The Economics of Ludwig von Mises: Toward a Critical Reappraisal

The Monetary Economics of

Ludwig von Mises

Laurence S. Moss

The first edition of Ludwig von Mises’
Theory of Money Credit appeared in 1912, one year after the publication of Irving Fisher’s
Purchasing Power of Money (1911) but more than a decade before Alfred Marshall’s
Money, Credit, and Commerce(1922).
*18 Despite the important contributions of Fisher and Marshall to the area of monetary economics, it was Mises who produced the first systematic study of the relationship among money, interest, and prices after Wicksell’s celebrated
Interest and Prices (1898).
*19 While Wicksell’s, Marshall’s, and Fischer’s respective contributions are ritualistically consulted by contemporary scholars, Mises’ contribution is largely neglected and is no longer considered essential to a mastery of the subject matter of monetary economics. Yet the
Theory of Money and Credit cannot be described as either an obscure book or one that has failed to influence the development of monetary economics. The list of scholars who have indicated at least some familiarity with Mises’ monetary thought is formidable and includes men of acknowledged reputation such as Knut Wicksell, Benjamin Anderson, Lionel Robbins, John Maynard Keynes, John R. Hicks, A. W. Marget, and Don Patinkin. If to this
list we add the names of several generations of veteran participants in Mises’ famous monetary seminars, offered first in Vienna, then in Geneva, and later in New York, the roster must be expanded to include Friedrich Hayek, Fritz Machlup, Gottfried Haberler, Alexander Kafka, Leland Yeager, Murray Rothbard, Israel Kirzner, and myself, to name only a few.
*20

What is it about this book and the arguments it contains that has kept it for nearly seventy years in limbo between virtual obscurity and academic acclaim? It is my view that Mises’
Theory of Money and Credit has all the earmarks of a genuine economic classic—it touches on more of the essential problems of monetary economics than any other single work of the first quarter of the twentieth century—but it lacks an acceptable methodological framework for analyzing monetary problems. Where J. R. Hicks, Oscar Lange, and Don Patinkin harnessed the mathematical technique of “mutual determination” to the solution of the fundamental issues in monetary economics, mises operated in the world of deductive-casual models in the acknowledged tradition of Menger and Böhm-Bawerk. While orthodox monetary theory developed its essential propositions for a world without lags and troublesome distribution effects, Mises put all this at the heart of his analytic system.

I shall illustrate these points by showing how Mises’ monetary economics is related to several currents of thought in the period before World War I. In section 1, I begin by critically evaluating the relation of Mises’ theory of the demand for money to the work of his mentor and founder of the Austrian school, Carl Menger. I show that by confusing the demand for money with the demand for the
services provided by money, Mises was forced to modify one of the basic tenets of the Austrian position in order to apply the theory of marginal utility to money. Also, I demonstrate how Mises’ insistence on the relative unimportance of the speculative demand for money actually cut short a line of development in Austrian thought that would have proved useful to his own theory of business fluctuations. I conclude by summarizing the important contributions Mises made toward our understanding of the relationship between price expectations and inflation.

1. THE DEMAND FOR MONEY

For both Menger and Mises, the important fact about money is that it does not come into existence by community vote or governmental fiat but instead is the unintended consequence of the historical evolution of the market economy. Individuals engage in trade and commerce in order to acquire commodities capable of satisfying human wants. They willingly trade commodities only if they expect to improve their situations by doing so. There are circumstances, however, in which an individual may find it profitable to accept a commodity in exchange, not because that commodity is itself directly suited or serviceable to his personal needs but rather because he expects to be able to market that commodity at a later date for other commodities that are directly serviceable to his wants. Such a commodity acts as a medium through which exchange takes place.
*21

In an exchange economy virtually all commodities are marketable, but not to the same extent. As commerce develops, individuals discover that certain commodities are acceptable on many markets; this acceptance establishes their reputation as media of exchange and further enhances their marketability. Even-
tually one commodity snowballs in reputation and becomes readily acceptable on all markets. This commodity is called “money,” and its essential feature is its universal marketability.

The marketability attribute of the money commodity is sometimes confused with its purchasing power, that is, its ability to command a definite quantity of another commodity in exchange. Marketability refers to the frequency with which a commodity is accepted in trade. It is true that this frequency itself must be conditioned by how many units of another commodity this first commodity may be expected to command in exchange, but it is not the extent of the purchasing power of this commodity in
particular markets that is important in defining “marketability”; rather it is the fact that a commodity is capable of being traded in
all markets. Stated another way, what is important about money is not that it is a “temporary abode of purchasing power” but that it is a temporary abode of purchasing power in all markets.
*22

In the typical model of the barter economy there can be no a priori way of deciding which of the commodities is best suited to be money, because all commodities are assumed to be traded against one another. One cannot say that it will be the commodity with the greatest purchasing power that will serve as the medium of exchange, because at any set of relative prices one can always make the objective exchange value of a commodity look greater by redefining the units in which it is measured. According to Menger, the “most marketable commodity” is determined as the outcome of a complex historical process, which can be described in only the most general manner. The origin of money is as elusive as the origin of language itself.
*23

While Menger used this historical account merely to explain that the process by which the community comes to adopt one commodity as its money is thoroughly market oriented, Mises attempted to expand the argument so as to account for the determination of the purchasing power of the monetary unit as well. According to Mises, when an individual decides what the size of his nominal, or cash, balances is to be, he consults the purchasing power of money as it appeared “yesterday” in the market. This decision on the part of all individuals about the optimal size of their nominal balances will
in turn affect the purchasing power of money “today” and thereby require that individuals readjust their balances “tomorrow,” until, according to Mises, an “equilibrium” position is reached.
*24 In this way the past behavior of market prices affects future market outcomes.

