4. Interpreting History: The Role of Theory

But though all our knowledge begins with experience, it does not follow that it all arises from experience.23
– IMMANUEL KANT

There is no comprehension of real events, of the reality of life, without theory. In order to recognize something like “interest,” “money supply” or “gross national product,” for example, one has to base one’s analysis on a theory; a theory that combines the “diversity of phenomena” in a systematic and consistent way. The fact that theory is indispensable for our knowledge of world events, however, is repeatedly overlooked and even questioned with fervor. Immanuel Kant pointed out this mistake in his essay “On the Old Saw: That May Be Right in Theory but It Won’t Work in Practice” as early as 1793.

Man must necessarily resort to theories in order to recognize reality. He cannot think without theory. Ludwig von Mises made this clear: “Thinking and acting are inseparable. Every action is always based on a definite idea about causal relations. He who thinks a causal relation thinks a theorem. Action without thinking, practice without theory are unimaginable. The reasoning may be faulty and the theory incorrect; but thinking and theorizing are not lacking in any action.”24

Economic theories are not vain academic basic exercises, not abstract games. Rather, they have great practical relevance. This can be seen, for example, in the interpretation of experiences of historical economic or social events, which are nothing more than past human actions. History is not a finished book, not an objective book, but its material, its testimonies in speech and writing, must be laid out and interpreted. Seen in this light, historical science is an understanding science: its task is to document what has happened, to make understandable the reasons why people have acted in one way or another.

Why did the Emperor Wilhelm II (1859–1941) dismiss Chancellor Otto von Bismarck (1815–98) in March 1890? What are the reasons that led many governments in the early 1970s to abolish their currencies’ gold backing and use unsecured paper money? Why did the global financial and economic crisis in 2008–09 occur? Why was Trump elected forty-fifth president of the United States?

Historical events of human action must necessarily be recorded and understood with the aid of theories. This is no easy task: anyone who wants to grasp and interpret the history of human action in a meaningful way must resort to a multitude of fields of knowledge: for example, natural sciences such as biology, chemistry, and medicine, but also social sciences such as economics in particular. In other words: it is necessary to apply the method of understanding based on the experiential and natural sciences but also the a priori sciences of logic, mathematics, and economics, and to ensure that understanding does not conflict with the knowledge provided by the natural and a priori sciences.25

With regard to economics, the important question arises: Which of their theories are right and which are wrong? For only by using the right theories and eliminating the wrong ones does it become possible to learn reliable lessons from the experience of human action. False theories lead to false interpretations. Economics, understood as an a priori science of action, is particularly useful in this context: it can be understood as a metatheory, as a theory of theories.

With the help of the method of reflecting on logic and action, it is possible to judge beyond doubt whether an economic theory is right or wrong. An economic theory must raise doubts about its correctness or can be rejected as false if it is not consistent with the a priori categories of action. Whether an economic theory is right or wrong can be decided without first having to “try out” the economic theory in practice.26

For example, by resorting to the logic of action, we can consider the following four (economic theory) statements to be true: (1) Any voluntary exchange is beneficial to all parties involved. If it were otherwise, it would not take place—human action means, after all, replacing one condition with another, more advantageous, condition. (2) The marginal utility of a good decreases with increasing stocks of goods; this also follows logically from the indisputable knowledge that humans act. (3) Minimum wages above market-clearing levels lead to involuntary unemployment. This is a direct result of the (logical) law of supply and demand. (4) If the money supply increases and the demand for money remains unchanged, the prices of goods rise and the purchasing power of money decreases; this also follows from the law of decreasing marginal utility, which can be justified logically.

One example of how a priori action science can shed light on history is the German hyperinflation which occurred in 1923, which, as is well known, almost completely destroyed the purchasing power of the German paper mark and led to a currency reform in November of the same year. For a long time, German economists cited the reparations paid to the victors of the First World War and a deficit in the German balance of payments as reasons for the massive decline in the value of Germany’s money. This was mainly because at that time the social scientists and economists were blindly following the thought processes of the so-called (younger) Historical school, which was inseparably linked to the economist Gustav von Schmoller (1838–1917).

