Money, Inflation and Business Cycles: The Cantillon Effect and the Economy 0367086654, 9780367086657

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Money, Inflation and Business Cycles

Who would disagree that money matters? Economists have yet to sufficiently explore issues related to monetary inflation in relation to the Cantillon effect, i.e. distribution and price effects resulting from uneven changes in the money supply and their impact on the economy. This book fills this important gap in the existing literature. The author classifies the various channels through which new money can be injected into the economy and demonstrates that it is not only the increase in money supply that is important, but also the way in which it occurs. Since the increase in money supply does not affect the cash balance of all economic entities in the same proportion and at the same time – new money is introduced into the economy through specific channels – a distribution of income and changes in the structure of relative prices and production occur. The study of money supply growth, carried out in the spirit of Richard Cantillon, offers an important analytical framework that facilitates the development of a number of sub-disciplines within economics and provides a better understanding of many economic processes. It significantly explores the theory of money and inflation, the business cycle and price bubbles, but also the theory of banking and central banking, income distribution, income and wealth inequalities, and the theory of public choice. This book is therefore an important voice in the fundamental debate on the role of monetary factors in the economy, as well as on the effects and legitimacy of a loose monetary policy. In 2017, the doctoral dissertation on which the book is based was awarded the Polish Prime Minister’s prize. In these times of non-standard monetary policy and rising income inequalities in OECD countries, the focus on the distribution effect of monetary inflation makes this a must read for researchers and policy-makers and for anyone working in monetary economics. Arkadiusz Sieron´, PhD, is as an assistant professor at the University of Wrocław, Poland. He is a member of the board of the Mises Institute of Economic Education and author of several dozen scientific publications (including in such periodicals as the Quarterly Journal of Austrian Economics and Prague Economic Papers). He received scholarships at The Ludwig von Mises Institute in America (2014 and 2018 Summer Fellowships), won the 2018 Lawrence W. Fertig Prize for the best paper advancing economic science in the Austrian tradition in 2017, and placed third in the 6th International Vernon Smith Prize for the Advancement of Austrian Economics.

Routledge International Studies in Money and Banking

94 The Rise and Development of Fintech Accounts of Disruption from Sweden and Beyond Edited by Robin Teigland, Shahryar Siri, Anthony Larsson, Alejandro Moreno Puertas, and Claire Ingram Bogusz 95 Money, Markets and Capital The Case for a Monetary Analysis Jean Cartelier 96 Monetary Equilibrium and Nominal Income Targeting Nicolás Cachanosky 97 Distance, Rating Systems and Enterprise Finance Ethnographic Insights from a Comparison of Regional and Large Banks in Germany Franz Flögel 98 Financial Markets of the Arab Gulf Power, Politics and Money Jean-François Seznec and Samer Mosis 99 Performance Measurement Systems in Banks Rahat Munir and Kevin Baird 100 Financial Literacy in Europe Assessment Methodologies and Evidence from European Countries Gianni Nicolini 101 Money, Inflation and Business Cycles The Cantillon Effect and the Economy Arkadiusz Sieron´ For more information about this series, please visit www.routledge.com/series/ SE0403

Money, Inflation and Business Cycles The Cantillon Effect and the Economy

Arkadiusz Sieron´ English translation by Martin Turnau

First published 2019 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN and by Routledge 52 Vanderbilt Avenue, New York, NY 10017 Routledge is an imprint of the Taylor & Francis Group, an informa business © 2019 Arkadiusz Sieron´ The right of Arkadiusz Sieron´ to be identified as author of this work has been asserted by him in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Names: Sieron´, Arkadiusz, 1988- author. Title: Money, inflation and business cycles : the Cantillon effect and the economy / Arkadiusz Sieron´. Description: Abingdon, Oxon ; New York, NY : Routledge, 2019. | Series: Routledge international studies in money and banking | Includes bibliographical references. Identifiers: LCCN 2018049162| ISBN 9780367086657 (hardback) | ISBN 9780429023644 (ebook) Subjects: LCSH: Money. | Inflation (Finance) | Business cycles. Classification: LCC HG221 .S575 2019 | DDC 338.5/42--dc23 LC record available at https://lccn.loc.gov/2018049162 ISBN: 978-0-367-08665-7 (hbk) ISBN: 978-0-429-02364-4 (ebk) Typeset in Bembo by Taylor & Francis Books

To my family

Contents

List of illustrations Acknowledgments Introduction 1 Neutrality of money

viii x 1 4

2 The theory of the Cantillon effect

15

3 The Cantillon effect in the history of economic thought

30

4 Classification of the Cantillon effect

53

5 The Cantillon effect and credit expansion

72

6 The Cantillon effect and the secondary characteristics of the business cycle

78

7 The Cantillon effect and price bubbles

95

8 The Cantillon effect and inequalities in income and wealth

104

9 The international Cantillon effect

114

Synopsis and final conclusions Appendix References Index

125 132 139 156

Illustrations

Figures 1.1 Key factors in (dynamic) non-neutrality of money 2.1 The relationship between monetary inflation, the Cantillon effect, and non-neutrality of money 2.2 Schematic of the Cantillon effect 2.3 Selected types of inflationary distribution of income 2.4 The role of the Cantillon effect in the business cycle 4.1 The ways in which money supply in a given economy may be increased, whether new money units are created or not 5.1 Diagram of the impact of the Cantillon effect resulting from credit expansion on the term structure of interest rates 6.1 Share of investments in securities and loans and leases in total assets of commercial banks in the United States in the period from January 1947 to May 2014 6.2 Values of investments in securities and various types of loans granted by commercial banks in the United States between 1960 and 1980 6.3 Value of investments in securities and various types of loans granted by commercial banks in the United States between 1980 and 2014 6.4 Percentage composition of loans granted by commercial banks in the United States between January 1947 and May 2014 7.1 Channels through which a growing money supply impacts asset prices 7.2 Ratio of market capitalization to GDP in the United States in the period from 1989 to 2010 7.3 Growth in the supply of real estate loans and total loans granted by American commercial banks in 1998–2009

7 17 19 19 24 54 76

87

88

88 89 96 97 99

Illustrations 8.1 Channels through which the Cantillon effect impacts income and wealth inequalities 9.1 Channels of international credit expansion and Cantillon effect A.1 “Family Portrait” by Nicolas de Largillierre, allegedly depicting Richard Cantillon with his wife and daughter A.2 Cover page of the original issue of the Essay on the Nature of Trade in General

ix 107 116 133 134

Tables 1.1 Types of money neutrality 4.1 Selected market and non-market methods to increase money supply in the national economy 4.2 The most important differences between the channels of increasing money supply 6.1 Differences between the banks’ creation of deposits by granting loans and by acquiring securities 6.2 The most important differences between granting various types of loan 6.3 Preliminary classification of business cycles due to the dominant credit expansion channel

5 55 67 80 84 91

Acknowledgments

Most of all, my thanks go to Professor Witold Kwas´nicki and Doctor Mateusz Machaj without whom this book would most certainly never have been created. I would also like to thank Professors Dariusz Filar and Stanisław Rudolf for their valuable remarks on the doctoral thesis, which greatly helped to improve the book version. Moreover, I would like to thank the participants of the Cassirer seminar for their critical approach and extraordinarily valuable comments. My thanks go also to the Ludwig von Mises Institute who generously offered me a Summer Fellowship in 2014, during which I conducted part of my research on the Cantillon effect. Finally, I am grateful to my loved ones for their endless support.

Introduction

Imagine, dear Reader, that a helicopter (or, if you prefer modern gadgets, a drone) flies over your town and drops money. Let’s suppose that it does so in a particular way: the new, crisp banknotes and jingling coins drop from the sky precisely at the same moment and they double the amount of money that each inhabitant has in their possession. What do you think will happen next? If your answer is “generally, nothing”, I have to congratulate you. You think exactly like the Nobel laureate, Milton Friedman – the author of this little story. Each inhabitant’s wallet will simply be twice as thick. And while they will most likely want to spend that extra cash, from the whole economy perspective the amount of money will not decrease (assuming that it’s a closed town, not trading with others). The amplified spending will therefore cause prices to rise and eventually the economy will find a new equilibrium with nominal wages and prices doubled, but with the real variables effectively unchanged. We could, therefore, say that money is neutral – an increase in money supply does not impact the real variables, only the nominal variables. The problem with this example is that it’s unrealistic. In the real world, helicopters (or drones) don’t drop money – but even that isn’t the biggest problem. The crux of the matter is that changes in money supply don’t impact cash balances of various business entities proportionately and at the same time. Quite the contrary, new money is introduced into the economy exclusively through selected channels, a method that leads to changes in income distribution and to reshuffling in the structure of relative prices and production. This causes money to not be neutral, even in the long term. The phenomenon is called the Cantillon effect (also known as the first-round effect) and it’s what the book you’re holding in your hands is about. The book is a modified version of my doctoral thesis entitled “The Effects of Money Supply Growth from the Perspective of Cantillon Effect”, which was supervised by Professor Witold Kwas´nicki and Doctor Mateusz Machaj (assistant supervisor). I defended the dissertation (with honors) at the Wrocław University of Economics in October 2016. In 2017, the thesis was selected for the President of the Council of Ministers Award. Fragments of the work, which have been successively published in scientific journals (both domestic and foreign), are thusly identified in this book.

2

Introduction

The inspiration for my treatise was the assertion by Skousen (1990) that there are several practical aspects to the deepening or lengthening of the structure of production, as well as Huerta de Soto’s (2006) suggestion that new money may be introduced into the economy not only through the banks and their narrowly defined credit channel. Originally, I planned to research if business cycles are affected by the methods in which money is introduced into the economy and by whom, as well as who receives it and how they spend it. Initially, I treated those issues as loosely connected, but after some time, I realized that what’s at play in every case is the Cantillon effect (which I will define more precisely in the second chapter – for now I’m asking the Readers for a bit more patience), only at a different distribution stage of the newly created money. I started to follow the money. I wasn’t looking for corruption scandals, though. I wanted to answer the question of the differences between the means of introducing money into the economy and distributing it through different channels. While it is true that since the “monetarist counter-revolution” the economists have begun to notice that money matters, they haven’t been interested in disaggregated study of monetary inflation and its impact on business cycles. It’s hard to say exactly why there is such lack of systematic coverage of the Cantillon effect in literature. Perhaps it’s because of focusing on other causes of non-neutrality of money, such as imperfect information or price rigidity. It’s also possible that Richard Cantillon’s works have been omitted because, after all, he had created them before Adam Smith, who is widely considered today to be the father of economy. But it was in the treatise of this Irish economist, written most likely in the 1730s and published a few decades later, entitled Essay on the Nature of Trade in General (Cantillon 1959 [1755]), that I found the starting point for my dissertation. What’s more (I hope the Readers will not consider this a lack of humility on my part – but truly, the literature on this subject is extremely scarce): my book is the first one to delve so deeply into and to talk so broadly about the Cantillon effect, as well as to undertake such a disaggregated study of monetary inflation and its impact on business cycles. It is also the first to systematically classify the different channels through which new money may be introduced into the economy, including typology of business cycles according to how credit expansion occurs. In times of loose and non-standard monetary policy on the one hand and growing income inequality in OECD countries on the other hand, examining this distribution effect of monetary inflation, a subject omitted in literature, is of particular importance. The book deals with issues primarily in the area of monetary and inflation theory, making a statement in the critical debate on the role of monetary factors in the economy. It should, however – at least I hope it will – inspire Readers interested in the business cycle theory, price bubble theory, income distribution theory, and even the history of economic thinking. In this book, I look at the consequences of the Cantillon effect. Drawing on the achievements of the Austrian School, I argue that due to this effect, money

Introduction 3 is not neutral, not even in the long term. I also attempt to demonstrate that what’s important for the economy is not merely increasing the money supply, but the methods of increasing it. This is because various channels of monetary inflation result in different forms of the Cantillon effect (they impact income, price, and production structures in different ways) and their influence on the real economic phenomena, including business cycles, is dissimilar. I will risk an assertion that my work is significant not only for theoretical reasons, but also because of its implications for business practice and broadly understood economic policy. Better understanding of the business cycle and its so-called secondary characteristics through a more disaggregated analysis of credit expansion (that is distinguishing its different types, depending on how and where the new money supply ends up) may be valuable not only from the purely cognitive point of view, but also for investors and decision makers responsible for shaping monetary policy. After all, the Cantillon effect causes the real changes in money supply to occur not only in the short term – as many researchers believe – but also in the long term. What’s more, the firstround effect undermines the economists’ rationale for focusing on general price level and it may explain many economic phenomena, such as: price bubbles, business cycles, and rising inequality of income and wealth. Thus, a careful study of the outcome of increasing money supply seems to be key to the debate on the effects and validity of expansive monetary policy. My work is theoretical in nature; however, the conclusions drawn from the analysis are compared with statistical data on significant historical and contemporary cases of monetary inflation in various countries (primarily though, due to the accessibility of data, in the United States). The book informally consists of three parts. The first part is a theoretical introduction, in which I present typology of money neutrality (Chapter 1), define the Cantillon effect (Chapter 2), and present its significance in the history of economic thought (Chapter 3). Such analysis permits proper treatment of the Cantillon effect on a broader canvas of historical and theoretical background. In the second part, I present classification of the Cantillon effect, according to which channel the new money is introduced into the economy, showing the variances that occur with different mechanisms of increasing money supply and the significance of those variances for the economy and for business cycles (Chapter 4). Part three focuses on the first-round effect in the process of credit expansion. In this part, I explain the role of the Cantillon effect in credit expansion (Chapter 5), I analyze its connections with secondary characteristics of business cycles (Chapter 6), price bubbles (Chapter 7), and inequalities in income and wealth (Chapter 8). I also investigate the international aspect of the first-round effect (Chapter 9). The book ends with a chapter summarizing the performed analysis, in which I present key conclusions and suggest directions for further research into the Cantillon effect. I have also included an addendum with a short biography of Richard Cantillon and his contributions to the theory of economy, in the hope that it will aid in greater appreciation of the economist’s achievements.

1

Neutrality of money1

The Cantillon effect constitutes an important argument in the debate on the neutrality of money. Before I get into the details, I want to explain what the economists mean when they say that money is neutral. This will provide the necessary context for the proper understanding of the first-round effect. In broad terms, neutrality of money means that monetary phenomena have no impact on real variables. The question of whether money is neutral – and if not, in what way does it affect the real sphere – is one of the central economic issues that every school of economic thought must address. Monetary phenomena, however, may be viewed from different perspectives, which leads to the existence of diverse concepts of money neutrality. Therefore, before we begin discussing neutrality of money, we should define it more precisely. Neutrality of money may be understood as a situation in which the existence of money has no effect on the functioning of the economy, or in which the volume of money has no effect on the real prosperity, or in which changes in money supply during the transition period do not impact the real economic variables, or in which varied pace of changes in money supply does not impact the sphere of real economy, or as a situation in which neither surplus demand for money nor surplus supply appear. Those meanings are shown in Table 1.1 – let’s analyze them now and prove that economists often wrongly color conclusions from one concept of neutrality with conclusions from another concept.

Institutional neutrality2 According to the first view, neutrality of money is defined as a situation in which monetary economy behaves like barter economy.3 In other words, in this definition money “is merely a ‘veil’ that can be removed and relative prices can be analyzed, as if the system was based on natural exchange” (Lange, 1961). Barter market, due to its supposed lack of “frictions”, is a standard benchmark used for analyzing the impact of monetary factors on economy (Hayek, 1935, pp. 130–1). The problem with this view is that barter economy in actuality experiences great frictions – that being one of the reasons which inclined people to begin using money, because it makes trading much quicker and more convenient. To put it another way, there is no sense in comparing monetary economy – which is something qualitatively different – to barter economy, as

Neutrality of money

5

Table 1.1 Types of money neutrality Types of money neutrality

Impact

Institutional neutrality

The existence of money does not impact the functioning of economy

Static neutrality

Quantity of money does not impact real prosperity

Dynamic neutrality

Changes in money supply do not impact real economic variables

Super-neutrality

Changes in the pace of increasing money supply do not impact real economic variables

Monetary neutrality

Existence of equilibrium on the money market, expressed as the MV constant (quantity of money in circulation multiplied by the speed of circulation)

Source: Author’s compilation

for the latter there would be no reason to use money if it were truly free of “frictions” (Visser, 2002). Such approach, named by Schumpeter (2006) the real analysis (as opposed to monetary analysis), was common among classical and neoclassical economists, who maintained that there is so-called classical dichotomy, in which nominal variables can be analyzed completely separately from real variables. Therefore, they treated money merely as numéraire, impacting only the nominal prices, while the relative prices were – according to them – determined solely by real variables (Mill, 2009 [1848]). Mises (1998 [1949], p. 203) describes such approach as follows: The whole theory of catallactics, it was held, can be elaborated under the assumption that there is direct exchange only. If this is once achieved, the only thing to be added is the “simple” insertion of money terms into the complex of theorems concerning direct exchange. In other words, researchers working in this tradition maintained that the introduction of money doesn’t change the economic reality in any way, other than making the exchange of goods easier to perform and that such exchanges will involve two separate transactions.4 The erroneous character of this thinking is largely due to the misconception of the nature of money5 and not appreciating that it is a good, the value of which is established the same way as with other goods or services. It isn’t merely a veil covering the real economy or “the great wheel of circulation” (Smith 1904 [1776]), but a good desired by the participants of the market for its usefulness in an uncertain world and for enabling economic calculations, which, in turn, lead to the creation of advanced economy.

6

Neutrality of money

What’s more, as a common means of exchange, money impacts all other markets. To put it another way, using the thought process of barter economy isn’t wrong in itself, and in some aspects of economy is indispensable; however, economists often draw erroneous conclusions based on this thought process, an example of which is the very concept of neutral money (Mises, 1998 [1949]).6

Static neutrality The second view attributes neutrality to money from the perspective of comparative statics, meaning that social welfare depends not on the nominal amount of money in possession of an individual, but rather on the purchasing power of money – the amount of goods it can buy. According to Friedman (1969b), that is the essence of quantity theory of money. It is true that, historically speaking, John Locke created that theory (which says that increase in money supply leads only to an increase in prices) partly in response to the mercantile view, which stated that wealth is determined by the amount of bullion per se.7 The latter is obviously false, because “society is always in enjoyment of the maximum utility obtainable from the use of money” (Mises, 1953 [1912], p. 142). That statement, however, will only be true within comparative statics. As Mises (1953 [1912], p. 145) continues: If we compare two static economic systems, which differ in no way from one another except that in one there is twice as much money as in the other, it appears that the purchasing power of the monetary unit in the one system must be equal to half that of the monetary unit in the other. Nevertheless, we may not conclude from this that a doubling of the quantity of money must lead to a halving of the purchasing power of the monetary unit; for every variation in the quantity of money introduces a dynamic factor into the static economic system. Unfortunately, many economists draw erroneous conclusions from comparative statics and argue that changes in money supply are neutral in the long term. As Blaug (1985, p. 19) accurately noticed, “this confusion between comparative statics and dynamics is one which we will encounter time and time again in the history of economic analysis.”

Dynamic neutrality So far, I’ve talked about the concept of money neutrality from the perspective of statics. The first view assessed whether the mere existence of money led to any perturbations in the real world, the second assessed whether the amount of money in an economy actually matters. The third view – the one usually associated with neutrality of money – deals with variations in the supply of money,8 therefore conclusions drawn from the analysis of this concept are vital for monetary policy.

Neutrality of money

7

According to this view, money neutrality is achieved when any fluctuations in its supply result only in proportional changes in nominal values. Non-neutrality of money implies – obviously – the opposite case, or a situation in which changes in the supply of money impact real variables, such as production or employment. Non-neutrality of money is the consequence of several factors. The most important ones are shown in Figure 1.1. As may be clearly seen in Figure 1.1, in order for the changes in money supply to impact only nominal variables and nothing else, several conditions would have to be satisfied. First of all, the new money would have to simultaneously and proportionately increase the cash balances of all entities. That assumes the absence of the Cantillon effect, or the price-distribution effect resulting from the uneven changes in the money supply, therefore from the very fact that new money reaches the economy only through certain channels. However, with that effect, some people – those who were the first to receive new money – would be able to spend the newly acquired money in an environment in which prices haven’t changed yet. People further down the line in this “monetary food chain” – when this new money finally reached them – would be met with prices that had already been raised. As can be seen, irregular increases of money supply cause changes in the distribution of income and wealth, as well as changes in the relative price structure (prices of products purchased by the first beneficiaries of increased money supply increase in relation to the prices of products purchased by the later recipients of the new cash). Second, people would have to be aware of the fact that, for instance, the money supply increased evenly and that now everybody has twice the amount

Sources of non-neutrality of money

The Cantillon effect

Price stickiness

Imperfect information

Money illusion (non-rational expectations)

Government interference

Figure 1.1 Key factors in (dynamic) non-neutrality of money Source: Author’s compilation

Transaction costs

8 Neutrality of money of cash at their disposal. As an example, if sellers don’t anticipate that consumers will be able to commit twice as much money to purchase their goods, they won’t necessarily raise prices right away. Individuals would also need to know how the changes in money supply will affect prices. In other words, for the changes to affect only nominal values, everyone should be fully informed and have rational expectations. Take, for example, employees who consider the nominal increase of their paycheck as a real increase, which then inclines them to increase the amount of work they do. The outcomes of monetary illusion have been researched by monetarists. Similarly, if manufacturers take an increase in prices of their products as a relative price increase, without tying it to the increase in money supply caused by the arrival of Friedman’s helicopter, they may increase production. The outcomes of imperfect information – and the resulting “money surprise” – are dealt with by the new classical economics. Third, all prices would have to change simultaneously, as is the case in Walras’ general equilibrium model. Otherwise, the relative price structure would change, which would impact allocation of supplies and production. So, what’s required is not only the so-called price rigidity, but also that everyone would try to spend their nominally increased cash balances at the same time and with identical elasticity of prices.9 Full price elasticity implies, among other things, that information about changes in money supply should be not only full, but also “retroactive”.10 In other words, in situations with long-term contracts, each unforeseen increase in money supply causes real changes. The significance of price rigidity in the adjustment process following monetary fluctuations is dealt with by the New Keynesian school.11 Fourth, it would be necessary to assume an unchanged expenditure structure of business entities. Therefore, in order to avoid any real effects, business entities would have to allocate the newly acquired funds in the same proportions as before not only for consumption and investments (including cash balances), but also for particular goods and services. Fifth, for money to remain neutral in the situation described by Friedman (1969a), people would have to assume its unexpected gain to be a singular event (or that it will occur in predetermined periods and the volume of increase in money supply will be known). Otherwise, the uncertainty regarding the possible arrival of the helicopter might affect the cash balances of business entities and thus the real sphere of the economy. In other words, there would have to be no destabilizing expectations. As can be seen from the above examples, accurate predictions play an important role in the hypothesis of money neutrality; however for money to be neutral, business entities would have to know about not only the increases in money supply and the overall prices, but also the details of the money’s flow through the economy.12 Sixth, money neutrality may refer only to fiat money, currency without intrinsic value, which itself is not a traded commodity nor a claim to it (Zijp and Visser, 1994). This is obvious when you look at gold as money – if its supply increased, the buying power would decrease, thus diminishing the profitability of gold mines and increasing the use of the yellow bullion for non-monetary purposes, which in turn would impact the relative price structure.

Neutrality of money

9

The seventh condition, which may seem obvious, is the non-interference of government, such as price controls or sales quotas. Cantillon (1959 [1755]) recalls a ban on cattle imports to Great Britain and from that example concludes that if consumer demand increased in response to an increase in money supply, meat prices would rise relative to price of bread, as cheaper corn could still be imported from abroad to replace domestic grain that had been made more expensive due to inflation. Also, taxes – since they are calculated on nominal income – would have a significant impact on the fruition of the Cantillon effect. An obvious example is becoming subject to a higher tax rate due to a nominal increase in income, even if real income remains unchanged. The eighth point is that neutrality of money in the fractional-reserve banking system requires a fixed relationship between cash and deposits (Saving, 1973) because the more money people keep in their current bank accounts, the more loans the banks can potentially create, which will have an impact on investment and production. As can be seen, it’s not only the quantity of money (in a broad sense) that matters, but also its structure (base money vs. money substitutes).13 The ninth condition requires the absence of transaction costs tied to storing and transporting large amounts of money or replacing price lists (so called menu costs). Otherwise, even in the case of immediate and proportional change of nominal prices, some of our real assets would be consumed to cover those costs, which would have an obvious effect on the structure of relative prices and production.14 Clearly, the above conditions are impossible to satisfy. It is hardly possible to imagine an economy in which each entity contributes equally to creating money (a requirement if money supply is to increase evenly among society), everyone is fully informed, and all transactions are concluded on the spot (no long-term contracts). So, when economists talk about money neutrality in a dynamic way, they refer only to long periods of time. It’s a common view, though, that money is not neutral in the short term. Different economic schools point to different causes of this phenomenon. Friedman, for example, talked about money illusion, neoclassicists blame imperfect information, while the new Keynesians criticize price rigidity. What is common for all those schools, however, is that they treat real changes that occur in response to monetary changes as a “transition period”, after which an economy returns to its previous growth path. It is known that such temporary effects can last as long as ten years (Fisher, 1922) – hence the conviction that monetary policy matters. There is a belief – its earliest signs can be found in Hume’s (1987a [1742]) work – that through constantly increasing the money supply, it is possible to maintain desirable outcomes attributed to monetary inflation15 and indefinitely delay the end of the transition period. Taking, in a way, an opposite view is the Austrian school, which focuses on the Cantillon effect as the most important cause and does not maintain that real changes somehow blur in the long term.16 On the contrary, it says that monetary phenomena cause permanent changes in the real economy.17

10

Neutrality of money

Summing up dynamic neutrality, while mainstream economists obviously agree that money matters, they still focus on such holistic concepts as “the velocity of money” or “the general price level” and, therefore, cannot explain the mechanism of changes in the value of money. They simply don’t consider the subjective valuations of entities, which effectively determine all market phenomena. As Mises (1953 [1912], p. 142) put it: The mistake in the argument of those who suppose that a variation in the quantity of money results in an inversely proportionate variation in its purchasing power lies in its starting-point. If we wish to arrive at a correct conclusion, we must start with the valuations of separate individuals; we must examine the way in which an increase or decrease in the quantity of money affects the value-scales of individuals, for it is from these alone that variations in the exchange ratios of goods proceed. The initial assumption in the arguments of those who maintain the theory that changes in the quantity of money have a proportionate effect on the purchasing power of money is the proposition that if the value of the monetary unit were doubled, half of the stock of money at the disposal of the community would yield the same utility as that previously yielded by the whole stock. The correctness of this proposition is not disputed; nevertheless, it does not prove what it is meant to prove (…) Half of the money at the disposal of the community would yield the same utility as the whole stock, even if the variation in the value of the monetary unit was not proportioned to the variation in the stock of money. But it is important to note that it by no means follows from this that doubling the quantity of money means halving the objective exchange-value of money. It would have to be shown that forces emanate from the valuations of individual economic agents which are able to bring about such a proportionate variation. Such approach rejects researching the Cantillon effect. The quantity theory of money – often used as a basis for proving neutrality of money – presupposes that production is affected only by the general price level (in both the short and mid term). There is, therefore, no need to analyze changes in relative prices because so long as the overall price level remains stable, production will remain at its “natural” level. What’s more, economists professing this theory do not really explain how changes in the general level of prices affect production and seem satisfied by merely pointing to the correlation between these two aggregates (Hayek, 1935).18

Super-neutrality There is also the concept of super-neutrality, which refers to a situation in which fluctuations in the pace of changes in money supply (it’s no longer just about the changes in the quantity of money) have no impact at the level of real variables, and lead only to fluctuations in growth rate of nominal variables. It’s

Neutrality of money 11 easy to see that neutrality is a prerequisite condition for super-neutrality (Brzoza-Brzezina et al., 2002), but by itself is not sufficient.19 For super-neutrality to exist, it is necessary to presuppose the absence of the Mundell-Tobin effect (Zijp and Visser, 1994). Presently, only theoreticians of real business cycle think that money is super-neutral (King and Plosser, 1984).20

Monetary neutrality The last view of neutrality concerns cases in which no excess of demand for money nor excess supply exist. Therefore, using the MV=PT equation, it doesn’t concern conditions, where increase in M causes a proportional increase in P, only conditions where the product of M
V remains constant. In other words, this view of neutrality concerns situations in which changes in the quantity of money do not, under certain conditions, affect prices and production, because they constitute merely a necessary response to the changes in the velocity of money or the changes in the velocity of money completely offset the increase in quantity. The second option is a so-called liquidity trap, while the first scenario is based on an assumption that an increase in demand for money not fulfilled with an appropriate increase in money supply will cause price deflation, which – assuming the existence of price rigidity (especially wage rigidity) – may lead to depression. The above reasoning is based on Keynesian theory or Yaeger’s theory of monetary disequilibrium, whereby to maintain monetary equilibrium the increase in money demand requires an increase in money supply.21

Summary Presented in this chapter were several views of money neutrality and I explained the reasons for distinguishing between them and precisely defining which type of neutrality is being discussed. I paid particular attention to dynamic neutrality, commonly synonymous with money neutrality. Not only did I define it, but I also presented conditions which must be satisfied for dynamic neutrality to exist, and I explained why, in reality, it does not happen. I showed that while mainstream economics usually posits neutrality of money in the long term, when addressing short-to-mid-term cycles, it is acknowledged that changes in money supply do have an impact on the real sphere. Different schools of economics present different views on the causes of this phenomenon. Monetarists emphasize adaptive expectations, neoclassicists point to imperfect information with rational expectations and the new Keynesians focus mostly on price rigidity. On the other hand, the Austrian school emphasizes the case in which “the monetary injection is not distributed among individuals in exact proportion to their previous shares of money holdings” (Blaug, 1985, p. 634), which is responsible for the non-neutrality of money that exists even in the long term. The concept of neutral money in its most popular view stems from erroneously applying conclusions drawn from static analysis of two equilibrium states to

12 Neutrality of money dynamic market processes (that is equating the hypothetical, final outcome of a market process – such as proportional increase in prices resulting from an increase in money supply – with the market itself), accepting simplified, unrealistic assumptions22 and holistic methodology. It seems, therefore, that the 11th of the 13 most important issues in economics, according to Morgenstern (1972), that demand resolution – that is departure from studying aggregates like “general price level” and more attention to dynamic analysis of money in Cantillon’s spirit – still remains unresolved. I trust that my book is a step in the direction suggested by Morgenstern.

