Bitcoin: Money of the Future or Old-Fashioned Bubble?
http://www.wealthwire.com/news/equities/4735?r=1Posted by Wealth Wire - Tuesday, April 9th, 2013
Bitcoin has been all the rage lately. The stuff, or lack thereof, runs on peer-to-peer technology, is fully decentralized, has no patents, and is open source. Currently, there are almost 11 million bitcoin units in existence and the maximum amount of bitcoin units that will ever be created by the logic of its design are 21 million. For more details on how they work, see the recent Mises Daily “The Money-Ness of Bitcoins” by economist Nikolay Gertchev.
While bitcoins are designed so that they cannot be hyperinflated in name, they certainly can be hyperinflated in substance. Already, there are numerous knockoffs such as litecoin, namecoin, and freicoin in place. This is a particularly valid point because bitcoin is a starfish, i.e., it is fully decentralized. As stated by Ori Brafman and Rod A. Beckstrom,
The starfish doesn’t have a head. Its central body isn’t even in charge. In fact, the major organs are replicated throughout each and every arm. If you cut the starfish in half, you’ll be in for a surprise: the animal won’t die, and pretty soon you’ll have two starfish to deal with.
After the music-sharing service Napster went under, Niklas Zennström (the creator of Skype) stepped in with his creation called Kazaa, which had no central server that could be shut down. Eventually, such peer-to-peer programs became more numerous, to include Kazaa Lite, eDonkey, eMule, BitTorrent, etc. While this may be good news for people who like to download and share content for free, it certainly is not for people who are under the impression that bitcoin is a hedge against inflation. Those who compare bitcoin to a language neglect the fact that most people do not have an incentive to create a new language out of the blue. On the other hand, a great chunk of human history consists of people searching for the philosopher’s stone to magically produce gold. There can be no doubt that bitcoin has a built-in gold rush mechanism, which has already spilled over to litecoin and will be sure to spill over to subsequent knockoffs as well.
Does bitcoin jibe with the Austrian stand on money? The only way to find out is to read what the great Austrians had to say. Let’s start with Carl Menger. In Principles of Economics, Carl Menger made the point that money, a general medium of exchange, has always tended to be the most “saleable” (i.e., “marketable” or “liquid”) commodity of the time.
What is saleability? It is not simply value. One may have a Picasso at home, which will fetch quite a sum at a Sotheby’s auction during a boom, but a Picasso, like a poem by Friedrich Shiller, a work of Sanskrit, or a decades-old bottle of red wine can never be the most saleable good. As Menger put it, saleability is the
facility with which [a good] can be disposed of at a market at any convenient time at current purchasing prices, or with less or more diminution of the same. (...) Compare only the number of persons to whom bread and meat can be sold with the number to whom astronomical instruments can be sold.
Menger went on to point out that cattle were the most saleable commodity in the ancient world. This is perfectly understandable in a world where bare-bones subsistence is a reality for most people and the structure of production is virtually nonexistent. As society progressed, however, cattle became less and less marketable.
As civilization progressed, Menger states that,
… peoples who were led to adopt a copper standard as a result of the material circumstances under which their economy developed, passed on from the less precious metals to the more precious ones, from copper and iron to silver and gold, with the further development of civilization, and especially with the geographical extension of commerce.
Gold won out due to a variety of reasons, such as being durable, amalgamable, malleable, divisible, homogeneous, and rare. Yet, the ultimate reason that gold won out is because it was the most saleable of commodities. As Menger went on to write,
Gold nuggets extracted from the sands of the Aranyos River by a dirty Transylvanian gypsy are just as saleable in his hands as in the hands of the owner of [the] gold mine, provided the gypsy knows where to find the right market for his commodity. Gold nuggets can pass through any number of hands without any decrease whatsoever in marketability. But articles of clothing, bedding, prepared foods, etc., would be suspect and almost unsaleable, or at any rate of greatly depreciated value, in the hands of the gypsy, even if they had not been used by him, and even if he had, from the beginning, acquired them only with the intention of passing them on in exchange.
This leads us to another criticism of bitcoin: It can never be the most saleable good. The reasoning for this is quite simple. Until the majority of the 7 billion or so people that inhabit this planet have either a smart phone or frequent access to the internet, a digital currency is out of the question.
Gold, on the other hand, is easily recognizable, as opposed to silver that may be mistaken for other metals such as nickel. Moreover, it melts at a relatively low temperature and is a relatively soft metal, which provides superior amalgamation and partly explains why it historically won out over metals such as platinum. If one questions the role of gold in the present monetary system, one only has to walk down the street in a metropolitan area and see a ‘We Buy Gold’ sign. Moreover, central banks hold gold and lots of it. They do not hold cattle, wheat, soybeans, copper, silver, or bitcoins.
Menger also wrote,
I am ready to admit that, under highly developed conditions of trade, money is regarded by many economizing men only as a token. But it is quite certain that this illusion would immediately be dispelled if the character of coins as quantities of industrial raw materials were lost. 
While it may very well be true that some early adopters valued bitcoins with what Menger described as imaginary value, the point of the most saleable good bears repeating. Gold is and has been seen as an object of beauty since the dawn of civilization. Thus, the argument that bitcoins are in accord with the regression theorem because a handful of people consume them as they would a Picasso, is like saying paper money has value because John Law or Ben Bernanke really enjoy playing monopoly. In fact, we might as well say that alchemy works, considering that a significant amount of human history and energy was spent in attempting to find the philosopher’s stone. Some people may enjoy work just for the sake of working. Unfortunately, this is not a sufficient justification for slavery nor the labor theory of value.
With the imminent hyperinflation meme fading away and no longer holding much water, the new reason to hold bitcoins is the anonymity, nay, the freedom that it provides. Want to gamble online or buy something illegal? Bitcoins are the solution. It is a way of circumventing the authorities and uplifting free and voluntary trade, or so goes the story. Unfortunately for many of the misinformed, the reality is toto caelo. It would be best to take it from bitcoin developer Jeff Garzik himself. The fun starts at 3:20.
The ironic part about this is that anyone and everyone who has participated in illegal activity using bitcoins, presumably because they thought it was anonymous, now has a permanent record of every single one of their transactions contained on the public ledger. Those who think they are clever by using add-ons such as Tor are just as foolish as those who think prepaid cards or smart phones are anonymous. Imagine if bitcoins existed 50 years ago. Chances are, none of the last three presidents (including Barack Obama) would have run for office.
