What would the world economy and financial markets look like had government controlled central banks not followed a course of relentless increases in credit and fiat money supply?
Any attempted answer to this question is sure to trigger a heated debate. In any case, however, answers would clearly depend on the alternative monetary systems that had been available at the time such decisions were taken.
Before the “Great Inflation”, seen between the late 1960s until the early 1980s, began to destroy monetary values in many industrial countries, Ludwig von Mises, one of the twentieth century’s most important libertarian thinkers, put forward a monetary regime that is diametrically opposed to what has become the standard monetary system used today.
Ludwig von Mises went to great lengths to rationalise and preserve a monetary system that would be compatible with the ideals of a free market society. It is important to note that from Mises’ perspective, preserving “sound money” was not an end it itself, or a principle defended on ideological or moral grounds, [1] but a necessary (pre-)condition for maintaining a free market order:
“It is impossible to grasp the meaning of the idea of sound money if one does not realise that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically, it belongs in the same class with political constitutions and bills of right.” [2] In an attempt to allow the money system to return to the gold standard, Mises had an unmistakable policy recommendation for national governments and the US government in particular, namely: stop creating new money. In his 1951 essay “The Return to Sound Money,” Mises wrote:
“The first step must be a radical and unconditional abandonment of any further inflation. The total amount of dollar bills, whatever their name or legal characteristic may be, must not be increased by further issuance. No bank must be permitted to expand the total amount of its deposits subject to check or the balance of such deposits of any individual customer, be he a private citizen or the US Treasury, otherwise than by receiving cash deposits in legal-tender banknotes from the public or by receiving a check payable by another domestic bank subject to the same limitations. This means a rigid 100 percent reserve for all future deposits; that is, all deposits not already in existence on the first day of the reform.” [3]
The transaction equation might help shed some light on the theoretical ramifications resulting from the US Federal Reserve’s decision to follow Mises’ recommendation of freezing the stock of money. Admittedly, Mises was highly critical of using the equation of exchange as it would, most importantly, be inconsistent with methodological individualism. [4] However, the implications emerging from Mises freezing-the-stock-of-money recommendation can most readily be grasped by making reference to the variables of that equation.
The transaction equation can be written as: 
, where M denotes the stock of money, V represents the velocity of money, whereas Y and P stand for real output and the price level, respectively; and t represents the period under review. Now assume the US Fed had kept the stock of money (in our example the stock of M1 or M2) at the level prevailing in the first quarter of 1959, so that 
. Furthermore, assume that income velocity of money (that is, nominal output divided by the stock of money) had followed the trends which could be observed in the period 1959-Q1 to 1973-Q4 (see Figure 1 (a) and (b)). [5]
Income velocity of M1 had been following an upward trend throughout the period under review. [6] In contrast, income velocity for M2 was relatively constant until the end of the 1990s. Thereafter, however, it seems to have moved towards a higher level. [7] Under the assumption that income velocity of M2 had remained stable at 1.66 — that is, the level seen in the period 1959-Q1 to 1973-Q4 — the “theoretical” US price level would have been a function of output according to the formula: 
.
Figure 2 (a) and (c) contrasts actual US consumer price inflation with the changes in theoretical price levels had the income velocities of M1 and M2 developed according to their behaviour seen in 1959-Q1 to 1973-Q4. As far as M1 is concerned, the theoretical price level would have declined by 1.2% p.a. in the period 1959-Q1 to 2006-Q1, contrasting with the findings of US consumer price inflation averaging 4.3% p.a. over the same period. Were it not for the average increase in income velocity of M1 of 2.1% p.a., the price level would have declined by 3.3% p.a. — equal to the rate of US output expansion. In Figure 2 (c), the same relationship is shown for M2. Given the assumption of a constant velocity of M2 of 1.66 throughout the period under review, the theoretical price level would have declined by around 3.3% p.a. — the average annual expansion rate of US output.
Figure 2
That said, under Mises’ constant money supply regime, changes in the purchasing power of money would be a function of (i) the (trend) growth rate of the economy and (ii) changes in the (long-term) income velocity of money. Such a result would be in line with what sober economics would suggest: money prices decline as supply increases (relative to demand), and money prices rise as relative supply becomes scarce.
