Study Guide to the Theory of Money and Credit

Chapter Outline

1.   On the Nature of the Problem

Interest accrues as the difference between what a producer pays upfront for inputs versus the total revenue he receives for the product (down the road). Up till now in the book, we have studied the forces that can change the exchange ratio between money and consumer goods, or what are called goods of the first order. Now we will investigate whether changes in the supply of and demand for money can affect the money-prices of goods of higher orders (i.e., producer goods) to a different extent.

Tooke, Fullarton, and other members of the Banking School thought that the banks had no power to influence prices, because any excess issue of fiduciary media would be immediately returned to them. Yet Lord Overstone, Torrens, and other members of the Currency School thought otherwise. They correctly recognized that by lowering the rate of interest, the banks could induce the public to accept more fiduciary media. This is the mechanism through which bank credit policy can influence the purchasing power of money and the rate of interest.

2.   The Connexion Between Variations in the Ratio Between the Stock of Money and the Demand for Money and Fluctuations in the Rate of Interest

There are three senses in which variations in the stock of and demand for money can influence the rate of interest. First, in the case of metallic currency, such variations can directly affect the rate of interest by directly affecting the subsistence fund. For example, a fall in the demand to hold gold as money, will release gold into industrial purposes and thereby make the community wealthier, in the same sense as if the amount of wheat stored in silos had increased.

Variations in the stock of and demand for money can influence the rate of interest indirectly and in the long run, by permanently changing the distribution of property and income. For example, a reduction in the stock of money could redistribute wealth into the hands of creditors, who tend to save more. Thus the rate of interest would be permanently lower because the overall rate of saving would have increased.

Finally, variations can influence the rate of interest in the short run as prices adjust to the new realities of the stock of and demand for money. When prices are generally rising, the rate of interest tends to be higher, as entrepreneurs are willing and able to offer more to borrow money. (Nowadays this is called a purchasing power or inflation premium in the contractual rate of interest.) When prices are falling, the rate of interest tends to be lower.

3.   The Connexion Between the Equilibrium Rate and the Money Rate of Interest

When the banks issue more fiduciary media, the immediate result is a reduction in the rate of interest. Because the banks typically invest the new issue themselves, or lend it to businesses for productive investment, the subsistence fund tends to increase and the rate of interest will remain permanently lower than the original level (though not as low as it was after its initial drop). However, there is no quantitative relationship between the amount of new fiduciary media issued, and the fall in the interest rate. Indeed, no matter how much new money the banks create and lend out, they will never force the contractual rate of interest below zero percent.

The gratuitous nature of credit refers to the fact that the banks can push down the rate of interest apparently at will. Are there any forces tending to reestablish the natural premium of present versus future goods? Wicksell argued that if the banks push the Money Rate of Interest below the Natural Rate of Interest, that forces will eventually restore the Money Rate back to the Natural Rate. But his argument for why this should occur is unsatisfactory.

4.   The Influence of the Interest Policy of the Credit-Issuing Banks on Production

As Böhm-Bawerk explained [see Technical Notes], the rate of interest governs the time for which resources are “tied up” in production processes. The lower the rate of interest, the longer the processes that entrepreneurs will select. In equilibrium, the money rate of interest equals the natural rate, and entrepreneurs invest resources in processes such that their fruits (consumption goods) are completed just as the available savings (subsistence fund) is exhausted. It is technically possible to lengthen the structure of production, but without additional savings, the subsistence fund will not be able to feed the workers while they labor in the longer processes.

When the banks lower the money rate of interest by issuing fiduciary media, they induce entrepreneurs to act as if the subsistence fund had really grown (when in fact it has not). Entrepreneurs borrow money at the lower rates, hire workers, and try to bid away resources from others to begin longer-term processes. A general boom period ensues, where most people feel prosperous.

Yet because the issue of fiduciary media doesn’t actually make society richer, the boom must necessarily come to an end. There are physically not enough savings to carry society forward, until the time when the new (longer) processes yield their final consumption goods. A bust (what we now call a recession) sets in. As the output of consumption goods declines, their prices rise. Realizing their errors, the entrepreneurs discontinue those projects that were only apparently profitable, because of the false interest rate. The prices of producer goods fall, and the money rate of interest returns to the natural rate.

