When the second German-language edition of Ludwig von Mises’s The Theory of Money and Credit appeared 100 years ago, in 1924, it was less than a year since the great German and Austrian inflations had come to an end in 1923. (See my article “The Great German and Austrian Inflations, 100 Years Ago,” Future of Freedom, March 2023.) The huge monetary expansions had pushed prices in general to astronomical heights, bringing social and economic havoc in their wake. It had these effects precisely because of the inherent and inescapable “non-neutral” manner in which increases in the money supply are “injected” and introduced into society.
During the war years, the monetary expansions had been primarily used to feed the fiscal needs of the imperial German and Austrian governments to finance their military expenditures. In the postwar period between 1918 and 1923, the monetary printing presses had been set loose to cover the interventionist and welfare statist policies and programs of the new “democratic” governments in the German “Weimar” Republic and the much smaller Republic of Austria. The unevenness with which prices rose, with some prices rising before others, in both systematic and unsystematic patterns, distorted the structures of relative prices and wages, bringing about the appearances of profits in some sectors of the German and Austrian economies and losses in others that influenced the attempted uses of resources, labor, and capital.
One aspect of this monetary inflationary process was what became known as “forced savings,” the rising of selling prices before input prices, especially wages, which resulted in the real incomes of many workers falling relative to profit margins of investors and capital owners. It was called forced savings due to it leading to attempts for greater capital investment than would have seemed possible and profitable in a noninflationary environment. This twisted process was highlighted due to the exaggerated nature of it under a hyperinflation, when prices were rising at hundreds of percent per month. The noted Italian economist Constantino Bresciani-Turroni, the author of The Economics of Inflation (1931), pointed out:
Inflation, and more especially “hyperinflation,” may be compared with a magnifying glass, which has allowed of distinctly observing many of the facts not easy to disentangle when following the sequence of events during an ordinary Trade Cycle. The changes in the structure of production, brought about by inflation, and later by a currency stabilization [in 1924], were most apparent in Germany. During the inflation period the substantial fall in real wages, which meant a ‘forced savings’ on a large scale, allowed the productive resources of the country to be deflected from the production of consumer goods to that of fixed capital. This continued as long as the new issues of paper money exerted a pressure upon real wages.
But when the German inflation came to an end in November 1923, there set in a “stabilization crisis” in which the German economy went through a reversal, with capital values falling relative to consumer goods prices, and a rebalancing of labor and capital uses and prices to reflect the new noninflationary setting. Bresciani-Turroni concluded, “It seems to me that these facts are significant” as an “inductive verification” of the Austrian theory of inflationary processes.
Another aspect of money’s non-neutrality, matching forced savings, was that of “capital consumption,” already emphasized by Mises in his earlier book, Nation, State, and Economy (1919), before the worst of the German and Austrian inflations had occurred. With selling prices often running ahead of input prices (including money wages) for a period of time, the inflation created the impression of increased profit margins that acted as the incentives to undertake capital investments and expand output levels. However, when private enterprises reentered resource markets to continue production processes anew, they often found that input prices now had (with a lag) risen more than the higher input prices they had previously earned; as a result, these recently earned sales revenues were sometimes not sufficient to purchase all of the needed inputs to continue output at the same and higher levels, with often the inability to replace capital that had been used up in production processes.
Hence, capital was “consumed,” bringing about declines in the productive capacities of the economy as a whole. All the inflationary “good times” turned out to be a great illusion with disastrous effects from a more longer-term perspective. Or as Mises expressed it in The Theory of Money and Credit, “Inflation had the great advantage of evoking the appearance of economic prosperity and of increased wealth, of falsifying calculations made in terms of money, and so concealing the consumption of capital.”
Money and choices in the present vs. the future
The other important aspect to Mises’s analysis of money and the monetary system, therefore, was the role of a medium of exchange in the relationship between savings and investment. All economic decision-making revolves around the problem of how best to use the means at our disposal to attain the desired ends. Many of these decisions involve us choosing between a variety of alternatives. Shall I use some of my available means to buy a hat today or a new shirt? Shall I order ham and eggs for breakfast at a local restaurant or pancakes with maple syrup? Shall I read the morning newspaper for the next half hour or watch my favorite 30-minute sitcom on my streaming service?
But other decisions involve us making choices between alternatives over and across time. Having graduated from high school, do I enter the job market right away and start earning a full-time income to buy many of the things I would like to have in the here-and-now? Or do I forego all or part of that earnable income for the next four years to go to college and finish with a degree that puts me on a career track that will result in my very likely earning far more income in the future than if I take a job right out of high school? Do I spend all or most of my earned income now, or do I put some of it aside to start accumulating a nest egg for retirement, or into savings in case of an unexpected emergency, or to have most or all of the tuition ready to pay for my child’s future college education?
