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Monetary Central Planning and the State, Part 6: Ludwig von Mises and the Non-Neutrality of Money


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In the late 1850s, the British economist John E. Cairnes published a series of articles analyzing the sequence of events that followed the gold discoveries in Australia. He explained that the increase in gold had its first impact on prices in the coastal towns and cities of Australia, where the miners first spent their new supplies of gold as money. The increased money demand for goods and services stimulated additional imports into Australia. The Australian merchants paid for these increased stocks of goods with the new gold paid to them by the miners. As the gold entered and then was spent in the European markets, prices for goods and services began to rise there, as well. Manufacturers in Europe, in turn, increased their demand for resources and raw materials from Asia and Africa, paying for them with portions of the new gold that had passed into their hands. Prices then began to rise in those other parts of the world.

The increase in gold supplies had brought about a general rise in prices in various parts of the world. But the rise in prices had followed the particular pattern of where the additional gold supplies had first been introduced into the market; then it followed the sequence of expenditures and receipts that reflected the increases in the demand for commodities and resources in the actual order of who received the new gold-money first, second, third and so on, and for what market purposes the gold was spent by those groups of people through time.

Changes in the quantity of money have long been understood as a primary long-run influence on the rise or decline of prices in general. But the particular method of analysis used by different economists has not only affected the explanation of money’s effects on an economy, it has influenced various policy conclusions drawn from this analysis as well.

In The Purchasing Power of Money (1911) and many of his other works, Irving Fisher presented a rather “aggregated” analysis. As we saw earlier (see “Monetary Central Planning and the State, Part II: The Rationale of a Stable Price Level for Economic Stability,” Freedom Daily, February 1997), Fisher argued that an increase in the supply of money tended to bring about a rise in selling prices in general, relative to the costs of production. The temporary increase in profit margins between selling prices and costs (due to input prices’ being fixed for a period of time by contract) acted as the stimulus for attempts to increase output. But when contracts came up for renewal and were revised upwards, profit margins would return to “normal” and the “boom” phase of the business cycle would end. It would be followed by a period of correction, in the wake of businessmen’s discovering that their over-expansive plans were unsustainable; this was the downturn or depression phase of the business cycle.

Fisher concluded that the cause and sequence of the business cycle were the result of unanticipated increases in the money supply that made selling prices rise relative to cost prices. His policy prescription was to keep the price level stable. If that were done, he argued, price-cost relationships would be kept in proper order, at least to the extent they were influenced by monetary forces. And that, in turn, would mitigate, if not eliminate, the primary cause behind the business cycle.

An alternative method of analysis for explaining money’s influence on prices and production was in the tradition represented by John E. Cairnes. In this alternative approach, the analysis is “disaggregated” into a study of money’s impact on the economy through tracing the particular path by which changes in the money supply are introduced into the economy and the sequence of events through time by which the change in the money supply passes from one individual to another and from one sector of the economy to another.

This alternative tradition of monetary analysis is the one followed by the Austrian economists, the leading expositor of whom was Ludwig von Mises. He developed this approach in The Theory of Money and Credit (1912, 2nd ed., 1924), in “Monetary Stabilization and Cyclical Policy” (1928), and in his comprehensive treatise on economics, Human Action (1949).

If increases or decreases in the quantity of money brought about simultaneous and proportional increases and decreases in all prices, changes in the supply of money would be neutral in their effects on the economy. That is, neither the structure of relative prices nor the patterns of relative income shares earned by individuals and groups in the society would be affected by changes in the quantity of money. Money’s effect on the economy would be nominal and not real.

Mises and the Austrians argued that money’s impact on the market was always non-neutral in its effects. Economists such as Irving Fisher reasoned that the non-neutrality of money was due only to the fact that changes in the money supply were less than fully anticipated, and as a result, resource and labor contracts did not completely incorporate the actual average rate of price changes into resource prices and wage negotiations. Hence, cost prices would temporarily lag behind selling prices, creating temporary profit differentials.

The Austrians, on the other hand, insisted that money would be non-neutral in its effects even if resource prices and wages were as flexible as selling prices and even if market participants were to fully anticipate the average rate of change in the general price level as measured by a price index.

The reason for that was the Austrians’ method of analysis. Mises pointed out that any change in market conditions must ultimately have its beginning in the circumstances of one or more individuals. Nothing happens in the market that does not start with the decisions and choices of acting individuals.

