Businessmen never deemed it necessary to free economic calculation in terms of gold from its dependence on the fluctuations in purchasing power. The proposals to improve the currency system by adopting a tabular standard based on index numbers or by adopting various methods of commodity standards were not advanced with regard to business transactions and to monetary calculation. Their aim was to provide a less fluctuating standard for long-run loan contracts. Businessmen did not even consider it expedient to modify their accounting methods in those regards in which it would have been easy to narrow down certain errors induced by fluctuations in purchasing power. It would, for instance, have been possible to discard the practice of writing off durable equipment by means of yearly depreciation quotas, invariably fixed in a percentage of the cost of its acquisition. In its place one could resort to the device of laying aside in renewal funds as much as seems necessary to provide the full costs of the replacement at the time when it is required. But business was not eager to adopt such a procedure.
All this is valid only with regard to money which is not subject to rapid, big cashinduced changes in purchasing power. But money with which such rapid and big changes occur loses its suitability to serve as a medium of exchange altogether.
8. The Anticipation of Expected Changes in Purchasing Power
The deliberations of the individuals which determine their conduct with regard to money are based on their knowledge concerning the prices of the immediate past. If they lacked this knowledge, they would not be in a position to decide what the appropriate height of their cash holdings should be and how much they should spend for the acquisition of various goods. A medium of exchange without a past is unthinkable. Nothing can enter into the function of a 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.
But the purchasing power handed down from the immediate past is modified by today’s demand for and supply of money. Human action is always providing for the future, be it sometimes only the future of the impending hour. He who buys, buys for future consumption and production. As far as he believes that the future will differ from the present and the past, he modifies his valuation and appraisement. This is no less true with regard to money than it is with regard to all vendible goods. In this sense we may say that today’s exchange value of money is an anticipation of tomorrow’s exchange value. The basis of all judgments concerning money is its purchasing power as it was in the immediate past. But as far as cashinduced changes in purchasing power are expected, a second factor enters the scene, the anticipation of these changes.
He who believes that the prices of the goods in which he takes an interest will rise, buys more of them than he would have bought in the absence of this belief; accordingly he restricts his cash holding. He who believes that prices will drop, restricts his purchases and thus enlarges his cash holding. As long as such speculative anticipations are limited to some commodities, they do not bring about a general tendency toward changes in cash holding. But it is different if people believe that they are on the eve of big cashinduced changes in purchasing power. When they expect that the money prices of all goods will rise or fall, they expand or restrict their purchases. These attitudes strengthen and accelerate the expected tendencies considerably. This goes on until the point is reached beyond which no further changes in the purchasing power of money are expected. Only then does the inclination to buy or to sell stop and do people begin again to increase or to decrease their cash holdings.
But if once public opinion is convinced that the increase in the quantity of money will continue and never come to an end, and that consequently the prices of all commodities and services will not cease to rise, everybody becomes eager to buy as much as possible and to restrict his cash holding to a minimum size. For under these circumstances the regular costs incurred by holding cash are increased by the losses caused by die progressive fall in purchasing power. The advantages of holding cash must be paid for by sacrifices which are deemed unreasonably burdensome. This phenomenon was, in the great European inflations of the ‘twenties, called flight into real goods (Flacht in die Sachwerte) or crack-up boom (Katastrophenhausse). The mathematical economists are at a loss to comprehend the causal relation between the increase in the quantity of money and what they call “velocity of circulation.”
The characteristic mark of the phenomenon is that the increase in the quantity of money causes a fall in the demand for money. The tendency toward a fall in purchasing power as generated by the increased supply of money is intensified by the general propensity to restrict cash holdings which it brings about. Eventually a point is reached where the prices at which people would be prepared to part with “real” goods discount to such an extent the expected progress in the fall of purchasing power that nobody has a sufficient amount of cash at hand to pay them. The monetary system breaks down; all transactions in the money concerned cease; a panic makes its purchasing power vanish altogether. People return either to barter or to the use of another kind of money.
The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services, as has been shown, at different dates and to a different extent.
This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.
But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against “real” goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.
It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German Mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last forever.
9. The Specific Value of Money
As far as a good used as money is valued and appraised on account of the services it renders for nonmonetary purposes, no problems are raised which would require special treatment. The task of the theory of money consists merely in dealing with that component in the valuation of money which is conditioned by its function as a medium of exchange.
