. 4
( 10)


been called an abstract fund that creates a permanent
flow, it has been referred to as “congealed waiting,” defined
as “the produced means of production,” or characterized as a
source of future service flows.
We look to the choices of individuals as the basis for our
economic theories. In Human Action, Mises says: “[Capital] is
a product of reasoning, and its place is in the human mind. It
is a mode of looking at the problems of acting, a method of
appraising them from the point of view of a definite plan.”
Israel Kirzner, in An Essay on Capital, defines capital goods as
way stations in someone™s plan to produce consumer goods.
What distinguishes capital goods are not any physical charac-
teristics or special circumstances under which they came into
being, but the fact that they are, today, a part of someone™s
plan to produce a consumer good. And capital is an
accounting convention for summing up those goods on a


firm™s balance sheet, in order to gain an overall view of the
firm™s health.
In a complex economy with many stages of production, it
is not necessary for each producer to envision exactly how his
product will aid in the manufacture of a consumer good. It is
enough for him to believe that someone wants this product.
That buyer can determine which lower-order good(s) will be
produced using his higher-order good. A computer manufac-
turer tries to gauge next year™s demand for computers. He is
not concerned with whether his computers will be used to
help produce cars or futons. However, we have seen that
every producer good must be part of a plan to produce a con-
sumer good, or it will cease to be an economic good at all.
That definition, as Mises and Kirzner illustrate, clears up
many of the confusions in capital theory. For instance, Merton
Miller and Charles Upton, in Macroeconomics: A Neoclassical
Introduction, say that the productivity of capital is something
assumed but left unexplained by economics. However, view-
ing capital as partially completed plans makes the explanation
clear: Of course, if we have completed part of our plan for
producing a good, we can produce it more readily than if we
have completed none of our plan. (Given, of course, that our
plan is sound.) And we will only choose a route to our goal
because we think it is superior to alternative routes, based on
our estimates of the cost of the various paths we might take.
As Mises says:
Capital goods are intermediary stations on the way
leading from the very beginning of production to its
final goal, the turning out of consumers™ goods. He
who produces with the aid of capital goods enjoys
one great advantage over the man who starts with-
out capital goods; he is nearer in time to the ulti-
mate goal of his endeavors. (Human Action)
, 123


T stretch the idea of capital as an accounting
item for a firm to yield a measure of “social capital” is
confounded by absurdities. A “firm™s capital” as a con-
cept in bookkeeping was an essential advance in man™s abil-
ity to plan for the future. By totaling the productive resources
available to a firm at any point in time, accountancy enabled
firms to determine how much of their income could be
devoted to current consumption without diminishing their
ability to produce in the future.
Such a summing up can only be done with the aid of mar-
ket prices. By totaling the market price of all its productive
resources, a firm can approximate its financial health. Taking
the same sum at a later date allows the firm to see if it has
been advancing (or declining) in its ability to produce in the
future. If it found it had a million dollars of capital on hand
last year, and only half a million on hand this year, it has been
engaged in capital consumption. It could be the case that the
owners have been taking out money that was not actually
profits, that the firm has been paying its workers too much,
has been undercharging for its products, or that it is simply
not a viable business. In any case, capital accounting informs
the firm that something must change or it will go broke.
The prices that are used to sum up a firm™s capital are esti-
mates. When pricing a particular capital good for the purposes
of capital accounting, it is a mistake to look back to the price
that was paid for the good. Rather, the firm must look forward
to the various streams of revenue it expects would result from
different possible uses of the good.
Consider the position of a horse-drawn-carriage manufac-
turer in 1900. Looking back to the prices originally paid for its

capital equipment might have left the firm with the impression
that it was doing fine. However, as the automobile began to
replace the carriage, the future yields the carriage manufac-
turer could reasonably expect on its equipment were proba-
bly declining drastically. It was only forward-looking prices
that would have informed the business owners that a change
in operations was necessary.
While one business can evaluate its capital in terms of its
estimated contribution to its various plans, what could it mean
to evaluate “society™s capital” in terms of all the different plans
being pursued at once? Many of the plans will turn out to con-
tradict each other. Two computer manufacturers may each be
planning to win the computer contract for a new automated
factory. One of them may succeed, but there is no way that
both of them can!
And what is the meaning of the total we would arrive at by
summing the capital of all firms? If we say that FooSoft has $2
billion in capital, we imply that the owners could realize
roughly $2 billion if they decided to liquidate the firm, selling
off that capital. But what would it mean if we said “society”
has $8 trillion in capital? To whom would society sell all of its
capital? Society can™t sell $8 trillion worth of goods without
someone else buying $8 trillion worth of goods.
Nor can “society™s capital” be said to be permanent unless
individuals correctly plan for its replacement. Capital goods
do not automatically spawn substitutes just as they are about
to wear out. Indeed, for long stretches of history, such as the
period of the decline of the Roman Empire and for several
centuries following its fall, we can find societies consuming
their previously built-up capital, leading to declining living
standards and falling population figures.
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A striking contemporary example of the fact that capital
does not represent an automatic flow is the destruction of
Kuwaiti oil wells by Iraq toward the end of the Gulf War. Sad-
dam Hussein, upon occupying Kuwait, no doubt regarded the
wells as valuable capital goods from which he could expect a
future stream of revenue. However, the Gulf War led him to a
radical reformulation of his plans. His troops detonated explo-
sives at 700 wells, leading to the destruction of the wells and
a large amount of oil. No stream of revenue flowed automat-
ically from them.
Such considerations lead us to the Austrian insight that the
most important feature of a society™s capital goods is not a
vague notion of their “total amount,” but is, instead, that the
goods are parts in an interlocking structure of individual


