I. THE PROBLEM

1. “Stable Value” Money

Gold and silver had already served mankind for thousands of years as generally accepted media of exchange—that is, as money—before there was any clear idea of the formation of the exchange relationship between these metals and consumers’ goods, i.e., before there was an understanding as to how money prices for goods and services are formed. At best, some attention was given to fluctuations in the mutual exchange relationships of the two precious metals. But so little understanding was achieved that men clung, without hesitation, to the naïve belief that the precious metals were “stable in value” and hence a useful measure of the value of goods and prices. Only much later did the recognition come that supply and demand determine the exchange relationship between money, on the one hand, and consumers’ goods and services, on the other. With this realization, the first versions of the Quantity Theory, still somewhat imperfect and vulnerable, were formulated. It was known that violent changes in the volume of production of the monetary metals led to all-round shifts in money prices. When “paper money” was used along side “hard money,” this connection was still easier to see. The consequences of a tremendous paper inflation could not be mistaken.

From this insight, the doctrine of monetary policy emerged that the issue of “paper money” should be avoided completely. However, before long other authors made still further stipulations. They called the attention of politicians and businessmen to the fluctuations in the purchasing power of the precious metals and proposed that the substance of monetary claims be made independent of these variations. Side by side with money as the standard of deferred payments,3 or in place of it, there should be a tabular, index, or multiple commodity standard. Cash transactions, in which the terms of both sides of the contract are fulfilled simultaneously, would not be altered. However, a new procedure would be introduced for credit transactions. Such transactions would not be completed in the sum of money indicated in the contract. Instead, either by means of a universally compulsory legal regulation or else by specific agreement of the two parties concerned, they would be fulfilled by a sum with the purchasing power deemed to correspond to that of the original sum at the time the contract was made. The intent of this proposal was to prevent one party to a contract from being hurt to the other’s advantage. These proposals were made more than one hundred years ago by Joseph Lowe (1822) and repeated shortly thereafter by G. Poulett Scrope (1833).4 Since then, they have cropped up repeatedly but without any attempt having been made to put them into practice anywhere.

2. Recent Proposals

One of the proposals, for a multiple commodity standard, was intended simply to supplement the precious metals standard. Putting it into practice would have left metallic money as a universally acceptable medium of exchange for all transactions not involving deferred monetary payments. (For the sake of simplicity in the discussion that follows, when referring to metallic money we shall speak only of gold.) Side by side with gold as the universally acceptable medium of exchange, the index or multiple commodity standard would appear as a standard of deferred payments.

Proposals have been made in recent years, however, which go still farther. These would introduce a “tabular,” or “multiple commodity,” standard for all exchanges when one commodity is not exchanged directly for another. This is essentially Keynes’s proposal. Keynes wants to oust gold from its position as money. He wants gold to be replaced by a paper standard, at least for trade within a country’s borders. The government, or the authority entrusted by the government with the management of monetary policy, should regulate the quantity in circulation so that the purchasing power of the monetary unit would remain unchanged.5

The American, Irving Fisher, wants to create a standard under which the paper dollar in circulation would be redeemable, not in a previously specified weight of gold, but in a weight of gold which has the same purchasing power the dollar had at the moment of the transition to the new currency system. The dollar would then cease to represent a fixed amount of gold with changing purchasing power and would become a changing amount of gold supposedly with unchanging purchasing power. It was Fisher’s idea that the amount of gold which would correspond to a dollar should be determined anew from month to month, according to variations detected by the index number.6 Thus, in the view of both these reformers, in place of monetary gold, the value of which is independent of the influence of government, a standard should be adopted which the government “manipulates” in an attempt to hold the purchasing power of the monetary unit stable.

However, these proposals have not as yet been put into practice anywhere, although they have been given a great deal of careful consideration. Perhaps no other economic question is debated with so much ardor or so much spirit and ingenuity in the United States, as that of stabilizing the purchasing power of the monetary unit. Members of the House of Representatives have dealt with the problem in detail. Many scientific works are concerned with it. Magazines and daily papers devote lengthy essays and articles to it, while important organizations seek to influence public opinion in favor of carrying out Fisher’s ideas.

II. THE GOLD STANDARD

1. The Demand for Money

Under the gold standard, the formation of the value of the monetary unit is not directly subject to the action of the government. The production of gold is free and responds only to the opportunity for profit. All gold not introduced into trade for consumption or for some other purpose flows into the economy as money, either as coins in circulation or as bars or coins in bank reserves. Should the increase in the quantity of money exceed the increase in the demand for money, then the purchasing power of the monetary unit must fall. Likewise, if the increase in the quantity of money lags behind the increase in the demand for money, the purchasing power of the monetary unit will rise.7

There is no doubt about the fact that, in the last generation, the purchasing power of gold has declined. Yet earlier, during the two decades following the German monetary reform and the great economic crisis of 1873, there was widespread complaint over the decline of commodity prices. Governments consulted experts for advice on how to eliminate this generally prevailing “evil.” Powerful political parties recommended measures for pushing prices up by increasing the quantity of money. In place of the gold standard, they advocated the silver standard, the double standard [bimetallism] or even a paper standard, for they considered the annual production of gold too small to meet the growing demand for money without increasing the purchasing power of the monetary unit. However, these complaints died out in the last five years of the nineteenth century, and soon men everywhere began to grumble about the opposite situation, i.e., the increasing cost of living. Just as they had proposed monetary reforms in the 1880s and 1890s to counteract the drop in prices, they now suggested measures to stop prices from rising.

The general advance of the prices of all goods and services in terms of gold is due to the state of gold production and the demand for gold, both for use as money as well as for other purposes. There is little to say about the production of gold and its influence on the ratio of the value of gold to that of other commodities. It is obvious that a smaller increase in the available quantity of gold might have counteracted the depreciation of gold. Nor need anything special be said about the industrial uses of gold. But the third factor involved, the way demand is created for gold as money, is quite another matter. Very careful attention should be devoted to this problem, especially as the customary analysis ignores most unfairly this monetary demand for gold.

During the period for which we are considering the development of the purchasing power of gold, various parts of the world, which formerly used silver or credit money (“paper money”) domestically, have changed over to the gold standard. Everywhere, the volume of money transactions has increased considerably. The division of labor has made great progress. Economic self-sufficiency and barter have declined. Monetary exchanges now play a role in phases of economic life where earlier they were completely unknown. The result has been a decided increase in the demand for money. There is no point in asking whether this increase in the demand for cash holdings by individuals, together with the demand for gold for nonmonetary uses, was sufficient to counteract the effect on prices of the new gold flowing into the market from production. Statistics on the height and fluctuations of cash holdings are not available. Even if they could be known, they would tell us little because the changes in prices do not correspond with changes in the relationship between supply and demand for cash holdings. Of greater importance, however, is the observation that the increase in the demand for money is not the same thing as an increase in the demand for gold for monetary purposes.

As far as the individual’s cash holding is concerned, claims payable in money, which may be redeemed at any time and are universally considered safe, perform the service of money. These money substitutes—small coins, banknotes and bank deposits subject to check or similar payment on demand (checking accounts)—may be used just like money itself for the settlement of all transactions. Only a part of these money substitutes, however, is fully covered by stocks of gold on deposit in the banks’ reserves. In the decades of which we speak, the use of money substitutes has increased considerably more than has the rise in the demand for money and, at the same time, its reserve ratio has worsened. As a result, in spite of an appreciable increase in the demand for money, the demand for gold has not risen enough for the market to absorb the new quantities of gold flowing from production without lowering its purchasing power.

2. Economizing on Money

If one complains of the decline in the purchasing power of gold today, and contemplates the creation of a monetary unit whose purchasing power shall be more constant than that of gold in recent decades, it should not be forgotten that the principal cause of the decline in the value of gold during this period is to be found in monetary policy and not in gold production itself. Money substitutes not covered by gold, which we call fiduciary media, occupy a relatively more important position today in the world’s total quantity of money8 than in earlier years. But this is not a development which would have taken place without the cooperation, or even without the express support, of governmental monetary policies. As a matter of fact, it was monetary policy itself which was deliberately aimed at a “saving” of gold and, which created, thereby, the conditions that led inevitably to the depreciation of gold.

The fact that we use as money a commodity like gold, which is produced only with a considerable expenditure of capital and labor, saddles mankind with certain costs. If the amount of capital and labor spent for the production of monetary gold could be released and used in other ways, people could be better supplied with goods for their immediate needs. There is no doubt about that! However, it should be noted that, in return for this expenditure, we receive the advantage of having available, for settling transactions, a money with a relatively steady value and, what is more important, the value of which is not directly influenced by governments and political parties. However, it is easy to understand why men began to ponder the possibility of creating a monetary system that would combine all the advantages offered by the gold standard with the added virtue of lower costs.

Adam Smith drew a parallel between the gold and silver which circulated in a land as money and a highway on which nothing grew, but over which fodder and grain were brought to market. The substitution of notes for the precious metals would create, so to speak, a “wagon-way through the air,” making it possible to convert a large part of the roads into fields and pastures and, thus, to increase considerably the yearly output of the economy. Then in 1816, Ricardo devised his famous plan for a gold exchange standard. According to his proposal, England should retain the gold standard, which had proved its value in every respect. However, gold coins should be replaced in domestic trade by banknotes, and these notes should be redeemable, not in gold coins, but in bullion only. Thus the notes would be assured of a value equivalent to that of gold and the country would have the advantage of possessing a monetary standard with all the attributes of the gold standard but at a lower cost.

Ricardo’s proposals were not put into effect for decades. As a matter of fact, they were even forgotten. Nevertheless, the gold exchange standard was adopted by a number of countries during the 1890s—in the beginning usually as a temporary expedient only, without intending to direct monetary policy on to a new course. Today it is so widespread that we would be fully justified in describing it as “the monetary standard of our age.”9 However, in a majority, or at least in quite a number of these countries, the gold exchange standard has undergone a development which entitles it to be spoken of rather as a flexible gold exchange standard.10 Under Ricardo’s plan, savings would be realized not only by avoiding the costs of coinage and the loss from wearing coins thin in use, but also because the amount of gold required for circulation and bank reserves would be less than under the “pure” gold standard.

Carrying out this plan in a single country must obviously, ceteris paribus, reduce the purchasing power of gold. And the more widely the system is adopted, the more must the purchasing power of gold decline. If a single land adopts the gold exchange standard, while others maintain a “pure” gold standard, then the gold exchange standard country can gain an immediate advantage over costs in the other areas. The gold, which is surplus under the gold exchange standard as compared with the gold which would have been called for under the “pure” gold standard, may be spent abroad for other commodities. These additional commodities represent an improvement in the country’s welfare as a result of introducing the gold exchange standard. The gold exchange standard renders all the services of the gold standard to this country and also brings an additional advantage in the form of this increase of goods.

However, should every country in the world shift at the same time from the “pure” gold standard to a similar gold exchange standard, no gain of this kind would be possible. The distribution of gold throughout the world would remain unchanged. There would be no country where one could exchange a quantity of gold, made superfluous by the adoption of the new monetary system, for other goods. Embracing the new standard would result only in a universally more severe reduction in the purchasing power of gold. This monetary depreciation, like every change in the value of money, would bring about dislocations in the relationships of wealth and income of the various individuals in the economy. As a result, it could also lead indirectly, under certain circumstances, to an increase in capital accumulation. However, this indirect method will make the world richer only insofar as (1) the demand for gold for other uses (industrial and similar purposes) can be better satisfied and (2) a decline in profitability leads to a restriction of gold production and so releases capital and labor for other purposes.

3. Interest on “idle” Reserves

In addition to these attempts toward “economy” in the operation of the gold standard, by reducing the domestic demand for gold, other efforts have also aimed at the same objective. Holding gold reserves is costly to the banks of issue because of the loss of interest. Consequently, it was but a short step to the reduction of these costs by permitting noninterest-bearing gold reserves in bank vaults to be replaced by interest-bearing credit balances abroad, payable in gold on demand, and by bills of exchange payable in gold. Assets of this type enable the banks of issue to satisfy demands for gold in foreign trade just as the possession of a stock of gold coins and bars would. As a matter of fact, the dealer in arbitrage who presents notes for redemption will prefer payment in the form of checks, and bills of exchange—foreign financial paper—to redemption in gold because the costs of shipping foreign financial papers are lower than those for the transport of gold. The banks of smaller and poorer lands especially converted a part of their reserves into foreign bills of exchange. The inducement was particularly strong in countries on the gold exchange standard, where the banks did not have to consider a demand for gold for use in domestic circulation. In this way, the gold exchange standard [Goldkernwährung] became the flexible gold exchange standard [Golddevisenkernwährung], i.e., the flexible standard.

Nevertheless, the goal of this policy was not only to reduce the costs involved in the maintenance and circulation of an actual stock of gold. In many countries, including Germany and Austria, this was thought to be a way to reduce the rate of interest. The influence of the Currency Theory had led, decades earlier, to banking legislation intended to avoid the consequences of a paper money inflation. These laws, limiting the issue of banknotes not covered by gold, were still in force. Reared in the Historical-Realistic School of economic thinking, the new generation, insofar as it dealt with these problems, was under the spell of the Banking Theory, and thus no longer understood the meaning of these laws.

Lack of originality prevented the new generation from embarking upon any startling reversal in policy. In line with currently prevailing opinion, it abolished the limitation on the issue of banknotes not covered by metal. The old laws were allowed to stay on the books essentially unchanged. However, various attempts were made to reduce their effect. The most noteworthy of these measures was to encourage, systematically and purposefully, the settlement of transactions without the use of cash. By supplanting cash transactions with checks and other transfer payments, it was expected not only that there would be a reduction in the demand for banknotes but also a flow of gold coins back to the bank and, consequently, a strengthening of the bank’s cash position. As German, and also Austrian, banking legislation prescribed a certain percentage of gold cover for notes issued, gold flowing back to the bank meant that more notes could be issued—up to three times their gold value in Germany and two and a half times in Austria. During recent decades, the banking theory has been characterized by a belief that this should result in a reduction in the rate of interest.

4. Gold Still Money

If we glance, even briefly, at the efforts of monetary and banking policy in recent years, it becomes obvious that the depreciation of gold may be traced in large part to political measures. The decline in the purchasing power of gold and the continual increase in the gold price of all goods and services were not natural phenomena. They were consequences of an economic policy which aimed, to be sure, at other objectives, but which necessarily led to these results. As has already been mentioned, accurate quantitative observations about these matters can never be made. Nevertheless, it is obvious that the increase in gold production has certainly not been the cause, or at least not the only cause, of the depreciation of gold that has been observed since 1896. The policy directed toward displacing gold in actual circulation, which aimed at substituting the gold exchange standard and the flexible standard for the older “pure” gold standard, forced the value of gold down or at least helped to depress it. Perhaps, if this policy had not been followed, we would hear complaints today over the increase, rather than the depreciation, in the value of gold.

Gold has not been demonetized by the new monetary policy, as silver was a short time ago, for it remains the basis of our entire monetary system. Gold is still, as it was formerly, our money. There is no basis for saying that it has been de-throned, as suggested by scatterbrained innovators of catchwords and slogans who want to cure the world of the “money illusion.” Nevertheless, gold has been removed from actual use in transactions by the public at large. It has disappeared from view and has been concentrated in bank vaults and monetary reserves. Gold has been taken out of common use and this must necessarily tend to lower its value.

It is wrong to point to the general price increases of recent years to illustrate the inadequacy of the gold standard. It is not the old style gold standard, as recommended by advocates of the gold standard in England and Germany, which has given us a monetary system that has led to rising prices in recent years. Rather these price increases have been the results of monetary and banking policies which permitted the “pure” or “classical” gold standard to be replaced by the gold exchange and flexible standards, leaving in circulation only notes and small coins and concentrating the gold stocks in bank and currency reserves.

III. THE “MANIPULATION OF THE GOLD STANDARD”

1. Monetary Policy and Purchasing Power of Gold

Most important for the old, “pure,” or classical gold standard, as originally formulated in England and later, after the formation of the Empire, adopted in Germany, was the fact that it made the formation of prices independent of political influence and the shifting views which sway political action. This feature especially recommended the gold standard to liberals11 who feared that economic productivity might be impaired as a result of the tendency of governments to favor certain groups of persons at the expense of others.

However, it should certainly not be forgotten that under the “pure” gold standard governmental measures may also have a significant influence on the formation of the value of gold. In the first place, governmental actions determine whether to adopt the gold standard, abandon it, or return to it. However, the effect of these governmental actions, which we need not consider any further here, is conceived as very different from those described by the various “state theories of money”—theories which, now at long last, are generally recognized as absurd. The continual displacement of the silver standard by the gold standard and the shift in some countries from credit money to gold added to the demand for monetary gold in the years before the World War [1914–1918]. War measures resulted in monetary policies that led the belligerent nations, as well as some neutral states, to release large parts of their gold reserves, thus releasing more gold for world markets. Every political act in this area, insofar as it affects the demand for, and the quantity of, gold as money, represents a “manipulation” of the gold standard and affects all countries adhering to the gold standard.

Just as the “pure” gold, the gold exchange and the flexible standards do not differ in principle, but only in the degree to which money substitutes are actually used in circulation, so is there no basic difference in their susceptibility to manipulation. The “pure” gold standard is subject to the influence of monetary measures—on the one hand, insofar as monetary policy may affect the acceptance or rejection of the gold standard in a political area and, on the other hand, insofar as monetary policy, while still clinging to the gold standard in principle, may bring about changes in the demand for gold through an increase or decrease in actual gold circulation or by changes in reserve requirements for banknotes and checking accounts. The influence of monetary policy on the formation of the value [i.e., the purchasing power] of gold also extends just that far and no farther under the gold exchange and flexible standards. Here again, governments and those agencies responsible for monetary policy can influence the formation of the value of gold by changing the course of monetary policy. The extent of this influence depends on how large the increase or decrease in the demand for gold is nationally, in relation to the total world demand for gold.

If advocates of the old “pure” gold standard spoke of the independence of the value of gold from governmental influences, they meant that once the gold standard had been adopted everywhere (and gold standard advocates of the last three decades of the nineteenth century had not the slightest doubt that this would soon come to pass, for the gold standard had already been almost universally accepted) no further political action would affect the formation of monetary value. This would be equally true for both the gold exchange and flexible standards. It would by no means disturb the logical assumptions of the perceptive “pure” gold standard advocate to say that the value of gold would be considerably affected by a change in United States Federal Reserve Board policy, such as the resumption of the circulation of gold or the retention of larger gold reserves in European countries. In this sense, all monetary standards may be “manipulated” under today’s economic conditions. The advantage of the gold standard—whether “pure” or “gold exchange”—is due solely to the fact that, if once generally adopted in a definite form, and adhered to, it is no longer subject to specific political interferences.

