Theory of Money and Credit

0:00Good morning. Welcome to the third installment of our seminar on the life and times and work of Ludwig von Mises. This morning we will be dealing with Mises' first great treatise, The Theory of Money and Credit. And unfortunately, there won't be any pictures or photos that I can show you because Mises didn't even use grass in his book. The book is, as I said, Mises's first great treatise. It is the first result of one of his two great research projects that you can see here. This is his first great treatise. It is the first result of one of his two great research projects that he pursued throughout his life.

0:56We can distinguish two great research projects. The one concerns economic theory or let's say social theory more narrowly. And the second research project concerned the epistemology of economics and the epistemology of economic science in particular.

1:19In his positive or economic research project, the central theme is the integration of monetary theory into the general theory of value and prices established by Carl Menger. So we have said Menger himself had neglected The Theory of Money for reasons that we'll discuss in a little bit more details in a minute. And so Mises filled this gap and he proposed a solution to this problem in The Theory of Money and Credit, which was first published in 1912. And he later on then spelled out all the further implications that he had partly only hinted at in this first book, and finally proposed a comprehensive system of economic analysis in his 1940 book, National Economie, which had an English follow-up nine years later in Human Action.

2:15Here we have treatise of economics which spells out all the implications that follow from Mises' solution to the problem of integrating money into the theory of value and prices. The second big research project, and we'll come to talk about this later on in the seminar, concerns epistemology, and this starts at the end of the 1920s and then extends until the end of his life, until the mid-1960s. in the 1960s. And it's important again, therefore I should like to point this out already now, that Mises did not start off with certain epioroi notions about what economic science should be like from a logical or epistemological point of view. He first dealt with economics in great detail And then only after he had made up his mind about the main questions or virtually all the questions that he had come into play, he started writing on epistemology.

3:13It was a second step. And that's of course how it should be done. Now, Mises could rely in part on Menger's theory of value because there were some elements, as I said Menger did not integrate money and integrate money into the theory of value and prices, but there were elements of a theory and this concerned in particular two elements. First of all, Menger had a cash-holding approach to the demand for money. That is, according to Menger, what people desired when they had a demand for money were cash-holding, certain amounts of money in their pocket. Today we have only ugly money, of course, like this, but this is a cash holding, whatever banknote we have in our pocket is a cash holding, so Menger stressed that the demand for money concerned this, to have money in the pocket.

4:10Of course, it was not detached from father reaching purposes, spending the money and so on, and so on, but holding the money in one's pocket was the use that we made of money until the very moment when we spend it. The second element on which Mises could rely, and this was the central concern in Menger's writing on money, was the spontaneous emergence of money. That is Menger contested the notion, which was at the time becoming prominent again in German economic thought, Menger thought that money was created by some sort of a convention or maybe even was created only through a decree of the state, a decree of the government.

5:02Menger explained that money arises spontaneously in the market process because people want to overcome the limitations of direct exchange. Direct exchange happens when people exchange consumer goods against one another or consumer goods against producer goods, what we also sometimes call real goods, exchange of real goods. A barter economy. Now barter economy is limited because you need to find somebody who is precisely interested in the kind of commodity you have to propose and those people are usually not very numerous. To overcome these limitations, we can introduce indirect exchange, and so Menger introduces this notion of indirect exchange. That is, we exchange our consumer goods that we have produced. For example, I've picked a couple of berries, three kilograms of berries, now sell them against not the goods that I directly desire myself, but some intermediate good that is very liquid or marketable, This is a marketable that is desired by many people on the market so that I can use this good again to buy something else.

6:12So this intermediate good is a medium of exchange and it becomes money once it is generally accepted. Now the question is how come that it is generally accepted and here the theory of the spontaneous emergence of money comes into play. The theory states, well, money becomes generally accepted through a step-by-step process in the course of which each individual for himself discovers those goods that are most suitable for the service of a medium of exchange. And those goods that are most suitable are so by virtue of their physical qualities. That's the heart of the Mengerian explanation. In particular, we might say the precious metals have physical qualities, malleability, they are durable, they are easily recognizable, easily divisible and so on, which make them more suitable for indirect exchange than, let's say, armchairs or microphones or eggs and other things.

7:18So, we have therefore a theory that explains how money emerges spontaneously in the market, which allows us to dispense with government as a necessary element in the explanation of the emergence of money. Menger was not original in this respect. He himself could rely on previous works by monetary theorists, Theorists starting from John Law in the early 18th century and then throughout the 18th century works of Gagliani, Kondiak, Smith, Genovese, and then later on the 19th century Jean-Baptiste Say and Richard Wakey. What Menger did was to highlight the importance of this theory of the spontaneous emergence of institutions.

8:07and the case of money was for him just one of the most striking examples that illustrate the general theory of the spontaneous emergence of institutions. Money was just one case but virtually all other institutions also, useful institutions also, emerge spontaneously on the market, language, law and other things. So, Mises could rely here on Menger. In what follows now, I will point out his five major contributions that he made in the theory of money and credit. First of all, he contributed several clarifications on the nature of money.

8:54Second, he developed a theory of the value of money. This is his main contribution, which concerned the full second part of the book, the first part being devoted to the discussion of the nature of money. The second part is about the value of money. He is filling the gap that Menger left in his Theory of Money. And then we have two minor contributions. One stresses the presence of Cantillon effects or redistribution effects resulting from the production of money. The second one concerns a reassertion of the purchasing power parity of exchange rates. And finally, in fifth, we have another major contribution which is a theory of the business cycle that he develops in the last part, in the third part of the book.

9:45In this 1912 edition, the book has only three parts. The edition that you can buy now, for example next door, is the 1954 edition which has four parts. The fourth part was added precisely after the war and here Mises discusses problems of monetary reform. Okay, so let's start off with Mises' clarifications of the nature of money. Again, we can distinguish four points. First, he stressed that the customary distinctions of several monetary functions, particular money is a medium of exchange, it is a unit of account, and it is a store of value.