A markedly from the mainstream in
the importance it places on the structure of capital. The
Neoclassical and Keynesian theories tend to treat capital
as a homogeneous lump or pool. That allows them to sum up
the amount of capital and treat the total capital of an economy
as a single number to be fed into mathematical equations.
From an Austrian point of view, treating capital as an amor-
phous blob eliminates from consideration the most important
features of capital. Capital goods, seen as the myriad elements
of different individuals™ plans, are not most usefully viewed as
a single lump. The plans change over time, creating new cap-
ital goods, shifting existing capital goods to unforeseen uses,

and leaving other items that once were capital goods useless.
The plans interact with each other, some of them comple-
menting each other and mutually aiding in their fulfillment,
others contradicting each other and resulting in one or
another plan being thwarted. Even in a socialist economy,
where one central planner directs all production, the concept
of the economy™s total capital does not make sense; in the
socialist commonwealth there is no market for capital goods,
and therefore no prices with which to sum them up.
The capital structure of the economy might be likened to a
coral reef. Each coral is connected to several others. The
corals below any particular animal are the higher-order goods
that went into its production. Those alongside it are comple-
mentary goods that help it to create the next layer of goods.
And the corals above it are that next layer of goods it helps to
The entire structure rests on the sandy sea bottom”land.
Land, taken in the economic sense to include all of the nature-
given factors of production, is the foundation of economic
life. At the very least, we need a place to stand or sit”and our
bodies”in order to produce something. The natural world is
the soil from which our reef grows, and it is built up from that
soil by human action. At the very top of the reef, waving in
the currents of human desire, are the consumer goods.
The “capital reef” is the basis for civilization. All of the
things that enrich our lives”Hamlet and HBO, the libraries
and the Internet, great paintings and comic books, symphony
orchestras and rock bands, synthetic carpeting and Oriental
rugs, tomatoes in the winter and ice in the summer, cathedrals
and shopping malls”are possible only because of the
painstaking building of the reef by previous generations,
going back to man™s earliest ancestors. If humans still relied
, 127

on hunting and gathering to eke out their existence, none of
those other things would exist.
The pattern of the reef is the web of interactions formed by
the entrepreneurs™ plans. That interaction will at times render
portions of the reef superfluous. The business plan created in
the hopes of raising funds may represent a major capital
investment for the creator of the plan. But if his company
folds while awaiting funding, there is no physical trace of that
former capital other than some stacks of paper and some data
on a hard disk. Furthermore, the change in those plans will
affect the disposition of physical capital. The price of an
unshipped, custom-built machine sitting at a supplier™s ware-
house suddenly sinks to its scrap value and drops out of the
reef™s structure altogether. Other physical goods may be
shifted into other arms of the reef, to play their part in other
Taking our metaphor one more step, we could say that the
intensity of the changes in the currents determines how
deeply they will affect the reef. As consumer preferences shift,
plans are abandoned, altered, and connected to new
sequences of plans, restructuring the reef. Minor changes,
such as consumers shifting from buying one doll one Christ-
mas to buying another the next, mostly affect the top layers.
The doll factory may have to retool to produce the new
design, but they will still need plastic, cardboard boxes, metal
for their molds, assembly-line workers, and so on.
Major changes in the currents will cause changes deep in
the structure of the reef. When consumers shifted their pref-
erence for personal transportation from horses to cars, capital
structures throughout the economy were destroyed, created,
and reconfigured. The need for hay production dropped
while that for oil production rose. Blacksmiths lost jobs while

factory workers were hired. Wealth changed hands from those
who continued production of goods now in less demand to
those who correctly anticipated the now higher demand for
other goods.
In the long run, it is the currents of consumer desire that
determine the overall shape of the reef of plan interactions”
what Hutt and Mises refer to as consumer sovereignty. Entrepre-
neurs realign the structure of the reef in their ceaseless quest for
profits. They succeed only in that the new alignment better
matches the desires of the consumers than did the previous one.
You might object to the notion of consumer sovereignty:
The producers, you say, are sovereign every bit as much as
the consumers. But simply because someone is, for example,
a business owner does not mean he is always acting as a pro-
ducer. Certainly, a business owner is free to use his business
for personal satisfaction instead of the satisfaction of the con-
sumers. He might decide to convert his factory into a huge
party space for himself and his friends. However, in doing so,
he is acting as a consumer.
Some economists, such as Alfred Marshall, criticized
Menger™s conception of goods arrayed in various orders as
vague and unhelpful, since one good can be in several differ-
ent orders at once. Measured along different paths, a single
coral may be one, two, three, and four layers away from the
top. (Marshall™s example was that a train carrying passengers
and various producer goods could belong to four orders at
The apparent difficulty melts away when it is remembered
that something is a capital good not because of its intrinsic
properties but because of its role in someone™s plan to create
a consumer good. Consider oil. Since the dawn of man, vast
pools of it had been sitting right where we drill it from today.
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However, nobody considered that oil a capital good, or,
indeed, a good at all. The physical properties of the oil did
not change, but one day it became valuable. It became a part
of people™s plans for improving human satisfaction.
If we view capital goods as elements of a plan, we can see
that the same good may play a different role in the plans of
different people. If I use my car to take Sunday drives, it is a
consumer good for me. To a traveling salesman, using the
same make of car for sales calls at people™s homes, the car is
a second-order good. The same model car, used to ferry plans
for the construction of a factory back and forth across town,
may be many orders of goods away from a final consumer
good. There is no reason why a good, like the train men-
tioned above, should not be a part of different levels of dif-
ferent plans at the same time. My train ticket might represent
the purchase of a consumer good while yours represents the
purchase of a fourth-order good. The capital nature of a good
is not something in the good itself but is the role the good
plays in the plans of acting man.
That is not to say that the physical properties of a good are
unimportant to its economic character. If oil didn™t have the
right chemical properties to be used as a fuel, it would not
have become a part of anyone™s plans for heating his home,
except, perhaps, by mistake. But the determining factor in
whether something is a capital good or not is a plan. For
instance, some people believe rhinoceros horns have medici-
nal properties. We might doubt that, and study might show
that we have good reason for our doubts. But as long as peo-
ple believe the horns are useful, the tools used to process the
horns will be capital goods. The tools will fetch a market price
that depends on the value assigned to the horns. The moment
the last person stops believing the horns have beneficial

properties, the tools will cease being capital goods and will
lose all their value, unless they have alternative uses.


