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The Monetary Approach to the Balance of Payments

Mises Daily: Friday, June 01, 2012 by


[This article is excerpted from Money, Sound and Unsound, chapter 6: "Ludwig von Mises and the Monetary Approach to the Balance of Payments: Comment on Yeager."]

Leland Yeager offers an illuminating discussion of a serious problem that has historically plagued monetary theory and continues to do so to this day: the failure to clearly distinguish between the individual and the overall viewpoints when analyzing monetary phenomena. I wish to emphasize particularly Yeager's insight that the source of this problem lies in the failure of monetary theorists to heed "the sound precept of methodological individualism," which dictates that bridges be constructed between the two viewpoints "by relating propositions about all economic phenomena, including the behavior of macroeconomic aggregates, to the perceptions and decisions of individuals." In detailing and critically analyzing the errors engendered by this confusion of viewpoints in monetary theory, Yeager has taught an elementary, yet much needed, lesson in the principles of economic reasoning and the dire consequences of neglecting them. I daresay this lesson would have been wholly unnecessary had economists attended more closely to the earlier lessons taught by Ludwig von Mises, certainly the foremost exponent and practitioner of methodological individualism in twentieth-century monetary theory.

Since I am in fundamental agreement with the thrust of Yeager's argument, I shall utilize one illustration in his discussion to elucidate an especially neglected contribution to monetary theory made by Mises in his consistent application of methodological individualism to the explanation of monetary phenomena. In this connection, I wish to focus attention on Yeager's treatment of the modern monetary approach to the balance of payments. I propose to show, first, that the valid and vitally important insight on which the monetary approach rests forms the basis of Mises's own elaboration of balance-of-payments theory and, second, that Mises's approach is not open to the objection that Yeager raises against the monetary approach, precisely because Mises firmly adheres to the precept of methodological individualism. This enterprise, it may be noted, has important implications for the contemporary formulation of the monetary approach as well as for doctrinal research into its historical antecedents. On the doctrinal side, it is a matter of setting the record straight. Several studies have appeared recently of the doctrinal roots of the monetary approach. With one minor exception,[1] all of them have completely neglected Mises's contribution. Hopefully, greater familiarity with Mises's approach to the balance of payments, which so strongly anticipates the monetary approach, will spark a rethinking of the latter approach and lead to its reformulation on sounder methodological foundations.

The fundamental insight of the monetary approach is that the balance of payments is essentially a monetary phenomenon. The very concept of a balance of payments implies the existence of money; as one writer puts it, "Indeed, it would be impossible to have a balance-of-payments surplus or deficit in a barter economy."[2] This being the case, any endeavor to explain balance-of-payments phenomena must naturally focus on the supply of and demand for the money commodity. The monetary approach consists in the rigorous delineation of the implications of this simple yet powerful insight for the analysis of balance-of-payments disequilibrium, adjustment, and policy. As I shall attempt to demonstrate, Mises fully anticipated the modern monetary approach by explicitly recognizing these implications.

Mises grounds his balance-of-payments analysis on the insight that the balance of payments is a monetary concept. He states that, "If no other relations than those of barter exist between the inhabitants of two areas, then balances in favor of one party or the other cannot arise."[3] Mises thus conceives of money as the active element in the balance of payments and not as a residual or accommodating item that passively adjusts to the "real" flows of goods and capital:

The surplus of the balance of payments that is not settled by the consignment of goods and services but by the transmission of money was long regarded as merely a consequence of the state of international trade. It is one of the great achievements of Classical political economy to have exposed the fundamental error in this view. It demonstrated that international movements of money are not consequences of the state of trade; that they constitute not the effect, but the cause, of a favorable or unfavorable trade balance. The precious metals are distributed among individuals and hence among nations according to the extent and intensity of their demand for money.[4]

Mises uses his marginal-utility theory of money to explain the "natural" or equilibrium distribution of the world money stock among the various nations. Regarding the case of a 100 percent specie standard, he writes that

the proposition is as true of money as of every other economic good, that its distribution among individual economic agents depends on its marginal utility … all economic goods, including of course money, tend to be distributed in such a way that a position of equilibrium among individuals is reached, when no further act of exchange that any individual could undertake would bring him any gain, any increase of subjective utility. In such a position of equilibrium, the total stock of money, just like the total stocks of commodities, is distributed among individuals according to the intensity with which they are able to express their demand for it in the market. Every displacement of the forces affecting the exchange ratio between money and other economic goods [i.e., the supply and demand for money] brings about a corresponding change in this distribution, until a new position of equilibrium is reached.[5]

Mises goes on to conclude that the same principles that determine the distribution of money balances among persons also determine the distribution of money stocks among nations, since the national money stock is merely the sum of the money balances of the nation's residents.[6] In thus building up his explanation of the international distribution of money from his analysis of the interpersonal distribution of money balances, Mises sets the stage for an analysis of balance-of-payments phenomena that conforms to the precept of methodological individualism.

