Karl* Knies has recommended to replace the traditional division of economic goods into consumer goods and producer goods with a threefold classification: producer goods, consumer goods, and means of exchange.1 Terminological questions of this kind, however, should be decided solely on the basis of their usefulness for furthering scientific work; definitions, concepts, and the taxonomy of phenomena have to prove their usefulness in the results of the research which makes use of them. When these criteria are applied to the classification and terminology suggested by Knies, it becomes apparent that they are extremely appropriate. Indeed, there is no theory of 2 catallactics which does not make use of them. The theory of the value of money is always reserved for special treatment and separated for the explanation of the price formation of producer goods as well as consumer goods, although it is obviously part of a uniform theory of value and price. Even if we do not use the Kniesian terminology and classification consciously, in all significant discussions we act as if we had adopted them completely.

But it is also necessary to note that the special role of money among economic goods has, if anything, been over-emphasized. The problems of the determination of the purchasing power of money have mostly been treated as if they had nothing or very little in common with the problems of non-monetary exchange. This led to a special status of monetary theory and has been detrimental to the development of economic understanding. Even today, we continually encounter attempts to defend certain unjustified peculiarities of monetary theory.

Roscher’s often quoted remark, “[that] the wrong definitions of money can be divided into two main groups: Those which think of it as more and those which think of it as less than the most saleable good,”3 applies not only to the question of the definition of money. Even a number of those who consider the theory of money a part of catallactics go too far in emphasizing its special position. This branch of our science offers plenty of difficulties and it is not necessary to construct artificial problems; the existing ones provide enough challenge.

I. Monetary Services and the Value of Money

It is clear that the naive conception of the layman that things have value in themselves, i.e., intrinsic value, necessarily leads to a position which draws the dividing line between money and money substitutes differently from the position according to which the value of a thing is derived from its usefulness. Those who conceive of value as the result of properties inherent in things must necessarily make a distinction between physically valuable money and means of exchange which provide monetary services but are without material value. This approach inescapably leads to a contrasting of normal money with bad and abnormal money, which, in reality, is not money at all.

Today there is no need to deal with this theory. For the modern subjective theory of value, the question has long been decided. No one would still openly defend a concept according to which the whole or a portion of value and price theory was based upon intrinsic exchange value, i.e., independent of the valuations of acting men. Once this is admitted, one has already adopted the fundamental principle of subjective value theory, i.e., the theory of marginal utility.

For prescientific economists—the predecessors of the Physiocrats and the Classical Economists—it was a significant problem to integrate the theory of the value of money with that of the value of other goods. Holding a crudely materialistic bias, they saw the source of value in the “objective” usefulness of goods. From this point of view, it is obvious why bread, which can still hunger, and cloth, which can protect from the cold, will have value. But from where does money, which can neither nourish people nor keep them warm, derive its value? Some responded that it arose “from convention” and others maintained that the value of money was “imaginary.”

The error in this view was discovered early. John Law had put it most succinctly. If all value is derived from usefulness, then it must be true that the adoption of the precious metals as means of exchange must generate a value for it. If one wishes to call the value of the metal used as money, insofar as it is derived from its monetary services, imaginary, one has to regard all value as imaginary,

Car aucune chose n’a de valeur que par l’usage auquel on l’applique, et a raison des demandes qu’on en fait, proportionellement a sa quantite.4

With these words, Law anticipated the subjective theory of value; he should not be denied the place he deserves in the history of our science. The importance of his accomplishment is not reduced by his inability to develop all the implications from his fundamental idea or that he got lost in the impenetrable thicket of error or, perhaps, even of guilt.

Researchers who came after him were also unable to make full use of the content of the clearly developed fundamental idea advanced by Law. In three respects we still encounter misconceptions.

First, some writers categorically deny that the service provided by money can generate value. Unfortunately, they do not provide a justification why monetary services should be different from the services provided by food and clothing. The difficulty posed by “paper money” is circumvented by viewing “paper money” as a claim on genuine, i.e., “materially” valuable, metallic money. Fluctuations in the rate of exchange of “paper money” are explained by changes in the probability of payment in species. In view of the development of monetary theory during the last decades, I consider it superfluous to challenge this theory. I have attempted an empirical refutation and have not encountered adequate opposition.5

In a way, the second error is connected with the first: the denial of the possibility of there being a money whose “substance” only produces monetary services and nothing else. It is usually granted that monetary services can generate value, just as every other service, in general. Without reservation, we have to agree with Knies when he argues, “[that] gold and silver would have been as unsuitable for the purpose of performing the functions of money as any other commodity, if they had not previously—before their adoption for monetary services—served as economic goods for the satisfaction of human wants, a ‘general’ economic need, a need that was widely felt and persistent.”6 But Knies is in error when he continues, “it is not sufficient that this primary use of the precious metals has preceded their use for monetary services; it is necessary that this use continues, lest the pieces of precious metal loose their usefulness as money. ... If people ceased to use gold and silver to satisfy their desire for jewelry or ornamentation, etc., then the other use of the precious metals, their use as a means of exchange, would be eliminated, also.”7 Knies did not succeed in proving the validity of this assertion. It is by no means evident why an economic good, which performs the services of a commonly used means of exchange, should loose its ability to serve as money simply because its use for other purposes are gradually discontinued.

That the adoption of a good as a medium of exchange requires the goods’ previous use or consumption for other purposes results from the fact that the specific demand for its services as a means of exchange presupposes an already existing objective exchange value. This objective exchange value, which subsequently will be modified by the demand for the good as a medium of exchange in addition to the demand for it in its “other” use, will be based exclusively upon its “other” use when it begins to be used as a means of exchange. But once an economic good has become money, then the specific demand for money can tie into an already existing exchange relationship between money and goods in the market, even if the demand for the money-good, as motivated by the other use, disappears.

Only very slowly and with difficulty has the human spirit freed itself from the crude materialistic mode of thought that has resulted in a prolonged resistance to the idea that the use of a good as a medium of exchange, like any other possible use for the good, generates a demand that establishes a price and is capable of changing that price. If the ability of a thing to satisfy a human need, as well as the recognition of this ability, are made the prerequisites for establishing the goods-quality of a thing,8 then one comes close to distinguishing between “real” and “unreal” goods among the objects of economic action. As soon as the economist steps upon this ground, he looses his footing and slides unintentionally out of the domain of scientific objectivity; he enters the realm of ethical valuations, morality, and policy. There, he will compare the “objectively useful” things to those which are merely “thought to be useful.” He will examine whether and to what extent the things which are thought to be useful (and therefore are treated accordingly) are indeed so in an “objective” sense. As soon as one has come this far, it is only logical to ask whether the usefulness provided by a good satisfies a genuine need or merely a fictitious one. This way of thinking may subsequently lead to the view that the value of precious metals (which serve “only” the desire for jewelry and do not satisfy a physiological need as e.g., food and clothing undeniably do from a crude materialistic point-of-view) is entirely imaginary, a result of inappropriate social institutions and human vanity. On the other hand, the result can be that the value of precious metals is admitted as legitimate since even the desire for jewelry is “genuine” and “justified.” The objective utility of the precious metals is not denied; rather, the general validity of the requirement for the services of money is questioned since society had once existed without money and, in any case, such a society is imaginable. It is an untenable assumption that the “goods-quality” requires a “natural” utility not limited to the particular requirements of any presupposed social order.

But an even cruder materialism was the view which wanted to deny monetary services their value-creating power because money in its performance of this service did not loose its ability to serve other purposes; in other words, because its “substance” was not used up in its services as money.

All of those who denied the ability of the services of money to determine its exchange value failed to recognize that the only decisive element is demand. The fact that there exists a demand for money—the most marketable (most saleable) good, for which the owners of other goods are prepared to exchange—means that the monetary function is capable of creating value.

II. Money Supply and Money Demand: The “Velocity of Circulation” of Money

The most disastrous of the unjustified deviations of monetary theory from the theory of direct exchange was the failure to base the analysis of the fundamental problem of the theory of the value of money on the relation between the stock of money and the demand for it by the individual economic units, or between the demand for money and the supply of money on the market. Rather, the analysis began with the objective usefulness of the monetary unit for the aggregate economy, which was expressed as the velocity of money relative to the money stock and which was then compared to the sum of transactions.

The old tendency, taken over from the Cameralists,9 to base the analysis of economic problems of the “national economy,” on the “totality” and not on the acting human subjects, seems hard to eradicate. In spite of all the warnings of the subjective economists, we continue to observe relapses. It is one of the lesser evils that ethical judgments regarding phenomena are presented under the guise of scientific objectivity. For example, productive activity (i.e., activity carried out in an imagined socialist community led by the critic) is contrasted with profit-seeking activity (i.e., the activity of individuals in a society based on private property in the means of production). The former will be viewed as the “just” and the latter as the “unjust” mode of production. Much more important is the fact that if one thinks in terms of the totality of a society’s economy, one can never understand the operation of a society based on private property in the means of production. It is erroneous to maintain that the necessity for the collectivist method can be proved by showing that actions of the individuals can only be understood within the framework of that individual’s environment. This is so because economic analysis does not depend on the psychological understanding of the motives of action, but only an understanding of action itself. It is unimportant for catallactics why bread, clothes, books, cannons or religious items are desired on the market; it is only important that a certain demand does exist. The mechanism of the market and, therefore, the laws of the capitalistic economy can only be grasped if one begins with the forces operating on the market. But on the market there are only individuals acting as buyers and sellers, never the “totality.” In economic theory, the totality can be taken only in the sense of an economic collective where the means of production are entirely outside the orbit of exchange and, therefore, cannot be sold for money. Here there is neither room for price theory nor a theory of money. But if we wish to grasp the value problems of a collective economy, we can—ironically—only use that method of analysis which has come to be known as the “individualistic method.”

The attempts to solve the problem of the value of money with reference to the aggregate economy, rather than through market factors, culminated in a tautological equation without any epistemological value. Only a theory which shows how subjective value judgments of buyers and sellers are influenced by changes in the different elements of the equation of exchange can legitimately be called a theory of the value of money.

Buyers and sellers on the market never concern themselves with the elements in the equation of exchange, of which two—velocity of circulation and the price level—do not even exist before market parties act and the other two—the quantity of money (in the whole economy) and the sum of transactions—could not possibly be known to the parties in the market. Only the importance which the various actors in the market attach, on the one hand, to the maintenance of a cash balance of a certain magnitude and, on the other hand, to the ownership of the various goods in question determines the formation of the exchange relationship between money and goods.

Connected with the concept of the velocity of circulation of money is the mental image that money generates its usefulness only at the instant of transaction, but is “idle” and useless at other times. A distinction between active and idle money is also made when one speaks of money hoarding and proceeds to a comparison between the “hoarded” quantity of money and the quantity of money that would be necessary to perform the monetary services; what distinguishes this from the previous case is the way in which the boundary between active and idle money is drawn. Both distinctions must be rejected.

The service of money is not confined to transactions. It fulfills its task not only at the moment it passes from one hand to the next. It also performs services when it rests in the till, as the most marketable good, in anticipation of its future use in trade as a generally used means of exchange. The demand for money of individuals, as well as the entire economy, is determined by the desire to maintain a cash balance and not by the aggregate of transactions to be carried out during a certain time period.10

It is an arbitrary procedure to divide the money stock into two parts: that which is designated to perform money services proper and that which serves as a money hoard. Of course, no damage will be done if, on the one hand, the demand for money is separated into a demand for hoarding and a demand to perform the monetary service proper. But a formula which portrays and solves only an arbitrarily delineated part of the problem must be rejected if we are able to show another one which will deal with and solve the whole problem in a uniform fashion.

III. Fluctuations in the Value of Money

One of the most peculiar phenomena in the history of monetary theory is the stubborn resistance encountered by the quantity theory. The imperfect formulation given to it by many of its advocates inevitably ran into opposition, with many—as, for example, Benjamin Anderson11 —ascribing to the concept a meaning quite different from that commonly accepted. As a result, what they call the quantity theory, and oppose as such, is not the theory itself but only a variation of it. This is not particularly astonishing. But what is quite surprising is that an attempt was made and sometimes is still made today to deny that changes in the relation between money supply and money demand will modify the purchasing power of the monetary unit. It is not sufficient to base an explanation on the special interests of inflationists, statists and socialists, of civil servants and politicians who would be harmed by a spreading of knowledge concerning monetary policy. We will never arrive at an answer by following the path of the Historical-Realistic School, which (following the Marxian example) explains all ideas by ideologies. It had never been a problem to explain why a particular ideology is developed and advocated by certain classes who believe they can benefit from it directly (even if this direct advantage is more than outweighed by indirect disadvantages). What has to be explained, however, is rather how incorrect theories come about and find followers. How does it come about that many people, without justification, come to assume that a certain policy benefits either the entire society or many groups in that society?

