Chapter 11. Money Makes the World Go Round. The Monetary Theory of the Business Cycle.
In his debut work, The Principles of Economics, Menger considered whether money developed
without any agreement, without legislative compulsion, and even without regard to the
Accordingly, money had a natural origin and is not an invention of the state. Even the
sanction of political authority is not necessary for its existence. Menger did not move beyond
this original explanation. Later economists ascertained that determining the value of
money with the principle of marginal utility led to a circular argument, as the exchange
The average value of money determines the demand for money, but the demand itself is in turn dependent on the value of money.
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.
During his inaugural lecture in 1903 at the University of Vienna,
Friedrich von Mises tried to explain the phenomenon of rising prices using the theory
of marginal utility for the first time. Mises emphasized that growing incomes lead to decreasing
marginal utility, to lower exchange values and finally to increased prices. Because increases
in income result from the steady expansion of monetary economy at the expense of the household
Economy, a rise in prices would thus be nothing but a necessary developmental syndrome of
the spreading monetary economy.
Mises' income theory of money found few adherents and changed little in the way of
the older Austrian school's abstinence from monetary theory.
But things changed abruptly with the sensation caused by the Staatliche Theorie des Geldes
Since 1905, literally Public Theory of Money, the work of Georg Friedrich Knopp, 1842-1926
of Strasbourg, a statistician and agrarian economist of the historical ethical school,
Knopp saw money purely as a creation of the legal system, based on an act of the sovereign
and having nothing to do with an agreement within society. Knopp's thesis clashed irreconcilably
with Menger's evolutionary thesis, some sort as further evidence of compliant trust
in the state, and academic mediocrity on the part of a large number of German economists.
Furthermore, closer inspection revealed serious factual errors. The visible tendency of the
older Austrian School to focus on the possibilities of malpractice by state authorities had its
origins in the sound judicial education of its members. What resulted was a particular
Carl Menger had taught Crown Prince Rudolf early on that governmental monetary policy
was despotism and implied violence against the citizens.
During currency reform consultations Menger made similar comments.
His own notes in Knupp's book and comments that have been transmitted orderly point in
the same direction. And of all people, Ludwig von Mises, the young researcher who later
founded the Austrian Theory of Money and the Austrian Business Cycle Theory, uncovered
a large-scale foreign exchange manipulation complete with a black money fund that had
taken place in the state-monopolized Österreichisch-Ungarische Bank. Mises was even on the receiving end
of Bribery Attempts
In his Habilitation Theses, Theorie des Geldes und der Umlaufsmittel 1912, The Theory of
Money and Credit, Mises had already adhered to his aim of applying the principle of marginal
utility to monetary theory in order to return the theory of money to the study of economics.
He avoided the eternal circle with the so-called regression theorem. When evaluating money,
The individual proceeds from a notion of purchasing power derived from previous exchanges. Those
earlier exchanges, in turn, were influenced by even earlier exchanges. In theory, these
experiences can be traced back to distant past times, in which money still had a purely
goods character as a means of exchange. It was thus possible to evaluate its direct use.
Mises' bold but simple solution was bound to provoke ironical commentary. For some it
was more ancient theory than economics, for others money had become as it were a ghost
of gold.
Mises followed up on Boehm-Bawerk's theory of capital and on Wichsel's distinction between
a natural rate of interest and the monetary rate of interest. Further developing Boehm-Bawerk's
The theory of interest, Knut Gustav Dixel, 1851-1926, had drawn a distinction between
a natural rate of interest and a money rate of interest.
The former would appear in a barter economy, meaning one without intermediation of money,
when supply and demand were in accord.
In modern economies, supply and demand certainly do not just meet in the form of goods, but
usually in the form of money, so that divergences from this natural rate of interest may occur.
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.
Fiduciary media appear in the form of checks, drafts or credit notes, or as circulation
credit guaranteed by banks.
They are effectively used as money, and thus expand the money supply of an economy.
These loans are granted out of a fund that did not exist before the loans were granted.
The going-quantity theory assumed that changes in the money supply affected all individuals
and prices in equal measure.
