Money: Mengers's Evolutionary Theory
No. 8508 MONEY: MENGERS'S EVOLUTIONARY THEORY
by Gerald P. O'Driscoll, Jr. Research Department Federal Reserve Bank of Dallas
Research Paper
Federal Reserve Bank of Dallas
This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library ([email protected]) No. 8508
MONEY:MENGERS'S EVOLUTI0NARY THEORY
oy
GeraldP. 0'Driscol1, Jr. Research Department Federal ReserveBank of Dallas
December1985
NOTFOR QUOTATION OR ATTRIBUTIONWITHOUT AUTHORIS PERMISSION. COMMENTSARE WELCOME
* The vievs expressed in this article are solely those of the author, and should not be attnibuted to either the Federal ReserveBank of Dallas or to the Federal ReserveSvstem. INTRODUCTION
Carl Menger is best known as the codiscoverer of marginalisn
and the founder of the Austrian School. In the last fifteen
years, there has been a renaissance of interest in Mengerrs work. Some of this interest was stir[ulated bv the centennia!- of 1 rtMarginalist the Revolution.?r Coincidental with this general- interest in the Marginalists, the revival of the Austrian School has generated specific interest i.n Menger. The nodern Austfians have focused chiefly on Mengerts nethodological views, especial-Ly his early statement of methodologlcal individualisrn. In this essay, I exarnine Mengerts theory of noney, which is less well known than his nethodological work. As I argue be1ow, however,
Mengerts theory of money is at least as inportant as his nethodology. Recent work in the mi c r o f o u n d a Li o n s of monetary theory hightens the relevance of Menger's analysis of money.' ,o. instance, the recent controversy over the legal restrictions theory of rnoney should provide us with renewed appreciation for
Mengerts approach, which constitutes an alternative explanataon of the demand for noninterest-bearing liabilities of the federal governrnent. Since Mengerrs theoretical and methodoloeical work
-1- are Ehe foundation of his nonetary analysis, I review these in the next. section. After that, I examine Mengerrs theory of the origin and developnent of a medium of exchange. I then contrast his theory with the 1egal restrictions theory. I conclude with an assessment of the Mengerian contribution to monetary theory.
MICROANALYSIS
rrMarginat I interpret the Revolutiontt as a microecononic revolt against Ricardian Economics. The differences anong the early participants lrere important. As Mark Blaug observed, the I'the Marginal Revolution took three distinctive forms: marginal uEili.ty revolution in England and America, the subJectivist revolution in Austria, and the general equilibriurn revolution in
tL Switzerland and Italy." To treat the three approaches as one would be to gloss over important differences, obscuring the
.l distinctiveness of each contribution. Nonethless, there is a nicroeconomic thread running through the work of the three great narginalists.
As a general microecononic revolution, the work of Jevons,
Menger and Walras was never brought to fruition. Large areas
-2- were effectively ceded to an older way of thinking, with nost
orthodox econonists accepting the nicro - macfo divis j-on as
natural, dictated by the phenomena. The acceptance of a nacro
realn of Lhinking in orthodox econonics goes against the spiri!
of the 1870's, the spirit that accounts for whatever homogeneity
exists i.n the work of the t.hree great figures discussed.
Menger shares with Jevons and l{alras the fate of having had his contribution diluted, as it were. Nonetheless, one cou1.d say that the microeconomic content of modern economics is the joint outcome of the work of a1l- three. I now turn, houever, to
Mengerts distinctive contribution. What is most distincti-ve about Menger is that which has been least absorbed into orthodo). economics.
Subjectivism
Methodological subjectivisn is the specifically Mengerian or
Austrian contribution to economics. Although Mengerts concern
6 with disequilibrium economj-cs has recently been emphasized, the connection betrveen his subjectivism and his emphasis on change and the econonic process -- a constant state of disequilibrium -- is not generally made.
A subjectivist analyzes all economic events in terrns of agents r perceptions of these events: a thing is a good, for example, because individuals believe it to be a good. They make decisions
-3- because of their respective beliefs about the relevant state of
the world, 11[ because of the actual or objective staEe of the
8 world as seen by the economist posing as ideal observer. Menger
held thaf "there is not a phenornenon of the real world rvhich does
not offer us the spectacle of constant change,rr a view
inconsistent with naking perfect knowledge constructs the central
focus of economics. The perfect knowledge assumption is
an t i s u b j e c t i v i s t because it lmplies that, despite the
pervasiveness of change, transactors have already acquired al1
relevant information. The assumption leads to the conclusion
that perceptions always correspond to reality, eliminating genuine informational problerns fron econornic anaJ-ysi.s. Since perfect knowledge is the def ini.ng characteristic of equilibriun, an economics in which uncertainty is central is i.nherently an
9 econonics of di s e qu i 1 i b r i u rn, the narket process and change. The emphasis on subjectivism, change and disequilibriurn goes far toward explaining why economists who followed Mengerts lead have felt uneasy with modern neoclassicaL econonics.
It is standard to suggest that demand is the subjective element in price determination, while cost is the objective elenent. The view that subjectivism applies to tastes or the dernand side of price determinatioo, while objective factors are relevant to the cost or supply side, is incornpatible with Menger I s analysis.
This point can best be seen by quoLing hlieser, who applied
-4- 10 I Menger s analysi-s to cost theory.
Between costs and utility there is no fundanental oppositlon. Costs are goods valued, i.n the individual case, according to thelr general utility. The opposition beLween costs and utiliEy is only that between the utility of the individual case, and utility on the who1e. I{hoever thinks of rutilitvr without rcost, t thinking of sinpLy neglects, in the utility of one production, the utility of the others. And whoever produces, in the individual case, at least cost, produces, on the who1e, with the hi.ghest utility, inasnuch as he thus saves all the opportunity of utility possible, and consequently in the long run utilizes all the opportunities to the utmost possible.