10:33These are typically the three major functions that we find in all textbooks being emphasized as characteristic of money. He urges us not to fall into the trap of considering that they are all of equal importance. There is in fact a dependence relationship between them. The fundamental function of money is one of serving as a medium of exchange. And he stresses this in particular in its relationship to the unit of account function. Why don't we, I mean, in principle we could use any economic good as a numeraire, as a measuring rod, a standard of value for economic calculations.

11:20We could use microphones or we could use a pair of shoes or oranges or whatever else. So why do we use money? How do we use money? Well, there is something like the economics of calculation. Calculation is an economic activity. It consumes scarce resources. And if we want to perform calculations in any other unit than the medium of exchange, than any other unit than the monetary unit itself, we have to add an additional operation. We have to retranslate all prices that are being paid on the market in terms of money, in terms of those other goods with which we want to calculate. If I do not want to calculate in US dollars but in oranges, I would have to translate the prices of chairs and of carpets and of light bulbs and so on in terms of oranges, which I can do with the help of dollar prices.

12:12But clearly that's a very complicated way of going about things. It simply adds another step in our intellectual process without contributing anything to the precision of the calculus. So fundamentally, therefore, the function of a medium of exchange is fundamental. And all other functions are, in particular, the function of a unit of account as derived from it. Second, Mises develops a typology of monetary objects. Oh, here's finally a diagram that I might show you, which is a good thing, but he didn't use this in the 1912 edition of the book.

13:07It's something that we found among his later documents, which was taken up in a later reprint of the 1954 edition.

13:23Can you see this? No? Okay, so let's try and work on the contrast, which presupposes that I find the right... Mises develops a typology of monetary objects and fundamentally he distinguishes between money in the narrow sense and money substitutes. We have one notion of money in the broader sense. This is a generally accepted medium of exchange.

14:11That's the definition of money in general or of money in the broader sense. But there are in fact two fundamentally different types of monetary objects, namely money in the narrow sense or in the proper sense and money substitutes. Money substitutes are legal titles for money. That is, from a technical point of view, they are issued by somebody, often a bank, and their issue comes with a legal obligation on the part of the issuer, contractual obligation usually, to redeem the substitutes back into money.

14:56So they are legal title and former times, so banknotes were such money substitutes or token coins, therefore we have this, we'll talk about this in a minute. And they could be exchanged back again into money in the narrow sense or money proper. Now, money proper are those monetary objects that are not legal titles. That is, they do not represent an underlying asset. They are an economic good in their own right, and they are therefore evaluated independently of any other good. or more precisely, they're not evaluated because they give a right to redeem them into something else.

15:54Today, of course, it's somewhat difficult to explain this. We had, again, I showed a dollar note before. So this today is money, it is paper money and it is not a money substitute because I can no longer redeem it into something else, something underlying. You can go to the Federal Reserve Bank of Atlanta or any other Federal Reserve Bank and say well I want to redeem this and at most you will get another one dollar note for this. So you cannot redeem it into any other economic good but dollar notes itself. But before 1971, which was the year in which the Federal Reserve Bank suspended its redemption of dollar notes into gold, the dollar was not money, it was a money substitute.

16:48Because you could redeem it, the Federal Reserve was legally obliged to redeem it, well not for us private persons but for foreign central banks, to redeem it into gold. So therefore the dollar was a money substitute at the time, it was simply a legal title for money. And the money underlying this legal title was gold, because we were on the gold standard. So this clarification is one of the fundamental contributions that Mises made. And from here all the major differences between his theory of money and those of others, and still today between the monetary theories inspired by Mises and those of other economists, can be referred back to this fundamental distinction.

17:46Non-Misesians typically overlook this distinction. One example that we can give today is the debate about currency competition. Most writers who have expressed themselves ever since the 1970s on the subject have fallen prey to a confusion because they confuse competition of money substitutes with competition between money and the rules of the game are very different in the two types of competition. Now, based on this fundamental distinction between money in the narrow sense and money substitutes, Mises established further distinctions, so in the case of money in the narrow sense, we can distinguish three types of money, Commodity money, credit money and fiat money or as Mises said in the German original Zeichengeld, fiat money or the original term was Zeichengeld, sign money, that is most important example is paper money.

18:47Commodity money is an economic good which has a non-monetary service or provides a non-monetary service, monetary services such as for example gold and silver which have many ornamental and industrial uses and which have a monetary use on top of this. So this is the fundamental or defining characteristic of a commodity money. We have two types of uses. Then we have credit money, in which case we use an IOU or a credit instrument, a financial title, as a generally accepted medium of exchange. So there are two. We have two services that are provided by this good. And finally then we have fiat money, and the characteristic mark of a fiat money is that it has no other use, but typically no other use.

19:45but that of a medium of exchange. On the side of the money substitutes, we have another fundamental distinction that is not original with Mises but of which he detailed the great implications, namely the distinction between money substitutes that are fully covered by underlying money. In this case we speak of money certificates, it should be on the same level as the other expression, fiduciary media should be up here. And then we have fiduciary media, which are money substitutes that are not fully covered by underlying money, money in the narrow sense.

20:34How is it possible to have money substitutes that are not fully covered by underlying money? Well, it's possible if and to the extent that those who use these money substitutes do not redeem them immediately into money. That is, to the extent that these money substitutes circulate in the market and that only a part of them are redeemed on a daily basis, Well, then the issuer can, from a technical point of view, afford not to cover all his issues by underlying money. He needs just to keep that part, such a coverage, as to put himself into a position of redeeming or satisfying all redemption demands on a daily basis.

21:22Let's say only 10% of all money substitutes that I as a banker issue are redeemed or submitted for redemption in the course of a month, well then I only need to retain a reserve ratio of 10%. If I issue let's say money substitutes for $10,000, I only need to keep $1,000 in my vault in order to be able to redeem these substitutes that are submitted to me on a monthly basis. Money certificates are fully covered and then, of course, there are different physical embodiments that we can imagine.

