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[Excerpted from Theory of Money and Fiduciary Media edited by Jörg Guido Hülsmann, which celebrates the centennial of the great work by Ludwig von Mises, known in English-speaking countries as The Theory of Money and Credit.]



Mises’s discussion of monetary policy concludes the second part of his book, which deals with the causes and consequences of the inner exchange value of money in general. In the subsequent third part, he turns to the particular characteristics of the demand for and supply of fiduciary media.

The entire third part can be read as one long, systematic, and exhaustive commentary on the great nineteenth century debate between the Currency School and the Banking School. It has not the form of a commentary, though, but of a treatise. Mises walks his readers through the six great questions under contention: (1) the nature of fiduciary credit, respectively the difference between genuine (commodity) credit and (false) fiduciary credit; (2) the question whether the production of fiduciary media has any limits, and which; (3) the crucial question whether the production of fiduciary media tends to be elastic in the sense that it would accommodate changes in the demand for money; (4) the role of bank reserves for maintaining the redemption of fiduciary media into species; (5) the dis-equilibrating nature of fiduciary media; (6) the appropriate policy to deal with them.

Mises had announced this discussion right from the preface to the first edition (not translated into English). There he wrote that the theory of banking was in a less satisfactory state than the theory of money (which could rely on the works of Menger and Wieser), even though the writings of the classical economists had provided remarkable elements, which in turn had been elaborated by the Currency School. The basic shortcoming of that school was that it lacked a solid foundation; it lacked the modern theory of value. Mises went on to declare:

Some of its errors have been rightly criticised by Tooke and Fullarton. But what the latter two have put at the place of the currency theory is not a useful theory at all. The banking theory does not just contain errors, it goes wrong in the very way it states the problem.

In the second part of the book, Mises had criticized one important element of the Banking School doctrine, namely, its contention that changes in money hoarding tended to neutralize the impact of changes in the money supply on the price level, and that therefore the quantity theory did not hold (see A160–65). Now he brought his critique full circle, refuting Fullarton’s and J.S. Mill’s contention that owning a banknote means granting credit to the bank (A311, C304f.), as well as the “law of reflux” (A355, C342) and other elements of the doctrine pioneered by Tooke and Fullarton. He concluded (A408f., C383f.):

The fatal error of Fullarton and his disciples was to have overlooked the fact that even convertible banknotes remain permanently in circulation and can then bring about a glut of fiduciary media the consequences of which resemble those of an increase in the quantity of money in circulation. Even if it is true, as Fullarton insists, that banknotes issued as loans automatically flow back to the bank after the term of the loan has passed, still this does not tell us anything about the question whether the bank is able to maintain them in circulation by repeated prolongation of the loan. The assertion that lies at the heart of the position taken up by the Banking School, namely, that it is impossible to set and permanently maintain in circulation more notes than will meet the public demand, is untenable; for the demand for credit is not a fixed quantity; it expands as the rate of interest falls, and contracts as the rate of interest rises. But since the rate of interest that is charged for loans made in fiduciary media created expressly for that purpose can be reduced by the banks in the first instance down to the limit set by the marginal utility of the capital used in the banking business, that is, practically to zero, the whole edifice built up by Tooke’s school collapses.

Mises went on to state that, in distinct contrast to the overrated Banking School, “the works of the much abused Currency School contain far more in the way of useful ideas and fruitful thoughts than is usually assumed . . .” (A409, C384).

He himself had highlighted the shortcomings of the Currency School in due detail. Its champions had based their reasoning about money prices on a mechanical interpretation of the quantity theory. In analyzing the production of fiduciary media, they had considered only the problems for independent groups of banks increasing its issues while some other banks did not follow suit, thus neglecting the fundamental theoretical question whether those problems could be overcome by a generalized expansion of the money supply through all banks at the same time (see A421, C393). Thus they were unable to come to grips with the question whether credit could be costless—which in his eyes was “the chief problem in the theory of banking.

Most importantly, however, the Currency School had failed to recognize that demand deposits and banknotes shared the same economic nature (see A438f., C407). In other words, it had remained stuck at the surface of visible phenomena, whereas the relevant essential differences were those between covered and uncovered money substitutes, irrespective of the physical embodiment.

But even this central shortcoming “is of small significance in comparison with that made by the banking principle” (A439, C408). Right from the first edition of his book, therefore, Mises endorsed both the basic methodological approach of the Currency School (comparative analysis of a purely metallic currency relative to a currency consisting of fiduciary media) as well as its central policy prescription (stopping the further creation of fiduciary media). He himself developed the theory of the Currency School and integrated it into the Mengerian approach. In 1912 as in his later publications on money and banking, he would highlight the central importance of the Currency School as a forerunner of his own thought.

The most famous element that Mises added to the theoretical edifice of the Currency School was his business cycle theory, presented in a chapter on “Geld, Umlaufsmittel und Zins” (Money, Fiduciary Media, and Interest). This theory was Mises’s answer to the fundamental question whether credit could be gratuitous. It was the crowning achievement of the third part of his book.

