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1. Stabilization of the Monetary Unit — From the Viewpoint of Theory (1923)

I. The Outcome of Inflation

Attempts to stabilize the value of the monetary unit strongly influence the monetary policy of almost every nation today.* They must not be confused with earlier endeavors to create a monetary unit whose exchange value would not be affected by changes from the money side.1 In those olden, and happier times, the concern was with how to bring the quantity of money into balance with the demand, without changing the purchasing power of the monetary unit. Thus, attempts were made to develop a monetary system under which no changes would emerge from the side of money to alter the ratios between the generally used medium of exchange (money) and other economic goods. The economic consequences of the widely deplored changes in the value of money were to be completely avoided.

There is no point nowadays in discussing why this goal could not then, and in fact cannot, be attained. Today we are motivated by other concerns. We should be happy just to return again to the monetary situation we once enjoyed. If only we had the gold standard back again, its shortcomings would no longer disturb us; we would just have to make the best of the fact that even the value of gold undergoes certain fluctuations.

Today's monetary problem is a very different one. During and after the war [World War I, 1914–1918], many countries put into circulation vast quantities of credit money, which were endowed with legal tender quality. In the course of events described by Gresham's Law, gold disappeared from monetary circulation in these countries. These countries now have paper money, the purchasing power of which is subject to sudden changes. The monetary economy is so highly developed today that the disadvantages of such a monetary system, with sudden changes brought about by the creation of vast quantities of credit money, cannot be tolerated for long. Thus the clamor to eliminate the deficiencies in the field of money has become universal. People have become convinced that the restoration of domestic peace within nations and the revival of international economic relations are impossible without a sound monetary system.

1. Monetary Depreciation2

If the practice persists of covering government deficits with the issue of notes, then the day will come without fail, sooner or later, when the monetary systems of those nations pursuing this course will break down completely. The purchasing power of the monetary unit will decline more and more, until finally it disappears completely. To be sure, one could conceive of the possibility that the process of monetary depreciation could go on forever. The purchasing power of the monetary unit could become increasingly smaller without ever disappearing entirely. Prices would then rise more and more. It would still continue to be possible to exchange notes for commodities. Finally, the situation would reach such a state that people would be operating with billions and trillions and then even higher sums for small transactions. The monetary system would still continue to function. However, this prospect scarcely resembles reality.

In the long run, trade is not helped by a monetary unit which continually deteriorates in value. Such a monetary unit cannot be used as a “standard of deferred payments.”3 Another intermediary must be found for all transactions in which money and goods or services are not exchanged simultaneously. Nor is a monetary unit which continually depreciates in value serviceable for cash transactions either. Everyone becomes anxious to keep his cash holding, on which he continually suffers losses, as low as possible. All incoming money will be quickly spent. When purchases are made merely to get rid of money, which is shrinking in value, by exchanging it for goods of more enduring worth, higher prices will be paid than are otherwise indicated by other current market relationships.

In recent months, the German Reich has provided a rough picture of what must happen, once the people come to believe that the course of monetary depreciation is not going to be halted. If people are buying unnecessary commodities, or at least commodities not needed at the moment, because they do not want to hold on to their paper notes, then the process which forces the notes out of use as a generally acceptable medium of exchange has already begun. This is the beginning of the “demonetization” of the notes. The panicky quality inherent in the operation must speed up the process. It may be possible to calm the excited masses once, twice, perhaps even three or four times. However, matters must finally come to an end. Then there is no going back. Once the depreciation makes such rapid strides that sellers are fearful of suffering heavy losses, even if they buy again with the greatest possible speed, there is no longer any chance of rescuing the currency.

In every country in which inflation has proceeded at a rapid pace, it has been discovered that the depreciation of the money has eventually proceeded faster than the increase in its quantity. If “m” represents the actual number of monetary units on hand before the inflation began in a country, “P” represents the value then of the monetary unit in gold, “M” the actual number of monetary units which existed at a particular point in time during the inflation, and “p” the gold value of the monetary unit at that particular moment, then (as has been borne out many times by simple statistical studies):

mP > Mp.

