Treatise on Money
Mises' greatest lifetime achievement was to build an all-encompassing systematic theory
of human action, which he first presented in Nationale économie 1940 and Human Action
1949. His system was the result of two large research projects overlapping in time, the
first one concerning economic science as such, while the second dealt with epistemological
and Methodological Foundations of this science. He published his Reflections on Epistemology
and Methodology in the period from 1929 to 1962. His great economic research project
extended from 1912 to 1940. It started with a treatise on money, in which Mises unfolds
an original theme that he later expands, systemises and eventually brings full circle in national
The great original theme of his economic writings concerned the integration of the theory of
money and banking into the framework of the Mengerian theory of value and prices. Mises
dealt with it in his first treatise, Theory of Money and Credit, which had earned him
the coveted license to teach at Austrian universities. Carl Menger too had obtained a habilitación
for an original theory of money, which he had published as Chapter 8 of Principles.
Mises thus continued a Mengerian tradition by grounding his academic reputation on monetary
analysis. He did not submit only one chapter, though, but a complete treatise.
In his Theory of Money, Carl Menger had been mainly concerned with explaining the origin
of money as a social institution. He stressed that money did not come into being like Athena
from the brow of Zeus, but developed step by step out of a non-monetary commodity. However,
Mises had not applied his marginal value theory to money itself. The reader of principles
could get the distinct impression that value theory only applied to consumers' goods and
factors of production, and that money was not subject to the same rules. What then is
the relationship between marginal value and money? This was the question at the heart
of the Theory of Money and Credit. Mises answered it in the second, the central part of the
the book and thereby brought the Austrian theory of value and prices full circle. Money was
no longer a special case but could be fully accounted for by the new marginal value theory.
In his treatise, Mises went as far as he could to integrate the theory of money and banking
into the general theory of value and prices. From the outset he was aware that his exposition
would be inadequate. He later explained, The greatest difficulty I faced in the preparation
of the book was the fact that I meant to give special attention to merely a limited part
of the total scope of economic problems. But economics necessarily must be a complete and
united whole. In economics there can be no specialisation. To deal with a part, one must
do so on the foundation of a theory that comprises all the problems. But I could not use any
of the existing theories. The systems of Menger and Boehm-Bawerk were no longer wholly satisfactory
According to prevailing opinion at the time, the theory of money could be clearly separated
from the total structure of economic problems. It did not, in fact, even belong with economics.
In a certain respect, it was an independent discipline. In accordance with this opinion,
the universities in Anglo-Saxon countries had created special professorships for currency
Strategy and Banking. It was my intention to reveal this position as erroneous and restore
the theory of money to its appropriate position as an integral part of this science of economics.
If I could have worked quietly and taken my time, I would have begun with a theory of
direct exchange in the first volume and then I could proceed to the theory of indirect
exchange. But I actually began with indirect exchange because I believed that I did not
Unfortunately, his forecast proved to be right, and for many years the war and its
aftermath prevented him from systematically elaborating his more general ideas in print.
But these ideas, nurtured through the war experience, came to light more powerfully
in an essay on the problems of economic calculation in socialist regimes, which Mises published
in 1920 in Max Weber's Archiv für Sozialwissenschaft und Sozialpolitik, arguably the most avant-garde
German social science journal of the day. Here he expanded on the difference between
valuation and money-based economic calculations, a difference he had stressed but not elaborated
Mises observed that economic calculation consists of the computation of market prices, prices
that can only emerge in the interaction of private property owners, since an extended
division of labour is possible only because decisions can be based on economic calculus.
It follows that socialist societies, which by definition have no private property in
the means of production and thus no market prices for them, could not possibly enjoy
In the manner of Boehm-Bawerk, Mises had derived crucial political insights from seemingly
arcane theoretical distinctions. He followed his calculation piece with a comprehensive
treatise on socialism, 1922, again thoughts he had kept to himself and developed over
over many years burst forth in the span of a few months. In Nationale Economie 1940 and
Human Action 1949, he finally gave a presentation of the whole body of economic science in light
of the difference between valuation and calculation.
My Nationale Economie finally afforded me the opportunity to present the problems of
economic calculation in their full significance. Thus, I accomplished the project that had
The Nature of Money
As a true disciple of Carl Menger, Ludwig von Mises began the presentation of his Theory
of Money with an analysis of the nature of money itself. He then went on to deal with
the determination of money's purchasing power and with the impact of what he called
Umlaufsmittel, fiduciary media, on the monetary system. In dealing with the nature of money,
Mises relied heavily on the work of Carl Menger. The founder of the Austrian School had shown
that money is not to be defined by the physical characteristics of whatever good is used as
money. Rather, money is characterized by the fact that the good under consideration
is one, a commodity that is, two, used in indirect exchanges, and three, bought and
sold primarily for the purpose of such indirect exchanges. Menger also stressed that money
Money emerges spontaneously on the market as a response to the lack of the double coincidence
of wants. Indirect exchanges are resorted to, for example, by the chairmaker seeking to
buy a dozen eggs from the farmer who already has enough chairs, or by the painter trying
to purchase a glass of beer from the brewer who does not care for art. They first exchange
their products into highly marketable commodities such as salt, wheat or silver coins in order
The significance of this fact was that a monetary system could come into being without a prior
social contract and without government fiat. Although Menger delivered a painstaking analysis
of the process of the emergence of money, a process that was, in his view, the best
illustration of the emergence of social institutions, he was not the first economist to point out
that money does not come into being by social contract. Among Menger's predecessors were
John Law, 1705, Ferdinando Galliani, 1751, Etienne de Condillac, 1776, Adam Smith, 1776,
Antonio Genovese, 1788, Jean-Baptiste Say, 1802, and Richard Watley, 1832. Mises added
to and refined this analysis of the nature of money in four ways. First, he took issue
with the idea that the functions of money, being a means of exchange, a store of value,
a means of payment, a means of deferred payments, a numéreur, measure of value, were of equal
importance. Mises argued that a commodity could play the role of numéreur only because
it was used as a means of exchange, and similarly, a commodity was held as a store of value precisely
Thus, there was a hierarchical order of the functions of money. The means of exchange was
primordial, being a necessary condition for the others. Second, Mises developed a comprehensive
typology of monetary objects, that is, in Mengerian language, of all the things generally
accepted as media of exchange. On the most fundamental level, he distinguished several
from several types of money in the narrower sense from several types of money surrogates
or substitutes.
Money in the narrower sense is a good in its own right.
In contrast, money substitutes were legal titles to money in the narrower sense.
They were typically issued by banks and were redeemable in real money at the counters of
the issuing bank.
In establishing this fundamental distinction between money and money titles, he applied
had crucial insights of Boehm-Bawerk's pioneering work on the economics of legal entities. He
stressed claims are not goods, they are means of obtaining disposal over goods. This determines
their whole nature and economic significance. As his exposition in later parts of the book
would show, these distinctions have great importance for both the integration of money
theory within the framework of Menger's theory of value and prices, and for the analysis
Mises of the role of banking within the monetary system.
At the heart of his theory of banking is a comparative analysis of the economic significance
of two very different types of money substitutes.
