Economics of the Free Society

This evolution is marked by a growing tendency to end the isolation of the theory of money from the main body of economic thought. Increasingly, monetary theory has been merged into the theories of credit, of capital, of wages, of interest, of foreign trade, and especially of cyclical theory. There is also increasing recognition of the fact that money is indissolubly linked to all economic phenomena, so that it is no longer sufficient in rigorous analysis to “abstract” from money in order to apprehend more precisely the “real” nature of economic processes. Representative contributions to this—for beginners, rather rarefied—area of inquiry are: J. M. Keynes, A Treatise on Money (London, 1930); J. M. Keynes, The General Theory of Employment, Interest, and Money (London, 1936); F. A. von Hayek (ed.), Beiträge zur Geldtheorie (Vienna, 1933); F. A. von Hayek, Prices and Production (2nd ed.; London, 1935); L. v. Mises, The Theory of Money and Credit (New Haven, 1953); D. H. Robertson, Banking Policy and the Price Level (3rd ed.; London, 1932); R. G. Hawtrey, Currency and Credit (3rd ed.; London, 1931); D. H. Robertson, Essays in Monetary Theory (London, 1940); Ch. Rist, Histoire des doctrines relatives au crédit et à la monnaie (Paris, 1938); G. N. Halm, Monetary Theory (2nd ed.; Philadelphia, 1946); G. N. Halm, Economics of Money and Banking (Homewood, 111., 1956); L. Baudin, La monnaie et la formation des prix (2nd ed.; Paris, 1947). The following works are suitable as introductions to the theory of money: D. H. Robertson, Money (6th ed.; London, 1948); F. Lutz, Das Grundproblem der Geldverfassung (Stuttgart, 1936); Luigi Federici, La moneta e l’oro (2nd ed.; Milan, 1943); Otto Veit, Der Wert unseres Geldes (Frankfurt am Main, 1958).

The theory which considers that changes in monetary systems have exerted an active influence on world history may be designated as the monetary interpretation of history. This theory is by no means to be summarily rejected. Cf. J. M. Keynes, A Treatise on Money, op. cit., Chapter 30; M. Herzfeld, “Die Geschichte als Funktion der Geldbewegung,” Archiv für Sozialwissenschaft, Vol. 56, 1926, pp. 654 ff.

Money acquires a strictly legal character when the state confers upon its possessor certain legal rights. Most notable of these are:

1. The right to convert money into other kinds of money. A money endowed with this right is known as “provisional” money (for example, the bank notes which circulated in the gold-standard countries before World War I as contrasted with inconvertible definitive money).

2. The right of the possessor to have his money accepted in payment of debts. Money endowed with this right (legal tender) must be accepted by creditors in settlement of all debts. This right is found in the following three forms:

(a) in the form of an unqualified right of the debtor to have his money accepted in payment of “all debts, public and private” (full legal tender, currency);

(b) in the form of a right to acceptance by creditors up to a certain maximum sum (limited legal tender, subsidiary coin such as silver coins and “minor coins” [nickels and pennies]);

(c) in the form of a right to acceptance only by the state treasury, for example, the gold certificates issued by the United States Treasury and now held only by Federal Reserve banks, or the Rentenmark in Germany after the stabilization of the mark in 1923.

The endowment of the different kinds of money with one of these rights or with a combination of several of these rights represents the principal means of which the state disposes for the regulation and stabilization of the monetary system. But it is an exaggeration to say that this legal character of money constitutes its origin and essence as was maintained by G. F. Knapp in his celebrated State Theory of Money (London, 1924). This view is refuted by the simple fact that in every age, including our own, we find monies which manage to function successfully without the sanction of the authorities (optional money or trade money; for example, the dollar notes used in Germany during the great inflation, or the silver Maria Theresa thalers struck in Vienna and used for decades in Abyssinia). The best criticism of Knapp’s theory is found in H. S. Ellis, German Monetary Theory, 1905-1933 (Cambridge [Mass.], 1934). See also A. Nussbaum, Money in the Law (2nd ed.; Brooklyn, N. Y., 1950).