At first sight, this appears to be a peculiar position for a member of the Austrian school to adopt. Menger and the Austrians that followed him never tired of explaining that the market process is “forward looking” and not imprisoned by the past. Commodities are valued today because they are capable of satisfying future wants, and resources are valued according to the intensity and extent of the future wants they are capable of satisfying. All market prices are ultimately derived from the marginal utilities of the commodities they help produce. In the market “bygones are forever bygones”; that is, while past historical data may guide the market participants in their plans, they never guarantee their successful outcome. Menger, Böhm-Bawerk, and Mises were in agreement that there is no greater fallacy in the entire science of economics than the pernicious doctrine that monetary costs expended on the production of commodities determine what the market prices of those commodities will be. The downfall of the English classical school was its failure to recognize that the value of resources is derived from the value of the commodities they help produce, and any coincidence between cost of production and market price simply indicates that entrepreneurs have been successful at their job of anticipating
future needs.
*25

It is not necessary to proceed further with this summary of the Austrian theory of value in order to indicated how heretical Mises’ position on money may seem to those familiar with the position of the older Austrian school. To assert that the value of money depends on its past purchasing power is to admit that the past behavior of prices exerts an influence on future prices—the very antithesis of Menger’s teachings. Let us see by what reasoning Mises came to this position.

We begin by developing Mises’ notion of “pure fiat money.” As is well known, the commodity that the community adopts as its money generally possesses certain physical characteristics that
make it capable of satisfying a variety of nonmonetary wants. For example, gold coins can be melted down to make jewelry, and paper money can be used to wallpaper a room. According to Mises, these other uses of the money commodity outside the sphere of exchange must be considered of secondary importance to a general theory of money. A pure theory of money must yield thorems that apply to all forms of money regardless of the material out of which it is made. Mises explained how the historical evolution of monetary and banking institutions (for example, the development of the clearing system and the introduction of a variety of paper monies into the exchange economy) demonstrates that no fact about money essential to the determination of its purchasing power depends on the stuff out of which the money is made.
*26 Thus it is necessary at the outset of any investigation into the pure theory of money to abstract completely from the real-world fact that money is often made of valuable materials that are themselves capable of satisfying nonmonetary wants. The reader may find it useful to think of the entire stock of money as consisting of paper money, with the paper of so poor a quality that it has no alternative use outside the monetary sphere. From now on our use of the term
money refers to these disembodied units of purchasing power. In Hicks’ felicitous phrase, money is the “ghost of gold.”
*27 The problem then is to explain how individuals decide how many units of money to hold, that is, how they determine the size of their cash balances.

Inasmuch as individuals do find it necessary to hold money and expend part of their wealth in order to acquire money, this disembodied object must satisfy some want. Furthermore, the stock of money in the possession of each individual is capable of variation, as individuals are constantly faced with the choice of building up or reducing their existing cash balances, that is, they are compelled to arrive at an estimate of the marginal utility of money. According to Mises, the marginal utility of money is derived from the marginal utility of the commodities money is capable of purchasing, or, stated another way, the use value of money coincides exactly with its exchange value.
*28 It would seem, therefore, that if the demand
for money depends entirely on the exchange value of money, individuals must have some idea of what the purchasing power of money is prior to determining the size of their cash balances. But how can individuals have any idea the purchasing power of money when it depends in large part on the size of the cash balances individuals are willing to hold? Thus we seem to have come full circle in our attempt to explain the purchasing power of money by means of utility theory. What we have arrived at is the infamous “circularity problem,” which was one of the leading problems in monetary theory at the time Mises wrote.
*29

It will be instructive at this point if we try to understand why this same problem does not arise in an analysis of the exchange value of a nonmonetary commodity such as bread. The marginal utility of bread depends on the physical characteristics of bread that make it serviceable to men’s wants and the hierarchy of wants themselves. According to Mises, both sets of conditions do not belong to the “economic at all but are partly of a technological and partly of a psychological nature.
*30 Having described the demand conditions for bread, it is in principle possible to determine the exchange value of bread. But with money the situation is altogether different because “the subjective value of money is conditioned by its [purchasing power] i.e., by a characteristic that falls within the scope of economics.”
*31 In the case of money it is not possible (even “in principle”) to conceive of its having value without making reference to its past purchasing power.

We may question whether this distinction between money and other commodities is not a bit overdrawn. There are many commodities that individuals demand partly for their want-satisfying characteristics and partly because they are capable of being exchanged at a later date for other commodities. We need not restrict our examples to rare coins and antiques, inasmuch as all commodities that shed their services over extended periods are capable of being resold during their lifetime in highly developed resale markets. In cases such as these would not the exchange value of the commodity itself affect the market demand? Certainly Mises would
be prepared to admit that in a highly developed economy, all commodities, insofar as they yield any liquidity services, could also serve as “assets.”