22:10In the case of money certificates, this diagram will be modified in the final printed edition. It can distinguish between fully covered token money and fully covered banknotes. Just on the side of fiduciary media, we can distinguish between partially uncovered token money and uncovered bank deposits and notes. So the physical embodiments can be different, it can be coins or it can be notes, but they are all legal titles. And again, so either they are fully covered or they are not fully covered. Now what Mises does in the third part of his book is to examine the implications of uncovered money substitutes.

22:58The entire third part of the book deals with this type of monetary objects, that is, with this here, fiduciary media. And in fact the German title of the book can be literally translated into theory of money and fiduciary media. The title is Theorie des Geldes und der Umlaufsmittel, and umlaufsmittel are nothing but fiduciary media, that is money substitutes that are only partially covered by underlying money. And what Mises shows is that these fiduciary media, particular money substitutes, have particular consequences for the economy. They have a particular impact on pricing and the most important consequence is to engender business cycles.

23:46In the English translation of the book, the title of this literal translation has not been used, probably for stylistic reasons. The theory of money and fiduciary media would have sounded awkward in 1934 when the first English tradition appeared. appeared, but well, I must tell you that in German, The Theory des Geldes and der Umlaufsmittel is not more elegant. So there was a reason why Mises insisted on this in the title and he clearly wanted to hammer this point, that this is an important distinction. Unfortunately, it vanished in the English editions that we had so far.

24:32Okay, so Mises develops this typology of monetary optics. It's fundamental and clearly for a beginner it's not immediately obvious if you read this book without knowing much about monetary theory, well you're likely to overlook this especially since he proposes this typology in the beginning of the book. The third clarification that Mises contributes on the nature of money concerns the role of money prices and in particular he refutes the notion that money prices are measures of value. Now again we need to recall that in the approach of Carl Menger there is a fundamental difference between value on the one hand and price on the other hand.

25:20It's not the same thing, because Visa and others had held that prices are just an expression of value. But this goes by no way self-evident. It would need to be explained, and Visa didn't really explain this assumption. So for Menger, prices are very different from value. Value is the thing, the quality of an economic good that explains prices that are being formed on the market. Mises could rely here, in his refutation of this notion that prices are measures of value, he could rely here on the work of a Czech economist, a Czech-Austrian, by the name of Franz Chuhel, of Frantiček Čuhel, I believe as the Czechs say it, and he published in 1907 a book with the title Zur Lehre von den Bedürfnissen, on the Theory of Needs.

26:25Now Čuhel was strongly inspired by Wieser, so rather in the Jevonsian lines of the Austrians, But he contributed a very important critique of the Viserian Theory of Value. In particular, True Health stressed that it is not listed to add values or utilities. If we have a stock of, let's say, 15 oranges, then we cannot simply, to determine the total value of the stock, We cannot simply take the marginal unit, the value of the marginal unit, that is the marginal value, and multiply it with the factor of 15. And the reason is that marginal value diminishes as the size of the stock increases.

27:13Therefore, so the consequence is we cannot add or subtract values and utilities. Utilities. Second, it follows from this that it is also illicit to perform interpersonal comparisons of utility. We cannot simply compare or add up or subtract the values of different individuals or the utilities of different individuals. Now this is important on his own right because it shows that so by 1907 or at least until World War I, the Austrian economists were We are well aware of this problem of interpersonal comparisons of utility. Later on, this debate resurfaced in the English language literature some 30 years later.

28:03And for the Austrians, this was already an old cut. It had to be debated again between Robbins and Herod and others. When Murray Rothbard in 1956 published his important paper on the reconstruction of welfare and utility economics, he also was, of course, ignorant of True Health's book. So the big implication of True Health's book is that there is no such thing as value calculation and not even such a thing as value measurement of total stocks. and Total Stocks, very important and fundamental thesis. And it follows from this that there can be no such thing as quantitative, purely quantitative laws in economics as we find them in the natural sciences.

28:56There can be no such thing as constant relationships between quantities, for example, between variations in the price and variations in quantities of goods being sold and bought, because the marginal utility of the goods that are being bought and sold varies from one person to another and from one moment of time to another. Now, why is this important? Well, because precisely at that moment in the early 1900s, Irving Fischer started reformulating economic theory as a quantitative discipline. Of course, he was not the first to do this, but Fischer sought to establish quantitative laws, constant quantitative relationships in economics.

29:48and economics, for example, again, relationships between variations in price and variations in quantities, but also other things, in economics. And it followed from Juhel's argument, although Juhel did not point this out himself, it followed that such a discipline was not possible. But Mises pointed it out, because Mises had read Fischer's 1911 book at this point, and he stressed this implication. There can be no such thing as a purely quantitative discipline. Economics deals, of course, with quantities, but it deals not with constant relationships between quantities. This is a fine distinction. Of course, economics has to deal with quantities because quantities are those things that are precisely limited.

30:40We are dealing with scarcity, but there are no constant relationships, constant quantitative relationships between those quantities. The fourth contribution or fourth clarification that Mises made on the nature of money concerned the rejection of the state theory of money or as it was called by one of its main German language advocates, This book is called Charterism. Charterism comes from the Latin word charter, C-H-A-R-T-A, which means token, it's a sign. So according to this theory, money is essentially a sign. It is something like an IOU for underlying goods and services that can be bought against money.

31:31So therefore, this whole distinction would not hold. We said here that money substitutes are legal titles for money. Well, according to the chart of this, money in the narrow sense is a substitute too, is something like a token. It can be exchanged for other goods and services. It represents other goods and services in the economy. Mises called this also the assignment theory of money, and of course it is very widely held even today, many textbook authors who hold this notion, who believe that money is something like an IOU for goods and services circulating in the economy, and they assimilate the functioning of a monetary economy to the functioning of a warehouse business.

32:24Inflation is, when you deliver a good or a service, for example you work for an employer, you get your money, so you get whatever, $3 for 10 minutes of work, inflation is running, then this represents the work, the economic goods that you have delivered into the economic warehouse, The Social Economic Warehouse, the entire society. So this for you then is a legal claim on other goods and services that you can take out of this warehouse. So this very roughly said is the assignment theory of money or the idea of economic chartelism, monetary chartelism. Now the charter is stated that money is essentially a creation of the state.

