III

TWO MYTHS: NEUTRAL MONEY AND STABLE PRICES

There are two myths in the monetary field, according to Mises: the myth of neutral money and the myth of the stable price level. His monetary theory avoided both of them.

NEUTRAL MONEY

In the chapter on “Indirect Exchange” — money — in Human Action, Mises begins Section 2, “Observations on Some Widespread Errors,” with this observation: “There is first of all the spurious idea of the supposed neutrality of money” (p. 398). The price effects of new money spread unevenly when it enters an economy. I have already discussed this unique aspect of Mises’s theory of money in Part II. Neutral money is money that is generated by a monetary system in which there are no involuntary wealth-redistribution effects inflicted on third parties when there are changes in the supply of money.

Mises was an advocate of market-generated money, both in theory and in practice: my point in Part I. He did not believe that any government agency or committee could design and operate a monetary system that would avoid the problems associated with wealth redistribution from those who gain access to new money late in the process to those who gained access early. He believed that the unhampered free market minimizes these effects by imposing high costs on mining, thereby reducing the flow of new money into the economy. A metallic money system, he believed, would reduce fluctuations in the value of money. This would also make accurate predictions less costly regarding the price of goods in relation to money. He writes in Human Action:

As money can never be neutral and stable in purchasing power, a government’s plans concerning the determination of the quantity of money can never be impartial and fair to all members of society. Whatever a government does in the pursuit of aims to influence the height of purchasing power depends necessarily on the rulers’ personal value judgments. It always furthers the interests of some groups of people at the expense of other groups. It never serves what is called the commonweal or the public welfare. In the field of monetary policies, there is no such thing as a scientific ought.

The choice of the good to be employed as a medium of exchange and as money is never indifferent. It determines the course of the cash-induced changes in purchasing power. The question is only who should make the choice: the people buying and selling on the market, or the government? It was the market which in a selective process, going on for ages, finally assigned to the precious metals gold and silver the character of money (p. 422).

http://www.mises.org/humanaction/chap17sec6.asp

There are two objections to a government-operated money system. First, governments choose monetary policies in terms of the personal value judgments of the responsible decision-makers. Second, these decision-makers cannot accurately foresee the long-term effects of their monetary policies. Mises wrote in The Theory of Money and Credit:

The state does not govern the market; in the market in which products are exchanged it may quite possibly be a powerful party, but nevertheless it is only one party of many, nothing more than that. All its attempts to transform the exchange ratios between economic goods that are determined in the market can only be undertaken with the instruments of the market. It can never foresee exactly what the result of any particular intervention will be. It cannot bring about a desired result in the degree that it wishes, because the means that the influencing of demand and supply place at its disposal only affect the pricing process through the medium of the subjective valuations of individuals; but no judgment as to the intensity of the resulting transformation of these valuations can be made except when the intervention is a small one, limited to one or a few groups of commodities of lesser importance, and even in such a case only approximately. All monetary policies encounter the difficulty that the effects of any measures taken in order to influence the fluctuations of the objective exchange value of money can neither be foreseen in advance, nor their nature and magnitude be determined even after they have already occurred (pp. 238-39).

http: //www.econlib.org/library/Mises/msT5.html

Mises believed that an unhampered free market is likely to produce a slowly rising money supply and slowly falling prices. These effects seem to be antitheses of each other. Was he predicting inflationary recession? Deflationary prosperity? What?

DEFINING INFLATION AND DEFLATION

The latest and by far the simplest statement by Mises regarding his definition of inflation was made at a seminar sponsored by the University of Chicago Law School in 1951. “Inflation, as the term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check.” (Economic Freedom and Intervention: An Anthology of Articles and Essays by Ludwig von Mises, 1990, p 99.) He went on: “But people today use the term ‘inflation’ to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise.” This was very close to his definition in Human Action: “What many people today call inflation or deflation is no longer the great increase or decrease in the supply of money, but its inexorable consequences, the general tendency toward a rise or a fall in commodity prices and wage rates” (p. 423).