When both gold and silver are standard money, the maintenance of the homogeneity of the monetary standard and of monetary stability becomes a knotty problem since, as we know from the experience of the last hundred years, the value relationships of the two metals to one another are subject to wide fluctuation. Two cases must be distinguished: (a) The parallel standard. This type of standard exists where gold and silver coins of full value circulate simultaneously without a legal ratio being fixed between them. In this case, the homogeneity of the monetary system is destroyed; there are now two monetary standards within one country between which emerges an exchange relationship (intra-monetary exchange rate) which fluctuates with market conditions exactly as the exchange rate between the currencies of different countries. Even the establishment of an official ratio between the two metals will not eliminate the inconveniences of this system, unless there is a real effort to enforce the ratio. The parallel standard was in general use throughout the world until the beginning of the nineteenth century. Eventually, the growth of business activity led to proposals for a reform of this split standard, (b) The double standard (alternative standard). In this case, gold and silver are made standard metals with an exchange ratio between them legally fixed and maintained, at 1: 151/2, for example. If there is a change in this value relationship in the metals market, money minted from the metal which has become dearer disappears from circulation (Gresham’s law: “bad money drives out good”). Under the double standard, coins minted from the metal which has become cheaper will become the dominant medium of exchange. This is so because the public stands to profit by bringing to the mint the lower-priced metal (which was silver at the close of the nineteenth century) and exchanging it for silver coin, since the nominal value of the “under-valued” silver coins is the same as that of the “over-valued” gold coins. If the price of silver should drop sharply, the standard is automatically established on silver as silver alone will be brought to the mint. This result may be forestalled by abolishing the free coinage of silver and by restricting its use to the minting of subsidiary coin. Gold will then be reestablished as the standard money. This, in fact, marks the last stage in the nineteenth-century evolution of monetary standards.

The problem of the early note-issuing bank—and later of the deposit bank-lay in the fact that it was at once a bank and an institution for issuing money, and that in it were combined the manufacture of both credit and currency. The history of more than a hundred years of banking shows that the dangerous situations thus produced were the prime concern of those entrusted with the making of banking policy. Out of this historical experience have crystallized the following principles:

1. A central bank of issue should be a state enterprise, or at least be placed under rigorous state control (principle of government monopoly).

2. Limitations should be placed upon the issuance of bank notes by the several methods available for this purpose (fixing of reserve requirements, establishing maximum quantities in which bank notes may be issued, taxing of bank notes, etc.).

3. The issuing of bank notes should be closely regulated and the nature of the credit operations involved strictly defined.

The practical result of the application of this last principle has been to limit the granting of credit by banks of issue to short-term working credits for business and industry, and to a particular species of these operations (discounting operations). A study of these limitations, which have been the subject of considerable debate, would take us deep into the domain of credit theory. Cf. L. von Mises, The Theory of Money and Credit, op. cit.; Argentarius, Die Notenbank, (1922); F. Somary, Bankpolitik (3rd ed., 1934); R. G. Hawtrey, The Art of Central Banking (London, 1932); J. M. Keynes, op. cit.; Victor Morgan, The Theory and Practice of Central Banking, 1797-1913 (Cambridge, 1943); Otto Veit, Der Wert unseres Geldes, op. cit.

Under the gold standard as it existed in most countries prior to 1914, a variety of arrangements caused money and gold to be so closely coupled that the material value and the nominal value of money were identical and all types of money were freely convertible into gold. This coupling mechanism was such that at all times money could be converted into gold, and gold into money at an unchanging and practically identical price. It was the maintenance of this kind of convertibility which was the objective of the prescriptions concerning free coinage of gold, the obligation of the monetary authorities to buy and sell gold at a fixed price, and the freedom to export and import gold. Under such a system, the prices of all goods can change while the price of gold remains the same; gold becomes the “pole star of the monetary universe.” The inestimable advantage of the gold standard is that it stabilizes the value of money and protects it from the caprices of governments. Despite the hopeful promises of monetary reformers, not even an approximate equivalent for it has as yet been discovered. Therewith is connected a further advantage of the gold standard, viz., that it united all the countries employing it into an essentially homogeneous monetary system supplied with a de facto world money. Cf. W. Röpke, International Order and Economic Integration (Dordrecht, Holland, 1959).

