Money Makes the World Go Around
In his debut work, the Principles of Economics, Menger considered whether money developed "without any agreement, without legislative compulsion, and even without regard to the public interest" (Menger 1950/2007, p. 260; emphasis in the original). Accordingly, money had a "natural" origin and is not an "invention of the state." "Even the sanction of political authority is not necessary for its existence" (ibid., pp. 261–262). Menger did not move beyond this original explanation. Later economists ascertained that determining the value of money with the principle of marginal utility led to a circular argument, as the exchange value of money determines the demand for money; but the demand itself is in turn dependent on the value of money (cf. Wicksell 1898/2006, pp. 38, 50; and Helfferich 1903, pp. 487–488). A young Viennese economist is reminded of the "everlasting circle" in a Viennese song, in which gaiety comes from merriness and merriness is in turn derived from gaiety (cf. Weiss 1910, p. 515).
During his inaugural lecture in 1903 at the University of Vienna, Friedrich von Wieser tried to explain the phenomenon of rising prices using the theory of marginal utility for the first time. Wieser emphasized that growing incomes lead to decreasing marginal utility, to lower exchange values, and finally to increased prices. Because increases in income result from the steady expansion of monetary economy at the expense of the household economy, a rise in prices would thus be nothing but "a necessary, developmental syndrome of the spreading monetary economy" (cf. Wieser 1904/1929, p. 64). Wieser's income theory of money found few adherents and changed little in the way of the older Austrian School's abstinence from monetary theory. But things changed abruptly with the sensation caused by the Staatliche Theorie des Geldes (1905) (literally, "Public Theory of Money"), the work of Georg Friedrich Knapp (1842–1926) of Strasbourg, a statistician and agrarian economist of the historical–ethical school. Knapp saw money purely as a "creation of the legal system," based on an act of the sovereign, and having nothing to do with an agreement within society. Knapp's thesis clashed irreconcilably with Menger's evolutionary thesis. Some saw it as further evidence of compliant trust in the state and academic mediocrity on the part of a large number of German economists (cf. Schumpeter 1954, pp. 1090–1091). Furthermore, closer inspection revealed serious factual errors (cf. Mises 1909, pp. 1027–1030; Mises 1978/2009, pp. 34–36).
The visible tendency of the older Austrian School — to focus on the possibilities of malpractice by state authorities — had its origins in the sound judicial education of its members. What resulted was a particular sensitivity on their part when it came to basic rights. They always viewed state intervention in the monetary system as a possible abuse. Experience with the history of currency in the Austrian monarchy contributed to this attitude as well. Carl Menger had taught crown prince Rudolf early on that governmental monetary policy was "despotism" and implied "violence against the citizens" (cf. Streissler and Streissler 1994, p. 136). During currency reform consultations, Menger made similar comments (cf. Menger 1892/197oa, pp. 228–229; or Menger 1892/1970b, pp. 198–199, p. 220). Menger's own notes in Knapp's book and comments that have been transmitted orally point in the same direction (cf. Boos 1986, pp. 77–82; Mises 1978/2009, p. 27; cf. Silberner 1975). And of all people, Ludwig von Mises, the young researcher who later founded the Austrian theory of money and the Austrian business cycle theory, uncovered a large-scale foreign exchange manipulation — complete with a "black money fund" — that had taken place in the state-monopolized Österreichisch–Ungarische Bank. Mises was even on the receiving end of bribery attempts (cf. Mises 1978/2009, pp. 36–37).
In his Habilitation thesis, Theorie des Geldes und der Umlaufsmittel (1912) (translation of the 2nd German edition 1924, The Theory of Money and Credit 1912/1953/2009), Mises had already adhered to his aim of applying the principle of marginal utility to monetary theory in order to "return the theory of money to the study of economics" (Mises 1978/2009, p. 44). He avoided the "eternal circle" with the so-called regression theorem: when evaluating money, the individual proceeds from a notion of purchasing power derived from previous exchanges. Those earlier exchanges in turn were influenced by even earlier exchanges. In theory, these experiences can be traced back to distant past times, in which money still had a purely goods character as a means of exchange. It was thus possible to valuate its direct use (cf. Mises 1912/1953/2009, pp. 120–121). This bold but simple solution was bound to provoke ironical commentary: for some, it was more "ancient history" than economics (cf. Somary 1913, p. 446), for others, money had become, as it were, a "ghost of gold" (cf. Hicks 1935/1962, p. 14).