5.   Credit and Economic Crises

In practice, the bust occurs when the banks slow down their issue of further fiduciary media, thereby allowing the money rate to rise toward its proper level. Yet even if the banks stubbornly tried to hold the money rate down, eventually they would fail. The growing expansion of the quantity of money in the broader sense drives prices higher and higher, and lenders insist on greater and greater premiums in the contractual rate of interest. The longer the banks hold the money rate below the natural rate, the worse is the eventual crisis.

Technical Notes

•   Eugen von Böhm-Bawerk was a successor of Menger and a predecessor of Mises in the development of Austrian economics. One of Böhm-Bawerk’s great contributions was to explain the capitalists’ interest income as a premium given to present versus future goods. For example, suppose consumers would pay $50 for a mature Christmas tree, but would only pay $40 for an airtight claim guaranteeing them a mature Christmas tree to be delivered in twelve months. If these were the final prices as determined by consumers’ subjective preferences, then the market price for an immature tree—one that needed another year to fully develop—would be $40 as well. Assuming nothing else changed, a capitalist who invested $40 in such a tree could wait one year, then sell the mature version for $50, netting a 25 percent annual return on his capital. Thus Böhm-Bawerk explained the ability to earn interest over time as due to the underlying subjective preference for present versus future goods. A capitalist who buys factors of production invests in “future goods” which then grow in market value as they ripen into “present goods.” Also note that the term “ripen” is not reserved for agricultural products: Böhm-Bawerk would say that a capitalist can invest (say) $100,000 in lumber, shingles, labor, and other inputs which represent a future house. Over the months, as the house is built, the goods-in-process gradually become a present house, and hence command a higher market value than the initial $100,000 investment.

•   In explaining the boom and bust cycle, Mises relies on Böhm-Bawerk’s capital theory. Böhm-Bawerk viewed the use of capital goods as a “roundabout” way of satisfying goals. For example, if someone wants to get coconuts from tree branches, a direct approach is to climb the tree and grab them with his bare hands. Yet a more roundabout (and physically productive) approach is to spend some time gathering sticks and vines, in order to construct a long pole. Then with this capital good, the person can knock down far more coconuts per hour of his labor. The tradeoff then is between getting more physical output per unit of labor, versus getting the coconuts sooner rather than later. (If the person is ravenous and wants to eat a few coconuts as quickly as possible, he will just climb the tree rather than search for sticks.) Böhm-Bawerk argued that the rate of interest reflected the community’s preferences for the timing of consumption as well as the technical opportunities for increased output resulting from further lengthening (or making more roundabout) the methods of production. If some people in the community saved more (by stockpiling coconuts, say), then the workers would be able to eat while production shifted out of tree-climbing and into pole-production. The savings would have augmented the subsistence fund to tide everyone over until the higher output of the more roundabout processes came online. The rate of interest in this scenario would permanently decline, and society would advance to a permanently higher standard of living, as workers could gather more coconuts per hour with the use of their new tools.

New Terminology

Interest: Income accruing to the owner of future goods as they mature into present goods, due to the higher valuation placed on present versus future goods.

Goods of the first order: Consumer goods.

Goods of higher orders: Goods used to produce consumer goods. (A capital good used to produce a consumer good is a second-order good. A capital good used to produce a second-order good is a third-order good, etc.)

Subsistence fund: A concept used by Böhm-Bawerk to denote the savings the capitalists must have first accumulated, in order to feed and otherwise support the workers as they engage in time-consuming production processes.

Purchasing power/inflation premium: An increase in the contractual rate of interest due to the expected rise in prices.

Study Questions

1.   What is “the problem,” the nature of which is outlined in section 1? (pp. 339–46)

2.   Why might the distribution of income and property alter the long-run rate of interest? (p. 347)

3.   If the Money Rate of Interest is pushed below the Natural Rate of Interest (or more accurately, the normal rate of interest), what happens to commodity prices, according to Wicksell? (p. 355)

4.   What are the two main mechanisms by which the money rate of interest rises back to the natural rate, after having been pushed down by the banks? (pp. 362–63)

5.   Explain: “Certainly, the banks would be able to postpone the collapse; but nevertheless ... the moment must eventually come when no further extension of the circulation of fiduciary media is possible. Then the catastrophe occurs....” (p. 365)