The question left to be answered is whether or not bitcoin is once again taking the shape of a bubble. The answer is yes. There is present a reflexive pattern of people buying because prices are rising, and prices rising because people are buying. The myopic are extrapolating the price trend of the past four months, which they deem is normal, and in so doing they exacerbate it to the upside, thus attracting even greater fools. The inflection point will come when the continuity of bullish thought is broken. One thing is for sure, the amount of suckers left who are willing to jump on the moving and ever-accelerating train is drawing thin, and so are their pockets.
When prices for any asset go parabolic, it does technical damage to a chart. It is sort of like someone deciding to go full speed in the middle of a marathon. Surely, one would look good for a few minutes. However, at a certain point one would inevitably collapse, with the possibilities of finishing the race being greatly diminished, let alone doing as well as they would have otherwise.
Gold went parabolic toward the second half of 2011 to $1,900/oz., which did a lot of technical damage to the charts that gold is just now beginning to shake off. Like Icarus, who had soared too high and melted the wax on his wings, parabolic moves always end in a correction, and if prolonged, a crash. Ironically, the best thing that can happen for bitcoin naysayers is if bitcoin skyrockets to $300/btc within a week.
There is nothing anti-Austrian about acknowledging that there exists in the market place a lot of naïve, irrational, and misinformed players. During the dotcom bubble, for example, a maintenance and building company called Temco Services almost tripled in a matter of minutes in 1998. The reason is because by 1998 every other layperson was involved in the market. Thus, the level of competence significantly dropped. The ticker symbol for Temco is TMCO, which was fairly close to that of Ticketmaster Online, which was TMCS. Ticketmaster Online (then TMCS) just happened to trade publicly for the first time on the day that Temco Services (TMCO) tripled. Rising asset prices create euphoria, and euphoria significantly drops the IQ of the participants.
Another reason why bitcoin is so susceptible to bubble behavior is because it is perceived as being something new. “New era” thinking always attracts lots of attention. The tulip was introduced to Europe by way of Turkey in the middle of the sixteenth century. (In fact, the word tulip came from the Turkish tulipan, which means turban.) The tulip was perceived as something new to Amsterdam, a country which at the time possessed an abundance of newly discovered gold and silver from the New World. Likewise, the Mississippi bubble, which was perpetrated by John Law, promised vast riches to be had from the New World. The manias in railways, the radio, the internet, you name it, most of them involved something new or something perceived to be new.
There is no doubt that bitcoin is a spontaneous answer to the monetary instability that we see all around us today. On one side of the pond people are worried about the glorified currency peg known as the Euro and on the other about the amount of damage that Bernanke is willing to inflict upon the world’s reserve currency. However, let us not become so enamored of an innovative stateless solution that we forget Austrian economics and hitch libertarianism’s wagon to something heading for a crash.
*Post courtesy of Patrik Korda at the Ludwig von Mises Institute.
Patrik Korda holds a bachelor’s degree in political science from BISLA and currently lives in New York, NY, where he works in market research. Follow him and Professor Mark Thornton on Fighting Apoplithorismosphobia. See Patrik Korda's article archives.
 The Starfish and the Spider was originally published in 2006
 Consider that bitcoin started at $35/btc in March and is currently at $185/btc, this is an increase of 429%. However, litecoin started at $0.07/ltc in March and is currently at $4.49/ltc, this is an increase of 6,314%. It makes perfect sense for people to pile into knockoffs because the potential profits, due to starting from a much smaller base, are exponentially higher. This is the gold rush mechanism at work.
 Underline added by the present writer
The Money-ness of Bitcoins
Bitcoins have been much in the news lately. Against
The Production of Bitcoins
A bitcoin is a unit of a nonmaterial virtual currency, also called crypto-currency, by the same name. They are stored in anonymous “electronic wallets,” described by a series of about 33 letters and numbers. Bitcoins can travel from a wallet to a wallet, by means of an online peer-to-peer network transaction. Any inter-wallet transfer is registered in the code of the bitcoin, so that the record of its entire transaction history clearly identifies its owner at any single moment, thereby preventing potential ownership conflicts. Bitcoins can be further divided into increments as small as one 100 millionth of a bitcoin. The current outstanding volume of bitcoins is above 10 million and is projected to reach 21 million in the year 2140.
This brings us to the truly fascinating production process of the bitcoins. They are “mined” based on a pre-defined mathematical algorithm, and come in a bundle, currently of 25 units, as a reward for carrying out a large number of computational operations that aim at discovering the solution to what could be described as a randomized mathematical puzzle. The role of the algorithm is to ensure a declining progression of the overall stock of bitcoins, by halving the reward every four years. Thus, somewhere in the beginning of 2017, the reward bundle will consist of 12.5 units only. Also, the more bitcoins are produced, the harder are the randomized mathematical puzzles to be solved.
Bitcoins come about as the uncertain pay-off for an energy—and hardware—-consuming process that is extended through time. The per-time pay-off varies, based on the efficiency and sophistication of the more-or-less specific hardware used for the mining. Individual miners have started to pool their efforts, and this cooperation has tremendously reduced the uncertainty that each individual miner bears.
Due to this costly production process, bitcoins, although virtual, are constrained by scarcity. While a bitcoin has no material shape or content, the algorithm that generates it has been designed to replicate the competitive production of a scarce good. First, entry in the business of producing bitcoins is open to anybody. Second, the production process is capital and labor intensive, extended through time, and also uncertain. Third, production is subject to decreasing returns, thereby conforming to the generalized scarcity faced by acting individuals in the better-known physical world. Thus, bitcoins turn out to be the exact opposite of the “Linden dollars” of the Second Life “virtual world.” The latter are produced by a monopolist central authority, out of thin air, and without any other limitation but the very discretion of that same monopolist authority.
However, it is not their costs of production that bestow on bitcoins the status of an economic good. After all, scarcity is not rooted in the absolute quantitative limitation of something; it comes from the insufficiency of the stock of that something, perceived as useful in some regard, relative to the individuals’ needs. Hence, we must ask ourselves how bitcoins have come to be valued at all. This leads us to an analysis of their demand.
The Demand for Bitcoins
At their inception, bitcoins were created and first held within a “crypto-punk” community. It could then be safely assumed that they served the purpose of conveying a specific antiestablishment worldview. The first demand factor, initially for producing bitcoins, and then unavoidably but only indirectly for holding them, was rooted in their capacity to project a certain point of view. In a sense, bitcoins were comparable to an artistic medium of expression, such as music, literature, and painting.