However, the theory of money as such is not interested in these psychological aspects which explain the reasons for the unpopularity of the quantity theory and the tendency to adopt other explanations for the value of money. Rather, it is interested in the question: which elements of the doctrines opposing the quantity theory could be useful? Since it was equally inadmissible to deny the importance of changes in supply for the formation of exchange relations in the area of indirect exchange as it was in the area of direct exchange, one could oppose the quantity theory only by admitting its correctness in principle, but arguing that notwithstanding its general validity another principle would regularly eliminate its effectiveness. This attempt was made by the Banking School with its famous theory of hoarding, and its offshoot, the theory of the automatic adjustment of the circulation of money substitutes to the demand for money in the broader sense. Today, both theories are overthrown.

As is the case with so many theories, the advocates of the quantity theory have harmed it more than its enemies. We have already mentioned the inadequacy of those theories based on the concept of the velocity of circulation of money. It was not any less erroneous to interpret the quantity theory as saying that the changes in the quantity of money resulted in proportional changes in the prices of goods. It was overlooked that every change in the relationship between the supply of money and the demand for money would necessarily bring about a shift in the distribution of wealth and income and that, therefore, the prices of the different goods and services could not be effected proportionally and simultaneously.

Nowhere has the practice of working with formulas modeled after mechanics, instead of paying attention to the problem of the influence of market factors, taken a greater toll than in this case. Economists wanted to operate with the equation of exchange without noticing that the changes in the volume of money and the demand for money can come about in only one way: at first, the evaluations and with them the actions of only a few economic subjects will be influenced, with the resulting changes in the purchasing power of the monetary unit only spreading through the economy in a step-by-step pattern. In other words, the problem of changes in the value of money have been treated with the method of “statics,” although there should never have been any doubt concerning the dynamic character of the problem.

IV. Money Substitutes

The most difficult and most important special problem of monetary theory is that of money substitutes. The fact that money services can also be rendered by secure money claims redeemable on demand, presents considerable difficulties to the monetary theorists’ attempt to define the supply of money and the demand for money. This difficulty could not be overcome as long as money substitutes were not clearly defined and separated into money certificates and fiduciary media, in order to treat the granting of credit through the issue of fiduciary media separately from all other types of credit.

Loans which do not involve the issuing of fiduciary media (i.e., bank notes or deposits which are not backed by money) is of no consequence for the volume of money. The demand for money can be influenced by lending as much as by any other institution of the economic order. Without knowledge of the data of the specific case, we cannot say in which direction this influence will operate. The widely-held opinion that an expansion of credit will always lead to a reduction in the demand for money is not correct. If many of the loan contracts provide for large repayments on certain days (for example, at the end of the month or quarter), the result will be an increase and not a reduction in the demand for money. The consequences of this increase in the demand for money will be expressed in prices, if it were not for clearing arrangements, on the one hand, and the practice of banks to increase the volume of fiduciary media on critical days, on the other hand.

Everything depends on the clear separation of money from money substitutes and within the category of money substitutes a distinction between money certificates (a money substitute fully backed by money) and the fiduciary medium (the money substitute not backed by money). But this is above all a question of terminological appropriateness. However, this question gains in importance in view of the difficulty and complexity of the problems. It is not—as so often is still maintained—the “granting of credit” but the issuing of fiduciary media which causes those effects on prices, wages, and interest rates, which banking theory has to deal with. It is, therefore, not inappropriate to refer to banking theory as the theory of fiduciary media.

V. Economic Calculation and the Problem of “Value Stability”

The old and widely accepted conception of money as a measure of price and value is out of the question for modern theory. But it was not an entirely harmless oversight of the subjective theory that it has not paid more attention to the importance of money for economic calculation, as well as the problem of economic calculation in general.

Traditionally, theoretical economics separates the theory of unintermediated (direct) exchange from the theory of intermediated (indirect) exchange. This division of catallactics is indispensible and without it, it would have been impossible to ever produce useful results. But one must always be aware that the assumption that economic goods are exchanged without the intermediation of a generally used means of exchange is realistic only for the cases involving the exchange of consumer goods and those producer goods of the lowest order, i.e., those closest to consumer goods. The direct exchange of consumer goods and closely related producer goods is, of course, possible; it exists today and did so in the past. However, the exchange of goods of a more remote order presupposes the use of money. The concept of the market as the essence of coordination of all elements of demand and supply, upon which modern theory does and must depend, is unthinkable without the use of money. Only with the use of money is it possible to compare the marginal utility of goods in all alternative employments. Only where money exists can we clearly analyze the difference in value between present and future goods. Only within a money economy can this value difference be comprehended in the abstract and separated from changes in the valuation of individual concrete economic goods. In a barter economy, the phenomenon of interest could never be isolated from the evaluation of future price movements of individual goods. To assume the existence of a highly developed market system without the intermediation of a generally accepted means of exchange would be a scientific fiction like Vaihinger’s “as if” theory.12

We will not deal here with the significance of monetary calculation for rational action and social cooperation; this is not a task for catallactics but one for sociology. The field of monetary theory is large enough if it confines itself to an exhaustive treatment of questions of its own immediate concern.

The paramount role of money within the sphere of economic goods was established by the practice of calculating in terms of money, by expressing the price of all other economic goods in terms of the corresponding amount of money and by basing economic decisions solely on the value of the monetary unit. One result of this practice is the contrast between money and goods as we encounter it in the phrase “the high cost of living” and even more clearly in mercantilist theory. But a more serious consequence of assigning such prominence to money has been the development of the idea of a “stable value” of money, which in spite of its naivete and vagueness has been a permanent influence on monetary policy.

As it came to be recognized that money is not of “stable value,” the political postulate arose that money should be of stable value or at least be designed in such a way that it would approximate this ideal as closely as possible. The advocates of the gold standard, as well as those of the bimetallic standard, have touted their monetary systems as the best guarantee for the greatest possible stability of the value of money. A number of proposals are based on the idea that the greatest possible constancy of the purchasing power of money is the ultimate and the most important goal of monetary policy. One such proposal foresees the creation of a commodity currency (tabular standard) for long-term contracts to supplement precious metal currency. The proposals by Irving Fisher13 and John Maynard Keynes14 go even farther by recommending a “manipulated currency” based on a system of index numbers.

The shortcomings of the “stable value” notion and the contradictions in a monetary policy based upon it do not have to be shown again.15 In everyday life, the actions of economizing subjects regarding value estimates usually cover only short periods of time, if we ignore for the moment long-term loan contracts with which we will have to deal in more detail later. The economic calculations of the entrepreneur is confined to the months and years ahead. Only conditions in the immediate future can be forecasted and considered in economic calculations. Apart from the difficulties which changes in the purchasing power of money present, it would be impossible to forecast the economic situation of a more distant future with any degree of reliability.

The desire for a “stable” store of purchasing power originated with attempts to protect wealth and income from the vicissitudes of the market. The goal was to maintain wealth and income for “eternity.” The agrarian mentality thought it had found such a store of wealth in the form of land. Land would always be land, and the fruits of agriculture would always be desirable; thus, it was believed that the ownership of land was a form of wealth which would assure a steady income. It is easy for us today, in an age of capitalistically organized agriculture, to show the error of this view. A self-sufficient farmer working on his own land might be able to insulate himself “forever” from the changes taking place around him. But for a business operating in a society based on an extensive division of labor, the situation is quite different. Capital and labor must only be applied to the best plots of land. To produce on land of lesser quality fails to yield any net returns. Even plots of land can fall drastically in value or lose it altogether when higher quality land becomes available in large amounts.

This type of thinking was soon transferred from land to claims secured by property in land. Later claims against the “State” and other creatures of public law were added to the secured claims. The State was thought to have eternal existence and its promises to pay were accorded unconditional faith. Consequently, government bonds appeared as a means to remove wealth and income from the uncertainties of life into the sphere of “eternity.” We need not waste any more words on the fallacy of this idea. It is sufficient to point out that even States can fall and that States repudiate their debts.

Contrary to prevailing opinion, in the capitalistic social order no wealth exists which automatically produces a return. In order to derive income from property in the means of production, property has to be either employed in a successful venture or has to be loaned to a promising entrepreneur. But for entrepreneurs, success is never “certain.” It can happen that a firm will decline and the capital invested vanishes, either partly or entirely. The capitalist who is not an entrepreneur himself, but merely lends to entrepreneurs, is less exposed to the danger of loss than is the entrepreneur; but even he bears the risk that the loss of the entrepreneur becomes so substantial that he is unable to repay the borrowed capital. Ownership of capital is not the source of automatically accruing income but a means whose successful application can produce income. To derive income from property in capital, one has to have the ability to invest it advantageously. He who does not have this ability, cannot count on income from his capital ownership and my loose it entirely.

To reduce these difficulties and uncertainties to the lowest possible level, capitalists acquire land, government obligations and mortgage bonds. But here the shortcomings of a money lacking “stable value” begins to cause problems. In the case of short-term credit, the effects of changes in the purchasing power of money on the value of the claim will be eliminated or at least reduced by the fact that market interest rates for short-term loans will rise and fall with the fluctuations in the prices of goods. This adjustment is not possible in the case of long-term loans.

The ultimate reason behind the striving for money of a “stable value” is to be found in the desire to create a medium capable of removing the ownership of capital from the domain of the temporal into the domain of the eternal. But the solution to the problem of value stability can only be accomplished if all movement and change is eliminated from the economic system. It is not sufficient to stabilize the exchange relationship between money and an average of commodity prices; one would also have to fix the exchange ratios between all goods.

If monetary policy abstains from everything which could cause violent changes in the exchange relationship between money and other economic goods which originate from the “money side”; if it chooses a commodity currency which is not subject to sudden fluctuations in value stemming either from its own supply or from its demand for industrial and other non-monetary uses; if it exercises restraint in the issue of fiduciary media: then it has done everything that can be done towards a mitigation of the harmful effects that flow from changes in the purchasing power of money. If monetary policy were confined to these tasks, it would contribute more to the elimination of these perceived evils than by conscious efforts to realize an unreachable ideal. No one who understands the meaning and implications of the theoretical concept of a “stationary state” can deny that all attempts to transplant this conceptualization from the world of economic theory into real life must remain unsuccessful.

• *[Originally published in Die Wirtschaftstheorie der Gegenwart vol. 2, Hans Mayer, Frank A. Fetter, and Richard Reisch, eds. (Vienna: Julius Springer, 1932). Translated for this volume by Albert H. Zlabinger—Ed].
• 1Karl Knies, Geld und Kredit, 2nd ed. (Berlin: Weidmann, 1885), pp. 20ff.
• 2[Catallactics is that part of praxeology that deals specifically with market phenomena. The term was first used by Bishop Richard Whately in his Introductory Lectures in Political Economy (1831)—Ed.]
• 3Wilhelm Röscher, Grundlagen der Nationalökonomie, 25th ed. (Stuttgart and Berlin: J. G. Cotta’sche Buchhandlung Nachtfolger, 1918), p. 340.
• 4John Law, Considerations sur le Numeraire et le Commerce (Paris: Buisson, 1851), pp. 447ff. The passage translates as: The value of a thing is only in the use we make of it and the expectations we put into it, proportional to its quantity.
• 5See Mises, The Theory of Money and Credit, 2nd ed. (Indianapolis,Ind.: Liberty Classics, 1981), pp. 146-53.
• 6Knies, Geld und Kredit, p. 322.
• 7Ibid., pp. 322ff.
• 8This is even done by Menger; see, his Principles of Economics [1871] (New York: New York University Press, 1981), pp. 52–53.
• 9[The Cameralist school, in the countries of central Europe during the seventeenth and eighteenth centuries advocated a total paternalistic state. Their program centered on how best to regulate industry, trade, and fiscal matters to fund the growing military and administrative state. The school held the basic tenants of mercantilism, advocated the dissolution of the guild system, and standardization of laws—Ed.]
• 10Also see, Edwin Cannan, Money, 4th ed. (Westminister: P. S. King and Son, 1932), pp. 72ff.
• 11Benjamin Anderson, The Value of Money (New York: Macmillan, 1917).
• 12[Hans Vaihinger (1852–1933) was a German philosopher who maintained that “An idea whose theoretical untruth or incorrectness, and therewith its falsity, is admitted, is not for that reason particularly valueless and useless; for an idea in spite of its theoretical nullity may have great practical importance,” The Philosophy of “As If,” C. K. Odgen, trans. (New York: Harcourt, Brace, 1935), p. viii—Ed.]
• 13Irving Fisher, Stabilizing the Dollar (New York: Macmillan, 1925), pp. 79ff.
• 14John Maynard Keynes, A Tract on Monetary Reform (London: Macmillan, 1923), pp. 177ff.
• 15[Ludwig von Mises, Monetary Stabilization and Cyclical Policy (1928), in On the Manipulation of Money and Credit, Percy L. Greaves, Jr., ed. (Dobbs Ferry, N.Y.: Free Market Books, 1978), pp. 83-103—Ed.]

