The Currency-Banking Dispute in the Early Writings of Mises and his Contemporaries

0:00In one of the previous sessions, Amadeus talked about the German predecessors to the Theory of Money and Credit, and my topic runs partly parallel to that because I'll be saying some things about Mises' British precursors in the currency school and also their banking school opponents and how the dispute between the two groups framed discussions in monetary theory in Mises' early days between Mises and his contemporaries. There's some overlap between my topic and Dr. Salerno's, so I hope that he won't steal too many of my ideas, We'll try at least try to minimize the redundancies. So I'll just say some things about the broader points of the currency banking controversy and what it was all about, and also say something about how it influenced later economists. The currency banking dispute was very important in its day, but in the 20th century the issues fell out of fashion in many discussions of monetary theory and policy, with the exception of some history of thought studies.

0:56But in the last few decades there's been a revival of interests in the topic by historians of thought, among them some Austrians, and so the literature is growing once again. The dispute itself lasted from roughly the 1820s to the mid-1860s when it sort of petered out, although it is worth noting that what is called the currency banking controversy is really a continuation of a previous dispute, the so-called bullionist controversy of the late 18th and early 19th centuries. After the Bank of England resumed payments in 1821, after almost 25 years of suspension of payments, bank panics and crises continued to be a problem in Britain, and so attention was intensely focused on problems relating to how to manage a mixed currency and avoid the depreciation of the currency, losses of gold to foreign countries and financial crises.

1:50As a starting point for discussing the issues, both the so-called currency and banking camps and perhaps favored convertibility of the currency. But all sorts of questions remained about exactly how to manage such a currency and what effect credit issues had on the market and furthermore what sort of limitations the market, especially the loan market, placed on credit expansion. And so this was a central issue around which the debate revolved. After Peel's Act of 1844, when it appeared that the currency principle had proven a failure, School and its influence fell into decline. To some extent, the same was also true of the Orthodox Banking School as well, although Mill continued to be a late supporter of parts of the doctrine. And the Banking School survived in at least one other important respect as well, which I'll mention in a moment. But about 50 years after the initial British currency and banking schools had their primary debates, a new generation of economists took interest in the same problems. In a very short period of time in Vienna, three young economists

2:52published books, each especially interested in money and banking. Rudolf Hilferding's Finance Capital in 1910, Joseph Schumpeter's Theory of Economic Development in 1911, and of course Mises' Theory of Money and Credit in 1912. And to some extent these three books can be read as a reopening of the British debate. The great difference, however, being that between the original conflict and the later one, two important events had happened in economic theory, Karl Marx and the Marginal Revolution. Mises, Schumpeter and Hilferding each represented a kind of economic thinking which had come into vogue in those decades, but at the same time each was also influenced by the currency or banking schools. Of course, Mises sided with Menger, Hilferding with Marx, and Schumpeter with Walras, or Valrav, if you want to get technical about it. This is actually sort sort of an interesting moment in the history of economic thought because all three were intimately familiar with the Austrian writings of the period because they were all students in Boehm-Bawerk's seminar at the University of Vienna and so to some extent their writings

3:59were informed by Boehm-Bawerk despite the fact they represented such different traditions in economic thought. But setting that aside, the British debates play a very important role in each of these major works, and they're a very useful lens, I think, for placing these ideas in context in the history of economic thought. Understanding the currency in banking schools is especially necessary to appreciate the legacy and importance of the theory of money and credit because to a large extent, Mises considered this debate to be the event in 19th century monetary economics. Throughout his career, he comes back to it again and again in reference to both theory Theory and Policy. When I mention the relationship of Mises to the currency school, I refer mostly to the currency theory of credit expansion and the trade cycle.

4:51Mises himself always said, for example, in the second edition of The Theory of Money and Credit, that his ideas about the trade cycle were just a continuation of the currency school tradition. In fact, because Mises' business cycle theory has its roots in classical economics, some economists have even argued that there is nothing particularly Austrian about the so-called and the Old Austrian Theory of the Business Cycle. But I'll have something to say about that in a minute. So for some particulars of the debate, the currency school, which was essentially a hard money school of the 19th century Britain, was defined by its support of what is called the currency principle. The currency principle states that the money supply under a regime of mixed currency, that is a currency of both gold and convertible paper, should expand and contract precisely as it would if the supply were purely metallic.

