Why is stock market investing so important? [The Cantillon Effect]

Investing in the stock market has been one of the most effective ways to build wealth for years. While financial markets can be volatile in the short term, in the long term, stocks have proven to be a better alternative to other asset classes, such as bonds, real estate, or cash in a savings account.

However, simply knowing that the stock market offers high returns is not enough. To invest effectively, it is worth understanding what influences stock prices and why markets grow faster in some periods than others. A key factor that has a huge impact on financial markets is the monetary policy of central banks. It is decisions regarding interest rates and the money supply that often determine whether the stock market rises or falls.

In this context, understanding Cantillon effect becomes extremely important. This mechanism explains how newly created money first flows into the financial sector before it even begins circulating in the real economy. This is why stock and real estate prices rise long before inflation hits ordinary consumers. If you want to use this mechanism to your advantage, investing in the stock market can be one of the best strategies for protecting and growing capital.

In this article, we will show you what the Cantillon effect is, how it affects financial markets, and why you need to invest to be on the right side of this process. To fully understand it, it is worth familiarizing yourself with with this article.

What is the Cantillon effect?

Cantillon effect is an economic phenomenon that describes how newly created money is distributed unevenly throughout the economy, leading to unequal benefits and a redistribution of wealth. Newly created money they always reach specific entities first – most often banks, financial institutions and large corporations. Only later, as they are spent, do they begin to spread more widely in society, which means that not all market participants have access to them at the same time and on the same terms.

In practice, this leads to a situation in which the earliest beneficiaries of the new money enjoy its full value, buying assets and goods at previous prices, while later recipients have to face higher costs for goods and services. This process takes place in stages, with prices changing depending on who received the new money first.

The problem is that the average citizen does not immediately have access to these funds. Wages are rising much slower than asset prices, which means that people who live primarily from work, not investment, are starting to lose purchasing power. The prices of apartments, shares and other investment goods are rising, which means that people without capital are gradually being pushed to the economic margins.

How does the Cantillon effect affect the stock market?

Modern central bank policy is based on massive increases in the money supply through quantitative easing (QE) and maintaining low interest rates. These actions are intended to “stimulate the economy,” but their effects are felt first on financial markets, and only later in the real economy.

When central banks decide to implement quantitative easing and lower interest rates, it means that they create new money and put it into circulation by purchasing financial assets such as government and corporate bonds or even stocks, and they also indirectly contribute to increased lending, as commercial banks can lend more money. Of course, with cheaper credit, demand for financing of various projects also increases, which is what banks make money from. Lower interest rates also have their second-order consequences, for example in the form of a general increase in risk appetite in investments, as investors look for alternatives that will give them more to earn than the decreasing interest rates on bank deposits (as we have seen in 2021, for example).

The process of introducing money into the financial market is therefore mainly carried out through commercial banks and large institutions, which are the first to receive access to new capital. However, these institutions do not store the new money in cash, but instead reinvest it in financial markets, which leads to an increase in demand for investment assets. As a result, the prices of various instruments rise, but most of all, shares.

The graphs below perfectly illustrate the phenomenon described in this article in practice. In the years 2015-2020, cumulative inflation in the United States was 9,22%. This means that on average it did not even exceed 2%, so most people did not even notice it. On the other hand, the M2 money supply, which is not the only and ideal measure of money in the economy, increased by about 20% during the same period.

Corporate Advantage – Cheap Credit and Rising Asset Values

The Cantillon effect not only causes asset prices to rise, but also favors large corporations at the expense of small businesses and consumersWhen central banks lower interest rates and create new money, large companies can borrow capital more cheaply and use it for operations or investments, giving them a competitive advantage.

Thanks to cheap credit, the largest corporations become even stronger because they can finance expansion, buy out competitors and increase their profits in a way that smaller entities cannot. Ultimately, this leads to concentration of capital in the hands of the largest companies and investors, which further fuels the rise in stock prices, as most large, global corporations are publicly listed companies.

Redistribution of wealth – who gains and who loses?

One of the key effects of Cantillon is unequal distribution of benefits from money creation. Those who receive the new money first – banks, investment funds, large corporations and investors – benefit from the increase in asset value. In turn, those who receive the newly created money last, including employees, experience negative effects, such as an increase in the prices of goods and services without a proportional increase in their income.

This means that the creation of new money benefits primarily the following:

• Stock market investors – thanks to the inflow of new capital, share prices are rising;
• Property owners – the value of their assets increases;
• Large corporations – they can borrow cheaply and finance development;
• Banks and investment funds – they have access to cheap money and can invest it in financial assets.

In turn, they lose:

• Employees and people who keep savings in cash – inflation reduces their purchasing power.
• Small and medium-sized enterprises – have relatively limited access to cheap capital.
• New investors entering the real estate market – high prices make purchasing an apartment increasingly difficult.

Most people do not invest in the stock market, and therefore do not benefit from the growth in this sector. This happens for various reasons, but one of the main ones is certainly the lack of trust and proper education in this area, and therefore, simply fear.

Meanwhile, when it comes to the U.S. stock exchange, as of today, 50% of all shares are owned by the TOP 1% of wealthiest investors who, due to the phenomenon discussed in this article, are getting richer, deepening the already huge gap that divides the richest 1% and the middle class and poor people.

The Cantillon effect shows that central banks and monetary policy favor financial markets and asset owners. Therefore investing in stocks is the best way to protect capital from inflation and the effects of money printing.

Investing in the stock market and risks and threats

Although the Cantillon effect favors stock market investors, it does not mean that investing in the stock market is risk-free. Every investor should be aware that financial markets can be unpredictable, and long-term growth does not eliminate periodic declines and crises, within which an investor can make a whole range of different mistakes. No matter how favorable monetary policy is, bad investment decisions can lead to losses.

Therefore, it is important to approach investing with caution and be aware of the potential risks.

Stock markets are characterized by high variability, which means that stock prices can change dramatically in a short period of time. Even if the long-term trend is up, in the short term investors can experience significant unrealized losses (or realized losses if the decision is made to close a position). Market sentiment can change as a result of geopolitical events, recessions, monetary policy changes or investor panic. Macroeconomic data (inflation, interest rates or financial results of companies) can influence investors' decisions and lead to sudden movements on the stock market, which in turn can be amplified by algorithmic transactions and high frequency trading (High-Frequency Trading, HFT).

In addition, long-term monetary expansion can lead to excessive growth in asset prices, which may end in a speculative bubble. After such a bubble bursts, zazwyczaj deep declines are coming.

Moving on, one of the most common mistakes investors make is allocating all capital to one company, sector or asset class. Such a strategy can lead to huge losses if the chosen investment turns out to be unsuccessful. Before investing, it is therefore necessary to think carefully about the investment strategy and risk management strategy.

Investing in the Stock Market: Summary

The Cantillon effect explains why newly created money ends up in financial markets in the first place and how this affects the price increases of assets such as stocks, real estate and commodities. History shows that those who understand this mechanism and position themselves appropriately can benefit from it, while those who keep their savings in cash or low-interest deposits, are gradually losing their purchasing power.

At the same time, as the data shows, if you want protect your assets against inflation, build capital over the long term and use the Cantillon effect to your advantage, investing in the stock market is the best strategy to achieve this.

At the same time, it is worth remembering that in practice there are many ways in which an inexperienced stock investor can lose money. So, in order not to get discouraged (because, as the article proved, it is not worth being negative about stocks), it is worth taking care of proper education stock and technical, think about the investment strategy and risk management strategy and base them on real market data. However, if this seems to be too time-consuming for you or you simply do not want to do it, it is worth considering finding a professional who will help you with this.