MISES CONTRIBUTIONS TO MONETARY THEORY

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1 Shannon Pietrangelo MISES CONTRIBUTIONS TO MONETARY THEORY Sit down before fact like a little child, and be prepared to give up every preconceived notion, follow humbly wherever and to whatever abyss Nature [of money] leads, or you shall learn nothing. ~T.H. Huxley In 1934 the English language translation of Ludwig von Mises Theorie des Geldes und der Umlaufsmittel was published which meticulously disclosed revolutionary analysis in Austrian monetary theory. It is the purpose of this investigation to discover what specific contributions Mises made to the monetary theory of the Austrian School, as well as his contributions to monetary theory for economics in general, and understand the significance of his analysis in this area of economics. CARL MENGER: CONTRIBUTIONS TO MONETARY THEORY Carl Menger, the founder of the Austrian School of Thought, formulated an innovative method of economic analysis in his investigative work, Principles of Economics. Menger s contributions to economic method, insightful analysis of problems facing economic theory, along with his own theory on the origin of money, paved the way for Mises later work on monetary theory. The fundamental principles laid out by Menger do not solely find their importance in the work that ensued from his analysis, but still find relevance today for one to obtain a comprehensive understanding of economics, and more specifically, to fully understand Mises contributions to monetary theory. The first, and most significant, foundation from which the entire Austrian method finds its genesis is Menger s consistent evaluation of all economic phenomena through analysis of the individual. Today, this approach is called methodological individualism and it is the keystone of the Austrian method. Methodological subjectivism asserts that 1

2 value judgments, and decisions based on those value judgments, are formed in the minds of each individual. Methodological subjectivism takes those value judgments and consequent decisions as given in an attempt to discover economic phenomena and theory from the individual s point of view. The Austrian method begins economic analysis from a priori axioms, or axioms assumed to be true that can be learned by reason alone with out prior knowledge or understanding, and employs deductive reasoning in search of economic truths that are universally applicable. An example of such an a priori axiom would be the truth that action happens through the passing of time. This fact is true for any system of logic and can be learned at once by any logical person with out prior knowledge on the subject. Menger asserts his intent: This is the ground on which I stand. In what follows I have endeavored to reduce the complex phenomena of human economic activity to the simplest elements that can still be subjected to accurate observation, to apply to these elements the measure corresponding to their nature, and constantly adhering to this measure, to investigate the manner in which the more complex economic phenomena evolve from their elements according to definite principles. (Menger 46-7) Menger is attempting to demonstrate that all economic phenomena can be deduced from definite axioms or laws. He further makes a clear distinction that it is not the task of economic theory to determine the rules pertaining to economic action but the conditions that presupposed by such action (Menger 47). Menger s next contribution was the discovery of marginal utility 1 in The discovery was made simultaneously by William Stanley Jevons and Léon Walras independently of Menger. Marginal utility relates to the least important use, or marginal use, that an individual considers when deciding to acquire an additional unit of a homogenous supply of goods. It is this marginal use to which an individual attaches value when deciding to increase (or decrease) his supply by an additional unit. As James Randolph Edwards neatly defines it, The utility of the marginal unit was simply the importance to the individual of the end which could no longer be obtained when a unit of supply was lost (Edwards 14). From Menger s work the law of diminishing marginal utility was derived, which states that as the supply of units increases, their marginal 1 Menger is not credited with coining the actual term, marginal utility. 2

3 utility (usefulness) decreases 2 because each additional unit is applied to the most important unsatisfied want for use and, over time, to less important uses until the utility derived in attainment of an additional unit is no longer valued more highly than the current unsatisfied want for use. Here one can clearly see the subjective value theory so important to Mises work and that of his predecessors. Namely, that an individual s valuations determine human action; one weighs anticipated costs with expected utility (or psychic satisfaction) when determining how to act. These individual actions based on subjective valuations will prove to be the basis for all economic phenomena. In the development of methodological subjectivism Menger identified key elements lacking in previous economic analysis. The first two, causality and time, are explicitly linked. To understand economic phenomena one must first look to the actions of individual actors that are based on each individual s subjective valuations. When an individual decides to act, time is necessary to carry out those actions, as all action must take place in time. Causality is first an action and then the result of that action, a means and an end. Menger illustrates it best: The idea of causality, however, is inseparable from the idea of time. A process of change involves a beginning and a becoming, and these are only conceivable as processes in time. Hence it is certain that we can never fully understand the causal interconnections of the various occurrences in a process, or the process itself, unless we view it in time and apply the measure of time to it. (Menger 67) As Menger has stated, for the cause and effect of action to be realized and observed, time is necessary. The means chosen by an individual are based on his subjective valuations, faced with needs (or wants) and limited resources available to him. This analysis presents a third key element identified by Menger and influential to Mises own contributions, scarcity. Scarcity is the condition of every human being, unlimited wants and needs in a world of limited, or scarce, resources. Scarcity is the defining characteristic of all economic goods. As has been stated, and logically deducible, an individual must take the condition of scarcity into account when making economic decisions and plans. Hayek makes note of Menger s insight, It is somewhat difficult to 2 The inverse is true as well; as the supply of units decreases, their marginal utility increases. 3

