The Theory of Money and Credit

This law of price is just as valid for indirect as for direct exchange. The price of money, like other prices, is determined in the last resort by the subjective valuations of buyers and sellers. But, as has been said already, the subjective use-value of money, which coincides with its subjective exchange value, is nothing but the anticipated use-value of the things that are to be bought with it. The subjective value of money must be measured by the marginal utility of the goods for which the money can be exchanged.
*20

It follows that a valuation of money is possible only on the assumption that the money has a certain objective exchange value. Such a
point d’appui is necessary before the gap between satisfaction and “useless” money can be bridged. Since there is no direct connection between money as such and any human want, individuals can obtain an idea of its utility and consequently of its value only by assuming a definite purchasing power. But it is easy to see that this supposition cannot be anything but an expression of the exchange ratio ruling at the time in the market between the money and commodities.
*21

Once an exchange ratio between money and commodities has been established in the market, it continues to exercise an influence beyond the period during which it is maintained; it provides the basis for the further valuation of money. Thus the past objective exchange value of money has a certain significance for its present and future valuation. The money prices of today are linked with those of yesterday and before, and with those of tomorrow and after.

But this alone will not suffice to explain the problem of the element of continuity in the value of money; it only postpones the explanation. To trace back the value that money has today to that which it had yesterday, the value that it had yesterday to that which it had the day before, and so on, is to raise the question of what determined the value of money in the first place. Consideration of the origin of the use of money and of the particular components of its value that depend on its monetary function suggests an obvious answer to this question. The first value of money was clearly the value which the goods used as money possessed (thanks to their suitability for satisfying human wants in other ways) at the moment when they were first used as common media of exchange. When individuals began to acquire objects, not for consumption, but to be used as media of exchange, they valued them according to the objective exchange value with which the market already credited them by reason of their “industrial” usefulness, and only as an additional consideration on account of the possibility of using them as media of exchange. The earliest value of money links up with the commodity value of the monetary material. But the value of money since then has been influenced not merely by the factors dependent on its “industrial” uses, which determine the value of the material of which the commodity money is made, but also by those which result from its use as money. Not only its supply and demand for industrial purposes, but also its supply and demand for use as a medium of exchange, have influenced the value of gold from that point of time onward when it was first used as money.
*22

2 The Necessity for a Value Independent of the Monetary Function Before an Object Can Serve as Money

If the objective exchange value of money must always be linked with a preexisting market exchange ratio between money and other economic goods (since otherwise individuals would not be in a position to estimate the value of the money), it follows that an object cannot be used as money unless, at the moment when its use as money begins, it already possesses an objective exchange value based on some other use. This provides both a refutation of those theories which derive the origin of money from a general agreement to impute fictitious value to things intrinsically valueless
*23 and a confirmation of Menger’s hypothesis concerning the origin of the use of money.

This link with a preexisting exchange value is necessary not only for commodity money, but equally for credit money and fiat money.
*24 No fiat money could ever come into existence if it did not satisfy this condition. Let us suppose that, among those ancient and modern kinds of money about which it may be doubtful whether they should be reckoned as credit money or fiat money, there have actually been representatives of pure fiat money. Such money must have come into existence in one of two ways. It may have come into existence because money substitutes already in circulation, that is, claims payable in money on demand, were deprived of their character as claims, and yet still used in commerce as media of exchange. In this case, the starting point for their valuation lay in the objective exchange value that they had at the moment when they were deprived of their character as claims. The other possible case is that in which coins that once circulated as commodity money are transformed into fiat money by cessation of free coinage (either because there was no further minting at all or because minting was continued only on behalf of the Treasury), no obligation of conversion being
de jure or
de facto assumed by anybody, and nobody having any grounds for hoping that such an obligation ever would be assumed by anybody. Here the starting point for the valuation lies in the objective exchange value of the coins at the time of the cessation of free coinage.

Before an economic good begins to function as money it must already possess exchange value based on some other cause than its monetary function. But money that already functions as such may remain valuable even when the original source of its exchange value has ceased to exist. Its value then is based entirely on its function as common medium of exchange.
*25

3 The Significance of Preexisting Prices in the Determination of Market Exchange Ratios

From what has just been said, the important conclusion follows that a historically continuous component is contained in the objective exchange value of money.

The past value of money is taken over by the present and transformed by it; the present value of money passes on into the future and is transformed in its turn. In this there is a contrast between the determination of the exchange value of money and that of the exchange value of other economic goods. All preexisting exchange ratios are quite irrelevant so far as the actual levels of the reciprocal exchange ratios of other economic goods are concerned. It is true that if we look beneath the concealing monetary veil to the real exchange ratios between goods we observe a certain continuity. Alterations in real prices occur slowly as a rule. But this stability of prices has its cause in the stability of the price determinants, not in the law of price determination itself. Prices change slowly because the subjective valuations of human beings change slowly. Human needs, and human opinions as to the suitability of goods for satisfying those needs, are no more liable to frequent and sudden changes than are the stocks of goods available for consumption, or the manner of their social distribution. The fact that today’s market price is seldom very different from yesterday’s is to be explained by the fact that the circumstances that determined yesterday’s price have not greatly changed overnight, so that today’s price is a resultant of nearly identical factors. If rapid and erratic variations in prices were usually encountered in the market, the conception of objective exchange value would not have attained the significance that it is actually accorded both by consumer and producer.

In this sense, reference to an inertia of prices is unobjectionable, although the errors of earlier economists should warn us of the real danger that the use of terms borrowed from mechanics may lead to a “mechanical” system, that is, to one that abstracts erroneously from the subjective valuations of individuals. But any suggestion of a causal relationship between past and present prices must be decisively rejected.

It is not disputed that there are institutional forces in operation which oppose changes in prices that would be necessitated by changes in valuations, and which are responsible when changes in prices that would have been caused by changes in supply and demand are postponed and when small or transitory changes in the relations between supply and demand lead to no corresponding change in prices at all. It is quite permissible to speak of an inertia of prices in this sense. Even the statement that the closing price forms the starting point for the transactions of the next market
*26 may be accepted if it is understood in the sense suggested above. If the general conditions that determined yesterday’s price have altered but little during the night, today’s price should be but little different from that of yesterday, and in practice it does not seem incorrect to make yesterday’s the starting point. Nevertheless, there is no causal connection between past and present prices as far as the relative exchange ratios of economic goods (not including money) are concerned. The fact that the price of beer was high yesterday cannot be of the smallest significance as far as today’s price is concerned—we need only think of the effect upon the prices of alcoholic drinks that would follow a general triumph of the Prohibition movement. Anybody who devotes attention to market activities is daily aware of alterations in the exchange ratios of goods, and it is quite impossible for anybody who is well acquainted with economic phenomena to accept a theory which seeks to explain price changes by a supposed constancy of prices.

It may incidentally be remarked that to trace the determination of prices back to their supposed inertia, as even Zwiedineck in his pleadings for this assumption is obliged to admit, is to resign at the outset any hope of explaining the ultimate causes of prices and to be content with explanations from secondary causes.
*27 It must unreservedly be admitted that an explanation of the earliest forms of exchange transaction that can be shown to have existed—a task to the solution of which the economic historian has so far contributed but little would show that the forces that counteract sudden changes in prices were once stronger than they are now. But it must positively be denied that there is any sort of connection between those early prices and those of the present day; that is, if there really is anybody who believes it possible to maintain the assertion that the exchange ratios of economic goods (not the money prices) that prevail today on the German stock exchanges are in any sort of causal connection with those that were valid in the days of Hermann or Barbarossa. If all the exchange ratios of the past were erased from human memory, the process of market-price determination might certainly become more difficult, because everybody would have to construct a new scale of valuations for himself; but it would not become impossible. In fact, people the whole world over are engaged daily and hourly in the operation from which all prices result: the decision as to the relative significance enjoyed by specific quantities of goods as conditions for the satisfaction of wants.

It is so far as the money prices of goods are determined by
monetary factors, that a historically continuous component is included in them, without which their actual level could not be explained. This component, too, is derived from exchange ratios which can be entirely explained by reference to the subjective valuations of the individuals taking part in the market, even though these valuations were not originally grounded upon the specifically monetary utility alone of these goods. The valuation of money by the market can only start from a value possessed by the money in the past, and this relationship influences the new level of the objective exchange value of money. The historically transmitted value is transformed by the market without regard to what has become its historical content.
*28 But it is not merely the starting point for today’s objective exchange value of money; it is an indispensable element in its determination. The individual must take into account the objective exchange value of money, as determined in the market yesterday, before he can form an estimate of the quantity of money that he needs today. The demand for money and the supply of it are thus influenced by the value of money in the past; but they in their turn modify this value until they are brought into equilibrium.

4 The Applicability of the Marginal-Utility Theory to Money

Demonstration of the fact that search for the determinants of the objective exchange value of money always leads us back to a point where the value of money is not determined in any way by its use as a medium of exchange, but solely by its other functions, prepares the way for developing a complete theory of the value of money on the basis of the subjective theory of value and its peculiar doctrine of marginal utility.

Until now the subjective school has not succeeded in doing this. In fact, among the few of its members who have paid any attention at all to the problem there have been some who have actually attempted to demonstrate its insolubility. The subjective theory of value has been helpless in face of the task here confronting it.

There are two theories of money which, whatever else we may think of them, must be acknowledged as having attempted to deal with the whole problem of the value of money.

The objective theories of value succeeded in introducing a formally unexceptionable theory of money into their systems, which deduces the value of money from its cost of production.
*29 It is true that the abandonment of this monetary theory is not merely to be ascribed to those shortcomings of the objective theory of value in general which led to its supersession by the theory of the modern school. Apart from this fundamental weakness, the cost-of-production theory of the value of money exhibited one feature that was an easy target for criticism. While it certainly provided a theory of commodity money (even if only a
formally correct one), it was unable to deal with the problem of credit money and fiat money. Nevertheless, it was a complete theory of money insofar as it did at least attempt to give a full explanation of the value of commodity money.

The other similarly complete theory of the value of money is that version of the quantity theory associated with the name of Davanzati.
*30 According to this theory, all the things that are able to satisfy human wants are conventionally equated with all the monetary metal. From this, since what is true of the whole is also true of its parts, the exchange ratios between commodity units and units of money can be deduced. Here we are confronted with a hypothesis that is not in any way supported by facts. To demonstrate its untenability once more would nowadays be a waste of time. Nevertheless, it must not be overlooked that Davanzati was the first who attempted to present the problem as a whole and to provide a theory that would explain not merely the variations in an
existing exchange ratio between money and other economic goods, but also the origin of this ratio.