C market economy sometimes claim it is
wasteful because it doesn™t make use of “idle capital
goods.” However, per Austrian capital theory, the items
in question have ceased to be capital goods, at least for the
time being. (Circumstances may change so that it again
becomes profitable to employ them, and they will again be
capital goods.) The cost of maintaining and employing such
goods has come to exceed the return they offer, so they are
no longer a part of anyone™s plan to produce a consumer
good. To put them back into production would waste
resources, as they require complementary goods that would be
better used elsewhere. For instance, a steel company may have
some plants sitting idle because they have become, in the
owner™s judgment, obsolete. In order to bring those plants back
on line, workers would have to be hired, iron and coke pur-
chased, buildings and driveways maintained, electricity and
water used, and so on.
Something is an economic good only if it is scarce. For
many of the scarce factors of production, there are several
alternative uses. By bidding various prices for consumer
goods, consumers indicate the importance of the various uses
in satisfying their unmet demands.
If the expected revenues from the output of the closed
steel plant do not exceed the cost of the complementary
goods needed to operate it, then consumers do not value that
use of those resources as much as they do an alternative use.
, 131

That fact is indicated to the owner of the steel company by
the fact that others are willing to bid more than he is for the
use of those complementary resources, such as iron, coke,
electricity, workers, and so on.
Another complaint leveled against the market is that it does
not abandon older, technologically less efficient methods of
production fast enough. (The foes of the market economy
have seldom worried about the consistency of their attacks.)
But technological efficiency is not the same thing as economic
efficiency. A new plant is more economically efficient than an
older one only if the returns it offers on invested capital are
higher than those of the older plant. That is precisely the point
when a profit-seeking entrepreneur will abandon his old plant
and build a new one. It is not the historical costs involved in
building and maintaining the old plant that restrain him.
Those are sunk costs, and, as we know, bygones are bygones.
Rather, it is the demand in other uses for the resources needed
to build the new plant that restrains the entrepreneur from
proceeding. To build new equipment, the necessary resources
must be bid away from other productive activities. The entre-
preneur determines if it is worthwhile to do so by estimating
whether he will make a profit despite bidding more for those
resources than their current users are bidding.


O frequent sources of puzzlement about the
Austrian School™s theory of capital has been the notion
of roundabout methods of production. Carl Menger™s
student, Eugen von Böhm-Bawerk, in his masterwork Capital
and Interest, attributed the bulk of increases in productivity to

the adoption of more time-consuming, or roundabout, meth-
ods of production.
Various writers have found themselves dumbfounded by
Böhm-Bawerk™s contention. How, they ask, could taking
longer to do something make one more productive? Why
don™t shorter processes mean increased productivity?
The bewilderment is understandable, but it can be cleared
up. Mises, Kirzner, Lachmann, Rothbard, and other writers
have refined Böhm-Bawerk™s theory and explained the appar-
ent paradox. There is nothing intrinsically more productive
about taking a long time to do something. Otherwise, we
could increase productivity by working very slowly!
However, if a longer process of production is adopted, it
can only be because the entrepreneur who adopts it suspects
that the new process will be more productive than the old
one. Let us imagine a software company, FooSoft, that has
been producing programs without the use of any specialized
software for creating graphics, windows, and the other items
of the program™s user interface. The owner of FooSoft decides
that he should buy a program to help the company with inter-
face building. This new tool will take time to install, config-
ure, and learn to use. Instead of directly producing programs
for the customers, the software engineers will be spending
some time working on a higher-order capital good, only then
to return to direct production of their final good.
Furthermore, the software tool itself will cost FooSoft
something. FooSoft could have used the money spent on this
tool, instead, to hire another engineer to directly produce
more of its final program.
It should be clear that FooSoft™s owner will only undertake
such a project if he believes that the higher productivity
offered by the more roundabout method will more than make
, 133

up for the costs of adopting it. Earlier, we saw that Rich will
only build rat traps as long as the benefit of another trap
exceeds the cost of what he gives up to build that trap. Simi-
larly, for an entrepreneur to invest in a new process, he must
believe that it will yield more than the risk-free rate of inter-
est and more than any other project he can conceive of
investing in instead. The expected return must exceed his
opportunity cost.
The economy generally advances through increasing the
“roundaboutness” of production because the shorter methods
have been tried already. Acting man attempts to move toward
his goals by the most direct route available to him. It is only
when he expects that what he can achieve on a direct route
will be less valuable than what he can achieve on an indirect
route that he will search out alternative methods.
Imagine that you are a coin collector with the goal of own-
ing one coin of every denomination from every date and mint
issued by the U.S. government. You can easily begin your col-
lection by pulling coins out of your pocket change. You will
rapidly assemble a collection of the most recent dates of the
currently circulating denominations. But gradually you will
find that the marginal benefit of your efforts is declining. Each
hour spent going through change yields fewer new coins for
your collection.
At some point you will come to contemplate a more round-
about method of acquiring coins. Perhaps you will drive to a
local trade show and see what is on display. To do so, you
will have to get in your car, drive it to the show, spend time
at the show, and drive home. You will wear out your car and
consume gasoline. You will only undertake those costs if you
expect that the reward, in terms of coins found, will exceed
the costs. (And note that you are also increasingly relying on

the roundabout production of others, who have produced
your car, refined the gasoline, set up the trade show, and so
Gradually, as your collection advances, you will find your-
self going to greater lengths to complete it”perhaps traveling
to shows in distant cities or joining a society devoted to
exchanging information on rare coins. You have exhausted
the gains you can achieve with shorter methods of production
and must turn to those that are more roundabout.
It is always true that an entrepreneur will choose a more
roundabout method of production only if he estimates that the
higher returns from that method exceed the cost of the longer
waiting time before the final product emerges. It is not always
true that the only available method of increasing production
is to adopt more roundabout methods. Perhaps a shorter route
to some goal just has not been imagined yet. In that case, a
conceptual breakthrough, rather than an adoption of more
roundabout methods, will lead most directly to increased pro-
ductivity. In our example above, you might suddenly discover
that your neighbor is also a U.S. coin collector, and that you
can complete more of your collection by walking next door
and buying from him than by driving to trade shows. But his-
torically, the constant agitation of humans to improve their cir-
cumstances is such that most of the opportunities to increase
productivity lie in the adoption of more roundabout
processes. Humans are adept at spotting the direct route to a
goal in the first place.
In a remarkable passage from Language and Myth, the
German philosopher Ernst Cassirer contended that the adop-
tion of more roundabout processes is the means by which the
human intellect itself advances:
, 135

All cultural work, be it technical or purely intellec-
tual, proceeds by the gradual shift from the direct
relation between man and his environment to an
indirect relation. In the beginning, sensual impulse
is followed immediately by its gratification; but
gradually more and more mediating terms intervene
between the will and its object. It is as though the
will, in order to gain its end, had to move away
from the goal instead of toward it; instead of a sim-
ple reaction, almost in the nature of a reflex, to
bring the object into reach, it requires a differentia-
tion of behavior, covering a wider class of objects,
so that finally the sum total of all these acts, by the
use of various “means,” may realize the desired end.