4 believe now that Menger was the first to base the distinction between free and economic goods on the idea of scarcity, he then adds, [ ] while all of Menger s analysis is grounded on the idea of scarcity, this simple term is no where used (Hayek qtd. in Menger 18). Menger s fore mentioned contribution to the subjectivist theory of value require a second evaluation for the purposes of understanding Mises contributions to monetary theory. Menger s analysis of the subjective use value of goods, or utility, was central to Mises final solution and explanation of the demand for money and his success in applying marginal utility analysis to that demand. Menger states, Things that can be placed in a causal connection with the satisfaction of human needs we term useful things. If, however, we both recognize this causal connection, and have the power actually to direct the useful things to the satisfaction of our needs, we call them goods (Menger 52, italics original). This insightful statement sheds light on the causal connection between human needs, the belief that, through action, one might be able to satisfy those needs, and lastly, a decision to direct one s actions towards satisfaction of his needs because he believes this end is attainable. This analysis set forth by Menger was in stark contrast to the cost theory of value espoused by some members of the Classical school of thought. The cost theory of value purports that it is the inputs of labor and materials that determine the value of the final output. For example, when determining the value of a loaf of bread, the cost to attain the materials would be taken into account, as well as the labor supplied to transform the materials, the use of equipment, and costs of transport etc. What Menger s subjective theory of value did, in effect, was completely reverse the process of valuation. The subjectivist theory of value would first acknowledge that individuals value bread to a certain degree, and the inputs to make the bread are ascribed value solely because bread, the final product, was valued in the first place by individuals. Menger s exposition of value is clearly a further analysis based on the individual and the subjective valuations of the individual. Though this description may seem simplistic at first glance, it is a core element of Austrian theory. In addition to Menger s methodological foundations of Austrian theory and the discovery of marginal utility, Menger made specific contributions to monetary theory as well. Menger begins his analysis with the isolated economic household and progresses to 4

5 the pure state of barter. He notes that an individual enters into trade as he becomes more fully aware of his economic interests and that his needs can be more fully satisfied through exchange (Menger 227). Today, we call barter direct exchange. It is through the analysis first of direct exchange that Menger differentiates between two core concepts pertinent to monetary theory: use value and exchange value. Menger poignantly reiterates, Value, we saw, is the importance a good acquires for us when we are aware of being dependent on command of it for the satisfaction of one of our needs that is, when we are conscious that a satisfaction would not take place if we did not have command of the good in question (Menger 227). The value just described is use value. Menger makes special note that one must realize that he is dependent on a good for his own satisfaction, and that only through recognition of this fact does one ascribe value to that good. Should an individual have a good that a second individual desires, and similarly, the second individual has a good that the first desires, an opportunity for direct trade emerges. The original stock of goods each man possesses has taken on exchange value, the goods have taken on value in exchange. Menger defines these concepts: [U]se value, therefore, is the importance that goods acquire for us because they directly assure us the satisfaction of needs that would not be provided for if he did not have the goods at our command. Exchange value is the importance that good acquire for us because their possession assures the same result indirectly (Menger 228, italics original). 3 Menger comments that economic goods usually have both use value and exchange value. Menger s next contribution to monetary theory was his own theory on the origin of money. Menger carefully illustrates how an individual, aware of his economic interests, soon realizes that there exist opportunities to gain through trade. Building on the prior discussion of direct exchange, Menger fully realized that the elements needed to overcome the slow process of direct exchange were always present (Menger 228). Problems occur in direct exchange; a simple example is the situation where an individual wants a good from another, but the second individual does not want what the first has to trade. The first must then find another individual who wants the good he has to offer 3 The use of the terms directly and indirectly in this quote are here referring to satisfaction and not direct or indirect exchange. 5