Thus when the law of costs obtains, utility remains the source of ya1ue. More than this, marginal utility renains the aeasure of value.
Nonetheless, in his fanous scissors analogy, Marshall
criticized the Austrians for treatlng utility alone as the source
of value or explanation of price. In arguing that the Austriansr
focus on utility emphasized too much the demand side, MarshalL misconstrued their position. Schumpeter' s criticisn of Marshall
11 on this issue r+as exacLly to the point.
They (the AusErians) stood in no need of bei.ng told about the two blades of Marshall's pair of scissors. What Lhey ained at showing was that L9![ bl-ades consist of the same material -- that both dernand and supply (no matter whether the case i-s one of exchanging exiscing commodities or of producing them) nay be explained in tprn< nf I'rt_i1i+- I
I2 Schumpeter further observed that:
. . .The marginal uLility pri.nciple applies to the demand and supply sides of the value problem in anv case, both in the long run and in the short run. Co"t of production is not an independent principl-e taking charge in the long run. But the marginal utility principle, acting upon the data of the situation, will
-5- in the long run (granting a nunber of assurnptions) so operate as Eo equate exchange value to cosEs.
Nevertheless, neolcassical econonists have generally accepted
Marshallrs synthesis of subjectivist dernand theory and objec!ive
13 cost theory, The question is not one of relative importance of ttob two types of factors, rrsubjectivett and jectivet', but one of consisLency in approach. Since the subjectivist is concerned wi!h otherst perceptions under unceriainty, all relevant econonic 'lsubjective. !0agnitudes are r If a'rfactr' (be it a technologi-ca1 relation or other condition) does not affect perceptions' it is not econor[ica11y relevant.
It musL be emphasized that Menger, though a nethodological subjectivist, was no epistemological subjectivist. That is, he did noE deny that there is an objecEive reality independent of individualsr knowledge of it. Being an Aristotel-ian, Menger affirmed the existence of this reality, as well as our ability to apprehend it. But our knowledge of reality is imperfect at each moment, even as lt is being perfected. Menger was thus 1ed to a subjectivist methodology, which emphasizes Ehe incompleteness of 74 knowledge pervading every rnarket transaction.
There is one more najor eLement to be fitted into our picture of the Mengerian approach. Having done that, I can then develop
Mengerrs theory of rnoney. In the next section, then, T develop
Menger's approach to lnstitutional analysis.
-6- Undesigned Social Institutions
As indicated above, subjectvists enphasize uncertainLy and disequilibrium. This emphasis naturally directs oners attention to how individuals acquire and disserninate information, an inqui,ry that alnost inevitably leads Eo a theory of institutions. InsEitutions play a cruciaL role in the production, disseroi-nation and use of information i-n society.
This viewpoint, which derives f rorn Menger, was fu11y developed in
Ilayekrs analysis of the price system and in Misest and Hayekrs 15 work on econonic calculation. The conparatively short shrift given to institutions i.n neoclassical economics is, at least in 16 part, an effect of its not having incorporated subjectivism.
Menger began his anaJ-ysis of Ehe evolution of social instiEutions with the f ollor+ing question: "Ig.g can it be that the institutions which serve the conmon welfare and are extremely sienificant for its develoDnent cone into being without a conmon L7 'rThe will direcred toward establishinq gLd.r' As he noted: solution of the nost irnportant problens of the theoretical sociaL sciences in general and of theoretical economics in particular is thus closely connected with the quesEion of theoretically I understanding the origin and change of organi-ca11y t created
l8 social structures." At the end of the book in which he takes up
"organic{ institutions, Menger explici-t1y sets down what he
.| beiieved the propermethod to be to addressthe problem-:19
l/e already alluded to the fact that a large number of the phenornena of economy which cannot usually be viewed I I as organically created I social structures, i e.g., market prices, wages, interest rates, etc., have come into exi.stence in exactly the same way as those social insEitutions which we nentioned in the preceding section. For they, too, as a rule are not the result of socially teLelogical causes, but the uninEended result of innurnerable efforts of economic subiects pursuing individual interests. The theoreticil un d e r s tanE i n g--T-Tt-ern, t he t he o r e t i c a 1 un d e r s L and i n g o f thei.r nature and their movement can thus be attained in an exact nanner only in the same way as the understanding of the abovernentioned social institutions. That is, it can be attai.ned by reducing then to their elements. to the individual factors of their causation, and by invesrifiEii-f,-ilE laws by which the complicaEed phenomena of hunan economy under discussion here are built up from these elements.
This is \,/haL Menger elsewhere referred to as the 'iconpositive" 20 nethod. In advocating that the actual, conplex s!ructures be built up from their indi.vidual e16hents, Menger articulated the case for rnethodological individualism. In characterizing social institutions as the results not of hurnan design ("not the result of socially telelogical causes"), but of hunan actions (rrthe unintended result of innurnerable efforts of economic subjects pursuing individual interestsr'), Menger reminded the reader of the need for causal analysis of the forces producing insti !utional change,
Menger's emphasis on the crucial inportance playecl by undesigned institutions differentiates his theory f rom contenporary econornic thinking, which increasingly sees every economj.c problem as amenable to optimal control analysi,s. Arnong
-8- modern Austrians, Hayek has followed Menger nost closely here by
2L focusing on the analysis of undesigned social insitu!ions.
