It is true, as we have said, that the only use for money is in exchange. From this, however, it must not be inferred, as some writers have done, that this exchange must be immediate. Indeed, the reason that a reservation demand for money exists and cash balances are kept is that the individual is keeping his money in reserve for future exchanges. That is the function of a cash balance—to wait for a propitious time to make an exchange.

Suppose the ERE has been established. In such a world of certainty, there would be no risk of loss in investment and no need to keep cash balances on hand in case an emergency for consumer spending should arise. Everyone would therefore allocate his money stock fully, to the purchase of either present goods or future goods, in accordance with his time preferences. No one would keep his money idle in a cash balance. Knowing that he will want to spend a certain amount of money on consumption in six months’ time, a man will lend his money out for that period to be returned at precisely the time it is to be spent. But if no one is willing to keep a cash balance longer than instantaneously, there will be no money held and no use for a money stock. Money, in short, would either be useless or very nearly so in the world of certainty.

In the real world of uncertainty, as contrasted to the ERE, even “idle” money kept in a cash balance performs a use for its owner. Indeed, if it did not perform such a use, it would not be kept in his cash balance. Its uses are based precisely on the fact that the individual is not certain on what he will spend his money or of the precise time that he will spend it in the future.

Economists have attempted mechanically to reduce the demand for money to various sources.7 There is no such mechanical determination, however. Each individual decides for himself by his own standards his whole demand for cash balances, and we can only trace various influences which different catallactic events may have had on demand.

• 7J.M. Keynes’ Treatise on Money (New York: Harcourt, Brace, 1930) is a classic example of this type of analysis.

One of the most obvious influences on the demand for money is expectation of future changes in the exchange-value of money. Thus, suppose that, at a certain point in the future, the PPM of money is expected to drop rapidly. How the demand-for-money schedule now reacts depends on the number of people who hold this expectation and the strength with which they hold it. It also depends on the distance in the future at which the change is expected to take place. The further away in time any economic event, the more its impact will be discounted in the present by the interest rate. Whatever the degree of impact, however, an expected future fall in the PPM will tend to lower the PPM now. For an expected fall in the PPM means that present units of money are worth more than they will be in the future, in which case there will be a fall in the demand-for-money schedule as people tend to spend more money now than at the future date. A general expectation of an imminent fall in the PPM will lower the demand schedule for money now and thus tend to bring about the fall at the present moment.

Conversely, an expectation of a rise in the PPM in the near future will tend to raise the demand-for-money schedule as people decide to “hoard” (add money to their cash balance) in expectation of a future rise in the exchange-value of a unit of their money. The result will be a present rise in the PPM.

An expected fall in the PPM in the future will therefore lower the PPM now, and an expected rise will lead to a rise now. The speculative demand for money functions in the same manner as the speculative demand for any good. An anticipation of a future point speeds the adjustment of the economy toward that future point. Just as the speculative demand for a good speeded adjustment to an equilibrium position, so the anticipation of a change in the PPM speeds the market adjustment toward that position. Just as in the case of any good, furthermore, errors in this speculative anticipation are “self-correcting.” Many writers believe that in the case of money there is no such self-correction. They assert that while there may be a “real” or underlying demand for goods, money is not consumed and therefore has no such underlying demand. The PPM and the demand for money, they declare, can be explained only as a perpetual and rather meaningless cat-and-mouse race in which everyone is simply trying to anticipate everyone else’s anticipations.

There is, however, a “real” or underlying demand for money. Money may not be physically consumed, but it is used, and therefore it has utility in a cash balance. Such utility amounts to more than speculation on a rise in the PPM. This is demonstrated by the fact that people do hold cash even when they anticipate a fall in the PPM. Such holdings may be reduced, but they still exist, and as we have seen, this must be so in an uncertain world. In fact, without willingness to hold cash, there could be no monetary-exchange economy whatever.

The speculative demand therefore anticipates the underlying nonspeculative demands, whatever their source or inspiration. Suppose, then, that there is a general anticipation of a rise in the PPM (a fall in prices) not reflected in underlying supply and demand. It is true that, at first, this general anticipation raises, ceteris paribus, the demand for money and the PPM. But this situation does not last. For now that a pseudo “equilibrium” has been reached, the speculative anticipators, who did not “really” have an increased demand for money, sell their money (buy goods) to reap their gains. But this means that the underlying demand comes to the fore, and this is less than the money stock at that PPM. The pressure of spending then lowers the PPM again to the true equilibrium point. This may be diagramed as in Figure 77.

Money stock is 0S; the true or underlying money demand is DD, with true equilibrium point at A. Now suppose that the people on the market erroneously anticipate that true demand will be such in the near future that the PPM will be raised to 0E. The total demand curve for money then shifts to DsDs, the new total demand curve including the speculative demand. The PPM does shift to 0E as predicted. But now the speculators move to cash in their gain, since their true demand for money really reflects DD rather than DsDs. At the new price 0E, there is in fact an excess of money stock over quantity demanded, amounting to CF. Sellers rush to sell their stock of money and buy goods, and the PPM falls again to equilibrium. Hence, in the field of money as well as in that of specific goods, speculative anticipations are self-correcting, not “self-fulfilling.” They speed the market process of adjustment.

Long-run influences on the demand for money in a progressing economy will tend to be manifold, and in both directions. On the one hand, an advancing economy provides ever more occasions for new exchanges as more and more commodities are offered on the market and as the number of stages of production increases. These greater opportunities tend greatly to increase the demand-for-money schedule. If an economy deteriorates, fewer opportunities for exchange exist, and the demand for money from this source will fall.

The major long-run factor counteracting this tendency and tending toward a fall in the demand for money is the growth of the clearing system.8 Clearing is a device by which money is economized and performs the function of a medium of exchange without being physically present in the exchange.

A simplified form of clearing may occur between two people. For example, A may buy a watch from B for three gold ounces; at the same time, B buys a pair of shoes from A for one gold ounce. Instead of two transfers of money being made, and a total of four gold ounces changing hands, they decide to perform a clearing operation. A pays B two ounces of money, and they exchange the watch and the shoes. Thus, when a clearing is made, and only the net amount of money is actually transferred, all parties can engage in the same transactions at the same prices, but using far less cash. Their demand for cash tends to fall.

There is obviously little scope for clearing, however, as long as all transactions are cash transactions. For then people have to exchange one another’s goods at the same time. But the scope for clearing is vastly increased when credit transactions come into play. These credits may be quite short-term. Thus, suppose that A and B deal with each other quite frequently during a year or a month. Suppose they agree not to pay each other immediately in cash, but to give each other credit until the end of each month. Then B may buy shoes from A on one day, and A may buy a watch from B on another. At the end of the period, the debts are canceled and cleared, and the net debtor pays one lump sum to the net creditor.

Once credit enters the picture, the clearing system can be extended to as many individuals as find it convenient. The more people engage in clearing operations (often in places called “clearinghouses”) the more cancellations there will be, and the more money will be economized. At the end of the week, for example, there may be five people engaged in clearing, and A may owe B ten ounces, B owe C ten ounces, C owe D, etc., and finally E may owe A ten ounces. In such a case, 50 ounces’ worth of debt transactions and potential cash transactions are settled without a single ounce of cash being used.

Clearing, then, is a process of reciprocal cancellations of money debts. It permits a huge quantity of monetary exchanges without actual possession and transfer of money, thereby greatly reducing the demand for money. Clearing, however, cannot be all-encompassing, for there must be some physical money which could be used to settle the transaction, and there must be physical money to settle when there is no 100-percent cancellation (which rarely occurs).

• 8On the clearing system, see Mises, Theory of Money and Credit, pp. 281–86.

A popular fallacy rejects the concept of “demand for money” because it is allegedly always unlimited. This idea misconceives the very nature of demand and confuses money with wealth or income. It is based on the notion that “people want as much money as they can get.” In the first place, this is true for all goods. People would like to have far more goods than they can procure now. But demand on the market does not refer to all possible entries on people’s value scales; it refers to effective demand, to desires made effective by being “demanded,” i.e., by the fact that something else is “supplied” for it. Or else it is reservation demand, which takes the form of holding back the good from being sold. Clearly, effective demand for money is not and cannot be unlimited; it is limited by the appraised value of the goods a person can sell in exchange and by the amount of that money which the individual wants to spend on goods rather than keep in his cash balance.

Furthermore, it is, of course, not “money” per se that he wants and demands, but money for its purchasing power, or “real” money, money in some way expressed in terms of what it will purchase. (This purchasing power of money, as we shall see below, cannot be measured.) More money does him no good if its purchasing power for goods is correspondingly diluted.

We have been discussing money, and shall continue to do so in the current section, by comparing equilibrium positions, and not yet by tracing step by step how the change from one position to another comes about. We shall soon see that in the case of the price of money, as contrasted with all other prices, the very path toward equilibrium necessarily introduces changes that will change the equilibrium point. This will have important theoretical consequences. We may still talk, however, as if money is “neutral,” i.e., does not lead to such changes, because this assumption is perfectly competent to deal with the problems analyzed so far. This is true, in essence, because we are able to use a general concept of the “purchasing power of money” without trying to define it concretely in terms of specific arrays of goods. Since the concept of the PPM is relevant and important even though its specific content changes and cannot be measured, we are justified in assuming that money is neutral as long as we do not need a more precise concept of the PPM.

