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The Creation of Money from the Perspective of the Austrian School of Economics

The Creation of Money from the Perspective of the Austrian School of Economics

In the preface to his classic work “The Theory of Money and Credit”, Ludwig von Mises says: “Nevertheless, the problem of money has remained one of the darkest chapters in economics to this day”  . Unfortunately one has to admit the nothing much has changed. In the following we would therefore like to explain how and why money developed.

Over the millennia people realised that an economy based on the division of labour yielded distinct material advantages due to the possibility to specialise. However, in order for individuals to survive in such an economy, they would have to resort to barter trade. Money was invented to facilitate the exchange of goods. Ludwig von Mises describes the precondition for money to emerge as follows: “The economic appearance of money requires an economic state that comes with the production based on the division of labour, and where private property does not only consist of goods of first order (consumer goods), but also of goods of more remote orders (capital goods)” .

Let us imagine a baker (we shall call him Ludwig) who lives in a free village 2000 years ago. His daily production is 10 loafs of bread. In order to keep his bakery running and to satisfy all his other needs on top of bread, Ludwig has to resort to barter. Let us assume that Ludwig fancies tomatoes. In order to buy tomatoes with his surplus bread, he has to find someone with a surplus of tomatoes who also has a need for bread. If Ludwig does not find anyone who is willing to exchange bread for tomatoes directly, he will probably try to find an exchange partner who is willing to exchange a durable good for bread. This means that Ludwig will try to reach his barter goal indirectly. He would also opt for the indirect approach if he wanted to swap one indivisible good for many different goods owned by different people.

In his indirect barter efforts Ludwig will take into account two essential factors: 1) the more durable a barter good is, the better, and 2) marketability: demand for some goods is more constant and general than for others; Ludwig will therefore try to acquire a very durable, marketable good in his indirect barter transaction.

In a first step, Ludwig will therefore try to swap his bread against the most commonly used means of exchange. With said means in his possession, Ludwig can now comfortably and without any further detours (i.e. further indirect barter transactions) achieve his barter goals. This process creates a “positive feedback loop”. Since the most marketable goods turn into means of exchange, their differentiation and marketability increases further vis-à-vis other goods. The choice of means of exchange differed at first from village to village and from country to country. But as the barter circle increased (N.B. globalisation is nothing but the continuous expansion of the barter circle), the choice of means of exchange narrowed down to two economic goods: gold and silver . Over the centuries, gold and silver asserted themselves over all other contenders of marketable means of exchange due to the outstanding characteristics in terms of durability, divisibility, and of course the limited supply.

Money is therefore nothing else but the term for the most marketable means of exchange in an economy. In order to acquire said means, every individual in the economy has to provide a service for which there is demand from the market. The money is therefore said to be covered by goods. The reader will agree that this system is very clever in that it guarantees that every individual has to provide the market with a service that is in demand in order to bring said means of exchange into their possession and thus ensure survival. Market participants making empty promises and providing the market with deficient services are quickly dressed down and cannot spread their influence. With the exception of theft, there is no alternative but to serve the general public in order to acquire the most marketable means of exchange and thus make a living. The most marketable means of exchange naturally turns into the means of payment of an economy.

Unfortunately this clever system is undermined if it is not the market that decides on the means of payment, but if the means is set and controlled by a central authority. If the natural circuit is broken, all sorts of loopholes emerge. Individuals close to the central authority may cheat other market participants out of the fruit of their labour without the theft coming to the surface. This means that a free market economy needs more than property rights to production factors and consumer goods. The other important and indispensable component is the free choice of the means of payment. Remarkably, this fact has become completely absurd to us these days. It is almost impossible for us to imagine the free choice of the means of payment by market forces. This is probably also the fact because historically speaking, our means of payment has always been centrally controlled by whatever form of government we had. This situation is of course based on an elementary reason: it simplifies the control and manipulation of the resource allocation. The majority of the population is not even aware of the damage that is done to them by the central money manipulation. The free choice of the means of payment would lead to a fairer allocation of real goods and increase the standard of living for all individuals of an economy. Because without any service demanded by the market there is no chance for a barter service, i.e. no chance to acquire the most marketable means of exchange. A market based on a freely chosen means of exchange would be the controlling authority for the benefit of the general public; it would nip any misallocation in the bud. Every individual who is member a of the economy would have to excel for the benefit of his fellow man in order to ensure his own survival. It would be impossible to leech upon others, unless by means of straightforward theft.

Although we are not fully aware of it anymore, we still live in a society that is based on the division of labour and barter trade. Every employee and every company, in a first step, exchanges their goods and services to the most marketable means of exchange, or in other words, the official means of payment. Real growth in prosperity can only be achieved if more goods of better quality up for barter are available to all members of society. In contrast to what some theoreticians (wrongly) believe, the increase in the centrally controlled monetary units does not create an increase in prosperity. That is like believing that a formerly blue car that has been painted red now goes faster on account of it being red.

Let us for example imagine a secluded island society. We shall call the island Maupiti. The Maupiti economy is based on the division of labour, and cowrie shells are the most marketable means of exchange – and there are exactly 1,000 units available. One night a tropical thunderstorm destroys a majority of the means of production. However, not only did all cowrie shells remain intact – the storm also washed ashore 1,000 more shells. In the face of the doubled number of cowrie shells in Maupiti, John Maynard Keynes would shout “eureka!” and contend that now, magically, every citizen of Maupiti is twice as rich as before and that the storm was a blessing. However, if you ask the citizens of Maupiti right after the catastrophe, they will hold a different point of view. As a result of the sudden loss of means of production, they will have to deal with a lower standard of living although the amount of monetary units has doubled. This example is supposed to illustrate that it is absurd to gauge the prosperity of a society in monetary units. We live in a society that is based on the division of labour and barter trade, and our prosperity depends exclusively on the number and quality of consumer and capital goods that we as society own.

By. Gerald Walek, CFA of Erste Group

Erste Group is the leading financial provider in the Eastern EU. More than 50,000 employees serve 17.4 million clients in 3,200 branches in 8 countries (Austria, Czech Republic, Slovakia, Romania, Hungary, Croatia, Serbia, Ukraine). As of 31 December 2010 Erste Group has reached EUR 205.9 billion in total assets, a net profit of EUR 1,015.4 million and cost-income-ratio of 48.9%.

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Leave a comment
  • Anonymous on March 23 2011 said:
    Funny, isn't it. I'm a superstar lecturer and I can remember a day in my life when I paid the slightest attention to Mr von Mises. Something is wrong with somebody, and it aint my good self.
  • Anonymous on March 24 2011 said:
    Did I say that I can remember. Actually I cant remember - CANT. In addition, I cant recall his name being called in any of the dozen universities in which I worked.

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