6 and, in trade, has a good the second individual desires as well. The situation could be laborious, but perhaps still not as laborious as providing for all needs on one s own. Over time, certain goods are found to be more easily traded than others. Menger calls these goods more saleable. Individuals acquire these goods specifically because they facilitate trade; they have a higher exchange value. When a good is acquired for the purpose of further employment in trade it becomes a medium of exchange. As certain goods become more popular among members of a society they are called the common medium of exchange. Money emerges in this way. The most commonly accepted medium of exchange is soon a society s money. When a medium of exchange is employed to attain goods for final consumption, it is called indirect exchange. Money is the common medium of exchange employed in indirect exchange. Menger contends: As each economizing individual becomes increasingly more aware of his economic interest, he is led by this interest, without agreement, without legislative compulsion, and even without regard to the public interest, to give his commodities in exchange for other, more saleable, commodities, even if he does not need them for any immediate consumption purpose. (Menger 260, italics original) This statement has strong implications for monetary theory. First, it is important to note that, over time, as individuals realized that certain commodities traded with more ease and aimed at acquiring those commodities to then acquire goods for the satisfaction of their needs, the precious metals eventually became the most saleable commodities for these purposes. The most important implication of Menger s statement (above) is that indirect exchange is a social phenomenon due to man s care for his own economic interest. That Menger acknowledges that the introduction of indirect exchange was not born of social agreement, compact, or a decree of law, he shows, then, that the emergence of money was a spontaneous occurrence of the actions of individuals. Again, Menger arrived at this significant conclusion by analysis of the individual. In his article, On the Origins of Money, Menger ardently begins, There is a social phenomenon which has from of old and in a peculiar degree attracted the attention of social philosophers and practical economists, the fact that certain commodities [ ] becoming universally acceptable media of exchange. In this article Menger finds task in explaining why an individual would acquire a good, not needed for consumption 6

7 purposes, but solely to secure the attainment of other goods and to uncover the origin of this phenomena. Menger refutes the historical explanation of the genesis of money, that money was born of convention or legal decree, first with the most logical and simple argument, namely, that there does not exist any historical evidence of this event. He further defends his argument conceding that even if the precious metals were chosen by convention or law, the choice presupposes the origin of money and its function in exchange; the problem is merely pushed back. The looming questions, Who would design media of exchange without first having need or want for it? Where did that need or want for money arise? are still left unsolved. Menger s explanation for the origin of money has been discussed above, and from this discussion Menger finds evidence to sustain his argument that the origin of money was not premeditated but was the spontaneous outcome of individuals acquiring commodities with higher degrees of saleability for the sole purpose to employ them in further acts of exchange to satisfy their needs. In the final analysis of Menger s work on monetary theory, one will find additional and significant contributions. First, Menger identified that money s primary function as a common medium of exchange to facilitate trade transactions and dually noted that all other functions attributed to money are secondary (Menger 280) 4. This insight will prove to be of strong importance to Mises own analysis on the nature of money. Menger shed light on the ways in which money might be employed as a general measure of price, but not without warning of some fallacies that can develop from this notion. Menger describes the convenience for an individual to describe the exchange value of one commodity in terms of another (Menger 273). When people consider a purchase, they say to themselves, This item costs X amount of dollars, and then decide which has more value to themselves, the item or the dollars necessary to exchange and attain the item. However, Menger warns of the inadequacy of employing money as a price index or measure of value because of the lack of a stable inherent value in money noting, [ ] money therefore provides a reliable measure of exchange value for any given moment but not for different points in time (Menger 273). In Economica, Enrich Roll writes, [Menger] exposes, however, the fallacy which often arises through the 4 The primary and secondary functions of money will be discussed more thoroughly in a later section. 7

8 belief that money is a measure of value in a more definite and technical sense. [ ] Price must simply be regarded as a relation between money and goods which is, moreover, changeable (457). 5 Menger s insight to money, as a commodity, having a relation to other commodities establishes yet another fundamental element from which Mises own work evolved. One can infer from this Menger s precocious understanding of the nonneutrality of money defended so heavily by Mises. Lastly, Roll offers the final contribution of Menger to monetary theory, that being, Menger s analysis of the demand for money. Roll relates, [Menger] shows the demand for money to be nothing more than the demand of individuals for money, i.e., for the services which money renders. It should, therefore, be investigated in comparison and contrast with their demand for other goods (Roll 458). However, even Menger himself identified that shortcomings of his own analysis of monetary theory and the problem of the value of money still ran rampant in the world of economics. In On the Origins of Money, he writes, The enigmatic phenomenon of money is even at this day without an explanation that satisfies; nor is there yet agreement on the most fundamental questions of its nature and functions. Even at this day we have no satisfactory theory of money. Questioning whether money is an organic member in the world of commodities or an economic anomaly Menger leaves the problem of the value of money unsolved. Menger s devastatingly insightful contributions to monetary theory, as well as Austrian methodology, provided the fundamental ground work from which Mises own contributions were able to be built upon. FRIEDRICK von WIESER: CONTRIBUTIONS TO MONETARY THEORY Friedrich von Wieser, an intellectual successor to Menger in the Austrian School, was the second predecessor to Mises. In the specific area of monetary theory, Wieser s greatest contribution was the continuation of Menger s methodology. While Wieser did put forth his own theories in many areas of monetary theory, his analysis proved to be a point of disagreement for Mises. However, by putting forth his ideas, Wieser 5 Roll draws his analysis from The Collected Works of Carl Menger, Volume IV, a text unobtainable to the author. 8

