The Cantillon effect, or the science of why it is worth owning shares

The world is not fair. People with more capital have an easier life and can use their advantage to further strengthen their position over less well-off people. A wealthier person can provide themselves with better education, create structures that reduce taxes, or extend their life thanks to access to better doctors and private treatments. It is therefore not surprising that wealth is unevenly distributed among people. Do you know what it is Cantillon effect? NO? We invite you to read this article, in which we will focus on the impact of monetary policy on social stratification. You will learn about, among others:

1. Who was Richard Cantillon and why did he have many enemies;
2. What contribution did this person make to the development of economics?
3. Examples of the Cantillon effect in the real economy.

Cantillon's story - speculator, debt collector, playboy

Richard Cantillon. Source: wikipedia.org

Richard Cantillon was a famous economist and financier who lived at the turn of the 17th and 18th centuries. He was born in Ireland in the late 17th century, his father was a landowner who had an estate near Ballyheigue. In the early 18th century, Richard moved to France, where he quickly obtained French citizenship. Thanks to this, he could take advantage of the enormous prospects offered by one of the most powerful countries in the world. His career began at the end of the Sun King's reign. In France, he developed a career in banking and specialized in money transfers between Paris and London. His path crossed with John Law, who promoted the use of credit money.

After the wars led by Louis XIV, France found itself in a terrible financial condition. This resulted in the regent Philip II of Orleans offering John Law the position "Comptroller General of Finance". He eagerly took advantage of the opportunity. Cantillon joined the project. A key element “new economy” was Mississippi Company, which was supposed to generate huge profits for its shareholders. Credit expansion powered “paper money” caused the Company's shares to grow rapidly. This was due to investors' high hopes for profits from the exploitation of North America. The shares rose very quickly from 500 francs per share to 10 francs. At this point, Cantillon began selling its shares and offering high-interest loans to investors looking to make money “a safe and profitable investment”. Importantly, the loan was not secured by shares, but by other property owned by investors. This was because our hero expected the shares to become worthless. After the Mississippi Company's shares rose to 15 francs, there was a dramatic decline in the company's value. The bear market caused the value of shares to drop by 97%, which made many people bankrupt.

Just as the bubble was about to burst, Cantillon left Paris for Amsterdam. While John Law was fleeing from the angry mob of Parisians, Cantillon was counting the profits. In the years after the bubble burst, he ruthlessly collected debts owed to him. This caused that he made a lot of enemies, which may have influenced his further fate. Profits from speculation and his role as a debt collector caused Richard Cantillon to buy more residences and live like a playboy. He also surrounded himself with a group of flatterers and dark people. Many financiers and aristocrats had a less than favorable opinion of our hero. Despite this, his wealth allowed him to shine in the salons. The death of the famous speculator is shrouded in mystery. In 1734, his residence burned down completely. Along with the tragedy, many theories regarding this event emerged. One of them says that Cantillon was murdered by his enemies. Then the fire was supposed to cover the crimes and erase the traces. Another theory is that Richard deliberately faked his death in order to live out the rest of his life in peace without fear of being killed by one of his many adversaries.

However, apart from life as a speculator, adventurer, debt collector and playboy, Cantillon was also a scientist. He presented his thoughts in his famous work, which we will mention later in the text.

General considerations on the laws of trade - Cantillon reveals his cards

The time of retirement and clipping coupons can sometimes be boring. It is therefore not surprising that Cantillon decided to pursue scientific work. A desperate person grasps at anything. His great self-confidence caused him to put down on paper his views on the economy, money and price formation. Around 1730, the work saw the light of day “Essai sur la Nature du Commerce en Général” (i.e. General Considerations on the Laws of Trade).

Richard Cantillon himself was able to present thoughts based on simple examples in his work. One of them is the description of a person from North America who came to Europe to sell beaver skins for hats. However, it turned out that there are woolen equivalents available on the market that also fulfill their functions. If customers are not interested in beaver hats, it does not matter what costs the seller incurred. If the demand for "American" products was high due to purchasing preferences, the profits may many times exceed the costs incurred for the production and transportation of beaver fur products.

In the above-mentioned book, Cantillion shares his thoughts on the impact of increasing the quantity of money on prices.  In his considerations, he gave the example of an increase in the amount of money that will come from mines gold i silver in the country. According to him, initially, the owners of mines, metallurgists and refiners will benefit from the increased supply of ores. This will result in an increase in their consumption, i.e. goods such as, among others: meat, wine or wool. Greater consumption will increase the prices of these goods. This in turn will reduce the purchasing power of ordinary people who do not work in the mining industry and have fixed prices. Their salaries will not increase, but the prices of the products they usually buy will. However, farmers who will achieve higher income from the sale of agricultural products will benefit. The Cantillon effect is a situation where the relative prices between particular goods and services change as a result of an increase in the money supply.

