Mark Madden (April 3, 2011): Sandusky a State Secret
Am I Miss Informed?: American Elections "Department of 'Huh?!'" Department

"Fictitious" Wealth and Ludwig von Mises

In comments, rootless_e warns:

Attempts to make sense out of right wing Austrian economics can never amount to anything.

Nevertheless, like a moth to a flame--or like a dog to vomit, or like a dog to something worse--whenever I see something like:

Ludwig von Mises: Attempts to carry out economic reforms from the monetary side can never amount to anything but an artificial stimulation of economic activity by an expansion of the circulation, and this, as must constantly be emphasized, must necessarily lead to crisis and depression. Recurring economic crises are nothing but the consequence of attempts, despite all the teachings of experience and all the warnings of the economists, to stimulate economic activity by means of additional credit...

I find myself under a mysterious but inexorable and irresistible compulsion to waste what would otherwise be productive work time trying to make some kind of sense of it--to at least understand wherein lies the error, and how somebody trying very hard to understand the economy (never mind that he is a big fan of the political leadership of Benito Mussolini) can go so pathetically wrong.

It is, of course, not the case that every expansion of the circulation is an "artificial" (and unnatural) "stimulation of economic activity" that must "necessarily lead to crisis an depression". So why does Ludwig von Mises think that it must?

Here is my current guess as to where von Mises is coming from:

Let us start out with a world of publicly-known technology and constant returns to scale in everything. People happily make things and trade them. And everything sells at its resource cost.

One of the things people make is little disks of gold, usually decorated with pictures of bearded men on one side and allegorical female figures on the other, with lettering saying things like: "Fecund Augustae" or "Concordia Militum" or "Fides Exercituum" on them. These little gold disks trade--like everything else--at their cost of production: the cost of digging the ore out of the ground, extracting the metal from the ore, and stamping the disk into the right shape.

Then somebody has a bright idea: Because these little metal disks are valuable and easy to carry, they are subject to theft. I will offer to perform a service: I will keep everybody's little metal disks in my stronghouse, and let's write out signed declarations that people have little metal disks in my stronghouse and they can trade those rather than the disks directly. Here is what one such might look like:

Google Image Result for http upload wikimedia org wikipedia commons 3 3e Zimbabwe $100 trillion 2009 Obverse jpg

And--as long as the circulating medium is backed by gold--everything goes on as before, with everything selling for its cost of production.

Then somebody else has a bright idea: They write out a whole bunch of signed declarations that they have little metal disks in the stronghouse even though they actually do not have any such. They then buy things with these pieces of the circulating medium that they have written out.

These people, Ludwig von Mises says, are thieves pure and simple. They have bought useful things. They have claimed that they have done so by trading valuable little metal disks for useful commodities. But they have lied: they did not have any valuable little metal disks for trade.

And, Ludwig von Mises would say, these lying thieves are governments that print dollar bills without having 100% gold bullion backing for them in Fort Knox. These lying thieves are banks that issue bank notes or allow you to write checks in amounts that exceed the specie reserves they have in their vaults.

The problem, I think Ludwig von Mises would say, is that a certain amount of work has gone into creating the commodities--the food, the clothing, the houses, the little gold disks--and yet people think that there is more wealth in society than their actually is. People count the food as wealth, the housing as wealth, the clothing as wealth, the little gold disks as wealth, the fiat money as wealth, and the bank credit as wealth--and the last two of these aren't wealth at all. They are fictions: false promises that there is somewhere some valuable gold that you have title to.

And, Ludwig von Mises would say, the larger the unbacked circulating medium the bigger the lie and the theft. And it is all guaranteed to end in tears, because if society thinks that it is richer than it is then plans will be inconsistent and unattainable. When that unattainability becomes manifest, that will trigger the crash and the depression.

That is, I think, where he is coming from.

And, of course, this is wrong--so so so so so so so so so unbelievably wrong. It is simply not the case that we can cheaply and easily buy things with money because it is valuable. It is, instead, the case that money is valuable because we can cheaply and easily buy things with it.

One way into the tangle of understanding why it is wrong is to ask each of us why we are happy accepting money in exchange when we sell useful commodities. Hint: it's not because we are looking forward to going down to the bank, exchanging our bank notes for the little disks of gold usually decorated with pictures of bearded men on one side and allegorical female figures on the other with lettering saying things like "Fecund Augustae" or "Concordia Militum" or "Fides Exercituum" on them, taking our little disks home, and feeling happy looking at them. That's not why we accept money. We accept money because if we don't have any money we have to buy commodities with other commodities, and when we do so we are unlikely to receive the cost of production for what we sell. Have you ever tried to buy a latte at Peets with a copy of Ludwig von Mises's Money and Credit? It does not go well.

The fact is that your wealth is only worth its cost of production if you are liquid--if you can wait to sell until somebody willing to pay full cost of production comes along, which is not every minute. The use value of money is that it allows you to time your other transactions so that you can realize the full exchange value of what you sell, rather than having to sell it at a discount.

Thus there is no paradox: no sense in which the existence of fiat money creates a situation in which society must necessarily think that it is richer than it is, with claims to total wealth valued at more than the value of total wealth itself. You think--correctly--that your fiat money has value, and that value is just equal to the discount from its cost of production that your other wealth incurs because it is illiquid. But what if the government prints more fiat money than the illiquidity gap in your other death? Well, then people will say: "I don't need to hold all this extra money. I would be liquid enough with less." Everybody will try to run down their money balances, and so the price level will rise until the real money stock is just what people think covers the illiquidity gap between their other wealth and its cost of production.

And what von Mises misses completely is that the size of this illiquidity gap can and does change suddenly and drastically--and it is the business of the central bank and of the government to alter the quantity of money to keep such changes from disrupting the real economy.