Notes 1 The contents of this chapter were previously published in Polish and in a slightly different form in Sieron´ (2014). 2 Samuelson (1968) uses the term “qualitative neutrality” to describe a situation in which the existence of money is irrelevant to the economic system. 3 In a way, analogous to the interest-rate neutrality according to Wicksell (1978), i.e. a situation in which the market interest rate equals the natural interest rate – that is, the one that would form in barter transaction, as a result of interaction between demand and supply of physical capital goods. In such a situation, the overall price level would be – as Wicksell claimed – stable, which, according to him, meant neutrality. However, as Hayek showed, it would mean only the lack of monetary factors impacting the general price level. In a developing economy, there is a natural tendency for prices of goods to decline due to increasing productivity, so to maintain stable prices, it would be necessary to lower the interest rate and increase the money supply (Hayek, 1935). 4 For other economists – mostly the post-Keynesians (e.g. Laidler, 2010) – the ability to delay the sale of goods and services from their purchase is a fundamental difference between both systems; it consists in the fact that, in the monetary economy, the demand for goods no longer automatically equates to supply (Hayek, 1935). 5 Although, from a theoretical point of view, the analysis of changes in the money supply first requires an understanding of its nature, one may be tempted to say that, in fact, these views on the effects of monetary inflation on the economy have prompted some economists to accept an erroneous concept of money. Classical economists – especially David Ricardo and John Stuart Mill – might have suggested the existence of a classic dichotomy, “thereby opposing the primitive inflationism of their mercantilist predecessors” (Blaug, 1985, p. 637). One can see here the unauthorized application of the conclusions resulting from the dynamic approach (which I discuss later in this chapter), in which changes in money supply affect only prices, for comparative analysis of monetary and barter economy. 6 According to Hayek (1984), the concept of neutral money was created as an instrument of theoretical analysis and should not be used as a benchmark in monetary policy. 7 This can also be expressed that mercantilists believed that changes in the money supply affect the volume of trade rather than prices (Blaug, 1985). 8 It is important to distinguish changes in the name of money from changes in the amount of money. Often the effects of denomination – or rather the lack of effects of this phenomenon on the real sphere of the economy – are invoked as proof of the correctness of the quantity theory of money. This is done, for example, by Fisher (1922), who describes – as one of the examples of how the amount of money in the economy can change – a situation in which the government doubles the

Neutrality of money

9 10 11 12 13

14

15

16

17

13

denomination of money in such a way that what was once a half-dollar becomes a dollar. Similarly, Friedman (1969a) also claims that multiplying a unit of money by one hundred will not cause any changes, other than proportional increase in prices. However, as Mises (1953 [1912]) notes, changing the name of money is something different from changing its quantity. One of the basic differences is that new money always enters the economy through specific channels – not proportionately to all cash balances – while denomination does have a proportionate effect on all money holders. In addition, it is hard to treat the change of the word “half-dollar” to “dollar” as an increase in the amount of money. This would imply that, in a sense, individuals treat the word itself as money. Cairnes (1878) already indicated that due to the differences in price elasticity, prices of various goods would not be adjusted at the same pace as the increase in money supply. I am grateful to Dr. Mateusz Machaj for this expression. Rzon´ca (2014) points out that the new Keynesian analytical scheme used by central banks to analyze the economic situation does not take into account uncertainty, money and credit, but instead emphasizes the importance of price rigidities. More on this in the next chapter. In other words, it is important not only who receives the new money, but also in what form. In other words, it is extremely important what form the newly created money will take in the broad sense of the word. The issue, in a sense, amounts to the Cantillon effect, i.e. the effects of how new money is introduced into the economy – for example, by gold mines, public spending, or perhaps by commercial banks that create deposits. Aschheim and Hsieh (1969, in Zijp and Visser, 1994) mention two other conditions: static price expectations and no portfolio effect, i.e. no modifications in the business asset portfolio due to changes in the money supply. It seems that the latter condition precludes open market operations. On the other hand, static price expectations are incompatible with the condition of perfect price flexibility – on this basis Aschheim (1973, in Zijp and Visser, 1994) concludes that neutrality of money requires … its absence. If, for example, wage adjustments lag behind adjustments of other prices, it can be argued that an increase in the money supply will have a positive impact on production and employment. Another argument, also cited by the classicists, may be the reduction of real burdens in the form of rents, taxes and loans, as a result of the decrease in the purchasing power of money, which encourages entrepreneurs – who are usually net borrowers – to increase production (Humphrey, 1991). What results from the fact that the Austrian school is interested in the study of dynamic market processes, not in the equilibrium states, which it believes the economy aims for, but which it will never achieve because of the unending changes in the economic system. In other words, the Austrian school is not interested in studying a long period or equilibrium conditions, only analyzing the real economic processes, i.e. the succession of many short periods. Although the Austrian school also assumes that the real sphere will eventually adapt to monetary changes (this is how it interprets the crisis phase – as an inevitable response of market forces to disruptions from the monetary sphere), it does not believe that the economy returns to its original balance or balance path. Therefore, it does not consider the growth of money supply as leading only to a proportional increase in prices over the long term. More on this in Chapters 2, 3, and 5. Even changes in money supply would not affect real variables (assuming no menu costs) in only one case (apart from the equivalent increase in the demand for money): if they were accompanied by immediate changes in all monetary prices by the same value (Mises, 1953 [1912]). More on the views of economists from the Austrian school on the neutrality of money and the Cantillon effect can be found in Chapter 3.

14

Neutrality of money

18 It is worth adding here that since the time of Hayek, not only has nothing changed in this matter, but econometric verification of the theory involving the study of correlation coefficients between selected macroeconomic variables has even increased. It’s enough to say that Robert Lucas – the winner of the 1995 Alfred Nobel Prize from the Bank of Sweden in the field of economics – uses this method (referring to statistical correlation) in his Nobel lecture (1996) to prove the correctness of the quantity theory of money. 19 Actually, as Dawid Mikołajczak brilliantly noticed in a private conversation, the condition of neutrality may turn out to be the condition of super-neutrality, if we break the analyzed period into smaller units of time. For example, the annual money supply growth rate of 7% can be divided into the semi-annual money supply growth rates of 2 and about 5%. 20 The school of the real business cycle reverses the cause-and-effect relationship of the observed dependence between monetary aggregates and production, arguing that changes in money supply are the response of commercial banks and monetary authorities to real disturbances in the economy (McCallum, 1986). 21 Patinkin (1969) also maintains a similar position, stating that monetary policy should be pursued in order to neutralize changes in demand for money so that the overall price level remains stable. Hayek (1935) did not agree with the postulate of a stable price level, which was the basis of contemporary monetary policy. He believed that money can have real economic effects even if the overall price level remains stable. For example, increasing the money supply – through credit expansion – following the increase in productivity will lower the market interest rate below the equilibrium level, which – according to Hayek – will cause disturbances in the structure of relative prices. 22 If we were to assume continuous market cleaning and tâtonnement process, then money would be excluded from such an economy. In addition, the assumption about the existence of homogeneous capital makes it impossible to study the impact of changes in the money supply on the production structure, and the assumption of the existence of a representative agent practically excludes the existence of distribution effects that result from various reactions of economic entities to the same monetary phenomena. More on this topic in Chapter 3.

2

The theory of the Cantillon effect1

The aim of this chapter is a theoretical analysis of the Cantillon effect. In it, I define this phenomenon and present how it relates to non-neutrality of money (covered in the previous chapter) and money supply variations in general. The expression “the Cantillon effect”, also known as “the first-round effect”, or “the injection effect”, was introduced in literature by Mark Blaug in 1962 (Hagemann and Trautwein, 1998), who described it rather enigmatically as “the differential effect of cash injection, as governed by the nature of the injection” (Blaug, 1985, p. 21).2 He named the effect in honor of Richard Cantillon,3 who was the first to describe it in his Essay on the Nature of Trade in General (Essai sur la Nature du Commerce in Général), written most likely around 1730 and published in 1755 (Thornton and Saucier, 2010). In his definition, Blaug emphasizes the fact that an increase in money supply affects the economy in different ways, depending on the manner in which it occurs. The impact of an increase in money supply depends on who the first recipients of new money are and what goods and services they will show demand for. The profiles of the initial recipients of new money and their expenditures matter because variations in money supply don’t affect cash balances of all business entities proportionately and at the same time, leading to changes in income distribution and then in the price structure and production. Thus, in this book I follow Blaug’s thinking and propose the following definition of the Cantillon effect: it’s a distribution effect resulting from uneven changes in money supply. There are three things we should look at. First of all, my definition includes the term “changes in money supply”, as those distribution effects occur during monetary inflation as well as deflation. Nonetheless, in my work I focus on the effects of new money flowing through the economy, for both practical and theoretical reasons. The fact that in real economy new money enters only through specific channels and only in certain places – and is not evenly distributed throughout the entire economy as “monetary diffusion” – has much more theoretical relevance, if only for the theory of business cycles and, consequently, for the rationale of economic policy. Secondly, the unevenness of changes in money supply (new money enters the economy through certain channels) means that it affects different business

16 The theory of the Cantillon effect entities – both qualitatively and quantitatively – in very dissimilar ways. In other words, this attribute is the reason that changes in money supply – unlike in Friedman’s example with the helicopter (Friedman, 1969a) – don’t affect all business entities proportionately and at the same time, which leads to changes in the distribution of income and wealth within a society. Thirdly, changes in the distribution of income and wealth lead to reshuffling of relative prices and production. It means that uneven changes in money supply and the resulting Cantillon effect are the root cause of non-neutrality of money. How these concepts are related shall be revealed in the next part of this chapter.

The Cantillon effect, monetary inflation, and the non-neutrality of money From the theoretical point of view, uneven changes in the money supply are neither sufficient nor necessary as a condition for money not to be neutral. It’s not a sufficient condition because unevenness of changes in money supply does not guarantee that money won’t be neutral. Imagine a situation in which people who were the first to receive new money decided in solidarity to destroy it all. In this case, their increased buying power would not materialize in the market (Hume, 1987b [1742]), so it wouldn’t bump up prices and wouldn’t lead to distribution effects. It’s also impossible to reject the possibility that, through some strange coincidence, the structure of expenditures in the society following such increase in the money supply, together with its distribution consequences, would be identical to the structure prior to the increase. Of course, those are purely theoretical cases. In practice, we can assume that unevenness of changes in money supply is, in fact, a condition sufficient for non-neutrality of money.4 At the same time, it is not a necessary condition, as it is also possible to envision non-neutrality of money in situations where changes in the money supply are even. As I have pointed out in the previous chapter, for money to be neutral, there are a few more conditions that must be satisfied, such as: absence of irrational expectations, absence of imperfect information, and absence of price rigidity. It’s clear, then, that unevenness of changes in the money supply is not the sole possible cause of the non-neutrality of money. Other causes – like long-term contracts and associated with it price rigidity or the absence of perfect information – also cause distribution effects. It seems, however, that they should be distinguished from the Cantillon effect for three reasons.5 First, theoretical: the Cantillon effect is caused – by definition – by changes in the money supply, not by price rigidity or the absence of perfect information, which can only impact its particular propagation. In other words, the Cantillon effect refers directly to the process of monetary inflation, while price rigidity or imperfect information are traits of economic reality, in which the increase of money supply occurs. It means that any increase in the money supply is not neutral, even without price rigidity and with perfect information. The Cantillon effect, therefore, is the pervasive

The theory of the Cantillon effect 17 cause of the non-neutrality of money with all increases in the money supply, regardless of assumptions about the process of price formation, the formulation of expectations by business entities, the scope of information they hold, etc. Second, for typological reasons, different economic schools treat different causes (and consequences) of the non-neutrality of money. Third, for historical reasons, as in his pioneering analysis of the phenomenon, Cantillon focused exactly on the uneven increase in money supply. Finally, it’s worthwhile considering whether an increase in money supply has to necessarily go through certain channels or if it’s just an institutional matter, as well as distinguishing monetary effects per se from effects that are strictly the outcome of uneven changes in money supply. This will allow us to better understand the nature of the phenomenon. Monetary inflation would generate certain costs, even if an increase in money supply were uniform and the resulting increase in prices immediate and proportional. Of course, we’re talking about transactional costs, which include menu costs – those costs associated with changing price lists, reprogramming cash registers, updating business software, etc. (Horwitz, 2003) – as well as increased costs of storing and transporting larger amounts of money. The relationship between monetary inflation, non-neutrality of money, and the Cantillon effect is shown in Figure 2.1. In reality, money supply does not increase uniformly – one could even risk the statement that the very nature of money precludes a uniform increase of money supply. A proportional increase in monetary resources requires each entity to equally produce money. While it’s possible to imagine that a central bank could increase the money supply by wiring an appropriate amount of money to each citizen, even in this unrealistic scenario one of the entities (the central bank) would be the first to have the enlarged monetary resources.6

Monetary inflation

Cantillon effect

Price rigidity and imperfect information

Non-neutrality of money

Costs that would exist, even with immediate and proportional change in prices, i.e. menu costs

Other factors

Figure 2.1 The relationship between monetary inflation, the Cantillon effect, and nonneutrality of money Source: Author’s compilation

18

The theory of the Cantillon effect

In the case of commodity money, it’s hard to imagine that the commodity used as money would be widely available to everybody. When it comes to private production of fiat money, there are two scenarios to consider. In the first one, everyone produces their own banknotes at the same rate, according to the concurrent currencies concept (Hayek 1990). However, in that scenario, it’s hard to refer to money as a common medium of exchange. In the second scenario, everyone produces the same medium of exchange. That, of course, would lead to the tragedy of the commons, as everyone would want to produce money faster than others in order to enter the market with higher purchasing power.7 As one can see, any increase in money supply means that money has to enter the market through a specific channel. Therefore, monetary inflation is always accompanied by Cantillon’s effect. Moreover, the sequential distribution of new money through the economy also seems unavoidable. This is because the same money cannot be used simultaneously in two different transactions. Therefore, transactions using the same money must take place one after the other (Bilo, 2013).

The essence of the Cantillon effect The theory of the first round is based on three components (Bilo, 2015): 1) changes in money supply occur through changes in the cash balances of certain individuals; 2) that inclines those individuals to modify their expenditures; 3) the expenditures lead to changes in the relative price structure and production, and to fluctuations in cash balances of the next individuals, which in turn leads to repeating the cycle in subsequent rounds.8 The essence of the first-round effect is shown schematically in Figure 2.2. Monetary inflation leads to complex and multi-faceted distribution of income (see Figure 2.3), the consequences of which are changes in relative price structure and production structure. Following are a few selected types of inflationary distribution of income.9 First of all, if money enters the economy unevenly, it means that some entities have larger cash balances at their disposal with prices still unchanged. As a result of the increase in money reserves at their disposal, and if all else remains the same, they will value each monetary unit less and will, therefore, increase their spending.10 This, in turn, will cause an increase in the prices of the goods being purchased by them. This will increase the incomes of the sellers, who in these new circumstances will also decide to thin out their unexpectedly swollen cash balances. While they will still be in a relatively good position, for them, the prices of some products – those purchased by the first recipients of new money – will have already increased. Certainly, the same logic can be applied to subsequent “rounds of new money being distributed through the economy”,11 until we reach a situation in which some people incur losses due to the fact that they are forced to buy products from previous sellers, before the prices of their own

The theory of the Cantillon effect

19

Increase of money supply

Increase in cash balances of certain individuals

Increase in expenditures of those individuals (changes in the structure of expenditures)

Changes in distribution of real income (income effect)

Changes in the price structure (price effect)

Changes in the production structure (allocation effect)

Figure 2.2 Schematic of the Cantillon effect From late to early recipients of new money

Monetary inflation

Income distribution

From creditors to borrowers

From holders of cash to nonholders

Figure 2.3 Selected types of inflationary distribution of income Source: Author’s compilation

products increase appropriately. In other words, what occurs is a distribution of income from people who the new money reached relatively late to people who received new money relatively early. This is one of the aspects of the so-called income effect.12 The second aspect is income distribution from people receiving fixed income to people making fixed payments.13 Within this dichotomy, we

20 The theory of the Cantillon effect should distinguish distribution from creditors to borrowers (of course, only insomuch as the agreed-upon interest rate doesn’t include an inflation premium of an appropriate amount). It is therefore expected – with all other factors remaining unchanged – that the value of debt instruments and shares of companies that are net creditors will go down, while the share value of net debtors will go up (Kessel and Alchian, 1962). It’s worthwhile to note here that the biggest debtor in an economy is usually the government, which means that monetary inflation causes distribution of resources from the private sector to the public sector. Indeed, Cantillon already remarked that the rulers have always reached for inflation as a way to finance their expenditures.14 The Irish economist even maintained that the national bank (presently the central bank) wouldn’t be particularly useful to the state without public debt (Cantillon, 1959 [1755]). The third aspect, according to Kessel and Alchian (1962), is the distribution of income from entities who keep relatively large amounts of money in cash to entities who keep relatively little cash. Those individuals will economize using cash, which leads to such phenomena as: vertical integration, escape to real values and an increase in land and real estate prices, escalation of barter transactions, rise in foreign currency deposits and exchange rates, as well as the value of shares of companies that keep cash balances in foreign currency, and finally a shift in production processes from more labor-intensive to more capital-intensive (because the necessity of paying the workers’ wages requires a higher cash balance). As one can see, the inflationary income distribution stems from the Cantillon effect. Distribution would not occur only if all nominal values were to change immediately and proportionally to changes in money supply. However, such a situation is the final outcome of the process initiated by changes in money supply and results from the actions taken by individuals in response to the increase in their nominal balances. Thus, the increase in prices of this kind could only occur in the case of perfect expectations formulated by individuals. Besides problems stemming from the fact that business entities would have to know each other’s future preferences, it is important to note that inflation expectations are formulated on the basis of prices from the immediate past, not on the basis of changes in money supply (Mises, 1998 [1949]).15 Should nominal values change immediately and proportionately to changes in money supply, people would not have the motivation to dispose of cash (as price increases would neutralize the increase in nominal cash balances). People try to reduce their cash balances just to get ahead of price increases, which is most visible during hyperinflation.16 However, there are a few reasons that seem to emphasize the importance of the price effect resulting from earlier changes in income distribution. First of all, the distribution of income itself cannot increase the overall wealth of society.17 It can affect the amount of available goods only indirectly, when the distribution of income benefits the classes which will use “their additional

The theory of the Cantillon effect 21 command of money to accumulate more capital than would have been accumulated by those people from whom the money was withdrawn” (Mises, 1953 [1912], p. 208). Still, even in this situation, it seems unlikely that income distribution itself could cause changes in production. Just imagine that at night, someone who is the opposite of Robin Hood takes half of the assets belonging – as Malthus would put it – to non-productive classes and proportionately increases the cash reserves of productive classes. In such a situation it is not obvious that the production would increase. If our analysis begins at a state of equilibrium, it would be necessary to lower the interest rate18 or reduce the time preference of entrepreneurs for them to make more investments that could increase production. Meanwhile, the question of whether the increase in income necessarily causes a decrease in time preference remains unresolved.19 Secondly, price effect is more significant than distribution effect exactly because it is the structure of relative prices that determines the allocation of production factors and, therefore, the size and structure of production (Hayek, 1935). Thirdly, the income distribution scheme presented earlier is highly simplified. It assumes the possibility of isolating and tracing the way in which specific monetary units “dissipate” in the economy. In fact, this is not possible because money is homogeneous, which makes it impossible to distinguish “old” from “new” money (Machaj, 2012).20 What’s more, it does not take into account that price adjustments can precede income changes by the accurate expectations, which means that people far down this symbolic “chain” won’t necessarily lose if they raise prices earlier or invest in a suitable instrument whose price grows along with inflation. Basically, even that is not necessary. It is enough to realize that with the increase in money supply and the increased demand for it, an increase in the price of particular goods benefits all owners of these goods. For example, the rise in real estate prices will result in an increase of wealth of all property owners – regardless of when (if at all) the newly created money reaches them. Nevertheless, the fact that, with the right expectations, price adjustments can precede changes in income does not, of course, mean that Cantillon’s effect would not exist if people correctly predicted an increase in the overall price level. In order for the distribution effect not to appear, individuals would have to anticipate not only the increase in money supply or the increase in the general price level, but also the exact distribution of money in the economy, which is obviously impossible. It is worth considering the example where a producer of a universal medium of exchange announces to everyone – and everyone finds out – that tomorrow it will print 100 million new one-dollar banknotes, thus increasing the money supply in the economy by 10%. Even if everyone raised the price of their products by 10%, then that producer would still be in a better position than he was before the announcement. The only difference is that before the price increase that producer would have had $100 million in purchasing power, and after the increase he or she would be able to purchase goods and services worth $90 million. In order for the Cantillon effect not to occur, business entities would have to know the future structure of

22 The theory of the Cantillon effect spending for all entities, i.e. know exactly what they would spend their money on and increase the prices of those exact products accordingly – thus, by increasing prices, neutralizing their increase in purchasing power. The same applies to the next person, etc. In other words, each person should know not only the exact amount by which the money supply has increased (and usually this is how the perfect information is defined in the context of the non-neutral nature of money), but also its precise distribution among business entities and their future (after the change) preferences that they will manifest through their expenditures. Of course, this is a completely unrealistic assumption, because the preferences of individuals are manifested only though actions, so they cannot be known beforehand to modify prices accordingly.21 So – apart from a completely unrealistic scenario, in which everybody knows everything about everybody22 – the Cantillon effect will occur independently of market expectations, as its essence is not the unexpected change in money supply, but uneven change. With the same increase in money supply, announced and perfectly foreseen by everybody and, consequently, the increase of the general price level, it will still matter who receives the newly created money first. Important here is the conclusion that due to the Cantillon effect, distinguishing between foreseen and unforeseen inflation is improper, because it is not possible to fully predict the effects of an increase in money supply (Horwitz, 2003).23 It’s impossible to predict inflation – in the sense that it’s impossible to guess what effect it will have on the entire price structure and production. We can only talk about a higher or lower degree of foresight that some entities attempt to use to predict the impact of increased money supply on their particular situation and their specific purchasing power, determined by the basket of goods and services, which is unique to every person. In other words, the mere existence of inflation may be more or less intentional, but its effects are not fully predictable. Fourthly and essentially, the most important effect of inflation – from the purely economic, not ethical point of view – is not the distribution of income, but the interruption of the proper functioning of the pricing mechanism. As Horwitz (2003) points out, prices – so long as they reflect real variables, i.e. individual preferences – have the function of coordinating the activities of business entities. Inflation increases informational noise, which makes rational economic calculations more difficult.24 Capital goods are characterized by different levels of specificity; hence part of the capital will be permanently wasted due to misallocation, which will undermine confidence in market calculations and may increase the time preference of individuals (Horwitz, 2006). This “epistemological uncertainty” that weakens the willingness to save will be further increased by the fact that less stable general price structure causes more dispersion in relative prices (Vining and Elwertowski, 1976).25 In this context, it is worth noting that the price aspect of Cantillon’s effect (uneven, sequential character of changes in the price structure) explains the existence of a series of difficulties in pursuing rational monetary policy, such as:

The theory of the Cantillon effect 23 problems with measuring changes in the general price structure (Wicksell, 1978), trouble with predicting the effects of changes in monetary matters (Horwitz, 2006), as well as the question of why monetary policy affects the economy only after 6–15 months (Friedman, 1969b). Importantly, the Cantillon effect is empirically confirmed by two characteristics (aspects) of inflation (Bilo, 2013). First, the increase of money supply and the general price level is tied to increased variations in relative prices (Fischer, 1981), which is consistent with predictions stemming from the sequential process of spreading new money through the economy and gradually raising prices. Second, the price increase is significantly skewed (Vining and Elwertowski, 1976), i.e. the increase in the general price level is generally caused by significant increases in the prices of a small group of goods and services, while the prices of most goods and services change less than the general price level. This is in line with the predictions that new money is introduced into the economy through specific channels.

The Cantillon effect in the business cycle According to the Austrian School, a business cycle is the outcome of money being injected into the economy not evenly, but through a particular channel, specifically through credit expansion, which lowers the market interest rate below the level normally established by social time preference. This, in turn, encourages entrepreneurs to invest in processes that generate consumer goods in a far more distant future than consumers would like. Such investment decisions lead to an imbalance in the form of an initial artificial boom, originated by the transfer of purchasing power not generated by consumers to entrepreneurs, and the subsequent, inevitable crisis, when, as a result of a slowdown in the pace of money supply, consumers’ preferences can finally be fully manifested (O’Driscoll and Rizzo, 1996). As one can see, Cantillon’s effect is the basis of the Austrian theory of the business cycle. Some scholars even suggest that what distinguishes the Austrian school from mainstream economics is the inclusion of the Cantillon effect in its money theory and business cycle (Zijp and Visser, 1994; Horwitz, 1994; O’Driscoll and Rizzo, 1996). Indeed, the Austrian business cycle theory examines a particular variant of the uneven spread of new money in the economy, namely, the creation of money in the form of loans to entrepreneurs by banks operating in the system of fractional reserves, and then the outlay of these funds by entrepreneurs – mainly those further from consumption (simply put, industries that are more sensitive to changes in interest rates, such as construction and real estate) – on factors of production, which increases their prices, and finally the increases in consumer spending due to higher wages, which raises the prices of consumer goods. This, in turn, can lead to a crisis outbreak, unless credit expansion continues (at an accelerated pace), which will provide entrepreneurs not directly connected to consumption with greater bargaining power to compete for inputs. The role of Cantillon’s effect in the business cycle is shown schematically in Figure 2.4.

24

The theory of the Cantillon effect Increase of money supply through the credit channel

Drop in interest rates

Forced savings

Unstable changes in production structure (boom), initiating the business cycle

Figure 2.4 The role of the Cantillon effect in the business cycle Source: Author’s compilation

There are some important points about the role of the first-round effect in the Austrian business cycle theory. First of all, in this theory it is crucial that new money is introduced into the economy through a specific channel – a credit channel. Of course, this is just one of the many possible implementations of Cantillon’s effect, but it seems to be of prime importance, since in the modern monetary system the newly created money is introduced into the economy precisely in the form of credit. Second, it contributes to the disturbance in the structure of relative prices, and more precisely to the decline in market interest rates.26 The importance of this is that the interest rate is the key price in a market economy.27 While other prices affect the allocation of resources in the horizontal dimension (between sectors or production processes), the interest rate determines the intertemporal allocation of resources (in the vertical dimension). Since all production processes take place over time, the interest rate not only affects the profitability of the investment, but also the volume and especially the structure of production.28 Third, entrepreneurs receive purchasing power in the form of loans, power that was not transferred to them by the consumers. Credit expansion, therefore, disturbs economic coordination by separating prices from consumer preferences.29 As one can see, the business cycle occurs not because individuals formulate unreasonable expectations or from having imperfect information per se. It is the credit expansion that distorts the structure of relative prices, which for entrepreneurs – who, even if they have theoretical knowledge of the phenomenon, are not able to determine whether the bank loan being offered at a lower interest rate is covered by voluntary savings – presents an opportunity to make a profit, which – due to the existing competition for rare factors of production30 – they will have to try to take advantage of. Fourth, since consumers didn’t change their time preferences and despite that fact, producers – by taking out a loan – invested in longer production processes, relatively less consumer goods will reach the market, which in turn will result in

The theory of the Cantillon effect 25 an increase of relative prices. Thus, in a sense, the distribution from consumers to producers is manifested precisely by the rise in prices of consumer goods. In literature, this phenomenon is called “forced savings”31 and, according to Hayek, causes the inevitability of a crisis (in other words, because voluntary savings have not increased and the natural interest rate remains unchanged, the change in production structure is not permanent). When entrepreneurs receive new funding in the form of ex nihilo loans, they will be slated for investment aimed at satisfying needs later than consumers would like.32 Meanwhile, the increase in the production of capital goods needed to lengthen the production structure can only take place at the expense of a temporary relative decline in the supply of consumer goods, so the amount of physical goods that consumers can purchase at their unchanged time preference decreases.33 Their price will increase, which will hurt some of the people whose income has not yet increased, reducing their consumption. In Hayek’s view, crisis begins when consumers, who have not increased their saving propensity, start spending more of their income (as a result of increased demand for labor and land services) in the same proportions as before. This means that people who have experienced forced savings – not because they have decided to consume less, but because relatively less consumer goods can now be purchased for their income (as the structure of production has moved toward producing goods of a higher order) – try to increase their consumption. This results in an increase in the prices of consumer goods relative to capital goods, and a shortening of the production structure. There is also a rise in the market interest rate to its natural level, which may prove higher than before the boom. This is due to the increase in overall market uncertainty, the Fisher effect, and the fact that entrepreneurs will want to complete their investments at all costs.34 Fifth, the existence of the Cantillon effect justifies why business cycles, which obviously have some common traits, do not progress the same way. Their course depends on how the new money “dissipates” through the economy, which is influenced by institutional conditions and actions of the government, banks, and entrepreneurs.35 In summary, Cantillon’s effect is the basis of Austrian business cycle theory. Hayek (1935) even argued that progress in the field of monetary theory will depend on rejecting the concept of a general price level and turning to study the causes of changes in the structure of relative prices, i.e. the effect of money on different ratios of exchange.36 Austrian economists stress not only the impact that an increase in money supply has on the distribution of income and wealth, but also, more importantly, on the price system, and, above all, on the interest rate, which is responsible for the intertemporal allocation and therefore the allocation of resources between the various stages of production.37 The Austrian School rejects the neoclassical equilibrium approach, and therefore places great importance on sound understanding of the price mechanism, which it

26 The theory of the Cantillon effect describes as a social institution that coordinates the actions of individuals in the world of uncertainty. In this context, Austrian business cycle theory can be perceived as a particular case of the more general theory of entrepreneurship, applied to the intertemporal allocation, examining how disturbed interest rate levels affect the calculation and operations of entrepreneurs (Huerta de Soto, 2006).

Summary In this chapter, I outlined what the Cantillon effect is. I showed what relationships exist between this phenomenon and the closely related, though broader notions such as the non-neutrality of money and monetary inflation as such. I proved that unequal changes in money supply result in different distribution effects – mainly from the people who are last to receive new money to the first beneficiaries of increased monetary income and from lenders to borrowers – and, consequently, price effects. I showed that the latter are much more important, because the distribution of income in itself cannot affect social well-being and the allocation of factors of production is determined by the price structure. In particular, they may lead to a business cycle – the increase in money supply through the credit channel distorts the interest rate that is responsible for the intertemporal allocation.

Notes 1 The content of this chapter was published earlier in Polish and in a slightly different form, as the article “Cantillon Effect” in the journal Optimum. Economic studies (Sieron´, 2015a). 2 In another place, Blaug (1985, p. 179) writes that the Cantillon effect asserts that: “changes in the price level produced by cash injections vary with the nature of the injection, and that the change in absolute prices is almost always associated with alterations in relative prices.” 3 Some economists, including Jevons and Schumpeter, consider Cantillon as the father of modern economics, and his Essay on the Nature of Trade in General as the first economic treaty (Hayek, 1991; Thornton, 1998). A short biography of Cantillon can be found in this book’s appendix, while a detailed biography is presented by Murphy (1986). 4 This will be true especially in the case of a decrease in money supply. While individuals can destroy or throw new money into the sea, it would be difficult for them to behave similarly in a situation of shrinking cash balances. 5 This is missed by Machaj (2012), who erroneously equates the Cantillon effect with the non-neutrality of money. 6 It is worth emphasizing here that the existence of the first-round effect is not necessarily a good argument for more balanced increases of money supply in the form of the so-called helicopter money (Bernanke, 2002). Distribution of new money directly to households could significantly increase the inflation rate. More about the concept of “helicopter money” can be found in Sieron´ (2016). 7 More on the application of the “tragedy of the commons” concept in the theory of money and banking has been written by Bagus (2010), Huerta de Soto (2006), and Hülsmann (2008).

