The Online Library of Liberty

A project of Liberty Fund, Inc.

• Titles In the Liberty Fund Library of the Works of Ludwig Von Mises
• Acknowledgments
• Preface
• Introduction
• Monetary and Economic Policy Problems Before, During, and After the Great War
• Part 1: Austro-hungarian Monetary and Fiscal Policy Issues Before the First World War
• Chapter 1: The Political-economic Motives of the Austrian Currency Reform 1
• Chapter 2: The Problem of Legal Resumption of Specie Payments In Austria-hungary 1
• Chapter 3: The Foreign Exchange Policy of the Austro-hungarian Bank 1
• Chapter 4: On the Problem of Legal Resumption of Specie Payments In Austria-hungary
• Chapter 5: The Fourth Issuing Right of the Austro-hungarian Bank 1
• Chapter 6: Financial Reform In Austria 1
• Chapter 7: The General Rise In Prices In the Light of Economic Theory 1
• Chapter 8: On Rising Prices and Purchasing Power Policies 1
• Chapter 9: Disturbances In the Economic Life of the Austro-hungarian Monarchy During the Years 1912-1913 1
• Part 2: Economic Policy Issues In the Midst of the Great War
• Chapter 10: On the Goals of Trade Policy 1
• Chapter 11: Inflation 1
• Chapter 12: On Paying For the Costs of War and War Loans 1
• Chapter 13: Remarks Concerning the Problem of Emigration 1
• Part 3: Austrian Fiscal and Monetary Problems In the Postwar Period
• Chapter 14: Monetary Devaluation and the National Budget 1
• Chapter 15: For the Reintroduction of Normal Stock Market Practices In Foreign Exchange Dealings 1
• Chapter 16: On Carl Menger’s Eightieth Birthday 1
• Chapter 17: How Can Austria Be Saved?
• Chapter 18: The Claims of Note Holders Upon Liquidation of the Bank 1
• Chapter 19: The Austrian Currency Problem Thirty Years Ago and Today 1
• Chapter 20: The Restoration of Austria’s Economic Situation 1
• Chapter 21: The Austrian Problem 1
• Chapter 22: The Gold-exchange Standard 1
• Chapter 23: The Social Democratic Agrarian Program 1
• Chapter 24: America and the Reconstruction of the European Economy 1
• Chapter 25: The Currency and Finances of the Federal State of Austria 1
• Chapter 26: The Economic Crisis and Lessons For Banking Policy 1
• Part 4: Interventionism, Collectivism, and Their Ideological Roots
• Chapter 27: The Economic System of Interventionism 1
• Chapter 28: Economic Order and the Political System 1
• Chapter 29: Remarks Concerning the Ideological Roots of the Monetary Catastrophe of 1923 1
• Appendixes
• Appendix A: Maxims For the Discussion of Methodological Problems In the Social Sciences: Paper Delivered At the Private Seminar 1
• Appendix B: Short Curriculum Vitae of Mayer Rachmiel Mises of Lemberg 1

CHAPTER 14

Monetary Devaluation and the National Budget1

There exists a close relationship between changes in the quantity of money and changes in the money prices of goods and services. If the quantity of money is increased while other conditions remain the same, then the prices of all goods and services will rise. Of course they will not all rise at the same time nor, as was long assumed, in the same proportion as the increase in the quantity of money; but they will rise, and no measure of economic policy is capable of stopping this from happening.

The rise in the prices of domestic goods and services and the rise of the foreign exchange rate are simply two sides of one and the same phenomenon. The foreign exchange rate is clearly determined by the domestic purchasing power of a country’s money. The exchange rate must be established at such a level that the purchasing power is the same regardless of whether I directly buy goods with an Austrian crown or if I first exchange the crown for Swiss francs and then proceed to buy goods with Swiss money.

