Chapter 2 The Theory of Money and Credit

In 1903, the influential monetary economist Karl Helfferich, in his work on Money, laid down a challenge to the Austrian School. He pointed out correctly that the great Austrians, Menger, Böhm-Bawerk, and their followers, despite their prowess in analyzing the market and the value of goods and services (what we would now call “micro-economics”), had not managed to solve the problem of money. Marginal utility theory had not been extended to the value of money, which had continued, as under the English classical economists, to be kept in a “macro” box strictly separate from utility, value, and relative prices. Even the best monetary analysis, as in Ricardo, the Currency School, and Irving Fisher in the United States, had been developed in terms of “price levels,” “velocities,” and other aggregates completely ungrounded in any micro analysis of the actions of individuals.

In particular, the extension of Austrian analysis to money faced a seemingly insuperable obstacle, the “problem of the Austrian circle.” The problem was this: for directly consumable goods the utility and therefore the demand for a product can be arrived at clearly. The consumer sees the product, evaluates it, and ranks it on his value scale. These utilities to consumers interact to form a market demand. Market supply is determined by the expected demand, and the two interact to determine market price. But a particular problem is posed by the utility of, and the demand for, money. For money is demanded on the market, and held in one’s cash balance, not for its own sake but solely for present or future purchases of other goods. The distinctive nature of money is that it is not consumed, but only used as a medium of exchange to facilitate exchanges on the market. Money, therefore, is only demanded on the market because it has a pre-existing purchasing-power, or value or price on the market. For all consumer goods and services, therefore, value and demand logically precede and determine price. But the value of money, while determined by demand, also precedes it; in fact, a demand for money presupposes that money already has a value and price. A causal explanation of the value of money seems to founder in unavoidable circular reasoning.

In 1906, his doctorate out of the way, Mises determined to take up the Helfferich challenge, apply marginal utility theory to money, and solve the problem of the Austrian circle. He devoted a great deal of effort to both empirical and theoretical studies of monetary problems. The first fruits of this study were three scholarly articles, two in German journals and one in the English Economic Journal in 1908–09, on foreign exchange controls and the gold standard in Austria-Hungary. In the course of writing these articles, Mises became convinced that, contrary to prevailing opinion, monetary inflation was the cause of balance of payments deficits instead of the other way round, and that bank credit should not be “elastic” to fulfill the alleged needs of trade.

Mises’s article on the gold standard proved highly controversial. He called for a de jure return in Austria-Hungary to gold redemption as a logical conclusion of the existing de facto policy of redeemability. In addition to running up against advocates of inflation, lower interest rates, and lower exchange rates, Mises was surprised to face ferocious opposition by the central bank, the Austro-Hungarian Bank. In fact, the Bank’s vice-president hinted at a bribe to soften Mises’s position. A few years later, Mises was informed by Böhm-Bawerk, then Minister of Finance, of the reason for the vehemence of the Bank’s opposition to his proposal for a legal gold standard. Legal redemption in gold would probably deprive the Bank of the right to invest funds in foreign currencies. But the Bank had long used proceeds from these investments to amass a secret and illegal slush fund, from which to pay subventions to its own officials, as well as to influential journalists and politicians. The Bank was keen on retaining the slush fund, and so it was fitting that Mises’s most militant opponent was the publisher of an economic periodical who was himself a recipient of Bank subsidies.

Mises came to a decision, which he pursued for the rest of his career in Austria, not to reveal such corruption on the part of his enemies, and to confine himself to rebutting fallacious doctrines without revealing their sources. But in taking this noble and self-abnegating position, by acting as if his opponents were all worthy men and objective scholars, it might be argued that Mises was legitimating them and granting them far higher stature in the public debate than they deserved. Perhaps, if the public had been informed of the corruption that almost always accompanies government intervention, the activities of the statists and inflationists might have been desanctified, and Mises’s heroic and lifelong struggle against statism might have been more successful. In short, perhaps a one-two punch was needed: refuting the economic fallacies of Mises’s statist enemies, and also showing the public their self-interested stake in government privilege.⁷

His preliminary research out of the way, Mises embarked, in 1909, on his first monumental work, published in 1912 as Theorie des Geldes and der Umlaufsmittel (The Theory of Money and Credit). It was a remarkable achievement, because for the first time, the micro/macro split that had begun in English classical economics with Ricardo was now healed. At long last, economics was whole, an integral science based on a logical, step-by-step analysis of individual human action. Money was fully integrated into an analysis of individual action and of the market economy.