We have seen how changes in the money relation change the PPM. In the determination of the interest rate, we must now modify our earlier discussion in chapter 6 to take account of allocating one’s money stock by adding to or subtracting from one’s cash balance. A man may allocate his money to consumption, investment, or addition to his cash balance. His time preferences govern the proportion which an individual devotes to present and to future goods, i.e., to consumption and to investment. Now suppose a man’s demand-for-money schedule increases, and he therefore decides to allocate a proportion of his money income to increasing his cash balance. There is no reason to suppose that this increase affects the consumption/investment proportion at all. It could, but if so, it would mean a change in his time preference schedule as well as in his demand for money.

If the demand for money increases, there is no reason why a change in the demand for money should affect the interest rate one iota. There is no necessity at all for an increase in the demand for money to raise the interest rate, or a decline to lower it—no more than the opposite. In fact, there is no causal connection between the two; one is determined by the valuations for money, and the other by valuations for time preference.

Let us return to the section in chapter 6 on Time Preference and the Individual’s Money Stock. Did we not see there that an increase in an individual’s money stock lowers the effective time-preference rate along the time-preference schedule, and conversely that a decrease raises the time-preference rate? Why does this not apply here? Simply because we were dealing with each individual’s money stock and assuming that the “real” exchange-value of each unit of money remained the same. His time-preference schedule relates to “real” monetary units, not simply to money itself. If the social stock of money changes or if the demand for money changes, the objective exchange-value of a monetary unit (the PPM) will change also. If the PPM falls, then more money in the hands of an individual may not necessarily lower the time-preference rate on his schedule, for the more money may only just compensate him for the fall in the PPM, and his “real money stock” may therefore be the same as before. This again demonstrates that the money relation is neutral to time preference and the pure rate of interest.

An increased demand for money, then, tends to lower prices all around without changing time preference or the pure rate of interest Thus, suppose total social income is 100, with 70 allocated to investment and 30 to consumption. The demand for money increases, so that people decide to hoard a total of 20. Expenditure will now be 80 instead of 100, 20 being added to cash balances. Income in the next period will be only 80, since expenditures in one period result in the identical income to be allocated to the next period.9 If time preferences remain the same, then the proportion of investment to consumption in the society will remain roughly the same, i.e., 56 invested and 24 consumed. Prices and nominal money values and incomes fall all along the line, and we are left with the same capital structure, the same real income, the same interest rate, etc. The only things that have changed are nominal prices, which have fallen, and the proportion of total cash balances to money income, which has increased.

A decreased demand for money will have the reverse effect. Dishoarding will raise expenditure, raise prices, and, ceteris paribus, maintain the real income and capital structure intact. The only other change is a lower proportion of cash balances to money income.

The only necessary result, then, of a change in the demand-for-money schedule is precisely a change in the same direction of the proportion of total cash balances to total money income and in the real value of cash balances. Given the stock of money, an increased scramble for cash will simply lower money incomes until the desired increase in real cash balances has been attained.

If the demand for money falls, the reverse movement occurs. The desire to reduce cash balances causes an increase in money income. Total cash remains the same, but its proportion to incomes, as well as its real value, declines.10

• 9Since no one can receive a money income unless someone else makes a money expenditure on his services. (See chapter 3 above.)
• 10Strictly, the ceteris paribus condition will tend to be violated. An increased demand for money tends to lower money prices and will therefore lower money costs of gold mining. This will stimulate gold mining production until the interest return on mining is again the same as in other industries. Thus, the increased demand for money will also call forth new money to meet the demand. A decreased demand for money will raise money costs of gold mining and at least lower the rate of new production. It will not actually decrease the total money stock unless the new production rate falls below the wear-and-tear rate. Cf. Jacques Rueff, “The Fallacies of Lord Keynes’ General Theory” in Henry Hazlitt, ed., The Critics of Keynesian Economics (Princeton, N.J.: D. Van Nostrand, 1960), pp. 238–63.

Many economists, beginning with Irving Fisher, have asserted that the market rate of interest, in addition to containing specific entrepreneurial components superimposed on the pure rate of interest, also contains a “price” or a “purchasing-power component.” When the purchasing power of money is generally expected to rise, the theory asserts that the market rate of interest falls correspondingly; when the PPM is expected to fall, the theory declares that the market rate of interest rises correspondingly.

These economists erred by concentrating on the loan rate rather than on the natural rate (the rate of return). The reasoning behind this theory was as follows: If the purchasing power of money is expected to change, then the pure rate of interest (determined by time preference) will no longer be the same in “real terms.” Suppose that 100 gold ounces exchange for 105 gold ounces a year from now—i.e., that the rate of interest is 5 percent. Now, suddenly, let there be a general expectation that the purchasing power of money will increase. In that case, a lower amount to be returned, say 102 ounces, may yield 5 percent real interest in terms of purchasing power. A general expectation of a rise in purchasing power, therefore, will lower the market rate of interest at present, while a general expectation of a fall in purchasing power will raise the rate.28

There is a fatal defect in this generally accepted line of reasoning. Suppose, for example, that prices are generally expected to fall by 50 percent in the next year. Would someone lend 100 gold ounces to exchange for 53 ounces one year from now? Why not? This would certainly preserve the real interest rate at 5 percent. But then why should the would-be lenders not simply hold on to their money and double their real assets as a result of the price fall? And that is precisely what they would do; they certainly would not give money away, even though their real assets would be greater than before. Fisher simply shrugged off this point by saying that the purchasing-power premium could never make the interest rate negative. But this flaw vitiates the entire theory.

The root of the difficulty consists in ignoring the natural rate of interest. Let us consider the interest rate in those terms. Then, suppose 100 ounces are paid for factors that will be transformed in one year into a product that sells for 105 gold ounces, for an interest gain of five and an interest return of 5 percent. Now a general expectation arises of a general halving of prices one year from now. The selling price of the product will be 53 ounces in a year’s time. What happens now? Will entrepreneurs buy factors for 100 and sell at 53 merely because their real interest rate is preserved? Certainly not. They will do so only if they do not at all anticipate the change in purchasing power. But to the extent that it is anticipated, they will hold money rather than buy factors. This will immediately lower factor prices to their expected future levels, say from 100 to 50.

What happens to the loan rate is analytically quite trivial. It is simply a reflection of the natural rate and depends on how the expectations and judgment of the people on the loan market compare with those on the stock and other markets. For the free economy, there is no point in separately analyzing the loan market. Analysis of the Fisher problem—the relation of the interest rate to price changes—should concentrate on the natural rate of interest. Discussion of the relation between price movements and the (natural) rate of interest should be divided into two parts: first, assuming “neutral money”—that all prices change equally and at the same time—and second, analyzing conditions where factor and product change at different rates. And these changes should first be analyzed without considering that they had been anticipated by people on the market.

Suppose, first, that all prices change equally and at the same time. Instead of thinking in terms of 100 ounces borrowed on the loan market, let us consider the natural rate. An investor buys factors in period 1 and then sells the product, say in period 3. Time, as we have seen, is the essence of the production structure. All the processes take time, and capitalists pay money to owners of factors in advance of production and sale. Since factors are bought before products are sold, what is the effect of a period of rising general prices (i.e., falling PPM)? The result is that the entrepreneur reaps an apparent extra profit. Suppose that he normally purchases original factors for 100 and then sells the product for 120 ounces two years later, for an interest return of 10 percent per annum. Now suppose that a decrease in the demand for money or an increase of money stock propels a general upward movement in prices and that all prices double in two years’ time. Then, just because of the passage of time, an entrepreneur who purchases factors for 100 now will sell for 240 ounces in two years’ time. Instead of a net return of 20 ounces, or 10 percent per annum, he reaps 140 ounces, or 70 percent per annum.

It would seem that a rise in prices creates an inherent tendency for large-scale profits that are not simply individual rewards for more accurate forecasting. However, more careful analysis reveals that this is not an extra profit at all. For the 240 ounces two years from now is roughly equivalent, in terms of purchasing power, to 120 ounces now. The real rate of net return, based on money’s services, is the same 10 percent as it has always been. It is clear that any lower net return would amount to a decline in real return. A return of a mere 120 ounces, for example, would amount to a drastic negative real return, for 100 ounces would then be invested for the equivalent gross return of only 60 ounces. It has often been shown that a period of rising prices misleads businessmen into thinking that their increased money profits are also real gains, whereas they only maintain real rates of return. Consider, for example, “replacement costs”—the prices which the businessmen will now have to pay for factors. The capitalist who earns 240 ounces on a 100-ounce investment neglects to his sorrow the fact that his factor bundle now costs 200 ounces instead of 100. Businessmen who under such circumstances treat their monetary profits as real profits and consume them soon find that they are really consuming their capital.

The converse occurs in the case of falling prices. The capitalist buys factors in period 1 and sells the product in period 3, when all-around prices are lower. If prices are to fall by a half in two years, an investment of 100, followed by a sale at 60, does not really involve the terrific loss that it appears to be. For the 60 return is equivalent in real terms, both in generalized purchasing power and in replacement of factors, to 120 previous ounces. His real rate of return remains the same. The consequence is that businessmen will be likely to overstate their losses in a period of price contraction. Perhaps this is one of the major reasons for the deep-seated belief of most businessmen that they always gain during a general price expansion and lose during a period of general contraction. This belief is purely illusory.