In contrast, Mises thought that the effects differed depending on each individual situation.
Individual economic subjects, after all, receive additional money supplies neither simultaneously
nor uniformly.
Accordingly, beneficiaries of monetary expansion are privileged compared with those who are
the last to receive the additional money or who only have fixed nominal income at their
disposal.
Fr. R. von Hayek compared this process to that of pouring vicious honey. It spreads unevenly
when it's poured and forms a little mound at the point of inflow. Contrary to popular
belief and that held by Menger and Boehm-Bawerk alike, Mises considered money to be anything
but neutral. The reception of Mises' thoughts was somewhere
between reserved and critical. Noteworthy was the misjudgment by John Maynard Keynes
1883-1946, who considered the book critical, rather than constructive, dialectical and
not original. For Knut Gustav Vixel, much of it was too obscure, and Mises's accomplishment
did not get as much as even a short mention in Josef R. Schumpeter's first Doctrinal
History. When Mises published a new edition of his Theory of Money 12 years later, 1924,
His analysis had evidently already been confirmed by the collapse of some of the European currencies.
As early as 1912, both Germany and Austria had gone off the gold standard completely
while preparing for war, and not without encouraging acclamation from renowned economists.
Even Schumpeter, in his Theorie der wirtschaftlichen Entwicklung 1912, The Theory of Economic Development,
had argued for increasing credit as a means of stimulating growth.
Boehm-Bawerk, who had already recognized the fatal link between expanding the money supply
and arming for war, warned the public in three newspaper articles against expanding the government
budget and thus living beyond existing means.
Shortly before his death, Boehm-Bawerk made it a point to once again emphasize the existence
of economic laws against which the will of man, and even the powerful will of the State,
remain impotent.
Regardless of the above, the First World War was financed by a limitless expansion of the
money supply.
Inflationism, wrote Mises in the preface for the second German edition of Theory of Money
and Credit, was the most important economic element in this war ideology.
In Vienna, the income of a worker's family sank from the index figure 100, 1913-1914,
to 34, 1917-1918, while that of a civil servant's family sank from 100 to 19. Inflation was
a relentless leveller. In 1915, a Viennese court counsellor still earned 8.6 times the
amount of the lowest earning civil servant. In 1920, it was only 3.3 times as much.
The inflationary policy was carried over after the war. According to Otto Bauer, 1881-1938,
and served the socialist government as a means to stimulate industry and to improve the lifestyle
of the working population for two years. At the same time, subsidies for food imports
and uneconomical state enterprises were financed with the help of an excessive increase in
the money supply. Food subsidies would soon become the main source of this essentially
self-inflicted inflation and put a heavy burden on the government budget. In 1920 to 1921,
They constituted no less than 59% of its total.
The money supply expanded in 1920 from 12 to 30 billion kronen, by the end of 1921 to
174 billion kronen, and it reached the level of 1 trillion in August of 1922.
Inflationary policies had shattered both the economy and the government budget in the most
devastating way.
Members of the Austrian School spoke out in the daily papers and professional journals
was against the evil of inflation again and again with Ludwig von Mises leading the way.
They demanded serious stabilization measures. In the second edition of his Theory of Money,
and more explicitly than in the first, Mises blamed the crisis on the unrestricted extension
of credit. Since banks and politicians had a common interest in further lowering the
interest rates to facilitate cheap money, a money system independent of deliberate human
and intervention should be established as the monetary ideal.
This would mean a return to money backed by gold.
The restructuring of the Austrian government budget in 1922 was indeed successful, but
only after politicians, amid the ferocious attacks of right and left-wing statists, committed
themselves to self-restraint.