Thanks to that initial source of value, bitcoins had a reference point that positioned them relative to other goods and services. From there onward, the technological features that characterize them led to an expansion of their demand. Bitcoins are imperishable. Storage and protection against theft or accidental loss come at a very low cost, as these are accessory services rendered by standard antivirus and back-up software. Marginal transaction costs are also practically zero, once the fixed cost of establishing and maintaining a network connection has been accounted for. All these aspects are common to real wealth assets. Thus, the second demand factor for bitcoins is explained by their capacity to store wealth at a low cost. From the status of a good which, as a “worldview-conveyor,” was largely used for personal enjoyment (and hence consumption), bitcoins evolved into an investment good that has become attractive well beyond its original crypto-punk community.
The growing investment demand also spurred the development of intermediary dealers in bitcoins. There are a number of exchanges where bitcoins can be bought and sold against currencies. Specialized online storage, presumably with increased security, has also been made available. Intermediation, though open to free entry, is likely to remain rather monopolistic, given the very low margins associated with transacting in and with bitcoins.
This latter aspect, namely the intrinsically low transaction fee, contributes to a third demand factor for bitcoins, namely as a means of payment. A number of online vendors, who are mostly specialized in web-related services and online sales of rather exotic items, accept final payment in bitcoins, not the least because of the guarantee for almost absolute anonymity. This last component of the demand for bitcoins is still nascent. After all, a very limited set of items can be purchased with bitcoins, and sellers still price their goods in dollars, euros, etc. The price is then converted into bitcoins, according to the prevailing exchange rate, at the final stage of finalizing the payment method of the transaction. Thus, while bitcoins do appear to serve as a means of payment, they are definitely not used yet for business calculation. This is most certainly attributable to their still very limited demand to hold as a means of exchange. Nevertheless, couldn’t they become full-fledged money in the foreseeable future?
Bitcoins as Money
Prima facie, bitcoins possess all the qualities required from a money (a generally-used medium of exchange). They are perfectly homogeneous, easily cognizable, conveniently divisible, storable at practically no cost, and imperishable. Also, they seem to be fully shielded from counterfeiting. In addition, because they exist as a consumption and investment good, they are appraised on their own, thereby satisfying the Misesian regression criterion for the free-market inception of a medium of exchange. However, in order to become a viable alternative to existing monies, bitcoins must generate a sufficiently large demand so that their usage becomes generalized. Without the certainty that they can be transacted for any other good in the economy, a demand to hold them as money could not develop. It is with respect to their capacity to become and remain commonly used that bitcoins suffer from a relative disadvantage.
Indeed, bitcoins are embodied in a specific and highly capital-intensive technology. They can become convenient enough for standard personalized transactions only if both parties of the exchange possess the necessary technology that gives access to bitcoins. Bitcoins can do the job already for internet-based impersonalized purchases, because the marginal cost of the exchange technology they go along with is already almost zero for those who possess it. However, the transposition of that technology in the physical world of common face-to-face shopping (getting a haircut, buying a sandwich, or purchasing vegetables at the local grocery shop) would imply extra costs. True, these costs would decrease progressively as portable smartphones with permanent internet access become more widely used, not only by buyers, but also by sellers. The key point, however, is that bitcoins could become a generalized medium of exchange only through the accessory use of other, specific and physical, goods in an economy that has reached a very high level of technological development. This is a tremendous disadvantage, for at least two reasons.
First, at any given moment, the level of technological development is not uniform for all individuals within the same (national) economy. While some have access to the latest technology in a given field of activity, others prefer to stick to older versions. This is definitely due to the cost of replacing existing capital goods, but also to individual preferences, and sometimes to personal wealth. Consequently, bitcoins could become money only at the point when the technology that embodies them becomes commonly used. We are not there yet.
Second, an economy in which the medium of exchange is dependent so much upon the widespread use of a specific technology would be extremely vulnerable. Technologies are not given; they are the result of individual choices with respect to capital accumulation and allocation that must be made time and again, and are subject to reversal. Then, if the medium-of-exchange-linked technology is abandoned, because for instance no sufficient savings are available any longer, the economy will have to find another medium of exchange. This transition phase might then involve significant disruptions in the structure of production. A technology-linked medium of exchange does not provide enough flexibility to economic relations and might be viewed as complicating, rather than facilitating, some actions, such as shifting from one technology to another. This is a significant drawback of any virtual currency.
In trying to understand whether the increased popularity of bitcoins is reflecting the emergence of a new money, we have actually come to a fundamental distinction between virtual and material media of exchange. The latter are technology-independent and matter-embodied; the former are technology-embodied and matter independent. This distinction is not trivial as it emphasizes the great advantage that material money offers: it is good enough for anybody and at any time, and is independent from individual choices with respect to investment, allocation and maintenance of capital. Virtual monies could be programmed to reproduce some aspects of material, whether commodity or fiat, monies. However, they will always be dependent on specific capital investment decisions. The latter reduce their degree of commonality as well as of adaptability to changing economic conditions.
In conclusion, virtual monies, of which bitcoins seem to be the most perfected specimen up to date, do not allow acting individuals to manage the uncertainty of the future as well as material monies do. They could serve to intermediate exchanges among those who invest in the technology that creates them, stores them, and transfers them. Nevertheless, they could never achieve that degree of universality and flexibility that material monies carry with them by nature. Thus, on the free market, commodity monies, and presumably gold and silver, still have a great comparative advantage.
You can receive the Mises Dailies in your inbox. Subscribe or unsubscribe.
XVII. INDIRECT EXCHANGE
4. The Determination of the Purchasing Power of Money
As soon as an economic good is demanded not only by those who want to use it for consumption or production, but also by people who want to keep it as a medium of exchange and to give it away at need in a later act of exchange, the demand for it increases. A new employment for this good has emerged and creates an additional demand for it. As with every other economic good, such an additional demand brings about a rise in its value in exchange, i.e., in the quantity of other goods which are offered for its acquisition. The amount of other goods which can be obtained in giving away a medium of exchange, its "price" as expressed in terms of various goods and services, is in part determined by the demand of those who want to acquire it as a medium of exchange. If people stop using the good in question as a medium of exchange, this additional specific demand disappears and the "price" drops concomitantly.
Thus the demand for a medium of exchange is the composite of two partial demands: the demand displayed by the intention to use it in consumption and production and that displayed by the intention to use it as a medium of exchange. With regard to modern metallic money one speaks of the industrial demand and of the monetary demand. The value in exchange (purchasing power) of a medium of exchange is the resultant of the cumulative effect of both partial demands.