Mises observed that money substitutes could be either covered by a corresponding amount
of money, in which case they were money certificates, or they could lack such coverage, in which
case they were fiduciary media, umlaufsmittel.
This is devoted the entire last third of his book to an analysis of the economic consequences
of the use of Umlaufsmittel. Regrettably, this comparative focus of his analysis was
lost in the English translation of the title of the book, Theory of Money and Credit. The
term Umlaufsmittel, which literally translates into means of circulation, was rendered in
the English text as fiduciary media. Consequently, the title of the book should have been Theory
of Money and Fiduciary Media, but the publisher decided that the unusual terminology would
irritate readers and thus opted for the smoother but toothless theory of money and credit,
failing to honour the fact that even in the original German version the expression was
unusual.
Mises was hostile to innovations in language that were not justified by the analyses of
hitherto neglected phenomena, but the difference between money certificates on one hand and
Umlaufsmittel, on the other hand, was such a neglected phenomenon to the point that established
scientific terminology even lacked the means for expressing this difference. Mises thus
introduced the expression Umlaufsmittel for this purpose and even used it in the title
of his book to highlight its importance.
Third, Mises refuted the idea that money prices are a measure of value. Here he relied on
the work of the Czech economist Franz Kuhl, who some years earlier in his Zur Lehrer von
von der Bedürfnissen on the theory of needs, had clarified several fundamental issues of
the new Mengerian price theory. Kuhl was a champion of the psychological theory of marginal
utility, Gosson, Jevons, Weiser, but several of his contributions to the theory of value
and utility proved useful despite that fact. Kuhl refuted Boehm-Bawerk and Weiser's quantitative
claims about marginal utility, which refer to homogenous units of a supply of goods,
where each individual unit provides the same utility. According to Boehm-Bawerk, the utilities
derived from the use of several units could be added to the point that the utility, say,
of consuming fifteen plums equals exactly fifteen times the utility of consuming one
plum. But Kuhl objected that this contradicted the basic idea of the law of diminishing marginal
utility, namely, that the satisfaction derived from the consumption of each additional unit
of the Good is lower than the utility derived from the consumption of the previous unit.
Boehm-Bawerk had made this claim in a long essay on the Theory of Value, his first statement
on value theory. It was this passage that met with criticism in Kuhl and Mises. Mises
said many years later that, in distinct contrast to corresponding passages in Boehm-Bawerk's
Positive Theory of Capital, the statement in Grundzüge was incompatible with the whole
Tenor of Boehm's Theory. This letter raises a certain problem because Mises here said
that Boehm-Bawerk eventually realized his error and expressed the correct formulation
in a later edition of Capital and Interest. But in the second edition of Theorie des Geldes
und der Umlaufmittel, Mises said Boehm-Bawerk had not said anything new on this matter.
Kuhl also made a devastating case against interpersonal comparisons of satisfactions.
The benefits derived from the consumption of two different goods could be compared only
from the fact that an individual chooses to enjoy satisfaction A rather than B, one can
infer that A yields more satisfaction to this person than B does, because at the time of
the choice both A and B were present and competed directly with one another. Hence the observed
choices of individuals provide evidence about the relative size of enjoyment. But this is
is the only type of evidence available, because it is fundamentally impossible to perceive
the comparative satisfactions of other people.
Cool, call subjective utilities by the unusual name of Eugenzen. In an analogous case, Wilfredo
Pareto called subjective utility Ophilimite. One can only have direct knowledge of the utilities
that the satisfaction of various needs has for oneself. Other people's utilities have
have to be inferred indirectly from their actual decision-making.
It follows that there is no such thing as value calculation or even value measurement.
Even money does not have a constant value and is therefore unable to provide the basis
for a value calculus.
Moreover, since money prices are the result of individual valuation processes, they are
individual historical events always determined by the particular circumstances in which they
emerge.
Contrary to what Balrassi's system of equations suggest, there are no constant relationships
between money prices of different times and places.
It was therefore out of the question to follow Erwin Fischer in his attempt to establish
a quantitative law such as in physics of the relationship between the quantity of money
and money prices, the price level.
Mises placed great emphasis on this crucial implication of value theory for the methodology
of economics.
Because there are no constant relations in the field of human action, the equations of
mathematical catallactics cannot be made to serve practical problems in the same way the
equations of mechanics solve problems through the use of data and constants that have been
ascertained empirically. In my book on money, I did not say one controversial word against
the mathematical school. I presented the correct doctrine and refrained from attacking the
I refuted mathematical economics by proving that the quantity of money and the purchasing
power of the monetary unit are not inversely proportional. This proof demonstrated that
the only constant relationship which was believed to exist between economic quantities is a
variable determined by the data of each individual case. It thus exploded the equations of exchange
Mises' criticism of the mechanical version of the quantity theory had an impact well
beyond the theory of money, for this version of the quantity theory represented a larger
agenda, a quantitative view of social science in general. Mises showed that there are no
quantitative constants linking human actions to repercussions in the social realm. An increased
Demand for Apples would in all cases lead to higher Apple prices than would otherwise
have existed, but there is no law that tells us that a 10% increase of the Apple demand
will cause, say, an 8% or a 14% increase of Apple prices. Actual quantities will always
depend on the particular circumstances of each individual case.
Fourth and finally, Mises dealt more explicitly than Menger with the claims of the monetary
by Statists or Charterists. Whereas Menger had argued that money could emerge spontaneously
on the market, the statist scholars asserted that money was a creation of the state. Debate
on this topic can be traced back to the times of Plato and Aristotle. It ran all through
the Middle Ages and was only settled for a short while by classical economists who had
argued along Nigerian lines. But at the time of the 19th century the statist struck back.
Cernucci in France, Neupalper in Austria and Lexis in Germany reasserted the view that
money is what the state declares to be such.
But the most famous champion of this view was Georg Knapp, the same Knapp who had pioneered
the studies on Germanic rule as a liberating force for East European peasants.
In his Stadtliche Theorie des Geldes, State Theory of Money, Knapp argued that money
was a creation of the legal order, and that the theory of money therefore had to be studied
as a branch of legal history. According to Knupp, money came into being through government
proclamation, the state says that this or that is money, and it suddenly becomes a token
for some corresponding amount of real goods. The essence of money was therefore to be a
government-proclaimed token, charter, in Latin, that could be used as a legally valid means
of payment. Knupp thought he had to create an entirely new vocabulary to adequately deal
Knupp's views were not well received at first, in particular Andreas Voigt, one of the leaders
of the small but growing cadre of anti-Schmoller economists, gave Knupp an unfavourable review,
but did find early support from prominent bankers, and eventually won many converts
to the State Theory of Money. His chartalist theory did, after all, perfectly complement
The Statist Convictions Already Prevalent Among German Economic Professors, as Mises
later observed. The Statist School of German Economics has probably reached its high point
in Georg Friedrich Knapp's State Theory of Money. It is not per se remarkable that
this theory has been formulated, after all its tenets have been championed for centuries
in the writings of canonists, jurists, romantics and certain socialists. What was remarkable
Typical was rather the success of the book. Mises referred to Anderson's verdict that
Knapp's book has had wide influence on German thinking on money. It is typical of the tendency
in German thought to make the state the centre of everything.