The theory of the Cantillon effect

27

8 Doroba˘¸t (2015) seems to perceive the Cantillon effect somewhat differently, as she writes that this concept describes disturbances in the structure of relative prices resulting from an increase in money supply and, consequently, in the distribution of resources in the economy both in the short and long term. Different interpretations of the first-round effect are probably due to the fact that changes in the structure of income, prices, and production may in fact take place in different order (or concurrently) and additionally affect one another. The diagram of the Cantillon effect presented in Figure 2.2 is therefore – as a logical conceptualization of the process – necessarily simplified. 9 Mainstream literature also mentions other types of inflationary income distribution, e.g. from employees to employers due to wage rigidities (Laidler and Parkin, 1975), but it usually neglects distribution from late to early recipients of new money. 10 As I showed in the first chapter, it is impossible to say how much less they will value it. On this basis, Mises (1953 [1912]) claims that the concept of money neutrality is contrary to the subjective nature of utility. 11 Of course, “distribution” of new money is a simplification. Money in the cash balances of individual entities is homogenous and there is no way to distinguish whether someone has spent “new” money or “old”. 12 A similar scheme was described by Cantillon (1959 [1755]), Hume (1987b [1742]), Cairnes (1878), and Mises (1953 [1912]). 13 Inevitably, the income of people receiving variable remuneration will increase relative to people on fixed income. During the Weimar hyperinflation, the middle class was the most affected, as the most numerous group receiving salaries (BrescianiTurroni, 2007). 14 Cantillon thus perceived the common interests of bankers and politicians, anticipating the work of public choice theoreticians who describe the actions of the rulers from the point of view of their private interests. For example, Wagner (1980) argues that the state will deliberately use the Cantillon effect for its own purposes, as it benefits more from policies that support certain groups of voters than from those that affect all voters in the same way. 15 It is not known how the increase of money supply translates into the growth of prices of particular goods and services. 16 It is worth noting in this context that, contrary to popular belief, monetary inflation is not a tax on cash per se. If the cash balances of all people increased evenly, and the prices rose immediately in the same proportion, the real wealth (aside from transaction costs) would not change. As Kessel and Alchian (1962) note, the “inflation tax” manifests itself through the increase in prices of goods and services, not through the mere printing of money. It does not, therefore, simply result from the fact that money supply has increased, only from the fact that it is introduced into the economy through specific channels and distributed sequentially. This means that the income of some people grows faster than the increase in prices – they will be the beneficiaries of inflation – while the income of others grows more slowly than price increases – those people are harmed as a result of inflation (O’Driscoll and Rizzo, 1996). 17 Of course, the persistent and unpredictably volatile monetary inflation may induce the lenders to reduce the pool of loans offered to the market, which in comparison to the situation without inflation can be described as a net loss for society (Horwitz, 2003). 18 In a state of equilibrium, all investment opportunities at the current interest rate have already been exhausted. What’s more (assuming the inflationary nature of distribution for entrepreneurs but omitting the immediate impact of credit expansion on the interest rate) the positive price agio will rather cause the increase in the interest rate, i.e. a Fisher effect (Fisher, 1907; Mises, 1998 [1949]). 19 Rothbard (2009 [1962]) and Hoppe (2001) believe that it is a priori relationship. Fisher (1907) and Mises (1953 [1912]) seem to agree, although Mises (1998 [1949]) and Block, Barnett, and Salerno (2006) consider it an empirical issue.

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The theory of the Cantillon effect

20 This explains why entrepreneurs – even if they were familiar with the Austrian theory of the business cycle and knew that part of the investment would probably not be completed (because there are no voluntary savings to support them) – willingly take out cheap loans and increase their investment and production. They are simply not able to distinguish between money from consumers and that created from thin air by the banking system. 21 Moreover, in an economy in which everyone knows the plans of others, there would be no uncertainty, and therefore no money, which makes this hypothetical example absurd. 22 The assumption that all entities formulate rational expectations and everyone knows about it could lead to the Holmes-Moriarty paradox (O’Driscoll and Rizzo, 1996). For example, if everyone knows that the cash resources of all people have increased in proportion to their cash balances and that everyone knows it, rationally anticipating individuals would recognize that trying to deplete their increased cash balances does not make sense, because if everyone did the same, it would simply cause prices to increase and no one would be able to buy more goods, so it makes no sense to incur the costs associated with trying to spend extra cash. However, if no one attempts to do so, it is likely that prices will not increase and an opportunity will arise for those individuals to increase real wealth. Rational individuals, however, will predict it and probably enter the market. If, in turn, they realize that other agents have come to the same conclusion, they will abandon it – in line with what was written at the beginning and so on, endlessly. 23 Accurately guessing the change in an indicator that measures the consumer price level is not enough, because such an index does not include all prices, and besides, it does not say anything about changes in the structure of relative prices. 24 In addition, inflation can lead to unintentional capital consumption. When expenditures are accounted for at historical costs, depreciation write-offs cannot keep up with price increases (Mises, 1998 [1949]). 25 Barro (1976) explains this fact by saying that observing the greater volatility of the general price level makes individuals – because it is now harder for them to distinguish between the increase in the general price level and changes in the structure of relative prices – respond slower to changes in demand (supply becomes less flexible), which causes prices to be more volatile. Hercovitz (1980) argues the same – except that he refers to the volatility of the money supply, not the general price level. 26 This is a deliberate simplification. In Chapter 5, I show that changes in the structure of interest rates actually will occur, as the new money supply is introduced into the economy mainly in the form of short-term loans, which will cause a relative decrease in short-term rates compared to long-term. 27 It is the price of present goods expressed in future goods. 28 According to the Austrian theory of capital, capital goods are not homogeneous and are characterized by different sensitivity to interest rates. It is worth noting that the neoclassical assumption about homogeneous capital necessarily excludes the study of the influence of the Cantillon effect on the structure of production, and thus reduces its significance. 29 This, however, does not apply – contrary to what some people think (Horwitz, 2003) – to the growth of the money supply in general. While it is true that in the case of disruptions on the monetary side, entrepreneurs must take into account an additional factor in their calculation, it should be noted that changes in prices, caused by, for example, higher expenses of gold mine owners due to greater extraction of the yellow bullion, result entirely from their preferences. The only problem that entrepreneurs face in such a situation is to guess how much monetary demand for their products will increase, but this problem is persistent – also in the case of a constant supply of money. It is worth noting that in the gold standard with a 100% banking reserve, money supply would be easy to calculate, and its increase

The theory of the Cantillon effect

30 31

32

33

34

35 36 37

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would depend on the profitability of mining operations rather than arbitrary decisions of politicians and central bankers, so entrepreneurs could easily anticipate such economic fluctuations and adapt accordingly (Sieron´, 2012). If they do not use the loan for the purchase of rare production factors and increase their investment, other entrepreneurs will do so, which will bump up their prices and may make it impossible to make investments in the future. Bresciani-Turroni (2007) analyzes the occurrence of this phenomenon during the Weimar hyperinflation, writing about the fact that during this period Germany produced mainly producer goods, as a result of which there was a relative lack of consumer goods. In equilibrium, only the application of more capital-intensive production methods can increase production and bring higher profits (when all else remains unchanged, entrepreneurs always choose shorter production methods with the same profitability). According to the canonical approach of the Austrian theory of the business cycle, declining interest rates cause the production structure to lengthen. Recently the nature of this relationship has been questioned by some economists from the Austrian school (Fillieule, 2007, Hülsmann, 2011, Machaj, 2015). Presented here is Hayek’s interpretation of the Austrian theory of the business cycle (Hayek, 1935). According to Mises (1998 [1949]), erroneous investments (“malinvestments”) are accompanied by overconsumption, and not by forced savings. A broader discussion of the Austrian theory of the business cycle can be found in Huerta de Soto (2006) or Garrison (2001). More on this in Chapter 6. As shown in the previous chapter, Morgenstern (1972) took a similar position. The Austrian theory of the business cycle can therefore be regarded as an expansion of the study of the Cantillon effect on the heterogeneous structure of capital. Indeed, the Austrian theory of the business cycle does not only examine the distribution of income between entrepreneurs and consumers, but also between the owners of various factors of production (it is about the diverse attractiveness of capital and work during individual phases of the cycle – the so-called Ricardo effect –as well as the fact that capital goods have varying degrees of sensitivity to the interest rates and varying degrees of specificity) and between entrepreneurs operating at various stages of production.

3

The Cantillon effect in the history of economic thought

In this chapter, I examine the existence of the first-round effect in the history of economic thought, and its perception and importance in various economic schools. Of course, I open with the presentation of Cantillon’s work, but I also present the views of Hume, Cairnes, Fisher, Keynes, Friedman, Mankiw, Lucas, Hayek, and other economists from different economic schools. Additionally, in this section I analyze the research of the first-round effect and I contemplate whether mainstream economics pays proper attention to this phenomenon.

Richard Cantillon Cantillon’s great contribution to the theory of economics is that, unlike many economists who wrote years later, he does not focus on analyzing proportional changes in the general level of prices as a result of changes in money supply. Yes, prices generally increase as a result of increased money supply, but not all at the same time and to the same extent. In other words, Cantillon rejects the mechanistic version of quantity theory of money calling for the existence of simple fixed quantitative laws, as the rate of price increases in the economy depends on the channel through which new money is introduced and the way (and how quickly) various entities will use the newly acquired funds. In other words, Cantillon does not assume that changes in money supply result only in temporary effects in the real world. What the Irishman considers most is the answer to the question of the exact way by which the general price levels rise – a question that his contemporary scholars did not consider at all. In particular, Cantillon criticized Locke for failing to explain how new money spreads through the economy and to what extent money supply growth translates into higher prices: Mr. Locke lays it down as a fundamental maxim that the quantity of produce and merchandise in proportion to the quantity of money serves as the regulator of Market price. I have tried to elucidate his idea in the preceding Chapters: he has clearly seen that the abundance of money makes everything dear, but he has not considered how it does so. The

Effect in the history of economic thought 31 great difficulty of this question consists in knowing in what way and in what proportion the increase of money raises prices. (Cantillon 1959, [1755] II.VI.5) Meanwhile, Cantillon (1959 [1755]) makes a systematic analysis of the various possible ways in which the amount of money in a state can be increased. He distinguishes the following situations: the increase of gold and silver output in domestic mines, trade surplus, foreign transfers, foreign investment, immigration, war, public expenditures, foreign loans, and credit expansion by banks. The Irishman notices that the way money supply increases is important to the economy because the different channels of monetary inflation affect the structure of income and expenditures differently and that further affects the structure of relative prices and production, leading to different economic effects. For example, in the case of an increase in money supply due to increased public spending on warfare, the armaments industry will gain the most. Due to the increased demand of these companies for loans to finance the development of production, as well as increased risk premium, the interest rate will go up. On the other hand, when new money comes from net exports, the export sector will profit most and the interest rate will drop, unless there are many wealthy people in the country whose increased consumption spending will force producers to take out new loans in order to expand their production to fill the new orders (Cantillon 1959 [1755]). Cantillon believes, therefore, that the cause of non-neutrality of money is the unevenness in increasing the money supply and the resulting changes in the structure of expenditures: The proportion of the dearness which the increased quantity of money brings about in the State will depend on the turn which this money will impart to consumption and circulation. Through whatever hands the money which is introduced may pass it will naturally increase the consumption; but this consumption will be more or less great according to circumstances. It will be directed more or less to certain kinds of products or merchandise according to the idea of those who acquire the money. Market prices will rise more for certain things than for others however abundant the money may be. (Cantillon,, 1959 [1755], II.VII.6) It is worth mentioning Cantillon’s reflections on the first method of increasing money supply in the economy in extenso, as they constitute the first ever description of the first-round effect in the history of economic thought. As Hayek (1935, p. 8) put it, Cantillon provides in his book “the first attempt (…) to trace the actual chain of cause and effect between the amount of money and prices”, which appreciates the varied impact that increases in money supply have on prices, depending on the nature of those increases. If the increase of actual money comes from Mines of gold or silver in the State the Owner of these Mines, the Adventurers, the Smelters, Refiners, and all the

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Effect in the history of economic thought other workers will increase their expenses in proportion to their gains. They will consume in their households more Meat, Wine, or Beer than before, will accustom themselves to wear better clothes, finer linen, to have better furnished Houses and other choicer commodities. They will consequently give employment to several mechanics who had not so much to do before and who for the same reason will increase their expenses: all this increase of expense in Meat, Wine, Wool, etc. diminishes of necessity the share of the other inhabitants of the State who do not participate at first in the wealth of the Mines in question. The altercations of the Market, or the demand for Meat, Wine, Wool, etc. being more intense than usual, will not fail to raise their prices. These high prices will determine the Farmers to employ more Land to produce them in another year: these same Farmers will profit by this rise of prices and will increase the expenditure of their Families like the others. Those then who will suffer from this dearness and increased consumption will be first of all the Landowners, during the term of their Leases, then their Domestic Servants and all the Workmen or fixed Wage-earners who support their families on their wages. All these must diminish their expenditure in proportion to the new consumption, which will compel a large number of them to emigrate to seek a living elsewhere. The Landowners will dismiss many of them, and the rest will demand an increase of wages to enable them to live as before. It is thus, approximately, that a considerable increase of Money from the Mines increases consumption, and by diminishing the number of inhabitants entails a greater expense among those who remain. If more money continues to be drawn from the Mines all prices will owing to this abundance rise to such a point that not only will the Landowners raise their Rents considerably when the leases expire and resume their old style of living, increasing proportionably the wages of their servants, but the Mechanics and Workmen will raise the prices of their articles so high that there will be a considerable profit in buying them from the foreigner who makes them much more cheaply. This will naturally induce several people to import many manufactured articles made in foreign countries, where they will be found very cheap: this will gradually ruin the Mechanics and Manufacturers of the State who will not be able to maintain themselves there by working at such low prices owing to the dearness of living. When the excessive abundance of money from the Mines has diminished the inhabitants of a State, accustomed those who remain to a too large expenditure, raised the produce of the land and the labour of workmen to excessive prices, ruined the manufactures of the State by the use of foreign productions on the part of Landlords and mine workers, the money produced by the Mines will necessarily go abroad to pay for the imports: this will gradually impoverish the State and render it in some sort dependent on the Foreigner to whom it is obliged to send money every year as it is drawn from the Mines. The great circulation of Money, which was general at the beginning, ceases: poverty and misery follow and the labour of the Mines appears to be only to the advantage of those employed upon them and the Foreigners

Effect in the history of economic thought 33 who profit thereby. This is approximately what has happened to Spain since the discovery of the Indies. (Cantillon, 1959 [1755], II.VI.9–II.VI.12) As one can see, an increase in mining output means, according to Cantillon, that mine owners will have higher incomes, which will allow them to increase their expenditures on consumption and salaries of employees, who will also increase their purchases. This will result in an increase of prices of the products they buy, such as meat, wine, beer, wool, etc., which in turn will result in higher incomes for people involved in the production of those goods and they, too, will start spending more. Cantillon notes, however, that not everyone will benefit from this process. Those not working in the mining sector or sectors that serve it will be in a worse situation, as their income will remain unchanged while the prices of consumer goods will increase. However, that’s not the last of monetary inflation’s distribution effects. Cantillon additionally notes that – due to long-term lease agreements – landowners will also be victims of monetary inflation. In a sense, he foretells not only the Austrian school but also the new Keynesians. Yet, it is not only the distribution of income and the structure of consumption, but also the structure of production that will change, as producers will try to adapt it to changes in consumption and, for example, increase the areas for cultivation (or livestock) of those farming goods, for which demand has increased the most. I will not go into detail of all of the cases considered by the Irish economist, as most of them fit into a general, cyclical pattern: an increase in money supply ! an increase in the incomes of a part of the population ! an increase in the consumption of that part of the population ! an increase in the prices of consumer goods ! an increase in imports and a decrease in money supply ! the fall of domestic industry. The rise in prices of consumer goods causes the emigration of parts of the population, the increase in imports of cheaper foreign goods, and, consequently, the outflow of gold abroad and the collapse of domestic industry, which – according to Cantillon – happened in Spain after the discovery of America. As one can see, the Irish economist – with the help of the first-round effect – formulates the theory of the business cycle based on trade balance.1 Describing the price–specie flow mechanism (before Hume!), Cantillon opposes the mercantilists, who had not noticed the effects of the increase in money supply, which effectively nullified any positive trade balance.

David Hume Although Cantillon was the first to systematically analyze the non-neutrality of money, many economists consider David Hume to be the precursor of such research.2 The Scot certainly saw the existence of the first-round effect and realized that an increase in money supply leads to not simultaneous but sequential price increases. Ultimately, it is precisely on the basis of the facts that some people buy goods at old prices and that wages generally increase later than prices (Hume assumed incomplete employment), he argued that the systematic increase of money supply would stimulate production and employment (Hume 1987b [1742]).

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Effect in the history of economic thought

Indeed, Hume (1987a [1742]; 1987b [1742]) argued that, from the point of view of economic dynamics, money was not neutral in the short run, and on that basis, he recommended continually increasing money supply to stimulate the economy. He assumed that the increase in prices, though proportionate, would not be immediate, so he argued that in the short term – between the surge in money supply and the moment when all prices have risen – they will have positive effects on the economy. Although the Scot has indeed departed from a simple, quantity theory of money, his interpretation of the first-round effect is not, as Bilo (2015) claims, identical to the version originally presented by Cantillon. First of all, what distinguishes the Irishman’s analysis from Hume’s is the microeconomic approach, which emphasizes changes in individual entities’ cash balances and incomes, and in the structure of relative prices. Cantillon emphasizes the uneven increases in money supply and the resulting changes in the structure of expenditures as the cause of non-neutrality of money, while the Scot pays more attention to the delayed rise in wages as the cause of non-neutrality of money in the short term. Moreover, as Keynes (1936) wrote: “Hume began the practice amongst economists of stressing the importance of the equilibrium position as compared with the ever-shifting transition towards it.” This approach, however, is erroneous because in reality long-term equilibrium does not exist, there are only successive short-lived states that move towards equilibrium and undergo continual changes (Rothbard, 2010 [1963]).

John Cairnes Cairnes (1878) presents an example very similar to Cantillon’s (although he does not analyze the differences between the various channels through which new money can be introduced into the economy). Let’s say – he writes – that the increased money supply translates into higher demand for shoes, which will increase their price and, in turn, the wages of workers who produce them. It is obvious that this will translate into an increase in their real wages, as their nominal wages have risen, and the only more expensive items are shoes. Consequently, Cairnes assumes that demand for clothing will increase, which will also translate into higher prices, and then tailor shop workers will also enjoy higher wages, both nominal and real, but to a lesser degree, as now the prices of two goods have gone up: shoes and clothes. The same reasoning can be repeated until the prices of all goods (and, subsequently, wages) have risen. On this basis, Cairnes concludes that the shoemaker’s relative profit corresponds exactly to the relative loss of the tailor, or, more generally, those whose wages have already risen benefit at the expense of those whose wages have not, although he assumes that this relative increase in real wages of the first beneficiaries of the increased money supply will only be temporary and will disappear as the prices of all other goods increase. While, as one can see, Cairnes thought that in the long run money was neutral, he nonetheless believed that it could take as much as half a century for

Effect in the history of economic thought 35 prices to rise proportionately to money supply. Indeed, Cairnes (1878) explicitly points out that wages and prices of goods and services do not change at the same time (Latin: per saltum), but only gradually. This is because the new money – as he writes – can have the effect of increasing prices only as an instrument of demand. And because demand is never distributed evenly across all goods and services, the new money that is held by certain individuals will affect the prices of selected goods and services – in line with the preferences of those persons. Moreover, Cairnes (1878) notes that prices of certain goods or services increase faster than others. He does not, however, explain it in the context of price rigidity – as the New Keynesians would later do – but the sequential propagation of new money in the economy and the varying elasticity of supply. In conclusion, while any conversation about the neutrality of money points to the works of Cantillon and Hume, Cairnes’ achievements seem to be forgotten.3 This is certainly an important oversight, because the latter economist is aware that prices do not change evenly and proportionately, which is not a failure of the market but its intrinsic quality.

Other classical economists According to some interpretations, the classical economists believed that money was neutral both in the long and the short term. Humphrey (1991), however, disagrees with them, pointing out that the classical economists referred to several causes of short-term monetary non-neutrality, anticipating contemporary economic schools. First, some of them assumed rigidity in nominal wages. For example, Torrens believed that increasing money supply when wage changes lag behind price changes will stimulate real production (Humphrey, 1991). Secondly, some classics saw the role of long-term contracts – monetary inflation and a decrease in purchasing power benefit borrowers, which in their opinion has a positive impact on production. For example, McCulloch and Attwood believed that monetary inflation has a positive effect in terms of production due to the reduction of real burdens in the form of pensions, taxes, and loans, which increases profitability and encourages production (Humphrey, 1991). It is here that they anticipate both new Keynesians, who deal with longterm contracts, as well as Fisher’s theory. J. S. Mill (1967 [1833]) anticipates the new classical macroeconomics, pointing out that inflation can cause an “erroneous opinion” among entrepreneurs because rising prices for their products, resulting from the increase in money supply, can be interpreted as an increase in the relative demand for their products and not correlated with the increase in the amount of money in circulation. The same thing applies to employees who increase their efforts because they mistakenly interpret the nominal increase in their salaries as a real increase (Mill, 2009 [1848]). Based on this, J. S. Mill believes that production will only increase temporarily, unless people become aware of the true nature of rising prices and wages. In other words, only unexpected or unnoticed inflation will have a real impact on the economy.

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Bentham was the first to present the theory of forced savings, which is a special case of the Cantillon effect.4 He said that redistribution of income from people receiving fixed income to entrepreneurs – as a result of increased money supply – would translate into greater capital accumulation, as entrepreneurs have greater propensity for saving and investing (Hayek, 1935). He believed, however, that this accumulation of capital would end when new money eventually reached “unproductive classes”. Hayek later adopted this concept in his business cycle analysis (Hayek, 1935).

Irving Fisher Irving Fisher is often remembered as the main proponent of quantity theory of money. He considered it obvious that in the long run, the increase in money would ultimately only affect the overall price level (Fisher, 1922). He realized, however, that this effect can only be realized after a prolonged transitional period (around 10 years), where the increase in money supply also affects other variables, such as the velocity of money (people will want to get rid of the devaluating cash), the ratio of deposits to cash-on-hand and the volume of monetary transactions. The key reason, according to Fisher, that changes in money supply affect real variables is the delay in adjusting the nominal interest rate to changes in other prices. In this way, he explains the existence of a business cycle, i.e. he regards it as the result of the existence of the so-called monetary illusion, thus anticipating the Philips curve (Fisher, 1922; Fisher 1933).5 As one can see, Fisher (1922) believed that in the short term, money is not neutral. And although he wrote about it as a transitional period, he does not seem to think that these effects blur in the long run. On the contrary, they can have real effects, permanently affecting, for example, the amount of capital. In addition, he wrote that transitional periods are the rule, while equilibrium is the exception. However, in his analysis of the non-neutrality of money, Fisher (1922) did not focus on examining the uneven increases of money and their effect on the structure of relative prices, but on the insufficiently rapid adjustment of the nominal interest rate to changes in the general level of prices, which, according to him, is the consequence of the money illusion (imperfect expectations regarding future changes in the general price level), which affects individuals. It seems that his mechanistic approach prevented him from seeing the importance of Cantillon’s effect. For example, Fisher certainly recognized that with increased money supply some prices will fluctuate more slowly than others and some will not rise at all (due to long-term contracts and legal or customary restrictions). Instead of concluding that this will shake up the structure of prices, wealth, and production, he said that other prices would have to increase accordingly to maintain a proportionate relationship between money supply and the overall price level. Ultimately, Fisher’s holistic approach led him to state that the overall price level should be analyzed separately from individual prices, which in no way determine the overall price level (Fisher, 1922).

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John Maynard Keynes, the New Keynesians, and the postKeynesians Keynes’s approach was significantly different from Fisher’s quantity theory of money. From a formal point of view, Fisher’s income approach and cash balance approach of the Cambridge school, within the bounds of which Keynes wrote, are equivalent, but Keynes’s distinction is that he was the first to explicitly treat the interest rate as the cost of holding cash and thus a function of demand for money (Blaug, 1985). Keynes (1930) also pointed out that monetary factors affect the economy through changes in the interest rate and, consequently, the level of investment. Keynes (1930) saw that changes in money supply did not result in immediate proportional changes in prices, but were related to underemployment when quantity money theory, according to him, did not apply. It was in this fact – that it may take a long time before relative wages return to their previous level – that he saw the harm of deflation and supported the economic policy to counter it. Although he saw inflation as the distribution of income from workers to entrepreneurs, he believed that it resulted in full employment and capital accumulation. Thus, Keynes can be described as a proponent of forced savings. He believed that without this phenomenon, the enormous material progress that had taken place in the 19th century would not have been possible (Keynes, 1930). So, while Keynes analyzed the distribution of income that is the result of inflation, he did not deal with its impact on the structure of relative prices, as he believed that it determined only the structure of production, and that the level of production, which the researcher was interested in studying, was determined by the general price level (Keynes, 1924). In other words, he thought that the general level of prices and the structure of relative prices are, in a sense, existentially separate from each other. The New Keynesian school The New Keynesian school rejects the classical dichotomy between the real and nominal realms, as changes in real variables such as production or employment translate into nominal price rigidity (Yilmazkuday, n.d.). One of the reasons for this rigidity is the cost of changing prices, or the so-called menu costs. In the menu cost model, it is assumed that in the face of a negative demand shock for companies – with relatively high costs of changing the menu – it will not be profitable to lower their prices, despite it being socially beneficial (Mankiw, 1985). In this model, the Cantillon effect was excluded by assuming that entrepreneurs set their prices simultaneously. In fact, it doesn’t happen precisely because money is unevenly distributed in the economy, at different times influencing the demand for particular goods.

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The second main cause of rigidity is long-term contracts. Fischer (1977) contemplates a model in which long-term wage contracts are entered into. Individuals formulate rational expectations, but when the central bank changes the money supply at more frequent intervals than contract terms allow, then money will prove to not be neutral (in the short and medium term). This is because when we have, for example, a two-year contract, in the second year the monetary authorities can act on the basis of information that became available only after one year, and so was inaccessible to individuals who formulated their expectations earlier. The non-neutrality of money in this model is due to incomplete information held by individuals at the time of making decisions on their employment and the fact that, due to the nature of the contracts, they cannot be changed after one year.6 As one can see, the New Keynesians are not interested in studying the Cantillon effect, because they assume that it’s the prices that are “sticky”, not money itself (in the sense that its diffusion in the economy takes time). Yes, they deal with the issue of non-neutrality of money, focusing on price rigidity as its cause. However, they only analyze the impact of rigidity on changes in overall price levels and aggregate production. They do not examine how the rigidity of different prices can lead to different rates of adjustment of individual prices, and hence changes in the structure of relative prices. This is strange, since price rigidity can affect investment and production only when input costs (including wages) change at a different pace than the prices of final products. In other words, the study of price rigidity in the analysis of the New Keynesians does not serve to answer the question of why money does not spread in the economy evenly and immediately, but rather to prove the truth of Keynes’ theory, for which the assumption of downward price rigidity (especially wages) is key (Barro, 1977). Post-Keynesian economics The post-Keynesians believe that what Keynes did was a radical break from the mainstream neoclassical doctrines, including the rejection of the quantity theory of money. Keynes: reversed the assumptions of the quantity theory, treating prices as fixed and output as flexible. Moreover, Keynes denied the stability of V or k and argued that a rise in M might well be offset by a fall in V, leaving nominal income or total spending, PT, unchanged, the more so because he regarded investment as typically unresponsive to variations in the interest rate. (Blaug, 1985, p. 644) Thus, the post-Keynesians assume the endogeneity of money and reject the quantity theory of money, which they consider to be the fruit of the wrong approach to equilibrium (Robinson, 1970).

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The post-Keynesians also reject classical dichotomy, believing that money should not be analyzed in isolation from the real world (Cottrel, 1994). They do not agree with first analyzing the economy, as if it were functioning without money, and later, while considering the real sphere, superimposing the theory of money on it. In other words, they believe that money is not neutral, even in the long run. But not in the same sense as Austrian economists, who argue that changes in the amount of money – through distribution and price effects – exert lasting consequences on the real economy, though in the sense that the existence of money in itself is not neutral, because it completely changes the functioning of the economy (compared to barter). Examples of such non-neutrality are long-term contracts denominated in money. Unlike the New Keynesians, however, who see them as a source of price rigidities and generally perceive them as frictions, the postKeynesians regard them as a precondition for the existence of a monetary economy that significantly reduces uncertainty among market participants. If all transactions were to be made on the spot and the prices were perfectly flexible, the resulting uncertainty would be too great (Laidler, 1988). Although the post-Keynesians study how the changes in money supply occur (without assuming unrealistic models such as Friedman’s “helicopter” model), they are primarily interested in investigating changes in large aggregates – such as the general price (wage) level – and not the changes in the structure of relative prices, as does the Austrian school.

Milton Friedman Friedman (1969a) analyzes a hypothetical example, in which a helicopter drops money over a certain community in such a way that the amount of new money acquired by each person is proportional to their existing cash balance. Prices will rise in this situation because people will try to reduce their increased nominal cash balances. However, since one person’s expenditure is another person’s income, the community will not be able to reduce their nominal cash balances and instead prices will increase, which will reduce the real cash balances to the desired proportions. Friedman notes, however, that not all prices have to rise at the same time – some individuals can adjust them sooner than others. He therefore believes that during the transitional period, there may be changes in the relative price structure and in the structure and volume of production. He even thinks that the increase in money supply, and more precisely the overreaction to it and the resulting “overshooting” of price adjustments, can be responsible for the cyclical price and output fluctuations (Friedman, 1969a). However, when the assumption of a proportional increase in cash balances is lifted, the adjustment process, according to Friedman, will not be instantaneous, as the distribution effects appear. Price increases are not enough, therefore, to return to equilibrium, but those whose balances have expanded excessively will have to transfer the newly acquired money to those whose balances have

40 Effect in the history of economic thought increased less proportionately. Thus, according to Friedman (1969a), in the transitional period, the consumption of the former will increase and production will decline, while the situation for the latter will be reversed. So far, I have considered the position of the 1976 Nobel Prize laureate only as it relates to a one-time change in money supply. Nevertheless, Friedman (1969a) also analyzes continuous changes in money supply, which only after some time become anticipated by people. He believes that a steady increase in money supply can cause permanent distribution effects if entities do not receive cash from the helicopter in proportion to their desired cash balance on an equilibrium path (Friedman, 1969a). Friedman’s attempt to explain changes in overall price levels as a result of increased money supply through changes in cash balances of individuals can certainly be considered as progress, compared to Fisher’s mechanical approach. Indeed, as Mises (1953 [1912], p. 136) rightly stated, monetary theory must “show the way in which subjective valuations are affected by variations in the ratio between the stock of money and the demand for money.” Friedman’s focus on the analysis of individuals’ demand for money and taking notice that people hold on to cash during uncertain times enabled him to see that the impact of money supply on prices would be more prolonged and complicated than was implied by a mechanical approach of quantity theory, in which money merely facilitates and accelerates the exchange of goods and services. For example, an increase in money supply will result in changes in the balance sheets of entities that will now want to adjust to the new conditions by buying other assets. These expenditures will contribute to the increase in the prices of these assets and thus the effect of the increase in money supply will gradually spread over the economy like ripples on a lake. Changes in the price of assets will result in changes in the structure of relative prices and the distribution of revenue, which in turn will result in further adjustments in the economic system (Friedman, 1969c). Friedman (1969f) extends this analysis in the spirit of Cantillon, describing the increase in the rate of monetary inflation that occurs as a result of open market operations.7 He believes that transactions of this type will increase the liquidity of commercial banks, which will enable them to expand their lending activities. This will occur both when the seller of the bond is the commercial bank itself and when someone else sells it, as this entity is likely to deposit the resulting cash in the bank. The seller of the bond will now have more money, so he will want to spend it on other assets, which will raise their price and make the remaining assets become relatively cheaper. Over time, newly acquired money will spread across the economy, affecting the prices of ever more financial assets. This will cause the non-financial assets to become cheaper, relative to financial assets, which will induce individuals to acquire them. This, in turn, will make the existing non-financial assets on the market relatively more expensive than the newly created non-financial assets. The rise in the price of non-financial assets will also increase the ratio of wealth to income, which will make leasing of assets more economical than their

Effect in the history of economic thought 41 purchase. Thus, the demand for production services and capital goods will increase, prompting entrepreneurs to produce more capital goods. This way Friedman (1969f) describes how monetary inflation spills over from the financial markets into the real sector. He also notes that the demand for capital goods translates into higher incomes of their producers, partly reflected in higher prices of raw materials and finished goods. There will also be a rise in prices of non-financial assets, which will reduce the relative prices of financial assets. In other words, changes in the cash balances of individuals will affect relative prices, and hence the income structure, which in turn will have further impact on the balance sheets of companies and individuals. The existence of such a complex adjustment period is, according to Friedman (1969g), the reason that monetary policy affects the economy with a delay of 6 to 15 months. Moreover, the 1976 Nobel Prize laureate claims that it is not a defect, but a necessity to impact the economy gradually. In other words, we shouldn’t be talking about lags, since the effect of changes in money supply will be immediate, it will just be sequential, impacting different classes of assets and sectors at different rates (Friedman, 1969g). On this basis, Friedman (1969d) considers that monetary policy should be guided by a fixed rule, and that money supply should increase by a constant percentage. For the same reason, he thinks that even small changes in money supply may have significant repercussions for the economy if they occur at an inappropriate time or are volatile and unpredictable (Friedman, 1969e). Taking all this into account, it is surprising that Friedman states in his last essay (1969h) – from The Optimum Quantity of Money and Other Essays collection – that in the long run, the effects of changes in money supply are only nominal, mostly in the general price level, and the changes in production are due only to the disturbances in the average growth rate of money supply and are short-lived. At the same time, Friedman expresses his view that changes in money supply do not affect secular changes in real variables, which depend on such things as the type of economic system, the characteristics of the population, the availability of natural resources, or the state of technology. In other words, the 1976 Nobel Prize laureate maintains that in the long run, “transitional effects” will simply disappear and the economy will return to the path of equilibrium driven by real variables. It is rather puzzling because Friedman repeatedly wrote that changes in the real sphere that are a result of changes in money supply could further influence the monetary sphere and thus cause further changes on the “real” side. Another interesting position of Friedman’s (1969h) is his so-called “plucking model”, which states that a boom is a way of rebuilding after a crisis, although in his earlier essays he regarded it as a transitional period. Moreover, as we have seen, he presented an exact microeconomic description of the adjustment process, but he did not elaborate on it when talking about the plucking model and how, after a contraction in money supply, there is a temporary decline in production, and seemed satisfied with the enigmatic statement that it will happen because of institutional price rigidity. It is worth remembering, however, that Friedman

42 Effect in the history of economic thought was a methodical positivist, focusing primarily on researching empirical data (Benedyk, 2012). His approach, in a way, forced him to look at large aggregates such as general price levels or total production. Inevitably, he could not test any of the hypotheses about the impact of monetary policy on the structure of production and relative prices.