What Goes Up, Must Come Down


W money arose because people were willing
to exchange a less marketable good for a more mar-
ketable one, even if it was not the good that they
ultimately desired. Gradually, one commodity, often gold,
emerged as the most marketable good of all. As participants
in the economy came to recognize that fact, the commodity
would take on the role of a universal medium of exchange:
There are disadvantages to lugging around gold, however.
One is that although it has a high value per unit of weight
compared to many other commodities (one of the reasons that
it often was chosen as money), its weight is not insignificant.
Another downside to gold is that, while it is divisible, it is not
easy to divide precisely, in the midst of a transaction. And
gold coins clinking around in your pocket alert potential
thieves to a target.
Because of these disadvantages, the practice of using
money certificates came into being. People could take their
gold to a bank, which might be a purely private business, an


official government bank, or, as in the U.S. today, a mix of the
two. The bank would hold their gold in a secure facility and
issue the depositor a piece of paper. Such an instrument is
called a bank notes, and it allows the depositor to reclaim the
gold at any time by turning in the note to the bank. The paper
is lighter than gold and therefore easier to carry. The bank
could also issue, for instance, four quarter-ounce bank notes
for a single one-ounce gold coin, easing the process of mak-
ing change and allowing for finer-grained prices. Token coins
minted with metals less valuable than gold (e.g., silver, nickel,
and copper) can serve the same purpose, as well as possess-
ing some residual value as a metal.
So long as others are confident that the bank will honor its
money certificates and coins, they will accept the notes and
coins as substitutes for money itself. The use of money sub-
stitutes lowers transaction costs.
The use of money substitutes does not change the amount
of money in circulation. For every note issued, a correspon-
ding amount of money proper (e.g., gold) has been stowed
away in a vault. But banks may notice that they have a poten-
tial source of profit beyond whatever fees they charge for stor-
ing gold. Since not all of the claims for gold are redeemed at
any one time, the bank may conclude that it can issue more
gold-redeemable bank notes than the amount of gold it is
holding. The bank can then lend those notes and earn inter-
est on them. As long as every depositor doesn™t show up on
the same day to claim his or her gold, the bank will remain
viable. Such notes, issued in excess of the amount of money
proper that a bank holds in reserve, are called fiduciary
If a bank miscalculates its need for gold reserves, and is
met with more demands for redemption than it can meet, it is
, 139

faced with a liquidity crisis. As soon as it is discovered that the
bank has failed to meet any of its obligations, all depositors
will attempt to withdraw their funds. There will be a run on
the bank. Hollywood produced a famous example of a bank
run when, in Mary Poppins, Michael demanded his tuppence
back. Customers, hearing what they thought was a depositor
being denied his funds, immediately began trying to withdraw
their own money. The bank shut down to avoid collapse.
There is spirited debate in the Austrian School as to
whether the issuance of fiduciary media, in a pure market
economy, is an acceptable practice. On the one side there are
those who argue that market forces will generally constrain
banks from issuing more fiduciary media than prudence per-
mits. Those that are overzealous in note issuance will fail, and
will serve as a notice to consumers to monitor the bank with
which they deposit their money. Many of those economists
contend that the issue of fiduciary media increases the ability
of the economy to adjust to changes in the demand for
money. They argue for a system of free banking.
On the other side of the issue are those who argue that the
issuance of fiduciary media is inherently fraudulent, as the
bank is not backing up each claim to gold with actual gold.
They contend that the practice will inevitably lead to banking
crises. The economists on that side of the debate argue for a
system of one-hundred-percent-reserve banking, where all
notes are fully backed by gold. There is an extensive literature
on each side of the issue, some of which I will mention in the
bibliography, but I won™t attempt to resolve the dispute here.
Both sides agree that what happens next is the cause of
enormous troubles. Banks, whether owned privately or by the
government, tend to be politically well connected. Historically,
when a bank has gotten into trouble by issuing more fiduciary

media than the market would support, it has gone to the gov-
ernment for protection against the inevitable run. Insolvent
banks, instead of being forced to liquidate, have been given
government relief. They have been allowed to suspend pay-
ments or been given special loans from the Treasury or cen-
tral bank.
The special status given to banks has allowed them to
operate in an almost risk-free environment. They may make
loans far beyond what prudence would counsel. If their bets
pay off, they profit. If they don™t, the government bails them
out. That leads to what is called moral hazard, where banks
are constantly tempted to take on more risk than if they were
forced to suffer the consequences on their own. The law
makes banks privileged players in the economy, with every-
one else left holding the bag for their mistakes. Both the free
bankers and the one-hundred-percent reservists agree that is
unjust and inefficient.
One of the chief means by which governments prop up
insolvent banks is through the creation of a central bank with
the power to act as a lender of last resort. (In the U.S., the cen-
tral bank is called the Federal Reserve.) Since every time the
banking system runs into trouble, the central bank is required
to supply it with reserves, the strain on its resources is often
tremendous. Eventually, it is likely that this bank will simply
stop paying out commodity money at all, declaring that the
circulating bank notes are the only real money. Money of that
kind, as we mentioned, is called fiat money”it is money
because the government has declared it so. Historically, the
U.S. moved to a fiat money system in two steps. The first took
place in 1933, when Franklin Roosevelt suspended domestic
redemption of gold and confiscated all privately held gold.
The U.S. completed the move away from gold as money in
, 141

1971 when Richard Nixon stopped exchanging U.S. dollars for
gold with foreign countries as well.