While Mises did not deny the obvious possibility that in an advanced money economy individuals may acquire nonmonetary commodities for the express purpose of being able to exchange them at a later date for other commodities directly serviceable to their needs, he insisted that this practice only becomes widespread during exceptional times, that is, when the existing monetary order is headed for a complete breakdown as during the course of hyperinflation. According to Mises, “Under present organization of the market, which leaves a deep gulf between the marketability of money on the one hand and 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.”
*32 Thus when Mises insisted that the marginal utility of commodities is determined by nonmarket considerations and the marginal utility of money is derived entirely from its exchange value, we must interpret this as pertaining to a money economy operating under what Mises described as “ordinary circumstances.”

In such economy individuals find it necessary to hold cash balances because they need to maintain a fund of instant purchasing power. The number of units of money they demand depends on the efficiency of the monetary unit in acquiring commodities, and this in turn depends on the past array of market prices. When planning their cash requirements on a particular market day, individuals have no basis for evaluating the purchasing power of money other than its past “track record.” Thus while all other market plans are essentially forward looking in the sense described earlier, the demand for money is necessarily “backward looking.” Mises explained that to “demand of a theory of the value of money that it should explain the exchange-ratio between money and [other] 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.”
*33

1. In his assertion that the
only way the demand for money can be consistently incorporated into the general body of utility theory is by introducing historical prices, Mises is quite mistaken. Patinkin demonstrated how to derive a demand curve for money without resorting to past price behavior by performing what is essentially a “thought experiment” in which the individual is confronted with alternative levels of commodity prices and asked how many units of money he will demand in each case. The set of all combinations of price levels and resulting money demands constitutes the individual demand curve for cash balances. The aggregation of all individual demand curves “horizontally” at all price levels yields the market demand curve for nominal balances, and this in conjunction with the (assumed inelastic) supply of money serves to define the “market-clearing” price level. This procedure is the analogue of the familiar neoclassical supply-and-demand analysis, which serves to define the market-clearing price for particular commodities. In Patinkin’s barter-money model there is no reference to past price behavior because the method of
“comparative statistics” abstracts completely from historical time.
*34

It is interesting to notice, however, that Patinkin and Mises agreed that the individual cannot decide the extent of his monetary needs (i.e., the size of his cash balances) without knowledge of the array of market prices. Both writers assumed that the demand for a certain number of units of the money commodity is really a disguised demand for a definite quantity of reserve purchasing power. The individual has no way of determining how many units of money he will require unless he has some knowledge of the absolute effectiveness of each unit in acquiring other commodities in the market. What enters into each individual’s utility function is not the demand for a certain quantity of money but the demand for a certain fund of ready purchasing power, what Patinkin appropriately called “real balances.”
*35

The introduction of “real balances” as a factor in the utility function is quite congenial to the spirit of Mises’ analysis. Mises argued at great length that the money commodity is desired only because of the nonmonetary commodities it is capable of purchasing. Individuals continually adjust the size of their cash balances so that the number of units of money they hold provides them with a certain quantity of purchasing power. If an individual perceives that his cash balances are providing him with a greater amount of purchasing power than he desires, he will buy either interest-bearing securities or commodities in an effort to “dispose of the superfluous stock of money that lies useless on his hands.” In the opposite case, where cash balances are too small, the individual will “take steps to reach the desired level of reserve purchasing power by suitable behavior in making sales and purchases.”
*36

Having decided that Mises’ demand for money is really a demand for a certain quantity of real cash balances, we ask what determines the size of real cash balances individuals desire to hold? The basic reason for holding money is the lack of simultaneity between payments and receipts and the need to hold transaction balances in order to bridge the gap between the two. Mises reasoned that since money enters into most transactions, in a grow-
ing economy, as the number of transactions per person increases, the individual is required to hold larger stocks of real cash balances.
*37

According to Mises, however, the largest part of the real balances held by individuals is used to provide for unplanned expenses that may arise in the future. A sudden illness or an unanticipated breakdown in plant machinery makes it necessary for economic agents to hold a certain quantity of reserve purchasing power as a type of insurance. Mises explained that this precautionary demand for real cash balances, unlike the transactions demand, tends to fall as the market economy develops highly liquid forms of interest-bearing property. The individual holds a precautionary stock of real balances because the transaction costs of moving out of nonmonetary assets into money are too great to effectively meet emergency payments. With the development of resale markets for certain types of securities these costs decline substantially, and individuals are thereby able to maintain a certain level of liquidity by substituting securities for real cash balances.
*38

It would seem then that the “premium” the individual pays for the marginal dollar of precautionary balances is measured by the interest forgone by not purchasing a dollar’s worth of “highly liquid” securities. But Mises denied this implication by stating that to regard “interest as compensation for the temporary relinquishing of money [is a view of] insurpassable naivety.”
*39 Elsewhere Mises was even more explicit about this matter when he denied that the demand for
real cash balances is in any way interest elastic: he wrote that there is no direct connection between the rate of interest and the amount of money held by the individuals who participate in the transactions of the market.
*40 Thus while Mises did describe something approximating a liquidity-preference demand for real cash balances, he insisted (without argument) that there is no regular functional relationship between the interest rate and the demand for such balances.

In the end Mises viewed real cash balances as something individuals must hold because of the structure of the payments mechanism and the uncertain nature of the world in which they
live. While the size of an individual’s real balances is a subjective matter determined by his own appraisal of his economic situation and subject to revision from time to time, the individual views these balances as sort of the dues he must pay in order to successfully participate in the market economy.
*41 Certainly they provide the individual with utility but only in the same way that the legal order provides individuals with utility—real balances are merely part of the framework within which market action takes place.

