1912 was the 100th anniversary of the publication of Ludwig von Mises’ book Theorie des Geldes und der Umlaufsmittel (The Theory of Money and Credit). In this month’s “Liberty Matters” online discussion our participants debate the importance of Mises’ work as the next step in the application of Austrian economic insights into monetary theory, and in the formulation of a unique Austrian Theory of the Business Cycle (ATBC) which was further developed by Friedrich Hayek and Murray Rothbard. The soundness of his theory of money is tested against the recent emergence of a new form of currency known as Bitcoin.

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The Debate

Lead Essay: Lawrence H. White, “Ludwig von Mises’s The Theory of Money and Credit at 101” [Posted: Jan. 7, 2014]

Responses and Critiques

The Conversation

About the Authors

Lawrence H. White is Professor of Economics at George Mason University and a senior scholar at the Mercatus Center at GMU. His most recent book, The Clash of Economic Ideas: The Great Policy Debates and Experiments of the Last Hundred Years (Cambridge University Press, 2012), traces the scholarly roots of contrasting views about the desirable role of government in the economy. Best known for his work on free banking, White is also the author of The Theory of Monetary Institutions (1999), Free Banking in Britain (2nd ed., 1995), and Competition and Currency (1989), and the editor of The History of Gold and Silver (2000), Free Banking (1993), and other volumes. His work has appeared in leading professional journals, including the American Economic Review, the Journal of Economic Literature, and the Journal of Money, Credit, and Banking. His popular writings have appeared in the Wall Street Journal and on <Forbes.com>. He hosts bimonthly podcasts for Econ Journal Watch Audio and blogs at <freebanking.org>.

Jörg Guido Hülsmann is a professor of economics at the University of Angers in France and member of the European Academy of Sciences and Arts. Professor Hülsmann is a Senior Fellow of the Ludwig von Mises Institute and directs the Austrian Economics Research Seminar in Paris. He is the author of Krise der Inflationskultur (2013), The Ethics of Money Production (2008), Mises:The Last Knight of Liberalism (2007), Ordnung und Anarchie (2007), Logik der Währungskonkurrenz (1996), and Kritik der Dominanztheorie (1993). He has edited seven books, most recently Theory of Money and Fiduciary Media (2012) on the occasion of the centennial of the first edition of Ludwig von Mises’ Theory of Money and Credit. Dr Hülsmann’s works have been translated into eighteen languages. He received an M.Sc. in mechanical engineering from the Technical University of Berlin, a PhD in economics from the same university, and a Habilitation à diriger des recherches from the University of Paris-Dauphine. His current research focuses on financial economics and capital theory. You can reach him at jgh@guidohulsmann.com , and visit his website, www.guidohulsmann.com.

Jeffrey Rogers Hummel is professor in the economics department at San Jose State University and has taught both history and economics. He is the author of Emancipating Slaves, Enslaving Free Men: A History of the American Civil War (the second edition of which was released in November 2013). He wrote the scripts for audio tapes produced by Knowledge Products on the Constitution (narrated by Walter Cronkite) and on American Wars (narrated by George C. Scott). His articles and reviews have appeared in the Journal of Economic History, Econ Journal Watch, the Texas Law Review, the Independent Review, the International Philosophical Quarterly, the Chapman Law Review, and such popular publications as the Wall Street Journal, Forbes.com, Investor’s Business Dailey, The Freeman, and Liberty Fund’s Library of Economics and Liberty. He has also contributed to such volumes as Boom and Bust Banking (David Beckworth, ed.), Government and the American Economy (Price Fishback, ed.), the Encyclopedia of American Business History and Biography, Reassessing the Presidency (John V. Denson, ed.), and Arms, Politics, and the Economy (Robert Higgs, ed.). Professor Hummel, a former National Fellow at Stanford University’s Hoover Institution, received his Ph.D. in history from the University of Texas at Austin. He has also worked as publications director at the Independent Institute and was a tank platoon leader in the U.S. Army.

George Selgin is a Professor of Economics at the University of Georgia’s Terry College of Business. He is a senior fellow at the Cato Institute. His research covers a broad range of topics within the field of monetary economics, including monetary history, macroeconomic theory, and the history of monetary thought. He is the author of The Theory of Free Banking (Rowman & Littlefield, 1988), Bank Deregulation and Monetary Order (Routledge, 1996), Less Than Zero: The Case for a Falling Price Level in a Growing Economy (The Institute of Economic Affairs, 1997), and, most recently, Good Money: Birmingham Button Makers, the Royal Mint, and the Beginnings of Modern Coinage (University of Michigan Press, 2008). He has written as well for numerous scholarly journals, including the British Numismatic Journal, The Economic Journal, the Economic History Review, the Journal of Economic Literature, and the Journal of Money, Credit, and Banking, and for popular outlets such as The Christian Science Monitor, The Financial Times, The Wall Street Journal, and other popular outlets. Professor Selgin is also, a co-editor of Econ Journal Watch, an electronic journal devoted to exposing “inappropriate assumptions, weak chains of argument, phony claims of relevance, and omissions of pertinent truths” in the writings of professional economists. He holds a B.A. in economics and zoology from Drew University, and a Ph.D. in economics from New York University.

Additional Reading

LEAD ESSAY: Lawrence H. White, “Ludwig von Mises’s The Theory of Money and Credit at 101”↩

In The Theory of Money and Credit by Ludwig von Mises we have an intellectual treasure chest: a work filled with theoretical and applied economic insights that continues to be cited and debated a century after its initial publication (first edition 1912). Like Mises’s Human Action, it is worth reading more than once. Each rereading yields gems of insight that were not fully appreciated on the previous reading.

Over the years the book has attracted critical attention from prominent economists, especially since its translation into English in 1934. Soon after the first edition appeared the great Swedish economist Knut Wicksell responded to particular points on which it had criticized his view (see Festré 2003). In a review, John Maynard Keynes (1914) praised the book in some respects, but professed to find nothing original in it, presumably due to his later-admitted inability to grasp unfamiliar ideas when reading German (Keynes 1930, p. 199 n.2). In well-known works, J. R. Hicks (1935, p. 2) and Don Patinkin (1956, pp. 71–2) felt compelled to note their differences from Mises’s analysis of the demand for money. More recently economists have cited Mises’s book as anticipating modern analysis, including Nobel laureate Edmund S. Phelps (1968, p. 682) with respect to inflation expectations, and Nobuhiro Kiyotaki and Randall Wright (1989, p. 194) with respect to search-theoretic models of how money emerges.

Economists who have commented on The Theory of Money and Credit in some detail (Moss 1976, Rothbard 1976, Schuler 2012, Hülsmann 2013), and others who have commented in passing, have often called attention to three major contributions.

(1) It was the first work to use marginal-utility analysis to explain money demand and thence to explain the purchasing power of the monetary unit and its variation. In doing so it began with the preferences and expectations of individuals. By contrast Irving Fisher’s near-contemporary Purchasing Power of Money (1911) propounded the “quantity theory of money,” beginning not with individuals but with aggregative variables in the “equation of exchange.”

(2) It marked a major departure in business-cycle theory by incorporating capital theory to explain real features of cycles. Mises combined (a) the Currency School’s analysis of unsustainable business booms due to the injection effects of an unwarranted money expansion with (b) Wicksell’s analysis of the effects of holding the market rate of interest below the equilibrium or “natural” rate of interest, and (c) Eugen von Böhm-Bawerk’s capital theory, in which having the interest rate at its equilibrium level is the key to coordinating saving preferences with the intertemporal structure of production. From these elements he forged a novel monetary-malinvestment theory of the business cycle. As noted by Festré (2003), “While Wicksell focused on price level fluctuations [as did, we may add, Irving Fisher and other price-level stabilizationists], Mises built a theoretical framework in which business cycles are due to shifts in relative prices.” Building on Mises, F. A. Hayek in a series of works spelled out in greater detail the theory of how a monetary expansion that holds the interest rate too low causes cyclical malinvestment, a systemic distortion in the economy’s intertemporal structure of production that cannot be sustained (1931, 1933, 1939, 1941).

(3) It provided a modern “purchasing power parity” theory of exchange rates, in the tradition of Henry Thornton (1802) and David Ricardo (1821), a few years before Gustav Cassel further developed and spread his own version of the theory (see Humphries 1979).

The second of these contributions has been widely discussed in the literature on Austrian Business Cycle theory. The third has been more or less absorbed into mainstream economics. In what follows I would like to further discuss the first one and to call attention to a fourth:

(4) It spelled out the role of competition among banks of issue in regulating the quantity of fractional-reserve bank-issued money (banknotes and checking accounts), putting the analysis and conclusions of the 19th-century Free Banking School on a firmer footing. In discussing this issue I will draw on an earlier but now inaccessible article of mine (White 1992) explicating Mises’s free-banking views.

The Purchasing Power of Money, the “Regression Theorem,” and Bitcoin

In seeking to explain the purchasing power of money (ppm) by reference to the marginal utility of money to individuals, Mises had to overcome the objection that such an explanation would necessarily be circular. The German economist Helfferich (see Mises 1981, p. 141) had reasoned that a unit of money is valued by any individual according to how much it can buy. Its valuation cannot then be used to explain how much it can buy. Mises showed that this vicious circle can be replaced by a harmless helix (McCulloch 1980). An individual values a unit of money according to how much he expects it to buy, and the process of forming this expectation will almost unavoidably draw in part (which is not to say exclusively) on his knowledge of the ppm he has most recently observed. Given his expectation of today’s ppm, the individual decides how many units he wants to hold, his quantity demanded. The market quantity demanded is the sum of individual quantities. Equilibrium ppm occurs where the market quantity demanded equals the market quantity supplied. As for all other goods, the exchange ratio for money is determined by the ratio “where both supply and demand are in exact quantitative equilibrium” (Mises 1981, p. 129). Where the quantity supplied exceeds the quantity demanded at the prevailing ppm, the ppm falls through the spending of excess balances. The ppm rises in the reverse case of an excess quantity demanded.