On the basis of this formula, some have tried to conclude that the devaluation had proceeded too rapidly and that the actual rate of exchange was not justified. From this, others have concluded that the monetary depreciation is not caused by the increase in the quantity of money, and that obviously the Quantity Theory could not be correct. Still others, accepting the primitive version of the Quantity Theory, have argued that a further increase in the quantity of money was permissible, even necessary. The increase in the quantity of money should continue, they maintain, until the total gold value of the quantity of money in the country was once more raised to the height at which it was before the inflation began. Thus:

Mp = mP.

The error in all this is not difficult to recognize. For the moment, let us disregard the fact—which will be analyzed more fully below—that at the start of the inflation the rate of exchange on the Bourse,4 as well as the agio [premium] against metals, races ahead of the purchasing power of the monetary unit expressed in commodity prices. Thus, it is not the gold value of the monetary units, but their temporarily higher purchasing power vis-à-vis commodities which should be considered. Such a calculation, with “P” and “p” referring to the monetary unit's purchasing power in commodities rather than to its value in gold, would also lead, as a rule, to this result:

mP > Mp.

However, as the monetary depreciation progresses, it is evident that the demand for money, that is for the monetary units already in existence, begins to decline. If the loss a person suffers becomes greater the longer he holds on to money, he will try to keep his cash holding as low as possible. The desire of every individual for cash no longer remains as strong as it was before the start of the inflation, even if his situation may not have otherwise changed. As a result, the demand for money throughout the entire economy, which can be nothing more than the sum of the demands for money on the part of all individuals in the economy, goes down.

To the extent to which trade gradually shifts to using foreign money and actual gold instead of domestic notes, individuals no longer invest in domestic notes but begin to put a part of their reserves in foreign money and gold. In examining the situation in Germany, it is of particular interest to note that the area in which Reichsmarks circulate is smaller today than in 1914,5 and that now, because they have become poorer, the Germans have substantially less use for money. These circumstances, which reduce the demand for money, would exert much more influence if they were not counteracted by two factors which increase the demand for money:

  1. The demand from abroad for paper marks, which continues to some extent today, among speculators in foreign exchange (Valuta); and
  2. The fact that the impairment of [credit] techniques for making payments, due to the general economic deterioration, may have increased the demand for money [cash holdings] above what it would have otherwise been.

2. Undesired Consequences

If the future prospects for a money are considered poor, its value in speculations, which anticipate its future purchasing power, will be lower than the actual demand and supply situation at the moment would indicate. Prices will be asked and paid which more nearly correspond to anticipated future conditions than to the present demand for, and quantity of, money in circulation.

The frenzied purchases of customers who push and shove in the shops to get something, anything, race on ahead of this development; and so does the course of the panic on the Bourse where stock prices, which do not represent claims in fixed sums of money, and foreign exchange quotations are forced fitfully upward. The monetary units available at the moment are not sufficient to pay the prices which correspond to the anticipated future demand for, and quantity of, monetary units. So trade suffers from a shortage of notes. There are not enough monetary units [or notes] on hand to complete the business transactions agreed upon. The processes of the market, which bring total demand and supply into balance by shifting exchange ratios [prices], no longer function so as to bring about the exchange ratios which actually exist at the time between the available monetary units and other economic goods. This phenomenon could be clearly seen in Austria in the late fall of 1921.6 The settling of business transactions suffered seriously from the shortage of notes.

Once conditions reach this stage, there is no possible way to avoid the undesired consequences. If the issue of notes is further increased, as many recommend, then things would only be made still worse. Since the panic would keep on developing, the disproportionality between the depreciation of the monetary unit and the quantity in circulation would become still more exaggerated. The shortage of notes for the completion of transactions is a phenomenon of advanced inflation. It is the other side of the frenzied purchases and prices; it is the other side of the “crack-up boom.”

3. Effect on Interest Rates

Obviously, this shortage of monetary units should not be confused with what the businessman usually understands by a scarcity of money, accompanied by an increase in the interest rate for short term investments. An inflation, whose end is not in sight, brings that about also. The old fallacy—long since refuted by David Hume and Adam Smith—to the effect that a scarcity of money, as defined in the businessman's terminology, may be alleviated by increasing the quantity of money in circulation, is still shared by many people. Thus, one continues to hear astonishment expressed at the fact that a scarcity of money prevails in spite of the uninterrupted increase in the number of notes in circulation. However, the interest rate is then rising, not in spite of, but precisely on account of, the inflation.