Throughout his work, Menger used this cornpositive method. In
focusing on the evolution of social institutions, he remained
closer to classical political econony than his contemporaries and
their intellectual descendan!s. But while he shared the
classical concern lrith 1egal, political and economic
institutions, he rejected the nacroecononic approach to these questions. Menger's use of his i.n d i v i d u a 1 i s t i c , compositive method in monetary econonics produced one of his most significant applications: a theory of the evolution of money. Almost alone arnong Mengerrs interpreters, Ilayek perceived fhe link between his general approach to econonics and Lhe subsLance of his monetary rrthe economics: consistent application to the theory of noney of the peculiar subjective or individualistic approach which, indeed, underlies the narginal utility analysis, but which has a
22 much wider and nore universal siAnificance.rl
-9- THE THEORYOF MONEY
It is now recognized tha! general equilibrium theory does not incorporate noney as a distinctive good with uni.que properties.
In general equilibrium models, money is merely a nurn5raire. The num6raire has no properties distinguishing it in principle from the- "nonnoney goods in the node1. Models in which money is nerely the nurn6raire good are barter nodels in disguise. In addition, the rrnoneyttin such constructs is inevitably neutraL in
"" its ef f ects. Link"d rvith these failings of contemporary general equilibriurn models is their inabilitv to exDlain "how...certai.n conmodities cone Eo be exalted in the qeneral media of
tt exchange. Menger solved the latter problem and avoided Ehe first two. These successes aLone comnend his analysis to nodern 25 theorists, who, however, are largely unaware of iE,
Menger sunmarized the process of t.he evolution of a monetary
26 unit in the following way:
As each economi-zing individual becones increasingly tnore Eifi. of his economic j.nterest, he is fed by inls interest. without anv agreement. without legislative cornpulsion and even .rithout'rithout regard to the public ;T6'*"t, uo g:.G-iri6-Zoiil5'aiFfEi-:.n eicnaffi-Ti'. other, more saleable, comrnodities, even if he does noE need them for any immediate consumption purpose. With economic progress, therefore, we can everywhere observe the phenonenon of a certain number of goods, especially those thaE are most easily saleable at a given time and p1ace, becoming, under the powerful influence of custom, acceptable to everyone in trade, and thus capabl-e of being given in exchange for any other commodity. These goods were caLLed rrGeldrr by our ancestors, a term derived from ttseltenrt which means to corpensaEe or pay, Hence the t eiE-n@]!" in our language designates the means of payi'EiT as such.
In an analysis reminiscent of Adan Smithrs invisible hand reasoning, Menger treated money's evolution as the unintendec consequence of individuals pursuing their own self-interest.
Indeed, there is some sinilarity be!ween MengerI s theorizing and the hypothetical history of Smith and the oEher Scottish social theorists of the eighteenth century. But Mengert s consisten! use of the compositive method enabled hirn to go further in this and other applications than had any who went before and nost r^rhocame after him .
nThe rrTheory In the Principles, Theory of Moneyt' follows the of the Comrnodity.I' Menger built his nonetary analysis upon his more general analysis of holding stocks of goods. An economy progresses fron econonic s e I f - s u f f i c i e n c y , !o production for the narket on order, to production for the market on speculation.
Concomitant with this developrnent is the increasing holding of stocks of unfinished and partl"y finished commodities, and, in the final evolutionary stage, stocks of finished comnodities. In this context, commodi.ties are stocks of goods intended for sale, ?rinherenL a relationship that is not in a good, no property of
11 it, but roerely a specific relationship of a good to the person 27 who has command of it.il
0nce they begin holding cornmodity sEocks, wealth ordners are
necessarily inLerested in the rnarketability (absatzfahigkeit) or
saleability of these stocks. Mengerrs analysis of this problen
treats questions on 1y recently rediscovered in the
transactj-ons-costs literature. Menger observed that though a
commodiLy is for sale, rrit is not intended for sale
t6 llnconditionallv.rt The stockholder is not i.nterested in the most
rapid possible sale of the entire stock, regardless of price.
Thus, "nerchants nay ... be jusLified if they compla j-n of
sluggish sa1es, since a1!hough their commodities are intended for sale ... they are intended for sa1e, not aL any price, but at 29 tr pri-ces that correspond to the egeral econornicsitualion.
rtgeneral The economic situationrt is a subjective category, dif f eri.ng for different holders of stocks. Roughly, Menger attempted to get at a neasure of the relative costliness of disposing of a unit, or the whole supply of a conmodity, aL the price that r,Jould obtain r{rere the seller in active communication with polential buyers. Mengerrs analysis is not ent j-re1y foreign rrperf to the idea of a ect market," but neither is it a crude approxinaEion of that idea. He dealt with the Drocess of trade and the evaluation of market.s, not vrith some hypothetlcal end
-72- point. Moreover, in being concerned with the narketability of
vari.ous commodities, he was -- to force his anlaysis into sLatic
terns -- concerned with 1e s s - t h a n - pe r f e c t markets that are becoming more perfect.
In Menger's analysis, traders discover that sone commodities
30 are particularLy marketable and widely acceptable. 1n other words, these commodities can be quickly disposed of at low transaction costs. Transactors eventually discover that certain commodities are more narkeLable while others are less so. over tine, they become increasingly r,ri11ing to invest their weaLth i.n the nore marketable cornrnodities. Indeed, individuals learn Eo accept certain conmodiLies In exchange simply because they are marketable, and not necessarily because they thernselves have any final denand for them. Th6 process is self-reinforciog. As more traders wi11ing1y accept saleable conrroditi.es in trade, their
31 acceptabiliEy to prospective traders increases.
This historical process rnarks the evolution of a medium of exchange. As the process continues, a parti-cu1ar good will ordinarily become the cornmon medium of exchange -- money..
Historically, go 1d and silver have generally been Lhose goods.
Demand for gold and silver is relat.ively great and widely dispersed, while supply is relatively srnall. In other words, gold and silver are both relatively valuable and highly marketable.