Now the extent of that part of the demand for a medium of exchange which is displayed on account of its service as a medium of exchange depends on its value in exchange. This fact raises difficulties which many economists considered insoluble so that they abstained from following farther along this line of reasoning. It is illogical, they said, to explain the purchasing power of money by reference to the demand for money, and the demand for money by reference to its purchasing power.
The difficulty is, however, merely apparent. The purchasing power [p. 409] which we explain by referring to the extent of specific demand is not the same purchasing power the height of which determines this specific demand. The problem is to conceive the determination of the purchasing power of the immediate future, of the impending moment. For the solution of this problem we refer to the purchasing power of the immediate past, of the moment just passed. These are two distinct magnitudes. It is erroneous to object to our theorem, which may be called the regression theorem, that it moves in a vicious circle.
But, say the critics, this is tantamount to merely pushing back the problem. For now one must still explain the determination of yesterday's purchasing power. If one explains this in the same way by referring to the purchasing power of the day before yesterday and so on, one slips into a regressus in infinitum. This reasoning, they assert, is certainly not a complete and logically satisfactory solution of the problem involved. What these critics fail to see is that the regression does not go back endlessly. It reaches a point at which the explanation is completed and no further question remains unanswered. If we trace the purchasing power of money back step by step, we finally arrive at the point at which the service of the good concerned as a medium of exchange begins. 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.
But, the critics continue, this means explaining that part of money's purchasing power which is due to its service as a medium of exchange by its employment for industrial purposes. The very problem, the explanation of the specific monetary component of its exchange value, remains unsolved. Here too the critics are mistaken. That component of money's value which is an outcome of the services it renders as a medium of exchange is entirely explained by reference to these specific monetary services and the demand they create. Two facts are not to be denied and are not denied by anybody. First, that the demand for a medium of exchange is determined by considerations [p. 410] of its exchange value which is an outcome both of the monetary and the industrial services it renders. Second, that the exchange value of a good which has not yet been demanded for service as a medium of exchange is determined solely by a demand on the part of people eager to use it for industrial purposes, i.e., either for consumption or for production. Now, the regression theorem aims at interpreting the first emergence of a monetary demand for a good which previously had been demanded exclusively for industrial purposes as influenced by the exchange value that was ascribed to it at this moment on account of its nonmonetary services only. This certainly does not involve explaining the specific monetary exchange value of a medium of exchange on the ground of its industrial exchange value.
Finally it was objected to the regression theorem that its approach is historical, not theoretical. This objection is no less mistaken. To explain an event historically means to show how it was produced by forces and factors operating at a definite date and a definite place. These individual forces and factors are the ultimate elements of the interpretation. They are ultimate data and as such not open to any further analysis and reduction. To explain a phenomenon theoretically means to trace back its appearance to the operation of general rules which are already comprised in the theoretical system. The regression theorem complies with this requirement. It traces the specific exchange value of a medium of exchange back to its function as such a medium and to the theorems concerning the process of valuing and pricing as developed by the general catallactic theory. It deduces a more special case from the rules of a more universal theory. It shows how the special phenomenon necessarily emerges out of the operation of the rules generally valid for all phenomena. It does not say: This happened at that time and at that place. It says: This always happens when the conditions appear; whenever a good which has not been demanded previously for the employment as a medium of exchange begins to be demanded for this employment, the same effects must appear again; no good can be employed for the function of a medium of exchange which at the very beginning of its use for this purpose did not have exchange value on account of other employments. And all these statements implied in the regression theorem are enounced apodictically as implied in the apriorism of praxeology. It must happen this way. Nobody can ever succeed in construction a hypothetical case in which things were to occur in a different way.
The purchasing power of money is determined by demand and supply, as is the case with the prices of all vendible goods and services. As action always aims at a more satisfactory arrangement of future [p. 411] conditions, he who considers acquiring or giving away money is, of course, first of all interested in its future purchasing power and the future structure of prices. But he cannot form a judgment about the future purchasing power of money otherwise than by looking at its configuration in the immediate past. It is this fact that radically distinguishes the determination of the purchasing power of money from the determination of the mutual exchange ration between the various vendible goods and services. With regard to these latter the actors have nothing else to consider than their importance for future want-satisfaction. If a new commodity unheard of before is offered for sale, as was, for instance, the case with radio sets a few decades ago, the only question that matters for the individual is whether or not the satisfaction that the new gadget will provide is greater than that expected from those goods he would have to renounce in order to buy the new thing. Knowledge about past prices is for the buyer merely a means to reap a consumer's surplus. If he were not intent upon this goal, he could, if need be, arrange his purchases without any familiarity with the market prices of the immediate past, which are popularly called present prices. He could make value judgments without appraisement. As has been mentioned already, the obliteration of the memory of all prices of the past would not prevent the formation of new exchange ratios between the various vendible things. But if knowledge about money's purchasing power were to fade away, the process of developing indirect exchange and media of exchange would have to start anew. It would become necessary to begin again with employing some goods, more marketable than the rest, as media of exchange. The demand for these goods would increase and would add to the amount of exchange value derived from their industrial (nonmonetary) employment a specific component due to their new use as a medium of exchange. A value judgment is, with reference to money, only possible if it can be based on appraisement. The acceptance of a new kind of money presupposes that the thing in question already has previous exchange value on account of the services it can render directly to consumption or production. Neither a buyer nor a seller could judge the value of a monetary unit if he had no information about its exchange value--its purchasing power--in the immediate past.
The relation between the demand for money and the supply of money, which may be called the money relation, determines the height of purchasing power. Today's money relation, as it is shaped on the ground of yesterday's purchasing power, determines today's purchasing power. He who wants to increase his cash holding restricts [p. 412] his purchases and increases his sales and thus brings about a tendency toward falling prices. He who wants to reduce his cash holding increases his purchases--either for consumption or for production and investment--and restricts his sales; thus he brings about a tendency toward rising prices.
Changes in the supply of money must necessarily alter the disposition of vendible goods as owned by various individuals and firms. The quantity of money available in the whole market system cannot increase or decrease otherwise than by first increasing or decreasing the cash holdings of certain individual members. We may, if we like, assume that every member gets a share of the additional money right at the moment of its inflow into the system, or shares in the reduction of the quantity of money. But whether we assume this or not, the final result of our demonstration will remain the same. This result will be that changes in the structure of prices brought about by changes in the supply of money available in the economic system never affect the prices of the various commodities and services to the same extent and at the same date.
