What is money: Part 5 - Problems with fiat money: The Cantillon effect

Welcome back to the What is money series. In this episode we shed light onto the so called Cantillon effect. The Cantillon effect describes the uneven effects the production of new monetary units (and the inflation that goes along with it) has on different kinds of actors and goods in an economy. This is a very important phenomenon to understand.

Richard Cantillon, an Irish-French economist first wrote about this phenomenon, based on the observation that market prices are not derived through intrinsic value but through supply and demand.

Cantillon therefore concluded the following:

• Inflation occurs gradually over time. When new money is added to the economy, it will raise the price of goods and assets, but not at the same time. The Cantillon Effect acknowledges that the first recipients of the new monetary units, are able to spend the money before prices increase, thus profiting from an arbitrage opportunity, effectively buying goods and assets at a discounted rate. As the newly created money flows from central banks to private banks to investors down to ordinary citizens, prices gradually begin to reflect the increase in the money supply. By the time ordinary citizens experience the increased money supply, market prices will have adjusted already and the respecitve goods need to be bought after the prices have increased. The flow of new money through the economy is therefore beneficial to those who receive the funds first. Individuals and institutions that are closest to the central bank – banks and lobbyists – are granted financial advantages which come at the cost of ordinary people, as they are least connected to the financial system.

The closer you are to the source of money creation, the more you benefit. Respectively, the further away you are from the source of money creation, the more disadvantaged you are.

• Inflation is relative. When new money is added to the economy, it will raise the price of goods and assets disproportionally. Not all goods and assets are equally scarce and easy to produce. Inflation will raise the prices of scarce, difficult to produce, things disproportionally, because their supply cannot be adjusted as quickly as the demand for them goes up. The newly added monetary units therefore drive up the prices of those scarce, difficult to produce assets like land, real estate, monetary metals, stocks and more. When looking at societies one finds that these assets are usually owned by upper class, wealthy individuals. Lower and middle class individuals often do not own substantial assets. As a result those already in posession of scarce assets see the value of their possessions rise, while they simultaneaously become less and less affordable to those who do not own them. In other words inflation significantly contributes to the widening of the wealth gap by disproportionally driving asset prices up.

The more inelastic the supply of any good, the more affected its price will be by the introduction of new monetary units. Inflation therefore affects assets disproportionally.

We learned that human beings naturally try to make more of the thing that is being used as money because it gives them an advantage. The Cantillon Effect explains how the addition of new monetary units benefits certain parties while disadvantaging others. The following graph shows the movement of new money with time in the US economy. Similarly it happens throught every economy.

New Money flowing through the system

In Episode 2 we investigated how the European mass production of aggry beads resulted in the transfer of wealth from the Africans who could not produce the thing used as money to the Europeans who could. Africans had to earn the pearls, Europeans could simply produce them. The mass production of bank notes follows the exact same logic. The transfer of wealth in this case is from the later recipients of new money to the earlier owners of new money.

"Money production... redistributes real income from later to earlier owners of the new money." - Jörg Guido Hülsmann

We can all carefully examine ourselves, where we sit in the ranking of recipients of newly added monetary units and what that means for us. The bank notes we use as money today are printed on paper. But this process is not open to all of us. We citizens need to earn the banknotes and numbers on our screen, central banks can simply create them out of thin air and allocate them where they want. The underlying process is one and the same. Every central bank in this world derives its validity from one key concept, which is: "You and me, we are not the same." And we have willingly accepted that premise.

Inflation is legalized counterfeiting and counterfeiting is criminalized inflation. - Robert Breedlove

In the next epsiode of the What is Money series we will examine the wide-ranging effects the Nixon shock has had on our society and why the question "WTF happened in 1971?" is not asked often enough.