The* monetary economists of the sixteenth and seventeenth centuries succeeded in dissipating the popular fallacies concerning an alleged stability of money. The old error disappeared, but a new one originated, the illusion of money’s neutrality.

Of course, classical economics did its best to dispose of these mistakes. David Hume, the founder of British Political Economy, and John Stuart Mill, the last in the line of classical economists, both dealt with the problem in a masterful way. And then we should not forget Cairnes, who in his essay on the course of depreciation paved the way for a realistic view of the issue involved.1

Notwithstanding these first steps towards a more correct grasp, modern economists incorporated the fallacy of money neutrality into their system of thought.

The reasoning of modern marginal utility economics begins from the assumption of a state of pure barter. The mechanism of exchanging commodities and of market transactions is considered on the supposition that direct exchange alone prevails. The economists depict a purely hypothetical entity, a market without indirect exchange, without a medium of exchange, without money. There is no doubt that this method is the only possible one, that the elimination of money is necessary and that we cannot do without this concept of a market with direct exchange only. But we have to realize that it is a hypothetical concept which has no counterpart in reality. The actual market is necessarily a market of indirect exchange and money transactions.

From this assumption of a market without money, the fallacious idea of neutral money is derived. The economists were so fond of the tool which this hypothetical concept provided that they overestimated the extent of its applicability. They began to believe that all problems of catallactics could be analyzed by means of this fictitious concept. In accordance with this view, they considered that the main work of economic analysis was the study of direct exchange. After that all that was left was to introduce the monetary terms into the formulas obtained. But this was, in their eyes, a work of only secondary importance, because, as they were convinced, the introduction of monetary terms did not affect the substantial operation of the mechanism they had described. The functioning of the market mechanism as demonstrated by the concept of pure barter was not affected by monetary factors.

Of course, the economists knew that the exchange ratio between money and commodities was subject to change. But they believed—and this is exactly the essence of the fallacy of money’s neutrality—that these changes in purchasing power were brought about simultaneously in the whole market and that they affected all commodities to the same extent. The most striking expression of this point of view is to be found in the current metaphorical use of the term “level” in reference to prices. Changes in the supply or demand of money—other things remaining equal—make all prices and wages simultaneously rise or fall. The purchasing power of the monetary unit changes, but the relations among the prices of individual commodities remain the same.

Of course, economists have developed for more than a hundred years the method of index numbers in order to measure changes in purchasing power in a world where the ratios between the prices of individual commodities are in continuous transition. But in doing so, they did not give up the assumption that the consequences of a change in the supply or demand of money were a proportional and simultaneous modification of prices. The method of index numbers was designed to provide them with a means of distinguishing between the consequences of those changes in prices which take their origins from the side of the demand for or supply of individual commodities and those which start from the side of demand for or supply of money.

The erroneous assumption of money neutrality is at the root of all endeavors to establish the formula of a so-called equation of exchange. In dealing with such an equation the mathematical economist assumes that something—one of the elements of the equation—changes and that corresponding changes in the other values must needs follow. These elements of the equation are not items in the individual’s economy, but items of the whole economic system, and consequently the changes occur not with individuals but with the whole economic system, with the Volkswirtschaft as a whole. Proceeding thus, the economists apply unawares for the treatment of monetary problems a method radically different from the modern catallactic method. They revert to the old manner of reasoning which doomed to failure the work of older economists. In those early days philosophers dealt in their speculations with universal concepts, such as mankind and other generic notions. They asked: What is the value of gold or of iron, that is: value in general, for all times and for all people, and again gold or iron in general, all the gold or iron available or even not yet mined. They could not succeed in this way; they discovered only alleged autinomies which were insoluble for them.

All the successful achievements of modern economic theory have to be ascribed to the fact that we have learned to proceed in a different way. We realize that individuals acting in the market are never presented with the choice between all the gold existing and all the iron existing. They do not have to decide whether gold or iron is more useful for mankind as a whole, but they have to choose between two limited quantities both of which they cannot have together. They decide which of these two alternatives is more favorable for them under the conditions and at the moment when they make their decision. These acts of choice performed by individuals faced with alternatives are the ultimate causes of the exchange ratios established in the market. We have to direct our attention to these acts of choice and are not at all interested in the metaphysical and purely academic, nay, vain question of which commodity in general appears more useful in the eyes of a superhuman intelligence surveying earthly conditions from a transcendental point of view.

Monetary problems are economic problems and have to be dealt with in the same way as all other economic problems. The monetary economist does not have to deal with universal entities like volume of trade meaning total volume of trade or quantity of money meaning all the money current in the whole economic system. Still less can he make use of the nebulous metaphor “velocity of circulation.” He has to realize that the demand for money arises from the preferences of individuals within a market society. Because everybody wishes to have a certain amount of cash, sometimes more, sometimes less, there is a demand for money. Money is never simply in the economic system, in the Volkswirtschaft, money is never simply circulating. All the money available is always in the cash holdings of somebody. Every piece of money may one day—sometimes oftener, sometimes more seldom—pass from one man’s cash holding to another man’s. But at every moment it is owned by somebody and is a part of his cash holdings. The decisions of individuals regarding the magnitude of their cash holdings constitute the ultimate factor in the formation of purchasing power.

Changes in the quantity of money and in the demand for money for cash holding do not occur in the economic system as a whole if they do not occur in the households of individuals. These changes in the households of individuals never occur for all individuals at the same time and to the same degree and they therefore never affect their judgments of value to the same extent and at the same time. It is exactly the merit of Hume and Mill that they tried to construct a hypothetical case where the changes in the supply of money could affect all individuals in such a way that the prices of all commodities would rise or fall at the same time and in the same proportion. The failure of their attempts provided a negative proof, and modern economics has added to this the positive proof that the prices of different commodities are not influenced at the same time and to the same extent. The oversimple formula both of the old quantity theory and of contemporary mathematical economists according to which prices, that is all prices, rise or fall in the proportion of the increase or decrease in the quantity of money, is disproved.

To simplify and to shorten our analysis let us look at the case of inflation only. The additional quantity of money does not find its way at first into the pockets of all individuals; not every individual of those benefited first gets the same amount and not every individual reacts to the same additional quantity in the same way. Those first benefited—in the case of gold, the owners of the mines, in the case of government paper money, the treasury—now have greater cash holdings and they are now in a position to offer more money on the market for goods and services they wish to buy. The additional amount of money offered by them on the market makes prices and wages go up. But not all the prices and wages rise, and those which do rise do not rise to the same degree. If the additional money is spent for military purposes, the prices of some commodities only and the wages of only some kinds of labor rise, others remain unchanged or may even temporarily fall. They may fall because there are now on the market some groups of men whose incomes have not risen but who nevertheless are obliged to pay more for some commodities, namely for those asked by the men first benefited by the inflation. Thus, price changes which are the result of the inflation start with some commodities and services only, and are diffused more or less slowly from one group to the others. It takes time till the additional quantity of money has exhausted all its price changing possibilities. But even in the end the different commodities are not affected to the same extent. The process of progressive depreciation has changed the income and the wealth of the different social groups. As long as this depreciation is still going on, as long as the additional quantity of money has not yet exhausted all its possibilities of influencing prices, as long as there are still prices left unchanged at all or not yet changed to the extent that they will be, there are in the community some groups favored and some at a disadvantage. Those selling the commodities or services whose prices rise first are in a position to sell at the new higher prices and to buy what they want to buy at the old still unchanged prices. On the other hand, those who sell commodities or services whose prices remain for some time unchanged are selling at the old prices whereas they already have to buy at the new higher prices. The former are making a specific gain, they are profiteers, the latter are losing, they are the losers, out of whose pockets the extra-gains of the profiteers must come. As long as the inflation is in progress, there is a perpetual shift in income and wealth from some social group, to other social groups. When all price consequences of the inflation are consummated, a transfer of wealth between social groups has taken place. The result is that there is in the economic system a new dispersion of wealth and income and in this new social order the wants of individuals are satisfied to different relative degrees, than formerly. Prices in this new order cannot simply be a multiple of the previous prices.

The social consequences of a change in the purchasing power of money are twofold: first, as money is the standard of deferred payments, the relations between creditors and debtors is changed. Second, as the changes in purchasing power do not affect all prices and wages at the same moment and to the same extent, there is a shift of wealth and income between different social groups. It was one of the errors of all proposals to stabilize purchasing power that they did not take into account this second consequence. We may say that economic theory in general did not pay enough attention to this matter. As far as it did, it principally considered it only in reference to the reaction of a change in a country’s currency on its foreign trade. But this is only a special application of a problem which has a much wider scope.

What is fundamental for economic theory is that there is no constant relation between changes in the quantity of money and in prices. Changes in the supply of money affect individual prices and wages in different ways. The metaphorical use of the term price level is misleading.

The erroneous opinion to the contrary was based on a consideration which may be represented thus: let us think of two absolutely independent systems of static equilibrium A and B. Both are in every respect alike except that to the total quantity of money (M) in A and to every individual cash holding (m) in A there correspond in B a total quantity of Mn and individual cash holdings mn. On these assumptions of course all the prices and wages in B are n times those in A. But they are exactly thus because these are our hypothetical assumptions. But nobody can devise a way by which the system A can be transformed into the system B. Of course it is unpermissible to operate with static equilibrium if we wish to approach a dynamic problem.

Setting aside all qualms about the use of the terms dynamic and static, I wish to say: money is necessarily a dynamic agent and it was a mistake to deal with monetary problems in a static way.

Of course there is no room left for money in a concept of static equilibrium. In forming the concept of a static society we assume that no changes are taking place. Everything is going on in the same old manner. Today is like yesterday and tomorrow will be like today. But under these conditions nobody needs a cash holding. Cash holding is necessary only when the individual does not know what situation he will have to face in an uncertain future. If everybody knows when and what he will have to buy, he does not need a private cash holding and can entrust all his money to the central bank as time deposits due on the dates and in the amounts necessary for his future payments. As everybody would proceed in the same way, the central bank does not need any reserves to meet its obligations. Of course, the total amount which it has to pay out to the buyers every day exactly balances the amount which it receives as deposits from the sellers. If we assume that in this world of static equilibrium once, before the equilibrium was attained, there was metallic currency only, let us say gold, we have to assume that with the gradual approach towards conditions of equilibrium the citizens deposited more and more of their gold and that the bank, which had no need for it, sold the gold to jewelers and others for industrial consumption. With the advent of equilibrium there is no more metallic money, there is in fact no more money at all, but an unsubstantial and immaterial clearing system, which cannot be considered as money in the ordinary sense. It is rather an unrealizable and even unthinkable system of accounting, a numeraire as some economists believed ideal money ought to be. This, if it could be called money, would be neutral money. But we should never forget, that the state of equilibrium is purely hypothetical, that this concept is nothing but a tool for our mental work. Not being able to make experiments, the social sciences have to forge such tools. But we must be very careful in their use. We have to be aware that the state of static equilibrium can never be attained in real life. Still more important is the fact, that in this hypothetical state the individual does not make choices, does not act and does not have to decide between incompatible alternatives. Life in this hypothetical state is therefore robbed of its essential element. In constructing this hypothetical state we want merely to understand the incentives of action, which always implies change, by conceiving conditions, in which no action takes place. But a changeless world would be a dead world. We do not just have to deal with death, but with life, action, and change. In a living world there is no room for neutrality of money.