These and many similar types of choices concern options nearer to the present or further into the future. These are time preference decisions and choices between alternatives. Indeed, our decisions about the purposes for which we will use some of our available means in the present always include the implicit choice of deferring some consumption desires today for some gain in the future (when that future could be minutes, hours, days, or years away from right now). And like all other choices, time preference decisions are also made “at the margin,” that is, a little bit less of something in the present in order to have a bit more of something desired in the future.
Time preference, gains from trade, and the rate of interest
Sometimes, individuals find themselves with differing time preferences. One person has less means at his disposal for some project that he would like to undertake over time, the desired outcome of which would not be until some point in the future. Another individual, however, might be willing to defer using some of his available means today for a desired end if there is a financial incentive to wait to use them until sometime in the future.
In the old Popeye-the-Sailor cartoons, Wimpy would say, “I will gladly pay you Tuesday for a hamburger today.” But the person asked to wait until Tuesday to be paid by Wimpy for that hamburger might reasonably reply, “Why should I forgo eating that hamburger myself today, or not selling it to someone else willing to pay for it right now?” Then Wimpy would have to ask himself how much more might he be willing to pay in the future for today’s hamburger, and how much the owner of that hamburger would want to be paid in the future to forgo his own consumption, or the premium over today’s hamburger price, to make it worth his while for him to wait until the future to be paid. That premium in the future over the item’s current value or price is the basis of a market rate of interest.
The rate of interest, in other words, as the Austrian economists argued almost from the origin of the Austrian school, is the price of future goods over present goods. Of course, in the developed market economy, goods in the present do not directly trade for goods in the future. As in all market transactions, the exchange is facilitated through the medium of money to overcome the difficulties and “impossibilities” of barter, due to a lack of a coincidence of wants or indivisibilities in the goods to be bought and sold, or because goods offered in the present are not necessarily the same goods to be received in the future.
The saver who consumes less than the full income he has earned lends to the borrower an agreed amount of money. The saver forgoes his demand for particular goods in the present that he might otherwise have spent his money in purchasing, and for which particular resources would have been used to meet that demand. Instead, that sum of money passes into the hands of the borrower for the period of the loan, and he demands other types of goods than the lender would have. Resources, labor, and capital (tools, equipment, machinery) are devoted to different uses over that period of time, the outcome of which will be a finished good or product of some sort that the borrower anticipates will meet a future demand and earn a profit that more than justifies the expenses incurred and the interest payments to be made to the lender. When the loan is repaid, the lender may roll over that sum of money to lend it again to earn additional interest income, or spend all or part of the original principal and interest income on some of the present demands he wishes to satisfy.
Maintaining and increasing capital through savings
Imagine that there is a baker who possesses an oven that enables him to bake one thousand loaves of bread each day. No matter how diligent the baker may be in repairing and maintaining his oven, at some point wear and tear will require it to be replaced.
There needs to be enough savings by some in the society for sufficient resources, labor, and certain other types of capital to be “freed up” from current consumption so that others on the production side of the market may have them available to manufacture the new replacement oven in a market-coordinated manner such that the new oven will be available for sale and installation when the old oven needs to be replaced. Only in that manner could a given level of production of a thousand loaves of bread per day be ensured.
We can also imagine that the time preferences of some members of the society change, such that they save more; that is, they demand fewer consumer goods today and therefore free up more resources for investment purposes. By some consuming less and saving more, the greater supply of savings on the loan market would tend to competitively lower the rate of interest. Since the lower rate of interest has, other things held the same, lowered the costs of producing ovens, the oven manufacturer could borrow the additional savings to now produce, say, two ovens. He could then offer the two to the baker at a lower price that makes it sufficiently attractive for the baker to purchase both the replacement oven and a second oven to expand his daily output of bread.
If the technology of the ovens has not changed, then the baker, with two ovens, could now supply two thousand loaves of bread every day on the market at a lower per unit price, bringing about a general rise in the standard of living with more food available for consumption. Thus, the “sacrifice” of some consumption satisfactions in the past due to greater savings is “rewarded” with more goods to consume when the future has arrived. While admittedly presented in a very simplified manner, this is, in essence, how societies economically grow and become wealthier in terms of more desired goods to better satisfy the wants of their members.
