The Cantillon Effect on Relative Prices

The Cantillon Effect on Relative Prices: the redistribution of wealth through monetary policy                                                                  
Pablo Paniagua                                                                                                                June, 2012                                                                                                      

“Mr. Locke lays it down as a fundamental maxim that the quantity of produce

and merchandise in proportion to the quantity of money serves as

the regulator of market price. I have tried to elucidate his idea in the preceding

chapters: he has clearly seen that the abundance of money makes

everything dear, but he has not considered how it does so. The great difficulty

of this question consists in knowing in what way and in what proportion

the increase of money raises prices.”

Richard Cantillon

Richard Cantillon, the Mississippi Bubble and the Non-neutrality of Money:

Richard Cantillon (1680’s – 1734) was an Irish-born economist and banker who lived most of his life in Paris as a bank owner. He was the author of “Essai sur la Nature du Commerce en General”(Essay on the Nature of Trade in General), but other essays that Cantillon may have published remain unknown.  It was during his life as a banker and speculator in Paris when Cantillon fully understood the real effect monetary policy has on real life economics. At the same time he applied this knowledge, helping him to build his fortune profiting from the Mississippi bubble during 1717-1720. His treatise is the only printed contribution of Cantillon that remains today; it was written around 1730 then circulated as a manuscript until it was finally published posthumously in 1755.  

When his manuscript circulated all around Central Europe and England, it is believed that his essay was widely read among Classic Economists at the time.  It was definitely read by and influenced most of David Hume’s insights on Monetary Policy. Richard Cantillon has the honor of being amongst the few fully cited by Adam Smith in the “Wealth of Nations”. Unfortunately right after Smith’s publication, Cantillon’s Essai fell into oblivion. The neglect of all the pre-Smithian Economics helped to established Smith’s work as the only reliable source, influencing more than 100 years of economic thinking.

   

Only after the Austrian Marginal Revolution of the 1870’s led by Carl Menger and then followed by Austrian generations, they returned some influence and value to the pre-Smithian thoughts. This is particularly true in the field of Individualistic-Subjectivist Theory of Value, much in line with the individualistic and methodological approach first used by Cantillon himself. Menger later revived the individualistic approach. The Austrian Revolution of individual-subjective methodology towards economic phenomena finally brought some attention to other theories outside the British Paradigm and contributed to a whole new spectrum of economic analysis and methodology in Social Sciences.

Professor Hayek defined Cantillon as “this gifted independent observer, enjoying an unsurpassed vantage point in the midst of the action, coordinated what he saw with the eyes of the born theoretician and was the first person who succeeded in penetrating and presenting to us almost the entire field which we call now economics”. Therefore the Austrians consider Cantillon as the “first of the modern economist”. He helped to emancipate economic analysis from the entanglement with ethical and political concerns in order to establish it as a subject of its own.   

Therefore after more than 250 years of neglect and oblivion, today we can say with confidence that Richard Cantillon, the French-Irish banker was the “Father of Modern Economics” since he wrote Essai a full 4 decades before the “Wealth of Nations”. Although little is known about Cantillon’s life, we have the certainty that most of his relevant work and life experience was conducted in Paris, where he experienced real life economics in a way that completely changed his insights forever.      

The most important experience during his life as a banker was his association and participation in the Mississippi Company with the Scottish adventurer and inflationist banker John Law (1571-1729). Law, backed by the King of France Lois XIV, secretly embezzled a great part of the French population with his financial scheme of issuing extensive paper money to keep financial assets highly valued. In particular, he kept the Mississippi Company’s stocks at unsustainable high levels while it devaluated the currency and decreased the French government’s debt burden. Law persuaded the King of France to take control of issuing money in order to “promote wealth”; therefore Law established a loose monetary policy.

He believed that with a massive flow of paper money to the economy, the government could reduce its deficit while “promoting growth” through the Mississippi Company. This inflation scheme ended abruptly in 1720 when the speculative Mississippi bubble burst. It was under this massive injection of liquidity and indiscriminate state intervention that influenced much of Cantillon’s Essai on Monetary Policy. Cantillon himself became a millionaire through of the speculative bubble: he understood the scheme and rode the bubble, then sold his assets before it burst. This left him wealthy and the entire French nation impoverished. Cantillon returned to London and in 1730 he wrote Essai based on his earlier first-hand experience with paper money and irresponsible monetary policies conducted by Law and the French monarchy.             

With the collapse of Law’s paper money scheme, Cantillon understood that market forces are the true determinant of money’s value. He also understood that money itself is not neutral in the real economy in terms of the production structure, consumption and income distribution. The real value of money is in its ability to facilitate transactions within a market economy. Therefore the intrinsic value of money relays on the commodity to which it is pegged but the money in the market will fluctuate around that intrinsic value. In most cases, it should be the intrinsic value of gold attached to its production and extraction cost. In a free market economy the value of the gold money will be set by the individual’s interaction within the system, or by the “consent of mankind”. Cantillon then realized that paper money has no cost of production therefore does not have intrinsic value. The market spontaneously sets the value of paper money at par with the gold money, just as long as the fiduciary paper can be redeemed in the commodity.  

