Ludwig Von Mises Money and Credit Theory

Ludwig Von Mises; The Theory Of Money and Credit

Ludwig Von Mises Theory

The classical economists treated money as neutral in its economic effects, and the Walrasian neoclassical economists, past and present, do not recognize the uniqueness of money. In general-equilibrium models money is merely a numeraire—it has no properties distinguishing it from the many nonmoney goods in the model. Austrian monetary theory rejects both these propositions. It considers money to be unique because of its intertemporal exchangability, and it concentrates on the relative price effects of changes in the money supply. The theory begins with a theory of the evolution of money and concludes with an analysis of the effects of changes in money on the fundamental economic decisions of individuals.

Although Carl Menger fashioned a theory of the evolution of money that stressed the unintended consequences of individual (self-interested) be­havior, he did not succeed in solving the question of what determines the value of money. Thus, monetary theory remained separated from value theory until the two were integrated by Ludwig von Mises, one of Bohm-Bawerk's students at the Uni­versity of Vienna. Mises achieved the integration of monetary and value theory by founding both on the same principle, the marginal utility of subjective individual wants.

Subjective Use Value Versus Objective Exchange Value

Mises recognized that the marginal utility of money comes from two separate sources. On the one hand, money has value derived from the value of the goods it can buy. On the other hand, money has a subjective use value of its own because it can be held for future exchange. What we call the value of money in common parlance springs from the ability of money to be exchanged for other things. Mises called this characteristic of money its objective exchange value in order to distinguish it from money's subjective use value. Today we call it the purchasing power of money.

How then do we measure the purchasing power of money? Conventional theory advanced the concept of a unitary (aggregate) price level, whereby the purchasing power of money (the reciprocal of the price level) is the outcome of the total vol­ume of transactions in society divided by the velocity of circulation. In terms of the familiar equation of exchange (see Chapter 19) where MV = PT, the price level P would be derived as follows: P = MV/T, and its reciprocal (the purchasing power of money), MP = T/MV. Mises recognized the grain of truth in the quantity theory, namely "the idea that a connection exists between variations in the value of money on the one hand and the supply of it on the other hand," but "beyond this proposi­tion," he argued, "the Quantity Theory can provide us with nothing. Above all, it fails to explain the mechanism of variations in the value of money" (Money and Credit, p. 130).

True to the Austrian tradition, Mises rejected the macroeconomic approach to monetary theory in favor of the individualistic approach. All valuation is done by individuals; therefore the key to understanding the value of money must be in the mind of the individual. The purchasing power of a dollar is the vast array of goods that can be purchased with that dollar. This array is heterogeneous and specific. At any point of time a dollar might buy three packs of chewing gum, one pair of socks, two floppy computer disks, two sodas, one pack of cigarettes, one-tenth of a hair­cut, and so forth and so on. The purchasing power of money therefore cannot be sum­marized in some unitary price-level figure. At all times a homogeneous good must be defined in terms of its usefulness to the consumer rather than by its technologi­cal properties. Likewise, price must be related to the specific usefulness of a good, and not to its technological properties. An apartment with the same technological properties in Manhattan and in Peoria will not have the same price because they are not equally useful to the purchaser. The apartment in New York has a more desirable location with more extensive consumption possibilities and hence will be more highly priced on the market. Mises emphasized locational (and temporal) aspects in explaining differences in the value of technologically similar goods, and this in turn complements the Austrian notion that the purchasing power of money is equal to an array of goods.

In applying the theory of marginal utility to the price of money, Mises confronted a thorny analytical problem. When an individual ranks coffee or shoes or vacations on a value scale, he or she values those goods for their direct use in consumption, and each valuation is independent of and prior to its price on the market. However, people hold money not because it can be used directly in consumption but because it can eventually be exchanged for goods that will be used directly. In other words, money is not useful in itself. It is useful because it has a prior exchange value—a preexisting purchasing power. The demand for money therefore not only is not in­dependent of its existing market price but derives precisely from its preexisting price in terms of other goods and services. And therein lies the problem. If the demand for money, and hence its utility, depends on its preexisting price or purchasing power, how can that price be explained by the demand? Mises' critics accused him of falling into a circular trap

Mises avoided the trap by means of a regression theorem. The demand for money on any given day, say day D, is equal to its purchasing power on the previous day, D-\. The demand for money on the previous day, D - 1, in turn was equal to the purchasing power of money on D - 2, and so on. In other words, the demand for money always has a historical (i.e., temporal) component. But is this not an infinite regression backward in time? No, Mises answered, we must push the analysis back­ward only to that point when the commodity used as money was not used as a medium of indirect exchange but was demanded instead solely for its own direct con­sumption use. Suppose we go back in time to the point when gold was introduced as money. Let us assume that before this day, all trade took place by barter. On the last day of barter, gold had value only for its direct consumption use, but on the first day of its use as money, it took on an additional use as a medium of exchange. In other words, on the first day of its use as a medium of exchange, gold had two di­mensions of utility: first, a direct consumption use; and second, a monetary use which had a historical component in its utility.

Evaluating this regression theorem, Murray Rothbard, a student of Mises, pointed out the continuity between Mises and Menger, who emphasized the evolutionary and institutional elements of money:

Not only does the Mises regression theorem fully explain the current demand for money and integrate the theory of money with the theory of marginal utility, but it also shows that money must have originated in this fashion—on the market—with individuals on the market gradu­ally beginning to use some previously valuable commodity as a medium of exchange. No money could have originated either by a social compact to consider some previously valueless thing as a 'money' or by sudden governmental fiat. For in those cases, the money commodity could not have a previous purchasing power, which could be taken into account in the individual's demand for money. In this way, Mises demonstrated that Carl Menger's historical insight into the way in which money arose on the market was not simply a historical summary but a theo­retical necessity ("The Austrian Theory of Money," p. 169).