Concepts: The Cantillon Effect

Gunnar Jaerv
Gunnar Jaerv 1 April 2021

The Cantillon effect describes the velocity of money through the economy, and the uneven effect its diffusion has on prices, wages and inflation.

The Cantillon Effect is an unintended side effect of pumping money into the economy that can make efforts to stimulate the economy less effective and more unfair. It was first observed by English Economist Richard Cantillon in the early 1700s, and is based on observations about how money makes its way through the economy from its point of entry: the Central Bank.

What is the Cantillon Effect?

The Cantillon Effect refers to changes in relative prices as a consequence of a change in the money supply. This change in relative prices across the economy takes place because the increased or decreased money supply happens in specific places in the economy; for instance, tax rises or quantitative easing. Thus, the changes wrought by these policy actions have specific pathways through the economy.

So the Cantillon Effect doesn’t refer only to an increase in the money supply; it refers to the effect of unequal access to that increased money supply as it makes its way into and around the economy. Some get easier access to it than others; for them, there is more money and prices are lower. This is a change in relative prices.

The Cantillon Effect, relative prices and money neutrality

Money neutrality is a basic economic principle, stating that the amount of goods or services that can be produced depends on factors of production — capital, labour, technical knowledge. Increasing the money supply doesn’t directly increase the supply of things money can buy. In practice, increasing aggregate demand by increasing the money supply can stimulate an increase in aggregate production, though it also usually increases inflation. Without methods to control inflation, money neutrality therefore reasserts itself in the long term.

Cantillon doesn’t deny money neutrality, at least in the limited form discussed above, but he does propose a structure to the process by which neutrality is restored. Before money goes back to being the same for everybody, there’s a period where different economic actors have more or less privileged access to it. Cantillon was concerned not with a rise or fall in aggregate prices across the economy, but with rising or falling relative prices.

Relative prices in action

To understand the effect better, picture two corporations. One qualifies for government money and the other doesn’t. To make the maths simple, we’ll say each corporation has liquid assets totalling $10 million. So spending $100,000 means spending 1% of their assets.

After the government injects more money into the economy, the A Corporation now has liquid assets totalling $20 million. Unlucky B Inc. has the same $10 million as before. When A Corp wants to buy $100,000 worth of tools or materials, it only has to spend 0.5% of its total liquid assets. B Inc is still stuck paying the old prices.

After both corporations have spent their $100,000, that money goes to the accounts of other businesses and into the pockets of individuals. A higher money supply drives up prices, which all those businesses and individuals must then pay.

Of course, A Corporation has to pay higher prices too, but it has more money to pay them with. People who work for A Corporation and B Inc.’s suppliers have to pay higher prices because more money is in circulation — but they never got the benefit of the additional money. They were paid the same as before. Only A Corporation has really profited here.

There has been an asymmetry based on how close you are to the site of the initial injection of money into the economy, and on the velocity of the money — how quickly it is spent. This is the Cantillon effect.

Richard Cantillon

The Cantillon Effect is named for Richard Cantillon, who was one of the earliest writers on economics and one of the first to attempt a ‘values-free’ approach in which he described relationships between economic entities rather than ethical ideals or political plans.

Cantillon’s take on prices and money included the understanding that there was an “underlying value” in terms of the materials and labour that went into the things money could buy, which is surprisingly modern for someone writing in the early 18th century. His Essai Sur La Nature Du Commerce En Général (Essay on the Nature of Commerce in General) is considered to be the first complete economic treatise. Among many other firsts, Cantillon’s Essai introduced the idea of the non-neutrality of money.

Non-neutral money: Velocity counts

The idea of neutral money is that an increase in the money supply leads to an increase in prices across the whole economy while leaving real productivity, investment and employment unaffected. In other words, put more money into the economy and all you buy yourself is higher prices. We know this isn’t fully true, and most people who argue that money is fully neutral are looking at the long term rather than the short-to-medium term.

But Cantillon argues against this, saying instead that increased money supply can be beneficial by increasing the velocity of money — later to become a key concern of economists like Maynard Keynes and Galbraith.

The effect would run deeper too. An increase in trusted commodity money like silver or gold would raise employment and prices, impose “forced savings” and lower real incomes on anyone whose income didn’t rise as a result, and create sharp inequalities among income earners based on access to the new influx of money.

Fundamental effects of relative price changes: Capital resource allocation, reduced money velocity, and economic growth

A change in relative prices also leads to a greater allocation of resources to long-term capital goods. Remember A Corporation earlier; while they effectively have double their money and double the money their competitor has, it’s a great time to retool and spend money on expensive long term projects like R&D.

