The Austrian exchange rate theory: mistakes of Mises and Salerno

“Prevailing opinion distinguishes two cases: that in which two or more domestic kinds of money exist side by side in the Parallel Standard, and that in which the money in exclusive use at home is of a kind different from money used abroad. Both cases are dealt with separately, although there is no theoretical difference between them as far as the determination of the exchange-ratio between the two sorts of money is concerned.” Mises (1971, p. 179)

There is one condition for this to hold true, however. Namely, the two separate areas are supposed to have trade relations with each other. In such a case, both moneys could serve as means to attain goods in both of the countries:

“If a gold-standard country and a silver-standard country have business relations with each other and constitute a unitary market for certain economic goods, then it is obviously incorrect to say that the common medium of exchange consists of gold only for the inhabitants of the gold-standard country, and of silver only for those of the silver-standard country. On the contrary, from the economic point of view both metals must be regarded as money for each area.” Mises (1971, pp. 179-180)

As soon as there are trade relations between both areas and one currency is exchanged for the other, both currencies could also serve as means for attainment of all goods in both territories concerned, including those purchasable directly only by the other currency. Mises sums up the point in a corresponding way:

“Whether the case is one of an exchange through the instrumentality of money used once or used more than once, the only important point is that the existence of international trade relations results in the consequence that the money of each of the single areas concerned is money also for all the other areas.” Mises (1971), p. 180

Mises is undisputably right in the point related with the introduction of interlocal trade relations to the picture of two locally separate monetary standards. Money of one area is in that case definitely means for attainment of goods of the other area, and both currencies are therefore means for attainment of all goods in both areas taken together. It is also true that in a parallel standard, all currencies are also means for attainment of all goods in the area. In this respect both standards have the same feature – all monies are means for attainment of all goods in the area considered. However, by showing these truths, Mises by no means proves his case for the fact that the exchange-rate formation in respect with these two monetary systems is governed by the very same principles and has the same equilibrium conditions.

This is even more apparent in course of his further considerations.

“For the exchange ratio between two or more kinds of money, whether they are employed side by side in the same country (the parallel standard) or constitute what is popularly called foreign money and domestic money, it is the exchange ratio between individual economic goods and the individual kinds of money that is decisive. The different kinds of money are exchanged in a ratio corresponding to the exchange ratios existing between each of them and the other economic goods. If 1 kg. of gold is exchanged for m kg. of a particular sort of commodity, and 1 kg. of silver for m/15.5 kg. of the same sort of commodity, then the exchange ratio between gold and silver will be established at 15.5. If some disturbance tends to alter this ratio between the two sorts of money, which we shall call the static or natural ratio, then automatic forces will be set in motion that will tend to reestablish it.”

Mises (1971, pp. 180-181)

The first sentence of the quoted text is clear – prices of goods that could be purchased by the monies in question are crucial for determination of the exchange rate between these monies.

And this holds in no respect with the fact whether they are in the position of separate standard or parallel standard. However, following parts of the story are more of a concern. The second sentence – “The different kinds of money are exchanged in a ratio corresponding to the exchange ratios existing between each of them and the other economic goods.” – makes perfect sense for the case of two parallel currencies. All goods could be purchased by all currencies in question and therefore it makes sense to talk about incentives of people to undertake actions that pushes the exchange rate and the ratio of prices of the same goods to be the same. And this mechanism for the parallel standard is illustrated in the rest of the quoted paragraph above.

But there is no counterpart for this equilibrium condition of the parallel standard in the case of separate monetary standards. The reason is simple: each good is directly sold for a single currency only. All goods are either sold for one currency, or for the other⁵⁶. It is true; both currencies could be used as means for attainment of goods purchasable by the other currency;

however, only via the exchange of one currency for the other at the foreign exchange market.