New classical economics The new classical economics school of thought examines the impact of monetary policy on the economy, using a model in which all prices ensure an equilibrium on the market, and entities behave optimally (within their objectives and expectations, which are rational). Money illusion is therefore excluded (Lucas, 1972). In an economy that consists of two physically separated markets, there are two types of disorders: stochastic fluctuations in the value of transactions in individual markets (which affect relative prices) and stochastic changes in the amount of money in the economy (which affect nominal prices). Information on the state of the economy is derived by the entities only from the prices in its own market, which are determined by the tâtonnement process. The agents are therefore the price takers, while prices ensure the continual market clearing (Lucas, 1972). Since manufacturers are unable to determine whether the price increase is due to actually increased demand for their products or solely from the increase in money supply, there will be shortand medium-term non-neutrality of money in the economy, illustrated by the Philips curve, as individuals react to the increase in prices by increasing production.8 Although the new classical school examines how the increase in money supply affects the real factors, and therefore it does deal with the non-neutrality of money, its assumptions exclude the Cantillon effect from the analysis (Zijp and Visser, 1994). This is because the islands model assumes that individuals – because they form rational expectations – know the “true” probability distribution of the general price level. Thus, all individuals formulate the same views about the difference between the local price on their market and the overall price level. This way, it turns out that actors in both markets are homogeneous, which reduces the model to a simpler example of a representative agent, who refutes in principle the existence of differences between individuals (Zijp and Visser, 1994), and thus, in practice, also distribution effects. This is because it is assumed in this approach that a representative entity is not an average company (or person) – like in Marshall’s approach – but a mathematical average (Zijp and Visser, 1994). Any deviations from the mean are leveled so that their expected value is zero. This is an unsustainable assumption because, as I have pointed out before, the different preferences, expectations, and production activities impacting the Cantillon effect will not neutralize themselves, but rather compound. The second assumption adopted by the new classicists, which excludes the existence of the first-round effect, is the presumption that prices are determined by the tâtonnement process. If all prices are set at the same time, then the impact of changes in money supply on the sequential evolution of the relative price system is effectively excluded.

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Another important problem associated with the approach of the new classical school to the study of non-neutrality of money, however, is that it uses the notion of a general price level that is not relevant to the homo agens. Entrepreneurs do not make decisions by comparing the prices of their products with the overall price level, but with the price of inputs. The overall price level per se does not matter to them, only the sustainability of the increase in the difference between the price of their products and the price of inputs. Therefore, although new classicists are concerned with the study of non-neutrality of money, their unrealistic assumptions and focusing on large aggregates suggest, according to Hayek’s (1935) criteria, that their work does not significantly contribute to progress in the field of monetary theory.9

The Austrian school Although – as we have seen – modern economic schools do examine the nonneutrality of money, they do not concern themselves with the Cantillon effect, focusing instead on how market actors formulate their expectations about future price levels and the outcomes of their unanticipated changes (the new classical school), as well as why prices are rigid (the new Keynesian school). The Austrian school, on the other hand, has long criticized the suggestion that money is neutral, emphasizing the fact that money flows into the market through specific channels and spreads across the economy in a sequential and uneven manner. Hayek (1935) criticizes the quantity theory of money for focusing on large aggregates, which by their nature cannot explain the evolution of market phenomena, because they do not affect the decisions made by individuals. This approach excludes the analysis of changes in relative prices and the Cantillon effect, since, as long as the overall price level remains stable, output remains at its “natural” level. Moreover, economists professing this theory do not really explain how changes in the general price level affect production and seem satisfied merely pointing to the correlation between these two aggregates (Hayek, 1935). Mises (1953 [1912]) goes on to argue that quantity theory of money, on the basis of which neutrality of money is proved, at least in the long run, is incompatible with methodological individualism because it is based on holistic concepts such as “price level” or “velocity of money”. Thus, it cannot explain the mechanism of changes in the value of money, because it does not refer to the subjective valuations of individuals, which determine all market phenomena. Mises even says that the concept of money neutrality is contradictory to the subjective nature of utility: If the possessor of a units of money receives h additional units, then it is not at all true to say that he will value the total stock a + h exactly as highly as he had previously valued the stock a alone. Because he now has disposal over a larger stock, he will now value each unit less than he did

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Effect in the history of economic thought before; but how much less will depend upon a whole series of individual circumstances, upon subjective valuations that will be different for each individual. Two individuals who are equally wealthy and who each possess a stock of money a, will not by any means arrive at the same variation in their estimation of money after an increase of h units in each of their stocks of money. It is nothing short of absurdity to assume that, say, doubling the amount of money at the disposal of an individual must lead to a halving of the exchange-value that he ascribes to each monetary unit. (Mises, 1953 [1912], pp. 141–2)

On this basis, Mises rejects the possibility of a proportional price change even if the money balances of all members of a given community were to increase in the same proportion: For, even in this quite impossible case, every increase in the quantity of money would necessarily cause an alteration in the conditions of demand, which would lead to a disparate increase in the prices of the individual economic goods. Not all commodities would be demanded more intensively, and not all of those that were demanded more intensively would be affected in the same degree. (Mises, 1953 [1912], p. 141) Only in one case changes in money supply (even steady) would not affect real variables: if they were accompanied by immediate changes in all nominal variables by the same value (Mises, 1953 [1912]). Of course, this situation is unlikely; in addition, assuming a proportional increase in prices removes the problem that had demanded a solution, i.e. how changes in the money supply could cause such an effect. Hence, for Mises, the real balance effect always goes hand in hand with the distribution effect (Salerno, 1994), so even in the extreme case of a steady increase in money, this increase would not be neutral. In reality, however, the new money always causes an increase in the amount of money held only by some people. According to the law of diminishing marginal utility, for people whose cash balances have increased, the marginal utility of a monetary unit will fall, prompting them to increase their spending, which will raise the prices of certain – not all – goods. This will affect other people’s incomes, which will also increase their spending and increase prices, but: there will not be such a complete adjustment of the increases that all prices increase in the same proportion. The prices of commodities after the rise of prices will not bear the same relation to each other as before its commencement; the decrease in the purchasing power of money will not be uniform with regard to different economic goods. (Mises, 1953 [1912], p. 140) In line with Cantillon’s approach, Mises describes the process of the gradual spread of money in the economy and the impact of this phenomenon on income and prices:

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But this rise of prices will by no means be restricted to the market for those goods that are desired by those who originally have the new money at their disposal. In addition, those who have brought these goods to market will have their incomes and their proportionate stocks of money increased and, in their turn, will be in a position to demand more intensively the goods they want, so that these goods will also rise in price. Thus, the increase of prices continues, having a diminishing effect, until all commodities, some to a greater and some to a lesser extent, are reached by it. (Mises 1953 [1912], p. 139) Since income does not grow evenly, you can hardly expect that such changes won’t affect the structure of relative prices: Since the increased quantity of money is received in the first place by a limited number of economic agents only and not by all, the increase of prices at first embraces only those goods that are demanded by these persons; further, it affects these goods more than it afterwards affects any others. (Mises 1953 [1912], p. 140) Although Austrian economists point to the distribution effects of monetary inflation, they also emphasize the price effect. Ultimately, the distribution of income and wealth itself cannot affect the growth of social wealth, and it is precisely these changes in the structure of prices that determine the structure of production and the course of the business cycle (Hayek, 1935). Indeed, the effect of the first round is the basis of the Austrian theory of the business cycle. It is quite understandable, given that, according to Austrian economists, there are forces in the market that constantly steer the economy toward equilibrium. If it is assumed that the unhindered price mechanism provides for the efficient allocation of resources and the coordination of the actions of various members of the public, however may be possible under the given historical circumstances, then the only cause of serious market disturbances – and business cycles (or at least some of their phases) are an example of such – may be interfering with the smooth functioning of the pricing system. Of course, the prices of goods are influenced by both monetary factors and those on the real side. However, it seems that what drives business cycles – those that affect the whole economy – must be on the monetary side, because money, as a common means of exchange, affects the value of all goods and services: “The essence of monetary theory is the cognition that cash-induced changes in the money relation affect the various prices, wage rates, and interest rates neither at the same time nor to the same extent” (Mises, 1998 [1949], p. 552). In conclusion, according to the Austrian school, the increase in money supply will always affect relative prices. This can be justified as follows. Money, unlike other goods, does not have its own specific market, or – what has the same effect – is exchanged on all markets. In other words, everyone is a “dealer” in money and maintains a certain reserve of it (Salerno, 1994).

46 Effect in the history of economic thought So, while changes in the market of some goods (other than money) do not necessarily affect the state of all other markets, the changes in the money market – by definition – must affect (more or less) all other markets (Machaj, 2012). As Mises (1998 [1949], p. 415) stated authoritatively: “Nothing can happen in the orbit of vendible goods without affecting the orbit of money, and all that happens in the orbit of money affects the orbit of commodities.” It becomes obvious when we realize that money does not really circulate, but is always in someone’s cash balance. Consequently, any money theory – if it wants to be in line with methodological individualism – should explain pricing adjustments that are a result of changes in money supply by referring to decisions made by individuals wishing to adjust their cash balances to the new situation. Since changes in money supply are never uniform, “the new money always increases the stock of money at the disposal of certain individual economic agents” (Mises, 1953 [1912], p. 138). In other words, because money is the subject of independent market actors’ activities – not a catalyst circulating in the economy, speeding up transactions – its impact on prices will not be immediate and uniform. Thus, the concept of neutral money derives from the wrong, holistic methodology and the erroneous application of the conclusions from the static analysis of two equilibrium states to the dynamic market process. It is obvious that in an economy where money supply is twice as large as in the other, prices in it will also be, ceteris paribus, twice as high. This does not, however, imply that the increase in money supply will result in a proportional increase in prices (Mises, 1953 [1912]). Unlike the neoclassical school, the Austrian school – assuming that in a world of constant change, the economy never achieves equilibrium, but merely strives for it – has always been more interested in exploring real economic processes rather than conditions for equilibrium. In addition, Austrian economists stress not only the impact of the increase in money supply on the distribution of income and wealth, but also, more importantly, on the pricing system, and in particular on the interest rate, which is responsible for the allocation of resources between the different stages of production. Indeed, the Austrian theory of the business cycle is essentially an analysis of a particular variant of the Cantillon effect. It examines how the increase in money supply by a particular channel – the credit channel – affects the specific price: the interest rate, leading to changes in the structure of production. In the same way, it can be said that the Austrian school is proposing non-neutrality of money even in the long run – because while there are forces in the economy constantly steering it toward equilibrium, it will not be the same equipoise, as before the credit expansion.

Other schools and directions of economic thought Of course, the preceding general overview of money’s non-neutrality and particularly of the Cantillon effect in the history of economic thought is by no means complete. I focused only on the views of those economists or schools of

Effect in the history of economic thought 47 economic thought which, in my opinion, are the most important from the point of view of this work. In this section, I have decided to briefly present the views on non-neutrality of money and the first-round effect among several economic schools, which I have not discussed in detail so far. The real business cycle theory The real business cycle theory assumes monetary neutrality in both the long and short term and reverses the cause-and-effect relationship of the observed interdependency of monetary aggregates and production, arguing that changes in the money supply are the response of the monetary authorities to real economic disturbances (McCallum, 1986). King and Plosser (1984) argue that the significant correlation observed between money and economic activity results from the relationship between production and inside money created by banks. More specifically, a positive change in productivity due to some real external shock will increase the demand for transaction services and bank deposits. In other words, outside money is neutral, while broader monetary aggregates such as M1 and M2 are linked to real economic activity through inside money (Plosser, 1990).10 Supporters of the real business cycle theory, therefore, embrace the classic dichotomy, failing to notice that in a money economy it is not possible to separate the real sphere from the nominal sphere, because – according to its nature – prices are expressed in money.11 Monetary disequilibrium theory The monetary disequilibrium theory refers to monetary neutrality and states that any deviation from “monetary equilibrium” (understood as stable MV) produces economic discoordination. While standard Austrian business cycle theory (ABCT) is a theory of economic discoordination and malinvestment that occurs as a result of changes in the supply of money, monetary disequilibrium theorists allege that similar kinds of problems occur from changes in the demand for money; that is, business cycles can be generated whenever there is an upset in monetary equilibrium, regardless of whether the disturbance originates from the supply or the demand side (Davidson, 2012). On this basis, proponents of this theory argue that in the case of increased demand for money, in order to maintain monetary equilibrium, an increase in the money supply is necessary. However, this is a static and holistic approach. Analysis of the aggregate demand for money obscures the fact that the effects of growth in the money supply don’t necessarily neutralize the effects of increased demand for money, but, on the contrary, they can compound them, if the money does not specifically reach those people whose demand for money has increased. In other words, the theory of monetary disequilibrium omits the Cantillon effect.12

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Economics of the monetary transmission mechanism This trend analyzes various channels through which monetary policy affects the real sphere of the economy. According to Brunner and Meltzer (1988), economists have long omitted the role of the asset channel in their analyses. In their opinion, this is the result of the well-established IS/LM model, which assumes the existence of only two assets in the economy and makes it impossible to study the relationship between money supply, financial assets, and real assets. According to Mishkin (1995), monetarists criticized the Keynesian approach precisely for the fact that by limiting its analysis only to cash and bonds, it exaggerated the interest rate channel. While allowing the existence of a larger number of assets, the monetarists drew attention to two other asset channels (apart from the interest rate channel, which, according to the mainstream approach, is treated as an alternative cost of maintaining cash), i.e. to the exchange rate channel and the equity price channel. The variations in the money supply affect the real sector not only through alterations in the exchange rate, but also through changes in share prices and, consequently, through the Tobin’s Q ratio (and its impact on investment) and the wealth effect (as an increase in share prices results in an increase in perceived wealth, which encourages individuals to consume more). This approach, as one can see, examines the effects of monetary policy resulting from the non-neutral character of money, which makes them very interesting. However, this is not the result of focusing on the analysis of the differences between the various ways of introducing new money into the economy, but rather from attempts to design an “optimal” monetary policy. According to the mainstream approach, economists studying the mechanism of monetary transmission examine the impact of changes in money supply on large aggregates, such as investment, production, or general price level, which precludes proper understanding of the Cantillon effect. Moreover, money does not play a significant role in the macroeconomic models used by central banks and in conducting monetary policy (Rzon´ca, 2014). Nevertheless, noticing that monetary phenomena can affect the prices of a wide range of assets, and not just the short-term interest rate, as maintained by Keynesians (Ireland, 2005), is certainly a significant advance in understanding the disruptions caused by monetary policy and by changes in money supply. Economics of asset market segmentation Economists dealing with asset market segmentation and monetary policy emphasize that new money does not reach all business entities at the same time, which makes the money non-neutral in the short-term. Some of the researchers in this trend focus on the fact that not all members of the society go to the bank at the same time (Grossman and Weiss, 1983), and therefore the new money first reaches only part of the society. Others investigate situations in which the first to have access to new money are the lenders (Fuerst, 1990) or active dealers of securities (Alvarez et al., 2000). This seems to be a very

Effect in the history of economic thought 49 promising approach that attempts to include the uneven growth of money in its analysis. However, it should be noted that researchers from this school of thought study the asymmetry of “monetary injections” as part of the general equilibrium with infinitely long-lived homogeneous entities (e.g. Fuerst, 1990), which makes it difficult to properly grasp the fundamental significance of the Cantillon effect. Chaos theory Finally, worth mentioning is the theory of chaos and its application in economics. According to this approach, even small disturbances in the initial conditions can lead to significant disturbances of the whole process. What’s more, this theory presupposes the existence of aperiodic functions, i.e. it excludes the existence of cyclical disturbances around the same growth path. In addition, even small differences in the initial variables – for example in the path of new money’s distribution – can lead to large discrepancies in the final results of the process (Butler, 1990). Although we do not think it would be possible to describe economic phenomena with deterministic equations, the above approach certainly shows appreciation for the fact that it matters not only how much money is put into the economy, but also in what way. It also acknowledges that the Cantillon effect leads to lasting changes in the economic system, and not only to transient deviations from the equilibrium path (Zijp and Visser, 1992).

Summary In this chapter, I have traced the significance of the Cantillon effect in the history of economic thought. I showed that Hume’s interpretation of the firstround effect is not identical to the version originally presented by Cantillon, and that Cairnes’ work in this realm seems to be forgotten. In addition, I showed that mainstream economists agree that, as Friedman puts it, money matters. One can risk the thesis that – apart from the real business cycle school – since the “monetarist counterrevolution”,13 there has been a shift towards the study of monetary phenomena, and economists started to associate economic cycles with impulses on the monetary side. It is enough to recall the research on the monetary transmission mechanism, which proves that economists are aware of the existence of both the direct mechanism (i.e. the direct effects of changes in money supply on prices) and an indirect mechanism (i.e. effects of changes in money supply through the interest rates). However, two important objections should be made. Firstly, mainstream economists believe that the real effects of changes in the money supply exist only in the short term (though, as we remember, the temporary character of these effects can last up to 10 years, hence the conviction that monetary policy matters), and in time become smaller and smaller, until they disappear completely in the long term, when the economy returns to an equilibrium (Cagan, 1969).

50 Effect in the history of economic thought Thus, they do not perceive the non-neutrality of money as something natural, only as a result of certain market imperfections (various frictions and lags, price rigidities or irrational expectations). The second point is that mainstream economists are not interested in studying the Cantillon effect,14 instead focusing on price rigidities (the new Keynesians) or imperfect information (new classics). This happens, I think, for several reasons. The first reason is a holistic, macroeconomic approach, based on large aggregates. Some economists do see the distribution effects of changes in the money supply, but assume that these effects counter each other in the aggregate (e.g., Caplin and Spulber, 1987). Second, even if economists try to take microeconomic principles into account, their assumption of the so-called representative agent, of the one good economy, or of the economy with only two classes of assets – money and capital – also prevent them from properly examining the Cantillon effect. Third, the models of setting prices in an immediate and synchronous tâtonnement process, used by economists who write in the tradition of general equilibrium, do not allow them to analyze the effects of the uneven and gradual impact of the increase in money supply on the price structure. One may risk a thesis that the lack of due attention devoted to the study of this phenomenon results from the equilibrium approach, which equates the final result of a market process with the market itself. That, in relation to the issue of money neutrality, presupposes a proportional increase in prices resulting from the increase in money supply. In other words, economists often erroneously transpose conclusions from comparative statics or from the barter model to the analysis of a dynamic market process. Fourth, the lack of advanced theory on capital prevents mainstream economists from tracking the impact of changes in money supply on the interest rate and, consequently, on the production structure. It is possible that this is why – as Harkness (1978) believes – the standard neoclassical models examine the impact of changes in money supply on the structure of assets rather than on the production structure. Fifth, as Fuerst (1990) notes, mathematical modeling of income and wealth distribution effects, resulting from monetary changes, is an extremely complicated task, which may discourage economists from tackling this problem.

Notes 1 However, as Thornton (2006) notes, the trade cycle described by the Irishman is much longer than a typical business cycle. Nevertheless, Cantillon recognizes the key role of monetary inflation in the business cycle. 2 For example, Lucas (1996), who in his Nobel lecture on monetary neutrality discusses the achievements of Hume, defining the Scot as the creator of the quantity theory of money, and doesn’t even mention Cantillon. 3 On the subject of neutrality of money, also omitted in the literature are the French liberals such as Leroy-Beaulieu (1914), who often noticed the non-neutral nature of money.

Effect in the history of economic thought

51

4 The theory of forced savings assumes that the increase in the amount of money results in an increase in the amount of capital. Thornton or Malthus (Hayek, 1935), among others, also referred to this concept. 5 According to Fisher (1922, 1933) because interest rates lag behind the general price level, the profits of entrepreneurs using debt financing increase. This encourages them to expand their activities and incur more debts. However, when the nominal interest rate “catches up” to the general price level, some of the entrepreneurs who did not predict this increase and decided to finance their investments at the interest rate that does not take Fisher’s effect into account will have to fail, which will upset the financial condition of the banks that financed such activities and will cause a run on banks. There will be a contraction of loans and a drop in prices, and thus a decrease in the value of the pledged assets and further bankruptcy. As the interest rate changes with a delay, it will fall slower than the general price level, which will deepen the depression. 6 It is worth noting, however, that the existence of long-term contracts helps individuals to minimize the uncertainty they have to deal with. Gordon (1981) argues that price rigidity in itself is not undesirable, only when such rigidity prevents rational individuals from achieving mutual benefits. 7 Interestingly, Friedman recognizes the essence of the Cantillon effect, which is that it matters how the new money is introduced into the economy. He clearly writes (1969f) that there will be different effects, depending on whether the central bank carries out open market operations, or the quantity of mined gold is increased, or the government prints money to cover its expenses or the ratio of deposits to cash or deposits to reserves increases. Unfortunately, he does not expand this analysis further. 8 It is worth noting that while new classicists emphasize the inability to differentiate between changes in relative prices and changes in the general price level, Austrians instead pay attention to the extent to which prices observed by traders reflect the real consumer preferences. 9 Both new classicists and economists from the Austrian school emphasize the monetary causes of the business cycle and emphasize that individuals undertake their actions in the absence of perfect information, and both their creation (new classical school) or revival (Austrian school) occurred in the 1970s. However, opinions about their similarity seem to be exaggerated. These two schools use a completely different research methodology. As Butos (1986) noted, new classical economists limit their conceptualization due to the available techniques of mathematical formalization, while Austrians believe that conceptualization of something as complex as the economy limits the use of these techniques. The use of mathematical formalization has forced new classicists to adopt a series of simplistic and unrealistic assumptions, such as the homogeneity of individuals in a given society, which exclude the study of distribution effects. This did not allow them to see that the non-neutrality of money may result not only from the imperfection of information in the possession of individuals and the impossibility of distinguishing nominal from real price growth, but also from uneven increases in money supply. 10 Outside money is the economic asset, which is not matched by the obligations of private economic entities, such as gold or monetary base. The opposite is inside money, e.g. bank deposits. 11 The polar position to the school of real business cycle is taken by the followers of the new monetary economics, who believe that money is by nature a destabilizing factor for the economy, and on this basis postulate that the function of the medium of exchange and that of the unit of accounting should be separated (Cowen and Kroszner, 1987). 12 In addition, changes in the demand for money are not able to induce macroeconomic disturbances, because they reflect the preferences of individuals. The

52

Effect in the history of economic thought

increase in precautionary demand will not lead to an imbalanced surplus, but it will be reflected by the fall in demand for various goods and services and the resulting fall in prices (Davidson, 2012). 13 Of course, one should be careful in formulating the thesis about the Keynesian revolution and monetaristic counterrevolution in this aspect. Classical economists also thought that money in the short term is not neutral. It is also not true that the Keynesians were not interested in analyzing changes in the money supply at all – they only stressed the impact on the economy that resulted from changes in the money supply taking place through the interest rate channel. 14 Admittedly, there seems to be more interest in this subject. For example, Daley and Wagner (2004) created a spatial model in which they compared the impact of two ways of injecting new money to the economy: proportionality equal helicopter drop in two regions and an increase in only one of the two regions of the economy, showing that the Cantillon effect leads to changes in the structure of the economy, although not necessarily to changes in large aggregates. Anthonisen (2007) also constructed a model in which new money is unevenly distributed to the economy in terms of space. He showed that the increase in money supply in this case will affect the structure of relative prices and production. Cheng and Angus (2012) examined the first-round effect, which occurs as a result of government expenditure financed by budget deficit. Their model confirms the conclusions that the effects money supply increases will depend on who receives the money first (they divide the economy into the classes of employees and savers), and in particular proves that the first recipients of new money gain at the expense of the others and that the savers lose during inflation regardless of whether they receive the newly created money first or second. Baeriswyl and Cornand (2015) conducted an experiment in which they compared the increase of money supply in the form of credit expansion and in the form of lump-sum monetary transfers. It turned out that only the first form of monetary inflation caused changes in the real sphere. Thus, the experiment confirms that the way of introducing new money into the economy is of great importance. Hopefully, the development of agent-based models will increase the interest of researchers in the Cantillon effect.

4

Classification of the Cantillon effect1

In previous chapters I discussed, among other things, the concept of money neutrality and the theoretical aspects of the Cantillon effect. In particular, I presented a general scheme of the first-round effect, stating that it is based on redistribution of income and wealth from relatively late recipients of new money and from creditors to relatively early recipients of new money and to debtors. Although this general scheme remains intact, there are differences in the outcomes of monetary inflation, depending on its variant. In other words, what is important for the economy is not only that fact that money supply increases, but also the way in which it happens. The aim of this chapter, therefore, will be to identify and describe the various channels through which new money can be introduced into the national economy. In it, I present the different economic effects that are caused by different mechanisms of increasing the money supply and what it means for the economy and the business cycle. The literature offers no such classification, and it appears that the most complete systematization is still the one made by Cantillon in the 18th century. The presented considerations and data prove that the first-round effect is of significant importance to the economy and can explain many economic phenomena. Cantillon (1959 [1755]) analyzed various possible ways in which money supply in a given economy can be increased. He distinguished the following scenarios: an increase in gold production of domestic mines, proceeds from a balance of foreign trade, transfers from abroad (orig. subsidies paid to the State by foreign powers), tourists’ purchases (orig. expenses of several Ambassadors, or of Travelers), arrival of immigrants and transfer of property, foreign investments, war, debasement of coins by the state, and credit expansion carried out by banks. In this chapter, I refer to his analysis, deepening and expanding it with a few important observations. There are two basic criteria for classifying the methods by which the amount of money in a given economy can be increased. First of all, we can identify cases in which the creation of new units of money increases the global money supply (production of commodity money, issue of fiat money,2 or fiduciary media)3 and cases where money is merely transferred from one

54 Classification of the Cantillon effect economy to another (due to exports of goods, tourist expenditures, foreign investment, immigration and property transfer, unilateral transfers, foreign aid or plunder). In this situation, the increase of money supply in one part of the world economy is countered by the contemporaneous decline of money supply in another. This classification is presented in Figure 4.1. Although from the global economy perspective, money supply increases only in the first case, in this chapter I adopt the traditional optics of national economies, in which money supply may also be increased through transfers from abroad. I believe that this is a more useful point of view in the context of the Cantillon effect, explaining a greater number of economic phenomena, especially that the effects of monetary inflation and the corresponding monetary deflation do not neutralize each other but rather coexist (therefore, although from the point of view of the global economy, the increase in money supply in one economy and the decrease in money supply in the other economy can balance out, it is also a fact that both countries will experience significant economic changes). The second possible criterion for classifying the channels of increasing money supply in the economy is their nature: market or non-market.4 This is an extremely important distinction, because – according to some representatives of the Austrian school (e.g. Huerta de Soto, 2006) – the business cycle can occur only as a result of a specific violation of free market principles in the realm of money. In this chapter, I use both criteria, the latter being the superior one. The classification of market and non-market ways of increasing money supply in the national economy is presented in Table 4.1. 5 The rest of the chapter is organized in the following manner. In the first section, I analyze market channels of increasing money supply, while the non-market mechanisms of monetary inflation are examined in the second.