In these examples, the natural interest rate on the market has contained a purchasing-power component, which corrects for real rates, positively in money terms during a general expansion, and negatively during a general contraction. The loan rate will be simply a reflection of what has been happening in the natural rate. So far, the discussion is similar to Fisher’s, except that these are the effects of actual, not anticipated, changes and the Fisher thesis cannot take account of the negative interest rate case. We have seen that rather than take a monetary loss, even though their real return will be the same, entrepreneurs will hold back their purchases of factors until factor prices fall immediately to their future low level. But this process of anticipatory price movement does not occur only in the extreme case of a prospective “negative” return. It happens whenever a price change is anticipated. Thus, suppose all entrepreneurs generally anticipate that prices will double in two years. The fact of an anticipated rise will lead to an increase in the price level now and an approach immediately toward a doubled price level. An anticipated fall will lead to an immediate fall in factor prices. If all changes were anticipated by everyone, there would be no room for a purchasing-power component to develop. Prices would simply fall immediately to their future level.

The purchasing-power component, then, is not the reflection, as has been thought, of expectations of changes in purchasing power. It is the reflection of the change itself; indeed, if the change were completely anticipated, the purchasing power would change immediately, and there would be no room for a purchasing-power component in the rate of interest. As it is, partial anticipations speed up the adjustment of the PPM to the changed conditions.

So far we have distinguished three components of the natural rate of interest (all reflected in the loan rate of interest). One is the pure rate of interest—the result of individual time preferences, tending to be uniform throughout the economy. Second are the specific entrepreneurial rates of interest. These differ from firm to firm and so are not uniform. They are anticipated in advance, and they are the rates that an investor will have to anticipate receiving before he enters the field. A particularly “risky” venture, if successful at all, will therefore tend to earn more in net return than what is generally anticipated to be a “safe” venture. The third component of the natural rate of interest is the purchasing-power component, correcting for general PPM changes because of the inevitable time lags in production. This will be positive in an expansion and negative in a contraction, but will be ephemeral. The more that changes in the PPM are anticipated, the less important will be the purchasing-power component and the more rapid will be the adjustment in the PPM itself.

There is still a fourth component in the natural rate of interest. This exists to the extent that money changes are not neutral (and they never are). Sometimes product prices rise and fall faster than factor prices, sometimes they rise and fall more slowly, and sometimes their behavior is mixed, with some factor prices and some product prices rising more rapidly. Whenever there is a general divergence in rates of movement between the prices of the product and of original factors, a terms-of-trade component emerges in the natural rate of interest.

Historically, it has often been the case that product prices rise more rapidly and fall more rapidly than the prices of original factors. In the former case, there is, during the period of transition, a favorable change in the terms of trade to the general run of capitalists. For selling prices are increasing faster than the buying prices of original factors. This will increase the general rate of return and constitute a general positive terms-of-trade component in the natural rate of interest. This, of course, will also tend to be reflected in the loan rate of interest. In the case of a contraction, a more sluggish fall in the prices of factors creates a general negative terms-of-trade component in the interest rate. The components are precisely the reverse whenever factor prices change more rapidly than product prices. Whenever there is no general change in the “terms of trade” to capitalist-entrepreneurs, no terms-of-trade component will appear in the interest rate.

Changes in terms of trade discussed here are only those resulting purely from differences in the speed of reaction to changing conditions. They do not include basic changes in the terms of trade resulting from changes in time preferences, such as we have discussed above.

It is clear that all the interest-rate components aside from the pure rate—entrepreneurial, purchasing power, and terms of trade—are “dynamic” and the result of uncertainty. None of these components would exist in the ERE, and therefore the market interest rate in the ERE would equal the pure rate determined by time preferences alone. In the ERE the only net incomes would be a uniform pure interest return and wages to labor (ground land rents being capitalized into an interest return).

• 28Irving Fisher, The Rate of Interest (New York, 1907), chap. v, xiv; idem, Purchasing Power of Money, pp. 56–59.

The total stock of money in a society is the total number of ounces of the money commodity available. Throughout this volume we have deliberately used “gold ounces” instead of “dollars” or any other name for money, precisely because on the free market the latter would only be a confusing term for units of weight of gold or silver.

The total stock, from one period to another, will increase from new production and decrease from being used up—either in industrial production as a nonmonetary factor or from the wear and tear of coins. Since one of the qualities of the money commodity is its durability, the usual tendency is a long-run increase in the money supply and a resulting gradual long-run decline in the PPM. This furthers social utility only in so far as more gold or silver is made available for nonmonetary purposes.

We saw in chapter 3 that the physical form of the monetary commodity makes no difference. It can be in nonmonetary use as jewelry, in the form of bars of bullion, or in the form of coins. On the free market, transforming gold from one shape to another would be a business like any other business, charging a market price for its service and earning a pure interest return in the ERE. Since gold begins as bullion and ends as coin, it would seem that the latter would command a small premium over the equivalent weight of the former, the bullion often being a capital good for coin. Sometimes, however, coins are remelted back into bullion for larger transactions, so that a premium for coin over bullion is not a certainty. If, as generally happens, minting coins costs more than melting, coins will command the equivalent premium over bullion. This premium is called brassage.

It is impossible for economics to predict the details of the structure of any market. The market for privately issued gold bars or coins might develop as homogeneous, like the market for wheat, or the coins might be stamped and branded by the coin-makers to certify to the quality of their product. Probably the public would buy only branded coins to ensure accurate quality.

One argument against permitting free private coinage is that compulsory standardization of the denominations of coins is more convenient than the diversity of coins that would ensue under a free system. But if the market finds it more convenient, private mints will be led by consumer demand to mint certain standard denominations. On the other hand, if greater variety is preferred, consumers will demand and obtain a more varied number of coins.29

• 29For an exposition of the feasibility of private coinage, see Spencer, Social Statics, pp. 438–39; Charles A. Conant, The Principles of Money and Banking (New York: Harper & Bros., 1905), I, 127–32; Lysander Spooner, A Letter to Grover Cleveland (Boston: B.R. Tucker, 1886), p. 79; B.W. Barnard, “The Use of Private Tokens for Money in the United States,” The Quarterly Journal of Economics, 1916–17, pp. 617–26.
       Recent writers favorable to private coinage include: Everett Ridley Taylor, Progress Report on a New Bill of Rights (Diablo, Calif.: the author, 1954); Oscar B. Johannsen, “Advocates Unrestricted Private Control over Money and Banking,” The Commercial and Financial Chronicle, June 12, 1958, pp. 2622f.; and Leonard E. Read, Government—An Ideal Concept (Irvington-on-Hudson, N.Y.: Foundation for Economic Education, 1954), pp. 82ff. An economist hostile to market-controlled commodity money has recently conceded the feasibility of private coinage under a commodity standard. Milton Friedman, A Program for Monetary Stability (New York: Fordham University Press, 1960), p. 5.

Chapter 2 described the difference between “claims to present goods” and “claims to future goods.” The same analysis applies to money as to barter. A claim to future money is a bill of exchange—an evidence of a credit transaction. The holder of the bill—the creditor—redeems it at the date of redemption in exchange for money paid by the debtor. A claim to present money, however, is a completely different good. It is not the evidence of an uncompleted transaction, an exchange of a present for a future good, as is the bill; it is a simple evidence of ownership of a present good. It is not uncompleted, or an exchange on the time market. Therefore, to present this evidence for redemption is not the completion of a transaction or equivalent to a creditor’s calling his loan; it is a simple repossessing of a man’s own good. In chapter 2 we gave as examples of a claim to present goods warehouse receipts and shares of stock. Shares of stock, however, cannot be redeemed in parts of a company’s fixed assets because of the rules of ownership that the companies themselves set up in their co-operative venture. Furthermore, there is no guarantee that such assets will have a fixed money value. We shall therefore confine ourselves to warehouse receipts, which are also more relevant to the supply of money.

When a man deposits goods at a warehouse, he is given a receipt and pays the owner of the warehouse a certain sum for the service of storage. He still retains ownership of the property; the owner of the warehouse is simply guarding it for him. When the warehouse receipt is presented, the owner is obligated to restore the good deposited. A warehouse specializing in money is known as a “bank.”

Claims to goods are often treated on the market as equivalent to the goods themselves. If no fraud or theft is suspected, then evidence of ownership of a good in a warehouse is considered as equivalent to the good itself. In many cases, individuals will find it advantageous to exchange the claims or evidences—the goods-substitutes—rather than the goods themselves. Paper is more convenient to transfer from person to person, and the expense of moving the goods is eliminated. When Jones sells Smith his wheat, therefore, instead of moving the wheat from one place to another, they may well agree simply to transfer the warehouse receipt itself from Jones to Smith. The goods remain in the same warehouse until Smith needs them or until the receipt is transferred to someone else. Of course, Smith may prefer, for one reason or another, to keep the goods in his own warehouse, in which case they are moved from one to the other.

Let us take the case of a warehouse owned by the Trustee Warehouse Company. It holds various goods in its vaults for safekeeping. Suppose that this company has developed a reputation for being very reliable and theft-free. Consequently, people tend to leave their goods in the Trustee Warehouse for a considerable length of time and, in the case of goods that they do not use frequently, will even tend to transfer the goods-certificates (the warehouse receipts, or evidences of ownership of the goods) and not redeem the goods themselves. Thus, the goods-certificates act as goods-substitutes in exchange. Suppose that the Trustee Company sees this happening. It realizes that a good opportunity for fraud presents itself. It can take the depositors’ goods, the goods that it holds for safekeeping, and lend them out to people on the market. It can earn interest on these loans, and as long as only a small percentage of depositors ask to redeem their certificates at any one time, no one is the wiser. Or, alternatively, it can issue pseudo warehouse receipts for goods that are not there and lend these on the market. This is the more subtle practice. The pseudo receipts will be exchanged on the market on the same basis as the true receipts, since there is no indication on their face whether they are legitimate or not.