't! Mengerts analysis dealt with the outcome of many individuals pursuing their self-inEerest, which in this instance, consisEed of a desire for liquiditv. Since Keynes, monetary Lheorists have emphasized the irnportance of liquidity. In his rescateroent of
Keynes' views, Sir John Hicks treated liquiditv as flexibilitv: rr... Liquidity is not a property of a single choice; it is a natter of a sequence of choice, a related sequence. It is concerned r,rith the passage f rox0 the known to the unknor,rn -- lrit.h 32 the knowledge that if we waiE we can have more knowledge.rr Sir
John's liquidity concept is basically Mengerrs. Above all e1se, liquidity gives the economic agen!, be he craftsman, nerchant, trader or consumer, flexibiJ.ity. Tn vastly reducing the costs of specialized production, trade and stockholding, hi.ghly liquid commodities greatly facilitate economic progress. The evolulion of a connon medium of exchange is surely crucial to the development of a cornplex econonic order.
Modern nonetary theorisLs have long grappLed with Mengerrs problem. Until recently, litt.le progress was made in analyzing the process by which a noney good came into existence, Most models inpl-icitly assumed noney was invented in sone sense, despite the fact that over 100 years ago Menger realized that
"money is not the product of an agreenent on the part of economizj-ng nan, not the producE of legislative acts. No one
5J invented it.rr Of much of the recent literature, Professor Jones
-14- rrAlLhough renarked that: these works illuminate how noney rnight
overcome logistical difficul-ties of reaching an ef f icient
allocation with decenEralized exchange, they offer no suggestions
of how a monetary pattern of trade coul-d evolve without a
34 centralized decision.tr Though Jones hirnself recognized Mengerrs
pioneering work, he rvas unable to solve the problen of
sinultaneously determining the rnoney good and its markeL va1ue.
Yet Menger had done this in the Principles and 1n rrGeldrt. Since what becones noney was originally the mosL narketable goocl, it always had an exchange value. Its very marketability enhanced the demand for it over and above its use va1ue. The addition of a denand for this good as a nedium 6f sachanoa i^ ir-< rrnonmonetaryrr demand. causes it.s relative price to rise over time.
There is, however, no unique point at which a good becomes noney. Hence, there is no logical or historical break in the sequence of its price history. One dayrs prices built upon yesterdayrs, together with agentsr expectations of future price movernents, in a way not differing in kind for any other good. If anything, the goodrs high narkeLability made this process nore certain lhan for the average good.
Menger analyzed rnoney as a connodity in order to explain theoretically its historical evolution. The modern system of pure f i.duciary noney postdates, of course, Mengerrs theory. This
- t5 - systen has devel-oped partly by evolution and partly by governtnent intervention. In a sense, Menger anticipated or at least allowed for Lhis developnent when he observed that. 'rt.he 1ega1 order usually has an influence on the rnoney-character of commoditles
35 which, though sma11, cannot be denied." Mises exlended Mengerrs analysi.s to nodern nonetary systems by examining the possibility
.1O trf of governnentrs making coins or notes rnoney by iatn.
All thaL the State can do by means of its of f j.cia1 stamp is to single out certain pieces of metal or paper f rorn all the other things of the same kind so that they can be subjected to a process of valuation independent of that of the rest. Thus it permits those objects possessing the special legal qualification to be used as a comnon nediurn of exchange while the other conmodities of the sane sort renain mere comnodities. It can also take various steps \,rith the object of encouraging actual enployment of the qualified conmodities as comnon media of exchange. But Lhese comnodities can never become money just because the State commands it; money can be created only by the usage of those L'ho take part in commercial transactions.
We can now assess the particular contributions of Menger to nonetary economics. First, he solved Lhe problem of the evolution of a cornmon nediun of exchange. He did so by applying his compositive method, which consisted of a thoroughgoing subjectivism. Jonesr renarks about his own rnodel apply wlth 37 equal force to Menger:
,..The approach suggests that a very comrnon good would emerge as a fi-rst comnodity money in a barter economy. The important point is that this comnonness is a market characteristic of goods rather than an intrinsic phy sical characteristic such as portability,
- 16 - divisibility, or cognizability. This i.s not to say that such physical characteristics play no role in determining r+hich good will be used as a rnedium of exchange. H6TE?6r-the analysis suggesrs rhar rhe ralionale for using a mediurn of exchange Ln the first place mi.ght be found in the di.f f ering market characteristics of the good and the decentralized iature of exchanse.
In the previous passage, Jcnes presented a subjectivist
vielarpoint on what constitutes a sound theoretical treatnent of
the origin of noney or any other econornic institution. physical
characteristics or objective conditions pLay a ro le in the
evolution of organic social institutions. Ennurnerating such
characteristics or conditions does not constitute, however, an
explanation or analysis of the evolutionary process. Relating
these characteristics and conditions to self-interesLed behavior of individuals can forn the basis of an evolutionary economic analysis. To paraphrase Jones, the economi.st must account for the way 1n which physical characteristics of things becorne rnarket characteristic of goods. Menger accomplished this in his theory of money by relating physical characterisEics Co narketabiliry,
Mengerts money is much rnore than a nu106raire or otherwise neutral econonic institution. rt is one of the driving forces of econonic development, replete \^'ith real effects. The distincti.ve properEy of the rooney good is that, being Lhe most rnarketable of all goods, it has evolved into a comnon medium of exchange.
Nearly al-1 transactions are executed with the use of money, so noney is the most Iiquid of aIl goods. It is "for sale" in everv market.. Though sti11 largely unfarniliar to contemporary noentary econonists, Mengerrs theory of noney has gained sorne exposure lndirectly through the work of Georg Sirnnel. Frankel has contrasted Sinmelts vlew of money as an evclved social institution with the "nnonetary noninalisnrr of Georg Friedrich 38 Knapp and John Maynard Keynes. Monetary nominalists contend that noney is a consci.ous creation of the state, which can, 39 moreover, be altered as the state pLeases.