He also quoted Carl Menger's exasperated comment on the success of the state theory
of money.
It is the logical development of Prussian police science. What are we to think of a
nation whose elite, after two hundred years of economics, admire such nonsense which is
is not even new as Highest Revelation.
Knopp's fundamental error was in failing to see that government orders can only be
relevant in the context of presently existing contracts involving deferred payments. Exposed
governments can determine what should be counted as money and hence what should be counted
as payment, but it does not have the power to impose on market participants the future
use of any means of exchange. Business usage alone can transform a commodity into a common
Integration of Value Theory and The Theory of Money
Although the new, marginalist approach to the theory of value and prices had thoroughly
transformed economic science, the theory of money had been left virtually untouched.
Here, Menger, Jevons and Walras championed the same view as the classical economists,
Stressing that money is merely instrumental in acquiring real goods, goods which have
some beneficial impact on human life without itself being such a good.
From an individual perspective, they argued the ultimate purpose of market exchanges is
never to exchange real goods against money, but to exchange real goods against other real
goods.
And taking the perspective of the national economy, they emphasized that the quantity
The Theory of Money did not affect the overall available quantity of goods. From these insights
they concluded that money was irrelevant to the wealth of the nation, and that political
economy which dealt with the economic interests of the whole nation could afford to ignore
money when analysing the nation's welfare. This particular standpoint for evaluating
social problems is also reflected in the standard German names for the disciplines of economics
Economics, nationale économie, national economics, and volkswirtschaftslehre, Theory of the Economy
of the Nation. The most famous metaphor for this view was the veil of money, the notion
that money is merely an intermediate layer between the human person and the real economy.
John Stuart Mill had given clear expression to this perspective. Things which by barter
The word exchange for one another will, if sold for money, sell for an equal amount of
it, and so will exchange for one another still, though the process of exchanging them will
consist of two operations instead of only one. The relations of commodities to one another
remain unaltered by money. The only new relation introduced is their relation to money itself.
How much or how little money they will exchange for, in other words, how the exchange value
The Theory of Money itself is determined. Money, according to Mill, did not influence
the wealth of nations whatsoever, it just reflected or corresponded to the underlying
non-monetary reality. Menger, Jevons and Walras also endorsed this view, and consequently
they accorded all their attention to the supposedly real factors of the economy, to the neglect
of the monetary theory. Neither champions nor opponents of the new economic theory failed
The Swedish economist Knut Wichsel observed that the new discoveries in value theory had
not been applied to money, and the brilliant German economist Karl Helfrich even thought
the new marginalist approach could not be applied to money.
In his book Das Geld, the future director of Deutsche Bank and German Minister of Finance
argued that in the marginal utility approach, which in his understanding explained the market
market prices of goods as a consequence of the psychological utility of the various services
of these goods, the price determining utility of a good depended exclusively on the available
quantity of the good.
But in the case of money, this exclusive dependency could never be given. While the services derived
from any other good were independent of its market price, the services derived from the
use of money depended directly on its market prices, that is, its purchasing power. In
In other words, the marginal utility of money depends not only on its quantity but also
on its market prices. Therefore, any attempt to explain the value of money on the basis
of the marginalist approach involved an inescapable circle. The market price for money could not
be inferred from its marginal utility, because its utility itself depended on its market
price. It is noteworthy that in his exposition Helferich conflates physical and value terms.
Wiese's Theory of Money The first reaction from the Austrian camp came
from Friedrich von Wiese when he chose the value of money as the topic for his inaugural
lecture at the University of Vienna on October 26th, 1903. The lecture was published under
the title Der Geld wird und seine geschichtlichen Veränderungen, The Value of Money and Its
Historical Changes. It was the first statement of Wiese's ideas on how the theory of money
related to the Austrian Theory of Value. Monetary theory remained at the centre of Mises economic
research until his death in 1926. He wrote two more lengthy papers for the 1909 Vienna
meeting of the Rhein für Sozialpolitik and also the lengthy entry on money for the post-war
edition of the standard German social science dictionary, the Handwerter Buch der Staatswissenschaften.
He worked on this last piece until he was virtually on his deathbed.
These publications, which presented the first attempt to integrate marginal value theory
and monetary theory, reserved for Wieser a place of great authority among German-language
monetary economists. His impact on German monetary thought was reinforced, of course,
by his authority as one of the founding fathers of the Austrian School, but the main reason
he rose to pre-eminence in monetary economics was that his ideas on money fit well with
the established notions of the great majority of his colleagues. Far better than the theory
of money that Mises was about to present in 1912. Mises was a representative of the banking
school, whose ideas reigned supreme in turn of the century Germany. Mises developed the
theory of the currency school. Mises later explained that the tenets of the currency school
were unacceptable to the Cattela socialist mindset, because it seemed to leave no scope
for government intervention. The German professors favoured the banking school. The victim was
The history of the historical school practically brought excommunication of the currency school.
Karl Marx, Adolf Wagner, Helferich, Hilferding, Havnstein and Ben Dixon held to the doctrines
of the banking school. Even after the First World War, the mainstream
opinion among German monetary economists was that the banking school had won the debate
with the currency school on virtually all substantive issues. The fact that John Stuart
Mill, arch-advocate of the Vale of Money theory, endorsed the banking theory with only slight
modifications, played a crucial role in its sweeping success. Mill's view was probably
strongly influenced by the crisis that erupted in 1846, despite the Bank Charter Act of 1844,
which sought to put the principles of the currency school into legislation.
In Geldsinn und Güterbeise, Knut Wichser had already delivered a scathing critique of
of the Main Tenants of the Banking School. His book was pointedly ignored at the time,
as was Mises's Theory of Money and Credit, only after the First World War did both books
enjoy a renaissance.
All essential elements of Wies' monetary thought were present in his initial 1903 lecture.
According to his fundamental assumption, there was no such thing as a demand for money per
To the extent that a good was used in indirect exchanges, it was not demanded as such, but
only as an intermediary to obtain a real good. Money did not have value per se, but only
represented the value of those other goods that could be exchanged for it. Weiser did
not deny that historical media of exchange, such as gold and silver, were commodity monies,
but in his view they were commodities only insofar as they were demanded for non-monetary
purposes Modern media of exchange, such as paper money
and money surrogates, legal claims on money that can be used in place of corresponding
amounts of real money, which were used exclusively as exchange intermediaries, were not commodities
at all. There was no demand for the paper notes themselves, only for the commodities
for which they were exchanged. The value of the former was entirely derived from the demand
for the latter. But if modern money is not a commodity, what is it? And how can it be
used in market exchanges if it cannot itself be the object of an exchange? Wieser insisted
that while money does enable the transfer of commodities from one owner to another, it
more importantly measures the value of the commodities it helps to transfer.