It should be clear that this practice is outright fraud. Someone else’s property is taken by the warehouse and used for its own money-making purposes. It is not borrowed, since no interest is paid for the use of the money. Or, if spurious warehouse receipts are printed, evidences of goods are issued and sold or loaned without any such goods being in existence.

Money is the good most susceptible to these practices. For money, as we have seen, is generally not used directly at all, but only for exchanges. It is, furthermore, a widely homogeneous good, and therefore one ounce of gold is interchangeable with any other. Since it is convenient to transfer paper in exchange rather than carry gold, money warehouses (or banks) that build up public confidence will find that few people redeem their certificates. The banks will be particularly subject to the temptation to commit fraud and issue pseudo money certificates to circulate side by side with genuine money certificates as acceptable money-substitutes. The fact that money is a homogeneous good means that people do not care whether the money they redeem is the original money they deposited. This makes bank frauds easier to accomplish.

“Fraud” is a harsh term, but an accurate one to describe this practice, even if not recognized as such in the law, or by those committing it. It is, in fact, difficult to see the economic or moral difference between the issuance of pseudo receipts and the appropriation of someone else’s property or outright embezzlement or, more directly, counterfeiting. Most present legal systems do not outlaw this practice; in fact, it is considered basic banking procedure. Yet the libertarian law of the free market would have to prohibit it. The purely free market is, by definition, one where theft and fraud (implicit theft) are illegal and do not exist.

To part with goods or money held in trust or to issue spurious warehouse receipts is, of course, a dangerous business, even when the law permits it. If the warehouse once failed to meet its contractual obligations, its fraud would be discovered, and a general panic “run” on the warehouse or bank would ensue. It would then be quickly plunged into bankruptcy. Such a bankruptcy, however, would not be similar to the failure of an ordinary speculative business enterprise. It is rather similar to the absconder who gets caught before he has returned the funds he has “borrowed.”

Even if the receipt does not say on its face that the warehouse guarantees to keep it in its vaults, such an agreement is implicit in the very issuance of the receipt. For it is obvious that if any pseudo receipts are issued, it immediately becomes impossible for the bank to redeem all of them, and therefore fraud is immediately being committed. If a bank has 20 pounds of gold in its vaults, owned by depositors, and gold certificates redeemable on demand for 30 pounds, then notes to the value of 10 pounds are fraudulent. Which particular receipts are fraudulent can be determined only after a run on the bank has occurred and the later claimants are left unsatisfied.

In a purely free market where fraud cannot, by definition, occur, all bank receipts will be genuine, i.e., will represent only actual gold or silver in the vaults. In that case, all the bank’s money-substitutes (warehouse receipts) will also be money certificates, i.e., each receipt genuinely certifies the actual existence of the money in its vaults. The amount of gold kept in bank vaults for redemption purposes is called its “reserves,” and the policy of issuing only genuine receipts is therefore a policy of “100-percent reserves” of cash to demand liabilities (liabilities that must be paid on demand).30 However, the term “reserve” is a misleading one, because it assumes that the bank owns the gold and independently decides how much of it to keep on hand. Actually, it is not the bank that owns the gold, but its depositors.31

An enormous literature has developed dealing with the physical form of the money receipts, and yet the physical form is of no economic importance. It may be in the form of a paper note, a token coin (essentially a note stamped on coin instead of paper), or a book credit (demand deposit) in the bank. The demand deposit is not tangibly held by the owner, but can be transferred to anyone he desires by written order to the bank. This order is called a check. The depositor has a choice of which form of receipt to take, according to his convenience. Which form he chooses makes no economic difference.

• 30Time deposits are, legally, future claims, since banks have a legal right to delay payment 30 days. Moreover, they do not pass as final media of exchange. The latter fact is not determining, however, since a secure claim to a money-substitute is itself part of the money supply. “Idle” cash balances are kept as “time deposits,” just as gold bullion is a more “idle” form of money than coins. The deciding factor, perhaps, is that the 30-day limit is virtually a dead letter, for if a “savings” bank should impose it, a bankrupting “run” on the bank would ensue. Furthermore, actual payments are sometimes made by “cashiers’ checks” on time deposits. Thus, “time” deposits now function as demand deposits and should be treated as part of the money supply. If banks wished to act as genuine savings banks, borrowing and lending credit, they could issue I.O.U’s for specified lengths of time, due at definite future dates. Then no confusion or possible “counterfeiting” could arise.
• 31Such items as bills of lading, pawn tickets, and dock warrants have been warehouse receipts rooted in the specific objects deposited, in contrast to the loose “general deposits” where a homogeneous good can be returned. See W. Stanley Jevons, Money and the Mechanism of Exchange (16th ed.; London: Kegan Paul, Trench, Trübner & Co., 1907), pp. 201–11.

Since money-substitutes exchange as money on the market, we must consider them as part of the supply of money. It then becomes necessary to distinguish between money (in the broader sense)—the common medium of exchange—and money proper. Money proper is the ultimate medium of exchange or standard money—here the money commodity—while the supply of money (in a broader sense) includes all the standard money plus the money-substitutes that are held in individuals’ cash balances. In the cases cited above, gold was the money proper or standard money, while the receipts—the demand claims to gold—were the money-substitutes.

The relation between these elements may be illustrated as follows: Assume a community of three persons, A, B, C, and three money warehouses, X, Y, Z. Suppose that each person has 100 ounces of gold in his possession and none on deposit at a warehouse. For the community, then:

The total supply of money is here identical with the total supply of money proper.

Now assume that A and B each deposits his 100 ounces of gold at warehouses X and Y respectively, while C keeps his gold on hand. The total supply of money is always equal to the total of individual cash balances. Its composition now is:

A—100 ounces of X-Money-Substitute
B—100 ounces of Y-Money-Substitute
C—100 ounces of Gold Money Proper

Total supply of money (in the broader sense) = Total cash balances = 200 ounces of money-substitutes + 100 ounces of money proper.

The effect of the deposit of money proper in the warehouses or banks is to change the composition of the total supply of money in cash balances; the total amount, however, remains unchanged at 300 ounces. Money-substitutes of various banks have replaced most of the standard money in individual cash holdings. Similarly, if A and B were to redeem their deposits, the total amount would remain unchanged, while the composition would revert to the original pattern.

What of the 200 ounces of gold deposited in the vaults of the banks? These are no longer part of the money supply; they are held in reserve against the outstanding money-substitutes. While in reserve, they form no part of any individual’s cash balance; the cash balances consist not of the gold, but of evidences of ownership of the gold. Only the money proper outside of bank reserves forms part of individuals’ cash balances and hence part of the community’s supply of money.

Thus, as long as all money-substitutes are full money certificates, an increase or decrease in the money-substitutes outstanding can have no effect on the total supply of money. Only the composition of that supply is affected, and such changes in composition are of no economic importance.

However, when banks are legally permitted to abandon a 100-percent reserve and to issue pseudo receipts, the economic effects are quite different. We may call the money-substitutes that are not genuine money certificates, uncovered money-substitutes, since they do not genuinely represent money. The issue of uncovered money-substitutes adds to individuals’ cash balances and hence to the total supply of money. Uncovered money-substitutes are not offset by new money deposits and so constitute net additions to the total supply. Any increase or decrease in the supply of uncovered money-substitutes increases or decreases to the same extent the total supply of money (in the broader sense).

Thus, the total supply of money is composed of the following elements: supply of money proper outside reserves + supply of money certificates + supply of uncovered money-substitutes. The supply of money certificates has no effect on the size of the supply of money; an increase in this factor only decreases the size of the first factor. The supply of money proper and the factors determining its size have already been discussed. It depends on annual production compared to annual wear and tear, and thus, on the unhampered market, the supply of money-proper changes only slowly. As for uncovered money-substitutes, since they are essentially a phenomenon of the hampered rather than the free market, factors governing their supply will be further discussed below, in chapter 12.

In the meanwhile, however, let us analyze a little further the difference between a 100-percent-reserve and a fractional-reserve bank. The Star Bank, let us suppose, is a 100-percent-reserve bank; it is established with 100 gold ounces of capital invested by its stockholders in building and equipment. In the familiar balance sheet, with assets on the left-hand side and liabilities and capital on the right-hand side, the condition of the bank now appears as follows:

The Star Bank is ready to begin operations. Several people now come and deposit gold in the bank, which in return issues warehouse receipts giving the depositors (the true owners of the gold) the right to redeem their property on demand at any time. Let us assume that after a few months 5,000 gold ounces have been deposited and stored in the bank’s vaults. Its balance sheet now appears as follows:

The warehouse receipts function and exchange as money-substitutes, replacing, not adding to, the gold stored in the bank. All the warehouse receipts are money certificates, 100-percent reserve has been maintained, and no invasion of the free market has occurred. The warehouse receipts may take the form of printed tickets (notes) or book credit (demand deposits) transferable by written order or “check.” The two are economically identical.