War and postwar actions, with respect to monetary policy, have radically changed the monetary situation throughout the entire world. One by one, individual countries are now [1928] reverting to a gold basis and it is likely that this process will soon be completed. Now, this leads to a second problem: Should the exchange standard, which generally prevails today, be retained? Or should a return be made once more to the actual use of gold in moderate-sized transactions as before under the “pure” gold standard? Also, if it is decided to remain on the exchange standard, should reserves actually be maintained in gold? And at what height? Or could individual countries be satisfied with reserves of foreign exchange payable in gold? (Obviously, the flexible standard cannot become entirely universal. At least one country must continue to invest its reserves in real gold, even if it does not use gold in actual circulation.) Only if the state of affairs prevailing at a given instant in every single area is maintained and, also, only if matters are left just as they are, including of course the ratio of bank reserves, can it be said that the gold standard cannot be manipulated in the manner described above. If these problems are dealt with in such a way as to change markedly the demand for gold for monetary purposes, then the purchasing power of gold must undergo corresponding changes.

To repeat for the sake of clarity, this represents no essential disagreement with the advocates of the gold standard as to what they considered its special superiority. Changes in the monetary system of any large and wealthy land will necessarily influence substantially the creation of monetary value. Once these changes have been carried out and have worked their effect on the purchasing power of gold, the value of money will necessarily be affected again by a return to the previous monetary system. However, this detracts in no way from the truth of the statement that the creation of value under the gold standard is independent of politics, so long as no essential changes are made in its structure, nor in the size of the area where it prevails.

2. Changes in Purchasing Power of Gold

Irving Fisher, as well as many others, criticize the gold standard because the purchasing power of gold has declined considerably since 1896, and especially since 1914. In order to avoid misunderstanding, it should be pointed out that this drop in the purchasing power of gold must be traced back to monetary policy—monetary policy which fostered the reduction in the purchasing power of gold through measures adopted between 1896 and 1914, to “economize” gold and, since 1914, through the rejection of gold as the basis for money in many countries. If others denounce the gold standard because the imminent return to the actual use of gold in circulation and the strengthening of gold reserves in countries on the exchange standard would bring about an increase in the purchasing power of gold, then it becomes obvious that we are dealing with the consequences of political changes in monetary policy which transform the structure of the gold standard.

The purchasing power of gold is not “stable.” It should be pointed out that there is no such thing as “stable” purchasing power, and never can be. The concept of “stable value” is vague and indistinct. Strictly speaking, only an economy in the final state of rest—where all prices remain unchanged—could have a money with fixed purchasing power. However, it is a fact which no one can dispute that the gold standard, once generally adopted and adhered to without changes, makes the formation of the purchasing power of gold independent of the operations of shifting political efforts.

As gold is obtained only from a few sources, which sooner or later will be exhausted, the fear is repeatedly expressed that there may someday be a scarcity of gold and, as a consequence, a continuing decline in commodity prices. Such fears became especially great in the late 1870s and the 1880s. Then they quieted down. Only in recent years have they been revived again. Calculations are made indicating that the placers and mines currently being worked will be exhausted within the foreseeable future. No prospects are seen that any new rich sources of gold will be opened up. Should the demand for money increase in the future, to the same extent as it has in the recent past, then a general price drop appears inevitable, if we remain on the gold standard.12

Now one must be very cautious with forecasts of this kind. A half century ago, Eduard Suess, the geologist, claimed—and he sought to establish this scientifically—that an unavoidable decline in gold production should be expected.13 Facts very soon proved him wrong. And it may be that those who express similar ideas today will also be refuted just as quickly and just as thoroughly. Still we must agree that they are right in the final analysis, that prices are tending to fall [1928] and that all the social consequences of an increase in purchasing power are making their appearance. What may be ventured, given the circumstances, in order to change the economic pessimism, will be discussed at the end of the second part of this study.

IV. “MEASURING” CHANGES IN THE PURCHASING POWER OF THE MONETARY UNIT

1. Imaginary Constructions

All proposals to replace the commodity money, gold, with a money thought to be better, because it is more “stable” in value, are based on the vague idea that changes in purchasing power can somehow be measured. Only by starting from such an assumption is it possible to conceive of a monetary unit with unchanging purchasing power as the ideal and to consider seeking ways to reach this goal. These proposals, vague and basically contradictory, are derived from the old, long since exploded, objective theory of value. Yet they are not even completely consistent with that theory. They now appear very much out of place in the company of modern, subjective economics.

The prestige which they still enjoy can be explained only by the fact that, until very recently, studies in subjective economics have been restricted to the theory of direct exchange (barter). Only lately have such studies been expanded to include also the theory of intermediate (indirect) exchange, i.e., the theory of a generally accepted medium of exchange (monetary theory) and the theory of fiduciary media (banking theory) with all their relevant problems.14 It is certainly high time to expose conclusively the errors and defects of the basic concept that purchasing power can be measured.

Exchange ratios on the market are constantly subject to change. If we imagine a market where no generally accepted medium of exchange, i.e., no money, is used, it is easy to recognize how nonsensical the idea is of trying to measure the changes taking place in exchange ratios. It is only if we resort to the fiction of completely stationary exchange ratios among all commodities, other than money, and then compare these other commodities with money, that we can envisage exchange relationships between money and each of the other individual exchange commodities changing uniformly. Only then can we speak of a uniform increase or decrease in the monetary price of all commodities and of a uniform rise or fall of the “price level.” Still, we must not forget that this concept is pure fiction, what Vaihinger termed an “as if.”15 It is a deliberate imaginary construction, indispensable for scientific thinking.

Perhaps the necessity for this imaginary construction will become somewhat more clear if we express it, not in terms of the objective exchange value of the market, but in terms of the subjective exchange valuation of the acting individual. To do that, we must imagine an unchanging man with never-changing values. Such an individual could determine, from his never-changing scale of values, the purchasing power of money. He could say precisely how the quantity of money, which he must spend to attain a certain amount of satisfaction, had changed. Nevertheless, the idea of a definite structure of prices, a “price level,” which is raised or lowered uniformly, is just as fictitious as this. However, it enables us to recognize clearly that every change in the exchange ratio between a commodity, on the one side, and money, on the other, must necessarily lead to shifts in the disposition of wealth and income among acting individuals. Thus, each such change acts as a dynamic agent also. In view of this situation, therefore, it is not permissible to make such an assumption as a uniformly changing “level” of prices.

This imaginary construction is necessary, however, to explain that the exchange ratios of the various economic goods may undergo a change from the side of one individual commodity. This fictional concept is the ceteris paribus of the theory of exchange relationships. It is just as fictitious and, at the same time, just as indispensable as any ceteris paribus. If extraordinary circumstances lead to exceptionally large and hence conspicuous changes in exchange ratios, data on market phenomena may help to facilitate sound thinking on these problems. However, then even more than ever, if we want to see the situation at all clearly, we must resort to the imaginary construction necessary for an understanding of our theory.

The expressions, “inflation” and “deflation,” scarcely known in German economic literature several years ago, are in daily use today. In spite of their inexactness, they are undoubtedly suitable for general use in public discussions of economic and political problems.16 But in order to understand them precisely, one must elaborate with rigid logic that fictional concept [the imaginary construction of completely stationary exchange ratios among all commodities other than money], the falsity of which is clearly recognized.

Among the significant services performed by this fiction is that it enables us to distinguish and determine whether changes in exchange relationships between money and other commodities arise on the money side or the commodity side. In order to understand the changes which take place constantly on the market, this distinction is urgently needed. It is still more indispensable for judging the significance of measures proposed or adopted in the field of monetary and banking policy. Even in these cases, however, we can never succeed in constructing a fictional representation that coincides with the situation which actually appears on the market. The imaginary construction makes it easier to understand reality, but we must remain conscious of the distinction between fiction and reality.17

2. Index Numbers

Attempts have been made to measure changes in the purchasing power of money by using data derived from changes in the money prices of individual economic goods. These attempts rest on the theory that, in a carefully selected index of a large number, or of all consumers’ goods, influences from the commodity side affecting commodity prices cancel each other out. Thus, so the theory goes, the direction and extent of the influence on prices of factors arising on the money side may be discovered from such an index. Essentially, therefore, by computing an arithmetical mean, this method seeks to convert the price changes emerging among the various consumers’ goods into a figure which may then be considered an index to the change in the value of money. In this discussion, we shall disregard the practical difficulties which arise in assembling the price quotations necessary to serve as the basis for such calculations and restrict ourselves to commenting on the fundamental usefulness of this method for the solution of our problem.

First of all it should be noted that there are various arithmetical means. Which one should be selected? That is an old question. Reasons may be advanced for, and objections raised against, each. From our point of view, the only important thing to be learned in such a debate is that the question cannot be settled conclusively so that everyone will accept any single answer as “right.”

The other fundamental question concerns the relative importance of the various consumer goods. In developing the index, if the price of each and every commodity is considered as having the same weight, a 50 percent increase in the price of bread, for instance, would be offset in calculating the arithmetical average by a drop of one-half in the price of diamonds. The index would then indicate no change in purchasing power, or “price level.” As such a conclusion is obviously preposterous, attempts are made in fabricating index numbers, to use the prices of various commodities according to their relative importance. Prices should be included in the calculations according to the coefficient of their importance. The result is then known as a “weighted” average.

This brings us to the second arbitrary decision necessary for developing such an index. What is “importance”? Several different approaches have been tried and arguments pro and con each have been raised. Obviously, a clear-cut, all-round satisfactory solution to the problem cannot be found. Special attention has been given the difficulty arising from the fact that, if the usual method is followed, the very circumstances involved in determining “importance” are constantly in flux; thus the coefficient of importance itself is also continuously changing.

As soon as one starts to take into consideration the “importance” of the various goods, one forsakes the assumption of objective exchange value—which often leads to nonsensical conclusions as pointed out above—and enters the area of subjective values. Since there is no generally recognized immutable “importance” to various goods, since “subjective” value has meaning only from the point of view of the acting individual, further reflection leads eventually to the subjective method already discussed—namely the inexcusable fiction of a never-changing man with never-changing values. To avoid arriving at this conclusion, which is also obviously absurd, one remains indecisively on the fence, midway between two equally nonsensical methods—on the one side the un-weighted average and on the other the fiction of a never-changing individual with never-changing values. Yet one believes he has discovered something useful. Truth is not the halfway point between two untruths. The fact that each of these two methods, if followed to its logical conclusion, is shown to be preposterous, in no way proves that a combination of the two is the correct one.

All index computations pass quickly over these unanswerable objections. The calculations are made with whatever coefficients of importance are selected. However, we have established that even the problem of determining “importance” is not capable of solution, with certainty, in such a way as to be recognized by everyone as “right.”

Thus the idea that changes in the purchasing power of money may be measured is scientifically untenable. This will come as no surprise to anyone who is acquainted with the fundamental problems of modern subjectivistic catallactics and has recognized the significance of recent studies with respect to the measurement of value18 and the meaning of monetary calculation.19

One can certainly try to devise index numbers. Nowadays nothing is more popular among statisticians than this. Nevertheless, all these computations rest on a shaky foundation. Disregarding entirely the difficulties which, from time to time, even thwart agreement as to the commodities whose prices will form the basis of these calculations, these computations are arbitrary in two ways—first, with respect to the arithmetical mean chosen and, secondly, with respect to the coefficient of importance selected. There is no way to characterize one of the many possible methods as the only “correct” one and the others as “false.” Each is equally legitimate or illegitimate. None is scientifically meaningful.

It is small consolation to point out that the results of the various methods do not differ substantially from one another. Even if that is the case, it cannot in the least affect the conclusions we must draw from the observations we have made. The fact that people can conceive of such a scheme at all, that they are not more critical, may be explained only by the eventuality of the great inflations, especially the greatest and most recent one.

Any index method is good enough to make a rough statement about the extremely severe depreciation of the value of a monetary unit, such as that wrought in the German inflation. There, the index served an instructional task, enlightening a people who were inclined to the “State Theory of Money” idea. Nevertheless, a method that helps to open the eyes of the people is not necessarily either scientifically correct or applicable in actual practice.

V. FISHER’S STABILIZATION PLAN

1. Political Problem

The superiority of the gold standard consists in the fact that the value of gold develops independent of political actions. It is clear that its value is not “stable.” There is not, and never can be, any such thing as stability of value. If, under a “manipulated” monetary standard, it was government’s task to influence the value of money, the question of how this influence was to be exercised would soon become the main issue among political and economic interests. Government would be asked to influence the purchasing power of money so that certain politically powerful groups would be favored by its intervention, at the expense of the rest of the population. Intense political battles would rage over the direction and scope of the edicts affecting monetary policy. At times, steps would be taken in one direction, and at other times in other directions—in response to the momentary balance of political power. The steady, progressive development of the economy would continually experience disturbances from the side of money. The result of the manipulation would be to provide us with a monetary system which would certainly not be any more stable than the gold standard.

If the decision were made to alter the purchasing power of money so that the index number always remained unchanged, the situation would not be any different. We have seen that there are many possible ways, not just one single way, to determine the index number. No single one of these methods can be considered the only correct one. Moreover, each leads to a different conclusion. Each political party would advocate the index method which promised results consistent with its political aims at the time. Since it is not scientifically possible to find one of the many methods objectively right and to reject all others as false, no judge could decide impartially among groups disputing the correct method of calculation.

In addition, however, there is still one more very important consideration. The early proponents of the Quantity Theory believed that changes in the purchasing power of the monetary unit caused by a change in the quantity of money were exactly inversely proportional to one another. According to this Theory, a doubling of the quantity of money would cut the monetary unit’s purchasing power in half. It is to the credit of the more recently developed monetary theory that this version of the Quantity Theory has been proved untenable. An increase in the quantity of money must, to be sure, lead ceteris paribus to a decline in the purchasing power of the monetary unit. Still the extent of this decrease in no way corresponds to the extent of the increase in the quantity of money. No fixed quantitative relationship can be established between the changes in the quantity of money and those of the unit’s purchasing power.20 Hence, every manipulation of the monetary standard will lead to serious difficulties. Political controversies would arise not only over the “need” for a measure, but also over the degree of inflation or restriction, even after agreement had been reached on the purpose the measure was supposed to serve.

All this is sufficient to explain why proposals for establishing a manipulated standard have not been popular. It also explains—even if one disregards the way finance ministers have abused their authority—why credit money (commonly known as “paper money”) is considered “bad” money. Credit money is considered “bad money” precisely because it may be manipulated.

2. Multiple Commodity Standard

Proposals that a multiple commodity standard replace, or supplement, monetary standards based on the precious metals—in their role as standards of deferred payments—are by no means intended to create a manipulated money. They are not intended to change the precious metals standard itself nor its effect on value. They seek merely to provide a way to free all transactions involving future monetary payments from the effect of changes in the value of the monetary unit. It is easy to understand why these proposals were not put into practice. Relying as they do on the shaky foundation of index number calculations, which cannot be scientifically established, they would not have produced a stable standard of value for deferred payments. They would only have created a different standard with different changes in value from those under the gold metallic standard.

To some extent Fisher’s proposals parallel the early ideas of advocates of a multiple commodity standard. These forerunners also tried to eliminate only the influence of the social effects of changes in monetary value on the content of future monetary obligations. Like most Anglo-American students of this problem, as well as earlier advocates of a multiple commodity standard, Fisher took little notice of the fact that changes in the value of money have other social effects also.

Fisher, too, based his proposals entirely on index numbers. What seems to recommend his scheme, as compared with proposals for introducing a “multiple standard,” is the fact that he does not use index numbers directly to determine changes in purchasing power over a long period of time. Rather he uses them primarily to understand changes taking place from month to month only. Many objections raised against the use of the index method for analyzing longer periods of time will perhaps appear less justified when considering only shorter periods. But there is no need to discuss this question here, for Fisher did not confine the application of his plan to short periods only. Also, even if adjustments are always made from month to month only, they were to be carried forward, on and on, until eventually calculations were being made, with the help of the index number, which extended over long periods of time. Because of the imperfection of the index number, these calculations would necessarily lead in time to errors of very considerable proportions.

3. Price Premium

Fisher’s most important contribution to monetary theory is the emphasis he gave to the previously little noted effect of changes in the value of money on the formation of the interest rate.21 Insofar as movements in the purchasing power of money can be foreseen, they find expression in the gross interest rate—not only as to the direction they will take but also as to their approximate magnitude. That portion of the gross interest rate which is demanded, and granted, in view of anticipated changes in purchasing power is known as the purchasing-power-change premium or price-change premium. In place of these clumsy expressions we shall use a shorter term—“price premium.” Without any further explanation, this terminology leads to an understanding of the fact that, given an anticipation of general price increases, the price premium is “positive,” thus raising the gross rate of interest. On the other hand, with an anticipation of general price decreases, the price premium becomes “negative” and so reduces the gross interest rate.

The individual businessman is not generally aware of the fact that monetary value is affected by changes from the side of money. Even if he were, the difficulties which hamper the formation of a halfway reliable judgment, as to the direction and extent of anticipated changes, are tremendous, if not outright insurmountable. Consequently, monetary units used in credit transactions are generally regarded rather naïvely as being “stable” in value. So, with agreement as to conditions under which credit will be applied for and granted, a price premium is not generally considered in the calculation. This is practically always true, even for long-term credit. If opinion is shaken as to the “stability of value” of a certain kind of money, this money is not used at all in long-term credit transactions. Thus, in all nations using credit money, whose purchasing power fluctuated violently, long-term credit obligations were drawn up in gold, whose value was held to be “stable.”

However, because of obstinacy and pro-government bias, this course of action was not employed in Germany, nor in other countries during the recent inflation. Instead, the idea was conceived of making loans in terms of rye and potash. If there had been no hope at all of a later compensating revaluation of these loans, their price on the exchange in German marks, Austrian crowns and similarly inflated currencies would have been so high that a positive price premium corresponding to the magnitude of the anticipated further depreciation of these currencies would have been reflected in the actual interest payment.

The situation is different with respect to short-term credit transactions. Every businessman estimates the price changes anticipated in the immediate future and guides himself accordingly in making sales and purchases. If he expects an increase in prices, he will make purchases and postpone sales. To secure the means for carrying out this plan, he will be ready to offer higher interest than otherwise. If he expects a drop in prices, then he will seek to sell and to refrain from purchasing. He will then be prepared to lend out, at a cheaper rate, the money made available as a result. Thus, the expectation of price increases leads to a positive price premium, that of price declines to a negative price premium.