Let us assume that the government issues an additional quantity of paper money. The government plans either to buy commodities and services or to repay debts incurred or to pay interest on such debts. However this may be, the treasury enters the market with an additional demand for goods and services; it is now in a position to buy more goods than it could buy before. The prices of the commodities it buys rise. If the government had expended in its purchases money collected by taxation, the taxpayers would have restricted their purchases and, while the prices of goods bought by the government would have risen, those of other goods would have dropped. But this fall in the prices of the goods the taxpayers used to buy does not occur if the government increases the quantity of money at its disposal without reducing the quantity of money in the hands of the public. The prices of some commodities--viz., of those the government buys--rise immediately, while those of the other commodities remain unaltered for the time being. But the process goes on. Those selling the commodities asked for by the government are now themselves in a position to buy more than they used previously. The prices of the things these people are buying in larger quantities therefore rise too. Thus the boom spreads from one group of commodities and services to other groups until all prices and wage rates have risen. The rise in prices is thus not synchronous for the various commodities and services.
When eventually, in the further course of the increase in the quantity [p. 413] of money, all prices have risen, the rise does not affect the various commodities and services to the same extent. For the process has affected the material position of various individuals to different degrees. While the process is under way, some people enjoy the benefit of higher prices for the goods or services they sell, while the prices of the things they buy have not yet risen or have not risen to the same extent. On the other hand, there are people who are in the unhappy situation of selling commodities and services whose prices have not yet risen or not in the same degree as the prices of the goods they must buy for their daily consumption. For the former the progressive rise in prices is a boon, for the latter a calamity. Besides, the debtors are favored at the expense of the creditors. When the process once comes to an end, the wealth of various individuals has been affected in different ways and to different degrees. Some are enriched, some impoverished. Conditions are no longer what they were before. The new order of things results in changes in the intensity of demand for various goods. The mutual ratio of the money prices of the vendible goods and services is no longer the same as before. The price structure has changed apart from the fact that all prices in terms of money have risen. The final prices to the establishment of which the market tends after the effects of the increase in the quantity of money have been fully consummated are not equal to the previous final prices multiplied by the same multiplier.
The main fault of the old quantity theory as well as the mathematical economists' equation of exchange is that they have ignored this fundamental issue. Changes in the supply of money must bring about changes in other data too. The market system before and after the inflow or outflow of a quantity of money is not merely changed in that the cash holdings of the individuals and prices have increased or decreased. There have been effected also changes in the reciprocal exchange ratios between the various commodities and services which, if one wants to resort to metaphors, are more adequately described by the image of price revolution than by the misleading figure of an elevation or a sinking of the "price level."
We may at this point disregard the effects brought about by the influence on the content of all deferred payments as stipulated by contracts. We will deal later with them and with the operation of monetary events on consumption and production, investment in capital goods, and accumulation and consumption of capital. But even in setting aside all these things, we must never forget that changes in the quantity of money affect prices in an uneven way. It depends on the data of each particular case at what moment and to what [p. 414] extent the prices of the various commodities and services are affected. In the course of a monetary expansion (inflation) the first reaction is not only that the prices of some of them rise more quickly and more steeply than others. It may also occur that some fall at first as they are for the most part demanded by those groups whose interests are hurt.
Changes in the money relation are not only caused by governments issuing additional paper money. An increase in the production of the precious metals employed as money has the same effects although, of course, other classes of the population may be favored or hurt by it. Prices also rise in the same way if, without a corresponding reduction in the quantity of money available, the demand for money falls because of a general tendency toward a diminution of cash holdings. The money expended additionally by such a "dishoarding" brings about a tendency toward higher prices in the same way as that flowing from the gold mines or from the printing press. Conversely, prices drop when the supply of money falls (e.g., through a withdrawal of paper money) or the demand for money increases (e.g., through a tendency toward "hoarding," the keeping of greater cash balances). The process is always uneven and by steps, disproportionate and asymmetrical.
It could be and has been objected that the normal production of the gold mines brought to the market may well entail an increase in the quantity of money, but does not increase the income, still less the wealth, of the owners of the mines. These people earn only their "normal" income and thus their spending of it cannot disarrange market conditions and the prevailing tendencies toward the establishment of final prices and the equilibrium of the evenly rotating economy. For them, the annual output of the mines does not mean an increase in riches and does not impel them to offer higher prices. They will continue to live at the standard at which they used to live before. Their spending within these limits will not revolutionize the market. Thus the normal amount of gold production, although certainly increasing the quantity of money available, cannot put into motion the process of depreciation. It is neutral with regard to prices.
As against this reasoning one must first of all observe that within a progressing economy in which population figures are increasing and the division of labor and its corollary, industrial specialization, are perfected, there prevails a tendency toward an increase in the demand for money. Additional people appear on the scene and want to establish cash holdings. The extent of economic self-sufficiency, i.e., of production for the household's own needs, shrinks and people become more dependent upon the market; this will, by and large, [p. 415] impel them to increase their holding of cash. Thus the price-raising tendency emanating from what is called the "normal" gold production encounters a price-cutting tendency emanating from the increased demand for cash holding. However, these two opposite tendencies do not neutralize each other. Both processes take their own course, both result in a disarrangement of existing social conditions, making some people richer, some people poorer. Both affect the prices of various goods at different dates and to a different degree. It is true that the rise in the prices of some commodities caused by one of these processes can finally be compensated by the fall caused by the other process. It may happen that at the end some or many prices come back to their previous height. But this final result is not the outcome of an absence of movements provoked by changes in the money relation. It is rather the outcome of the joint effect of the coincidence of two processes independent of each other, each of which brings about alterations in the market data as well as in the material conditions of various individuals and groups of individuals. The new structure of prices may not differ very much from the previous one. But it is the resultant of two series of changes which have accomplished all inherent social transformations.
The fact that the owners of gold mines rely upon steady yearly proceeds from their gold production does not cancel the newly mined gold's impression upon prices. The owners of the mines take from the market, in exchange for the gold produced, the goods and services required for their mining and the goods needed for their consumption and their investments in other lines of production. If they had not produced this amount of gold, prices would not have been affected by it. It is beside the point that they have anticipated the future yield of the mines and capitalized it and that they have adjusted their standard of living to the expectation of steady proceeds from the mining operations. The effects which the newly mined gold exercises on their expenditure and on that of those people whose cash holdings it enters later step by step begin only at the instant this gold is available in the hands of the mine owners. If, in the expectation of future yields, they had expended money at an earlier date and the expected yield failed to appear, conditions would not differ from other cases in which consumption was financed by credit based on expectations not realized by later events.