Frankel broughL out the correspondence between Sinmelrs views
40 on money and those of Menger. In a review article, Laidl-er and
Rowe correctly emphasized the intellectual nrecedence of
4I Menger. Sinrnel, the sociologis!, apparently drew on Mengerrs theory of money in developing his sociology of rnoney. As inportant and deserving of econonistrs attention as Simmelrs work is, Mengerrs is Lhe source of the economic analysis of the origin of money.
In the next section, I utilize Mengerrs insights to analyze a contemporary monetary debate. In the process, I try to illuninate further Menger I s contribution,
- 18 - 42 I'lhy Money ?
The simultaneous existence of noninterest-bearing fiat money
and I n t e r e s t - be a r i n g governnent debt presents an a p par ent paradox. The two assets are obligations of the sarne issuer, yer 43 bear very different rates of return. In a classic articLe, Tobin rrthe wrote of apparent irrationality of hoLding cash" and rWhy posed the question: should anyone hold non-interest bearing
obligations of the governnent instead of interest bearlng
44 cbligations. rl
Many have argued that, indeed, in a stationary staLe, there would be no demand for money. SEationarity implies certainty of paynents and receipts, including certainty of timing.
Individuals could then bridge payments gaps through the purchase 45 and sa 1e of liquid financial assets.
Along with a stochastic elenent to payments and receipt.s, transaction costs nust be added to neoclassical rnodels in order to generate a demand for money. Uncertai-nty is needecl t.o generate a precau!ionary demand. Transaction costs in the forn of brokerage fees are needed to insure tha! the precautj.onary
_ 19 _ demand is for money and not for interest-bearing liabilities of the government ( bonds ) .
There are two problerns with this orthodox approach. First, the uncerLainty of these neolclassical models is severely li.rnited, if not contrived. rrUncerLainty does play a role in the analysis,
46 but only uncertainty with respect to the tining of paynents.rl
Second, brokerage fees on highly narketable financial asseLs are quite 1ow. Treasury bills in denominati.ons of $10,000 can be purchased for connissions of 30 basis points (3/10 of 1 percent) or 1ess. In a world of 3-percent interest rates, this may have been a non-negl-ibl-e transaction cost. It is surely neg1ib1e, however, in a worLd of double-digit interest rates.
Any plausibilty this approach had was lost in the recent era of high interest rates, whieh saw the introduction of noney-rnarkeL nutual funds and other financial innovations. With as little as
$1r000, an individual investor can now place idle balances at interest rates only slightly below wholesale rnoney-narket raE.es.
There is no bid-asked spread involved in going in and out of the new noney-market instruments. And, of course, one can writ.e
47 checks Eo draw on his funds. An approach !ha! at.tempted to rationaLize a denand for noney in terns of c ha r ac t.e r i s t i c s of noney markeLs was rendered i.napplicable by innovations in these markets. Theorists have recenEly reasserted the paradox of a demand for n on i n t.e r e s t - b ea r i n g money. They deny that the paradox is the
result of rnarket forces, but argue chat it is the effect of legal 48 restrictions. Neil Wallace seated !he case forecfully:
Laissez-faire means the absence of 1ega1 restrictions thaL tend, anong other things, to enhance the demand for a governmentrs currency. Thus, the imposition of laissez-faire would alnost certainly reduce the demand for government currency. It could even reduce it to zeto. A zero denand for a governnentrs currency should be interpreted as Ehe abandonment of one monetary unit in favor of another -- for exampLe, the abndonnnent of the do11ar 1n favor of one ounce of go1d. Thus, ny predicEion of Lhe effects of imposing laissez-faire takes the form of an either or statement: either noninal interest rates go Xo zeto or exisLing governnent currency becomes worthless.
I'Ia11ace dubbed his analysis ttthe 1ega1 restrictions theory" of the demand for money and the description has gained acceptance.
According to the t.heory, there would be no demand for n o n i n t e r e s t - b ea r i n g money (e.g., currency ) in an unregulaLed
(trlaissez-faire") banking system. By inplication, i n t e r e s t - b ea r i n g noney woul-d be indistinguishable from other financial assets. Wallacers intellectuaL antecedenCs were ever clearer on the last point. For instance, Eischer Black firsc identified an unregulated financj.al system as one in which trcomrnercial banks and other financial institutions are free to offer checking accoun!s ( and savings accounts) on any terrns they might want to set, and in which there are no reserve requirements,rr He then argued that in such a world ttit would not be possible to give any reasonable definition of Lhe quantity of
t1 noney. The paynenLs nechanisn in such a world would be very
49 efficient, buL noney in the usual sense would not exist. tt rn
place of money, Bl ack predicted that equity-based cash-management accounEs would emer ge
It would appear that one rnust choose between subscribing to a contrived market analysi.s or accepting the bold assertion Lhat the demand for currency is the result of tegal restrictions.
There is, however, a !hlrd choice, which i.s to adopt Menger's theory of monetary evolution.
A Mengerian analysi.s sharpl-y distinguishes between money, a perfectLy liquid good, and highly liquid, nonmoney financial assets. Certain historical and institutional facts nust then consi.dered. First, even in the freesL of banking systens currency has not ordinarily borne i.nterest. Second, in the
United States, most 1ega1 restrictions on the creation of financial assets, including money, are of cornparatively recent vintage. Restrictions on the payrnent of interest rates on demand
50 deposits date only to the Banking Act of 1933. The restri.ctions on banksr issuing currency date only to t.he National Bank Act
(f863). Even so, although interest was fornerly paid on some demand-deposit accounts before Lhe rest.rictions, currencv did not generally bear interest.