The Austrian School and its monetary theory stood in stark contrast to the ideas of the
The large majority of German economists, whose competency in monetary theory seems, in retrospect,
to be stunningly inadequate. Faced with the destruction of their currency, they were quite
powerless. Even their publications, which played down the significance of inflation,
were delayed because the funds designated for their printing had become casualties of
hyperinflation. But economists like Schumpeter, Keynes, and Carl Gustav Kassel, 1866-1945,
Ludwig von Mises cultivated his legendary private seminar as an unsalaried lecturer
at the University of Vienna despite various animosities. It became the nucleus for monetary
and business cycle research and gained an international reputation. A succession of
of Gifted Economists in his circle made remarkable contributions. Banker Carl Schlesinger, 1889-1938,
wrote analyses based on malrasse and a well-researched report on practical banking experience. Gottfried
von Habeler, 1900-1995, published a critique of Schumpeter's Monetary Theory and a monograph
on index numbers in which he demonstrated the limits of the measurability of economic
Variables, Fritz Machlup, 1902-1983, delivered a dissertation on the gold bullion standard,
Marta Stephanie Braun, 1898-1990, authored reviews on monetary theory and banking, and
Friedrich R. von Hayek, 1899-1992, wrote on currency policy and banking.
While on a 14-month study visit in the United States and before joining Mises' private
Seminar Hayek, soon to become the person upon whom the hopes of the Austrian school would
rest, had already considered the question of currency policy and business cycle data.
Hayek became the first head of the Österreichische Institut für Konjunkturforschung, Austrian
Institute for Business Cycle Research, today Wirtschaftsforschungsinstitut WIFO.
It first commenced operations in 1927 after judicious preparations by Mises.
For so long, the Institute became a European pioneer of empirical economic research. Oskar
Morgenstern, 1902-1977, who had published his first work, Wirtschaftsprognose, Economic
Forecasting in 1928, became Hayek's first associate and succeeded him in 1931 as the
Institute's leader. In his Habilitationthesis Geldtheorie und Konjunkturtheorie in 1929,
According to a theory on the trade cycle, 1933, Hayek, like Mises, assumed that the
ups and downs of the business cycle are invariably caused by credit expansion. An expansion of
the money supply, claimed Hayek, always brings about a falsification of the pricing process
and thus a misdirection of production. Credit expansion is fuelled by the bank's business
model as they want to provide their customers with as much liquidity as possible. The interest
Demanded by the banks is therefore not natural interest, or in Hayek's terminology an equilibrium
rate of interest, but interest that is determined by the bank's liquidity considerations.
He linked this theoretical approach to observations of economic activities in the markets of commodities,
money and stocks by using a three-market barometer, and in December of 1928 already came to the
conclusion that the United States was on the brink of a severe economic slump.
In October of 1929, the Great Depression did in fact appear with full vehemence.
In 1931, Hayek was invited to hold a series of lectures at the London School of Economics,
in which he developed, among other things, the notion of forced saving.
Changes in the money supply or in the interest rate, according to Hayek, would invariably
lead to a shift in demand for consumer goods and investment goods.
In contrast to voluntary saving, which is based on true consumer desires, consumers
Mises as a whole would, in the case of monetary expansion, be forced to forgo part of what
they used to consume, not because they want to consume less, but because they get less
goods for their money income. Even though the abstract and complex constructs were not
easy to understand, Hayek's theses earned him a considerable international reputation
within a short time. Mises, who by then had refined his circulation credit theory, dared
With the combined contributions of Machloub, Habeler, Morgenstern and Richard von Stregel
1891-1942, the Austrian School was able to present itself in Zürich as the authoritative
research group in monetary and business cycle theory, and it showed itself to be on the
were cutting edge again in a fest schrift containing 62 contributions some years later.
In this fest schrift, however, it became clear that divergent forces had made strong gains.
Hans Meyer, 1879-1955, Long, the only tenured professor of the school, and his circle contributed
little to monetary and business cycle theory. Even Mises' non-university seminar views
Studies on methodology and political economy were moving ever further apart. Striegel,
who in his Angewandte Lohntheorie 1926 supplied Theory of Wages, had analyzed the effects
of the business cycle on the production process from an Austrian point of view, was considered
an interventionist on questions of economic policy. Braun's Theorie der staatlichen Wirtschaftspolitik
in 1929, Theory of State-run Economic Policy, ultimately spoke for a moderate statism. The
question of whether the purchasing power of money could be measured at all was also hotly
debated. Mises denied that it could, while Habeler accused him of not even being able
to define the allegedly non-measurable. In addition, Habeler considered Hayek's Price
Mises und Produktion, 1931, prices and production, sketchy and unfinished
Differences grew when Mises began to view economics more and more as an a priori science.