The same cannot be said of other versions of the quantity theory. These all tacitly assume a certain value of money as given, and absolutely refuse to investigate further into the matter. They overlook the fact that what is required is an explanation of what determines the exchange ratio between money and commodities, and not merely of what causes changes in this ratio. In this respect, the quantity theory resembles various general theories of value (many versions of the doctrine of supply and demand, for example), which have not attempted to explain price as such but have been content to establish a law of price variations.
*31 These forms of the quantity theory are in fact nothing but the application of the law of supply and demand to the problem of the value of money. They introduce into monetary theory all the strong points of this doctrine; and of course all its weak points as well.
*32

The revolution in economics since 1870 has not yet been any more successful in leading to an entirely satisfactory solution of this problem. Of course, this does not mean that the progress of the science has left no trace on monetary theory in general and on the theory of the value of money in particular. It is one of the many services of the subjective theory of value to have prepared the way for a deeper understanding of the nature and value of money. The investigations of Menger have placed the theory on a new basis. But till now one thing has been neglected. Neither Menger nor any of the many investigators who have tried to follow him have even so much as attempted to solve the fundamental problem of the value of money. Broadly speaking, they have occupied themselves with checking and developing the traditional views and here and there expounding them more correctly and precisely, but they have not provided an answer to the question: What are the determinants of the objective exchange value of money? Menger and Jevons have not touched upon the problem at all. Carver
*33 and Kinley
*34 have contributed nothing of real importance to its solution. Walras
*35 and Kemmerer
*36 assume a given value of money and develop what is merely a theory of variations in the value of money. Kemmerer, it is true, approaches very close to a solution of the problem but passes it by.

Wieser expressly refers to the incomplete nature of the previous treatment. In his criticism of the quantity theory he argues that the law of supply and demand in its older form, the application of which to the problem of money constitutes the quantity theory, has a very inadequate content, since it gives no explanation at all of the way in which value is really determined or of its level at any given time, but confines itself without any further explanation merely to stating the direction in which value will move in consequence of variations in supply or demand; that is, in an opposite direction to changes in the former and in the same direction as changes in the latter. He further argues that it is no longer possible to rest content with a theory of the economic value of money which deals so inadequately with the problem; that since the supersession of the old law of supply and demand as applied to commodities, the case for which it was originally constructed, a more searching law must also be sought to apply to the case of money.
*37 But Wieser does not deal with the problem whose solution he himself states to be the object of his investigation, for in the further course of his argument he declares that the concepts of supply of money and demand for money
as a medium of exchange are useless for his purpose and puts forward a theory which attempts to explain variations in the objective exchange value of money (
objektive innere Tauschwert des Geldes)
*38 by reference to the relationship that exists in an economic community between money income and real income. For while it is true that reference to the ratio between money income and real income may well serve to explain
variations in the objective exchange value of money, Wieser nowhere makes the attempt to evolve a
complete theory of money—an attempt which, admittedly, the factors of supply and demand being excluded from consideration, would be certain to fail. The very objection that he raises against the old quantity theory, that it affirms nothing concerning the actual determination of value or the level at which it must be established at any time, must also be raised against his own doctrine; and this is all the more striking inasmuch as it was Wieser who, by revealing the historical element in the purchasing power of money, laid the foundation for the further development of the subjective theory of the value of money.

The unsatisfactory results offered by the subjective theory of value might seem to justify the opinion that this doctrine and especially its proposition concerning the significance of marginal utility must necessarily fall short as a means of dealing with the problem of money. Characteristically enough, it was a representative of the new school, Wicksell, who first expressed this opinion. Wicksell considers that the principle which lies at the basis of all modern investigation into the theory of value, namely, the concept of marginal utility, may well be suited to explaining the determination of exchange ratios between one commodity and another, but that it has practically no significance at all, or at most an entirely secondary significance, in explaining the exchange ratios between money and other economic goods. Wicksell, however, does not appear to detect any sort of objection to the marginal-utility theory in this assertion. According to his argument, the objective exchange value of money is not determined at all by the processes of the market in which money and the other economic goods are exchanged. If the money price of a single commodity or group of commodities is wrongly assessed in the market, then the resulting maladjustments of the supply and demand and the production and consumption of this commodity or group of commodities will sooner or later bring about the necessary correction. If, on the other hand, all commodity prices, or the average price level, should for any reason be raised or lowered, there is no factor in the circumstances of the
commodity market that could bring about a reaction. Consequently, if there is to be any reaction at all against a price assessment that is either too high or too low it must in some way or other originate outside the commodity market. In the further course of his argument, Wicksell arrives at the conclusion that the regulator of money prices is to be sought in the relations of the commodity market to the money market, in the broadest sense of the term. The cause which influences the demand for raw materials, labor, the use of land, and other means of production, and thus indirectly determines the upward or downward movement of commodity prices, is the ratio between the money rate of interest (
Darlehnszins) and the “natural” or equilibrium rate of interest (
natürliche Kapitalzins), by which we are to understand that rate of interest which would be determined by supply and demand if real capital was itself lent directly without the intermediation of money.
*39

Wicksell imagines that this argument of his provides a theory of the determination of the objective exchange value of money. In fact, however, all that he attempts to prove is that forces operate from the loan market on the commodity market which prevent the objective exchange value of money from rising too high or falling too low. He never asserts that the rate of interest on loans determines the actual level of this value in any way; in fact, to assert this would be absurd. But if we are to speak of a level of money prices that is “too high” or “too low,” we must first state how the ideal level with which the actual level is compared has been established. It is in no way sufficient to show that the position of equilibrium is returned to after any disturbance, if the existence of this position of equilibrium is not first explained. Indubitably, this is the primary problem, and its solution leads directly to that of the other; without it, further inquiry must remain unfruitful, for the state of equilibrium can only be maintained by those forces which first established it and continue to reestablish it. If the circumstances of the loan market can provide no explanation of the genesis of the exchange ratio subsisting between money and other economic goods, then neither can they help to explain why this ratio does not alter. The objective exchange value of money is determined in the market where money is exchanged for commodities and commodities for money. To explain its determination is the task of the theory of the value of money. But Wicksell is of the opinion that “the laws of the exchange of commodities contain in themselves nothing that could determine the absolute level of money prices.”
*40 This amounts to a denial of all possibility of scientific investigation in this sphere.

Helfferich also is of the opinion that there is an insurmountable obstacle in the way of applying the marginal-utility theory to the problem of money; for while the marginal-utility theory attempts to base the exchange value of goods on the degree of their utility to the individual, the degree of utility of money to the individual quite obviously depends on its exchange value, since money can have utility only if it has exchange value, and the degree of the utility is determined by the level of the exchange value. Money is valued subjectively according to the amount of consumable goods that can be obtained in exchange for it, or according to what other goods have to be given in order to obtain the money needed for making payments. The marginal utility of money to any individual, that is, the marginal utility derivable from the goods that can be obtained with the given quantity of money or that must be surrendered for the required money, presupposes a certain exchange value of the money; so the latter cannot be derived from the former.
*41

Those who have realized the significance of historically transmitted values in the determination of the objective exchange value of money will not find great difficulty in escaping from this apparently circular argument. It is true that valuation of the monetary unit by the individual is possible only on the assumption that an exchange ratio already exists in the market between the money and other economic goods. Nevertheless, it is erroneous to deduce from this that a complete and satisfactory explanation of the determination of the objective exchange value of money cannot be provided by the marginal-utility theory. The fact that this theory is unable to explain the objective exchange value of money entirely by reference to its
monetary utility; that to complete its explanation, as we were able to show, it is obliged to go back to that original exchange value which was based not on a monetary function at all but on other uses of the object that was to be used as money—this must not in any way be reckoned to the discredit of the theory, for it corresponds exactly to the nature and origin of the particular objective exchange value under discussion. To demand of a theory of the value of money that it should explain the exchange ratio between money and commodities solely with reference to the monetary function, and without the assistance of the element of historical continuity in the value of money, is to make demands of it that run quite contrary to its nature and its proper task.

The theory of the value of money as such can trace back the objective exchange value of money only to that point where it ceases to be the value of money and becomes merely the value of a commodity. At this point the theory must hand over all further investigation to the general theory of value, which will then find no further difficulty in the solution of the problem. It is true that the subjective valuation of money presupposes an existing objective exchange value; but the value that has to be presupposed is not the same as the value that has to be explained; what has to be presupposed is
yesterday’s exchange value, and it is quite legitimate to use it in an explanation of that of today. The objective exchange value of money which rules in the market today is derived from day’s under the influence of the subjective valuations of the individuals frequenting the market, just as yesterday’s in its turn was derived under the influence of subjective valuations from the objective exchange value possessed by the money the day before yesterday.

If in this way we continually go farther and farther back we must eventually arrive at a point where we no longer find any component in the objective exchange value of money that arises from valuations based on the function of money as a common medium of exchange; where the value of money is nothing other than the value of an object that is useful in some other way than as money. But this point is not merely an instrumental concept of theory; it is an actual phenomenon of economic history, making its appearance at the moment when indirect exchange begins.

Before it was usual to acquire goods in the market, not for personal consumption, but simply in order to exchange them again for the goods that were really wanted, each individual commodity was only accredited with that value given by the subjective valuations based on its direct utility. It was not until it became customary to acquire certain goods merely in order to use them as media of exchange that people began to esteem them more highly than before, on account of this possibility of using them in indirect exchange. The individual valued them in the first place because they were useful in the ordinary sense, and then additionally because they could be used as media of exchange. Both sorts of valuation are subject to the law of marginal utility. Just as the original starting point of the value of money was nothing but the result of subjective valuations, so also is the present-day value of money.

But Helfferich manages to bring forward yet another argument for the inapplicability of the marginal-utility theory to money. Looking at the economic system as a whole, it is clear that the notion of marginal utility rests on the fact that, given a certain quantity of goods, only certain wants can be satisfied and only a certain set of utilities provided. With given wants and a given set of means, the marginal degree of utility is determined also. According to the marginal-utility theory, this fixes the value of the goods in relation to the other goods that are offered as an equivalent in exchange, and fixes it in such a manner that that part of the demand that cannot be satisfied with the given supply is excluded by the fact that it is not able to offer an equivalent corresponding to the marginal utility of the good demanded. Now Helfferich objects that while the existence of a limited supply of any goods except money is in itself sufficient to imply the limitation of their utility also, this is not true of money. The utility of a given quantity of money depends directly upon the exchange value of the money, not only from the point of view of the individual, but also for society as a whole. The higher the value of the unit in relation to other goods, the greater will be the quantity of these other goods that can be paid for by means of the same sum of money. The value of goods in general results from the limitation of the possible utilities that can be obtained from a given supply of them, and while it is usually higher according to the degree of utility which is excluded by the limitation of supply, the total utility of the supply itself cannot be increased by an increase in its value; but in the case of money, the utility of a given supply can be increased at will by an increase in the value of the unit.
*42

The error in this argument is to be found in its regarding the utility of money from the point of view of the community instead of from that of the individual. Every valuation must emanate from somebody who is in a position to dispose in exchange of the object valued. Only those who have a choice between two economic goods are able to form a judgment as to value, and they do this by preferring the one to the other. If we start with valuations from the point of view of society as a whole, we tacitly assume the existence of a socialized economic organization in which there is no exchange and in which the only valuations are those of the responsible official body. Opportunities for valuation in such a society would arise in the control of production and consumption, as, for example, in deciding how certain production goods were to be used when there were alternative ways of using them. But in such a society there would be no room at all for money. Under such conditions, a common medium of exchange would have no utility and consequently no value either. It is therefore illegitimate to adopt the point of view of the community as a whole when dealing with the value of money. All consideration of the value of money must obviously presuppose a state of society in which exchange takes place and must take as its starting point individuals acting as independent economic agents within such a society,
*43 that is to say, individuals engaged in valuing things.