Cantillon noted that an increase in the monetary paper base has the same effect as an increase in the real gold commodity. He noticed that this process happens as long as the market participants are confident and do not notice the paper money’s monetary debasement. Cantillon understood that since paper money has zero production cost for governments and it is treated as gold money in the market, it puts the governments in an advantageous position. It is a large temptation to increase the monetary base and print more money, but this would create unforeseen distortions. It is the paper money introduced by the state which lies outside the spontaneous accord of mankind that unsettles the market’s interactions. Therefore is not neutral, as Cantillon stated:

“When money circulates there in greater abundance than among its neighbors a national bank does more harm than good. An abundance of fictitious and imaginary money causes the same disadvantages as an increase of real money in circulation, by raising the price of land and labor, or by making works and manufactures more expensive at the risk of subsequent loss. But this furtive abundance vanishes at the first gust of discredit and precipitates disorder.”

Then the real value of gold as money is set within the interaction of individuals and its value will sporadically fluctuate with the market process. Therefore Cantillon understood that if the state introduces a centralized paper money, along with the gold currency, money will diverge from being neutral to creating instability in the market prices. The Mississippi bubble was his most lively reminder of this fact.   

Individualistic Approach and the Cantillon Effect:

Cantillon in many ways is considered a proto-Austrian since he carried much of the individualistic insights of the Austrian School that enriched the development of ideas about economic phenomena. This approach is attributed to Carl Menger, the founder of the Austrian School, but Cantillon reflects them as well. Like the Austrian School, he believed that economic phenomena should be analyzed on the base of individual economic decisions and actions of single persons.

Following this approach, it becomes comprehensible that under a form of spontaneous order in which economic actors interact and make decisions (adjusting their actions to the contingency of others), the only way to create an efficient communication system among decentralized activities is through a price system.  It is this sort of price system that can truly reflect the real spontaneous interactions of decentralizing decisions made by individuals. Therefore prices are the way to disseminate relevant information within a market economy and are the most efficient and decentralized allocation of resources. 

We can see that if societies rely on any form of spontaneous order in their economic activities, unadulterated prices are the way that relevant information gets transmitted to actors. Under this system, the relevance of relative prices on economic decisions becomes extremely evident. It is under the Austrian and Cantillon’s individualistic approach that the flexibility of individual interactions can be reflected in relative prices and not in macroeconomic aggregates. This is why single and relative prices are so important to the economy. This approach is in complete contrast with other Economic schools that rely on macroeconomic aggregates. The approach led by Cantillon and Menger was a huge paradigmatic change in economic methodology since it rejected the macroeconomic approach for methodological individualism.

Cantillon also preceded the Austrians in the business cycles theory and the effect of monetary expansions, what is now considered the “Cantillon Effect”. His analysis in Monetary Policy preceded those of Mises and Hayek in realizing that the biggest problem with any sort of monetary stimulus is that it is not equally distributed to all economic actors; it is rather a step-by-step process in which the new money permeates throughout the economy and industries at various speeds.  As Wenli Cheng and Simon D. Angus defined in their last paper:

“Since new money does not reach everyone at the same time, the injection of money increases the purchasing power of those who receive the new money first, enabling them to bid resources away from those who receive that money at a later time. As a result, relative prices will change, resources will be reallocated and income will be redistributed during the time interval between money injection and its final permeation in the economy. These changes are referred to as the Cantillon Effect”.

Therefore the Effect starts with some actors receiving money then it slowly transmits to other actors in the economy. In this process relative prices are extremely important because there will be prices which rise more sharply than others, especially those prices correlated with the activities involved with the freshly introduced new money.

During this adjustment only some prices will increase, therefore the full increase of overall prices is not straightforward or noticeable at an aggregate level; the stimulus’ consequences cannot be fully followed on a macroeconomic base. Since the alteration due to the new money affects relative prices and not the overall aggregate level, certain prices will respond faster to the stimulus than others. This distorts and affects the decisions of entrepreneurs and individuals, skewing their resource allocation and drastically changing the whole economic structure and production. This creates relative inflation and disproportionate price increases of different assets.

Richard Cantillon was the first to criticize the naïve belief of aggregate monitoring and the false notion of price stabilization being determined by an aggregate entity. He criticized monetary theory based on macroeconomic aggregates because he believed in the individualistic approach of economic phenomena: the relative prices and interaction of single individuals.