Money, of course, is a dynamic factor and as such cannot be discussed in terms of static equilibrium.

Let me now briefly point out some of the major conclusions derived from an insight into the non-neutrality of money.

First we have to realize that the abandonment of the fallacious concept of neutral money destroys the last stronghold of the advocates of quantitative economics. For a very long time eminent economists have believed that it will be possible one day to replace qualitative economics by quantitative economics. What renders these hopes vain, is the fact, that in economic quantities we never have any constant ratios among magnitudes. What the economist discovers when he studies relations between demand and prices is not comparable with the work of the natural scientist who determines by experiments in his laboratory constant relations, e.g., the specific gravity of different substances. What the economist determines is of historical value only; he is in his statistical work a historian, but not an experimenter. The work of the late lamented Henry Schultz2 was economic history; what we learn from his research is what happened with some commodities in a limited period of the past in the United States and Canada. It tells us nothing about what happened with the same commodities elsewhere or in another period or what will happen in the future.

But there still has remained the belief that it is different with money. I may cite, for example, Professor Fisher’s book on the Purchasing Power of Money, which is founded on the assumption that the purchasing power of the monetary unit changes in inverse proportion to the quantity of money.3 I think that this assumption is arbitrary and fallacious.

The second conclusion which we have to draw is the futility of all endeavors to make money stable in purchasing power. It is beyond the scope of my short address to explain the advantages of a sound money policy and the disadvantages of both inflation and deflation. But we should not confuse the political concept of sound money with the theoretical concept of stable money. I do not wish to discuss the inner contradictions of this stability concept. From the point of view of the present subject it is more important to emphasize that all proposals for stabilization, apart from other deficiencies, are based on the idea of money’s neutrality. They all suggest methods to undo changes in purchasing power already effected if there has been an inflation they wish to deflate to the same extent and vice versa. They do not realize that by this procedure they do not undo the social consequences of the first change, but simply add to it the social consequences of a new change. If a man has been hurt by being run over by an automobile, it is no remedy to let the car go back over him in the opposition direction.

The popularity of all schemes for stabilization invites us to a philosophical consideration. It is a general weakness of the human mind to regard the state of rest and absence of change as more perfect than the state of motion. The absolute, that old phantom of misguided philosophical speculation, is still with us; its modern name is stability. But stability, e.g., absence of change, is, we have to repeat, absence of life.

The third conclusion which we may draw is the futility of the distinction between statics and dynamics and between short-run and long-run economics. The way in which we have to study monetary changes provides us with the best evidence that every correct economic consideration has to be dynamic and that static concepts are only instrumental. And at the same time we have to realize that all correct economic theorizing is a gradual progress from short-run to long-run effects.

But the most important value of the theory of money’s dynamism is its use for the development of the monetary theory of the trade cycle. The old British Currency-Theory was already in a restricted sense a monetary explanation of the cycle. It studied the consequences of credit expansion on the assumption only that there is credit expansion in one country whereas in the rest of the world things are left unchanged. This seemed to be enough for the explanation of the business cycle in Great Britain in the first half of the nineteenth century. But the explanation of an external drain does not provide an answer to the question what may happen in a completely isolated country or in the case of a simultaneous credit expansion all over the world. But only the answer to this second question could be considered satisfactory under the conditions prevailing in the twentieth century. Only the answer to this second question is important, if we have to consider the proposals for eliminating the cyclical changes either by loosening the international ties of the national economy or by making credit expansion international in the way the Bretton Woods Agreements4 provide. It is the boast of the monetary theory of the trade cycle that it provides us with a satisfactory answer to these and to some other serious problems.

I do not wish to infringe more upon your time and so I wish only to add some remarks on the treatment of the problem by certain younger economists. I myself am not responsible for the term “neutral money.” I have developed a theory of the changes in purchasing power and its social consequences. I have demonstrated that money acts as a dynamic agent and that the assumption that the changes in purchasing power are inversely proportional to the changes in the relation of demand for to the supply of money is fallacious. The term “neutral money” was coined by later authors.5 I do not wish to consider the question of whether it was a happy choice. But in any case I must protest against the belief that it has to be a goal of monetary policy to make money neutral and that it is the duty of the economists to determine a method of doing so. I wish to emphasize that in a living and changing world, in a world of action, there is no room left for a neutral money. Money is non-neutral or it does not exist.

• *[This essay was delivered as a lecture to a group in Paris in 1938 and again to the New York City Economics Club in 1945 and previously unpublished—Ed.]
• 1[David Hume, “On Money,” in Writings on Economics, Eugene Rotwein, ed. (University of Wisconsin Press, Madison, 1970), pp. 33–46; John Stuart Mill, Principles of Political Economy, Sir William Ashley, ed. (1909), bk. 3, chap. 8; John E. Cairnes, Essays in Political Economy (London: MacMillan, 1873), pp. 1–65—Ed.]
• 2[In his treatise Theory and Measurement of Demand (Chicago: University of Chicago Press, 1938) he set forth his crop theory of cycles—Ed.]
• 3[Irving Fisher, The Purchasing Power of Money, 2nd ed. (New York: Macmillan, 1920), p. 157. “there is no possible escape from the conclusion that a change in the quantity of money (M) must normally cause a proportional change in the price level”—Ed.]
• 4[The Bretton Woods agreement in 1945 established an international gold exchange standard that valued the dollar at l/35th of an ounce of gold—Ed.]
• 5[F. A. Hayek, Prices and Production, 2nd ed. (New York: Augustus M. Kelley, 1935), pp. 31 and 129–31—Ed.]

Introduction*

The expressions, “fluctuations in the purchasing power of gold” and “measurement of the fluctuations in the purchasing power of gold” cannot be used unless we have, at the same time, a conception of the purpose for the attainment of which it is essential to have an exact definition of these terms. They have been evolved to meet mainly practical requirements, not purely theoretical ones. Being conscious of the undesirable effects of certain changes in prices, we seek ways and means of eliminating their undesirable effects or, even better, the causes which generate them. Consequently, any study referring to these expressions must take as its starting-point a consideration of what it is we find undesirable, why we find it undesirable and what can be done with a view towards its removal without putting something more undesirable in its place.

I. The Social Effects of Changes in the Purchasing Power of Gold

There are two distinct reasons why changes in the purchasing power of gold affect income and capital conditions. If it were not for the operation of these factors, changes in purchasing power would be a matter of no more importance, so far as social effects are concerned, than changes in the system of weights and measures or changes in the calendar. If (a) there were no deferred payments, i.e., no debts or claims expressed in terms of gold, with all money transactions being cash transactions and (b) if changes in the purchasing power of money affected the whole economic system and every particular commodity simultaneously and to the same extent, we would have no reason to concern ourselves with the effects of changes in the purchasing power of gold.

(a) Changes in Purchasing Power and Indebtedness

Changes in purchasing power affect debt contracts expressed in terms of gold due to the fact that the parties contracting such liabilities do not make allowance for changes in the purchasing power of gold. In general, the world clings to the view that gold is of “stable value,” naive as that view may be and as incapable as it may be of withstanding any exact analysis. However, even if this view was not prevalent, in the case of long-term commitments it would not be possible to adjust for changes in the purchasing power of gold; there is no means of making any sort of estimate about either the direction or the extent of future changes in purchasing power over a considerable future time-period. The case of short-term liabilities is different. If it is anticipated that the prices of commodities will rise in the course of the next few weeks or months, the rate of interest for short-term loans correspondingly rises, and it falls if it is expected that commodity prices will fall. Therefore, the problem of the effect of changes in purchasing power arises only in the case of long-term debt contracts, and not in the case of short-term liabilities.

(b) The Second Category of Consequences of Changes in Purchasing Power

English and American writers have investigated the influence of changes in purchasing power on the tenor of debt contracts with exceptional thoroughness for more than a century, at a time when this problem was almost entirely neglected on the Continent and, especially, in Germany. On the other hand, English and American writers have devoted very little attention to the second category of consequences that are caused by changes in purchasing power. As a result, the numerous projects and proposals for the elimination of the unfavorable consequences of such changes have, as a rule, been concerned exclusively with the effect on debt contracts, while leaving other effects of such changes unaccounted for.

If changes in purchasing power affected all commodities and services simultaneously and to the same extent, the effect on people’s incomes and expenditures would be identical, and nobody would be a penny the better or the worse for the change (apart from the case of debt contracts discussed in the previous section). However, this is never the case. Eminent economists, from David Hume and John Stuart Mill downwards, have vainly endeavored to construct a theoretical case in which a change in purchasing power might affect all commodities and services simultaneously and to the same extent. It is impossible to construct such a case.

Changes in purchasing power always make themselves felt, at first, at some particular point of the economic system, and its effects only then spread from there by successive stages. When the volume of money is increased, those into whose hands the additional new money first passes are able—with their increased income—to go on paying the previous market prices for commodities and services, i.e., at prices formed without regard, as yet, to the new supply of money. In this case, an increase in money income is tantamount to an increase in real income and may even ultimately result in an increase in capital. On the other hand, those whose incomes are the last to be increased are at a disadvantage, owing to the fact that they are compelled to pay for a large portion of the commodities and services they purchase at prices formed with regard to the new supply of money, i.e., before their incomes have risen correspondingly. This process was clearly observed in every country in the inflationary period during and after the war. But it is most conspicuous in the field of international economic relations; Cairnes has an admirable account of its operation in his Essays in Political Economy, in which he traces the effects of the discoveries of gold and the progressive course of depreciation to which they gave rise.

Study of the social consequences of changes in purchasing power cannot be restricted to the consideration of their effect on indebtedness. The effects of the time-lag, which I have described, also have to be taken into the account.

But it is just when we endeavor to do this that we become aware of the immense difficulties in the way. If we only consider the effect of changes of purchasing power on indebtedness we are prone to assume that all that is required is to determine an average figure for the purchasing power of money, leaving the rise of one price to be off-set by the fall of another. But this is not enough, if we take the second category of consequences of changes in purchasing power into account; for these consequences are due precisely to the fact that some prices have risen while others are still lagging behind. Therefore, if we proceed along the lines of the proposals for the stabilization of purchasing power, i.e., by correcting changes in purchasing power after they have occurred in accordance with some system of index-numbers, we shall have done nothing to eliminate this particular category of social effects.

II. Analysis of Attempts at Stabilization

Obviously, before we enter upon the task set by our topic, we must understand the object towards which these measures are to be applied.

The serious disturbances, which follow in the train of cyclically reoccurring economic depressions, have led many in the world to entertain the conceptual ideal of a “stable” economic system. However, this can never mean an economic system in which all prices remain unchanged. All that can be attempted is the establishment of a system which is not exposed to grave shocks from the “money-side.”

A number of writers have argued in favor of altering the legal basis of debt contracts in the sense of expressing them, not in terms of gold, but in terms of a definite quantity of commodities. The aim of such proposals is the establishment of what is called a “commodity standard” or a “tabular standard.” For a long time it was innocently assumed that such a standard would necessarily be “equitable.” I have, I think, sufficiently shown, as have other economists before me, that this assumption is not likely to be universally accepted.1

But even if we ignore the objections to the “equitable character” of commodity and tabular standards, we cannot fail to see what has already been pointed out, namely, that the establishment of such a standard can only eliminate a part of the social effects of changes in purchasing power. It will, perhaps, be said that it is much to be able to eliminate the consequences in the case of debt contracts, even if the more difficult problem of the elimination of the second category of consequences would have to be left to the future. This, however, is not a tenable view. No doubt, the problem of a standard of deferred payment is extremely important; but here as in other questions, the economy “helps itself,” certainly in the case of short-term, and possibly even in the case of long-term, debt contracts. The circumstance that in the last few decades those who have lent money at long-term, i.e., bond-holders, have suffered losses has induced a certain caution on the market for long-term obligations. This tendency is apparent today; but it has also been noticeable in earlier periods of depression, even if not to the same extent. The reluctance of those elements which might otherwise be purchasers of bonds—as a result of the unfortunate experiences of the last few decades—is responsible for the very wide margin between the rates for money at short-term and the rates for long-term capital investment. If this cautious attitude persists, those who desire to take up long-term credits will be compelled to pay a premium as a contingency against falls in purchasing power, in addition to the interest on their loans; otherwise, they will have to satisfy their requirements on the short-term market, where (as has already been pointed out) allowance is made for probable changes in purchasing power.2

In the case of the second category of social consequences of changes in purchasing power, no similar adjustment mechanism is present. Some people are inclined to ignore this second category on the grounds that its effects are only temporary; this is true only in the sense that the effect on income and capital conditions caused by the irregular and unequal incidence of changes in purchasing power cease to operate when the changes have permeated the entire economic system. The effects on the income and capital conditions, however, remain. One man has gained and another has lost. In this respect, then, the second category of effects does not differ from the first.