In Theory of Money and Credit, he went out of his way to avoid defining inflation and deflation. “Observant readers may perhaps be struck by the fact that in this book no precise definition as given of the terms Inflation and Deflation (or Restriction or Contraction); that they are in fact hardly employed at all, and then only in places where nothing in particular depends upon their precision” (p. 239). Thus, anyone who relies on his earlier definitions of these terms necessarily involves himself in imprecision — a deliberate imprecision that Mises self-consciously adopted in that book. Here is his imprecise definition, which raised the theoretically peripheral issue of a goods-induced price competition:

In theoretical investigation there is only one meaning that can rationally be attached to the expression inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange value of money must occur. Again, deflation (or restriction, or contraction) signifies a diminution of the quantity of money (in the broader sense) which is not offset by a corresponding diminution of the demand for money (in the broader sense), so that an increase in the objective exchange value of money must occur. If we so define these concepts, it follows that either inflation or deflation is constantly going on, for a situation in which the objective exchange value of money did not alter could hardly ever exist for very long. The theoretical value of our definition is not in the least reduced by the fact that we are not able to measure the fluctuations in the objective exchange value of money, or even by the fact that we are not able to discern them at all except when they are large (p. 240).

http: //www.econlib.org/library/Mises/msT5.html

The problem with this definition is that it ignores the heart of his theory of the uneven spread of new money, namely, that any increase or decrease in the money supply must produce uneven price effects through time. When there is an increase in the money supply, new money appears at specific points in the economy. Early users of the new money spend it before their competitors are aware of the new conditions of supply and demand. They buy at yesterday’s prices, which generally prevail today. Rival consumers are unaware of the increase in the supply of money. But, as the information regarding the new conditions of money supply — higher bids in terms of money — spread to more market participants, they lower the marginal value of money in their personal value scales, and they raise the marginal value of non-monetary goods and services. They bid additional money, so prices rise. Those participants who gain access later suffer a loss of purchasing power, whether or not market prices have risen. These prices would otherwise have fallen. There is no way that an increase of supply of money will not have price effects. Mises’s later definition of inflation is consistent with his theory of changes in the money supply in the economy. His definition in 1912 (1924) was not clearly consistent with his theory. Fortunately, he warned readers of its imprecision. Those who regard themselves as Misesians should honor this warning. They should adopt his later definition.

SLOWLY FALLING PRICES

The second myth that Mises exposes is the myth of stable prices. Mises’s case for free market money is the case for relatively slow and predictable increases in the money supply. There are two main sources of these increases in a free market economy: the output of mines and the expansion of credit fiduciary money in a free banking system.

Mises did not call for the legislative prohibition of all gold and silver mining, nor did he call for 100% reserve banking as a legislative requirement, as I explain in Part IV. He did not trust the civil government enough to empower it to this degree. “The concept of money as a creature of Law and the State is clearly untenable. It is not justified by a single phenomenon of the market. To ascribe to the State the power of dictating the laws of exchange, is to ignore the fundamental principles of money-using society” (TM&C, p. 69).

In a growing economy, Mises argued, the division of labor is increasing. The market’s specialization of production is therefore also increasing. Population also may be growing. Under such conditions, “there prevails a tendency toward an increase in the demand for money. Additional people appear on the scene and want to establish cash holdings” (Human Action, p. 414). Economic self-sufficiency is replaced by dependence on the market, which is a market identified by the use of money. “Thus the price-raising tendency emanating from what is called the ‘normal’ gold production encounters a price-cutting tendency emanating from the increased demand for cash holding” (p. 415). These two tendencies do not neutralize each other. They are separate phenomena. “Both processes take their own course. . .” (p. 415). The gold from the mines moves into the economy, one transaction at a time.

When we say that there is an increase in the demand for cash balances, this is another way of saying an increase in bids for money. Those people with goods or services to exchange enter the market and offer them for sale. If the money supply is relatively stable, those with items for sale must offer more for the money they want to obtain. In the auction for money, higher bids appear. “Higher bids for money” is another way of saying “lower bids in money.” Sellers of goods (buyers of money) offer more goods at yesterday’s prices. Prices denominated in money go down = prices denominated in goods go up.

More goods and services are available for purchase. This means that there has been an increase of choices available to people per unit of currency at the newer, lower prices. Probably the best definition of “increase in wealth” is “increase of choices.” As Mises says, “such a fall in money prices does not in the least impair the benefits derived from the additional wealth produced” (p. 431). This is not deflation, as he defined it later in his career. This is price competition.

