Full Reserve Banking

CHAPTER 6

Some Clarifications Concerning
Mises’s Monetary Theory

At this point I would like to clarify some more specific comments and critiques raised in Rallo’s book.

6.1 An Unquestionable Canon

Rallo (13) suggests that Mises’s (1912, 1953) book has become an “(almost) unquestionable canon” of Austrian monetary theory. This formulation seems to suggest that no critical thinking concerning Mises’s monetary system is allowed or has been made.

However, Rallo’s statement is a misrepresentation. There have been several critiques of Mises’s monetary theory from within the Austrian school. For instance, Selgin and White (1996) have argued in the Quarterly Journal of Austrian Economics in favor of fractional reserve banking. Barnett and Block (2005) have argued, also erroneously, that money is a production good. I have criticized Mises for his stand on deflation (Bagus 2003) and monetary reform (Bagus 2008a).

Hülsmann (2012, ix), while emphasizing the importance of Mises’s work, points to critical engagement with The Theory of Money and Credit: “As a consequence, for many years, the Theorie des Geldes und der Umlaufsmittel has been read, studied, criticized, and developed mainly by Mises’s own students. F. A. Hayek and Fritz Machlup in the interwar period, and Hans Sennholz, Murray Rothbard, and George Reisman after WWII were first in line” (emphasis added).

Besides this criticism, Mises himself changed and adapted his monetary theory in Human Action (Mises 1998), a fact that is neglected by Rallo. Rallo (13) focuses on The Theory of Money and Credit, as if Mises’s monetary thought did not develop later on. This is quite unfortunate. Why would you criticize an outdated version of an author’s theory, if a newer, changed, and improved version exists?

Indeed, Mises’s monetary thought did not end with The Theory of Money and Credit, neither its first (1912) nor its second (1924) edition. Hülsmann (2012) elaborates on the main differences between the first and the second editions and how Mises changed his mind on several issues. And as Nicolay Gertchev (2004) indicates, Mises corrects part of his monetary analysis in Human Action, where he effectively integrates value and money theory.

Among the issues on which Mises changed his opinion are the following. In The Theory of Money and Credit Mises considers money to not be an independent good but only to have derived utility from the goods it serves to purchase. Mises (1998, 387–401) later corrects this view in Human Action, where he points out that money is valued and appraised on its own merits. Moreover, the regression theorem is better founded in Human Action (405–7), as the valuation process is future oriented but based on past purchasing power. Thus, Gertchev (2004, 69) maintains that Mises develops a coherent subjectivist theory on the value of money only in Human Action.

There are other important differences. In The Theory of Money and Credit Mises still sees some advantages of fiduciary media. Mises finds the issue of fiduciary media beneficial for capital accumulation and has in general a more positive assessment of fiduciary media in this earlier book (Gertchev 2004, 77). In Human Action Mises concludes that the issue of fiduciary media has no advantage (Gertchev 2004, 82). Nevertheless, Mises (1998, 419) still does see gold mining as unproductive though still a lesser evil than the issue of fiduciary media (Gertchev 2004).

Furthermore, in The Theory of Money and Credit, Mises has no unequivocal answer on the limitations of the issuance of fiduciary media. In Human Action, Mises offers a new analysis of fiduciary media that rests on his study of economic calculation, his theory of interest, and his insight that the market economy rests on the monetary system (Gertchev 2004).

Moreover, in his early work Mises regards falling prices in response to an increase in the demand for money as problematic because of certain frictions. In Human Action Mises makes clear that a fall in prices caused by an increase in the demand for money poses no special problem in a market economy. Moreover, he states that the necessity of adjustment cannot be prevented by an increase in the quantity of money. For entrepreneurs, Mises finds, the movement of the general price level is not essential. What is important is the discrepancies between individual prices and costs.

Another change in Mises’s thought is that in The Theory of Money and Credit he argues that there is no limit to credit expansion, while in Human Action he states that free banking puts limits on credit expansion (Gertchev 2004). Thus, Mises corrects important parts of his analysis in The Theory of Money and Credit in his later work, Human Action.

While Rallo occasionally cites Human Action, his focus and starting point is The Theory of Money and Credit, as shown in his very first sentence (Rallo, 13). However, it is an error to reduce Mises’s monetary thought to The Theory of Money and Credit; indeed, this early work has problems (Gertchev 2004). Mises’s treatment of money in his magnum opus, Human Action, is in all relevant parts better than in The Theory of Money and Credit. So Rallo’s focus on The Theory of Money and Credit makes no sense. He should have directed his critique at Human Action instead.