5:37So if paper does not conform to what would be the fluctuations of metal, then so much the worse for paper. Any attempt to extend the circulation beyond the supply of a purely metallic system would result in depreciating currency and gold drains to other countries. In practice, this required a monetary policy where new issues of paper from banks would have to be fully backed by metal. So that's a brief summary of the unifying principle of the currency school, but I'm actually going to focus I'll focus less on the currency aspects because I think Dr. Salerno was going to talk more about that. And I'll focus instead on Mises' criticism of the opponents of the currency school. The currency school was opposed by the so-called banking school, which is usually associated with Thomas Hooke, John Fullerton, James Wilson, and later, and to a lesser extent, John Stuart Mill.

6:25The key proposition of the banking school was that convertibility, and only convertibility, was necessary to safeguard against excessive issues of bank credit. Given convertibility, it was simply impossible for banks to issue notes excessively, and thus depreciate the currency. The reason for this, and the core theme of the writings of the banking school, is what John Fullerton called the law of reflux, or the law of the reflux. The reflux refers to the process whereby excess notes are returned to the bank, and thus how their issue is limited. The idea was that any time a bank issued more paper than was demanded by the business community, The notes would be immediately returned to the bank for redemption. And so because of this, the supply of credit, bank credit, could never exceed the quantity necessary for the ordinary operations of business or what were described as the needs of trade.

7:19Now there are many problems with this banking school position, but the one pointed out by Robert Torrens of the currency school in which Mises develops explicitly in The Theory of Money and Credit is that it views banks as being essentially passive, as simply responding according to the so-called needs of trade, which, by the way, the banking school had never really defined. But what Torrens and Mises point out is that, of course, this is not the case. Banks are not passive in this situation because banks have the power to influence the interest rate, which is a determinant of the demand for credit. So by lowering the interest rate, one can increase the demand for credit, which is not not independent of bank policy, as it would have to be for the banking school. This for Mises was essentially the death blow for the banking school doctrine, this argument.

8:08But the banking school didn't see this simple flaw, because they were focused on an entirely different view of how money prices worked. They largely ignored the role of interest in this regard, because its relation to the supply of credit was simply not important for them, because in their view, the quantity of money did not influence prices. This orthodox banking school view was then adopted in Mises' own day by Rudolf Hilfreding, and that may partly explain why Mises devotes special attention to attacking it, because it may have seemed like the reflex theory was on the rise again in 1912, as it was being promoted by scholars of Mises' acquaintance.

8:55Hilferding was a member of the relatively short-lived so-called Austro-Marxist School, which is a branch of Marxism which grew up around a Boehm-Bawerk seminar in Vienna. Hilferding's economic research project revolved around, first, defending Marx against his Austrian critics, and second, flushing out the unfinished ideas in Marx's system, particularly the problems of money, banking, finance, and the business cycle, which Marx had only begun to discuss. And so to address these problems, Hilferding published Finance Capital in 1910, which is a sort of spiritual successor to the unfinished volumes of Das Kapital, especially the third volume. Now, Marx had supported some of the tenets of the banking school already, especially with regard to the needs of trade and the causal effect of prices on money.

9:43But as I mentioned, Marx never really finished this part of his project. So Hilferding steps in to develop the blueprint Marx had laid out regarding the decline of of Capitalist Society, particularly with regard to ideas about the finance industry and the business cycle, but also war and imperialism and some other issues as well. Huffreding basically argued that the last phase of capitalism, before capitalism would become socialism, would involve the expansion of the finance industry to incorporate and control all the other sectors of the economy. In order to do this, Hilferding inserted into his Marxist theory the banking school notion of the reflux. So what he required was a theory which would explain a great deal of credit expansion but would avoid the problems of excess issues of unbacked paper.

