Mises’ battle against monetary socialismMay 1, 2013·Kristoffer Mousten Hansen
It is more than 20 years since the collapse of communism in Eastern Europe and the Soviet Union.
One would think that the rest of the world had learned one obvious lesson from this — that free market economics offers the best means for the advancement of human wealth, living standards and general happiness.
To an extent, this is the case: Eastern Europe is certainly a freer, more prosperous place than under the socialist regimes. Across the western world the 1980s and 1990s saw deregulation and economic liberalisation became fashionable, and certain advances were made in some countries — notably in terms of privatising formerly state owned industries and curbing trade union power. These changes were personified best in the forms of British Prime Minister Margaret Thatcher and US President Ronald Reagan. Not for nothing did "Reaganomics" and "Thatcherism" enter the political lexicon.
It is therefore no surprise that in the years following the financial upheaval of 2007-08, social democrats, socialists and "reformed" communists are pointing to liberalisation and free markets as the culprits for all that bedevils economies — claiming that these caused the bubble and subsequent recession of the first decade of the third millennium.
Plausible as this explanation may seem to some, it is simply wrong. For while capitalism may have flourished in certain sectors of the economy over the last three decades — notably in the electronics and computer industries — there is a crucial sector of society where government control and central planning has not receded, but instead expanded to a point where the state is more dominant than at any time since the years immediately following the Second World War. This is in the field of money and banking. Throughout the western world central banks control the money supply, fix reserve ratios for banks, set interest rates, and regulate the financial sector. Most economists think that this is right and proper. It is therefore vital that the lessons of Ludwig von Mises and his followers are not forgotten, or else we risk heading for the kind of economic crisis that will make 2008 look like child's play.1
Ludwig von Mises was the foremost member of the Austrian school of economics in his day. His work in the field of monetary theory is based on studies by Carl Menger, the Austrian School's founder, whose theory of money was first put forward in the 1871 book Principles of Economics.2
Mises' contribution to economics was made possible because he consistently grounded his thinking in the subjective theory of value first developed by Menger. It is this realisation that economic phenomena are derived from people's subjective valuations and their actions informed by them, that set Menger apart from the other "fathers" of the Marginal Revolution — Jevons and Walras, and which to this day distinguishes the Austrian school from all others.
Money is the common medium of exchange.3 It is a good used in exchange between individuals not because they want it for its own use-value, but because it can be used to exchange for goods wanted for consumption or production uses. Money came into being not by government fiat or at the dictate of a powerful king.4 Rather, it arose out of barter as individuals gradually realised that they could better reach their aims by exchanging the goods they brought to market for goods that they did not want for their own sake, but which had a greater marketability. The problem of the double coincidence of wants present in direct exchange, that is, the need to find someone offering what you want while wanting what you offer, was gradually overcome as more and more people began exchanging their goods for more marketable goods. As they did so, these more marketable goods would again become more marketable because of this added demand, and there would be a gradual process of selection between these goods until only the most marketable of them remained in demand for their marketability. That is, until a money was established in a given society.
This process has played out several times in the course of history. Goods as diverse as cigarettes and precious metals have been used as money. The current monetary and financial system, though at present nearly entirely under the control of governments, grew out of a centuries-long process of selection that began before the Classical Age of Antiquity. The oldest forms of money we know of are the iron spits used by the Greeks — the obols.
Obols had many of the characteristics that denote a "good" form of money: they were durable, divisible and portable. And they had a high use-value independent of their use as a medium of exchange. Iron was, however, soon replaced as even better materials for monetary use were found: gold and silver. These had an even higher use-value, were more durable as they did not corrode, and could easily be subjected to purity tests. Silver was used for small day-to-day transactions while gold was used for large purchases and in wholesale trading.5
These early moneys were simply pieces of metal. Coinage was invented as an easy means to test metal purity: the imprint on the coins was a guarantee by the mint that the coin contained the proper quantity and quality of the precious metal in question.6
We need not go too deeply into the history of how rulers and governments arrogated to themselves the privilege of being the sole issuer of coinage. Before the birth of Christ, coinage was everywhere in the classical world a government monopoly. The problem with this monopoly was that it allowed governments to pursue the fraudulent practice of debasement unchecked: they would mix the silver or gold with a base metal and stamp the coin as being pure precious metal, thereby swindling the public.7
It may appear a grave objection to all this that the monies currently in use throughout the world have no independent use-value. They exist by government fiat, it would seem, and are therefore called fiat money. Mises recognised the possibility that there might be such a thing as fiat money, though he doubted (in 1912) that it had ever existed.8 What at that time might be called fiat money was properly credit money: claims to underlying commodity money, like for instance the notes of the Bank of England after Britain suspended redemption into specie during the Napoleonic Wars.