O historical effects of the move from commod-
ity money to fiat money has been greater volatility in
prices. That has increased the importance of a proper
understanding of inflation and deflation.
The standard definition of inflation is “too much money
chasing too few goods,” and the corresponding one for defla-
tion runs something like “too little money chasing too many
goods.” These definitions are imprecise, because prices, given
time, can adjust to any particular amount of money existing in
the economy. There are practical limits on the amount of
some good that must be available for it to be used as money.
But goods not falling within those limits will not be chosen as
money. Neither a metal so rare that it would need to be
divided at the atomic level to make change, nor a commodity
so plentiful that a shopping cart full of it is required to buy a
pack of gum, will be suitable as money. For any good that
might realistically be chosen as money, Murray Rothbard
points out “there is no such thing as ˜too little™ or ˜too much™
money . . . whatever the social money stock, the benefits of
money are always utilized to the maximum extent ” (Man,
Economy, and State).
Economist Paul Krugman frequently has cited what he
believes is a simple, contrary example to that principle. He
describes a baby-sitting co-op in the Washington, D.C., area.
To ensure that each parent did his fair share of sitting, it used

coupons as a “currency,” each representing one hour of baby-
sitting. It essentially created its own fiat baby-sitting money,
which each participant could trade for baby-sitting from any
of the other participants.
Krugman contends that the currency was too scarce. The
residents hoarded it, even when they might have wanted to
hire a sitter, because they couldn™t get enough of it to guar-
antee they™d have some when they really needed a sitter.
Because others were hoarding coupons, each person had dif-
ficulty acquiring more of them. So, Krugman concludes, all the
residents had to do to get their baby-sitting economy going
again was to circulate more coupons. The market had failed
and the “government” (the sitters™ association) had to step in
and prime the pump.
His example actually illustrates the danger of price-fixing
rather than the need for an active monetary policy. The prob-
lem the sitters™ co-op had was that it had tried to arbitrarily set
the price of baby-sitting in terms of coupons. If it had let peo-
ple needing sitters bid whatever they wanted to for an hour
of sitting, the price in coupons would have dropped until the
amount of currency was completely adequate to meet their
The desire to hold cash alters prices. It is true that not
everyone in the economy can put more dollars under their

Krugman would answer by pointing to the “stickiness” of prices,
especially wages, in the downward direction. We™ll discuss that
problem later. He might also contend that it was the change in peo-
ple™s desire for cash holdings that was the problem, although his
article in Slate describing the co-op emphasizes the quantity of
, 143

mattress at the same time. As there are only so many dollars
in existence, everyone™s efforts to trade goods for a certain
number of dollars cannot all succeed. They need someone on
the other side of the exchange, trading dollars for goods. But
even if all market participants are trying to trade goods for
dollars, they can achieve their goal in the sense that the real
value of each person™s cash holdings can rise at the same time.
Trying to gain cash by selling goods, people drive the price of
money up and that of all other goods down. There won™t be
more dollars in the economy, but at the new, lower price
level, each dollar can buy more.
The opposite effect occurs if everyone desires smaller cash
balances. They cannot all achieve their wish in terms of the
number of dollars they hold, unless people simply burn their
money in the backyard. That is because each person™s attempt
to hold fewer dollars by purchasing other goods will
inevitably result in the seller-of-the-goods™ holdings of dollars
increasing. Economists say that the nominal value of the total
cash holdings cannot be altered in such a fashion, where
nominal means “measured in dollars.” (If your country uses
the pound, peso, mark, or lira, just substitute that for the dol-
lar.) But in what economists call real (purchasing power, not
dollar amount) terms, everyone can reduce his or her cash
balance. Attempting to shed cash by buying goods, people
drive the price level up. Although the dollar amount of the net
cash balances will not have changed, each dollar is able to
buy less.
The effects described in the previous two paragraphs do
not make everyone, on the whole, wealthier or poorer.
Although each person prefers his or her new level of cash
holding to the previous one, it makes no sense to say “soci-
ety” can increase or decrease its cash balance. If the net of
everyone™s decision to hold more cash has driven the price

level down, that doesn™t mean that “society” has a larger cash
balance. For each individual, his cash balance is larger in that
it can now buy more goods. But if everyone attempts, at the
same time, to use his higher real balances to purchase more
goods, it would be a reversal of the general desire to hold
larger cash balances, and it simply would drive the price level
back up.
Since, given time, prices can adjust to any particular amount
of money in the economy, inflation and deflation are best
viewed as rapid changes in the amount of money in the econ-
omy. Rapid increases in the money supply are called inflation,
and rapid decreases are called deflation. It is the fact that it
takes time for all prices to adjust to the new amount of money
that makes inflation and deflation economically significant.
If the government is in charge of creating money, its inter-
est generally will run toward inflating the money supply. It
can use the new money for increased spending, without hav-
ing to go through the unpopular measure of raising taxes.
That helps explain why prices have been more volatile since
governments have replaced the gold standard with fiat
money. Gold must be dug up from the ground and processed,
and that takes time and effort. It is much easier to set a print-
ing press running. The adoption of fiat money has made infla-
tion simpler to achieve than it had been under the gold stan-
Historically, deflation is less important than inflation, so we
will concentrate our discussion on inflation. There have been
few historical examples of governments deliberately deflating.
(Britain™s return of the pound to the prewar parity with gold
after the Napoleonic Wars and World War I are notable excep-
tions.) That is because, as pointed out above, inflation is a
source of revenue for the government that is doing the inflating.
, 145