Mises followed up on Böhm-Bawerk's theory of capital and on Wicksell's distinction between the natural rate of interest and the monetary rate of interest. Further developing Böhm-Bawerk's theory of interest, Knut Gustav Wicksell (1851–1926) had drawn a distinction between a "natural rate of interest" and a "money rate of interest." The former would appear in a barter economy, meaning one without intermediation of money, when supply and demand were in accord. In modern economies, supply and demand certainly do not just meet in the "form of goods," but usually in the "form of money," so that divergences from this "natural rate of interest" may occur. Banks can expand the money supply by pushing the "money rate of interest" even below the "cost price" or the "natural rate of interest" (Wicksell 1898/2006, pp. 150–151).
Because Mises had proceeded on the assumption of an economic but not a legal concept of money, he included the so-called fiduciary media (Umlaufsmittel), which was understood to mean "claims to the payment of a given sum on demand, which are not covered by a fund of money" (Mises 1912/1953/2009, p. 278). Fiduciary media appear in the form of checks, drafts or credit notes, or as "circulation credit" (ibid., pp. 265–266, 483) guaranteed by banks. They are effectively used as money and thus expand the money supply of an economy; these "loans are granted out of a fund that did not exist before the loans were granted" (ibid., p. 271). The going quantity theory assumed that changes in the money supply affected all individuals and prices in equal measure. In contrast, Mises thought that the effects differed depending on each individual situation (ibid., p. 139). Individual economic subjects, after all, receive additional money supplies neither simultaneously nor uniformly. Accordingly, beneficiaries of monetary expansion are privileged compared with those who are the last to receive the additional money or who only have fixed, nominal income at their disposal (ibid., pp. 232–233). Friedrich A. von Hayek compared this process to that of pouring viscous honey: It spreads unevenly when it is poured and forms a little mound at the point of inflow (cf. Hayek 1978/2009, p. 173). Contrary to popular belief and that held by Menger and Böhm-Bawerk alike, Mises considered money to be anything but "neutral" (cf. Mises 1978/2009, p. 47).
The reception of Mises's thoughts was somewhere between reserved and critical. Noteworthy was the (mis-)judgment by John Maynard Keynes (1883–1946), who considered the book "critical rather than constructive; dialectical and not original" (cf. Keynes 1914, p. 417). For Knut Gustav Wicksell, much of it was "too obscure" (cf. Wicksell 1914, pp. 14–15). And Mises's accomplishment did not get as much as even a short mention in Joseph A. Schumpeter's first doctrinal history (cf. Schumpeter 1914/1954, pp. 195–196).
When Mises published a new edition of his Theory of Money 12 years later (1924), his analysis had evidently already been confirmed by the collapse of some of the European currencies. As early as 1912, both Germany and Austria had gone off the gold standard completely while preparing for war — and not without encouraging acclamation from renowned economists. Even Schumpeter, in his Theorie der wirtschaftlichen Entwicklung (1912) (The Theory of Economic Development, 1912/1934/1961), had argued for increasing credit as a means of stimulating growth. Böhm-Bawerk, who had already recognized the fatal link between expanding the money supply and arming for war, warned the public in three newspaper articles against expanding the government budget and thus living beyond existing means (cf. Böhm-Bawerk 1914/1924–1925). Shortly before his death, Böhm-Bawerk made it a point to once again emphasize the existence of economic laws "against [which] the will of man, and even the powerful will of the state, remain impotent" (cf. Böhm-Bawerk 1914/2010, p. 7).