Thus Mises’ writing reveal a tendency to view the individual’s desired level of real balances as something relatively constant and determined by the structure of the world in which he operates and the way he perceives that world. This approach is actually a retrogression from Menger’s concept of the demand for money. In his late writings Menger argued that the bulk of the cash balances are held by individuals for speculative purposes. For Menger, market prices are subject to wide dispersion over both time and place; consequently, individuals hold money balances in search of “bargain prices.” For example, an individual seeking to purchase a “used” typewriter must have the ready cash to move into the market for typewriters without delay as soon as he spies a machine being offered on favorable terms. In this way, Menger called attention to the speculative demand for money that applies to all markets wherever future prices are uncertain.
*42

Although the holding of speculative balances means forgoing the opportunity of purchasing an interest-bearing asset, this loss promises to be offset by the marginal capital gain of buying a commodity on more favorable terms than would otherwise be possible. Clearly, a lowering of the market rate of interest must encourage an increased holding of real balances for speculative purposes, and hence the liquidity-preference approach is entirely consistent with Menger’s treatment of the demand for money. In Menger’s view, the speculative balances held by individuals are a rational response to a world of uncertain prices, and balances held for this purpose are actually a type of investment, the rate of return on which can be measured by the expected capital gain of the individual.

Without explanation Mises simply rejected the Mengerian notion of an investment demand for money except during the exceptional times of monetary crisis. Mises agreed with Menger that during the long evolutionary period before a single money came into existence the competing media of exchange had to be marketable over both time and place. However, with the appearance of highly developed markets for the resale of interest-bearing property, this store-of-value function of money loses importance, as few will demand real cash balances for investment purposes when they can own interest-bearing assets instead. Here Mises simply failed to recognize that from the economic point of view speculative balances are not “barren” but perform a valuable service for the individual.
*43

If it were possible to measure the amount of price variation that characterizes each market in the economy, the resulting “coefficients of price variation” would come out lowest for those markets in which standardized commodities like bread, milk, and other articles of final consumption are sold and highest for the markets in which the industrial ovens for baking bread and the machinery needed to process the milk are sold. What I have in mind here is that capital goods transactions as well as all other transactions that involve other highly specialized goods may offer an opportunity for speculative behavior that does not exist in markets closer to the consumer. If this is true, a lowering of the market rate of interest will produce not only an increased demand for speculative balances but also an increased trade in markets for what Menger called “higher order” goods. This may result in a deepening of the capital structure, something that both Mises and later Hayek described as characteristic of the boom period of the business cycle, when banks encourage borrowing by lowering the market rate of interest. It is unfortunate that Mises overlooked Menger’s speculative demand for money and the implied interest elasticity of the demand for real balances, because it really opens a line of investigation that might have proved quite congenial to his own work on the business cycle.
*44

To summarize: Mises explained the individual’s demand for real cash balances in terms of both the transactions and precautionary
motives, motives that depend on “the organization of the whole social apparatus of production and exchange” and not on either the interest rate or the individual’s own wealth position. Thus while real cash balances enter into the individual’s utility function (as they must since they are the object of purposive market action), they enter into it as a fixed magnitude. The individual forms no estimate of the marginal utility of real cash balances but only of the marginal utility of the monetary unit so that he may decide how many units of the money commodity he must hold in order to have some already decided fund of real purchasing power. Patinkin’s formulation of the demand for (real) cash balances, which emphasized the substitution effect between real balances and other forms of nonmonetary wealth, applies the marginal utility theory directly to the question of what level of real balances is optimal and hence is a more general development of the strand of marginal utility analysis Mises pioneered.
*45

Why did Mises apply the marginal utility theory to the demand for the money commodity rather than to the demand for real balances, which the money commodity only represents? I believe the answer has to do with Mises’ unwillingness to include anything but goods of final consumption in the individual’s untility function.
*46 This explains why Mises emphasized that the marginal utility of money must be defined in terms of the marginal utility of the commodities that money is exchanged for in the market. But in other places he mentioned the twin services money provides as a bridge between payments and receipts and as a fund of real purchasing power against future unforeseen contingencies. Yet it is not enough that real cash balances are serviceable to wants because they satisfy them in a manner different from all other commodities. Mises explained that, when an individual destroys, say, one dollar’s worth of milk, the (real) national product falls, but when that same individual burns a dollar’s worth of the money commodity, the (real) national product remains unchanged.
*47 Let us elaborate on the relationships involved here in more detail. The immediate impact of the destruction of a dollar’s worth of money is to lower the in-
dividual’s real cash balances by one dollar. If the individual seeks to reestablish his level of real purchasing power, he must consume fewer commodities in the market. This brings about a tendency for market prices to fall just a little, and everyone else’s real cash balances to rise just a little. As the other individuals increase their consumption in order to reduce their real cash balances to their desired level, the essentially release the money the first individual is looking for. In equilibrium once again, the stock of money has fallen by one dollar, the price level is a bit lower, but all real magnitudes are left unchanged, including each individual’s real cash balances, which have returned to the original level.
*48

Certainly, this suggests that the marginal utility of the money commodity must be zero, since the loss of one unit ultimately results in the loss of nothing real. Mises may well have been troubled by this conclusion, because it implies that individuals seek to acquire something which in the aggregate they really do not want—a position that strikes a sour note among economists who view man as a purposive agent. Had Mises realized that the marginal utility theory should be applied to the
services provided by real cash balances and not to the money commodity itself, a great deal of obscurity in his discussion might have disappeared. But the year was 1911, and there was much more that had to be said before J. R. Hicks could at last clarify the distinction between the demand for money and the demand for the services provided by money in his famous 1935 article.
*49