He was aware of the danger that these relative relations and prices were completely neglected by central authorities. The naïve belief of macro entities monitoring monetary stimulus is unfortunately still widely accepted by both Neoclassic and Monetarist Economists. For example, Monetarist Economist and the Chicago School see inflation as harmonized whereas Mises and Hayek based on the Cantillon’s powerful insight were certain that this harmonization of rising prices is a fantasy. Nowadays this macro approach is used by practically all central banks worldwide and after the 2007 financial crises, we have empirical evidence of how this approach appears to be working for our society.

  

Fortunately for Cantillon, real life economics through the Law scheme and the Mississippi bubble showed him money printing’s powerful distortion on relative prices, which create the boom and bust cycles. Under this form of stimulus, the “Cantillon Effect” appears.

When money first appears, it is channeled into the economy only to some actors or into industries previously selected by the central authority. The new money increases the spending availability and purchasing power of these initial actors, increasing their well-being and purchasing capacity without any price increase at first. This positive effect comes at the expense of the people at the end of the monetary stimulus chain; those who receive it after it has already circulated around the economy will face higher prices than the initial individuals. This therefore damages their expending power and produces a zero-sum game.

After the money has circulated, it raised enough prices so that the last people see an increase in their cost of living, diminishing their purchasing power and their quality of life. Consequently income and wealth are being redistributed or even more expropriated from the last receivers to the benefit of the “enlightened” individuals who received the stimulus first. Therefore monetary stimulus led by government interventions is always discretionary and predestined to favor only a part of society.

Moreover the worst part of this stimulus is that relative prices or goods will change in unpredicted ways, depending on which goods the early receivers of the money will spend their money on. Therefore relative prices will change arbitrarily and the overall measure of the price changes will not reflect these interactions, nor be able to unveil further distortions and assets price bubbles. As Cantillon stated “The important truth is that economic laws are qualitative and not quantitative”. Consequently any attempt to foresee the changes in relative prices for any sort of economic stimulus is futile.

In addition, Cantillon understood that interest rates are not purely a monetary phenomenon; he realized that they are determined by the spontaneous interaction of borrowers and lenders in open market operations, once again like money, using the individualistic methodology. Natural interest rates are determined by the spontaneous cooperation of individuals and again the fundamental problem arises and the “Cantillon Effect” appears. This time it affects interest rates: to whom this new money injection will be channeled will determine the change and the overall stimulus result on the interest rate in the short run.

If the new money finishes in the lenders’ hands then the interest rates will fall; but if the money is poured to the borrowers or consumers, then the stimulus will incentive consumption today rather than investment. Then if the stimulus increases consumption, it will change the time preferences of some savers and consumers, raising the interest rates and counterbalancing the previous effect on the lenders. Therefore an increase in the supply of money can have both effects: it can either decrease the interest rate or can increase it due to the overall stimulus effect being channeled to consumers.

The outcome will finally depend on the new money’s velocity of circulation, on the stimulus’ initial entrance into the economy, and also how it spreads across industries and actors. The final result is nonetheless out of the central authorities’ reach.

“Of course, it is one thing to assert that monetary changes are the key to major movements in money income; it is quite a different thing to know in any detail what is the mechanism that links monetary change to economic change; how the influence of the one is transmitted to the other; what sectors of the economy will be affected first; what the time pattern of the impacts will be, and so on. We have a great confidence in the first assertion. We have little confidence in our knowledge of the transmission mechanism, except in such a broad and vague terms as to constitute little more than an impressionistic representation rather than an engineering blueprint”.

-Milton Friedman and Anna J. Schwartz

Finally, Cantillon not only provided us with the cause and effect of monetary stimulus but he also provided its cure: the fundamental alleviation is preventing governments or central authorities in intervening in the economy and with the intertemporal preferences of heterogeneous individuals being settled by the market’s spontaneous order. According to Cantillon, this is the only way to prevent further unnatural allocation of resources, further monetary crisis and above all indiscriminate policies of expropriation of wealth in our society.

* Edited by Victoria Finn

Sources:

- Cantillon on the Cause of the Business Cycle, Mark Thorton, The Quarterly Journal of Austrian   Economics Vol. 9, NO.3. (FALL 2006): 45–60

- Essai sur la Nature du Commerce en Général, Cantillon, Richard. [1755] 1959,Henry

Higgs, ed. and trans. London: Frank Cass.

- The Cantillon Effect of Money Injection through Deficit Spending, Wenli Cheng and Simon Angus, Discussion paper, Department of Economics Monash University.

- The Trend of Economic Thinking, Richard Cantillon, The Collected Works of F.A. Hayek.

- Paper Money Collapse, Detlev Schlichter, John Wiley.

- New Directions in Austrian Economics, Spontaneous Order and the Coordination of Economic Activities, Gerald P. O’Driscoll, Jr., Lundwig Von Mises Institute 1978.

- The Optimum Quantity of Money, Milton Friedman and Anna Schwartz, Chicago: Aldine Publishing Co. 1969.