5 “Monetary” and “Nonmonetary” Influences Affecting the Objective Exchange Value of Money

Now, the first part of the problem of the value of money having been solved, it is at last possible for us to evolve a plan of further procedure. We no longer are concerned to explain the
origin of the objective exchange value of money; this task has already been performed in the course of the preceding investigation. We now have to establish the laws which govern
variations in existing exchange ratios between money and the other economic goods. This part of the problem of the value of money has occupied economists from the earliest times, although it is the other that ought logically to have been dealt with first. For this reason, as well as for many others, what has been done toward its elucidation does not amount to very much. Of course, this part of the problem is also much more complicated than the first part.

In investigations into the nature of changes in the value of money it is usual to distinguish between two sorts of determinants of the exchange ratio that connects money and other economic goods; those that exercise their effect on the money side of the ratio and those that exercise their effect on the commodity side. This distinction is extremely useful; without it, in fact, all attempts at a solution would have to be dismissed beforehand as hopeless. Nevertheless its true meaning must not be forgotten.

The exchange ratios between commodities—and the same is naturally true of the exchange ratios between commodities and money—result from determinants which affect both terms of the exchange ratio. But existing exchange ratios between goods may be modified by a change in determinants connected only with one of the two sets of exchanged objects. Although all the factors that determine the valuation of a good remain the same, its exchange ratio with another good may alter if the factors that determine the val uation of this second good alter. If of two persons I prefer A to B, this preference may be reversed, even though my feeling for A remains unchanged, if I contract a closer friendship with B. Similarly with the relationships between goods and human beings. He who today prefers the consumption of a cup of tea to that of a dose of quinine may make a contrary valuation tomorrow, even though his liking for tea has not diminished, if he has, say, caught a fever overnight. Whereas the factors that
determine prices always affect both sets of the goods that are to be exchanged, those of them which merely modify existing prices may sometimes be restricted to one set of goods only.
*44

(II) Fluctuations in the Objective Exchange Value of Money

Evoked by Changes in the Ratio Between the

Supply of Money and the Demand for It

6 The Quantity Theory

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.
*45

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.
*46 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.
*47

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.
*48

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.
*49

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.
*50 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.
*51 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.

7 The Stock of Money and the Demand for Money

The process, by which supply and demand are accommodated to each other until a position of equilibrium is established and both are brought into quantitative and qualitative coincidence, is the higgling of the market. But supply and demand are only the links in a chain of phenomena, one end of which has this visible manifestation in the market, while the other is anchored deep in the human mind. The intensity with which supply and demand are expressed, and consequently the level of the exchange ratio at which both coincide, depends on the subjective valuations of individuals. This is true, not only of the direct exchange ratios between economic goods other than money, but also of the exchange ratio between money on the one hand and commodities on the other.

For a long time it was believed that the demand for money was a quantity determined by objective factors and independently of subjective considerations. It was thought that the demand for money in an economic community was determined, on the one hand by the total quantity of commodities that had to be paid for during a given period, and on the other hand by the velocity of circulation of the money. There is an error in the very starting point of this way of regarding the matter, which was first successfully attacked by Menger.
*52 It is inadmissible to begin with the demand for money of the community. The individualistic economic community as such, which is the only sort of community in which there is a demand for money, is not an economic agent. It demands money only insofar as its individual members demand money. The demand for money of the economic community is nothing but the sum of the demands for money of the individual economic agents composing it. But for individual economic agents it is impossible to make use of the formula: total volume of transactions ÷ velocity of circulation. If we wish to arrive at a description of the demand for money of an individual we must start with the considerations that influence such an individual in receiving and paying out money.

Every economic agent is obliged to hold a stock of the common medium of exchange sufficient to cover his probable business and personal requirements. The amount that will be required depends upon individual circumstances. It is influenced both by the custom and habits of the individual and by the organization of the whole social apparatus of production and exchange.

But all of these objective factors always affect the matter only as motivations of the individual. They are never capable of a direct influence upon the actual amount of his demand for money. Here, as in all departments of economic life, it is the subjective valuations of the separate economic agents that alone are derisive. The store of purchasing power held by two such agents whose objective economic circumstances were identical might be quite different if the advantages and disadvantages of such a store were estimated differently by the different agents.

The cash balance held by an individual need by no means consist entirely of money. If secure claims to money, payable on demand, are employed commercially as substitutes for money, being tendered and accepted in place of money, then individuals’ stores of money can be entirely or partly replaced by a corresponding store of these substitutes. In fact, for technical reasons (such, for example, as the need for having money of various denominations on hand) this may sometimes prove an unavoidable necessity. It follows that we can speak of a demand for money in a broader and in a narrower sense. The former comprises the entire demand of an individual for money and money substitutes; the second, merely his demand for money proper. The former is determined by the will of the economic agent in question. The latter is fairly independent of individual influences, if we disregard the question of denomination referred to above. Apart from this, the question whether a greater or smaller part of the cash balance held by an individual shall consist of money substitutes is only of importance to him when he has the opportunity of acquiring money substitutes which bear interest, such as interest-bearing banknotes—a rare case—or bank deposits. In all other cases it is a matter of complete indifference to him.

The individual’s demand and stock of money are the basis of the demand and stock in the whole community. So long as there are no money substitutes in use, the social demand for money and the social stock of money are merely the respective sums of the individual demands and stocks. But this is changed with the advent of money substitutes. The social demand for money in the narrower sense is no longer the sum of the individual demands for money in the narrower sense, and the social demand for money in the broader sense is by no means the sum of the individual demands for money in the broader sense. Part of the money substitutes functioning as money in the cash holdings of individuals are “covered” by sums of money held as “redemption funds” at the place where the money substitutes are cashable, which is usually, although not necessarily, the issuing concern. We shall use the term
money certificates for those money substitutes that are completely covered by the reservation of corresponding sums of money, and the term
fiduciary media*53 for those which are not covered in this way. The suitability of this terminology, which has been chosen with regard to the problem to be dealt with in the third part of the present work, must be demonstrated in that place. It is not to be understood in the light of banking technique or in a juristic sense; it is merely intended to serve the ends of economic argument.

Only in the rarest cases can any particular money substitutes be immediately assigned to the one or the other group. That is possible only for those money substitutes of which the whole species is either entirely covered by money or not covered by money at all. In the case of all other money substitutes, those the total quantity of which is partly covered by money and partly not covered by money, only an imaginary ascription of an aliquot part to each of the two groups can take place. This involves no fresh difficulty. If, for example, there are banknotes in circulation one-third of the quantity of which is covered by money and two-thirds not covered, then each individual note is to be reckoned as two-thirds fiduciary medium and one-third money certificate. It is thus obvious that a community’s demand for money in the broader sense cannot be the sum of the demands of individuals for money and money substitutes, because to reckon in the demand for money certificates as well as that for the money that serves as a cover for them as the banks and elsewhere is to count the same amount twice over. A community’s demand for money in the broader sense is the sum of the demands of the individual economic agents for money proper and fiduciary media (including the demand for cover). And a community’s demands for money in the narrower sense are the sum of the demands of the individual economic agents for money and money certificates (this time
not including cover).

In this part we shall ignore the existence of fiduciary media and assume that the demands for money of individual economic agents can be satisfied merely by money and money certificates, and consequently that the demand for money of the whole economic community can be satisfied merely by money proper.
*54 The third part of this book is devoted to an examination of the important and difficult problems arising from the creation and circulation of fiduciary media.

The demand for money and its relations to the stock of money form the starting point for an explanation of fluctuations in the objective exchange value of money. Not to understand the nature of the demand for money is to fail at the very outset of any attempt to grapple with the problem of variations in the value of money. If we start with a formula that attempts to explain the demand for money from the point of view of the community instead of from that of the individual, we shall fail to discover the connection between the stock of money and the subjective valuations of individuals—the foundation of all economic activity. But on the other hand, this problem is solved without difficulty if we approach the phenomena from the individual agent’s point of view.

No longer explanation is necessary, of the way in which an individual will behave in the market when his demand for money exceeds his stock of it. He who has more money on hand than he thinks he needs, will buy, in order to dispose of the superfluous stock of money that lies useless on his hands. If he is an entrepreneur, he will possibly enlarge his business. If this use of the money is not open to him, he may purchase interest-bearing securities; or possibly he may decide to purchase consumption goods. But in any case, he expresses by a suitable behavior in the market the fact that he regards his reserve of purchasing power as too large.

And he whose demand for money is less than his stock of it will behave in an exactly contrary fashion. If an individual’s stock of money diminishes (his property or income remaining the same), then he will take steps to reach the desired level of reserve purchasing power by suitable behavior in making sales and purchases. A shortage of money means a difficulty in disposing of commodities for money. He who is obliged to dispose of a commodity by way of exchange will prefer to acquire some of the common medium of exchange for it, and only when this acquisition involves too great a sacrifice will he be content with some other economic good, which will indeed be more marketable than that which he wishes to dispose of but less marketable than the common medium of exchange. Under the present organization of the market, which leaves a deep gulf between the marketability of money on the one hand and the marketability of other economic goods on the other hand, nothing but money enters into consideration at all as a medium of exchange. Only in exceptional circumstances is any other economic good pressed into this service. In the case mentioned, therefore, every seller will be willing to accept a smaller quantity of money than he otherwise would have demanded, so as to avoid the fresh loss that he would have to suffer in again exchanging the commodity that he has acquired, which is harder to dispose of than money, for the commodity that he actually requires for consumption.

The older theories, which started from an erroneous conception of the social demand for money, could never arrive at a solution of this problem. Their sole contribution is limited to paraphrases of the proposition that an increase in the stock of money at the disposal of the community while the demand for it remains the same decreases the objective exchange value of money, and that an increase of the demand with a constant available stock has the contrary effect, and so on. By a flash of genius, the formulators of the quantity theory had already recognized this. We cannot by any means call it an advance when the formula giving the amount of the demand for money (volume of transactions ÷ velocity of circulation) was reduced to its elements, or when the attempt was made to give exact precision to the idea of a stock of money, so long as this occurred under a misapprehension of the nature of fiduciary media and of clearing transactions. No approach whatever was made toward the central problem of this part of the theory of money so long as theorists were unable to show the way in which subjective valuations are affected by variations in the ratio between the stock of money and the demand for money. But this task was necessarily beyond the power of these theories; they break down at the crucial point.
*55

Recently, Wieser has expressed himself against employing the “collective concept of the demand for money” as the starting point for a theory of fluctuations in the objective exchange value of money. He says that in an investigation of the value of money we are not concerned with the total demand for money. The demand for money to pay taxes with, for example, does not come into consideration, for these payments do not affect the value of money but only transfer purchasing power from those who pay the taxes to those who receive them. In the same way, capital and interest payments in loan transactions and the making of gifts and bequests merely involve a transference of purchasing power between persons and not an augmentation or diminution of it. A functional theory of the value of money must, in stating its problem, have regard only to those factors by which the value of money is determined. The value of money is determined in the process of exchange. Consequently the theory of the value of money must take account only of those quantifies which enter into the process of exchange.
*56

But these objections of Wieser’s are not only rebutted by the fact that even the surrender of money in paying taxes, in making capital and interest payments, and in giving presents and bequests, falls into the economic category of exchange. Even if we accept Wieser’s narrow definition of exchange, we must still oppose his argument. It is not a peculiarity of money that its value (Wieser obviously means its objective exchange value) is determined in the process of exchange; the same is true of all other economic goods. For all economic goods it must therefore be correct to say that the theory of value has to investigate only certain quantities, namely, only those that are involved in the process of exchange. But there is no such thing in economics as a quantity that is not involved in the process of exchange. From the economic point of view, a quantity has no other relationships than those which exercise some influence upon the valuations of individuals concerned in some process or other of exchange.

