Study Guide to the Theory of Money and Credit

Summary

Originally, citizens judged the success of monetary policy by the soundness of the coinage it maintained in circulation. In modern times monetary policy refers to government (or central bank) efforts to alter the purchasing power of money. The chief instrument through which the State carries out monetary policy is its strong influence on the kind of money used by the citizenry.

Inflationism is that monetary policy that seeks to increase the quantity of money. Naïve inflationism believes that money constitutes wealth, and that creating more money will turn poor into rich. A second group of inflationists understands that printing more money will cause prices to rise, but endorses the policy because they want to help debtors or achieve some other goal. A third group of inflationists understands that the policy in general will wreak economic havoc, but they support it too because they believe some essential government programs sometimes must be paid for through an “inflation tax.” Economics can say, without making any value judgments, that inflationism is a very poor policy for achieving its stated objectives.

Restrictionism or deflationism is policy that aims at raising the objective exchange value of money. It is unpopular for various reasons.

Because neither inflationism nor deflationism is capable of achieving its stated objectives, the only sensible monetary policy is one that aims at eliminating all government interference with the purchasing power of money. In practice, this means a rigid adherence to a commodity standard, which in modern times means either the gold or silver standard.

In technical economic theory, the only coherent definition for inflation is an increase in the quantity of money (in the broader sense of the term) that is not offset by a corresponding increase in the demand for money (in the broader sense of the term), with the necessary result being a fall in the purchasing power of money. Deflation is the opposite, namely a reduction in the quantity of money that is not offset by a fall in the demand for it, such that prices tend to fall. The economist who wishes to influence public policy and avert disaster shouldn’t lecture others on their sloppy use of terminology, but instead should expose the errors of inflationism.

Chapter Outline

1. Monetary Policy Defined

Originally, citizens judged the success of monetary policy by the soundness of the coinage it maintained in circulation. If and when governments violated that trust by debasing the coinage, it was for fiscal (i.e., budgetary) ends: the authorities needed more money and so turned to inflation.

In modern times, however, governments use monetary policy to achieve other socio-political aims. Although particular factions may favor one monetary policy versus another because of the specific advantages they expect to derive—for example, the owners of gold mines favoring a return to the gold standard—in general monetary policy nowadays refers to government (or central bank) efforts to alter the purchasing power of money.

2.   The Instruments of Monetary Policy

The chief instrument through which the State carries out monetary policy is its strong influence on the kind of money used by the citizenry. As controller of the mint and sole issuer of money substitutes, the modern State has wide discretion in this “choice” by its subjects. If the State decides to remain on a metallic standard (such as gold or silver), then it still must choose which precious metal. More generally, if the State opts for a credit or fiat money, then the State has the further option of altering the quantity of money at will, to achieve its objectives regarding the purchasing power of money.

3. Inflationism

Inflationism is that monetary policy that seeks to increase the quantity of money. Naïve inflationism believes that money constitutes wealth, and that creating more money will turn poor into rich. A second group of inflationists understands that printing more money will cause prices to rise (an elementary fact that the first group fails to see). Yet even so this second group endorses the policy, because they want to help debtors, or achieve some other goal, by raising prices. Finally, a third group of inflationists understands that the policy in general will wreak economic havoc, but they support it too because they believe some government programs (such as defense from foreign invaders) are absolutely essential, and sometimes must be paid for through an “inflation tax.”

This third defense of inflation underscores the anti-democratic nature of the policy. Its proponents candidly admit that the public would never support certain programs (such as major wars) if they were forced to explicitly bear the full financial burden through taxation or government deficits financed by genuine savings. But when the programs are funded (partially) through the printing press, it is not clear to the average voter what is causing prices to rise and his standard of living to fall. He blames unions or currency speculators, not government spending.

Ironically, if the public anticipates a sharp future decline in the purchasing power of money because of an influx of new notes (printed by the government), then prices in the present can rise in expectation. Yet until the new notes physically exist, there may appear a shortage of notes. Thus the public and academics may clamor for more inflation, in order to satisfy the apparent “needs of commerce.” Yet it is inflationism itself that has caused the problem, and further bouts will only exacerbate the situation.

Economic science cannot judge the policy objectives of inflationism; it cannot say whether it is proper to (say) help debtors or exporters at the expense of others. But what economics can say, without making any value judgments, is that inflationism is a very poor policy for achieving its stated objectives. Each of its alleged goals (helping debtors, helping exporters, etc.) can be achieved much more directly by other interventions besides a general debasement of the monetary unit. In this sense economics can criticize inflationism.

4.   Restrictionism or Deflationism

Restrictionism or deflationism is policy that aims at raising the objective exchange value of money. It is unpopular for various reasons. First, governments do not benefit from it because they must sacrifice potential spending in order to (say) retire some of the notes collected through taxation. Second, a nation with an appreciating currency would see a “deteriorating” trade balance in the eyes of the public, which is also unpopular. Finally, the primary beneficiaries of deflationism are creditors, who generally speaking are a small and unpopular group.

The only time deflationism is politically viable occurs after a period of inflationism, either for matters of prestige or to assure international creditors to continue using a certain country’s financial institutions. Yet even here, a policy of deflationism does not simply reverse the harms of the prior inflation, but instead causes many new harms of its own. For example, many of the creditors who will be helped by the current round of deflation were not the same people harmed during the inflation. In general it must be concluded that deflationism is a poor method for achieving the specific aims of its proponents.