The gold bullion standard, as distinguished from the pure gold standard (gold circulation system), is a system under which the free coinage of gold is abolished and gold coins cease to be legal tender. The coupling mechanism is restricted to the maintenance of a stable ratio between money and a central fund of gold. From this fund, gold is sold as before at a fixed price, but only for a limited number of specific purposes, and not in the form of gold coin. Nevertheless, the state treasury must continue to buy gold at a fixed price as it is offered. A variant of the bullion system is the gold exchange standard in which the central fund may consist of foreign exchange instead of, or in addition to gold. This, however, is an extremely questionable substitute which, as experiences with this system up to 1931 demonstrated, can easily lead to international inflation. The gold bullion standard may be properly describe as a “gold” standard since, as a result of its retention of the coupling mechanism, it assures a fixed price for gold, avoids arbitrary fixing of the money supply, and automatically stabilizes rates of exchange. Compared with the true gold standard, it offers the advantage of economizing gold, but it is an advantage which is secured at the cost of certain serious inconveniences. Above all, the automatism of the system is seriously weakened, bringing us one step closer to a paper standard. Cf. F. Machlup, Die Goldkernwährung, (1924); W. A. Brown, Jr., The International Gold Standard Reinterpreted, 1914-1934 (New York, 1940); X. Zolotas, L’étalonor en théorie et en pratique (Paris, 1933); T. E. Gregory, Gold, Unemployment, and Capitalism (London, 1933); W. Röpke, International Order and Economic Integration, op. cit.; Luigi Federici, La moneta e l’oro, op. cit.

The most important sources of further information on this subject are: L. A. Hahn, Volkswirtchaftliche Theorie des Bankkredits (3rd ed., 1930); L. A. Hahn, Geld und Kredit (Frankfurt am Main, 1960); F. A. von Hayek, Geldtheorie und Konjunkturtheorie (Vienna, 1929); J. M. Keynes, A Treatise on Money, op. cit.; Hans Neisser, Der Tauschwert des Geldes (1928); C. A. Philipps, Bank Credit (New York, 1920); W. F. Crick, “The Genesis of Bank Deposits,” Economica, June 1927; Hans Gestrich, Kredit und Sparen (2nd ed.; Godesberg, 1948). On the problems connected with the manufacture of credit see F. Lutz, Das Grundproblem der Geldverfassung, op. cit.

It is undoubtedly correct that a reform of our economic system may be effected, to a large extent, by a reform of the monetary system. But we must proceed with great prudence in order to prevent such an undertaking from ending in disaster. It is unfortunate that the most imprudent of such reform projects are the ones which have the most enthusiastic backing; they attract by their radicalism and by the almost religious zeal which informs their promises to save the world economically and socially by revolutionizing its monetary system. All these theories of “monetary redemption,” of which Silvio Gesell’s theory of stamp money is perhaps the best known, tend with monotonous regularity to end in inflation. Cf. F. Haber, “Geld (Geldreformer)”, Handwörterbuch der Staatswissenschaften, (4th ed.), Vol. IV; H.T.N. Gaitskell, “Four Monetary Heretics” in What Everybody Wants to Know about Money (Cole ed.; London, 1933); L. Federici, op. cit., Chapter III.

To explain adequately the theory of exchange rates would require a book, a fact which gives some idea of the complex interrelationships involved. It should never be forgotten that one of the most important determinants of foreign estimate of the value of money is the domestic purchasing power of that money as compared with the domestic purchasing power of foreign money (theory of purchasing power parities). Here too, the more macroscopic the relationships involved, that is, the greater the changes in the purchasing power ratios, the more will this factor outweigh others in the final determination of the exchange rate. During the German inflation even the crudest form of the purchasing power parity theory was infinitely more correct than the attempts to explain the fall in the exchange rate of the mark by the “balance of payments deficit.” In other words: the principal cause of the fall of the mark exchange rate was an excessive use of the Reichsbank printing press, resulting in a rapid depreciation of the mark within Germany. In comparison with this principal cause, other factors were reduced to insignificance. Under the microscopic conditions of normal times, the interrelationships in question are far more complicated. Cf. G. Haberler, The Theory of International Trade (London, 1936); B. Whale, International Trade (2nd ed.; London, 1934; a small book which makes an excellent introduction to the subject); F. Machlup, “The Theory of Foreign Exchanges,” Economica, November 1934; H. v. Stackleberg, “Die Theorie des Wechselkurses bei vollständiger Konkurrenz,” Jahrbücher für Nationalökonomie u. Statistik, Vol. 161.