But now suppose that law enforcement is lax and the bank sees that it can make money easily by engaging in fraud, i.e., by lending some of the depositors’ gold (or, rather, issuing pseudo warehouse receipts for nonexistent gold and lending them) to people who wish to borrow it.32 Let us say that the Star Bank, chafing at the mere interest return earned on its fees for warehouse service, prints 1,000 ounces of pseudo warehouse receipts and lends them on the credit market to businesses and consumers who desire to borrow money. The balance sheet of the Star Bank is now as follows:

The warehouse receipts still function as money-substitutes on the market. And we see that new money has been created by the bank out of thin air, as if by magic. This process of money creation has also been called the “monetization of debt,” an apt term since it describes the only instance where a liability can be transformed into money—the supreme asset. It is obvious that the more money the bank creates, the more profits it will earn, for any income earned on newly created money is a pure unalloyed gain. The bank has been able to alter the conditions of the free market system, in which money can be obtained only by purchase, mining, or gift. In each of these routes, productive service—either one’s own or one’s ancestor’s or benefactor’s—was necessary in order to obtain money. The bank’s inflationary intervention has created another route to money: the creation of new money out of thin air, by issuing receipts for nonexistent gold.33 ,34

• 32We might ask why the owners of the bank do not really reap the spoils and lend the money to themselves. The answer is that they once did so profusely, as the history of early American banking shows. Legal regulations forced the banks to abandon this practice.
• 33This discussion is not meant to imply that bankers, particularly at the present time, are always knowingly engaged in fraudulent practices. So embedded, indeed, have these practices become, and always with the sanction of law as well as of sophisticated but fallacious economic doctrines, that it is undoubtedly a rare banker who regards his standard occupational procedure as fraudulent.
• 34For a brilliant discussion of fractional-reserve banking, see Amasa Walker, The Science of Wealth (3rd ed.; Boston: Little, Brown & Co., 1867), pp. 138–68, 184–232.

One popular criticism of 100-percent bank reserves charges that the bank could not then earn any income or cover costs of storage, printing, etc. On the contrary, a bank is perfectly capable of operating like any goods warehouse, i.e., by charging its customers for its services to them and reaping the usual interest return on its operations.

Another popular objection is that a 100-percent-reserve policy would eliminate all credit. How would businessmen be able to borrow funds for short-term investment? The answer is that businessmen can still borrow saved funds from any individual or institution. “Banks” may still lend their own saved funds (capital stock and accumulated surplus) or they may borrow funds from individuals and relend them to business firms, earning the interest differential.35 Borrowing money (e g., floating a bond) is a credit transaction; an individual exchanges his present money for a bond—a claim on future money. The borrowing bank pays him interest for this loan and in turn exchanges the money thus gathered for promises by business borrowers to pay money in the future. This is a further credit transaction, in this case the bank acting as the lender and businesses as the borrowers. The bank’s income is the interest differential between the two types of credit transactions; the payment is for the services of the bank as an intermediary, channeling the savings of the public into investment. There is, furthermore, no particular reason why the short-term, more than any other, credit market should be subsidized by money creation.

Finally, an important criticism of a governmentally enforced policy of 100-percent reserves is that this measure, though beneficial in itself, would establish a precedent for other governmental intervention in the monetary system, including a change in this very requirement by government edict. These critics advocate “free banking,” i.e., no governmental interference with banking apart from enforcing payment of obligations, the banks to be permitted to engage in any fictitious issues they desire. Yet the free market does not mean freedom to commit fraud or any other form of theft. Quite the contrary. The criticism may be obviated by imposing a 100-percent-reserve requirement, not as an arbitrary administrative fiat of the government, but as part of the general legal defense of property against fraud. As Jevons stated: “It used to be held as a general rule of law, that any present grant or assignment of goods not in existence is without operation,”36 and this general rule need only be revived and enforced to outlaw fictitious money-substitutes. Then banking could be left perfectly free and yet be without departure from 100-percent reserves.37

• 35Swiss banks have successfully and for a long time been issuing debentures to the public at varying maturities, and banks in Belgium and Holland have recently followed suit. On the purely free market, such practices would undoubtedly be greatly extended. Cf. Benjamin H. Beck-hart, “ To Finance Term Loans,” The New York Times, May 31, 1960.
• 36Jevons, Money and the Mechanism of Exchange, pp. 211–12.
• 37Jevons stated:
  If pecuniary promises were always of a special character, there could be no possible harm in allowing perfect freedom in the issue of promissory notes. The issuer would merely constitute himself a warehouse keeper and would be bound to hold each special lot of coin ready to pay each corresponding note. (Ibid., p. 208)

The price of any commodity tends to be the same throughout the entire area using it. We have seen that this rule is not violated by the fact that cotton in Georgia, for example, is priced lower than cotton in New York. When cotton in New York is a consumers’ good, cotton in Georgia is a capital good in relation to the former. Cotton in Georgia is not the same commodity as cotton in New York because goods must first be processed in one location and then transported to the places where they are consumed.

Money is no exception to the rule that the price of every commodity will tend to be uniform throughout the entire area in which it is used. In fact, the scope for the money commodity is broader. Other commodities are produced in certain centers and must then be transported to other centers where they are consumed. They are therefore not the same “good” in different geographical locations; in the producing centers they are capital goods. Money, it is true, must first be mined and then shipped to places of use. But, once mined, the money commodity is used only for exchange. For these purposes, it is from then on shipped back and forth throughout the world market. Therefore, there is no really important capital-good location for money separate from a consumers’-good location. Whereas all other goods are first produced and then moved to the place where they are used and consumed, money is used interchangeably throughout the entire market area, moving back and forth. Therefore, the tendency toward geographical uniformity in the purchasing power of money holds true for the physical commodity gold or silver, and there is no need for that commodity to be treated as a different good in one place or another.

The purchasing power of money will therefore be identical over the entire area. Should the PPM be lower in New York than in Detroit, the supply of money for the exchange of goods will diminish in New York and increase in Detroit. Prices of goods being higher in New York than in Detroit, people will spend less in New York and more in Detroit than heretofore, this shift being reflected in the movement of money. This action will tend to raise the purchasing power of money in New York and lower it in Detroit, until its purchasing power in the two places is equal. The purchasing power of money will, in this way, tend to remain equal in all places where the money is used, whether or not national boundaries happen to intervene.

Some people contend that, on the contrary, there do exist permanent differences in the purchasing power of money from place to place. For example, they point to the fact that prices for food in restaurants are higher in New York City than in Peoria. For most people, however, New York has certain definite advantages over Peoria. It has a vastly wider range of goods and services available to the consumer, including theaters, concerts, colleges, high-quality jewelry and clothing, and stockbrokerage houses. There is a great difference between the commodity “restaurant service in New York” and the commodity “restaurant service in Peoria.” The former allows the purchaser to remain in New York and to enjoy its various advantages. Thus, the two are distinct goods, and the fact that the price of restaurant service is greater in New York signifies that the preponderance of individuals on the market value the former more highly and consider it a commodity of higher quality.40

Costs of transport, however, do introduce a qualification into this analysis. Suppose that the PPM in Detroit is slightly higher than in Rochester. We would expect gold to flow from Rochester to Detroit, spending relatively more on goods in the latter place, until the PPM’s are equalized. If, however, the PPM in Detroit is higher by an amount smaller than the transport cost of shipping the gold from Rochester, then relative PPM’s have a leeway to differ within the zone of shipping costs of gold. It would then be too expensive to ship gold to Detroit to take advantage of the higher PPM. The interspatial PPM’s may vary in either direction within this cost-of-transport margin.41

Many critics allege that the PPM cannot be uniform throughout the world because some goods are not transferable from one locale to another. Times Square or Niagara Falls, for example, cannot be transferred from one region to another; they are specific to their locale. Therefore, it is alleged, the equalization process can take place only for those goods which “enter into interregional trade”; it does not apply to the general PPM.

Plausible as it seems, this objection is completely fallacious. In the first place, disparate goods like Times Square and other main streets are different goods, so that there is no reason to expect them to have the same price. Secondly, so long as one commodity can be traded, the PPM can be equalized. The composition of the PPM may well be changed, but this does not refute the fact of equalization. The process of equalization can be deduced from the fact of human action, even though, as we shall see, the PPM cannot be measured, since its composition does not remain the same.

Finally, since any good can be traded, what is there to prevent, for example, Oshkosh capital from buying a building on Times Square? The Oshkosh capitalists need not literally transport a good back to Oshkosh in order to buy it and make money from their investment. Every good, then, “enters into interregional trade”; no distinction between “domestic” and “interregional” (or “international”) goods can be made.

Thus, suppose the PPM is higher in Oshkosh than in New York. New Yorkers tend to buy more in Oshkosh, and Oshkoshians will buy less in New York. This does not only mean that New York will buy more Oshkosh wheat, or that Oshkosh will buy less New York clothing. It also means that New Yorkers will invest in real estate or theaters in Oshkosh, while Oshkoshians will sell some of their New York holdings.

• 40For an appreciation of Mises’ achievement in clarifying this problem, see Wu, An Outline of International Price Theories, pp. 127, 232–34.
• 41As we shall see below, however, interlocal clearing can greatly narrow these limits.

Clearing is particularly appropriate for interlocal transactions, since costs of transporting money from one locale to another are likely to be heavy. Bills of exchange on each town (i.e., I.O.U.’s owed by each town) can be reciprocally canceled. Suppose that there are two traders, A and B, in Detroit, and two in Rochester, C and D. A sells C a refrigerator for 200 gold grams, and D sells B a TV set for 200 grams. The two debts can be cleared, and no money need be shipped from one place to the other. On the other hand, D’s sale of a TV set may total 120 grams. Suppose for a moment that these are the only traders in the two communities. Then 80 grams will have to be shipped from Rochester to Detroit. In the latter case, the citizens of Detroit have, on net balance, decided to add to their cash holdings, while the Rochesterites have decided to diminish their cash holdings.