In the course of history various commodities have been employed as media of exchange. A long evolution eliminated the greater part of these commodities from the monetary function. Only two, the precious metals gold and silver, remained. In the second part of the nineteenth century more and more governments deliberately turned toward the demonetization of silver.
In all these cases what is employed as money is a commodity which is used also for nonmonetary purposes. Under the gold standard gold is money and money is gold. It is immaterial whether or not the laws assign legal tender quality only to gold coins minted by the government. What counts is that these coins really contain a fixed weight of gold and every quantity o
f bullion can freely be transformed into coins. Under the gold standard the dollar and the pound sterling were merely names for a definite weight of gold, within very narrow margins precisely determined by the laws. We may call such a sort of money commodity money.
A second sort of money is credit money. Credit money evolved out of the use of moneysubstitutes. It was customary to use claims, payable on demand and absolutely secure, as substitutes for the sum of money to which they gave a claim. (We shall deal with the features and problems of moneysubstitutes in the next section.) The market did not stop using such claims when one day their prompt redemption was suspended and thereby doubts about their safety and the solvency of the obligee were raised. As long as these claims had been daily maturing claims against a debtor of undisputed solvency and could be collected without notice and free of expense, their exchange value was equal to their face value; it was this perfect equivalence which assigned to them the character of moneysubstitutes. Now, as redemption was suspended, the maturity date postponed to an undetermined day, and consequently doubts about the solvency of the debtor or at least about his willingness to pay emerged, they lost a part of the value previously ascribed to them. They were now merely claims, which did not bear interest, against a questionable debtor and falling due on an undefined day. But as they were used as media of exchange, their exchange value did not drop to the level to which it would have dropped if they were merely claims.
One can fairly assume that such credit money could remain in use as a medium of exchange even if it were to lose its character as a claim against a bank or a treasury, and thus would become fiat money. Fiat money is a money consisting of mere tokens which can neither be employed for any industrial purposes nor convey a claim against anybody.
It is not a task of catallactics but of economic history to investigate whether there appeared in the past specimens of fiat money or whether all the sorts of money which were not commodity money were credit money. The only thing that catallactics has to establish is that the possibility of the existence of fiat money must be admitted.
The important thing to be remembered is that with every sort of money, demonetization—i.e., the abandonment of its use as a medium of exchange—must result in a serious fall of its exchange value. What this practically means has become manifest when in the last eighty years the use of silver as commodity money has been progressively restricted.
There are specimens of credit money and fiat money which are embodied in metallic coins. Such money is printed, as it were, on silver, nickel, or copper. If such a piece of fiat money is demonetized, it still retains exchange value as a piece of metal. But this is only a very small indemnification of the owner. It has no practical importance.
The keeping of cash holding requires sacrifices. To the extent that a man keeps money in his pockets or in his balance with a bank, he forsakes the instantaneous acquisition of goods he could consume or employ for production. In the market economy these sacrifices can be precisely determined by calculation. They are equal to the amount of originary interest he would have earned by investing the sum. The fact that a man takes this falling off into account is proof that he prefers the advantages of cash holding to the loss in interest yield.
It is possible to specify the advantages which people expect from keeping a definite amount of cash. But it is a delusion to assume that an analysis of these motives could provide us with a theory of the determination of purchasing power which could do without the notions of cash holding and demand for and supply of money.12 The advantages and disadvantages derived from cash holding are not objective factors which could directly influence the size of cash holdings. They are put on the scales by each individual and weighed against one another. The result is a subjective judgment of value, colored by the individual’s personality. Different people and the same people at different times value the same objective facts in a different way. Just as knowledge of a man’s wealth and his physical condition does not tell us how much he would be prepared to spend for food of a certain nutritive power, so knowledge about data concerning a man’s material situation does not enable us to make definite assertions with regard to the size of his cash holding.
10. The Import of the Money Relation
The money relation, i.e., the relation between demand for and supply of money, uniquely determines the price structure as far as the reciprocal exchange ratio between money and the vendible commodities and services is involved.
If the money relation remains unchanged, neither an inflationary (expansionist) nor a deflationary (contractionist) pressure on trade, business, production, consumption, and employment can emerge. The assertions to the contrary reflect the grievances of people reluctant to adjust their activities to the demands of their fellow men as manifested on the market. However, it is not an account of an alleged scarcity of money that prices of agricultural products are too low to secure to the submarginal farmers proceeds of the amount they would like to earn. The cause of these farmers’ distress is that other farmers are producing at lower costs. What is wrong with British manufacturing is not that the “level” of prices is too low, but the fact that they did not succeed in raising the productivity of the capital invested and the men employed to a height that would provide all the goods the British want to consume.