Regardless of the above, World War I was financed by a limitless expansion of the money supply. "Inflationism," wrote Mises in the preface for the second German edition of Theory of Money and Credit, was "the most important economic element in this war ideology" (cf. Mises 1980/2000, p. 23). In Vienna, the income of a worker's family sank from the index figure 100 (1913–1914) to 34 (1917–1918), while that of a civil servant's family sank from 100 to 19 (cf. Winkler 1930, pp. 159, 206). Inflation was a relentless leveler: in 1915, a Viennese court counselor still earned 8.6 times the amount of the lowest earning civil servant; in 1920 it was only 3.3 times as much (cf. Sandgruber 1995/2005, p. 354). The inflationary policy was carried over after the war. According to Otto Bauer (1881–1938), inflation served the socialist government as "a means to stimulate industry and to improve the lifestyle of the working population for two years." At the same time, subsidies for food imports and uneconomical state enterprises were financed with the help of an excessive increase in the money supply. Food subsidies would soon become the main source of this essentially self-inflicted inflation (Bauer 1923, p. 254), and put a heavy burden on the government budget: In 1920–1921 they constituted no less than 59 percent of its total (cf. Bachinger and Matis 1974, p. 26). The money supply expanded in 1920 from 12 to 30 billion kronen, by the end of 1921, to 174 billion kronen, and it reached the level of 1 trillion in August of 1922 (cf. Sandgruber 1995/2005, pp. 354–355). Inflationary policies had shattered both the economy and the government budget in the most devastating way.
Members of the Austrian School spoke out in the daily papers and professional journals against the "evil of inflation" again and again, with Ludwig von Mises leading the way. They demanded serious stabilization measures (cf. Hülsmann 2007a, pp. 350–360). In the second edition of his Theory of Money, and more explicitly than in the first, Mises blamed the crisis on the "unrestricted extension of credit" (cf. Mises 1912, p. 434; Mises 1912/1953/2009, p. 365). Since banks and politicians had a common interest in further lowering the interest rate to facilitate "cheap" money, a money system "independent of deliberate human intervention" should be established as the monetary ideal (Mises 1912/1953/2009, p. 238). This would mean a return to money backed by gold (ibid., pp. 238, 438–439). The restructuring of the Austrian government budget in 1922 was indeed successful, but only after politicians — amid the ferocious attacks of right- and left-wing statists — committed themselves to self-restraint (cf. Hanisch 1994/2005, p. 282).
The Austrian School and its monetary theory stood in stark contrast to the ideas of the large majority of German economists, whose competency in monetary theory seems, in retrospect, to be stunningly inadequate (cf. Pallas 2005, p. 12 n. 6). Faced with the destruction of their currency, they were quite powerless. Even their publications, which played down the significance of inflation, were delayed because the funds designated for their printing had become casualties of hyperinflation (cf. Pallas 2005, p. 104; Boese 1939, p. 181). But economists like Schumpeter, Keynes, and Carl Gustav Cassel (1866–1945) supported the policy of monetary expansion and argued more or less eloquently against a gold-backed currency (cf. Pribram 1983, pp. 473–474).
Ludwig von Mises cultivated his legendary private seminar as an unsalaried lecturer at the University of Vienna despite various animosities. It became the nucleus for monetary and business cycle research and gained an international reputation (cf. Mises 1978/2009, pp. 81–83). A succession of gifted economists in his circle made remarkable contributions: banker Karl Schlesinger (1889–1938) wrote analyses based on Walras (Schlesinger 1914) and a well-researched report on practical banking experience (Schlesinger 1916 and 1920); Gottfried von Haberler (1900–1995) published a critique of Schumpeter's monetary theory (Haberler 1924) and a monograph on index numbers, in which he demonstrated the limits of the measurability of economic variables (Haberler 1927); Fritz Machlup (1902–1983) delivered a dissertation on the gold bullion standard (Machlup 1925). Martha Stephanie Braun (1898–1990) authored reviews on monetary theory and banking, and Friedrich A. von Hayek (1899–1992) wrote on currency policy and banking (cf. Hennecke 2000, pp. 8, 394).
While on a 14-month study visit in the United States (ibid., pp. 66–70) and before joining Mises's private seminar, Hayek — soon to become the person on whom the hopes of the Austrian School would rest — had already considered the questions of currency policy and business cycle data. Hayek became the first head of the Österreichische Institut für Konjunkturforschung ("Austrian Institute for Business Cycle Research"), today's Wirtschaftsforschungsinstitut (Wifo). It first commenced operations in 1927 (after judicious preparations by Mises). Before long the institute became a European pioneer of empirical economic research. Oskar Morgenstern (1902–1977), who had published his first work, Wirtschaftsprognose ("Economic Forecasting") in 1928, became Hayek's first associate and succeeded him in 1931 as the institute's leader.