Thus we have seen that Mises’ statements about the
form the utility theory must take when applied to the demand for money are largely incorrect and result from a failure to distinguish adequately between the “utility of money” and the “utility of the services provided by money.” Patinkin’s technique of counting real balances as a part of the individual’s wealth, and thereby incorporating real balances directly into the individual’s utility function, permits the development of a theory of the demand for money that is not related to historical prices. But while Patinkin’s approach offers much in the way of generality, something is also lost. In the Patinkin barter-money model the money commodity can be any of
the many commodities available, since all commodities are assumed to be freely tradable in all markets. The barter economy is transformed into a money economy by the deceptively simple assumption that “the nth commodity is money.” In the Mises formulation, however, the whole point of the analysis is to explain the exchange value of a commodity that is different from all others
because it is freely tradable on all markets. Whether the gains in historical realism offered by Mises’ approach are worth the sacrifice of the theoretical compactness of Patinkin’s approach and whether the two approaches can be combined are questions worth discussing, especially in light of Clower’s criticisms of the barter-model approach.
*50 I shall not stop to consider this problem here.

2. One of the principal contributions of the
Theory of Money and Credit is the consistency with which Mises explored the implications of the fact that individuals consult the past behavior of market prices when planning the current size of their cash balances. Here historical prices are used to develop a bold empirical hypothesis about the way expectations about future prices are formed. In this area I consider Mises’ contributions to be of great doctrinal importance.

Mises employed the hypothesis that the past behavior of prices affects current planned cash holdings to explain why, in countries where inflation has been most rapid, “the decrease in the value of the money has occurred faster than the increase in its quantity.”
*51 What happens, according to Mises, is that people come to expect the inflation to continue well into the future and, rather than have the purchasing power of their cash balances steadily erode, take actions to reduce their real cash reserves. This causes the inflation to accelerate as large numbers of individuals go about substituting commodities and securities for cash. It remained for later economists to develop a theory of the “optimal” demand for real cash balances at each level of inflation, but Mises was certainly one of the early developers of this line of thought.
*52

Mises was also one of the earliest to explain why during prolonged inflations individuals experience a definite “shortage of
money” when it is actually an “abundance of money” that is causing the inflation in the first place. What happens is that the individuals (anticipating an increase in the
rate of inflation) allow their real cash balances temporarily to fall below their (long-run) desired level. In such circumstances the prices being asked and bid for most commodities are no longer related to the present quantity of money in circulation but to the future expected quantity of money. Individuals allow their cash balances to fall dangerously low in the expectation that their future money incomes will rise by enough to allow them to restore their cash balances to the desired level. If the monetary authorities suddenly lower the growth rate of the money supply, money incomes will not increase quickly enough to restore cash balances, and individuals will experience a definite shortage of money. They will complain to the monetary authorities about a lack of liquidity and will insist that all would be well if the monetary authorities would pursue a less restrictive policy. The inability of bankers to understand the causes of this shortage-of-money phenomenon soon leads them down the perilous path of stepping up the growth rate of the money supply.
*53

Mises also applied his price-expectations hypothesis to the problem of “sellers inflation” and sketched an argument that is especially interesting in light of the current economic confrontations of a cartelized world economy. Mises explained that the modern economy is characterized by a wide variety of markets in which cartels, trusts, monopolies, and state-regulated prices predominate. Ordinarily, the profit-maximizing monopolist discovers the maximum price he can charge by raising his price and watching what happens to his sales. If sales fall off by enough to lower total receipts, the monopolist knows that he has gone too far. But during a prolonged inflation the buyers find it more economical to pay the higher price asked than to abstain and chance paying a still higher price later. In Mises’ words, buyers pay the high prices in the hope of “screwing up” the prices of the goods they sell by enough to offset the difference. Thus the result is that market demand curves become more inelastic, and cash balances are reduced to raise the extra revenues. Thus the inflation indirectly leads to an increase in
the monopoly power of existing cartels and creates the incentives for other cartels to be formed. This argument is an interesting one and may explain why the cartelization of industry and prolonged inflation are not separate events coincidently occurring at the same point in time but rather interconnected phenomena.
*54

While the tendency among economists of Mises’ day was to link the demand for cash balances to the current level of economic activity and then bring price expectations in as a sort of afterthought, Mises placed the past behavior of prices at the very heart of his conception of money. The hypothesis that the past behavior of price is the basis on which market participants form their expectations about future price behavior has proved extremely valuable in the econometric investigation of the demand for money, especially during severe inflations.
*55 I do not think that Mises has been given adequate credit for having pioneered this approach.
*56

2.
THE PROPORTIONALITY THEOREM

There is an affinity between Wicksell’s
Interest and Prices and Mises’
Theory of Money and Credit because both economists attempted to put the quantity theory on a firm basis by reconciling it with the then-recent marginal utility theory of value.
*57 According to Wicksell, the marginal utility theory explains the structure of relative commodity prices but not the absolute level level of the prices themselves. The quantity theory, on the other hand, specifies the price level that is consistent with a given stock of money, volume of output, and “velocity of circulation,” but does not explain the mechanism by which changes in the supply of money bring about changes in the level of prices. Wicksell resolved these difficulties by emphasizing the pivotal role cash balances play in linking the money and commodity markets. Every individual is required to hold a certain quantity of (real) money balances in order to conduct his ordinary economic affairs, and when his existing cash balances exceed (or fall short of) this required level, he must expand (or contract) his commodity purchases accordingly. This
same behavior carried out simultaneously by large numbers of economic agents results in movements in the absolute level of commodity prices. In the event the money supply increases and (real) cash balances are larger than individuals desire them to be, the increased spending in the commodity market will raise the level of prices and lower real balances until the community is willing to hold the expanded stock of money. When actual (real) cash balances are once again equal to desired (real) cash balances for all individuals, the equilibrium level of prices has been attained.
*58