Under Mises’s hypothesis about money demand, today’s ppm draws on yesterday’s, and yesterday’s on that of the day before, and so on. Mises called this proposition “the regression theorem.” How far back does the regression, or historical linkage, go? From a forward-looking perspective of explaining movements in the ppm from here on out, it really doesn’t matter. But logically, Mises explained, for a commodity money it goes back to the day before the commodity first started being used as a medium of exchange. On that day it had an exchange value or purchasing power due only to the interaction of its supply with the demand for it as an ordinary commodity (for consumption or for use as a productive input) and not for use as a medium of exchange. For a fiat money like the U.S. dollar that became a fiat money by terminating the redeemability of what had been a claim to a commodity money (Federal Reserve Notes were once redeemable in silver or gold coin), the historical chain goes back to the day before termination, and thence back to the day before that commodity became a medium of exchange. Application of the logic to a new fiat money that was initially a redeemable claim for an established fiat money (like the Lithuanian talonas, redeemable 1:1 for the Russian ruble) follows straightforwardly.

George Selgin (1994) has insightfully applied Mises’s historical-component hypothesis to explain why all governments that have successfully launched new fiat monies have first given them a fixed redemption value in terms of a commodity or an established fiat money. Donald Patinkin (1956, pp. 114–16, 573–75), on the other hand, has criticized the inclusion of a historical component in Mises’s account of money demand on the grounds that the purchasing power of money (like the relative price of any good in Walrasian general equilibrium theory) can be derived completely ahistorically by thought experiment. Putting real money balances (in purchasing power units) into each agent’s utility function, the economic theorist determines the real quantity of money the agent demands when faced with various hypothetical price vectors. The theorist then aggregates the individual real money demands, confronts them with the nominal supply, and solves at the market level for the ppm (and simultaneously for the vector of other relative prices) consistent with clearing all markets. Taken seriously, this approach suggests that a government might introduce a new fiat money merely by announcing its nominal quantity, leaving its purchasing power to be determined by the market-clearing requirement. Yet this has never been done, which casts doubt on the practical relevance of Patinkin’s logical construct.

J. R. Hicks (1935), in a well-known article published one year after the English translation of The Theory of Money and Credit, and four years after the British pound had become irredeemable in gold, commented that the historical component in Mises’s theory makes the value of any fiat paper money the “ghost of gold.” But that is possibly a misleading metaphor. A fiat money is not a specter, but a living money. Its purchasing power evolves according to its own supply and demand changes, uninfluenced (or should we say unhaunted?) by the monetary unit’s past definition. So it might be better to say that in Mises’s theory a fiat standard is the descendent of a deceased commodity standard.

The historical component is only one component that goes into ppm expectations. Mises does not say that a money-demander will base his expected ppm for today exclusively on yesterday’s ppm. Thus one should not characterize the regression theorem as saying that today’s observed ppm by itself determines tomorrow’s subjective value of money. The former rather influences the latter via the individual’s ppm expectation. Mises says, quite reasonably, that the money-demander’s ppm-expectation-formation incorporates his experience. Ppm expectations need not be static. In a fiat money economy with chronic inflation, the informed individual will make ongoing downward adjustments to his expected ppm. He can also factor in changes in the expected trend of inflation following central bank announcements or his own diagnosis of likely movements in supply or demand. In the case where a commodity standard is suspended (for the duration of a war, say) but resumption is expected, expectations of the future ppm and hence the path of the actual ppm will be accordingly constrained.

While all governments that have successfully launched new irredeemable monies have first given them a fixed redemption value, this is not true of the private irredeemable digital medium of exchange known as Bitcoin. A Bitcoin is basically a unique digital string of characters kept on one’s hard drive or other storage medium. There are currently about 12 million Bitcoins in existence. The dollar value per unit changes daily. On December 1, 2013, Bitcoin traded at just above $958 per unit, making the total stock equivalent to more than $11.8 billion. (The latest value of Bitcoin and other crypto-currencies can be tracked at http://coinmarketcap.com/.) As I understand it, the Bitcoin system produces new units at a preprogrammed diminishing rate, set to max out eventually at 21 million units, and awards new units to “miners” whose computers solve math problems generated by the system. Bitcoin units seem to have no ordinary commodity use (no value as anything other than a medium of exchange) and are not redeemable claims to anything. Bitcoin seems to have lifted itself by its own bootstraps from nothingness to a positive purchasing power.

It is accordingly a challenge to account for Bitcoin (its acceptance as a medium of exchange with a positive purchasing power) using Mises’s regression theorem. But, as Robert P. Murphy (2013a, 2013b) has argued, it would be a mistake to believe that if Bitcoin doesn’t seem to fit the regression theorem then Bitcoin cannot possibly become money. Bitcoin is already a medium of exchange, that is, some people do trade for Bitcoins in order to use them to purchase goods and services. All that Bitcoin needs to become money (a commonly accepted medium of exchange) is wider acceptance, which the regression theorem does not rule out. (See also Šurda 2013.)

Two responses to the challenge seem possible. One is to say that the historical component posited by the regression theorem is not strictly necessary to explain the purchasing-power expectations people initially formed for Bitcoin. The historical component is important to the initial medium-of-exchange value of a good that did have a market value the previous day as an ordinary commodity, or as a redeemable claim, but it cannot be important to a new medium of exchange that had neither. In such a case purchasing-power expectations must arise entirely from forward-looking speculation. Early adopters who paid positive numbers of dollars (or traded pizzas or devoted CPU time) to acquire Bitcoins did so because they believed that it might attain a higher dollar value in the future. In this account, the value of Bitcoin is basically a bubble, a self-feeding phenomenon unanchored by fundamentals. The trouble with a bubble story, of course, is that is consistent with any price path, and thus gives no explanation for a particular price path. Consistent with the bubble story, some Bitcoin-imitator crypto-currencies have crashed to zero after trying to launch into positive value.

The other possible response is to preserve the universal applicability of the regression theorem by saying that Bitcoin must have been a useful commodity to some people before it became a medium of exchange. As Murphy (2013b) puts a version of this case, it could be argued that “the very first people to trade for it did so because it provided them with direct utility because they knew there was at least a chance that it would serve to chafe the governments of the world with their printing presses.… [T]he early adopters of Bitcoin were doing it for ideological reasons, not for pecuniary reasons.” Then, once it had an observable positive price, “it was off to the races in terms of standard Misesian theory.” This scenario, however, does not deliver what the argument requires, namely, an account of how Bitcoins initially had a positive value apart from their actual or prospective use as medium of exchange. The value at every point in this scenario derives entirely from use or prospective use as a medium of exchange (only such use as a dollar competitor is what might “chafe the governments,” not the existence of untraded digital character strings). The ideological-value story, like the bubble story, does not tell us what the value per Bitcoin might be but is consistent with any arbitrary value. It does not explain why, in the fabled first trade of Bitcoins for goods in 2010, the transactors settled on 10,000 BTC for two Papa John’s pizzas (Mangu-Ward 2013), or why anyone else took that price seriously as a basis for forecasting the next day’s Bitcoin purchasing power.

But perhaps there is no explanation for the exchange rate in the first Bitcoin transaction other than whimsy. (Did the transactors consult the electricity costs of mining one Bitcoin at that time?) Perhaps what allowed other traders to begin taking Bitcoin prices seriously was the observed wiliness of many people to engage in similar whimsies, including exchanging dollars for Bitcoins, which gave a historical component to expectations of a positive purchasing power for one Bitcoin.

Mises’s Understanding of Fiduciary Media and Free Banking

In The Theory of Money and Credit (1981, p. 299) Mises clearly explained how it is not generally feasible to hold a fractional reserve behind redeemable claims to ordinary commodities, but it is feasible in banking. A firm that issues 1000 tickets reading “redeemable on demand for one loaf of bread” will have to have to be prepared to hand over 1000 loaves of bread, because people who want to eat bread will redeem them. Bread tickets cannot satisfy hunger without being redeemed. But trusted claims to silver or gold coin are different: they can take the place of coins as media of exchange. To the extent that sellers in the marketplace accept payment in a bank’s notes (or checks), holders of the notes (or checking account balances) need not redeem them for coin before heading to the marketplace. Thus the trusted banker who issues 1000 banknotes can prudently count on only a fraction of them, and possibly a very small fraction, being redeemed on any given day. In Mises’s words (p. 300), the trusted banker “is therefore in a position to undertake greater obligations than he would ever be able to fulfill; it is enough if he takes sufficient precautions to ensure his ability to satisfy promptly that proportion of the claims that is actually enforced against him.” The banker does of course face the problem of accurately estimating the percentage of claims that will actually be redeemed, but “prudent and experienced” bankers “usually manage pretty well with it” (p. 362).

Mises understood and explained the limits on the volume of bank-issued money, or what he called “fiduciary media” (banknotes and checkable account balances in excess of specie reserves), much better than the 19th-century Banking School or Currency School. In the tradition of Henry Thornton (1802) and other “Bullionists,” he showed that the Banking School’s “real bills doctrine” erred in supposing that the banking system could not over-expand by lending on the right kind of collateral. A banking system acting in unison can always lend more by lowering its interest rate on loans. Contrary to Banking School doctrine, “the quantity of fiduciary media in circulation has no natural limits. If for any reason it is desired that it should be limited, then it must be limited by some sort of deliberate human intervention—that is by banking policy.” (p. 346).