Money supply increase in national economy

Global increase of money supply (e.g. in gold standard, by increased mining of precious metals)

Transfer of money from abroad (e.g. foreign aid)

Figure 4.1 The ways in which money supply in a given economy may be increased, whether new money units are created or not Source: Author’s compilation

Classification of the Cantillon effect

55

Table 4.1 Selected market and non-market methods to increase money supply in the national economy Market

Non-market

Global increase in money supply

Global increase in money supply

Private production of commodity money

Production of commodity money by the State

Private emission of fiat money

Debasement of coins

Transfer of money from abroad

Printing banknotes

Expenditures of foreign tourists

Credit expansion

Transfer of property (liquidated) through immigration

Transfer of money from abroad

Unilateral foreign transfers

Plunder

Export of goods

Inter-government foreign assistance

Foreign investment

Public debt

Source: Author’s compilation

Market channels of increasing the money supply The term “market channels” is understood as those mechanisms that do not violate the voluntary principle, characteristic of the free market, and therefore do not rely on coercion (Weber, 2004 [1919]).6 Theoretically, there are two market channels of increasing the global money supply (which happens when new monetary units are created): production of commodity money (which, in addition to monetary utility, also has non-monetary utility) and the issuance of private fiat money. However, in practice, this second option has never played a significant role.7 Although private fiat currencies have been and continue to be issued, it should be noted that none of them has achieved, at least as of yet, the status of money, that is the universal means of exchange.8 Therefore, this section will focus on the first mechanism – especially since historically it has been the fundamental market channel of growing the global money supply. For thousands of years, mining of precious metals was the most important channel through which new money entered the economy. When it comes to market channels of private money flow from one economy to another, we distinguish exports of goods and services, including the expenditures of foreign tourists in a given economy, immigration and transfer of liquidated assets, unilateral foreign transfers, and foreign investments.9 Private production of commodity money According to Cantillon (1959 [1755]), in the case of an increase in gold mining output, the newly extracted bullion first reached the mine owners and miners,

56 Classification of the Cantillon effect and then their suppliers (e.g. tool manufacturers), gradually spreading through the economy and bumping up prices. The increase in the prices of goods and services negatively impacted the late recipients of new money, people receiving fixed payments (Roske, 1963), and the competitiveness of exporters and enterprises, whose products had substitutes on world markets. In addition, the increase of wages in the mining industry caused the outflow of employees from other sectors. A significant outflow of production factors to the mining industry was characteristic of the so-called gold fevers (Gilbert, 1933; Maddock and McLean, 1984; Roske, 1963), which had all the hallmarks of the so-called Dutch disease (Neary, 1982). The increase in the supply of bullion led to the increase in domestic prices,10 loss of competitiveness by certain sectors (unrelated to the extraction and processing of gold), increase in imports (often goods that had previously been exported), and, consequently, to the outflow of gold. It should be noted, however, that the increase in imports ought not be surprising because, for obvious reasons, the country extracting gold had a comparative advantage in the field of money production. Such a country would register a gain in relation to other countries, because its citizens could spend more of their income on imported products whose prices remained stable (Cairnes, 1873). In addition, the bullion supply increased through voluntary actions of market participants involved in the production of money under private ownership. It was also limited by the natural rarity of precious metals and a self-regulating mechanism of profits and losses, which explains the short-term nature of the so-called gold rush. The increase in money supply led to an increase in prices and wages that not only encouraged immigration (Maddock and McLean, 1984) – which contributed to reducing the pressure on increasing wages – and resulted in an outflow of gold and a reduction of price pressures, but also reduced the profitability of gold mining operations. The extraction of ore – in contrast, for example, to the growth of monetary base by central banks – was subject to market mechanisms and mines could not arbitrarily increase production. In other words, the decision to increase the extraction of gold depended on the profitability of mining operations, which in turn determined the price of the gold in relation to other goods and services, i.e. the market purchasing power of money. To bring this point home, two things are worth noting. First, according to Skousen (1990), annual gold production has never increased the total gold stock by more than 5% in a given year, including periods of so-called gold rush, so the scale of monetary inflation taking place this way was relatively small. Second, the increase in the supply of gold meant a drop in its price, which had a positive impact on the sectors using bullion as raw material (jewelry, industry). Thus, the increase in the supply of commodity money could not be neutral. Expenditures of foreign tourists11 The increase in tourist expenditures – like any increase in money supply – leads to an increase in prices, from which some gain, while others lose. The first recipients of new money, i.e. the broadly understood tourism industry, its

Classification of the Cantillon effect 57 suppliers and employees, gain (Bond and Landman, 1972), while people on fixed income and people working in completely different, not tourism-related parts of the country find new money relatively late and, until that time, have to pay more – for example for construction services or for domestic holidays (their income does not keep up with the price increase).12 Property buyers are particularly affected, as are people who rent real estate or land services – due to the increase in property and land prices (Ardahaey, 2011).13 It seems, therefore, that the Cantillon effect of tourist travel expenditures (i.e. the redistribution of income and wealth from one to another) is an argument against government support for tourism. The increase in the money supply through the tourist channel is characterized by two things. First of all, the tourism sector is relatively labor intensive, and therefore the increase in expenditures in this sector will translate into an increase in employment at a relatively high level (Bond and Landman, 1972).14 Secondly, because tourist expenses are largely for consumption (for example: hotel accommodations, meals in restaurants, or souvenirs), they are not conducive to economic growth, which comes from savings and investments. At the end of this point, it is worth noting that the expenditures of foreign tourists express the preferences of individuals from other parts of world economy (their growth may therefore be interpreted as the implementation of the law of one price applied to comparable tourist goods and services), thus having a balancing effect on a global scale. Immigration and transfer of cashed assets Immigration generally occurs in countries with a higher standard of living. It therefore has the character of equalizing global inequalities in the real wages. Immigration and the transfer of cashed assets increase the money supply in the destination country and in turn cause the Cantillon effect. It is difficult to indicate a priori on what exactly the immigrants will spend the money they brought, but you can risk the thesis that the beneficiary of immigration will be primarily the real estate sector – because, as a result of increased demand, real estate prices and rents will increase – and its suppliers, such as the construction and furniture sectors. Those property owners who had signed long-term lease agreements before the arrival of immigrants, will therefore be harmed, as will marginal buyers and tenants who now cannot afford to buy or rent a flat they want. This presumption is confirmed by the example of Israel, to which many immigrants from the (former) USSR arrived in the early 1990s. As reported by Beenstock and Fisher (1997), the short-term effect of this migration was a significant increase in real property prices (between 1989 and 1995 prices doubled). The second specific feature of this method of increasing money supply may be a rise in the social savings rate, a relative decline in consumer goods prices, an increase in investment, and a lengthened production structure – research suggests that immigrants have a greater propensity to save than the local population (Piracha and Zhu, 2007).

58

Classification of the Cantillon effect

Private, unilateral foreign transfers Private, unilateral foreign transfers increase money supply and prices, leading to the Cantillon effect in the recipient country. The exact impact of the firstround effect realized through private, unilateral foreign transfers depends on the structure of their recipients’ expenses. If households receiving foreign transfers spend more on investments than on current consumption, compared to households not receiving any transfers – as Castaldo and Reilly argue (2007) – it seems that private, unilateral foreign transfers can contribute to economic growth, and also to the relative increase in asset prices (Adams, 1991). A distinctive feature of this method of increasing money supply is that regularly received transfers increase the disposable income of their recipients, which may contribute to a decrease in the supply of labor, negatively affecting the volume of production (Jansen et al., 2012). What is also important is that private, unilateral foreign transfers may be considered a consequence of equalization of wages in the global economy – therefore, the increase in money supply through this channel is endogenous and equilibrating. Export of goods Another way in which money can be introduced into the economy is the sale of goods abroad (exports).15 The main beneficiaries of this implementation of the first-round effect will, of course, be the exporters, as well as their suppliers. Their relative gain distinguishes this way of monetary inflation and may partly explain the popularity of supporting exports by governments, even though it is not always associated with general economic benefits. If exporters and their suppliers spend their enlarged cash balances domestically, prices of national goods and services will increase, which after some time will cause a drop in profitability of exports, and an increase in imports. Relative losers in this implementation of the first-round effect will be the consumers of goods that do not have foreign substitutes, i.e. buyers of services, land, and real estate. As in the case of other market channels of increasing money supply in the economy, the inflow of funds due to exports is the result (actually, one of two sides) of voluntary transactions that express the preferences of the individuals involved in it. Thus, such transfers of money will have a balancing nature, equalizing prices on an international scale, according to the law of one price. Foreign investment The last of market methods that Cantillon mentions, by which money can be introduced into the economy, is foreign investment. The Irish economist noted that inflow of investments into the country reduces the interest rate. He could tell that the impact of changes in money supply on interest rates depends on the specific way that the first-round effect is realized. In other words, Cantillon was aware that the decline in interest rates does not simply result from a greater

Classification of the Cantillon effect 59 supply of money in the economy, but from the fact that new money enters the economy through the lenders’ cash balances (Cantillon, 1959 [1755]). The beneficiaries of such realization of the first-round effect will be, first of all, issuers of shares and bonds and all borrowers who can borrow needed funds at a lower interest rate, as well as the broadly understood financial sector handling incoming capital and owners of the now higher-valued assets (as a result of lower interest rate) – regardless of when (if at all) new money reaches them. As one can see, issuers of shares and bonds do not gain directly from the increase in demand for their instruments (as transactions on the secondary market do not increase the capital available to the company), but through a decrease in the cost of capital that they can now acquire. At the same time, domestic lenders will be at a relative disadvantage, as a result of foreign competition – they will have to reduce the amount of interest they demand. The increase in money supply through foreign investments will, as in other cases, entail the first-round effect, consisting of an increase in the income of the first recipients of new money and owners of certain assets, and, as a consequence, distribution of income within the society. This channel is unique because – unlike in the previous cases – the money that flows through it does not constitute a unilateral transfer of purchasing power, payment for various types of commercial goods or expenditure on consumer services, but savings invested in various assets – such as shares, bonds, or real estate – or in physical assets in order to set up a business. This has two implications. The first is the decline in the interest rate and a gradual increase in the prices of different asset classes (depending on which market the new funds will be the first to hit). The second implication is that an increase in money supply through this channel will result in increased investment and production. Although in literature you can often find the opinion that an excessive inflow of foreign capital may cause economic instability and financial crises (e.g. Reinhart and Reinhart, 2008), it is necessary to distinguish the increase in investments financed only from voluntary savings (and those are the only ones we are discussing in this chapter) from investments financed by credit expansion in countries that export capital. It seems that in the first case, foreign investment is not able to trigger business cycle phenomena, but rather provide sustained economic growth, as a result of productive use of substantial savings. This results from the fact that the flow of capital on the free market is determined by factors that are completely endogenous (in this context: coming from the economic system), i.e. the structure of interest rates. In other words – if all other relevant factors remain unaltered – savings will be directed to where there is a higher interest rate, which will lead to the equalization of the interest rate on a global scale.

Non-market channels of increasing money supply By “non-market channels”, I mean those mechanisms that violate the voluntary principle of free market transactions and are based on coercion – that is

60 Classification of the Cantillon effect both the channels of increasing the global money supply, as well as transfers from abroad. As far as the first category is concerned, I distinguish debasement of coins, printing banknotes, and expansion of credit. In the case of the latter, I detail war plunder, public foreign aid, and foreign loans taken up by the government. I decided to change the order in this chapter and start the analysis from foreign transfers, because I want to stay away from the subject of money creation for as long as possible. Plunder I use the term “plunder” to mean transfer or theft of money from another country with the use of violence (or its threat), primarily as a result of military operations or war reparations. The non-market nature of plunder is obvious: one state forcibly takes money belonging to citizens or the government of another state. Although war reparations are compensation for losses incurred in a war, we include them at this point because they constitute a forced transfer of money taking place in connection with military operations between states. History shows that such a way of introducing new money into the economy could sometimes exert a considerable influence on that economy. An example may be the war reparations that France had to pay to Prussia after losing the war in 1871. They amounted to 22% of France’s GDP in that year and a slightly smaller percentage of the GDP of the winning state (Devereux and Smith, 2005). Buhr (1999) suggests that war reparations could have contributed to the economic boom in Germany and the subsequent crisis in 1873. This method of monetary inflation is characterized by the fact that it first affects the government and military sectors. It is worth noting that the Cantillon effect may partly explain why states are so often involved in hostilities that are extremely expensive. Even if running a war is unprofitable in the context of the entire economy, the rulers can certainly benefit from it. This is because funds that are eventually obtained first come to the government sector and sectors closely related to it (mainly to the military sector), while the costs of waging a war are dispersed among many members of the society. Non-market foreign aid The term “non-market foreign aid” is used to mean the official development assistance, which consists of grants and loans on preferential terms.16 Because there are many different aid programs, it is difficult to point out the general effects of introducing new money into the economy through this channel. Nevertheless, because the government sector is generally responsible for allocating official aid funds, it stands to reason that it will be the first and main beneficiary of foreign aid (Boone, 1995).17 An increase in money supply in the form of foreign aid will therefore cause development of the public sector, at the expense of the private sector (Friedman, 1958), and, consequently, the redistribution of income (in the

Classification of the Cantillon effect 61 form of higher prices) from the general public to the ruling class and entities supported by it (Khan and Ahmed, 2007). On this basis, one may risk a thesis that more money flowing into the economy in the form of non-market foreign aid will have a negative impact on economic growth in the long run. Boone (1995) showed that the vast majority of such funds is spent on consumption. In other words, foreign aid itself is not able to contribute to economic growth, as appropriate conditions for investing must exist in advance of such aid. Non-market foreign aid increases the supply of funds available to the government in the beneficiary country, which reduces the pressure on economic reforms that would create appropriate conditions for investment by private investors (Friedman, 1958). In contrast to private foreign transfers, which indicate the voluntary preferences of individuals, foreign assistance is often dictated by political factors and, in a sense, constitutes official consumption (all too often, officials decide on the form of assistance and allocation of aid funds). This has an important implication: foreign aid does not have a balancing effect. On the contrary, it causes many negative effects, such as an increase in the prices of domestic goods,18 including production factors and, consequently, the fall in profitability of private production of many goods, as well as growth of the public sector (Lal, n.d.) and the accompanying effect of crowding out, increased corruption, and erroneous government investments (Osterfeld, 1990). To summarize this point, the Cantillon effect realized through the inflow of foreign aid will cause redistribution of income from the taxpayers of donor states (through taxes) and the citizens of beneficiary countries (as a result of price inflation) to the public sector and related entities, but also to all persons involved in the allocation of aid funds (for example, to members of non-governmental organizations). The first-round effect may explain the widespread support for aid programs, which is partly due to not taking into consideration that fact that money is not injected evenly into the economy of developing countries, but rather through the government sector and related entities (Bauer and Yamey, 1983). Foreign public debt Foreign public debt is another mechanism mentioned by Cantillon (1959 [1755]) for increasing money supply in one country by transferring it from abroad. Foreign public debt is a non-market channel because the state can ultimately pay off its debts only with money it creates or money collected in taxes. The main beneficiary of this method of increasing money supply in the economy is the public sector (and bond dealers), and later, the beneficiaries of its expenditures. The issuance of bonds by the state resulting in the increase of public debt will cause, ceteris paribus, an increase in interest rates on treasury bonds, and then other interest rates (because interest on government bonds is considered a “risk-free rate” and, as such, forms the basis for setting interest rates on

62 Classification of the Cantillon effect other securities debt) and, consequently, it will lead to the crowding-out effect. The increase in money supply through this channel cannot, therefore, trigger the business cycle – as a result of the increase in interest rates, the profitability of many thus far lucrative investment projects decreases, and the production structure is shortened (the number of production stages decreases). This method of monetary inflation also causes intersectoral distortions. They result from the redistribution of income from domestic taxpayers to the government, the financial sector, and the foreign lenders, and, consequently, from the implementation of another, non-market expenditure structure, which will cause shifts in the structure of relative prices and production. Borrowing funds from abroad by the government is distinguished by two characteristic features. First of all, the money supply growth is unstable, limited in time to the redemption date of debt securities or the moment of their sale on the secondary market to domestic investors. Secondly, because debt requires payment of interest, public debt has a deflationary character. However, the inflationary and deflationary effects do not cancel each other out. The need to pay interest also determines the type of expenses financed in this way. Historically speaking, the largest beneficiary of inflows of foreign loans, in addition to the government and banking sectors servicing these transactions, has been the military or construction sector, as governments borrowed almost solely to finance military expenditures (Hoppe, 1995) or infrastructure investments. However, in the modern monetary system, the issue of government bonds is rather a tool for creating money, because those bonds are indirectly monetized through central banks. Acquired by commercial banks, they are often the basis for lending, as a result of which money supply in the economy increases (Buchanan and Wagner, 1967). Debasement Debasement of the coin was historically the first and the longest used method of increasing the global money supply, which resulted from the fact that for the better part of human civilization people used commodity money. Banknotes appeared only in the 17th century (or the 14th century, if we include promissory notes issued in what today is Italy). This process (also called peioratio monetae) involved reducing the amount of bullion in the coin in relation to its face value. This could be done in three ways (or any combination thereof): a) by reducing the weight of the coin; b) by lowering the coin fineness; c) by raising the face value without changing the precious metal content in the coin. From the precious metals obtained as a result of the first or second method, new coins were then minted, supplying the royal treasury (the state treasury). Debasing of the coin was therefore founded on a certain asymmetry of information between the rulers (and minters), who knew that they were putting into circulation coins whose nominal value was inconsistent with the value of the precious metal in them, and the citizens who did not always know it, and that learning about it required certain transaction costs. When people finally realized

Classification of the Cantillon effect 63 that the nominal value of the coins in question did not match the amount of gold contained in them, they discounted them in relation to full-value coins and bullion, which led to an increase in the prices of goods and services expressed in these coins. Such iteration of the Cantillon effect benefitted primarily the net debtors and the first recipients of new money – i.e. primarily the prevailing public administration, as well as the military sector (mainly soldiers), as the coin was mainly debased for financing military operations (or in order to pay off loans taken earlier for the needs of the war). Also, minters, goldsmiths, currency dealers, and people bringing ore for smelting and minting benefitted, as well as holders of gold and high-denomination coins, which were less often debased. However, net creditors and people receiving regular payments lost money. Most often, it was the clergy and landowners (gentry) who received rent at a fixed rate (Bordo, 1986). It is not surprising, then, that there were numerous conflicts between the monarchs and the clergy or wealthy individuals during the Middle Ages. People, who were relatively late in receiving new money or people, who were the last to be aware of the real content of gold in the coins they received (i.e. generally the poorest social strata), and employees receiving a fixed salary were also on the losing side of the equation. The scale of monetary inflation taking place through debasing of the coin was relatively small (compared to the subsequent inflation of paper money) (Hülsmann, 2008). This way of increasing money supply was associated with significant restrictions: the rulers could not arbitrarily increase the physical quantity of bullion, they were also unable to force the people to bring valuables and old coins for re-melting, other than through a significant increase in the price of minting, which, after all, resulted in a decline in seniority rate (Spufford, 1988). In addition, debasing of the coin was hampered by the threat of outflow of bullion abroad, according to the Gresham-Copernicus law. The process of debasing the coin was also relatively easy to notice (at least for part of the society), because the coins were a kind of certificate confirming the weight and the fineness of bullion, which, after all, was physically and inseparably tied to it. Printing of money by the state The Cantillon effect resulting from the increase in money supply through printing of paper money19 – originally the most common had been money substitutes (or titles to land), the conversion of which into proper currency was later canceled or postponed – does not qualifiedly differ from the increase in money supply through debasement, because in both cases new money is introduced into the economy through public expenditure (as salaries of public administration, soldiers’ pay, etc.) What this means is that implementing the first-round effect this way does not result in a business cycle, but only invigorates the sectors that receive public spending (historically speaking, it has mainly been the military sector), and thus generates intersectoral but not intertemporal perturbations.

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Thus, the first holders of newly created money, debtors and those who receive payments in gold (or have it) have always gained through the Cantillon effect. The losers were the creditors (the clergy, the aristocracy), people that were last to receive the newly created money, people who didn’t use bullion (poor people, farmers), and those who received regular payments (public administration, soldiers, teachers). As in the case of debasing the coin, printing of paper money by the government – if the newly introduced paper money is legally equal to the previously used commodity currency – could lead to the outflow of gold (in accordance with the Gresham-Copernicus law). The fall in bullion supply caused the deflationary Cantillon effect (concurrent with the inflationary effect of the first round) and inhibited the increase in the general price level. The basic difference between debasing of the coin and increasing the supply of paper money is quantitative: governmental paper money allows monetary inflation on a much larger scale, which obviously entails a stronger price increase and the Cantillon effect. The Roman denarius fell over a period of about 270 years, while the French assignat or the American continental currency took only a few years to disappear. According to Bernholz (2003), all known cases of hyperinflation occurred as a result of excessive printing of paper money, while price inflation taking place as a result of an increase in gold supply, on average, had not exceeded 2% per annum. It is worth noting, however, that currently the monetary base – in the form of cash and bank reserves – is increased by central banks. The creation of a monetary base by central banks also leads to the Cantillon effect, but its influence on the price increase is limited, compared to printing money by governments. This is due to the fact that in modern economies, central banks increase the supply of banknotes at the request of commercial banks, which in turn pay for it with the reserves accumulated in the central bank (McLeay et al., 2014a). In the past, as a result of their operations, central banks – like the Reichsbank during the Weimar hyperinflation that resulted from direct debt monetization (Bresciani-Turroni, 2007) – introduced banknotes into the economy. Currently, central bank operations (e.g. open market operations) result in an increase in bank reserves, not cash. Since bank reserves are used only in transactions between commercial banks and between them and the central bank, and not in transactions with the general public (McLeay et al., 2014a), the increase in their supply does not translate (automatically) into a price increase.20 Credit expansion The creation of money by the state allows public expenditures to increase. However, the direct printing of paper money by governments does not result in lowering the interest rate and thus is not able to create (artificial) economic boom. This effect can only be achieved as a result of banking operations, and more specifically credit expansion. This is one of the reasons why, in the course

Classification of the Cantillon effect 65 of history, there were state (national) banks providing loans, and those banks eventually evolved into modern central banks. Initially, public land banks were instituted to issue land loans (Kemmerer, 1939). The state-owned Banque Royale led by John Law provided loans for the purchase of shares (Hamilton, 1936). The Reichsbank did not grant loans for the purchase of land or shares during hyperinflation in the Weimar Republic, but it directly and indirectly monetized public debt; it also discounted private securities presented to it by commercial banks. Therefore, there was no strong speculative bubble on the land, stock or other specific market. Instead, there was a general economic boom (Graham, 1930), especially noticeable in industries producing higherorder goods (capital goods). In modern economies, however, commercial banks introduce the majority of the money supply to the economy by creating bank deposits through granting loans or acquiring assets (e.g. McLeay et al., 2014b). This way, the increase in money supply through the credit channel leads to a drop in interest rates, which not only supports debtors, but also leads to an increase in asset prices and the business cycle. There is more on the Cantillon effect in the process of credit expansion in the next chapter.

Summary In this chapter, in accordance with the approach that was initiated by Richard Cantillon, I made a systematic classification of distribution effects resulting from an increase in money supply in the national economy, depending on how it is done. To my knowledge, this is the first classification of this type since the publication of Essai sur la Nature du Commerce en Général, where small fragments on this subject can be found. I divided the channels, through which new money can be introduced into the economy, into market and non-market ones, while within these two main categories, I further distinguished mechanisms of transferring money from abroad and mechanisms that increase the global money supply. Then in each of these subcategories, I discussed a number of further channels through which new money can be introduced into the economy, ones that, in my opinion, are most important from the practical and most interesting from a theoretical point of view. Of course, my classification does not claim to be complete and is only a step towards a more extensive classification. There are important differences between the global increase in money supply and the mere transfer of money between particular economies. Only in the latter case, the inflationary effect of the first round in the recipient economy will be accompanied by the deflationary Cantillon effect in the economy sending the money. In other words, an increase in global money supply – in contrast to the transfer of purchasing power – will lead to global price inflation. This can be stated differently: the condition for the transfer of money is the decline in demand for money by foreign entities.

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But what are the differences between market and non-market channels of increasing the supply of money? Although the effect of the first round appears as a result of any (uneven) increase in money supply, it is important to realize the differences between these two general cases. In the first one, money supply increases as a result of voluntary activities of market participants involved in the production of money (or its transfer from abroad) under private ownership. Market production of money is undertaken for profit, which can take place on a completely unhampered market only by adequately meeting the needs of the money users, as a result of providing an appropriate amount of universal medium of exchange of appropriate quality. This means that such production has a balancing effect. If the increase in money supply is too big, prices will rise to the point where the purchasing power of the money produced will drop to the level at which further production will no longer be profitable. Market production of money is therefore subject to a selfregulating profit-and-loss mechanism. In contrast, the creation of money can be practically unlimited. While in the case of fiduciary media, there are some physical or institutional limits resulting from the limited amount of money proper, on the basis of which they are issued, in the case of fiat money, there are no such restrictions. Its supply can be increased until the monetary system collapses. According to the Austrian theory of the business cycle, it is this creation – if the newly created money is introduced into the economy through the credit market – which is responsible for the business cycle. Credit expansion lowers the interest rate and leads to discrepancies between investments and savings, which cause an economic boom. However, with the level of savings unchanged, it will not be possible to complete all of the investment processes that were initiated, which will eventually cause a crisis. As one can see, not only the scale of monetary inflation is important, but also the way, in which it takes place. Different channels of increasing money supply have different impact on the economy and the course of the business cycle. The second basic difference is that the non-market increase in money supply increases the funds available to the public sector. What’s important is that these are funds that were not transferred to the government by its own citizens either in the form of a loan or in the form of taxes. Thusly acquired funds allow the implementation of projects that the lenders refused to finance and the citizens would not agree to, if they had to be financed via a tax increase. Those activities will therefore tend to be particularly useless to the private sector – for example, wars. Although citizens do not transfer part of their income and property directly to the government, redistribution still occurs, only this time through the increase in prices of goods and services. Because the government is the first to receive and dispose of new money, it can acquire goods and services at prices yet unchanged, increasing the amount of goods at its disposal and depleting the amount of goods and services that can be used by the private sector.21 As the purchasing power of money decreases, income is redistributed from net creditors to net debtors. The Cantillon effect therefore explains the propensity of the public sector to increase money supply. It also explains why: a) governments engage in wars, despite the

Classification of the Cantillon effect 67 fact that they are very expensive – this is because the funds obtained in this way first go to the government sector; b) foreign assistance does not contribute to economic growth in developing countries (Lal, n.d., Chart 1) – this is because the funds obtained this way first go to the government sector, which in itself is the cause of many negative effects; c) for most of history, governments have almost exclusively indebted themselves in order to finance wars, as the inflationary effect of the first round, associated with the inflow of foreign loans, will necessarily be accompanied by the deflationary Cantillon effect, and more precisely, the redistribution of income from taxpayers to foreign creditors.22 Despite the many differences between the various ways of introducing money into an economy, the general pattern of distribution remains the same. The first recipients of new money and debtors always gain at the expense of creditors and late recipients of new money. The differences are in who, under given circumstances, composes these model groups, and how these distribution channels are accented. Sometimes other distribution channels were also involved, such as from cash holders to owners of gold, land, or real estate (the relative increase in land and real estate prices results from the increase in demand with a very limited supply).23 The most important differences between the channels of increasing money supply discussed in this chapter are presented in a very synthetic form in Table 4.2. 24 Table 4.2 The most important differences between the channels of increasing money supply Channels of increasing money supply

Unique results (characteristics)

Market channels of increasing money supply

Result from voluntary actions within private property, do not lead to economic disruption

Channels of increasing global money supply

Small scale of monetary inflation – limited by natural scarcity (or algorithm), depends on the price structure

Private production of commodity money

Possibility of the occurrence of so-called Dutch disease, production limited by natural scarcity and self-regulating mechanism of profits and losses

Private emission of fiat money No occurrence in reality, a rarity artificially created by virtue of a specific algorithm Channels of transferring money from abroad

Balancing characteristic

Tourist expenditures

Negative impact on economic growth

Transfer of property through immigration

Growth of the real estate market

Unilateral foreign transfers

Negative impact on the labor market

Export of goods

Relative increase in the income of exporters

(continued)

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Table 4.2 (Cont.) Channels of increasing money supply

Unique results (characteristics)

Foreign investments

A drop in interest rates, a relative increase in asset prices, a positive impact on economic growth

Non-market channels of increasing money supply

Relative gain of the public sector, redistribution of income

Channels of transferring money from abroad

Lack of balancing characteristic

Plunder

Relative gain of the military sector

Inter-government foreign aid

Relative gain of the public sector as well as the construction, education and health sectors, crowding-out effect, negative impact on long-term economic growth

Public foreign debt

Increase in interest rates, crowding-out effect

Channels of increasing global money supply

Monetary demand for goods and services does not result from previous production

Debasement of money

Limited scale of monetary inflation, Gresham-Copernicus law, relative gain of the military sector and holders of gold or high-denomination coins, the role of information asymmetry, and monetary certificates physically tied to money

Printing of money by the state

Historically, the first hyperinflations, relative gain of the military sector and owners of gold, GreshamCopernicus law

Credit expansion

Leads to a drop in the interest rates as well as the business cycle and forced savings, can lead to investment bubbles and relative profit of the financial sector

Source: Author’s compilation

Notes 1 The content of this chapter was previously published in Polish and in a slightly different form, as the article “Classification of the Cantillon Effect” in the journal Ekonomia. Wroclaw Economic Review (Sieron´, 2015b). 2 Fiat money is a currency without intrinsic value, that is money that is neither a commodity of commercial value (i.e. commodity money) nor a title to it (Hoppe, 1994). 3 Fiduciary media are part of monetary substitutes (claims to proper money perceived as interchangeable with it) that are not fully covered by the reserves in money proper, in contrast to money certificates that are covered (Mises, 1998 [1949]). For example, if a bank stores only 10% of the deposited 100 dollars in cash as reserve (the proper money), and loans out the rest, creating deposits, then deposits of $10 will be money certificates, and the rest will be fiduciary.

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4 The analysis of the Cantillon effect can also be carried out from the point of view of the places where new money begins its “journey” through a given economy (Nenovsky, 2002). However, I think that the channel via which it ends up in the economic system is more important than the physical place – for example, the central bank can create base money both through standard open market operations and through less conventional activities such as quantitative easing. 5 The literature divides money into exogenous and endogenous. Although such a division is useful, it is not always precise. For example, it is generally assumed that the increase of gold supply in the gold standard was exogenous, although gold mining reacted to the price of gold. Moreover, there is a debate in the literature (Knakiewicz, 1998), on whether in the modern monetary system, central banks increase the supply of base money in an exogenous manner or rather in response to the needs of the banking system (and therefore endogenously). For these reasons, I do not use this criterion in this chapter. 6 I therefore omit the creation of money by state institutions (government, central bank) or private ones, but with certain privileges granted by the state (commercial banks operating on the basis of fractional reserve) – in other words, because the fractional reserve can be regarded as a violation of traditional legal principles (Huerta de Soto, 2006), in this point I assume that there are no fiduciary media (money substitutes that are not based on the proper money). My classification draws from the distinction proposed by Oppenheimer (1926) for economic measures and political measures through which a person can get rich. The former are production and peaceful exchange between individuals, while the latter consist of violence and robbery. According to Oppenheimer, the state primarily uses this second type of measures. 7 According to Hülsmann (2008), this is due to the fact that individuals on the free market will always prefer the commodity money with which there is no risk of total loss (because it also has a non-monetary, use value) than fiat money, which – in his opinion – has existed only due to governmental interference in the realm of money. 8 Of course, the term “universal” is imprecise, but it is not a big mistake to say that these currencies, including Bitcoin, have not yet achieved the status of a good, which any would-be buyer of any other goods (at least in a given area) must acquire (Sieron´, 2013). 9 My goal is not to address in detail all channels of the balance of payments, through which money can be introduced into the economy, but rather to expand the analysis made by Cantillon (1959 [1755]). Of course, every classification is arbitrary, but I think that the examples presented here cover all the most important methods, through which money supply can be increased globally or transferred to a given economy: spending on trade goods, spending on services, unilateral transfers, transfer of assets, and foreign investments. 10 At the same time, the prices of non-tradable goods, such as land, real estate, or services, grew relatively more than the prices of tradable goods (Gilbert, 1933, Maddock and McLean, 1984). 11 Cf. Sieron´ (2015d). 12 In the modern monetary system, the domestic currency sellers and importers will also relatively gain, while the exporters will lose, because tourist expenditures increase demand for the domestic currency and its exchange rate. 13 This effect seems to be the strongest in island economies (and coastal regions), where the supply of land is naturally limited, and the demand from tourists is strong. The price increase may be so significant that some people may be forced to emigrate outside the area attractive to tourists (Buchsbaum, 2004, Wilson, 1976). 14 In addition, because – as Lee and Kang (1998) show – work in this industry generally does not require any special qualifications and does not provide high salaries, the increase of money supply through the tourist channel, on the one hand, relatively benefits the poorest persons, which translates into an increase in their demand and the

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15 16

17

18

19

20

Classification of the Cantillon effect structure of the goods produced. On the other hand, relatively poorer people often have fewer assets (e.g. land), the price of which increases as a result of the increase in tourist expenses (Shah and Gupta, 2000). Besides, the tourism sector often generates less income for the poorest people than they lose because of the deterioration of the situation in other export sectors that is due to the appreciation of the national currency or increase in prices of production factors (Blake, 2008). It is worth noting that tourist expenditures are a form of export of goods and services. Since tourism expenditures are largely spent on services, we focus on the export of goods in this section. Official development assistance are donations and loans (but only those that include a donation element worth at least 25% of the aid value) provided to developing countries by official governmental institutions of donor countries or international organizations to support economic development and well-being in these countries (OECD, 2008). Official development assistance is a non-market channel, as it is a direct or indirect (through non-governmental organizations) transfer of purchasing power between the governments of the countries concerned (Friedman, 1958). The funds transferred had to be either taken earlier from the citizens of the donor country in the form of taxes or gained as a result of creating money. It is worth noting that from this point of view, the conclusions apply also, mutatis mutandis, to European funds. As in the case of official development assistance, the inflow of EU funds leads to some negative effects resulting from a specific manifestation of the Cantillon effect, i.e. that EU funds are introduced into the economy as de facto non-market foreign assistance. It is also worth noting that the inflow of EU funds may additionally increase the monetary base in the recipient country if the euros received are converted into the national currency at the central bank. Indeed, the exchange of the euro into Polish zloty by the National Bank of Poland has been one of the factors determining the size of reserves and the level of liquidity of the Polish banking sector over recent years (Kaczor and Soszyn´ski, 2010; Zajder, 2008). Who gains next in this manifestation of the Cantillon effect depends on the aid’s exact allocation by governments. According to OECD (2015) data, foreign aid for developing countries in 2013 was primarily targeted at social needs (38%) – such as education, health, population, government and civil society; economic needs (22%) – mainly to transport, communication and energy sectors; and production needs (8%) – mainly for agriculture, forestry and fishing. Needless to say, the increase in money supply and, consequently, price inflation in developing countries, where exports often play a significant role, may entail serious repercussions and nullify the noble intentions behind the idea of foreign aid and, at best, not contribute to economic growth in beneficiary states (Rajan and Subramanian, 2009). As I mentioned in the previous point, banknotes were widely used in Europe in the 17th century. This was partly due to the monetary chaos caused by the state production of coins, culminating in the Kipper und Wipperzeit period (Schnabel and Shin, 2006). Banks weighed and tested the fineness of deposited coins, accepting only those of high quality, which eliminated the problem of information asymmetry – it was mainly for this reason that banknotes became a better substitute for money (they didn’t wear out like coins, and were less expensive and similarly convenient to use). While banknotes initially had full coverage in gold, governments soon realized that printing paper money (banknotes) makes it possible to create monetary inflation on a much larger scale than in the case of debasing coins. This explains why – contrary to many fears – quantitative easing initiated by major central banks after the outbreak of the financial crisis in 2008 did not lead to hyperinflation or even significant price inflation (understood as an increase in the prices of consumer goods and services).

