The Theory of Money and Credit

Mises argues that money's primary and sole function is as a common medium of exchange, and that monetary theory must be integrated into the general analysis of individual choice. Before this book, monetary theory and microeconomics were separate domains. Mises showed that money's value, like any other good's, is determined by marginal utility—but he had to solve a circularity problem: money's value depends on its purchasing power, which depends on money's value. His regression theorem resolves this by tracing money's value back to the objective exchange-value of the commodity from which it originated. The book also presents his monetary theory of the business cycle.

Mises introduced the regression theorem, which explains how the value of money can be determined by marginal utility despite the apparent circularity of money's value depending on its purchasing power. The theorem holds that money's present value derives from the value of the commodity that previously served as money, tracing back historically to a point where the good was valued for non-monetary uses. This made it possible to apply marginal-utility theory to money for the first time. The book also introduced the Austrian theory of the business cycle, which was later developed by F.A. Hayek and remains a defining feature of Austrian macroeconomics.

When Mises wrote The Theory of Money and Credit at age thirty-one, monetary theory was fragmented, with contending theories that were not securely integrated into general economic analysis. The book integrated monetary theory into the main body of economic analysis for the first time, providing fresh insights into the nature of money and its role in the economy. It brought Mises into the front rank of European economists. The book also presented a new monetary theory of the trade cycle, which under further development by Mises's student F.A. Hayek came to challenge all previous trade-cycle theories.

The regression theorem solves the problem of how money's value can be explained by marginal utility when money's utility derives entirely from its purchasing power. Mises argues that the value of money today is based on the expectation of its future purchasing power, which in turn is based on the purchasing power it had yesterday, and so on back through history. The regression ends at the point where the commodity that became money was valued for its non-monetary uses—as a metal, ornament, or tool. Once a good has been accepted as a medium of exchange, its value can then be determined like any other good's. This theorem is a foundational contribution to monetary theory.

Mises argued that the business cycle originates outside the market, in government-sponsored credit expansion. When banks expand money and credit below the natural rate of interest, businesses are misled into investing in capital goods and long-term projects that consumers' time preferences do not support. The boom is artificial: prices and wages rise, resources shift into higher-order production, but consumers have not increased their saving. When the new money reaches consumers, they spend it according to their unchanged preferences, revealing that the boom's investments were malinvestments. The depression is the necessary liquidation of these errors, returning production to the proportions consumers actually prefer.

A common misconception is that Mises claimed fiat money is impossible or that governments cannot create money. In fact, Mises distinguished commodity money, credit money, and fiat money, and acknowledged that fiat money has existed. His argument is about sound money and the dangers of credit expansion, not about the impossibility of government-issued currency. Another misreading treats his business cycle theory as claiming that any credit expansion inevitably causes a depression. Mises's point is that credit expansion not backed by voluntary saving distorts the structure of production, but the severity of the necessary adjustment depends on the scale and duration of the expansion.