If a halt to the inflation is not anticipated, the money lender must take into consideration the fact that, when the borrower ultimately repays the sum of money borrowed, it will then represent less purchasing power than originally lent out. If the money lender had not granted credit but instead had used his money himself to buy commodities, stocks, or foreign exchange, he would have fared better. In that case, he would have either avoided loss altogether or suffered a lower loss. If he lends his money, it is the borrower who comes out well. If the borrower buys commodities with the borrowed money and sells them later, he has a surplus after repaying the borrowed sum. The credit transaction yields him a profit, a real profit, not an illusory, inflationary profit. Thus, it is easy to understand that, as long as the continuation of monetary depreciation is expected, the money lender demands, and the borrower is ready to pay, higher interest rates. Where trade or legal practices are antagonistic to an increase in the interest rate, the making of credit transactions is severely hampered. This explains the decline in savings among those groups of people for whom capital accumulation is possible only in the form of money deposits at banking institutions or through the purchase of securities at fixed interest rates.

4. The Run From Money

The divorce of a money, which is proving increasingly useless, from trade begins when it starts coming out of hoarding. If people want marketable goods available to meet unanticipated future needs, they start to accumulate other moneys—for instance, metallic (gold and silver) moneys, foreign notes, and occasionally also domestic notes which are valued more highly because their quantity cannot be increased by the government, such as the Romanov ruble of Russia or the “blue” money of Communist Hungary.7 Then too, for the same purpose, people begin to acquire metal bars, precious stones and pearls, even pictures, other art objects and postage stamps. An additional step in displacing a no-longer-useful money is the shift to making credit transactions in foreign currencies or metallic commodity money which, for all practical purposes, means only gold. Finally, if the use of domestic money comes to a halt even in commodity transactions, wages too must be paid in some other way than with pieces of paper with which transactions are no longer being made.

Only the hopelessly confirmed statist can cherish the hope that a money, continually declining in value, may be maintained in use as money over the long run. That the German mark is still used as money today [January 1923] is due simply to the fact that the belief generally prevails that its progressive depreciation will soon stop, or perhaps even that its value per unit will once more improve. The moment that this opinion is recognized as untenable, the process of ousting paper notes from their position as money will begin. If the process can still be delayed somewhat, it can only denote another sudden shift of opinion as to the state of the mark's future value. The phenomena described as frenzied purchases have given us some advance warning as to how the process will begin. It may be that we shall see it run its full course.

Obviously the notes cannot be forced out of their position as the legal media of exchange, except by an act of law. Even if they become completely worthless, even if nothing at all could be purchased for a billion marks, obligations payable in marks could still be legally satisfied by the delivery of mark notes. This means simply that creditors, to whom marks are owed, are precisely those who will be hurt most by the collapse of the paper standard. As a result, it will become impossible to save the purchasing power of the mark from destruction.

5. Effect of Speculation

Speculators actually provide the strongest support for the position of the notes as money. Yet, the current statist explanation maintains exactly the opposite. According to this doctrine, the unfavorable configuration of the quotation for German money since 1914 is attributed primarily, or at least in large part, to the destructive effect of speculation in anticipation of its decline in value. In fact, conditions were such that during the war, and later, considerable quantities of marks were absorbed abroad precisely because a future rally of the mark's exchange rate was expected. If these sums had not been attracted abroad, they would necessarily have led to an even steeper rise in prices on the domestic market. It is apparent everywhere, or at least it was until recently, that even residents within the country anticipated a further reduction of prices. One hears again and again, or used to hear, that everything is so expensive now that all purchases, except those which cannot possibly be postponed, should be put off until later. Then again, on the other hand, it is said that the state of prices at the moment is especially favorable for selling. However, it cannot be disputed that this point of view is already on the verge of undergoing an abrupt change.

Placing obstacles in the way of foreign exchange speculation, and making transactions in foreign exchange futures especially difficult, was detrimental to the formation of the exchange rate for notes. Still, not even speculative activity can help at the time when the opinion becomes general that no hope remains for stopping the progressive depreciation of the money. Then, even the optimists will retreat from German marks and Austrian crowns, part company with those who anticipate a rise and join with those who expect a decline. Once only one view prevails on the market, there can be no more exchanges based on differences of opinion.