Had he been aware of the historical statistics, Mises no doubt would have made good use of the example of the falling price of computing power since 1965. It is not likely that any economist would want to present a theoretical case for a theory that the world has been made poorer by the fall in the prices of computers. What engineer would turn in his multi-function, solar-powered, scientific $20 calculator in order to go back to a slide rule? (“Where was that decimal point supposed to go?”) This steady drop in the price of computing power has been going on since at least 1910. Computing speed per dollar doubled every three years (1910-1950), then every two years (1950-1965), and then every year (1966-2000). Nothing in human history has matched this reduction in price (increase in output) at such a rate for so long a period. But the fact that such a steady increase in consumer value is both possible and economically profitable to producers indicates that there is no need for an increase in the money supply to facilitate exchanges. This price-cutting process is not a defect of the free market economy; it is a benefit. Mises said, that “one must not say that a fall in prices caused by an increase in the production of the goods concerned is proof of some disequilibrium which cannot be eliminated otherwise than by increasing the quantity of money” (p. 431).

Economists define scarcity as “an excess of demand over supply at zero price.” The goal of production, economists assure us, is to increase consumption. Put differently, the goal is to reduce scarcity. Put differently again, the goal is to approach the price of zero as a limit for all scarce economic resources. The goal of production, in short, is to achieve constantly falling prices. Yet only Mises and his disciples defend this outcome of a free market monetary order coupled with capitalism’s productivity: falling prices.

In this sense, the Misesians are the true macro-economists. Their theory of the autonomous (“endogenous”) entrepreneurial market process is consistent with their theory of an integrated, coherent outcome. The market does not require intervention by the State’s economic planners or by its licensed monopolistic agency, the central bank. All other schools of economic opinion recommend monetary inflation as the only way to overcome increased productivity’s outcome in the macro economy — falling prices — which they proclaim as the goal of production at the micro level: falling prices. They do not believe that the free market endogenously supplies the correct quantity of money to facilitate voluntary exchange. They see macroeconomics as fundamentally inconsistent with microeconomics. They want Big Brother and the holding company (the central bank) to supply new money scientifically, so that the market pricing process can function properly. This is true of the Keynesians, the monetarists, and the supply-siders. None of them trusts the free market in the area of monetary policy.

If output is rising in a free market, and the money supply is fairly constant, then prices will fall. The market’s clearing price is that price which allows a sale in which there are no further buyers or sellers at the sale price. The high bid wins. When output is rising, buyers of money (sellers of goods) increase their bids by offering more goods for sale at the old price. This is another way of saying that prices denominated in money fall, or at least do not rise as high as they would otherwise have risen, had there been no increase in the quantity of goods and services offered for sale. Mises describes this process in his 1951 addition to Theory of Money and Credit, in the essay titled, “The Principle of Sound Money.” He speaks of “a general tendency of money prices and money wages to drop” (p. 417). This is not deflation, which Mises defined as a decrease in the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. Price competition is not deflation.

On a free market, there cannot be either stable prices or stable money. Conditions of supply and demand keep changing, including people’s tastes and their subjective valuations. There can be a moderately stable supply of free market money. Whether prices in general rise or fall, or which prices rise or fall, is determined by the productivity of the participants in the economy in relation to their demand for cash balances.

If prices fall in a productive economy with free-market money, then the goal of stable prices can be achieved in one of two ways: (1) reduce production; (2) inflate the money supply. Only the advocates of zero economic growth are willing to affirm the first option. The entire economic profession, except for the Misesians, affirms the second. I would go so far as to say that there is no better litmus test of orthodox Misesianism than a denial of any monetary policy that has stable prices as its goal. Mises made this clear.

