A Critical Review of Ludwig Von Mises's Theory of Money and Credit [Part V/VII]

—Compiled by Chinedu Okoye 

The Problems of Credit Policy:

Policies adopted by governments since the time of the currency school, with regards to fiduciary media has been guided by the idea that it is necessary to impose some sort of restrictions upon banks in order to prevent them from extending fiduciary media to the extent that it causes a rise in prices (or fall in the objective exchange-value of money) that culminates in an economic crisis.

But these policies have been continually broken by "contrary aims" as endeavors have been made to keep interest rates low and prices "reasonably" high. This happened during the war and some time after. Mises gives separate considerations to the problems as they exhibited themselves before the war and after.

He says that the view that note issue should be restricted somehow "In order to guard against serious evil is still accepted to-day as the essence of government wisdom in matters of banking policy". The conclusions of two generations of economist (the banking Principle and the Currency School) have not been able to shake this opinions [of restrictive monetary policy] which were supposed to be the result of practical banking experience.

 

The Currency School v Banking Principle:

There were many serious errors in the currency principle Mises' adds, the most serious of which is the failure to recognize the essential similarity of Bank notes and bank deposits.

But the doctrine of the currency school doesn't stand or fall on its views on the nature of cheques and deposits. That is whatever mistakes of the currency school on this part is of small significance compared to that made by the banking Principle.

Peel's Act:

Peel' Act he says has a fundamental flaw, like other systems at the time, which was the restriction of notes in circulation which failed to "forsee the extension of the quota of notes not backed by metal that went with the increase in the demand for money in the broader sense"

As far as the past was concerned, the Act sanctioned the creation of a certain amount of Fiduciary media and the influence it had on the objective exchange-value of money but did nothing to counteract the effects of this issuances.

In order to guard the capital markets from shocks, it removed the possibility of partly or wholly satisfying increases in demand for money by the issue of Fiduciary media, mitigating a rise in objective value of money. This is not to dissimilar from the opponents of all fiduciary media.

 

Bank Deposits and Bank Notes:

But the Currency Theorists overlooked one thing in their calculations. That is: unbacked deposits are "substantially the same as unbacked notes". And this they failed to legislate for the former as they had the latter.

This forced the technique of English banking in a direction in which it had already been urged in some degree "by the circumstance of rights issues was an exclusive privilege of the Bank of England".

The deposit system then developed at the expense of the note system , but the community was indifferent to the use of notes or deposits as they fulfill the same function.

Thus, fiduciary media suppressed as Bank notes, developed in the form of deposits marking a failure of the Peel's Act failing to fulfill its aim —restricting the issuance of Fiduciary media.

A Non-Legislative Obstacle to Unlimited Extension of Fiduciary Media Issuances:

The real obstacle in the way of unlimited extension of the issue of fiduciary media is not constituted by legislative restrictions of the note-issue, which after all, only affects a certain kind of fiduciary medium, but the lack of a centralized world bank or of uniform procedure in the part of all credit-issuing banks.", Mises' stated.

For "so long as banks do not come to an agreement among themselves concerning the extension of credit, the circulation of fiduciary media can indeed be increased slowly, but it cannot be increased in a sweeping fashion." Each bank can only take a small step in that direction, and even so, they must take into account what there do, when formulating in-house interest policy.

 

The Nature of Discount Policy:

Every credit-issuing bank is obliged to fix the rate of interest it charges for loans in a certain conformity with that of the other credit-issuing banks."

The rate cannot be allowed to sink below this level, for that would increase the sums of money needed by the bank's increasing clientele in such a fashion that the bank's solvency would be jeopardized.

It is by rasing the discount (or interest) rates that the bank safeguards it's own capacity to pay, not by protecting the redemption fund, but by "avoiding extension of the circulation of fiduciary media that would result from asking less interest than the other banks". In doing so it avoids the it avoids any increase in demand for the redemption of the fiduciary media.

Rates are also set in consideration with international credit-issuing bank rates as well, as an allowance of capital mobility, means a domestic rates would have to adjust downwards if institutions aboard offer lower rates.

So, there's always an inactive to depress domestic rates. This action however influences the international movement of capital and is particularly pronounced in the money market (market for shorterm loans) but less, if at all in the market for long-term capital (capital markets).