Changes in the extent of the desired cash holding of various people neutralize one another only to the extent that they are regularly recurring and mutually connected by a causal reciprocity. Salaried people and wage earners are not paid daily, but at certain pay days [p. 416] for a period of one or several weeks. They do not plan to keep their cash holding within the period between pay days at the same level; the amount of cash in their pockets declines with the approach of the next pay day. On the other hand, the merchants who supply them with the necessities of life increase their cash holdings concomitantly. The two movements condition each other; there is a causal interdependence between them which harmonizes them both with regard to time and to quantitative amount. Neither the dealer nor his customer lets himself be influenced by these recurrent fluctuations. Their plans concerning cash holding as well as their business operations and their spending for consumption respectively have the whole period in view and take it into account as a whole.
It was this phenomenon that led economists to the image of a regular circulation of money and to the neglect of the changes in the individuals' cash holdings. However, we are faced with a concatenation which is limited to a narrow, neatly circumscribed field. Only as far as the increase in the cash holding of one group of people is temporally and quantitatively related to the decrease in the cash holding of another group and as far as these changes are self-liquidating within the course of a period which the members of both groups consider as a whole in planning their cash holding, can the neutralization take place. Beyond this field there is no question of such a neutralization.
. The problems of money exclusively dedicated to the service of a medium of exchange and not fit to render any other services on account of which it would be demanded are dealt with below in section 9.
. The present writer first developed this regression theorem of purchasing power in the first edition of his book Theory of Money and Credit, published in 1912 (pp. 97-123 of the English-language translation). His theorem has been criticized from various points of view. Some of the objections raised, especially those by B. M. Anderson in his thoughtful book The Value of Money, first published in 1917 (cf. pp. 100 ff. of the 1936 edition), deserve a very careful examination. The importance of the problems involved makes it necessary to weigh also the objections of H. Ellis (German Monetary Theory 1905-1933 [Cambridge, 1934], pp. 77 ff.). In the text above, all objections raised are particularized and critically examined.
XVII. INDIRECT EXCHANGE
5. The Problem of Hume and Mill and the Driving
Force of Money
Is it possible to think of a state of affairs in which changes in the purchasing power of money occur at the same time and to the same extent with regard to all commodities and services and in proportion to the change affected in either the demand for or the supply of money? In other words, is it possible to think of neutral money within the frame of an economic system which does not correspond to the imaginary construction of an evenly rotating economy? We may call this pertinent question the problem of Hume and Mill.
It is uncontested that neither Hume nor Mill succeeded in finding a positive answer to this question. Is it possible to answer it categorically in the negative?
We imagine two systems of an evenly rotating economy A and B. The two systems are independent and in no way connected with one another. The two systems differ from one another only in the fact [p. 417] that to each amount of money m in A there corresponds an amount n m in B, n being greater or smaller than 1; we assume that there are no deferred payments and that the money used in both systems serves only monetary purposes and does not allow of any nonmonetary use. Consequently the prices in the two systems are in the ratio 1 : n. Is it thinkable that conditions in A can be altered at one stroke in such a way as to make them entirely equivalent to conditions in B?
The answer to this question must obviously be in the negative. He who wants to answer it in the positive must assume that a deus ex machina approaches every individual at the same instant, increases or decreases his cash holding by multiplying it by n, and tells him that henceforth he must multiply by n all price data which he employs in his appraisements and calculations. This cannot happen without a miracle.
It has been pointed out already that in the imaginary construction of an evenly rotating economy the very notion of money vanishes into an unsubstantial calculation process, self-contradictory and devoid of any meaning. It is impossible to assign any function to indirect exchange, media of exchange, and money within an imaginary construction the characteristic mark of which is unchangeability and rigidity of conditions.
Where there is no uncertainty concerning the future, there is no need for any cash holding. As money must necessarily be kept by people in their cash holdings, there cannot be any money. The use of media of exchange and the keeping of cash holdings are conditioned by the changeability of economic data. Money in itself is an element of change; its existence is incompatible with the idea of a regular flow of events in an evenly rotating economy.
Every change in the money relation alters--apart from its effects upon deferred payments--the conditions of the individual members of society. Some become richer, some poorer. It may happen that the effects of a change in the demand for and supply of money encounter the effects of opposite changes occurring by and large at the same time and to the same extent; it may happen that the resultant of the two opposite movements is such that no conspicuous changes in the price structure emerge. But even then the effects on the conditions of the various individuals are not absent. Each change in the money relation takes its own course and produces its own particular effects. If an inflationary movement and a deflationary one occur at the same time or if an inflation is temporally followed by a deflation in such a [p. 418] way that prices finally are not very much changed, the social consequences of each of the two movements do not cancel each other. To the social consequences of an inflation those of a deflation are added. There is no reason to assume that all or even most of those favored by one movement will be hurt by the second one, or vice versa.
Money is neither an abstract numeraire nor a standard of value or prices. It is necessarily an economic good and as such it is valued and appraised on its own merits, i.e., the services which a man expects from holding cash. On the market there is always change and movement. Only because there are fluctuations is there money. Money is an element of change not because it "circulates," but because it is kept in cash holdings. Only because people expect changes about the kind and extent of which they have no certain knowledge whatsoever, do they deep money.
While money can be thought of only in a changing economy, it is in itself an element of further changes. Every change in the economic data sets it in motion and makes it the driving force of new changes. Every shift in the mutual relation of the exchange ratios between the various nonmonetary goods not only brings about changes in production and in what is popularly called distribution, but also provokes changes in the money relation and thus further changes. Nothing can happen in the orbit of vendible goods without affecting the orbit of money, and all that happens in the orbit of money affects the orbit of commodities.
The notion of a neutral money is no less contradictory than that of a money of stable purchasing power. Money without a driving force of its own would not, as people assume, be a perfect money; it would not be money at all.
It is a popular fallacy to believe that perfect money should be neutral and endowed with unchanging purchasing power, and that the goal of monetary policy should be to realize this perfect money. It is easy to understand this idea as a reaction against the still more popular postulates of the inflationists. But it is an excessive reaction, it is in itself confused and contradictory, and it has worked havoc because it was strengthened by an inveterate error inherent in the thought of many philosophers and economists.
