Richard Cantillon was a 17th century merchant and banker, as well as arguably the world’s first modern economist. He authored Essai sur la Nature du Commerce en Général (Essay on the Nature of Trade in General), which 19th century English economist William Stanley Jevons later referred to as the “cradle of political economy”.
Cantillon’s most famous idea, the eponymous Cantillon Effect, describes the effect of money creation on relative prices and wealth inequality within a society.
The Cantillon Effect is not commonly taught in undergraduate economics courses. Could this be a simple oversight, or perhaps a calculated omission?
Below we will take a brief look at the mainstream view of macroeconomics, the nature of the Cantillon Effect, and how it leads to predictable – and some would say ‘unjust’ – enrichment of certain groups in a society at the expense of others.
Mainstream Economics: Keynesianism
According to traditional Keynesian economics, economic output in a nation can be increased by stimulating aggregate demand for goods and services.
During an economic downturn, a central bank can respond by increasing the money supply. An increased availability of money makes credit more easily available and at lower interest rates. The reduced cost of funding makes it more attractive for businesses to invest and for individuals to consume. This increased spending leads to rising economic output.
In the short run, Keynesian economics works as described. Lower interest rates encourage businesses and individuals to borrow and spend, which stimulates output.
In the long run, however, constant bouts of easy credit lead to rising debt levels, and ultimately rising levels of default risk. When debt levels become too high, prudent banks have an incentive to restrict lending. This should push up interest rates, and make it attractive for borrowers to repay their debts. Which in turn should reduce spending in the economy, and lead to falling output and asset prices.
Of course, if an economy could grow faster than debt levels forever then the game could be prolonged indefinitely. But this tends not to happen. At least not in the long run.
Today, America and many other countries find themselves somewhere near the end of the long run credit cycle.
Responding to high levels of debt and financial instability, one would expect to see each bank try to protect itself by shrinking its loan book. However, national governments and central banks have different ideas. Governments guarantee bank deposits in order to prevent bank runs. This inadvertently removes each bank’s incentive to act prudently. Central banks pursue “inflation at any cost” in order to oil the wheels of the credit markets. This inadvertently fuels asset bubbles and financial instability. In 2020, the Fed has galloped over the precipice, increasing its balance sheet by around $2.8 trillion over the last 5 months.
The day of reckoning may have been delayed. However, this has only been possible by significantly expanding the amount of debt in the system. A crash, when it comes, may well be much larger and more catastrophic than might have been the case if small recessions over the decades had been allowed to run their natural course.
If the US Federal Reserve can delay but not ultimately prevent a downturn from occurring, then why do they continually intervene in financial markets in order to create credit fuelled asset bubbles and prevent supply and demand from finding a market clearing price? The answer is the same one we have seen many times before. Moral hazard means that kicking the can down the road is a rational policy for each individual Fed Chairman and bank CEO to pursue, even if it imposes costs on other groups and creates higher levels of financial risk in the economy as a whole.
Let us consider one of the hidden costs of continual money creation.
The Cantillon Effect
Cantillon explored the effect of money creation by considering what would happen if a large gold deposit were discovered by a nation state. (Gold and silver coins being commonly used as money in Cantillon’s day.)
Those who gained access to the new money – the mine owners, business associates, and preferred merchants – would be enriched, being able to increase their expenditure in proportion to their profits.
The abundance of money would lead prices to rise. However, in contrast to the naive quantity theory of money, doubling the quantity of money would not double all prices equally. Relative prices would change depending on how the new money was spent by those who acquired it.
Ultimately, prices would rise to the point where property owners would increase rents, merchants would raise prices, and workers would bargain for higher wages.
Prices would eventually rise so high that there would be considerable profit to be made in buying goods from foreigners who make them cheaper. Local merchants would see their trade decline, many workers would lose their employment, and the society would slide slowly and inexorably into ruin.
Inequality and Unrest
Although gold coins are not currently used as money, as they were in Cantillon’s day, the analogy of Cantillon’s gold mine example to today’s situation will hopefully be clear.