Economists have often described interlocal trade in terms of “gold export points” and “gold import points.” The use of such expressions assumes, however, that even though two localities both use gold money, it makes sense to talk of an “exchange rate” of the money of one locality for that of another. This exchange rate is set between the margins fixed by the cost of transporting money—the “gold import” and “gold export” points. This does not hold true on the free market, however. On such a market, all coins and bullion are expressed in terms of weight of gold, and it makes no sense whatever to speak of an “exchange rate” of the money of one place for the same money in another. How can there be an “exchange rate” of an ounce of gold for an ounce of gold? There will be no legal tender or other laws to separate the value of the coins of one area from those of another. Therefore, there may be slight variations in the PPM in each locale, within the limits of the cost of transporting gold, but there could never be deviations from par in interlocal “exchange rates.” For there are no exchange rates on the free market, except for two or more coexisting money commodities.

We saw in chapter 3 how one or more very easily marketable commodities were chosen by the market as media of exchange, thereby greatly increasing their marketability and becoming more and more generally used until they could be called money. We have implicitly assumed that there are one or two media that are fully marketable—always salable—and other commodities that are simply sold for money. We have omitted mention of the degrees of marketability of these goods. Some goods are more readily marketable than others. And some are so easily marketable that they rise practically to the status of quasi moneys.

Quasi moneys do not form part of the nation’s money supply. The conclusive test is that they are not used to settle debts, nor are they claims to such means of payment at par. However, they are held as assets by individuals and are considered so readily marketable that an extra demand arises for them on the market. Their existence lowers the demand for money, since holders can economize on money by keeping them as assets. The price of these goods is higher than otherwise because of their quasi-monetary status.

In Oriental countries jewels have traditionally been held as quasi moneys. In advanced countries quasi moneys are usually short-term debts or securities that have a broad market and are readily salable at the highest price the market will yield. Quasi moneys include high-grade debentures, some stocks, and some wholesale commodities. Debentures used as quasi moneys have a higher price than otherwise and therefore a lower interest yield than will accrue on other investments.44

• 44Cf. Mises, Human Action, pp. 459–61.

In previous sections we saw that bills of exchange are not money-substitutes, but credit instruments. Money-substitutes are claims to present money, equivalent to warehouse receipts. But some critics maintain that in Europe at the turn of the nineteenth century bills did circulate as money-substitutes. They circulated as final payment in advance of their due dates, their face value discounted for the period of time left for maturity. Yet these were not money-substitutes. The holder of a bill was a creditor. Each of the acceptors of the bill had to endorse its payment, and the credit standing of each endorser had to be examined to judge the soundness of the bill. In short, as Mises has stated:

The endorsement of the bill is in fact not a final payment; it liberates the debtor to a limited degree only. If the bill is not paid then his liability is revived in a greater degree than before.45

Hence, the bills could not be classed as money-substitutes.

• 45Mises, Theory of Money and Credit, pp. 285–86.

In olden times, before the development of economic science, people naively assumed that the value of money remained always unchanged. “Value” was assumed to be an objective quantity inhering in things and their relations, and money was the measure, the fixed yardstick, of the values of goods and their changes. The value of the monetary unit, its purchasing power with respect to other goods, was assumed to be fixed.58 The analogy of a fixed standard of measurement, which had become familiar to the natural sciences (weight, length, etc.), was unthinkingly applied to human action.

Economists then discovered and made clear that money does not remain stable in value, that the PPM does not remain fixed. The PPM can and does vary, in response to changes in the supply of or the demand for money. These, in turn, can be resolved into the stock of goods and the total demand for money. Individual money prices, as we have seen in section 8 above, are determined by the stock of and demand for money as well as by the stock of and demand for each good. It is clear, then, that the money relation and the demand for and the stock of each individual good are intertwined in each particular price transaction. Thus, when Smith decides whether or not to purchase a hat for two gold ounces, he weighs the utility of the hat against the utility of the two ounces. Entering into every price, then, is the stock of the good, the stock of money, and the demand for money and the good (both ultimately based on individuals’ utilities). The money relation is contained in particular price demands and supplies and cannot, in practice, be separated from them. If, then, there is a change in the supply of or demand for money, the change will not be neutral, but will affect different specific demands for goods and different prices in varying proportions. There is no way of separately measuring changes in the PPM and changes in the specific prices of goods.

The fact that the use of money as a medium of exchange enables us to calculate relative exchange ratios between the different goods exchanged against money has misled some economists into believing that separate measurement of changes in the PPM is possible. Thus, we could say that one hat is “worth,” or can exchange for, 100 pounds of sugar, or that one TV set can exchange for 50 hats. It is a temptation, then, to forget that these exchange ratios are purely hypothetical and can be realized in practice only through monetary exchanges, and to consider them as constituting some barter-world of their own. In this mythical world, the exchange ratios between the various goods are somehow determined separately from the monetary transactions, and it then becomes more plausible to say that some sort of method can be found of isolating the value of money from these relative values and establishing the former as a constant yardstick. Actually, this barter-world is a pure figment; these relative ratios are only historical expressions of past transactions that can be effected only by and with money.

Let us now assume that the following is the array of prices in the PPM on day one:

• 10 cents per pound of sugar
• 10 dollars per hat
• 500 dollars per TV set
• 5 dollars per hour legal service of Mr. Jones, lawyer.

Now suppose the following array of prices of the same goods on day two:

• 15 cents per pound of sugar
• 20 dollars per hat
• 300 dollars per TV set
• 8 dollars per hour of Mr. Jones’ legal service.

Now what can economics say has happened to the PPM over these two periods? All that we can legitimately say is that now one dollar can buy 1/20 of a hat instead of 1/10 of a hat, 1/300 of a TV set instead of 1/500 of a set, etc. Thus, we can describe (if we know the figures) what happened to each individual price in the market array. But how much of the price rise of the hat was due to a rise in the demand for hats and how much to a fall in the demand for money? There is no way of answering such a question. We do not even know for certain whether the PPM has risen or declined. All we do know is that the purchasing power of money has fallen in terms of sugar, hats, and legal services, and risen in terms of TV sets. Even if all the prices in the array had risen we would not know by how much the PPM had fallen, and we would not know how much of the change was due to an increase in the demand for money and how much to changes in stocks. If the supply of money changed during this interval, we would not know how much of the change was due to the increased supply and how much to the other determinants.

Changes are taking place all the time in each of these determinants. In the real world of human action, there is no one determinant that can be used as a fixed benchmark; the whole situation is changing in response to changes in stocks of resources and products and to the changes in the valuations of all the individuals on the market. In fact, one lesson above all should be kept in mind when considering the claims of the various groups of mathematical economists: in human action there are no quantitative constants.59 As a necessary corollary, all praxeological-economic laws are qualitative, not quantitative.

The index-number method of measuring changes in the PPM attempts to conjure up some sort of totality of goods whose exchange ratios remain constant among themselves, so that a kind of general averaging will enable a separate measurement of changes in the PPM itself. We have seen, however, that such separation or measurement is impossible.

The only attempt to use index numbers that has any plausibility is the construction of fixed-quantity weights for a base period. Each price is weighted by the quantity of the good sold in the base period, these weighted quantities representing a typical “market basket” proportion of goods bought in that period. The difficulties in such a market-basket concept are insuperable, however. Aside from the considerations mentioned above, there is in the first place no average buyer or housewife. There are only individual buyers, and each buyer has bought a different proportion and type of goods. If one person purchases a TV set, and another goes to the movies, each activity is the result of differing value scales, and each has different effects on the various commodities. There is no “average person” who goes partly to the movies and buys part of a TV set. There is therefore no “average housewife” buying some given proportion of a totality of goods. Goods are not bought in their totality against money, but only by individuals in individual transactions, and therefore there can be no scientific method of combining them.

Secondly, even if there were meaning to the market-basket concept, the utilities of the goods in the basket, as well as the basket proportions themselves, are always changing, and this completely eliminates any possibility of a meaningful constant with which to measure price changes. The nonexistent typical housewife would have to have constant valuations as well, an impossibility in the real world of change.

All sorts of index numbers have been spawned in a vain attempt to surmount these difficulties: quantity weights have been chosen that vary for each year covered; arithmetical, geometrical, and harmonic averages have been taken at variable and fixed weights; “ideal” formulas have been explored—all with no realization of the futility of these endeavors. No such index number, no attempt to separate and measure prices and quantities, can be valid.60

• 58Conventional accounting practice is based on a fixed value of the monetary unit.
• 59Professor Mises has pointed out that the assertion of the mathematical economists that their task is made difficult by the existence of “many variables” in human action grossly understates the problem; for the point is that all the determinants are variables and that in contrast to the natural sciences there are no constants.
• 60See the brilliant critique of index numbers by Mises, Theory of Money and Credit, pp. 187–94. Also see R.S. Padan, “Review of C.M. Walsh’s Measurement of General Exchange Value,” Journal of Political Economy, September, 1901, p. 609.