Like the later proponents of the monetary approach, Mises envisages balance-of-payments disequilibrium as an integral phase in the process by which individual and hence national money holdings are adjusted to desired levels. Thus, for example, the development of an excess demand for money in a nation will result in a balance-of-payments surplus as market participants seek to augment their money balances by increasing their sales of goods and securities on the world market. The surplus and the corresponding inflow of the money commodity will automatically terminate when domestic money balances have reached desired levels and the excess demand has been satisfied. Conversely, a balance-of-payments deficit is part of the mechanism by which an excess supply of money is adjusted.

The role played by the balance of payments in the monetary-adjustment process is clearly spelled out by Mises in the following passage.

In a society in which commodity transactions are monetary transactions, every individual enterprise must always take care to have on hand a certain quantity of money. It must not permit its cash holding to fall below the definite sum considered necessary for carrying out its transactions. On the other hand, an enterprise will not permit its cash holding to exceed the necessary amount, for allowing that quantity of money to be idle will lead to loss of interest. If it has too little money, it must reduce purchases or sell some wares. If it has too much money, then it must buy goods.…

In this way, every individual sees to it that he is not without money. Because everyone pursues his own interest in doing this, it is impossible for the free play of market forces to cause a drain of all money out of the city, a province or an entire country.

If we had a pure gold standard, therefore, the government need not be the least concerned about the balance of payments. It could safely let the market take care of maintaining a sufficient quantity of gold within the country. Under the influence of free-trade forces, gold would leave the country only if a surplus of cash balances were on hand. Conversely it would always flow into the country if cash balances were insufficient. Thus, for Mises, the monetary-adjustment process ensures that gold money, like all other commodities, is imported when in short supply and exported when in surplus.[7]

An implication of this view of the balance of payments as a phase in the monetary adjustment process is that international movements of money that do not reflect changes in the underlying monetary data can only be temporary phenomena. "Thus," writes Mises, "international movements of money, so far as they are not of a transient nature and consequently soon rendered ineffective by movements in the contrary direction, are always called forth by variations in demand for money."[8]

Although Mises therefore does regard the long-run causes of balance-of-payments disequilibrium as exclusively monetary in nature, he does not make the error, which Yeager attributes to the more radical, global-monetarist proponents of the monetary approach, of identifying a balance-of-payments surplus with the process of satisfying an excess demand for domestic money or a deficit with the process of working off an excess supply of domestic money. Mises explicitly recognizes that changes occurring on the "real" side of the economy, for example, a decline in the foreign demand for a nation's exports, may well have a disequilibrating impact on the balance of payments, even in the absence of a change in the underlying conditions of monetary supply and demand. However, in Mises's view, such nonmonetary disturbances of balance-of-payments equilibrium are merely short-run phenomena. It is one of the functions of the balance-of-payments adjustment mechanism to reverse the disequilibrating flows of money that attend these disturbances and to restore thereby the equilibrium distribution of the world money stock, which is determined solely by the configuration of individual demands for money holdings.

If the state of the balance of payments is such that movements of money would have to occur from one country to the other, independently of any altered estimation of money on the part of their respective inhabitants, then operations are induced which re-establish equilibrium. Those persons who receive more money than they will need hasten to spend the surplus again as soon as possible, whether they buy production goods or consumption goods. On the other hand, those persons whose stock of money falls below the amount they will need will be obliged to increase their stock of money, either by restricting their purchases or by disposing of commodities in their possession. The price variations, in the markets of the countries in question, that occur for these reasons give rise to transactions which must always re-establish the equilibrium of the balance of payments. A debit or credit balance of payments that is not dependent upon an alteration in the conditions of demand for money can only be transient.[9]

The foregoing passage illustrates the difference between Mises and the global monetarists, who deny the possibility that international flows of money can proceed from nonmonetary causes. Their denial is tantamount to claiming that all international movements of money are necessarily equilibrating, since they are undertaken solely in response to disequilibrium between national supplies of and demands for money. As Yeager has pointed out, this line of reasoning leads to the outright and fallacious identification of balance-of-payments surpluses and deficits with the process of adjusting national money stocks to desired levels.