The mine owners are the US Federal Reserve, their business associates are Wall Street and the primary dealers who can sell financial assets (including worthless junk bonds) to the Fed for 100 cents on the dollar, and the preferred merchants are the industries that high income finance professionals tend to patronise, such as luxury brands, high end real estate, and elite schools. As a case in point, from 1975 to 2019 the average annual increase in Harvard tuition was 5.1% compared with an average inflation rate in America of 3.7%, and an average annual increase in the median household income of around 3.1%. In other words, the average worker in America has year by year slowly fallen further behind.
Many pundits like to blame outside forces for America’s difficulties. In this regard, Donald Trump, Steve Bannon, Kyle Bass, and many others are getting good political mileage out of scapegoating China. However, while China is definitely not immune from criticism, the primary cause of America’s slow decline might be more accurately located closer to home.
The wealth inequality caused by excess money creation is likely a cause of rising social unrest.
- In 2016, Brexit and Trump’s victory came as a one-two punch. Both events were a surprise to the champagne sipping elites in San Francisco, New York and London. They were shocked that Trump’s pledge to “drain the swamp” and “bring jobs back to America” would resonate so widely. They were equally befuddled by the appeal of Boris Johnson’s leave campaign that promised to “take back control” and “unleash Britain’s potential”.
- In 2018, the Mouvement des gilets jaunes (yellow vest movement) was sparked in France by rising fuel taxes. Keen to signal their support for the environment, French elites had supported higher taxes on fuel, the costs of which were borne disproportionately by the working class.
- In 2020, protests have broken out across America railing against inequality and injustice. Initially, the death of George Floyd was the catalyst for a nation wide protest against police brutality. Not wanting to let a good protest go to waste, activists also managed to focus the energy of the crowds on attacking historical monuments, churches, and courthouses.
The reasons given for the unrest in America, the UK, France, and other places in recent years have varied. However, the emotions in each case are familiar: anger about perceived inequality and injustice, hope that the system can be changed for the better, and a healthy dose of humour or resentment depending on whether the participants are able to laugh at misfortune or become consumed by it.
While the emotions are real, the inequality that often motivates these protests and campaigns is to some extent merely a symptom of a much longer running hidden underlying cause: excess money creation.
Remedies to the Cantillon Effect
The Cantillon Effect posits that increased money creation enriches those who gain access to it. Rising prices over time create an incentive for production to move abroad, and the resulting decrease in productive capacity causes a society to decline.
It appears that Richard Cantillon and Adam Smith were in agreement about the source from which the wealth of a nation is derived. Adam Smith famously stated that:
“The riches, and so far as power depends upon riches, the power of every country must always be in proportion to the value of its annual produce, the fund from which all taxes must ultimately be paid.”
America and other nations that find themselves in relative decline in 2020 might want to consider three possible remedies:
- Returning to a gold standard would limit the ability of central banks to create money, and so limit the wealth inequality, rising prices and societal decline predicted by the Cantillon Effect.
- Abandoning the advice of Keynesian economists who argue that it is possible to grow an economy by encouraging spending and consumption rather than saving and production. Producing goods creates jobs, requires investment in productive capital, and can lead to new technology and comparative advantages being formed. Free trade is certainly important, but one has to wonder about the soundness of the generally accepted policy of offshoring as much production as possible to low cost jurisdictions. A company that shifts production offshore in order to increase profits in the short run may not be acting in its strategic long term best interests, or in the interests of employees, taxpayers, or the nation that made its existence possible.
- Returning to a free market system where prices are determined by supply and demand rather than by government or central bank policy. The desire of political leaders and technocrats to centrally plan national economies is often motivated by noble ideals, but humanity’s painful experiences from the 20th century are a reminder that the road to hell is often paved with good intentions. The extreme power of central planners is a corrupting influence, which can lead them to become overconfident in their ability to control economic outcomes. However, even if central planners could remain level headed, the dynamic complexity of each market, and the large number of markets operating within each nation, means that central planners will never have better or more up to date information about markets than the buyers and sellers participating therein and acting in their own self interest.
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