According to Ludwig von Mises, the Standard Textbook Equation of Exchange, MV = PT, Is a Superficial and Unsatisfactory Theory of the Purchasing Power of Money

One of the main contributions of Mises’s TMC [The Theory of Money and Credit] is his trenchant criticism of the classical equation of exchange MV = PT. This equation, however, is still used today in every standard textbook—what is more, it is often the only formulation of the quantitative theory of money that is offered to students. The criticism by Mises is clearly unknown to the current writers belonging to the “orthodox” paradigm. This is unfortunate because Mises has convincingly shown that the equation of exchange is a superficial and ultimately unsatisfactory theory of the purchasing power of money. His main criticism is aimed at the concept of velocity of money: counting how many times a unit of money changes hands on average in a year cannot replace the concept of the subjective demand for money. The velocity of money is only a manifestation of the effects of the demand for money, and it obfuscates the causal processes through which the value of money is determined. The concept of the subjective demand for money is, as we have seen in the previous section, the necessary foundation for an explanation of the PPM. Mankiw (2011) and Milton Friedman (in his entry “Quantity Theory of Money” in the New Palgrave) both recognize this fact. They begin their respective presentations of the quantity theory with the subjectivist theory expounded above, but then they fall back and focus on the holistic and mathematical equation only.

—Renaud Fillieule, “The Monetary Theory in Current Textbooks in Light of The Theory of Money and Credit,” in Theory of Money and Fiduciary Media: Essays in Celebration of the Centennial, ed. Jörg Guido Hülsmann (Auburn, AL: Ludwig von Mises Institute, 2012), 256.

In Order to Understand the Austrian Business Cycle Theory, We Must Distinguish Commodity Credit (Good Kind of Credit) from Circulation Credit (Bad Kind of Credit)

In order to understand the ABCT [Austrian Business Cycle Theory] it is necessary to grasp a distinction between two different kinds of credit first introduced by Ludwig von Mises himself. The first one, commodity credit, is, in Mises’s opinion, the healthy kind of credit. Somebody saves out of his income and transfers the savings to somebody else, mainly by means of financial intermediaries. As this kind of credit necessitates savings, it involves an exchange of present goods for future goods. In the words of Mises, credits of this kind are

characterized by the fact that they impose a sacrifice on that party who performs his part of the bargain before the other does—the foregoing of immediate power of disposal over the exchanged good.

In short, before commodity credit can be granted, somebody must have saved up goods or money that can now be lent to the debtors. The sacrifice of the savers is the necessary condition for this kind of credit.

The second kind of credit Mises calls circulation credit. In his opinion, it constitutes the unhealthy kind of credit. It does not stem from anybody’s savings, but from the power of banks to lend additional money into existence. It is not necessary to go into the details of fractional reserve banking here. That this kind of banking is able to create additional credit via lending out its own banknotes (in earlier times) or demand deposits that are at any time convertible into money is generally accepted by economists. The phenomenon is called the money multiplier. Mises’s point is that this kind of credit creation does not presuppose savings and therefore causes nearly no costs to either the issuing bank or anybody else. This

group of credit transactions is characterized by the fact that in them the gain of the party who receives before he pays is balanced by no sacrifice on the part of the other party.

According to Mises’s definition, what he calls circulation credit is not a proper credit transaction from an economic point of view. “[T]he essential element, the exchange of present goods for future goods, is absent.” No savings and no sacrifices are necessary:

If a creditor is able to confer a loan by issuing claims which are payable on demand, then the granting of the credit is bound up with no economic sacrifice for him.

Now, in all of his versions of the ABCT, Mises maintains that an expansion of circulation credit, as distinguished from an increase of commodity credit, causes a boom that must ultimately result in a bust. So far, the earlier and the later versions are homogeneous. However, they differ in the way that Mises explains the effect that an expansion of circulation credit has on the economy. It will be shown that it is on this point that Mises’s first theoretical book, The Theory of Money and Credit, has to be preferred to all of his later writings.

--Eduard Braun, “The Subsistence Fund in Ludwig von Mises's Explanation of the Business Cycle,” in Theory of Money and Fiduciary Media: Essays in Celebration of the Centennial, ed. Jörg Guido Hülsmann (Auburn, AL: Mises Institute, 2012), 194-195.

The Interest Rate Bears a Close Relationship to the Subsistence Fund

So in the Theory of Money and Credit, it is the subsistence fund, the fund of saved-up consumers’ goods that determines the length of the period of production.