Since the government prints the money, it gets to spend it
first. With more money in circulation, each dollar is worth
less: Inflation acts as a stealth tax on the value of citizens™ cash
Inflation also creates the illusion of prosperity, adding to its
popularity. We will examine the relationship between inflation
and the booms and busts of the modern economy further in
Chapter 13. For now, I simply will point out that the relation-
ship between economic growth and inflation frequently
implied by the financial press is backward. Whenever aggre-
gate measures of economic growth, such as gross domestic
product (GDP), gross national product (GNP), and so on, rise
at a relatively fast rate, we hear that the growing economy
may “ignite inflation.”
But a general price rise simply is a decrease in the value of
money relative to other goods. Economic growth”in other
words, more goods”cannot possibly cause inflation! The
analysis of the process in the popular press reverses cause and
effect. Inflation creates the illusion of rapid growth in the
economy. Before it is realized that a general price rise is under
way, some people feel richer, due to higher money profits and
money wages, while other people really are richer, since they
received the new money first, before a general rise in prices
occurred. Those people will tend to spend more than they
would have otherwise, making it seem that the economy is
growing more rapidly.
Some people mistake this illusory prosperity for real
growth and recommend constant inflation as a means to con-
tinuing prosperity. They call their policy “low interest rates.”
Since, when the Fed sets rates artificially low, it must increase
the money supply to keep them low, it comes to the same
thing. But inflation cannot really make society as a whole

wealthier. Every transaction that is income for person A is
an expense for person B. If we try to use a rise in prices to
universally boost incomes, we must, simply by definition, also
universally (and to the same extent) boost expenses. It is as
though my wife and I tried to get rich by paying each other
an increasing amount of money every week.
Similarly, deflation is not necessarily an evil. Even if nomi-
nal wages are dropping, standards of living can still rise, as
long as prices for consumer goods are dropping even faster.
The worker does not care about his nominal wage, but about
what standard of living that wage will support.
Let™s isolate the effect of inflation on the overall price level
with the use of a thought experiment. We™ll imagine an iso-
lated village”we™ll call it Walras. Walras has some important
characteristics for our purposes”the stuff it uses as money
has no other use, and it is, in every sense, perfect money: it
is perfectly and effortlessly divisible, weightless, without vol-
ume, can™t be lost or stolen, and so on. (Such money is, of
course, impossible, but we want to abstract away all but one
aspect of inflation in our tale.)
Walras is visited, late one night, by the legendary Ghost of
Fisher. The phantom mysteriously doubles the amount of
money held by every person in the village. What™s more, the
Ghost of Fisher is able to communicate, to everyone, an exact
and complete understanding of what has happened to the
money supply.
The result of the ghost™s activities is that all prices in Wal-
ras will immediately double. We have postulated that every
person has complete knowledge of the new state of the
money supply. Therefore, everyone will understand that, with
the new doubled quantity of money and nothing new to
spend it on, buyers will bid up prices to twice what they were.
, 147

But since our assumption also implies that everyone knows
that everyone else knows that prices will double, there is no
point in anyone bidding less than twice what he used to for
something; the seller knows the price will double. As soon as
the Ghost of Fisher transmits the knowledge of the inflation,
the price of everything has, essentially, already doubled.
There is more money in Walras, but the usefulness of each
money unit has declined commensurately.
That is the world in which the quantity theory of money
fully describes the effect of inflation. This theory, originated
by Jean Bodin, John Locke, and David Hume, relates changes
in the quantity of money to changes in the price level. Econ-
omist Irving Fisher formulated the algebraic expression of the
theory in 1911: MV = PT, or the quantity of money M times the
rate at which it circulates, V, equals the price level P times the
volume of transactions T. If we regard the equation as a rough
description of the equilibrium position toward which the mar-
ket process will guide prices after a change in the quantity of
money, it is a useful tool. Much like the evenly rotating econ-
omy, it can give us a picture of the general direction of a cen-
tral tendency in the economy.
But it is highly misleading to regard the equation as a pic-
ture of the most significant effects of inflation in the real
world. We have abstracted out the important elements of the
picture, from the point of view of human action. Humans are
uninterested in a phenomenon that will leave their state of sat-
isfaction unchanged, such as the instantaneous doubling of
cash holdings and all prices. Such a change could occur every
night, and no one in Walras would give a hoot.
Human creativity in the face of the uncertain future means
that the actors in our economy, who in reality do not all learn
about all changes instantly, will strive to understand first the

effects of economic changes. Those who comprehend early
the nature of change will attempt to buy and sell before the
new knowledge becomes widespread. Rather than complain
that they are taking advantage of others, it seems more useful
to note that it is only the entrepreneurial search for profit that
drives prices toward equilibrium. There simply is no other
way to discover equilibrium prices than by allowing people to
employ their wits in trying to figure them out. Allowing them
to profit from more accurate estimates and lose on less accu-
rate ones is the only way to align their motivation with the
need for price discovery.
The knowledge of the new state of monetary affairs will
not be instantly in everyone™s head. Nor will the new money
be distributed proportionately into everyone™s pocket. The
new money cannot possibly hit all areas of the economy at
the same time. Who it does go to first is determined, in a fiat
money economy, by government policy. Curiously enough,
quite often the answer seems to be large and politically well-
connected banks.
The definitions of inflation and deflation we are using here
are Austrian, not mainstream, definitions. When most econo-
mists talk about inflation, they are referring to an increase in
the price level (the P of the Fisher equation), and by deflation,
they mean a decrease in the price level. However, the Austrian
definitions have two major advantages over those of the main-
stream. First, the notion of measuring the price level is itself
problematic, as we will see in the next section.
Even if we assume away that difficulty, a second problem
exists: The mainstream definitions mask the most significant
economic phenomena involved, pointing, instead, to a symp-
tom of those phenomena. The Fischer equation shows
roughly where the economy is headed, once all of the effects
, 149

of the inflation or deflation have worked themselves out. It is
the working out that is the more interesting topic. As we have
seen above, the creation of new money in an economy
inevitably alters economic relations among people, in addition
to altering the relationship between goods and money. Those
who get the new money first are aided; those who get it last,
hurt. These are called Cantillon effects, named after the great
Irish-French economist Richard Cantillon.
The first recipients of the newly created money are in a
position to spend it before the inflation raises prices through-
out the entire economy. They now have more cash, but,
unlike the people in Walras, they have it before everyone else,
and before the effect of the new money is fully felt through-
out the economy. Unlike the people of our mythical village,
the new amount of money they possess will buy them more
goods than the previous amount they had.
The process by which new money flows into the economy
is not like the neutral money image of a bathtub filling evenly
from all sides. Rather, it is like the discharging of a liquid into
a river. The chaotic flow of the turbulent market process car-
ries the new liquid along paths that are inherently unpre-
dictable, even by those creating the money. Human action is
creative, and we cannot even say ourselves what course of
action we might take if we awake tomorrow to a new world.


