The Cantillon Effect: The Distributional Effects of Newly Created Fiat Money.
‘The Cantillon Effect’, the most important economics concept you’ve never heard of !?
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The Cantillon effect - What it is and why you should care?!
‘The Cantillon Effect’, the most important economics concept you’ve never heard of !?Here is a breakdown of what it is and why you should care:
The Cantillon effect is termed after Richard Cantillon, who was an Irish-French economic philosopher born in 1680. He achieved success as a banker and at a young age had learned of the impact of proximity to power.
Cantillon wrote a paper on the Nature of Commerce in General “Essai Sur La Nature Du Commerce En General,” which was widely accepted as the foundational work for further studies of the political economy. The paper was extensively propagated in manuscript form, though, only published in 1755, well after his death.
Cantillon advanced that the early recipients of newly created money entering the economy will benefit more significantly than those it trickles down to. In simpler terms, the flow path of the new money matters. Broadly, Cantillon observed that the new money creates distributional effects based on where it enters the system.
The Cantillon effect was born.
Let us use a very simple example to illustrate Cantillon’s focal point: Imagine you wake up to find a package on your doorstep.
Great, but now what?
You now secretly have a R1 Million new rands. Naturally you start spending it [and maybe investing it] quickly! Prices are still low because no one knows these new rands exist yet. Your standard of living improves rapidly. You buy yourself a bit of land, nice proprty, and clothes, and still have some money left over.
But now, people start to see and feel the new money through the system. Prices begin to rise as supply has yet to catchup to the new demand. It takes time. So, while the money improved your standard of living. It did not benefit others in the same way. The sellers of the goods who received your cash now face rising prices when they consume, and the same workers who produced the goods are in the same position.
There were distributional effects, the flow path mattered.
This is a simplified example, but it gets at the essence of the problem that Cantillon highlighted - Proximity to the source of new money is relevant, the entry point and flow path have distributional consequences.
So why should you care today?
Well, with the “money printing” activity of central banks globally and expanding wealth inequality problem, talks of the Cantillon effect have accelerated.
The effect of such is at pinnacle when the reserve bank makes new money and distributes it through the financial institution pathway [financial assets]. This is achieved by the reserve bank buying assets from financial institutions, assets such as mortgage-backed securities [loans given out by banks to homeowners, which are assets in the bank’s balance sheets, packaged, graded, and sold to other institutions, who then collect the loans from homebuyers].
When the reserve bank buys these assets from the banks, it simply pays for them by crediting the reserve account of the member banks through an accounting or book entry [printing money]. In a case where the banks wish to convert the reserve balance into hard cash, the reserve bank provides them rand bills.
The first recipients of new money that is fiat currency [financial institutions, asset owners = the wealthy] benefit better as their increased wealth faces normal prices [unaffected by inflation due to the new money] than the last recipients of new money [ retirees, pensioners, economically vulnerable who don’t own assets = the poor] who have been disappointingly affected by inflation caused by new money.
The Cantillon Effect is widely accepted as a close associate in driving income inequality. Reports by the Wealth Inequality Lab posit that the income inequality gap in South Africa has remained unchanged since apartheid. Further interestingly, 10% of the South African population own more than 85% of household wealth, leaving the remaining 90% with just less than 15%. In 2019, the world bank recognised South Africa as the most income unequal country!
This should not be a political debate, but rather a grounded discussion we all have when we consider the impact of various monetary and fiscal policies proposed by those charged with governance.
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I hope everyone is good, special regards to my friends I am with down in Durban - with the flooding we’ve seen this week. Stay Safe and hang on tight!