Study Guide to the Theory of Money and Credit
12. The Social Consequences of Variations in the Objective Exchange Value of Money
Chapter Outline
1. The Exchange of Present Goods for Future Goods
People often exchange present goods for future goods, for example by lending money today (a present good) in exchange for a promise of repayment of future principal plus interest, or by agreeing today to exchange goods against money in the future. Although businesspeople take great caution regarding changes in the prices of particular commodities, they typically do not take into account the possible fall in the objective value of money itself. To the extent that people do protect themselves in contracts from possible changes in the value of a currency, it is only a paper currency the value of which might fall relative to a currency backed by gold. Hardly anyone (at the time of Mises’s writing) realizes that the exchange value of gold itself could change during the length of a contract.
If changes in the purchasing power of money could be anticipated, then their impact could be offset by altering the terms of credit transactions. If both lenders and borrowers expect a weaker currency in the future (i.e., rising prices of most goods and services quoted in the currency), then lenders will insist on charging a higher interest rate and borrowers will be willing to pay it, because loans will be repaid in weaker currency.
2. Economic Calculation and Accountancy
Accountancy is imperfect in several respects. For example, it relies on subjective estimates of uncertain factors, such as the value of inventory (which is dependent on future demand) and the likelihood of default by the issuers of bonds. Yet another major flaw is that accountants use monetary figures as if they were akin to measures of length and weight. But since the purchasing power of money itself can change, accountancy is analogous to an architect designing blueprints in a world where rulers have variable lengths. Monetary depreciation can cause businesspeople to overestimate their profits and unwittingly engage in capital consumption.
3. Social Consequences of Variations in the Value of Money When Only One Kind of Money is Employed
If the quantity of a commodity such as coal is suddenly and unexpectedly increased, it will cause its price to drop. This will hurt those people who were holding large amounts of coal (such as the owners of coal mines and wholesalers) at the moment of the price drop, and it will help the consumers of coal (such as the owners of railroads and power plants). However, the gains will exceed the losses for the community as a whole, because the greater quantity of coal can yield more goods and services.
Things are different with the money commodity. Insofar as its monetary services are concerned, additional quantities confer no net benefits on the community. When new quantities of money enter the economy (from a new gold mine, for example), it spreads unevenly throughout the system. The chief beneficiaries are the original owners, then those upon whom they first spend the new money, and so on. The losers are those whose incomes (measured in money) do not rise even as they see prices going up in the things that they buy. Wealth is redistributed from some groups to others, but the community as a whole is not made richer by the influx of new money (except possibly indirectly if the beneficiaries of the inflation make more productive use of their redistributed wealth than the former owners).
4. The Consequences of Variations in the Exchange Ratio Between Two Kinds of Money
The uneven increase in prices due to an influx of new money (either from gold discoveries or from the issuance of more paper money and fiduciary media) can lead to redistribution even among groups using different currencies. For a modern example, suppose initially that one U.S. dollar trades for one euro, and that the price of a bushel of wheat initially is $5 and also €5. Then the Federal Reserve promises to sharply increase the quantity of dollars over the next few months, so that speculators on the foreign exchange market push down the value of the dollar so that it now trades for only one-half of a euro.
In this situation, the price of U.S. wheat would be €2.50 from the perspective of European millers, while wheat purchased from European farmers would be the original €5. The demand for American exported wheat would increase, while the American demand for European wheat would collapse. The prices of wheat in the two currencies would quickly adjust until balance had been restored, with U.S. wheat selling for (say) $8 and European wheat selling for €4. But even after this quick adjustment, there would be a lasting advantage given to American wheat exporters, because they could sell wheat for $8 instead of $5, even though their expenses (on labor, tractors, etc.) had not yet risen proportionally. European millers and consumers of bread would also benefit, because from their perspective the price of wheat would have fallen from €5 to €4 per bushel, even while their money incomes stayed the same. Two large groups of losers would be U.S. consumers and European wheat farmers. Only after all U.S. domestic prices had adjusted to the new quantity of dollars would the redistribution cease.
Technical Notes
• On pages 195–96, Mises writes, “When anybody buys (or sells) corn, cotton, or sugar futures . . . he is well aware of the risks that are involved in the transaction. He will carefully weigh the chances of future variations in prices, and often take steps, by means of insurance or hedging transactions ... to reduce the aleatory factor in his dealings.” His purpose in this passage is to contrast the businessman’s wariness concerning individual price changes over time, with the businessman’s (at that time) ignorance of changes in the purchasing power of money over time. However, Mises’s description is difficult to explain to a novice, because normally economists would describe the use of futures contracts as themselves “insurance” or “hedging” operations. For example, if a farmer knows he will have a large harvest of wheat to sell in six months, and his ability to make his mortgage payments and pay other expenses depends critically on the price of wheat, the farmer may want to “lock in” the price by selling futures contracts in wheat. On the other side of the transaction, a large operation that makes bread may itself want to lock in the price of one of its major inputs, so that a sudden price spike won’t cripple operations. The bread producer would thus gladly buy the futures contracts issued by the farmer. This is a mutually beneficial arrangement in which no money changes hands in the present, but the two parties today lock in the price at which they will exchange wheat for money in the future. (Technically we have described a forward contract, which is economically very similar to a futures contract.) The use of futures contracts and other derivatives can allow market participants to hedge away their exposure to particular price swings, where they forfeit the potential benefits of a favorable move while avoiding the downside of an unfavorable move. This is the sense in which such contracts can serve as insurance.
