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Bond MarketPrimer: The Cantillon Effect

Primer: The Cantillon Effect

The Cantillon Effect is the label applied to a process described in Richard Cantillon’s , «Essai sur la nature du commerce en général», published in 1755. (One English translation of the title is “An Essay on Economic Theory.”) The basic premise is that an initial inflow of money will raise prices as the original recipients of the money spend it, which will then raise other prices as the “new money” enters others’ hands.

The version of the theory in the original referred to an inflow of gold, such as from new mines, or taken from the Americas. In the case of a mine, the mine owner and workers will be spending the new gold on things like fancy shovels and luxuries in the town near the mine.

Since we no longer base our monetary system on gold coins, we do not have mines creating new money. Instead, we have “money printing,” and so the Cantillon Effect now refers to the effects of this.

The modern populist version of this is that the central bank “prints money,” and the first recipients of this money are either “Wall Street” (or The City in London, Bay Street in Canada, etc.), or “the banks.” These first recipients of the money are sharp enough to know what is going to happen, and so they rush out to buy equities or other risk assets.

In the 2010s, this story was used to explain why there was no hyperinflation in response to “money printing” (Quantitative Easing). The “money” allegedly made its way into financial markets and the upscale luxuries consumed by financiers. The money did not trickle down to the masses, hence there was no broad-based inflation that shows up in the CPI. (That said, fans of the Cantillon Effect would also be likely to argue that the CPI is bogus.)

Not Saying Too Much

I largely think the generic concept is correct, that is not saying too much. In practice, the Cantillon Effect is either used to complain about the nefarious financial sector (popular among the populist right) or used an excuse as to why a high inflation call failed.

From a high-level standpoint, equity markets are considered a leading economic indicator (that is, they move ahead of the business cycle, e.g., the level of GDP), whereas inflation is a lagging indicator (that is, they move later than the business cycle). This can readily by explained by the fact that investors are supposed to be embedding economic forecasts into the prices that they are willing to pay for financial assets – no need to invoke money creation. Meanwhile, inflation appears to react to “tightness” in the economy, and thus tends to rise after a period of growth. So, we do not need the Cantillon Effect to explain stock prices rising ahead of the prices of other goods and services.

And if we look at “money creation,” it is typically associated with the purchase of something in a fiat economy.

  • Bank money is created by new (net) lending. It is rare for people to borrow money for the sake of having a larger bank balance – they buy something with the proceeds (house, renovations, a car, business equipment). It is not “the money is created, and the people rush out to buy something” – the money was created because they wanted to buy something. If we want to look at financial asset markets, bank loans are not a major source of leverage in the modern era, rather investors use margin, derivatives, and repurchase agreements (which might only get into the widest monetary aggregates, like M4). The major market one could point to for the Cantillon Effect is housing – people enthusiastically borrowing to buy houses tends to raise their price. No kidding.
  • Government money growth can be the result of deficit spending. All major economic schools of thought agree that government spending can cause inflationary pressures – the debate is about the size of any effect.
  • Central bank purchases of bonds – Quantitative Easing (QE) – increases government money while reducing the number of bonds (typically government bonds) outstanding in the private sector. This has been the most important source of discussion of the Cantillon Effect – critics argued that QE generated asset bubbles. How far asset prices rose solely because of QE is disputed – I am in the camp that the effects were negligible (outside an initial period where the purchases stabilised risky asset prices when private sector balance sheets were strained during the Financial Crisis of 2008).

Concluding Remarks

It is not surprising that asset market prices rise ahead of price indices like the CPI. Since money creation is normally associated with spending in a fiat currency, there is no equivalent to new gold mines driving money supply growth, with an associated local economic stimulus. As such, it is unclear how much Cantillon’s insights translate to the modern era.

References and Further Reading

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(c) Brian Romanchuk 2023


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