To the extent that this process correctly anticipates the price movements that actually result, with respect to short-term credit, it cannot very well be maintained that the content of contractual obligations are transformed by the change in the purchasing power of money in a way which was neither foreseen nor contemplated by the parties concerned. Nor can it be maintained that, as a result, shifts take place in the wealth and income relationship between creditor and debtor. Consequently, it is unnecessary, so far as short-term credit is concerned, to look for a more perfect standard of deferred payments.

Thus we are in a position to see that Fisher’s proposal actually offers no more than was offered by any previous plan for a multiple standard. In regard to the role of money as a standard of deferred payments, the verdict must be that, for long-term contracts, Fisher’s scheme is inadequate. For short-term commitments, it is both inadequate and superfluous.

4. Changes in Wealth and Income

However, the social consequences of changes in the value of money are not limited to altering the content of future monetary obligations. In addition to these social effects, which are generally the only ones dealt with in Anglo-American literature, there are still others. Changes in money prices never reach all commodities at the same time, and they do not affect the prices of the various goods to the same extent. Shifts in relationships between the demand for, and the quantity of, money for cash holdings generated by changes in the value of money from the money side do not appear simultaneously and uniformly throughout the entire economy. They must necessarily appear on the market at some definite point, affecting only one group in the economy at first, influencing only their judgments of value in the beginning and, as a result, only the prices of commodities these particular persons are demanding. Only gradually does the change in the purchasing power of the monetary unit make its way throughout the entire economy.

For example, if the quantity of money increases, the additional new quantity of money must necessarily flow first of all into the hands of certain definite individuals—gold producers, for example, or, in the case of paper money inflation, the coffers of the government. It changes only their incomes and fortunes at first and, consequently, only their value judgments. Not all goods go up in price in the beginning, but only those goods which are demanded by these first beneficiaries of the inflation. Only later are prices of the remaining goods raised, as the increased quantity of money progresses step by step throughout the land and eventually reaches every participant in the economy.22 But even then, when finally the upheaval of prices due to the new quantity of money has ended, the prices of all goods and services will not have increased to the same extent. Precisely because the price increases have not affected all commodities at one time, shifts in the relationships in wealth and income are effected which affect the supply and demand of individual goods and services differently. Thus, these shifts must lead to a new orientation of the market and of market prices.

Suppose we ignore the consequences of changes in the value of money on future monetary obligations. Suppose further that changes in the purchasing power of money occur simultaneously and uniformly with respect to all commodities in the entire economy. Then, it becomes obvious that changes in the value of money would produce no changes in the wealth of the individual entrepreneurs. Changes in the value of the monetary unit would then have no more significance for them than changes in weights and measures or in the calendar.

It is only because changes in the purchasing power of money never affect all commodities everywhere simultaneously that they bring with them (in addition to their influence on debt transactions) still other shifts in wealth and income. The groups which produce and sell the commodities that go up in price first are benefited by the inflation, for they realize higher profits in the beginning and yet they can still buy the commodities they need at lower prices, reflecting the previous stock of money. So during the inflation of the World War [1914–1918], the producers of war materiel and the workers in war industries, who received the output of the printing presses earlier than other groups of people, benefited from the monetary depreciation. At the same time, those whose incomes remained nominally the same suffered from the inflation, as they were forced to compete in making purchases with those receiving war inflated incomes. The situation became especially clear in the case of government employees. There was no mistaking the fact that they were losers. Salary increases came to them too late. For some time they had to pay prices, already affected by the increase in the quantity of money, with money incomes related to previous conditions.

5. Uncompensatable Changes

In the case of foreign trade, it was just as easy to see the consequences of the fact that price changes of the various commodities did not take place simultaneously. The deterioration in the value of the monetary unit encourages exports because a part of the raw materials, semi-produced factors of production and labor needed for the manufacture of export commodities, were procured at the old lower prices. At the same time the change in purchasing power, which for the time being has affected only a part of the domestically-produced commodities, has already had an influence on the rate of exchange on the Bourse. The result is that the exporter realizes a specific monetary gain.

The changes in purchasing power arising on the money side are considered disturbing not merely because of the transformation they bring about in the content of future monetary obligations. They are also upsetting because of the uneven timing of the price changes of the various goods and services. Can Fisher’s dollar of “stable value” eliminate these price changes?

In order to answer this question, it must be restated that Fisher’s proposal does not eliminate changes in the value of the monetary unit. It attempts instead to compensate for these changes continuously—from month to month. Thus the consequences associated with the step-by-step emergence of changes in purchasing power are not eliminated. Rather they materialize during the course of the month. Then, when the correction is made at the end of the month, the course of monetary depreciation is still not ended. The adjustment calculated at that time is based on the index number of the previous month when the full extent of that month’s monetary depreciation had not then been felt because all prices had not yet been affected. However, the prices of goods for which demand was forced up first by the additional quantity of money undoubtedly reached heights that may not be maintained later.

Whether or not these two deviations in prices correspond in such a way that their effects cancel each other out will depend on the specific data in each individual case. Consequently, the monetary depreciation will continue in the following month, even if no further increase in the quantity of money were to appear in that month. It would continue to go on until the process finally ended with a general increase in commodity prices, in terms of gold, and thus with an increase in the value of the gold dollar on the basis of the index number. The social consequences of the uneven timing of price changes would, therefore, not be avoided because the unequal timing of the price changes of various commodities and services would not have been eliminated.23

So there is no need to go into more detail with respect to the technical difficulties that stand in the way of realizing Fisher’s Plan. Even if it could be put into operation successfully, it would not provide us with a monetary system that would leave the disposition of wealth and income undisturbed.

VI. GOODS-INDUCED AND CASH-INDUCED CHANGES IN THE PURCHASING POWER OF THE MARKET

1. The Inherent Instability of Market Ratios

Changes in the exchange ratios between money and the various other commodities may originate either from the money side or from the commodity side of the transaction. Stabilization policy does not aim only at eliminating changes arising on the side of money. It also seeks to prevent all future price changes, even if this is not always clearly expressed and may sometimes be disputed.

It is not necessary for our purposes to go any further into the market phenomena which an increase or decrease in commodities must set in motion if the quantity of money remains unchanged.24 It is sufficient to point out that, in addition to changes in the exchange ratios among individual commodities, shifts would also appear in the exchange ratios between money and the majority of the other commodities in the market. A decrease in the quantity of other commodities would weaken the purchasing power of the monetary unit. An increase would enhance it. It should be noted, however, that the social adjustments which must result from these changes in the quantity of other commodities will lead to a reorganization in the demand for money and hence cash holdings. These shifts can occur in such a way as to counteract the immediate effect of the change in the quantity of goods on the purchasing power of the monetary unit. Still for the time being, we may ignore this situation.

The goal of all stabilization proposals, as we have seen, is to maintain unchanged the original content of future monetary obligations. Creditors and debtors should neither gain nor lose in purchasing power. This is assumed to be “just.” Of course, what is “just” or “unjust” cannot be scientifically determined. That is a question of ultimate purpose and ethical judgment. It is not a question of fact.

It is impossible to know just why the advocates of purchasing power stabilization see as “just” only the maintenance of an unchanged purchasing power for futuremonetary obligations. However, it is easy to understand that they do not want to permit either debtor or creditor to gain or lose. They want contractual liabilities to continue in force as little altered as possible in the midst of the constantly changing world economy. They want to transplant contractual liabilities out of the flow of events, so to speak, and into a timeless existence.

Now let us see what this means. Imagine that all production has become more fruitful. Goods flow more abundantly than ever before. Where only one unit was available for consumption before, there are now two. Since the quantity of money has not been increased, the purchasing power of the monetary unit has risen and with one monetary unit it is possible to buy, let us say, one-and-a-half times as much merchandise as before. Whether this actually means, if no “stabilization policy” is attempted, that the debtor now has a disadvantage and the creditor an advantage is not immediately clear.

If you look at the situation from the viewpoint of the prices of the factors of production, it is easy to see why this is the case. For the debtor could use the borrowed sum to buy at lower prices factors of production whose output has not gone up; or if their output has gone up, their prices have not risen correspondingly. It might now be possible to buy for less money, factors of production with a productive capacity comparable to that of the factors of production one could have bought with the borrowed money at the time of the loan. There is no point in exploring the uncertainties of theories which do not take into consideration the influence that ensuing changes exert on entrepreneurial profit, interest and rent.

However, if we consider changes in real income due to increased production, it becomes evident that the situation may be viewed very differently from the way it appears to those who favor “stabilization.” If the creditor gets back the same nominal sum, he can obviously buy more goods. Still, his economic situation is not improved as a result. He is not benefited relative to the general increase of real income which has taken place. If the multiple commodity standard were to reduce in part the nominal debt, his economic situation would be worsened. He would be deprived of something that, in his view, in all fairness belonged to him. Under a multiple commodity standard, interest payable over time, life annuities, subsistence allowances, pensions, and the like, would be increased or decreased according to the index number. Thus, these considerations cannot be summarily dismissed as irrelevant from the viewpoint of consumers.

We find, on the one hand, that neither the multiple commodity standard nor Irving Fisher’s specific proposal is capable of eliminating the economic concomitants of changes in the value of the monetary unit due to the unequal timing in appearance and the irregularity in size of price changes. On the other hand, we see that these proposals seek to eliminate the repercussions on the content of debt agreements, circumstances permitting, in such a way as to cause definite shifts in wealth and income relations, shifts which appear obviously “unjust,” at least to those on whom their burden falls. The “justice” of these proposed reforms, therefore, is somewhat more doubtful than their advocates are inclined to assume.

2. The Misplaced Partiality to Debtors

It is certainly regrettable that this worthy goal cannot be attained, at least not by this particular route. These and similar efforts are usually acknowledged with sympathy by many who recognize their fallacy and their unworkability. This sympathy is based ultimately on the intellectual and physical inclination of men to be both lazy and resistant to change at the same time. Surely everyone wants to see his situation improved with respect to his supply of goods and the satisfaction of his wants. Surely everyone hopes for changes which would make him richer. Many circumstances make it appear that the old and the traditional, being familiar, are preferable to the new. Such circumstances would include distrust of the individual’s own powers and abilities, aversion to being forced to adapt in thought and action to new situations and, finally, the knowledge that one is no longer able, in advanced years of life, to meet his obligations with the vitality of youth.

Certainly, something new is welcomed and gratefully accepted, if the something new is beneficial to the individual’s welfare. However, any change which brings disadvantages or merely appears to bring them, whether or not the change is to blame, is considered “unjust.” Those favored by the new state of affairs through no special merit on their part quietly accept the increased prosperity as a matter of course and even as something already long due. Those hurt by the change, however, complain vociferously. From such observations, there developed the concepts of a “just price” and a ‘’just wage.” Whoever fails to keep up with the times and is unable to comply with its demands, becomes a eulogist of the past and an advocate of the status quo. However, the ideal of stability, of the stationary economy, is directly opposed to that of continual progress.

For some time popular opinion has been in sympathy with the debtor. The picture of the rich creditor, demanding payment from the poor debtor, and the vindictive teachings of moralists dominate popular thinking on indebtedness. A byproduct of this is to be found in the contrast, made by the contemporaries of the Classical School and their followers, between the “idle rich” and the “industrious poor.” However, with the development of bonds and savings deposits, and with the decline of small-scale enterprise and the rise of big business, a reversal of the former situation took place. It then became possible for the masses, with their increasing prosperity, to become creditors. The “rich man” is no longer the typical creditor, nor the “poor man” the typical debtor. In many cases, perhaps even in the majority of cases, the relationship is completely reversed. Today, except in the lands of farmers and small property owners, the debtor viewpoint is no longer that of the masses. Consequently it is also no longer the view of the political demagogues. Once upon a time inflation may have found its strongest support among the masses, who were burdened with debts. But the situation is now very different. A policy of monetary restriction would not be unwelcome among the masses today, for they would hope to reap a sure gain from it as creditors. They would expect the decline in their wages and salaries to lag behind, or at any rate not to exceed, the drop in commodity prices.

It is understandable, therefore, that proposals for the creation of a “stable value” standard of deferred payments, almost completely forgotten in the years when commodity prices were declining, have been revived again in the twentieth century. Proposals of this kind are always primarily intended for the prevention of losses to creditors, hardly ever to safeguard jeopardized debtor interests. They cropped up in England when she was the great world banker. They turned up again in the United States at the moment when she started to become a creditor nation instead of a land of debtors, and they became quite popular there when America became the great world creditor.

Many signs seem to indicate that the period of monetary depreciation [due to inflation] is coming to an end. Should this actually be the case, then the appeal which the idea of a manipulated standard now enjoys among creditor nations also would abate.

VII. THE GOAL OF MONETARY POLICY

1. Liberalism25 and the Gold Standard

Monetary policy of the preliberal era was either crude coin debasement, for the benefit of financial administration (only rarely intended as Seisachtheia,26 i.e., to nullify outstanding debts), or still more crude paper money inflation. However, in addition to, sometimes even instead of, its fiscal goal, the driving motive behind paper money inflation very soon became the desire to favor the debtor at the expense of the creditor.

In opposing the depreciated paper standard, liberalism frequently took the position that after an inflation the value of paper money should be raised, through contraction, to its former parity with metallic money. It was only when men had learned that such a policy could not undo or reverse the “unfair” changes in wealth and income brought about by the previous inflationary period and that an increase in the purchasing power per unit [by contraction or deflation] also brings other unwanted shifts of wealth and income, that the demand for return to a metallic standard at the debased monetary unit’s current parity gradually replaced the demand for restoration at the old parity.

In opposing a single precious metal standard, monetary policy exhausted itself in the fruitless attempt to make bimetallism an actuality. The results which must follow the establishment of a legal exchange ratio between the two precious metals, gold and silver, have long been known, even before Classical economics developed an understanding of the regularity of market phenomena. Again and again Gresham’s Law, which applied the general theory of price controls to the special case of money, demonstrated its validity. Eventually, efforts were abandoned to reach the ideal of a bimetallic standard. The next goal then became to free international trade, which was growing more and more important, from the effects of fluctuations in the ratio between the prices of the gold standard and the suppression of the alternating [bimetallic] and silver standards. Gold then became the world’s money.

With the attainment of gold monometallism, liberals believed the goal of monetary policy had been reached. (The fact that they considered it necessary to supplement monetary policy through banking policy will be examined later in considerable detail.) The value of gold was then independent of any direct manipulation by governments, political policies, public opinion or Parliaments. So long as the gold standard was maintained, there was no need to fear severe price disturbances from the side of money. The adherents of the gold standard wanted no more than this, even though it was not clear to them at first that this was all that could be attained.

2. “Pure” Gold Standard Disregarded

We have seen how the purchasing power of gold has continuously declined since the turn of the century. That was not, as frequently maintained, simply the consequence of increased gold production. There is no way to know whether the increased production of gold would have been sufficient to satisfy the increased demand for money without increasing its purchasing power, if monetary policy had not intervened as it did. The gold exchange and flexible standards were adopted in a number of countries, not the “pure” gold standard as its advocates had expected. “Pure” gold standard countries embraced measures which were thought to be, and actually were, steps toward the exchange standard. Finally, since 1914, gold has been withdrawn from actual circulation almost everywhere. It is primarily due to these measures that gold declined in value, thus generating the current debate on monetary policy.

The fault found with the gold standard today is not, therefore, due to the gold standard itself. Rather, it is the result of a policy which deliberately seeks to undermine the gold standard in order to lower the costs of using money and especially to obtain “cheap money,” i.e., lower interest rates for loans. Obviously, this policy cannot attain the goal it sets for itself. It must eventually bring not low interest on loans but rather price increases and distortion of economic development. In view of this, then, isn’t it simply enough to abandon all attempts to use tricks of banking and monetary policy to lower interest rates, to reduce the costs of using and circulating money and to satisfy “needs” by promoting paper inflation?

The “pure” gold standard formed the foundation of the monetary system in the most important countries of Europe and America, as well as in Australia. This system remained in force until the outbreak of the World War [1914]. In the literature on the subject, it was also considered the ideal monetary policy until very recently. Yet the champions of this “pure” gold standard undoubtedly paid too little attention to changes in the purchasing power of monetary gold originating on the side of money. They scarcely noted the problem of the “stabilization” of the purchasing power of money, very likely considering it completely impractical. Today we may pride ourselves on having grasped the basic questions of price and monetary theory more thoroughly and on having discarded many of the concepts which dominated works on monetary policy of the recent past. However, precisely because we believe we have a better understanding of the problem of value today, we can no longer consider acceptable the proposals to construct a monetary system based on index numbers.

3. The Index Standard

It is characteristic of current political thinking to welcome every suggestion which aims at enlarging the influence of government. If the Fisher and Keynes27 proposals are approved on the grounds that they are intended to use government to make the formation of monetary value directly subservient to certain economic and political ends, this is understandable. However, anyone who approves of the index standard, because he wants to see purchasing power “stabilized,” will find himself in serious error.

Abandoning the pursuit of the chimera of a money of unchanging purchasing power calls for neither resignation nor disregard of the social consequences of changes in monetary value. The necessary conclusion from this discussion is that stability of the purchasing power of the monetary unit presumes stability of all exchange relationships and, therefore, the absolute abandonment of the market economy.

The question has been raised again and again: What will happen if, as a result of a technological revolution, gold production should increase to such an extent as to make further adherence to the gold standard impossible? A changeover to the index standard must follow then, it is asserted, so that it would only be expedient to make this change voluntarily now. However, it is futile to deal with monetary problems today which may or may not arise in the future. We do not know under what conditions steps will have to be taken toward solving them. It could be that, under certain circumstances, the solution may be to adopt a system based on an index number. However, this would appear doubtful. Even so, an index standard would hardly be a more suitable monetary standard than the one we now have. In spite of all its defects, the gold standard is a useful and not inexpedient standard.

