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NOTE 11. Money Makes the World Go Round: The Monetary Theory of the Business Cycle

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Chapter 11. Money Makes the World Go Round. The Monetary Theory of the Business Cycle.

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In his debut work, The Principles of Economics, Menger considered whether money developed

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without any agreement, without legislative compulsion, and even without regard to the

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Accordingly, money had a natural origin and is not an invention of the state. Even the

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sanction of political authority is not necessary for its existence. Menger did not move beyond

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this original explanation. Later economists ascertained that determining the value of

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money with the principle of marginal utility led to a circular argument, as the exchange

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The average value of money determines the demand for money, but the demand itself is in turn dependent on the value of money.

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A young Viennese economist is reminded of the everlasting circle in a Viennese song in which gayety comes from merriness and merriness is in turn derived from gayety.

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During his inaugural lecture in 1903 at the University of Vienna,

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Friedrich von Mises tried to explain the phenomenon of rising prices using the theory

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of marginal utility for the first time. Mises emphasized that growing incomes lead to decreasing

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marginal utility, to lower exchange values and finally to increased prices. Because increases

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in income result from the steady expansion of monetary economy at the expense of the household

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Economy, a rise in prices would thus be nothing but a necessary developmental syndrome of

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the spreading monetary economy.

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Mises' income theory of money found few adherents and changed little in the way of

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the older Austrian school's abstinence from monetary theory.

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But things changed abruptly with the sensation caused by the Staatliche Theorie des Geldes

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Since 1905, literally Public Theory of Money, the work of Georg Friedrich Knopp, 1842-1926

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of Strasbourg, a statistician and agrarian economist of the historical ethical school,

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Knopp saw money purely as a creation of the legal system, based on an act of the sovereign

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and having nothing to do with an agreement within society. Knopp's thesis clashed irreconcilably

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with Menger's evolutionary thesis, some sort as further evidence of compliant trust

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in the state, and academic mediocrity on the part of a large number of German economists.

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Furthermore, closer inspection revealed serious factual errors. The visible tendency of the

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older Austrian School to focus on the possibilities of malpractice by state authorities had its

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origins in the sound judicial education of its members. What resulted was a particular

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Carl Menger had taught Crown Prince Rudolf early on that governmental monetary policy

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was despotism and implied violence against the citizens.

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During currency reform consultations Menger made similar comments.

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His own notes in Knupp's book and comments that have been transmitted orderly point in

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the same direction. And of all people, Ludwig von Mises, the young researcher who later

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founded the Austrian Theory of Money and the Austrian Business Cycle Theory, uncovered

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a large-scale foreign exchange manipulation complete with a black money fund that had

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taken place in the state-monopolized Österreichisch-Ungarische Bank. Mises was even on the receiving end

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of Bribery Attempts

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In his Habilitation Theses, Theorie des Geldes und der Umlaufsmittel 1912, The Theory of

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Money and Credit, Mises had already adhered to his aim of applying the principle of marginal

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utility to monetary theory in order to return the theory of money to the study of economics.

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He avoided the eternal circle with the so-called regression theorem. When evaluating money,

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The individual proceeds from a notion of purchasing power derived from previous exchanges. Those

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earlier exchanges, in turn, were influenced by even earlier exchanges. In theory, these

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experiences can be traced back to distant past times, in which money still had a purely

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goods character as a means of exchange. It was thus possible to evaluate its direct use.

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Mises' bold but simple solution was bound to provoke ironical commentary. For some it

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was more ancient theory than economics, for others money had become as it were a ghost

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of gold.

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Mises followed up on Boehm-Bawerk's theory of capital and on Wichsel's distinction between

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a natural rate of interest and the monetary rate of interest. Further developing Boehm-Bawerk's

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The theory of interest, Knut Gustav Dixel, 1851-1926, had drawn a distinction between

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a natural rate of interest and a money rate of interest.

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The former would appear in a barter economy, meaning one without intermediation of money,

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when supply and demand were in accord.

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In modern economies, supply and demand certainly do not just meet in the form of goods, but

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usually in the form of money, so that divergences from this natural rate of interest may occur.

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Because Mises had preceded on the assumption of an economic, but not a legal concept of money, he included the so-called fiduciary media, Umlaufsmittel, which was understood to mean claims to the payment of a given sum on demand, which are not covered by a fund of money.