But Mises immediately added that a natural limit is absent only when a uniform interest rate policy is followed by all banks. Otherwise the banks that expand by lending more at lower rates will be restrained by their losing reserves to banks that don’t. This means that a natural limit is absent only when the entire banking system is cartelized or directed by a central bank. Under free banking competition, by contrast, any bank “will be able to circulate more fiduciary media only if there is a demand for them even when the rate of interest charged is not lower than that charged by the banks competing with it” (p. 347). Under free banking there is a natural limit to the volume of fiduciary media.

Indeed, free banking competition compels the banks “to increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow an independent interest policy.” This has an unintended benefit: “But in so doing, they help stabilize the objective exchange value of money” (p. 347). The Banking School had vaguely recognized that the money stock is self-limiting in a competitive system, but they misunderstood the cause (it is gold redeemability working through the clearing system, not the properties of “real bills”). By failing to understand that the quantity of money is self-regulating only under free banking, the Banking School failed to grasp the danger of overexpansion of money under a central-banking system absent some deliberate policy constraint.

The costliness of expanding a bank’s clientele, or the costliness of reserve losses for a bank that issues additional redeemable liabilities without expanding its clientele, means that it is incorrect to characterize fiduciary media as “essentially costless to produce” or to speak of credit as “gratuitous” under redeemability and competition. The quantity of fiduciary media lacks natural limits only under central banking (or, implausibly, a cartel that institutes a uniformly expansionary policy).

Mises’s clear understanding of the natural limits under free banking means that we should regard his recommendations – in the last chapter of Part III of the book, and in the Part IV that was added in 1953 – for “legal limitation of the issue of fiduciary media” as second-best remedies for a polity that will not get rid of its central bank and reinstitute free banking. He writes there about the need for legal restrictions to limit the fiduciary issues of a central bank, not of any need – there is no such need in his view – to artificially limit the issues of a free banking system.

RESPONSES AND CRITIQUES↩

1. Jörg Guido Hülsmann, “Mises and His First-Best Option” ↩

The Theory of Money and Credit reinvigorated the two central assertions of classical economics, that: (1) the wealth of nations depends on nonmonetary factors; and (2) it cannot be increased by stimulating the production of money through political interference. But the mainstream of 20th-century economics did not follow Mises. It followed Irving Fisher and John Maynard Keynes. This is precisely why it is still important and inspiring to read Mises today. Lawrence White is right on target in praising The Theory of Money and Credit as an “intellectual treasure chest” that is “worth reading more than once.” He draws our attention to Mises’s regression theorem and to his favorable assessment of the role of competition among banks of issue. We shall follow him onto these grounds, with some more emphasis on free banking.

The Regression Theorem and Bitcoins

Mises developed the regression theorem based on the work of Friedrich von Wieser (Wieser 1929; Hülsmann 2007), who himself could rely on the 19th-century German literature (see Gabriel 2012). Contrary to Wieser, Mises argued in terms of demand and supply, and he later emphasized that the demand for money was not just derived from the subjective value of nonmonetary goods, but from the subjective value of the cash balances themselves.

From an epistemological point of view, the regression theorem does not seem to be an element of Misesian praxeology. It does not concern an a priori causal relation (see Hülsmann 2006, North 2012). The subjective value of money depends on the expected future purchasing power of money (PPM), but these expectations are not necessarily based on the prior PPM (see Hülsmann 1996, pp.168–71). Moreover, as the case of Bitcoin shows, the subjective value of a medium of exchange need not be based on its expected future PPM at all.

On the question whether Bitcoin initially had a nonmonetary value, I therefore think that Robert Murphy (2013) has a better case than Lawrence White. By contrast, White correctly points out the difficulty of the quantitative determination of the initial Bitcoin value. He offers an initial-whim explanation. This is plausible. Indeed, whimsies are implied in the ideological nature of Bitcoin’s nonmonetary value component.

This ideological component is essential not only for Bitcoin’s initial value, but also for its survival. All media of exchange need a nonmonetary value component. Otherwise their future purchasing power is indeterminate, and they would be driven out of the market when that future purchasing power is – for whatever reason – widely expected to decline (Hülsmann 1996, pp. 263ff). The nonmonetary component of precious metals is well known. The nonmonetary component of fiat monies is the threat of violence (Kusnetzov 1997). The value of U.S. dollars ultimately derives from the fact, known to all users, that U.S. citizens will be coerced into accepting dollars as legal tender for all debts public and private. This provides a rock bottom to the value of U.S. dollars. What is the rock bottom of Bitcoin? Presently it is antistatist ideology. If ever the ideology vanishes, something else will have to take its place. At present, it is not clear what that could be.

Free Banking

Contrary to mainstream monetary thought, Mises insists that changes in the supply of and demand for money do not benefit the economy as a whole. This central idea runs through his monetary thought from beginning to end.

In the third part of The Theory of Money and Credit, he refutes one by one the claims purporting to show that the creation of fiduciary media by fractional-reserve banks could be beneficial from an overall point of view. Mises showed that credit granted in the form of fiduciary media was not “true credit”; that the issue of fiduciary media was not “elastic” in the sense that it accommodated changes in the demand for money at a constant price level; and that the issue of fiduciary media was in principle unlimited. It was also in that third part of his book that he presented his new crisis theory. The point was that not only are fractional-reserve banks useless from an overall point of view, but they are also in fact harmful to the economy. In conclusion he adopted the policy recommendation of the Currency School (see Hülsmann 2000, Hülsmann 2012, Salerno 2012), arguing that any further creation of fiduciary media should be outlawed.

Starting with the second edition, Mises began to highlight the beneficial role that competition might play in limiting the issue of fiduciary media. I thoroughly disagree with Lawrence White that this was Mises’s first-best policy, whereas the outlawing of additional fiduciary media was just a second-best option. It is exactly the other way round. Mises thought the outlawing of additional fiduciary media was the straightforward solution. But the government did not wish to go that way because it had an interest in perpetuating the practice of artificial money creation. It wished to control the banking system in order to channel funds into the public purse, and it imposed central banks upon the market to facilitate the extension of fiduciary media. Compared to that policy, Mises preferred not to regulate fractional-reserve banks at all.

But even this stance was not categorical. After all, fractional-reserve banks have an interest in agreeing on uniform policies to facilitate credit expansion. They do not need governments and central banks in this regard (see Mises 1912, p. 426; 1953, p. 397). The long-run implication is patent: “The quantity of fiduciary media in circulation has no natural limits. If for any reason it is desired that it should be limited, then it must be limited by some sort of deliberate human intervention – that is by banking policy” (1912, p. 360; 1980, p. 346). Mises therefore qualified his endorsement of free banking, admonishing his readers not to conflate it with an endorsement of fractional-reserve banking. The prudent approach was to continue watching the banking industry and act accordingly: “If it should prove easier now for the credit-issuing banks to extend their circulation, then failure to adopt measures for limiting the issue of fiduciary media will involve the greatest danger to the stability of economic life” (Mises 1924, p. 410; 1980, p. 439).

Therefore, in spite of his favorable reconsideration of free banking, Mises still maintained the general conclusion of the first edition, in which he advocated the legal interdiction of any further issues of fiduciary media.

Response Essay 2: Jeffrey Rogers Hummel, “Mises, the Regression Theorem, and Free Banking”↩

My thoughts about The Theory of Money and Credit by Ludwig von Mises are inevitably colored by the fact that my first introduction to the discipline of economics was at Grove City College in 1967 in a class taught by Hans Sennholz, a devoted student of Mises. All of us who studied under Sennholz were encouraged to read Mises, and I soon tackled The Theory of Money and Credit. The only other book on monetary theory I had read before that was Murray Rothbard’s What Has Government Done to Our Money? (1964). Consequently, Mises’s delving into advanced and somewhat abstruse monetary controversies and his critiquing of other authors with whom I was entirely unfamiliar left me a bit lost, particularly since I was a history major. It is only with subsequent study over the intervening years that I came to understand fully Mises’s contributions. I therefore find myself in general agreement with Larry White’s appreciation of The Theory of Money and Credit. So I will focus my comments on two of the issues he discusses, offering a few elaborations, reservations, and unresolved questions.

Fiat Money and the Regression Theorem

Mises employed his Regression Theorem to explain the acceptance of fiat moneys as media of exchange. According to Larry, “[A]ll governments that have successfully launched new fiat monies have first given them a fixed redemption value in terms of a commodity or an established fiat money.” Yet if we interpret the term “redemption” strictly, this is not quite historically accurate. Among the earliest fiat moneys in the West were those issued by the British colonies in North America. Rarely if ever were these “bills of credit,” as they were called at the time, directly and immediately redeemable for gold or silver at a fixed rate. Instead, they usually were indirectly linked to commodity money at a fixed rate through taxes (and often also through legal tender laws that applied to debts enforced in the courts). In other words, unlike Federal Reserve notes, which initially could be exchanged for gold before they became fiat money, bills of credit were denominated in the colony’s unit of account and could be used to pay taxes and other government levies in lieu of the monetary commodity. But bills of credit were rarely immediately redeemable, although they were often accompanied by a promise that at some future date they would become so (Michener 2011).

This reliance on taxation and future redeemability applies also to the Continental currency issued by the U.S. during the American Revolution, to the Greenbacks issued by the Union during the Civil War, and to the currency issued by the Confederacy during the same conflict. Indeed, Confederate currency, unlike Union Greenbacks, was not made legal tender in private transactions but only publicly receivable for taxes. George Selgin’s extensive treatment of fiat money’s emergence (1994, 816–21), which invokes Mises analysis, is somewhat difficult to interpret. On the one hand, he seems to require only a fixed exchange rate rather than strict redeemability for successful launching of fiat money, thereby encompassing the historical instances I have mentioned. And when George explicitly rejects taxes as a sufficient mechanism, he appears to be referring to a new fiat money using an entirely new unit of account, completely unrelated to and floating against the existing commodity money. However, he also claims that “[p]ublic receivability laws can confer value on a new money only” if “there be real resources at the disposal of government to be exchanged for the new money at administered prices,” which was hardly the case with bills of credit, Greenbacks, and Confederate currency. Whatever George’s position, Mises was clearly wrong when he stated that fiat money emerges exclusively “when the coins or notes in question have already been in circulation as money-substitutes,” by which he meant “perfectly secure and immediately convertible claims” (emphasis mine; 1953, 78).