By basing his analysis on individual action, Mises was able to show the deep fallacies of the orthodox, mechanistic, Anglo-American quantity theory and of Irving Fisher’s “equation of exchange.” An increase in the quantity of money does not mechanically yield a proportional increase in a non-existent “price level,” without affecting relative utilities or prices. Instead, an increase lowers the purchasing power of the money unit, but does so by inevitably changing relative incomes and prices. Micro and macro are inextricably commingled. Hence, by focusing on individual action, on choice and demand for money, Mises not only was able to integrate the theory of money with the Austrian theory of value and price; he transformed monetary theory from an unrealistic and distorted concentration on mechanistic relations between aggregates, to one consistent with the theory of individual choice.⁸

Moreover, Mises revived the critical monetary insight of Ricardo and the British Currency School of the first half of the nineteenth century: that while money is a commodity subject to the supply-and-demand determination of value of any other commodity, it differs in one crucial aspect. Other things being equal, an increase in the supply of consumer goods confers a social benefit by raising living standards. But money, in contrast, has only one function: to exchange, now or at some time in the future, for capital or consumer goods. Money is not eaten or used as are consumer goods, nor used up in production as are capital goods. An increase in the quantity of money only serves to dilute the exchange effectiveness of each franc or dollar; it confers no social benefit whatever. In fact, the reason why the government and its controlled banking system tend to keep inflating the money supply, is precisely because the increase is not granted to everyone equally. Instead, the nodal point of initial increase is the government itself and its central bank; other early receivers of the new money are favored new borrowers from the banks, contractors to the government, and government bureaucrats themselves. These early receivers of the new money, Mises pointed out, benefit at the expense of those down the line of the chain, or ripple effect, who get the new money last, or of people on fixed incomes who never receive the new influx of money. In a profound sense, then, monetary inflation is a hidden form of taxation or redistribution of wealth, to the government and its favored groups and from the rest of the population. Mises’s conclusion, then, is that, once there is enough of a supply of a commodity to be established on the market as money, there is no need ever to increase the supply of money. This means that any supply of money whatever is “optimal”; and every change in the supply of money stimulated by government can only be pernicious.⁹

In the course of refuting the Fisherine notion of money as some sort of “measure of value,” Mises made an important contribution to utility theory in general, a contribution that corrected an important flaw in the Austrian utility analysis of Menger and Böhm-Bawerk. Although the older Austrians did not stress this flaw as much as Jevons or Walras, there were indications that they believed utility to be measurable, and that there is sense in talking of a “total utility” of the supply of a good that would be an integral of its “marginal utilities.”

Mises built on an important insight from the Czech economist Franz Cuhel, a student at Böhm-Bawerk’s graduate seminar, that since marginal utility was strictly subjective to each individual, it was purely an ordinal ranking, and could in no sense be added, subtracted, or measured, and a fortiori could not be compared between persons. Mises developed this theme to demonstrate that therefore the very concept of “total utility” makes no sense at all, particularly as an integral of marginal utilities. Instead, the utility of a larger batch of a good is simply another marginal utility of a larger unit. Thus, if we take the utility to the consumer of a carton of a dozen eggs, it is impermissible to make this utility some sort of a “total utility,” in some mathematical relation to the “marginal utility of one egg.” Instead, we are merely dealing with marginal utilities of different-sized units. In one case a dozen-egg package, in the other case of one egg. The only thing we can say about the two marginal utilities is that the marginal utility of a dozen eggs is worth more than one egg. Period. Mises’s correction of his mentors was consistent with the fundamental Austrian methodology of focusing always on the real actions of individuals, and allowing no drift into relying on mechanistic aggregates.¹⁰

If the Cuhel-Mises insight had been absorbed into the mainstream of utility theory, economics would have been spared, on the one hand, the tossing out of marginal utility altogether in the late 1930s as hopelessly cardinal, in favor of indifference curves and marginal rates of substitution; and, on the other, the current absurd micro-textbook discussions of “utils,” nonexistent entities subject to measurement and mathematical manipulation.

What of the famous problem of the Austrian circle? Mises solved that in one of his most important, and yet most neglected, contributions to economics: the Regression Theorem. Mises built on Menger’s logical-historical account of the origin of money out of barter, and demonstrated logically that money can only originate in that way. In doing so, he solved the problem of the circular explanation of the utility of money. Specifically, the problem of the circle is that, at any given time, say Day_N, the value (purchasing power) of money on that Day is determined by two entities: the Supply of Money_N and the Demand for Money—which itself depends on a pre-existing Purchasing Power on Day_N-1. Mises broke out of this circle precisely by understanding and grasping the time dimension of the problem. For the circle on any given day is broken by the fact that the Demand for Money on that day is dependent on a previous day’s purchasing power, and hence on a previous day’s demand for money. But haven’t we broken out of the circle only to land ourselves in an infinite regress backward in time, with each day’s purchasing power resting on today’s demand for money, in turn dependent on the previous day’s purchasing power, in turn determined by the previous day’s demand, etc.? It is no help to escape circular reasoning only to land in a regress of causes that can never be closed.