33:18This notion is of course very old. You find it already in the Greek philosophers. The Greek word for money is, or the ancient Greek word for money is numisma, which comes from nomos, the law. So money is an economic good that is the creation of the law, it is imposed by the government, it is imposed by the state. And this theory survived throughout the ages, we find it in the middle ages, and we of course find it also in modern times. About the time when Mises published, it had found champions in France, like Henri Cernuski, in Germany, like William Lexis, and in Austria, a very famous economist by the name of Neupauer.

34:06But its most brilliant advocate was Georg Friedrich Knapp, about whom we talked already yesterday, when we talked about Peasant Lib. So Knapp in 1905 publishes a book with the title Die Staatliche Theorie des Geldes or The State Theory of Money in which he claims from the outset without proof or demonstration by the way that money is essentially a creation of the state. Which is again from the point of view of analytical philosophy, unobjectionable, you just define, you give a definition, you say well I'm just talking about the creations of the state. It's a different question whether you exhaust the full range of empirically verifiable monetary objects and clearly Mises objected to this notion that it's simply not true that all monies, that all generally accepted media of exchange are created by the state.

35:04What the state can do with its fiat, that is with its decrease, is to impose the use of a certain medium of exchange for those contracts that already exist. That is, essentially it concerns deferred payments. If we make an exchange, I buy from Mr. Perry, let's say a car, he delivers me the car today, Today, and I promise payment of 500 ounces of silver tomorrow. The state can say, well, from now on, no more payment in silver may take place and all people shall use our paper notes that we issue hereby. And then, indeed, he would be obliged to accept the paper notes issued by the government. So the government can impose the use of its money in the case of all contracts that already exist.

35:58But this does not mean that it can thereby impose its money also for those contracts that do not yet exist. Ultimately, well, I'm free to make a contract or not. If I know that I have to accept this paper money of the government, well, maybe I won't make a contract at all. Or I will make my contract only abroad in some territory where the law doesn't apply. Of course, that's precisely what we observe in empirical practice. That is, the law cannot impose just any medium of exchange. It is strongly constrained by the freedom of choice of the market participants. And therefore, empirically, we find that the government can by and large impose only those media of exchange that are not completely unuseful for the market participants.

36:45It can impose paper notes because paper notes can be easily handled and so on, but it could not, for example, impose the use of armchairs as media of exchange. Then people would rather renounce to making any further contracts than respecting the law. Okay, now let's move on to the second big contribution, the central contribution of Mises' book, which is his theory of the value of money. It's probably useful to start briefly with the monetary theory of the classics, which is a reaction against the monetary theories prevalent before the classical economist, that is until the mid 18th century approximately.

37:38The classical theorists rejected the exaggerated hopes that the mercantilist writers had in the creative power of money. What Adam Smith reacted to in particular was the notion that you could enrich the nation by printing paper notes, that you could enrich the nation by banking, for example. This was precisely the prevailing notion until Adam Smith. Many people had reacted against this, but it was the main doctrine against which Adam Smith reacted. The title of his book was The Wealth of Nations, and The Wealth of Nations, that was his thesis, does not derive from creating money, but it derives from work and from capital accumulation and division of labor under capital accumulation.

38:32So the classical economists reject what we from an Austrian point of view would call the inflationists or the inflationist theories maintained by the mercantilists. And so it remained throughout the 19th century the dominant monetary theory was the one of the classics who denied in principle any creative power of monetary production. But the classics went beyond this. They fell into another exaggeration and another trap. What they claimed was that money had no impact on the economy at all. Money prices were just a veal, a monetary veal layered over the real economy.

39:20So we have here the theory of the veal of money. We find this theory in particular most clearly expressed in John Stuart Mill, Principles of Economics. So here is what John Stuart Mill says about this. says about this, things which by barter would exchange for one another will, if sold for money, sell for an equal amount of it, and so will exchange for one another still, though the process of exchanging them will consist of two operations instead of one.

40:07The relations of commodities to one another remain unaltered by money. The only new relation introduced is their relation to money itself, how much or how little money they will exchange for. In other words, how the exchange value of money itself is determined. So we have here a distinction that we still find in some textbooks today, the distinction between the price level and between relative prices. According to the classical economists, these two things had nothing to do with one another. The price level could change and it would change as a consequence of altering the money supply. But this would not affect relative prices. Money would leave everything intact just as it would have been in a barter economy.

40:57Money is neutral. Money is just a veil. is just a veil. Now, this veil theory of money was maintained by all the main economists who brought about the Marginalist Revolution, that is by Carl Menger, Leon Barra and William Stanley Jevons. They didn't deal with money at all because they fundamentally accepted the point of the classical economist, yet the nation could not enrich itself by money production. So they were not interested in the theory of money. They neglected it. But then came another step in the form of an outside critique.

41:47And the critique said that this new value theory, well, willy-nilly had to neglect the case of money because in fact it cannot explain the value of money. And this critique came from a brilliant German economist of the time by the name of Carl Helferich, H-E-L-F-F-E-R-I-C-H. Carl Helferich, and I don't have a picture of him here, but he was, again, a brilliant economist. He was later director of the Deutsche Bank, the main commercial bank in Germany until today, and also finance minister after World War I. So Helfrich claimed that it is impossible in fact to deliver any such a proof because it would involve circular reasoning.

42:39In the case of money we have the following problem. If we want to apply the typical form of explanation that we find in marginal value theory, we start with value as the explaining factor and we explain the prices. It's the thing to be explained. Now in the case of money, if we start with the value of money as the explaining factor and we want to explain monetary prices as being formed on the market, we encounter the following problem. The value of money itself obviously must depend on the prices that I can obtain for it. The value of a dollar in my pocket obviously depends on how many things I can buy for such a dollar.

43:24But then, don't we have circular reasoning here? We want to explain the prices by the value, but the value can only be explained by the prices. So we have a circle here and the procedure cherished by the Austrian School cannot apply, cannot work. Now, the first response from the Austrian side to the Helfrich critique came from Frederic von Wieser. And Wieser made one very important contribution by explaining how the Helfrich critique could be sidestepped or could be overcome. For Visa said that ultimately we do not have here a synchronic co-determination of value and prices, but we have a diachronic determination through our time.