The relation between output growth and changes in the theoretical price level, based on M1, are plotted in Figure 2 (b). As can be seen, under the assumptions made, rising (declining) output is accompanied by a declining (increasing) price level. The same negative relationship can be observed when M2 is used to calculate changes in the theoretical price level (Figure 2 (d)).
The illustrations above indicate that under Mises’ constant money supply regime, US prices would have, on average, declined as output increased (adjusted for changes in the income velocity of money), and the short-term volatility of prices would have corresponded to cyclical changes in output growth. However, an ongoing, and random, rise in the price level as a result of discretion on the part of the central bank — as is the case in today’s government-controlled paper money system — would not have been possible.
In general, under Mises’ constant money supply regime, the real market interest rates would have reflected the expected (trend) increase in production. With the change in the purchasing power of money reflecting the negative of the latter, nominal interest rates would have been fluctuating around zero. [8]
Certainly, with nominal zero rates, savers could have earned a living from holding deposits with banks and buying bonds in capital markets. The compensation for savers and investors would simply be the real return as implied by the growth rate of total output: as the price level declines as output increases, the value of each money unit deposited and lent increases over time.
A constant money supply would clearly have strengthened the principle of the free market economy, given the increased need for prices to respond to changes in demand and supply. Producers could not have relied on inflation to restore equilibrium of relative prices, but would have to step up efforts to provide goods and services that meet customers’ demand. Furthermore, government interventionism, as far as prices are concerned (allowing wage rigidities, etc.), would have translated into an immediate loss of output and employment.
Indeed, the required decline in the price level, in line with productivity gains of the economy, would have affected consumer goods prices as well as asset prices. For instance, stock and housing prices could have shown (marked) increases over time. However, such a development would have been accompanied by an over-proportional decline in prices elsewhere — which would be a necessary factor in causing the economy’s price level to decline over time.
Under a constant stock of money, the financial sector could of course have been active in all kinds of businesses: lending, deposit taking, M&A, foreign exchange and bond trading, etc. The crucial difference, however, would be that banks were no longer in a position to increase the stock of money through lending as they do today under the fractional reserve system. With the nominal transaction volume remaining constant over time, the real rather than nominal credit supply would have expanded.
Clearly, with a constant money supply there would be no monetary policy. As a result, monetary-policy-induced booms and busts would be prevented; monetary policy-induced swings, boom and bust, in the economy would no longer be possible.
This contrasts with the status quo, under which central banks are regularly called upon to lower their interest rates to below the economy’s “natural rate”, thereby stimulating additional demand for (bank) credit. As an increase in the stock of credit and money “out of thin air” is bound to induce misallocation of capital, additional money-induced booms and bust would not have occurred.
The constant money supply regime would presumably entail another important implication as far as societal organisation is concerned. It would have made the de facto build-up of government debt by stealth much more difficult, perhaps impossible. This is because under a given stock of money, any increase in government bond supply would have tended to push up market yields, thereby directly and noticeably affecting the funding conditions of private households and firms (”crowding out”), which are competing for a given stock of payments.
Today’s central bank practise of expanding the money supply over time eliminates this important disciplinary market effect: the ongoing increase in money supply counteracts upward pressure on interest rates. As a result, running into debt on the part of a government can go on more or less unnoticed, given the isolation of the economy from an increase in yields, thereby causing little societal opposition.
By making it rather difficult, if not impossible, to generate an ongoing build-up of government debt, a constant money supply would serve as an insurance policy against one of the greatest threats to the principle of sound money and a free market society: as experience shows, the biggest monetary catastrophes, which have inflicted so much damage on the people and on the ideal of capitalism, can in one way or another be traced to governments defaulting on their debts.
What is more, a constant money supply regime would have presumably reduced the increase in peoples’ real tax burden under a proportional income tax system. In most countries, the marginal tax rate on income is positively related with the level of nominal income. As the latter increases with inflation, the real tax burden increases as the marginal tax rate applied to nominal income will rise (”creeping bracket”). Under a system in which the price level declines over time, however, an increase in real taxation would require increases in tax rates — which might (as it would be far more obvious) meet strong(er) opposition from the electorate.