The period of free banking in Scotland most closely
-22_ approxj.rnates a laissez-faire banking syslen. ScoLtish banks did not pay interest on their bank notes even though there \'tas no
51 prohibition on their doing so. In his recent study of Scottish free banking, tr'lhire concl-uded that: iCompetitive free banking is therefore not inconsistent with an absence of i nt er es t - be a r i ng currency. Notice that travelers checks today, even though they are paid over but once and are issued conpetitively' do not bear
)z in t eres t . It
Historical experience casts doubt on the thesis of the legal ttparadoxrr restrictions theory. fn theoretical terns, the suggested by the lega1 restrictions theory is at issue. Fron a
Mengerian perspective, there is no paradox in the fact that bonds yield interest and money either does not or else yields a lower rate of interest. This reflects noneyts superlor liquidity' superior even to the nost liquid, short-tern nonmoney financial assets. As Menger emphasi.zed, money is not just highly liquid but is perfectly liquid. Bei.ng the good that circulates routinely as the medium of exchange' money trades in every narket
53 and is never sold at a discount from par.
Klein characterized Lhe distinction in the following way: it is moneyrs nonDecuniarv services that distinguish it from nonmoney financial assets. Tn other r,tords, rnoney yields nonpecuniary recurns while other assets yield pecuniary ret.urns. Liquidity is
-23- the peculiar nonpecuniary return yielded by rnoney. Because rnoney is perfec!1y liquid and yi.elds a nonpecuniary return, it will not also yi.e1d a market rate of interest. If rnoney were both perfectly liquid and yi.elded an explicit market rate of interest, then its total return wouLd be supra-norma1. Cornpetitive forces would drive down its explicit yield so that the total rate of
54 return equaLed that of nonmoney fLnancial assets.
Kleinrs analysis is certainly consisLent with Mengerts approach. IL is a narket analysis, with a sound basis in both nicro theory and institutional features of financial markets.
The approach also obviates the necessity of invoking J.ega1 restrictj.ons, which are of recent origin, in order to explain patterns of return that. have persisted across time and differing lnstitutions.
A School Apart
Mark Blaug once attributed to T. W. Ilutchinson the clain that ttwhat was inportant in marginal uti.lity was the adjective rather
:)o than the noun." This observation is decidedly not true of
it Mengerrs work. Utility or subjective value was the paramount concept in Mengerrs analysis. His analysis was subjectivist both 58 in rnethodology and in content. The !heories of the other marginal"ists certainly contained subjectivist elements bu! none was as thoroughgoing in its subjectivism as was Mengerrs. Indeed,
the enduring contributi-on of the Austrian School flows from its
subjectivism. Streissler best sumrnedup the situation when he rrthe obseryed that AusLri.ans always stressed, and stressed
rightly, r think, that they were the school of subjective values, 59 a school apart. tr
Mengerts mosE enduring legacy to rnonetafy econornics -- as to economics generall-y -- was his subjectivisrn. Havlng rejected an explanation of noney as being the result of a centralized decision, Menger used his individualistic or microeconornic method to develop a theoretical soluti-on. This approach enabletl him to develop an evolutionary theory of money. This theory is less weLl known, however, then his nethodological writings. In this paper, I have attempted to remedy the situation. I have also tried to Lndicate the contenporary relevance of Mengerrs theory 60 of nroney.
rrTo 1. See, for instance, Erich Streissler, What Extent Was the Austrian School Marginalist?" in R. D. ColLison 81ack, A. W.
- z) - Coats and Craufurd D. W, Goodwin, eds., The MarginaL Revolutron in Economics: Interpretation and (Durhan, -T6O:75;:i:-: _=_i__=:_::_:_=_:_:Evaluatfo-n= N.C.: Duk. Uni_versiry PreEEl-T973)l-!'!-T aTso see rhe essays in J. R. I{icks and W. Weber, eds., Carl Menger and the Austriin SchooI gf Econgpigp (Oxfordl Oxford Unlversity Prass, The Clarendo; rress, L9tJ).
24. bee,J torfor exampte,example, Lawrence H. White, Methodology of the -&!.ffiCLAUStr:.ant School, Occasional. Paper No. I (New Yorlc: Cencer tor Libertarian Srudies , 1977) , pp. 2-5
3.. See,,.for exanple, R. I^1.Cl.ower, ttFoundations of Monetary Theory," in Monetary Theorv (Baltinore: penguin Books, Igi-O), 'iMo;;y pp . 2O2-1I;-f,o-G-F-n U.-T$ioy ancl Ross M. Siarr , and' ttre De c en t. r a1 i za t i on of Exchange,tr EconorneErica 42 (November L974): i,Ttr;-6'if[Tn-Zi-a' 1093-1114; Robert A. Jones, Development of Media of-Exchange,' Journal of Polirical Econony 84 (August I9l6) z tJo-tJi and Robert A. Jones and Joseph M. Ostroy, r'Flexibility rr and Uncertainty, R.31-q11of Econqlqics and Statistics 5l ( Ja nuar y 1984) : 13-s2. rrl'Jas 4. Mark B1aug, There a Marginal Revolution?rr in BI_ack, Coats and Goodwin, p. 14.
5. See William Jaffe, ttMenger, Jevons and Walras De-Hornogenized,rr Economic Inquirv XIV (Decenber 1976).
6. Cf. Jaffe, 579-20 and Srreisster, pp. L7Z-73.
7. Streissler does make this connection, but in the conLext of a more general thesis with which I cannot agree. (See footnote 59.) See Streissler, ItTo what Extent Was the Austrian School Marginalist ?rl
8. Cf. Friedrich A. Hayek, I'The Facts of the Social Sciencesl in Individ.uqli:m and Egonomic 0rder (Chicago: University of Chicago rress, IY45), p. b0. rrEconomics 9. See Hayek, and Knowledge," in ibid. , p. 42. Also :ge^Sg.rn, "The Use of Knowledge in Soclety, "E--_l_bi4.. , pp.