6. Final Phases

The process of driving notes out of service as money can take place either relatively slowly or abruptly in a panic, perhaps in days or even hours. If the change takes place slowly that means trade is shifting, step-by-step, to the general use of another medium of exchange in place of the notes. This practice of making and settling domestic transactions in foreign money or in gold, which has already reached substantial proportions in many branches of business, is being increasingly adopted. As a result, to the extent that individuals shift more and more of their cash holdings from German marks to foreign money, still more foreign exchange enters the country. As a result of the growing demand for foreign money, various kinds of foreign exchange, equivalent to a part of the value of the goods shipped abroad, are imported instead of commodities. Gradually, there is accumulated within the country a supply of foreign moneys. This substantially softens the effects of the final breakdown of the domestic paper standard. Then, if foreign exchange is demanded even in small transactions, if, as a result, even wages must be paid in foreign exchange, at first in part and then in full, if finally even the government recognizes that it must do the same when levying taxes and paying its officials, then the sums of foreign money needed for these purposes are, for the most part, already available within the country. The situation, which emerges then from the collapse of the government's currency, does not necessitate barter, the cumbersome direct exchange of commodities against commodities. Foreign money from various sources then performs the service of money, even if somewhat unsatisfactorily.

Not only do incontrovertible theoretical considerations lead to this hypothesis. So does the experience of history with currency breakdowns. With reference to the collapse of the “Continental Currency” in the rebellious American colonies (1781), Horace White says: “As soon as paper was dead, hard money sprang to life, and was abundant for all purposes. Much had been hoarded and much more had been brought in by the French and English armies and navies. It was so plentiful that foreign exchange fell to a discount.”8

In 1796, the value of French territorial mandats fell to zero. Louis Adolphe Thiers commented on the situation as follows:

Nobody traded except for metallic money. The specie, which people had believed hoarded or exported abroad, found its way back into circulation. That which had been hidden appeared. That which had left France returned. The southern provinces were full of piasters, which came from Spain, drawn across the border by the need for them. Gold and silver, like all commodities, go wherever demand calls them. An increased demand raises what is offered for them to the point that attracts a sufficient quantity to satisfy the need. People were still being swindled by being paid in mandats, because the laws, giving legal tender value to paper money, permitted people to use it for the satisfaction of written obligations. But few dared to do this and all new agreements were made in metallic money. In all markets, one saw only gold or silver. The workers were also paid in this manner. One would have said there was no longer any paper in France. The mandats were then found only in the hands of speculators, who received them from the government and resold them to the buyers of national lands. In this way, the financial crisis, although still existing for the state, had almost ended for private persons.9

7. Greater Importance of Money to a Modern Economy

Of course, one must be careful not to draw a parallel between the effects of the catastrophe, toward which our money is racing headlong on a collision course, with the consequences of the two events described above. In 1781, the United States was a predominantly agricultural country. In 1796, France was also at a much lower stage in the economic development of the division of labor and use of money and, thus, in cash and credit transactions. In an industrial country, such as Germany, the consequences of a monetary collapse must be entirely different from those in lands where a large part of the population remains submerged in primitive economic conditions.

Things will necessarily be much worse if the breakdown of the paper money does not take place step-by-step, but comes, as now seems likely, all of a sudden in panic. The supplies within the country of gold and silver money and of foreign notes are insignificant. The practice, pursued so eagerly during the war, of concentrating domestic stocks of gold in the central banks and the restrictions, for many years placed on trade in foreign moneys, have operated so that the total supplies of hoarded good money have long been insufficient to permit a smooth development of monetary circulation during the early days and weeks after the collapse of the paper note standard. Some time must elapse before the amount of foreign money needed in domestic trade is obtained by the sale of stocks and commodities, by raising credit, and by withdrawing balances from abroad. In the meantime, people will have to make out with various kinds of emergency money tokens.

Precisely at the moment when all savers and pensioners are most severely affected by the complete depreciation of the notes, and when the government's entire financial and economic policy must undergo a radical transformation, as a result of being denied access to the printing press, technical difficulties will emerge in conducting trade and making payments. It will become immediately obvious that these difficulties must seriously aggravate the unrest of the people. Still, there is no point in describing the specific details of such a catastrophe. They should only be referred to in order to show that inflation is not a policy that can be carried on forever. The printing presses must be shut down in time, because a dreadful catastrophe awaits if their operations go on to the end. No one can say how far we still are from such a finish.

