This is Part 11 of a 17-part series of posts summarizing Bob Murphy’s indispensable book Choice: Cooperation, Enterprise, and Human Action. Murphy’s book is itself is a summary of Ludwig von Mises’s classic treatise “Human Action.” Like previous posts, this post is a summary of a summary.
The purpose of these posts is to popularize and spread the word about Austrian economics and educate the public. Rather than list all the previous parts, I have created a category for all these posts, called “Human Action and Choice,” so that all these posts can be read (in reverse order) with a single click. Note well: any errors in these summaries are mine and not Murphy’s.
This is one of the longest chapters in the book, and I think it’s the toughest post in the series (at least so far). Some paragraphs may need to be read twice, or perhaps you should just read them more slowly than you’d normally read a blog post. But I think the concepts are among the most fascinating. You should learn something today.
Murphy begins by explaining the difference between direct and indirect exchange. We have explored simple examples of direct exchange before, in post 7 (trading one flavor of ice cream for another) and post 10 (selling ice cream for money). Let me illustrate indirect exchange while sticking with the ice cream example.
Say Milton has chocolate, but wants vanilla. Murray has vanilla, but wants strawberry. Ludwig has strawberry, but wants chocolate. No two of these men can trade with one another and have both sides directly obtain they want. But any two of the three can trade directly, and thereby have one side get what they want directly, and have the other side obtain what he needs to successfully trade with the third party. The party that uses the first transaction to get what he needs for a second transaction is engaged in indirect exchange.
For example, if Milton trades his chococate for Murray’s vanilla, Milton is immediately happy, because he wanted vanilla. Murray, exchanging his vanilla for chocolate, is not happy yet — because Murray wanted strawberry, and he has chocolate. But now Murray can go to Ludwig, and exchange strawberry for chocolate. After two transactions, everyone’s happy.
Here, Murray used strawberry ice cream as a medium of exchange. Trading something of value for strawberry did not satisfy Murray immediately, but using that strawberry ice cream as a medium of exchange allowed Murray to get what he wanted.
THE ORIGINS OF MONEY
Carl Menger, the father of Austrian economics, explained that money got its start with this sort of indirect exchange. People recognized that they could not always trade goods directly. But they also realized that if they could trade their goods or services in return for a widely accepted medium of exchange, they could get what they wanted.
Menger explained that money must of necessity emerge in this way. His was not a historical analysis, as there are no clear records of how this happened; rather, he argued from economic logic. Money could not have emerged because a wise ruler said: “everyone should start accepting these shiny rocks” (or pieces of metal, or whatever) “in return for the valuable stuff they have.” It seems very unlikely that people would have signed onto such a bizarre-sounding plan. And if a wise ruler had managed to pull this off, how would he know how many shiny rocks people should have to exchange for one sheep? for three cows? for one day’s labor picking crops? and so forth.
No: instead people started trading for things that they knew would be widely accepted, because they were useful commodities on their own. In some societies the initial medium of exchange was tobacco. It has been cocoa beans at times. (I explained the origins of money more fully in May 2014, and for a fuller description, I refer you to that post, but here we will just summarize it.) But over time, people gravitated towards previous metals like gold and silver, because they had the properties you would expect from a medium of exchange: they were recognizable, scarce, liquid, divisible, durable, easily stored, and transportable. The general idea, however, is that money was a commodity — and it cannot logically emerge any other way. (Gold is thus a “commodity money” — as contrasted with fiat money, which is money simply because government declares it to have value.)
Now comes the fun part — that I think is going to upset some of you, because it may run counter to the conventional way you have likely thought about money for most of your life. (Why “fun”? Well, where’s the fun if I’m not challenging your ingrained beliefs a little bit?)
ANALYZING MONEY USING SUPPLY AND DEMAND
Mises’s great insight into money (one of them, anyway) is that money is a good that is demanded by people, just as they demand any other good. It’s not just what’s left after you get through satisfying your other demands. It’s something you demand just as you demand traditional goods or services. Money is demanded, not so we can consume it (obviously), but because we can hold it, and it provides a flow of services to the person who holds it.
If you view money as a good, there are immediately some problems that need to be addressed. For one, how do you value it? Oranges might be said to be worth $2 per pound. Bicycles might be $200 each. What is money “worth”? The answer is: the reciprocal of all the goods and services it could purchase. If oranges are $1 for a half pound, then $1 is worth a half pound of oranges. If bicycles are $200, then $1 is worth 1/200 of a bicycle. Etc.
Viewing money in this way helps you to understand general price fluctuations as a function of the demand for money. If the price of money goes up (because the demand for money goes up), then the price of all these other goods goes down. When people demand money more, prices fall. Put another way, money’s purchasing power rises. Like any other good, as its price goes up, people will hold less of it, because they can get more for it. (As a side note — and this is my own observation, not endorsed by Murphy — this is why deflation is not worrisome. As people hoard money, it becomes more valuable, and naturally people will want to exchange it for goods, since they can buy more with it.)
By contrast, when money’s purchasing power (or price) falls, prices of other goods go up. This is what is typically thought of as “inflation” (price inflation, or rising prices) — and it is a function of money losing its purchasing power. Put another way, the price of money is falling, which is often a side effect of expansion of the money supply — the marginal utility of extra units of money decreases as the supply available increases.