• 3[In the German text Mises uses the English term, “Standard of deferred payments,” commenting in a footnote: “Standard of deferred payments is ‘Zahlungsmittel’ in German. Unfortunately this German expression must be avoided nowadays. Its meaning has been so compromised through its use by Nominalists and Chartists that it brings to mind the recently exploded errors of the state theory of money.” See above for comments on “state theory of money,” p. 12, n. 9, and “chartism,” p. 20, n. 15.—Ed.]
• 4William Stanley Jevons, Money and the Mechanism of Exchange, 13th ed. (London, 1902), pp. 328ff.
• 5John Maynard Keynes, A Tract on Monetary Reform (London, 1923; New York, 1924), pp. 177ff.
• 6Irving Fisher, Stabilizing the Dollar (New York, 1925), pp. 79ff.
• 7[This is not the place to examine further the theory of the formation of the purchasing power of the monetary unit. In this connection, see The Theory of Money and Credit; 1953, pp. 97–165; 1980, pp. 117–85.—Ed.]
• 8The quantity of “money in the broader sense” is equal to the quantity of money proper [i.e., commodity money] plus the quantity of fiduciary media [i.e., notes, bank deposits not backed by metal, and subsidiary coins].
• 9Fritz Machlup, Die Goldkernwährung (Halberstadt, 1925), p. xi.
• 10[A monetary standard based on a unit with a flexible gold parity; Golddevisenkernwährung, literally a standard based on convertibility into a foreign monetary unit, in effect a “flexible gold exchange standard.” In later writings, Professor Mises shortened this to “flexible standard” and this term will be used henceforth in this translation. See Human Action (1949; 3rd rev. ed. (New Haven, Conn.: Yale University Press, 1966); Scholar’s Edition (Auburn, Ala.: Ludwig von Mises Institute, 1998), chapter XXXI, section 3.—Ed.]
• 11I employ the term “liberal” in the sense attached to it everywhere in the nineteenth century and still today in the countries of continental Europe. This usage is imperative because there is simply no other term available to signify the political and intellectual movement that substituted free enterprise and the market economy for the precapitalistic methods of production; constitutional representative government from the absolutism of kings or oligarchies; and freedom of all individuals from slavery, serfdom, and other forms of bondage. (“Foreword to the Third Edition,” Human Action [New Haven, Conn.: Yale University Press, 1963], p. v)
• 12Gustav Cassell, Währungsstabilisierung als Weltproblem (Leipzig, 1928), p. 12.
• 13[Eduard Suess (1831–1914) published a study in German (1877) on “The Future of Gold.”—Ed.]
• 14[The Theory of Money and Credit, 1953, pp. 116ff.; 1980, pp. 138ff.—Ed.]
• 15Hans Vaihinger (1852–1933), author of The Philosophy of As If (German, 1911; English translation, 1924).
• 16[The Theory of Money and Credit, 1953, pp. 239ff; 1980, pp. 271ff.—Ed.]
• 17[At this point, in a footnote, Professor Mises commented on a controversy he had had with a student over terminology. He again recommended, as he had in 1923 (see above, p. 1, n. 1), continuing to use Menger’s terms which enjoyed general acceptance. The simpler English terms, which Mises developed and adopted later—notably in Human Action (3rd rev. ed., 1966, pp. 419–24; 1998, pp. 416–21), where he describes “goods-induced” or “cash-induced” changes in the value of the monetary unit—are used in this translation. For those who may be interested in this controversy, the original footnote follows: Carl Menger referred to the nature and extent of the influence exerted on money/goods exchange ratios [prices] by changes from the money side as the problem of the “internal” exchange value (innere Tauschwert) of money [translated in this volume as “cash-induced changes”]. He referred to the variations in the purchasing power of the monetary unit due to other causes as changes in the “external” exchange value (aussere Tauschwert) of money [translated as “goods-induced changes”]. I have criticized both expressions as being rather unfortunate—because of possible confusion with the terms “extrinsic and intrinsic value” as used in Roman canon doctrine, and by English authors of the seventeenth and eighteenth centuries. (See the German editions of my book on The Theory of Money and Credit, 1912, p. 132; 1924, p. 104). Nevertheless, this terminology has attained scientific acceptance through its use by Menger and it will be used in this study when appropriate. There is no need to discuss an expression which describes a useful and indispensable idea. It is the concept itself, not the term used to describe it, which is important. Serious mischief is done if an author chooses a new term unnecessarily to express a concept for which a name already exists. My student, Gottfried Haberler, has criticized me severely for taking this position, reproaching me for being a slave to semantics. (See Haberler, Der Sinn der Indexzahlen [Tübingen, 1927], pp. 109ff.). However, in his relevant remarks on this problem, Haberler says nothing more than I have. He too distinguishes between price changes arising on the goods and money sides. Beginners should seek to expand knowledge and avoid spending time on useless terminological disputes. As Haberler points out, it would obviously be wasted effort to “seek internal and external exchange values of money in the real world.” Ideas do not belong to the “real world” at all, but to the world of thought and knowledge. It is even more astonishing that Haberler finds my critique of attempts to measure the value of the monetary unit “inexpedient,” especially as his analysis rests entirely on mine.—Ed.]
• 18[See The Theory of Money and Credit, 1953, pp. 38ff.; 1980, pp. 51ff.—Ed.]
• 19[See Socialism (New Haven, Conn.: Yale University Press, 1951), pp. 121ff. and (Indianapolis, Ind.: Liberty Fund, 1981), pp. 104.—Ed.]
• 20[See The Theory of Money and Credit, 1953, pp. 139ff.; 1980, pp. 161ff.—Ed.]
• 21Irving Fisher, The Rate of Interest (New York, 1907), pp. 77ff.
• 22Hermann Heinrich Gossen, Entwicklung der Gesetze des menschlichen Verkehrs und der daraus fliessenden Regeln für menschliches Handeln (new ed.; Berlin, 1889), p. 206.
• 23See also my critique of Fisher’s proposal in The Theory of Money and Credit, pp. 403ff.; 1980, pp. 442ff.
• 24Whether this is considered a change of purchasing power from the money side or from the commodity side is purely a matter of terminology.
• 25I.E., “classical liberalism.” See above, p. 68, note 11.
• 26[In conversation, Professor Mises explained that this is a Greek term, meaning “shaking off of burdens.” It was used in the seventh century B.C. and later to describe measures enacted to cancel public and private debts, completely or in part. Creditors then had to bear the burden, except to the extent that they might be indemnified by the government.—Ed.]
• 27Keynes’s 1923 proposal, A Tract on Monetary Reform.

I. STABILIZATION OF THE PURCHASING POWER OF THE MONETARY UNIT AND ELIMINATION OF THE TRADE CYCLE

1. Currency School’s Contribution

“Stabilization” of the purchasing power of the monetary unit would also lead, at the same time, to the ideal of an economy without any changes. In the stationary economy there would be no “ups” and “downs” of business. Then, the sequence of events would flow smoothly and steadily. Then, no unforeseen event would interrupt the provisioning of goods. Then, the acting individual would experience no disillusionment because events did not develop as he had assumed in planning his affairs to meet future demands.

First, we have seen that this ideal cannot be realized. Second, we have seen that this ideal is generally proposed as a goal only because the problems involved in the formation of purchasing power have not been thought through completely. Finally, we have seen that even if a stationary economy could actually be realized, it would certainly not accomplish what had been expected. Yet neither these facts nor the limiting of monetary policy to the maintenance of a “pure” gold standard mean that the political slogan, “Eliminate the business cycle,” is without value.

It is true that some authors, who dealt with these problems, had a rather vague idea that the “stabilization of the price level” was the way to attain the goals they set for cyclical policy. Yet cyclical policy was not completely spent on fruitless attempts to fix the purchasing power of money. Witness the fact that steps were undertaken to curb the boom through banking policy, and thus to prevent the decline, which inevitably follows the upswing, from going as far as it would if matters were allowed to run their course. These efforts—undertaken with enthusiasm at a time when people did not realize that anything like stabilization of monetary value would ever be conceived of and sought after—led to measures that had far-reaching consequences.

We should not forget for a moment the contribution which the Currency School made to the clarification of our problem. Not only did it contribute theoretically and scientifically but it contributed also to practical policy. The recent theoretical treatment of the problem—in the study of events and statistical data and in politics—rests entirely on the accomplishments of the Currency School. We have not surpassed Lord Overstone28 so far as to be justified in disparaging his achievement.

Many modern students of cyclical movements are contemptuous of theory—not only of this or that theory but of all theories—and profess to let the facts speak for themselves. The delusion that theory must be distilled from the results of an impartial investigation of facts is more popular in cyclical theory than in any other field of economics. Yet, nowhere else is it clearer that there can be no understanding of the facts without theory.

Certainly it is no longer necessary to expose once more the errors in logic of the Historical-Empirical-Realistic approach to the “social sciences.”29 Only recently has this task been most thoroughly undertaken once more by competent scholars. Nevertheless, we continually encounter attempts to deal with the business cycle problem while presumably rejecting theory.

In taking this approach one falls prey to a delusion which is incomprehensible. It is assumed that data on economic fluctuations are given clearly, directly and in a way that cannot be disputed. Thus it remains for science merely to interpret these fluctuations—and for the art of politics simply to find ways and means to eliminate them.

2. Early Trade Cycle Theories

All business establishments do well at times and badly at others. There are times when the entrepreneur sees his profits increase daily more than he had anticipated and when, emboldened by these “windfalls,” he proceeds to expand his operations. Then, due to an abrupt change in conditions, severe disillusionment follows this upswing, serious losses materialize, long established firms collapse, until widespread pessimism sets in which may frequently last for years. Such were the experiences which had already been forced on the attention of the businessman in capitalistic economies, long before discussions of the crisis problem began to appear in the literature. The sudden turn from the very sharp rise in prosperity—at least what appeared to be prosperity—to a very severe drop in profit opportunities was too conspicuous not to attract general attention. Even those who wanted to have nothing to do with the business world’s “worship of filthy lucre” could not ignore the fact that people who were, or had been considered, rich yesterday were suddenly reduced to poverty, that factories were shut down, that construction projects were left uncompleted, and that workers could not find work. Naturally, nothing concerned the businessman more intimately than this very problem.

If an entrepreneur is asked what is going on here—leaving aside changes in the prices of individual commodities due to recognizable causes—he may very well reply that at times the entire “price level” tends upward and then at other times it tends downward. For inexplicable reasons, he would say, conditions arise under which it is impossible to dispose of all commodities, or almost all commodities, except at a loss. And what is most curious is that these depressing times always come when least expected, just when all business had been improving for some time so that people finally believed that a new age of steady and rapid progress was emerging.

Eventually, it must have become obvious to the more keenly thinking businessman that the genesis of the crisis should be sought in the preceding boom. The scientific investigator, whose view is naturally focused on the longer period, soon realized that economic upswings and downturns alternated with seeming regularity. Once this was established, the problem was halfway exposed and scientists began to ask questions as to how this apparent regularity might be explained and understood.

Theoretical analysis was able to reject, as completely false, two attempts to explain the crisis—the theories of general overproduction and of underconsumption. These two doctrines have disappeared from serious scientific discussion. They persist today only outside the realm of science—the theory of general overproduction, among the ideas held by the average citizen; and the underconsumption theory, in Marxist literature.

It was not so easy to criticize a third group of attempted explanations, those which sought to trace economic fluctuations back to periodic changes in natural phenomena affecting agricultural production. These doctrines cannot be reached by theoretical inquiry alone. Conceivably such events may occur and reoccur at regular intervals. Whether this actually is the case can be shown only by attempts to verify the theory through observation. So far, however, none of these “weather theories”30 has successfully passed this test.

A whole series of a very different sort of attempts to explain the crisis are based on a definite irregularity in the psychological and intellectual talents of people. This irregularity is expressed in the economy by a change from confidence over the future, which inspires the boom, to despondency, which leads to the crisis and to stagnation of business. Or else this irregularity appears as a shift from boldly striking out in new directions to quietly following along already well-worn paths.

What should be pointed out about these doctrines and about the many other similar theories based on psychological variations is, first of all, that they do not explain. They merely pose the problem in a different way. They are not able to trace the change in business conditions back to a previously established and identified phenomenon. From the periodical fluctuations in psychological and intellectual data alone, without any further observation concerning the field of labor in the social or other sciences, we learn that such economic shifts as these may also be conceived of in a different way. So long as the course of such changes appears plausible only because of economic fluctuations between boom and bust, psychological and other related theories of the crisis amount to no more than tracing one unknown factor back to something else equally unknown.

3. The Circulation Credit Theory

Of all the theories of the trade cycle, only one has achieved and retained the rank of a fully-developed economic doctrine. That is the theory advanced by the Currency School, the theory which traces the cause of changes in business conditions to the phenomenon of circulation credit. All other theories of the crisis, even when they try to differ in other respects from the line of reasoning adopted by the Currency School, return again and again to follow in its footsteps. Thus, our attention is constantly being directed to observations which seem to corroborate the Currency School’s interpretation.

In fact, it may be said that the Circulation Credit Theory of the Trade Cycle31 is now accepted by all writers in the field and that the other theories advanced today aim only at explaining why the volume of circulation credit granted by the banks varies from time to time. All attempts to study the course of business fluctuations empirically and statistically, as well as all efforts to influence the shape of changes in business conditions by political action, are based on the Circulation Credit Theory of the Trade Cycle.

To show that an investigation of business cycles is not dealing with an imaginary problem, it is necessary to formulate a cycle theory that recognizes a cyclical regularity of changes in business conditions. If we could not find a satisfactory theory of cyclical changes, then the question would remain as to whether or not each individual crisis arose from a special cause which we would have to track down first. Originally, economics approached the problem of the crisis by trying to trace all crises back to specific “visible” and “spectacular” causes such as war, cataclysms of nature, adjustments to new economic data—for example, changes in consumption and technology, or the discovery of easier and more favorable methods of production. Crises which could not be explained in this way became the specific “problem of the crisis.”

Neither the fact that unexplained crises still recur again and again nor the fact that they are always preceded by a distinct boom period is sufficient to prove with certainty that the problem to be dealt with is a unique phenomenon originating from one specific cause. Recurrences do not appear at regular intervals. And it is not hard to believe that the more a crisis contrasts with conditions in the immediately preceding period, the more severe it is considered to be. It might be assumed, therefore, that there is no specific “problem of the crisis” at all, and that the still unexplained crises must be explained by various special causes somewhat like the “crisis” which Central European agriculture has faced since the rise of competition from the tilling of richer soil in Eastern Europe and overseas, or the “crisis” of the European cotton industry at the time of the American Civil War. What is true of the crisis can also be applied to the boom. Here again, instead of seeking a general boom theory we could look for special causes for each individual boom.

Neither the connection between boom and bust nor the cyclical change of business conditions is a fact that can be established independent of theory. Only theory, business cycle theory, permits us to detect the wavy outline of a cycle in the tangled confusion of events.32

II. CIRCULATION CREDIT THEORY

1. The Banking School Fallacy

If notes are issued by the banks, or if bank deposits subject to check or other claim are opened, in excess of the amount of money kept in the vaults as cover, the effect on prices is similar to that obtained by an increase in the quantity of money. Since these fiduciary media, as notes and bank deposits not backed by metal are called, render the service of money as safe and generally accepted, payable on demand monetary claims, they may be used as money in all transactions. On that account, they are genuine money substitutes. Since they are in excess of the given total quantity of money in the narrower sense, they represent an increase in the quantity of money in the broader sense.

The practical significance of these undisputed and indisputable conclusions in the formation of prices is denied by the Banking School with its contention that the issue of such fiduciary media is strictly limited by the demand for money in the economy. The Banking School doctrine maintains that if fiduciary media are issued by the banks only to discount short-term commodity bills, then no more would come into circulation than were “needed” to liquidate the transactions. According to this doctrine, bank management could exert no influence on the volume of the commodity transactions activated. Purchases and sales from which short-term commodity bills originate would, by this very transaction, already have brought into existence paper credit which can be used, through further negotiation, for the exchange of goods and services. If the bank discounts the bill and, let us say, issues notes against it, that is, according to the Banking School, a neutral transaction as far as the market is concerned. Nothing more is involved than replacing one instrument which is technically less suitable for circulation, the bill of exchange, with a more suitable one, the note. Thus, according to this School, the effect of the issue of notes need not be to increase the quantity of money in circulation. If the bill of exchange is retired at maturity, then notes would flow back to the bank and new notes could enter circulation again only when new commodity bills came into being once more as a result of new business.

The weak link in this well-known line of reasoning lies in the assertion that the volume of transactions completed, as sales and purchases from which commodity bills can derive, is independent of the behavior of the banks. If the banks discount at a lower, rather than at a higher, interest rate, then more loans are made. Enterprises which are unprofitable at 5 percent, and hence are not undertaken, may be profitable at 4 percent. Therefore, by lowering the interest rate they charge, banks can intensify the demand for credit. Then, by satisfying this demand, they can increase the quantity of fiduciary media in circulation. Once this is recognized, the Banking Theory’s only argument, that prices are not influenced by the issue of fiduciary media, collapses.

One must be careful not to speak simply of the effects of credit in general on prices, but to specify clearly the effects of “increased credit” or “credit expansion.” A sharp distinction must be made between (1) credit which a bank grants by lending its own funds or funds placed at its disposal by depositors, which we call “commodity credit,” and (2) that which is granted by the creation of fiduciary media, i.e., notes and deposits not covered by money, which we call “circulation credit.”33 It is only through the granting of circulation credit that the prices of all commodities and services are directly affected.

If the banks grant circulation credit by discounting a three month bill of exchange, they exchange a future good—a claim payable in three months—for a present good that they produce out of nothing. It is not correct, therefore, to maintain that it is immaterial whether the bill of exchange is discounted by a bank of issue or whether it remains in circulation, passing from hand to hand. Whoever takes the bill of exchange in trade can do so only if he has the resources. But the bank of issue discounts by creating the necessary funds and putting them into circulation. To be sure, the fiduciary media flow back again to the bank at expiration of the note. If the bank does not give the fiduciary media out again, precisely the same consequences appear as those which come from a decrease in the quantity of money in its broader sense.

2. Early Effects of Credit Expansion

The fact that in the regular course of banking operations the banks issue fiduciary media only as loans to producers and merchants means that they are not used directly for purposes of consumption.34 Rather, these fiduciary media are used first of all for production, that is to buy factors of production and pay wages. The first prices to rise, therefore, as a result of an increase of the quantity of money in the broader sense, caused by the issue of such fiduciary media, are those of raw materials, semimanufactured products, other goods of higher orders, and wage rates. Only later do the prices of goods of the first order [consumers’ goods] follow. Changes in the purchasing power of a monetary unit, brought about by the issue of fiduciary media, follow a different path and have different accompanying social side effects from those produced by a new discovery of precious metals or by the issue of paper money. Still in the last analysis, the effect on prices is similar in both instances.