These historical counterexamples are particularly interesting because Mises, in other passages, inadvertently describes them. He divided what he called “money in the narrower sense” (or what has come to be called outside money in modern monetary theory) into not just two categories: commodity and fiat money. He introduced a third category, which in the English translation was designated “credit money.” The Theory of Money and Credit defined credit money as “a claim against any physical or legal person,” but one that “must not be both payable on demand and absolutely secure.… Credit money … is a claim falling due in the future that is used as a general medium of exchange” (1953, 61–62). Mises continued to posit these three categories in the final edition of Human Action (1966, 429). He considered the notes of banks that had temporarily suspended redemption in specie (gold or silver coin) as one example of credit money, but irredeemable moneys launched through taxation fit the category equally well. In fact, Mises (1953, 153) referred to Confederate currency as a specific example of credit money. The Theory of Money and Credit went so far as to speculate that most forms of so-called fiat money might in reality be credit money: “Whether fiat money has ever actually existed is, of course, another question, and one that cannot offhand be answered affirmatively. It can hardly be doubted that most of those kinds of money that are not commodity money must be classified as credit money. But only detailed historical investigation could clear this matter up” (1953, 61).

Outside of Sennholz in his lectures, the only Austrian economist (to my knowledge) who has pursued Mises’s distinction between fiat and credit money, albeit cursorily, is Joe Salerno (2010, 68–70, 586). Yet this distinction may be more than a terminological quibble. One recent development in monetary theory is the Fiscal Theory of the Price Level (FTPL), most ably advocated by John Cochrane (2005) of the University of Chicago. It is a highly mathematical attempt to formally integrate the impacts of both monetary policy and fiscal policy, and one of its crucial underlying assumptions is that the current value of fiat money depends on people’s expectations of the government’s future taxes. In other words, it explicitly treats fiat money as what Mises called credit money, and moreover contends that future expected taxes have a significant effect on money’s velocity (that is, the reciprocal of the portfolio demand for money) and therefore on the price level. In this respect, the FTPL is building on an extensive literature arguing that expected taxes played the major role in determining the price level in the early fiat (credit) money issues in America. (Smith 1984,1985a, 1985b, 1988; Wicker 1985; Calomiris 1988a, 1988b; critiques of this literature include Michener 1988; McCallum 1992; and Sumner 1993; for surveys of the debate see Michener and Wright 2006 and Michener 2011.) It is also consistent with Michael Sproul’s (2003) much cruder “backing theory of money,” which denies the existence of fiat money altogether and about which Sproul (2013) is currently debating Kurt Schuler at the Free Banking blog.

The FTPL does not necessarily undermine the validity Mises’s Regression Theorem as an explanation for the launching of fiat (or credit) money. Nor is it entirely inconsistent with a sophisticated interpretation of the quantity theory of money. Yet it has some far more intriguing implications. Tyler Cowen once emailed me that the FTPL “is formally correct but not so useful; just a way of re-explaining the traditional boxes,” while Greg Mankiw in personal conversation similarly described it as merely “a new vocabulary.” But I believe they are both mistaken. If correct, the FTPL implies that neither fiat nor credit money are true outside money in the sense of being assets only, with no offsetting liability. Instead they are really what current monetary theorists refer to as inside money, with future taxes representing the offsetting liability-side, making them much like shares of stock, whose value depends on an anticipated future income stream. Not only does this conclusion eliminate any real-balance effect that can result from fiat or credit money constituting net wealth (unlike commodity money), but it impinges on the long-standing debate over whether a pure inside-money economy would be feasible. Initiated by Knut Wicksell (1936) and addressed by Don Patinkin (1965), this debate was part of the wide-ranging development during the late 1980s and early 1990s of the New Monetary Economics, with Leland Yeager (1997), Tyler Cowen and Randy Kroszner (1994), and George Selgin and Larry White (1994) major participants. I am not myself convinced that the FTPL is correct, but it deserves more attention and discussion than those influenced by Mises’s Theory of Money and Credit have given it.

Mises and Free Banking

Larry credits The Theory of Money and Credit with “putting the analysis and conclusions of the 19th-century Free Banking School on firmer footing.” Here he is reiterating his interpretation in an earlier article that coincidentally appeared in a Sennholz festschrift (White 1992). Larry was somewhat more cautious in that version, admitting that the first edition of The Theory of Money and Credit “endorsed free banking mainly by implication” before drawing upon Mises’s subsequent writings to buttress his conclusion. Undoubtedly Mises, like Sennholz, favored unregulated banking and, by the last edition of Human Action (1964, 443), was skeptical of any legal imposition of 100 percent reserves, as advocated by Rothbard. But we must carefully distinguish between favoring free banking as a legal regime and predicting how it would operate in practice. I think Larry goes too far when he seems to imply that Mises had in mind the kind of free banking that he (1999) and George (1988) predict would emerge without regulation: that is, a system in which reserve ratios are extremely low and banks adjust the money supply to demand in a way that stabilizes velocity. As much as I may agree with their prediction, I can assure them that Sennholz repeatedly affirmed his belief that unregulated competition among banks would drive reserve ratios up very high and possibly close to 100 percent, and he left the impression that such was Mises’s opinion as well.

Mises himself was never entirely clear whether or not he advocated free banking as a means of approximating Rothbardian ends, neither in The Theory of Money and Credit nor in Human Action. Yet revealing is his division of “money substitutes” (i.e., inside money) into “money certificates,” that portion 100 percent redeemable for outside money, and “fiduciary media,” the remaining portion exceeding the amount of outside money. The passage that Larry cites where Mises (1953, 312 [note my pagination is different from Larry’s because I am using a different printing of the same edition]) admits that free banking might “help stabilize the objective exchange-value of money” appears to be no more than a minor concession to the Banking School’s penchant for currency elasticity rather than an expression of something Mises found economically desirable. And in Human Action (1966, 443) he evinced an unambiguous desire to keep fiduciary media tightly constrained: “Free banking is the only method available for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks… . But under free banking, it would have been impossible for credit expansion to have developed into a regular—one is tempted to say normal—feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.”

The key phrase, “credit expansion,” did not appear in The Theory of Money and Credit until Mises added Part Four to the 1952 edition. But it relates to Austrian business cycle theory, which Mises had first sketched out in the original edition of that work. I have never been entirely comfortable with this theory (Hummel 1979), despite believing that it contains some penetrating insights. Mises defined credit expansion as any net increase in fiduciary media in Human Action (1966, 434). Although he earlier had conceded that such increases through fractional-reserve banking had, as world output grew, prevented the “undesirable consequence” of a “tremendous increase in the exchange-value of money” (i.e., significant secular deflation), with its “additional harm” of increasing commodity money’s resource cost (1953, 298–99); in the final edition of Human Action he is insisting that “the trade cycle” can arise in a “pure market economy” from any credit expansion (1964, 573–74). This tension simply highlights one major difficulty with Austrian business cycle theory, no matter which variant from its assorted advocates we examine. It is a theory that hinges on specifying two firm dividing lines: (a) between those financial instruments that constitute inside money and those comprising what Mises considered genuine manifestations of people’s savings, and (b) between those increases in the money stock, however defined, that generate a self-reversing boom and those that do not. Alas, after myriad attempts, no consensus has emerged on either question among Austrian economists.

Response Essay 3: George Selgin, “Mises Was Lukewarm on Free Banking”↩

I first read The Theory of Money and Credit in the spring of 1981. I ought to have been working on a master’s degree in resource economics at the University of Rhode Island. But I’d had my fill of Hotelling’s Rule and was itching to broaden my economic horizons.

Having read many general economics classics while I was an undergrad, I decided to start taking on works dealing with specific fields. Inflation was in the headlines, and monetary theory sounded challenging, so my plan was to start with it and then move on to easier stuff. That I’d read a couple dozen books before yanking The Theory of Money and Credit off the shelf turned out to be a lucky break: had I read it too soon, I’d certainly have found it dense, if not impenetrable. Instead, comparing it to everything I’d managed to glean from the other books, I never doubted that, despite its age, it towered over the rest. Indeed, though I’ve read hundreds of other books about money since, including some awfully good ones, none has had a greater influence upon my own thinking on the subject.

The Regression Theorem

Like Larry, I regard Mises’s treatment of the determination of money’s purchasing power, and the “regression theorem” that plays the central part in that treatment, as one of his book’s most important contributions. As Israel Kirzner makes clear in an excellent, though (so far as I’m aware) never-published, essay on the regression theorem, Mises’s approach was unique, not so much because of the particular explanation he offered of how agents come to form their expectations regarding an inconvertible money’s purchasing power, but because he realized that no theory of a fiat money’s equilibrium value could be considered complete unless it accounted for the people’s willingness to treat some particular paper medium, not as so many mere bits of paper, but as an economy’s generally accepted medium of exchange, to which a positive exchange value might reasonably be assigned.[1]Many other theorists—and Don Patinkin, most notoriously of all— simply failed to recognize the challenge posed by the presence of what we would today refer to as “multiple equilibrium solutions” to the value of a (potential) fiat money problem. One solution—the one taken for granted by Patinkin using the Walrasian “tâtonnement” approach—implies a positive equilibrium purchasing power.[2] The other is the one in which a would-be fiat “money” is not actually accepted as such, so that it commands no value at all. Patinkin assumes, in effect, that because agents might humor a Walrasian auctioneer by telling him that they would equip themselves with n units of some would-be paper “money” if each unit could buy q baskets of goods, and with n+x units if each could buy q-z baskets (and so on), those agents will in fact happily exchange valuable goods for the “money” in question at the determined equilibrium rate. To see the flaw in this approach, one has only to imagine the Walrasian polling being done using stage money. Evidently we need a theory that can account for the fact that one can buy things with actual fiat monies, but not with stage monies. Yet Patinkin didn’t see this, and neither do most of his readers, even today.

