Study Guide to the Theory of Money and Credit

Chapter Outline

1.   The Classical Idea of Sound Money

The principle of sound money must be placed in the context of the broader, classical liberal program of containing government tyranny. Just as a constitution or a bill of rights would be adopted, in light of historical abuses of civil liberties, in the same way the classical liberals of the nineteenth century wanted to prevent governments from wrecking currencies as had occurred throughout history.

Sound money involves a metallic standard, with all tokens and paper notes being redeemable in the metallic money upon demand. In practice, this has meant gold since the late nineteenth century.

Although their ideas were correct, the classical liberals did not adequately defend the gold standard from its critics, and the public fell sway to erroneous inflationary doctrines.

2.   The Virtues and Alleged Shortcomings of the Gold Standard

It is true that the public generally welcomes inflationism as opposed to the orthodoxy of the gold standard, but only because they misunderstand the true situation. Producers welcome “high prices” when it is their own prices in question, but they don’t welcome increasing prices in the items they themselves must purchase. Inflation can only give even the appearance of prosperity, in situations where the majority don’t recognize what is happening. For this reason, inflationism cannot be a lasting economic policy.

Contrary to its critics, the gold standard did not “collapse.” Rather, it was systematically and intentionally destroyed by governments bent on inflation. Those writers who blame the “rules of the gold standard game” for keeping interest rates high, do not understand the function of interest rates and how credit expansion causes economic booms and busts.

3.   The Full-Employment Doctrine

An employer will only hire a man if he is productive enough to justify the wage he expects to be paid. If the employer would lose money by hiring the man, he will remain unemployed. When government policies and unions use coercion to hold wage rates above the market-clearing level, institutional unemployment results.

In this setting, it is true that monetary inflation may cause commodity prices to rise faster than wage rates. This will decrease the unemployment rate, but only because it effectively lowers the workers’ real wages. Once the labor unions realize what is happening, they will begin demanding automatic wage increases tied to the “cost of living.” Then the apparent benefits of inflation (in reducing unemployment) will disappear.

4.   The Emergency Argument in Favor of Inflation

Some writers concede the negative effects of inflation, but argue that in certain emergency situations, it is the only method by which governments can carry out vital tasks. Yet inflation per se does not increase the physical and human resources at a country’s disposal. If an apologist for inflation claims that it is the only way to finance a war, he is admitting that the public would not agree with the government’s war expenditures if it fully understood the sacrifice they would entail.

Important Contributions

•   On pages 420–21 Mises responds to a critique of the gold standard that its opponents continue to use. Modern-day critics still say (as they did in Mises’s time) that the gold standard “collapsed” and that governments are no longer willing to play the “rules of the gold standard game.” What they mean is that governments were no longer willing to renounce the (short-term) benefits to themselves of inflation, and so they refused to redeem their currencies in specie. Yet Mises points out that the governments did much more than this. In order to wean the public off gold, they employed “policemen, customs guards, penal courts, prisons, in some countries even executioners.” In Mises’s view, governments actively combat the public’s preference for a sound commodity money. Contrary to the claims of the inflationists, maintenance of a commodity money doesn’t require a special commitment from the government, but rather requires only that the government obey its contractual obligations like everybody else in a market economy.

•   On pages 423–26, Mises places Keynesian analysis in a tradition of faulty theories going back to the “spurious grocer philosophy ... exploded by Adam Smith and Jean-Baptist Say.” These classical economists argued that a general business depression was not caused by a “dearness of money,” and consequently could not be solved by monetary inflation. Say’s discussion (which later came to be summarized as “Say’s Law”) explained that ultimately, the grocer’s customers earned the purchasing power to demand his products by first supplying their own goods and services. As an economy grew over time, the various sectors increased their output across the board. Say argued that relative prices would adjust to maintain the proper balance among the sectors, but there was not a danger that the economy as a whole could produce a “general glut” that could only be remedied by an expansion of the stock of money.

New Terminology

Institutional unemployment: The situation where workers are qualified and willing to accept jobs at prevailing wage rates, yet cannot find employers to hire them.

Real wages: Wage rates relative to the prices of goods and services.

Study Questions

1.  What was the “serious blunder” of the nineteenth-century advocates of the gold standard? (p. 415)

2.  What connection does Mises make between the gold standard and representative government? (p. 416)

3.  How did governments manage to abandon the gold standard? (p. 420)

4.  What is the only efficacious way to raise real wage rates? (p. 424)

5.  What’s wrong with the emergency argument in favor of inflation? (pp. 426–28)