Investment and the time structure of production
At the same time, all such investment processes take time and usually go through a variety of stages of production. We can imagine that from start to finish, such an investment process passes through five stages to be completed, with each stage, just for the sake of the example, requiring one month of time. Again, for simplification, we might assume that at each of the stages, the inputs (resources, labor, use of capital equipment) require expenditures of $100. We can further suppose that each stage is undertaken by a separate enterprise, which sells its partially completed version of the product to the next enterprise, until at the end of the fifth month, the product is in its finished form and ready for sale to an interested buyer.
Thus, the value added at each stage cumulatively comes to $500; if we presume that the entrepreneurial decisions at each stage had correctly anticipated the demand at the next stage, the final, finished product would sell for the $500 that has gone into its successful completion. If consumer demand for the product continues month after month, then each of these stages of production must be in process simultaneously through time. If this product is wanted for consumption in May, then the first of the five stages must be set in motion in January if it is to go through the remaining stages and be ready for sale at the end of May.
If the product is also wanted in June, then the same process must begin, again, in February, while the product to be sold in May is presently in stage two of this five-stage production process. If the product is also wanted in July, then stage one must start in March, while the May product is simultaneously in stage three and the June product is in stage two. In other words, each product planned to be brought to market must go through its own timeline
of production simultaneously with the others for the period-after-period desired output of the desired goods.
At each stage of production in the manufacture of every product, there is employed not only labor but some forms of capital equipment (machines, tools, etc.), which, like the oven in the earlier example, have to be eventually replaced due to wear and tear. In other investment sectors of the market, there must be in progress projects whose purposes are to plan and anticipate the demand by other enterprises needing replacement capital equipment. And each of these must be planned ahead so they will have gone through their respective stages of production and are ready for sale and installation so that other investment activities can continue in smooth coordination, with supplies tending to match future demands based on entrepreneurial anticipation of what future market conditions will be.
All of this overlapping and interdependent complexity of investment, production, supply, and demand are held together through the competitive price system. This price system facilitates the economic calculations concerning possible profits and losses that are estimated to be possible in changing circumstances and how best to produce what others want at the least cost. This is what enables a developed and extensive social system of division of labor to exist and coordinate the actions of multitudes of people, all of whom rely upon all those unknown others doing all the unknown things that generate the goods and services desired, and which results in the rising standards of living that so many of us simply take for granted with little or no thought about the social and economic institutional arrangements that make it possible.
Banking as the intermediary institution linking savings and investing
Key to all of this is a banking system that coordinates the willingness of savers to forgo current consumption so others may borrow what is saved (and the resources that savings represents) to undertake the time-consuming investment projects that enable capital and time-using production activities to begin. The rate of interest is not only the intertemporal price that brings saving and borrowing decisions into balance (like any other price that coordinates supply and demand). It also acts as a “break” on the time horizons of the investment projects undertaken, so the multi-stage production activities can be successfully completed (given the accuracy with which supply-side entrepreneurs effectively anticipate what consumers want and the prices they may be willing to pay in the future when goods in their finished forms are available for sale).
Of course, errors and misreading of particular future market conditions are not only possible but inescapable in a world in which all of us have less than perfect knowledge about the future. The problem that Mises became interested in were the frequent cycles of booms and busts, inflations followed by recessions or depressions. That is, disharmonies in the market process that impact not just one or few sectors of the economy at any particular time but economy-wide imbalances simultaneously. The answer, in his view, was to be found in the distinctive qualities of a money economy and modern banking systems.
Whenever a product is produced and sold in the market, its sale represents the seller’s demand for other things that he would like to buy. After all, in a system of division of labor, we each specialize in one line of activity and use what we produce as the means to pay for all the other things we desire that other individuals produce. Why else would anyone devote the time and trouble to produce an item and bring it to market?
But money turns what is one exchange under barter – a hat traded directly for a pair of shoes – into two transactions: the trading of one good for money and then the trading away of the money earned for some other good that is wanted. The hat I produce and sell need not be to the particular individual who has the shoes I want. The shoe manufacturer may have no need for my hats. So, instead, I sell my hat to someone in need of a hat in exchange for money, even though I may have no interest in buying the shirts or pants that the buyer of my hat specializes in offering on the market. Instead, having earned that sum of money, I use some of it to buy the pair of shoes I desire. Or as Mises expressed it in The Theory of Money and Credit:
Anybody who sells commodities and is paid by means of a cheque and then immediately uses either the cheque itself or the balance that it puts at his disposal to pay for commodities that he has purchased in another transaction, has by no means exchanged commodities directly for commodities. He has undertaken two independent acts of exchange, which are connected no more intimately than any other two transactions.