44:21If I want to explain the prices that exist here at point of time 0, then I must explain them in terms of the value of money that it has at point of time 0 minus 1. But then this value that exists here at t-1 is itself determined by the prices that existed even before, not by those prices here of t, but t-2 for example. And then these prices would be explained by the value existing at t-3 and so on. So we have a determination running through time, there's no circle involved, there is a sequence, a causal sequence. and so we get out of the Helfrich circle and the Austrian approach can work, can be applied to money.

45:14We have here therefore the fundamental idea underlying what Mises later called the regression theorem of the value of money. That is, we explain the value of money by regressing our causal chain back into the past In order to explain the value of money, at one point of time we go back to the money prices existing previously, which themselves result from valuations existing even before that and so on. It's the regression theorem. Wieser didn't use this expression, Mises used it later on, not in 1912. But Wieser also did not deliver a coherent theory of money because he shared the assumption of the classical economist that money has no impact on the real economy, that money is just a veil.

46:20Money has no value per se, money is just an IOU for other goods and services. So in other words, Mises cherished the assignment theory of money. Now this approach to monetary theory implied two major problems. The first one is that Mises only developed a theory of the value of money, The second one is that Visa had to make in the case of money an important exception from the general rule of value theory held by Carl Menger, namely that things have always an unequal value.

47:09If an exchange takes place, then obviously the things, well again, my exchange with Richard Perry, I buy the car, then obviously my money has for me less value than the car. Therefore I give up the money and I take the car. For him it's the other way around. He prefers my money to his car. Therefore he gives up the car for my money. So there's always unequality of value, which is the fundamental precondition that must be given for an exchange to take place. take place. Now if Visa is right and money is just an IOU, well then we value money obviously not on its own terms, not for its own sake, but as being equal to these other goods and services. In any case that was the notion that Visa held. And monetary exchange does not demonstrate inequality between the objects being exchanged, but equality.

48:04And then of course we run into a fundamental contradiction. How can we explain such an exchange at all? Now Mises could overcome this problem by stressing the traditional notion that money is in fact a real good. It is a good on its own and by combining this notion with the regression theorem. So it took the regression theorem from Mises but did not adhere to the assignment theory. So Mises created a synthesis in his theory of the value of money that has been solid because we can still adhere to this theory today by and large in the way he exposes in 1912.

49:03Still, we have to make one exception because Mises at one point in his book, and it's important, he fell back into the Viserian era, because there's in fact one passage that can be read, or must in fact be read, is if he adheres to Vise's assignment theory of money. I will read this passage for you now. So Mises says the following, Here is the following. The subjective value of money always depends on the subjective value of the other economic goods that can be obtained in exchange for it. So far so good. If we wish to estimate the significance that a given sum of money has in view of the known dependence upon it of a certain satisfaction, we can do this only on the assumption that the money possesses a given objective exchange value.

49:52Again, so far so good, but now comes a quote, and he quotes Visa. The exchange value of money is the anticipated use value of the things that can be obtained with it. I'll read it again. The exchange value of money is, that is, is the same thing. It's not just dependent on, depends on is a function of, but is the same thing as the anticipated use value of the things that can be obtained for it. That is, the subjective value of money is equal to the subjective value of the things that can be exchanged for it. Again, there's a nuance here. Therefore, I repeat myself again.

50:38It's not the same thing if you say, well, it depends on the use value of the things that you can use for it. That's fine. So it's one element in the function. But he goes beyond this and says it is the same thing, which means there's no demand for money itself, there's only a demand for these other things. Now that of course is untenable, it amounts to saying that money has no value of its own, exclusively determined by the value of the other goods. Now, it was only later in his economic treatise on national economy and human action that he gets rid of this error.

51:25But by the time he published these treatises in the 1940s, his earlier monograph on the theory of money was still being taken are still being taken by some as the final word on the subject, most notably by Don Patinkin, one of the eminent monetary authorities, authorities in monetary theory after World War II. Patinkin criticized Mises by referring precisely to the passage that I had just read to you, in which the old veil of money notion shows through. So, Patinkin said that these views implied a circular explanation of the value of money. This was correct. But, of course, Patinkin's general thesis that none of his predecessors had come up with a coherent explanation of the value of money ignored Mises' later restatements in national economy and human action.

52:24And so the main reason why Mises was neglected, Mises contribution to monetary theory was neglected in the post-World War II period, well, can be traced back to this one passage in which the Vissarion heritage excessively shines through.

52:45Okay, then let's move on to the three last, three other contributions that we mentioned in the beginning. Here we have, first of all, the Cantillon effects, or redistribution effects resulting from the production of money. The fact in question is the following. If you raise the question, how does money affect the prices being paid on the market? Well, the Misesian explanation goes as follows. If we increase the quantity of a homogeneous good, then its marginal value must decrease. That's of course the Mengerian point. If I increase the quantities of oranges, then the additional oranges can serve certain purposes that are less important than those projects that I realized with the help of the smaller supply of oranges that existed before.

53:45Let's say before I just had two oranges, and the first one I used to eat myself, and the second one I give to my beloved one. These are the two most important projects. Now I have a third orange, and I can use it for something else. For example, I can use it to throw it at George Crispin. Then clearly this third project is less important than the two other projects. In the case of money, it's the same thing. The more I have of money, the more things I can do, but necessarily these additional things that I can do are less important than the things that I could do before. Therefore, the relative importance of money decreases as compared to other goods and services.

54:32In other words, I will now be ready to pay higher prices for other goods and services, and if I buy money, that is, for example, if I work for money, well, I will insist on getting paid more money for the same amount of money that I deliver, because money loses in relative importance for me. So the general tendency is therefore for money prices to increase. But now there is another aspect of this process, namely that money prices will increase, but they will not increase all at the same time. They will increase to the extent that the additional money supply makes itself felt in the cash holdings of individuals. Now, if I increase the quantity of money, not all individuals will be concerned at the same time.