Ultimately, then, the purchasing power of money is a function of the demand for money. (Remember, Mises liked to explain the economy in terms of demand.) The purchasing power of money throughout the economy adjusts so that the total quantity of money demanded by all people (taking into account what they would have to exchange to get it) equals the total amount of money in existence. (This is the same thing that happens with goods and services: the quantity of a good in an unhampered market economy tends towards the level equal to the total amount demanded at the market clearing price.)
Viewing money as a good collapses the artificial distinction between microeconomics and macroeconomics. It allows Austrian economists to analyze the macro economy according to the common-sense principles (incentives and purposeful behavior) that govern decisions on the individual level.
THE REGRESSION THEOREM
Other problems come to mind, however. Remember, we have said all value is subjective. How can we use subjective value theory to explain the value of money without engaging in circular logic? Before Mises, explanations of the purchasing power of money seemed to travel in a circle: money can buy stuff because people demand it . . . and people demand money it because it can buy stuff.
Mises introduced the time element to break the circle. He explained that money’s purchasing power today is based on people’s expectations of what money’s purchasing power will be in the future. We’re no longer explaining money’s current purchasing power by reference to money’s current purchasing power, but rather by referring to the purchasing power we expect it will have in the future. This evaluation of the future is crucially aided by knowledge of what money was worth in the recent past.
You might say: that breaks the logical circle, but it leads us into a another problem: of infinite regress. If today’s purchasing power is based on yesterday’s expectations, and yesterday’s purchasing power was based on the previous day’s expectations, where did the original purchasing power come from? That’s where Menger’s explanation of the origin of money, described above, comes in. Mises said all money started as commodity money, like gold. Mises called this the “regression theorem.” At some point in the past, the community was in a situation of direct exchange (as opposed to indirect exchange) and this explains the origin of the purchasing power of money.
Mises argued that, if everyone in the world suddenly forgot tomorrow what the prices had been for everything in the past, people could reconstruct the process of comparing the relative values of different goods or services (a Ferrari is worth more than an orange), but nobody would know what a “dollar” is worth anymore. This is why Mises says that money — a medium of exchange — must begin as an economic good for which people assign an exchange value. People who have commonly used nothing but fiat money in their lives may have a hard time accepting this. But there is no fiat currency in existence whose value can’t be traced backwards in time to a commodity money. (This may help explain why people are having such a hard time determining a stable value for Bitcoin. Murphy acknowledges in a footnote that Misesians are still debating whether Bitcoin can escape the logic of the regression theorem.)
THE NON-NEUTRALITY OF MONEY
Mises also argued that money is not “neutral.” As noted, many economists would explain prices through the examples of a barter system, and throw in money as an afterthought. Mises did not. One effect of this view is Mises’s views on the effects of new money entering the economy. Many people seem to assume that if you double the stockpile of money, prices will double and purchasing power will halve, but otherwise people’s relative economic positions will remain constant. First, it’s not so neat and mathematical as that — but more importantly, money enters the economy in different places, and the people who get to use it before the prices rise are benefited. So, during QE, for example, large investment banks received the new money injected in the economy first, and benefited at the expense of others.
Another Mises tenet was that the currently available quantity of money is sufficient. Many people assume that, as the population rises, it is necessary to expand the money supply to forestall that horrible bogeyman called “deflation.” Mises emphatically disagreed. Doubling the money supply does not make people richer, and halving it does not make people poorer.
THE GOLD STANDARD
Mises was also a fan of the gold standard, seeing it as a critical bulwark against government power — as important as a written constitution or bill of rights. (I hesitate to use the words “gold standard” in a post, as it is almost certain that the comment section will fixate on it, making arguments that have nothing to do with the points made in the post. Still, this is part of the chapter.) Mises did not want governments to have the power to take action (even war) without the political accountability that comes with raising the money for the government action through taxation or borrowing. Simply inflating the currency allows governments to pretend that the government action costs them nothing.
The gold standard sets an automatic brake on inflation. If countries tried to inflate their currency, gold would flow out of the country as the government would be forced to redeem the inflated currency for gold. The money supply would have to shrink (or, if you were insistent on inflating, you could just pull a Richard Nixon and kill the gold standard — the “to hell with everything” strategy — leading to the price inflation we saw in the 1970s).
This mechanism also keeps foreign trade in balance; if more Americans bought British products than vice versa, they would have to buy pounds to do so. The surfeit of dollars chasing pounds would cause pounds to increase in value relative to dollars. But the gold standard would keep this from getting out of control, because if the value of a dollar became too low vis-a-vis the pound (meaning it took more dollars to buy a pound), gold owners could simply sell gold to England, buy U.S. dollars with the pounds, exchange those dollars for gold in the U.S., and end up with more gold than they started with. The net effect is that gold would flow out of the U.S., causing U.S. prices to fall, which would cause the British to buy more American goods, bringing everything back into balance. This mechanism has been understood since the days of Hume and Ricardo.
THE MEANING OF “INFLATION”
Finally, Mises was very clear that we should use the term “inflation” to refer to the quantity of money, and not the rise in prices that an increased quantity of money causes. (In a slight concession to the widespread use of the term to refer to the latter concept, Murphy uses “price inflation” to refer to the rise in prices, and “monetary inflation” to refer to an expansion in the money supply, which is what Mises insisted inflation really means.) Mises reasoned: “It is impossible to fight a policy which you cannot name.” (Shades of Ted Cruz talking about radical Islamic terrorism!) The root cause of price inflation is monetary inflation, and if we call rising prices “inflation,” we are then left without a term to describe what the real problem really is.
That was a bear of a chapter; possibly the toughest one in the book. I may give you a few days to reflect on this one before moving ahead with the next post.