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21 To put it differently: the creation of money enables the acquisition of goods without prior production. Due to the created purchasing power, entities with new money may “outbid” other market participants and increase their share in the social wealth (the supply of goods and services remained unchanged). Less goods and services remain on the market for others, which manifests itself in higher prices. This results in redistribution of income and wealth from the public to the issuer. 22 In other words, incurring a pure public debt means increasing the tax burden at some point in the future (or monetizing debt), to which – influenced by the classic doctrine – there was social consent only during wartime. It was justified by the fact that the current generation was suffering enough during the armed conflict, and the future generation will benefit from the possible victory (Wagner, 2001). Saying that (pure) public debt is not a shift of tax burdens to the future, or that, in a way, we borrow it from ourselves, is a sign of lack of due attention to the Cantillon effect, and thus accurately tracing the way (from whom and to whom) the borrowed money is introduced into the economy, and then how (from whom and to whom) it “flows out” when the debt is repaid. 23 I believe that the observation, according to which monetary inflation leads to a relative increase in real estate and land prices, is a valuable hint for investors and all those who want to protect themselves against the effects of increased money supply. As one can see, this analysis is not only theoretical, but it can also serve as the basis for extremely important decisions in economic practice. 24 For simplicity, in my analysis I have assumed the existence of one commodity money all over the world. Meanwhile, the modern monetary system is characterized by the existence of many national fiat currencies. Changes in money supply will therefore also affect the exchange rates. In such a monetary system, monetary inflation will affect various social groups not only as a result of changes in relative prices in the national currency, but also as a result of changes in the exchange rate. In general, the increase in the global money supply in a given country will lead to the weakening of the local currency, and the transfer of money to the economy will cause its appreciation. One of the first people experiencing the Cantillon effect occurring in such a monetary regime will be people trading the currency and to some extent all its holders, and because of the existence of the foreign exchange market, exporters etc. on the one hand and importers etc. on the other hand will feel positive or negative changes resulting from changes in the money supply more quickly.

5

The Cantillon effect and credit expansion

In Chapter 4, I presented my classification of the Cantillon effect and analyzed the differences that occur depending on the channel through which money supply is increased, and their economic significance. One of the channels in my classification was credit expansion. The purpose of this chapter is to describe the Cantillon effect resulting from the increase in the supply of loans, which is by far the most important channel through which new money is introduced into the economy in modern times. Cantillon (1959 [1755]) mentions credit expansion, but he does not analyze it in detail. In this part of the book, I intend to extend the insights of the Irish economist by presenting the first-round effect of credit expansion and its impact on the business cycle, in line with the standard approach of the Austrian school. In the following chapters, I will elaborate further on these considerations by examining the international aspects of the Cantillon effect resulting from credit expansion and its impact on the socalled secondary features of the business cycle1, price bubbles, and an increase in income and wealth inequality in OECD countries over the past several decades.

What is credit expansion? In order to understand the Cantillon effect resulting from credit expansion, it is necessary to first define the process itself and briefly present how it occurs. Credit expansion means an increase in the supply of loans above the level resulting from the supply of voluntary savings. It is, therefore, an increase in the supply of credit through the issuance of fiduciary media (Mises, 1998 [1949], p. 369). Loan creation can only take place in the fractional reserve system, in which commercial banks do not hold 100% of deposits as a cash reserve (Mankiw, 2011). This is not a new phenomenon, as it has existed since antiquity, but it wasn’t noticed by economists until much later (Huerta de Soto, 2006). According to Hayek (1933) the first theory of the credit creation in modern times was presented in 1913 by Herbert J. Davenport, who wrote The Economics of Enterprise (Davenport, 1913).2 Today, the process of creating money and loans by commercial banks is covered by practically all economic textbooks (e.g. Abel and Bernanke, 2001).

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According to a standard textbook approach, commercial banks create loans predicated on a monetary base that is created by the central bank and the reserve requirement rate it sets. This approach assumes that a commercial bank must first receive a deposit to generate a loan. From this original deposit, the bank places the required fraction in reserve, and the rest is used to grant loans. However, the ability of the banking system to create loans does not end there. Borrowers spend the received funds on purchases of various goods and services, and pay for them by debit card or make wire transfers, as a result of which money received from the lending operation goes to the seller’s account, which is most likely at another bank. This bank will treat this amount as an increase in deposits and will also expand its loans. This process will be repeated many times, until the last part of the originally deposited amount is allocated to the reserve. The scope of lending by the banking system according to this approach is defined by the so-called money multiplier. The description of this mechanism is well known and can be found in many economic textbooks, so I will not analyze it in detail here. I would just like to add two things. First of all, economists from the Austrian school accept this description (e.g. Hayek, 1933, Huerta de Soto, 2006). What distinguishes the Austrian school from other economic schools is the nature of implications that it draws from analyzing the credit expansion process. Economists from the Austrian school believe that credit expansion leads to a reduction in the market interest rate below the equilibrium rate: “To secure borrowers for this additional amount of money, the rate of interest must be kept sufficiently below the equilibrium rate to make profitable the employment of just this sum and no more” (Hayek, 1935, 266). According to the Austrian theory of the business cycle, increasing money supply through the credit channel – one of the possible manifestations of the Cantillon effect – is exactly what is responsible for the business cycle. It is worth noting that the outbreak of the financial crisis of 2007–8 increased the interest of mainstream economists in the relationship between the supply of money and loans, and the business cycle. For example, Jordà et al. (2012) analyzed data from 14 developed economies between 1870 and 2008 and concluded that the supply of loans largely shapes the course of the business cycle. The authors also argue that the greater the increase in loan supply during the boom, the deeper the subsequent recession. Secondly, more and more economists are questioning the textbook model of money and loan creation by commercial banks. For example, in the Bank of England’s publication, McLeay et al. (2014b) profess that commercial banks first create loans, as a result of which they create corresponding deposits and, thus, new money (actually money substitutes).3 They also claim that the supply of deposits and reserves does not actually limit the issuing of loans, because commercial banks can always borrow missing reserves on the interbank market or from the central bank. Therefore, the amount of created deposits determines the level of bank reserves that commercial banks want to maintain and which are provided by the central bank, as if on demand. As a consequence, central

74 The Cantillon effect and credit expansion banks do not directly influence the money supply by determining the size of the monetary base and the reserve requirement rate (the money multiplier), but only indirectly by affecting the interest rate.4 However, how does the credit expansion work and what are its consequences? First, commercial banks create new money, which induces the Cantillon effect. Second, central banks also create new money by issuing a monetary base (cash or bank reserves), which also gives rise to the first-round effect. Third, central banks influence the course of money creation, affecting commercial banks (if not directly, then indirectly), so their monetary policy has a significant impact on the whole process and, consequently, on the final implementation of the Cantillon effect.

What is the Cantillon effect in the process of credit expansion? What is the first-round effect of credit expansion and how does it differ from the Cantillon effect associated with other monetary inflation channels? First, as in the case of other mechanisms of growing the money supply, the beneficiaries are net debtors (by reducing the real value of their debt) and the first recipients of new money.5 In the case of credit expansion, the first recipients of new money are the broadly defined financial sector, public sector, and the borrowers. The issuance of monetary base (cash and bank reserves) benefits primarily the central bank, which creates new money out of thin air, and the recipients of this money, i.e. commercial banks, as well as other financial institutions engaged in open market operations and entities trading in treasury debt instruments (so-called primary dealers), which are widely used by them. Money created by commercial banks benefits those banks and the borrowers, who receive loans, as well as sellers of assets that commercial banks purchase with the newly created money. Since the central bank is a public institution, whose possible profits are transferred to the Treasury, and since open market operations (and other central bank operations, such as quantitative easing) involve government debt instruments, the public sector also benefits from credit expansion. The relative benefits of the financial sector from credit expansion and being one of the first recipients of newly created money may explain the significant increase in the financial sector’s share of GDP in the United States over the last several decades (Greenwood and Scharfstein, 2012). This will be discussed in detail in Chapter 8 devoted to the increase in income and wealth inequalities in the OECD countries observed since the 1970s. Additionally, according to Hayek (1935), in the case of credit expansion, what also occurs is redistribution of income from consumers to entrepreneurs (so-called forced savings). According to this approach, such redistribution takes place because new money goes into the economy as loans, which “are generally granted for the production processes” (Huerta de Soto, 2006, p. 263). It should be noted, however, that since the (original) edition of Hayek’s Price and Production ([1935] 2008), the share of mortgage loans to households has increased significantly at the expense

The Cantillon effect and credit expansion 75 of commercial and industrial loans. Jordà et al. (2014) note that commercial banks currently mainly provide mortgage loans to households. This means that credit expansion taking place in the modern economy will rather lead to the redistribution of income from people who don’t own any real estate to owners of real estate or from the entire economy to the construction sector and the real estate market. Hayek (1935) believed that credit expansion would also lead to redistribution between entrepreneurs: from entrepreneurs in the lower-order sector (close to consumption) to entrepreneurs in the higher-order goods sector (more distant from consumption).6 The new loans go predominantly to the latter group, because the production of capital goods is more sensitive to changes in interest rates (Robbins, 1934). The longer the production process lasts, the more sensitive it is to changes in interest rates. Since new loans can be introduced into the economy only at a reduced interest rate (ceteris paribus), they will most likely be taken by entrepreneurs whose investment projects will benefit most from the reduction of borrowing costs, and thus probably to entrepreneurs in the capital goods sector (Machlup, 1932). Second, the new money generated as a result of credit expansion, as the name suggests, is introduced into the economy not by, for example, government spending, but through the credit channel. This entails extremely important consequences, because credit expansion – in contrast to other types of monetary inflation – increases the loanable funds and, as a consequence, reduces interest rates, whether due to loans granted by banks or as a result of purchasing securities (interest rates are inversely related to asset prices). According to the theory of the Austrian school (e.g. Hayek, 1935), this spurs the business cycle and leads to an increase in asset prices, which may result in price bubbles, and provides additional support for debtors (including the government) who not only have a debt that is worth less in real terms because of price inflation, but who also can rollover their debt more cheaply. At the same time, the increase in prices worsens the position of creditors who are left with money that is worth less. Additionally, the drop in interest rates hits those who save, especially pension funds and insurance companies (Berends et al., 2013), which due to low interest rates may be forced to look for more risky projects with a higher rate of return (Antolin, Schich, and Yermo, 2011). It should be noted that credit expansion does not reduce all interest rates to the same extent and thus does not affect all classes and types of assets in the same way. It has a greater impact on short-term rates (Robbins, 1934), which sharpens the yield curve.7 The elevation of the yield curve due to credit expansion results from the fact that open market operations most often use short-term securities, so new money first hits the short-term loans market, causing a relatively larger reduction in short-term interest rates. The Cantillon effect in credit expansion is also responsible for changes in the term structure of interest rates, which is schematically illustrated in Figure 5.1. Such a change in the structure of interest rates generally helps banks, as they borrow short-term and provide long-term loans (Genay, 2014). On the other hand, the sharpening of the yield curve negatively affects entities who have long-term liabilities and short-term assets.

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The Cantillon effect and credit expansion

Figure 5.1 Diagram of the impact of the Cantillon effect resulting from credit expansion on the term structure of interest rates (with the length of loan terms in years on the abscissa axis and the interest rate level on the ordinates axis) Source: Author’s compilation

Finally, it is worth noting that credit expansion also leads to a significant Cantillon effect in the international dimension. Monetary inflation taking place in one country (especially one that issues reserve currency or is important from the point of view of the global economy) will also affect other economies, for example through international trade, interest rate arbitrage, or changes in currency exchange rates. The international Cantillon effect will be discussed in more detail in Chapter 9. In summary, credit expansion causes business cycle phenomena and relatively supports net borrowers, the financial sector, and the public sector. The specific structure of income and wealth redistribution depends on how central banks conduct monetary policy and how commercial banks create new money (about which I write more in the next chapter), as well as how borrowers spend it. The process of credit expansion, and thus the manner in which the Cantillon effect occurs, may also be affected, in a broad sense, by the government’s economic policy and the activities of financial institutions that are not banks.

Notes 1 Secondary features of the business cycle are its unnecessary features, which depend on specific circumstances (such as the manner of creation and distribution of new money in the economy) and make each business cycle different. 2 The history of this theory is introduced by Hayek (1933). As the publishing date of Davenport’s book, Hayek gives 1915, while the first edition actually appeared in 1913. 3 Cf. Carpenter and Demiralp (2010); Disyatat (2008).

The Cantillon effect and credit expansion

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4 How commercial banks actually create new money and the role of central banks in this process are extremely important issues. However, for the purpose of this chapter, a general scheme will suffice. Many factors remain unchanged regardless of whether we adopt the more monetarist or post-Keynesian optics. 5 A net debtor can be defined as an entity which in the given period incurred a debt of a higher value than the acquired financial assets or loans granted. The net creditor is, in turn, an entity that granted loans or acquired financial assets of a higher value than the debt incurred in a given period. In most modern economies, the government is one of the largest net debtors. As for other business entities, the distribution pattern changes over time, as discussed in more detail in Chapter 8. 6 According to other perspectives of the Austrian theory of the business cycle, there will be a redistribution of income from entrepreneurs producing middle-order goods to both entrepreneurs from the higher-order goods sector and the lower-order goods sector – see Garrison (2004). A comparison of the different variants of the Austrian Business Cycle Theory goes beyond the subject matter of this book. 7 The yield curve is a graphic illustration of the relationship between the bond yield and the maturity date. Normally, the yield curve is upward-sloping, which illustrates that the interest rate increases with the longer maturity date. The yield curve may be subject to lateral shifts when all types of interest rates (short-term, medium-term, and long-term) change approximately by the same amount, but also its curvature and slope may change. Changes in the slope mean that short-term and long-term rates change by a different value. The flattening of the yield curve means a situation in which the difference between the short-term and long-term interest rates is reduced. In turn, the sharpening of the yield curve means a situation in which the difference between the short-term and long-term interest rates widens, for example due to a greater decline in short-term interest rates in relation to long-term interest rates (Fabozzi, 2000).

6

The Cantillon effect and the secondary characteristics of the business cycle1

In the previous chapter, I demonstrated how the Cantillon effect resulting from credit expansion drives the business cycle. In this chapter, I will examine how different manifestations of the first-round effect are responsible for the so-called secondary features of business cycles. It is a fact that there are no two identical business cycles (Mukherjee, 2005). Although many factors contribute to the differences in their course, including different institutional conditions, I argue in this chapter that the differences in how new money is introduced through the credit channel are largely responsible for the nonhomogeneous course of business cycles. I focus on the impact of investment policies of commercial banks, but it is worth remembering that also differences in monetary policy and investment decisions of enterprises affect the course of the business cycle – I will return to these issues at the end of the chapter. There is a consensus among researchers that commercial banks create deposits and thus the majority of money supply in modern economies (McLeay et al., 2014b). However, economists are not interested in researching how commercial banks bring new money into the economy, focusing instead on the analysis of large aggregates. Meanwhile, differences in the process of creating bank deposits are of significant importance to the economy, because commercial banks, through their investment policy and decisions regarding the structure of assets, influence the course of the business cycle.

The Cantillon effect and various ways of creating deposits First of all, commercial banks can create deposits, and thus money, both by granting loans and by buying assets.2 The creation of deposits by granting loans has been sufficiently described in the existing literature (e.g. Huerta de Soto, 2006, McLeay et al., 2014b), therefore I will not be presenting this process in detail here. It is enough to say that in the modern economy, banks provide loans by crediting the borrower’s bank account, which increases the supply of deposits basically ex nihilo. I would point out here that the purchase of securities by commercial banks results in exactly the same effect as granting loans, because if the bank buys assets from its client, the bank will pay for those assets by increasing the client’s deposit balance, just like when granting a loan. If,

The Cantillon effect and the business cycle 79 which is more likely, the bank buys certain securities from customers of other banks, it will pay by bank transfer. In this case, the bank may lose some reserves (such as when borrowers pay for goods and services purchased from customers of other banks), but from the point of view of the banking system the effect is the same: an increase in bank deposits (Kent, 1947). Thus, the acquisition of assets by commercial banks in the system of fractional reserves also leads to the creation of deposits and – in accordance with the Austrian theory – drives the business cycle. This is because the acquisition of assets also results in a decline of market interest rate below its natural level, which leads to erroneous investments made by entrepreneurs. Investing in both bonds and stocks (for the sake of simplicity, I distinguish only these two types of investments) disturbs the structure of interest rates and, consequently, the structure of production. The easiest way to understand this is in the case of bonds, whose price is directly, though inversely, related to the interest rate (however, the same reasoning scheme applies to stocks). The increase in their prices due to purchases made by banks leads to a decrease in their yields, which then leads – on the basis of arbitrage (an increase in bond prices makes other assets more attractive) – to shifts in other markets and lowering of the entire yield curve (Philips et al., 1937). In other words, the securities market is part of the broad credit market just like the bank loan market. This means that the purchases of securities by commercial banks also lead to inter-temporal disturbances (i.e. to lowering of market interest rates below their natural level) and drive the business cycle. However, there is no reason to assume that both channels of increasing money supply will affect the economy in the same way. The new money first reaches different people, affecting different markets in different ways. In this section – in the spirit of Cantillon’s pioneering analysis – I look at the differences in the processes of creating deposits by granting loans and by acquiring securities. The summary of those differences is presented in Table 6.1. First of all, buying assets can cause a price bubble in the financial assets market more quickly, because new money goes directly to the asset market. Second, the injection of newly created money into the assets market leads to a different redistribution of income and wealth. It is obvious that the financial sector benefits from such a creation of deposits to a much greater extent, because that’s where the new money goes in the first place (Greenwood and Scharfstein, 2012). This channel of growing the money supply also supports holders of financial assets (an increase in prices of stocks, for example, benefits all shareholders, even if the new money only reaches some of them). However, this is done at the expense of marginal buyers who, in the face of price increases, cannot afford a given purchase. According to Hülsmann (2013) this leads to an increase in wealth inequalities. The above redistribution scheme is fundamentally different from the standard version of “forced savings” by Hayek (1935), according to which new money is given to entrepreneurs for investment, which is relatively disadvantageous to consumers. If banks buy government bonds, as is often the case in modern economies, then the government sector also gains from this type of credit expansion.

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Table 6.1 Differences between the banks’ creation of deposits by granting loans and by acquiring securities Aspects of impact from creating deposits/method of creating deposits by commercial banks

Granting loans

Acquisition of securities

Impact on the asset market and price bubbles

New money does not have to go directly to the asset market

New money goes directly to the asset market, which can contribute to faster forming of a price bubble

Impact on the redistribution of income

Forced savings

Redistribution benefitting the financial sector

Impact on the production structure

Faster

Slower, as long as new money remains in the financial sector for some time

Impact on restructuring

Low demand for loans may force restructuring

The ability to acquire assets delays the adjustment processes

Impact on the size of credit expansion

Weaker

Stronger (assets can be used as collateral for loans)

Impact on business investments

Weaker

Stronger (by increasing Tobin’s Q ratio and the value of collateral)

Impact on liquidity

Loans (short-term) are quickly repaid

Assets are harder to get rid of from the point of view of the entire banking system

Impact on long-term interest rates

Weaker

Stronger (when acquiring long-term assets)

Impact on the effectiveness of monetary policy

Monetary policy works normally

Monetary policy is weakened (new money goes to the financial market, the possession of assets makes the commercial banks independent of the central bank)

Source: Author’s compilation

Third, purchasing of assets by banks may delay the start of a general economic boom or extend its duration. As long as new money does not end up in the “real” economy (but is somehow absorbed in the chain of financial transactions),3 it does not distort the production structure (Machlup, 2013 [1940]; Bagus, 2007). This is due to the fact that the business cycle is not driven by creating loans per se, but by allocating newly created money into more roundabout (indirect) methods of production. Fourth, the acquisition of securities by banks may delay the necessary adjustment processes during a crisis or depression. The reason for this is that banks can buy assets (and this is usually the case) when the demand for

The Cantillon effect and the business cycle 81 loans is low. As a consequence, the process of credit expansion (creation of deposits) may take longer (than in the case of banks only granting loans), leading to subsequent erroneous investments in the production structure. In particular, commercial banks may decide to increase the amount of government bonds they hold, which, as a result of pushing out private investment, further complicates the necessary adjustment process during a recession (Spencer and Yohe, 1970).4 It is worth noting here that by converting loans into securities in the securitization process, commercial banks may circumvent capital regulations, improve capital ratios on their books and, consequently, increase their lending activities. Fifth, the purchase of assets by commercial banks may lead to greater credit expansion, and therefore to a stronger Cantillon effect. This is because – in addition to the aforementioned role of securitization – the increase in asset prices (a consequence of asset acquisitions by banks) may then enable potential borrowers to take out loans secured by those assets (Robbins, 1934). In other words, the creation of money through the acquisition of assets raises their prices. More expensive assets become more valuable as collateral, which can then be used against more loans, including those granted by the central bank to commercial banks, increasing the potential for further expansion of deposits (Prithard, 1964). Sixth, an increase in asset prices may lead to increased corporate investment, as a result of a rise in the Tobin’s Q ratio, and an increase in the net value of their assets and collateral held for loans (Mishkin, 2001). Seventh, the acquisition of securities by banks may reduce their liquidity and increase the banks’ sensitivity to fluctuations in the prices of financial assets (as compared to granting loans). Of course, whether this will happen depends on the type of assets purchased (and loans granted). However, it should be noted that short-term loans are naturally repaid rather quickly, while assets have to be sold, which may take some time, especially if prices are falling and banks are not willing to accept losses. Moreover, it is much more difficult to get rid of assets from the point of view of the entire banking system, as removing them from the consolidated balance sheets requires finding buyers from outside the banking sector, which is not always easy, especially during a recession (Philips et al., 1937).5 This is extremely important because the slower the process of liquidation of erroneous assets, the longer the recession lasts (the condition for recovery is that assets incorrectly allocated during the boom are re-employed in truly productive investments, and this requires the process of restructuring and liquidation of unprofitable assets). Eighth, acquiring long-term assets has a greater impact on the long-term interest rate, which may lead to a temporary boom (especially in interest-sensitive sectors such as the real estate sector). In other words, long-term investments of commercial banks may drive the business cycle faster and easier than short-term

82 The Cantillon effect and the business cycle loans, because the impact of a long-term interest rate reduction on investments is stronger than short-term. Ninth, buying securities weakens the effectiveness of the central bank’s monetary policy. Because the newly created money goes to the financial sector, the central bank cannot easily influence real economic variables. For example, in the 1920s, the Fed wanted to halt the growth of the asset market bubble and stimulate the “real” economy at the same time, which was impossible (because the increased money supply hit the financial market first) (May, 1935). What is more, possession of financial assets (and their sale) by commercial banks allows them to expand their loan granting activities without the need to obtain additional funds from the central bank. Summing up, the very method of creating deposits (through granting loans or by acquiring assets) is extremely important, as it leads to different manifestations of the Cantillon effect, affecting the course of the business cycle in different ways. Of course, lending is the primary activity of banks, and changes in the amount of assets held can often be a passive reflection of economic activity rather than the result of an active investment policy (Bolton, 1963). For example, banks often buy securities during a recession, when they turn to more secure investments, such as treasury bonds (Klein, 1965), or when they cannot find reliable borrowers, or when demand for loans falls, and asset purchase is associated with a higher expected rate of return (Kent, 1947; Philips et al., 1937). In light of this interpretation, the acquisition of assets by banks would be one of the many unintended consequences of monetary policy. Nevertheless, it is true that banks, through their investment policy – regardless of the reasons behind the decisions that shape it – may impose significant economic effects and influence the course of the business cycle (Bolton, 1963).

The Cantillon effect and various types of loans The above analysis can be disaggregated even more. Banks can create new money by buying various types of assets and by providing various types of loans, each of which will lead to a different Cantillon effect. At this point, I will focus on the differences in loans granted by banks, but it is worth noting that when it comes to investing in assets, they can be divided into investments in foreign assets, Treasury bonds, and domestic private securities. Buying the foreign assets supports exporters and, in a way, exports inflation and the business cycle to other countries. On the other hand, the purchase of government bonds supports government spending and leads to the redistribution of income and assets from the private sector to the government sector. This method of monetary inflation may also result in higher (or more quickly materialized) inflation of prices of consumer goods and services, because newly created money will go into the economy through government spending. Buying Treasury bonds by commercial banks may also weaken their motivation to carry out restructuring during the recession, and increase their dependence on fiscal authorities (and vice versa) (Rzon´ca, 2014). While, the acquisition of private domestic assets by commercial banks may lead to a price bubble.6

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Bank loans can be granted to many different entities or sectors for financing various projects. The specific choices made by commercial banks when granting loans – and thus the different ways of introducing new money into the economy – will lead to different economic consequences (Fraser, 1933). In other words, the allocation of credit affects the structure of investment and production (entities that have received financing can develop their investment projects and increase production) (Steiner et al., 1958). Loans can be classified according to a number of criteria. You can divide them into, for example, those denominated in national currency and those in foreign currencies.7 Another criterion may be the type (households, financial companies, non-financial companies, etc.) or the size of the borrower (small and medium businesses, large businesses). In this work – due to the significance and availability of data – I distinguish mortgages, commercial and industrial loans, brokerage loans, and consumer loans (for purposes other than the purchase of real estate). Let me start by discussing mortgages. Providing mortgage loans leads to some unique effects for this channel of monetary inflation. First of all, it is obvious that prices of real estate will grow, which is beneficial for homeowners and the construction sector, but negatively affects marginal buyers and owners renting out apartments and houses (higher property prices mean lower profitability at unchanged rental rates). Second, granting mortgage loans reduces banks’ liquidity and is associated with a relatively high risk.8 Third, the increase in the supply of this type of loan may reduce employee mobility (selling real estate purchased on credit may be more difficult and time-consuming than terminating a lease agreement), which affects the efficiency of the labor market (Ferreira et al., 2012). In turn, the less flexible the labor market, the longer the necessary process of reallocating work during a recession. Fourth, because real estate is generally the dominant component of a population’s assets, the increase in real estate prices may lead to an increase in consumer spending due to the wealth effect (Carroll et al., 2006). Fifth, granting mortgages can lead to a housing bubble, whose burst generally results in a slower economic growth rate than the bursting of bubbles on other assets markets (Detken and Smets, 2004). This is due to the fact that granting mortgages leads to a significant debt overhang among households,9 which reduces financial stability and usually leads to deeper recessions and slower subsequent economic recovery (Jordà et al., 2014). Sixth, because real estate is essentially immobile and relatively specific (houses and buildings have less different possible uses), the financial crisis resulting from the burst of a real estate bubble is associated with higher costs for the society. Granting brokerage loans has very similar effects to direct purchases of investment assets by banks. In this case, the prices of assets will also grow, while the inflationary redistribution of income and wealth will support the financial sector. It should be noted, however, that brokerage loans also support borrowers who are the first to receive the newly created deposits, while in the case of direct purchases of investment assets, new money goes directly to the sellers. Commercial banks may introduce newly created funds into the “real” economy indirectly (via the stock exchange) or directly through loans to entrepreneurs for investment purposes. There are many types of business loans, but

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Table 6.2 The most important differences between granting various types of loan Type of loan granted

Unique consequences (characteristics)

Mortgages

Real estate prices increase (possible price bubble), wealth effect, lower liquidity of banks, lower employee mobility, less stability of the financial system

Commercial-industrial loans

Forced savings, increasing production capital

Brokerage loans

Faster rise in prices of financial assets, redistribution of income to the financial sector

Consumer loans

Lack of forced savings, faster inflation of consumer prices, lower productivity

Source: Author’s compilation

they all have one thing in common: it seems that they inflate the prices of goods and services more quickly than loans that first reach the asset market. Historically, banks have mainly provided loans of this type. Unlike other types of loans, loans granted to entrepreneurs lead to a redistribution of income from consumers to entrepreneurs, that is to forced savings (Hayek, 1935). According to researchers, loans granted to entrepreneurs are the most conducive to economic growth because they finance investments to the greatest extent (Rzon´ca, 2014). Consumer loans are a different type of loan, because their expansion does not lead to a lengthening of the production structure, but to its shortening – provided that the borrowers do not allocate the money (or other financial resources released by the loan) for durable goods,10 but for current consumption (Huerta de Soto, 2006). Granting such loans implies, therefore, a different scheme for the redistribution of income and wealth. Newly created money is passed on to the consumers, not to entrepreneurs. This is important, as it may lead to higher (materialized more quickly) inflation of consumer goods and services than in the case of loans to entrepreneurs. Finally, it is worth noting that non-mortgage consumer loans are often provided for the purchase of cars, so this way of monetary inflation can support the automotive industry. The type of loan granted by commercial banks (and, thus, the creation of new deposits) is therefore of great importance for the real economy, the implementation of the Cantillon effect, and the course of the business cycle. The most important differences between granting various types of loan are summarized in Table 6.2.

Empirical data on differences in investment policy of commercial banks In the previous section, I presented theoretical considerations on the differences in the way that new money is introduced into the economy as part of credit expansion and the different resulting manifestations of the Cantillon effect. In

The Cantillon effect and the business cycle 85 this section, I will present empirical examples from the economic history of the United States, which confirm that the manner of creation of deposits by commercial banks and the type of assets purchased or loans granted significantly affects the real economic variables and is largely responsible for the so-called secondary features of the business cycle. Before World War I, American commercial banks provided mainly shortterm loans. However, due to more and more entrepreneurs raising funds on the securities market, together with improved methods of asset valuation, relatively loose monetary policy of the newly created central bank, and inflow of funds into commercial banks, the share of securities in their balance sheets increased (Willis and Chapman, 1934; May, 1934). During the War and shortly thereafter, Treasury bonds played a key role. In 1916, their share was slightly less than a third of all investments of domestic commercial banks, while in 1919 they constituted 62.8% of their investment portfolio,11 only to drop to 50.2% in 1921 (Kazakévich, 1934). Between March 1917 and June 1919, the value of loans increased by 70%, while the value of investments in Treasury bonds increased by 450%. Also, between March 1917 and June 1920, the value of all investments of the Federal Reserve member banks increased by 130%, while the value of Treasury bonds they held increased by 300% (Philips et al., 1937). It can therefore be argued that the mentioned expansion and the subsequent recession were caused, at least in part, by changes in the value of government bonds held by commercial banks. In order to finance military expenditures, the federal government encouraged banks to buy government bonds and grant loans against these bonds (E. White, 2009). This way of credit expansion resulted in an increase of military expenditures and redistribution of income and wealth from the private to the government sector. This period is also an example of how the acquisition of Treasury bonds by commercial banks may lead to higher monetary inflation compared to a different method of creating deposits. Between March 5, 1917 and June 1918, the value of government bonds held by Federal Reserve member banks increased by $ 1.78 billion, ultimately leading to a $7 billion increase in all loans and investments (Philips et al., 1937). The economic boom in the 1920s, which preceded the Great Depression, was largely due to the increase in investments by commercial banks and the proportion of brokerage and mortgage loans on their balance sheets.12 Indeed, the share of securities in the value of all investments and loans of domestic banks increased from 23.5% in 1920 to 31% in 1929 (Kazakévich, 1934). Between March 8, 1922 and December 29, 1926, the value of domestic bank investments increased by 52.8%, while the value of all investments and loans granted increased only by 38.4%. The impact of bank investments on the securities market was amplified by brokerage loans granted against stocks and bonds. Between 1921 and 1929, the value of brokerage loans granted by Federal Reserve member banks increased from 3.7 billion to 8.3 billion dollars (May, 1934). The share of loans granted by domestic banks for investments in securities increased from 22.5% to 34.6% of the value of all loans (Kazakévich, 1934).