The ideal of a money with an exchange value that is not subject to variations due to changes in the ratio between the supply of money and the need for it that is, a money with an invariable innere objektive Tauschwert [objective exchange-value] demands the intervention of a regulating authority in the determination of the value of money; and its continued intervention. But here immediately most serious doubts arise from the circumstance, already referred to, that we have no useful knowledge of the quantitative significance of given measures intended to influence the value of money. More serious still is the circumstance that we are by no means in a position to determine with precision whether variations have occurred in the exchange value of money from any cause whatever, and if so to what extent, quite apart from the question of whether such changes have been effected by influences working from the monetary side. Attempts to stabilize the exchange value of money in this sense must therefore be frustrated at the outset by the fact that both their goal and the road to it are obscured by a darkness that human knowledge will never be able to penetrate. But the uncertainty that would exist as to whether there was any need for intervention to maintain the stability of the exchange value of money, and as to the necessary extent of such intervention, would inevitably give full license again to the conflicting interests of the inflationists and restrictionists. Once the principle is so much as admitted that the state may and should influence the value of money, even if it were only to guarantee the stability of its value, the danger of mistakes and excesses immediately arises again (p. 237).

http: //www.econlib.org/library/Mises/msT5.html

One more time: “Once the principle is so much as admitted that the state may and should influence the value of money, even if it were only to guarantee the stability of its value, the danger of mistakes and excesses immediately arises again.”

MISES VS. INDEX NUMBERS

The idea of a stable price level necessarily involves both the theoretical possibility and the technical requirement of index numbers. To speak of “stable prices” is necessarily to speak of a representative statistical index of all prices. Some prices rise. Other prices fall. Others stay the same. The economist who says that the State must supply additional money in order to keep free market prices stable is either calling for a world without change — the denial of history — or else he has in mind a statistical index of prices.

All index numbers lack what true measures require: objectivity and permanence. Mises included a critique of index numbers in Human Action. It appears in Chapter 12, “The Sphere of Economic Calculation,” Section 4, “Stabilization.” He specifically targeted Irving Fisher, the famous Yale University economist who had long promoted government monetary policies to provide stable purchasing power. Fisher became famous after his prediction in September, 1929, that the American stock market was at a permanently high plateau. He lost his personal fortune in the four years that followed. He was the inventer of the Rolodex, a far more useful tool than the index number, which he also invented.

Mises had four criticisms of index numbers. First, they do not measure product quality changes. Second, they do not measure changes in people’s valuations, which cause changes in demand and production. Third, they require their creators to assign importance to the various categories of goods and services. This procedure is arbitrary. Fourth, they require the use of averages for the data. There are different methods of doing this. “Each of them leads to different results” (p. 221). “The pretentious solemnity which statisticians and statistical bureaus display in computing indexes of purchasing power and cost of living is out of place. These index numbers are at best rather crude and inaccurate illustrations of changes which have occurred” (p. 222). In the preface to the English edition of Theory of Money and Credit, he wrote:

If it should be thought that index numbers offer us an instrument for providing currency policy with a solid foundation and making it independent of the changing economic programs of governments and political parties, perhaps I may be permitted to refer to what I have said in the present work on the impossibility of singling out any particular method of calculating index numbers as the sole scientifically correct one and calling all the others scientifically wrong. There are many ways of calculating purchasing power by means of index numbers, and every single one of them is right, from certain tenable points of view; but every single one of them is also wrong, from just as many equally tenable points of view. Since each method of calculation will yield results that are different from those of every other method, and since each result, if it is made the basis of practical measures, will further certain interests and injure others, it is obvious that each group of persons will declare for those methods that will best serve its own interests. At the very moment when the manipulation of purchasing power is declared to be a legitimate concern of currency policy, the question of the level at which this purchasing power is to be fixed will attain the highest political significance. Under the gold standard, the determination of the value of money is dependent upon the profitability of gold production. To some, this may appear a disadvantage; and it is certain that it introduces an incalculable factor into economic activity. Nevertheless, it does not lay the prices of commodities open to violent and sudden changes from the monetary side. The biggest variations in the value of money that we have experienced during the last century have originated not in the circumstances of gold production, but in the policies of governments and banks-of-issue. Dependence of the value of money on the production of gold does at least mean its independence of the politics of the hour. The dissociation of the currencies from a definitive and unchangeable gold parity has made the value of money a plaything of politics. Today we see considerations of the value of money driving all other considerations into the background in both domestic and international economic policy. We are not very far now from a state of affairs in which “economic policy” is primarily understood to mean the question of influencing the purchasing power of money (p. 17).

http: //www.econlib.org/library/Mises/msT0.html

It is not possible to achieve a stable price level in a neutral manner. New money must be spent into circulation at specific points in the economy. The uneven spread of this new money is inescapable. The wealth effects are not equal to all participants in the economy. Mises was adamant: “The notion of neutral money is no less contradictory than that of a stable price level” (Human Action, p. 418). “With the real universe of action and unceasing change, with the economic system which cannot be rigid, neither neutrality of money nor stability of its purchasing power are compatible. . . . All plans to render money neutral and stable are contradictory. Money is an element of action and consequently of change” (p. 419).