Changes in the purchasing power of the monetary unit do not directly affect the height of the rate of interest. An indirect influence on the height of the interest rate can take place as a result of the fact that shifts in wealth and income relationships, appearing as a result of the change in the value of the monetary unit, influence savings and, thus, the accumulation of capital. If a depreciation of the monetary unit favors the wealthier members of society at the expense of the poorer, its effect will probably be an increase in capital accumulation since the well-to-do are the more important savers. The more they put aside, the more their incomes and fortunes will grow.

If monetary depreciation is brought about by an issue of fiduciary media, and if wage rates do not promptly follow the increase in commodity prices, then the decline in purchasing power will certainly make this effect much more severe. This is the “forced savings” which is quite properly stressed in recent literature.35 However, three things should not be forgotten. First, it always depends upon the data of the particular case whether shifts of wealth and income, which lead to increased saving, are actually set in motion. Second, under circumstances which need not be discussed further here, by falsifying economic calculation, based on monetary bookkeeping calculations, a very substantial devaluation can lead to capital consumption (such a situation did take place temporarily during the recent inflationary period). Third, as advocates of inflation through credit expansion should observe, any legislative measure which transfers resources to the “rich” at the expense of the “poor” will also foster capital formation.

Eventually, the issue of fiduciary media in such manner can also lead to increased capital accumulation within narrow limits and, hence, to a further reduction of the interest rate. In the beginning, however, an immediate and direct decrease in the loan rate appears with the issue of fiduciary media, but this immediate decrease in the loan rate is distinct in character and degree from the later reduction. The new funds offered on the money market by the banks must obviously bring pressure to bear on the rate of interest. The supply and demand for loan money were adjusted at the interest rate prevailing before the issue of any additional supply of fiduciary media. Additional loans can be placed only if the interest rate is lowered. Such loans are profitable for the banks because the increase in the supply of fiduciary media calls for no expenditure except for the mechanical costs of banking (i.e., printing the notes and bookkeeping). The banks can, therefore, undercut the interest rates which would otherwise appear on the loan market, in the absence of their intervention. Since competition from them compels other money lenders to lower their interest charges, the market interest rate must therefore decline. But can this reduction be maintained? That is the problem.

3. Inevitable Effects of Credit Expansion on Interest Rates

In conformity with Wicksell’s terminology, we shall use “natural interest rate” to describe that interest rate which would be established by supply and demand if real goods were loaned in natura [directly, as in barter] without the intermediary of money. “Money rate of interest” will be used for that interest rate asked on loans made in money or money substitutes. Through continued expansion of fiduciary media, it is possible for the banks to force the money rate down to the actual cost of the banking operations, practically speaking that is almost to zero. As a result, several authors have concluded that interest could be completely abolished in this way. Whole schools of reformers have wanted to use banking policy to make credit gratuitous and thus to solve the “social question.” No reasoning person today, however, believes that interest can ever be abolished, nor doubts but what, if the “money interest rate” is depressed by the expansion of fiduciary media, it must sooner or later revert once again to the “natural interest rate.” The question is only how this inevitable adjustment takes place. The answer to this will explain at the same time the fluctuations of the business cycle.

The Currency Theory limited the problem too much. It only considered the situation that was of practical significance for the England of its time—that is, when the issue of fiduciary media is increased in one country while remaining unchanged in others. Under these assumptions, the situation is quite clear: General price increases at home; hence an increase in imports, a drop in commodity exports; and with this, as notes can circulate only within the country, an outflow of metallic money. To obtain metallic money for export, holders of notes present them for redemption; the metallic reserves of the banks decline; and consideration for their own solvency then forces them to restrict the credit offered.

That is the instant at which the business upswing, brought about by the availability of easy credit, is demonstrated to be illusory prosperity. An abrupt reaction sets in. The “money rate of interest” shoots up; enterprises from which credit is withdrawn collapse and sweep along with them the banks which are their creditors. A long persisting period of business stagnation now follows. The banks, warned by this experience into observing restraint, not only no longer underbid the “natural interest rate” but exercise extreme caution in granting credit.

4. The Price Premium

In order to complete this interpretation, we must, first of all, consider the price premium. As the banks start to expand the circulation credit, the anticipated upward movement of prices results in the appearance of a positive price premium. Even if the banks do not lower the actual interest rate any more, the gap widens between the “money interest rate” and the “natural interest rate” which would prevail in the absence of their intervention. Since loan money is now cheaper to acquire than circumstances warrant, entrepreneurial ambitions expand.

New businesses are started in the expectation that the necessary capital can be secured by obtaining credit. To be sure, in the face of growing demand, the banks now raise the “money interest rate.” Still they do not discontinue granting further credit. They expand the supply of fiduciary media issued, with the result that the purchasing power of the monetary unit must decline still further. Certainly the actual “money interest rate” increases during the boom, but it continues to lag behind the rate which would conform to the market, i.e., the “natural interest rate” augmented by the positive price premium.

So long as this situation prevails, the upswing continues. Inventories of goods are readily sold. Prices and profits rise. Business enterprises are overwhelmed with orders because everyone anticipates further price increases and workers find employment at increasing wage rates. However, this situation cannot last forever!

5. Malinvestment of Available Capital Goods

The “natural interest rate” is established at that height which tends toward equilibrium on the market. The tendency is toward a condition where no capital goods are idle, no opportunities for starting profitable enterprises remain unexploited and the only projects not undertaken are those which no longer yield a profit at the prevailing “natural interest rate.” Assume, however, that the equilibrium, toward which the market is moving, is disturbed by the interference of the banks. Money may be obtained below the “natural interest rate.” As a result businesses may be started which weren’t profitable before, and which become profitable only through the lower than “natural interest rate” which appears with the expansion of circulation credit.

Here again, we see the difference which exists between a drop in purchasing power, caused by the expansion of circulation credit, and a loss of purchasing power, brought about by an increase in the quantity of money. In the latter case [i.e., with an increase in the quantity of money in the narrower sense] the prices first affected are either (1) those of consumers’ goods only or (2) the prices of both consumers’ and producers’ goods. Which it will be depends on whether those first receiving the new quantities of money use this new wealth for consumption or production. However, if the decrease in purchasing power is caused by an increase in bank created fiduciary media, then it is the prices of producers’ goods which are first affected. The prices of consumers’ goods follow only to the extent that wages and profits rise.

Since it always requires some time for the market to reach full “equilibrium,” the “static” or “natural”36 prices, wage rates and interest rates never actually appear. The process leading to their establishment is never completed before changes occur which once again indicate a new “equilibrium.” At times, even on the unhampered market, there are some unemployed workers, unsold consumers’ goods and quantities of unused factors of production, which would not exist under “static equilibrium.” With the revival of business and productive activity, these reserves are in demand right away. However, once they are gone, the increase in the supply of fiduciary media necessarily leads to disturbances of a special kind.

In a given economic situation, the opportunities for production, which may actually be carried out, are limited by the supply of capital goods available. Roundabout methods of production can be adopted only so far as the means for subsistence exist to maintain the workers during the entire period of the expanded process. All those projects, for the completion of which means are not available, must be left uncompleted, even though they may appear technically feasible—that is, if one disregards the supply of capital. However, such businesses, because of the lower loan rate offered by the banks, appear for the moment to be profitable and are, therefore, initiated. However, the existing resources are insufficient. Sooner or later this must become evident. Then it will become apparent that production has gone astray, that plans were drawn up in excess of the economic means available, that speculation, i.e., activity aimed at the provision of future goods, was misdirected.

6. “Forced Savings”

In recent years, considerable significance has been attributed to the fact that “forced savings,” which may appear as a result of the drop in purchasing power that follows an increase of fiduciary media, leads to an increase in the supply of capital. The subsistence fund is made to go farther, due to the fact that (1) the workers consume less because wage rates tend to lag behind the rise in the prices of commodities, and (2) those who reap the advantage of this reduction in the workers’ incomes save at least a part of their gain. Whether “forced savings” actually appear depends, as noted above, on the circumstances in each case. There is no need to go into this any further.

Nevertheless, establishing the existence of “forced savings” does not mean that bank expansion of circulation credit does not lead to the initiation of more roundabout production than available capabilities would warrant. To prove that, one must be able to show that the banks are only in a position to depress the “money interest rate” and expand the issue of fiduciary media to the extent that the “natural interest rate” declines as a result of “forced savings.” This assumption is simply absurd and there is no point in arguing it further. It is almost inconceivable that anyone should want to maintain it.

What concerns us is the problem brought about by the banks, in reducing the “money rate of interest” below the “natural rate.” For our problem, it is immaterial how much the “natural interest rate” may also decline under certain circumstances and within narrow limits, as a result of this action by the banks. No one doubts that “forced savings” can reduce the “natural interest rate” only fractionally, as compared with the reduction in the “money interest rate” which produces the “forced savings.”37

The resources which are claimed for the newly initiated longer time consuming methods of production are unavailable for those processes where they would otherwise have been put to use. The reduction in the loan rate benefits all producers, so that all producers are now in a position to pay higher wage rates and higher prices for the material factors of production. Their competition drives up wage rates and the prices of the other factors of production. Still, except for the possibilities already discussed, this does not increase the size of the labor force or the supply of available goods of the higher order. The means of subsistence are not sufficient to provide for the workers during the extended period of production. It becomes apparent that the proposal for the new, longer, roundabout production was not adjusted with a view to the actual capital situation. For one thing, the enterprises realize that the resources available to them are not sufficient to continue their operations. They find that “money” is scarce.

That is precisely what has happened. The general increase in prices means that all businesses need more funds than had been anticipated at their “launching.” More resources are required to complete them. However, the increased quantity of fiduciary media loaned out by the banks is already exhausted. The banks can no longer make additional loans at the same interest rates. As a result, they must raise the loan rate once more for two reasons. In the first place, the appearance of the positive price premium forces them to pay higher interest for outside funds which they borrow. Then also, they must discriminate among the many applicants for credit. Not all enterprises can afford this increased interest rate. Those which cannot run into difficulties.

7. A Habit-Forming Policy

Now, in extending circulation credit, the banks do not proceed by pumping a limited dosage of new fiduciary media into circulation and then stop. They expand the fiduciary media continuously for some time, sending, so to speak, after the first offering, a second, third, fourth, and so on. They do not simply undercut the “natural interest rate” once, and then adjust promptly to the new situation. Instead they continue the practice of making loans below the “natural interest rate” for some time. To be sure, the increasing volume of demands on them for credit may cause them to raise the “money rate of interest.” Yet, even if the banks revert to the former “natural rate,” the rate which prevailed before their credit expansion affected the market, they still lag behind the rate which would now exist on the market if they were not continuing to expand credit. This is because a positive price premium must now be included in the new “natural rate.” With the help of this new quantity of fiduciary media, the banks now take care of the businessman’s intensified demand for credit. Thus, the crisis does not appear yet. The enterprises using more roundabout methods of production, which have been started, are continued. Because prices rise still further, the earlier calculations of the entrepreneurs are realized. They make profits. In short, the boom continues.

8. The Inevitable Crisis and Cycle

The crisis breaks out only when the banks alter their conduct to the extent that they discontinue issuing any more new fiduciary media and stop undercutting the “natural interest rate.” They may even take steps to restrict circulation credit. When they actually do this, and why, is still to be examined. First of all, however, we must ask ourselves whether it is possible for the banks to stay on the course upon which they have embarked, permitting new quantities of fiduciary media to flow into circulation continuously and proceeding always to make loans below the rate of interest which would prevail on the market in the absence of their interference with newly created fiduciary media.

If the banks could proceed in this manner, with businesses improving continually, could they then provide for lasting good times? Would they then be able to make the boom eternal?

They cannot do this. The reason they cannot is that inflationism carried on ad infinitum is not a workable policy. If the issue of fiduciary media is expanded continuously, prices rise ever higher and at the same time the positive price premium also rises. (We shall disregard the fact that consideration for (1) the continually declining monetary reserves relative to fiduciary media and (2) the banks’ operating costs must sooner or later compel them to discontinue the further expansion of circulation credit.) It is precisely because, and only because, no end to the prolonged “flood” of expanding fiduciary media is foreseen, that it leads to still sharper price increases and, finally, to a panic in which prices and the loan rate move erratically upward.

Suppose the banks still did not want to give up the race? Suppose, in order to depress the loan rate, they wanted to satisfy the continuously expanding desire for credit by issuing still more circulation credit? Then they would only hasten the end, the collapse of the entire system of fiduciary media. The inflation can continue only so long as the conviction persists that it will one day cease. Once people are persuaded that the inflation will not stop, they turn from the use of this money. They flee then to “real values,” foreign money, the precious metals, and barter.

Sooner or later, the crisis must inevitably break out as the result of a change in the conduct of the banks. The later the crack-up comes, the longer the period in which the calculation of the entrepreneurs is misguided by the issue of additional fiduciary media. The greater this additional quantity of fiduciary money, the more factors of production have been firmly committed in the form of investments which appeared profitable only because of the artificially reduced interest rate and which prove to be unprofitable now that the interest rate has again been raised. Great losses are sustained as a result of misdirected capital investments. Many new structures remain unfinished. Others, already completed, close down operations. Still others are carried on because, after writing off losses which represent a waste of capital, operation of the existing structure pays at least something.

The crisis, with its unique characteristics, is followed by stagnation. The misguided enterprises and businesses of the boom period are already liquidated. Bankruptcy and adjustment have cleared up the situation. The banks have become cautious. They fight shy of expanding circulation credit. They are not inclined to give an ear to credit applications from schemers and promoters. Not only is the artificial stimulus to business, through the expansion of circulation credit, lacking, but even businesses which would be feasible, considering the capital goods available, are not attempted because the general feeling of discouragement makes every innovation appear doubtful. Prevailing “money interest rates” fall below the “natural interest rates.”

When the crisis breaks out, loan rates bound sharply upward because threatened enterprises offer extremely high interest rates for the funds to acquire the resources, with the help of which they hope to save themselves. Later, as the panic subsides, a situation develops, as a result of the restriction of circulation credit and attempts to dispose of large inventories, causing prices [and the “money interest rate”] to fall steadily and leading to the appearance of a negative price premium. This reduced rate of loan interest is adhered to for some time, even after the decline in prices comes to a standstill, when a negative price premium no longer corresponds to conditions. Thus, it comes about that the “money interest rate” is lower than the “natural rate.” Yet, because the unfortunate experiences of the recent crisis have made everyone uneasy, the incentive to business activity is not as strong as circumstances would otherwise warrant. Quite a time passes before capital funds, increased once again by savings accumulated in the meantime, exert sufficient pressure on the loan interest rate for an expansion of entrepreneurial activity to resume. With this development, the low point is passed and the new boom begins.

III. THE REAPPEARANCE OF CYCLES

1. Metallic Standard Fluctuations

From the instant when the banks start expanding the volume of circulation credit, until the moment they stop such behavior, the course of events is substantially similar to that provoked by any increase in the quantity of money. The difference results from the fact that fiduciary media generally come into circulation through the banks, i.e., as loans, while increases in the quantity of money appear as additions to the wealth and income of specific individuals. This has already been mentioned and will not be further considered here. Considerably more significant for us is another distinction between the two.

Such increases and decreases in the quantity of money have no connection with increases or decreases in the demand for money. If the demand for money grows in the wake of a population increase or a progressive reduction of barter and self-sufficiency resulting in increased monetary transactions, there is absolutely no need to increase the quantity of money. It might even decrease. In any event, it would be most extraordinary if changes in the demand for money were balanced by reciprocal changes in its quantity so that both changes were concealed and no change took place in the monetary unit’s purchasing power.

Changes in the value of the monetary unit are always taking place in the economy. Periods of declining purchasing power alternate with those of increasing purchasing power. Under a metallic standard, these changes are usually so slow and so insignificant that their effect is not at all violent. Nevertheless, we must recognize that even under a precious metal standard periods of ups and downs would still alternate at irregular intervals. In addition to the standard metallic money, such a standard would recognize only token coins for petty transactions. There would, of course, be no paper money or any other currency (i.e., either notes or bank accounts subject to check which are not fully covered). Yet even then, one would be able to speak of economic “ups,” “downs” and “waves.” However, one would hardly be inclined to refer to such minor alternating “ups” and “downs” as regularly recurring cycles. During these periods when purchasing power moved in one direction, whether up or down, it would probably move so slightly that businessmen would scarcely notice the changes. Only economic historians would become aware of them. Moreover, the fact is that the transition from a period of rising prices to one of falling prices would be so slight that neither panic nor crisis would appear. This would also mean that businessmen and news reports of market activities would be less occupied with the “long waves” of the trade cycle.38

2. Infrequent Recurrences of Paper Money Inflations

The effects of inflations brought about by increases in paper money are quite different. They also produce price increases and hence “good business conditions,” which are further intensified by the apparent encouragement of exports and the hampering of imports. Once the inflation comes to an end, whether by a providential halt to further increases in the quantity of money (as for instance recently in France and Italy) or through complete debasement of the paper money due to inflationary policy carried to its final conclusions (as in Germany in 1923), then the “stabilization crisis”39 appears. The cause and appearance of this crisis correspond precisely to those of the crisis which comes at the close of a period of circulation credit expansion. One must clearly distinguish this crisis [i.e., when increases in the quantity of money are simply halted] from the consequences which must result when the cessation of inflation is followed by deflation.

There is no regularity as to the recurrence of paper money inflations. They generally originate in a certain political attitude, not from events within the economy itself. One can only say, with certainty, that after a country has pursued an inflationist policy to its end or, at least, to substantial lengths, it cannot soon use this means again successfully to serve its financial interests. The people, as a result of their experience, will have become distrustful and would resist any attempt at a renewal of inflation.

Even at the very beginning of a new inflation, people would reject the notes or accept them only at a far greater discount than the actual increased quantity would otherwise warrant. As a rule, such an unusually high discount is characteristic of the final phases of an inflation. Thus an early attempt to return to a policy of paper money inflation must either fail entirely or come very quickly to a catastrophic conclusion. One can assume—and monetary history confirms this, or at least does not contradict it—that a new generation must grow up before consideration can again be given to bolstering the government’s finances with the printing press.

Many states have never pursued a policy of paper money inflation. Many have resorted to it only once in their history. Even the states traditionally known for their printing press money have not repeated the experiment often. Austria waited almost a generation after the banknote inflation of the Napoleonic era before embarking on an inflation policy again. Even then, the inflation was in more modest proportions than at the beginning of the nineteenth century. Almost a half century passed between the end of her second and the beginning of her third and most recent period of inflation. It is by no means possible to speak of cyclical reappearances of paper money inflations.