Bitcoin

The regression theorem itself constitutes, as I’ve said, but one particular solution—a solution that might now be labeled “backward-looking” expectations-formation. Actual fiat monies are valuable, while stage monies aren’t, because the fact that the former have been valued historically makes the “Patinkin” equilibrium more salient, to backward-glancing agents, than the alternative, zero-value equilibrium. For a long time, as Larry points out, I also regarded this theorem as being the only practical solution. Consequently I saw in it the key, not only to the history of fiat money (and, in particular, to the “commodity money—redeemable money substitutes—fiat money” pattern of money’s historical development), but also to the successful launching of new official monies.[3]

Bitcoin’s success has, however, caused me to reconsider my previous understanding of the significance of the regression theorem; for that reason I think it only right that Larry should devote a substantial part of his retrospective to discussing a subject that some may think both esoteric in itself and at most tangential to the subject of Mises’s great work. Bitcoins aren’t even “money,” after all—not, at least, according to the standard definition, which holds that to be “money” a thing must be, not just an occasionally accepted, but a generally accepted, medium of exchange. But though Bitcoins aren’t money, their story challenges Mises’s theorem by suggesting that an otherwise valueless medium might become money despite not having a provenance linking it with some commodity progenitor.

Why, in that case, was anyone willing to be the first person to trade something having a well-established value, whether their labor or a pizza or some other good, for an as-yet useless medium? Here there was no question of a “friendly helix” of backward-looking expectations coming to the rescue. From a backward-looking perspective a Bitcoin was no better than a piece of stage money; the salient equilibrium, viewed from that angle, was the zero-value one, based on the prediction that nothing would change. Yet things did change, so that as of this writing a Bitcoin is worth about $1000. How was this possible?

In a post published at Freebanking.org a couple months before Bob Murphy’s EconLib essay appeared,[4] I dubbed this question “the oyster problem”:

It is said[5] that the first person to eat an oyster had to have been exceedingly brave or exceedingly crazy or some of each. But that primordial mollusk eater had nothing on the first, equally anonymous person to receive bitcoins in exchange for valuable merchandise, in the hope of somehow fobbing them off in turn on others. The earlier pioneer might, after all, have simply taken his cue from a seagull or oyster-catcher. Unlike the rise of bitcoin’s network, that of various past money commodities like tobacco, cowries, and salt poses no puzzle: whoever first toyed with accepting such commodities for goods could count on the existence of persons who desired the commodities in question for their own sake, even if no one else was prepared to hazard their employment as exchange media…. The first person to accept bitcoins in exchange, in contrast, couldn’t hope to smoke them, make them into a nice bracelet, or sprinkle them on his food, in case he couldn’t trade them away: he (or she) could only hope that someone else would attempt a similar leap of faith, or face the consequences of trading some useful goods or service for so many units of digital dross.[6]

I went on to ask persons having intimate knowledge of Bitcoin transactions to submit their own explanations concerning how Bitcoin solved the oyster problem, and received a bunch of intriguing replies.[7] My own preferred theory invoked what I called “expressive exchange”—a counterpart to the “expressive voting” solution to the paradox of voting—a solution that treats voting as a source of direct satisfaction, like cheering on one’s favorite sports team while watching them on TV. The person who accepted Bitcoins for that first pizza did it, in other words, because he liked the ideas Bitcoin stood for, and wanted to root for them.

As I said, I liked the theory. But now I realize I wasn’t giving the Bitcoin team enough credit. Records show that a just a few persons took part in most early Bitcoin transfers, and especially in the larger-volume ones. My guess is that they all knew each other, and that those trades were more-or-less fictitious, with large values being traded and then traded back again, with the intent of enhancing the prominence of the positive-value equilibrium by drawing attention away from the much larger set of inactive Bitcoin markets. Bitcoin’s inventors, I’m now almost certain, were making conspicuous leaps onto their own bandwagon, so as to encourage others to do so, whether to express themselves or to profit by doing so. In short, a clever marketing strategy, including a little strategic sleight-of-hand, can substitute for history in putting a positive sign on the expected value of an otherwise useless potential exchange medium.

Criticisms

Mises, of course, can hardly be faulted for not having anticipated a possibility that has come as a surprise even to those of us who have watched it unfold. The Theory of Money and Credit does, however, suffer, in my humble opinion, from some serious shortcomings. One of them stems from Mises’s refusal to employ raw statistics, let alone econometrics of any sort, to bolster his claims regarding the merits or drawbacks of alternative monetary arrangements. Statistical measures of such things as money’s purchasing power are, admittedly, far from perfect. Nor would they serve any use if alternatives could be judged and compared on strictly a priori grounds. Generally, though, a priori reasoning alone will not allow one to conclude that monetary arrangement A performs better than arrangement B. In particular, it cannot tell us whether a managed fiat standard is likely to have a more stable purchasing power than a gold standard. Whether it does or doesn’t is an empirical matter, and as such it is one best settled by reference to the best available statistics, for such statistics, as crude as they may be, are at least better than mere assertions.

Alas, Mises’s disdain for statistics, and especially for statistics purporting to represent “price level” (or the inverse of what Mises’s called money’s “outer objective exchange value”), caused him to rely upon mere assertions in assessing the relative merits of gold and fiat money, and to do so even when available statistics would have supported his case. This was unfortunate, both because it rendered Mises’s particular policy recommendations less persuasive than they might otherwise have been, and because it almost certainly limited the overall appeal of The Theory of Money and Credit within a discipline that was becoming more-and-more statistically minded.[8]

Other significant shortcomings of The Theory of Money and Credit stem from Mises’s failure to rid himself of certain Currency School prejudices: although Mises, unlike many of his contemporaries, was never a doctrinaire exponent of either Banking or Currency School views, he did not succeed, in my view, in completely resisting some Currency School fallacies. In particular, he endorsed the Currency School view that, under a gold standard, a nation’s money stock ought to vary in strict accord with its monetary gold reserves, while blaming business cycles on deviations from this strict pattern. Mises sets out his opinion most clearly in Human Action:

Issuance of fiduciary media, no matter what its quantity may be, always sets in motion those changes in the price structure the description of which is the task of the theory of the trade cycle. Of course, if the additional amount issued is not large, neither are the inevitable effects of the expansion.[9]

The same Currency School prejudice is, however, also implicit in the terminology employed in The Theory of Money and Credit, where Mises distinguishes between “commodity credit” and “circulation credit,” the first of which refers to credit based on actual savings.[10] It is not difficult to see how even such terminology, not to mention more explicit statements like that quoted above, have been understood by Rothbard and many others as embodying an implicit endorsement of 100-percent reserve “banking” as against any fractional alternatives, including free banking. At very least, it must be said (and here I’m afraid I disagree with Larry) that Mises’s defense of free banking was a lukewarm one, based on his (mistaken) belief that free banking would offer no scope for any substantial creation of fiduciary media.

Endnotes

[1] Israel Kirzner, “A Note on the Circularity ‘Bogey’ in the History of the Marginal Utility Theory of Money.” Ms., New York University, n.d.

[2] Don Patinkin, Money, Interest, and Prices, 2nd. ed. (New York: Harper & Row, 1965), pp. 115–16.

[3] George Selgin, “On Ensuring the Acceptability of a New Fiat Money,” Journal of Money, Credit, and Banking 26 (4) (November 1994), pp. 808–26, and idem.; “Adaptive Learning and the Transition to Fiat Money,” Economic Journal 113 (484) (January 2003), pp. 147–65.

[4] Robert P. Murphy, “The Economics of Bitcoin,” Library of Economics and Liberty, June 3, 2013. http://www.econlib.org/library/Columns/y2013/Murphybitcoin.html.

[5] In fact the common statement misquotes Jonathan Swift, who observed, in dialogue 2 of his Polite Conversation, that “He was a bold man that first eat an oyster.”

[6] “Bitcoin,” Freebanking.org, April 22, 2013, http://www.freebanking.org/2013/04/22/bitcoin/.

[7] “A Challenge to the Bitcoin Community,” Freebanking.org, May 2, 2013, http://www.freebanking.org/2013/05/02/a-challenge-to-the-bitcoin-community/.

[8] See George Selgin, “Ludwig von Mises and the Case for Gold.” The Cato Journal 19(2) (Fall 1999), pp. 259–77.

[9] Ludwig von Mises, Human Action (Chicago: Regnery, 1949), p. 4439n.

[10] Theory of Money and Credit, part III, chap. 15, sections 10–12.

The Conversation↩

1. Lawrence H. White, “A Response to Hülsmann, Hummel, and Selgin” [Posted: Jan. 15, 2014]↩

I thank Professors Guido Hülsmann, Jeff Hummel, and George Selgin for their thoughtful commentaries. I am broadly in agreement with Hummel’s and Selgin’s comments, but not surprisingly have some serious differences with Hülsmann’s views on banking theory and his interpretation of Mises. (See our previous exchange on free banking in Hülsmann 2003 and White 2003.)

Hülsmann writes that “All media of exchange need a nonmonetary value component.” For fiat money, he says, this component is the “threat of violence,” meaning the collection of taxes and the enforcement of legal-tender laws. This seems to me an unnecessary concession to the state theory of money. Some important evidence weighs against the view that state enforcement is a necessary condition for the continued circulation of a fiat money once it has been launched. In particular, the Somali shilling continued to circulate in Somalia even after the state disappeared, ending the state’s ability to collect taxes or enforce legal-tender laws (Luther and White 2013).