This is true, even if we admit that value only arises in connection with exchange in the narrow sense intended by Wieser. But those who participate in exchange transactions, and consequently desire to acquire or dispose of money do not value the monetary unit solely with regard to the fact that they can use it in other acts of exchange (in Wieser’s narrower sense of the expression), but also because they require money in order to pay taxes, to transfer borrowed capital and pay interest, and to make presents. They consider the level of their purchasing-power reserves with a view to the necessity of having money ready for all these purposes, and their judgment as to the extent of their requirements for money is what decides the demand for money with which they enter the market.

8 The Consequences of an Increase in the Quantity of Money While the Demand for Money Remains Unchanged or Does Not Increase to the Same Extent

Those variations in the ratio between the individual’s demand for money and his stock of it that arise from purely individual causes cannot as a rule have a very large quantitative influence in the market. In most cases they will be entirely, or at least partly, compensated by contrary variations emanating from other individuals in the market. But a variation in the objective exchange value of money can arise only when a force is exerted in one direction that is not canceled by a counteracting force in the opposite direction. If the causes that alter the ratio between the stock of money and the demand for it from the point of view of an individual consist merely in accidental and personal factors that concern that particular individual only, then, according to the law of large numbers, it is likely that the forces arising from this cause, and acting in both directions in the market, will counterbalance each other. The probability that the compensation will be complete is the greater, the more individual economic agents there are.

It is otherwise when disturbances occur in the community as a whole, of a kind to alter the ratio existing between the individual’s stock of money and his demand for it. Such disturbances, of course, cannot have an effect except by altering the subjective valuations of the individual; but they are social economic phenomena in the sense that they influence the subjective valuations of a large number of individuals, if not simultaneously and in the same degree, at least in the same direction, so that there must necessarily be some resultant effect on the objective exchange value of money.

In the history of money a particularly important part has been played by those variations in its objective exchange value that have arisen in consequence of an increase in the stock of money while the demand for it has remained unchanged or has at least not increased to the same extent. These variations, in fact, were what first attracted the attention of economists; it was in order to explain them that the quantity theory of money was first propounded. All writers have dealt most thoroughly with them. It is perhaps justifiable, therefore, to devote special attention to them and to use them to illuminate certain important theoretical points.

In whatever way we care to picture to ourselves the increase in the stock of money, whether as arising from increased production or importation of the substance of which commodity money is made, or through a new issue of fiat or credit money, the new money always increases the stock of money at the disposal of certain individual economic agents. An increase in the stock of money in a community always means an increase in the money incomes of a number of individuals; but it need not necessarily mean at the same time an increase in the quantity of goods that are at the disposal of the community, that is to say, it need not mean an increase in the national dividend. An increase in the amount of fiat or credit money is only to be regarded as an increase in the stock of goods at the disposal of society if it permits the satisfaction of a demand for money which would otherwise have been satisfied by commodity money instead, since the material for the commodity money would then have had to be procured by the surrender of other goods in exchange or produced at the cost of renouncing some other sort of production. If, on the other hand, the nonexistence of the new issue of fiat or credit money would not have involved an increase in the quantity of commodity money, then the increase of money cannot be regarded as an increase of the income or wealth of society.

An increase in a community’s stock of money always means an increase in the amount of money held by a number of economic agents, whether these are the issuers of fiat or credit money or the producers of the substance of which commodity money is made. For these persons, the ratio between the demand for money and the stock of it is altered; they have a relative superfluity of money and a relative shortage of other economic goods. The immediate consequence of both circumstances is that the marginal utility to them of the monetary unit diminishes. This necessarily influences their behavior in the market. They are in a stronger position as buyers. They will now express in the market their demand for the objects they desire more intensively than before; they are able to offer more money for the commodities that they wish to acquire. It will be the obvious result of this that the prices of the goods concerned will rise, and that the objective exchange value of money will fall in comparison.

But this rise of prices will by no means be restricted to the market for those goods that are desired by those who originally have the new money at their disposal. In addition, those who have brought these goods to market will have their incomes and their proportionate stocks of money increased and, in their turn, will be in a position to demand more intensively the goods they want, so that these goods will also rise in price. Thus the increase of prices continues, having a diminishing effect, until all commodities, some to a greater and some to a lesser extent, are reached by it.
*57

The increase in the quantity of money does not mean an increase of income for all individuals. On the contrary, those sections of the community that are the last to be reached by the additional quantity of money have their incomes reduced, as a consequence of the decrease in the value of money called forth by the increase in its quantity; this will be referred to later. The reduction in the income of these classes now starts a countertendency, which opposes the tendency to a diminution of the value of money due to the increase of income of the other classes, without being able to rob it completely of its effect.

Those who hold the mechanical version of the quantity theory will be the more inclined to believe that the increase in the quantity of money must eventually lead to a uniform increase in the prices of all economic goods, the less clear their concept is of the way in which the determination of prices is affected by it. Thorough comprehension of the mechanism by means of which the quantity of money affects the prices of commodities makes their point of view altogether untenable. Since the increased quantity of money is received in the first place by a limited number of economic agents only and not by all, the increase of prices at first embraces only those goods that are demanded by these persons; further, it affects these goods more than it afterward affects any others. When the increase of prices spreads farther, if the increase in the quantity of money is only a single transient phenomenon, it will not be possible for the differential increase of prices of these goods to be completely maintained; a certain degree of adjustment will take place. But there will not be such a complete adjustment of the increases that all prices increase in the same proportion. The prices of commodities after the rise of prices will not bear the same relation to each other as before its commencement; the decrease in the purchasing power of money will not be uniform with regard to different economic goods.

Hume, it may be remarked, bases his argument concerning this matter on the supposition that every Englishman is miraculously endowed with five pieces of gold during the night.
*58 Mill rightly remarks on this, that it would not lead to a uniform increase in the demand for separate commodities; the luxury articles of the poorer classes would rise more in price than the others. All the same, he believes that a uniform increase in the prices of all commodities, and this exactly in proportion to the increase in the quantity of money, would occur, if “the wants and inclinations of the community collectively in respect to consumption” remained the same. He assumes, no less artificially than Hume, that “to every pound, or shilling, or penny, in the possession of any one, another pound, shilling, or penny were suddenly added.”
*59 But Mill fails to see that even in this case a uniform rise of prices would not occur, even supposing that for each member of the community the proportion between stock of money and total wealth was the same, so that the addition of the supplementary quantity of money did not result in an alteration of the relative wealth of individuals. For, even in this quite impossible case, every increase in the quantity of money would necessarily cause an alteration in the conditions of demand, which would lead to a disparate increase in the prices of the individual economic goods. Not all commodities would be demanded more intensively, and not all of those that were demanded more intensively would be affected in the same degree.
*60

There is no justification whatever for the widespread belief that variations in the quantity of money must lead to inversely proportionate variations in the objective exchange value of money, so that, for example, a doubling of the quantity of money must lead to a halving of the purchasing power of money.

Even assuming that in some way or other—it is confessedly difficult to imagine in what way—very individual’s stock of money were to be increased so that his relative position as regards other holders of property was unaltered, it is not difficult to prove that the subsequent variation in the objective exchange value of money would not be proportioned to the variation in the quantity of money. For, in fact, the way in which an individual values a variation in the quantity of money at his disposal is by no means directly dependent on the amount of this variation; but we should have to assume that it was, if we wished to conclude that there would be a proportionate variation in the objective exchange value of money. If the possessor of a units of money receives
b additional units, then it is not at all true to say that he will value the total stock
a +
b exactly as highly as he had previously valued the stock
a alone. Because he now has disposal over a larger stock, he will now value each unit less than he did before; but
how much less will depend upon a whole series of individual circumstances, upon subjective valuations that will be different for each individual. Two individuals who are equally wealthy and who each possess
a stock of money a, will not by any means arrive at the same variation in their estimation of money after an increase of
b units in each of their stocks of money. It is nothing short of absurdity to assume that, say, doubling the amount of money at the disposal of an individual must lead to a halving of the exchange value that he ascribes to each monetary unit. Let us, for example, imagine an individual who is in the habit of holding a stock of a hundred kronen and assume that a sum of a further hundred kronen is paid by somebody or other to this individual. Mere consideration of this example is sufficient to show the complete unreality of all the theories that ascribe to variations in the quantity of money a uniformly proportionate effect on the purchasing power of money. For it involves no essential modification of this example to assume that similar increases in the quantity of money are experienced by all the members of the community at once.

The mistake in the argument of those who suppose that a variation in the quantity of money results in an inversely proportionate variation in its purchasing power lies in its starting point. If we wish to arrive at a correct conclusion, we must start with the valuations of separate individuals; we must examine the way in which an increase or decrease in the quantity of money affects the value scales of individuals, for it is from these alone that variations in the exchange ratios of goods proceed. The initial assumption in the arguments of those who maintain the theory that changes in the quantity of money have a proportionate effect on the purchasing power of money is the proposition that if the value of the monetary unit were doubled, half of the stock of money at the disposal of the community would yield the same utility as that previously yielded by the whole stock. The correctness of this proposition is not disputed; nevertheless, it does not prove what it is meant to prove.

In the first place, it must be pointed out that the levels of the total stock of money and of the value of the money unit are matters of complete indifference as far as the utility obtained from the use of the money is concerned. Society is always in enjoyment of the maximum utility obtainable from the use of money. Half of the money at the disposal of the community would yield the same utility as the whole stock, even if the variation in the value of the monetary unit was not proportioned to the variation in the stock of money. But it is important to note that it by no means follows from this that doubling the quantity of money means halving the objective exchange value of money. It would have to be shown that forces emanate from the valuations of individual economic agents which are able to bring about such a proportionate variation. This can never be proved; in fact, its contrary is likely. We have already given a proof of this for the case in which an increase of the quantity of money held by individual economic agents involves at the same time an increase of their income or wealth. But even when the increase in the quantity of money does not affect the wealth or income of the individual economic agents, the effect is still the same.