Interventions to reduce rates are therefore more effective in the money market than in the capital markets.

Mises reviewed the systems that supposedly maintained the level of the rate of discount in national money, by making it more expensive to procure gold below the international determined rates.

The purpose of the gold premium (as in France then) was to postpone as long as possible,"the moment when the conditions of the international money market would force the Bank to raise the discount rate in order to prevent an efflux of Gold".

So rates are tied to Gold to prevent a fall in the value of the national money in question, relative to other currencies,, that would lead to an efflux of Gold.

So, Central Banks eg France had to endeavor to keep domestic rates at a level that foreign investments didn't become attractive to home capitalists and threaten the banks solvency.

If investors stop sending money abroad —because domestic rates are relatively higher— and keep the money in the domestic money market, it could lead to fewer foreign investors to bring in money (capital) into the country as well, these imbalances threaten the Central Banks control over money flows and financial stability.

This is as less investments (say imports of production goods), could affect incomes and this the ourchsinf power of the entire country, as invetstos weigh the strenght and profitability of the market.

Central Banks are therefore challenged to strike a balance between keeping interest at a level that encourages and  attracts investments, without creating distortions that undermine money flow and stability.

Promotion of Cheques and Clearing Transactions as a Means of Reducing the Rate of discount:

Before the war Germany had lots of gold in circulation and "there was a growing endeavor to withdraw it from circulation by extension of Cheque and Clearing Transactions and to divert it into the vaults of the Reichsbank." (That is they sought to substitute gold used as money for money-substitutes mentioned).

The high interest rates in Germany according to the "Elders of the Kaufmannschaft of Berlin" (in 1907), where to be "traced and rooted to large extent in the circumstance that the German people make greater use than those in other countries of cash media of circulation (gold and silver, for payments arising. And put of the course of business".

They hadn't accustomed themselves to "procedure that might replace the use of gold and silver. If a significant number of transactions are settled by fiduciary media (cheques, clearing systems..), it would save the country large sums of currency in gold and silver as well as in bank notes. This gold and silver accumulation from the substitution would lead to a stronger cash or base money position of the Reichsbank.

This increase would then allow the Bank to issue more credit at lower rates. Thus, countries with more sophisticated and efficient clearing house and Cheques system, required less gold in circulation, allowing their banks to maintain liver discount rates.

Mises faults this by saying that the above might lead to a dimunition of interest rates, only if gold becomes superfluous and was employed for obtaining goods and services abroad. The replacement of notes without a metal backing by deposits without metal backing (as in Fiat), is of no consequence in this connexion.

It isn't the legal restrictions that made banks aim for a discount policy that would prevent any tension arising between the natural and discount rate, but it's inevitable solvency. For so a as capital mobility isn't restricted, it is impossible for one credit-issuing banks to pursue independent

Problems of Credit Policy in thePeriod immediately after the War:

So far the chapter (6 Part Three) has dealt with problems of credit policy before the War, and we now move to the second part of the issues faced after the war.

The Gold Exchange Standard; where inflation "has thrown monetary policy into confusion", the primary aim of currency policy shifts focus and looks to bring the printing to a standstill (ie Money stock).

Once it becomes clear that policy of raising the exchange value of money has undesired and Unintended consequences,, the chief thing to do would be to attempt to stabilize the value of money. This prompts the attempt to adopt a gold standard.

After the war European institutions turned to the gold standard, even though it was already undermined before the war.

The first steps was to abolish the use of physical gold for payments and the accumulation of gold in banks vaults. Next; holding gold reserves at the Central banks. The war, he said didn't create this situation but merely hastened it.

Governments or Central Banks were always headed in this direction –where Gold Reserves are held by the Central Bank and tokens representing gold (gold-backed money) become the primary medium of exchange it's value backed by the base money (Central Bank Gold Reserves).

Challenges of upholding the gold Standard After the War:

Mises rightly predicted that, the policy the US then, which involved on obvious sacrifices "might one day be changed", and "variations in the price of gold would then occur and this would be bound to give rise in other gold countries to the question of whether it would not be better in order to avoid further rises in prices to dissociate the currency standard from gold."