This was also Knut Wixels in Geld, Sinns und Güterpeise, where he elaborates on the distinction
between Relative Prices and Money Prices. Vixel's book had virtually no impact on
the German scene at the time it first appeared, but his monetary views seemed to have influenced
his countryman Gustav Kassel, and through Kassel they eventually reached a broad academic
audience after the First World War when Kassel's textbook became the main work of reference
on theoretical economics at German universities. In short, money is essentially a standard
of Value, a measuring rod, or numéraire, and it is used in market exchanges to measure
the value of the commodities against which it is exchanged. For Wiesel, this measuring
process is essentially a ranking of the exchanged commodity against the total array of the other
commodities from which money derives its value. For similar reasons, Wiesel believed that
a cashless payment system or a pure credit economy was possible. It is modern money's
elasticity according to Wieser that makes it such an ideal standard of value.
Praising Thomas Tuck, the great champion of the banking school, Wieser argued that increases
in the quantity of commodities induce a corresponding rise in the quantity of money surrogates and
of the so-called velocity of money. These increases do not exercise an independent influence
on money prices. Rather, their elasticity ensures that monetary equilibrium is automatically
Preserved at the Existing Purchasing Power of Money.
What about Helferich's critique? Is it not circular to assert that money measures the
value of commodities if its own value is entirely derived from commodities?
Wieser, who did not bother to mention Helferich's book, probably thought that he had disposed
of the circularity problem by stressing that money is not a commodity. There is no circularity
because money is a mere placeholder for those other goods that can be bought with its help.
The goods measure themselves, so to speak, through money. Of course, market prices are
not necessarily proportional to values, but as he had already argued in Natural Value
1889, this problem vanishes to the extent that the national economy approaches the ideal
of a perfect communist society.
Wieser also analysed the determination of the value of money from a completely different
angle by introducing the diachronic perspective, how the value of money is based in changes
over time. Again, he did not explicitly mention the Helfrich Kritique, but his diachronic
determination of the value of money implicitly refutes the charge of circular reasoning.
The Helfrich Kritique applies only to attempts at a synchronic determination of the purchasing
power of money. One cannot derive market prices for today's money from today's value of
money, but this criticism does not apply if the value of today's money depends on yesterday's
is Prices, Visa showed that this was in fact the case.
The apparent circularity vanishes, and a pure causal chain appears. Money prices from two
days ago determine the value of money yesterday, which determines money prices today, etc.
Visa argued that the value of money had a historical source in the needs that are satisfied
by those commodities that were first used as money. This original use value of the original
Total Money Commodity was the base from which further changes to the purchasing power of
money occurred. At each point, the past value of money served as a basis to evaluate the
commodities that were now being exchanged. In so far as these exchanges modified already
existing prices, or added new prices to the total array of commodity prices, the value
of money was itself modified, thus changing the basis for future measurements.
Mises stressed that his theory implied that 1. money could come into existence only as
commodity money, but 2. once it had come into existence and a historical basis for future
modifications of its value had been created, it no longer had to remain commodity money.
A pure paper money was therefore possible at some later stage.
Visa placed great emphasis on this point, because it alone seemed to explain recent
events in the development of the Austro-Hungarian monetary system.
Before 1892, Austria-Hungary had officially been on a silver standard, but in order to
finance its wars of 1848-1949, 1859-1860 and 1866, the monarchy had issued great quantities
of paper notes. These notes were irredeemable at the time of issue, but there were hopes
of future redeemability and thus they were used as money. Their circulation was further
fell drastically. Or was it? Mises believed that the event was actually a refutation of
what he called the metalistic theory of money. According to this theory, the value of money
did not come from demand, but from the inherent value of the metal that was used as money.
The champions of metalism could therefore easily explain why paper circulated at a discount
– after all, it was not real money – but they were at a loss to explain how the paper
For 13 years the Austro-Hungarian monetary system seemed to be real-world proof of the
possibility of a pure fiat money, and Wieser's diachronic theory of the value of money delivered
the only available explanation of this phenomenon. But this did not exhaust the explanatory power
of Wieser's approach to monetary analysis. Making use of his measuring rod theory of
of Money, Wieser also gave an original account of the secular rise of money prices. He argued
that this phenomenon resulted from a great transformation observable in all developed
nations, namely the abandonment of barter and the adoption of monetary exchanges. In
short, the purchasing power of money decreased because the monetary economy became even more
widespread. He admitted that the increased production of commodity money was another
Another factor explaining the secular decline of the purchasing power of money. Another
factor was government expenditures, which were shifted forward in the form of taxation
and thus added to prices, implying a lower purchasing power of money.
Visa argued as follows, because more and more commodities were exchanged against money,
the marginal value of these additional commodities constantly decreased, the lower marginal value
who led in turn to a corresponding decrease of the marginal value of money, that is, to
a lower purchasing power of money. Six years later he presented important clarifications
of his theory in Der Geld wird und seine Veränderungen, The Value of Money and Its Changes, a lengthy
paper he wrote for the 1909 Vienna meeting of the Verein. In this paper he made his case
for the full integration of monetary theory and general value theory, spelling out how
How This Theory of the Value of Money Related to the Subjectivist Theory of Value
The central argument of what later came to be called the income theory of the value of
money runs as follows. As an individual's income increases, the value of the marginal
money unit decreases. Consider an individual agent who, in a given period, spends his entire
disposable monetary income at given prices on consumer goods. Visa argued that the subjective
Subjective marginal value of money was derived from, equal to, the utility of the least
important consumer's good that he could buy with this income. Equipped with the knowledge
of his subjective marginal value of money, which henceforth serves him as a personal
measuring rod, the agent then sets out to buy and sell goods on the market, always measuring
them in comparison to the utility of the least important consumer's good he can afford to
to Buy.
Wieser stressed that the value of money was determined in monetary exchanges of consumers'
goods only. This precluded taking into consideration, for example, idle cash holdings not used in
market exchanges or monetary exchanges on the market for producers' goods. The values
of producers' goods were in fact merely derived from the values of consumers' goods.
In his 1903 lecture Wieser had emphasised that because the value of money is merely derivative,
It is not really money that is exchanged on the market. Real goods are exchanged against
one another.
Visa here argued that money was an object of exchange only in the case it was bought
and sold as monetary capital. Money subdivides the original exchange into two separate parts.
First commodity A is exchanged for a sum of money. Then this sum is exchanged against
and some other commodity B. In 1909, Wieser further clarified this view, stating that
demand and supply on the market were manifest only in A and B, whereas money was merely
interposed. According to Wieser, this was the only difference between direct and indirect
exchange. The benefit of this interposition is that money makes a great social bookkeeping
Banking.
Visa uses language borrowed from the warehouse business to describe economic processes within
the national economy.
In his metaphor, each quantity of money functions as a deposit receipt that can be easily transferred
from one member of the community to another, thereby giving them both access to a common
pool where each deposits the fruit of his labour.
Between all those who throw commodities into the national economic process in order to
Mises later called this characterization of the nature of money assignment theory, unweisungstheorie,
because its essence is to conceive of money as a token. In the English edition of Mises's
The term claim involves an underlying legalistic interpretation of what the assignment theorists
hold the nature of money to be. But compared to a legal interpretation of money as a claim,
the flaws of the assignment theory look minor. It is obvious that market exchanges are categorically
different from the redemption of claims. But assignment theorists never subscribe to such
The Theory goes back to the 18th century to John Law, the greatest champion of inflation
before Keynes. Blurring the difference between money and credit, Law wrote,
Domestic trade depends on the money. A greater quantity employs more people than a lesser
While Mises rejected this view, he accepted as fundamental the distinction that law had
made between the monetary and non-monetary demand for money.