6.2 The Definition of Credit Money

Rallo’s (21) presentation of Mises’s definition of credit money appears to be incorrect. Rallo argues that credit money is a right to collect money proper, whose value derives not from the expectation of this future collection but from its present utility as a medium of exchange. He gives the example of a 10-year government bond that is used as a medium of exchange independently from the expectation of payment. However, Mises would rather consider an instrument such as a very liquid government bond that is used as a means of payment as a secondary medium of exchange. In fact, Mises defines secondary media of exchange as goods of a high marketability such as first-class bonds (1998, 459). The difference between money substitutes (such as fiduciary media) and secondary media of exchange is that the latter cannot be redeemed on demand at par.

As Howden (2023, 166) points out, “The difference between money and other assets is one of kind, and not only of degree. . . . Money is demanded for its uniqueness. Money [as well as perfect money substitutes] is the only asset that combines both value attributes—on demand availability at par value—in one package.”

For Mises, a credit money is a generally accepted medium of exchange that evolved out of money substitutes that gave the right to a daily maturing claim. But then redemption was suspended up to an undetermined future date. Nevertheless, these money substitutes continue to be used as media of exchange (1998, 425–26). There is still hope that in the future redemption will be resumed. If this hope dies, then we have fiat money.

On credit money, Mises writes (1998, 426):

Now, as redemption was suspended, the maturity date postponed to an undetermined day, and consequently doubts about the solvency of the debtor or at least about his willingness to pay emerged, they lost a part of the value previously ascribed to them. They were now merely claims, which did not bear interest, against a questionable debtor and falling due on an undefined day. But as they were used as media of exchange, their exchange value did not drop to the level to which it would have dropped if they were merely claims.

Thus, in contrast to Rallo’s presentation, the possibility and expectation of payment in money proper is still essential for credit money. If that possibility ceases, the credit money turns into fiat money.

6.3 Are Money Substitutes Present Goods?

Rallo (26) maintains that Mises contradicts himself in regard to money substitutes. Mises (1953, 52) first says that money substitutes are claims to other goods and not goods themselves, and later Mises (1953, 272) writes that bank notes are present goods. As bank notes are money substitutes, it is a contradiction to say that they are both not goods (but claims) and present goods at the same time.

Mises would have been more consistent, indeed, if he had stated that fiduciary media are regarded by their users as perfect substitutes for present goods (even though they are not the goods themselves but just a claim to them). Thus, money substitutes act as if they are present goods (and are really claims to present goods).

As discussed in section 4.1.1, financial assets imply an exchange of present goods for future goods. In contrast, money is a present good (Huerta de Soto 2012, 696n141). Money satisfies human desires in the present. Fiduciary media are considered perfect money substitutes. Not for nothing does M1 today include both physical currency and demand deposits.

Financial assets imply that someone has given up present goods (money) and has received in return the promise of future goods. A bond, for instance, is a financial asset representing an exchange of present goods for future goods. When money is transferred to the issuer of the bond, the issuer receives money and purchasing power while the purchaser gives it up. If the bond were also considered money and a present good by its bearer, then we would have an inflationary duplication of money in circulation (Huerta de Soto 2012, 696n140). This is exactly what happens with fractional reserve banking when fiduciary media are considered perfect money substitutes.

6.4 Was Mises a Supporter of Friedman’s Quantity Theory?

Rallo (45–46) makes the argument that Mises reached the same conclusions as Milton Friedman did in his “Quantity Theory of Money—a Restatement” (Friedman 1956). It is strange to put Mises close to Milton Friedman in monetary matters since Mises (1998, 402) was one of the most vocal critics of the mechanistic quantity theory of money, which he criticized for its holistic approach and the proportionality between changes in the money supply and changes in prices.

Rallo argues that Mises, like Friedman, assumed the stability of the demand for money, the independence of the supply of and demand for money, the determination of interest rates by nonmonetary factors, and a negligible influence of interest rates on the demand for money. It is true that Mises analyzed the effects of changes in the demand for and supply of money in ceteris paribus terms. But his ceteris paribus analysis does not imply that he thought that the demand for money must always be stable, as Rallo seems to suggest.

