The Theory of Money and Credit

That the objective exchange value of money as historically transmitted (der geschichtlich überkommene objektive Tauschwert des Geldes) is affected not only by the industrial use of the material from which it is made, but also by its monetary use, is a proposition which hardly any economist would nowadays deny. It is true that lay opinion was molded entirely by the contrary belief until very recent times. To a naive observer, money made out of precious metal was “sound money” because the piece of precious metal was an “intrinsically” valuable object, while paper money was “bad money” because its value was only “artificial.” But even the layman who holds this opinion accepts the money in the course of business transactions, not for the sake of its industrial use-value, but for the sake of its objective exchange value, which depends largely upon its monetary employment. He values a gold coin not merely for the sake of its industrial use-value, say because of the possibility of using it as jewelry, but chiefly on account of its monetary utility. But, of course, to do something, and to render an account to oneself of what one does and why one does it, are quite different things.26

Judgment upon the shortcomings of popular views about money and its value must be lenient, for even the attitude of science toward this problem has not always been free from error. Happily, the last few years have seen a gradual but definite change in popular monetary theory. It is now generally recognized that the value of money depends partly on its monetary function. This is due to the increased attention that has been devoted to questions of monetary policy since the commencement of the great controversy about the standards. The old theories proved unsatisfactory; it was not possible to explain phenomena such as those of the Austrian or Indian currency systems without invoking the assumption that the value of money originates partly in its monetary function. The naivety of the numerous writings which attacked this opinion and their complete freedom from the restraining influence of any sort of knowledge of the theory of value may occasionally lead the economist to regard them as unimportant; but they may at least claim to have performed the service of shaking deep-rooted prejudices and stimulating a general interest in the problem of prices. No doubt they are a gratifying indication of a growing interest in economic questions; if this is kept in mind, it is possible to think more generously of many erroneous monetary theories.

It is true that there has been no lack of attempts to explain the peculiar phenomena of modern monetary systems in other ways. But they have all been unsuccessful. Thus, in particular, Laughlin’s theory comes to grief in failing to take account of the special aspects of the value of money that are associated with the specifically monetary function. Quite correctly, Laughlin stresses as the peculiar characteristic of money substitutes their constant and immediate convertibility into money.27  Nevertheless, he would seem to be mistaken on a fundamental point when he applies the name of token money to such currencies as the rupee from 1893 to 1899 and the Russian ruble and Austrian gulden at the time of the suspension of cash payments. He accounts for the fact that a piece of paper which is not immediately convertible into gold can have any value at all, by reference to the possibility that it will nevertheless someday be converted. He compares inconvertible paper money with the shares of a concern which is temporarily not paying any dividend but whose shares may nevertheless have a certain exchange value because of the possibility of future dividends. And he says that the fluctuations in the exchange value of such paper money are consequently based upon the varying prospects of its ultimate conversion.28

The error in this conclusion may be most simply demonstrated by means of an actual example. Let us select for this purpose the monetary history of Austria, which Laughlin also uses as an illustration. From 1859 onward the Austrian National Bank was released from the obligation to convert its notes on demand into silver, and nobody could tell when the state paper money issued in 1866 would be redeemed, or even if it would be redeemed at all. It was not until the later 1890s that the transition to metallic money was completed by the actual resumption of cash payments on the part of the Austro-Hungarian Bank.

Now Laughlin attempts to explain the value of the Austrian currency during this period by reference to the prospect of a future conversion of the notes into metallic commodity money. He finds the basis of its value, at first in an expectation that it would be converted into silver, and afterward in an expectation that it would be converted into gold, and traces the vicissitudes of its purchasing power to the varying chances of its ultimate conversion.29

