Monetary Central Planning and the State, Part 5: The Austrian Economists on the Origin and Purchasing Power of Money

Even before the First World War, a number of prominent American economists had criticized Irving Fisher’s proposal for stabilization of the price level through monetary manipulation by the government. Frank Taussig of Harvard University, J. Laurence Laughlin of the University of Chicago, and David Kinley of the University of Illinois had forcefully argued that implementing Fisher’s scheme would generate more, not less, economic instability.

But it was the Austrian economists who reasoned most persuasively against a price-level stabilization policy in the 1920s. To understand their criticisms of price-level stabilization, it is necessary to begin with Carl Menger, the founder of the Austrian school.

In his Principles of Economics (1871) and in a monograph entitled “Money” (1892), Menger explained the origin of a medium of exchange. Often there are insurmountable difficulties preventing people from trading one good for another. One of the potential trading partners may not want the good the other possesses. Perhaps one of the goods offered in exchange cannot readily be divided into portions reflecting possible terms of trade. Therefore, the transaction cannot be consummated.

As a result, individuals try to find ways to achieve their desired goals through indirect methods. An individual may first trade away the good in his possession for some other commodity for which he has no particular use. But he may believe that it would be more readily accepted by a person who has a good he actually wants to acquire. He uses the commodity for which he has no direct use as a medium of exchange. He trades commodity A for commodity B and then turns around and exchanges commodity B for commodity C. In this sequence of transactions, commodity B has served as a medium of exchange for him.

Menger went on to explain that, over time, transactors discover that certain commodities have qualities or marketable attributes that make them especially serviceable as media of exchange. Some commodities are in greater general demand among a wide circle of potential transactors. Some commodities are more readily transportable and more easily divisible into convenient amounts to reflect agreed-upon terms of exchange. Some are relatively more durable and scarce and difficult to reproduce. The commodities that possess the right combinations of these attributes and characteristics tend to become, over a long period of time, the most widely used and readily accepted media of exchange in an expanding arena of trade and commerce.

Therefore, those commodities historically became the money-goods of the market because the very definition of a money is that commodity that is most widely used and generally accepted as a medium of exchange in a market.

Money begins as one of the ordinary commodities of the market. But because of its particular marketable qualities, it slowly comes to be demanded for its usefulness as a medium of exchange, as well. And, indeed, over time, its use as a medium of exchange may supersede its other uses as an ordinary commodity. Historically, gold and silver came to serve as the most widely accepted media of exchange — the money-goods of the market.

For Menger and later members of the Austrian school, this was a strong demonstration, both theoretically and historically, that money is not a creation or a creature of the state. In its origin, money naturally emerges out of the processes of the market, as individuals search for better and easier ways to satisfy their wants through trade and exchange.

A second question that the Austrians asked was: Once a money is in use, how does one define its purchasing power or value in the market? First Menger and then Ludwig von Mises, in his book The Theory of Money and Credit (1912; 2nd ed., 1924), devoted careful attention to this question.

In a state of barter, when every commodity directly trades for all the others, each good on the market has as many prices as goods against which it exchanges. But in a money-using economy, goods no longer trade directly one for the other. Instead, each good is first sold for money, and then with the money earned from selling commodities, individuals turn around and purchase other goods they wish to buy. Each good comes to have only one price on the market — its money price.

But money remains the one exception to this. Money is the one commodity that continues to trade directly for all the other goods offered on the market. As a result, money has no single price. Rather, money has as many prices as goods with which it trades on the market. The purchasing power of money, therefore, is the array or set of exchange ratios between money and each of the other goods against which it trades. And the actual value of money at any moment in time is that set of specific exchange ratios that have emerged on the market through the trading of money for each of those other goods in the economy.

By definition, the purchasing power or value of money is always subject to change. Anything that changes people’s willingness and ability to sell goods for money or to sell money for goods will modify the exchange ratios between money and goods. If people have a change in their preferences such that they now want to consume more chicken and less hamburger, the demand for chicken on the market would rise and the demand for hamburger would fall. This would change the relative price between chicken and hamburger, as the price of chicken tended to go up relative to the price of hamburger. But at the same time, it would also change the purchasing power or value of money, since now the money price of chicken would have increased and the money price of hamburger would have decreased. The array or set of exchange ratios between money and other goods on the market would, therefore, also now be different from what they were before.