It is ironic that Rallo criticizes Mises for supposedly assuming independence between the supply of and demand for money when Rallo’s own argument implies that the demand for fiduciary media is independent of the supply of money. The real bills doctrine maintains that real bill discounting is determined by real causes. However, as mentioned in section 4.4, by increasing the supply of loans and reducing the interest rate, fractional reserve banking can increase the demand for loans. That is, the demand for loans is not independent of the supply of fiduciary media and the interest rate.

It is also true that while Mises mentions that holding money has costs in the form of forgone interest (1998, 460), he does not analyze the consequences in detail.

It is not true, however, that Mises does not consider monetary factors as determinants of the interest rate. He states that the gross market rate of interest has several components: originary interest, determined by time preference; an entrepreneurial component; a risk premium; and a price premium (1998, 535–42). And the price premium is, of course, influenced by monetary factors. Mises (1998, 545–47) explicitly analyzes “the effects of changes in the money relation upon originary interest.” It is one of Mises’s main points that monetary inflation affects the gross market rate of interest, leading to the Austrian business cycle (1998, 547–62). Therefore, it is not true that Mises concludes that interest rates are determined by nonmonetary factors (only). Moreover, Mises was a fierce critic of the equation of exchange (1998, 410; 1953, 143–45), which Friedman defended.

6.5 Money: Capital Good or Medium of Exchange?

Mises (1953, 83–84) argues that money is not a capital good. It is neither a consumer good nor a producer good. It facilitates exchange. Rallo argues contra Mises that money is a capital good. This ties into his argument that fiduciary media are financial assets that help to produce additional goods. Rallo thereby follows a line of argument defended also by Walter Block and Bill Barnett (2005), who argued before him that money is a capital good.

There are important differences between capital goods and money. An increase in well-employed capital goods increases overall production of goods and services. In contrast, the functions of money qua money are to facilitate exchanges and reduce uncertainty. These are money’s services. The existence of more money does not mean that exchanges are facilitated more efficiently or that uncertainty is decreased and real production soars. When the money supply increases, prices will tend to increase. If a zero is added to all monetary units, then the money supply increases tenfold. However, exchanges do not become easier. Prices just rise. And real cash balances do not increase either. Therefore, there is no reduction of uncertainty.

A capital good is an intermediate stage in the production process that is necessary to attain the final end. Money is not necessary to attain the final end in the sense that without money, the final end could not be reached. Indeed, roundabout production is also possible in a barter economy. The introduction of money merely facilitates exchanges and a more complex structure of production.

Moreover, capital goods are consumed during the production process. They are transformed into consumer goods. However, money, while facilitating the coordination of production, does not disappear. It is not transformed into a consumer good.

In addition, Salerno (2020) reminds us that the market prices of capital goods tend toward the sum of the discounted income flow they produce. For its participation in the production process, each capital good is paid its discounted marginal value product (DMVP). What about money? Is it paid its DMVP? Indeed, money is not paid at all. In fact, when all capital goods and factors of production are paid, what is left over is pure entrepreneurial profit.

Lachmann (1978, 87–88) supports Mises in this matter:

Money is an asset, but it is not a capital good like other elements of a production plan. That it is not, becomes clear as soon as we ask ourselves why and when it is required for carrying out a production project. A cash balance is necessary to buy labour, and current services of capital goods not physically controlled by the planner (water, electric power) during the plan period. But if, as we have to, we regard these services themselves as ‘factor services’, i.e. elements of the plan, we cannot at the same time treat the money that pays for them as a capital good: we should be guilty of double counting.

Money is the general medium of exchange that facilitates production, but it is not a capital good.

6.6 The Regression Theorem

Rallo criticizes Mises for his regression theorem. Mises argues (1998, 406) that a commodity, before it starts to have monetary demand, must have a price in the barter economy—i.e., it must have a nonmonetary demand. Furthermore, Mises (1998, 405–6) claims that the demand for money today is based upon yesterday’s purchasing power of money. Rallo criticizes these two main points.

First, Rallo asserts (138) that the utility of money consists in its liquidity and that a good could be demanded as money even if it has no past purchasing power. According to Rallo what really matters is the expected stability of the value of the future money (108) and not its past price.

Second, Rallo adds (138) that the demand for money today does not necessarily depend on its past purchasing power, as the regression theorem states, but depends rather on the expected stability of the value of money (liquidity). Rallo even states that gold could have become money even if it had had no nonmonetary use value—i.e., if gold had not been a commodity with a nonmonetary demand.