• Mises warns (pp. 204–06) that a depreciating currency can lead to capital consumption. For a simple example, suppose a man spends $100,000 on a machine that lasts for ten years. If prices are stable (and disregarding interest), the man needs to earn at least $10,000 each year in sales revenue over and above labor and other expenses, in order to account for the depreciation on his machine. If inflation causes him to earn far more than he originally anticipated over the years from the sale of his goods, after setting aside $10,000 each year the man might spend the remaining “profit” on fancy dinners and vacation cruises. However, after ten years (with $100,000 in hand, disregarding interest) the man may discover that because of the fall in the purchasing power of money, a new machine has a price of $200,000. Thus the man unwittingly consumed half of his capital over the decade: he started with one new machine and ended up with the means to buy only half of a new machine. The man realizes that his fancy dinners and cruises were funded not out of profits but by eating away at his business assets.
New Terminology
Capital consumption: A metaphor denoting the reduction in capital because of a failure to reinvest enough out of current output.
Futures contract: A standardized contract, traded on an organized exchange, where two parties agree to exchange a good at a specified price (the futures price) at a specified future date (the delivery date). As conditions change and alter the futures price pertaining to the delivery date, the exchange will credit or debit the accounts of the buyer and seller of the original futures contract on a daily basis to reflect the change. (If the futures price goes up, the buyer gains and the seller loses, etc.) These daily episodes of marking-to-market restore the market value of the futures contract itself to zero. Upon delivery, the seller of the futures contract delivers the good, while the buyer pays the current spot price for that date, not the futures price as originally specified.
Forward contract: Similar to a futures contract, though a forward contract is not standardized. Furthermore, there is no daily marking-to-market. On the delivery date, the buyer pays the forward price as originally specified in the contract. Thus the forward contract can achieve a positive or negative market value, as conditions change and cause the actual spot price (on the delivery date) to move above or below the originally specified forward price.
Hedging transaction: A financial transaction in which an individual attempts to reduce his or her exposure to a market outcome. For example, someone who believes that Stock XYZ will outperform most other stocks might “go long” by purchasing several thousand shares of it. But to hedge himself against a general fall in the market, he might also “go short” an index fund holding all the stocks in the S&P 500. Thus, even if XYZ falls in price, the investor will still make money, so long as Stock XYZ drops by a smaller amount than most other stocks.
Aleatory: Dependent on chance, luck, or an uncertain outcome.
Study Questions
1. Relate the following comment to Mises’s earlier discussion (p. 61) of the hypothetical possibility of fiat money: “Lenders and borrowers are not in the habit of allowing for possible future fluctuations in the objective exchange value of money.” (p. 195)
2. If the purchasing power of money unexpectedly falls, who is hurt—creditors or debtors? (p. 200)
3. What is necessary to eliminate the undesirable consequences of “unlimited inflationary policy”? (p. 203)
14. Mises writes, “If the objective exchange value of all the stocks of money in the world could be instantaneously and in equal proportion increased or decreased, [and] if all at once the money-prices of all goods and services could rise or fall uniformly, the relative wealth of individual economic agents would not be affected” (p. 207). Does Mises’s argument assume that everyone holds the same fraction of his or wealth in the form of cash balances, or does it also work if some people hold (say) large amounts of real estate, while others hold mostly cash? (Keep in mind that for this argument Mises has assumed away the problem of contracts for future goods.)
5. Explain: “Europe had exported ships and rails, metal goods and textiles, furniture and machines, for gold which it little needed or did not need at all, for what it had already was enough for all its monetary transactions.” (p. 211)
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2Questions with an asterisk signify the question is a particularly difficult one.
- 1*Questions with an asterisk signify the question is a particularly difficult one.
- 2*4. Mises writes, “If the objective exchange value of all the stocks of money in the world could be instantaneously and in equal proportion increased or decreased, [and] if all at once the money-prices of all goods and services could rise or fall uniformly, the relative wealth of individual economic agents would not be affected” (p. 207). Does Mises’s argument assume that everyone holds the same fraction of his or wealth in the form of cash balances, or does it also work if some people hold (say) large amounts of real estate, while others hold mostly cash? (Keep in mind that for this argument Mises has assumed away the problem of contracts for future goods.)