9 inadvertently gave Mises material to digest and interpret while Mises toiled at his own analysis. The majority of Mises criticisms concern Wieser s work on the value of money. Places of divergence from Wieser s work include his analysis of total value (Mises, 1934 [1981], 59), portions of Wieser s analysis of the objective exchange value and total demand for money (Mises, 1934 [1981], 158-9), and Wieser s discussion of alterations in the objective exchange value, or purchasing power, of money (Mises, 1934 [1981], 180-5). These areas of divergence are, in fact, a contribution of Wieser. However, Mises did accredit two portions of Wieser s work. The first piece of Wieser s work that Mises notes as influential was Wieser s objection to the old quantity theory of money and its explanation of purchasing power of money. 6 Thus, the first contribution of Wieser was his identification of the historical element in the basis for purchasing power. Wieser sets forth his insight in Social Economics, There is a temporal parallelism which suggests some sort of causal connection between the two processes of the depreciation of money and the disappearance of the rural natural economy as it was absorbed into the monetary economy (Wiser 287). 7 While Mises credits Wieser s insight in The Theory of Money and Credit, Wieser s solution and analysis to the purchasing power of money found criticism with Mises (Mises 139). In The Theory of Money and Credit Mises notes Wieser s definition of the exchange value of money. Mises includes this quote from Wieser s book, Natural Value, The exchange value of money is the anticipated use-value of the things that can be obtained with it (Wieser qtd. in Mises 1934 [1981]119). This definition sheds light on the simple fact that individuals value money because they assume it to have a a certain purchasing power (Mises, 1934 [1981] 119). Wieser s definition is a key element in explaining the value of money. However, Wieser, too, failed at solving the problem of the value of money. In his discussion of the objective exchange value of money he writes: 6 The old quantity theory consisted of the application of supply and demand to money to account for changes in the purchasing power of money and the price level. The neo-classical quantity theory, commonly called the equation of exchange put forth by Irving Fisher, MV=PQ; where M is money stock, V is velocity, P is price level, and Q quantity was not employed at the time of Wieser s work. 7 The rural natural economy refers to a state of direct exchange, while the monetary economy refers to a state of indirect exchange. 9

10 [I]t is implied that because of the general price level, money has a certain significance for everybody in the economic process. This significance of the value of money is more clearly experienced when economic changes affect its purchasing power than under conditions of perfect stability. The statement that money has risen or fallen in value does not merely inform us that the general price level has gone up or down [ ] it gives us to understand that simultaneously with the general change of prices, money has taken on a different value for everybody. In this statement it is predicated that the relation of the unit of money to that of utility has changed; that in order to cover the same marginal use, more or less money as to be expended. [ ] Accordingly we may define the value of money more accurately as the significance attaching to a unit of money because of its relation to a unit of utility. (Wieser 263, italics inserted by current author) Wieser has the correct idea in mind; that money, like all economic goods, is valued because of marginal utility. One must make note, though, that Wieser is still using cardinal utility. His analysis omits the logical explanation of how this value is subject to change and the origination of this value. In addition, Wieser offers another comment telling of his err in analysis, The value of money is not an objective value; it is the general cross-section of the subjective or personal valuations of money; it is the value as to which all persons are agreed (Wieser 263). That the objective exchange value of money finds its value in the subjective valuations of individuals is true indeed. His analysis, however, fails to explain the process by which the subjective valuations of individuals and the significance attached to money because of its relation to marginal utility translate into the objective exchange value of today. Wieser, so close to the solution, failed to provide a concrete solution to the value of money. EUGEN von BÖHM-BAWERK: CONTRIBUTIONS TO MONETARY THEORY The second successor to Menger and last predecessor to Mises in the Austrian School of Thought was Eugen von Bohm-Bawerk. Though Bohm-Bawerk was extremely influential in capital and interest theory, it seems he omitted monetary theory from his work. Roger W. Garrison compiled a revealing set of quotes from letters written by Böhm-Bawerk to Knut Wicksell, a Swedish economist: 10