55:23In the course of time, when the money spreads, the new money spreads throughout the economy, all individuals will be concerned. That is, everybody will feel a lower marginal value of money. But, at first, the additional money is present only in the hands of certain individuals. And for them, therefore, at first, the marginal value of money declines, therefore they first will pay higher money prices. Whereas for the others, it will stay at first the same. Now money spreads throughout the economy, prices rise step by step. This implies a redistribution process, because some individuals, those who have not yet seen their monetary incomes increase, will already have to pay the higher prices, namely because the first receivers of the new monetary units will bid up the prices on the markets.

56:21So the last receivers have their money income not to increase, but they already have to pay higher money prices. In other terms, the real value of their monetary income, their real income, will decrease. It follows, therefore, that any type of monetary production goes in hand with a redistribution in favor of the first receivers or first users of money, of the new money, and to the detriment of the last receivers or last users of this new money. Money. This is an unavoidable consequence of any monetary production and these effects, this redistribution effect, well, is called Cantillon effect. It's a Cantillon effect after Richard Cantillon, an Irish-French banker economist of the early 18th century, who first described this mechanism. So Cantillon insisted that plays special emphasis on the analysis of the flows of money throughout the economy was one of the first ones to conceive of the monetary economy as an economy of a circular flow of money.

57:38And in tracing the spending streams throughout the economy, well, he found precisely this mechanism that prices do not increase all at once, all at the same time, all to the same extent, but at different points of time and to different extents. And one consequence of this was that there must be a redistribution in favor of the first receivers and to the detriment of the last receivers. Now, Mises stressed this redistribution effect very much in the second part of his theory of money and credit.

58:24and we must say he was about the last major monetary economist who did this. Before Mises, this point was still common knowledge of monetary economists. I'll give you just a few names of major economists before Mises who had also recognized this point and stressed this. I want to stress this, so David Hume, David Ricardo, John Stuart Mill, Hermann Heinrich Gossen, John Carnes, and others. And as I said, Mises was about the last one, because just at the time when Mises was writing, publishing his work in 1912, a new movement set in that stressed monetary analysis in terms of aggregates.

59:12The main proponents of this new movement were Irving Fischer again, the evil Irving, and Gustav Kassel. The other major economist next to Mises who also stressed it was John Maynard Keynes in his writings before the 1930s when he also joined the macroeconomic aggregate camp. Okay, so of course if you look at the monetary economy only from an aggregate point of view, if you're only interested in money supply in general, in the price level and not in individual prices, then of course the Cantillon effects drop out of your radar screen, you don't see them anymore, because it's a micro phenomenon below the macroeconomic or aggregate surface.

1:00:00Another important contribution that Mises made by stressing an important point, though it was not original with him, was the theory of exchange rates in which he restated the Ricardian theory of the purchasing power parity. That is, according to this theory, exchange rates between two monies were ultimately determined by the purchasing power of each of them. Let's say if an orange costs $2 in the US and it will cost 1 euro in Europe, then the exchange rate between dollars and euros will tend to be 2 to 1. Because at this exchange rate it doesn't matter whether you buy the good in dollars or in euros.

1:00:50As soon as there's any difference, as soon as it's more favorable to buy the good with euros rather than with dollars, well then of course you will try to buy them with euros. That is, you will sell your dollars against euros in order to have the better deal, but this of course implies that the exchange rate of the dollar will fall. and so it will become in term, in equilibrium it will be again indifferent whether you buy them with euros or with dollars. Now Mises stressed this in the context of intellectual time in which another approach to the exchange rate determination was prevalent, namely the balance of payments theory of exchange rates.

1:01:36According to this theory, it was the balance of payments that is imports and exports that determined the balance, determined the exchange rates. If more goods were being imported, then of course the demand for our currency would increase and as a consequence its exchange rate will increase and inversely. Now, Mises' critique of this balance of payments approach is that it does not go far enough. It's true that immediately the exchange rates are determined by imports and exports. But the question is, why are there imports and exports? And here we have to rely on price differentials. There are imports and exports, well, because the prices are different for the goods.

1:02:24The goods are exported from the country where it costs less to the country or where it can command a higher price. and the higher price. So again fundamentally it's the purchasing power of money that determines exchange rates. Now let's come finally to his third big contribution. So we have clarifications of the nature of money, we have a new theory of the value of money. Now we have a third contribution, major contribution, which is his business cycle theory. And Mises develops this business cycle theory in the third part of the book, in the part that deals with fiduciary media, uncovered money substitutes. In the second part of the book he had shown that money certificates, those substitutes that are fully covered by underlying money, do not affect values and prices and therefore production.

1:03:26In the third part he shows that the same thing cannot be said about fiduciary media. And the reason is that fiduciary media are money in the broader sense. They are generally accepted media of exchange. But if they are money, well, then increasing their supply must entail a decreasing marginal value of money. That is, it must entail an increase of money prices with continual effects and so on. So, whereas money certificates do not have an independent impact on the working of a monetary economy, fiduciary media do have such an impact. They must have such an impact because they increase the money supply.

1:04:11If a banker increases the amount of banknotes that he issues without having a greater reserve of money proper in his vault, well then he increases the money supply. As a consequence then he will create a tendency for the price level to increase, but moreover, as Mises has stressed, he also creates a redistribution effect. He and his customers will profit at the expense of the other money users within the economy. But there's also something else, so redistribution itself is of course a very important fact, especially from a political, social point of view, but there's more.

1:05:03There is more. It is the possibility that as a consequence of these uncovered issues, there will be something like inter-temporal misallocation of resources. That is, it is possible that these issues of fiduciary media affect the structure of production in such a way that it becomes physically impossible to terminate all the investment projects. How is this possible?

1:05:38Let's start the following way. First, we need to consider that in any economy, a wise use of available resources presupposes that we invest them only in such projects as can be finished, can be completed with the available quantities of factors of production. Available quantities of labor and available quantities of all material factors, streets, roads, machines and so on. If we start investment projects that are too long, then we will run out of supplies before we can complete them. And so we would have to abandon these investment projects and all our previous investment would be lost, would be wasted.