In other words, we need to know the exchange rate in order to be able to figure out price of a foreign good in terms of the domestic currency; and the other way round: we need to know the exchange rate in order to be able to figure out price of a domestic good in terms of the foreign currency. The problem is that the ratio of prices of certain good can by no means in this case stand for a condition of equilibrium of the exchange rate market. The reason is that the exchange rate “creates” both values to be compared – exchange rate itself on the one hand,

56 We reject the solution based on the possibility that there are physically same goods sold in both regions – in one for one currency, in the other for the other currency. Cf. section 2.2.3 of this work.

and the amount by how much is price of the good higher in one currency when compared to the, other on the other hand. In this case, the condition thus holds always by the very definition for all prices and all exchange rates. This reasoning could be clarified also by the following example: Price of any good sold for x£ is in dollars expressed as x times the exchange rate (ER), i.e. x*ER. If the condition of the equilibrium is on the basis of comparison of the actual ER and the ratio of the prices of a certain good expressed in different currencies – which is x*ER/x, then the two values - ER and the ratio - are naturally always equal, always ER.⁵⁷

Mises’ equilibrium conditions for the exchange rate in case of parallel currencies is therefore of no use for the case of separate currencies; just a mere tautology saying ER=ER. Mises himself seems to be, at least to some extent, aware of this problem. As he is trying to illustrate a scenario of equilibrium conditions for the separate monetary standards, he is forced to find out brand new “helping tool” – exchange ratios of a barter economy:

“Let us consider the case of two countries each of which carries on its domestic trade with the aid of one sort of money only, which is different from that used in the other country. If the inhabitants of two areas with different currencies who have previously exchanged their commodities directly without the intervention of money begin to make use of money in the transaction of their business, they will base the exchange ratio between the two kinds of money on the exchange ratio between each kind of money and the commodities. Let us assume that a gold-standard country and a silver-standard country had exchanged cloth directly for wheat on such terms that one meter of cloth was given for one bushel of wheat. Let the price of cloth in the country of its origin be one gram of gold per meter; that of wheat, 15 grams of silver per bushel. If international trade is now put on a monetary basis, then the price of gold in terms of silver must be established at 15. If it were established higher, say at 16, then indirect exchange through the instrumentality of money would be disadvantageous from the point of view of the owners of the wheat as compared with direct exchange; in indirect exchange for a bushel of wheat they would obtain only fifteen-sixteenths of a meter of cloth as against a whole meter in direct exchange. The same disadvantage would arise for the owners of the cloth if the price of gold was established at anything lower, say at 14 grams of silver. This, of course, does not imply that the exchange ratios between the different kinds of money have actually developed in this manner. It is to be understood as a logical, not a historical, explanation.”

(Mises (1971), pp. 181-182)

57 We could put the case also to a practical example: The price of a domestic apple is 1£ and the exchange rate is 2$/£. The only way how to figure out pound price of an apple is to multiply the price in dollars with the exchange rate, i.e. 1£*2$/£=2$. The price of an apple is thus 2£. The dollar/pound price ratio is “magically”

2$/1£, which is at the same time equal to the exchange rate.

As it was stated just above the quote, the equilibrium condition of the case of parallel standards was substituted by “logical tool” of barter exchange. The problem is that this is really only “logical tool”. It has no counterpart in the reality as it is in the case of the parallel standard and related equilibrium conditions. In case of the parallel standard, there are existing prices of goods in both currencies and there is an existing exchange rate. They are independently existing entities with a strong relationship: people in some actions buy one currency for the other, in other actions people buy goods for the currencies, and there are also people who are willing to make profit out of price inconsistencies of the prices and the exchange rate. There is nothing like “barter parity” in our economies, however. There is no system of barter “prices” that could be consistently compared with monetary prices of the economy and that could be used for arbitrage chains of actions. There are monetary prices only. As a consequence, relationship of the exchange rate and the barter price in the separate standards could not be the counterpart to the parallel standard equilibrium conditions.