Oskar Morgenstern strictly rejected Mises' a priorism. His keen interest in mathematics
and statistical empirical research, which had led to an analysis of capital depreciation
of companies listed on the Viennese stock exchange, provided another dividing line.
Hayek no longer wished to follow Mises' philosophical shift and gradually moved away from him in
terms of methodology. The old polarities represented by Boehm-Bawerk, Wieser and Zucks were conspicuously
revived and forces were divided.
As the most exposed representative of the Austrian School internationally, Hayek became
involved in several disputes, his literary feud with Keynes is well known. It was so
So intense that letters were even exchanged on Christmas Day in 1931.
As he had done seven years previously, Hayek weighed Keynes's thesis on money and monetary
policy and found them wanting, only this time more broadly and thoroughly.
Keynes disputed the capacity of the market to regulate itself and recommended interventions
to guide the economy and the currency system.
Hayek rejected the notion emphatically, seeing in these very interventions the cause of the
and Crises. Hayek was able to hold his ground during the intense debate, and Keynes diluted
or even revoked some of his positions. But the astute and aggressive criticism of Piero
Srava 1898-1983 left behind an unsettled professional audience. Hayek's distinction between voluntary
saving and forced saving had begun to become unhinged, and so had the Austrian assumption
that the equilibrium rate of interest should not be interfered with in a barter economy
without money and banks.
Hayek's reply was unable to clear up any lingering doubts.
Some later thought that Hayek's grounding in capital theory was inadequate, which was
the ultimate cause of the problem.
Hayek tried to substantiate his position with ten additional articles in the four years
that followed, but during this period of a fundamental reorientating in English economics,
The charm of the Austrian theory of money and business cycles had already begun to lose
its freshness and allure.
Works reflecting the Austrian theory were still published.
Machlub wrote on Börsenkredit, Industriekredit und Kapitalbildung, 1931, the stock market,
credit and capital formation.
Von Schiff wrote on capital consumption in Kapitalbildung und Kapitalaufziehung im Konjunkturverlauf,
1933, Formation and Depletion of Capital in the Course of the Business Cycle.
And von Striegel made a contribution on business cycles and production with Kapital und Produktion
1934, Capital and Production, but for the time being they made no impact on the discourse
in English-speaking countries.
With political turmoil in Central Europe claiming its first victims and naming its first offenders
among economists, the stepwise exodus of the Austrian School began.
The Austrian monetary and business cycle theory lacked active propagation. After a fulminant
start in the early 1930s, discourse concerning Austrian theoretical constructs had now come
to a near standstill.
Habler and many of his colleagues were already living outside of Austria by the time, in
1936, he had completed his standard work on business cycle theories, a monument to the
Austrian contribution. The Austrian School had been paralysed by the political events
of the Time and its reaction to Keynes' general theory of employment, interest and money,
if there was any reaction at all, was spiritless or subdued. Looking back, Hayek would call
it his greatest strategic mistake not to have taken a more extensive stand on Keynes' general
theory. Only Gottfried Habler in Geneva at the time demonstrated the usual professional
and critical rigour and considered Keynes' multiplier theory to be indefensible. Fritz
Schmachrup supported him later on. Keynes' work was treated with kid gloves otherwise.
It would be more than two decades before Henry Hazlitt, an American inspired by the Austrian
School, would submit the general theory to strong criticism in the failure of the New
Economics, 1959. The scene had undergone a dramatic change by the time Hayek, during
the war, completed his magnificent attempt at a modified Austrian Theory of Money and
and Business Cycles. The Austrian School had become a little regarded outsider. Keynes's
thesis dominated economic theory in English-speaking countries. Against the traumatic backdrop
of the economic depression, politics and public opinion readily followed the man who had so
brilliantly and on the surface convincingly proposed to secure the future welfare of the
world through government control of the economy, currency management and state investment programs.
Mises also provided welcome arguments for a radical change of the social functions of
economists, whom he qualified as indispensable advisers on economic policies.