5.   Invariability of the Objective Exchange Value of Money as the Aim of Monetary Policy

If neither inflationism nor deflationism is capable of achieving its stated objectives, the only sensible monetary policy is one that aims at eliminating all government interference with the purchasing power of money. In practice, this means a rigid adherence to a commodity standard, which in modern times means either the gold or silver standard.

6.   The Limits of Monetary Policy

As all government efforts to influence the purchasing power of money must ultimately work through the subjective valuations of individuals, in this realm as in others the government’s power is limited. The authorities cannot anticipate the precise, long-run effects of their efforts to manipulate the currency, and this is one of the strongest arguments against such manipulation in the first place.

7.   Excursus: The Concepts Inflation and Deflation

In technical economic theory, the only coherent definition for inflation is an increase in the quantity of money (in the broader sense of the term) that is not offset by a corresponding increase in the demand for money (in the broader sense of the term), with the necessary result being a fall in the purchasing power of money. Deflation is the opposite, namely a reduction in the quantity of money that is not offset by a fall in the demand for it, such that prices tend to fall. However, outside the realm of technical economics, the terms inflation and deflation have certain connotations. The economist who wishes to influence public policy and avert disaster shouldn’t lecture others on their sloppy use of terminology, but instead should expose the errors of inflationism.

Technical Notes

•   On page 219 Mises writes, “If a country has a metallic standard, then the only measure of currency policy that it can carry out by itself is to go over to another kind of money.” What Mises has in mind—and this is borne out by the important phrase “by itself”—is that the classical gold standard placed strict limits on each of the participating countries. In the period before the first World War, for example, the United States government pegged the dollar to 23.22 grains of gold (working out to around $20.67 per ounce), while the British government pegged its own currency at the rate of £4.25 to an ounce of gold. Thus the exchange rate between the dollar and British pound was fixed at $4.86 to a pound. If the United States government began printing up excessive amounts of new dollars, this would tend to cause domestic prices (quoted in dollars) to rise faster than they did (quoted in pounds) in Great Britain. Americans would start importing more from (cheaper) British producers, and the resulting trade deficit would allow the British to accumulate more and more dollars. This in turn would put pressure on the foreign exchange rate, which would (under a fiat standard) simply cause the dollar to depreciate against the British pound. But since both currencies were tied to gold at fixed rates, the falling dollar would open up an arbitrage opportunity for speculators to turn their dollars into the U.S. authorities in exchange for gold. Thus, as its gold reserves began to dwindle, the U.S. would have to abandon its inflationary path. Thus a metallic standard keeps sharp limits on the inflationary policies of any single country.

•   On page 227 Mises writes, “In all countries where inflation has been rapid, it has been observed that the decrease in the value of the money has occurred faster than the increase in its quantity.” On the following page he explains that the value of money is influenced by both supply and demand. For a modern example, suppose that the Chairman of the Federal Reserve announced that he would cause the quantity of U.S. dollars to rise by a factor of 1,000 in the course of a week. Even ignoring the step-by-step process of inflation, the end result would not simply be a general 1,000–fold rise in prices. Instead, prices (quoted in U.S. dollars) would rise by much more than that, because Americans would no longer want to hold dollars. They would no longer view the dollar as a safe currency, and would seek to replace their dollar holdings with either other currencies or perhaps the precious metals. In order to restore equilibrium, then, prices would have to rise not merely on account of the extra quantity of dollars, but also because of the sharp drop in the subjective desire to hold them.

New Terminology

Monetary policy: Government or central bank efforts to alter the purchasing power of money.

Inflationism: Monetary policy that seeks to increase the quantity of money.

Naïve inflationism: Inflationism supported by the belief that money constitutes wealth.

Inflation tax: The redistribution of wealth from the citizenry to the government (or its designated beneficiaries) through inflation.

Restrictionism/Deflationism: Monetary policy that aims at raising the objective exchange value of money.

Inflation: An increase in the quantity of money (in the broader sense of the term) that is not offset by a corresponding increase in the demand for money (in the broader sense of the term), with the necessary result being a fall in the purchasing power of money. (Note that this is a technical economic definition, not necessarily having the connotations of “inflation” in popular discussions.)

Deflation: A reduction in the quantity of money that is not offset by a fall in the demand for it, such that prices tend to fall. (Note that this is a technical economic definition, not necessarily having the connotations of “deflation” in popular discussions.)

Study Questions

1.   What unflattering possibility does Mises suggest regarding Ben Franklin’s support of paper money early in his career? (p. 217)

2.   Why does “naïve inflationism” recommend an increase in the quantity of money? (pp. 219–20)

3.   Is it possible for someone to support inflationism, even if he understands that it will have grave economic consequences? (pp. 221–22)

4.   Explain: “[I]nflation becomes the most important psychological resource of any economic policy whose consequences have to be concealed; and so in this sense it can be called an instrument of unpopular, i.e., of anti-democratic, policy, since by misleading public opinion it makes possible the continued existence of a system of government that would have no hope of the consent of the people if the circumstances were clearly laid before them.” (pp. 223–24)

5.   Would Mises have been surprised by the second half of the twentieth century, since he writes, “In the long run, a money which continually fell in value would have no commercial utility. It could not be used as a standard of deferred payments” (p. 227)?