10. Friedrich von Wieser, Natural Value, trans. by Williarn Smart (New York: Augustus M. KeIley, 1971), t. 183; reprinr of the 1893 edition. Two pages af t.er this passage, Wieser added thaE: "Possibly it is the greatest triumph of the theory of rnarginal utility that it f ul1y explains the obscure conception of costs, rrith vhich every other theory had to reckon, and with which no theory could cone to any reckonj-ng.it
-26- 11. Joseph Schurnpeter, Historv of Economic Analvsis (New York: 0xford University Press, 1954) , p. o),
12. Ibid., p. 922n. The reader unfaniliar wiLh Mar sha11 I s argunent can find references in Schurnpeter, Pp. 920-24.
13. But see James M. Buchanan, Cost and Choice: An lnquirv Econonic Theory (Chicago: Markham, 1969). Buchanan defends subj ectivist analysis of costs.
14. 0n Mengerts Aristotelianism, see Emil Kauder, A Historv of MaLginal UEility Theory (Princeton: Princeton University Press, I965), pp. 83 and 95-100; cf. White, Methodology of the Austrian School, pp. 3-4.
15. For HayekI s analysis of the price system, see t'Economics and Knowledge,rr rrThe Use of Knowledge in Society," and t'The Meaning of Conpetition,rr aII reprinted in Individualism and Economic 0rder. 0n the Mises-Hayek analysis of econonic calculation, see D. C. Lavoie, Rivalry and Central Planning: Socialist Calculation Debate Reconsidered (Canbridge: Cambridge University Press, 19E5J
16. For an excellent aasessment of the role of institutions in ttThe rNer.t economic theory, see Rlchard N. Langlois, InstitutionaL Economicsr 3 An Introductory Essayrtt itt ilgg., ed., Economics as a Process: Essavs in trThg Nert Inqtaqllt:Lenq! Econonicstr (Cambridge: e anEi iI ge-Tn i ve rETri-Fie65i I 98-6'I.
17. Carl Menger, Problems of Economics and Sociologv, trans. by Francis J. Nock and ed. by Louis Schneider (Urbana, 11L.: Universlty of I11inoi.s Press, 1963), p. 146.
18. Ibid., p. 147.
19. Ibid, pp. 158-59.
20. Menger did so in a nanuscript note to Schrnollerrs revj-ew of Mengerrs Methoden der So c i a1 w i s se n sh a f Le n . See F. A. Ilayek, The Counter-revolution of Science: Studies on the Abuse of Reason-Ttz Irl"r vott t tlucmirrar, The lre. FiEJF-or-TrE'nlo6l rds5T, w (note 33).
21. For exanpl-e, see Fredrich A. Hayek, rrThe Results of Hunan Action but not of HurnanDesignrtt in Studies in Philosophv, Politics-TS6tt,-pp. and Econornics, (New York: Simon and Schuster, Clarion s..ks, e6:tos.
22. F.A. Hayek, "Carl Yenger," Economica, N.S. 1(Novernber 1934): 474.
23. Cf. Friedrich A. Lutz, "0n Neutral Moneyrt' in Erich
-27 - Striessler, et a1., eds., Roads to Freedon: Essays in Ilonour of | ! ! ed r i c h 1,--req-!_cJel 1lt ew-T o?k :-e us u s r u s M:-KelTelT T969Jl pp . 105-09; and R. lJ. Clower, "Foundations of Monetary Theory,rr in Monetarv Theory (Battimore: Penguin Books, 1970), pp. 2O2-tL.
24. Robert A. Jones, 758.
25. Two proninent exceptions are Sir John Hicks in his Theorl of Economic Historv (New York: 0xford University Press, GaG-ii- Books, f969), pp. 28-29 and 63-68; and Boris P. Pesek and Thonas R- Saving in their Money. Wealth and Econonic Theorv (New York: The Macrnillan Compai!l-T967)-: ntl-
26. Carl Menger, Principles of Economics, First, General Part. Trans. and ed. by JaEE; DingTeTT-fnd Aert F. Iloselitz with an Introduction by Frank H. Knight (G1encoe, I1L.: The Free Press, 1950), p. 260.
27. Ibid., p. 241. Mengerrs subjectivist emphasis is evident in this passage and in his analysi.s of noney generally; see ![g1!., pp. 236-41 .
28. Ibid., p. 248.
29. Ibid.
30. Menger was alnost exhaustive in discussing factors inpeding and facilitating narkeLability. Ibid. , p. 248-53.
31. Cf. Lawrence I{. White, rrConDetitive pavnents Svsterns and the Unit of Account,rt American Econornic Review 74 (September 1984): 703.
32. Sir John Hicks, Tlle -3E:59.-EiEJ-FiiEE"i-i6EedCrisis in Keynesian Economics (New york: Basic Books, 1974), pp. rhar ,'by holding the i.nperf ectly liquid asset the holder has narrowed the trend of opportunities which nay be open Eo him ... He has rlocked trr himseLf in. Ib:!{., pp. 43-44. Cf . G. L. S. Shackle, IgEr._gof IIigh Tt-reorv (Canbrldge: Cambridge University press, 1967), p. _6, where money is described ai "the refug! from specialized conmitr[ent, the postponer of the need to take f ar-reaching decisi-ons. rl
33. Menger, Principles, p. ') 6',)
34. Jones , 759.
35. Menger, Principles, p. 26t.
36. Ludwig von Mises, !hg Theory of Money and Credi!, 2nd ed. Trans. by H. E. Batson ( I r v i ng t on - on - Hu d s on , N.Y.: Foundation for Economic Education, 1971), pp. 60-61. For Misesr criticj.sm of
-28- rr tt the s !at e theory of noney, see pp. 7L-78 and 463-69.