11 In 1907 he wrote: I have not myself given thought to or worked on the problem of money as a scholar, and therefore I am insecure vis-à-vis this subject. In 1912: You know that I do not really feel competent as regards the extremely difficult theory of money. Also in 1912, referring to The Theory of Money and Credit, in which Mises first articulates the Austrian Theory of the Business Cycle, Böhm-Bawerk mentions to Wicksell a book on the theory of money by a young Viennese scholar, Dr. von Mises. Mises is a student of myself and Prof. Wieser, which, however, does not mean that I would want to take responsibility for all his views. I have just begun to read his book myself, and am not yet familiar with its content. And finally in 1913, a year before his death, I have not yet included the theory of money in the subject-matter of my thinking, and I therefore hesitate to pass judgment on the difficult questions it raises. (Garrison, 15 Great Economists, ) Nevertheless, Böhm-Bawerk s work on capital and interest theory proves useful to Mises work in a more subtle and roundabout way. In The Theory of Money and Credit Mises heralds Böhm-Bawerk for his work on the law of price, in congruence with Menger, which gave explanation of exchange ratios and accounts exhaustively for all the phenomena of direct exchange (Mises ). Though Böhm-Bawerk made no specific contributions to monetary theory, he was highly influential to Mises as an economist and his work on capital and interest theory did render assistance in Mises work on monetary theory. MISES ON THE NATURE OF MONEY Mises monetary theory holds, at its core, the theory of indirect exchange. 8 Menger s insight into indirect exchange as the basis for the development of money is the first substantial element necessary in understanding Mises work on monetary theory. In Human Action Mises asserts, The theory of money was and is always the theory of indirect exchange and of the media of exchange (398). It is appropriate, then, to begin the analysis of Mises contributions to monetary theory with a second review of indirect exchange. Indirect exchange is the act of exchanging a good or service to obtain a medium of exchange; to then employ this medium of exchange to gain the good or 8 From this point forth in the paper a citation of Mises will refer to The Theory of Money and Credit and citations from Human Action will be specifically denoted as such. 11

12 service desired by an individual for consumption purposes. A medium of exchange can be any good which one acquires for the purpose to employ it in a further act of exchange, but not for consumption or production. Today, media of exchange are money. Indirect exchange at its most primitive levels can involve many acts of exchange. At present, this inconvenience has been eradicated with the birth of money. In congruence with the previous discussion on Menger, Mises avows, Indirect exchange becomes more necessary as the division of labor increases and wants become more refined (Mises 43). Mises contends that the theory set forth by Menger on the origin of money is an irrefutable praxeological theory. Mises cites the claim that money was created by decree or covenant, either by assimilating individuals or by the state. Mises argues against this claim, much like Menger, that for individuals to whom indirect exchange was foreign, the design of such a system different from the economic order known to them, and the realization of the importance of this new system was entirely inconceivable. If one concedes that the state did, in fact, think up this new method of indirect exchange, how would it entice individuals to accept and adopt it? Mises reiterates the defense that history cannot account for such a development of indirect exchange through decree or covenant. Furthermore, claiming that the origin of money finds its birth in decree or covenant is of no practical use because it states nothing of action. [ ] it is merely pushing back the problem involved (Human Action 407). However, by analyzing the actions of individuals traced back through time, the emergence of money, and before it, indirect exchange are not only highly plausible but the only explanation supported by history as well as praxeological analysis. Mises, Menger, and the Austrians in general stress the importance of the spontaneous emergence of all economic phenomena, and the development of money bears no exception. Mises maintains, The only relevant thing is that indirect exchange and money exist because the conditions for their existence were and are present (Human Action 407). Individuals first acquired goods for their subjective use value, or utility. There arrived a moment when a good was employed in trade and valued solely for its industrial use, or subjective use value. Individuals found it in their best interest to engage in trade and, over time, certain goods became more easily traded. Soon people began acquiring these goods for the sole purpose of employment in trade, and here one finds the birth of media of 12

13 exchange, or money. By understanding the theory of indirect exchange one is better able to understand the Mengerian theory of the origin of money and money s function in the life of economic man. Mises clearly asserts the role which money plays in the life of economic man, the function of money is to facilitate the business of the market by acting as a common medium of exchange (Mises 42). Mises makes a special point to note that money is not desired where the opportunity to trade freely ones goods for another s does not exist. 9 There exists a strong emphasis throughout Mises work that the primary function of money is to facilitate exchange. Mises illustrates, with reference to Menger s work, that all secondary functions of money can be deduced from its primary function as a medium of exchange (Mises 47). Mises makes the clear distinction between money s primary function and derived secondary functions as it is money s primary function that is relevant for proper analysis into the value of money and the secondary functions are merely appendices from its sole purpose for existing. These secondary functions include facilitating credit transactions, a store of value, and as a medium of payment. Mises deals with these secondary functions in an expedient and laconic way. Money s functions in facilitating credit transactions are merely a component of its function as a medium of exchange. Mises affirms the Austrian view with regards to credit transactions saying, Credit transactions are in fact nothing but the exchange of present goods against future goods (Mises 47). The above statement, simply summed, is the notion that one values acquiring a good or service today more so than the future money necessary to exchange (or pay for ) in order to obtain the good or service. The second function mentioned, money as a store of value 10, can similarly be deduced from money s primary function. Mises notes that as certain economic goods prove themselves as facilitating trade more easily individuals will then try to accumulate more of these goods. He draws on the image of a farmer relocating from Europe to America, who sells his property in Europe to then purchase new property in the Americas with the money obtained in the sale of his property. The money as stored the value of 9 Examples include the socialist society where the means of production are owned by the state and central planners of the state distribute all goods; the isolated economic household that is self-sufficient would neither have use for money. 10 In The Theory of Money and Credit Mises calls this function a transmitter of value through time and space. 13