These thinkers are misled by the widespread belief that a state of rest is more perfect than one of movement. Their idea of perfection implies that no more perfect state can be thought of and consequently that every change would impair it. The best that can be said of a motion is that it is directed toward the attainment of a state of perfection in which there is rest because every further movement would [p. 419] lead into a less perfect state. Motion is seen as the absence of equilibrium and full satisfaction, as a manifestation of trouble and want. As far as such thoughts merely establish the fact that action aims at the removal of uneasiness and ultimately at the attainment of full satisfaction, they are well founded. But one must not forget that rest and equilibrium are not only present in a state in which perfect contentment has made people perfectly happy, but no less in a state in which, although wanting in many regards, they do not see any means of improving their condition. The absence of action is not only the result of full satisfaction; it can no less be the corollary of the inability to render things more satisfactory. It can mean hopelessness as well as contentment.
With the real universe of action and unceasing change, with the economic system which cannot be rigid, neither neutrality of money nor stability of its purchasing power are compatible. A world of the kind which the necessary requirements of neutral and stable money presuppose would be a world without action.
It is therefore neither strange nor vicious that in the frame of such a changing world money is neither neutral nor stable in purchasing power. All plans to render money neutral and stable are contradictory. Money is an element of action and consequently of change. Changes in the money relation, i.e., in the relation of the demand for and the supply of money, effect the exchange ratio between money on the one hand and the vendible commodities on the other hand. These changes do not affect at the same time and to the same extent the prices of the various commodities and services. They consequently affect the wealth of the various members of society in a different way.
. Cf. Mises, Theory of Money and Credit, pp. 140-142.
. Cf. above, p. 249.
XVII. INDIRECT EXCHANGE
6. Cash-Induced and Goods-Induced Changes in
Changes in the purchasing power of money, i.e., in the exchange ratio between money and the vendible goods and commodities, can originate either from the side of money or from the side of the vendible goods and commodities. The change in the data which provokes them can either occur in the demand for and supply of money or in the demand for and supply of the other goods and services. We may accordingly distinguish between cash-induced and goods-induced changes in purchasing power.
Goods-induced changes in purchasing power can be brought about by changes in the supply of commodities and services or in the demand for individual commodities and services. A general rise or fall [p. 420] in the demand for all goods and services or the greater part of them can be effected only from the side of money.
Let us now scrutinize the social and economic consequences of changes in the purchasing power of money under the following three assumptions: first, that the money in question can only be used as money--i.e., as a medium of exchange--and can serve no other purpose; second, that there is only exchange of present goods against future goods; third, that we disregard the effects of changes in purchasing power on monetary calculation.
Under these assumptions all that cash-induced changes in purchasing power bring about are shifts in the disposition of wealth among different individuals. Some get richer, others poorer; some are better supplied, others less; what some people gain is paid for by the loss of others. It would, however, be impermissible to interpret this fact by saying that total satisfaction remained unchanged or that, while no changes have occurred in total supply, the state of total satisfaction or of the sum of happiness has been increased or decreased by changes in the distribution of wealth. The notions of total satisfaction or total happiness are empty. It is impossible to discover a standard for comparing the different degrees of satisfaction or happiness attained by various individuals.
Cash-induced changes in purchasing power indirectly generate further changes by favoring either the accumulation of additional capital or the consumption of capital available. Whether and in what direction such secondary effects are brought about depends on the specific data of each case. We shall deal with these important problems at a later point.
Goods-induced changes in purchasing power are sometimes nothing else but consequences of a shift of demand from some goods to others. If they are brought about by an increase or a decrease in the supply of goods they are not merely transfers from some people to other people. They do not mean that Peter gains what Paul has lost. Some people may become richer although nobody is impoverished, and vice versa.
We may describe this fact in the following way: Let A and B be two independent systems which are in no way connected with each other. In both systems the same kind of money is used, a money which cannot be used for any nonmonetary purpose. Now we assume, as case 1, that A and B differ from each other only in so far as in B the [p. 421] total supply of money is n m, m being the total supply of money in A, and that to every cash holding of c and to every claim in terms of money d in A there corresponds a cash holding of n c and a claim of n d in B. In every other respect A equals B. Then we assume, as case 2, that A and B differ from each other only in so far as in B the total supply of a certain commodity r is n p, p being the total supply of this commodity in A, and that to every stock v of this commodity r in A there corresponds a stock of n v in B. In both cases n is greater than 1. If we ask every individual of A whether he is ready to make the slightest sacrifice in order to exchange his position for the corresponding place in B, the answer will be unanimously in the negative in case 1. But in case 2 all owners of r and all those who do not own any r, but are eager to acquire a quantity of it--i.e., at least one individual--will answer in the affirmative.
The services money renders are conditioned by the height of its purchasing power. Nobody wants to have in his cash holding a definite number of pieces of money or a definite weight of money; he wants to keep a cash holding of a definite amount of purchasing power. As the operation of the market tends to determine the final state of money's purchasing power at a height at which the supply of and the demand for money coincide, there can never be an excess or a deficiency of money. Each individual and all individuals together always enjoy fully the advantages which they can derive from indirect exchange and the use of money, no matter whether the total quantity of money is great or small. changes in money's purchasing power generate changes in the disposition of wealth among the various members of society. From the point of view of people eager to be enriched by such changes, the supply of money may be called insufficient or excessive, and the appetite for such gains may result in policies designed to bring about cash-induced alterations in purchasing power. However, the services which money renders can be neither improved nor repaired by changing the supply of money. There may appear an excess or a deficiency of money in an individual's cash holding. But such a condition can be remedied by increasing or decreasing consumption or investment. (Of course, one must not fall prey to the popular confusion between the demand for money for cash holding and the appetite for more wealth.) The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do.
From the point of view of this insight one may call wasteful all expenditures incurred for increasing the quantity of money. The fact that things which could render some other useful services are [p. 422] employed as money and thus withheld from these other employments appears as a superfluous curtailment of limited opportunities for want-satisfaction. It was this idea that led Adam Smith and Ricardo to the opinion that it was very beneficial to reduce the cost of producing money by resorting to the use of paper printed currency. However, things appear in a different light to the students of monetary history. If one looks at the catastrophic consequences of the great paper money inflations, one must admit that the expensiveness of gold production is the minor evil. It would be futile to retort that these catastrophes were brought about by the improper use which the governments made of the powers that credit money and fiat money placed in their hands and that wiser governments would have adopted sounder policies. As money can never be neutral and stable in purchasing power, a government's plans concerning the determination of the quantity of money can never be impartial and fair to all members of society. Whatever a government does in the pursuit of aims to influence the height of purchasing power depends necessarily upon the rulers' personal value judgments. It always furthers the interests of some groups of people at the expense of other groups. It never serves what is called the commonweal or the public welfare. In the field of monetary policies too there is no such thing as a scientific ought.