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The Cantillon effect and the business cycle

The example of the 1920s also shows the importance of mortgage loans for the course of the business cycle. Mortgages gained significantly in popularity at that time, contributing first to the boom in the real estate market, and then to the bursting of its bubble (Becker, 1934). Indeed, the value of these loans granted by domestic commercial banks increased from 184 million dollars in 1919 to 725 million in 1926, which corresponds to an increase from 1.7% to 7.6% of all loans granted (Becker, 1934). According to Philips et al. (1937), although brokerage and mortgage loans are classified as loans, they have a lot in common with proper investments and lead to similar inflationary processes. All these “methods” of creating deposits affect the long-term interest rate and reduce the liquidity of banks. Acquisition of securities by commercial banks in the 1920s extended the maturity of bank assets, which reduced the banks’ liquidity, contributing to their problems after the stock market crash, when stock prices began to fall (Philips et al., 1937).13 Mortgage loans had a similar effect on the liquidity of banks. According to Becker (1934), excessive mortgage lending in the 1920s contributed significantly to the lack of liquidity of US banks, often forcing them to suspend operations or into bankruptcy. During that decade, long-term interest rates also fell (as a result of banks’ investments in assets), which increased the profitability of issuing new bonds and stocks. This favorable situation on the capital market – according to Philips et al. (1937) – led to the boom in the real estate market: the first market to heat up was Florida, before the fever eventually took over the entire country. Another beneficiary of excessive credit expansion was the stock market, which ultimately led to the stock market bubble. It is worth noting that these long-term investments of commercial banks caused a certain pro-cyclical feedback loop. Lowering long-term interest rates prompted entrepreneurs to replace short-term bank loans by issuing shares and bonds. As a result of a drop in the demand for loans, banks were willing to acquire newly issued securities, which deepened the decline in long-term interest rates and, as a consequence, strengthened the boom in asset markets (Philips et al., 1937). In other words, significant purchases of securities by commercial banks and granting brokerage and mortgage loans caused an unsustainable boom in the real estate market and inflated the stock bubble that burst in 1929. That stock market crash was also related to the investment policy of commercial banks, and more specifically to the selling securities by commercial banks in order to increase the amount of mortgage and brokerage loans granted (Philips et al., 1937). This clearly confirms that method of credit expansion and changes in the structure of commercial banks’ assets have a significant impact on the course of the business cycle. The 1930s and World War II were the next periods when American commercial banks eagerly created deposits through the purchase of government bonds. The share of loans in the asset portfolios of the Federal Reserve banks decreased from 71.2% in 1925 to 38.9% in 1936 and down to 22.8% in 1946, while the share of government bonds increased from 12.1% in 1925 to 70.9% in 1946 (their value increased nineteen-fold in the same period) (Kent, 1947).

The Cantillon effect and the business cycle 87 These changes in the structure of commercial banks’ assets were extremely important because they delayed the necessary adjustment processes during the Great Depression. Banks supported government spending, which displaced productive investments of the private sector. The purchase of government bonds allowed banks to access central bank funds (using those bonds as collateral), despite the fact that their credit policy left much to be desired (Shere, 1935). My disaggregated analysis can also be applied to the post-war period in the United States. As can be seen in Figure 6.1, from 1947 to 1970, the share of securities in commercial banks’ assets decreased. This does not mean, however, that the acquisition of assets ceased to be an important channel of credit expansion, as shown in Figures 6.2 and 6.3. They present the value of investments and various types of loans (commercial and industrial, mortgage, consumer, and other) granted by commercial banks in the years 1960–80 and 1980–2014, respectively. As one can see, investments in securities (dotted line) were an important channel of credit expansion in both periods. For many years it was relatively the most important category of banking assets – from the early 1990s, only mortgage loans (long dashed line) reached higher values. Figures 6.1–6.3 show two important things. First, between 1960 and the mid1980s, commercial and industrial loans were a very important and periodically dominant channel of credit expansion. Monetary inflation occurring this way may

90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

1947-01 1949-06 1951-11 1954-04 1956-09 1959-02 1961-07 1963-12 1966-05 1968-10 1971-03 1973-08 1976-01 1978-06 1980-11 1983-04 1985-09 1988-02 1990-07 1992-12 1995-05 1997-10 2000-03 2002-08 2005-01 2007-06 2009-11 2012-04

Shares of loans and leases vs. securities in assets of commercial banks

Securitires

Loans

Figure 6.1 Share of investments in securities (dashed line) and loans and leases (solid line) in total assets of commercial banks in the United States in the period from January 1947 to May 2014 (monthly data, seasonally adjusted) Source: Board of Governors of the Federal Reserve System, H.8 Assets and Liabilities of Commercial Banks in the United States for June 13, 2014, www.federalreserve.gov/ releases/H8/, 23.06.2014

Figure 6.2 Values of investments in securities and various types of loans granted by commercial banks in the United States between 1960 and 1980. Investments in securities (solid line); commercial and industrial loans (dotted line); mortgage loans (small dashed line); consumer loans (long dashed line).14 Source: Board of Governors of the Federal Reserve System, H.8 Assets and Liabilities of Commercial Banks in the United States for June 13, 2014, www.federalreserve.gov/ releases/H8/, 23.06.2014

Figure 6.3 Value of investments in securities and various types of loans granted by commercial banks in the United States between 1980 and 2014. Mortgage loans (small dashed line); investments in securities (solid line); commercial and industrial loans (dotted line); consumer loans (long dashed line). Source: Board of Governors of the Federal Reserve System, H.8 Assets and Liabilities of Commercial Banks in the United States for June 13, 2014, www.federalreserve.gov/ releases/H8/, 23.06.2014

The Cantillon effect and the business cycle 89 have contributed to the commodity boom and the increase in price inflation (measured both by CPI and PPI indexes) (Bordo and Landon-Lane, 2013).15 Second, the value of mortgage loans granted by commercial banks increased from the mid-1980s to 2009. The proportion of this type of loan in all the loans granted by commercial banks also increased significantly. This can be seen in Figure 6.4, which shows the structure of commercial bank loans from January 1947 to May 2014. Such a significant increase in the relevance of mortgage loans contributed to the creation of a price bubble in the US real estate market in the first decade of the 21st century, accompanied by an increase in consumer spending due to the wealth effect (Carroll et al., 2006) and a decline in household mobility (Ferreira et al., 2012).16 The increase in the proportion of mortgage loans also caused an increase in household debt, which may explain the relatively slow pace of economic recovery after the end of the Great Recession in 2009 (Jordà et al., 2014). The changes occurring in the structure of loans granted by commercial banks may also explain the relative growth of the construction sector and the redistribution of income from people who don’t own real estate to the owners.17 The above-mentioned upward trend in the value of granted mortgage loans – especially for households – means that credit expansion is used less and less to increase production capacity through investments in physical capital – as Hayek assumed ([1935] 2008) – but rather to smooth out consumption in the life cycle or for speculative purposes associated with the expectation of an

Structure of loans granted by commercial banks 60% 50% 40% 30% 20% 10% 19 47 -0 1 19 52 -0 1 19 57 -0 1 19 62 -0 1 19 67 -0 1 19 72 -0 1 19 77 -0 1 19 82 -0 1 19 87 -0 1 19 92 -0 1 19 97 -0 1 20 02 -0 1 20 07 -0 1 20 12 -0 1

0%

Commercial-industrial loans

Mortgage loans

Consumer loans

Other loans

Figure 6.4 Percentage composition of loans granted by commercial banks in the United States between January 1947 and May 2014 (commercial and industrial loans – dotted line; mortgage loans – solid line; consumer loans – dashed line; other loans – dot and dash line) Source: Board of Governors of the Federal Reserve System, H.8 Assets and Liabilities of Commercial Banks in the United States for June 13, 2014, www.federalreserve.gov/ releases/H8/, 23.06.2014

90 The Cantillon effect and the business cycle increase in the prices of existing assets (Turner, 2010).18 The changes in the structure of loans granted by commercial banks have a significant impact on the rate of economic growth – according to Beck et al. (2012) corporate loans are positively correlated with economic growth, while a similar correlation for household loans does not occur. Rzon´ca (2014) believes that the expansion of loans to households for the purchase of real estate is most dangerous because it results in a capital structure that is least suited to the structure of aggregate demand, i.e., that is characterized by high adjustment costs and limited opportunities for rapid restructuring (e.g. due to the specific nature of the capital involved in housing construction19).

Summary In Chapter 4, I classified the various channels of monetary inflation and showed that they lead to different manifestations of the Cantillon effect and different economic results. Credit expansion is currently the most important mechanism of introducing new money to the economy. What is important, however, is that it’s not a homogeneous monetary inflation channel. There are different “methods” of creating bank deposits. This is a very important issue, because commercial banks, through their investment policy and decisions regarding the structure of assets, affect the course of the business cycle. All the more surprising is the lack of literature on the effects of granting various types of loans (or buying assets) by commercial banks (Moulton, 1935). In other words, various mechanisms for introducing new money into the economy (within the credit expansion channel) lead to different secondary features of business cycles. For example, granting a significant amount of mortgage loans may lead to a boom in the real estate market and relative growth of the construction sector in relation to the entire economy, wealth effect, reduction of employee mobility, and lower liquidity of banks and a larger debt overhang – these phenomena do not necessarily occur (or may occur to a lesser extent) in the case of banks granting other types of loans or purchasing securities. I think, therefore, that it is important to analyze credit expansion in a more disaggregated way, following – in the spirit of Cantillon’s analysis – where newly created money goes, because such disaggregated analysis of credit expansion and changes in the structure of commercial banks’ assets can help us better understand the business cycle and secondary phenomena accompanying it, such as price bubbles. Of particular value may be the classification of business cycles according to the dominant channel of credit expansion. My initial proposal distinguishes business cycles driven by: (1) the stock market (through direct purchases of securities by banks or brokerage loans), as in the 1920s before the Great Depression; (2) investments in treasury bonds, as in the 1930s and during the two World Wars; (3) the real estate market (through mortgage loans and investments in mortgage bonds), as in the first decade of the 21st century; (4) the commodity market (through commercial and industrial loans), as in the

The Cantillon effect and the business cycle 91 1960s and 1970s. The above classification of business cycles due to the dominant credit expansion channel is presented in Table 6.3. These different credit expansion channels do not affect the basic mechanism of the business cycle (characterized by erroneous investments as a result of the artificially lowered interest rate) but are responsible for the differences in the so-called secondary features of business cycles that make them nonidentical despite obvious similarities. Finally, it is worth noting that the course of the business cycle and the implementation of the Cantillon effect are influenced not only by the investment policy of commercial banks, but also by other factors. I mention a few of them here. First of all, central banks may conduct monetary policy in various ways and create a monetary base, which has varied effects on credit expansion and, consequently, on the course of the business cycle. For example, quantitative easing is a different mechanism of introducing new money into the economy, relative to traditional open market operations, generating a slightly different first-round effect. While in the open market operations the most frequently purchased debt instruments are short-term Treasury bonds, quantitative easing may take place through also buying long-term bonds, including non-treasury bonds (e.g. corporate bonds or bonds secured by mortgages) (Bowdler and Radia, 2012). This entails different redistributive effects, also affecting the yield curve and the risk premium in different ways. Second, the type of entity that creates new money through the credit market and the way it is created is also important for the course of the business cycle and the implementation of the accompanying Cantillon effect. At present, a significant portion of loans are granted for the purpose of converting them into securities or, in general, by entities other than commercial banks. Indeed, banking activity has changed significantly in recent years and banks have largely abandoned traditional commercial banking based on taking deposits and lending, and instead adopted a business model based on loan securitization and their distribution to the so-called shadow banks (Meeks et al., 2013). The effects of increasing the money supply (in the form of credit) vary, therefore, depending

Table 6.3 Preliminary classification of business cycles due to the dominant credit expansion channel Dominant channel of credit expansion

Historical example

Stock market

1920s

Treasury bond market

1930s and periods of world wars

Mortgage loans, real estate market

First decade of the 21st century

Commercial and industrial loans, commodity and raw material market

1960s and 1970s

Source: Author’s compilation

92 The Cantillon effect and the business cycle on what type of bank (rural or urban, small or large) or institution provides the loan. Loans can be created not only by commercial banks. Other depository institutions (such as savings banks or credit unions) and the so-called shadow banking system also participate in this. The creation of money by shadow banks seems particularly important in the modern economy, because securitization enables traditional commercial banks to increase lending (including through transfer of credit risk outside the bank balance sheets to investors purchasing securities), and intermediation of liabilities allows the so-called shadow banks to create loans by themselves (Claessens et al., 2012). The creation of a loan through a shadow banking system implies a different implementation of the Cantillon effect, because the shadow banks’ asset structure differs from the structure of traditional banks’ assets, and certain types of loans are more readily used in the securitization process. Third, the course of the business cycle and the effect of the first round are also influenced by the size and type of investments made by the borrowers. Similarly, as in the case of loans, not only the volume of investments is important, but also their structure and the changes occurring within it. Investments are often divided into investments in equipment and software, and investments in structures. It turns out that this first type increases productivity much more significantly (Stewart and Atkinson, 2013). Equipment and software embody a substantial part of technical progress (Rzon´ca, 2014). Fourth, government regulations and fiscal policy may also affect the course of the business cycle and the implementation of the Cantillon effect. Contrary to Ricardian equivalence, it is important whether the government finances its expenditures by means of debt or taxes. This is due to the fact that the issue of public debt in the current monetary system that is based on central banking and fractional reserve is inflationary (as indirect monetization of public debt occurs), that is, it leads to an increase in the money supply and all related economic consequences.

Notes 1 The content of this chapter has been previously published in different form, as the article entitled “Disaggregating the Credit Expansion: The Role of Changes in Banks’ Asset Structure in the Business Cycle”, Quarterly Journal of Austrian Economics (Sieron´, 2015c). 2 This possibility was noticed and analyzed by some authors several dozen years ago (e.g. Kent, 1947). As for more contemporary literature, see Federal Reserve Bank of Chicago (1994). 3 This is a situation when none of the participants in the transaction “pull” money from the asset market for a sufficiently long time. For example, sellers of assets sold to banks invest their money also in the securities market. I am not saying that money can be permanently absorbed in the asset market, but rather that it can reach the consumer goods and services market with a significant delay. The continuous growth of money supply, which hits the asset market in the first place, will systematically support this market, which may give the impression of permanent absorption of new money by the asset market.

The Cantillon effect and the business cycle

93

4 Rzon´ca (2014) points out that in banks with low capital, treasury securities push out loans, because increasing their share in the balance sheet allows banks to increase the capital adequacy ratio and, at the same time, continue to make profit (without carrying out the necessary restructuring of the loan portfolio). 5 Based on this, perhaps it would be better not to write about the lower liquidity of asset investments, but rather about replacing the liquidity of loans with shiftability of assets (Mitchell, 1923; Willis and Chapman, 1934). 6 Needless to say, this analysis can be disaggregated even further. The specific manifestation of the Cantillon effect will vary depending on whether the banks purchase shares or bonds. For example, since various entities own unequal proportions of certain securities, a stock market boom will support different entities than the same phenomenon in the bond market. 7 This is an important distinction because granting loans in foreign currencies is riskier than granting loans denominated in local currency and often leads to unstable credit booms (Yes¸in, 2013). 8 As Kowalczyk-Rólczyn´ska (2013, p. 190) put it, “The activity of banks engaging in financing the real estate market is a special type of economic activity burdened with complex risks due to: long-term nature of financing, high dependence on the macroeconomic situation of the country and the cyclical nature of the economy, low liquidity of assets, the need to commit a significant amount of available funds, the risk of a decline in market prices for real estate pledged as collateral, interest rate risk, exchange rate risk (in the case of foreign currency loans), loss of borrower’s ability to pay during the term of the loan agreement, problems with access to reliable sources of information about the real estate market, the local nature of the property.” 9 According to Jordà et al. (2014), household loans in selected 17 developed countries represented, on average, two-thirds of the increase in bank loans between 1960 and 2010, mainly due to mortgage loans. And, the average share of mortgage loans in the commercial banks’ loan portfolio roughly doubled from around 30% to around 60%. As a result, the ratio of household debt to owned assets in many countries significantly increased. 10 From the economic point of view, consumer durables are very similar to capital goods. However, they are not identical, as claimed by Huerta de Soto (2006), because the increase in the supply of capital goods increases labor productivity to a greater extent than the increase in the supply of durable consumer goods. 11 This increase would not have occurred, had it not been for legal changes that allowed banks to submit treasury bonds to the central bank for rediscounting (Kazakévich, 1934). 12 During this period (as well as in the previous decade), the value of foreign assets on the balance sheets of all commercial banks also increased. Between April 28, 1909 and June 30, 1932, it increased 23.6 times – from 24.6 million dollars to 580.8 million dollars – while the value of all assets increased only 2.71 times (Kazakévich, 1934). On this basis, Robbins (1934) stated that inflation was not limited to America, but also spread to other countries through foreign loans. 13 Another example of problems with liquidity after a stock bubble burst may be Japanese banks in the 1980s and 1990s. Because they held a significant number of shares listed on the domestic stock exchange, the stock boom that continued in the second half of the 1980s led to a significant increase in their activity and international expansion. In turn, the bursting of the bubble on the stock and real estate market in December 1989 led to significant losses for the banks, stoppage of credit expansion, and recession lasting for the entire decade. 14 For clarity of presentation, I did not include other loans, which include brokerage loans, agricultural loans, foreign loans, loans to local governments authorities, loans to non-banking depository institutions, loans to financial institutions that are not

94

15

16 17

18 19

The Cantillon effect and the business cycle depository institutions, unplanned overdrafts, loans not elsewhere classified, and lease financing receivables – see Board of Governors of the Federal Reserve System (2015). Another period when this type of loan played a significant role in the course of the business cycle may be the Weimar hyperinflation. According to Graham (1930), German banks at that time were not willing to provide loans for speculative purposes (e.g. for the purchase of shares), which meant that little of the newly created money went to the financial markets. Instead, the loans were going to the “real” economy, which led to a significant increase in commodity prices. More about the price bubble in the US real estate market in the first decade of the 21st century in the next chapter. Rognlie (2015) showed that the observed increase in capital share in the United States’ gross national product between 1948 and 2013 – a fact that caught Piketty’s attention (2014) – resulted almost entirely from the increase in income related to real estate. Rzon´ca (2014, p. 199) notes that “while loans to enterprises contribute to directing savings to the most effective endeavors, loans to households – by lowering the liquidity barrier that some of them encounter – reduce the savings rate.” Among the reasons for reduced chances of quick restructuring after the financial crisis resulting from the bursting of the real estate bubble, Rzon´ca (2014) also indicates greater difficulties in coordinating the restructuring of household loans than commercial loans (due to the large number of households and the dispersion of assets). Other reasons include mechanisms of political nature (the mass nature of household debt may increase the chances of banks that do not restructure their assets to gain support from the government and favorable banking supervision), the characteristics of housing loans (long maturity), and the lack of incentives to initiate restructuring by creditors (because housing efficiency cannot be significantly improved by a change of ownership) as well as debtors (due to the intangible value of living in a given place).

7

The Cantillon effect and price bubbles

This chapter will show that the Cantillon effect may also explain the formation of price bubbles (speculative bubbles on assets markets), i.e. situations, in which asset prices deviate from their fundamental values (Scherbina, 2013).1 Economists have long been interested in price fluctuations of financial assets, especially after the stock market crash in 1929 and the Great Depression. Cantillon (1755) – who, by the way, made a fortune on investments related to the Mississippi Bubble and the South Sea Bubble (Murphy, 1986) – was among the first who wrote about speculative bubbles. Although economists tend to disagree about the causes, nature, and mechanism of the formation, maturation, and subsequent bursting of price bubbles (Scherbina, 2013), the literature increasingly mentions monetary factors as being inseparable from the formation of speculative bubbles. For example, Kindleberger and Aliber (2005) believe that each “speculative manias” has been associated with an increase in the supply of loans. Similarly, economists from the Austrian school point to credit expansion as the cause of structural disruptions in the economy, including speculative bubbles in asset markets (Skousen, 1990). A similar view has also been expressed by economists associated with the Bank for International Settlements, according to whom the deregulation of the financial sector that resulted in an increase in credit supply contributed to a significant rise in asset prices in many countries in the 1980s (Borio et al., 1994). According to them, the increase in money supply and credit, and consequently asset prices, may lead to economic imbalances, even when the consumer price index is low (Borio and Lowe, 2002). After the collapse of the last real estate bubble in the United States, more and more economists began to connect the loose monetary policy of central banks and increases in the supply of money and credit with price bubbles (Taylor, 2007). Based on a study of speculative bubbles in 18 OECD countries between 1920 and 2011, Bordo and Landon-Lane (2013) concluded that loose monetary policy significantly contributes to the formation of speculative bubbles on the stock, real estate, and commodities markets.

96

The Cantillon effect and price bubbles

Channels through which a growing money supply impacts asset prices How does the increase in money supply affect asset prices? There are five channels through which the growth of money supply impacts asset prices. They are presented, in a synthetic form, in Figure 7.1. The first channel is the portfolio rebalancing channel. The increase in money supply leads to changes in cash balances and, as a consequence, to a decrease in marginal utility of the monetary unit and to changes in the entire investment portfolio, which causes an increase in asset prices (Adalid and Detken, 2007). For example, the increase in money supply that is a result of open market operations first affects the price of short-term government bonds; however, as a result of an increase in the cash balance of bond sellers and a decline in the government bond yields, investors will also be willing to purchase other financial assets (Friedman, 1969f). Because money is “dispersed” in the economy sequentially, it will necessarily take some time before monetary inflation “spills” from the financial markets to the real sector (due to the increase in prices of financial assets, other goods and services will become relatively cheaper, which will lead to increased purchases of those goods and services). Although the final effect of this process will be an increase in the general price

Portfolio rebalancing

Lowering of the interest rates

Channels, through which a growing money supply impacts asset prices

Impression of general economic prosperity

Low elasticity of asset supply

Inflow of new money to the asset market (the Cantillon effect)

Figure 7.1 Channels through which a growing money supply impacts asset prices Source: Author’s compilation

The Cantillon effect and price bubbles 97 level, the prices of financial assets may be relatively overvalued for some time, especially if new money is still going first (and to a larger extent) to the financial assets market (e.g. through open market operations or brokerage loans). Second, increasing money supply through the credit channel lowers interest rates. Because the present value of assets is the discounted sum of future cash flows that they generate, the drop in interest rates will lead to an increase in asset prices.2 It should be noted, however, that by itself, the drop in interest rates could not lead to a lasting speculative bubble (rather to a one-time price increase). Also necessary is the increase in money supply, as well as increased expenditures on a given class of assets. This is because the price bubble grows as long as there is capital flowing into the market (Scherbina, 2013). Of course, many factors (including psychological) determine on what market the bubble will appear and those factors also affect its course,3 but without an increasing supply of money, the (exponential) price increase could not take place.4 Third, credit expansion leads to a business cycle in which the phase of boom generates the impression of general economic prosperity. As a consequence, the rise in prices of financial assets may, to a certain extent, reflect the inflationary processes taking place in the real economy and the expectations of higher revenues in the future (Borio et al., 1994). The demand for financial assets serving as collateral for bank loans may also grow during the boom. However, price bubbles arise when a given asset market develops much faster than the economy as a whole. This is illustrated in Figure 7.2, showing the ratio of capitalization of the American stock exchange to GDP. As one can see, this ratio doubled from around 70 to around 140% in the second half of the 1990s, when the stock market bubble grew. After the bubble burst, it fell to about 110%. Fourth, the increase in asset prices relative to consumer goods and services may result from the lower elasticity of supply of the former (Belke et al., 2008). Because quantitative adjustments take more time in the case of assets (especially in the case 150 140 130

Percent

120 110 100 90 80 70 60 50 1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

Stock Market Capitalization to GDP for United States

Figure 7.2 Ratio of market capitalization to GDP in the United States in the period from 1989 to 2010 Source: Federal Reserve Bank of St. Louis, 2015, research.stlouisfed.org, access: 6 January 2015 Note: shaded areas indicate U.S. recessions

98 The Cantillon effect and price bubbles of land or real estate) than in the case of consumer goods and services, the increase in money supply will result in a more significant price increase in the asset markets. A relative increase in asset prices due to monetary inflation may, therefore, simply be a manifestation of the sequential nature of inflation. Fifth, commercial banks may grant loans that are directly allocated for the purchase of given assets. The constant inflow of capital to a given market may, in consequence, lead to a price bubble. This phenomenon is particularly noted by the Austrian school, which always emphasizes the importance of the Cantillon effect. For example, Thornton (2006) writes that the effects of monetary inflation will vary, depending on where the newly created money flows. Particularly the markets, where it goes first, are subject to forming a speculative bubble.5 In other words, the banking system creates money, the inflow of which is necessary to create a bubble, but it is the expenditures of individuals that determine which market it is created on. Thornton (2006) argues that the increase in money supply that occurred from 1984 to 2000 (partly as a result of an earlier final break with the gold standard in 1971 and the deregulation of depository institutions)6 first went to the New York Stock Exchange (NYSE), then to NASDAQ stock exchange, contributing to the creation of the dot-com bubble,7 and finally to the real estate market, leading to a bubble there, too. Mortgage loans accounted for a significant portion of all loans in this period. Thornton (2006) reports that the increase in the supply of mortgage loans from the end of the 2001 recession corresponds almost exactly to the increase in money supply (measured by Money of Zero Maturity). As shown in the previous chapter (Figures 6.1, 6.2, 6.3), the value of mortgage loans granted by US commercial banks increased from the mid-1980s, accelerating even more in the second half of the 1990s. As a consequence, the share of this type of loans in all loans granted by commercial banks increased significantly. In turn, L. White (2009) points to a higher rate of money supply growth in response to the recession from 2001 to mid-2003. He also notes that the Fed lowered the federal funds rate from 6.25% in 2001 to 1% in mid-2003 and that the supply of mortgage loans increased on average 12.26% annually from mid-2003 to mid-2007. What seems to be key in creating the housing bubble from mid-1999 to mid-2007 was that mortgage loans supply grew faster than total credit supply (see Figure 7.3). Consequently, in 2000–7 property prices represented by the S&P/Case Schiller U.S. index The National Home Price Index rose by more than 84%, and those represented by the S&P/Case Schiller 20-City Composite Home Price Index more than doubled. Another example confirming the relationship between the growth of money supply – with the accompanying Cantillon effect – and the speculative bubbles may be Japan in the 1980s. The Japanese central bank had been cutting interest rates from the beginning of the decade (radically lowering them in 1985–8) while the money supply also increased considerably, especially from 1987 (Okina et al., 2000). However, what is most important during this period is that the supply of loans increased significantly, especially mortgage loans. From

The Cantillon effect and price bubbles

99

Percent change from year ago

20 15 10 5 0 -5 -10 Jan 1998 Jan 1999 Jan 2000 Jan 2001 Jan 2002 Jan 2003 Jan 2004 Jan 2005 Jan 2006 Jan 2007 Jan 2008 Jan 2009 Real Estate Loans, All Commercial Banks

Loans and Leases in Bank Credit, All Commercial Banks

Figure 7.3 Growth in the supply of real estate loans (solid line) and total loans (dashed line) granted by American commercial banks in 1998–2009 (percentages, year to year) Source: Federal Reserve Bank of St. Louis, 2015, research.stlouisfed.org, accessed: 6 January 2015 Note: shaded areas indicate U.S. recessions

1981 to 1989 the supply of loans increased on average by 9.6% annually, while the supply of mortgage loans increased by 18.4% (Fengyun, 2013). As a result, the Nikkei 225 stock index more than tripled from September 1985 to the end of 1989, while land prices reflected by The Urban Land Price Index almost quadrupled from September 1985 to September 1990 (Okina et al., 2000).

The Cantillon effect caused by monetary inflation occurring through the asset market What is different about increasing the supply of money via the asset market compared to other possible manifestations of the Cantillon effect, especially to credit expansion occurring through business loans, described by Mises and Hayek? Before answering this question, it is worth noting that any credit expansion will result in an excessive increase in the prices of (specific) assets.8 This is mainly due to the reduction of interest rates. Because the capital goods market, which also includes securities (legal titles to capital) and real estate, reacts more strongly to changes in interest rates,9 credit expansion, and the accompanying cuts in interest rates lead to an increase in asset prices, relative to consumer goods (Skousen, 1990). This also applies to commodities that are furthest away from consumption and are needed by manufacturers to increase production.10 It is clear, then, that the boom in the commodities, real estate, and securities markets is a manifestation of structural disorders caused inevitably by credit expansion (Robbins, 1934).11 However, it is the spending pattern and amounts that determine the relative increase in prices of given asset classes, including the possible formation of a bubble. For example, from the mid-1990s, both real estate and stock prices rose in the United States (while prices of commodities

100 The Cantillon effect and price bubbles fell); however, the bubble formed only in the stock market. In contrast, during the past decade all three asset classes saw an increase in prices, though real estate prices rose the most (while in the 1920s the stock prices rose more). An increase in the money supply resulting in a price bubble will lead to a different distribution of income and wealth, compared to a more balanced credit expansion. Obviously, the financial sector and holders of given assets will benefit from this (until the bubble bursts). In addition, an increase in the prices of kept assets leads to an increase in (perceived) wealth, which should increase the spending of their owners (Bowdler and Radia, 2012). An increase in asset prices may also lead to increased corporate investment, as a result of a rise in the q-ratio and an increase in the value of the collateral held for loans (Mishkin, 2001). The second important difference is that bubbles on asset markets threaten financial stability to a greater degree. The bursting of speculative bubbles often leads to a banking crisis – due to the falling prices of collateral – and, consequently, to a credit crunch (Kaufman, 1998).12 Kindleberger and Aliber (2005) analyzed several dozen cases of financial and banking crises in Western Europe and the United States, noting that the peak of a speculative bubble preceded the outbreak of a crisis. In turn, Borio (2012) indicates that the recessions which are accompanied by financial crises are deeper by as much as 50%. The best example is the Japanese economy, which after the bursting of the stock market bubble in December 1989 plunged into a recession that lasted a decade.13 The problems in which the Japanese economy found itself resulted precisely from the fact that the fall in asset prices led to losses for banks that held a significant number of shares and to the accumulation of non-performing loans resulting from business bankruptcies, as well as household problems resulting from falling asset prices. The deterioration of the banks’ situation led to a credit crunch, limiting the supply of business loans (Hutchison et al., 2005). It is worth noting that the issue of price bubbles is extremely important for monetary policy. It has long been debated in the literature whether central banks should consider asset prices in setting their monetary policy (Cecchetti et al., 2000; Mishkin, 2001). If the increase in money supply leads to the deviation of asset prices from their fundamental value and if the correction after the bubble’s collapse contributes to a longer and more serious recession, then this is another argument against loose monetary policy. It also seems that in such situations central banks should take into account the dynamics of asset prices. When central banks focus solely on the consumer price index, they may not be able to see all the negative consequences of increased money and credit supply, including imbalances in the asset market.14

Summary In summary, the emergence of bubbles on the asset markets is the best proof that the prices of various goods and services in the economy do not increase evenly (like in Friedman’s helicopter model), but rather unevenly, as described

The Cantillon effect and price bubbles 101 by Cantillon. A speculative bubble is a situation in which prices on a given market increased excessively, to a much greater extent than on other markets. Overvalued assets mean that other assets are undervalued. The relative increase in asset prices results from credit expansion, that is from a specific manifestation of the Cantillon effect. This effect also explains the formation of price bubbles. If money flowed into the economy evenly (that is in a way that affects the cash balance of all economic entities in the same proportion and at the same time), such a phenomenon would be impossible. In reality, however, new money is introduced into the economy through specific channels (even within the credit expansion channel). The prices of those assets, on which monetary demand is concentrated and on which newly created money is first spent, will grow the most. In an extreme case, a continuous inflow of cash to a given market, together with appropriate institutional factors (e.g. moral hazard) and psychological factors (e.g. expectations of further price increases) may lead to the creation of a speculative bubble. Such manifestation of the Cantillon effect leads to a different distribution of income and wealth, and to a greater extent threatens financial stability and may lead to a deeper recession, compared to credit expansion not accompanied by a speculative bubble. Although asset prices play an important role in monetary transmission (Mishkin, 2001), central banks do not take into account inflation of asset prices (or at least not explicitly). As a consequence of overlooking the fact that new money can be introduced into the economy not through consumer goods and services market but through the asset market – and generate strong inflationary processes there – central banks may conduct monetary policy that is too loose, leading to greater financial instability.