Mises begins with a discussion of the causes of monetary interest, continuing the analysis begun in the second part. His analysis starts most notably from Böhm-Bawerk’s conception, according to which inter-temporal subjective values determine the size of the subsistence fund, which in turn determines the interest rate. Another starting point is Wicksell’s distinction between natural interest and monetary interest. Mises first focuses on the impact of money in the narrow sense on interest rates, making three related claims: (1) There is no constant direct relationship between the supply of and demand for money on the one hand, and the interest rate on the other hand. (2) Neither is there any direct relationship between changes in monetary conditions and changes in the interest rate. (3) However, monetary conditions and the interest rate are indirectly related, because changes in the demand for and supply of money affect the distribution of incomes and wealth, and thereby also affect the interest rate. Thus Mises concludes the analysis of the social consequences of a changing value of money, which he had begun in chapter 12 (chapter 6 of the second part).

After these preliminary clarifications, he turns to analyzing fiduciary media. Here he raises the same basic question as before, namely, whether there is any relationship between the supply of and demand for fiduciary media on the one hand, and the interest rate on the other hand. Most importantly, was it possible, by increasing the supply of fiduciary media, to bring the interest rate down to zero? In Mises words (A417, B360, C390):

It is indisputable that the banks are able to reduce the rate of interest on the credit they grant down to any level above their working expenses (for example, the cost of manufacturing the notes, the salaries of their staffs, etc.). If they do this, the force of competition obliges other lenders to follow their example. Accordingly, it would be entirely within the power of the banks to reduce the rate of interest down to this limit, provided that in so doing they did not set other forces in motion which would automatically re-establish the rate of interest at the level determined by the circumstances of the capital market, that is, the market in which present goods and future goods are exchanged for one another. The problem that is before us is usually referred to by the catch-phrase “gratuitous nature of credit.” It is the chief problem in the theory of banking.

He went on to discuss the three principal answers to this question that could be found in the literature (see A418–24). The first answer was the one of the money cranks, which asserted that, indeed, credit could be gratuitous if only the money supply was sufficiently increased. The second answer was the one of the Banking School. Its answer was to say that the problem did not exist. It was impossible to increase the money supply beyond the needs of trade. Therefore, the interest rate could not fall to zero. The third answer came from Knut Wicksell. He argued (a) that commercial banks would sooner or later be concerned about the redemption of their issues, and (b) that as a consequence of the increase of the overall money supply, the price level would increase, and therefore also the price of gold. Thus sooner or later people would start redeeming their fiduciary media into gold and the banks then had to stop issuing them. Mises replied that argument (b) only concerned commodity-money systems, but not fiat-money systems, and that argument (a) contradicted Wicksell’s own assumption, namely, that money had been entirely replaced by fiduciary media.

Mises answer was different. He argued that the increase of the supply of fiduciary media entailed an inter-temporal disequilibrium that put the entire economy on an unsustainable path. In his words:

Now if the rate of interest on loans is artificially reduced below the natural rate as established by the free play of the forces operating in the market, then entrepreneurs are enabled and obliged to enter upon longer processes of production.

. . . The situation is as follows: despite the fact that there has been no increase of intermediate products and there is no possibility of lengthening the average period of production, a rate of interest is established in the loan market which corresponds to a longer period of production; and so, although it is inadmissible and impracticable from an overall point of view, a lengthening of the period of production becomes at first profitable. But there cannot be the slightest doubt as to where this will lead. A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods. This time must come all the more quickly inasmuch as the fall in the rate of interest weakens the motive for saving and so slows up the rate of accumulation of capital. The means of subsistence will prove insufficient to maintain the laborers during the whole period of the process of production that has been entered upon.

Sooner or later, therefore, it will be impossible to continue the investment projects that have been begun under the impact of the initial expansion of the money supply. Further expansions, even if pursued with utmost determination, can only delay, but not prevent the eventual outbreak of the crisis (see A436, B375, C404).

In the light of these considerations, Mises comes to endorse his policy conclusions in the last chapter of the third part of his book, dealing with the “Legal limitation of the issue of fiduciary media and discount policy,” as well as in the final fourth part giving an “Outlook into the future of money and fiduciary media.” The central point of his position is the recommendation to outlaw the issue of any further fiduciary media.

Mises does not recommend outlawing any and all fiduciary media, but only further issues. The reason is that the disappearance from one day to another of all fiduciary media would have a very strong deflationary impact on the price level and thus on the distribution of income and wealth (see A376–79).

Mises opposes further issues of fiduciary media, first because they lead to price inflation and thus also to a redistribution of incomes and wealth; second, and most importantly, because they inevitably lead to wasteful boom-bust cycles and, in fact, to the ultimate destruction of the monetary and banking system. He recommends outlawing any such further issues because he does not think that competition between fractional-reserve banks is a sufficient bulwark against the virtually unlimited expansion of fiduciary media. He acknowledges that competition slows down this expansion:

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. Every bank is obliged to regulate its interest policy in accordance with that of the others.

However, the banks have a very strong self-interest in coming to an agreement. In practice the coordination between commercial banks has been promoted by governments and central banks. But even without such political support, the banks would eventually work out an agreement anyway. 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” (A360, C346). Mises therefore recommends a monetary reform in the spirit of Peel’s Act, with the explicit objective of suppressing “all further issues of fiduciary media.” In his words: “The basic conception of Peel’s Act ought to be restated and more completely implemented than it was in the England of his time by including the issue of credit in the form of bank balances within the legislative prohibition” (A473, B418, C447). This was his bottom-line and conclusion from the first German edition of 1912 to the last American edition of 1953.