14 what was sold so that the farmer could obtain new property. Money has then stored value through time and space, and this function too, derived from the primary function of money in facilitating exchange. Lastly, in dealing with money as a general medium of payment, Mises thought the confusion between legal and economic terms to blame for this error in analysis (Mises 49). Each exchange that employs the use of money can be divided into two parts, sale and purchase. Sale and purchase can occur at different times, for example, the purchase of good using credit. Mises shows how confusion then arises when one considers the acts of sale and purchase independent of each other. When the law considers what money is, it asks this in relation to how debts may be settled and debt is considered independent of the origin of obligation to pay (Mises 49). Similarly, by viewing money as a general medium of payment, any transaction, then, can be viewed as a credit transaction. One works for his employer on credit until Friday when his employer gives him his wages for the week. The law is concerned with payment and to that end, money becomes a medium of payment. It is important to note that legal definitions can differ quite extremely from economic, and this is the Mises first warning to be watchful of this common confusion. In sum, the primary function of money is to facilitate exchange, and all other functions of money can be derived from this primary function alone. MISES ON VALUE THEORY In addition to his acknowledgement of the primary function of money, Mises made another clear distinction concerning the measurement of value that is essential to one s understanding and comprehension of Mises monetary theory set forth herein. The Austrian subjective theory of value attests that the value of economic goods is established in the minds of individuals and, therefore, this value cannot be measured. The values can vary as the subjective valuations made by individuals vary. Mises maintains, Every economic transaction presupposes a comparison of values (Mises 51). According to Mises, the individual making the valuation must consider if the goods to be acquired have more value to him than the goods he must give up in exchange. It is in this manner that, every economic act may be regarded as a kind of exchange (Mises 52). Following 14

15 from this insight, that value cannot be measured, comes the notion of rank. Because value cannot be measured due to its basis in the subjective valuations of individuals, one can only rank those goods in order of importance to him. One can claim that good A is more important than good B by his own subjective evaluation, but he is incapable of measuring by how much good A bears importance in a specific quantifiable unit. The sole basis for all economic activity, then, is the subjective valuations arrived at by each individual. James Rolph Edwards relates: Mises theory originated as a result of irritation at assertions that money was a measure of value. He noted that this notion presupposes and originates from a classical or objective value theory in which exchange involves the reciprocal surrender of equivalent goods (i.e., goods of equivalent value). (Edwards 33) The correction that Mises made, then, is that individuals make valuations when comparing the significance of different wants which are unequal and not subject to measure, but only ranking in their importance. Value exists solely because individuals ascribe such value to a want based on their own appraisal. Nowhere is value inherent in anything. MISES EVALUATION OF THE MONEY STOCK The next pivotal step in Mises analysis of money is his precise definition of the components of the money stock. Mises stresses that it is the task of economic theory to determine the exchange ratio between money and other economic goods (Mises 65). To that end, the appropriate terminology must be employed in order to accurately solve the specific problems of monetary theory. Mises notes two observations concerning the stock of money that are of high importance to his method of classification. First, Mises comments that the exchangeability, or replaceability, of money is nearly without limit while that of most economic goods is highly limited. Even more important, Mises divulges, is that claims to money may be exchanged several times without the original issuer ever being called upon to redeem the claim. Mises attests that this peculiarity is 15

16 not applicable to other economic goods, which are always destined for ultimate consumption (Mises 63-4). In Human Action Mises asserts, A medium of exchange which is commonly used as such is called money. The notion of money is vague, as its definition refers to the term commonly used (398). Mises refers to the above vague definition as money in the broader sense. Money in the broader sense includes money proper (or money in the narrower sense) and money substitutes. The first component of money in the broader sense is money proper (or money in the narrower sense). Money proper contains three components. The first is commodity money, generally thought of as gold or silver. For Mises, it is immaterial what commodity is employed as money the commodity exchanged commodity that constitutes the money and that money is merely this commodity (Mises 76). The second classification of money proper is credit money, which circulates as a general medium of exchange and is a claim due for redemption at some future time. Unlike money substitutes, they cannot be both payable on demand and perfectly secure. Because time must pass until the redemption of the claim is due, they are valued independently from the amount of money to which they give one right (Mises 74-5). The third classification of money proper is fiat money, the only defining feature of which is a stamp or certification given by law that deems it a medium of exchange (Mises 74). The second component of money in the broader sense is money substitutes. For Mises, money substitutes are claims to money that are both perfectly secure and immediately convertible (Mises 65). The fact that money substitutes are regularly exchanged and accepted in market transactions is viable enough reason to include them in the broad definition of money (Mises 64). In Human Action Mises included the insight that money substitutes replace the cash holdings of individuals (432). The first component of money substitutes is fiduciary media, or bank deposits for which the issuer holds less than a 100% reserve of money proper, and this classification includes token money as well. Money substitutes for which the issuer holds 100% reserve of money proper are deemed money certificates by Mises. The distinction between fiduciary media and money certificates is of high importance for economic analysis because of their differing affects on the money supply. Because a 100% reserve of money proper is kept by the issuer of money certificates, issuance of money certificates does not affect the 16