Suppose, instead, that people had a change in their preferences and wanted to demand fewer goods and wanted to hold a larger amount of the money they earned from selling goods as an available cash balance for some future exchange purposes. The demand for goods would decrease and the demand for holding money as a cash balance would increase. The money prices of goods would tend to decline, raising the purchasing power or value of each unit of money, since at lower money prices, each unit of money would command a greater buying power over goods offered on the market.

Unless people decreased their demand for goods proportionally, at the same time that the value of money was rising, the relative prices among goods would change, as well. Why? Because if the demand for, say, chicken decreased more than the demand for hamburger, then even at the overall lower scale of money prices, the money price of chicken will have tended to decrease more than the money price of hamburger. The structure of relative prices would have changed as part of the same process that had changed the scale or level of money prices in general.

Irving Fisher’s proposal, therefore, to “stabilize, or standardize, the dollar just as we have already standardized the yardstick, the pound weight, the pint cup. . . .” was built on a false analogy. (See “Monetary Central Planning and the State, Part II” in Freedom Daily, February 1997). A yardstick is a multiple of a fixed unit of measurement — an inch.

But the purchasing power or value of money is not a fixed unit of measurement. It is composed of a set of exchange ratios between money and other goods, reflecting the existing and changing valuations of the participants in the market about the desirability and their demand for various commodities relative to the attractiveness of spending money or holding it as a cash balance of a certain amount.

In The Theory of Money and Credit and his later monograph, “Monetary Stabilization and Cyclical Policy” (1928), Ludwig von Mises also challenged Irving Fisher’s proposal for measuring changes in the purchasing power of money through the use of index numbers. A consumer price index, for example, is constructed by selecting a group of commodities chosen as “representative” of the normal and usual types of goods bought by an average family within a particular community. The items in this representative basket of consumer purchases are then “weighted” in terms of the relative amounts of each good in the basket that this representative family is assumed to purchase during any normal period. The prices for these goods times the relative quantities bought of each one is then defined as the cost of purchasing this representative basket of consumer items

The prices of these goods, multiplied by the fixed relative amounts assumed to be bought, are tracked over time to determine whether the cost of living for this representative consumer-family has increased or decreased. Whether or not the sum of money originally required to buy the basket at the beginning of the series is able to buy a larger, smaller, or the same basket at a later period is then taken to be a measure of the extent to which the purchasing power or value of money has increased, decreased, or stayed the same.

Mises argued that the construction of index numbers, rather than being a supposedly precise method for measuring changes in the purchasing power of money, was in fact a statistical fiction built on arbitrary assumptions. The first of these arbitrary assumptions concerned the selection of goods to include in the basket and the relative weights to assign to them. Preferences for goods vary considerably among individuals, including among individuals in similar income and social groups or geographic locations. Which group of goods to include, therefore, can claim no scientific precision, nor can the judgment concerning the relative quantities labeled as “representative” in the basket.

The second arbitrary assumption also concerns the “weights” assigned to the goods in the basket. It is assumed that over the periods compared, the same relative amounts purchased in the beginning period are purchased in future periods. But in the real world of actual market transactions, the relative amounts of various goods purchased are always changing. People’s preferences and desires for goods are constantly open to change. Even when people’s basic preferences for goods have not changed, in the real world the relative prices of various goods are changing. People tend to buy less of goods that are rising in price and more of goods decreasing in price or more of those not rising in price as much as others.

The third arbitrary assumption is that new goods are not being offered on the market and that older goods are being taken off the market. But both occurrences are common and modify the types and quantities of goods in a consumer’s basket.

The fourth arbitrary assumption concerns changes in the qualities of the goods offered for sale on the market. A good that improves in quality but continues to be sold at the same price is now a cheaper good, i.e., the consumer now gets more for his money. But the index records no increase in the value of the consumer’s dollar. A good may rise in price and, at the same time, be improved in its quality. But there is no exact way to determine how much of the higher price may be due to the product’s being better and how much may just be due to other changes in its supply and demand conditions that have occurred at the same time.

Ludwig von Mises’s conclusion, therefore, was that there is no scientific way of knowing with any precision whether and by how much the purchasing power or value of money may have changed over a given period of time. Thus, the statistical method considered by Irving Fisher to be the key for guiding monetary policy for purposes of stabilizing the price level was fundamentally and irreparably flawed.

But whether the construction and application of index numbers was flawed or not, stabilization of the price level became a guiding target for the Federal Reserve in the 1920s. And that policy became a prime ingredient for creating the imbalances in the market that resulted in the Great Depression.

Categories: Freedom Daily Archive, Monetary Policy