It is reasonable to think silver was bartered as it was valued for its uses as a metal,
and was given as money according to its value in barter. The additional use of money silver
was applied to would add to its value because as money it remedied the disadvantages and
inconveniences of barter, and consequently the demand for silver increasing, it received
an additional value equal to the greater demand its use as money occasioned.
In the mid-19th century, the assignment theory came to be fully developed in the writings
of the champions of the banking school. See in particular Henry D. Macleod's Theory of
Practice of Banking. In the first chapter, the author characterises money as an evidence
of debt being made transferable. Again, although Mises rejected this option, he learned an
important lesson from Macleod, namely that bank deposits are substitutes for money in
essentially the same way as banknotes. However, while Macleod inferred that there was no point
Mises concluded that deposit creation had to be limited, just as note issues had been limited through Peel's Bank Charter Act.
From there, it made its way into the Germanys. Early German proponents of the Anweisungstheorie were Otto Michaelis and Adolf Wagner.
The latter wrote, The idea of money is the one of a transferable IOU for the services that the money owner has provided to civil society. It empowers this money owner to withdraw the value equivalent of his services in terms of goods he desires from any owner of the latter.
In the age of the historical school, which despised economic theorizing, Wagner's writings on money became the primary source of information on these topics.
He converted the next few generations of German language economists to the principles of the
banking school.
In Austria his ideas were developed by Wieser, Schumpeter and Hilferding. The very first
German language economist who contested this new orthodoxy was Mises. He sought to vindicate
the principles of the currency school, which he blended with Menger's analysis of money.
At the heart of his theory is the insight that money is an economic good in its own
and Right, not just a representation of other goods. Nothing precise is known about how
Mises came to hold these views, but Menger's influence was certainly compounded by Boehm-Bawerk's
analogous perspectives on the subject. He had emphasised the crucial points in his university
lectures. Money is by its nature a good like any other good. It is merely in greater demand
and can circulate more widely than all other commodities. Money is no symbol or pledge.
It is not the sign of a good, but bears its value in itself. It is itself really a good.
This from his Innsbruck lectures in the early 1880s. One must assume that Boehm-Bawerk stressed
the same point in his lectures in Vienna. It is not surprising that Boehm-Bawerk and
Mises came to radically different policy conclusions from Wieser and Schumpeter. Whereas Mises
held that the stock of money was ultimately irrelevant, Wieser stressed that money's
Visa's function as a measuring rod must not be interfered with. Its value should be as
stable as possible and all destabilizing influences should be eliminated. Visa suggested that
one could optimize the national currency by abolishing commodity money and putting a pure
paper money in its place. In fact, paper would be more stable because its value is not subject
to the influence of the non-monetary demand for the monetary commodity. Visa also clarified
His theory that the secular increase of money prices was a consequence of the substitution
of monetary exchanges for barter. He argued that the development of the monetary economy
brings ever more factors of production within the network of monetary exchanges. The money
prices that have to be paid for these factors, which before were paid in natura, represent
an increase of the monetary costs of production, and these increased costs have to be added
to the Selling Prices. It is obvious that in this process, aggregate monetary income
increases, while aggregate real income does not change. Thus, the value of money decreases.
Quad erat demonstrandum.
Mises's Theory of the Value of Money
Visa had not gotten everything wrong. Explaining the present value of money by reference to
to its past value was a crucial breakthrough in monetary theory.
Wieser's work inspired two young Vienna economists, Franz X. Weiss and Ludwig von Mises, to refine
the raw idea and hammer out a new doctrine of the value of money.
The regression theorem, as Mises later called it, would become one of the pillars of his
monetary thought, but first let us consider two related problems of Wieser's version.
First, Mises could not integrate the regression with the pricing process of the market. He
had developed a pure value theory of the purchasing power of money. His general assumption was
that the exchange ratios established between the various goods on the market were only
a different expression of their value ratios. Vixel relied on the same assumption, but Mises
thought this assumption entirely untenable. There was no such correspondence between value
and Price, even in a perfect Viserian communism. Menger and Boehm-Bawerk had convincingly
argued that while market prices did result from individual valuations, they were quantitatively
unrelated to the value from which they emerged. The second fundamental flaw in Mises' argument
was that he did not think of money as a good in its own right. Money was but a token of
underlying real goods, avail or assignment, unvisal, and thus, had no independent impact
on the pricing process. This assumption contradicted one of the main tenets of marginal value theory,
while all other market exchanges result from inverse valuations with each trading partner
preferring the commodity that he bought to the price that he paid, market exchanges in
And money were, in Mises' theory, acts that acknowledged equality of value. Again, Vixir's
monetary thought suffered from the same flaw. By paying a certain amount of money to take
some commodity out of the social warehouse, one acknowledged it to be of equal value to
the good one had sold before, deposited in the social warehouse, to obtain that sum of
money. Mises' great achievement in this theory of money and credit was in liberating
Money is a commodity by its very nature, not just by historical accident.
By realizing this, Mises was in a position to integrate the theory of money into the
general framework of marginal value theory.
His integration would combine the commodity nature of money with Menger's theory of
value and prices, as refined by Boehm-Bawerk and also Mises' insight that the present
value of money required a diachronic explanation.
Mises could even rely on Menger's theory of cash holdings, which already contained, in noose, the insight that money is itself an economic good, and not just representative of other goods, but to combine these elements into one coherent theory, required a radical break with the time-honoured pillars of monetary economics, in particular with the classical tradition of presenting money as a mere veil.
But this was the key to his theory, which is why in an introductory chapter of his book
he engaged in the somewhat tedious exercise of distinguishing various types of money proper
– money in the narrow sense – from money substitutes. It was these substitutes in fact
that were the sort of tokens or placeholders that Mises and the other champions of the
assignment theory tacitly had in mind when they spoke of money. Mises' painstaking
Banking Analysis demonstrated that mainstream theory had unduly generalized the features
of money substitutes to money itself. While it is true that the value of a money substitute
corresponds exactly to the value of the underlying good, for example one ounce of gold, the value
of the gold money itself does not correspond to anything. Rather, it is determined by the
and the same general law of diminishing marginal value that determines the values of all goods.
Mises almost succeeded in dumping the Vale of Money myth. At one place, he still reverted
to this fallacious doctrine. He claimed that the value of a marginal unit of money is equal
to the value of the commodity that the unit is destined to buy. Here is the relevant passage.
The subjective value of money always depends on the subjective value of the other economic
goods that can be obtained in exchange for it. Its subjective value is in fact a derived
concept. If we wish to estimate the significance that a given sum of money has, in view of
the known dependence upon it of a certain satisfaction, we can do this only on the assumption
One that the money possesses a given objective exchange value.