It is not difficult to pinpoint the source from which this erroneous line of reasoning stems: it is the tendency of the monetary approach to depart from the sound precept of methodological individualism and to focus on the nation rather than the individual as the basic unit of analysis. In so doing, it has naturally, although quite illegitimately, applied to the nation analytical concepts and constructs that are appropriate only to the analysis of individual action. In particular, the monetary approach attempts to explain balance-of-payments phenomena by conceiving the nation in the manner of a household or firm that is consciously aiming at acquiring and maintaining an optimum level of money balances. The concept of what Ludwig Lachmann has called "the equilibrium of the household and of the firm" is then invoked to describe the actions which the nation-household must and will undertake in the service of this goal.[10] As Lachmann explains, the concept of household-firm equilibrium is implied in the very logic of choice.[11] An economic agent will always choose the course of action consistent with his goals and their ranking given his knowledge of available resources and of technology. His actions are, therefore, always equilibrating in the sense that they are always aimed at bringing about a (possibly only momentarily) preferred state of affairs.

In the context of the issues dealt with by the monetary approach, the implication of this analytical concept is that the nation will never alter the level of its stock of money unless it is dissatisfied with it, that is, unless there is an excess supply of or demand for domestic money. A further implication is that all international movements of money will be equilibrating, the result of deliberate steps undertaken by nations to adjust their actual money balances to desired levels. National payments, surpluses and deficits, then, are logically always associated with the adjustment of monetary disequilibrium. To argue that balance-of-payments disequilibria may arise, even temporarily, for reasons unrelated to monetary disequilibrium is to argue that the economic agent, in this case the nation, has taken leave of economic rationality. Why else acquire or rid oneself of money balances, if not as a deliberate act of choice aimed at securing a more preferred position? Thus the global monetarists are prepared to deny, for example, that a shift in relative demands from domestic to foreign products would create even a temporary deficit in the balance of payments in the absence of the development of an excess supply of domestic money.

This clearly illustrates the confusion that results when monetary theorists lapse into methodological holism and apply to hypostasized entities such as the nation concepts whose use is inappropriate outside the realm of individual action. The concept of household-firm equilibrium has meaning only within the framework of the logic of choice. And the logic of choice itself is meaningful only within the context of individual action.

By virtue of his thoroughgoing methodological individualism, Mises maintains a firm grasp on the all-important distinction between the equilibrium of the individual actor and interindividual equilibrium in his balance-of-payments analysis. This difference between Mises's approach and the monetary approach may be seen in their divergent analyses of the effects on the balance of payments of a change emanating from the "real" or "goods" side of the economy. Assuming an international pure specie currency and starting from a situation of monetary and balance-of-payments equilibrium, let us suppose that domestic consumers increase their expenditures on foreign imports and that this increase reflects increased valuations of foreign products relative to domestic products. Let us further assume that the overall demand for money balances remains unchanged and that no other changes in the real or monetary data occur elsewhere in the system.

Under these conditions, those proponents of the monetary approach who are inclined to identify balance-of-payments surpluses and deficits with the process of adjusting monetary disequilibrium would naturally deny any disequilibrating effect on the balance of payments, since the nation, by hypothesis, does not wish to alter its level of money balances but merely its mix of consumers' goods. The adjustment will thus proceed entirely in the goods sphere, with the nation simply increasing its exports of domestic products, which it now demands less urgently, to pay for the increased imports of the now more highly esteemed foreign products, while the level of its money balances remains unchanged.

For Mises, however, things are not simple, since the adjustment process does not consist of the mutually consistent choices and actions of a single macroeconomic agent. Rather, it involves a succession of configurations of mutually inconsistent individual equilibria representing numerous microeconomic agents who are induced by the price system to bring their individual actions into closer and closer coordination until a final interindividual equilibrium is effected.