Interpreting Mises’s argument in The Theory of Money and Credit, Hülsmann writes: “Mises insists that changes in the supply of and demand for money do not benefit the economy as a whole.” In fact, this is true only of a change in the nominal quantity of fiat money. It was Mises’s view (and it is my view) that a gold standard is different because monetary gold is costly to produce.

Mises explained how a reduction in the demand for monetary gold due to the development of fractional-reserve banking is beneficial under a gold standard. Consider the ordinary case of the global economy in which the stock of monetary gold continues to rise due to gold mining. Because there is no benefit to the economy from increasing the stock of monetary gold in the world as a whole, the labor and capital sacrificed to produce an increased stock is a cost without a benefit. Banking developments that reduce the demand for monetary gold accordingly benefit the economy by avoiding this cost. With respect to the development of fractional-reserve banknotes and checking accounts as substitute media of exchange in a specie economy, Mises accordingly wrote (Theory of Money and Credit, Book III, Chapter 17, para. 4): “If metallic money is employed, then the advantages of a diminution of the demand for money due to the extension of such other means of payment are obvious.” Historically, given the growth of real economic activity,

the tremendous increase in the exchange value of money, which otherwise would have occurred as a consequence of the extension of the use of money, has been completely avoided, together with its undesirable consequences. If it had not been for this the increase in the exchange value of money, and so also of the monetary metal, would have given an increased impetus to the production of the metal. Capital and labor would have been diverted from other branches of production to the production of the monetary metal.... [In consequence] the welfare of the community would have suffered. The increase in the stock of precious metals which serve monetary purposes would not have improved the position of the individual members of the community, would not have increased the satisfaction of their wants; for the monetary function could also have been fulfilled by a smaller stock. And, on the other hand, a smaller quantity of economic goods would have been available for the direct satisfaction of human wants if a part of the capital and labor power that otherwise would have been used for their production had been diverted to mining precious metals.

Mises went on to note that this resource-cost-saving argument applies to a commodity money regime, but not to a credit money or a fiat money.

The statement just quoted comes from the third part of The Theory of Money and Credit. It is thus not correct to write, as Hülsmann does, that “In the third part of The Theory of Money and Credit, he [Mises] refutes one by one the claims purporting to show that the creation of fiduciary media by fractional-reserve banks could be beneficial from an overall point of view.” In the above-quoted passage Mises makes an important claim of exactly this sort himself.

Likewise it is incorrect to attribute to Mises the (unwarranted) view that “not only are fractional-reserve banks useless from an overall point of view, but they are also in fact harmful to the economy.” Compared to a system where payments can only be made in specie or in transferable titles to specie issued by money warehouses, fractional-reserve banks – far from being useless – provide payment services at lower cost both from the individual transactor’s point of view and from the overall point of view.

In my lead essay I credited Mises with improving economists’ understanding of how adverse clearings limit the quantity of bank-issued money. Hülsmann, by contrast, attributes to Mises the view “that the issue of fiduciary media was in principle unlimited,” which I take to be a paraphrase of Mises’s statements (Theory of Money and Credit Book III, ch. 17, para. 26) that “[t]he circulation of fiduciary media ... is only elastic in the sense that it allows of any sort of extension of the circulation, even completely unlimited extension,” and that “[t]he quantity of fiduciary media in circulation has no natural limits.” I quoted the second statement and pointed out that we will miss Mises’s key insight that it does not apply to a competitive free-banking system if one ignores, as Hülsmann does, the immediately following paragraph. There -- I quote it again in hopes that it will not be overlooked again -- Mises writes:

Of course, all of this [lack of a natural limit to bank-issued money] is true only under the assumption that all banks issue fiduciary media according to uniform principles, or that there is only one bank that issues fiduciary media. A single bank carrying on its business in competition with numerous others is not in a position to enter upon an independent discount policy. If regard to the behavior of its competitors prevents it from further reducing the rate of interest in bank-credit transactions, then -- apart from an extension of its clientele -- it will be able to circulate more fiduciary media only if there is a demand for them even when the rate of interest charged is not lower than that charged by the banks competing with it. Thus the banks may be seen to pay a certain amount of regard to the periodical fluctuations in the demand for money. They increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow an independent interest policy. But in doing so, they help to stabilize the objective exchange value of money. To this extent, therefore, the theory of the elasticity of the circulation of fiduciary media is correct; it has rightly apprehended one of the phenomena of the market, even if it has also completely misapprehended its cause.

What is the referenced “theory of the elasticity of the circulation of fiduciary media” that has “completely misapprehended” the cause of the demand-elasticity of bank-issued money? It is the pair of erroneous Banking School doctrines known as the Fullartonian “law of the reflux” and the Real Bills Doctrine. The correct apprehension of the cause is the theory of adverse clearings, as partially understood by some Free Banking School writers in the 19th century, better understood by Mises, and as most thoroughly explained in recent years by George Selgin in The Theory of Free Banking (1988) and other works.

Under what conditions is it true that “the issue of fiduciary media [is] in principle unlimited”? The issue of fiat money is unlimited by economic forces, but “fiduciary media” refers to redeemable bank liabilities and not to fiat money. Redeemable liabilities are not gratuitously issued but are costly for any bank to keep in circulation in a competitive environment. The issue of fiduciary is unlimited only in the analytical limiting case (never historically realized) of a single world banking system with a single issuer of fiduciary media (or a perfect cartel among all issuers) and zero public demand to hold the medium of redemption (which, by the way, is inconsistent with gold being the medium of redemption), so that the issuing bank’s risk of reserve loss is zero no matter how great the volume issued. Short of that case, the risk of adverse clearings or over-the-counter reserve losses strictly limits the ratio of bank-issued money to bank reserves to a finite number.

Hülsmann seems to think – despite all historical evidence (Dowd 1993, White 1995, White 2003) – that a perfect cartel among all banks of issue is a reasonable approximation to historical systems in which banks were free to issue fiduciary media. He even cites Mises in a way suggesting that he thinks that this was Mises’s position: “After all, fractional-reserve banks have an interest in agreeing on uniform policies to facilitate credit expansion. They do not need governments and central banks in this regard (see Mises 1912, p. 426; 1953, p. 397).”

This statement is mistaken in three respects. First, if banks could collude, their interest would lie, like any monopolist’s or monopoly cartel’s, in restricting industry output and thereby getting a higher price and a monopoly profit. In banking, this means that a profit-seeking bank cartel would seek to charge higher interest rates on loans (and to pay lower interest rates on deposits). To do so requires the cartel to move up the industry demand curve for bank loans to a smaller volume of loans, which implies a smaller volume of liabilities (holding constant banks’ other interest-earning assets and non-deposit sources of funds) than under competition. Second, again like firms in any industry, there is no reason to think that banks can successfully collude without government (via the government central bank or otherwise) to enforce the cartel’s prices. When the rest of the industry is charging loan rates above the competitive level (the interest rate on deposits plus the marginal cost of intermediation), any individual bank can profit by undercutting the cartel, lending more at a slightly lower loan rate, thereby undermining the cartel’s attempt to fix the loan rate. Third, Mises quite clearly found it absurd to suppose that a banking industry could collude to bring about a uniform proportional expansion in every bank’s liabilities, so as to avoid the adverse clearings that constrain any non-uniform expansion. Mises noted in Human Action that the self-interest of reputable banks lies in not cooperating with less responsible banks. He wrote (Mises 1966, ch. 17, para. 159):

But, some people may ask, what about a cartel of the commercial banks? Could not the banks collude for the sake of a boundless expansion of their issuance of fiduciary media? The objection is preposterous. As long as the public is not, by government interference, deprived of the right of withdrawing its deposits, no bank can risk its own good will by collusion with banks whose good will is not so high as its own.… Under free banking a cartel of banks would destroy the country’s whole banking system. It would not serve the interests of any bank.

Let me turn to Jeff Hummel’s contribution. Hummel notes that historically some governments have launched new monies without first giving them a fixed spot-redemption value, by promising future redemption in gold or receivability for taxes. These, he rightly notes, are “credit money” in Mises’s terminology (as translated). He considers this a correction of my statement that the launching of new government fiat monies has always proceeded by ending redeemability of a previously spot-redeemable money. I do not dispute these cases, and I would have worded my statement differently if I had thought about them. However, Hummel and I are not in disagreement, because when I said fiat money, I meant fiat money, not credit money.

Hummel cautions that my essay “goes too far when he seems to imply that Mises had in mind the kind of free banking … system in which reserve ratios are extremely low and banks adjust the money supply to demand in a way that stabilizes velocity.” Mises did of course emphasize the restraint that free banking imposes on the volume of bank-issued money. Hummel refers to Mises’s “unambiguous desire to keep fiduciary media tightly constrained,” and appropriately quotes Human Action (Mises 1966, p. 443): “Free banking is the only method available for the prevention of the dangers inherent in credit expansion.”

I see no difference between Mises’s view and my own view in that regard – I also desire a system that keeps the volume of money tightly constrained to its warranted volume.

But Mises in Human Action (p. 446) does quote Cernuschi to the effect that free banking would have narrowed the use of banknotes considerably, and in other ways suggests that reserve ratios under free banking would be, as Hummel puts it, “up very high and possibly close to 100 percent.” If that is Mises’s prediction, then on this point I do depart from Mises. In my 1992 essay that Hummel cites, I criticized Mises for suggesting that free banking would produce reserve ratios close to 100 percent. The best historical evidence we have, from the Scottish free-banking system and other mature systems, shows reserve ratios below 10 percent. This appears to be another instance of the point Selgin made in his contribution: that an empirical question of magnitude cannot be settled by a priori reasoning. We need to look at the historical evidence.