1:06:27Now what Mises shows in his theory is that the increase of fiduciary media can induce precisely such a tendency. It can lure entrepreneurs into investing into projects that are too long. How is this possible? Well, this happens in particular if fiduciary media are injected into the economy that is first sold onto the market, on the credit market. and if they there decrease the interest rate that is being paid for credit. If the interest rate is artificially decreased, then more investment projects seem to be profitable than is really the case.

1:07:14The interest rate is the regulator, if you wish, that allows us to separate the most important from the less important investment projects. and of course the fundamental economic problem in any economy is only to realize the most important investment projects. But the interest rate, as any other price does, is to separate those who can command the factor of production in question and those who cannot. Those who cannot are not able to do it because of any malignancy, but because their investments are not important enough, they're not profitable enough. Now, if we artificially reduce the interest rate by injecting more money on the credit market, the supply of money increases, the supply of credit increases.

1:08:01If we have a given demand, well, then of course the interest rate will decrease. And therefore, in the calculations of entrepreneurs, it will seem as if more investment projects are not possible than are really possible. So, entrepreneurs will start too many investment projects, and from a macroeconomic point of view, it's not possible to complete all these projects. At some point, we have to stop, because we run out of real resources, we cannot element all the investment projects that we have launched. So in such a scenario then, we have an economy-wide error, systematic error, or as Murray Rothbard would later say, a cluster of error.

1:08:47What Mises delivers is an explanation of how error can be systematic, how it can come to clusters of errors. And he identifies a very important mechanism, namely the mechanism of production of fiduciary media through the banks. and Mises theory also explains why this process cannot be maintained, why it has to collapse at some point or another namely because we are now caught up in a physical impossibility, we cannot complete all these investment projects therefore at some point we've got to stop short and this point when the entrepreneurs realize that they cannot go on that they cannot complete all the One of the things that they have started, that's the economic crisis. So Mises delivers at the same token a coherent theory of economic crisis.

1:09:38He could rely on two predecessors, one is the currency school, the British currency school of the early 19th century, which has dressed a similar mechanism also focusing on the production of fiduciary media. But the explaining element was slightly different in the case of the currency school. If you look, for example, at David Ricardo's explanation, what he says is it comes to a point when the expansion of the money supply, expansion of fiduciary media can no longer be maintained because the banks run out of reserves. They need, as we have said before, they need to retain certain amount of minimum reserves in order to satisfy ongoing redemption demands.

1:10:32If they expand beyond this, they won't be able to satisfy these redemption demands, that is, they would violate their contracts, so they would go bankrupt. And at this point, in order to avoid this, the banks would at some point cut back issues or would even reduce their fiduciary issues and so it comes to a crisis. But the currency school did not see the issue of inter-temporal misallocations within the structure of production. And that did not translate this mechanism into the physical realm of production. That's what Mises did. The second predecessor was Knut Wichsel, a Swedish economist, inspired by the Austrians, in particular by Boehm-Bawerk and Wichsel.

1:11:21And Wichsel introduced the distinction between monetary and real rates of interest. And so we have here the kernel of Mises' theory which plays on, well, interest rates that can be depressed their natural level. What does it mean, this natural level? According to Vixel, this natural level is the one that would prevail in a barter economy. So, Excel was still also imbued by the notion that money is a veil. He compares the operation of a monetary economy to the operation of a barter economy. He says if the monetary interest rate deviates from the interest rate that would prevail in a barter economy, then we have a particular type of cumulative effects of dynamics that go on.

1:12:11For example, if the monetary interest rate is lower, then the money supply would increase, would increase and therefore prices would increase and so on. But Vixel did not explain why this process had to come to a stop. We did not see the implication that there was inter-temporal misallocation within the production structure. We had no theory or conception of this creation of an economy-wide or systematic error among the market participants. So Mises again, out of elements that were already available and with some contribution of his own, creates a new synthesis and an original theory of the business cycle.

1:13:03In the first edition, 1912, he somewhat qualifies his contribution. He says, well, it's one element or one aspect of business cycles. And in 1924, then, he becomes categorical and he says, well, that is the theory of the business cycle. There are no other elements, no other aspects. Why this change of mind? Well, because maybe he was, in 1912, hesitant. Maybe he thought that other theories could also be fruitfully developed. Another explanation might be that in 1912, he was, after all, still a student. He was trying to get a degree, a habillitation degree and it was therefore wise not to offend the sensibilities of his examiners who might maybe cherish other theories of the business cycle.

1:13:56So he was very ecumenical in 1912 and categorical in 1924. He got his habillitation degree and he was officially working under Filipovic, about whom we talked yesterday. The reason is that Filipovic was one of the few Austrians who had specialized in monetary questions, who had also written some things on monetary questions. Filipovic had written his habillitation thesis under Carl Menger and he dealt with the monetary policy of the Bank of England. So he was kind of an expert on the question, so Mises was writing under Filippowicz, but Filippowicz clearly did not have any sensible impact on the views that Mises propounded in his volume.

1:14:46He got the degree nevertheless, because in those days professors tended to be torrent, especially with deviating views of their pupils, which is not always the case today, unfortunately. And so Mises was allowed, was also admitted shortly thereafter as a privatozen, a private lecturer at the University of Vienna. So he got his degree in late 1911. The book was printed, published in 1912. Based on this in 1913, he was licensed as a private lecturer at the University of Vienna, of Vienna, which meant that he could give seminars with students who were willing to listen to him, and of course unpaid.

1:15:31It's a system that still exists in Germany today, which allows for a greater competition among suppliers of education. Okay, we'll stop at this point my talk and I'll give you, well, 12 minutes for questions. There's no obligation for you to exhaust the 12 minutes. I wonder whether Mises used in any of his works at least one graph, and the answer is yes he did.