Compared to the current system of increasing money and credit supply, a constant money supply would appear to have worked much more in line with the requirements of a free market economy. At the same time, however, such a system would be some way off the calls currently being made in Austria for making money a free market phenomenon.
This is because it would allow the government to retain its money supply monopoly. Viewed from that perspective, Mises’ recommendation would bear an affinity to Milton Friedman’s “constant” money supply rule. Both concepts, driven by efforts to reduce catastrophic consequences deriving from government interference in the monetary system, assign the authority in monetary matters to governments and, at the same time, want to greatly reduce discretionary scope on the part of central banks.
Admittedly, the concepts put forward by Mises and Friedman attempt to discourage a monopolist’s inherent incentive to reduce quality and/or raise the cost of money production (which, of course, includes the monopolist’s own reward). [9] But could one really be assured that the government, once assigned authority over money supply, would stick to its decision going forward? Especially so if peoples’ preferences change and there is a (re-)emergence of “new theories” promising higher output and employment if only money and credit could be supplied “more abundantly”?
If not Mises, then who was aware of the societal dangers emerging from assigning coercive power to government? Mises, when recommending freezing money supply, actually spoke of a “first step”.
To Mises, stopping any increase in the money supply would be just a first move (which was presumably not intended to last for long), followed by a second step — at which point, Mises’ concept clearly departs from Friedman’s: Mises called for a re-establishment of a functioning gold market, to ultimately allow the workings of the free market to freely adopt gold as the means of payments. Mises wrote: “The classical or orthodox gold standard alone is a truly effective check on the power of the government to inflate the currency. Without such a check, all other constitutional safeguards can be rendered vain.” [10]
To Mises, freezing money supply did not represent, per se, a desirable money system, even though the consequences derived from it would make such a system appear more in line with a free market economy than the current system of relentless increase in credit and fiat money supply, controlled by the government. To him, it was just a means to an end: to wrest money supply from the hands of the government and return it to the free forces of the market, which would most likely decide on gold as their form of money.
In sum, there should be little doubt that had the gold standard been upheld, world economies had been spared many of the severe fiat-money-induced economic, social and political crises experienced seen in the latest decades, from which resulted the growing disenchantment with the idea of a free market order.
[1] This is emphasized, for instance, by Selgin, G. (1999), Ludwig von Mises and the Case for Gold, in: Cato Journal, Vol. 19, No. 2, Fall, p. 260.
[2] Mises, L. v. (1981), The Theory of Money and Credit, Liberty Fund, Indianapolis, p. 454.
[3] Ibid, p . 491.
[4] In this context see Mises, L. v. (1996), Human Action, 4 th Edition, Fox & Wilkes, San Francisco, pp. 399.
[5] Without government-induced changes in the purchasing power of money it might have well be that the income velocity of money would have been much more stable over time than it actually was.
[6] This finding implies that market agents in the US have actually reduced their holdings of “real” balances in the form of M1 (that is the means of payments) relative to real income over time. Its result corresponds to James Tobin’s inventory demand for money demand; see Tobin, J. (1956), The interest elasticity of transaction demand for cash, in: Review of Economics and Statistics, 38 (3), August, pp. 241 — 247.
[7] For a discussion of the upward shift in the income velocity of M2 in the early 1990s see, for instance, Carlson, J. B., Hoffman, D. L., Keen, B. D., Rasche, R. H. (2000), Results of a Study of the Stability of Cointegrating Relations Comprised of Broad Monetary Aggregates, in: Journal of Monetary Economics, 46, pp. 345 — 383.
[8] Of course, this would hold true if one disregards any risk premium in market yields.
[9] For the argument that a monopolistically provided paper money’s costs will over time, if not right from the beginning, exceed the costs associated with providing a commodity money see Hoppe, H.-H. (2006), How is Fiat Money Possible — or, The Devolution of Money and Credit (reprinted), in: The Economics and Ethics of Private Property, 2 nd Edition, Auburn, Alabama, pp. 189.
[10] Mises, L. v. (1981), p. 495.