There can be little doubt that Mises’ own presentation of the cash-balance mechanism owed much to Wicksell. However, what disturbed Mises most about Wicksell’s presentation of the cash-balance mechanism was his conclusion that the price level generally changes in direct proportion to changes in the quantity of money. What we shall call the “proportionality theorem” is based on the following reasoning: Since, in equilibrium, relative commodity prices are equivalent to the relative marginal utilities of the commodities whose prices are being compared, changes in the size of individual cash balances cannot affect relative prices unless they in some way alter the underlying marginal utilities for the goods in question. Furthermore, the marginal utility of commodities depends entirely on the relationship among the physical characteristics of commodities, their supply, and the hierarchy of human needs, and so alterations in cash holding that do not affect these underlying real magnitudes must leave relative marginal utilities unaltered. Thus when a monetary disturbance has finally worked itself out, all relative prices must be at their original values, which implies that if prices have changed, they must have changed in the same proportion. Said another way, Wicksell argued that changes in the quantity of money have a
neutral impact on relative commodity prices.
*59

Mises flatly denied that there was any way by which the
physical quantity of money could be increased and relative commodity prices remain unaltered. According to Mises, even if it were possible by some magically defined formula to distribute a given increase in the money supply among individuals in such a way as to
leave their relative wealth positions unaltered, demand curves still would not shift to the right by enough to raise prices proportionally. According to Mises, for this shift to occur, the marginal utility schedule of the money commodity must be a rectangular hyperbola so that, say, a doubling of the individual’s cash balances lowers the marginal utility of the monetary unit by one-half. Mises dismissed this possibility by stating that it is an “absurdity” to assume that for each individual a doubling of money leads to a halving of the exchange value he ascribes to each unit.
*60

What Mises evidently failed to realize is that this allegedly absurd assumption is implicit in his own account of the demand for money. If the individual demands a certain fund of real purchasing power and continually adjusts his nominal cash balances with this object in mind, then a doubling of his nominal balances will result in a halving of the marginal utility of the monetary unit. To escape this conclusion Mises would have to assume that the individual’s demand for real cash balances is itself a variable subject to utility calculations. Then a doubling of the individual’s nominal money balances would have the immediate effect of making him wealthier, which probably would increase his demand for
real balances and prevent the marginal utility of the money commodity from falling by a full one-half.
*61 But this approach requires that we include real balances within the individual’s utility function, something that, as we have seen, Mises was not willing to do.

Mises also erred when he assumed that Wicksell’s “proportionality theorem”
necessarily requires that the marginal utility of the money commodity be inversely proportional to the size of the individual’s nominal cash holdings. As Patinkin elegantly demonstrated for an economy where everyone’s wealth position is permanently fixed, all that is required for a given increase in the money supply to lead to a proportional increase in prices is a positive excess demand for each commodity in each market
until its price has finally doubled. This condition includes the situation Mises described as a special case.
*62

Mises was on more solid ground when he argued that as a
practical matter an increase in the
physical quantity of money alters the ex-
isting distribution of community wealth and hence cannot have the neutral effect on relative commodity prices that Wicksell and other advocates of the proportionality theorem supposed it would. In this context Mises criticized Irving Fisher for basing part of his defense of the proportionality theorem on a subtle confusion between a change in the physical quantity of money and a change in the accounting definition of the money unit. As Fisher explained in
Purchasing Power of Money, when the government changes the denomination of money so that what was previously called a “half dollar” is now called a “dollar,” all market prices change in the same proportion. Fisher claimed that this is an instance where a doubling of the nominal quantity of money is accompanied by a doubling of all money prices.
*63 Mises explained, however, that only the accounting definition of the monetary unit has been changed, not the actual quantity of money. If tomorrow the Bureau of Weights and Measures decrees that all one-inch units are to be renamed “one foot,” and all twelve-inch rulers renamed “four yards,” and so on, only a fool would insist that the absolute size of all real objects has increased. Changes in the accounting definition of money are of a purely legal, or stipulative, nature and do not necessitate a process of market adjustment.
*64