This has benefits for A Corporation, and for their consumers, but it can have negative consequences for the wider economy. New plant and other capital purchases can represent a kind of crystallization of money; its velocity has sunk to zero, and the capital goods so acquired are susceptible only to changes in price because nothing else about them can be changed.

This can leave businesses on the hook for capital goods that must be sold at a loss, damaging the economy and driving firms out of business. Of course, it can also have a multiplier effect if the capital goods purchased are more profitable than investing the extra money would have been. Thus, economies can be stimulated to grow in this manner, but they can also be frustrated and made to stagnate. The effect depends on other factors than the money supply.

The Cantillon Effect in practice

The Cantillon Effect is visible in the contemporary US economy. Stimulus packages aimed at creating economic activity by increasing the money supply (Quantitative Easing) gave businesses large sums of new money, spent into being by the government — particularly in April of 2020 when the Trump administration rolled out a stimulus package in response to the Coronavirus pandemic.

The result was that businesses put their affairs in order. On Wall Street, accounts overflowed and confidence boomed. Businesses paid debt, bought stock and generally did what Richard Cantillon forecast they would do with their money. As they did so, they drove up prices, and not just on the stock market. What’s worse is, they took money right back out of the economy again by using it to pay down debts and buying up capital goods. The public at large will see the inflation, but not most of the money. There has been deflation for some economic actors, then, and inflation for others. This is called biflation.

Biflation: Inflation and deflation simultaneously

Biflation is a special case of the Cantillon Effect in which both deflation and inflation happen simultaneously in the economy. Of course the value of money can’t simultaneously rise and fall; what’s really happening is that the value of money is rising in some sectors of the economy and falling in others. This is the relative price effect in action. Some economic actors suddenly have plenty of money relative to prices, granting them deflation — while others mostly see prices rise, relative to the money supply, experiencing inflation.

The result is a sharp imbalance based on the type of good. Debt-based assets like mortgages fall in price; commodity-based assets rise in price. Typically, businesses and industries that already own significant assets, or whose assets are non-tangible (such as the tech industry), fare well in such circumstances while wage earners, small businesses and businesses whose business model involves significant debt do not. In many ways this is the opposite of what we’d like to see as the result of an economic stimulus package. It also carries the danger that highly-leverage financial systems become suddenly even more vulnerable as debt-based assets crumble in value.

So will the new stimulus be any different?

The Cantillon Effect, Digital Assets — and the Biden stimulus package

The Trump administration’s stimulus package provided relatively small amounts of direct financial aid to individuals: a $1,200 check and later a $600 check to individuals earning less than $75,000. The majority of his stimulus money went to businesses, intended to stimulate their economic activity which would then be passed on to wage earners in the form of wages. However, in tandem with a relaxation of the tax regime on businesses and high earners, much of the effect of the Trump stimulus bill was “Cantilloned away”.

For many who did receive checks, digital assets were their first port of call. Forbes was very clear: “Americans are using their stimulus checks to buy Bitcoin”. BTC boomed as money from stimulus flowed in — from retail investors putting their $600 where it might do them some good, sure, but also from institutional investors and HNWIs. Again, BTC is largely used as a store of value rather than a spending currency, so the effect was to cancel out the stimulatory effect and retain the inflation.

Will the Biden stimulus package perform differently?

Can focusing on infrastructure negate some of the Cantillon Effect? We’re about to find out

There’s a chance it will. Biden’s stimulus package will focus on government-funded green infrastructure projects with the stated aim of increasing employment; the speed with which money will get into people’s pockets will therefore be higher, and the tendency to lock new money up in capital purchases is much less among the newly-employed than among businesses.

In this it resembles the New Deal. Government will keep money out of the hands of businesses until after individuals have spent it, meaning the Cantillon Effect should work in wage-earners’ favour.

How will it affect digital assets?

In March 2020, BTC passed $60,000 for the first time after the stimulus package was passed by the House. In some cases this is fuelled by a perception of BTC as “digital gold”, an inflation-proof asset that can’t be quantitatively eased or fractionally banked. And in some cases, it’s retail investors lacking other investment and spending opportunities; businesses are shuttered, stocks and bonds aren’t yielding, the dollar is actually falling but BTC is going up.

It’s also an even greater influx of HNWI and institutional investors, seeking an inflation hedge, a safe haven and a base for their financial and economic activities more certain than the shifting sands of the US dollar. And of course BTC’s supply is totally inflexible; even Cantillon, writing in the age of gold and silver coins, couldn’t imagine a coin this certainly scarce.


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