The inadmissibility of this argument can be demonstrated in a striking fashion. In the year 1884—the year is chosen at random—the five percent Austrian government bonds were quoted on the Viennese Stock Exchange at an average rate of 95.81, or 4.19 percent below par. The quotation was in terms of Austrian paper gulden. The government bonds represented claims against the Austrian state bearing interest at five percent. Thus both the bonds and the notes were claims against the same debtor. It is true that these government bonds were not repayable, that is to say, not redeemable on the part of the creditor. Nevertheless, seeing that interest was paid on them, this could not prejudice their value in comparison with that of the non-interest-bearing currency notes, which also were not redeemable; furthermore, the interest on the bonds was payable in paper money, and, if the government redeemed them, it could do this also in paper money. In fact, the bonds in question were redeemed voluntarily in 1892, long before the currency notes were converted into gold. The question now arises: How could it come about that the government bonds, bearing interest at five percent, could be valued less highly than the non-interest-bearing currency notes? This could not possibly be attributed, say, to the fact that people hoped that the currency notes would be converted into gold before the bonds were redeemed. There was no suggestion of such an expectation. Quite another circumstance decided the matter.

The currency notes were common media of exchange—they were money—and consequently, besides the value that they possessed as claims against the state, they also had a value as money. It is beyond doubt that their value as claims alone would not have been an adequate basis even for a relatively large proportion of their actual exchange value. The date of repayment of the claims that were embodied in these notes was in fact quite uncertain, but in any case very distant. As claims, it was impossible for them to have a higher exchange value than corresponded to the then value of the expectation of their repayment. Now, after the cessation of free coinage of silver it was fairly obvious that the paper gulden (and incidentally the silver gulden) would not be converted at a rate appreciably in excess of the average rate at which it circulated in the period immediately preceding the conversion. In any case, after the legal determination of the conversion ratio by the Currency Regulation Law of August 2, 1892, it was settled that the conversion of the currency notes would not take place at any higher rate than this. How could it come about, then, that the gold value of the krone (the half-gulden) already fluctuated about this rate as early as the second half of the year 1892 although the date of conversion was then still quite unknown? Usually a claim to a fixed sum, the date of payment of which lies in the uncertain future, is valued considerably less highly than the sum to which it refers. To this question Laughlin’s theory cannot offer an answer; only by taking account of the fact that the monetary function also contributes toward value is it possible to find a satisfactory explanation.

The attempts that have so far been made, to determine the quantitative significance of the forces emanating from the side of money that affect the exchange ratio existing between money and other economic goods, have followed throughout the line of thought of the quantity theory. This is not to say that all the exponents of the quantity theory had realized that the value of money is not determined solely by its nonmonetary, industrial employment, but also or even solely by its monetary function. Many quantity theorists have been of another opinion on this point and have believed that the value of money depends solely on the industrial employment of the monetary material. The majority have had no clear conception of the question at all; very few have approached its true solution. It is often hard to decide in which class certain of these authors should be placed; their phraseology is often obscure and their theories not seldom contradictory. All the same, let us suppose that all quantity theorists had recognized the significance of the monetary function in the determination of the value of the monetary material, and criticize the usefulness of their theory from this point of view.

When the determinants of the exchange ratios between economic goods were first inquired into, attention was early devoted to two factors whose importance for the pricing process was not to be denied. It was impossible to overlook the well-known connection between variations in the available quantity of goods and variations in prices, and the proposition was soon formulated that a good would rise in price if the available quantity of it diminished. Similarly, the importance of the total volume of transactions in the determination of prices was also realized. Thus, a mechanical theory of price determination was arrived at—the doctrine of supply and demand, which until very recently held such a prominent position in our science. Of all explanations of prices it is the oldest. We cannot dismiss it offhand as erroneous; the only valid objection to it is that it does not go back to the ultimate determinants of prices. It is correct or incorrect, according to the content given to the words demand and supply. It is correct, if account is taken of all the factors that motivate people in buying and selling. It is incorrect, if supply and demand are interpreted and compared in a merely quantitative sense.30

It was an obvious step to take this theory, that had been constructed to explain the reciprocal exchange ratios of commodities, and apply it to fluctuations in the relative values of commodities and money also. As soon as people became conscious of the fact of variations in the value of money at all, and gave up the naive conception of money as an invariable measure of value, they began to explain these variations also by quantitative changes in supply and demand.