In Mises’ view, every increase in the physical quantity of the money commodity must manifest itself as an increase in the cash balances of one or more economic agents in the market. For this reason, a successful reformulation of the quantity theory must begin with the brute fact that an injection of new money into the economy always results in an increase in the cash balances of certain individuals and never in the cash balances of everyone at once. According to Mises, the economic consequences of this phenomenon necessarily give rise to a redistribution of wealth and hence to an alteration in relative commodity prices. Suppose (under a fiat standard) the monetary authorities print a new batch of money to pay for the completion of a highway project. The members of society directly involved in the highway project find their cash balances greater than they expected and go out to spend the new money on commodities and various financial assets.
*65 This
increased expenditure brings about a tendency for prices to rise, especially the prices of products favored by the recipients of the new money. However, the money that is spent shows up as an increase in the cash balances of other individuals, and the rise in prices spreads to other commodities. This inflationary process continues and reduces the real balances of individuals
but not to the same extent. Individuals “weigh” the impact of a change in relative prices differently, and hence some individuals will judge the decline in the purchasing power of money to be very great, while others may view it as being quite small. The more heterogeneous the consumption patterns of individuals (i.e., the wider the currency area), the less reliable will be any single “price index” as a measure of the decline in the purchasing power of the money commodity.
*66 When a new equilibrium “price level” is finally attained, the now larger stock of money will be distributed among the market agents in such a way that each is holding his desired level of real purchasing power in the form of cash balances once again. In this new equilibrium position those individuals who were the first to receive the new money (i.e., the highway people) will probably find their wealth positions increased, and those who were the last to receive the new money will probably find their wealth positions worsened. What has happened is that the increase in the quantity of money has given rise to a process of market adjustment that has altered the relative wealth positions of individuals.
*67

It may happen that when relative and absolute prices change so as to make all economic agents once again content with the size of their cash balances, the shift in wealth ends up favoring those individuals with high propensities to save. Secondary effects will be promoting the accumulation of capital, lowering the “natural” rate of interest, and augmenting the productive capacity of the nation. In this way an increase in the quantity of money brings about an increase in production—the well-known phenomenon of “forced savings.” But it is just as likely that the increase in the quantity of money could result in “forced consumption” and the destruction of productive capacity. Mises contended that in most cases the phenomena involved are too complex for the monetary authorities
to know in advance which tendency will prevail. The only thing that may be said for certain is that some redistribution will occur.
*68

Mises correctly pointed out that the fundamental cause of these elusive “distribution effects” is the lack of simultaneity among various price changes. Those individuals who find their revenues increasing more quickly than their expenses are made wealthier while those in the reverse situation are made poorer. Mises explained (citing Fisher and Knies) that, if it were possible to fully anticipate the extent of the future decrease in the purchasing power of money, these wealth effects could be mitigated by altering contractual interest rates to include an “extra” compensation for the decline in the purchasing power of money. According to Mises, this does happen over short periods as the market rate of interest is observed to move upward during inflations.
*69 Over a long period, however, it is difficult if not impossible for individuals to anticipate what impact changes in the purchasing power of money will have on personal standards of welfare.

It is worth mentioning that contemporary discussions of “real in-indebtedness effects” support Mises’ contention that “once-and-for-all” type increases in the quantity of money will have nonneutral effects on the money economy. In a world where it is possible to convert transitory gains into permanent gains by buying and selling bonds, an increase in the quantity of money will not only alter relative commodity prices but will change the real rate of return on capital as well.
*70 The “proportionality theorem” still has a place in contemporary monetary theory as a long-run proposition about the relationship between money and prices during prolonged, and therefore anticipated, inflations. Consider the situation where the money supply grows during each period by a certain fixed percentage. According to the standard analysis, after a transitional period during which desired real balances are reduced and long-term contracts “indexed,” prices will rise continuously at the same rate as the money supply. The “new” money flows through the economy augmenting individual cash balances by enough to keep their real value constant, and the inflationary revenue that the money-issuing authorities receive is equal to the nominal value of the new money
issued.
*71 Much discussion has centered on the question of whether the benefits of inflationary finance exceed the burdens imposed on the economic community, but little discussion has focused on the problem Mises raised of the mechanism of market adjustment that these long-run consequences are supposed to follow.

In a world where individual cash balances simply grow in size automatically (like Frank Knight’s famous Crusonia Plant), the “proportionality theorem” Would have some validity, inasmuch as the new money would never change hands and hence would never give rise to a lagged process of adjustment. But in a world where the money-issuing authorities introduce the new money by buying different types of goods, services, and financial assets (and at different points in time as well), the “first round” of monetary expansion affects the cash balances of individuals differently. To dramatize this point, let us consider the existence of just one individual named Miser Joe whose demand for real balances in infinitely elastic. If new money is given to Miser Joe, the process stops dead in its tracks, despite the fact that the percentage increase in the money supply may be the same in this period as it was in the preceding period. It seems that analysis of fully anticipated inflation requires not only that the rate of growth of money remain fixed but also that the route by which the new money enters and passes through the system stay the same from one period to the next. How this assumption is at all relevant to the historical process by which new money is injected into the economy by existing governments is a point that has not received adequate attention by contemporary theorists.

3.
THE ORIGIN OF THE AUSTRIAN THEORY OF THE BUSINESS CYCLE

We have seen that the essence of Mises’ approach to monetary economics consists of the view that not only the size of the increase in the money supply but also the route by which the new money enters and makes its way through the economic system affect the
final market outcome. It was in applying this method of analysis to a problem raised by Wicksell’s famous theory of cumulative expansion that Mises laid the foundations of the Austrian theory of the trade cycle.