Entrepreneurs, when they evaluate the profitability of the different investments and decide about the production processes they want to implement, do not, of course, orientate themselves by the size of the national subsistence fund. They have probably never heard of such a thing, and even if they had, they surely could not determine its size. Instead, they are guided by the interest rate. Yet, in the Theory of Money and Credit, the interest rate bears a close relationship to the subsistence fund. It provides the entrepreneurs with the information as to how lengthy the production processes can reasonably become, that is, it informs them about the size of the subsistence fund. Th is can be seen especially in Mises’s exposition of the ABCT [Austrian Business Cycle Theory].

--Eduard Braun, "The Subsistence Fund in Ludwig von Mises's Explanation of the Business Cycle," in Theory of Money and Fiduciary Media: Essays in Celebration of the Centennial, ed. Jörg Guido Hülsmann (Auburn, AL: Ludwig von Mises Institute, 2012), 197.

Savings, in Influencing the Size of the Subsistence Fund, Determine the Way Production Is Organised in the Economy

In Theorie des Geldes und der Umlaufsmittel, Mises explains the influence of circulation credit on the economy in terms of the so-called subsistence fund. This fund—which consists of saved-up consumers’ goods—looms large in his then exposition of the production process. To explain the subsistence fund theory in a few words: Consumers’ goods are a necessary pre-condition of every production process. Without something to eat, something to drink, clothes, and so forth, nobody will participate in production. The owners of the originary factors of production, most notably workers, need to be furnished with consumers’ goods during the production process. The subsistence fund is especially important when it comes to determining the possible length of the production processes. It is this point which Mises stresses in his 1912 book . . .

He further states that the “national subsistence fund is necessarily altered
by the increase of savings.” Thus savings, in influencing the size of the subsistence fund, determine the way production is organised in the economy:

A lengthening of the period of production is only practicable . . . when either the means of subsistence have increased sufficiently to support the laborers and entrepreneurs during the longer period or when the wants of producers have decreased sufficiently to enable them to make the same means of subsistence do for the longer period.

--Eduard Braun, "The Subsistence Fund in Ludwig von Mises's Explanation of the Business Cycle," in Theory of Money and Fiduciary Media: Essays in Celebration of the Centennial, ed. Jörg Guido Hülsmann (Auburn, AL: Ludwig von Mises Institute, 2012), 196.

Would the Austrian Business Cycle Disappear with Rational Expectations?

A related question is if better information of entrepreneurs about credit expansion and its effects could cushion its effects. Mises argues that entrepreneurs may in the future anticipate the effects of credit expansion and avoid using the easy credit. But would the Austrian business cycle disappear with rational expectations? For that to be the case, as Huerta de Soto argues all economic agents would have to agree that ABCT [the Austrian Business Cycle Theory] is the correct theory, and exactly know how much money is injected and where in the economy it is injected. They would have to have all the relevant information. And even if they had this information, the future would remain uncertain. Thus, economic agents would be tempted to participate in the boom trying to withdraw from the corresponding investment projects before the recession sets in. But they could not know how long the boom would last.

--Philipp Bagus, "Modern Business Cycle Theories in Light of the ABCT," in Theory of Money and Fiduciary Media: Essays in Celebration of the Centennial, ed. Jörg Guido Hülsmann (Auburn, AL: Ludwig von Mises Institute, 2012), 235.

The British Currency School and the Principle of Sound Money

Throughout his body of work on monetary economics, Mises steadfastly proclaimed his adherence to the basic doctrines of the mid-nineteenth century British Currency School and, in fact, upheld its “currency principle” as the essence of his own conception of sound money. According to the currency principle, the ideal monetary system was one in which the supply of money, comprising circulating gold plus bank notes and deposits redeemable in gold, should be made to behave exactly like the supply of a pure gold money.

I contend that Mises was indeed an admirer and follower of the Currency School, and that he deliberately attempted to revise and improve its doctrine and apply it to contemporary conditions. Second, I review Mises’s strong support for a free banking system and argue that it was based on his view that free banking would result in the almost total suppression of the issue of new fiduciary media and thus produce a money supply that functioned exactly as a “purely metallic currency” (in the terminology of the Currency School).

--Joseph T. Salerno, "Ludwig von Mises as Currency School Free Banker," in Theory of Money and Fiduciary Media: Essays in Celebration of the Centennial, ed. Jörg Guido Hülsmann (Auburn, AL: Ludwig von Mises Institute, 2012), 96.