All the proposals that have been made for stabilizing the purchasing power of money are vitiated by the fact that they are designed only to eliminate the effect on the tenor of debt contracts. They leave entirely out of account the second effect of such changes, in the belief that it is only, or mainly, the effect on debt contracts that matters. Everyone of these proposals for stabilizing the value of money contemplate adjustments after the event and according to the changes in purchasing power calculated on the basis of a system of average values.

A distinction should be made between two such systems. The older system is that of the “tabular standard” and makes the adjustments only in the case of deferred payments; that is to say, it merely alters the nominal amount of the debt contract without touching the monetary system at all. The second system, represented by Irving Fisher’s “stabilized dollar” and J. M. Keynes’“manipulated currency,” involves an adjustment of the purchasing power of the money in circulation as a whole. Here, again, there is to be no adjustment until after the change in purchasing power has taken place and after its unequal and irregular incidence has had its effect. Such ex post facto adjustments do nothing either to eliminate or to mitigate the effects of the second category; it can only apply to the effects of the first category. That is the essential point that needs to be made.

In general, therefore, it may be said that all proposals which aim at stabilizing the value of money have regard only to one part of the effects of changes in purchasing power. They can only eliminate those effects touching upon the tenor of long-term debt contracts in terms of gold. They can do nothing to remove the other effects of changes in purchasing power, which are no less acute than those of the first category and, perhaps, maybe are even more important.

If this is borne in mind, it will be realized that radical though these proposals sound, they would by no means be so drastic in practice. They are far from being as superior to the old, more modest, programme of the “sound currency” school as one is tempted at first to imagine. This older programme did not attempt to stabilize the value of money; it was content to aim at the elimination, as far as possible, of all factors likely to give rise to sudden and excessive changes in purchasing power. It was from this standpoint that the decision was made in favor of the gold standard, because it was felt that the gold standard offered at least relative, if not absolute, stability.

Has anything happened to disappoint the expectations entertained some decades ago by the English and Continental adherents of the classical gold standard?

III. Causes of the Changes in Purchasing Power the Last Few Decades

Since the second half of the last decade of the nineteenth century, the purchasing power of gold has steadily declined. There is no need to go into what has been generally written about the extent of this change or the reasons for it. But one point must be emphasized with special insistence, because, as a rule, it has unfortunately been completely overlooked in recent discussions of the problem. I refer to the fact that the chief cause behind the fall in the purchasing power of gold during the period in question is to be found in the monetary policies of the various governments, rather than in the conditions of gold production. In their monetary policies, the various governments have consciously aimed at an “economizing” of gold, with these efforts leading to a much greater fall in the purchasing power of gold than would have been the case if endeavors had not been made to drive gold out of effective circulation. If we had gold coins in actual daily circulation everywhere in the world, as was the case some decades ago in Germany and England, and if the banks of issue of the smaller and poorer States kept their currency reserves in actual gold and not principally in gold claims on foreign countries, the depreciation of gold would either not have taken place at all, or at least not to anything like the extent to which this actually occurred between 1896 and 1920.

It is no doubt true that individual governments did not realize that the consequence of all countries following this same policy would be a general rise in prices. What each State had in view was a cheapening of the costs of circulation in its own country. Above all else, they were influenced by the fallacious idea that it was possible to bring about a decrease in interest rates by various monetary policy measures, including a concentration of the national supplies of gold in the basements of the central banks. But whatever individual governments may have had in view in following this policy, one thing is beyond dispute: the result was bound, other things being equal, to lead to a fall in the purchasing power of gold and an increase of commodity prices in terms of gold. Therefore, it is remarkable that public opinion should have regarded the rise in prices during this period as due solely to the conditions of gold production—quite independent of governmental policies—and have failed to realize that the increase in prices could never have assumed the dimensions it did if a different policy had been followed by their governments.

If governments had followed a different policy and the rise in the prices of commodities (in terms of gold) had, for this reason, either not taken place or, at any rate, not taken place to the extent that it did, there would never have been any talk at the time of a failure of the gold standard. And if today, at a time of falling prices, the cry for a departure from the gold standard is even more clamant, it can only be pointed out, once again, that the great collapse of prices—which has been the outstanding economic event of the last few years—represents an inevitable reaction after the previous expansion of credit. Credit policy mistakes may be blamed for many things, but the gold standard is certainly not one of them. It is, therefore, quite unjustified to say that events have shown the inapplicability of the gold standard. It is not the old classical gold standard, with effective gold circulation, which has failed; what has failed is the gold “economizing” system and the credit policy of the central banks of issue.

All that can be said is that no conclusions should be drawn for the future. Apprehensions are expressed today that the transition to the gold standard by countries which have so far not adopted it, coupled with a decline in the production of gold, will lead in the future to a fall in the gold prices of commodities (i.e., a rise in the purchasing power of gold). These apprehensions certainly cannot be dismissed offhand, though all prophecy as to the future value of money must be taken with the utmost reserve. But it is just as well to remember that, even if the production of gold in the next few decades should decline, and even if the gold standard should be adopted everywhere (including China and Russia), it need not necessarily involve a fall in prices. This would be the case if the policy of “economizing” gold, which has gradually spread during the last few decades to all the countries in the world, is maintained and, perhaps, even strengthened.

The problem is rendered particularly complex by the fact that it is closely connected with the question of the issue of currency via credit expansion, i.e., banknotes and bank balances without gold cover.

Public opinion, looking upon a low rate of interest as the ideal of economic policy, more or less openly encourages the banks of issue to follow a policy of expanding credit in order to reduce the rates for money below the market rates, i.e., the rate which would prevail on the money market if the banks did not intervene. The fact that this policy must necessarily lead to a rise in prices is not seen as an objection from the businessman’s point-of-view; on the contrary, he regards rising prices as a sign of prosperity. It was not until the interests of classes in the population other than the entrepreneur’s began to have increased influence on judgments about general economic conditions that the world began to realize that rising prices were not an unmixed blessing. To the businessman, a period of rising prices is a period of “expansion” and “boom”; to the renter, the civil servant and, in general, the man with a relatively fixed income, rising prices mean an “increased cost of living.”

The businessmen, who want cheap money through the intervention of the banks, pay no attention to the lesson taught by the older economists of the Currency School and, more recently, by Wicksell and all modern adherents of the monetary theory of the trade cycle (or more accurately, the circulation credit theory of the trade cycle). The gist of this lesson is that all efforts by the banks to artificially lower the free market rates for money by expanding credit may at first lead to increased business, but in the long-run must inevitably create a situation of crisis and depression.

Those believing that changes in purchasing power are susceptible to exact measurement are quite consistent in demanding that banking policy should be tied to the results of these measurements in such a way that the banks should be required to make the goal of their credit policy the stability of the purchasing power of the monetary unit. Therefore, before going further, we must consider the question whether the various methods proposed for measuring fluctuations in purchasing power do, in fact, provide an instrument that can profitability be used for the purposes of economic policy.

IV. The Various Methods of Measuring Fluctuations in Purchasing Power and Their Importance for the Problem of Stabilization

The assumption that changes in the purchasing power of money are susceptible to exact measurement is based on the belief that modifications in the exchange relationships of particular commodities and services are sufficiently taken into account when a general average is taken. It is upon this fiction that the conception of a “level” of prices is based; all that appears to be necessary is an ascertainment of whether this “level” has risen or fallen as a whole. The avowed neglect of changes taking place among the prices of particular commodities and services relative to one another has been fostered by the fact that among the effects of changes in purchasing power those mainly considered are the ones arising out of money’s function as a standard of deferred payment; the other social consequences of changes in purchasing power, caused by the fact that all commodities and services do not feel their incidence at the same time or to the same extent, have been almost completely left out of account.

But even on the assumption that it is quite sufficient to calculate changes in the purchasing power of money with reference to an average of the prices of commodities and services, there are a number of fundamental difficulties for which there appears no single solution. In the first place, there is the question of “the average.” Is it to be the arithematical mean, the geometrical mean, the harmonic mean, or any other form of “mean” known to mathematics? There is no categorical answer to this question.

Second, what method is to be followed in the weighting of the individual prices, that is to say, what coefficients of relative importance are to be assigned to the particular commodities and services? Here, again, there is no single solution.

It is just because there is no single solution for these two questions, i.e., no solution which can be said to be indubitably the right one and all the others wrong, that we are driven to the conclusion that the index number method is fundamentally unsuitable for the purpose of an accurate measurement of changes in the purchasing power of money. It is not contested that the majority of the systems proposed are well suited for affording the approximate indication of the changes in purchasing power which have taken place, and that they have, pro tonto, much educative value in directing public attention to the fact that changes have taken place. Nor need it be disputed that as a general rule and over relatively short periods of time, the calculated results by the different methods do not diverge very greatly from one another. But it is none the less necessary to insist, with all possible emphasis, on the fact that all such calculations are only approximate and not exact, and that an exact calculation is fundamentally impossible. It is necessary to emphasize this point, not merely to calm the conscience of theoreticians, but in order to draw attention to the far-reaching effect which it has as regards the practical application of index numbers for currency and banking policy.

As there are various methods for calculating an index of changes in purchasing power—all of which are equally right and wrong, equally correct and incorrect—and as each of these methods gives different results, it is inevitable that, once the index figures cease to be of a purely academic interest and acquire a direct bearing on economic policy, this purely scientific problem will become the field of serious conflicts of interest. Supposing the dollar were stabilized in accordance with the proposals of Irving Fisher, or that a “manipulated currency” was introduced on the lines of Keynes’ system, or that the credit policy of the central banks were made dependent on the results of the index measurements, the various interest groups would immediately take sides on behalf of this or that method of calculation, according to whether they were interested in a rise or a fall of prices. The purchasing power of the monetary unit, which under a gold standard is to a certain extent independent of direct political influence and is ultimately based on the profit to be earned from the production of gold, would then become the plaything of political parties and political struggles. A sudden change in the purchasing power policy of the government, or even the anticipation of such a change, would be the occasion for grave disturbances within the individual countries. And the position vis-à-vis international trade would be completely intolerable. Just imagine the consequences if particular States—or all States—were to make an attempt through some joint organization, appointed by the League of Nations perhaps, to pursue a uniform currency policy based on the results of index measurements. The commercial antagonisms of the several countries would be automatically intensified, with an element of quite peculiar bitterness at once introduced into the conflict by the fact that the world is divided into two groups of people—the debtor and creditor countries.

The various writers, who have argued for some kind of tabular standard, have been so convinced of the correctness of their own particular methods of calculation that they have not seen this fundamental defect in their systems. Irving Fisher, again, attaches too much importance to the assertion that the several methods of calculating index numbers do not differ greatly in their results. It is not true that they do not differ; but even if it were so, it must be remembered that in view of the great importance of manipulations in purchasing power, even small differences would be sufficient to give rise to serious conflicts of interest in each country, and even more importantly, conflicts between one country and another.

Even if the fundamental difficulties standing in the way of index calculations could be overcome, the practical difficulties remaining would still be very great. The most correct manner of arriving at the prices of commodities and services would be to consider only commodities and services which are ripe for consumption, i.e., at the point of delivery to the ultimate consumer. Any other system will break down (apart from all other theoretical objections) for the reason that it must be a matter of entirely arbitrary selection as to how many intermediate stages of production are to be included in the calculation. The results are bound to be largely influenced by the number of times a product is treated as a separate commodity in its intermediate stages of production, and included as such in the calculations. The insuperable difficulties which stand in the way of a survey of the final consumer products are due to the impossibility of establishing any unvarying standard for dealing with changes in product quality. In order to eliminate the problem of variations to quality, all index number systems are compelled to restrict themselves to the not very large number of articles (mainly raw materials) in the case of which the identity of quality can be ascertained beyond dispute. In addition to variations to quality, changes in consumption (due to the consumer including new articles in his consumption “basket”) present immense difficulties in the way of statistical measurements. Once again we are led to the conclusion that disputes between the various interests in each country—and still more between nations—are bound to arise as soon as these statistical calculations emerge from the sphere of theory and assume practical economic significance.