The knowledge that the purchasing power of money could vary led some economists to try to improve on the free market by creating, in some way, a monetary unit which would remain stable and constant in its purchasing power. All these stabilization plans, of course, involve in one way or another an attack on the gold or other commodity standard, since the value of gold fluctuates as a result of the continual changes in the supply of and the demand for gold. The stabilizers want the government to keep an arbitrary index of prices constant by pumping money into the economy when the index falls and taking money out when it rises. The outstanding proponent of “stable money,” Irving Fisher, revealed the reason for his urge toward stabilization in the following autobiographical passage: “I became increasingly aware of the imperative need of a stable yardstick of value. I had come into economics from mathematical physics, in which fixed units of measure contribute the essential starting point.”61 Apparently, Fisher did not realize that there could be fundamental differences in the nature of the sciences of physics and of purposeful human action.

It is difficult, indeed, to understand what the advantages of a stable value of money are supposed to be. One of the most frequently cited advantages, for example, is that debtors will no longer be harmed by unforeseen rises in the value of money, while creditors will no longer be harmed by unforeseen declines in its value. Yet if creditors and debtors want such a hedge against future changes, they have an easy way out on the free market. When they make their contracts, they can agree that repayment be made in a sum of money corrected by some agreed-upon index number of changes in the value of money. Such a voluntary tabular standard for business contracts has long been advocated by stabilizationists, who have been rather puzzled to find that a course which appears to them so beneficial is almost never adopted in business practice. Despite the multitude of index numbers and other schemes that have been proposed to businessmen by these economists, creditors and debtors have somehow failed to take advantage of them. Yet, while stabilization plans have made no headway among the groups that they would supposedly benefit the most, the stabilizationists have remained undaunted in their zeal to force their plans on the whole society by means of State coercion.

There seem to be two basic reasons for this failure of business to adopt a tabular standard: (a) As we have seen, there is no scientific, objective means of measuring changes in the value of money. Scientifically, one index number is just as arbitrary and bad as any other. Individual creditors and debtors have not been able to agree on any one index number, therefore, that they can abide by as a measure of change in purchasing power. Each, according to his own interests, would insist on including different commodities at different weights in his index number. Thus, a debtor who is a wheat farmer would want to weigh the price of wheat heavily in his index of the purchasing power of money; a creditor who goes often to nightclubs would want to hedge against the price of night-club entertainment, etc. (b) A second reason is that businessmen apparently prefer to take their chances in a speculative world rather than agree on some sort of arbitrary hedging device. Stock exchange speculators and commodity speculators are continually attempting to forecast future prices, and, indeed, all entrepreneurs are engaged in anticipating the uncertain conditions of the market. Apparently, businessmen are willing to be entrepreneurs in anticipating future changes in purchasing power as well as any other changes.

The failure of business to adopt voluntarily any sort of tabular standard seems to demonstrate the complete lack of merit in compulsory stabilization schemes. Setting this argument aside, however, let us examine the contention of the stabilizers that somehow they can create certainty in the purchasing power of money, while at the same time leaving freedom and uncertainty in the prices of particular goods. This is sometimes expressed in the statement: “Individual prices should be left free to change; the price level should be fixed and constant.” This contention rests on the myth that some sort of general purchasing power of money or some sort of price level exists on a plane apart from specific prices in specific transactions. As we have seen, this is purely fallacious. There is no “price level,” and there is no way that the exchange-value of money is manifested except in specific purchases of goods, i.e., specific prices. There is no way of separating the two concepts; any array of prices establishes at one and the same time an exchange relation or objective exchange-value between one good and another and between money and a good, and there is no way of separating these elements quantitatively.

It is thus clear that the exchange-value of money cannot be quantitatively separated from the exchange-value of goods. Since the general exchange-value, or PPM, of money cannot be quantitatively defined and isolated in any historical situation, and its changes cannot be defined or measured, it is obvious that it cannot be kept stable. If we do not know what something is, we cannot very well act to keep it constant.62

We have seen that the ideal of a stabilized value of money is impossible to attain or even define. Even if it were attainable, however, what would be the result? Suppose, for example, that the purchasing power of money rises and that we disregard the problem of measuring the rise. Why, if this is the result of action on an unhampered market, should we consider it a bad result? If the total supply of money in the community has remained constant, falling prices will be caused by a general increase in the demand for money or by an increase in the supply of goods as a result of increased productivity. An increased demand for money stems from the free choice of individuals, say, in the expectation of a more troubled future or of future price declines. Stabilization would deprive people of the chance to increase their real cash holdings and the real value of the dollar by free, mutually agreed-upon actions. As in any other aspect of the free market, those entrepreneurs who successfully anticipate the increased demand will benefit, and those who err will lose in their speculations. But even the losses of the latter are purely the consequence of their own voluntarily assumed risks. Furthermore, falling prices resulting from increased productivity are beneficial to all and are precisely the means by which the fruits of industrial progress spread on the free market. Any interference with falling prices blocks the spread of the fruits of an advancing economy; and then real wages could increase only in particular industries, and not, as on the free market, over the economy as a whole.

Similarly, stabilization would deprive people of the chance to decrease their real cash holdings and the real value of the dollar, should their demand for money fall. People would be prevented from acting on their expectations of future price increases. Furthermore, if the supply of goods should decline, a stabilization policy would prevent the price rises necessary to clear the various markets.

The intertwining of general purchasing power and specific prices raises another consideration. For money could not be pumped into the system to combat a supposed increase in the value of money without distorting the previous exchange-values between the various goods. We have seen that money cannot be neutral with respect to goods and that, therefore, the whole price structure will change with any change in the supply of money. Hence, the stabilizationist program of fixing the value of money or price level without distorting relative prices is necessarily doomed to failure. It is an impossible program.

Thus, even were it possible to define and measure changes in the purchasing power of money, stabilization of this value would have effects that many advocates consider undesirable. But the magnitudes cannot even be defined, and stabilization would depend on some sort of arbitrary index number. Whichever commodities and weights are included in the index, pricing and production will be distorted.

At the heart of the stabilizationist ideal is a misunderstanding of the nature of money. Money is considered either a mere numeraire or a grandiose measure of values. Forgotten is the truth that money is desired and demanded as a useful commodity, even when this use is only as a medium of exchange. When a man holds money in his cash balance, he is deriving utility from it. Those who neglect this fact scoff at the gold standard as a primitive anachronism and fail to realize that “hoarding” performs a useful social function.

• 61Irving Fisher, Stabilised Money (London: George Allen & Unwin, 1935), p. 375.
• 62The fact that the purchasing power of the monetary unit is not quantitatively definable does not negate the fact of its existence, which is established by prior praxeological knowledge. It thereby differs, for example, from the “competitive price–monopoly price” dichotomy, which cannot be independently established by praxeological deduction for free-market conditions.

Investment, though the dynamic and volatile factor in the Keynesian system, is also the Keynesian stepchild. Keynesians have differed on the causal determinants of investment. Originally, Keynes determined it by the interest rate as compared with the marginal efficiency of capital, or prospect for net return. The interest rate is supposed to be determined by the money relation; we have seen that this idea is fallacious. Actually, the equilibrium net rate of return is the interest rate, the natural rate to which the bond rate conforms. Rather than changes in the interest rate causing changes in investment, as we have seen before, changes in time preference are reflected in changes in consumption-investment decisions. Changes in the interest rate and in investment are two sides of a coin, both determined by individual valuations and time preferences.

The error of calling the interest rate the cause of investment changes, and itself determined by the money relation, is also adopted by such “critics” of the Keynesian system as Pigou, who asserts that falling prices will release enough cash to lower the interest rate, stimulate investment, and thus finally restore full employment.

Modern Keynesians have tended to abandon the intricacies of the relation between interest and investment and simply declare themselves agnostic on the factors determining investment. They rest their case on an alleged determination of consumption.70

• 70Some Keynesians account for investment by the “acceleration principle” (see below). The Hansen “stagnation” thesis—that investment is determined by population growth, the rate of technological improvement, etc.—seems happily to be a thing of the past.

If Keynesians are unsure about investment, they have, until very recently, been very emphatic about consumption. Investment is a volatile, uncertain expenditure. Aggregate consumption, on the other hand, is a passive, stable “function” of immediately previous social income. Total net expenditures determining and equaling total net income in a period (gross expenditures between stages of production are unfortunately removed from discussion) consist of investment and consumption. Furthermore, consumption always behaves so that below a certain income level consumption will be higher than income, and above that level consumption will be lower. Figure 82 depicts the relations among consumption, investment, expenditure, and social income.

The relation between income and expenditure is the same as shown in Figure 78. Now we see why the Keynesians assume the expenditure curve to have a smaller slope than income. Consumption is supposed to have the identical slope as expenditures; for investment is unrelated to income, as the determinants are unknown. Hence, investment is depicted as having no functional relation to income and is represented as a constant gap between the expenditure and consumption lines.

The stability of the passive consumption function, as contrasted with the volatility of active investment, is a keystone of the Keynesian system. This assumption is replete with so many grave errors that it is necessary to take them up one at a time.

(a) How do the Keynesians justify the assumption of a stable consumption function with the shape as shown above? One route was through “budget studies”—cross-sectional studies of the relation between family income and expenditure by income groups in a given year. Budget studies such as that of the National Resources Committee in the mid-1930’s yielded similar “consumption functions” with dishoardings increasing below a certain point, and hoardings above it (i.e., income below expenditures below a certain point, and expenditures below income above it).

This is supposed to intimate that those doing the “dissaving,” i.e., the dishoarding, are poor people below the subsistence level who incur deficits by borrowing. But how long is this supposed to go on? How can there be a continuous deficit? Who would continue to lend these people the money? It is more reasonable to suppose that the dishoarders are decumulating their previously accumulated capital, i.e., that they are wealthy people whose businesses suffered losses during that year.