10:33And so the bank's, banking school's needs of trade approach fit very nicely into his system. And his idea was that credit expansion would eventually form the foundation of the finance Finance Industry, and that through expanding loans to other sectors of the economy, credit would eventually form a link between all sectors of the economy, uniting them all under the control of the finance industry in a first step toward full socialization. In fact, he actually didn't really attempt to even update the banking theory at all, or especially adapt it into his Marxist framework, and that was something which Schumpeter later pointed out is a major shortcoming of his book. So anyway, this forms an interesting contrast with Mises because while Hilferding almost blindly added the old theory to his newer one, Mises of course revised and enriched the currency theory with his own insights as well as those of others.

11:26And especially in his criticism of the reflux, Mises put some emphasis on using the insights of Torrance and the currency school to solve these recurring problems in the theory of credit expansion. Hilferding wrote an extremely negative review of the Theory of Money and Credit, which is, in large part, it's a diatribe against the subjective theory of value, but it's also significant because Hilferding seems to unintentionally point out that Mises' monetary theory is not just a logical development of Boehm-Bawerk's interest theory and Mengerian value theory, but also he seems to argue that Mises' acceptance of the currency school doctrine is also just with a logical development of the Austrian approach to value.

12:11And as far as his own work is concerned, especially in finance capital, Hilferding positions himself and Marx in the labor theory with the banking school. So this is sort of a fairly novel interpretation of the history of thought which sees these two types of value theory coincide with these distinct strands of banking theory as well. And if this view has merit, it would seem to downplay The view of those Austrians who don't count business cycle theory as one of the core pieces of the tradition. Hilferding recognizes, of course, that Mises posed a significant challenge to the banking school by pointing out that the interest rate influences the demand for credit. But because he was under the sway of orthodox banking school ideas, he seems to have misunderstood Mises' warnings about the dangers of the overissue of fiduciary media.

13:03Because for the banking school, there could be no such thing as undue credit expansion, as long as convertibility prevailed. Credit expansion is never more than just a natural part of business activities. And in following this notion, Hilferding also believed that credit expansion in basically all its forms is just a natural component of the capitalist process, and he takes Mises to mean this as well. And thus, because Mises talks about the business cycle and how banks possess the ability to expand credit in unison, and how this poses a great danger to capitalist economies. Hilferding reaches the conclusion that even Mises admits that capitalism contains the seeds of its own destruction and so Marx is right after all. But again it's interesting that while Hilferding dismisses Mises' view of the importance of the interest rate in determining the demand for credit and how that influences banks' incentives for collusion. At the same time, he also argues for his own reasons that banks naturally tend to concentrate and cartelize

14:03eventually to the point that they form a central bank to solidify the finance industry's control over the entire economy. And this development into a central bank is supposed to be one of the most important in explaining the transition from capitalism to socialism because once banking and finance control everything, the economy is sort of effectively socialized already. So as sometimes is the case with these sorts of economists, even when Hilferding gets it completely wrong, he still has some sort of interesting points to consider. The same thing might also be said about Mises' other contemporary, Joseph Schumpeter. Schumpeter's 1911 book, The Theory of Economic Development, is usually remembered as a treatise on entrepreneurship. But what is often forgotten is that it is also fundamentally, in fact inextricably, a theory of credit expansion as well.

14:53Credit expansion is the key to the whole problem of economic development for Schumpeter, because it is literally the only way for the economy to leave the static circular flow. So in addition to being the creator and the innovator, the ideas everyone is familiar with, Schumpeter's entrepreneur is also the necessary recipient of new bank credit. Now, as far as his own influences are concerned, Schumpeter is a bit slippery. He was certainly familiar with the currency banking literature, as you can tell from other things he wrote at the same time, especially his early history of thought pieces and his famously unfinished treatise on money. But in keeping with the style of the period, he cites very few sources in the theory of economic development. But the book does seem to be informed by the older debates and certainly is informed by his contemporaries.

15:41The historical issues of currency and banking come into Schumpeter's work through the entrepreneur. The credit-based view of the entrepreneur gives Schumpeter a big problem to solve because if credit is credited for the entrepreneur ex nihilo, surely there must be some inflationary effects he may have to explain. Schumpeter gets around this by saying, by sort of incorporating a pseudo banking school explanation of credit expansion, but what he says is, well, when the credit initially floods the market, prices do rise, and there was a transfer of purchasing power to the first recipients of credit, but after a time when the entrepreneurs finish introducing new goods, the new goods balance out the new money and everything just sort of settles back to where it was, just at a higher price level.