The above considerations may be summed up as follows: any economist is able to propose a system for the approximate ascertaining of changes in purchasing power, which he thinks comes nearest to the solution of this insoluble problem. But no economist is able to prove conclusively to an unprejudiced party the necessity of preferring his system to all others. The selection of a method for calculating index numbers is always more or less arbitrary. If far-reaching practical consequences are involved in such selections, as must be the case if they serve as a basis for currency policy, there will be no possibility of agreement on the part of the various nations—or the various social groups within nations—since the individual interests of each nation and of each social group will be effected.

The above arguments may appear not only as drastic and skeptical, but at first sight to be in conflict with the results of more than a hundred years of industrious research into these problems by a series of the most eminent economists. But, in fact, my comments represent nothing more than the conclusion which inevitably emerges from the entire literature on the subject. What lends them special weight is the fact that they alone explain why the ingenious proposals of eminent economists for the creation of stable currencies based on index numbers have hitherto never been put into effect. Up to the present, it has been more than a purely conservative attitude which has led statesmen and businessmen to stand aloof from these proposals; rather, it has been the recognition of the fundamental defects inherent in them.

These objections are especially weighty when the problem is considered from the international standpoint. It is astonishing that even people who are aware of the importance of the international exchange of commodities and money take the standpoint that the stability of domestic prices is more important than the stability of the international exchanges. The consequence of such proposals, if they were put into force, would be that each separate country would pursue a monetary policy based on the index system it considered best, with the result of exposing the international exchanges (the movements of which, under the gold standard, are confined within narrow limits) to abrupt and extensive fluctuations. No one can fail to see that this would introduce a major factor of instability and uncertainty into international commercial relations and, more importantly, into the conditions of international indebtedness.

V. The Pure Gold Standard and the Gold Standard Influenced by the Banks

Before considering the function of international cooperation in the field of currency policy, something must be said about the influence of banking policy on purchasing power.

In view of the disadvantages which arise from manipulations of purchasing power, the principle underlying the pure gold standard is that it is preferable to make the world’s supply of money dependent on the accident of gold production. As matters stand today, a pure gold standard would give us a monetary system under which prices of commodities would slowly fall. It is improbable that discoveries of gold will again take place on such a scale as to reduce the purchasing power of gold. But whether it rises or falls, purchasing power under a pure gold standard, at any rate, changes slowly and the changes continue over a considerable period of time in the same direction. With a pure gold standard, an increase of the world’s supply of money (in a wide sense) can only come from new gold being produced and put into circulation in the form of money. A decrease in the supply of money can only come from gold being diverted from monetary to industrial uses.

It is characteristic of the gold standard that the banks are not allowed to increase the amount of notes and bank balances without a gold backing, beyond the total which was in circulation at the time the system was introduced. Peel’s Bank Act of 1844, and the various banking laws which are more or less based on it, represent attempts to create a pure gold standard of this kind. The attempt was incomplete because its restrictions on circulation included only banknotes, leaving out of account bank balances on which cheques could be drawn. The founders of the Currency School failed to recognize the essential similarity between payments by cheque and payments by banknote. As a result of this oversight, those responsible for this legislation never accomplished their aim.

If this omission had not existed in the bank laws and if, in consequence, all expansion of credit by the banks had been effectively precluded, the world would have had a monetary system in which—even apart from the discoveries of gold in California, Australia, and South Africa—prices would have shown a general tendency to fall. The majority of our contemporaries will find that a sufficient ground for regarding such a monetary system as bad in itself, since they are wedded to the belief that good business and high prices are one and the same thing. But that is a prejudice. If we had had slowly falling prices for eighty years or more, we would have become accustomed to look for improvements in the standard of living and increases in real income through falling prices with stable or falling money income, rather than through increases in money income. At any rate, a solution to the difficult problem of reforming our monetary and credit system must not be rejected offhand merely for the reason that it involves a continuous fall in the price level. Above all, we must not allow ourselves to be influenced by the evil consequences of the recent rapid fall in prices. A slow and steady decline of prices cannot in any sense be compared with what is happening under the present system: namely, sudden and big rises in the price level, followed by equally sudden and sharp falls.

As a result of the Currency School’s oversight, the world has acquired a monetary system which is affected not only by the fluctuations in the production of gold, but also by fluctuations in banking policy. Spurred on by a public opinion looking for salvation through low interest rates and rising prices, the banks are perpetually endeavoring after periods of depression to give an artificial stimulus to economic activity by means of credit expansion. They create a period of rising prices and continue with their expansionary policy until a point is reached at which they are at last compelled to call a halt; and once more they, then, bring about a decline in prices via restriction of credit.

It is such a period through which we are now passing. Eminent economists look for the cause of the depression in the restrictive measures of the banks. But the root cause of the evil is not in the restrictions, but in the expansion which preceded them. The policy of the banks does not deserve criticism for having at last called a halt to the expansion of credit, but, rather, for ever having allowed it to begin.

Consider what would happen if the banks were to perpetually continue a policy of credit expansion once it had begun. To maintain the artificially induced situation they would be compelled to have recourse to continually increasing the expansion of credit, the result of which would be an ever sharper and more rapid rise of prices. But once the business world realizes that there is no end in sight to the progressive expansion of credit, i.e., that prices are going to rise uninterruptedly, it will at once speculatively discount the price increases in advance by applying to the banks for more and more credit—since every purchase on credit will be a profitable transaction—and the end result becomes a progressive inflation. But inflation cannot last forever without leading to a panic and a collapse of the entire monetary system; this is a truth on which it is no longer necessary to expatiate, since it is amply confirmed by the experiences of the inflationary period of the last decade and a half and been explained in numerous works on the subject.

Therefore, when it is argued in various quarters that the recent fall in prices is due to the change in the policy of the banks, it is, literally speaking, true. A closer scrutiny of the facts, however, will show that sooner or later the policy of expanding credits must come to an end and that the evil consequences for which it is responsible will be the more serious the longer it has been pursued. The evil is not in the restrictions, but in the expansionist policy which preceded them. One ultimate reason for the present drop in prices is the circumstance that the banks—with the assent of public opinion, and indeed at the direct instigation of the press, the business world, and the Governments—have made use of their power to issue additional circulation, i.e., to increase credit artificially. If the banks were to make no use of this power—which could only be the case either if the Central Banks were explicitly prohibited in their reserve-issuing privileges or if public opinion rigorously condemned the practice—we should have no economic fluctuations. We would probably have slowly falling prices, since the purchasing power of money would depend exclusively on the production of gold. But we should certainly not have the abrupt transitions from a sharp rise in prices to an equally sharp fall in prices, such as we have been through twice during the last ten years.

VI. Attainable Reform Objectives

From the outset any systematic policy of influencing the purchasing power of money should be kept within narrow limits, if it is not to do more harm than would result from leaving events to take their own course. To begin with, it is necessary to completely get away from the attempt, as unscientific as it is impracticable, to maintain the purchasing power of money “stable.” Furthermore, we have to rid ourselves of the notion that a decline in purchasing power is in some way better than an increase in purchasing power. Lastly, we have to realize that theories based on the idea that the rate of interest can be lowered by banking policy are wrong; all endeavors in this direction may, indeed, at first provoke an expansion of business, but in the end it can only lead to crisis and depression owing to the diversion of capital into wrong channels.

It also has to be borne in mind that proposals for a radical transformation of the constitutions of the banks of the various nations of the world have no prospect of being put into effect now or for a number of years to come. All that can be done is to take mitigating action during periods when the tendency for purchasing power to continuously increase is clearly marked and to take contrary action in periods showing an equally well established tendency towards a continuous fall in purchasing power. In neither case should action be taken to the point of interfering with the normal tendency conditioned by gold production, either to the extent of arresting or actually reversing its operation.

Whether taken by each country separately or as part of a programme of international cooperation, the extent of such action will have to be exercised with great caution. To prevent a policy that influences purchasing power from becoming the plaything of the various economic interests—because of the impossibility of finding any one method of calculating index numbers which by itself is correct—it is essential to restrict that interference to those changes in purchasing power, in one direction or the other, which are admitted without question by all parties. That implies that action to increase the purchasing power of money should only be taken when the decline in purchasing power is unquestionably established by all the different possible methods, and should, again, be suspended the moment any one of the methods yields divergent results; the same applies to measures to bring about a decrease in the purchasing power of money.

Any other policy followed by a single country would lead to serious conflicts between internal interests; and if followed by some common international organization it would lead to serious conflicts between nations. In all probability, at the first appearance of such conflicts all attempts at uniform international treatment of questions concerning currency and banking policy would have to be abandoned.

It is not the object of this memorandum to investigate the measures which should be taken for the attainment of these aims. Its objective is merely to consider which method of ascertaining changes in purchasing power is the best. The above explanatory digression was necessary in order to answer this question. We can now proceed to give a concrete reply.

VII. The Measurement of Changes in Purchasing Power as a Standard for Currency and Banking Policy

The considerations set forth above considerably restrict the functions which an instrument for the measurement of changes in purchasing power would perform. The problem is no longer that of satisfying the impossible demand for an exact standard for measuring changes in the purchasing power of money: the question is only one of forming an approximate estimate of the direction which those changes are taking. Up to the present, nearly all the proposals that have been made have been aiming at a correct standard—the one “correct” standard, the one “scientific” standard—of measurement. We must realize, however, that all we are looking for is a conventional standard, which means an arbitrarily selected standard. That is not a reproach to our proposal, since any and every standard is open to weighty objections and whatever standard is decided upon, the decision must always be an arbitrary one. The justification for our proposal is simply the fact that, at the outset, we set up much narrower aims for the currency and banking policy which would be guided by our standard, as opposed to the schemes which aim at stabilization. Our policy only comes into operation when the change in purchasing power has been ascertained over a considerable period with such unquestionable certainty that no one can dispute it; it ceases to operate as soon as it has been successful in bringing purchasing power back to a point at which it is possible for doubts to arise as to whether the tendency which it is desired to combat still exists or not. Under these circumstances, there is no need to criticize particular proposals which have been made for the measurement of changes in purchasing power. Dozens of volumes have been written on the subject and the acutest economists have dealt with it. It would be altogether a mistake to attempt to add a new proposal to those which have already been made. But what must be realized is that any proposal of this kind is inevitably defective.

The advantage of the suggestion put forward here is to be found in the fact that it makes possible, to a certain extent, a general conspectus of changes in purchasing power, which can serve as a basis for currency and banking policy without provoking conflicts and antagonisms of interest. That a number of proposals which have been made for the measurement of changes in purchasing power are impracticable at the outset—irrespective of their theoretical advantages—is clear. This is especially the case with proposals to base the calculation of changes in purchasing power on wages and retail prices. The only practical proposals are those which take wholesale prices as their primary foundation; even in this case it will be necessary, in order to get around the difficulties connected with variations of quality, to make a selection and confine the calculation to articles whose constancy of quality can be indisputably established.

Systematic attempts to regulate purchasing power can only be made through international agreement. If separate countries were to take such action they would find themselves in a position of monetary isolation; as a result, one of the most important achievements facilitating international trade, namely, the monetary unification ensured by the gold standard, and its corollary of relatively stable exchanges, would be lost. But international action in this field can only be attempted if conflicts of interest are avoided from the outset. The attenuation of sharp changes in the purchasing power of money in one direction or the other is an object on which all nations will readily agree, and for such a purpose the methods which we have at our disposal are sufficient for the measurement of changes in purchasing power. To attempt anything more than this would be asking an international organization to assume a heavier burden that it is able to carry.

With the adoption of such a policy as has been indicated above, the problem of the measurement of changes in purchasing power is relatively easy to solve. But with a policy pursuing more far-reaching aims, the problem would be altogether insoluble.

• *[Memorandum prepared for the Gold Delegation of the Financial Committee of the League of Nations, F/Gold/51 (Geneva: October 10, 1930). This memo had been forgotten and only rediscovered when doing research for this volume in the League of Nations Library Archives—Ed.]
• 1[Ludwig von Mises, “Monetary Stabilization and Cyclical Policy” [1928], in On the Manipulation of Money and Credit, Percy L. Greaves, Jr., ed. (Dobbs Ferry, N.Y.: Free Market Books, 1978), p. 99ff—Ed.]
• 2[The reader should recall this was written in 1930—Ed.]