Our present fiat money regime grew out of Bretton Woods system, which was still based on gold, though not in as direct a form as existed prior to the First World War. From 1944 to 1971, dollars were claims to the gold in Fort Knox and other depositories, even if only foreign central banks could act on these claims. Whether the European currencies before 1971 can be regarded as fiat money or some sort of credit money is difficult to decide, given that although they weren't tied directly to gold, they were indirectly via their fixed links to the dollar. There is however no question that post-Bretton Woods, all currencies are fiat money — albeit ones that evolved from the credit and commodity monies of earlier times.
Mises showed that money is a market phenomenon. Any material is only given currency as money as a result of commercial usage. Even government's fiat paper money is only money so long as it is accepted as such in free exchange.
As important as these basic insights are, Mises' contributions did not end there. For derived from the development of money and nearly as important is the whole world of financial economics; of banks and loans and deposits, and in this field too Mises made important contributions that led him to the first development of the Austrian theory of the business cycle.
Coins and notes are money, but there is another type of money — what Mises called money substitutes. These consist nowadays principally inchequeing accounts and demand deposits in banks, but bank notes were in earlier times also money substitutes. A money substitute is essentially only a claim tomoney. They are usable because of the peculiar nature of money as an economic good that is never consumed in use but only exchanged. A secure claim to money can perform all the functions of proper money so long as it is accepted as a secure claim.9 It is the peculiar character of money substitutes that makes it possible for banks to create fiduciary media — claims to money not backed by actual money on deposit in banks.10
The creation of fiduciary media and the system of fractional reserve banking underlying it can exist on the unhampered market. A bank may fraudulently increase the amount of claims to money beyond what it has in store, or there may be some confusion as to the legal nature of the deposits, leading the banks to create more claims than they have backing for.11
In the environment of free banking, the amount of fiduciary media a bank can issue is always very limited. For while the claims to money issued by the bank are perfect money substitutes among its own clientèle, this is not so for clients of other banks. Once a cheque or bank note is presented at a competing bank, this bank will seek to redeem it in base money at the issuing bank very quickly. Even if fractional reserve banking is permitted, then, in a regime of free banking there will be severe limitations on the amounts of fiduciary media any bank can create.12
The creation of fiduciary media has more severe effects than simply exposing a single bank to the risk of bankruptcy. The whole capital structure of the economy and the interest rates are affected. When a bank emits a batch of fiduciary media it typically does so in the form of loans to businesses. This drives down the interest rates, making it cheaper for businessmen to loan money and thus encouraging them to engage in projects and investments that would not have been profitable at the higher interest rate before creation of fiduciary media. In Mises' words, a gap is created between the monetary rate of interest and the equilibrium or natural rate of interest.13 Once one bank starts the expansion of credit, offering lower interest rates, the other banks have no alternative but to follow suit or they will be driven out of business. The crucial point is that by thus artificially lowering the rate of interest, the banks create the illusion that there are more funds available for investment than is really the case.
This process of credit expansion takes a certain amount of time to complete. If for instance reserves are halved it takes time before all that extra money and fiduciary media filter through the banks out to the non-banking sectors of the economy. But once the expansion is completed the rate of interest will rise to its "natural" level, and people will suddenly realise that there is not enough credit for the businessmen to finish all the projects they had begun. Either a depression must clear the system of these malinvestments or a new round of credit expansion by the banks will postpone the depression, allowing the businessmen time to complete their projects.