T stable money has led to a desire for price
indices that can measure the value of money. There are
two common fallacies at the root of the desire for stable

money. One is that money is a “measure of value,” and the
other is that it is a “store of value.”
Value is subjective and cannot be measured. If two parties
exchange $10 for a bag of onions, it does not mean that we have
“measured” the value of onions to be $10. It means that the per-
son who bought the onions valued them more than $10, while
the person who sold the onions valued them less than the $10.
No measurement is involved. It does not make sense to assign
to the onions and dollars “equal” values. To whom are the val-
ues equal? Valuation means preferring one thing to another,
never indifference between them. Prices are not measurements
but historical facts, indicating that at such-and-such a place and
time, two parties exchanged one bag of onions for $10.
Nor is money a “store of value.” The phrase implies that
money is some sort of container, into which value can be
poured. When we have inflation, it seems that some of the
value has “leaked out” of money, while in a deflation, value
has somehow “seeped in” to money. What people who use
that phrase are talking about can be indicated much more
clearly: people value money, and they can store it. (The fact
that it can be stored is one of the reasons a good emerges as
money.) While they store it, its value may rise or fall. There is
nothing special about money in that respect: you can store a
painting or a book, and its value might also rise or fall while
it is being stored.
Even if we ignore the fact that money is not a measure of
value, the idea of a price index encounters a second difficulty.
Economist Richard Timberlake, in defense of price indices in an
article “Austrian ˜Inflation,™ Austrian Money,” compares them to
thermometers. True, his line of reasoning goes, they are not
perfectly accurate”but neither are thermometers, yet we still
use them.
, 151

But let us see whether the consumer price index (CPI) and
other measures like it are really analogous to a thermometer.
A thermometer is a measuring device that we can place in an
environment where an independent phenomenon (in the case
of a thermometer, molecular motion) is taking place. The
measuring device responds to that phenomenon in a pre-
dictable manner, most often by some sort of visible display.
The display is interpreted as having some correspondence
with the quantity we want to measure. For example, the
height of mercury in a thermometer corresponds to the tem-
perature in the area where it is placed. The position of the
needle on an ammeter corresponds to the current passing
through the wires to which it is connected.
When it comes to price levels, what are we measuring? And
what is the measuring device? Our readings are all in terms of
prices, in other words, the exchange rate of various goods for
money. For the thermometer analogy to hold we must take
money itself as the measuring device.
But a price index is not measuring the monetary tempera-
ture of a good”or indeed, all goods”at a single point in
time. It is an attempt to track the readings of our thermome-
ter over time, to see if the readings are stable. A price index
tries to track changes in the money price of the “same” basket
of goods. Therefore, since money is our thermometer, a price
index is an attempt to gauge the stability of our measuring
Now we can construct a more accurate thermometer anal-
ogy. We have a device, money, which we suppose is measur-
ing the value of goods. That device gives us various read-
ings”gold traded for $275 today, bread is $1.19 a loaf, and so
on. What we are interested in is finding out whether, over
time, that thermometer is drifting; is it giving us generally

higher or lower readings for all goods on average, rather than
just for some particular good?
If we had some “measure” of value besides money prices,
our venture would be much easier. However, we don™t. So
those advocating price indices are recommending that we
check for drift in our thermometer by wandering from place
to place, checking the temperature from time to time”with
the very thermometer whose accuracy we are testing!
We can see that we have arrived at a severe problem. There
is no way to determine which changes in measured tempera-
ture are real, and which are caused by drift in our thermome-
ter. Let™s look at one example that illustrates the problem.
We™ll say that we are trying to determine whether the cost
of computer programming has risen in the last thirty years.
The services of today™s programmers, armed with significant
advances in software engineering and capitalized with better
tools, are just not the same good as those of the programmers
of thirty years ago. (That is no comment on the people them-
selves”any particular person programming today should be
vastly more productive than he was thirty years ago.) We can
guess that an hour of programming today should be more
valuable than an hour of programming was thirty years ago.
In order to determine if the cost of programming has risen, we
will have to establish some ratio between the goods”for
example, one hour of 1972 programming is equivalent to fif-
teen minutes of 2002 programming”and compare the cost
after applying this ratio.
However, there is no way to measure the change in valua-
tion other than by comparing what employers are willing to
pay for programmers now with what they paid in 1972. To try
and gauge the value of programmers™ labor by lines of code
or something of the sort is to fall back into the fallacious labor
, 153

theory of value. The only possible thermometer for measuring
the change in valuation”money”is precisely the device
whose accuracy we wish to check.
The attempt to measure the price level is not useless, as
long as it is taken as a rough approximation of changes in the
value of money. To return to the thermometer: If, in our peri-
patetic attempts to check its accuracy, we read 80 degrees,
walk five feet, then read 40 degrees, we might suspect that
something is up with the thermometer. Similarly, when the
Consumer Price Index (CPI) shows 20-percent inflation,
money is probably losing value. Such figures may be useful
for economic history or for planning a year™s business
expenses. However, if CPI figures show that inflation has
“ticked up” from 2.5 percent to 2.6 percent, we are justified in
doubting that this .1-percent increase is really indicating any-
thing about the value of money.
As Mises said in Human Action:
The pretentious solemnity which statisticians and
statistical bureaus display in computing indexes of
purchasing power and cost of living is out of place.
These index numbers are at best rather crude and
inaccurate illustrations of changes which have
occurred. In periods of slow alterations in the rela-
tion between the supply of and the demand for
money they do not convey any information at all. In
periods of inflation and consequently of sharp price
changes they provide a rough image of events
which every individual experiences in his daily life.
A judicious housewife knows much more about
price changes as far as they affect her own house-
hold than the statistical averages can tell. She has lit-
tle use for computations disregarding changes both
in quality and in the amount of goods which she is

able or permitted to buy at the prices entering into
the computation. If she “measures” the changes for
her personal appreciation by taking the prices of
only two or three commodities as a yardstick, she is
no less “scientific” and no more arbitrary than the
sophisticated mathematicians in choosing their
methods for the manipulation of the data of the