I*

All the misfortunes from which Europe has suffered in the last two decades have been the inevitable result of the application of the theories which have dominated the social and economic philosophy of the last fifty years. Our troubles are the upshot of much laborious thought. The German inflation, above all, was the outcome of the monetary and banking theory which for many years had obsessed the men who occupied the chairs of economics at the Universities, the men who governed the financial policy of the Reich, and the editors of the most influential newspaper and periodicals.

The central feature of these erroneous theories was a total rejection of the Quantity Theory1 and of all the teachings of the Currency School.2 The empirisch-realistische Volkswirt,3 who distrusted every “theory”—especially theories imported from abroad—was firmly convinced that both the Quantity Theory and the Theories of the Currency School were nothing but an inexplicable blunder committed by Ricardo and his followers. The German Kathedersozialisten4 did not waste their time on the study of English political economy. Hence they were unaware of the problems which were the subject of the long-lasting controversy between the Banking School and the Currency School. The only source of their knowledge of the matter was the book published in 1862 by Adolph Wagner under the title Theorie der Peel’schen Bankakte. Wagner lacked absolutely the gift of economic ratiocination. He accepted without any criticism all the statements of the Banking School; from his book it was utterly impossible to gather what objections the Currency School had had against the theories of the Banking School.

The other leading authority on monetary and banking problems, Wilhelm Lexis, was still less endowed with the power of economic reasoning. He, like Wagner, was entirely innocent of any understanding of the Ricardian theory of the foreign exchanges—the “purchasing power parity” theory. Each firmly believed that the foreign exchanges are governed by the balance of payments.

Hence would-be economists who owed their education to the teachings of such men were prepared to accept without criticism the doctrines of Knapp and Bendixen, who in the years immediately preceding the outbreak of the war dominated German monetary and banking theory. Knapp, Professor of Political Science at the University of Strasburg, was a trained statistician and had devoted much time in archives to the study of Prussian policy concerning the peasantry. There is not the slightest indication in his writings that he had ever glanced at Ricardo or any other of the British monetary economists. The occasional allusions to Ricardo’s ideas, which one finds in Knapp’s writings, impute to Ricardo opinions which are rather the contrary of what we read in Ricardo’s books and pamphlets. Knapp ignored absolutely the problem of prices. In his view the task of monetary theory is nothing else than the purely formal classification of the various kinds of currency. He had not the slightest idea that government interference in the mechanism of price-making is subject to certain conditions which cannot be controlled simply by governmental decree.

Not less fatal for the formation of German views on monetary theory was the influence of Bendixen, the manager of a mortgage corporation, who, inspired by Knapp, wrote some booklets, which expounded the principles of the Banking School. The most striking feature of Bendixen’s contribution was that, being unfamiliar with monetary literature, he honestly believed he was enunciating something entirely new!

In passing under review the German monetary and banking policy from the outbreak of the war to the catastrophe of 1923, the most startling thing is the absolute ignorance even of the most elementary principles of monetary science on the part of literally all German statesmen, politicians, bankers, journalists, and would-be economists. It is impossible for any foreigner even to realize how boundless this ignorance was. For this reason, in the last three years of the German inflation, some foreigners came to believe that the Germans ruined their own currency of set purpose in order to involve other countries in their own ruin, and to evade the payment of reparations. Such imputation of secret satanism to German policy does it wrong. The only secret of German policy was Germany’s total lack of any acquaintance with economic theory.

Thus Herr Havenstein, the governor of the Reichsbank, honestly believed that the continuous issue of new notes had nothing to do with the rise of commodity prices, wages, and foreign exchanges. This rise he attributed to the machinations of speculators and profiteers and to intrigues on the part of external and internal foes. Such indeed was the general belief. Nobody durst venture to oppose it without incurring the risk of being denounced both as a traitor to his country and as an abettor of profiteering. In the eyes both of the public and of the rulers the only reason why monetary conditions were not healthy was the lamentable indulgence of the government in regard to profiteering. For the restoration of sound currency nothing else seemed to be necessary than a powerful suppression of the egotistic aims of unpatriotic people.

It would be very interesting to show that this attitude was the necessary sequel to the whole system of social and economic philosophy as taught by the school of Schmoller. According to the étatiste outlook of this school, power (Macht) is the deciding factor in social life. That even the most powerful government is not free to do everything, that there exist certain unalterable conditions of human existence insusceptible to the influence of the most powerful intervention, are propositions which it never admitted. The study of economic theory, it said, was useless, for the various systems of theoretical economics all overlooked the fact that governments had the power to alter all conditions. It was ready to admit that the Ricardian system was a faithful description of the state of England at his time, but it denied its applicability to Germany. In the realm of the Electors of Brandenburg and the Kings of Prussia everything was different. It therefore replaced the study of economic theory by the history of Prussian administration in the academic curriculum. It taught that there is nothing important in social life but power, and its notion of power was very materialistic. Power in its eyes was soldiers and guns. It had never understood Hume’s discovery that all government is founded on opinion.

But to trace this evolution would involve writing the entire history of the transition of the German mind from the liberal thought of Goethe, Schiller, and Humboldt to the militarist ideas of Treitschke, Schmoller, and Houston Stewart Chamberlain. It would involve writing the history of the Prussian hegemony of the nation which has been styled the nation of poets and thinkers, and the history of the Reich founded by Bismarck and lost by Wilhelm II. It is obvious that this would exceed the purpose of these lines.

II

In these circumstances it is easy to understand that the German books dealing with the history of the Inflation Period are for the greater part of little value. They are so full of prejudices, and are often so entirely lacking in the theoretical insight which must necessarily precede all historical description that they cannot even give an adequate picture of the great historical event. For this reason this work by a learned American is all the more welcome. In his Exchange, Prices and Production in Hyper-Inflation: Germany, 1920–1923, Professor F. D. Graham of Princeton University has taken great pains to provide a reliable narrative.

In judging this valuable book we must bear in mind that all the experience of the German inflation brought nothing that could puzzle the theoretical economist. There were many things which were quite inexplicable to the étatiste Volkswirt5 of the Schmoller type, nay, the whole thing was quite inexplicable to them, but there was nothing that had not been observed and satisfactorily explained by the theorist in previous inflations.

In reading Professor Graham’s historical survey even those who were witnesses of the inflation must again and again be amazed at the incredible incapacity evinced in regard to the monetary problem by all sections of the German nation. For the economist the most astonishing fact is the inadequacy of the Reichsbank’s discount policy. This is Professor Graham’s verdict: “From the early days of the war till the end of June 1922 the Reichsbank rate remained unchanged at 4 per cent.; it was raised to 6 per cent, in July, to 7 per cent, in August, 8 per cent, in September and 10 per cent, in November 1922, to 12 per cent, in January 1923, 19 per cent, in April, 30 per cent, in August and 90 per cent, in September. But these increases were as nothing when measured alongside the progressive lightening in the burden of a loan during the time for which it ran. Though, after September 1923, a bank or private individual had to pay at the rate of 900 per cent, per annum for a loan from the Reichsbank, this was no deterrent to borrowing. It would have been profitable to pay a so-called interest, in reality an insurance, charge, of thousands or even millions of per cents, per annum, since the money in which the loan would be repaid was depreciating at a speed which would have left even rates like these far in the rear. With a 900 per cent, interest rate in September 1923 the Reichsbank was practically giving money away and the same is true of the lower rates in the preceding months when the course of depreciation was not quite so headlong. The policy of the Reichsbank authorities in encouraging the discount of commercial bills that they might thus mitigate the scarcity of credit was but further evidence of the Alice-in-Wonderland determination of the directors of that institution to run ever faster in order to keep up with themselves. The scarcity of credit was due solely to currency depreciation and the cure prescribed was to increase the volume of means of payment!”6

But one should not forget that the Reichsbank was not alone in this folly. The private banks, too, lent money to every speculator who furnished collateral security. It was very easy to get rich by buying shares with the money borrowed from the banks. In this way some acquired big fortunes in a very short time and painlessly. Since then all these much-admired and envied profiteers have lost all that they won, and in many cases even much more—a proof that they were not gifted with great business ability. Indeed, no great business ability was needed to outwit any one of the big German banks. That their managers and directors were really incompetent has been proved by the subsequent failure of the institutions which they governed.

It took years for German business men to understand that the mark was no longer a suitable unit for economic calculations. For a very long time they really believed that the profits, which an account of profit and loss reckoned in Marks showed, were genuine earnings. They did not understand that a computation made in a more stable currency would lead to quite a different result. Of course the business men discovered this truth somewhat earlier than the general public. They then replaced the Markrechnung by the Goldrechnung. This was the beginning of the end. The Mark-currency had perforce to break down when its unrestrainable depreciation could no longer be overlooked.

As long as the inflation was working, socialist labor leaders and the socialists of the chair were all in its favor and taught that not the increase in quantity of money but the unpatriotic behavior of the profiteers was the cause of the depreciation of the Mark. After inflation was over they changed their minds. Now they accuse the “capitalists” of having of set purpose made the inflation to enrich themselves. For the German public mind every misfortune is due to the machinations of the “exploiter class.”

III

For the economist the German inflation brought some interesting illustrations of his theoretical principles, but no experience which did not conform to them. In this instance monetary and economic theory had nothing new to learn. Of course, the German politico-economic science of the Schmoller-Knapp type had everything to learn from it. But in fact, with the exception of some of the younger men, they have declined to draw the conclusion. Unteachable as they are, they still believe in the theory which attributes changes in the value of a national currency to variations in the national balance of payments. The failure of the policy of inflation they attribute to lack of energy on the part of the government and to lack of patriotism on the part of the people.

Nor has the German politician learned a whit more from the inflation. The government and the Reichsbank both believe that monetary troubles arise from an unfavorable balance of payments, from speculation and from unpatriotic behavior of the capitalist class. They therefore attempt to fight the menace of depreciation of the Reichsmark by controlling dealings in foreign currency and by confiscating German holdings of foreign assets. They do not understand that the only safeguard against the fall of a currency’s value is a policy of rigid restriction. But though the government and the professors have learned nothing, the people have. When the war inflation came nobody in Germany understood what a change in the value of the money unit meant. The business-man and the worker both believed that a rising income in Marks was a real rise of income. They continued to reckon in Marks without any regard to its falling value. The rise of commodity prices they attributed to the scarcity of goods due to the blockade. When the government issued additional notes it could buy with these notes commodities and pay salaries because there was a time lag between this issue and the corresponding rise of prices. The public was ready to accept notes and to keep them because they had not yet realized that they were constantly losing purchasing power. This went on for years. But as they learned that the government was determined not to stop with the further issue of notes and that the increase of their quantity must needs lead to a progressive rise of prices their conduct changed. Everybody became anxious not to keep the money in his pocket. The service which money renders consists in its being the commodity which is saleable at the best terms. By keeping money in his purse everybody is enabled to buy in the most convenient way any commodity he may want one day. But when money loses purchasing power from day to day its retention involves a loss. Whoever gets money, therefore, spends it immediately—even by buying something for which he has no present use and maybe even no future use. In the last days of the inflation the employees got their payment daily. At once they handed it over to their wives and these hurried to spend it as quickly as possible by buying at any rate something or other. Nobody wished to retain money, everybody dropped it like a live coal. When this tendency, which on the Stock Exchange was called Flucht in die Sachwerte—flight into investments in goods—became general, so that even the least business-like people adopted it, the end was at hand. The Mark broke down. The government gained no further advantage by issuing notes because the depreciation then outran the increase.

A nation which has experienced inflation till its final breakdown will not submit to a second experiment of this type until the memory of the previous one has faded. No German government could succeed in the attempt to inflate the currency by issues in favor of the Treasury as long as the men and women are still alive who have been the witnesses and victims of the 1923 inflation. Made overcautious by what they suffered, at the very outset of the inflation they would start a panic. The rise of prices would be out of all proportion to the increase in the quantity of paper money; it would anticipate the expected increase of notes. The more money the government issued, the less it would be able to buy. The higher the salaries the civil servants and the soldiers drew, the less goods would they be able to purchase. So the government would fail in the endeavor to ameliorate its financial position by issuing notes. From the point of view of officialdom, inflation would be nugatory.

The economist might urge that this lesson could have been learned at a lower cost from theory than from experience. Had the German people paid more attention to the teachings of economic theory they could have learned all these things without having to pay so dearly. This is a melancholy comment to have to make after the event.