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Fiduciary media appear in the form of checks, drafts or credit notes, or as circulation

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credit guaranteed by banks.

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They are effectively used as money, and thus expand the money supply of an economy.

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These loans are granted out of a fund that did not exist before the loans were granted.

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The going-quantity theory assumed that changes in the money supply affected all individuals

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and prices in equal measure.

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In contrast, Mises thought that the effects differed depending on each individual situation.

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Individual economic subjects, after all, receive additional money supplies neither simultaneously

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nor uniformly.

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Accordingly, beneficiaries of monetary expansion are privileged compared with those who are

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the last to receive the additional money or who only have fixed nominal income at their

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disposal.

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Fr. R. von Hayek compared this process to that of pouring vicious honey. It spreads unevenly

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when it's poured and forms a little mound at the point of inflow. Contrary to popular

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belief and that held by Menger and Boehm-Bawerk alike, Mises considered money to be anything

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but neutral. The reception of Mises' thoughts was somewhere

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between reserved and critical. Noteworthy was the misjudgment by John Maynard Keynes

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1883-1946, who considered the book critical, rather than constructive, dialectical and

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not original. For Knut Gustav Vixel, much of it was too obscure, and Mises's accomplishment

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did not get as much as even a short mention in Josef R. Schumpeter's first Doctrinal

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History. When Mises published a new edition of his Theory of Money 12 years later, 1924,

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His analysis had evidently already been confirmed by the collapse of some of the European currencies.

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As early as 1912, both Germany and Austria had gone off the gold standard completely

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while preparing for war, and not without encouraging acclamation from renowned economists.

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Even Schumpeter, in his Theorie der wirtschaftlichen Entwicklung 1912, The Theory of Economic Development,

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had argued for increasing credit as a means of stimulating growth.

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Boehm-Bawerk, who had already recognized the fatal link between expanding the money supply

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and arming for war, warned the public in three newspaper articles against expanding the government

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budget and thus living beyond existing means.

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Shortly before his death, Boehm-Bawerk made it a point to once again emphasize the existence

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of economic laws against which the will of man, and even the powerful will of the State,

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remain impotent.

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Regardless of the above, the First World War was financed by a limitless expansion of the

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money supply.

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Inflationism, wrote Mises in the preface for the second German edition of Theory of Money

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and Credit, was the most important economic element in this war ideology.

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In Vienna, the income of a worker's family sank from the index figure 100, 1913-1914,

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to 34, 1917-1918, while that of a civil servant's family sank from 100 to 19. Inflation was

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a relentless leveller. In 1915, a Viennese court counsellor still earned 8.6 times the

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amount of the lowest earning civil servant. In 1920, it was only 3.3 times as much.

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The inflationary policy was carried over after the war. According to Otto Bauer, 1881-1938,

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and served the socialist government as a means to stimulate industry and to improve the lifestyle

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of the working population for two years. At the same time, subsidies for food imports

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and uneconomical state enterprises were financed with the help of an excessive increase in

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the money supply. Food subsidies would soon become the main source of this essentially

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self-inflicted inflation and put a heavy burden on the government budget. In 1920 to 1921,

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They constituted no less than 59% of its total.

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The money supply expanded in 1920 from 12 to 30 billion kronen, by the end of 1921 to

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174 billion kronen, and it reached the level of 1 trillion in August of 1922.

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Inflationary policies had shattered both the economy and the government budget in the most

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devastating way.

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Members of the Austrian School spoke out in the daily papers and professional journals

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was against the evil of inflation again and again with Ludwig von Mises leading the way.

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They demanded serious stabilization measures. In the second edition of his Theory of Money,

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and more explicitly than in the first, Mises blamed the crisis on the unrestricted extension

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of credit. Since banks and politicians had a common interest in further lowering the

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interest rates to facilitate cheap money, a money system independent of deliberate human

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and intervention should be established as the monetary ideal.

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This would mean a return to money backed by gold.

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The restructuring of the Austrian government budget in 1922 was indeed successful, but

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only after politicians, amid the ferocious attacks of right and left-wing statists, committed

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themselves to self-restraint.