If there is an increase in the supply of money, it must necessarily take the form of an increase in the cash holdings of particular people, who are the starting point of the resulting social consequences of a change in the quantity of money. Finding themselves with a greater amount of cash than they normally find it advantageous to hold, they will proceed to spend that “surplus” cash on the specific goods and services they find it attractive and profitable to buy.

The demand for goods and services in the market now begins to rise because of the increase in the money supply. But it is not all demands that initially increase, but only the particular demands for the particular goods that the individuals with the additional cash balances wish to purchase in greater quantities. Prices start to rise, but in this “first round” of the process, it is only the prices of the particular goods for which there has been an increased demand.

As the money is spent on those particular goods, the resulting sales become additional money receipts for the sellers of those goods. Those sellers now find their cash positions improved, enabling them to increase their demands for various goods and services offered on the market. There is now a “second round” increase in prices, but again the prices affected in this second round are those of the goods for which this second group of recipients of the new money wish to increase their demand.

The money spent in the second round becomes additional money receipts for another group of sellers. These sellers, likewise, find their cash position improved, enabling them, in turn, to increase their demands for various goods and services on the market. That now results in a “third round” increase in prices, but once again for the particular goods for which they have increased their demand.

The process will continue until the demand for all goods and services in the economy, in principle, will have been affected, with all prices to one extent or another having been changed by the monetary expansion. Prices in general will now be higher, but they will each have been impacted by the monetary increase in a particular sequence, to a different degree, and at different times in the process.

The fact that the monetary change works its way through the economy in a particular temporal sequence means that relative price relationships in the market will have been modified. The sequential price-increase differentials modify the relative profitabilities of producing various goods, which in turn influence the demand for and the allocation of resources and labor among the various sectors of the economy. As long as the inflationary process is working its way through the market, the patterns of demand for goods and services and the distribution of the factors of production are different from what they were before the inflationary process began and are different from what they will be when the inflationary process has reached its end.

At the same time, the very fact that the prices for those goods and resources (including labor) are changing in a non-neutral manner means that income and wealth are redistributed among individuals and groups as an integral part of the monetary process. Those who receive the increases in the money supply earlier in the inflationary process are able to purchase more goods and services before the full price effect on the economy has materialized. On the other hand, those whose demands and incomes are only impacted by the monetary expansion much later in the sequential process find themselves having to pay higher prices for many of the goods they buy, while their own prices and wages have either not increased at all or not to an extent equal to the general rise in prices. That inevitably creates groups of net gainers and net losers during the sequential-temporal process following changes in the money supply.

Any anticipation by the participants in the market of the increase in the average level of prices remains just that — a statistically calculated average of the individual price changes. Both during an inflationary (or deflationary) process and at its end, some prices will have increased (or decreased) more than the average and some less than the average. For money to be neutral during an inflationary (or deflationary) process, it would be necessary for each participant in the market to correctly anticipate when and to what extent the demand and the price for his particular resource (including labor services) would be affected by the monetary expansion (or contraction) in the particular temporal sequence of that historically distinct time frame. This clearly involves a greater degree of knowledge than can ever be possessed by agents in the market.

Nor is the non-neutrality of money dependent upon the fact that the prices for many types of resources and labor services are fixed by contract for various periods of time. Even if they were not, in the temporal-sequential stages of an inflationary (or deflationary) process, the prices for different goods are affected at different times, necessarily modifying the relative profitabilities of producing those different goods. It is those price-differential effects that influence producers to change their production decisions during an inflation (or deflation) and not merely the fact that some prices and wages are fixed by contract.

Likewise, it is not the unanticipated changes in the money supply per se that cause money to be non-neutral, and, therefore, to have real output and employment effects on the economy. Rather it is the fact that monetary changes work their way through the economy in a manner that necessarily cannot be fully anticipated and that actually modifies the relative prices of goods and the relative incomes positions among individuals and groups as an inherent part of any inflationary or deflationary process.

If any monetary change is always non-neutral in its effect on the market, then changes in the money supply by the government’s monetary authority in an attempt to maintain a “stable” price level can itself be a destabilizing force in an economy. And this, in fact, was the argument made by Mises’s fellow Austrian economist, Friedrich A. Hayek.

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    Richard M. Ebeling is a professor of economics at Northwood University. He was formerly president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).