The Historical school took the view that there were no laws and no a priori findings in economics. For them, therefore, the economist’s task was to sift through historical documents and interpret them subjectively; economists proceeded as if interpreting a literary text. No wonder that the German economists who took this academic approach blundered about more or less completely intellectually befogged and did not understand the world. The German economist Moritz J. Bonn (1873–1965) wrote about it:

For years the economic education of the Prussian bureaucracy was in the hands of Schmoller and his students. The negative result of this became visible in the inflation crisis after the First World War. The bureaucracy had no idea of the simplest economic terms—there was hardly anyone in the Prussian or Reich Ministry of Finance who knew anything about inflation (things were different in Austria). Moreover, Schmoller’s relativism had convinced the civil service of the insignificance of expert consultants. His students had not learned to look at the present with a view to the future, they had been taught to look backwards. They could not say what had to be done; they only knew what had been done.27

The economists of the Historical school were unaware that it was the out-of-control increase in the money supply by the Reichsbank that sealed the fate of the paper money market—a realization that can be drawn directly from the logic of human action! The explanation is that money is the generally accepted medium of exchange. The medium of exchange function is the core function of money, the increase in the money supply therefore leads—in accordance with the law of diminishing marginal utility—to a reduction in the exchange value of the monetary unit.

If the money supply increases in the hands of the market actors, then the marginal utility of the additionally received monetary unit decreases and the other goods become comparatively more valuable compared to money. The money holders then exchange their money for other goods—offer their money on the market for other goods. The consequence is that goods prices rise. And the steeper the rise of the money supply, the greater will be the effect of price increases and thus the decline in money’s purchasing power. Ludwig von Mises formulated the logical a priori explanation demonstrating that the demand for money is not independent of the money supply or its increase as follows:

But if once public opinion is convinced that the increase in the quantity of money will continue and never come to an end, and that consequently the prices of all commodities and services will not cease to rise, everybody becomes eager to buy as much as possible and to restrict his cash holding to a minimum size. For under these circumstances the regular costs incurred by holding cash are increased by the losses caused by the progressive fall in purchasing power. The advantages of holding cash must be paid for by sacrifices which are deemed unreasonably burdensome. This phenomenon was, in the great European inflations of the Twenties, called flight into real goods (Flucht in die Sachwerte) or crack-up boom (Katastrophenhausse).28

The a priori science of action, however, does not only help to interpret historical individual events in a rational, scientifically objective way.29 It also allows us to understand the social evolution, the motives for the cooperative and productive coexistence of human beings—the process of civilization—without having to resort to vague assumptions or metaphysical references. It also reveals that no state (as we have seen and experienced in history) was necessary for human civilization, for orderly coexistence in the community. This will be explained in more detail in the following chapter.

• 23Immanuel Kant, Critique of Pure Reason, trans. Marcus Weigelt (London: Penguin Books, 2007).
• 24Ludwig von Mises, Human Action: A Treatise on Economics, scholar’s ed. (Auburn, AL: Ludwig von Mises Institute, 1998), p. 177.
• 25 See Mises, Nationalökonomie, p. 55.
• 26If one were to assume, for example, that action does not require time, how would a simple supply-and-demand model be judged? If action could be taken without extending time, all the objectives pursued by the actor would be achieved immediately and instantly—and there would be no reason or possibility of acting. There would be no more action. But this cannot be thought without contradiction: humans cannot not act. For any supply-and-demand model, however simple, to be meaningful and realistic, it must explicitly or implicitly assume that any action takes place in time. Without acting in time there would be no supply-and-demand curve!
• 27Moritz Julius Bonn, So macht man Geschichte (Munich: List Verlag, 1953), pp. 53–54.
• 28Mises, Human Action, pp. 423–24.
• 29For the principles of such an interpretation of history, see Joseph T. Salerno, Introduction to A History of Money and Banking in the United States: The Colonial Era to World War II, by Murray N. Rothbard (Auburn, AL: Ludwig von Mises Institute, 2002), pp. 7–43.