The exchange value of money is the anticipated use value of the things that can be obtained
with it. Whenever money is valued by anybody, it is because he supposes it to have a certain
purchasing power. His error is precisely the anticipated use
value sentence he quotes from Visa. It is irreconcilable with his latest statements
in National Economy and Human Action, where he explains that the subjective value of the
sum of money is the value of holding this quantity in one's cash balance. The same
error seems to be behind his claim that the increase of money substitutes in the previous
20 years or so, up to 1911, had allowed for higher economic growth than would have been
possible with the quantity of gold which grew at a slower pace. Similarly, in his first
Publication on Monetary Problems, he had asserted at the beginning of his exposition
that the media of circulation need to be adjusted to the demand for money, and in the same vein
he talks about conditions for a possible lack of fiduciary media. Such a condition holds
when the quantity of the means of payment lags behind the economic development. This
would certainly lead to credit restrictions and, as a consequence, symptoms of economic
Crises. Discussing a somewhat different issue, Mises later admitted that, at the time he
wrote The Theory of Money and Credit, he was still too much under the influence of Mill.
This prevented him from decisively arguing against Boehm-Bawerk's ideas about money-induced
frictions, but Mill's influence seems to have reached further than that.
By the time he published his treatise, Nationale Economie, 1940, he had removed these errors
But his earlier monograph on the theory of money was still being taken as his final word
on the subject. Don Patinkin, the most influential monetary theorist of the post-1945 era, criticised
Mises by referring precisely to the passage quoted above, in which the old veil-of-money
notion shows through. Patinkin said that these views implied a circular explanation of the
The Value of Money
Money is not neutral. Cantillon effects. The insight that money is a good in its own
right and not just a placeholder for other goods led Mises to place special emphasis
is on the impact of money on the real economy. It was customary to highlight the impact of
inflation and deflation on deferred payments. Inflation would entail higher money prices,
that is, a lower purchasing power of money in the future, which in turn benefited debtors
at the expense of creditors. Inversely, deflation would benefit creditors at the expense of
Debtors. So far so good. Following classical economists such as David Ricardo, Mises stressed
that inflation and deflation of the money supply could not possibly enhance the productive
potential of the nation as a whole, but such changes did have other social consequences,
in particular for the composition of society and the allocation of resources. Although
So inflation and deflation could not make society as a whole better off. They modified
the distribution of resources among the individual members of society, and this necessarily affected
the marginal value of the various uses of these resources. For example, inflation put
more money in the hands of individual A, a debtor, and less money in the hands of individual
B, a creditor, since these two individuals have different subjective values and different
and entrepreneurial visions and talents. They will use the money differently, investing
it at different times and places, paying different wages to different persons at different rates,
etc. These simple considerations illustrate the pervasive impact of changes in the money
supply on the real world, a fact that did not sit well with many of Mises' contemporaries,
imbued as they were with the veil of money doctrine. Boehm-Bawerk, for instance, was
Mises was reluctant to admit the real impact of money because he was used to thinking of
money in aggregate terms, not on the basis of the intra-social distribution and allocation.
He tried to minimise the significance of Mises' findings. He thought that the income effect
creates some occasional frictions, but did not alter the long-term state of the economy
and the society. In his lectures, Boehm-Bawerk had stressed the continual effects, but believed
that they would mainly entail a higher price level, besides they would merely affect the
relationship between debtors and creditors. Mises' analysis of the social consequences
of inflation and deflation was not limited to the consideration of deferred payments.
He also analysed the redistributive impact of inflation and deflation on spot exchanges.
In the case of inflation, for example, he observed that if it affected all members of
of Society at the same time and to the same proportional extent, no redistributive effects
would result, but in the real world this condition never holds true. Inflation first affects
only some members of society, and through their interaction with others, it eventually
affects the rest of society. Let us for instance suppose that a new gold
mine is opened in an isolated state. The supplementary quantity of gold that streams from it into
To commerce goes at first to the owners of the mine, and then by turns to those who have
dealings with them, if we schematically divide the whole community into four groups, the
mine owners, the producers of luxury goods, the remaining producers and the agriculturalists,
the first two groups will be able to enjoy the benefits resulting from the reduction
in the value of money, the former of them to a greater extent than the latter.
But even as soon as we reach the third group, the situation is altered. The profit obtained
and by this group as a result of the increased demands of the first two will already be offset
to some extent by the rise in the prices of luxury goods, which will have experienced
the full effect of the depreciation by the time it begins to affect other goods. Finally,
for the fourth group the whole process will result in nothing but loss. The farmers will
have to pay dearer for all industrial products before they are compensated by the increased
First Prices of Agricultural Products It is true that when at last the prices of
agricultural products do rise, the period of economic hardship for the farmers is over,
but it will no longer be possible for them to secure profits that will compensate them
for the losses they have suffered. That is to say, they will not be able to use their
increased receipts to purchase commodities at prices corresponding to the old level of
the value of money, for the increase of prices will already have gone through the whole community.
Thus, the losses suffered by the farmers at the time when they still sold their products
at the old low prices but had to pay for the products of others at the new and higher prices
remain uncompensated. It is these losses of the groups that are the last to be reached
by the variation in the value of money which ultimately constitute the source of the profits
made by the mine owners and the groups most closely connected with them. Thus, inflation
Inflation and by implication deflation are essentially redistributive phenomena. They
cannot enrich society as a whole, but do affect distribution, allocation and incomes within
society. Mises' analysis of effects of money on the
real economy was based on his study of the great inflations of the past and on his study
of classical economics. His teacher, Grünberg, had analysed the redistributive impact of
of Inflation during the Napoleonic Wars in Grünberg. Mises had dealt with these cases
in the first edition of Theorie des Geldes und der Umlaufsmitte in 1912. He eliminated
these passages from further editions because he believed historical illustrations of the
harmful effects of inflation were no longer necessary in light of recent first-hand experiences
in Germany and Austria. He quotes David Hume and David Ricardo. Among his contemporaries
Mises he merely refers to Rudolf Auspitz and Richard Lieben. Mises quotes them in His Theory
of Money and Credit. Other forerunners, who Mises did not mention, were Mill, Principles
of Political Economy, Hermann Heinrich Gossen, Entwicklung der Gesetze des menschlichen Verkehrs
und der da ausfließenden Regeln für menschliches Handeln, and John Ekans, Essay towards the
Solution of the Gold Question, The Course of the Depreciation, Essays in Political
Financial Economy, Theoretical and Applied. Today, these effects are sometimes called
the Cantillon effects. The expression is Mark Blaugs, named for the early 18th century Irish
French banker and economist Richard Cantillon, who in his essay on the nature of commerce
in general had first described the redistribution and reallocation effects of inflation. Similarly,
Mises also revived the analysis of local price differences, which had been neglected since
Richard Cantillon
The Theory of Money and Credit was one of the last treatises on the subject to highlight
their importance. At the time of Mises's writing, Erwin Fisher, Gustav Kassel and other
economists began to neglect them and concentrate only on the aggregate consequences of changes
in the money supply. Their approach won the day, and thus one of inflation's most pernicious
effects came to fall beneath the purview of the new macroeconomic radar. In contrast,
Mises' analysis might have influenced John Maynard Keynes, who recognised the great importance
of contillon effects and advocated monetary stabilisation as a strategy for social conservation.
Keynes had dismissively reviewed Mises' book in the Economic Journal in fairly vague
and evasive terms. Later he confessed that, in German I can only clearly understand what
I know already.
