capital) may strike some readers as difficult or even tedious. However, in these passages Mises demonstrates his command of the literature, but also he explains why he favors one view over another. At times Mises differs from Eugen von Böhm-Bawerk, the great pioneer in (what we now call) Austrian economics after Menger. The reader can see that Mises is not simply following in the path laid out by his predecessors in the Austrian tradition, but instead weighs the arguments by various thinkers, and builds the Misesian system with the strongest components of each.

• As with his classification of money substitutes, credit money, etc., in this chapter Mises exercises great precision in defining his concepts and justifying his decisions. For the issues in this chapter, Mises tells the reader (p. 86) that the groundwork will be important for understanding the discussion of the equilibrium and money rates of interest, which will occur in part III of the book.

New Terminology

Equilibrium rate of interest: The rate of interest corresponding to the true supplies of capital goods and consumer preferences for present versus future consumption. Also known as the natural rate of interest.

Money rate of interest: The rate of interest determined in the marketplace for loans of money. (The money rate can deviate from the equilibrium [or natural] rate of interest, in a process that is explained in part III of the book.)

Private capital: The aggregate of the products that serve as a means to the acquisition of goods.

Social (productive) capital: The aggregate of the products intended for employment in further production.

Study Questions

1. What are the views of Roscher and Knies with respect to classifying money? (p. 79)

2. What was Helfferich’s objection to those (like Knies) who wanted to deny that a monetary exchange was an act of production? (pp. 79–80)

3. Explain: “Money is obviously not a ‘commercial tool’ in the same sense as account books, exchange lists, the Stock Exchange, or the credit system.” (p. 83)

4. Explain: “[W]hereas the changes in the value of ... production goods and consumption goods do not mitigate the loss or reduce the gain of satisfaction resulting from ... changes in their quantity, ... changes in the value of money are accommodated in such a way to the demand for it that, despites increase or decreases in its quantity, the economic position of mankind remains the same.” (p. 85)

5. What hindered the development of a scientific understanding of capital and interest? (pp. 88–89)

CHAPTER 6

THE ENEMIES OF MONEY

Chapter Outline

1. Money in the Socialist Community

If a socialist society completely abolishes all property rights and distributes scarce goods and services according to a central plan, then there is no scope for even direct exchange (let alone indirect exchange) and therefore no room for money.

However, some socialist visionaries concede that even in their ideal society, people would retain ownership rights in personal consumption goods such as cigarettes, apples, loaves of bread, sweaters, and so forth. In this case, people would naturally engage in mutually beneficial trades, and ultimately would foster the development of money.

2. Money Cranks

Throughout the ages, reformers have blamed money for social ills. (The love of money is famously declared to be the root of all evil.) The hostility to gold and silver is particularly intense. Yet these reformers never explain their full vision of a world without money, for if they attempted such a description, the problems with their schemes would be obvious.

Other critics do not call for the abolition of money per se, but merely for an “elastic credit system,” which expands or contracts the money supply according to the community’s “need for currency.” According to this particular group of money cranks, the current money and banking system imposes an artificial scarcity by restricting credit and charging higher interest rates than necessary.

Technical Notes

• Some socialists viewed money itself as a “dirty” product of the market economy, and believed that in a pure socialist society, there would be no need for it. However, as Mises explains, some of the more sophisticated theorists imagined that the workers in a socialist community would have property rights in consumption goods (and perhaps personal tools of the trade for skilled artisans etc.). However, what cannot be allowed in a socialist community—lest it become a system of capitalism—is private ownership in the large-scale means of production, such as farmland, factories, railroads, etc.

• Mises concedes that a socialist community that retained private ownership in personal consumption goods, could foster the emergence of genuine money. However, Mises is not here referring to the “labor certificates” envisioned by some socialist theorists. For example, we could imagine that socialist factory and farm managers hand out one certificate for every labor hour (of suitable quality) that each worker performs. Then, once the “crop” of output goods has been “harvested” from all the various factories and farms—including not just bottles of milk but also television sets and basketballs—the socialist leaders determine what fraction of the crop each certificate entitles the bearer to, based on the size of the harvest and the total number of certificates that were issued. Although many casual observers think that this is basically what money is—a claim on the “real output” of society—such a view is very superficial. Actual money (as opposed to a money substitute) is not a claim on anything; it is its own good, but of course it is valued because of its expected purchasing power. If a fire destroys half of the crop, then the labor certificates will necessarily entitle their holders to one-half as much. But with one unit of money, it is not necessarily true that its exchange value in the market would drop by exactly one-half, and in any event the processes governing its purchasing power are completely different from those governing the “redemption power” of a labor certificate in a socialist community.

• When dealing with the last category of “money cranks” on page 94, Mises explains that the mainstream economists of his day could not effectively refute those who claimed that a massive expansion of the money supply—in order to drive the interest rate down to zero—would bring about material abundance. Although most economists and practical businessmen shied away from such extreme proposals, they were merely the logical extension of the prevailing economic doctrines concerning money and banking. It would take Mises’s own work, in particular his development of the circulation credit theory of the trade cycle, to adequately explode this variety of monetary crankishness.

New Terminology

Circulation credit theory of the trade cycle: The theory developed by Mises (in the present book) explaining the boom phase of the business cycle as due to the artificial expansion of bank credit, made possible by fiduciary media. The bust is then inevitable, as capital goods are malinvested during the boom.

Money cranks: Very naïve writers who believe that scarcity is an artificial institutional constraint, and that prosperity requires only a sufficient willingness to create more money and/or issue more bank credit.

Study Questions

1. What two trends cause the emergence of indirect exchange to become inevitable? (p. 91)

2. Would the isolated household use money? Why or why not? (p. 91)

3. Do all socialists propose the complete abolition of money? (p. 91)

4. If the amount of “real output”—number of apples, TVs, heart surgeries, etc.—were to fall in half, would the purchasing power of money necessarily fall in half? (p. 92)

5. Does Mises endorse the banking theories of Tooke and Fullarton? (p. 94)