In his Habilitation thesis, Geldtheorie und Konjunkturtheorie (1929) (Monetary Theory and the Trade Cycle, 1933) Hayek, like Mises, assumed that the ups and downs of the business cycle are invariably caused by credit expansion. An expansion of the money supply, claimed Hayek, "always brings about a falsification of the pricing process, and thus a misdirection of production" (Hayek 1929/1933, p. 140). Credit expansion is fuelled by the banks' business model, as they want to provide their customers with as much liquidity as possible (ibid.). The interest demanded by the banks is therefore not "natural" interest or (in Hayek's terminology) an "equilibrium rate of interest," but interest that is determined by the banks' liquidity considerations (cf. Hayek 1929/1933, pp. 179–139, 179–180; cf. Schlesinger 1914, p. 128). He linked this theoretical approach to observations of economic activities in the markets of commodities, money, and stocks by using a "Three-Market-Barometer," and in December of 1928 already came to the conclusion that the United States was on the brink of a severe economic slump. In October of 1929 the Great Depression did in fact appear with full vehemence (Hayek 1928, p. 188). In 1931 Hayek was invited to hold a series of lectures at the London School of Economics, in which he developed, among other things, the notion of "forced saving." Changes in the money supply or in the interest rate, according to Hayek, would invariably lead to a shift in demand for consumer goods and investment goods. In contrast to "voluntary" saving, which is based on true consumer desires, consumers as a whole would, in the case of monetary expansion, be "forced to forego part of what they used to consume … not because they want to consume less, but because they get less goods for their money income" (Hayek 1931/1935, p. 57).
Even though the abstract and complex constructs were not easy to understand, Hayek's theses earned him a considerable international reputation within a short time (cf. Haberler 1933a, p. 97; Lachmann 1986, p. 226; Steele 2001, p. 100). Mises, who by then had refined his "circulation credit theory," dared to state, in a preparatory text for the 1928 Zurich convention of the Verein für Sozialpolitik, that there was only one monetary theory left, namely the "monetary theory of business cycles" (cf. Mises 1928, p. 1). With the combined contributions of Machlup, Haberler, Morgenstern, and Richard von Strigl (1891–1942), the Austrian School was able to present itself in Zurich as the authoritative research group in monetary and business cycle theory. And it showed itself to be on the cutting edge again in a Festschrift containing 62 contributions some years later (cf. Festschrift für Spiethoff, 1933).
In this Festschrift, however, it became clear that divergent forces had made strong gains. Hans Mayer (1879–1955; long the only tenured professor of the School) and his circle contributed little to monetary and business cycle theory (ibid., pp. 171–174). Even Mises's nonuniveristy seminar, views on methodology and political economy were moving ever further apart. Strigl, who in his Angewandte Lohntheorie (1926) ("Applied Theory of Wages") had analyzed the effects of the business cycle on the production process from an Austrian point of view, was considered an "interventionist" (cf. Mises 1929, p. 38) on questions of economic policy. Braun's Theorie der staatlichen Wirtschaftspolitik (1929) ("Theory of State-Run Economic Policy") ultimately spoke for a (moderate) statism. The question of whether the purchasing power of money could be measured at all was also hotly debated. Mises denied that it could (cf. Mises 1928, p. 22), while Haberler accused him of not even being able to define the allegedly nonmeasurable (cf. Haberler 1927, pp. 109–110; Haberler 1933a, p. 95). In addition, Haberler considered Hayek's Preise und Produktion (1931) (Prices and Production, 1931/1935) sketchy and unfinished (Haberler 1933a, pp. 97–100).
Differences grew when Mises began to view economics more and more as an a priori science; Oskar Morgenstern strictly rejected Mises's apriorism (cf. Morgenstern 1934, pp. 8–10, 134). His keen interest in mathematics and statistical–empirical research, which had led to an analysis of capital depreciation of companies listed on the Viennese stock exchange (cf. Morgenstern 1932), provided another dividing line. Even Hayek no longer wished to follow Mises's philosophical shift and gradually moved away from him in terms of methodology. The old polarities represented by Böhm-Bawerk, Wieser, and Sax were conspicuously revived and forces were divided.