3. The Cycle Process of Credit Expansions

Regularity can be detected only with respect to the phenomena originating out of circulation credit. Crises have reappeared every few years since banks issuing fiduciary media began to play an important role in the economic life of people. Stagnation followed crisis, and following these came the boom again. More than ninety years ago Lord Overstone described the sequence in a remarkably graphic manner:

We find it [the “state of trade”] subject to various conditions which are periodically returning; it revolves apparently in an established cycle. First we find it in a state of quiescence,—next improvement,—growing confidence,—prosperity,—excitement,—overtrading,—convulsion,—pressure,—stagnation,—distress,—ending again in quiescence.40

This description, unrivaled for its brevity and clarity, must be kept in mind to realize how wrong it is to give later economists credit for transforming the problem of the crisis into the problem of general business conditions.

Attempts have been made, with little success, to supplement the observation that business cycles recur by attributing a definite time period to the sequence of events. Theories which sought the source of economic change in recurring cosmic events have, as might be expected, leaned in this direction. A study of economic history fails to support such assumptions. It shows recurring ups and downs in business conditions, but not ups and downs of equal length.

The problem to be solved is the recurrence of fluctuations in business activity. The Circulation Credit Theory shows us, in rough outline, the typical course of a cycle. However, so far as we have as yet analyzed the theory, it still does not explain why the cycle always recurs.

According to the Circulation Credit Theory, it is clear that the direct stimulus which provokes the fluctuations is to be sought in the conduct of the banks. Insofar as they start to reduce the “money rate of interest” below the “natural rate of interest,” they expand circulation credit, and thus divert the course of events away from the path of normal development. They bring about changes in relationships which must necessarily lead to boom and crisis. Thus, the problem consists of asking what leads the banks again and again to renew attempts to expand the volume of circulation credit.

Many authors believe that the instigation of the banks’ behavior comes from outside, that certain events induce them to pump more fiduciary media into circulation and that they would behave differently if these circumstances failed to appear. I was also inclined to this view in the first edition of my book on monetary theory.41 I could not understand why the banks didn’t learn from experience. I thought they would certainly persist in a policy of caution and restraint, if they were not led by outside circumstances to abandon it. Only later did I become convinced that it was useless to look to an outside stimulus for the change in the conduct of the banks. Only later did I also become convinced that fluctuations in general business conditions were completely dependent on the relationship of the quantity of fiduciary media in circulation to demand.

Each new issue of fiduciary media has the consequences described above. First of all, it depresses the loan rate and then it reduces the monetary unit’s purchasing power. Every subsequent issue brings the same result. The establishment of new banks of issue and their step-by-step expansion of circulation credit provides the means for a business boom and, as a result, leads to the crisis with its accompanying decline. We can readily understand that the banks issuing fiduciary media, in order to improve their chances for profit, may be ready to expand the volume of credit granted and the number of notes issued. What calls for special explanation is why attempts are made again and again to improve general economic conditions by the expansion of circulation credit in spite of the spectacular failure of such efforts in the past.

The answer must run as follows: According to the prevailing ideology of businessman and economist-politician, the reduction of the interest rate is considered an essential goal of economic policy. Moreover, the expansion of circulation credit is assumed to be the appropriate means to achieve this goal.

4. The Mania for Lower Interest Rates

The naïve inflationist theory of the seventeenth and eighteenth centuries could not stand up in the long run against the criticism of economics. In the nineteenth century, that doctrine was held only by obscure authors who had no connection with scientific inquiry or practical economic policy. For purely political reasons, the school of empirical and historical “Realism” did not pay attention to problems of economic theory. It was due only to this neglect of theory that the naïve theory of inflation was once more able to gain prestige temporarily during the World War, especially in Germany.

The doctrine of inflationism by way of fiduciary media was more durable. Adam Smith had battered it severely, as had others even before him, especially the American William Douglass.42 Many, notably in the Currency School, had followed. But then came a reversal. The Banking School confused the situation. Its founders failed to see the error in their doctrine. They failed to see that the expansion of circulation credit lowered the interest rate. They even argued that it was impossible to expand credit beyond the “needs of business.” So there are seeds in the Banking Theory which need only to be developed to reach the conclusion that the interest rate can be reduced by the conduct of the banks. At the very least, it must be admitted that those who dealt with those problems did not sufficiently understand the reasons for opposing credit expansion to be able to overcome the public clamor for the banks to provide “cheap money.”

In discussions of the rate of interest, the economic press adopted the questionable jargon of the business world, speaking of a “scarcity” or an “abundance” of money and calling the short term loan market the “money market.” Banks issuing fiduciary media, warned by experience to be cautious, practiced discretion and hesitated to indulge the universal desire of the press, political parties, parliaments, governments, entrepreneurs, landowners and workers for cheaper credit. Their reluctance to expand credit was falsely attributed to reprehensible motives. Even newspapers, that knew better, and politicians, who should have known better, never tired of asserting that the banks of issue could certainly discount larger sums more cheaply if they were not trying to hold the interest rate as high as possible out of concern for their own profitability and the interests of their controlling capitalists.

Almost without exception, the great European banks of issue on the continent were established with the expectation that the loan rate could be reduced by issuing fiduciary media. Under the influence of the Currency School doctrine, at first in England and then in other countries where old laws did not restrict the issue of notes, arrangements were made to limit the expansion of circulation credit, at least of that part granted through the issue of uncovered banknotes. Still, the Currency Theory lost out as a result of criticism by Tooke (1774–1858) and his followers. Although it was considered risky to abolish the laws which restricted the issue of notes, no harm was seen in circumventing them. Actually, the letter of the banking laws provided for a concentration of the nation’s supply of precious metals in the vaults of banks of issue. This permitted an increase in the issue of fiduciary media and played an important role in the expansion of the gold exchange standard.

Before the war [1914], there was no hesitation in Germany in openly advocating withdrawal of gold from trade so that the Reichsbank might issue sixty marks in notes for every twenty marks in gold added to its stock. Propaganda was also made for expanding the use of payments by check with the explanation that this was a means to lower the interest rate substantially.43 The situation was similar elsewhere, although perhaps more cautiously expressed.

Every single fluctuation in general business conditions—the upswing to the peak of the wave and the decline into the trough which follows—is prompted by the attempt of the banks of issue to reduce the loan rate and thus expand the volume of circulation credit through an increase in the supply of fiduciary media (i.e., banknotes and checking accounts not fully backed by money). The fact that these efforts are resumed again and again in spite of their widely deplored consequences, causing one business cycle after another, can be attributed to the predominance of an ideology—an ideology which regards rising commodity prices and especially a low rate of interest as goals of economic policy. The theory is that even this second goal may be attained by the expansion of fiduciary media. Both crisis and depression are lamented. Yet, because the causal connection between the behavior of the banks of issue and the evils complained about is not correctly interpreted, a policy with respect to interest is advocated which, in the last analysis, must necessarily always lead to crisis and depression.

5. Free Banking

Every deviation from the prices, wage rates and interest rates which would prevail on the unhampered market must lead to disturbances of the economic “equilibrium.” This disturbance, brought about by attempts to depress the interest rate artificially, is precisely the cause of the crisis.

The ultimate cause, therefore, of the phenomenon of wave after wave of economic ups and downs is ideological in character. The cycles will not disappear so long as people believe that the rate of interest may be reduced, not through the accumulation of capital, but by banking policy.

Even if governments had never concerned themselves with the issue of fiduciary media, there would still be banks of issue and fiduciary media in the form of notes as well as checking accounts. There would then be no legal limitation on the issue of fiduciary media. Free banking would prevail. However, banks would have to be especially cautious because of the sensitivity to loss of reputation of their fiduciary media, which no one would be forced to accept. In the course of time, the inhabitants of capitalistic countries would learn to differentiate between good and bad banks. Those living in “undeveloped” countries would distrust all banks. No government would exert pressure on the banks to discount on easier terms than the banks themselves could justify. However, the managers of solvent and highly respected banks, the only banks whose fiduciary media would enjoy the general confidence essential for money-substitute quality, would have learned from past experiences. Even if they scarcely detected the deeper correlations, they would nevertheless know how far they might go without precipitating the danger of a breakdown.

The cautious policy of restraint on the part of respected and well-established banks would compel the more irresponsible managers of other banks to follow suit, however much they might want to discount more generously. For the expansion of circulation credit can never be the act of one individual bank alone, nor even of a group of individual banks. It always requires that the fiduciary media be generally accepted as a money substitute. If several banks of issue, each enjoying equal rights, existed side by side, and if some of them sought to expand the volume of circulation credit while the others did not alter their conduct, then at every bank clearing, demand balances would regularly appear in favor of the conservative enterprises. As a result of the presentation of notes for redemption and withdrawal of their cash balances, the expanding banks would very quickly be compelled once more to limit the scale of their emissions.

In the course of the development of a banking system with fiduciary media, crises could not have been avoided. However, as soon as bankers recognized the dangers of expanding circulation credit, they would have done their utmost, in their own interests, to avoid the crisis. They would then have taken the only course leading to this goal: extreme restraint in the issue of fiduciary media.

6. Government Intervention in Banking

The fact that the development of fiduciary media banking took a different turn may be attributed entirely to the circumstance that the issue of banknotes (which for a long time were the only form of fiduciary media and are today [1928] still the more important, even in the United States and England) became a public concern. The private bankers and joint-stock banks were supplanted by the politically privileged banks of issue because the governments favored the expansion of circulation credit for reasons of fiscal and credit policy. The privileged institutions could proceed unhesitatingly in the granting of credit, not only because they usually held a monopoly in the issue of notes, but also because they could rely on the government’s help in an emergency. The private banker would go bankrupt, if he ventured too far in the issue of credit. The privileged bank received permission to suspend payments and its notes were made legal tender at face value.

If the knowledge derived from the Currency Theory had led to the conclusion that fiduciary media should be deprived of all special privileges and placed, like other claims, under general law in every respect and without exception, this would probably have contributed more toward eliminating the threat of crises than was actually accomplished by establishing rigid proportions for the issue of fiduciary media in the form of notes and restricting the freedom of banks to issue fiduciary media in the form of checking accounts. The principle of free banking was limited to the field of checking accounts. In fact, it could not function here to bring about restraint on the part of banks and bankers. Public opinion decreed that government should be guided by a different policy—a policy of coming to the assistance of the central banks of issue in times of crises. To permit the Bank of England to lend a helping hand to banks which had gotten into trouble by expanding circulation credit, the Peel Act was suspended in 1847, 1857 and 1866. Such assistance, in one form or another, has been offered time and again everywhere.

In the United States, national banking legislation made it technically difficult, if not entirely impossible, to grant such aid. The system was considered especially unsatisfactory, precisely because of the legal obstacles it placed in the path of helping grantors of credit who became insolvent and of supporting the value of circulation credit they had granted. Among the reasons leading to the significant revision of the American banking system [i.e., the Federal Reserve Act of 1913], the most important was the belief that provisions must be made for times of crises. In other words, just as the emergency institution of Clearing House Certificates was able to save expanding banks, so should technical expedients be used to prevent the breakdown of the banks and bankers whose conduct had led to the crisis. It was usually considered especially important to shield the banks which expanded circulation credit from the consequences of their conduct. One of the chief tasks of the central banks of issue was to jump into this breach. It was also considered the duty of those other banks who, thanks to foresight, had succeeded in preserving their solvency, even in the general crisis, to help fellow banks in difficulty.

7. Intervention No Remedy

It may well be asked whether the damage inflicted by misguiding entrepreneurial activity by artificially lowering the loan rate would be greater if the crisis were permitted to run its course. Certainly many saved by the intervention would be sacrificed in the panic, but if such enterprises were permitted to fail, others would prosper. Still the total loss brought about by the “boom” (which the crisis did not produce, but only made evident) is largely due to the fact that factors of production were expended for fixed investments which, in the light of economic conditions, were not the most urgent. As a result, these factors of production are now lacking for more urgent uses. If intervention prevents the transfer of goods from the hands of imprudent entrepreneurs to those who would now take over because they have evidenced better foresight, this imbalance becomes neither less significant nor less perceptible.

In any event, the practice of intervening for the benefit of banks, rendered insolvent by the crisis, and of the customers of these banks, has resulted in suspending the market forces which could serve to prevent a return of the expansion, in the form of a new boom, and the crisis which inevitably follows. If the banks emerge from the crisis unscathed, or only slightly weakened, what remains to restrain them from embarking once more on an attempt to reduce artificially the interest rate on loans and expand circulation credit? If the crisis were ruthlessly permitted to run its course, bringing about the destruction of enterprises which were unable to meet their obligations, then all entrepreneurs—not only banks but also other businessmen—would exhibit more caution in granting and using credit in the future. Instead, public opinion approves of giving assistance in the crisis. Then, no sooner is the worst over, than the banks are spurred on to a new expansion of circulation credit.

To the businessman, it appears most natural and understandable that the banks should satisfy his demand for credit by the creation of fiduciary media. The banks, he believes, should have the task and the duty to “stand by” business and trade. There is no dispute but that the expansion of circulation credit furthers the accumulation of capital within the narrow limits of the “forced savings” it brings about and to that extent permits an increase in productivity. Still it can be argued that, given the situation, each step in this direction steers business activity, in the manner described above, on a “wrong” course. The discrepancy between what the entrepreneurs do and what the unhampered market would have prescribed becomes evident in the crisis. The fact that each crisis, with its unpleasant consequences, is followed once more by a new “boom,” which must eventually expend itself as another crisis, is due only to the circumstances that the ideology which dominates all influential groups—political economists, politicians, statesmen, the press and the business world—not only sanctions, but also demands, the expansion of circulation credit.

IV. THE CRISIS POLICY OF THE CURRENCY SCHOOL

1. The Inadequacy of the Currency School

Every advance toward explaining the problem of business fluctuations to date is due to the Currency School. We are also indebted to this School alone for the ideas responsible for policies aimed at eliminating business fluctuations. The fatal error of the Currency School consisted in the fact that it failed to recognize the similarity between banknotes and bank demand deposits as money substitutes and, thus, as money certificates and fiduciary media. In their eyes, only the banknote was a money substitute. In their view, therefore, the circulation of pure metallic money could only be adulterated by the introduction of a banknote not covered by money.

Consequently, they thought that the only thing that needed to be done to prevent the periodic return of crises was to set a rigid limit for the issue of banknotes not backed by metal. The issue of fiduciary media in the form of demand deposits not covered by metal was left free.44 Since nothing stood in the way of granting circulation credit through bank deposits, the policy of expanding circulation credit could be continued even in England. When technical difficulties limited further bank loans and precipitated a crisis, it became customary to come to the assistance of the banks and their customers with special issues of notes. The practice of restricting the notes in circulation not covered by metal, by limiting the ratio of such notes to metal, systematized this procedure. Banks could expand the volume of credit with ease if they could count on the support of the bank of issue in an emergency.

If all further expansion of fiduciary media had been forbidden in any form, that is, if the banks had been obliged to hold full reserves for both the additional notes issued and increases in customers’ demand deposits subject to check or similar claim—or at least had not been permitted to increase the quantity of fiduciary media beyond a strictly limited ratio—prices would have declined sharply, especially at times when the increased demand for money surpassed the increase in its quantity. The economy would then not only have lacked the drive contributed by any “forced savings,” it would also have temporarily suffered from the consequences of a rise in the monetary unit’s purchasing power [i.e., falling prices]. Capital accumulation would then have been slowed down, although certainly not stopped. In any case, the economy surely would not then have experienced periods of stormy upswings followed by dramatic reversals of the upswings into crises and declines.

There is little sense in discussing whether it would have been better to restrict, in this way, the issue of fiduciary media by the banks than it was to pursue the policy actually followed. The alternatives are not merely restriction or freedom in the issue of fiduciary media. The alternatives are, or at least were, privilege in the granting of fiduciary media or true free banking.

The possibility of free banking has scarcely even been suggested. Intervention cast its first shadow over the capitalistic system when banking policy came to the forefront of economic and political discussion. To be sure, some authors, who defended free banking, appeared on the scene. However, their voices were overpowered. The desired goal was to protect the noteholders against the banks. It was forgotten that those hurt by the dangerous suspension of payments by the banks of issue are always the very ones the law was intended to help. No matter how severe the consequences one may anticipate from a breakdown of the banks under a system of absolutely free banking, one would have to admit that they could never even remotely approach the severity of those brought about by the war and postwar banking policies of the three European empires.45

2. “Booms” Favored

In the last two generations, hardly anyone, who has given this matter some thought, can fail to know that a crisis follows a boom. Nevertheless, it would have been impossible for even the sharpest and cleverest banker to suppress in time the expansion of circulation credit. Public opinion stood in the way. The fact that business conditions fluctuated violently was generally assumed to be inherent in the capitalistic system. Under the influence of the Banking Theory, it was thought that the banks merely went along with the upswing and that their conduct had nothing to do with bringing it about or advancing it. If, after a long period of stagnation, the banks again began to respond to the general demand for easier credit, public opinion was always delighted by the signs of the start of a boom.

In view of the prevailing ideology, it would have been completely unthinkable for the banks to apply the brakes at the start of such a boom. If business conditions continued to improve, then, in conformity with the principles of Lord Overstone, prophecies of a reaction certainly increased in number. However, even those who gave this warning usually did not call for a rigorous halt to all further expansion of circulation credit. They asked only for moderation and for restricting newly granted credits to “non-speculative” businesses.

Then finally, if the banks changed their policy and the crisis came, it was always easy to find culprits. But there was no desire to locate the real offender—the false theoretical doctrine. So no changes were made in traditional procedures. Economic waves continued to follow one another.

The managers of the banks of issue have carried out their policy without reflecting very much on its basis. If the expansion of circulation credit began to alarm them, they proceeded, not always very skillfully, to raise the discount rate. Thus, they exposed themselves to public censure for having initiated the crisis by their behavior. It is clear that the crisis must come sooner or later. It is also clear that the crisis must always be caused, primarily and directly, by the change in the conduct of the banks. If we speak of error on the part of the banks, however, we must point to the wrong they do in encouraging the upswing. The fault lies, not with the policy of raising the interest rate, but only with the fact that it was raised too late.

V. MODERN CYCLICAL POLICY

1. Pre-World War I Policy

The cyclical policy recommended today, in most of the literature dealing with the problem of business fluctuations and toward which considerable strides have already been made in the United States, rests entirely on the reasoning of the Circulation Credit Theory.46 The aim of much of this literature is to make this theory useful in practice by studying business conditions with precise statistical methods.