(b) Aside from the fact that budget studies are misinterpreted, there are graver fallacies involved. For the curve given by the budget study has no relation whatever to the Keynesian consumption function! The former, at best, gives a cross section of the relation between classes of family expenditure and income for one year; the Keynesian consumption function attempts to establish a relation between total social income and total social consumption for any given year, holding true over a hypothetical range of social incomes. At best, one entire budget curve can be summed up to yield only one point on the Keynesian consumption function. Budget studies, therefore, can in no way confirm the Keynesian assumptions.

(c) Another very popular device to confirm the consumption function reached the peak of its popularity during World War II. This was historical-statistical correlation of national income and consumption for a definite period of time, usually the 1930’s. This correlation equation was then assumed to be the “stable” consumption function. Errors in this procedure were numerous. In the first place, even assuming such a stable relation, it would only be an historical conclusion, not a theoretical law. In physics, an experimentally determined law may be assumed to be constant for other identical situations; in human action, historical situations are never the same, and therefore there are no quantitative constants! Conditions and valuations could change at any time, and the “stable” relationship altered. There is here no proof of a stable consumption function. The dismal record of forecasts (such as those of postwar unemployment) made on this assumption should not have been surprising.

Moreover, a stable relation was not even established. Income was correlated with consumption and with investment. Since consumption is a much larger magnitude than (net) investment, no wonder that its percentage deviations around the regression equation were smaller! Furthermore, income is here being correlated with 80–90 percent of itself; naturally, the “stability” is tremendous. If income were correlated with saving, of similar magnitude as investment, there would be no greater stability in the income-saving function than in the “income-investment function.”

Thirdly, the consumption function is necessarily an ex ante relation; it is supposed to tell how much consumers will decide to spend given a certain total income. Historical statistics, on the other hand, record only ex post data, which give a completely different story. For any given period of time, for example, hoarding and dishoarding cannot be recorded ex post. In fact, ex post, on double-entry accounting records, total social income is always equal to total social expenditures. Yet, in the dynamic, ex ante, sense, it is precisely the divergence between total social income and total social expenditures (hoarding or dishoarding) that plays the crucial role in the Keynesian theory. But these divergences can never be revealed, as Keynesians believe, by study of ex post data. Ex post, in fact, saving always equals investment, and social expenditure always equals social income, so that the ex post expenditure line coincides with the income line.71

(d) Actually, the whole idea of stable consumption functions has now been discredited, although many Keynesians do not fully realize this fact.72 In fact, Keynesians themselves have admitted that, in the long run, the consumption function is not stable, since total consumption rises as income rises; and that in the short run it is not stable, since it is affected by all sorts of changing factors. But if it is not stable in the short run and not stable in the long run, what kind of stability does it have? Of what use is it? We have seen that the only really important runs are the immediate and the long-run, which shows the direction in which the immediate is tending. There is no use for some sort of separate “intermediate” situation.

(e) it is instructive to turn now to the reasons that Keynes himself, in contrast to his followers, gave for assuming his stable consumption function. It is a confused exposition indeed.73 The “propensity to consume” out of given income, according to Keynes, is determined by two sets of factors, “objective” and “subjective.” It seems clear, however, that these are purely subjective decisions, so that there can be no separate objective determinants. In classifying subjective factors, Keynes makes the mistake of subsuming hoarding and investing motivations under categories of separate “causes”: precaution, foresight, improvement, etc. Actually, as we have seen, the demand for money is ultimately determined by each individual for all sorts of reasons, but all tied up with uncertainty; motives for investment are to maintain and increase future standards of living. By a sleight of hand completely unsupported by facts or argument Keynes simply assumes all these subjective factors to be given in the short run, although he admits that they will change in the long run. (If they change in the long run, how can his system yield an equilibrium position?) He simply reduces the subjective motives to current economic organization, customs, standards of living, etc., and assumes them to be given.74 The “objective factors” (which in reality are subjective, such as time-preference changes, expectations, etc.) can admittedly cause short-run changes in the consumption function (such as windfall changes in capital values). Expectations of future changes in income can affect an individual’s consumption, but Keynes simply asserts without discussion that this factor “is likely to average out for the community as a whole.” Time preferences are discussed in a very confused way, with interest rate and time preference assumed to be apart from and influencing the propensity to consume. Here again, short-run fluctuations are assumed to have little effect, and Keynes simply leaps to the conclusion that the propensity to consume is, in the short run, a “fairly” stable function.75

(f) The failure of the consumption-function theory is not only the failure of a specific theory. It is a profound epistemological failure as well. For the concept of a consumption function has no place in economics at all. Economics is praxeological, i.e., its propositions are absolutely true given the existence of the axioms—the basic axiom being the existence of human action itself. Economics, therefore, is not and cannot be “empirical” in the positivist sense, i.e., it cannot establish some sort of empirical hypothesis which could or could not be true, and at best is only true approximately. Quantitative, empiricohistorical “laws” are worthless in economics, since they may only be coincidences of complex facts, and not isolable, repeat-able laws which will hold true in the future. The idea of the consumption function is not only wrong on many counts; it is irrelevant to economics.

Furthermore, the very term “function” is inappropriate in a study of human action. Function implies a quantitative, determined relationship, whereas no such quantitative determinism exists. People act and can change their actions at any time; no causal, constant, external determinants of action can exist. The term “function” is appropriate only to the unmotivated, repeat-able motion of inorganic matter.

In conclusion, there is no reason whatever to assume that at some point, expenditures will be below income, while at lower points it will be above income. Economics does not and cannot know what ex ante expenditure will ever be in relation to income; at any point, it could be equal, or there could be net hoarding or dishoarding. The ultimate decisions are made by the individuals and are not determinable by science. There is, therefore, no stable expenditure function whatever.

• 71See Lindahl, “On Keynes’ Economic System—Part I,” p. 169 n. Lindahl shows the difficulties of mixing an ex post income line with ex ante consumption and spending, as the Keynesians do. Lindahl also shows that the expenditure and income lines coincide if the divergence between expected and realized income affects income and not stocks. Yet it cannot affect stocks, for, contrary to Keynesian assertion, there is no such thing as hoarding or any other unexpected event leading to “unintended increase in inventories.” An increase in inventories is never unintended, since the seller has the alternative of selling the good at the market price. The fact that his inventory increases means that he has voluntarily invested in larger inventory, hoping for a future price rise.
• 72Summing up disillusionment with the consumption function are two significant articles: Murray E. Polakoff, “Some Critical Observations on the Major Keynesian Building Blocks,” Southern Economic Journal, October, 1954, pp. 141–51; and Leo Fishman, “Consumer Expectations and the Consumption Function,” ibid., January, 1954, pp. 243–51.
• 73Keynes, General Theory, pp. 89–112.
• 74Ibid., pp. 109–10.
• 75What is “fairly” supposed to mean? How can a theoretical law be based on “fair” stability? More stable than other functions? What are the grounds for this assumption, particularly as a law of human action? Ibid., pp. 89–96.

The once highly esteemed “multiplier” has now happily faded in popularity, as economists have begun to realize that it is simply the obverse of the stable consumption function. However, the complete absurdity of the multiplier has not yet been fully appreciated. The theory of the “investment multiplier” runs somewhat as follows:

Social Income = Consumption + Investment

Consumption is a stable function of income, as revealed by statistical correlation, etc. Let us say, for the sake of simplicity, that Consumption will always be .80 (Income).76 In that case,

Income = .80 (Income) + Investment.
.20 (Income) = Investment; or
Income = 5 (Investment).

The “5” is the “investment multiplier.” It is then obvious that all we need to increase social money income by a desired amount is to increase investment by 1/5 of that amount; and the multiplier magic will do the rest. The early “pump primers” believed in approaching this goal through stimulating private investment; later Keynesians realized that if investment is an “active” volatile factor, government spending is no less active and more certain, so that government spending must be relied upon to provide the needed multiplier effect. Creating new money would be most effective, since the government would then be sure not to reduce private funds. Hence the basis for calling all government spending “investment”: it is “investment” because it is not tied passively to income.

The following is offered as a far more potent “multiplier,” on Keynesian grounds even more potent and effective than the investment multiplier, and on Keynesian grounds there can be no objection to it. It is a reductio ad absurdum, but it is not simply a parody, for it is in keeping with the Keynesian method.

Social Income = Income of (insert name of any person, say the reader) + Income of everyone else.

Let us use symbols:

Social income = Y
Income of the Reader = R
Income of everyone else = V

We find that V is a completely stable function of Y. Plot the two on coordinates, and we find historical one-to-one correspondence between them. It is a tremendously stable function, far more stable than the “consumption function.” On the other hand, plot R against Y. Here we find, instead of perfect correlation, only the remotest of connections between the fluctuating income of the reader of these lines and the social income. Therefore, this reader’s income is the active, volatile, uncertain element in the social income, while everyone else’s income is passive, stable, determined by the social income.

Let us say the equation arrived at is:

This is the reader’s own personal multiplier, a far more powerful one than the investment multiplier. To increase social income and thereby cure depression and unemployment, it is only necessary for the government to print a certain number of dollars and give them to the reader of these lines. The reader’s spending will prime the pump of a 100,000-fold increase in the national income.77

• 76Actually, the form of the Keynesian function is generally “linear,” e.g., Consumption = .80 (Income) + 20. The form given in the text simplifies the exposition without, however, changing its essence.
• 77Also see Hazlitt, Failure of the “New Economics,” pp. 135–55.