In his concluding remarks to his book, Monetary Stabilization and Cyclical Policy (1928), Mises wrote: “Abandoning the pursuit of the chimera of a money of unchanging purchasing power calls for neither resignation nor disregard of the social consequences of changes in monetary value. The necessary conclusion from this discussion is that the stability of the purchasing power of the monetary unit presumes stability of all exchange relationships and, therefore, the absolute abandonment of the market economy” (Mises, On the Manipulation of Money and Credit [1978], p. 107).

The period from 1815 to 1914 was the era of the international gold standard. It was not a pure gold coin standard. Fractional reserve banking did operate. There were booms and busts, which, he taught, were caused by the practices of fractional reserve banks. (See Part V.) But it was a long period of generally stable prices, at least according to some economic historians’ index numbers. Prices in 1914 at the outbreak of World War I were about what they were in 1815, at the end of the Napoleonic Wars. Mises explained this price stability in terms of an increase in the money supply. The price-competition associated with an increase in the division of labor was offset in the index by the increase of bank-credit money.

Economic history shows us a continual increase in the demand for money. The characteristic feature of the development of the demand for money is its intensification; the growth of division of labor and consequently of exchange transactions, which have constantly become more and more indirect and dependent on the use of money, have helped to bring this about, as well as the increase of population and prosperity. The tendencies which result in an increase in the demand for money became so strong in the years preceding the war that even if the increase in the stock of money had been very much greater than it actually was, the objective exchange value of money would have been sure to increase. Only the circumstance that this increase in the demand for money was accompanied by an extraordinarily large expansion of credit, which certainly exceeded the increase in the demand for money in the broader sense, can serve to explain the fact that the objective exchange value of money during this period not only failed to increase, but actually decreased (TM&C, p. 151).

http: //www.econlib.org/library/Mises/msT3.html

CONCLUSION

Mises argued that the unregulated free market makes full use of the existing money supply. Any additional money cannot be said to add social value. Mining adds money, but this cannot be stopped in a free market society. The increase of the money supply through mining is slow and relatively predictable. Unregulated free banking allows some addition to the money supply through fractional reserve credit expansion, but this process is restrained by the fear of bankers regarding the threat of bank runs against the gold that supposedly is in reserve against all issues of fiduciary media. (See Part IV.)

If the money supply is restricted by free market forces, and if output is increasing through the extension of the division of labor through capital accumulation, then prices of these increasingly plentiful goods should steadily fall. Sellers compete against sellers through price competition in their quest to add to gain money: cash holdings and bank balances. If there were a free market in money, there would be falling prices. Supply would equal demand at prices steadily approaching zero as a limit.

Mises opposed all attempts by the government or the central bank to stabilize prices. There is no way to stabilize prices in a changing world. At best, monetary intervention allows the interventionists to target a particular index number, and then try to keep it stable retroactively, as an echo of today’s monetary policy. This leads to the involuntary redistribution of wealth because of the non-neutrality of money. It also leads to the boom-bust business cycle. (See Part V.)

With all of this in mind, let us once again consider the legitimacy of this policy goal:

“There is nothing more important that the government can provide individual producers than a reliable standard of value, a unit of account that retains its constancy as a measuring device.”

It should be clear by now that this policy is not based on Misesian economics. Mises did not recommend government monetary policy. He recommended anti-government monetary policy. “The first aim of monetary policy must be to prevent governments from embarking on inflation and from creating conditions which encourage credit expansion on the part of banks. But this program is very different from the confused and self-contradictory program of stabilizing purchasing power” (Human Action, p. 224).

If the civil government is not supposed to attempt to produce money with stable purchasing power, what of government-licensed banks? I deal with this question in Part IV.

January 23, 2002