Tuesday, 12 March 2013

The Non-Neutrality of Money

By Ludwig von Mises
The Non-Neutrality of Money
The monetary economists of the sixteenth and seventeenth centuries succeeded in dissipating the popular fallacies concerning an alleged stability of money. The old error disappeared, but a new one originated, the illusion of money's neutrality.
Of course, classical economics did its best to dispose of these mistakes. David Hume, the founder of British Political Economy, and John Stuart Mill, the last in the line of classical economists, both dealt with the problem in a masterful way. And then we should not forget Cairnes, who in his essay on the course of depreciation paved the way for a realistic view of the issue involved.
Notwithstanding these first steps towards a more correct grasp, modern economists incorporated the fallacy of money neutrality into their system of thought.
The reasoning of modern marginal utility economics begins from the assumption of a state of pure barter. The mechanism of exchanging commodities and of market transactions is considered on the supposition that direct exchange alone prevails. The economists depict a purely hypothetical entity, a market without indirect exchange, without a medium of exchange, without money. There is no doubt that this method is the only possible one, that the elimination of money is necessary and that we cannot do without this concept of a market with direct exchange only. But we have to realize that it is a hypothetical concept which has no counterpart in reality. The actual market is necessarily a market of indirect exchange and money transactions.
From this assumption of a market without money, the fallacious idea of neutral money is derived. The economists were so fond of the tool which this hypothetical concept provided that they overestimated the extent of its applicability. They began to believe that all problems of catallactics could be analyzed by means of this fictitious concept. In accordance with this view, they considered that the main work of economic analysis was the study of direct exchange. After that all that was left was to introduce the monetary terms into the formulas obtained. But this was, in their eyes, a work of only secondary importance, because, as they were convinced, the introduction of monetary terms did not affect the substantial operation of the mechanism they had described. The functioning of the market mechanism as demonstrated by the concept of pure barter was not affected by monetary factors.
Of course, the economists knew that the exchange ratio between money and commodities was subject to change. But they believed?and this is exactly the essence of the fallacy of money's neutrality?that these changes in purchasing power were brought about simultaneously in the whole market and that they affected all commodities to the same extent. The most striking expression of this point of view is to be found in the current metaphorical use of the term "level" in reference to prices. Changes in the supply or demand of money?other things remaining equal?make all prices and wages simultaneously rise or fall. The purchasing power of the monetary unit changes, but the relations among the prices of individual commodities remain the same.
Of course, economists have developed for more than a hundred years the method of index numbers in order to measure changes in purchasing power in a world where the ratios between the prices of individual commodities are in continuous transition. But in doing so, they did not give up the assumption that the consequences of a change in the supply or demand of money were a proportional and simultaneous modification of prices. The method of index numbers was designed to provide them with a means of distinguishing between the consequences of those changes in prices which take their origins from the side of the demand for or supply of individual commodities and those which start from the side of demand for or supply of money.
The erroneous assumption of money neutrality is at the root of all endeavors to establish the formula of a so-called equation of exchange. In dealing with such an equation the mathematical economist assumes that something one of the elements of the equation?changes and that corresponding changes in the other values must needs follow. These elements of the equation are not items in the individual's economy, but items of the whole economic system, and consequently the changes occur not with individuals but with the whole economic system, with the Volkswirtschaft as a whole. Proceeding thus, the economists apply unawares for the treatment of monetary problems a method radically different from the modern catallactic method. They revert to the old manner of reasoning which doomed to failure the work of older economists. In those early days philosophers dealt in their speculations with universal concepts, such as mankind and other generic notions. They asked: What is the value of gold or of iron, that is: value in general, for all times and for all people, and again gold or iron in general, all the gold or iron available or even not yet mined. They could not succeed in this way; they discovered only alleged autinomies which were insoluble for them.

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