On the Manipulation of Money and Credit. Людвиг фон Мизес

months, the German Reich has provided a rough picture of what must happen, once the people come to believe that the course of monetary depreciation is not going to be halted. If people are buying unnecessary commodities, or at least commodities not needed at the moment, because they do not want to hold on to their paper notes, then the process which forces the notes out of use as a generally acceptable medium of exchange has already begun. This is the beginning of the “demonetization” of the notes. The panicky quality inherent in the operation must speed up the process. It may be possible to calm the excited masses once, twice, perhaps even three or four times. However, matters must finally come to an end. Then there is no going back. Once the depreciation makes such rapid strides that sellers are fearful of suffering heavy losses, even if they buy again with the greatest possible speed, there is no longer any chance of rescuing the currency.

      In every country in which inflation has proceeded at a rapid pace, it has been discovered that the depreciation of the money has eventually proceeded faster than the increase in its quantity. If m represents the actual number of monetary units on hand before the inflation began in a country, P represents the value then of the monetary unit in gold, M the actual number of monetary units which existed at a particular point in time during the inflation, and p the gold value of the monetary unit at that particular moment, then (as has been borne out many times by simple statistical studies):

      mP > Mp.

      On the basis of this formula, some have tried to conclude that the devaluation had proceeded too rapidly and that the actual rate of exchange was not justified. From this, others have concluded that the monetary depreciation is not caused by the increase in the quantity of money, and that obviously the Quantity Theory could not be correct. Still others, accepting the primitive version of the Quantity Theory, have argued that a further increase in the quantity of money was permissible, even necessary. The increase in the quantity of money should continue, they maintain, until the total gold value of the quantity of money in the country was once more raised to the height at which it was before the inflation began. Thus:

      Mp = mP.

      The error in all this is not difficult to recognize. For the moment, let us disregard the fact—which will be analyzed more fully below—that at the start of the inflation the rate of exchange on the Bourse,¹ as well as the agio [premium] against metals, races ahead of the purchasing power of the monetary unit expressed in commodity prices. Thus, it is not the gold value of the monetary units, but their temporarily higher purchasing power vis-à-vis commodities which should be considered. Such a calculation, with P and p referring to the monetary unit’s purchasing power in commodities rather than to its value in gold, would also lead, as a rule, to this result:

      mP > Mp.

      However, as the monetary depreciation progresses, it is evident that the demand for money, that is for the monetary units already in existence, begins to decline. If the loss a person suffers becomes greater the longer he holds on to money, he will try to keep his cash holding as low as possible. The desire of every individual for cash no longer remains as strong as it was before the start of the inflation, even if his situation may not have otherwise changed. As a result, the demand for money throughout the entire economy, which can be nothing more than the sum of the demands for money on the part of all individuals in the economy, goes down.

      To the extent to which trade gradually shifts to using foreign money and actual gold instead of domestic notes, individuals no longer invest in domestic notes but begin to put a part of their reserves in foreign money and gold. In examining the situation in Germany, it is of particular interest to note that the area in which Reichsmarks circulate is smaller today than in 1914,² and that now, because they have become poorer, the Germans have substantially less use for money. These circumstances, which reduce the demand for money, would exert much more influence if they were not counteracted by two factors which increase the demand for money:

      1 The demand from abroad for paper marks, which continues to some extent today, among speculators in foreign exchange (Valuta); and

      2 The fact that the impairment of [credit] techniques for making payments, due to the general economic deterioration, may have increased the demand for money [cash holdings] above what it would have otherwise been.

2. Undesired Consequences

      If the future prospects for a money are considered poor, its value in speculations, which anticipate its future purchasing power, will be lower than the actual demand and supply situation at the moment would indicate. Prices will be asked and paid which more nearly correspond to anticipated future conditions than to the present demand for, and quantity of, money in circulation.

      The frenzied purchases of customers who push and shove in the shops to get something, anything, race on ahead of this development; and so does the course of the panic on the Bourse where stock prices, which do not represent claims in fixed sums of money, and foreign exchange quotations are forced fitfully upward. The monetary units available at the moment are not sufficient to pay the prices which correspond to the anticipated future demand for, and quantity of, monetary units. So trade suffers from a shortage of notes. There are not enough monetary units [or notes] on hand to complete the business transactions agreed upon. The processes of the market, which bring total demand and supply into balance by shifting exchange ratios [prices], no longer function so as to bring about the exchange ratios which actually exist at the time between the available monetary units and other economic goods. This phenomenon could be clearly seen in Austria in the late fall of 1921.³ The settling of business transactions suffered seriously from the shortage of notes.

      Once conditions reach this stage, there is no possible way to avoid the undesired consequences. If the issue of notes is further increased, as many recommend, then things would only be made still worse. Since the panic would keep on developing, the disproportionality between the depreciation of the monetary unit and the quantity in circulation would become still more exaggerated. The shortage of notes for the completion of transactions is a phenomenon of advanced inflation. It is the other side of the frenzied purchases and prices; it is the other side of the “crack-up boom.”

3. Effect on Interest Rates

      Obviously, this shortage of monetary units should not be confused with what the businessman usually understands by a scarcity of money, accompanied by an increase in the interest rate for short-term investments. An inflation, whose end is not in sight, brings that about also. The old fallacy—long since refuted by David Hume and Adam Smith—to the effect that a scarcity of money, as defined in the businessman’s terminology, may be alleviated by increasing the quantity of money in circulation, is still shared by many people. Thus, one continues to hear astonishment expressed at the fact that a scarcity of money prevails in spite of the uninterrupted increase in the number of notes in circulation. However, the interest rate is then rising, not in spite of, but precisely on account of, the inflation.

      If a halt to the inflation is not anticipated, the money lender must take into consideration the fact that, when the borrower ultimately repays the sum of money borrowed, it will then represent less purchasing power than originally lent out. If the money lender had not granted credit but instead had used his money himself to buy commodities, stocks, or foreign exchange, he would have fared better. In that case, he would have either avoided loss altogether or suffered a lower loss. If he lends his money, it is the borrower who comes out well. If the borrower buys commodities with the borrowed money and sells them later, he has a surplus after repaying the borrowed sum. The credit transaction yields him a profit, a real profit, not an illusory, inflationary profit. Thus, it is easy to understand that, as long as the continuation of monetary depreciation is expected, the money lender demands, and the borrower is ready to pay, higher interest rates. Where trade or legal practices are antagonistic to an increase in the interest rate, the making of credit transactions is severely hampered. This explains the decline in