Hummel highlights Mises’s division of bank-issued money into “money certificates” and “fiduciary media.” According to this conceptual scheme, if a bank issues 100 in banknotes against 10 in reserves and 90 in loans, the first 10 banknotes are “money certificates” and the remaining 90 are “fiduciary media.” I am puzzled by this way of dividing things. It seems anti-subjectivist, because from the point of view of a banknote’s holder, the “last” banknote issued by a bank with fractional reserves is identical to the “first.” It makes more sense to distinguish inside money from outside (base) money, or equivalently, bank-issued money from reserve money.

Hummel goes on to quote Mises’s statement that free banking “would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks.”

It isn’t entirely clear what proposition Mises is advancing in this sentence. Under a constant set of parameters, the equilibrium quantity of bank-issued money is determined. A slow credit expansion requires a slow change in one or more of the parameters. But exactly what parametric change is Mises supposing? A slow secular decline in the cost of topping up low reserves on short notice? A slow rise in the fraction of the public prepared to hold bank-issued media? If one of these two secular trends is assumed, then I am in full agreement the proposition that a free banking system would respond with an appropriately slow expansion in bank-issued money.

Turning now to George Selgin’s comments, I agree with most of what Selgin has to say about the regression theorem and Bitcoin. I would reemphasize the point I tried to make in my lead essay, that while Bitcoin’s appeal to antistatists in undeniable, that link does not determine the magnitude of the real purchasing power of one Bitcoin in the same way as a “rock-bottom” (to use Hülsmann’s term) purchasing power of gold is determined by the intersection of the supply curve with the nonmonetary demand curve for gold. To know where to draw the demand curve for real Bitcoins, we would have to suppose that the ideological desire is not merely to participate in holding a nonstate medium of exchange, but to hold so many dollars-worth.

Selgin’s hypothesis that Bitcoin’s founders were “making conspicuous leaps onto their own bandwagon, so as to encourage others to do so,” and in so doing were pursuing “a clever marketing strategy,” seems plausible, but awaits historical documentation. Since there is a public record of all Bitcoin transactions, it should be possible to discover whether there was an in-group pattern of offsetting trades in the early transactions. If true, we should expect to see the same pattern in the launchings of the 70 other cyber-currencies (listed at <http://coinmarketcap.com/>) that emulate Bitcoin, the largest of which is Litecoin.

Needless to say, given my own efforts (White 2013, 2014) to show that the gold standard has outperformed fiat money as judged by price indices and other historical statistics, I agree with Selgin that “reference to the best available statistics” trumps “mere assertions.”

Finally, I agree with Selgin that Mises was far too sweeping when he wrote that “Issuance of fiduciary media, no matter what its quantity may be, always sets in motion those changes in the price structure the description of which is the task of the theory of the trade cycle.” As I noted in a footnote in my 1992 essay, an increase of bank-issued money that matches an increase in the demand to hold bank-issued money is not disequilibrating but the reverse. It prevents a liquidity spillover from the market for money balances to the market for loanable funds, and thereby prevents a disequilibrating rise of the market interest rate above the natural rate, rather than causing the market rate to fall below the natural rate.

2. Jörg Guido Hülsmann, "What Mises Said" [Posted: Jan. 16, 2014]↩

In his response to my comment, Professor White focuses on two questions pertaining to Mises’s theory of banking:

whether Mises thought there were advantages to the economy as a whole if the demand for monetary gold diminishes due to the development of fractional-reserve banking; and whether Mises thought that the production of fiduciary media tends to be limited under fractional-reserve banking.

Lawrence White believes my interpretation of Mises to be wrong, at any rate as far as these two points are concerned. Let me therefore address them in turn.

(1) It is correct that the development of fractional-reserve banking tends to diminish the demand for base money under a gold standard. It is correct that Mises, in the second and third parts of The Theory of Money and Credit, highlighted that this tendency implied that more original factors of production could be devoted to the production of other goods. And it is also correct that, in the first edition (1912), Mises considered this tendency to be beneficial from an overall point of view.

However, he thoroughly reconsidered his position in later works, especially in second edition of The Theory of Money and Credit (1924) and again in the fourth part added to the 1953 American edition. More precisely, while he still acknowledged that the development of fractional-reserve banking tends to diminish the production of gold, he no longer held this to be beneficial.

In the concluding chapter of the third part (chap. 20, III, sections 9 and 10) he now stated that the (fractional reserve) gold-exchange standard was pointless because it did not effectively rein in monetary interventionism. The only alternative was either to go the full way to fiduciary media or to return to the actual use of gold in daily exchanges. He clearly opted for the latter alternative. (See Mises 1924, pp. 403f; 1980, pp. 432f.)

He explains his reform plan in more detail in the fourth part added to the 1953 edition. But the objective is the same as in 1924, namely, the establishment of an effective gold-coin circulation. He wrote: “Gold must be in the cash holdings of everybody. Everybody must see gold coins changing hands, must be used to having gold coins in his pockets, to receiving gold coins when he cashes his paycheck, and to spending gold coins when he buys in a store.” (1980, p. 493)

Let us now step back and consider what this means. Mises did not change his analysis of the resource-cost-saving mechanism. The development of fractional-reserve banking tends to diminish the production of gold, and this liberates labor and land resources that can now be devoted to other production projects. But this tendency no longer appears to be beneficial. The “resource-cost-savings” made possible by fractional-reserve banking now appear to be as foolish as the resource-cost-savings of building a car without breaks or shock absorbers.

In other words, Mises had come to the conclusion that the resource costs of gold production were worth the while. In Human Action he recognized that he had once been wrong in endorsing the gold-exchange standard in previous works. (See Mises 1949, chap. 31, section 3, p. 780.) In another chapter he stated: “If one looks at the catastrophic consequences of the great paper money inflations, one must admit that the expensiveness of gold production is the minor evil.” (Mises 1949, chap. 17, section 6, p. 419)

Hence, Lawrence White’s contention that Mises considered the resource-cost-saving induced by fractional-reserve banking to be beneficial from an overall point of view is correct only for the German-language first edition of 1912. In all other editions Mises revised this earlier stance, both in the third part of the Theory of Money and Credit, but also in the fourth part of the same book, as well as in Human Action.

(2) According to Lawrence White, Mises thought that the production of fiduciary media tended to be limited under fractional-reserve banking. Professor White was kind enough to reiterate a lengthy quote from Mises that allegedly substantiates this contention. I shall reciprocate the favor by quoting this passage again, yet with two supplements: First, I shall also quote the few lines that immediately follow the said passage and that conclude section 4 of chapter 17. Second, I shall modify a few sentences of the translation (highlighted), because the English text is here not 100 percent covered by the German collateral:

The circulation of fiduciary media is in fact not elastic in the sense that it automatically accommodates the demand for money to the stock of money without influencing the inner objective exchange value of money, as is erroneously asserted. It is only elastic in the sense that it allows of any sort of extension of the circulation, even completely unlimited extension, just as it allows of any sort of restriction. The quantity of fiduciary media in circulation has no natural limits. If for any reason it is desired that it should be limited, then it must be limited by some sort of deliberate human intervention -- that is by banking policy. Of course, all of this is true only under the assumption that all banks issue fiduciary media according to uniform principles, or that there is only one bank that issues fiduciary media. A single bank carrying on its business in competition with numerous others is not in a position to enter upon an independent discount policy. If regard to the behavior of its competitors prevents it from further reducing the rate of interest in bank-credit transactions, then—apart from an extension of its clientele—it will be able to circulate more fiduciary media only if there is a demand for them even when the rate of interest charged is not lower than that charged by the banks competing with it. Thus we see that, up to a point, the banks pay regard to the periodical fluctuations in the demand for money. They increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow an independent interest policy. But in doing so, they make an essential contribution to stabilizing the inner objective exchange value of money. In this regard, therefore, the theory of the elasticity of the circulation of fiduciary media is correct; it has rightly apprehended a tendency manifesting itself on the market, even if it has also completely misapprehended its cause. And precisely because it has employed a false principle for explaining the phenomenon that it has observed, it has also completely closed the way to understanding of a second tendency of the market that emanates from the circulation of fiduciary media. It was possible for it to overlook the fact that so far as the banks proceed uniformly, there must be a continual augmentation of the circulation of fiduciary media, and consequently a fall of the inner objective exchange value of money. [Mises 1912, pp. 360f; cf. Mises 1980, pp. 346f]

The crucial point is this: Mises held that the production of fiduciary media entailed two possible tendencies. If the banks agree on common procedures, the production of fiduciary media is in principle unlimited. If the banks do not agree on common procedures, the further production of fiduciary media is slowed down. He repeats this view in several passages of the third part of his book. (See for example Mises 1912, pp. 340, 420, 425f, 444.)

Then why did he state that “quantity of fiduciary media in circulation has no natural limits”? I think the reason is quite straightforward. Mises believed that the second tendency dominates the first one. Temporarily, it is possible and even likely that fractional-reserve banks do not reach the agreement needed for quick credit expansion. But credit expansion is nevertheless the long-run tendency, for two reasons.

On the one hand, credit expansion does not necessarily have to be fast; it can also occur in a creeping trial-and-error process. Mises wrote (1980, p. 411): “So long as the banks do not come to an agreement among themselves concerning the extension of credit, the circulation of fiduciary media can indeed be increased slowly, but it cannot be increased in a sweeping fashion. Each individual bank can only make a small step forward and must then wait until the others have followed its example.”