Let us assume that a man gets half his income in the form of interest-bearing securities and half in the form of money; and that he is in the habit of saving three-quarters of his income, and does this by retaining the securities and using that half of his income which he receives in cash in equal parts for paying for current con sumption and for the purchase of further securities. Now let us assume that a variation in the composition of his income occurs, so that he receives three-quarters of it in cash and only one-quarter in securities. From now on this man will use two-thirds of his cash receipts for the purchase of interest-bearing securities. If the price of the securities rises or, which is the same thing, if their rate of interest falls, then in either case he will be less willing to buy and will reduce the sum of money that he would otherwise have employed for their purchase; he is likely to find that the advantage of a slightly increased reserve exceeds that which could be obtained from the acquisition of the securities. In the second case he will doubtless be inclined to pay a higher price, or more correctly, to purchase a greater quantity at the higher price, than in the first case. But he will certainly not be prepared to pay
double as much for a unit of securities in the second case as in the first case.

As far as the earlier exponents of the quantity theory are concerned, the assumption that variations in the quantity of money would have an inversely proportionate effect on its purchasing power may nevertheless be excusable. It is easy to go astray on this point if the attempt is made to explain the value phenomena of the market by reference to exchange value. But it is inexplicable that those theorists also who suppose they are taking their stand on the subjective theory of value could fall into similar errors. The blame here can only be laid to the account of a mechanical conception of market processes. Thus even Fisher and Brown, whose concept of the quantity theory is a mechanical one, and who attempt to express in mathematical equations the law according to which the value of money is determined, necessarily arrive at the conclusion that variations in the ratio between the quantity of money and the demand for it lead to proportionate variations in the objective exchange value of money.
*61 How and through what channels this comes about is not disclosed by the formula, for it contains no reference at all to the only factors that are decisive in causing variations of the exchange ratios, that is, variations in the subjective valuations of individuals.

Fisher and Brown give three examples to prove the correctness of their conclusions. In the first, they start with the supposition that the government changes the denomination of the money, so that, for example, what was previously called a half-dollar is now called a whole dollar. It is obvious, they say, that this will cause an increase in the number of dollars in circulation and that prices reckoned in the new dollars will have to be twice as high as they were previously. Fisher and Brown may be right so far, but not in the conclusions that they proceed to draw. What their example actually deals with is not an increase in the quantity of money but merely an alteration in its name. What does the “money” referred to in this example really consist of? Is it the stuff of which dollars are made, the claim that lies behind a credit dollar, the token that is used as money, or is it the word
dollar?

The second example given by Fisher and Brown is no less incorrectly interpreted. They start from the assumption that the government divides each dollar into two and mints a new dollar from each half. Here again all that occurs is a change of name.

In their third example they do at least deal with a real increase in the quantity of money. But this example is just as artificial and misleading as those of Hume and Mill which we have already dealt with in some detail. They suppose that the government gives everybody an extra dollar for each dollar that he already possesses. We have already shown that even in this case a proportionate change in the objective exchange value of money cannot follow.

One thing only can explain how Fisher is able to maintain his mechanical quantity theory. To him the quantity theory seems a doctrine peculiar to the value of money; in fact, he contrasts it outright with the laws of value of other economic goods. He says that if the world’s stock of sugar increases from a million pounds to a million hundredweight, it would not follow that a hundredweight would have the value that is now possessed by a pound. Money only is peculiar in this respect, according to Fisher. But he does not give a proof of this assertion. With as much justification as that of Fisher and Brown for their mechanical formula for the value of money, a similar formula could be set out for the value of any commodity, and similar conclusions drawn from it. That nobody attempts to do this is to be explained simply and solely by the circumstance that such a formula would so clearly contradict our experience of the demand curves for most commodities, that it could not be maintained even for a moment.

If we compare two static economic systems, which differ in no way from one another except that in one there is twice as much money as in the other, it appears that the purchasing power of the monetary unit in the one system must be equal to half that of the monetary unit in the other. Nevertheless, we may not conclude from this that a doubling of the quantity of money must lead to a halving of the purchasing power of the monetary unit; for every variation in the quantity of money introduces a dynamic factor into the static economic system. The new position of static equilibrium that is established when the effects of the fluctuations thus set in motion are completed cannot be the same as that which existed before the introduction of the additional quantity of money. Consequently, in the new state of equilibrium the conditions of demand for money, given a certain exchange value of the monetary unit, will also be different. If the purchasing power of each unit of the doubled quantity of money were halved, the unit would not have the same significance for each individual under the new conditions as it had in the static system before the increase in the quantity of money. All those who ascribe to variations in the quantity of money an inverse proportionate effect on the value of the monetary unit are applying to dynamic conditions a method of analysis that is only suitable for static conditions.

It is also entirely incorrect to think of the quantity theory as if the characteristics in question affecting the determination of value were peculiar to money. Most of both the earlier and the later adherents of the theory have fallen into this error, and the fierce and often unfair attacks that have been directed against it appear in a better light when we know of this and other errors of a like kind of which its champions have been guilty.

9 Criticism of Some Arguments Against the Quantity Theory

We have already examined one of the objections that have been brought against the quantity theory: the objection that it only holds good
ceteris paribus. No more tenable as an objection against the determinateness of our conclusions is reference to the possibility that an additional quantity of money may be hoarded. This argument has played a prominent role in the history of monetary theory; it was one of the sharpest weapons in the armory of the opponents of the quantity theory. Among the arguments of the opponents of the currency theory it immediately follows the proposition relating to the elasticity of cash-economizing methods of payment, to which it also bears a close relation as far as its content is concerned. We shall deal with it here separately; nevertheless all that we can say about it in the present place needs to be set in its proper light by the arguments contained in the third part of this book, which is devoted to the doctrine of fiduciary media.

For Fullarton, hoards are the regular
deus ex machina. They absorb the superfluous quantity of money and prevent it from flowing into circulation until it is needed.
*62 Thus they constitute a sort of reservoir which accommodates the ebb and flow of money in the market to the variations in the demand for money. The sums of money collected in hoards lie there idle, waiting for the moment when commerce needs them for maintaining the stability of the objective exchange value of money; and all those sums of money, that might threaten this stability when the demand for money decreases, flow back out of circulation into these hoards to slumber quietly until they are called forth again. This tacitly assumes
*63 the fundamental correctness of the arguments of the quantity theory, but asserts that there is nevertheless a principle inherent in the economic system that always prevents the working out of the processes that the quantity theory describes.

But Fullarton and his followers unfortunately neglected to indicate the way in which variations in the demand for money set in motion the mechanism of the hoards. Obviously they supposed this to proceed without the will of the transacting parties entering into the matter at all. Such a view surpasses the naivest versions of the quantity theory in its purely mechanical conception of market transactions. Even the most superficial investigation into the problem of the demand for money could not have failed to demonstrate the untenability of the doctrine of hoards.

In the first place, it must be recognized that from the economic point of view there is no such thing as money lying idle. All money, whether in reserves or literally in circulation (that is, in process of changing hands at the very moment under consideration), is devoted in exactly the same way to the performance of a monetary function.
*64 In fact, since money that is surrendered in an exchange is immediately transferred from the ownership of the one party to that of the other, and no period of time can be discovered in which it is actually in movement, all money must be regarded as at rest in the cash reserve of some individual or other The stock of money of the community is the sum of the stocks of individuals; there is no such thing as errant money, no money which even for a moment does not form part of somebody’s stock. All money, that is to say, lies in some individual’s stock, ready for eventual use. It is a matter of indifference how soon the moment occurs when a demand for money next arises and the sum of money in question is paid out. In every household or family the members of which are at least moderately prosperous there is a minimum reserve whose level is constantly maintained by replenishment. (The fact has already been mentioned, that besides objective conditions, subjective factors influencing the individual economic agent help to determine the amount of the individual demand for money.) What is called storing money is a way of using wealth. The uncertainty of the future makes it seem advisable to hold a larger or smaller part of one’s possessions in a form that will facilitate a change from one way of using wealth to another, or transition from the ownership of one good to that of another, in order to preserve the opportunity of being able without difficulty to satisfy urgent demands that may possibly arise in the future for goods that will have to be obtained by way of exchange. So long as the market has not reached a stage of development in which all, or at least certain, economic goods can be sold (that is, turned into money) at any time under conditions that are not too unfavorable, this aim can be achieved only by holding a stock of money of a suitable size. The more active the life of the market becomes, the more can this stock be diminished. At the present day, the possession of certain sorts of securities which have a large market so that they can be realized without delay and without very considerable loss, at least in normal times, may make the holding of large cash reserves to a certain extent unnecessary.

The demand for money for storage purposes is not separable from the demand for money for other purposes. Hoarding money is nothing but the custom of holding a greater stock of it than is usual with other economic agents, at other times, or in other places. The hoarded sums of money do not lie idle, whether they are regarded from the social or from the individual point of view. They serve to satisfy a demand for money just as much as any other money does. Now the adherents of the banking principle seem to hold the opinion that the demand for storing purposes is elastic and conforms to variations in the demand for money for other purposes in such a way that the total demand for money, that is, that for storing purposes and that for other purposes taken together, adjusts itself to the existing stock of money without any variation in the objective exchange value of the monetary unit. This view is entirely mistaken. In fact, the conditions of demand for money, including the demand for storage purposes, is independent of the circumstances of the supply of money. The contrary supposition can be supported only by supporting a connection between the quantity of money and the rate of interest,
*65 that is, by asserting that the variations arising from changes in the ratio between the demand for money and the supply of it, influence to a different degree the prices of goods of the first order and those of goods of higher orders, so that the proportion between the prices of these two classes of goods is altered. The question of the tenability of this proposition, which is based on the view that the rate of interest is dependent on the greater or lesser quantity of money, will have to be brought up again in part three. There the opportunity will also arise for showing that the cash reserves of the banks that issue fudiciary media no more act as a buffer in this way than these mythical hoards do. There is no such thing as a “reserve store” of money out of which commerce can at any time supply its extra requirements or into which it can direct its surpluses.

The doctrine of the importance of hoards for stabilizing the objective exchange value of money has gradually lost its adherents with the passing of time. Nowadays its supporters are few. Even Diehl’s membership of this group is only apparent. He agrees, it is true, with the criticism directed by Fullarton against the currency theory. On the other hand, he concedes that Fullarton’s expressions
inert and
dormant are erroneously applied to reserves of money; since these reserves are not idle but merely serve a different purpose from that served by circulating money; he also agrees that sums of money in such reserves and sums used for purposes of payment are not sharply distinguishable, and that the same sums serve now one purpose and now the other. In spite of this, however, he supports Fullarton as against Ricardo. He says that, even if the sums taken out of the reserves must again be replaced out of the stocks of money present in the community; this need not occur immediately; a long period may elapse before it is necessary; and that in any case it follows that the mechanical connection which Ricardo assumes to exist between the quantity of money
in circulation and the prices of commodities cannot be accepted, even with regard to hoards.
*66 Diehl does not show in greater detail
why a long period may elapse before the sums supposed to be taken from the reserves are replaced. But he does admit the fundamental correctness of the criticism leveled at Fullarton’s arguments; it is possible to grant the sole reservation that he makes if we interpret it as meaning that time may and must elapse before changes in the quantity of money express themselves all over the market in a variation of the objective exchange value of money. For that the increase in individuals’ stocks of money which results from the inflow of the additional quantity of money must bring about a change in the subjective valuations of the individuals, and that this occurs immediately and begins immediately to have an effect in the market, can hardly be denied. On the other hand, an increase in an individual’s demand for money while his stock remains the same, or a decrease of his stock while his demand remains the same, must lead at once to changes in subjective valuations which must be expressed in the market, even if not all at once, in an increase of the objective exchange value of money. It may be admitted that every variation in the quantity of money will impel the individual to check his judgment as to the extent of his requirements for money and that this may result in a reduction of his demand in the case of a diminishing stock of money and an augmentation of it in the case of an increasing stock, but the assumption that such a limitation or extension
must occur has no logical foundation, not to speak of the assumption that it must occur in such a degree as to keep the objective exchange value of money stable.