37. Ibid. , I TJ.
38. S. Herbert Frankel, Money: Tr*o Philosophies (0xford: Basil nrackwel-l, t9tt)
39. Ibid., p. 48
40. Ibid., pp. 32, 34, 35, and nores thereto
41. David Laidler and Nicholas Rowe, ttGeorg Sinnelrs Philosophv of Money: A Review Article for Econonists, tr Journa 1 of Economi c LiteraEure 18 (March 1980): 97-105.
42. With apologies to Armen Alchian. See his t'Why Money?ttJournal of Monev, Credit and Bankins 9 (February L977): 133-40.
43. Currency is the paradigmatic noney in these accounts, and treasury bills the paradigmatic i nt er es t - be a r i ng debt.
44. Jarnes Tobin, Liquidity Preference as Behavior Toward Risk,,t Review of Econqqlic Studies 25 (February 1958): 65. Cf . Willian J. BaumlT,TfiE-TianiaEtion Demand for Money: An Inventory Theoretic Approach, " 0uaterl v Journal of Econonics 66 (Novenbet 1952).. 545-5b; and Don Patinkin, Money, InLerest, and Prices: An lstcsrelig.s or Mg n g t ar v e"aEsr.-@; za Gcl--( tter" T6-rt : Harper & Row, 1965), pp. ZS- t SS.
45. Cf. Baurnol, pp. 169 and 175n. Baumol cited Knight, Divisia, Patinkin and Rosenstan-Rodan as sources of stationarv-state argurnent.
46. Patinkin, p. 80, emphasis added
47. These financial innovations are exanined in nore detail in Gerald P. 0rDrisco11, Jr., "Money in a Deregulated Financial SystenrI Econornic Review of the Federal Reserve Bank of Dal]-as (May 1985) z l-12, especially pp. 2-6. Deregularion of interesr rates paj,d on deposits has accelerated the process described here. rrA 48. Neil Wa11ace, Legal Restrictions Theory of the Demand for rMoneyr and the Role of Monetary Policy,'r Quaterlv Review of che Federal Reserve Bank of Minneapolis (Winter 1983): 4. Eor an earlier sLatenent of the theory, see John Bryant and Neil I'The hla11ace, Inefficiency of I nt er es t - be a r i ng Natlonal Debt, rr Jounral of Political Econornv87 (Apri1 1919); 365-81. Also see Jo tri- nryii'tl-tT"aIyzi;g- DEiTcit Finance in a-Regime of Unbacked Governrnent Paper," Econonic Review of the Federal Reserve Bank of Da11as (January 1985): 17-27. Some of the precursors of the Bryant-Wa11ace view are examined in 0rDriscol.1, pp. 6-10.
-29- 49. Fischer B1ack, Banking and Interest RaLes in a World Without t' Money: The Ef f ects of Uncontrolled Banking, &gIg! of Bank Research 1 (Autumn 1970): 9
50. These restrictions have recently been substantially el-iminated for individuals.
51. These notes did pay a contractually set rate of interest in the event that specie payment were suspended.
52. Lawrence II. White, Free Bankin& in Britain: TheorV, Experience, and Debate, 1800-1845 (Carnbridge, U.K.: Cambridge University Press, 1984) , pp. 8-9.
53. Cf. O'Dri.scoll, p. 11.
54. Benjamin R1ein, "The CompeLitive SuppLy of Money,I Journal- of Monev, Credit, and Banking 6 (November 1974) 2425i cf. b'5Fisc6, f, pp.-To:T-f-
55. It would be beyond the scope of this paper to resolve the question of whether assets can have varyi.ng degrees of ttnoneyness,r? or whether they can straddle the demarcation between noney and nonmoney. Certainly lhere are bank accounts, like noney narket deposit accounts, which yield interest and appear to have some of noneyrs properLies. Many if not most noneEary econonisls would argue that assets do vary in their moneyness or liquidity. For a contrary view, however, see Dale K. Osborne, ttWhat is Money Today?" Econornic Review of the Federal Reserve Bank of Da1las ( January-I9--6'ifl-
56. See Streissler, p. 160.
57. The AusLrian concept of the margin differs from the nodern neoclassical concept. Thus, the Austrians did not even agree on the meani.ng of the adjective. See J. lluston McCuLloch, ItThe Austrian Theory of Marginal Use and of 0rdinal Marginal Utility,rr Zeitschrift fur Na t i on a 1 o k on o rn i e 37 (1977) z 249-8O. 58. This distinction is develooed furCher in Gerald P. OrDriscoll-, Jr. and Mario J. Rizzo. The Economics of Time -and Isnorance (Oxford: Basil Black*eff , ES)ll'p. t7:54.- rrTo 59. Streissler, l,Ihat Extent Was the AusLrian School MarginaList?rr p. 161. This paper, along with Streisslerrs cornpanion piece, "Mengerts Theories of Money and Uncertainty -- .{ rr Modern I nt er pr et at i on , is extremely inportant for any reassessment of Ehe Austrians. f have not dealt lrit.h them in more detail for two reasons. First, I had wanted to focus on the primary rather than the secondary literature. Second, I believe Streissler ttreads backrr Lo Mengerrs monetary economics, making
- JU - him seem too nuch like a precursor of Keynes. Moreover, I thinlc Streissler went too far in separating r]nqrginalists,tr Menger- from the partLy becausl St r ei i s 1e r p1 a y e d down the dl-tterent concept of the rnarginal unit for the early Austrians. This 4ifferent concept played no less a role for them than did Ene alEernative concept for Lhe Lausanne School. (See the reference footnote 57. )
60. T would like to acknowledge the helpful conments of Lyla H. 0tDriscoLl, Lawrence II. White and two anonymous referees.- The viens expressed in the article are solely the authorrs and do not necessarily represent the official position of anv Dart of the Federal Reserve System.
- 31 -