Saving and investing through the medium of money
The peculiarities of the modern banking system in facilitating the coordination of savings and investment, Mises argued, enables an understanding and analysis of how things may go wrong and bring about the business cycle, especially under central banking. Mises suggests a particular terminology to better appreciate the reason banking systems may be susceptible to economy-wide fluctuations. The starting point is when savers loan money directly to interested borrowers. What is lent is a sum of money that represents an amount of purchasing power in the market given the market value of the monetary unit.
That sum of purchasing power is transferred to the borrower, and it is used to demand and direct the use of scarce resources into the production of the particular goods the borrower wishes to invest in and use, rather than the particular goods that would have been demanded and supplied if the original income earner had chosen to spend it on current consumption rather than lending it for investment purposes to someone else. Thus, some of the scarce resources in society, instead of being used to supply, say, more dinners out at restaurants in the present, are freed up to be used to make that second oven, from the earlier example, that would enable an increase in bread production.
The trade-offs in society, as we saw earlier, involve not only whether to demand more shirts versus to demand more meals in the present, given the scarcity of means to serve the ends we desire; the trade-offs are also between shirts and meals in the present versus more goods of various types in the future by freeing up some of those resources from current uses.
Now, if banking had evolved in such a way that only the money saved by some was lent to others, the connection between foregoing more goods in the present in exchange for more goods in the future would have remained a fairly close fit. Even through that two-transaction exchange process of goods traded for money and then money traded for goods, there still would have been maintained a fairly close balanced relationship between the decisions of savers with those of borrowers to assure a coordination between consumption and investment activities consistent with the limited means at people’s disposal.
Banknotes and fractional reserve banking
One of the uses and conveniences of banking was that it made possible the use of banknotes issued by banks as claims to sums of commodity money — gold and silver — deposited with them as a “money substitute” for everyday transactions in lieu of directly using actual gold and silver left with the banks for safekeeping. If a bank had a good and reliable reputation of always “making good” when any holder of their banknotes demanded the withdrawal of the quantity of gold and silver the banknotes represented, that bank had greater leeway in issuing such money-substitute banknotes to those who wanted to borrow for some future-oriented investment plan that they might have in mind.
Suppose that the bank’s depositor clients were to deposit $10,000 in gold and silver into their accounts for which banknotes were issued as claims to the specie money. If these were literal savings accounts, and if the bank managers were confident that holders of those deposits would not make any significant or noticeable withdrawals from their accounts for, say, two years, then that bank could lend that $10,000 for two-year loans to those deemed “credit worthy,” with limited concern that the borrowed sum would not be repaid at the end of the two-year period, when it was anticipated that its savings depositors might make significant withdrawals. The savings-investment nexus would have been kept in a reasonably close demand and supply balance in the use of scarce resources across time.
But banks also discovered that on the basis of those deposits of $10,000 in gold and silver into their accounts, they could extend loans to borrowers significantly greater than that $10,000. Every day, there are bank customers making new deposits, while others are making withdrawals. Suppose the bank learns from experience that, on average, those who hold and use their banknotes for transactions in the marketplace only make, on net, withdrawals in gold or silver equal to 10 percent of whatever the bank’s total banknote liabilities may be. Thus, if depositors have $10,000 of actual gold and silver in the bank, depositors are unlikely to demand more than $1,000 in actual specie or commodity money during any particular period of time.
The bank could issue total loans, in the form of banknotes of, say, $20,000. If that bank’s business pattern were to hold, only 10 percent of those outstanding $20,000 bank-notes are likely to be turned in for redemption, or $2,000 of actual gold or silver withdrawn from the bank. Likewise, if the bank’s depositor and banknote users’ patterns were to remain the same, the bank could issue a maximum of $100,000 in banknotes, $10,000 of them representing the actual gold and silver of their claimants who deposited that actual specie or commodity money with it, plus $90,000 of
additional banknotes issued as loans to presumed credit-worthy borrowers.
Mises used the term commodity credit (or transfer credit) to represent the $10,000 of actual savings lent to some of those deemed to be credit-worthy borrowers; Mises called the amount of banknotes issued by such a bank in excess of that actual savings fiduciary media, or circulation credit (or created credit), that is, not backed by actual gold and silver deposited as savings by bank customers. Here, in Mises’s view, was the origin and the bases of the savings-investment relationship being thrown out of balance, resulting in an attempt to undertake investment projects, with their time structures of production, inconsistent with the actual available real savings to bring them to a profitably successful conclusion, or to be profitably maintained if completed before or after an economic crisis finally sets in.
Why an economic crisis grows out of this type of savings-investment imbalance, and what Ludwig von Mises considered to be the institutional changes needed to prevent or reduce the likelihood of the business cycle sequences to continue, will be the theme of part 3 in this series.
This article was originally published in the April 2024 issue of Future of Freedom.