As the most exposed representative of the Austrian School internationally, Hayek became involved in several disputes. His literary feud with Keynes is well known. It was so intense that letters were even exchanged on Christmas Day, 1931 (cf. Dimand 1988, p. 57). As he had done seven years previously (cf. Hayek 1924, pp. 389–390), Hayek weighed Keynes's theses on money and monetary policy and found them wanting — only this time more broadly and thoroughly. Keynes disputed the capacity of the market to regulate itself and recommended interventions to guide the economy and the currency system. Hayek rejected the notion emphatically, seeing in these very interventions the cause of the crises (cf. Butos 1994, esp. p. 473).
Hayek was able to hold his ground during the intense debate, and Keynes diluted or even revoked some of his positions. But the astute and aggressive criticism of Piero Sraffa (1898–1983) left behind an unsettled professional audience. Hayek's distinction between "voluntary" saving and "forced saving" had begun to become unhinged. And so had the Austrian assumption that the "equilibrium rate of interest" should not be interfered with in a barter economy without money and banks (cf. Kurz 2000, pp. 169–170).
Hayek's "Reply" was unable to clear up any lingering doubts (cf. Lachmann 1986, p. 240). Some later thought that Hayek's grounding in capital theory was inadequate, which was the ultimate cause of the problem (cf. Kurz 2000, p. 170; Steele 2001, p. 140). Hayek tried to substantiate his position with ten additional articles in the four years that followed. But during this period of a fundamental reorienting in English economics the charm of the "Austrian theory of money and business cycles" had already begun to lose its freshness and allure. Works reflecting the "Austrian" theory were still published — Machlup wrote on Börsenkredit, Industriekredit und Kapitalbildung (1931) (The Stock Market, Credit and Capital Formation, 1940), von Schiff wrote on capital consumption in Kapitalbildung und Kapitalaufzehrung im Konjunkturverlauf (1933) ("Formation and Depletion of Capital in the Course of the Business Cycle"), and von Strigl made a contribution on business cycles and production with Kapital und Produktion (1934) (Capital and Production, 1934/2000) — but for the time being they made no impact on the discourse in English-speaking countries. With political turmoil in central Europe claiming its first victims and naming its first offenders among economists, the stepwise exodus of the Austrian School began. The "Austrian monetary and business cycle theory" lacked active propagation. After a fulminant start in the early 1930s, discourse concerning Austrian theoretical constructs had now come to a near standstill.
Haberler and many of his colleagues were already living outside of Austria by the time (1936) he had completed his standard work on business cycle theories, a monument to the "Austrian" contribution (cf. Haberler 1937, pp. 33–72). The Austrian School had been paralyzed by the political events of the times, and its reaction to Keynes's General Theory of Employment, Interest and Money, if there was any reaction at all was spiritless or subdued. Looking back, Hayek would call it his "greatest strategic mistake" not to have taken a more extensive stand on Keynes's General Theory (cf. Hennecke 2000, p. 107; see also Caldwell 1998 and Hawson 2001). Only Gottfried Haberler, in Geneva at the time, demonstrated the usual professional and critical rigor and considered Keynes's "multiplier theory" to be indefensible (Haberler 1936b); Fritz Machlup supported him later on (Machlup 1939–1940). Keynes's work was treated with kid gloves otherwise (cf. Schüller 1936; Steindl 1937). It would be more than two decades before Henry Hazlitt, an American inspired by the Austrian School, would submit the General Theory to strong criticism in The Failure of the "New Economics" (1959).
The scene had undergone a dramatic change by the time Hayek, during the war, completed his magnificent attempt at a modified "Austrian theory of money and business cycles" (Hayek 1939 and 1941). The Austrian School had become a little-regarded outsider. Keynes's theses dominated economic theory in English speaking countries. Against the traumatic backdrop of the economic depression, politics and public opinion readily followed the man who had so brilliantly and, on the surface, convincingly proposed to secure the future welfare of the world through government control of the economy, currency management, and state investment programs (cf. Steele 2001, p. 6). Keynes also provided "welcome arguments for a radical change of the social functions of economists; whom he qualified as indispensable advisers on economic policies" (Pribram 1983, p. 513; cf. also Steele 2001).
 In the following we refer to the English translation, Mises 1919/1983/2000, of the 2nd and revised German edition from 1924.