In the long run, the foreign exchange rate cannot vary from the rate that reflects the relationship between that currency’s domestic purchasing power and that of a unit of foreign money. This rate of foreign exchange, therefore, can be designated the natural or static rate. As soon as the market exchange rate departs from it, it becomes profitable to buy up goods with that money which appears undervalued at its rate of exchange relative to its domestic purchasing power and to sell those goods for that money which at its rate of exchange is overvalued with respect to its purchasing power. Whenever such profit possibilities present themselves, buyers will appear on the foreign exchange market with a demand for the undervalued currency, and this will drive up its rate of exchange until it has reached its static or equilibrium rate.2

However, it should be noted that the changes in the purchasing power of a nation’s currency do not take place immediately and do not occur at the same time in regard to all goods. The rise in prices resulting from the increase in the money supply does not happen overnight; a certain time passes before they appear. The additional quantity of money appears somewhere in the economy, and then spreads out gradually. At first, it flows only into certain businesses and certain branches of production, raising the demand for only certain goods and services, and not all of them; later, the prices for other goods and services also start to rise.

The foreign exchange rate is, however, a speculative rate; that is, it arises from the transactions of businessmen who not only consider the current situation but also take into consideration possible future developments. As a result, the devaluation of the currency in the foreign exchange market occurs at a relatively early stage, or at least long before the prices for all goods and services have been fully affected by the inflation in the domestic economy. The market rate of foreign exchange races ahead of expected future price movements, just like every market rate.

The popular view, however, is mistaken that sees the cause for the unfavorable condition of the foreign exchange rate in the actions of speculators. It is true that both at home and abroad those with unclean hands are often the ones dealing in foreign currency and foreign exchange. But to no small degree this is due to government measures that are implemented to obstruct foreign exchange dealings.3

But one thing cannot be denied in regard to these speculators, namely, that they carry out their business in order to earn profits, and not to suffer losses. They can profit only if they have correctly foreseen the future value of a currency. If they have deluded themselves about the future state of the market, they will pay dearly for their mistake. The “bears” lose if they have underestimated the demand for a currency on the foreign exchange market, and the rate of exchange for that currency instead goes up. As was explained above, such an increase in demand must occur if there exists a divergence between the purchasing power of the crown with respect to goods in Austria and its value relative to a foreign currency.

It is also incorrect to try to explain the foreign exchange rate on the basis of the balance of payments rather than on the currency’s purchasing power. This view distinguishes between the devaluation of money on the foreign exchange and its declining value in terms of its domestic purchasing power. Between the two phenomena there supposedly exists only a distant or—as many maintain—no connection at all.

It is argued that a currency’s foreign exchange rate is a result of the current state of a country’s balance of payments. If the amount of payments to be made abroad rises without a corresponding increase in payments to be received from abroad, or if the level of payments from abroad decreases without an accompanying reduction in the payments to be made abroad, then the rates of exchange for foreign currency must rise.

The fundamental error with this theory is that it completely forgets that the amount of imports and exports depends, first of all, on prices. People do not import or export on the basis of a whim or from any “pleasure” just from doing business. They do so in order to make money from differences between prices, and that importing or exporting will continue until those price differentials have disappeared.

This theory overlooks the significance of prices in the international movement of goods. It incorrectly looks at the act of paying for goods rather than seeing the reason for the act of exchange. This is the consequence of that pseudocurrency doctrine which insists on looking at money only as a means of payment, and not as a general medium of exchange, a doctrine that has borne the most disastrous fruits for economic science, as well as for economic policy.

The buyer does not start worrying about how he will obtain the foreign currency to cover the cost of his transactions only when the payment comes due. A buyer who acts in this way will not be able to continue in business for very long. In his calculations, the buyer gives very careful consideration to currency relationships since he must always keep his eye on his selling price; whether he takes advantage of methods for insuring against changes in foreign exchange rates or bears the risk himself, he always keeps in mind expected fluctuations in the foreign exchange rate. The same thing applies also, mutatis mutandis, for those involved in the international travel and freight business.