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The Austrian School and its monetary theory stood in stark contrast to the ideas of the

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The large majority of German economists, whose competency in monetary theory seems, in retrospect,

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to be stunningly inadequate. Faced with the destruction of their currency, they were quite

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powerless. Even their publications, which played down the significance of inflation,

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were delayed because the funds designated for their printing had become casualties of

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hyperinflation. But economists like Schumpeter, Keynes, and Carl Gustav Kassel, 1866-1945,

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Ludwig von Mises cultivated his legendary private seminar as an unsalaried lecturer

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at the University of Vienna despite various animosities. It became the nucleus for monetary

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and business cycle research and gained an international reputation. A succession of

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of Gifted Economists in his circle made remarkable contributions. Banker Carl Schlesinger, 1889-1938,

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wrote analyses based on malrasse and a well-researched report on practical banking experience. Gottfried

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von Habeler, 1900-1995, published a critique of Schumpeter's Monetary Theory and a monograph

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on index numbers in which he demonstrated the limits of the measurability of economic

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Variables, Fritz Machlup, 1902-1983, delivered a dissertation on the gold bullion standard,

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Marta Stephanie Braun, 1898-1990, authored reviews on monetary theory and banking, and

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Friedrich R. von Hayek, 1899-1992, wrote on currency policy and banking.

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While on a 14-month study visit in the United States and before joining Mises' private

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Seminar Hayek, soon to become the person upon whom the hopes of the Austrian school would

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rest, had already considered the question of currency policy and business cycle data.

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Hayek became the first head of the Österreichische Institut für Konjunkturforschung, Austrian

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Institute for Business Cycle Research, today Wirtschaftsforschungsinstitut WIFO.

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It first commenced operations in 1927 after judicious preparations by Mises.

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For so long, the Institute became a European pioneer of empirical economic research. Oskar

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Morgenstern, 1902-1977, who had published his first work, Wirtschaftsprognose, Economic

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Forecasting in 1928, became Hayek's first associate and succeeded him in 1931 as the

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Institute's leader. In his Habilitationthesis Geldtheorie und Konjunkturtheorie in 1929,

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According to a theory on the trade cycle, 1933, Hayek, like Mises, assumed that the

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ups and downs of the business cycle are invariably caused by credit expansion. An expansion of

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the money supply, claimed Hayek, always brings about a falsification of the pricing process

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and thus a misdirection of production. Credit expansion is fuelled by the bank's business

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model as they want to provide their customers with as much liquidity as possible. The interest

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Demanded by the banks is therefore not natural interest, or in Hayek's terminology an equilibrium

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rate of interest, but interest that is determined by the bank's liquidity considerations.

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He linked this theoretical approach to observations of economic activities in the markets of commodities,

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money and stocks by using a three-market barometer, and in December of 1928 already came to the

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conclusion that the United States was on the brink of a severe economic slump.

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In October of 1929, the Great Depression did in fact appear with full vehemence.

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In 1931, Hayek was invited to hold a series of lectures at the London School of Economics,

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in which he developed, among other things, the notion of forced saving.

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Changes in the money supply or in the interest rate, according to Hayek, would invariably

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lead to a shift in demand for consumer goods and investment goods.

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In contrast to voluntary saving, which is based on true consumer desires, consumers

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Mises as a whole would, in the case of monetary expansion, be forced to forgo part of what

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they used to consume, not because they want to consume less, but because they get less

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goods for their money income. Even though the abstract and complex constructs were not

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easy to understand, Hayek's theses earned him a considerable international reputation

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within a short time. Mises, who by then had refined his circulation credit theory, dared

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With the combined contributions of Machloub, Habeler, Morgenstern and Richard von Stregel

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1891-1942, the Austrian School was able to present itself in Zürich as the authoritative

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research group in monetary and business cycle theory, and it showed itself to be on the

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were cutting edge again in a fest schrift containing 62 contributions some years later.

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In this fest schrift, however, it became clear that divergent forces had made strong gains.

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Hans Meyer, 1879-1955, Long, the only tenured professor of the school, and his circle contributed

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little to monetary and business cycle theory. Even Mises' non-university seminar views

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Studies on methodology and political economy were moving ever further apart. Striegel,

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who in his Angewandte Lohntheorie 1926 supplied Theory of Wages, had analyzed the effects

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of the business cycle on the production process from an Austrian point of view, was considered

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an interventionist on questions of economic policy. Braun's Theorie der staatlichen Wirtschaftspolitik

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in 1929, Theory of State-run Economic Policy, ultimately spoke for a moderate statism. The

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question of whether the purchasing power of money could be measured at all was also hotly

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debated. Mises denied that it could, while Habeler accused him of not even being able

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to define the allegedly non-measurable. In addition, Habeler considered Hayek's Price

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Mises und Produktion, 1931, prices and production, sketchy and unfinished

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Differences grew when Mises began to view economics more and more as an a priori science.