A weightier objection is the denial of the practical importance of the quantity theory, that is implied in the attribution to the present organization of the money, payment, and credit system of a tendency to cancel out variations in the quantity of money and prevent them from becoming effective. It is said that the fluctuating velocity of circulation of money, and the elasticity of methods of payment made possible by the credit system and the progressive improvement of banking organization and technique, that is, the facility with which methods of payment can be adjusted to expanded or contracted business, have made the movement of prices as far as is possible independent of variations in the quantity of money, especially since there exists no quantitative relation between money and its substitutes, that is, between the stock of money and the volume of transactions and payments. It is said that if in such circumstances we still wish to preserve the quantity theory we must not base it merely upon current money but “extend it to embrace all money whatever, including not only all the tangible money substitutes that are capable of circulation, but also every transaction of the banking system or agreement between two parties to a contract that replaces a payment of money.” It is admitted that this would make the theory quite useless in practice, but it would secure its theoretical universality. And it is not denied that this raises an almost insoluble problem—that of the conditions under which credit comes into being and of the manner in which it affects the determination of values and prices.
*67

The answer to this is contained in the third part of the present work, where the problem of the alleged elasticity of credit is discussed.
*68

10 Further Applications of the Quantity Theory

In general the quantity theory has not been used for investigating the consequences that would follow a
decrease in the demand for money while the stock of money remained the same. There has been no historical motive for such an investigation. The problem has never been a live one; for there has never been even a shadow of justification for attempting to solve controversial questions of economic policy by answering it. Economic history shows us a continual increase in the demand for money. The characteristic feature of the development of the demand for money is its intensification; the growth of division of labor and consequently of exchange transactions, which have constantly become more and more indirect and dependent on the use of money, have helped to bring this about, as well as the increase of population and prosperity. The tendencies which result in an increase in the demand for money became so strong in the years preceding the war that even if the increase in the stock of money had been very much greater than it actually was, the objective exchange value of money would have been sure to increase. Only the circumstance that this increase in the demand for money was accompanied by an extraordinarily large expansion of credit, which certainly exceeded the increase in the demand for money in the broader sense, can serve to explain the fact that the objective exchange value of money during this period not only failed to increase, but actually decreased. (Another factor that was concerned in this is referred to later in this chapter.)

If we were to apply the mechanical version of the quantity theory to the case of a decrease in the demand for money while the stock of money remained unaltered, we should have to conclude that there would be a uniform increase in all commodity prices, arithmetically proportional to the change in the ratio between the stock of money and the demand for it. We should expect the same results as would follow upon an increase of the stock of money while the demand for it remained the same. But the mechanical version of the theory, based as it is upon an erroneous transference of static law to the dynamic sphere, is just as inadequate in this case as in the other It cannot satisfy us because it does not explain what we want to have explained. We must build up a theory that will show us how a decrease in the demand for money while the stock of it remains the same affects prices by affecting the subjective valuations of money on the part of individual economic agents. A diminution of the demand for money while the stock remained the same would in the first place lead to the discovery by a number of persons that their cash reserves were too great in relation to their needs. They would therefore enter the market as buyers with their surpluses. From this point, a general rise in prices would come into operation, a diminution of the exchange value of money. More detailed explanation of what would happen then is unnecessary.

Very closely related to this case is another, whose practical significance is incomparably greater. Even if we think of the demand for money as constantly increasing it may happen that the demand for
particular kinds of money diminishes, or even ceases altogether so far as it depends upon their characteristics as general media of exchange, and this is all we have to deal with here. If any given kind of money is deprived of its monetary characteristics, then naturally it also loses the special value that depends on its use as a common medium of exchange, and only retains that value which depends upon its other employment. In the course of history this has always occurred when a good has been excluded from the constantly narrowing circle of common media of exchange. Generally speaking, we do not know much about this process, which to a large extent took place in times about which our information is scanty. But recent times have provided an outstanding example: the almost complete demonetization of silver. Silver, which previously was widely used as money, has been almost entirely expelled from this position, and there can be no doubt that at a time not very far off, perhaps even in a few years only, it will have played out its part as money altogether. The result of the demonetization of silver has been a diminution of its objective exchange value. The price of silver in London fell from 60 9/10d. on an average in 1870 to 23 12/16d. on an average in 1909. Its value was bound to fall, because the sphere of its employment had contracted. Similar examples can be provided from the history of credit money also. For instance, the notes of the southern states in the American Civil War may be mentioned, which as the successes of the northern states increased, lost
pari passu their monetary value as well as their value as claims.
*69

More deeply than with the problem of the consequences of a diminishing demand for money while the stock of it remains the same, which possesses only a small practical importance, the adherents of the quantity theory have occupied themselves with the problem of a diminishing stock of money while the demand for it remains the same and with that of an increasing demand for money while the stock of it remains the same. It was believed that complete answers to both questions could easily be obtained in accordance with the mechanical version of the quantity theory, if the general formula, which appeared to embrace the essence of the problems, was applied to them. Both cases were treated as inversions of the case of an increase in the quantity of money while the demand for it remained the same; and from this the corresponding conclusions were drawn. Just as the attempt was made to explain the depreciation of credit money simply by reference to the enormous increase in the quantity of money, so the attempt was made to explain the depression of the seventies and eighties by reference to an increase of the demand for money while the quantity of money did not increase sufficiently. This proposition lay at the root of most of the measures of currency policy of the nineteenth century. The aim was to regulate the value of money by increasing or diminishing the quantity of it. The effects of these measures appeared to provide an inductive proof of the correctness of this superficial version of the quantity theory, and incidentally concealed the weaknesses of its logic. This supposition alone can explain why no attempt was ever made to exhibit the mechanism of the increase of the value of money as a result of the decrease in the volume of circulation. Here again the old theory needs to be supplemented, as has been done in our argument above.

Normally the increase in the demand for money is slow, so that any effect on the exchange ratio between money and commodities is discernible only with difficulty. Nevertheless, cases do occur in which the demand for money in the narrower sense increases suddenly and to an unusually large degree, so that the prices of commodities drop suddenly. Such cases occur when the public loses faith in an issuer of fiduciary media at a time of crisis, and the fiduciary media cease to be capable of circulation. Many examples of this sort are known to history (one of them is provided by the experiences of the United States in the late autumn of 1907), and it is possible that similar cases may occur in the future.

(III) A Special Cause of Variations in the

Objective Exchange Value of Money Arising from the

Peculiarities of Indirect Exchange

11 “Dearness of Living”

Those determinants of the objective exchange value of money that have already been considered exhibit no sort of special peculiarity. So far as they are concerned, the exchange value of money is determined no differently from the exchange value of other economic goods. But there are other determinants of variations in the objective exchange value of money which obey a special law.

No complaint is more widespread than that against “dearness of living.” There has been no generation that has not grumbled about the “expensive times” that it lives in. But the fact that “everything” is becoming dearer simply means that the objective exchange value of money is falling. It is extraordinarily difficult, if not impossible, to subject such assertions as this to historical and statistical tests. The limits of our knowledge in this direction will have to be referred to in the chapter dealing with the problem of the measurability of variations in the value of money. Here we must be content to anticipate the conclusions of this chapter and state that we can expect no support from investigations into the history of prices or from the methods employed in such investigations. The statements of the average man, even though it may very easily happen that these are founded on self-deception and even though they are so much at the mercy of variations in the subjective valuations of the individual, would almost form a better substantiation of the fact of a progressive fall in the objective exchange value of money than can be provided by all the contents of voluminous statistical publications. Certainty can be afforded only by demonstration that chains of causes exist, which are capable of evoking this sort of movement in the objective exchange value of money and would evoke it unless they were cancelled by some counteracting force. This path, which alone can lead to the desired goal, has already been trodden by many investigators-with what success, we shall see.

12 Wagner’s Theory: The Influence of the Permanent Predominance of the Supply Side over the Demand Side on the Determination of Prices

With many others, and in agreement with general popular opinion, Wagner assumes the predominance of a tendency toward the diminution of the objective exchange value of money. He holds that this phenomenon can be explained by the fact that the supply side is almost invariably the stronger and the most capable of pursuing its own acquisitive interest. Even apart from actual cartels, rings, and combinations, and in spite of all the competition of individual sellers among themselves, he claims that the supply side has more solidarity than the opposing demand side. He argues further that the tradesmen engaged in retail trade are more interested in an increase of prices than their customers are in the continuance of the old prices or in price reductions; for the amount of the tradesmen’s earnings, and consequently their whole economic and social position, depends largely on the prices they obtain, while as a rule only special, and therefore relatively unimportant, interests of the customers are involved. Hence the growth on the supply side of a tendency toward the maintenance and raising of prices, which acts as a kind of permanent pressure in the direction of higher prices, more energetically and more universally than the opposing tendency on the demand side. Prices certainly are kept down and re duced in retail trade with the object of maintaining and expanding sales and increasing total profits, and competition may, and often does, make this necessary. But neither influence, according to Wagner, is in the long run so generally and markedly effective as the interest in and striving for higher prices, which is in fact able to compete with and overcome their resistance. In this permanent predominance of the supply side over the demand side, Wagner sees one of the causes of the general increases in prices.
*70

Wagner, that is to say, attributes the progressive fall in the objective exchange value of money to a series of factors which have no effect on the determination of wholesale prices but only in the determination of retail prices. Now it is a well-known phenomenon that the retail prices of consumption goods are affected by numerous influences which prevent them from responding rapidly and completely to movements of wholesale prices. And, among the peculiar determinants of retail prices, those predominate which tend to keep them above the level corresponding to wholesale prices. It is, for instance, well known that retail prices adapt themselves more slowly to decreases in wholesale prices than to increases. But it must not be overlooked that the adjustment must eventually take place, all the same, and that the retail prices of consumption goods always participate in the movements of the prices of production goods, even if they lag behind them; and that it is only small, transient movements in wholesale trade that have no effect on retail trade.

Even if we were willing to admit the existence of a permanent predominance of the supply side over the demand side, it would still be decidedly questionable whether we could deduce a tendency toward a general increase of dearness from it. If no further cause could be shown to account for an increase of wholesale prices—and Wagner does not attempt this at all—then we can argue a progressive increase of retail prices only if we are prepared to assume that the time lag between the movements of retail and of wholesale prices is continually increasing. But Wagner makes no such assumption; and it would be very difficult to support it, if he did. It may be said, in fact, that modern commercial development has brought about a tendency toward a
more rapid adjustment of retail prices to wholesale and manufacturers’ prices. Multiple and chain stores and cooperative societies follow the movements of wholesale prices much more closely than peddlers and small shopkeepers.