A World Become One


P the head planner of a global social-
ist state. The recent spring months in the Northern
Hemisphere have been unusually hot and dry. Your
minions come to you to ask how to adjust the agricultural plan
for the upcoming summer. All of the farm managers are cry-
ing out for more water, but there is not enough to meet all of
their requests, while still supplying the city-folk with drinking
water and keeping the factories that use water up and run-
Your alternatives are legion. To help comprehend the mul-
titude of options facing you, consider some of the numbers
involved. In 1999 there were over two million farms in the
U.S. alone. If the growing season was dry across the Northern
Hemisphere as a whole, then millions of other farms will have
been affected.
Since water is extremely divisible, you could allocate to any
particular farm perhaps one of millions of different amounts
of water. Of course, to be useful, the water must arrive at the
farm. There are probably many ways to deliver it. For any par-
ticular farm, you might decide to re-route city drinking water


to it, build an aqueduct servicing its area, construct a de-salin-
ization plant nearby, have trucks regularly deliver it water, or
some other method of which I haven™t conceived. Each strat-
egy will differently affect other water users.
A particular farm, given its allotment of water under the
new plan, might cope in a variety of ways. Water conservation
devices could be installed, different crops raised, less total
weight of crop produced, or, I™m sure, the reduced supply
might be dealt with by other means that a farmer could tell you
about but I can™t. The central plan must take into account all
such possibilities. And you, as the central planner, might also
consider closing some farms, thereby freeing resources for
other employment. Just what is the number of possible solu-
tions you might consider? Is it in the trillions? Quadrillions?
How can you decide which course of action you should
take? Unfortunately, there aren™t any rational means by which
you can decide. You must simply venture a guess as to how the
plan should be adjusted, then order your minions to so adjust
it. You can™t arrive at a reasoned answer to your dilemma
because you lack market prices for the factors of production to
which you must assign a use. Market prices are the foundation
of business accounting. Without them, there can be no mean-
ingful calculation of the profit or loss resulting from any enter-
prise. (Sometimes socialists claim that is unimportant, since
profit and loss are concepts that only apply to the market econ-
omy. As we have seen, that is not true: all human action aims
at profiting the actor and seeks to avoid loss. Socialism cannot
dodge the fact that the means we use to achieve our goals are
scarce, and, therefore, must be economized.)
The central feature of socialism is that the factors of pro-
duction must not be under private control. If they were, then
greedy capitalists would use their ownership of those goods to

exploit the workers. Instead, capital goods should be controlled
by “the public,” which always, in practice, means the state.
Therefore, the market process, the ceaseless striving of
entrepreneurs to locate price discrepancies and profit from
them, thus better adjusting production to the wishes of the
consumers, is absent from the socialist economy. Unfortu-
nately for the hopes of socialists, there is no adequate substi-
tute. The mathematical equations describing the equilibrium
prices of the evenly rotating economy are of no use in deter-
mining what actions, if undertaken in the real world, would
move prices toward that equilibrium. Attempts to create
“pseudo-markets” among socialist managers, hopefully result-
ing in “market-like” prices, are similar to playing chess against
one™s self: without the real competition that exists among pri-
vate property owners, the socialist managers lack both the
incentives and the feedback necessary to drive the market
process towards the discovery of better prices.
To aid in understanding this crucial fact, let™s now envision
a drought in a place where water is bought and sold on a free
market. (The U.S. is not such a place, as local, state and fed-
eral agencies all continually intervene in the market for water.)
There, it is the interplay of the choices of all affected individ-
uals that determines the response to a drought. Most of those
individuals are better aware of their own circumstances and
options than is anyone else. Perhaps Farmer Joe has some
rolls of black plastic sitting around in his barn. When water
prices rise in response to the drought, he finds it worth his
while to unroll them and lay them around his crops, thereby
reducing his need for water. For some time Farmer Mary has
been thinking of installing a drip irrigation system; in response
to the price rise she calculates that it is now profitable to do
so. Other farmers may dig deeper wells, or invest in a water
cooperative that will build an aqueduct, or plant a different

crop that needs less water. Entrepreneurs operating in the
water market will be on the lookout for local price variations,
which are a sign of differing, but as yet unmet, urgencies in
the demand for water. They will attempt to take advantage of
price discrepancies by diverting water from places where the
price is lower to those where it is higher.
Some farmers may need extra cash to see them through the
drought period. Which are worth investing in, and which ones
will not weather the crisis even if granted credit? A local water
dealer decides the question based on his personal knowledge
of how long a farmer has been his customer, how strong the
farmer™s ties to the community are, and how quickly he has
paid his bills in the past. People who have dealt with local
merchants long enough to become a “regular customer” know
that they try to determine which customers should be
extended credit during a rough time, in the hope of retaining
them as patrons when better times return.
Suppose that as a socialist state™s chief central planner, you
are considering how to allocate your country™s steel supply.
You know of a multitude of things that might be made with
it. You also know that your subjects want cars, tractors,
microchips, strong buildings, and electrical wire, among the
many goods that could be made from that steel. However,
because you don™t have an infinite amount of steel, to say
nothing of the complementary goods and services that are
needed to produce useful items from steel, you must decide
which of its possible uses are most important. You hope to
use it to produce, at the least cost, those things most desired
by the consumers in your country.
You are faced with a hopeless task! Lenin promised that
under socialism “the population will gradually learn by them-
selves to understand and realize how much and what kind of

work must be done, how much and what kind of recreation
should be taken.” But such learning cannot occur if there are
no market prices alerting individuals to the opportunity to
profit by adjusting their actions to better meet the wishes of
their fellows. You, the planner, will end up in a fix like the
one Mises described in Economic Calculation in the Socialist
There will be hundreds and thousands of factories
in operation. Very few of these will be producing
wares ready for use; in the majority of cases what
will be manufactured will be unfinished goods and
production goods. All these concerns will be interre-
lated. Every good will go through a whole series of
stages before it is ready for use. In the ceaseless toil
and moil of this process, however, the administration
will be without any means of testing their bearings. It
will never be able to determine whether a given
good has not been kept for a superfluous length of
time in the necessary processes of production, or
whether work and material have not been wasted in
its completion. How will it be able to decide whether
this or that method of production is the more prof-
itable? At best it will only be able to compare the
quality and quantity of the consumable end product
produced, but will in the rarest cases be in a position
to compare the expenses entailed in production.


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