For five years, government policy with respect to currency devaluation has been constructed on incorrect ideas concerning its cause. It is no wonder that this policy has completely failed. Domestic price controls have had no success. In spite of all the official countermeasures, the prices of all goods and services have been continuously rising. Likewise, the attempts to stabilize the rates of foreign exchange by preventing foreign currency dealings and to improve the balance of payments by limiting imports have led nowhere.

The official foreign currency regulations are not only useless; they are, in fact, directly harmful. For example, exporters are burdened with the obligation to sell their foreign exchange earnings to the central currency office at a price set below the day’s actual rate of exchange (for the central currency office’s rates of exchange always lag behind the actual rate). The currency office then sells that foreign currency to importers, again below the day’s actual exchange rate, so they can pay for those imports that the government wishes to promote.

The obligation imposed upon the exporters [to sell export earnings to the central currency office] hinders the exporting of goods; it works exactly like an export duty. Its effect is to reduce the total amount of exports and thereby to reduce the amount of foreign currency that is available to pay for imports. No other foreign exchange policy is so clearly harmful as this one. This interference with exports also interferes with the importing of the goods that the government wishes to promote. The importer, of course, appears to enjoy an apparent advantage because foreign currency is sold to him more cheaply than at the actual rate of exchange. But the total amount of foreign currency at his disposal to cover all import transactions is less by the corresponding amount by which exports have been reduced, and thus the total value of all imports is less than it might have been.

No less harmful is the requirement to sell exported goods only in exchange for foreign currency. That our exporters are forced to refuse payment in Austrian crowns from foreign buyers has a severely negative effect on the standing of our currency on the foreign exchange market. What are foreigners to think about a currency that the citizens of the country in which that currency circulates are not allowed to accept payment in by order of their own government?

The decline in the value of our currency cannot be stopped by monetary regulations. When the central currency office was set up, the Swiss franc in Zurich stood at 152 crowns; today it stands at 1,215 crowns! We must finally realize that the rise in the prices of goods and in the rate of foreign exchange for the crown will come to a halt only if the state renounces any further use of the monetary printing press by reestablishing balance in the national budget. The problem of putting the national budget in order is the most important problem in our economy. It is high time that it be solved. Otherwise, one day our currency will reach the point that the French assignats came to, namely, a monetary value of absolute zero.4 For our urban population that would be a catastrophe the extent of which one can hardly imagine.

[1. ][This article originally was published in German in the Neues Wiener Tagblatt (October 5, 1919).—Ed.]

[2. ][Mises was one of the formulators of the modern purchasing power parity theory of foreign exchange rates; see Ludwig von Mises, The Theory of Money and Credit (Indianapolis: Liberty Fund, 3rd rev. ed., [1924; 1952] 1981), pp. 205-24; and Human Action, A Treatise on Economics (Irvington-on-Hudson, N.Y.: Foundation for Economic Education, 4th rev. ed., 1996), pp. 452-58. Also see Joseph T. Salerno, “International Monetary Theory,” in Peter J. Boettke, ed., The Elgar Companion to Austrian Economics (Brookfield, Vt.: Edward Elgar, 1994), pp. 249-57, for an exposition of the “Austrian” theory of foreign exchange rates along the lines developed by Mises.—Ed.]

[3. ][Mises is referring to the development of a large black market trade in foreign exchange as a result of the Austrian government’s imposition of foreign exchange controls on all foreign currency dealings.—Ed.]

[4. ][The assignats were the paper money issued by the Revolutionary government in France between March 1790 and December 1795, during which time they generated an extremely destructive inflation, resulting in the imposition of wage and price controls that disrupted the French economy even more. See Richard M. Ebeling, “Inflation and Controls in Revolutionary France: The Political Economy of the French Revolution,” in Stephen J. Tonsor, ed., Reflections on the French Revolution (Washington, D.C.: Regnery Gateway, 1990), pp. 138-56; also Richard M. Ebeling, “The Great French Inflation,” The Freeman: Ideas on Liberty (July/August 2007), pp. 2-3.—Ed.]