17 supply of money and the money relation (Human Action 433). In contrast, because fiduciary media is not backed by 100% reserves, changes in the quantity issued do affect the money supply and the money relation; the effects of such changes can be felt in the alteration of money s purchasing power and can be seen in price fluctuations (Human Action 433-4). Mises outlined three factors which comprise the value of a claim to money, or money substitute. First, the value of the goods to whom the claim grants possession; second, the probability that the claim will be fulfilled; and third, the time period after which the possession of the goods may take place if applicable. Mises avows giving credit to Böhm-Bawerk that, claims are not goods but merely an instrument by which procurement, or possession, of goods is obtained (Mises 65). Similarly, when dealing with money substitutes, it is important to realize that they are valued indirectly and their value finds origin in the goods to which they make claim (Mises 65). The cases of fiat money and credit money have a special condition of which Mises makes strong mention. While commodity money is a physical commodity, credit and fiat money only differ from other material things by a special quality bestowed upon them by law (Mises 74). What is significant about this situation is that though the law can regulate what is money by a legal certification, it must first find employment as a common medium of exchange. The law cannot force anyone to value something he does not value of his own accord, and therefore, cannot force an individual to value something for the purposes in exchange. Again, all the state can do is regulate issuance (Mises 74). The distinctions made by Mises in his monetary terminology were vital to his determination of the essential features and relations concerning monetary theory. MISES SOLUTION OF THE PROBLEM OF THE VALUE OF MONEY With a firm grasp of Mises analysis on the nature of money, which includes its origin and function, and knowledge of his classifications of its stock, the stage is set for deeper inspection of the more complex and radical contributions of Mises to monetary theory. Mises identified the purchasing power of money, or objective exchange value, as the central element in the economic analysis of the problem of money (Mises 117). To solve this problem it is first necessary to understand the source of the demand for money. 17

18 In addition to the demand for money, the explanation for money s purchasing power, or objective exchange value, is not complete without also understanding the value of money. Money, or a medium of exchange, is an economic good because it is scarce. There does not exist an unlimited supply of money. There exists a demand for media of exchange. Mises elucidates that individuals surrender other goods, including their labor, to acquire media of exchange; they pay prices to obtain money (Human Action 402). An eccentricity exists in these prices people pay for money because they cannot be represented in money terms. People may speak in terms of money prices when referring to all other economic goods, but in the case of money, one refers to its purchasing power in relation to other economic goods. Subjective valuations of individuals are the determining factors of value of all economic goods and money is of exception. Similarly, these subjective valuations are born of the utility to which an individual ascribes to both money and other economic goods. However, Mises makes the clear distinction that while the utility or subjective value of other economic goods depends on both their objective use value and ranking in the scale of human need, the utility of money is ascribed to it solely by its objective exchange value, or purchasing power (Mises 117-8). Whereas the analysis of the value of all other economic goods can begin with the subjective use value, or utility, ascribed to them, the case is not so with money. Here in lies the central problem for economic analysis of monetary theory: if the subjective exchange value is derived from money s purchasing power, where, then, does money s purchasing power derive its origin? Mises charges, The task of the theory of value of money is to expound the laws which regulate the determination of the objective exchange value of money (Mises 127). Mises resolution to the problem of the value of money and, congruently, the determination of money s purchasing power find provenance in the innovative application of marginal utility analysis to the theory of money. Though Menger discovered the concept of marginal utility, he, along with his successors Wieser and Böhm-Bawerk, never succeeded in applying marginal utility analysis to monetary theory. There existed a common criticism of the attempt to apply marginal utility analysis to the demand for money, alleging that the explanation was circular. The circularity criticism suggested that money has utility (subjective use value) to individuals due to its 18