But the brilliance of Mises’s solution is that the logical regress backward in time is not infinite: it closes precisely at the point in time when money is a useful non-monetary commodity in a system of barter. In short, say that Day₁ is the first moment that a commodity is used as a medium of indirect exchange (to simplify: as a “money”), while the previous Day₀ is the last day that commodity, say gold, was used only as a direct good in a system of barter. In that case, the causal chain of any day’s value of money, say Day_N, goes back logically in time, to Day₁, and then goes back to Day₀. In short, the demand for gold on Day₁ depends on the purchasing power of gold on Day₀. But then the regress backward stops, since the Demand for Gold on Day₀ consists only of its direct value in consumption, and hence does not include a historical component, i.e., the existence of prices for gold on the previous day, Day₁.

In addition to closing the determinants of the value or purchasing power of money and thereby solving the Austrian circle, Mises’s demonstration showed that, unlike other goods, the determinants of the value of money include an important historical dimension. The Regression Theorem also shows that money, in any society, can only become established by a market process emerging from barter. Money cannot be established by a social contract, by government imposition, or by artificial schemes proposed by economists. Money can only emerge, “organically” so to speak, out of the market.¹¹

Comprehension of Mises’s Regression Theorem would spare us numerous impossible schemes, some proffered by Austrians or quasi-Austrians, to create new moneys or currency units out of thin air: such as F.A. Hayek’s proposed “ducat,” or plans to separate units of account from media of exchange.

In addition to his feat in integrating the theory of money with general economics and placing it on the micro-foundations of individual action, Mises, in Money and Credit, transformed the existing analysis of banking. Returning to the Ricardian-Currency School tradition, he demonstrated that they were correct in wishing to abolish inflationary fractional-reserve credit. Mises distinguished two separate kinds of functions undertaken by banks: channeling savings into productive credit (“commodity credit”), and acting as a money-warehouse in holding cash for safekeeping. Both are legitimate and non-inflationary functions; the trouble comes when the money-warehouses issue and lend out phony warehouse receipts (notes or demand deposits) to cash that does not exist in the bank’s vaults (“fiduciary credit”). These “uncovered” demand liabilities issued by the banks expand the money supply and generate the problems of inflation. Mises therefore favored the Currency School approach of 100 percent specie reserves to demand liabilities. He pointed out that Peel’s Act of 1844, established in England on Currency School principles, failed and discredited its authors by applying 100 percent reserves only to bank notes, and not realizing that demand deposits were also surrogates for cash and therefore functioned as part of the money supply. Mises wrote his book at a time when much of the economics profession was still not sure that demand deposits constituted part of the money supply.

Not wishing to trust government to enforce 100 percent reserves, however, Mises advocated totally free banking as a means of approaching that ideal. Money and Credit demonstrated that the major force coordinating and promoting bank credit inflation was each nation’s central bank, which centralized reserves, bailed out banks in trouble, and made sure that all banks inflated together. Eight years before C.A. Phillips’s famous demonstration, Money and Credit showed that an individual bank enjoyed very little room to expand credit.

But this is not all. For Mises began, on the foundations of his theory of money and banking, to develop what was to become his famous theory of the business cycle—the only such theory integrated with general micro-economics and built on the foundations of the analysis of individual action. These rudiments were further developed in the second edition of Money and Credit in 1924.

In the first place, Mises was brilliantly able to identify the process as essentially the same: (a) one bank’s expanding credit, soon leading to a contraction and demand for redemption; and (b) all banks in the nation, guided by a central bank, expanding money and credit together and thereby gaining more time for a Hume-Ricardo specie-flow price mechanism to develop. Thus credit and the money supply expand, incomes and prices rise, gold flows out of the country (i.e., a balance of payments deficit), and a resulting collapse of credit and the banks, force a contraction of money and prices, and a reverse specie flow into the country. Not only did Mises see that these two processes were basically the same; he was also the first to see that here was a rudimentary model of a boom-bust cycle, created and driven by monetary factors, specifically expansion and later contraction of “created” bank credit.

