I’ve decided to re-read part three of the Theory of Money and Credit and start fresh with my notes because I basically dismissed key points the first time around. I supported a 100% reserve rate and therefore had little interest in the complexities of his argument, and automatically assumed that this was his position as well. I must say, chapter 17 (Fiduciary Media and The Demand for Money) is the most complicated chapter I’ve ever read in my entire life, and it seems as though Mises supports Wicksell and completely obliterates him simultaneously. There is continuous controversy over Mises’ position in this book, and for good reason—both sides are able to quote passages out of context in order to defend their positions. Essentially I want to better understand Mises’ argument so that I can reach an unbiased conclusion when it comes to monetary theory—my area of interest. By the way, I’m looking for an open and honest discussion here.
First of all, Mises defines inflation as an increase in the supply of money (in the broader sense) in excess of the demand for cash holdings. This is also the definition put forth by Wicksell, and for obvious reasons. When individuals have more money (or money substitutes/fiduciary media) then they deem necessary, they will increase their demand for other economic goods, and will therefore arbitrarily increase their objective exchange ratios. It seems, then, if the supply of money is kept at par with the demand for money, then relative price ratios would remain at their normal levels preventing misdirection’s of resources towards unwarranted economic activities (“neutral money”). Mises also mentions that inflation is what gives rise to entrepreneurial pseudo-profits, sets off the business cycle, causes the consumption of capital, and international disturbances—namely dumping (pp. 254). This definition of inflation doesn’t correspond to the mainstream notion of inflation (as a general rise in prices), as its affects are masked by rising productivity. This is what the free-bankers are talking about when they say they want to “keep MV stable,” though both Mises and Wicksell obliterate this “spurious notion taken from quantum mechanics.”
The very first paragraph of this chapter seems to defend the free-banker’s position:
“In fact, the development of the clearing system and fiduciary media has at least kept pace with the potential increase of the demand for money brought about by the extension of the money economy, so that the tremendous increase in the exchange value of money, which otherwise would have occurred as a consequence of the extension of the use of money, had been completely avoided, together with its undesirable consequences (pp. 333).”
The “undesirable consequences” clearly suggests more than one negative effect of deflation (deflation not stemming from productivity gains, but from an inadequate supply of money below the demand for cash holdings). Unfortunately, Mises only puts forth one objection, which is the very same objection raised by Smith and Ricardo when it comes to commodity money. Essentially, it keeps the price of gold and silver lower than it otherwise would have been. If the price of monetary metals were allowed to rise then there would be massive allocations of resources towards generally unproductive ends (production would have picked up and there would be an increase in the supply of gold stabilizing prices, having the same affect. But this way labor and capital does not have to be reallocated towards this relatively barren activity). One way to think of it is to imagine a nation which does not produce either gold or silver. They would have to exchange other economic goods in order to satiate their demand for money. Thus, fiduciary media has prevented a major allocation of resources towards gold/silver production and discovery, freeing labor and capital towards more economically remunerative ends.
Now, Mises never explicitly states other negative consequences prevented by the introduction of fiduciary media. This may mean that he assumes a high level of competency from his readers (which he does quite often), or that they’re well acquainted with Wicksell’s work. Wicksell states that a diminution in the supply of money below the demand for cash holdings will elevate the market rate of interest above the natural rate, and as such, businesses along with individuals will increase their sales and limit purchases. The effects of which would cause prices to fall faster than costs depressing general business activity (something Keynes focuses on in his Treatise on Money, but sees the economy continuously in this position due to the inelasticity of the gold-standard, and doesn’t understand the natural rate of interest which comes directly from Bohm-Bawerk).
Mises takes issue with another key assumption held by both Wicksell and those of the Banking school, namely the organic automatic adjustment of the supply of money to the demand for cash holdings. The argument is essentially that competition amongst banks prevents them from suppressing the market rate below or elevating it above the natural rate (banks will hoard notes and seek redemption and international banks have to fear gold flows). Thus the banking system, according to Wicksell and the Banking school, is merely a passive agent which reacts to the demand for money, and does not exert any influence over the real economy (sometimes called the “endogenous” view of money).
Mises states:
“The doctrine of the elasticity of fiduciary media, or more correctly expressed, of their automatic adjustment at any given time to the demand for money in the broader sense, stands in the very center of modern discussions of banking theory. We have to show that this doctrine does not correspond to the facts, or at least not in the form in which it is generally expounded and understood; and the proof of this will at the same time refute one of the most important arguments of the opponents of the quantity theory (pp. 339).”
I’m sure we’re all aware of his argument, namely the ability of the banking system to suppress the market rate below the natural rate and create a demand for credit which stimulates a boom followed by a depression of business activity. And this process can theoretically go on indefinitely. He attributes the confusion to intrinsic differences between money in the broader sense, and the nature of fiduciary media.
He continues,
“The circulation as of fiduciary media is in fact not elastic in the sense that it automatically accommodates the demand for money to the stock of money without influencing the objective exchange value of money, as is erroneously asserted. It is only elastic in the sense that it allows of any sort of extension of the circulation, even completely unlimited extension, just as it allows of any sort of restriction. The quantity of fiduciary media in circulation has no natural limits. If for any reason it is desired that it should be limited, then it must be limited by some sort of deliberate human intervention—that is by banking policy (pp. 346).”
It seems then, that the banking system is in utter chaos and that the supply of money is not regulated by the competition of the banking system. But then, at the same time, he states:
“Of course, all of this is true only under the assumption that all banks issue fiduciary media according to uniform principles, or that there is only one bank that issues fiduciary media. A single bank carrying on its business in competition with numerous others is not in a position to enter upon an independent discount policy… Thus the banks may be seen to pay a certain amount of regard to the periodical fluctuations in the demand for money. They increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow and independent interest policy. But in doing so, they help to stabilize the objective exchange value of money. To this extent, therefore, the theory of the elasticity of the circulation of fiduciary media is correct; it has rightly apprehended one of the phenomena of the market, even if it has also completely misapprehended its cause (pp. 347).”
Thus, either quote out of context is extremely misleading. But his position here seems to be aimed against the banking school, and defends the market’s ability to regulate the supply of fiduciary media.
But then Mises claims that the demand for money is always the demand for real capital (here I assume he means social capital as defined by Bohm-Bawerk). And if fiduciary media is created in order to satiate this demand, without actual backing, then the effects “are borne by those who are injured by the consequent variation in the objective exchange value of money, pp. 349.” This argument is consistent with those put forth by Rothbardians who insist that fractional reserve must mean an arbitrary redistribution of wealth and therefore constitutes theft. But there is a far more interesting implication here: he rejects the distinction between the demand for money as money, and the demand for money as capital (this distinction is supported by Hayek and Wicksell). The demand for money is always the demand for real capital, and must therefore always exert an influence on the natural rate of interest as represented on the loan market (the rate at which real capital would be exchanged in a theoretical barter economy, that is, without the influence of money).
And finally, he concludes the chapter with:
“All that we can be sure of is that at least a part of the increase in the demand for money in the broader sense has been robbed of its influence on the purchasing power of money by the increase in the quantity of money and fiduciary media on circulation, pp. 353.”
So essentially I’m left with a giant question mark. Fiduciary media has evolved naturally in the market through competition, arbitrarily redistributes wealth, prevents negative consequences of a continuous appreciation in the objective exchange value of money, and causes business cycles. So this is the question at hand (at least in my opinion): is the trade cycle caused by monetary intervention on the part of government authorities, or by fractional reserve banking? This chapter does not give me a definitive answer.