1:16:16In his book Socialism, when he talks about labor economics, he uses a graph that he reproduced from William Stanley Jevons, a graph that shows the utility and disutility of labor. I'll show up in later works, in different works, it's just in this one book, in all editions. I have no evidence that he ever regretted this or confessed. How long was the business cycle theory accepted in the German speaking world and outside of Germany? First, not at all. There is one thing that I did not mention. So I said that fundamentally Mises asserted that money was a good in its own right.

1:17:09This is the fundamental notion that we also find in the currency school, the British currency school of the 19th century. And it's precisely this notion also that was fundamentally objected to by the banking school. Now in Germany, the banking school ruled supreme in the entire second half of the 19th century and certainly until the time when Mises was writing. In fact, Mises was the first major economist to re-emphasize again the currency school. So he had, on these fundamental grounds alone, he had the entire profession against himself. Did not accept this analysis, there was too much of a quantity theory of money in it, although in the first edition he stressed the quantity theory of money much less than in the second edition.

1:18:02There was some appreciation of his views only after it came to the great hyperinflations after World War I. So Austria had a big inflation that culminated in 1922 and Germany had a hyperinflation culminating in 1923 with the collapse of the currency and so on. And then finally people started saying, well, I mean, maybe it's not completely absurd what Mises said in 1912. So there were more appreciative views. But at first he was completely disparaged by the profession. I'm just wondering if you can describe the Misesian theory of business cycle. It seems to me that it was written in 1912.

1:18:55So I'm wondering what was, for example, Hayek's contribution to this theory of business cycle? What was the main difference between business and life? Since the Austrian business cycle theory seemed to be fully fledged and ready in all its essential elements already in 1912, what were the roles of later contributions such as Hayek's writings on business cycle theory in the late 1920s and early 1930s? That's a very good question. I cannot fully answer to this, but I'll say it very briefly and maybe you will get something out of this. At the end of the 19th century and the early 20th century, there emerged a new movement that started within international economics and try to get rid of or try to get away from explanation in terms of real factors and center the explanation entirely of economic processes on the relationships that exist between prices.

1:20:02That's a new movement that started there. And what Hayek and others did in the late 1920s was to transport this into business cycle theory. Whereas Mises had very strongly stressed these real factors, the underlying economy, and Hayek did not deny this or did not reject this, but Hayek wanted to construct a mechanism that could be expressed entirely in terms of the formation of money prices. That was Hayek's contribution. And the question is, is it a valid or viable contribution? And I will not discuss this now.

1:20:44A very minor point, this 2L book, Mises was familiar with it, but Rothbard wasn't. 2L, yes. But there's no English translation. But first, Rothbard didn't know it at all? I would have to look up the article again. I don't think there's any reference to this book. I don't think so. When Rothbard restates the debate, because that's what he does, he starts in the 1930s. The question is whether Mises held that there was no other source of systematic error in the economy besides the production of fiduciary media.

1:21:48And if we take the 1924 edition, we would have to say yes, apparently that's what he believed at that point of time. I don't necessarily agree with Mises on this, but that's a different issue. The question is, can I give an example that would illustrate why the value of money only depends on, but is not the same as the value of the goods that can be bought for money?

1:22:33Let's take two individuals sitting in the front row and let's assume they're in exactly the same economic position, same revenue, same cash holdings in their pockets. Since they are part of the same economy, they can buy the same goods and services. But their evaluation of this possibility might be very different. This individual might, given the same possibilities, not desire a certain quantity of money in his pockets, and the other individuals might desire a higher quantity. So from the mere fact that money renders the same services, that it has the same money prices, its value is dependent for both individuals on the same objective exterior factors, does not imply the same reaction to the same evaluation.

1:23:28The two individuals or the same individual at a different point of time might evaluate these monetary services very differently.

1:23:46The question is which country developed hyperinflation first in Europe?

1:23:54Well, hyperinflation entailing, the first case of hyperinflation entailing quick collapse of the monetary economy is actually not one in terms of paper money but one in terms of debasement of coinage. And we find that in the 15th century in the Germanys, when the Austrian Emperor was short of money, as he had to lead several wars and so on, you know the problems of governments, in order to finance himself, so he needed to get quick funds, so he sold the right to coin money to several neighboring princes. The Princes, also two bishops, I believe, one abbot and one prince, and they made general's use of the possibility to issue a legal tender coin because that's what it was.

1:24:50Each of them had the right to struck a pfennig, which was a penny, and everybody was legally obliged to accept it as if it were equal to the pennies that had been struck with a higher metallic content before. and so they managed to run down the currency within one year because we had competing producers of the money who were then in a competition to run down the currency as quickly as possible because if they didn't reduce the metallic content as quickly as possible, the other guys would do it. So within a year there was no trace of silver left and the penny was a pure copper coin. And the same type of thing we find then again at the end of the 16th century, early 17th century in Spain, with the Maravedi coins, same thing, it was a coin that had silver content, it was run down immediately within one or two years to a pure copper coin.

1:25:52The first modern hyperinflation is the case of France in the early 18th century when John Law ran the production of money within the country. He set the country on a paper standard and the government's appetite was greatly with it. So he was urged to increase paper money production as quickly as possible, also to maintain prices on the stock market and so on, and again, hyperinflation set in within a few months only, 17-18. And from there, the next major example, all the hyperinflations that we had thereafter were in inflation of paper money.

1:26:41You had the American Continentals, you had the French Revolutionary money, the Asenias. And then in the 20th century, we had about 20 paper money hyperinflations. German hyperinflation of 1923 was only the most spectacular case. and the various others too. Until recently a spectacular present case is in Zimbabwe. Ten years ago we had the hyperinflation in Yugoslavia. The thing to retain and I stress this always to my students who sometimes have difficulties believing me that there can be no hyperinflation without paper money by and large. Virtually all hyperinflations that we ever had were inflation of paper money. You cannot do this if you have commodity money and especially if you do have competitive production of commodity money.

1:27:32Because then people will simply switch to the better product and abandon the depreciated product. Sorry for the long answer. There's maybe time for one other question. Okay, I made you all happy this morning. We'll meet again at two o'clock. Thank you for your attention.