There is no need to explain further that there is only one business cycle theory—the Circulation Credit Theory. All other attempts to cope with the problem have failed to withstand criticism. Every crisis policy and every cyclical policy has been derived from this theory. Its ideas have formed the basis of those cyclical and crisis policies pursued in the decades preceding the war. Thus, the Banking Theory, then recognized in literature as the only correct explanation, as well as all those interpretations which related the problem to the theory of direct exchange, were already disregarded. It may have still been popular to speak of the elasticity of notes in circulation as depending on the discounting of commodity bills of exchange. However, in the world of the bank managers, who made cyclical policy, other views prevailed.

To this extent, therefore, one cannot say that the theory behind today’s cyclical policy is new. The Circulation Credit Theory has, to be sure, come a long way from the old Currency Theory. The studies which Walras, Wicksell and I have devoted to the problem have conceived of it as a more general phenomenon. These studies have related it to the whole economic process. They have sought to deal with it especially as a problem of interest rate formulation and of “equilibrium” on the loan market. To recognize the extent of the progress made, compare, for instance, the famous controversy over free credit between Bastiat and Proudhon.47 Or compare the usual criticism of the Quantity Theory in prewar German literature with recent discussions on the subject. However, no matter how significant this progress may be considered for the development of our understanding, we should not forget that the Currency Theory had already offered policy making every assistance in this regard that a theory can.

It is certainly not to be disputed that substantial progress was made when the problem was considered, not only from the point of view of fiduciary media, but from that of the entire problem of the purchasing power of money. The Currency School paid attention to price changes only insofar as they were produced by an increase or decrease of circulation credit—but they considered only the circulation credit granted by the issue of notes. Thus, the Currency School was a long way from striving for stabilization of the purchasing power of the monetary unit.

2. Post-World War I Policies

Today these two problems, the issuance of fiduciary media and the purchasing power of the monetary unit, are seen as being closely linked to the Circulation Credit Theory. One of the tendencies of modern cyclical policy is that these two problems are treated as one. Thus, one aim of cyclical policy is no more nor less than the stabilization of the purchasing power of money. For a discussion of this see Part I of this study.

Like the Currency School, the other aim is not to stabilize purchasing power but only to avoid the crisis. However, a still further goal is contemplated—similar to that sought by the Peel Act and by prewar cyclical policy. It is proposed to counteract a boom, whether caused by an expansion of fiduciary media or by a monetary inflation (for example, an increase in the production of gold). Then, again, depression is to be avoided when there is restriction irrespective of whether it starts with a contraction in the quantity of money or of fiduciary media. The aim is not to keep prices stable, but to prevent the free market interest rate from being reduced temporarily by the banks of issue or by monetary inflation.

In order to explain the essence of this new policy, we shall now explore two specific cases in more detail:

1. The production of gold increases and prices rise. A price premium appears in the interest rate that would limit the demand for loans to the supply of lendable funds available. The banks, however, have no reason to raise their lending rate. As a matter of fact, they become more willing to discount at a lower rate as the relationship between their obligations and their stock of gold has been improved. It has certainly not deteriorated. The actual loan rate they are asking lags behind the interest rate that would prevail on a free market, thus providing the initiative for a boom. In this instance, prewar crisis policy would not have intervened since it considered only the ratio of the bank’s cover which had not deteriorated. As prices and wages rise [resulting in an increased demand for business loans], modern theory maintains that the interest rates should rise and circulation credit be restricted.

2. The inducement to the boom has been given by the banks in response, let us say, to the general pressure to make credit cheaper in order to combat depression, without any change in the quantity of money in the narrower sense. Since the cover ratio deteriorates as a result, even the older crisis policy would have called for increasing the interest rate as a brake.

Only in the first of these two instances does a fundamental difference exist between old and new policies.

3. Empirical Studies

Many now engaged in cyclical research maintain that the special superiority of current crisis policy in America rests on the use of more precise statistical methods than those previously available. Presumably, means for eliminating seasonal fluctuations and the secular general trend have been developed from statistical series and curves. Obviously, it is only with such manipulations that the findings of a market study may become a study of the business cycle. However, even if one should agree with the American investigators in their evaluation of the success of this effort, the question remains as to the usefulness of index numbers. Nothing more can be added to what has been said above on the subject, in Part I of this study.

The development of the Three Market Barometer48 is considered the most important accomplishment of the Harvard investigations. Since it is not possible to determine Wicksell’s natural rate of interest or the “ideal” price premium, we are advised to compare the change in the interest rate with the movement of prices and other data indicative of business conditions, such as production figures, the number of unemployed, etc. This has been done for decades. One need only glance at reports in the daily papers, economic weeklies, monthlies and annuals of the last two generations to discover that the many claims, made so proudly today, of being the first to recognize the significance of such data for understanding the course of business conditions, are unwarranted. The Harvard institute, however, has performed a service in that it has sought to establish an empirical regularity in the timing of the movements in the three curves.

There is no need to share the exuberant expectations for the practical usefulness of the Harvard barometer which has prevailed in the American business world for some time. It can readily be admitted that this barometer has scarcely contributed anything toward increasing and deepening our knowledge of cyclical movements. Nevertheless, the significance of the Harvard barometer for the investigation of business conditions may still be highly valued, for it does provide statistical substantiation of the Circulation Credit Theory. Twenty years ago, it would not have been thought possible to arrange and manipulate statistical material so as to make it useful for the study of business conditions. Here real success has crowned the ingenious work done by economists and statisticians together.

Upon examining the curves developed by institutes using the Harvard method, it becomes apparent that the movement of the money market curve (C Curve) in relation to the stock market curve (A Curve) and the commodity market curve (B Curve) corresponds exactly to what the Circulation Credit Theory asserts. The fact that the movements of A Curve generally anticipate those of B Curve is explained by the greater sensitivity of stock, as opposed to commodity, speculation. The stock market reacts more promptly than does the commodity market. It sees more and it sees farther. It is quicker to draw coming events (in this case, the changes in the interest rate) into the sphere of its conjectures.

4. Arbitrary Political Decisions

However, the crucial question still remains: What does the Three Market Barometer offer the man who is actually making bank policy? Are modern methods of studying business conditions better suited than the former, to be sure less thorough, ones for laying the groundwork for decisions on a discount policy aimed at reducing as much as possible the ups and downs of business? Even prewar [World War I] banking policy had this for its goal. There is no doubt but that government agencies responsible for financial policy, directors of the central banks of issue and also of the large private banks and banking houses, were frankly and sincerely interested in attaining this goal. Their efforts in this direction—only when the boom was already in full swing to be sure—were supported at least by a segment of public opinion and of the press. They knew well enough what was needed to accomplish the desired effect. They knew that nothing but a timely and sufficiently far-reaching increase in the loan rate could counteract what was usually referred to as “excessive speculation.”

They failed to recognize the fundamental problem. They did not understand that every increase in the amount of circulation credit (whether brought about by the issue of banknotes or expanding bank deposits) causes a surge in business and thus starts the cycle which leads once more, over and beyond the crisis, to the decline in business activity. In short, they embraced the very ideology responsible for generating business fluctuations. However, this fact did not prevent them, once the cyclical upswing became obvious, from thinking about its unavoidable outcome. They did not know that the upswing had been generated by the conduct of the banks. If they had, they might well have seen it only as a blessing of banking policy, for to them the most important task of economic policy was to overcome the depression, at least so long as the depression lasted. Still they knew that a progressing upswing must lead to crisis and then to stagnation.

As a result, the trade boom evoked misgivings at once. The immediate problem became simply how to counteract the onward course of the “unhealthy” development. There was no question of “whether,” but only of “how.” Since the method—increasing the interest rate—was already settled, the question of “how” was only a matter of timing and degree: When and how much should the interest rate be raised?

The critical point was that this question could not be answered precisely, on the basis of undisputed data. As a result, the decision must always be left to discretionary judgment. Now, the more firmly convinced those responsible were that their interference, by raising the interest rate, would put an end to the prosperity of the boom, the more cautiously they must act. Might not those voices be correct which maintained that the upswing was not “artificially” produced, that there wasn’t any “overspeculation” at all, that the boom was only the natural outgrowth of technical progress, the development of means of communication, the discovery of new supplies of raw materials, the opening up of new markets? Should this delightful and happy state of affairs be rudely interrupted? Should the government act in such a way that the economic improvement, for which it took credit, gives way to crisis?

The hesitation of officials to intervene is sufficient to explain the situation. To be sure, they had the best of intentions for stopping in time. Even so, the steps they took were usually “too little and too late.” There was always a time lag before the interest rate reached the point at which prices must start down again. In the interim, capital had become frozen in investments for which it would not have been used if the interest rate on money had not been held below its “natural rate.”

This drawback to cyclical policy is not changed in any respect if it is carried out in accordance with the business barometer. No one who has carefully studied the conclusions, drawn from observations of business conditions made by institutions working with modern methods, will dare to contend that these results may be used to establish, incontrovertibly, when and how much to raise the interest rate in order to end the boom in time before it has led to capital malinvestment. The accomplishment of economic journalism in reporting regularly on business conditions during the last two generations should not be underrated. Nor should the contribution of contemporary business cycle research institutes, working with substantial means, be overrated. Despite all the improvements which the preparation of statistics and graphic interpretations have undergone, their use in the determination of interest rate policy still leaves a wide margin for judgment.

5. Sound Theory Essential

Moreover, it should not be forgotten that it is impossible to answer in a straightforward manner not only how seasonal variations and growth factors are to be eliminated, but also how to decide unequivocably from what data and by what method the curves of each of the Three Markets should be constructed. Arguments which cannot be easily refuted may be raised on every point with respect to the business barometer. Also, no matter how much the business barometer may help us to survey the many heterogeneous operations of the market and of production, they certainly do not offer a solid basis for weighing contingencies. Business barometers are not even in a position to furnish clear and certain answers to the questions concerning cyclical policy which are crucial for their operation. Thus, the great expectations generally associated with recent cyclical policy today are not justified.

For the future of cyclical policy more profound theoretical knowledge concerning the nature of changes in business conditions would inevitably be of incomparably greater value than any conceivable manipulation of statistical methods. Some business cycle research institutes are imbued with the erroneous idea that they are conducting impartial factual research, free of any prejudice due to theoretical considerations. In fact, all their work rests on the groundwork of the Circulation Credit Theory. In spite of the reluctance which exists today against logical reasoning in economics and against thinking problems and theories through to their ultimate conclusions, a great deal would be gained if it were decided to base cyclical policy deliberately on this theory. Then, one would know that every expansion of circulation credit must be counteracted in order to even out the waves of the business cycle. Then, a force operating on one side to reduce the purchasing power of money would be offset from the other side. The difficulties, due to the impossibility of finding any method for measuring changes in purchasing power, cannot be overcome. It is impossible to realize the ideal of either a monetary unit of unchanging value or economic stability. However, once it is resolved to forgo the artificial stimulation of business activity by means of banking policy, fluctuations in business conditions will surely be substantially reduced. To be sure this will mean giving up many a well-loved slogan, for example, “easy money” to encourage credit transactions. However, a still greater ideological sacrifice than that is called for. The desire to reduce the interest rate in any way must also be abandoned.

It has already been pointed out that events would have turned out very differently if there had been no deviation from the principle of complete freedom in banking and if the issue of fiduciary media had been in no way exempted from the rules of commercial law. It may be that a final solution of the problem can be arrived at only through the establishment of completely free banking. However, the credit structure which has been developed by the continued effort of many generations cannot be transformed with one blow. Future generations, who will have recognized the basic absurdity of all interventionist attempts, will have to deal with this question also. However, the time is not yet ripe—not now nor in the immediate future.

VI. CONTROL OF THE MONEY MARKET

1. International Competition or Cooperation

There are many indications that public opinion has recognized the significance of the role banks play in initiating the cycle by their expansion of circulation credit. If this view should actually prevail, then the previous popularity of efforts aimed at artificially reducing the interest rate on loans would disappear. Banks that wanted to expand their issue of fiduciary media would no longer be able to count on public approval or government support. They would become more careful and more temperate. That would smooth out the waves of the cycle and reduce the severity of the sudden shift from rise to fall.

However, there are some indications which seem to contradict this view of public opinion. Most important among these are the attempts or, more precisely, the reasoning which underlies the attempts to bring about international cooperation among the banks of issue.

In speculative periods of the past, the very fact that the banks of the various countries did not work together systematically, and according to agreement, constituted a most effective brake. With closely-knit international economic relations, the expansion of circulation credit could only become universal if it were an international phenomenon. Accordingly, lacking any international agreement, individual banks, fearing a large outflow of capital, took care in setting their interest rates not to lag far below the rates of the banks of other countries. Thus, in response to interest rate arbitrage and any deterioration in the balance of trade, brought about by higher prices, an exodus of loan money to other countries would, for one thing, have impaired the ratio of the bank’s cover, as a result of foreign claims on their gold and foreign exchange which such conditions impose on the bank of issue. The bank, obliged to consider its solvency, would then be forced to restrict credit. In addition, this impairment of the ever-shifting balance of payments would create a shortage of funds on the money market which the banks would be powerless to combat. The closer the economic connections among peoples become, the less possible it is to have a national boom. The business climate becomes an international phenomenon.

However, in many countries, especially in the German Reich, the view has frequently been expressed by friends of “cheap money” that it is only the gold standard that forces the bank of issue to consider interest rates abroad in determining its own interest policy. According to this view, if the bank were free of this shackle, it could then better satisfy the demands of the domestic money market, to the advantage of the national economy. With this view in mind, there were in Germany advocates of bimetallism, as well as of a gold premium policy.49 In Austria, there was resistance to formalizing legally the de facto practice of redeeming its notes.

It is easy to see the fallacy in this doctrine that only the tie of the monetary unit to gold keeps the banks from reducing interest rates at will. Even if all ties with the gold standard were broken, this would not have given the banks the power to lower the interest rate, below the height of the “natural” interest rate, with impunity. To be sure, the paper standard would have permitted them to continue the expansion of circulation credit without hesitation, because a bank of issue, relieved of the obligation of redeeming its notes, need have no fear with respect to its solvency. Still, the increase in notes would have led first to price increases and consequently to a deterioration in the rate of exchange. Second, the crisis would have come—later, to be sure, but all the more severely.

If the banks of issue were to consider seriously making agreements with respect to discount policy, this would eliminate one effective check. By acting in unison, the banks could extend more circulation credit than they do now, without any fear that the consequences would lead to a situation which produces an external drain of funds from the money market. To be sure, if this concern with the situation abroad is eliminated, the banks are still not always in a position to reduce the money rate of interest below its “natural” rate in the long run. However, the difference between the two interest rates can be maintained longer, so that the inevitable result—malinvestment of capital—appears on a larger scale. This must then intensify the unavoidable crisis and deepen the depression.

So far, it is true, the banks of issue have made no significant agreements on cyclical policy. Nevertheless, efforts aimed at such agreements are certainly being proposed on every side.

2. “Boom” Promotional Problems

Another dangerous sign is that the slogan concerning the need to “control the money market,” through the banks of issue, still retains its prestige.

Given the situation, especially as it has developed in Europe, only the central banks are entitled to issue notes. Under that system, attempts to expand circulation credit universally can only originate with the central bank of issue. Every venture on the part of private banks, against the wish or the plan of the central bank, is doomed from the very beginning. Even banking techniques, learned from the Anglo-Saxons, are of no service to private banks, since the opportunity for granting credit, by opening bank deposits, is insignificant in countries where the use of checks (except for central bank clearings and the circulation of postal checks) is confined to a narrow circle in the business world. However, if the central bank of issue embarks upon a policy of credit expansion and thus begins to force down the rate of interest, it may be advantageous for the largest private banks to follow suit and expand the volume of circulation credit they grant too. Such a procedure has still a further advantage for them. It involves them in no risk. If confidence is shaken during the crisis, they can survive the critical stage with the aid of the bank of issue.

However, the bank of issue’s credit expansion policy certainly offers a large number of banks a profitable field for speculation—arbitrage in the loan rates of interest. They seek to profit from the shifting ratio between domestic and foreign interest rates by investing domestically obtained funds in short term funds abroad. In this process, they are acting in opposition to the discount policy of the bank of issue and hurting the alleged interests of those groups which hope to benefit from the artificial reduction of the interest rate and from the boom it produces. The ideology, which sees salvation in every effort to lower the interest rate and regards expansion of circulation credit as the best method of attaining this goal, is consistent with the policy of branding the actions of the interest rate arbitrageur as scandalous and disgraceful, even as a betrayal of the interests of his own people to the advantage of foreigners. The policy of granting the banks of issue every possible assistance in the fight against these speculators is also consistent with this ideology. Both government and bank of issue seek to intimidate the malefactors with threats, to dissuade them from their plan. In the liberal50 countries of western Europe, at least in the past, little could be accomplished by such methods. In the interventionist countries of middle and eastern Europe, attempts of this kind have met with greater success.

It is easy to see what lies behind this effort of the bank of issue to “control” the money market. The bank wants to prevent its credit expansion policy, aimed at reducing the interest rate, from being impeded by consideration of relatively restrictive policies followed abroad. It seeks to promote a domestic boom without interference from international reactions.

3. Drive for Tighter Controls

According to the prevailing ideology, however, there are still other occasions when the banks of issue should have stronger control over the money market. If the interest rate arbitrage, resulting from the expansion of circulation credit, has led, for the time being, only to a withdrawal of funds from the reserves of the issuing bank, and that bank, disconcerted by the deterioration of the security behind its notes, has proceeded to raise its discount rate, there may still be, under certain conditions, no cause for the loan rate to rise on the open money market. As yet no funds have been withdrawn from the domestic market. The gold exports came from the bank’s reserves, and the increase in the discount rate has not led to a reduction in the credits granted by the bank. It takes time for loan funds to become scarce as a result of the fact that some commercial paper, which would otherwise have been offered to the bank for discount, is disposed of on the open market. The issuing bank, however, does not want to wait so long for its maneuver to be effective. Alarmed at the state of its gold and foreign exchange assets, it wants prompt relief. To accomplish this, it must try to make money scarce on the market. It generally tries to bring this about by appearing itself as a borrower on the market.

Another case, when control of the money market is contested, concerns the utilization of funds made available to the market by the generous discount policy. The dominant ideology favors “cheap money.” It also favors high commodity prices, but not always high stock market prices. The moderated interest rate is intended to stimulate production and not to cause a stock market boom. However, stock prices increase first of all. At the outset, commodity prices are not caught up in the boom. There are stock exchange booms and stock exchange profits. Yet, the “producer” is dissatisfied. He envies the “speculator” his “easy profit.” Those in power are not willing to accept this situation. They believe that production is being deprived of money which is flowing into the stock market. Besides, it is precisely in the stock market boom that the serious threat of a crisis lies hidden.