From the extensive literature on this subject may be mentioned: C. Bresciani-Turroni, The Economics of Inflation: a Study of Currency Depreciation in Postwar Germany (New York, 1940); Frank D. Graham, Exchange, Prices, and Production in Hyper-Inflation: Germany, 1920-1923 (Princeton, 1930); E. L. Hargreaves, Restoring Currency Standards (London, 1926); E. W. Kemmerer, Modern Currency Reforms (London, 1928); J. Rueff, L’ordre social (Paris, 1947). On “repressed inflation”: W. Röpke, “Offene und zurückgestaute Inflation,” Kyklos, Vol. I, no. 1, 1947; W. Röpke, “Repressed Inflation,” Kyklos, Vol. I, no. 3, 1947; F. A. Lutz, “The German Currency Reform and the Revival of the German Economy,” Economica, May 1949.

For more extensive treatment of this phenomenon, see my book A Humane Economy (Chicago, 1960), Chapter IV. Excellent treatments of the subject are G. Haberler, Inflation, Its Causes and Cures (Washington, D.C., 1960); Henry Hazlitt, What You Should Know About Inflation (New York, 1960).

The phenomenon was described first in my essay of 1956, “Das Dilemma der importierten Inflation” (reprinted in my book Gegen die Brandung [2nd ed.; Zurich, 1959]) in which this terminology was also suggested. See also the special section on inflation in my previously mentioned book A Humane Economy, pp. 199 ff.

An index number is constructed by selecting the prices of fifty or more representative commodities and multiplying these prices by a coefficient which corresponds to their economic importance (weighted index number). The amounts thus obtained are added together. The average of prices for the year which is selected as a “base”, say 1913, is equated with 100; subsequent changes in prices are then expressed as a percentage of the base average (100). For comment on the problematical aspects of such calculations see G. Haberler, Der Sinn der Indexzahlen (1927).

Our observations on the theory of exchange rates apply equally to the quantity theory of money. Considered in detail, it has many problematical aspects, but its basic truth is indisputable; and it is the more apt, the greater is the fluctuation in the value of money. For extended discussion of this theory see the bibliography listed under Note 1.

This concept is based on the fact that within a certain period of time the same piece of money may be used over and over again to purchase different goods. Here again, we may observe the essential difference between money and goods: a loaf of bread can be eaten only once, but a piece of money can be repeatedly used as a medium of exchange so long as it remains in circulation. The faster money is passed from hand to hand or, what amounts to the same thing, the briefer are its rest periods in our pockets, the more it can buy within a given period of time. This speed of circulation of money (or its reciprocal, the average rest period) is affected by various factors, such as the average intervals between income payments, the mode of payment, the degree of differentiation in the economy, the proportion of durable goods to total production, bookkeeping customs, and other factors. Velocity of circulation is an especially sensitive barometer of the public’s confidence in the stability of money. Hence, in times of inflation there will be sudden and marked changes in this velocity. The effects on the value of money of an increase in the quantity of money will be aggravated by a rise in the velocity of circulation or, vice versa, a fall in velocity may offset the effects of an increase in quantity. It was particularly easy to follow the working of this monetary law during the great German inflation which followed World War I. It was observed that in the first phase of this inflation, the depreciation of money was less than proportional to the increase in the quantity of money. The reason was to be found in the fact that the public, in the expectation of a future appreciation of the mark, was less disposed to spend money; for this and other reasons (tax evasion and general political uneasiness), the public increased its cash holdings; it “hoarded” money. At the peak of the inflation, however, the depreciation of money was much more than proportional to the increase in the quantity of money. The reason for this was the tremendously accelerated rate of bank-note circulation which followed the complete collapse of public confidence in the mark, the general flight into “real values,” and the shortening of all payment intervals necessitated by the galloping currency inflation. The velocity of circulation increased enormously and thereby multiplied many times over the inflationary effects of the increased supply of money. It is interesting, also, to note that while the value of the paper marks in circulation reached an astronomical figure, the gold value of the money supply based on the dollar rate of exchange continued to fall, finally amounting to only a few millions, a clear indication that the depreciation of money was proceeding at a faster rate than the increase in its quantity. On the difficult problems connected with the velocity of circulation of money see M. W. Holtrop, De Omloopssnelheid van het geld, (Amsterdam, 1928); F. A. Lutz, “Velocity Analysis and the Theory of the Creation of Deposits,” Economica, May 1939; H. S. Ellis, “Some Fundamentals in the Theory of Velocity,” Quarterly Journal of Economics, May 1938; L. Federici, op. cit., Chapter V.