But in any case the monetary history of the last three lustrums in Germany and many other European countries proves that no nation can afford to treat economic theory with contempt.

• *[This is a review article of Frank D. Graham’s book, Exchange, Prices and Production in Hyper-Inflation: Germany 1920–23 (Princeton, N.J.: Princeton University Press, 1930). The review is reprinted here from Economica (May 1932)—Ed.]
• 1[The Quantity Theory says that the general price level is primarily a function of the money supply—Ed.]
• 2[As Mises understood it both the British Currency School and the British Banking School, broadly speaking, were advocates of central banking. The Currency School, however, advocated rules for the expansion of money and credit with some theorists even favoring 100% specie reserves. The Banking School advocated a discretionary central banking policy with few or no rules concerning money and credit expansion—Ed.]
• 3[Translated as empiricist-relativist political economist—Ed.]
• 4[Members of the “Younger” German Historical School who used their university positions as vehicles to advocate political intervention and reform in the economy. These professors were called “academic socialists” or “socialists of the chair”—Ed.]
• 5[Translated as a political economist who advocates total control of all economic planning as a function of the government—Ed.]
• 6Cf. p. 65 of Graham’s book.

Nassau William Senior’s famous lectures* on money and international trade have been newly issued by the London School of Economics and Political Science in their series of reprints.1 On re-reading these classic treatises one is led to the conclusion that the practical application of economic reasoning seems to meet with very great difficulties. We are living in a world where trade barriers become more and more insurmountable. In defending the system of protection and prohibition, every day the same arguments are heard again which Senior and his fellow economists have refuted and which Ricardo had already refuted years before. Why could this acute criticism of the Mercantile Theory of Wealth2 not succeed in convincing public opinion? Is there a weak point in the demonstration of the futility of the protection doctrine?

The foremost argument in the protectionist’s reasoning today is again, as in the days of the Mercantile Theory, the monetary standpoint. Restriction of imports is said to be indispensable for the maintenance of a country’s monetary equilibrium. It is true, one no longer speaks of the danger of losing the circulating stock of coined precious metals to foreign countries. But the only reason for this is the fact that practically no country maintains today an effective circulation of gold coins as most of them did till the outbreak of the War. The modern protectionist insists rather upon the necessity to secure the exchange ratio between the national and the foreign currency. What he does not wish to admit is that the exchange ratio does not ultimately depend on the balance of payments and that there is no danger of its being impaired so long as there is no over-issue of notes at home.

The question to be answered today is exactly the same as is expounded in Senior’s lectures on the “Transmission of the Precious Metals from Country to Country.” The difference lies only in the formulation, not in the substance. The problem is whether there is an automatic readjustment of the balance of payments or whether government is bound to interfere lest disastrous consequences follow. The chain of reasoning by which Senior proves that governmental interference is superfluous for this purpose considers a state of things where imports and exports of commodities dominate international business relations. For the present situation it seems necessary to keep in view the importance of credits, and accordingly to lay stress not only on the prices of commodities but also on the rates of interest. This, of course, does not in any way alter the essence of the problem, but it does seriously affect the political and ethical aspect of the question.

Considerations of this nature play in the eyes of public opinion a bigger role than is generally supposed. In discussing the problem of trade restrictions primarily with reference to the prices of goods, one imagines a selfish producer who demands higher prices from the poor consumer. In this case sympathy is on the side of the consumer. But in regard to rates of interest sympathy is given to the lender. Whereas in the question of commodity prices public opinion splits into two parties so that against the friends of higher prices stand always friends of lower prices, in the problem of interest there is but one opinion, i.e., in favor of low interest. As the matter of controversy seems to lie in the dilemma whether to maintain at home a lower rate of discount at the cost of import restrictions or to let the price of money rise under free trade, the scale goes down in favor of import restrictions. There is in every country a considerable opposition against import duties which one tries to justify by the necessity of raising the home price level in favor of home production. The opposition is very weak when import duties are apologized for by the expediency of maintaining a low rate of interest.

There is no doubt that in countries where capital is very abundant the rate of interest would be much lower were there not opportunities of exporting capital to countries with a higher rate of interest. Had the United Kingdom or had France in the fifty or sixty years preceding the War not invested a large amount of money abroad, the money rate at London and Paris would have been much lower than it actually was. If at this time someone in England had demanded a restriction of foreign investments from the labor point of view, as the Liberal Industrial Report did after the War, it would have been intelligible at least from the point of view of a short-sighted class policy. But the strange thing was that at this time, not the capital-exporting countries, but the capital-importing countries complained more about the consequences of the international capital movements, assuming that it must lead to higher interest, whereas its effect for them was the contrary. Strange to say, in the ’seventies of the nineteenth century in Austria the theory was evolved that the Austrian paper currency isolated the country from the solidarity of international money markets and so enabled the bank of issue to expand credit and maintain a comparatively low rate of interest without any disadvantages. This false theory was duly refuted by Wilhelm Luccam, the then manager of the Austrian Central Bank. But nevertheless it survived in Austria and had from year to year more success in the whole of Europe, especially in Germany, and even in America.

When people today generally assert that things have so radically changed since the time in which the classical theory of money and foreign exchanges was expounded, that one cannot apply their results to modern conditions, they unfortunately do not give any proof. It is totally wrong to pretend that raising the rate of discount would not have any effect today on the flow of gold and on the exchange rate, or an insufficient effect. There is no proof that discount policy of the old type is inapplicable to the present situation. The fact is that the ruling parties prefer the consequences of a depreciation of the national currency to the consequences resulting from non-interference in the market’s money rate.

Let us consider separately the different recent cases of departure from the old gold parity. There was the case of England in 1931. Britain had to choose between a policy of defending the gold standard by raising the rate of discount, as has been done over and over again, and a policy of depreciation. She decided for the second because it made it possible to maintain unchanged the British level of prices and wages in the midst of a world a falling gold prices. Opinions differ on the soundness of this policy, and there is no doubt that it was very unsound from the point of view of Senior’s ideas. But there was nothing in the situation which could not be explained from the point of view of Senior’s theoretical teaching. It is true that his decision would have been very different from that of Great Britain’s rulers in 1931. He would have believed that nominal wages had to fall pari passu with prices, and that there was nothing alarming in a situation where the prices of raw materials which England buys fall more rapidly than the prices of the manufactures which England exports. But Senior in discussing these problems with Mr. Norman and Mr. Keynes would at the end of the conversation have said: “I see, gentlemen, that you follow other aims.” But he would have had no reason to say: “You have to cope with a situation which my theory does not cover.”

Yet in another respect a radical change in the financial situation has been accomplished. In the modern banking system the short-term debts play a dominating role. The banks of the lending countries have lent enormous sums to the banks of the borrowing countries. Literally they had the right to withdraw this money at short notice. But in fact such withdrawals could not be effected at once, as the borrowing banks had lent this money to business which could not pay it back at all or at least only after some delay. The international credit relations were based on a fallacious assumption of liquidity. The moment the lenders tried to exert their right of withdrawal there were only two alternatives: open declaration of bankruptcy by the debtor banks or intervention of the government which suspended payments to foreign countries. The introduction of foreign exchange control in some continental countries in the summer of 1931 was a makeshift for a formal moratorium.

Banking today is not sounder when considered from the point of view of the home situation. Deposits subject to cheques and saving deposits are two entirely different things. The saver wishes to entrust his money for a longer period; he wishes to get interest. The bank which receives his money has to lend it to business. A withdrawal of the money entrusted to it by the saver can only take place in the same measure as the bank is able to get back the money it has lent. As the total amount of the saving deposits is working in the country’s business, a total withdrawal is not possible. The individual saver can get back his money from the bank, but not all savers at the same time. That does not mean that banking is unsound. It does not become unsound until the banks explicitly or tacitly promise what they cannot perform: to pay back the savings at call or at short notice.

The deposits subject to cheques have a different purpose. They are the business man’s cash like coins and bank notes. The depositor intends to dispose of them day by day. He does not demand interest, or at least he would entrust the money to the bank even without interest. The bank, to be sure, could not earn anything if it were to hold the whole amount of these deposits available. It has to lend the money at short notice to business. If all depositors simultaneously were to ask their deposits back, it could not meet the demand. This fact that a bank which issues notes or receives deposits subject to cheque cannot hold the total amount corresponding to the notes in circulation and to the deposits in its vaults, and therefore can never redeem at once the total amount of its liabilities of this kind, is the knotty problem of banking policy. It is the consideration of this difficulty which has to govern the credit policy of the banks which issue notes or receive deposits subject to cheque. It is this consideration that led to the legislation which limits the issue of bank notes and imposes on the central banks the retention of a reserve fund of a certain magnitude.

But the case of the saving deposits is different. Since the saver does not need the deposited sum at call or short notice it is not necessary that the saving banks and the other banks which take over such deposits should promise repayment at call or at short notice. Nevertheless, this is what they did. And so they became exposed to the dangers of a panic. They would not have run this danger, if they had accepted the saving deposits only on condition that withdrawal must be notified some months ahead.

Public opinion assumes that the real danger to maintenance of monetary stability lies in the flight of capital. This assumption is not correct. Capital invested in real estate or in industrial plants or in shares of companies holding property of this nature cannot fly. You can sell such property and leave the country with the proceeds. But—unless there is no expansion of credit—the buyer simply replaces you. If he is a foreigner, then the capital flight of the native is compensated by the immigration of capital from abroad. If the buyer is another native, then he can provide the means—when additional credit is not granted by credit expansion—merely by selling his property, and so the case with him is the same. One person or another can withdraw his capital from a country, but this can never be a mass movement. There is only one apparent exception, i.e., the saving deposit which can be withdrawn from the bank at once or at short notice. When the saving deposits are subject to instant withdrawal and the bank of issue renders the immediate withdrawal possible by advancing credits for these savings to be withdrawn, then credit expansion and inflation cause the exchange ratio to rise. It is obvious that not the flight of capital but the credit expansion in favor of the saving banks is the root of the evil.

The pith of the problem lies in the deposit policy. Banks which promise no more than they can fulfill without extraordinary assistance from the central bank, never jeopardize the stability of the country’s currency. And even the other banks who have been imprudent enough to assume liabilities which they cannot meet are only a danger when the central bank tries to assist them. If the Central Bank were to leave them to their fate, their peculiar embarrassment would not have any effect on foreign exchanges. That the additional issue of great amounts of bank notes for the sake of the repayment of the total amount or of a great portion of the country’s saving deposits makes the foreign exchange go up is easy to understand. It is not simply the wish of the capitalists to fly with their capital, but the expansion of the circulation, that imperils monetary stability.

Had the central banks not believed that it was their duty to cover up the consequences of the deposit banks’ wrong policy they would have not only maintained without artificial and, at the same time, ineffective measures of the stability of the exchange ratio, but would have forced the deposit banks to make agreements with their clients concerning the payments due. By such agreements they would have adjusted the payments due to the payments receivable. The Standstill Agreements would have been made definitively and for all debts, foreign, and domestic.

To sum up, we are not entitled to say that Senior in his writings on money and monetary subjects had to deal with problems other than those which we have today. The task of monetary and banking theory is in principle not different today from Senior’s time. Different, of course, are the conditions of our banking organization, the institutions, and the considerations which politicians keep in mind. Different are the data, but not the mechanism of exchange and social cooperation. All the questions of principles which Senior had to face are identical with those which our theory has to answer. We may differ from Senior in regard to the treatment of the fundamental items of value and exchange, but we have still the same problems to solve. And notwithstanding all changes in economic thought and reasoning, in social conditions and political aspects, in banking organization and in business life generally, no one can read these old pamphlets without profit.

• *[This review article is reprinted from the Economic Journal (September 1933)—Ed.]
• 1Nassau W. Senior: 1. Three Lectures on the “Transmission of the Precious Metals from Country to Country and the Mercantile Theory of Wealth.” 2. Three Lectures on the “Value of Money.” 3. Three Lectures on the “Cost of Obtaining Money and on some Effects of Private and Government Paper Money.” Numbers 3, 4, and 5 in the Series of Reprints of Scarce Tracts in Economic and Political Science (London: London School of Economics and Political Science, 1931).
• 2[The Mercantilists believed that gold and other precious metals embodied true wealth, thus they advocated maximizing a country’s exports while minimizing its imports—Ed.]