16:29So there's no real inflation, there's just the semblance of it, he calls it. And of course there are no business cycle-like effects in the sense of Mises. The strange part about this explanation though is that in the second edition of The Theory of Economic Development, Schumpeter quotes Mises on the concept of force saving when he explains this problem. And he uses Mises to explain what's happening in between the time of credit creation and the time of successful entrepreneurial innovation. And he says, oh yes, it's good that Mises pointed out this forced savings problem for us. But of course he doesn't go on to draw any conclusions from this because he's so involved in solving his own problem of development that he doesn't seem to accept the significance of what Mises is really arguing.

17:18The other point which is worth exploring is the relationship between Schumpeter's business cycle theory and that of the banking school. Since the banking school had opposed the currency school on the issue of monetary theories of the trade cycle, they had to replace those theories with something. And generally they argued for an explanation that looked for the source of problems in the so-called real economy. Thomas Took, for example, argued that cycles are caused by essentially exogenous events like the opening of new markets, the introduction of innovations and bad harvests. And this is of course not far from Schumpeter's own innovation theory of the business cycle, which is a part of the same family of theories. Both types rely on the idea of disproportionality in investment, especially over-investment in fixed capital. The banking school is one of the primary 19th century sources of these over-production sorts of theories of the business cycle.

18:08And it's in contrast to their ideas and those of economists like Schumpeter that Mises' development of the currency school theory gains additional significance. Because Mises' theory is, of course, not one of overinvestment, but of malinvestment, a distinction which critics of the Austrian approach continue to struggle with to this day. Now, of course, Mises did not accept the currency school theory entirely. He did identify what he called two great errors of the school, which are mostly the subject of the next paper, so I won't dwell on them. I will point out that it is indicative of how strongly Mises associated himself with the currency school, that he still maintained that identity while acknowledging the errors of the school, even though one of the errors involved central banking, which was of course anathema to Mises.

18:55Related to this, I just want to make one last point about the Currency School and its reform program. A very quick reading of the controversy might imply that the banking school believed more in the power of the market than the currency school did, in the sense that the currency school favored a rule instituted by a central bank to govern monetary policy, whereas the banking school believed that only a guarantee of convertibility was required to maintain economic stability. But this reading would overlook a couple of critical details. The most important point is to note that it was not that the currency school preferred some sort of monetary rule instead of a market-based system of monetary management. For them, the monetary rule would necessarily realize the market-based system, which was for them a system of purely metallic money.

19:45So, to take one example, if more cash were needed for circulation, and there would be a tendency for the value of money to rise relatively to what it was elsewhere. Gold would flow in and the need would be met. So it is important to point out that this, that they imagined that this was actually a sort of a, we might call a market-based system of monetary management, even though they of course advocated the use of a central bank. Furthermore, the banking school's views on monetary policy did not imply a free market and money, but rather the discretion of the central bank in deciding how to expand the circulation. The so-called needs of trade would have to be interpreted somehow and translated into monetary policy by the administrators of the bank.

20:32But it's important to recognize that even without this oversight on the part of the banking school, the position of the currency school on this issue is not necessarily threatened. Looking at the banking school in the light of the idea of free markets in banking, we We can see that even without a central bank, the banking school would still have had to explain how the needs of trade translate into a market-based system of monetary management and furthermore why that system would succeed better than the currency principle. So it's important to emphasize that despite the shortcomings, the currency school were not necessarily anti-market in this way and the orthodox banking school were not necessarily pro-market. So just to sum up, I would just like to point out that these debates still hold a great deal of significance, not just for historians of thought, but for anyone interested in really understanding, teaching, developing the ideas of Mises and the Austrians. The theories discussed by the currency school, as well as the errors of the banking school, and of Mises contemporaries,

21:37they helped give shape to the system that Mises built, starting with the Theory of Money And there's a system which has continued to blossom over the last 100 years and which I hope will continue to grow long past the next 100. So, thank you.