This process cannot go on indefinitely, however. A depression must come at some point, otherwise the amount of fiduciary media will grow so large as to usher in rising inflation until the whole economy is finally wrecked as people flee into real value in a “crack-up boom”.14 This happens when the public becomes convinced that the prices of all commodities will rise substantially. If this happens everyone will try to buy as much as possible as soon as possible, restricting cash holdings to a minimum.
Once the credit expansion is under way, it is merely a question of how large the depression that will end it is to be, as there is no way to inflate your way out of the problems once the bubble has been blown.15
It should be clear that Mises points the way towards a sound foundation for the world’s monetary and financial system — one based squarely on the apodictic truths of economic science. A Misesian monetary reform would, whatever the specifics in any given case, consist of two basic changes: first, the banks would be prohibited from issuing any more fiduciary media. Second, governments would be prevented from engaging in inflationary practices. This is most simply done by separating government from the monetary sphere completely — there is, as should be plain from the above, no reason to think that government intervention should be beneficial in monetary affairs; and both historical experience and theorical economics teach us that it is always and everywhere maleficent.
It is doubtful whether fundamental reforms according to Austrian monetary theory are imminent. It is therefore more important than ever to make the world aware of the basic economic laws governing human life. For, as Mises himself wrote, if men do disregard the teachings and warnings of economics they will not annul economics; “they will stamp out society and the human race.”16
1 That Mises was right in the debate over the impossibility of socialism was famously acknowledged in 1989 by Robert Heilbroner. We can only hope that economists and politicians will also realize the truth of Mises’ monetary theories before it is too late.
2 C. Menger, Principles of Economics, trans. J. Dingwall and B. F. Hoselitz (Vienna, 1871 / Institute for Humane Studies 1976)
3 L. von Mises, The Theory of Money and Credit, trans. H. E. Batson (New Haven: Yale University Press, 1953) p. 29
4 For the following, see Menger, Principles of Economics p. 257ff.
5 Mises, Theory of Money and Credit, pp. 62-67
6 See J. G. Hülsmann, The Ethics of Money Production (Auburn, AL: The Ludwig von Mises Institute, 2008) p. 35ff.
7 See M. N. Rothbard, The Mystery of Banking 2nd ed. (Auburn, AL: The Ludwig von Mises Institute, 2008) pp. 11-12 for some examples of the extent of debasements. See also L. von Mises, Human Action, the scholar’s edition (Auburn, AL:The Ludwig von Mises Institute, 1998) pp. 761-763 for the role of debasement and price manipulation in the decline of ancient civilization.
8 Mises, Theory of Money and Credit p. 61
9 Ibid., p. 267
10 Ibid., p. 263ff. The best current overviews of how fiduciary media are created are Rothbard, The Mystery of Banking and J. Huerta de Soto, Money, Bank Credit and Economic Cycles, trans. M. A. Stroup (Madrid: Unión Editorial, 2006 / Auburn, AL: The Ludwig von Mises Institute, 2009) chapter 4
11 Rothbard, Mystery of Banking, p. 89
12 This is why Mises looked favourably on a regime of free banking as a means to end the recurring business cycles, as he did not trust government to wield the power of setting the legal reserve requirement. For if it could set it at 100%, what was to stop it from lowering it and thereby reap the short-term benefits of the business cycle? See Mises, Human Action, p. 443, quoting Henri Cernuschi; compare however The Theory of Money and Credit p. 323 where Mises seems to suggest that the introduction and use of fiduciary media was a sign of progress as it helped extent the money economy
13 Mises, The Theory of Money and Credit p. 349ff.
14 Mises, Human Action pp. 424, 433
15 The phenomenon of deflation during recession, which some may argue is properly fought by inflation, is really just a consequence of the malinvestments and overconsumption of the boom and is simply part of the necessary readjustment. See the Mises Daily by W. L. Anderson ‘Murray Rothbard and the Deflation Bogey’ http://mises.org/daily/4602
16 Mises, Human Action, p. 881
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