Therefore, the aim is to withdraw money from stock exchange loans in order to inject it into the “economy.” Trying to do this simply by raising the interest rate offers no special attraction. Such a rise in the interest rate is certainly unavoidable in the end. It is only a question of whether it comes sooner or later. Whenever the interest rate rises sufficiently, it brings an end to the business boom. Therefore, other measures are tried to transfer funds from the stock market into production, without changing the cheap rate for loans. The bank of issue exerts pressure on borrowers to influence the use made of the sums loaned out. Or else it proceeds directly to set different terms for credit depending on its use.

Thus we can see what it means if the central bank of issue aims at domination of the money market. Either the expansion of circulation credit is freed from the limitations which would eventually restrict it or the boom is shifted by certain measures along a course different from the one it would otherwise have followed. Thus, the pressure for “control of the money market” specifically envisions the encouragement of the boom—the boom which must end in a crisis. If a cyclical policy is to be followed to eliminate crises, this desire, the desire to control and dominate the money market, must be abandoned.

If it were seriously desired to counteract price increases resulting from an increase in the quantity of money—due to an increase in the mining of gold, for example—by restricting circulation credit, the central banks of issue would borrow more on the market. Paying off these obligations later could hardly be described as “controlling the money market.” For the bank of issue, the restriction of circulation credit means the renunciation of profits. It may even mean losses.

Moreover, such a policy can be successful only if there is agreement among the banks of issue. If restriction were practiced by the central bank of one country only, it would result in relatively high costs of borrowing money within that country. The chief consequence of this would then be that gold would flow in from abroad. Insofar as this is the goal sought by the cooperation of the banks, it certainly cannot be considered a dangerous step in the attempt toward a policy of evening out the waves of the business cycle.

VII. BUSINESS FORECASTING FOR CYCLICAL POLICY AND THE BUSINESSMAN

1. Contributions of Business Cycle Research

The popularity enjoyed by contemporary business cycle research, the development of which is due above all to American economic researchers, derives from exaggerated expectations as to its usefulness in practice. With its help, it had been hoped to mechanize banking policy and business activity. It had been hoped that a glance at the business barometer would tell businessmen and those who determine banking policy how to act.

At present, this is certainly out of the question. It has already been emphasized often enough that the results of business cycle studies have only described past events and that they may be used for predicting future developments only on the basis of extremely inadequate principles. However—and this is not sufficiently noted—these principles apply solely on the assumption that the ideology calling for expansion of circulation credit has not lost its standing in the field of economic and banking policy. Once a serious start is made at directing cyclical policy toward the elimination of crises, the power of this ideology is already dissipated.

Nevertheless, one broad field remains for the employment of the results of contemporary business cycle studies. They should indicate to the makers of banking policy when the interest rate must be raised to avoid instigating credit expansion. If the study of business conditions were clear on this point and gave answers admitting of only one interpretation, so that there could be only one opinion, not only as to whether but also as to when and how much to increase the discount rate, then the advantage of such studies could not be rated highly enough. However, this is not the case. Everything that the observation of business conditions contributes in the form of manipulated data and material can be interpreted in various ways.

Even before the development of business barometers, it was already known that increases in stock market quotations and commodity prices, a rise in profits on raw materials, a drop in unemployment, an increase in business orders, the selling off of inventories, and so on, signified a boom. The question is, when should, or when must, the brakes be applied. However, no business cycle institute answers this question straightforwardly and without equivocation. What should be done will always depend on an examination of the driving forces which shape business conditions and on the objectives set for cyclical policy. Whether the right moment for action is seized can never be decided except on the basis of a careful observation of all market phenomena. Moreover, it has never been possible to answer this question in any other way. The fact that we now know how to classify and describe the various market data more clearly than before does not make the task essentially any easier.

A glance at the continuous reports on the economy and the stock market in the large daily newspapers and in the economic weeklies, which appeared from 1840 to 1910, shows that attempts have been made for decades to draw conclusions from events of the most recent past, on the basis of empirical rules, as to the shape of the immediate future. If we compare the statistical groundwork used in these attempts with those now at our disposal, then it is obvious that we have recourse to more data today. We also understand better how to organize this material, how to arrange it clearly and interpret it for graphic presentation. However, we can by no means claim, with the modern methods of studying business conditions, to have embarked on some new principle.

2. Difficulties of Precise Prediction

No businessman may safely neglect any available source of information. Thus no businessman can refuse to pay close attention to newspaper reports. Still diligent newspaper reading is no guarantee of business success. If success were that easy, what wealth would the journalists have already amassed! In the business world, success depends on comprehending the situation sooner than others do—and acting accordingly. What is recognized as “fact” must first be evaluated correctly to make it useful for an undertaking. Precisely this is the problem of putting theory into practice.

A prediction, which makes judgments which are qualitative only and not quantitative, is practically useless even if it is eventually proved right by the later course of events. There is also the crucial question of timing. Decades ago, Herbert Spencer recognized, with brilliant perception, that militarism, imperialism, socialism and interventionism must lead to great wars, severe wars. However, anyone who had started about 1890, to speculate on the strength of that insight on a depreciation of the bonds of the Three Empires51 would have sustained heavy losses. Large historical perspectives furnish no basis for stock market speculations which must be reviewed daily, weekly, or monthly at least.

It is well known that every boom must one day come to an end. The businessman’s situation, however, depends on knowing exactly when and where the break will first appear. No economic barometer can answer these questions. An economic barometer only furnishes data from which conclusions may be drawn. Since it is still possible for the central bank of issue to delay the start of the catastrophe with its discount policy, the situation depends chiefly on making judgments as to the conduct of these authorities. Obviously, all available data fail at this point.

But once public opinion is completely dominated by the view that the crisis is imminent and businessmen act on this basis, then it is already too late to derive business profit from this knowledge. Or even merely to avoid losses. For then the panic breaks out. The crisis has come.

VIII. THE AIMS AND METHOD OF CYCLICAL POLICY

1. Revised Currency School Theory

Without doubt, expanding the sphere of scientific investigation from the narrow problem of the crisis into the broader problem of the cycle represents progress.52 However, it was certainly not equally advantageous for political policies. Their scope was broadened. They began to aspire to more than was feasible.

The economy could be organized so as to eliminate cyclical changes only if (1) there were something more than muddled thinking behind the concept that changes in the value of the monetary unit can be measured, and (2) it were possible to determine in advance the extent of the effect which accompanies a definite change in the quantity of money and fiduciary media. As these conditions do not prevail, the goals of cyclical policy must be more limited. However, even if only such severe shocks as those experienced in 1857, 1873, 1900/01 and 1907, could be avoided in the future, a great deal would have been accomplished.

The most important prerequisite of any cyclical policy, no matter how modest its goal may be, is to renounce every attempt to reduce the interest rate, by means of banking policy, below the rate which develops on the market. That means a return to the theory of the Currency School, which sought to suppress all future expansion of circulation credit and thus all further creation of fiduciary media. However, this does not mean a return to the old Currency School program, the application of which was limited to banknotes. Rather it means the introduction of a new program based on the old Currency School theory, but expanded in the light of the present state of knowledge to include fiduciary media issued in the form of bank deposits.

The banks would be obliged at all times to maintain metallic backing for all notes—except for the sum of those outstanding which are not now covered by metal—equal to the total sum of the notes issued and bank deposits opened. That would mean a complete reorganization of central bank legislation. The banks of issue would have to return to the principles of Peel’s Bank Act, but with the provisions expanded to cover also bank balances subject to check. The same stipulations with respect to reserves must also be applied to the large national deposit institutions, especially the postal savings.53 Of course, for these secondary banks of issue, the central bank reserves for their notes and deposits would be the equivalent of gold reserves. In those countries where checking accounts at private commercial banks play an important role in trade—notably the United States and England—the same obligation must be exacted from those banks also.

By this act alone, cyclical policy would be directed in earnest toward the elimination of crises.

2. “Price Level” Stabilization

Under present circumstances, it is out of the question, in the foreseeable future, to establish complete “free banking” and place all banking transactions, including the granting of credit, under ordinary commercial law. Those who speak and write today on behalf of “stabilization,” “maintenance of purchasing power” and “elimination of the trade cycle,” can certainly not call this more limited approach “extreme.” On the contrary! They will reject this suggestion as not going far enough. They are demanding much more. In their view, the “price level” should be maintained by countering rising prices with a restriction in the circulation of fiduciary media and, similarly, countering falling prices by the expansion of fiduciary media.

The arguments that may be advanced in favor of this modest program have already been set forth above in the first part of this work. In our judgment, the arguments which militate against all monetary manipulation are so great that placing decisions as to the formation of purchasing power in the hands of banking officials, parliaments and governments, thus making it subject to shifting political influences, must be avoided. The methods available for measuring changes in purchasing power are necessarily defective. The effect of the various maneuvers, intended to influence purchasing power, cannot be quantitatively established—neither in advance nor even after they have taken place. Thus proposals which amount only to making approximate adjustments in purchasing power must be considered completely impractical.

Nothing more will be said here concerning the fundamental absurdity of the concept of “stable purchasing power” in a changing economy. This has already been discussed at some length. For practical economic policy, the only problem is what inflationist or restrictionist measures to consider for the partial adjustment of severe price declines or increases. Such measures, carried out in stages, step by step, through piecemeal international agreements, would benefit either creditors or debtors. However, one question remains: Whether, in view of the conflicts among interests, agreements on this issue could be reached among nations.

The viewpoints of creditors and debtors will no doubt differ widely, and these conflicts of interest will complicate still more the manipulation of money internationally, than on the national level.

3. International Complications

It is also possible to consider monetary manipulation as an aspect of national economic policy, and take steps to regulate the value of money independently, without reference to the international situation. According to Keynes,54 if there is a choice between stabilization of prices and stabilization of the foreign exchange rate, the decision should be in favor of price stabilization and against stabilization of the rate of exchange. However, a nation which chose to proceed in this way would create international complications because of the repercussions its policy would have on the content of contractual obligations.

For example, if the United States were to raise the purchasing power of the dollar over that of its present gold parity, the interests of foreigners who owed dollars would be very definitely affected as a result. Then again, if debtor nations were to try to depress the purchasing power of their monetary unit, the interests of creditors would be impaired. Irrespective of this, every change in value of a monetary unit would unleash influences on foreign trade. A rise in its value would foster increased imports, while a fall in its value would be recognized as the power to increase exports.

In recent generations, consideration of these factors has led to pressure for a single monetary standard based on gold. If this situation is ignored, then it will certainly not be possible to fashion monetary value so that it will generally be considered satisfactory. In view of the ideas prevailing today with respect to trade policy, especially in connection with foreign relations, a rising value for money is not considered desirable, because of its power to promote imports and to hamper exports.

Attempts to introduce a national policy, so as to influence prices independently of what is happening abroad, while still clinging to the gold standard and the corresponding rates of exchange, would be completely unworkable. There is no need to say any more about this.

4. The Future

The obstacles, which militate against a policy aimed at the complete elimination of cyclical changes, are truly considerable. For that reason, it is not very likely that such new approaches to monetary and banking policy, that limit the creation of fiduciary media, will be followed. It will probably not be resolved to prohibit entirely the expansion of fiduciary media. Nor is it likely that expansion will be limited to only the quantities sufficient to counteract a definite and pronounced trend toward generally declining prices. Perplexed as to how to evaluate the serious political and economic doubts which are raised in opposition to every kind of manipulation of the value of money, the people will probably forgo decisive action and leave it to the central bank managers to proceed, case by case, at their own discretion. Just as in the past, cyclical policy of the near future will be surrendered into the hands of the men who control the conduct of the great central banks and those who influence their ideas, i.e., the moulders of public opinion.

Nevertheless, the cyclical policy of the future will differ appreciably from its predecessor. It will be knowingly based on the Circulation Credit Theory of the Trade Cycle. The hopeless attempt to reduce the loan rate indefinitely by continuously expanding circulation credit will not be revived in the future. It may be that the quantity of fiduciary media will be intentionally expanded or contracted in order to influence purchasing power. However, the people will no longer be under the illusion that technical banking procedures can make credit cheaper and thus create prosperity without its having repercussions.

The only way to do away with, or even to alleviate, the periodic return of the trade cycle—with its denouement, the crisis—is to reject the fallacy that prosperity can be produced by using banking procedures to make credit cheap.

• 28[Lord Samuel Jones Loyd Overstone (1796–1883) was an early opponent of inconvertible paper money and a leading proponent of the principles of the Peel’s Act of 1844.—Ed.]
• 29[See Theory and History (1957; 1969; Auburn, Ala.: Ludwig von Mises Institute, 1985).—Ed.]
• 30[Regarding the theories of William Stanley Jevons, Henry L. Moore and William Beveridge, see Wesley Clair Mitchell’s Business Cycles (New York: National Bureau of Economic Research, 1927), pp. 12ff.—Ed.]
• 31As mentioned above, the most commonly used name for this theory is the “monetary theory.” For a number of reasons the designation “circulation credit theory” is preferable.
• 32If expressions such as cycle, wave, etc., are used in business cycle theory, they are merely illustrations to simplify the presentation. One cannot and should not expect more from a simile which, as such, must always fall short of reality.
• 33[For further explanation of the distinction between “commodity credit” and “circulation credit” see Mises’s 1946 essay “The Trade Cycle and Credit Expansion: The Economic Consequences of Cheap Money” included later in this volume, especially, pp. 193–94.—Ed.]
• 34[In 1928, fiduciary media were issued only by discounting what Mises called commodity bills, or short-term (90 days or less) bills of exchange endorsed by a buyer and a seller and constituting a lien on the goods sold.—Ed.]
• 35Albert Hahn and Joseph Schumpeter have given me credit for the expression “forced savings” or “compulsory savings.” See Hahn’s article on “Credit” in Handwörterbuch der Staatswissenschaften (4th ed., vol. V, p. 951) and Schumpeter’s The Theory of Economic Development (2nd German language ed., 1926 [English translation, Harvard University Press, 1934), p. 109n.]). To be sure, I described the phenomenon in 1912 in the first German language edition of The Theory of Money and Credit [see 1953, pp. 208ff. and 347ff.; 1980, pp. 238ff. and 385ff. of the English translations]. However, I do not believe the expression itself was actually used there.
• 36In the language of Knut Wicksell and the classical economists.
• 37I believe this should be pointed out here again, although I have exhausted everything to be said on the subject (pp. 105–07) and in The Theory of Money and Credit [1953, pp. 361ff.; 1980, pp. 400ff.]. Anyone who has followed the discussions of recent years will realize how important it is to stress these things again and again.
• 38To avoid misunderstanding, it should be pointed out that the expression “long-waves” of the trade cycle is not to be understood here as it was used by either Wilhelm Röpke or N.D. Kondratieff. Röpke (Die Konjunktur [Jena, 1922], p. 21) considered “long-wave cycles” to be those which lasted 5–10 years generally. Kondratieff (“Die langen Wellen der Konjunktur” in Archiv für Sozialwissenschaft 56, pp. 573ff.) tried to prove, unsuccessfully in my judgment, that, in addition to the 7–11 year cycles of business conditions which he called medium cycles, there were also regular cyclical waves averaging 50 years in length.
• 39[The German term, “Sanierungskrise,” means literally “restoration crisis,” i.e., the crisis which comes at the shift to more “healthy” monetary relationships. In English this crisis is called the “stabilization crisis.”—Ed.]
• 40Lord Samuel Jones Loyd Overstone, “Reflections Suggested by a Perusal of Mr. J. Horsley Palmer’s Pamphlet on the Causes and Consequences of the Pressure on the Money Market,” 1837. (Reprinted in Tracts and Other Publications on Metallic and Paper Currency [London, 1857], p. 31.)
• 4141 See Theorie des Geldes und der Umlaufsmittel (1912), pp. 433ff. I had been deeply impressed by the fact that Lord Overstone was also apparently inclined to this interpretation. See his “Reflections,” pp. 32ff.
• 42William Douglass (1691–1752), a renowned physician, came to America in 1716. His “A Discourse Concerning the Currencies of the British Plantations in America” (1739) first appeared anonymously.
• 43[See the examples cited in The Theory of Money and Credit (pp. 387ff.; 1980, pp. 426ff.).—Ed.]
• 44Even the countries that have followed different procedures in this respect have, for all practical purposes, placed no obstacle in the way of the development of fiduciary media in the form of bank deposits.
• 45[According to Professor Mises, the “three European empires” were Austria-Hungary, Germany and Russia. This designation probably comes from the “Three Emperors’ League” (1872), an informal alliance among these governments. Its effectiveness was declining by 1890, and World War I dealt it a final blow.—Ed.]
• 46[Mises undoubtedly refers here to the way the Federal Reserve System reacted to the post World War I boom, when it brought an end to credit expansion by raising the discount rate, thus precipitating the 1920–1921 correction period, popularly called a “recession.”—Ed.]
• 47[Frédéric Bastiat (1801–1850) replied to an open letter addressed to him by an editor of Voix du Peuple (October 22, 1849). Then the Socialist, Pierre Jean Proudhon (1809–1865), answered. Proudhon, an advocate of unlimited monetary expansion by reduction of the interest rate to zero, and Bastiat, who favored moderate credit expansion and only a limited reduction of interest rates, carried on a lengthy exchange for several months, until March 7, 1850. (Oeuvres Completes de Frédéric Bastiat, 4th ed., vol. 5 [Paris, 1878], pp. 93–336.)—Ed.]
• 48This Harvard barometer was developed at the University by the Committee on Economic Research from three statistical series which are presumed to reveal (1) the extent of stock speculation, (2) the condition of industry and trade and (3) the supply of funds.
• 49[See above p. 41, note 26.—Ed.]
• 50[See above p. 68, note 11.—Ed.]
• 51Austria-Hungary, Germany, and Russia. [See above p. 130, note 45.—Ed.]
• 52Also, as a result of this, it became easier to distinguish crises originating from definite causes (wars and political upheavals, violent convulsions of nature, changes in the shape of supply or demand) from cyclically-recurring crises.
• 53[The Post Office Savings Institution, established in Austria in the 1880s and copied in several other European countries, played a significant, if limited, role in monetary affairs. See Mises’s comments in Human Action, pp. 445–46.—Ed.]
• 54John Maynard Keynes, A Tract on Monetary Reform (London, 1923; New York, 1924), pp. 156ff.