An increase in the quantity of goods produced, other things being unchanged, must bring about an improvement in people’s conditions. Its consequence is a fall in the money prices of the goods the production of which has been increased. But such a fall in money prices docs not in the least impair the benefits derived from the additional wealth produced. One may consider as unfair the increase in the share of the additional wealth which goes to the creditors, although such criticisms are questionable as far as the rise in purchasing power has been correctly anticipated and adequately taken into account by a negative price premium.13 But one must not say that a fall in prices caused by an increase in the production of the goods concerned is the proof of some disequilibrium which cannot be eliminated otherwise than by increasing the quantity of money. Of course, as a rule every increase in production of some or of all commodities requires a new allocation of factors of production to the various branches of business. If the quantity of money remains unchanged, the necessity of such a reallocation becomes visible in the price structure. Some lines of production become more profitable, while in others profits drop or losses appear. Thus the operation of the market tends to eliminate these much discussed disequilibria. It is possible by means of an increase in the quantity of money to delay or to interrupt this process of adjustment. It is impossible either to make it superfluous or less painful for those concerned.
If the governmentmade cashinduced changes in the purchasing power of money resulted only in shifts of wealth from some people to other people, it would not be permissible to condemn them from the point of view of catallactics’ scientific neutrality. It is obviously fraudulent to justify them under the pretext of the commonweal or public welfare. But one could still consider them as political measures suitable to promote the interests of some groups of people at the expense of others without further detriment. However, there are still other things involved.
It is not necessary to point out the consequences to which a continued deflationary policy must lead. Nobody advocates such a policy. The favor of the masses and of the writers and politicians eager for applause goes to inflation. With regard to these endeavors we must emphasize three points. First: Inflationary or expansionist policy must result in overconsumption on the one hand and in malinvestment on the other. It thus squanders capital and impairs the future state of want-satisfaction.14 Second: The inflationary process does not remove the necessity of adjusting production and reallocating resources. It merely postpones it and thereby makes it more troublesome. Third: Inflation cannot be employed as a permanent policy because it must, when continued, finally result in a breakdown of the monetary system.
A retailer or innkeeper can easily fall prey to the
illusion that all that is needed to make him and his colleagues more prosperous is more spending on the part of the public. In his eyes the main thing is to impel people to spend more. But it is amazing that this belief could be presented to the world as a new social philosophy. Lord Keynes and his disciples make the lack of the propensity to consume responsible for what they deem unsatisfactory in economic conditions. What is needed, in their eyes, to make men more prosperous is not an increase in production, but an increase in spending. In order to make it possible for people to spend more, an “expansionist” policy is recommended.
This doctrine is as old as it is bad. Its analysis and refutation will be undertaken in the chapter dealing with the trade cycle.15
11. The MoneySubstitutes
Claims to a definite amount of money, payable and redeemable on demand, against a debtor about whose solvency and willingness to pay there does not prevail the slightest doubt, render to the individual all the services money can render, provided that all parties with whom he could possibly transact business are perfectly familiar with these essential qualities of the claims concerned: daily maturity and undoubted solvency and willingness to pay on the part of the debtor. We may call such claims moneysubstitutes, as they can fully replace money in an individual’s or a firm’s cash holding. The technical and legal features of the moneysubstitutes do not concern catallactics. A moneysubstitute can be embodied either in a banknote or in a demand deposit with a bank subject to check (“checkbook money” or deposit currency), provided the bank is prepared to exchange the note or the deposit daily free of charge against money proper. Token coins are also moneysubstitutes, provided the owner is in a position to exchange them at need against money free of expense and without delay. To achieve this it is not required that the government be bound by law to redeem them. What counts is the fact that these tokens can be really converted free of expense and without delay. If the total amount of token coins issued is kept within reasonable limits, no special provisions on the part of the government are necessary to keep their exchange value at par with their face value. The demand of the public for small change gives everybody the opportunity to exchange them easily against pieces of money. The main thing is that every owner of a moneysubstitute is perfectly certain that it can, at every instant and free of expense, be exchanged against money.
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