On the other hand, the banks may eventually reach an agreement, in which case credit expansion can proceed at a much faster pace. This is actually the scenario that Mises envisioned in developing his business-cycle theory in chapter 19. He wrote:

We know … that all credit-issuing banks endeavor to extend their circulation of fiduciary media as much as possible, and that the only obstacles in their way nowadays are legal prescriptions and business customs concerning the covering of notes and deposits, not any resistance on the part of the public. If there were no artificial restriction of the credit system at all, and if the individual credit-issuing banks could agree to parallel procedure, then the complete cessation of the use of money would only be a question of time.

This passages is intriguing for more than one reason. It not only shows that Mises believed that the “second tendency” – the one toward a continual augmentation of the circulation of fiduciary media – dominated the first tendency. It also highlights the fact that Mises had a different conception of the workings of free fractional-reserve banking, and of the collusion between such banks, than Professor White.

Mises held that all credit-issuing banks try to issue as many fiduciary media as possible. They do not need to be cartelized through government interventions (although that might possibly speed up the process), but have a self-interest in doing so. In spite of political interference, such as legal reserve ratios, however, the long-run tendency was for fractional-reserve banks to cartelize, first on the national level and eventually on a global level. This is what Mises purports to show in chapter 16, where he deals with the “evolution of fiduciary media.” The driving force of this process is the basic and perennial motivation of all banks to increase their issue of fiduciary media. At the time of writing The Theory of Money and Credit, he saw the biggest obstacle to the establishment of a world bank and the full cartelization of all fractional-reserve banks not in the inability of the banks to come to an agreement, but in the reluctance of governments. (See Mises 1912, pp. 339f; 1980, p. 329.)

It is true that, starting from the second edition (1924), Mises underscored the short-run benefits of competition between fractional-reserve banks, and in Human Action he downplayed the strength and even the existence of the “second tendency.” Professor White gives a pertinent quote in which Mises (1949, chap. 17, p. 444) questions the likelihood of the establishment of a banking cartel without government support. However, even then Mises upheld his standard position. Free fractional-reserve banking is the second-best option. The first-best option is to stop any further production of fiduciary media. The very section in Human Action in which Mises rejects the scenario of a banking cartel ends with the following statement:

Government interference with the present state of banking affairs could be justified if its aim were to liquidate the unsatisfactory conditions by preventing or at least seriously restricting any further credit expansion. In fact, the chief objective of present-day government interference is to intensify further credit expansion. This policy is doomed to failure. Sooner or later it must result in a catastrophe. [Mises 1949, p. 445]

These are Mises’s views. Now we can discuss the question whether they are correct. Professor White does not think they are, but he will not be surprised that I think he is wrong. For the sake of brevity, however, I shall conclude with a few cursory statements pertaining to three of his errors.

First, Lawrence White claims that the “issue of fiduciary media is unlimited only in the analytical limiting case (never historically realized) of a single world banking system with a single issuer of fiduciary media,” etc. It is true that such a unified world banking system has never existed, but that does not mean that there is no tendency toward its establishment. I happen to think that such as tendency exists, or is at any rate much more plausible than the model of free fractional-reserve banking cherished in the writings of Professor White. Fractional-reserve banking without collusion not only is an “analytical limiting case (never historically realized),” but there is also not the slightest reason to think that it ever will come to be.

Second, it is not correct that collusion among banks could only aim at restricting industry output. The point of collusion is to increase the revenues of cartel members beyond the level that would be possible under competition. Usually that involves restricting output, but in the case of fractional-reserve banking it implies increasing output.

Third, is there really “no reason to think that banks can successfully collude without government … to enforce the cartels’ prices”? I agree that this is improbable in most circumstances, but then again the fractional-reserve industry is special because it is built on the obfuscation and outright violation of property rights. And then there is also another consideration, highlighted by Professor White himself, who has argued that private central banks can evolve out of clearing house associations. (See White 1999, pp. 70ff.)

3. George Selgin, "Reading off the Page" [Posted: Jan. 16, 2014]↩

Although I suppose that I’m expected to reply to Larry’s remark concerning my comment on his essay, it is to Guido Hülsmann’s latest reply to Larry that I find myself tempted to respond. For in that reply Professor Hülsmann exhibits the tendency, all too common among 100-percent reserve types, to confuse Mises’ opinions with their own.

For example, Hülsmann points out that Mises thought the gold exchange standard “pointless because it did not effectively rein in monetary intervention.” He then states that the only other options were “to go the full way to fiduciary media or to return to the actual use of coins in daily exchanges” and that Mises “clearly opted for the latter alternative.” Finally, he says that “this means” that, despite its capacity to limit gold production, fractional reserve banking was not, in Mises’s opinion, beneficial. If you cannot spot the non sequitur lurking in this chain of reasoning, then perhaps you have never heard of the classical gold standard -- an arrangement in which both actual gold coins and fractionally backed bank deposits and notes serves as exchange media. I do not doubt, however, that Professor Hülsmann has heard of it. So why does he overlook it in interpreting Mises? Could it be that he is tempted to do so because he must do so in order to portray Mises as having opposed fractional reserves?

By the way, Adam Smith, who believed no less than Mises did that “Everybody must be used to having gold coins in his pockets,” and whose well-known opinion on this matter almost certainly informed Mises’s stand, also wrote eloquently of the resource-cost savings to be had from fractional reserve banking. If in insisting on a gold-coin standard Adam Smith also meant to condemn fractional reserve banking, he has yet to be properly understood by anyone.

Further on in his reply, Hülsmann refers to Mises’s claim that if banks manage to “agree on common procedures” (meaning that they arrange to expand credit in unison), “the production of fiduciary media is in principle unlimited” (my emphasis). Next he brandishes Mises’s claim that “all credit-issuing banks endeavor to extend their circulation of fiduciary media as much as possible” (my emphasis again), which he proceeds to reiterate: “banks try to issue as many fiduciary media as possible” (ditto), this being their “perennial motivation.” Finally, he concludes, once again without clear warrant, that Mises did not think it unlikely that banks could succeed in expanding credit in unison, particularly by lobbying either for the establishment of a central bank or for “full cartelization” of the banking industry, and that Mises therefore regarded free fractional reserve banking as a second-best alternative, if that, to its outright prohibition.

All of which is, or ought to be, deeply unsatisfying to anyone conversant with the general thrust of economics, and of the theory of competition especially, since Adam Smith. Of course businessmen covet monopoly power; of course they’d like to be members of a cartel, if only they could hold one together; of course they may try to get the government to cater to their desires. The question is, what should economists to do about it? Should they conclude that competition is a bad thing, or a distant “second best” thing? Should they plead for banning any industry that might harm the public if the government makes either a monopoly or a cartel of it, instead of pleading for the government to stay out of it? I’m pretty sure that Hülsmann, asked to answer this question with reference to any industry other than banking, would offer the conventional answer. He is, in any case, entitled to be as inconsistent as he likes. But if he wishes to attribute the same inconsistency to Mises, he is a long way from making his case.

4. Jeffrey Rogers Hummel, “Fractional Reserve Banking and Austrian Business Cycle Theory” [Posted: Jan. 27, 2014]↩

As I feared, the discussion so far has descended to the interminable debate over the legitimacy and desirability of fractional-reserve banking. Larry, George, and I line up on one side, concluding that fractional-reserve banking, if unregulated and unsubsidized, provides important monetary and economic benefits that far outweigh any potential downside. Guido embraces Murray Rothbard’s total opposition to anything but 100 percent reserves. This has spilled over into our interpretations of Mises’s texts, with Larry, George, and me in fundamental agreement (with possibly some slight disagreements), while Guido tries to demonstrate that Mises ultimately came to the same position as Rothbard. These interpretative disputes are inevitable. The reason is that Mises, like all writers and thinkers, displayed occasional ambiguity and (as Guido does point out) was not perfectly consistent and unchanging across writings that spanned over half a century.

To nudge the discussion in a more productive direction, I would like to explore how Mises’s contributions impinge on an issue of current concern to economists of all stripes: the business cycle.

At the close of my initial contribution to the discussion, I mentioned two unresolved questions about Austrian business cycle theory. The Theory of Money and Credit’s first edition introduced this theory, which since then has evolved into four slightly different variants. (1) The original variant of both Mises and Friedrich Hayek (1931, 1933, 1939), despite minor differences in emphasis, primarily focused on how credit expansion --instigated either by government or the banking system -- causes self-reversing malinvestment in the economy’s capital structure. (2) Rothbard’s variant (1963) added his blanket hostility to fractional-reserves and a concomitant enthusiasm for deflationary bank panics that cleanse the economy. (3) Roger Garrison’s variant (2001), building on his understanding of some passages in Mises, posits that malinvestment and the resulting correction drive the economy off its long-run production possibilities frontier, first outward and then inward. This permits the boom to simultaneously increase both consumption and investment. Garrison thereby implicitly incorporates the upward-sloping short-run aggregate supply curve that populates so many mainstream models of the macroeconomy. (4) George’s (1988), Larry’s, and Steve Horwitz’s (1992) variant, building instead on Hayek, grants almost equal billing to velocity shocks along with monetary shocks as a source of business cycles and couples that with Leland Yeager’s (1997) analysis of the disequilibrating effects of excess supplies and demands for money, making their version into a kind of Austrian-Keynesian-Monetarist amalgam.

Despite what they have in common, these four variants imply divergent answers to the two questions I raised in my previous comment. As I emphasized, Austrian business cycle theory “hinges on specifying two firm dividing lines: (a) between those financial instruments that constitute inside money and those comprising what Mises considered genuine manifestations of people’s savings, and (b) between those increases in the money stock, however defined, that generate a self-reversing boom and those that do not.” The Rothbard variant denies that autonomous changes in velocity play any role in the cycle, contending that they merely represent changes in people’s preferences about the demand for money. Not only does this differ from the Selgin-White-Horwitz position, which like Keynesian theory, views negative velocity shocks as a potential source of depressions. B