Exchange Rate Determination – Purchasing Power Theory
Mises also took a position at odds with the mainstream view on another important issue
– the factors determining the exchange rate between two monies. To do so, he revived an
older doctrine that had been displaced by the prevailing veil of money myth. Because
mainstream economists conceived of the value of money as a mere reflection of the value
of underlying real commodities, it was only natural for them to stipulate that exchange
Exchange rates too were merely a reflection of some real state of affairs. Thus, the balance
of payments theory enjoyed a virtual monopoly in higher economic education and guided the
policies of the German and Austro-Hungarian central banks. According to this theory, international
monetary movements and thus the exchange rate between different national currencies tended
to equal whatever rate equilibrated the relative weight of imports and exports of commodities
and Services, and of foreign credit and foreign debts. These real factors were the independent
variables, whereas international monetary payments and the exchange rate were dependent variables.
The political implication was that, when faced with an undesired depreciation in the exchange
rate, governments had to act on those real factors to prevent their expression in monetary flows.
Those. They had to curtail imports through tariffs, import quotas and other measures.
Mises had already rebelled against this orthodoxy in his first publication on monetary policy,
his 1907 article on the motives behind the Austro-Hungarian Bank's regulation of exchange
rates. There he asserted that the theory of the value of money was not yet sufficiently
developed, and the relationship between the quantity of money and the exchange rate was
was unknown. Five years later, the theory of the value of money was sufficiently well
developed in his mind. He demonstrated that the balance of payments theorists had turned
to the real chain of causation on its head. The volume of imports and exports and of foreign
liabilities and credits was not independent of the exchange rate, but entirely dependent
on it. The balance of payments theory forgets that the volume of foreign trade is completely
dependent upon prices, that neither exportation nor importation can occur if there are no
differences in prices to make trade profitable, he went on to explain the root of the error.
It cannot be doubted that if we simply look at the daily or hourly fluctuations on the
exchanges, we shall only be able to discover that the state of the balance of payments
at any moment does determine the supply and the demand in the foreign exchange market,
But this is a mere beginning of a proper investigation into the determinants of the rate of exchange.
The next question is, what determines the state of the balance of payments at any moment?
And there is no other possible answer to this than that it is the price level and the purchases
and sales induced by the price margins that determine the balance of payments. Foreign
commodities can be imported at a time when the rate of exchange is rising only if they
Mises points out that it was Ricardo who had first developed the correct view of exchange
rate determination. The exchange rate between two monies depended exclusively on the relative
purchasing power of each. In a free market, exchange rates would tend to make it irrelevant
which money is used to buy a non-monetary commodity. The different kinds of money are
are exchanged in a ratio corresponding to the exchange ratios existing between each of
them and the other economic goods. If one kilogram of gold is exchanged for the monetary
aggregate kilogram of a particular sort of commodity and one kilogram of silver for the
monetary aggregate of fifteen and a half kilograms of the same sort of commodity, then the exchange
ratio between gold and silver will be established at fifteen and a half. If some disturbance
tends to alter this ratio between the two sorts of money, which we shall call the static
or natural ratio, then automatic forces will be set in motion that will tend to re-establish
it. The political implications of this analysis are diametrically opposed to the ones suggested
by the balance of payments doctrine. There is in fact no need to prevent a depreciation
of the exchange rate through government intervention, because sooner or later the falling exchange
rate would equilibrate the purchasing powers of the two monies, preventing a further fall.
As Mises later acknowledged, this idea was essentially contained already in the classical
quantity theory of money, as well as Gresham's Law and the doctrine of the British Currency
School. His analysis, which was based on the modern theory of subjective value, had refined
these older views and restated them in a more nuanced manner, but the practical conclusion
had remained the same. Mises said in retrospect, governmental interventions that seek to regulate
international monetary flows to provide the necessary quantities of money for the economy
are superfluous. In all cases, the undesired outflow of money can only be the result of
a governmental intervention that endows differently valued monies with the same legal purchasing
Banking Power, all that the government must do not to destroy the monetary order, and
all that it can do, is to avoid any such interventions, that is the nub of the monetary theory of
classical economics, and of its immediate successors, the theoreticians of the currency
school. Here Mises referred to his treatment of these predecessors in the first edition
It was possible to refine and develop this doctrine with the modern subjective theory,
but it was impossible to overhaul it and put something else at its place. His exposition
would eventually have an impact on central bank policy, but at first it was dismissed
and its application prevented. One of the most vituperative dismissals came from a certain
Eugen Kurt Singer, a follower of Knapp, who had attacked Mises for lack of logic. Years
later Mises commented on Singer in a letter to Emil Lederer.
I myself regretted very much today that history has proved me right rather than the champions
of inflation. My income would be substantially higher if Knapp and his disciples had turned
out to be right. Mises felt it was necessary to return to the subject of exchange rate
Determination after the First World War, because the continued prevalence of the balance-of-payment
doctrine had Austria well on its way to hyperinflation. In the feverish days of 1919 he wrote a paper
on Saarungsbilanz und Wechselkurse, balance of payments and exchange rates, which proved
to be influential in turning Austrian monetary policy away from the path of hyperinflation
before it was too late. Some years after Mises' book had come out,
The Swedish economist Gustav Kassel, who would play an important role in interwar economic
science in Germany, developed a variant of the same theory without referring to his contemporary
Austrian predecessor. Kassel's exposition had a great deal more success, which was probably
due to the fact that he had coined the popular new phrase, purchasing power parity, to describe
the equilibrium exchange rate, and also because he was less vitriolic than Mises, who had
fractional reserve banking and business cycles
Mises's careful distinction between money proper and money substitutes naturally led
to the question of the role of money substitutes.
In the second part of his book, Mises showed that bank-issued money substitutes could not
affect the value and purchasing power of money, as well as the distribution and allocation
of resources, as long as they were true representatives of a corresponding amount of money deposited
with the bank, that is, in Mises' terminology, as long as they were money certificates. Only
if they were issued without being backed 100% by a money deposit could they have an influence
on Prices, Distribution and Allocation. These issuances of uncovered or partially covered
money substitutes, fiduciary media, added to the quantity of money in the larger sense,
increasing money prices and redistributing resources in favour of their first recipients,
and at the expense of their last recipients. It was therefore necessary to single them
out for separate analysis, inquiring after the particular consequences of an expansion
First Mises showed why fiduciary media had an impact on money prices. Although they are
only legal documents, they are dealt with, bought and sold, as if they were real money,
whether or not they are backed by real money. As a consequence, an increase in the quantity
of fiduciary media leads to an increase of the price level in the same way and for the
are the same reasons that an increase of real money has this effect. Moreover, there is
a tendency in a fractional reserve banking system steadily to increase the issuance of
fiduciary media. No bank can afford drastically to exaggerate its note issues because it would
have faced too many redemption claims at once. But if its increases of fiduciary media are
are small enough allowing other banks to follow suit, it can steadily increase the issuances.