19 purchasing power (objective exchange value), but the purchasing power can only be determined if the current exchange ratio between money and other economic goods is known. Because purchasing power is literally the representation of the exchange ratio between money and other economic goods, if one should attempt to discuss the marginal utility of money, one would then assume away the problem of purchasing power that was one s aim to explain. Mises analysis, however, resolved the confusion put forth by the criticisms claiming circularity in the employment of marginal utility analysis. Mises adduces: The demand for money and its relations to the stock of money form the starting point for an explanation of the fluctuations in the objective exchange value of money. [ ] the problem is solved without difficulty if we approach the phenomena from the individual agent s point of view. (Mises 157) Mises makes note that the demand for media of exchange exist because individuals desire to keep a stock of them. This stock is called an individual s cash holdings, and it includes money substitutes (Human Action 402). Furthermore, Mises explains that the utility of money, or subjective use value, is merely the expected use value of the goods for which money can be exchanged, hence, the marginal utility of the goods to be obtained in exchange are a measure of the subjective use value of money (Mises 130). This analysis again leads to the conclusion that the valuation of money implies that money has a certain purchasing power (Mises 130). This is where the Austrian Circle begins its rounds. It is at this juncture that Mises introduces his new analysis to the problem of the value of money. Mises contends that there exists a historical element of continuity that is inherent in the purchasing power of money; this insight will prove to be the missing link in the explanation of the objective exchange value of money. Before further investigation of Mises solution it is important to reiterate that value can be attributed to money only on the supposition of a preexisting purchasing power (Mises 130). The existing purchasing power of money today is based on an individual s notion of what it was yesterday, and yesterday s purchasing power was determined by the day preceding it (Human Action 409). This historical continuity in the objective exchange value of 19

20 money is known as Mises Regression Theorem. The Regression Theorem continues backwards in time until the moment is reached when an economic good was first employed as in indirect exchange. In this moment a commodity was offered in trade not because it had acquired the function of a medium of exchange, but was traded due to its value in use. Mises offers, At this point yesterday s exchange value is exclusively determined by the nonmonetary-industrial-demand which is displayed only by those who want to use this good for other employments than that of a medium of exchange (Human Action 409). Furthermore, it is of absolute importance to recognize that a good could not attain value in exchange without first having value attributed to it due to its use for industrial purposes (Human Action 410). It is from this point onward that individuals soon discover the greater ease it is to trade certain goods and begin to acquire these goods not for their industrial uses but to employ them in further acts of exchange. These goods, originally valued for their industrial purposes are now additionally valued for their services in exchange, or objective exchange value. According to Mises, the explanation of the purchasing power of money is impossible without this historically transmitted concept of value. From this analysis Mises concludes that an individual is only able to determine the quantity of money he needs, his cash holdings, by first evaluating money s purchasing power in the immediate past, yesterday. In this way the supply and demand for money are established and, similarly, today s purchasing power, based on evaluation of yesterday s, will prove the starting point in tomorrow s evaluation of quantity of money needed. In this way Mises shows that the analysis aimed at determining the objective exchange value of money guides one to a moment when money, or media of exchange, were not valued as such, but for their industrial (useful) functions. When analysis of the value of money is executed properly, according to Mises, the resulting study will lead one to the point where media of exchange were valued as a commodity in and of itself and the industrial uses for which this commodity can be employed. Money s value, at this point, in based on the commodity s subjective use value, also called utility. Mises, again, asserts the importance of Carl Menger s inquiry into the nature and origin of money necessary in properly determining the value of money. Mises strongly states, But this point is not merely an instrumental concept of theory; it is an actual 20

21 phenomenon of economic history, making it appearance at the moment when indirect exchange begins (Mises 143). It is only with this understanding of the origin of value for media of exchange that the application of marginal utility analysis will prove effective in providing a theory of the value of money, thorough and sound, without equivocation (Mises 136). Mises makes the logical argument that goods were first acquired solely for their usefulness, or utility, and hence value was bestowed upon these goods by the subjective valuations of individuals who each, alone, determined how useful a certain commodity was to him. These valuations were certainly the basis for trade relationships when these relationships were born out of need or want. An individual offered good A in trade because he had knowledge that others desired this good because it was useful. Overtime, it was discovered that certain goods traded with more ease, and people would acquire these goods because they facilitated trade more easily and other traders were more likely to accept these goods. In Human Action Mises maintains that it is impossible to have a medium of exchange void of a past and contends, Nothing can enter into the function of medium of exchange which was not already previously an economic good and to which people assigned exchange value already before it was demanded as such a medium (426). Yesterday s purchasing power, which is the starting point from which individuals base their expectations about today s purchasing power, is still further modified by the demand for and supply of money today and thus, today s purchasing power is born. Still, each link of the chain is based on the subjective valuations of individuals who are making decisions for the future in their own best interest. To demand a proper theory of the value of money and ignore the historical continuity of money s value is diametrically opposed to the nature of value and the analysis of its determination (Mises 144). After determining the objective value of money by employing his Regression Theorem, Mises reveals the importance of the element of continuity in value, one is able to arrive at the phenomenal moment when money is not valued by its service as a medium of exchange, but by its industrial services or uses. Mises advances that the arrival at this point in analysis prepares the way for developing a complete theory of the value of money on the basis of the subjective theory of value and its peculiar doctrine of 21