It is immaterial whether the continuation of inflation is considered desirable or merely not harmful. It is immaterial whether inflation is looked on as an evil, although perhaps a lesser evil in view of other possibilities. Inflation can be pursued only so long as the public still does not believe it will continue. Once the people generally realize that the inflation will be continued on and on and that the value of the monetary unit will decline more and more, then the fate of the money is sealed. Only the belief, that the inflation will come to a stop, maintains the value of the notes.

  • *. Die geldtheoretische Seite des Stabilisierungsproblems (Schriften des Vereins für Sozialpolitik 164, part 2 [Munich and Leipzig: Duncker and Humblot, 1923]). The original manuscript for this essay was completed and submitted by the author to the printer in January 1923, more than eight months before the final breakdown of the German mark.
  • 1. [Following the terminology of Carl Menger, Mises wrote here of changes in the “internal objective exchange value” of the monetary unit. However, in this translation, the more familiar English term, later adopted by Mises, will be used—i.e, changes in the value of the monetary unit arising on the money side or, simply, “cash-induced changes.” Menger's term for changes in the monetary unit's “external exchange value” will be rendered as “changes from the goods side” or “goods-induced changes.” See below p. 76, note 17. Also Mises's Human Action (1949; 1963 [Chicago: Contemporary Books, 1966], p. 419; Scholar's Edition [Auburn, Ala.: Ludwig von Mises Institute, 1998], p. 416).—Ed.]
  • 2. [Mises uses the term “inflation” in its historical and scientific sense as an increase in the quantity of money.—Ed.]
  • 3. [Here in the German text Mises used, without special comment, the English term “standard of deferred payments.” For his reasons, see below, p. 58, note 3.—Ed.]
  • 4. Bourse (French). A continental European stock exchange, on which trades are also made in commodities and foreign exchange.
  • 5. The Treaty of Versailles at the end of World War I (1914–1918) reduced German controlled territory considerably, restored Alsace-Lorraine to France, ceded large parts of West Prussia and Posen to Poland, ceded small areas to Belgium and stripped Germany of her former colonies in Africa and Asia.
  • 6. [The post World War I inflation in Austria is not as well known as the German inflation of 1923. The Austrian crown depreciated disastrously at that time, although not to the same extent as the German mark. The leader of the Christian-Social Party and Chancellor of Austria (1922–1924 and 1926–1929), Dr. Ignaz Seipel (1876–1932), acting on the advice of Professor Mises and some of his associates, succeeded in stopping the Austrian inflation in 1922.—Ed.]
  • 7. Moneys issued by no longer existing governments. The Romanovs were thrown out of power in Russia by the Communist Revolution in 1917; Hungary's post World War I Communist government lasted only from March 21, to August 1, 1919.
  • 8. Horace White, Money and Banking: Illustrated by American History (Boston, 1895), p. 142. [NOTE: We could not locate a copy of the 1895 edition to verify this quotation. However, it appears, without the last sentence, in the 5th (1911) edition, p. 99.—Ed.]
  • 9. Louis Adolphe Thiers, Histoire de la Revolution Française, 7th ed., vol. V (Brussels, 1838), p. 171. The interpretation placed on these events by the “School” of G.F. Knapp is especially fantastic. See H. Illig's Das Geldwesen Frankreichs zur Zeit der ersten Revolution bis zum Ende der Papiergeldwährung [The French monetary system at the time of the first revolution to the end of the paper currency] (Strassburg, 1914), p. 56. After mentioning attempts by the state to “manipulate the exchange rate of silver,” he points out: “Attempts to reintroduce the desired cash situation began to succeed in 1796.” Thus, even the collapse of the paper money standard was a “success” for the State Theory of Money. [NOTE: The “State Theory of Money” has been the basis of the monetary policies of most governments in this century. Mises frequently credited the book of Georg Friedrich Knapp (3rd German edition, 1921; English translation by H.M. Lucas and J. Bonar, State Theory of Money, London, 1924) for having popularized it among German-speaking peoples. Knapp held that money was whatever the government decreed to be money—individuals acting and trading on the market had nothing to do with it. See Mises's The Theory of Money and Credit (New Haven, Conn.: Yale University Press, 1953), pp. 463–69; and (Indianapolis, Ind.: LibertyClassics, 1980), pp. 506–12.—Ed.]