The choice of the good to be employed as a medium of exchange and as money is never indifferent. It determines the course of the cash-induced changes in purchasing power. The question is only who should make the choice: the people buying and selling on the market, or the government? It was the market which in a selective process, going on for ages, finally assigned to the precious metals gold and silver the character of money. For two hundred years the governments have interfered with the market's choice of the money medium. Even the most bigoted etatists do not venture to assert that this interference has proved beneficial.
Inflation and Deflation; Inflationism and Deflationism
However, those applying these terms are not aware of the fact that purchasing power never remains unchanged and that consequently there is always either inflation or deflation. They ignore these necessarily perpetual fluctuations as far as they are only small and inconspicuous, and reserve the use of the terms to big changes in purchasing power. Since the question at what point a change in purchasing power begins to deserve being called big depends on personal relevance judgments, it becomes manifest that inflation and deflation are terms lacking the categorial precision required for praxeological, economic, and catallactic concepts. Their application is appropriate for history and politics. Catallactics is free to resort to them only when applying its theorems to the interpretation of events of economic history and of political programs. Moreover, it is very expedient even in rigid catallactic disquisitions to make use of these two terms whenever no misinterpretation can possibly result and pedantic heaviness of expression can be avoided. But it is necessary never to forget that all that catallactics says with regard to inflation and deflation--i.e., big cash-induced changes in purchasing power--is valid also with regard to small changes, although, of course, the consequences of smaller changes are less conspicuous than those of big changes.
The terms inflationism and deflationism, inflationist and deflationist, signify the political programs aiming at inflation and deflation in the sense of big cash-induced changes in purchasing power.
The semantic revolution which is one of the characteristic features of our day has also changed the traditional connotation of the terms inflation and deflation. What many people today call inflation or deflation is no longer the great increase or decrease in the supply of money, but its inexorable consequences, the general tendency toward a rise or a fall in commodity prices and wage rates. This innovation is by no means harmless. It plays an important role in fomenting the popular tendencies toward inflationism.
First of all there is no longer any term available to signify what inflation used to signify. It is impossible to fight a policy which you cannot name. Statesmen and writers no longer have the opportunity of resorting to a terminology accepted and understood by the public when they want to question the expediency of issuing huge amounts of additional money. They must enter into a detailed analysis and description of this policy with full particulars and minute accounts whenever they want to refer to it, and they must repeat this bothersome procedure in every sentence in which they deal with the subject. As this policy has no name, it becomes self-understood and a matter of fact. It goes on luxuriantly.
The second mischief is that those engaged in futile and hopeless attempts to fight the inevitable consequences of inflation--the rise in prices--are disguising their endeavors as a fight against inflation. [p. 424] While merely fighting symptoms, they pretend to fight the root causes of the evil. Because they do not comprehend the causal relation between the increase in the quantity of money on the one hand and the rise in prices on the other, they practically make things worse. The best example was provided by the subsidies granted in the Second World War on the part of the governments of the United States, Canada, and Great Britain to farmers. Price ceilings reduce the supply of the commodities concerned because production involves a loss for the marginal producers. To prevent this outcome the governments granted subsidies to the farmers producing at the highest costs. These subsidies were financed out of additional increases in the quantity of money. If the consumers had had to pay higher prices for the products concerned, no further inflationary effects would have emerged. The consumers would have had to use for such surplus expenditure only money which had already been issued previously. Thus the confusion of inflation and its consequences in fact can directly bring about more inflation.
It is obvious that this new-fangled connotation of the terms inflation and deflation is utterly confusing and misleading and must be unconditionally rejected.
. Cf. below, Chapter XX.
XVII. INDIRECT EXCHANGE
7. Monetary Calculation and Changes in Purchasing Power
Monetary calculation reckons with the prices of commodities and services as they were determined or would have been determined or presumably will be determined on the market. It is eager to detect price discrepancies and to draw conclusions from such a detection.
Cash-induced changes in purchasing power cannot be taken into account in such calculations. It is possible to put in the place of calculation based on a definite kind of money a mode of calculation based on another kind of money b. Then the result of the calculation is made safe against adulteration on the part of changes effected in the purchasing power of a; but it can still be adulterated by changes effected in the purchasing power of b. There is no means of freeing any mode of economic calculation from the influence of changes in the purchasing power of the definite kind of money on which it is based.
All results of economic calculation and all conclusions derived from them are conditioned by the vicissitudes of cash-induced changed in purchasing power. In accordance with the rise of fall in purchasing power there emerge between items reflecting earlier prices and those reflecting later prices specific differences; the calculation shows profits or losses which are merely produced by cash-induced changes effected in the purchasing power of money. If we compare such profits or [p. 425] losses with the result of a calculation accomplished on the basis of a kind of money whose purchasing power had been subject to less vehement changes, we can call them imaginary or apparent only. But one must not forget that such statements are only possible as a result of the comparison of calculations carried out in different kinds of money. As there is no such thing as a money with stable purchasing power, such apparent profits and losses are present with every mode of economic calculation, no matter on what kind of money it may be based. It is impossible to distinguish precisely between genuine profits and losses and merely apparent profits and losses.
It is therefore possible to maintain that economic calculation is not perfect. However, nobody can suggest a method which could free economic calculation from these defects or design a monetary system which could remove this source of error entirely.
It is an undeniable fact that the free market has succeeded in developing a currency system which serves all the requirements both of indirect exchange and of economic calculation. The aims of monetary calculation are such that they cannot be frustrated by the inaccuracies which stem from slow and comparatively slight movements in purchasing power. Cash-induced changes in purchasing power of the extent to which they occurred in the last two centuries with metallic money, especially with gold money, cannot influence the result of the businessmen's economic calculations so considerably as to render such calculations useless. Historical experience shows that one could, for all practical purposes of the conduct of business, manage very well with these methods of calculation. Theoretical consideration shows that it is impossible to design, still less to realize, a better method. In view of these facts it is vain to call monetary calculation imperfect. Man has not the power to change the categories of human action. He must adjust his conduct to them.
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 [p. 426] depreciation quotas, invariably fixed as 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 cash-induced 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.
XVII. INDIRECT EXCHANGE
8. The Anticipation of Expected Changes in
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 cash-induced 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 [p. 427] believe that they are on the eve of big cash-induced 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 this 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 the 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 (Flucht 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 this 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 [p. 428] 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.