Serrano (2022) dedicates an entire article to addressing Rallo’s arguments against the regression theorem, showing in detail Rallo’s errors.

Serrano raises the reasonable question of how it can be that a good not having purchasing power could have stable value. How can one detect whether a good has stable value (high liquidity) if the good has no price? It is easy to see that such an endeavor is impossible. A good must have purchasing power before value stability can be established. Without knowing a good’s (past) price one cannot establish that its value has been stable. Thus, the demand for money is based on its past purchasing power. Money’s past purchasing power is the starting point for the expectation of money’s future purchasing power. Without such a starting point, the expectation of money’s price would be free floating.

Serrano also addresses the argument that gold could have become money without a nonmonetary use value. He points out that without nonmonetary use value, gold would not have been a good but just a thing. The qualities of gold, such as scarcity, transportability, and production cost, would have been unknown. Gold had to be a commodity with known properties before it could have monetary demand. A good must have nonmonetary value to become money.

Last, it must be clarified that Mises’s regression theorem is not about historical necessity or determinism. It merely states that the demand for a good as a medium of exchange must be based on a certain nonmonetary utility and that the demand for money is based on experience with the past value of money.

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As should be clear from my argument, especially in sections 2.3.1 and 2.2 on the resource cost of a full reserve money standard and on ideal money, I do not agree with Mises on the point that gold mining is unproductive.

Mises (1998, 428) writes, “But one must not say that a fall in prices caused by an increase in the production of the goods concerned is the proof of some disequilibrium which cannot be eliminated otherwise than by increasing the quantity of money. . . . It is possible by means of an increase in the quantity of money to delay or to interrupt this process of adjustment. It is impossible either to make it superfluous or less painful for those concerned.”

Mises (1998, 466) writes, “[Entrepreneurs] do not heed the general movement of all prices. All that matters for them is the existence of discrepancies between the prices of the complementary factors of production and the anticipated prices of the products.”

There is an unsurmountable gap between money (money substitutes) and secondary media of exchange.

Therefore, the expression “moneyness” used by Hayek (1999, 162) in his Denationalization of Money to refer to different degrees of money is one of the most unfortunate neologisms in economics. Hayek refers to Machlup (1970, 220, 225) as the first user of the term “moneyness.” However, Hayek and Machlup seem to mean slightly different things. Hayek’s expression caused much damage to economic theory, as it is the source of confusion that has led to important theoretical errors. The expression is the source of theoretical misconceptions such as the Feketian real bills doctrine, which holds that all financial assets, fiduciary media being one of them, have a certain moneyness. Yet “money” is not an adjective. If there existed a monetary continuum, the money supply would not be determinable, and money would be neither scarce nor a good (Hülsmann 1996, 152). One should also remember that the condition for “moneyness” is the existence of money. For an excellent critique of the concept of “moneyness,” see Hansen (2021). Similarly, Howden (2023, 164–65) states, “Money is . . . not just an asset on the liquidity spectrum or value scale. Instead it is an asset with definite qualities that differentiate it categorically from other assets.”

Money is not just the most liquid good. The liquidity of all other goods can be inferred by the easiness of converting them into money. The easier it is to convert an asset into money, the more liquid it is. Money is the basis and reference for liquidity. Similarly, money perfectly preserves nominal wealth. The capacity of other assets to nominally maintain wealth is tied to money. Money is the basis and reference.

I point again to a crucial statement from Mises (1953, 272): “A person who accepts and holds notes, grants no credit; he exchanges no present good for a future good. The immediately-convertible note of a solvent bank is employable everywhere as a fiduciary medium instead of money in commercial transactions, and nobody draws a distinction between the money and the notes which he holds as cash. The note is a present good just as much as the money.”

Murphy (2021, 108) states that Mises changes his definition of the natural rate of interest. While in The Theory of Money and Credit the natural rate of interest is determined by the supply of and demand for real capital without the mediation of money (Mises 1953, 306–7), in Human Action the originary rate of interest stems from the difference between the valuations of present and future goods (Mises 1998, 521).

Of course, the money-stuff may be a capital good. For instance, gold may be used in production. Then, the money-stuff is a capital good. But money qua money is a medium of exchange, and its increases do not increase production.