It is entirely incomprehensible why Wagner should connect this tendency to a general rise of prices, arising from the predominance of the supply side over the demand side, with the individualistic system of free competition or freedom of trade, and declare that it is under such a system that the tendency is clearest and operates with the greatest force and facility. No proof is given of this assertion, which is probably a consequence of Wagner’s antipathy to economic liberalism; neither could one easily be devised. The more developed the freedom of trade, the more easily and quickly are movements in wholesale prices reflected in retail prices, especially downward movements. Where legislative and other limitations on freedom of trade place small producers and retailers in a favored position, the adjustment is slower and sometimes complete adjustment may even be prevented altogether.

A striking example of this is afforded by the Austrian attempts during the last generation to favor craftsmen and small shopkeepers in their competition against factories and large stores, together with the subsequent considerable rise in prices between 1890 and 1914. It is not under free competition that the conditions which Wagner calls the permanent predominance of the supply side over the demand side are most strongly in evidence, but in those circumstances where the development of free competition is opposed by the greatest obstacles.

13 Wieser’s Theory: The Influence on the Value of Money Exerted by a Change in the Relations Between Natural Economy and Money Economy

Wieser’s attempt
*71 to explain an increase in the money prices of goods unaccompanied by any considerable change in their value in terms of other goods, is not entirely satisfactory either. He holds the opinion that most of the changes in the value of money that have actually occurred are to be attributed to changes in the relations between the “natural economy”
(Naturalwirtschaft) and the “money economy”
(Geldwirtschaft). When the money economy flourishes, the value of money is reduced; when it decays, the value of money rises again. In the early stages of a money economy most wants are still satisfied by the methods of the natural economy. The family is self-supporting; it lives in its own house, and itself produces the greater part of what it needs; the sale of its products constitutes only a supplementary source of income. Consequently, the cost of living of the producer, or, what comes to the same thing, the value of his labor, is not fully allowed for or not allowed for at all in the cost of the products that are sold; all that is included is the cost of the raw materials used and the wear and tear of those tools or other instruments that have had to be specially constructed, which in any case do not amount to much under conditions of extensive production. So it is with the buyer also; the wants that he satisfies by purchase are not among his more important wants and the use-values that he has to estimate are not very great.

Then gradually all this changes. The extension of the sphere of the money economy introduces into cost calculations factors that were not included before but were dealt with on “natural economic” principles. The list of the costs that are reckoned in monetary terms grows longer, and each new element in the cost calculation is estimated by comparison with the factors already expressed in money, and added to them, with the effect of raising prices. Thus a general rise of prices occurs, but this is not interpreted as a consequence of changes in supply conditions, but as a fall in the value of money.

According to Wieser, if it is not possible to explain the increasing rise in the prices of commodities as originating in monetary factors alone (that is, in variations in the relations between the supply of money and the demand for it), then we must seek another reason for these changes in the general level of prices. Now it is impossible to find the reason by reference to such fluctuations in the values of commodities as are caused by factors belonging to the commodity side of the price ratio; for nowadays we are not worse supplied with goods than our forefathers were. But, to Wieser, no other explana tion seems more natural than that which attributes the diminution of the purchasing power of money to the extension of the money economy which was its historical accompaniment. For Wieser, in fact, it is this very inertia of prices which has helped to bring about the change in the value of money during each period of fresh progress; it must have been this that caused the older prices to be raised by the amount of the additional values involved whenever new factors were co-opted into that part of the process of production that was regulated by the money economy. But the higher the money prices of commodities rise, the lower must the value of money fall in comparison. Increasing dearness thus appears as an inevitable symptom of the development of a growing money economy.

It cannot be denied that this argument of Wieser’s reveals important points in connection with the market and the determination of prices, which, if followed up, have important bearings on the determination of the exchange ratios between the various economic goods other than money. Nevertheless, so far as Wieser’s conclusions relate to the determination of money prices, they exhibit serious shortcomings. In any case, before his argument could be accepted as correct, it would have to be proved that, not forces emanating from the money side, but only forces emanating from the commodity side, are here involved. Not the valuation of money, but only that of the commodities, could have experienced the transformation supposed to be manifested in the alteration of the exchange ratio.

But the chain of reasoning as a whole must be rejected. The development of facilities for exchanging means that the new recruits to the economy increase their subjective valuations of those goods which they wish to dispose of. Goods which they previously valued solely as objects of personal use are now valued additionally on account of their exchangeability for other goods. This necessarily involves a rise in their subjective value in the eyes of those who possess them and are offering them for exchange. Goods which are to be disposed of in exchange are now no longer valued in terms of the use-value that they would have had for their owners if consumed by them, but in terms of the use-value of the goods that may be obtained in exchange for them. The latter value is always higher than the former, for exchanges only occur when they are profitable to both of the parties concerned.

But on the other hand—and Wieser does not seem to have thought of this—the subjective value of the goods
acquired in exchange sinks. The individuals acquiring them no longer ascribe to them the significance corresponding to their position in a subjective scale of values
(Wertskala) or utilities
(Nutzenskala), they ascribe to them only the smaller significance that belongs to the other goods that have to be surrendered in order to get them.

Let us suppose that the scale of values of the possessor of an apple, a pear, and a glass of lemonade, is as follows:

1. An apple

2. A piece of cake

3. A glass of lemonade

4. A pear

If now this man is given the opportunity of exchanging his pear for a piece of cake, this opportunity will increase the significance that he attaches to the pear. He will now value the pear more highly than the lemonade. If he is given the choice between relinquishing either the pear or the lemonade, he will regard the loss of the lemonade as the lesser evil. But this is balanced by his reduced valuation of the cake. Let us assume that our man possesses a piece of cake, as well as the pear, the apple, and the lemonade. Now if he is asked whether he could better put up with the loss of the cake or of the lemonade, he will in any case prefer to lose the cake, because he can make good this loss by surrendering the pear, which ranks below the lemonade in his scale of values. The possibility of exchange introduces considerations of the objective exchange value of goods into the economic decisions of every individual; the original primary scale of use-values is replaced by the derived secondary scale of exchange values and use-values, in which economic goods are ranked not only with regard to their use-values, but also according to the value of the goods that can be obtained for them in exchange. There has been a transposition of the goods; the order of their significance has been altered. But if one good is placed higher, then—there can be no question of it—some other must be placed lower. This arises simply from the very nature of the scale of values, which constitutes nothing but an arrangement of the subjective valuations in order of the significance of the objects valued.

The extension of the sphere of exchange has the same effects on objective exchange values as on subjective values. Here also every increase of value on the one side must be opposed by a decrease of value on the other side. In fact the alteration of an exchange ratio between two goods in such a way that both become dearer is inconceivable. And this cannot be avoided by the interposition of money. When it is asserted that the objective exchange value of money has experienced an alteration, some special cause for this must be demonstrated, apart from the bare fact of the extension of the sphere of exchange. But nobody has ever provided this demonstration.

Wieser commences by contrasting, after the fashion of economic historians, the natural economy and the money economy. These terms fail to provide that scientific abstraction of concepts that is the indispensable basis of all theoretical investigation. It remains uncertain whether the contrast of an exchangeless state with an order of society based upon exchange is intended, or a contrast between conditions of direct exchange and of indirect exchange based upon the use of money. It seems most likely that Wieser intends to contrast an exchangeless state with one of exchange through money. This is certainly the sense in which the expressions natural economy and money economy are used by economic historians; and this definition corresponds to the actual course of economic history after the full development of the institution of money. Nowadays, when new geographical areas or new spheres of consumption are brought within the scope of exchange, there is a direct transition from the exchangeless state to that of the money economy; but this has not always been so. And in any case the economist must make a clear distinction.

Wieser speaks of the townsman who is in the habit of spending his summer holiday in the country and of always finding cheap prices there. One year, when this townsman goes on holiday he finds that prices have suddenly become higher all round; the village has meanwhile been brought within the scope of the money economy. The farmers now sell their milk and eggs and poultry in the town and demand from their summer visitors the prices that they can hope to get at market. But what Wieser describes here is only half the process. The other half is worked out in the town, where the milk, eggs, and poultry coming on the market from the newly tapped sources of supply in the village exhibit a tendency toward a reduction of price. The inclusion of what has hitherto been a natural economy within the scope of an exchange system involves no one-sided rise of prices, but a leveling of prices. The contrary effect would be evoked by any contraction of the scope of the exchange system; it would have an inherent tendency to increase the differences between prices. Thus we should not use this phenomenon, as Wieser does, to substantiate propositions about variations in the objective exchange value of money.

14 The Mechanism of the Market as a Force Affecting the Objective Exchange Value of Money

Nevertheless, the progressive rise of prices and its complement, the fall in the value of money, may quite well be explained from the monetary side, by reference to the nature of money and monetary transactions.

The modern theory of prices has stated all its propositions with a view to the case of direct exchange. Even where it does include indirect exchange within the scope of its considerations, it does not take sufficient account of the peculiarity of that kind of exchange which is dependent upon the help of the common medium of exchange, or money. This, of course, does not constitute an objection to the modern theory of prices. The laws of price determination which it has established for the case of direct exchange are also valid for the case of indirect exchange, and the nature of an exchange is not altered by the use of money. Nevertheless, the monetary theorist has to contribute an important addition to the general theory of prices.

If a would-be buyer thinks that the price demanded by a would be seller is too high, because it does not correspond to his subjective valuations of the goods in question, a direct exchange will not be feasible unless the would-be seller reduces his demands. But by indirect exchange, with money entering into the case, even without such a reduction there is still a possibility that the transaction may take place. In certain circumstances the would-be buyer may decide to pay the high price demanded, if he can hope similarly to obtain a better price than he had reckoned upon for those goods and services that he himself has to dispose of. In fact, this would very often be the best way for the would-be buyer to obtain the greatest possible advantage from the transaction. Of course, this will not be true, as in the case of transactions like those of the stock exchange, or in individual bargaining, when both parties cooperate immediately in the determination of prices and consequently are able to give direct expression to their subjective estimates of commodity and medium of exchange. But there are cases in which prices appear to be determined one-sidedly by the seller, and the buyer is obliged to abstain from purchase when the price demanded is too high. In such a case, when the abstention of the purchaser indicates to the seller that he has overreached his demand, the seller may reduce his price again (and, of course, in so doing, may possibly go too far, or not far enough). But under certain conditions a different procedure may be substituted for this roundabout process. The buyer may agree to the price demanded and attempt to recoup himself elsewhere by screwing up the prices of the goods that he himself has for sale. Thus a rise in the price of food may cause the laborers to demand higher wages. If the entrepreneurs agree to the laborers’ demands, then they in turn will raise the prices of their products, and then the food producers may perhaps regard this rise in the price of manufactured goods as a reason for a new rise in the price of food. Thus increases in prices are linked together in an endless chain, and nobody can indicate where the beginning is and where the end, or which is cause and which effect.