During the 1920s, Mises formulated his business cycle theory out of three pre-existing elements: the Currency School boom-bust model of the business cycle; the Swedish “Austrian” Knut Wicksell’s differentiation between the “natural” and the bank interest rates; and Böhm-Bawerkian capital and interest theory. Mises’s remarkable integration of these previously totally separate analyses showed that inflationary or created bank credit, by pumping more money into the economy and by lowering interest rates on business loans below the free market, time-preference level, inevitably caused an excess of malinvestments in capital goods industries remote from the consumer. The longer the boom of inflationary bank credit continues, the greater the scope of malinvestments in capital goods, and the greater the need for liquidation of these unsound investments. When the credit expansion stops, reverses, or even significantly slows down, the malinvestments are revealed. Mises demonstrated that the recession, far from being a strange, unexplainable aberration to be combated, is really a necessary process by which the market economy liquidates the unsound investments of the boom, and returns to the right consumption/investment proportions to satisfy consumers in the most efficient way.

Thus, in contrast to interventionists and statists who believe that the government must intervene to combat the recession process caused by the inner workings of free-market capitalism, Mises demonstrated precisely the opposite: that the government must keep its hands off the recession, so that the recession process can quickly eliminate the distortions imposed by the government-created inflationary boom.

Despite these dazzling contributions of The Theory of Money and Credit, Mises felt frustrated. He had carved out a theory of money and credit, and, for the first time, integrated it into general economic theory. He saw, also, that the general theory itself needed revising, and he originally intended to set forth a revised theory of direct exchange and relative price, along with his new theory of money. He also wished to present a thoroughgoing critique of the newly fashionable mathematical method in economics. But he had to shelve his grand plan for an integrated positive theory and a critique of mathematical economics, because he rightly believed that a world war would soon break out. As Mises wrote, in the midst of the next tragic world war,

If I could have worked quietly and taken my time, I would have begun with a theory of direct exchange in the first volume; and then I could proceed to the theory of indirect exchange. But I actually began with indirect exchange, because I believed that I did not have much time; I knew that we were on the eve of a great war and I wanted to complete my book before the war’s outbreak.¹²

It was only in the 1940s, with Nationalökonomie (1940), and its greatly expanded English edition, his masterwork, Human Action (1949), that Mises was able to complete his grand reconstruction and culmination of economic theory.

---

⁷ On Mises’s articles on gold and foreign exchange, on Böhm-Bawerk’s revelations, and on Mises’s decision, see Mises, Notes, pp. 43–53.

⁸ Mises’s stress on the utility of, and demand for, cash balances anticipated a seemingly similar emphasis by Alfred Marshall and his Cambridge School disciples, Pigou and Robertson. The difference, however, is that the Marshallian k, the demand for cash balances, was as aggregative and mechanistic as the Fisherine V, or “velocity of circulation,” so that the Cambridge k could easily be trivialized as the mathematical inverse of the Fisherine V. Mises’s demand for cash balance, grounded as it is in each individual’s demand, cannot be mathematically reduced in this way.

⁹ When gold or some other useful commodity is money, an increase in the stock of gold does confer a social benefit in its non-monetary uses; for now there is more gold available for jewelry, for industrial and dental uses, etc. Only in its monetary uses is any supply of gold optimal. When fiat paper is the monetary standard, in contrast, there are no non-monetary uses to render palatable an increase in its supply.

¹⁰ For a discussion of this point, see Murray N. Rothbard, Toward a Reconstruction of Utility and Welfare Economics (New York: Center for Libertarian Studies, [1956] 1977), pp. 9–15. Franz Cuhel’s contribution is in his Zur Lehre von den Bedürfnissen (Innsbruck, 1906), pp. 186ff. Böhm-Bawerk’s attempt to refute Cuhel can be found in Eugen von Böhm-Bawerk, Capital and Interest (South Holland, Ill.: Libertarian Press, 1959), III, pp. 124–36.

¹¹ The presentation of the Regression Theorem is in Ludwig von Mises, The Theory of Money and Credit, 3rd ed. (New Haven, Conn.: Yale University Press, 1953), pp. 108–23. Mises later answered critics of the theorem in his Human Action (New Haven, Conn.: Yale University Press, 1949), pp. 405–13. For a reply to more recent critics, Gilbert and Patinkin, see Rothbard, Toward a Reconstruction, p. 13, and Rothbard, Man, Economy and State (Princeton, N.J.: D. Van Nostrand, 1962), I, pp. 231–37, and esp. p. 448. Also see Rothbard, “The Austrian Theory of Money” in Edwin Dolan, ed., The Foundations of Modern Austrian Economics (Kansas City: Sheed and Ward, 1976), p. 170. For the most recent discussion of the Regression Theorem, including a reply to Moss’s critique of Mises, see James Rolph Edwards, The Economist of the Country: Ludwig von Mises in the History of Monetary Thought (New York: Carlton Press, 1985), pp. 49–67.

¹² Mises, Notes, p. 56.