It is true that the usual criticism of the quantity theory (often expressed with more resentment than is consonant with that objectivity which alone should be the distinctive mark of scientific investigation) had an easy task so far as it was leveled against the older, incomplete, version. It was not difficult to prove that the supposition that changes in the value of money must be proportionate to changes in the quantity of money, so that for example a doubling of the quantity of money would lead to a doubling of prices also, was not in accordance with facts and could not be theoretically established in any way whatever.31  It was still simpler to show the untenability of the naive version of the theory which regarded the total quantity of money and the total stock of money as equivalent.

But all these objections do not touch the essence of the doctrine. Neither can any sort of refutation or limitation of the quantity theory be deduced from the fact that a number of writers claim validity for it only on the assumption ceteris paribus; not even though they state further that this supposition never is fulfilled and never could be fulfilled.32  The assumption ceteris paribus is the self-evident appendage of every scientific doctrine and there is no economic law that can dispense with it.

Against such superficial criticism the quantity theory has been well able to defend itself triumphantly, and through the centuries, condemned by some and exalted as an indisputable truth by others, it has always been in the very center of scientific discussion. It has been dealt with in an immense literature, far beyond the power of any one person to master. It is true that the scientific harvest of these writings is but small. The theory has been adjudged “right” or “wrong,” and statistical data (mostly incomplete and incorrectly interpreted) have been used both to “prove” and to “disprove” it—although sufficient care has seldom been taken to eliminate variations brought about by accidental circumstances. On the other hand, investigation on a basis of the theory of value has but seldom been attempted.

If we wish to arrive at a just appraisal of the quantity theory we must consider it in the light of the contemporary theories of value. The core of the doctrine consists in the proposition that the supply of money and the demand for it both affect its value. This proposition is probably a sufficiently good hypothesis to explain big changes in prices; but it is far from containing a complete theory of the value of money. It describes one cause of changes in prices; it is nevertheless inadequate for dealing with the problem exhaustively. By itself it does not comprise a theory of the value of money; it needs the basis of a general value theory. One after another, the doctrine of supply and demand, the cost-of-production theory, and the subjective theory of value have had to provide the foundations for the quantity theory.

If we make use in our discussion of only one fundamental idea contained in the quantity theory, the idea that a connection exists between variations in the value of money on the one hand and variations in the relations between the demand for money and the supply of it on the other hand, our reason is not that this is the most correct expression of the content of the theory from the historical point of view, but that it constitutes that core of truth in the theory which even the modern investigator can and must recognize as useful. Although the historian of economic theory may find this formulation inexact and produce quotations to refute it, he must nevertheless admit that it contains the correct expression of what is valuable in the quantity theory and usable as a cornerstone for a theory of the value of money.

Beyond this proposition, the quantity theory can provide us with nothing. Above all, it fails to explain the mechanism of variations in the value of money. Some of its expositors do not touch upon this question at all; the others employ an inadequate principle for dealing with it. Observation teaches us that certain relations of the kind suggested between the available stock of money and the need for money do in fact exist; the problem is to deduce these relations from the fundamental laws of value and so at last to comprehend their true significance.

• 26See Wieser, Über den Ursprung und die Hauptgesetze des wirtschaftlichen Wertes, op. cit., pp. iii.
• 27See Laughlin, The Principles of Money (London, 1903), pp. 513 f.
• 28Ibid., pp. 530 f.
• 29Ibid., pp. 531 ff.
• 30See Zuckerkandl, op. cit., pp. 123 ff.
• 31See Mill, Principles of Political Economy (London, 1867), p. 299.
• 32Cf. Marshall, before the Indian Currency Committee, “Report” (London, 1898—99; Q. 11759), in Official Papers (London, 1926), p. 267.