This analysis led Mises to one of the central contributions of his book, an entirely new
business cycle theory. Here Mises created a synthesis of Boehm-Bawerk's capital theory
and the business cycle theory of the currency school. At about the same time, two other
members of Boehm-Bawerk's seminar presented original business cycle theories in elaboration
of the Principles of the Banking School. Mises argued that the issuance of uncovered
money substitutes could depress the interest rate below its equilibrium level, thus inciting
entrepreneurs to launch investment projects that consume too many resources. Production
takes time and thus requires the support of the human beings engaged in production during
the entire production period. For a new project to be successful, one needs a sufficient provision
Production of all the goods that the consumers consider to be more important than the goods
that will result from this project. Consequently, the realization of additional production projects
requires that additional consumer's goods be put at the disposal of the entrepreneurs.
These additional consumer's goods can only come from net savings. Without sufficient
savings, therefore, no extension of the structure of production is possible. It follows that
And if new projects are started not because of net savings, but only because fractional
reserve banks have depressed the interest rate below its equilibrium level, then the
resulting structure of production is unsustainable. It is now physically impossible for all production
processes to be carried to completion. There are simply not enough savings to sustain the
more extensive structure of production. The existence of such an unsustainable situation
is not immediately evident because the additional investments are made in higher production
stages which are removed in time from their final products, the consumer's goods. But
as time goes on, it becomes increasingly evident that something has gone deeply wrong in the
entire economy. The day of reckoning is reached in what is commonly called an economic crisis.
Entrepreneurs then discover that not all projects can be carried out as planned for lack of
of Originary Capital. Some projects can only be continued in a reduced form, and others
have to be stopped altogether. Hence, the material resources and human energies invested
in these projects are now seen to have been wasted. Society is impoverished, individuals
are out of work, firms go bankrupt, etc. How can fiduciary media bring about a situation
of malinvestment in the first place? Mises argued that this happens when they are brought
into circulation through the credit market. In this case, the additional supply of credit
reduces the rate of interest, thus pushing it below its equilibrium or natural level.
Entrepreneurs are able to obtain more credit on better terms and invest these additional
funds in new projects in the stages of production most removed from final consumers' goods.
Deluded by the increased activities and apparent blossoming of new opportunities, everyone
One believes at first that the economy is growing faster than before. This is the so-called
boom. But sooner or later the market participants will become conscious of the fact that this
boom is unsustainable, at which point the economy goes bust. An economic crisis.
In developing his theory, Mises could rely on two important discoveries of previous thinkers.
The first was the business cycle theory of the British currency school. According to
According to this school of thought, fractional reserve banking led to a constant increase
of fiduciary media until the banks, in particular the central bank, proved to be unable to satisfy
redemption demands. Then the monetary circulation collapsed because the fiduciary media immediately
lost all their value, and this in turn ushered in a crisis. A group of French economists
had developed similar ideas in the mid-1800s. Victor Bonnet argued that excessive investments
in Fixed Capital. Excessive meaning disproportionate in comparison to the investments in circulating
capital were responsible for economic crises, and Charles Coquelin had anticipated Knut Vixer
in elaborating the hypothesis that business cycles were caused by credit expansions. The
second was Knut Vixer's discovery that monetary expansion could result from discrepancies
between the money rate of interest and the equilibrium rate of interest. Yet none of
One of these predecessors had developed the main theme of Mises' business cycle theory,
namely the causation and propagation of economy-wide error, as well as the notion that the error-ridden
process necessarily has to come to an end because it involves an inter-temporal misallocation
of resources. In 1903, Werner Sombart had presented a disproportionality theory of the
At a meeting of the Verein für Sozialpolitik in Hamburg, Zombard argued that increased
gold production had provoked a reallocation of resources that was unsustainable after
the gold production ceased. The ensuing crisis, which hit Germany in 1900-1902, was therefore
a structural crisis that reflected the unsuitable use that had been made of the capital goods.
Zombard's theory does not take into account the problem of intertemporal misallocation.
In Wichsel's famous book Geldsinns und Güterpreise, Money Interest and Commodity Prices, he elaborated
on David Ricardo's observation that an inflationary monetary policy could reduce the rate of interest
only temporarily, because sooner or later commodity prices catch up. It followed that
any attempt to reduce the interest rate on a permanent basis required constant increases
of the money supply. Now, the question was whether any such policy of permanent inflation
could be sustainable. Vixel answered this question by first pointing out that the notion
of reduced interest rate did not concern any absolute level of the interest rate, but rather
a relative comparison of the market rate of money interest to what he called the natural
rate of interest. In Viserion fashion, Vixel defined the natural rate of interest as the
rate that would come into existence under the sole influence of real, non-monetary factors.
He also defined it as the rate at which the price level would remain constant. Both distinctions
led to great confusion among later theorists, but Mises's business cycle theory seemed
to show that it was useful to make some such distinction.
In Human Action, he would eventually show that the relevant distinction is between the
equilibrium rate of interest and the market rate. Both rates are monetary rates and can
can therefore coincide. He then claimed that indefinite deviations of the money rate from
the natural rate were not possible, because the constant influx of new money would sooner
or later entail an over-proportional increase of commodity prices, which would induce the
banks to adjust the money rate to the natural rate.
Wixel noticed that Frederic Bastiat had made a similar point in his polemic against Proudhon,
only Bastiat had not insisted that a concomitant price increase would be over-proportional.
are proportional. But, as Mises pointed out, Vixel did not substantiate this claim by showing
which mechanism forced the banks to perform such an adjustment. Strictly speaking, Vixel
had no explanation of the business cycle at all, and, despite his fundamental distinction
between the natural and the money rates of interest, he did not see that deviations between
these two rates entail an inter-temporal misallocation of resources. Vixel comes closest to Mises's
Mises' discovery when he points out that a low money rate relative to the natural rate
will incite businessmen to launch additional investment projects, and even observes that
the low money rate disrupts general equilibrium, but he does not see the implication that the
structure of production is set on a path that is physically impossible to complete.
Mises would later develop and refine the business cycle theory he had presented in his Habilitation
work.
As far as the exposition of Mises's business cycle theory is concerned, there are no differences
between the first edition and later editions. But for a few exceptions, the text is exactly
the same. The same is true for the entire chapter 5, except for paragraph 5. Thus, from
the first edition, Mises's business cycle theory contains the same discussion of forced
savings, the reverse movement of prices, the natural rate of interest and deviations from
The difference between the first and the second
edition relates to the concluding paragraph 5 of chapter 5, where Mises discusses the
significance of his own contribution to business cycle theory. In 1912 he thought he had found
merely one out of a number of conceivably complementary explanations of the business
Business Cycle. Thus, he qualified his findings right in the opening sentence of the concluding
paragraph 5. It is not the task of this work to develop a theory of economic crises. We
take account of crisis phenomena only insofar as they can spring from the mechanism of money
and fiduciary media. He goes on in a somewhat lengthy manner to assert that there might
be other sources for business cycles, and in particular that they might also exist in
In a barter economy, it could well be that these qualifications of the significance of
his discoveries were meant to shield him against criticism from his elders. After all, the
book was the basis on which he sought to be granted his habilitación. Be this as it may,
Mises eventually made up his mind and came to adopt more definite views on behalf of
business cycle research.
Starting from the second edition of Theory of Money and Credit, the qualifications in
in paragraph 5 are left out, and the first sentence now reads, Our theory of banking
leads ultimately to a theory of business cycles.