The message of the Mises’ example above in respect with separate standards could therefore stand only for the most general application of the laws of supply and demand: people have some preferences at the given exchange rate. If the prices of goods resulting from the prevailing exchange rate differ from those that represent the equilibrium prices (those that are represented by the prices of the barter exchange in the example), people necessary act accordingly, until the price and demanded and supplied quantities accommodate to each other.

As it is the exchange rate that determines this price, also the exchange rate has to accommodate correspondingly. However, if this is the message that was supposed to be given by Mises, the question is why he tried so hard to put the equality between parallel and separate standards with all the illustrations. Present author argues that Mises’ argumentation was useless in this respect, as it does not really broaden scope of our understanding in respect with the theory of exchange rate determination.

Joseph Salerno, however, followed⁵⁸ these endeavors of Ludwig von Mises and kept insisting on importance of the insights of the later⁵⁹. In this respect, Salerno introduced an interesting point that highlights untenability of the whole theory. He starts questioning

58 Cf. Salerno (1994a) and Salerno (1994b).

59 Cf. Slerno (1994a, pp. 253-254).

“… whether the exchange rate is exclusively a monetary phenomenon or whether changes in the real data via movements in relative prices are capable of bringing about a permanent departure of the equilibrium exchange rate from the rate which maintains strict PPP between the two currencies.” Salerno (1994a, pp. 254-255)

Salerno’s answer to this question is that the exchange rate – at least in respect with the equilibrium towards which it always tends – is exclusively monetary phenomenon, in other words, the exchange rate of the currencies is supposed to correspond to the exchange ratios holding for each of the currency and other economic goods. Other factors play just a transient role in Salerno’s eyes:

“Austrians conceive purchasing power parity between currencies as a condition which fully holds only in equilibrium and that real factors do play a role, albeit subordinate and transient, in the determination of the spot exchange rate that is actually realized at each moment on the foreign exchange markets.” Salerno (1994a, p 256)

Our own findings⁶⁰ based on the Austrian method, however, suggest the opposite result.

Relative prices do play important role and as far as the preferences do not change, we could call them to be those that affect the “equilibrium exchange rate”. Unfortunately, with exception of one example, Salerno does not offer much evidence in respect with the proposed claim. We believe, however, that this sole example is sufficient for clear refutation of Salerno’s idea:

“[L]et us consider the case of a monopolistically induced increase in the price of oil, the US import, relative to the US export, wheat. While the terms of trade turn against the USA, ceteris paribus, that is, in the (unlikely) absence of any induced changes in the monetary data, there will be no long-run depreciation of the US dollar against the Saudi riyal, because both currencies experience an equal reduction of their purchasing powers in terms of oil and, assuming the demand for oil is elastic along the relevant segment of the global demand curve, equal increases of their purchasing power in terms of wheat.” Salerno (1994), p. 254

Two countries, two separate currencies, one good per country. The price of one good increases, what happens to the exchange rate? According to Salerno, not much. There will be no change because the equilibrium condition – ratio of the prices of the good being equal to the exchange rate, holds. This is the only reason – use of the condition of the parallel standard for the case of separate standards – the present author could see is backing the claim that there is no need for change in the exchange rate. However, we have already seen above, that in case

60 Cf. previous sections of this work.

of two separate monetary standards, this “condition” stands just for a meaningless truism. It holds for all exchange rates and for all prices, whatever they are. Moreover, we have already argued in one of the sections above⁶¹ that change in the price of a good could have an impact on the exchange rate. This impact depends just on the preferences of holders of the currency, whether they understand the good the price of which is changed as a complement or rather a substitute to goods purchasable by the other currency.

This section discussed one part of the Austrian analysis of exchange rate determination, namely its equilibrium purchasing power condition. We have showed that while this condition does have something to say for the case of parallel currencies, it brings no additional knowledge to the case of two separate monetary standards that is of our interest. This branch of the analysis is not useful for the purposes it claims itself to be.