In modern selling policies “fixed prices” play a large part. It is customary for cartels and trusts and in fact all monopolists, including the state, to fix the prices of their products independently, without consulting the buyers; they appear to prescribe prices to the buyer. The same is often true in retail trade. Now this phenomenon is not accidental. It is an inevitable phenomenon of the unorganized market. In the unorganized market, the seller does not come into contact with all of the buyers, but only with single individuals or groups. Bargaining with these few persons would be useless, for it is not their valuations alone but those of all the would-be purchasers of the good in question that are decisive for price determination. Consequently the seller fixes a price that in his opinion corresponds approximately to what the price ought to be (in which it is understandable that he is more likely to aim too high than too low), and waits to see what the buyers will do. In all of those cases in which he alone appears to fix prices, he lacks exact knowledge of the buyers’ valuations. He can make more or less correct assumptions about them, and there are merchants who by close observation of the market and of the psychology of buyers have become quite remarkably expert at this; but there can be no certainty. In fact, estimates often have to be made of the effects of uncertain and future processes. The sole way by which sellers can arrive at reliable knowledge about the valuations of consumers is the way of trial and error Therefore they raise prices until the abstention of the buyers shows them that they have gone too far. But even though the price may seem too high, given the current value of money the buyer may still pay it if he can hope in the same way to raise the price which he “fixes” and believes that this will lead more quickly to his goal than abstention from purchasing, which might not have its full effect for a long time and might also involve a variety of inconveniences to him. In such circumstances the seller is deprived of his sole reliable check upon the reasonableness of the prices he demands. He sees that these prices are paid, thinks that the profits of his business are increasing proportionately, and only gradually discovers that the fall in the purchasing power of money deprives him of part of the advantage he has gained. Those who have carefully traced the history of prices must agree that this phenomenon repeats itself a countless number of times. It cannot be denied that much of this passing on of price increases has indeed reduced the value of money, but has by no means altered the exchange ratios between other economic goods in the intended degree.

In order to guard against any possible misunderstanding, it should be explicitly stated that there is no justification for drawing the conclusion from this that all increases of prices can be passed on in this way, and so perhaps for assuming that there is a fixed exchange ratio between the different economic goods and human efforts. To be consistent, we should then have to ascribe the rise in the money prices of goods to the vain efforts of human greed. A rise in the money price of a commodity does as a rule modify its exchange ratio to the other commodities, although not always in the same degree as that in which its exchange ratio to money has been altered.

The champions of the mechanical version of the quantity theory may perhaps admit the fundamental correctness of this line of argument, but still object that every variation in the objective exchange value of money that does not start from changes in the relations between the supply of money and the demand for it must be automatically self-correcting. If the objective exchange value of money falls, then the demand for money must necessarily increase, since in order to cope with the volume of transactions a larger sum of money is necessary. If it were permissible to regard a community’s demand for money as the quotient obtained by dividing the volume of transactions by the velocity of circulation, this objection would be justified. But the error in it has already been exposed. The dependence of the demand for money on objective conditions, such as the number and size of the payments that have to be coped with, is only an indirect dependence through the medium of the subjective valuations of individuals. If the money prices of commodities have risen and each separate purchase now demands more money than before, this need not necessarily cause individuals to increase their stocks of money. It is quite possible, despite the rise of prices, that individuals will form no intention of increasing their reserves, that they will not increase their demand for money. They will probably endeavor to increase their money incomes; in fact this is one way in which the general rise of prices expresses itself. But increase of money incomes is by no means identical with increase of money reserves. It is of course possible that individuals’ demands for money may rise with prices; but there is not the least ground for assuming that this will
occur, and in particular for assuming that such an increase will occur in such a degree that the effect of the decrease in the purchasing power of money is completely canceled. Quite as justifiably, the contrary assumption might also be hazarded, name1y that the avoidance of unnecessary expenditure forced upon the individual by the rise of prices would lead to a revision of views concerning the necessary level of cash reserves and that the resultant decision would certainly be not for an increase, but rather for even a decrease, in the amount of money to be held.

But here again it must be observed that this is a matter of a variation brought about through dynamic agencies. The static state, for which the contention attributed to the adherents of the mechanical version of the quantity theory would be valid, is disturbed by the fact that the exchange ratios between individual commodities are necessarily modified. Under certain conditions, the technique of the market may have the effect of extending this modification to the exchange ratio between money and other economic goods also.
*72

(IV) Excursuses

15 The Influence of the Size of the Monetary Unit and Its Subdivisions on the Objective Exchange Value of Money

The assertion is often encountered that the size of the monetary unit exerts a certain influence on the determination of the exchange ratio between money and the other economic goods. In this connection the opinion is expressed that a large monetary unit tends to raise the money prices of commodities while a small monetary unit is likely to increase the purchasing power of money. Considerations of this sort played a notable part in Austria at the time of the currency regulation of the year 1892 and were decisive in causing the new krone, or half-gulden, to be substituted for the previous, larger, unit, the gulden. So far as this assertion touches the determination of wholesale prices, it can hardly be seriously maintained. But in retail trade the size of the monetary unit admittedly has a certain significance, which, however, must not be overestimated.
*73

Money is not indefinitely divisible. Even with the assistance of money substitutes for expressing fractional sums that for technical reasons cannot conveniently be expressed in the actual monetary material (a method that has been brought to perfection in the modern system of token coinage), it seems entirely impossible to provide commerce with every desired fraction of the monetary unit in a form adapted to the requirements of a rapid and safe transaction of business. In retail trade, rounding off must necessarily be resorted to. The retail prices of the less valuable commodities—and among these are the prices of the most important articles of daily use and those of certain services such as the carriage of letters and passenger transport on railways and tramways—must be adjusted in some way to the available coinage. The coinage can only be disregarded in the case of commodities whose nature allows
them to be subdivided to any desired extent. In the case of commodities that are not so divisible, the prices of the smallest quantity of them that is offered for independent sale must coincide with the value of one or more of the available coins. But in the case of both groups of commodities, continual subdivision of quantities for retail sale is hindered by the fact that small values cannot be expressed in the available coinage. If the smallest available fractional coin is too large to express exactly the price of some commodity, then the matter may be adjusted by exchanging several units of the commodity on the one hand against one or more coins on the other. In the retail market for fruit, vegetables, eggs, and other similar commodities, prices such as two for three heller, five for eight heller, and so on, are everyday phenomena. But in spite of this there remain a large number of fine shades of value that are inexpressible. Ten pfennigs of the currency of the German Reich (equivalent to 1/27900 kg. of gold) could not be expressed in coins of the Austrian krone currency; eleven heller (equivalent to 11/328000 kg. of gold) were too little, twelve heller (equivalent to 3/82000 kg. of gold) were too much. Consequently there had to be small differences between prices which otherwise would have been kept equal in both countries.
*74

This tendency is intensified by the circumstance that the prices of particularly common goods and services are usually expressed, not merely in such fractions of the monetary unit as can be expressed in coins, but in amounts corresponding as nearly as possible to the denominations of the coinage. Everybody is familiar with the tendency toward “rounding off” which retail prices exhibit, and this is based almost entirely on the denominations of money and money substitutes. Still greater is the significance of the denominations of the coinage in connection with certain prices for which custom prescribes payment “in round figures.” The chief examples of this are tips, fees, and the like.

16 A Methodological Comment

In a review devoted to the first edition of this book,
*75 Professor Walter Lotz deals with the criticism that I have brought forward against Laughlin’s explanation of the value of the Austrian silver gulden in the years 1879-92.
*76 His arguments are particularly interesting, inasmuch as they offer an excellent opportunity of exemplifying the difference that exists between the conception and solution of problems in modern economic theory based on the subjective theory of value on the one hand, and under the empirico-realistic treatment of the historically and sociopolitically oriented schools of Schmoller and Brentano on the other.

According to Professor Lotz it is “a question of taste” whether my arguments are “recognized as having any value.” He does not “find them impressive.” He says that he himself was not at first able to agree with Laughlin’s view, until “Laughlin mentioned information, which makes his arguments at least very probable.” Laughlin, in fact, told him that “in the eighties he received the information from the leading house of Viennese high finance, that people were reckoning with the fact that the paper gulden would be eventually converted at some rate or other.” Professor Lotz adds to this: “Certainly it was also of importance that the circulation of paper gulden and silver gulden was quantitatively very moderate, and that these means of payment were accepted by the public banks at their nominal value. All the same, the expectations for the future that the leading house of Viennese high finance had reason to nurse cannot have been quite without effect on the international valuation of the Austrian paper gulden. Consequently it may be justifiable in view of this information to ascribe some weight to Laughlin’s argument, in spite of von Mises.”

The mysterious communication made to Laughlin by “the leading house of Viennese high finance,” and handed on by him to Professor Lotz, was a
secret de Polichinelle. The innumerable articles devoted to the question of the standard that appeared during the eighties in the Austrian and Hungarian papers, especially in the
Neue Freie Presse, always assumed that Austria-Hungary would go over to the gold standard. Preparation for this step had been made as early as 1879 by the suspension of the free coinage of silver All the same, proof of this fact, which is denied by nobody (or at least not by me), in no way solves the problem we are concerned with, as Professor Lotz apparently supposes it to do. It merely indicates the problem that we have to solve. The fact that the gulden was “eventually” to be converted into gold “at some rate or other” does not explain why it was at that time valued at a certain amount and not higher or lower. If the gulden were to be converted into gold, and the national debt certificates into gulden, how did it come about that the interest-bearing national debt bonds were valued less highly than the gulden notes and coined gulden which did not bear interest? That is what we have to explain. It is obvious that our problem is only just beginning at the point where it is finished with for Professor Lotz.

It is true that Professor Lotz is prepared to admit that it was “also of importance” that the circulation of paper gulden and silver gulden was “quantitatively very moderate”; and he grants the validity of yet a third explanation in addition, namely that this means of payment was accepted by the Treasury at its nominal value. But the relationship of these explanations to each other remains obscure. Possibly it has not occurred to Professor Lotz that the first and second are difficult to reconcile. For if the gulden was valued only in consideration of its eventual conversion into gold, it is fair to assume that it could have made no difference whether more or fewer gulden were in circulation, so long, say, as the funds available for conversion were not limited to a given amount. The third attempt at an explanation is altogether invalid, since the “nominal value” of the gulden was only the “gulden” over again and the very point at issue is to account for the purchasing power of the gulden.

The sort of procedure that Professor Lotz adopts here for solving a problem of economic science must necessarily end in failure. It is not enough to collect the opinions of businessmen—even if they are “leading” men or belong to “leading” houses—and then serve them up to the public, garnished with a few
on the one hand’s and
on the other hand’s, an
admittedly or so, and a sprinkling of
all the same’s. The collection of “facts” is not science, by a long way. There are no grounds for ascribing authoritative significance to the opinions of businessmen; for economics, these opinions are nothing more than material, to be worked upon and evaluated. When the businessman tries to explain anything he becomes as much a “theorist” as anybody else; and there is no reason for giving a preference to the theories of the practical merchant or farmer. It is, for instance, impossible to prove the cost-of-production theory of the older school by invoking the innumerable assertions of businessmen that “explain” variations in prices by variations in costs of production.

Nowadays there are many who, busied with the otiose accumulation of material, have lost their understanding for the specifically
economic in the statement and solution of problems. It is high time to remember that economics is something other than the work of the reporter whose business it is to ask X the banker and Y the commercial magnate what they think of the economic situation.