As a consequence, in Mises's analysis there will indeed emerge an initial balance-of-payments deficit and corresponding outflow of money from the nation as domestic consumers shift their expenditures from domestic products to foreign imports. Now, from the point of view of these individual domestic consumers, this outflow of money is certainly "equilibrating" in the logic-of-choice sense, because it demonstrably facilitates their attainment of a more preferred position. Nevertheless, from the point of view of the economic system as a whole, far from serving to adjust a preexisting monetary disequilibrium, this flow of money disrupts the prevailing equilibrium in the interindividual distribution of money balances and is therefore ultimately self-reversing. Thus, the domestic producers of those goods for which demand has declined experience a shrinkage of their incomes, which threatens to leave them with insufficient money balances. On the other hand, the foreign producers, the demand for whose products have increased, experience an augmentation of their incomes and a consequent buildup of excess money balances. Without going into detail, suffice it to say that the steps undertaken by both groups to readjust their money balances to desired levels will initiate a balance-of-payments adjustment process that will reestablish the original, equilibrium distribution of money holdings among individuals, and hence among nations.

Mises thus arrives at the same long-run, comparative-static conclusion as the proponents of the monetary approach do, to the effect that the change in question will not result in any alteration in national money stocks. However, his focus on the individual economic agent leads him to analyze the dynamic macroeconomic process by which the comparative-static, macroeconomic result emerges.

Before concluding, I wish to briefly note two other important ways in which Mises anticipated the monetary approach. The first involves the global perspective of the monetary approach, which contrasts so sharply with the narrowly national focus of closed-economy macro-models typical of the various Keynesian approaches to the balance of payments. The monetary approach views the world economy as a unitary market with the various national commodity and capital submarkets fully integrated with one another and subject to the rule of the law of one price. As a consequence, arbitrage insures that a particular nation's prices and interest rates are rigidly determined by the forces of supply and demand prevailing on the world market.

The analytical importance of the global perspective, which has revolutionized modern balance-of-payments analysis, was grasped completely by Mises:

The mobility of capital goods, which nowadays is but little restricted by legislative provisions such as customs duties, or by other obstacles, has led to the formation of a homogeneous world capital market. In the loan markets of the countries that take part in international trade, the net rate of interest is no longer determined according to national, but according to international, considerations. Its level is settled, not by the natural rate of interest in the country, but by the natural rate of interest anywhere…. So long and in so far … as a nation participates in international trade, its market is only a part of the world market; prices are determined not nationally but internationally.[12]

I might add that Mises's individualist and subjectivist analytical focus enables him to deal more trenchantly than the writers on the monetary approach with the objection that the existence of internationally nontraded goods and services, for example, houses, haircuts, ice cream cones, severely limits the operation of the law of one price and thus undermines the unity of the world price level. The response of the proponents of the monetary approach, such as Jacob Frankel and Harry Johnson, is the empirical assertion that the elasticities of substitution between the classes of traded and nontraded goods approaches infinity in both consumption and production, a condition that places extremely narrow limits on the range of relative price changes between the two classes of goods.[13]

Mises, on the other hand, disposes of the objection theoretically.[14] His argument is based on the important insight that the location of a good in space is a factor conditioning its usefulness and, therefore, its subjective value to the individual economic agent. For this reason, technologically identical goods that occupy different positions in space are, in fact, different goods. To the extent that the overall valuations and demands of market participants for such physically identical goods differ according to their locations, there will naturally be no tendency for their prices to be equalized. Mises is able to conclude logically, therefore, that the existence of so-called nontraded goods whose prices tend to diverge internationally does not constitute a valid objection to the worldwide operation of the law of one price in the case of each and every good and the corollary tendency to complete equalization of the purchasing power of a unit of the world money.

A final respect in which Mises can be considered as a forerunner of the monetary approach is in his analysis of the causes and cures of a persistent balance-of-payments disequilibrium. For Mises and for the monetary approach, a chronic balance-of-payments deficit can only result from an inflationary monetary policy that continuously introduces excess money balances into the domestic economy via bank-credit creation. The deficit and the corresponding efflux of gold reflects the repeated attempts of domestic money holders to rid themselves of these excess balances, which are being re-created over and over again by the inflationary intervention of the monetary authority. The deficits will only be terminated when the inflationary monetary policy is brought to a halt or the stock of gold reserves is exhausted. Tariffs and other protectionist measures will fail to rectify the situation, since they do not address the fundamental cause of monetary disequilibrium.