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Oskar Morgenstern strictly rejected Mises' a priorism. His keen interest in mathematics

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and statistical empirical research, which had led to an analysis of capital depreciation

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of companies listed on the Viennese stock exchange, provided another dividing line.

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Hayek no longer wished to follow Mises' philosophical shift and gradually moved away from him in

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terms of methodology. The old polarities represented by Boehm-Bawerk, Wieser and Zucks were conspicuously

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revived and forces were divided.

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As the most exposed representative of the Austrian School internationally, Hayek became

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involved in several disputes, his literary feud with Keynes is well known. It was so

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So intense that letters were even exchanged on Christmas Day in 1931.

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As he had done seven years previously, Hayek weighed Keynes's thesis on money and monetary

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policy and found them wanting, only this time more broadly and thoroughly.

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Keynes disputed the capacity of the market to regulate itself and recommended interventions

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to guide the economy and the currency system.

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Hayek rejected the notion emphatically, seeing in these very interventions the cause of the

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and Crises. Hayek was able to hold his ground during the intense debate, and Keynes diluted

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or even revoked some of his positions. But the astute and aggressive criticism of Piero

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Srava 1898-1983 left behind an unsettled professional audience. Hayek's distinction between voluntary

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saving and forced saving had begun to become unhinged, and so had the Austrian assumption

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that the equilibrium rate of interest should not be interfered with in a barter economy

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without money and banks.

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Hayek's reply was unable to clear up any lingering doubts.

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Some later thought that Hayek's grounding in capital theory was inadequate, which was

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the ultimate cause of the problem.

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Hayek tried to substantiate his position with ten additional articles in the four years

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that followed, but during this period of a fundamental reorientating in English economics,

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The charm of the Austrian theory of money and business cycles had already begun to lose

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its freshness and allure.

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Works reflecting the Austrian theory were still published.

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Machlub wrote on Börsenkredit, Industriekredit und Kapitalbildung, 1931, the stock market,

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credit and capital formation.

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Von Schiff wrote on capital consumption in Kapitalbildung und Kapitalaufziehung im Konjunkturverlauf,

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1933, Formation and Depletion of Capital in the Course of the Business Cycle.

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And von Striegel made a contribution on business cycles and production with Kapital und Produktion

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1934, Capital and Production, but for the time being they made no impact on the discourse

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in English-speaking countries.

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With political turmoil in Central Europe claiming its first victims and naming its first offenders

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among economists, the stepwise exodus of the Austrian School began.

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The Austrian monetary and business cycle theory lacked active propagation. After a fulminant

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start in the early 1930s, discourse concerning Austrian theoretical constructs had now come

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to a near standstill.

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Habler and many of his colleagues were already living outside of Austria by the time, in

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1936, he had completed his standard work on business cycle theories, a monument to the

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Austrian contribution. The Austrian School had been paralysed by the political events

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of the Time and its reaction to Keynes' general theory of employment, interest and money,

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if there was any reaction at all, was spiritless or subdued. Looking back, Hayek would call

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it his greatest strategic mistake not to have taken a more extensive stand on Keynes' general

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theory. Only Gottfried Habler in Geneva at the time demonstrated the usual professional

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and critical rigour and considered Keynes' multiplier theory to be indefensible. Fritz

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Schmachrup supported him later on. Keynes' work was treated with kid gloves otherwise.

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It would be more than two decades before Henry Hazlitt, an American inspired by the Austrian

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School, would submit the general theory to strong criticism in the failure of the New

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Economics, 1959. The scene had undergone a dramatic change by the time Hayek, during

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the war, completed his magnificent attempt at a modified Austrian Theory of Money and

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and Business Cycles. The Austrian School had become a little regarded outsider. Keynes's

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thesis dominated economic theory in English-speaking countries. Against the traumatic backdrop

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of the economic depression, politics and public opinion readily followed the man who had so

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brilliantly and on the surface convincingly proposed to secure the future welfare of the

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world through government control of the economy, currency management and state investment programs.

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Mises also provided welcome arguments for a radical change of the social functions of

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economists, whom he qualified as indispensable advisers on economic policies.