The book states:

“A river flowing and rising will not double its rate when its water is doubled.”

This means that the prices of different products cannot increase at the same rate. The money always goes somewhere first, causing a sequence of price disruptions and the establishment of a new equilibrium level. According to the above-mentioned logic, the greatest beneficiaries are people, companies and institutions that receive new funds first. Then, the beneficiaries' consumption causes the prices of specific goods to increase (according to their preferences). This also benefits the producers of the above-mentioned goods, whose prices rise faster than their costs. This contributes to improving the sales margin. There is also a change in relative prices, i.e. a comparison of the relationship between the prices of given goods. If the price of wine increases faster than that of beer, then wine is relatively more expensive than before the price increase. Therefore, an increase in money in the economy does not result in a proportional increase in all prices. It always happens "disorder", which changes only selected prices the most.

The author of this work believed that if additional funds went to lenders, there would be an increase in the supply of credits and loans. This will lead to an increase in investment and a reduction in interest rates. According to Cantillon, loan interest rates depend on the mutual relationship between sellers and buyers. An increase in the supply of loans and credits causes the interest rate to fall, while an increase in demand for loans contributes to an increase in the interest rate.

Richard also analyzed the impact of changes in the money supply on international balance. According to him, in the long term, the market always tends to monetary equilibrium, i.e. it succumbs to the so-called the metal flow mechanism. He dealt with the above-mentioned issue before David Hume. Cantillon's book was named by W. S. Jevson "the first treatise on economics". FA Hayek also expressed favorable opinions about our today's hero.

Cantillon effect – examples

Politics since abandoning the gold standard Federal Reserve favors owners of capital, real estate and investors. The losers are the wage earners. In effect the gap between the richest 10% and the poorer half of society is at some of the highest levels. In the US, there are leading commercial and investment banks and other important Wall Street firms “distributors” new money into the economy. They offer the capital received from the central bank to other entities, either through loans and credits or through investments on the capital market.

The policy of stimulating demand on the housing market produces the Cantillon effect

According to Cantillon's theory, the beneficiaries of monetary policy are the people and institutions that are closest to the funds going into the economy. For example: if the government introduces preferential loans for the purchase of apartments (how do we know this?), the beneficiaries of such a policy are owners of apartments and building plots, real estate agents, flippers and real estate developers. The poorer part of society loses out as it will be able to buy a smaller apartment than before such a policy (if it does not qualify for such a program). The reason will be that increased demand will increase real estate prices. It can be expected that this situation will also cause an increase in the prices of luxury products, because Entrepreneurs will use more income from their companies to emphasize their status. This will therefore increase the income of producers of expensive handbags, cars, jewelry and watches.

The Cantillon effect through an increase in the prices of financial assets

In the 21st century, central banks used loose fiscal policy. This involved reducing interest rates to very low levels and introducing the so-called QE, i.e quantitative easing. The inflow of new funds to the capital market through financial institutions may result in an increase in share and bond prices. This will mean that the beneficiaries of the increase in QE will be primarily investors and business owners. When the money supply goes directly to the capital market, instead of to the real economy, the "Kowalskis" may not feel the inflow of more funds into the economy. The effect of such a policy will be to widen the wealth gap between those who have and those who do not have financial assets. This was clearly visible during the use of "covid" packages in the USA. Then, aid for entrepreneurs resulted in an increase in sales of companies offering premium and luxury products. Startup owners also benefited and were able to sell shares in their companies for huge amounts of money. Share holders were also beneficiaries, as capital flowed widely into the equity securities market. It was similar after the bubble burst in 2008. The increase in the money supply resulted in an increase in the value of stocks and real estate, which grew much faster than earnings. As a result, the rich in the United States began to get richer faster, while the middle class began to shrink.

Summation

The Cantillon effect describes an economic phenomenon in which the money supply affects the economy unevenly. Those who receive the new funds first benefit most from the change in supply. Due to the fact that the economy adapts to the new equilibrium slowly, there is a change in the structure of prices and the allocation of resources in the economy. Who will get it first “new measures”, he will be able to invest or consume at lower prices before the money supply affects inflation. The Cantillon effect may lead to increased wealth inequality because loose monetary policy mainly benefits holders of financial assets, real estate and companies. The lower and middle classes relatively lose out from such policies. It is worth mentioning, however, that attempts at redistribution using communism or the socialist system a la the Polish People's Republic ended in failure. In some cases, in addition to the impoverishment of society and technological backwardness, crimes against humanity were added (e.g. the USSR or Cambodia Khmer Rouge).