Lesson 2 of 9
How money gets a price
Money is wanted for what it buys, and what it buys depends on its price. Mises's answer to that circle is to send it backwards through time until it stops.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The circle: a unit of money is valued for what it buys, and what it buys is its purchasing power, which is what was to be explained.
- Mises breaks it with time. Today's purchasing power is formed from yesterday's, which was formed from the day before, and so on backwards.
- The chain does not run forever. It ends at the point where the commodity was valued for a non-monetary use, which is a value that needs no monetary explanation.
Subjective value says a thing is worth what it does for somebody. Applied to money that produces an immediate circle, and Mises spends the middle of The Theory of Money and Credit on getting out of it.
The circle, and where the chain stops
- TodayPurchasing power nowPeople estimate what a unit buys, from what it bought yesterday.
- YesterdayThe same againWhich was itself estimated from the day before.
- EarlierBack through the chainEach step is an estimate formed from an actual experience, not from a guess.
- The startNon-monetary valueThe commodity was wanted for use, and that value needed no monetary explanation.
The problem, stated exactly
Ordinary goods are valued for something they do. A coat keeps you warm and that use can be assessed without any reference to a price.
Money has no such use. Mises's point in his chapters on the value of money is that nobody would hold it if it had no purchasing power, so its usefulness consists entirely in what it exchanges for. Try to explain its value by its usefulness and you are explaining its purchasing power by its purchasing power.
The move: yesterday, not today
His solution is that when a person today estimates what a unit of money is worth, they are not reasoning from its present purchasing power. They are reasoning from what it bought yesterday, which they observed.
That estimate, together with today's supply of money and today's demand to hold it, produces today's purchasing power, which will in turn be what tomorrow's estimate is formed from. The apparent circle is not a circle because the two terms sit at different dates: today's value is explained by yesterday's experience, not by itself.
Why the chain terminates
A regress that never ended would be no better than a circle. Mises's answer is that the chain runs back to a point at which the commodity had a value from some other use entirely, before anyone used it as a medium of exchange.
At that point the value is an ordinary one, explained by marginal utility in the usual way with no reference to money at all. Additional demand for it as a medium of exchange then added to that value rather than creating it from nothing.
What the argument is and is not
It is an explanation of how money can have a purchasing power consistently with subjective value. It is not a prediction of what any purchasing power will be, and nothing in it says what money ought to be made of.
The best-known objection is about money that has no commodity history at all. A defender of the theorem replies that the requirement is historical rather than ongoing, so a currency that began as a claim on a commodity can continue after that link is cut, since each day's estimate still comes from the previous day's experience. Whether that reply is sufficient is argued about, and the critique course later in this track returns to it.
Check yourself
What is the circularity Mises is trying to escape?
- That money is scarce because it is valuable
- That money is valued for its purchasing power, which is the thing to be explained
- That prices are set by other prices
Show the answer
Answer: B.
Money has no use apart from exchange, so explaining its value by its usefulness explains purchasing power by purchasing power.How does the regression argument avoid the circle?
- By assuming a fixed quantity of money
- By explaining today's purchasing power from yesterday's, so the two terms sit at different dates
- By treating money as a commodity like any other
Show the answer
Answer: B.
The estimate people form is of what a unit bought, which they observed. Today's value is explained by an earlier experience rather than by itself.Where does the chain terminate?
- At the founding of a central bank
- At a point where the commodity was valued for a non-monetary use
- It does not terminate
Show the answer
Answer: B.
At that point the value is explained by ordinary marginal utility with no reference to money, which is what stops the regress from being endless.Sources
- Mises, The Theory of Money and Credit, German original 1912, English translation by Batson 1934, part two, chapters 7 and 8, on the concept of the value of money and on the determinants of its objective exchange value, where the regression argument is set out and the chain is traced back to non-monetary use.
- Menger, Principles of Economics, 1871, English translation 1950, chapter III, for the theory of value the argument is extending.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The worker example is invented to show the direction of the explanation. It describes no currency and no period.
- Whether the theorem holds for money with no commodity history is disputed, including by economists sympathetic to the rest of this tradition. This lesson states the objection and the usual reply without settling either.