In Wicksell’s analysis of bank credit expansion, the commercial banks by holding the market rate of interest below the real rate of interest bring about a cumulative increase in the demand for bank loans and consequently a cumulative increase in commodity prices. The problem Wicksell raised in
Interest and Prices is whether there is an automatic “brake” on the process of bank credit expansion that would prevent the rise in prices from going on indefinitely if the bank authorities keep the market rate of interest below the natural rate and are willing to meet all demands for credit. Wicksell argued that the prices of credit expansion must come to a halt when the reserved-deposit ratio of the commercial banks falls below the legal limit or simply becomes too low for the bankers’ own comfort. The banks, fearing either “fines” or a full-scale liquidity crises, raise the money rate of interest, and the inflation comes to a halt with absolute prices remaining permanently higher. In the case of a pure fiat system in which there are no required reserves or convertibility pledges to worry about, the cumulative expansion of the money supply and subsequent inflation can continue as long as the bankers keep the money rate of interest below the real rate of interest.
*72

Mises found Wicksell’s analysis of the problem unsatisfactory, and in the third part of his
Theory of Money and Credit he tried to explain why the cumulative expansion process must come to an end
even under a pure fiat system.*73 According to Mises, when the commercial banks encourage additional borrowing by lowering the market rate below its natural level, entrepreneurs are encouraged to make more long-term investments, that is, to lengthen the “period of production.”
*74 With the newly issued bank money entrepreneurs bid resources out of the production of consumption goods into the production of capital goods despite the fact that no additional planned savings has taken place. Consumer prices must rise to generate the “forced savings” required to make the increased
capital goods construction possible. Finding wages and resource costs higher than expected, the entrepreneurs turn to the banks to demand a larger quantity of money than before. Mises believed that the size of the money supply would increase not only absolutely but proportionately as well, so that the Wicksellian cumulative expansion process could not go on indefinitely without a collapse of the monetary order under the strains of hyperinflation.
*75 The only alternative to the destruction of the monetary order is for the banks to restore equality between the money rate of interest and the natural rate of interest, in which case the sudden cutoff of entrepreneurial loans will require the liquidation of partly completed projects and the transfer of resources to other parts of the economy.
*76

The details of the theory are sketchy, and Mises failed to prove that the rate of growth of the money supply must necessarily accelerate when the market rate is held below the natural rate. It remained for Mises’ student F. A. Hayek to develop Mises’ idea into a full-fledged theory of the modern trade cycle.
*77 The Mises Hayek theory of the business cycle centers around the idea that the route by which newly created money enters the economy is essential in determining its impact on the monetary order. The analysis treats increases in the quantity of money as necessarily involving changes in relative prices and transfers in wealth among individuals. If present-day monetary economics seems far removed from the concerns of Mises and Hayek, the only reason is that it treats all increases in the quantity of money as being essentially alike and disregards the question of the “transmission mechanism” by which the new money makes its impact felt on the money economy by assuming relative prices are (after a brief transition period) left unchanged.

4.
CONCLUSION

Having come to the end of my survey of the monetary economics of Ludwig von Mises, I would like to say a few words about his con-
tribution to the theory of economic policy. Mises favored an international monetary mechanism that would constrain the money-issuing proclivities of modern governments. He recognized that one of the great threats to the liberal ideal of a free, mobile, and prospering world economy is the tendency on the part of government to increase state coffers by using the “printing press’ rather than by borrowing or issuing new taxes. For Mises the guaranteed consequence of this policy, which he termed “inflationism,” is the wholesale redistribution of the wealth and property of individual citizens. This redistribution is accomplished, not by the method of parliamentary debate and legislative action, but by haphazard and cruel method that leave the poorest and most disadvantaged segments of the population worse off than before. In Mises’ view the great threat to the survival of democratic ideals and the organization of modern industrial life is a hyperinflation that would ravage the world economy like an angry fire, destroying the property and aspirations of the masses and creating conditions for military takeover and total state control.
*78

As a practical matter, Mises favored commodity gold standard whereby each government would have to maintain the convertibility of money in terms of gold. Any policy of inflationism would be short lived in the wake of declining gold reserves, or the state would suffer the diplomatic embarrassment of having to redefine its currency unit in terms of gold. Mises, of course, realized that the resource costs of such a monetary arrangement are high, and the system itself is never totally insured against sudden and sometimes massive changes in the quantity of money that originate from, say, technological innovations in the processing of gold or new mine discoveries.
*79 But the virtue of the arrangement is not that it makes it too costly for the size and growth of the money supply to become an object of government policy. Mises preferred the impersonal mechanisms of the market, no matter how imperfect, to the whims and gluttonous excesses of power-hungry politicians. In Mises’ view, the strategy that is currently favored in liberal quarters, that of moving toward a less expensive fiat currency system while urging
the monetary authorities to pass parliamentary decrees limiting their own appetities, is as idealistic as expecting a child not to eat candy placed in his hand.

Following Wicksell, Mises called attention to the fact that commercial banks issue deposits that act as a substitute for currency in the cash balances of individuals.
*80 According to Mises, the specific way by which banks create money under fractional reserve arrangements and the manner in which they introduce the new money into the economic system necessarily bring about an overinvestment of resources in capital goods production and the need for subsequent business readjustments. For this reason, Mises paired his advocacy of the gold standard with a system of free (competitive) banking in order to eliminate the possibility of severe business downturns.
*81

By modern-day standards Mises must be termed a “monetarist,” for he surely believed that changes in the quantity of money are the primary cause of aggregate instability. In one respect, however, Mises was even more radical in his monetarism than traditional advocates of the quantity theory, such as Wicksell, Fisher, and Friedman; for he refused to consider the “proportionality theorem” as being at all relevant to the experiences of modern money economies. The proportionality theorem suggests that there are circumstances in which changes in the quantity of money can lead to changes in the absolute level of commodity prices but level all real economic magnitudes (i.e., relative prices) unchanged. For Mises there are no circumstances in which the modern technology of money creation permits it to have a neutral impact on the money economy. In short, not only does money matter, but it matters all the time!