The connection between inflationist, interventionist monetary policies and chronic balance-of-payments disequilibrium is delineated by Mises in the following passage:

If the government introduces into trade quantities of inconvertible banknotes or government notes, then this must lead to a monetary depreciation. The value of the monetary unit declines. However, this depreciation in value can affect only the inconvertible notes. Gold money retains all, or almost all, of its value internationally. However, since the state — with its power to use the force of the law — declares the lower-valued monetary notes equal in purchasing power to the higher-valued gold money and forbids the gold money from being traded at a higher value than the paper notes, the gold coins must vanish from the market. They may disappear abroad. They may be melted down for use in domestic industry. Or they may be hoarded.…

No special government intervention is needed to retain the precious metals in circulation within a country. It is enough for the state to renounce all attempts to relieve financial distress by resorting to the printing press. To uphold the currency, it need do no more than that. And it need do only that to accomplish this goal. All orders and prohibitions, all measures to limit foreign exchange transactions, etc., are completely useless and purposeless.[15]

In conclusion, Mises's contribution to balance-of-payments analysis should be hailed not only as a doctrinal milestone in the development of the monetary approach but, much more importantly, as a shining exemplar of methodological individualism in monetary theory.[16]


Akhtar, M.A. 1978. "Some Common Misconceptions about the Monetary Approach to International Adjustment." In The Monetary Approach to International Adjustment, Bluford H. Putnam and D. Sykes Wilford, eds. New York: Praeger.

Frenkel, Jacob A., and Harry G. Johnson. 1976. "The Monetary Approach to the Balance of Payments: Essential Concepts and Historical Origins." In The Monetary Approach to the Balance of Payments, Jacob A. Frenkel and Harry G. Johnson, eds. Toronto: University of Toronto.

Humphrey, Thomas M. 1980. "Dennis H. Robertson and the Monetary Approach to Exchange Rates." Federal Reserve Bank of Richmond Economic Review 66 (May/June).

Lachmann, Ludwig M. 1977. Capital, Expectations, and the Market Process: Essays on the Theory of the Market Economy, Walter E. Grinder, ed. Kansas City: Sheed Andrews and McMeel.

Mises, Ludwig von. 1971. The Theory of Money and Credit, new enl. ed. H.E. Batson, trans. Irvington-on-Hudson, N.Y.: Foundation for Economic Education.

——. 1978. On the Manipulation of Money and Credit, Percy L. Greaves, Jr., ed. Bettina Bien Greaves, trans. Dobbs Ferry, N.Y.: Free Market Books.


[1] The exception is Thomas M. Humphrey, "Dennis H. Robertson and the Monetary Approach to Exchange Rates," Federal Reserve Bank of Richmond Economic Review 66 (May/June 1980), p. 24, wherein Mises is briefly mentioned as one whose contributions to the monetary approach have been largely overlooked.

[2] M.A. Akhtar, "Some Common Misconceptions about the Monetary Approach to International Adjustment," in The Monetary Approach to International Adjustment, eds. Bluford H. Putnam and D. Sykes Wilford (New York: Praeger, 1978), p. 121.

[3] Ludwig von Mises, The Theory of Money and Credit, new enl. ed., trans. H.E. Batson (Irvington-on-Hudson, N.Y.: Foundation for Economic Education, 1971), p. 182.

[4] Ibid.

[5] Ibid., pp. 183–84.

[6] Ibid., p. 184.

[7] Ludwig von Mises, On the Manipulation of Money and Credit, ed. Percy L. Greaves, trans. Bettina Bien Greaves (Dobbs Ferry, N.Y.: Free Market Books, 1978), pp. 53–54.

[8] Mises, Theory of Money and Credit, p. 185.

[9] Ibid., pp. 184–85.

[10] Ludwig M. Lachmann, Capital, Expectations, and the Market Process: Essays on the Theory of the Market Economy, ed. Walter E. Grinder (Kansas City: Sheed Andrews and McMeel, 1977), p. 117.

[11] Ibid., pp. 117, 189.

[12] Mises, Theory of Money and Credit, pp. 374–75.

[13] Jacob A. Frenkel and Harry G. Johnson, "The Monetary Approach to the Balance of Payments: Essential Concepts and Historical Origins," in The Monetary Approach to the Balance of Payments, eds. Jacob A. Frenkel and Harry G. Johnson (Toronto: University of Toronto, 1976), pp. 27–28.

[14] Mises, Theory of Money and Credit, pp. 170–78.

[15] Mises, Manipulation of Money and Credit, p. 55.

[16] Limitation of space has precluded a discussion of Mises's analysis of the exchange rate. Suffice it to say that Mises anticipated the monetary approach to the exchange rate, both in his pathbreaking explanation of the purchasing-power-parity theory (which predated Cassel) and also in his integration of expectations into the explanation of short-run exchange-rate movements. Moreover, Mises brought his global perspective to bear in his insight that the exchange rate between national currencies is to be explained on the same principles as the exchange rate between parallel currencies circulating in the same nation.