Should this happen, it would mean "a further drop in the price of gold and a further reduction of the usefulness of gold for monetary purposes".

Prior to the war, it couldn't not be foreseen that the fluctuations in the price of gold would be dependent on the policy actions of one government, and that countries of great economic significance (England, France, Germany, Russia, etc.) would have at least temporarily or partially abandoned it.

If the gold standard was to retained, questions must be asked, he says, of whether or not it would be better to substitute for a credit-money standard whose fluctuations was more susceptible to control than gold is.

Where fluctuations in Gold prices are dependent on political interventions, governments should be restricted at all by confirming to a gold standard, and "the cost of additional gold for monetary purposes that is borne by the whole world, might as well be saved. (ie less resources spent on gold accumulation or exploration. Given that the desired effect of the gold standard –stability from fe market price determination is negated.

The alternative here would be to return to the actual use of gold again for currency. (But that is not feasible as Gold is deflating money (ie rises in value), and less divisible than currency notes.

Returning to Gold Currency:

Reruning to Gold Currency would have effects that are "scarcely welcomed. "it would lead to a rise in the price of gold or, what is the same thing, to a fall in prices of commodities". The gold standard he said would be reproached with depressing prices, or an increased exchange value of money (gold), forcing real interest rates up.

This he said would lead to agents calling for a "modification" of the gold standard (and possibly evisceration as would happen decades later).[this, though it may not be Mises' intention, underscores and validates my point on the limiting nature of fixed money]

However he goes on to say that; the necessity of making a recurrent inflationary policies is made more difficult by holding on to the gold standard or actual gold money, and that led to Etatistic Monetary Policy restriction of the circulation of gold by concentrating it in the central bank of issue.This he said happened for three reasons.

First; because states wished to inflate without repealing Central banking laws; second because it wished to accumulate a war chest; and thirdly, because it wished to wean people from the use of gold coins to "pave the way for the inflationary policy of the coming Great War.”

Fischer's Proposal for a Commodity Standard:

The more the view that general business fluctuations can be explained by reference to the credit policy of banks, the more "eagerly are ways sought for by which to eliminate the alteration of boom and depression in economic life".

The currency school aimed to prevent this periodic occurrence of general economic crises by setting a maximum limit to the issue of fiduciary media.

If this were done, it would no longer be possible to underbid the "equilibrium" market rate of interest by over issuing new quantities of fiduciary media which has an immediate effect of artificially stimulating businesses but leading to an inevitable bust of the cycle.

Such a decisive step depends on the credit policy followed by banks in the future as one bank to increase or decrease it's issue of fiduciary media if the others don't do the same. This cuts across borders too.

Fischer v Earlier Commodity Standard Advocates;

The fundamental idea of Fischer's Proposal was for stabilzing purchasing power of money by replacing the gold standard with a "commodity standard"

The intentions of earlier propositions okwas aimed at supplementing the gold standard with additional commodities. Their proposal is that; monetary obligations that fall due in the future (a specified time period), should be discharged by virtue of legal probisions or special contracts between parties not in the nominal sum that is owed, but by payment of the exact sum that would have purchased the same  quantity of the commodity the instrument  (or debt is tied to) in the day of the credit issuance, at settlement.

Fischer however didn't look to supplement the gold standard but to replace it entirely by means of an ingenious combination of the fundamental concept of the the gold standard with that of the Tabular Standard.

Instead of redeeming credit in a currency tied at a fixed rate to gold, Fischer proposed that the currency units be converted to the purchasing power of the quantity of gold to which it corresponds at the time of the agreement.

By this an index of goods and services are used benchmarked in gold prices. Mises however doesn't agree with this and finds it inadequate, but concedes that for short period of time it could be employed with at least sufficient exactitude for practical purposes"

But the execution in Fischer's scheme, according to Mises, could not ameliorate the social consequences of variations in the value of money. "The scientific inadequacy of all methods of calculating index numbers means there can be no 'correct' one and therefore non that could command general recognition.'

This is half true, and has been dealt with in my earlier comments, where I stated that the fact that index numbers scarcely every moves in different directions to individual economic goods makes it a reasonably accepted form of measuring price changes and therefore the value money carries.