Notes 1 Of course, the definition of price bubble can vary. According to Kindleberger and Aliber (2005), it is an increase in prices over a considerable period of time (from 15 to 40 months), which eventually implodes. In the economic dictionary, Kindleberger (1987) defines the price bubble as follows: “continuous sharp rise in the price of particular assets generating expectations of further rises and attracting new investors seeking capital gains”. 2 Low interest rates may particularly induce investors to invest in riskier asset classes, which offer higher interest rates. 3 A discussion on various factors responsible for the formation of speculative bubbles can be found in Scherbina (2013). The literature often emphasizes – apart from the increase in money supply – the moral hazard. If investors expect bailouts or support from the central bank in case the bubble bursts (the so-called Greenspan put), they are more willing to invest in a given market. You can read more about the role of moral hazard in the creation of price bubbles in Mueller (2001); O’Driscoll (2008); E. White (2009). 4 Huerta de Soto (2006, pp. 461–6) writes on this topic as follows: “In an economy which shows healthy, sustained growth, voluntary savings flow into the productive structure by two routes: either through the self-financing of companies, or through the stock market. Nevertheless, the arrival of savings via the stock market is slow and gradual and does not involve stock market booms or euphoria. Only when the

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banking sector initiates a policy of credit expansion unbacked by a prior increase in voluntary saving do stock market indexes show dramatic and sustained overall growth. (…) Prices may continue to mount as long as credit expansion is maintained at an accelerated rate. (…) Only continuous, disproportionate growth in the money supply in the form of credit expansion can feed the speculative mania (or ‘irrational exuberance’) which characterizes all stock market booms.” Machlup (1940) made similar statements. A similar opinion – in the context of price bubbles – is expressed by Cochran (2010), who notes that the allocation of resources and the valuation of assets, including prices detached from the fundamental value, are shaped by the non-neutral nature of the money supply growth, and more specifically by the Cantillon effect. Thornton (2006) reports that the money supply (MZM) increased by an average of 5.26% annually from January 1959 to August 1971, then from August 1971 to 1984 by 8.25% annually, and in 1984–2000 by 10%. Money zero maturity (MZM) is a measure of money supply that includes financial assets, which are subject to repurchase on demand at nominal value (or all paper that can be “immediately liquidated”). It covers the same components as M2 excluding small-denomination time deposits, while taking into account institutional money market mutual funds (Mises Wiki: https://wiki.mises.org/wiki/Money_supply). Callahan and Garrison (2003) argue that the dot-com bubble was developed because the new money created by the Federal Reserve went through the banking system to online companies. The increase in the price of assets used as collateral for loans may, in turn, strengthen the process of credit expansion. Robbins (1934, p. 37) writes “The longer-lived the capital instrument, or the greater its distance from consumption, the more its value is affected by the change in the rate of interest. The shorter-lived it is, or the less its distance from consumption, the less is it affected. The value of flour in the baker’s shop is hardly affected at all by a cheapening of the cost of borrowing. The value of mines, forests, houses and heavy factory equipment is enormously affected.” Estey (1950, p. 101; for: Skousen, 1990, p. 291) writes that “The rise in prices that is characteristic of the expansion phase is, however, by no means uniform. Wholesale prices rise more than retail prices. Indexes of the cost of living that reflect retail prices rise but modestly. Of the wholesale prices, it would seem that the greater the distance from the consumer, the greater and quicker the rise in price. Thus raw materials rise higher than semi-finished goods, and the semi-finished goods rise higher than goods ready for the consumer.” Mills (1946; for: Skousen, 1990) notes that in the expansion phase, commodity prices on average grow the most, the prices of production goods less, and the least affected are the prices of consumer goods. Mises (1998 [1949], p. 790) writes clearly on this subject: “Discrimination in lending is no substitute for checks placed on credit expansion, the only means that could really prevent a rise in stock exchange quotations and an expansion of investment in fixed capital. The mode in which the additional amount of credit finds its way into the loan market is only of secondary importance. What matters is that there is an inflow of newly created credit. If the banks grant more credits to the farmers, the farmers are in a position to repay loans received from other sources and to pay cash for their purchases. If they grant more credits to business as circulating capital, they free funds which were previously tied up for this use. In any case they create an abundance of disposable money for which its owners try to find the most profitable investment. Very promptly these funds find outlets in the stock exchange or in fixed investment. The notion that it is possible to pursue a credit expansion without making stock prices rise and fixed investment expand is absurd.” The bursting of some bubbles may also lead to the growth of others – either as a result of loosening monetary policy by the central bank or as a result of transferring

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investors’ funds to other markets. Baker (2008) reports that the stock bubble burst in the United States in 2000–2 prompted investors to buy real estates because they were seen as a safe alternative to stocks. 13 Another example is the slow economic recovery in the United States after the Great Recession. Jordà et al. (2014) believe that it resulted from a debt overhang from loans taken by households during the housing bubble for the purchase of homes. 14 Rothbard (2000 [1963]) gives the example of the Great Depression in the United States. According to him, because the general price level in the 1920s remained more or less stable, most economists neglected the potential effects of credit expansion, which ultimately led to crisis. Borio and Lowe (2002) give the example of Japan (and also other countries). In the years 1986–8, which is when the real estate and stock bubbles were growing, the inflation rate of consumer goods and services (CPI) in Japan remained virtually zero.

8

The Cantillon effect and inequalities in income and wealth1

The Cantillon effect is based on (re)distribution of income and wealth within a society (and the resulting changes in the structure of prices and production) that is the result of introducing money into the economy only through specific channels. In this process, some people receive newly created money earlier than others, before the general price increase, which causes their real income to go up and their wealth to grow. In this book, I have analyzed various patterns of distribution of new money and the resulting consequences, especially for the structure of relative prices. In this chapter, I focus on the relationship between the Cantillon effect and inequalities in income and wealth. There are strong indicators that the effect of the first round causes such (re)distribution, which increases these inequalities. Economists have long studied the relationship between price inflation and inequalities in income and wealth, but they do not provide an unambiguous answer as to its nature.2 For example, Romer and Romer (1998) or Easterly and Fischer (2001) believe that high inflation leads to an increase in inequality, while Heer and Maussner (2005) or Maestri and Roventini (2012) argue that inflation reduces inequalities. According to Galli and Hoeven (2001), who offer an interesting review of literature, contradictory results suggest a non-linear relationship: initially, the rise in inflation reduces inequalities, but sufficiently high inflation rate widens the gap. The literature on the impact of monetary policy on income and wealth inequalities, however, remains significantly poorer. For many years, economists were not interested in studying this relationship (Mersch, 2014), an attitude that resulted from the conviction about the long-term neutrality of money and from accepting the assumption of a representative agent in economic models (Raskin, 2013). Researchers either did not see such a connection altogether (Bernanke, 2007, Yellen, 2014), maintained that inequalities were outside of their areas of interest (Greenspan, 1997), or limited themselves to asserting that monetary policy focused on low and stable inflation, smoothing out the business cycle, and sustainable, longterm economic growth will also prevent the emergence of excessive income and wealth inequalities (Greenspan, 1998; Cœuré, 2012).

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However, recently – as a result of implementing unconventional monetary policy by central banks in the aftermath of the 2008 financial crisis, and due to Piketty’s (2014) publication on inequality – interest has been rising in how monetary policy, including its unconventional variants, affects income and wealth inequalities. For example, the Bank of England (2012) noted that the richest households benefited the most from the increase in asset prices, which resulted from the bank’s quantitative easing program (in 2011, the richest 5% held 40% of financial assets kept outside of pension funds), and that increased wealth inequalities in the United Kingdom. Similarly, Dobbs et al. (2013) state that in 2012, the richest 10% of American households owned 90% of net financial assets, so on the one hand they lost on relatively lower interest payments, but on the other hand they benefited more from the increase in prices of their assets. According to Saiki and Frost (2014), the increase in asset prices resulting from unconventional monetary policy pursued by the Bank of Japan, especially after 2008, benefited mainly the richest households, which held a relatively large part of their assets in stocks and bonds. Mersch (2014) also believes that unconventional monetary policy leads to increased inequality, but stresses that the exact impact is difficult to quantify. Rzon´ca (2014) claims that intensive quantitative easing promotes income inequalities and an increase in the share of capital in GDP. As for the euro zone, both Adam and Tzamourani (2015), as well as Claeys et al. (2015) note that the increase in prices of financial assets resulting from unconventional monetary policy leads to a deepening of inequality.3 The literature on the subject largely ignores the Cantillon effect, focusing on other aspects of monetary policy and inflation. For example, Yeager (1997) points out that due to imperfect indexation, inflation reduces the real value of social benefits that are an important source of income for relatively poorer people. Wilson (1982) indicates that inflation increases the tax burden in countries with progressive income tax due to the so-called tax bracket creep, i.e. falling into higher tax brackets, as a result of nominal increase in remuneration. Economists often treat inflation as a regressive tax on cash, because the share of cash in assets held decreases when income increases (Kennickell and Starr-McCluer, 1996), and richer people can more easily protect themselves against the fall in the purchasing power of money (Mulligan and Sala-i-Martin, 2000) and incur lower unit costs of using financial services or buying on credit (Erosa and Ventura, 2002). Other researchers focus on the effects of inflation depending on whether it is expected or not (e.g. Laidler and Parkin, 1975; Fischer and Modigliani, 1978), but this does not seem to be the right approach because (as I showed in the second chapter) unequal growth of the money supply will generate redistributive effects even when the inflation rate is expected. This does not mean that economists do not investigate the impact of inflation on the redistribution of income and wealth, but rather analyze redistribution from employees to employers (due to the increase in wages taking place later than the increase in prices of consumer goods and services) or from net creditors to net debtors (e.g. Laidler and Parkin, 1975; Li and Zou, 2002), ignoring the redistribution from the later recipients of new money to those, who received it earlier.

106 The Cantillon effect and inequalities Among the authors referring to the Cantillon effect (although not always explicitly) are Ledoit (2011) and Coibion et al. (2012), who bring the segmentation of the financial market to attention. They note that if some entities engage in transactions on the financial market more frequently than others, and if changes in money supply affect them sooner than others, then the increase in money supply will lead to redistribution of wealth to people more strongly associated with the financial market. Brunnermeier and Sannikov (2012) also emphasize that if new money goes to a specific sector, that sector will benefit from it the most. They see, therefore, the redistributive effects of monetary policy, and even consider it one of the channels through which such policy can deliberately influence the economy. Wilson (1982) writes that although inflation means an increase in the general price level, not all prices grow the same, which leads to the redistribution of income and wealth in a way completely unrelated to the objectives of economic policy. Balac (2008) also does not directly refer to the Cantillon effect, but considers the increase in money supply as a tax imposed on those who receive the money last. He also believes that banks grant loans to the most credible entities, which increases income and wealth inequalities, because creditworthiness is a function of wealth already owned. The Hülsmann’s article (2013) is to this day the most comprehensive discussion on the relationship between monetary inflation and the Cantillon effect, and inequalities in income and wealth. He argues in it that the widening inequality in the United States in 1971–2001 resulted from the relatively loose monetary policy that began after the departure from the gold standard. He also points to a more significant growth in wealth inequalities than in income, which impedes the process of social advancement (young people have to work longer to be able to acquire a given asset). However, Hülsmann does not satisfactorily explain how exactly monetary inflation leads to inequality. I will attempt to fill this gap in this chapter and systematically elaborate on the channels through which monetary inflation and the Cantillon effect impact income and wealth inequalities. Considering the increased interest in the subject of income and wealth inequalities in recent times (especially in the context of ultraloose monetary policy conducted by central banks since the financial crisis in 2008) and opinions that growing income and wealth inequalities may limit the rate of economic growth (Ostry et al., 2014), contribute to financial instability (Kumhof et al., 2013; Treeck, 2012), and influence the transmission mechanism of monetary policy (Mersch, 2014), the relationship between the Cantillon effect and income and wealth inequalities seems to be most worthy of closer examination.

Channels through which the Cantillon effect impacts income and wealth inequalities How can the first-round effect lead to greater inequalities in income and wealth? There are five channels through which monetary inflation and the Cantillon effect can have impact on income and wealth inequality. Those channels are synthetically depicted in Figure 8.1.

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Channels through which the Cantillon effect impacts income and wealth inequalities

Redistribution from late to early recipients of new money

Creditworthiness is a function of owned property

Structure of expenditures

Structure of assets

Redistribution from creditors to debtors

Figure 8.1 Channels through which the Cantillon effect impacts income and wealth inequalities Source: Author’s compilation

First, introducing new money through specific channels means that income is (re)distributed to people who get new money first, from people, whom this money reaches later. It results from the fact that the first recipients of newly created money have more of it while the prices have not yet changed. This effect may explain the growth of the financial sector over the last several decades in developed countries, which – due to credit expansion and transactions with the central bank – is one of the first recipients of new money. In the years 1980–2007, the share of the financial sector in US GDP grew much faster than between 1950 and 1980. As a consequence, the share of the financial sector in GDP increased from 4.9% in 1980 to 7.9 % in 2007,4 while the stock market capitalization increased from 50% to 141% GDP (Greenwood and Scharfstein, 2012), and the share of employment in finance, insurance, and real estate increased in the private sector from 6.6% in 1979 to 7.3% in 2005 (Palley, 2007). The impact on income inequalities seems obvious. In 1980, an average employee in the financial sector earned more or less the same as employees in other sectors, while in 2006 his salary was already an average of 70% higher than in other sectors (Greenwood and Scharfstein, 2012).5 In turn, the ratio of chief executives’ compensation (which largely depends on the stock market) to the average employee’s salary increased from 27/1 in 1973 to 300/1 in 2000 (Gordon and Dew-Becker, 2005). Lin and Tomaskovic-Devey (2013) draw attention to the increase in the importance of profits from financial activities in American enterprises in the years 1970–2007. During this period, the share of financial income to the realized profits for manufacturing companies increased from 20% to 61%. According to Lin and Tomaskovic-Devey (2013), this increase contributed to the decline in the labor’s share of national income and the increase in income inequality in the United States in the years 1970–2008.

108 The Cantillon effect and inequalities As one can see, it is the monetary inflation and the Cantillon effect, not the free market mechanism, that can explain the growth of the financial sector in developed economies over the past several decades, which corresponds to some extent to the increase in income and wealth inequalities. This is an extremely important observation, considering that according to many studies, the growth of the financial sector (above a certain level) – as a result of greater instability in the economy, lowering the savings rate by weakening the liquidity barrier for households, and inflationary redistribution of resources that could be used in other sectors in more productive ways – can have a negative impact on economic growth (Rzon´ca, 2014). Second, expansion of credit by commercial banks increases income and wealth inequalities by granting loans to relatively richer individuals, who can provide more valuable collateral and have higher creditworthiness. Therefore, because creditworthiness is a function of owned assets, and commercial banks primarily grant loans to individuals or companies with the highest creditworthiness, credit expansion is inherently associated with the deepening of inequalities. This is most evident in the classic description of the Austrian theory of the business cycle (Hayek, 1935), in which loans are granted primarily to entrepreneurs for production purposes. Considering that individuals taking out loans for expanding production are not among the poorest people,6 such a method of introducing new money into the economy should contribute to an increase in the inequalities of income and wealth.7 It should also be noted here that larger entities have easier access to financing (especially in the period of restrictive monetary policy) compared to small and medium-sized enterprises (e.g. Oliner and Rudebusch, 1996), which leads to an increase in income and wealth inequalities within the sector of enterprises, and that in turn shapes the situation of households from various income quintiles. Third, the increase in money supply never leads to an even increase of prices, but affects prices differently – partly due to the uneven distribution of newly created money. Thus, the impact of inflation on the redistribution of income also depends on the pace of price increases for various goods and services, and the share of those expenditures in total expenditures of various people. Considering that poorer people spend more of their money on basic necessities – such as food (Wilson, 1982) – the increase in the prices of those goods will affect poor people more than the richer ones. Piachaud (1978) showed that in the United States, in the years 1956–74, prices of goods purchased by the lower 5% of households increased by 26 percentage points more than the prices of goods purchased by households with average incomes. Hagemann (1982) obtained similar results for the American economy in the period from 1972/1973 to 1982, when the prices of goods purchased more often by people with lower income grew faster than the prices of goods that were more important in the structure of expenditures of relatively richer people. A similar relationship (also, the fourth inflationary redistribution channel) exists in the structure of assets held. People holding (more of) the assets, whose price increases (more) due to monetary inflation,8 will relatively profit at the

The Cantillon effect and inequalities 109 expense of others. Key here is that richer people in the United States not only own more assets than poorer people, but also more of the specific type of assets that proportionately increase in price, such as stocks. For example, in 2007, the richest 10% of households held 80–90% of all stocks (in terms of value) (Wolff, 2010). On this basis, Wolff (2010) claims that the increase in wealth inequalities in the United States is largely due to the increase in stock prices relative to real estate prices, which are more evenly owned by American citizens. It is worth noting that although the increase in asset prices is beneficial to their holders, it nevertheless increases the gap between those who own assets and those who don’t (Hülsmann, 2013). This means that the have-nots need to work longer to accumulate a given level of wealth, which hampers the process of vertical social mobility. Fifth, the redistributive effects of inflation also result from the fact that some incomes or prices are relatively rigid and cannot change quickly. Obvious examples include fixed-income securities or prices agreed upon in long-term contracts (wages, rents, etc.). This implies a redistribution of income from broadly defined creditors to broadly defined debtors. As a net debtor, the primary beneficiary in this scenario is the government. As far as other economic entities are concerned, the redistribution scheme changes over time. For example, in the United States in the 1960s and 1970s, in addition to the government, the net debtor was the non-financial sector, while the financial sector, including households, was a net creditor. In turn, in the 1980s and 1990s, the financial sector was a net debtor, which resulted in the increased share of income from that sector in the American economy during that period. In the first decade of the new millennium, households that had traditionally been net creditors became net debtors, while the financial sector again became a net creditor (Eichner et al., 2010). On the basis of data from 2001, it can be said that redistribution inside American households is a bit more complex, because it does not run from the poorest to the richest (or vice versa) but from the poorest and richest to the middle class, which has the most net debt (Doepke and Schneider, 2005).

Empirical data on the formation of income and wealth inequalities in the United States The effects discussed in the previous point may explain the positive correlation between inflation and income and wealth inequalities in the United States over the years. Inequalities grew in this country during World War I, decreased during deflationary post-war depression, and increased in the inflationary years of the 20th century (Piketty and Saez, 2003).9 According to Rothbard (2000 [1963]), from June 30, 1921 to June 30, 1929, the money supply in the United States increased by 61.8%, entering the economy mainly through purchases of financial assets. Such manifestation of the Cantillon effect resulted in the creation of a stock bubble and led to significant changes in the distribution of income and wealth. In short, the 1920s

110 The Cantillon effect and inequalities were beneficial for the middle and upper classes, which gained from rising wages and higher dividends. However, the situation of people with relatively lower incomes, such as laborers or farmers, deteriorated (Radice, 1935). This redistribution of income is illustrated by the growing share of the richest 10% of households in total income from 40.59% in 1923 to 46.09% in 1928 (Piketty and Saez, 2003).10 Inequalities began to decline after the collapse of the stock bubble in 1929 (Piketty and Saez, 2003), and rose again during the inflationary period of World War II, before falling toward the 1950s. Inequalities in the United States remained stable or slightly decreased until the 1970s,11 when the gold standard was finally abandoned, which accelerated the rate of increase in money supply. Between 1959 and 1971, the monetary base grew on average (geometric average) by 4.62% annually, while M1 grew by 3.72%. In the years 1971–2013, it was already 9.26% and 5.97%, respectively (Federal Reserve Bank of St. Louis, 2015a). A higher rate of monetary inflation could have resulted in stronger redistributive effects that outweighed other factors, such as increased productivity. The Gini index for US households increased from 0.396 in 1971 to 0.470 in 2006 (Federal Reserve Bank of St. Louis, 2015b), and the ratio of the average income to the median, which measures the degree of income concentration in the upper half of the distribution of income between households, increased from 1.14 in 1969 to 1.35 in 2007 (Hülsmann, 2013).12 It is worth noting that income inequalities increased in the 1997–2000 and 2003–7 inflationary periods, and fell after the end of the stock boom in 2000 and during the Great Recession, when the share of the richest 1% of American households in total income fell from 21.3% to 17.2% (Wolff, 2010). The increase in income inequalities was accompanied by a deepening of wealth inequalities, which should not be surprising, given the fact that income inequality is one of the main contributors to wealth inequality. According to some estimates from Kumhof et al. (2013), in the years 1922–9, the share of the richest 1% of households in total wealth increased from 36.7% to 44.2%. In the years 1983–2007, the Gini coefficient that illustrates the net wealth inequality increased from 0.799 to 0.834 (Wolff, 2010). The wealth of the richest 1% of American households increased in this period by 103%, while the wealth of the bottom 40% shrank by 63% (Wolff, 2010). As for the Gini coefficient in the U.S. in recent years, during the 1997–2000 boom it increased from 0.53 to 0.56, then dropped to 0.54 after the dot-com bubble burst in 2003, then increased to 0.57 in 2007 (Wolff, 2010), then dropped again to 0.55 in 2010 during the Great Recession (Wolff, 2012). In turn, the ratio of the average value of wealth to the median, which measures the degree of concentration of wealth in the upper half of the distribution, increased from 3.65 in 1969 to 5.23 in 2007, while the share of total wealth owned by the richest 10% of American households increased from 67.2% in 1989 to 71.5% in 2007 (Kennickell, 2009). What is also significant, as a result of increase in asset prices, the ratio of average American’s wealth to annual income increased from 4.10 in 1969 to 7.93 in 2007 (Hülsmann, 2013).

The Cantillon effect and inequalities 111 This means an increase in inequality between the haves and have-nots – the owners of assets and those, who do not yet have any, and who now have to work much longer than before to purchase them. Generally speaking, the analysis of the formation of income and wealth inequality indicators over time reveals that inequalities began to deepen significantly in the United States since the 1970s, when the pace of growth of money supply increased, and generally became deeper during speculative bubbles caused by an uneven increase in money supply, then they became smaller after the collapse of the bubbles. It seems as no coincidence that the income of the richest 10% of American households peaked before the outbreak of major economic crises in 1929 and 2008 (Piketty, 2014). The above facts suggest that the Cantillon effect related to monetary inflation was one of the factors13 responsible for the inequality dynamic observed in the United States since the 1970s.14

Summary To sum up, money supply never increases evenly, which leads to changes in the structure of relative prices, the business cycle, and speculative bubbles. It turns out that relatively poorer individuals lose out on monetary inflation to richer people. This is because they are not the first to have access to the newly created money and, additionally, the changes in the structure of relative prices are comparatively unfavorable for them. The Cantillon effect, therefore, causes a redistribution of income and wealth, which increases income and wealth inequalities. What is important, because the first-round effect causes money to not be neutral even in the long run, the impact of monetary inflation on income and wealth inequalities occurs not only in the short term, as a temporary effect. In other words, the Cantillon effect is one of the reasons why not only fiscal policy but also monetary policy leads to the redistribution of income and wealth of citizens (despite the lack of legitimacy to redistribute income between individuals). A thorough analysis of the redistributive effects of increasing the money supply can strengthen our understanding of the effects of monetary policy and business cycles (Raskin, 2013). The existence of the first-round effect may also be another argument against monetary policy that’s too loose, one of the unintended effects of which is the redistribution of income and wealth that in many aspects leads to a deepening of income and wealth inequalities. Because monetary policy affects income and wealth inequalities through many channels, it is difficult to estimate its net effect.15 However, this does not change the fact that the increase in money supply implies a redistribution of income from late to early recipients of new money, who are the relatively richer entities from the financial sector. Redistribution from creditors to debtors relatively supports the middle class at the expense of the poorest and the richest people, while the increase in prices of financial assets benefit the richest households the most.

112 The Cantillon effect and inequalities

Notes 1 The content of this chapter has been previously published in a different form, as the article titled “Inflation and Income Inequality” (Sieron´, 2017). 2 The representatives of the Austrian school have always noticed the redistributive character of inflation (e.g. Mises, 1990, Hayek, 1935). However, they had not – until recently (e.g. Balac 2008, Hülsmann, 2013, Hollenbeck, 2014) – analyzed its impact on income and wealth inequalities. 3 However, it should be remembered that non-standard monetary policy affects income and wealth inequalities not only through the prices of financial assets, but also through other channels such as: interest rates, economic growth rate, unemployment rate and real estate prices that are held more evenly throughout the society. On this basis, some researchers believe that the net effect of unconventional monetary policy may be a reduction of income and wealth inequalities (Claeys et al., 2015). 4 Kumhof et al. (2013) state that in the period from 1920 to 1928, when inequalities also significantly increased, the share of the financial sector in US GDP increased from 2.8% to 4.3%. 5 Interestingly, Piketty and Saez (2003) admit that the increase in income inequality since the 1970s was not – as Piketty (2014) maintains – due to the growing role of capital but rather due to the increase in wages of the top-earning employees. 6 According to the definition adopted by Cagetti and De Nardi (2003), entrepreneurs accounted for only 13.3% of the American society, but they owned 48.8% of net assets. In addition, entrepreneurs accounted for 76% of households in the richest 1%, but only for 36% of households in the richest 20%. 7 The most vivid example of such a situation may be credit expansion during the Weimar hyperinflation. Because loans were largely granted to large industrialists, income and wealth disparities increased in the post-World War I period, with the middle class being the most affected (Bresciani-Turroni, 2007). 8 It is worth noting that the rise in asset prices in recent years resulted not only from the fact that newly created money reached this market first, but also from the low interest rates due to credit expansion of commercial banks and ultra-loose monetary policy, including direct purchases of assets by central banks, as part of quantitative easing programs. 9 It is worth noting that inequalities in Great Britain were becoming smaller in the deflationary second half of the 19th century, when the so-called classic gold standard was observed (Saito, 2010; Williamson, 1985). 10 The share of the richest 5% of households increased from 27.4% in 1920 to 34.8% in 1929 (Kumhof et al., 2013). 11 In most OECD countries, however, income inequalities began to grow only in the 1980s (OECD, 2011). 12 The share of the richest 5% of households in total income increased from 21.8% to 33.8% between 1983 and 2007 (Kumhof et al., 2013). 13 The dynamics of income and wealth inequality are, of course, the result of many factors. Other determinants that may have influenced the increase in inequalities in developed countries since the 1970s include: socio-demographic changes such as a change in the structure of households (high earners were more willing to form a joint household, while people earning less would tend to live alone or only with children) (Burtless, 1999), and technical progress favoring skilled workers (skillbiased technical progress) (e.g. Acemoglu, 2000), along with globalization, which increased competition in the unskilled workers segment (OECD, 2011), and uneven access to the growing in importance education (e.g. Gregorio and Lee, 2002). It should be noted, however, that the above factors are not able to explain why income inequalities grew in the 1920s or why they diminished in some years during the last four decades.

The Cantillon effect and inequalities

113

14 Kumhof et al. (2013) reverse this link, arguing that the increase in inequality led to excessive indebtedness of poorer households and, as a consequence, to the economic crises. Although their analysis is certainly valuable, the mere increase in inequality could not be the reason for the unstable booms and subsequent crises, as these are monetary phenomena. It seems, therefore, that the economic boom preceding the crisis together with the increase in debt and inequality was caused by the same factor, namely the increase in the money supply taking place through the credit channel. 15 It should be remembered, however, that the increase in asset prices and the resulting wealth effect were the intended outcome of quantitative easing. It should not be forgotten that the public choice theory treats monetary policy in general as a result of rent-seeking, the actions of bureaucrats or politicians who want to win elections (Wagner, 1986).

9

The international Cantillon effect

Until now – to simplify our analysis – I have considered the Cantillon effect occurring within a closed economy. In this chapter, I will examine the international aspects of the Cantillon effect – in the modern global economy the growth of money supply in one country (especially in a large economy on a global scale or in a country that is the issuer of reserve currency) may also lead to significant distribution and price effects in other countries. More and more researchers emphasize the synchronization of the business cycle between countries (e.g. Canova et al., 2004; Bordo and Helbling, 2010) and the fact that inflation is a global phenomenon and they are the international and supranational factors that are largely responsible for the inflation rates seen in national economies (Ciccarelli and Mojon, 2005; Borio and Filardo, 2007). The following analysis of the international Cantillon effect broadens and extends the research of the international business cycle, which omits the first-round effect, and the Austrian theory of the business cycle, which in its traditional approach examines a closed economy (Cachanosky, 2012).1

The international Cantillon effect in various monetary systems The international Cantillon effect varies depending on the monetary system. In the monetary system with one global commodity currency and 100% bank reserves, monetary inflation in the country producing money will affect other countries mainly through changes in international trade (resulting from changes in cash balances and the structure of relative prices in one country and abroad) and through the price–specie flow mechanism. The power of this effect will depend on the propensity to import, and the scheme of income distribution will depend on the relative prices of imported vs. exported goods (terms of trade). In other words, monetary inflation in one country can affect other countries, even without direct inflow of new money to them, but only through changes in world prices. Ultimately, however, the international Cantillon effect in such a monetary system is not significantly different from the domestic first-round effect.2

The international Cantillon effect 115 In the system of national currencies, the trade channel continues to have influence: a country that increases money supply is its first recipient and can buy more goods from abroad, which increases the income of the sellers of those goods and transmits inflation to other countries until prices increase everywhere, according to the law of one price. In the system of floating exchange rates, however, inflation will also have an effect through the exchange rate. Actually, exchange rates will be impacted first (because new money relatively quickly reaches the foreign exchange market), which changes the Cantillon effect scheme. In such a situation – when the exchange rate changes faster than the prices of domestic goods – the beneficiaries of the inflation are the exporters, not importers. According to Cachanosky (2012), the exchange rate in such a monetary system is the second important price – apart from the interest rate – disturbed by monetary policy of central banks and credit expansion. As presentday monetary inflation leads to depreciation and increased profitability of exports, credit expansion also causes horizontal disturbances, which increase profitability of production of exchangeable goods relative to the production of goods that are not exchangeable in foreign trade in the country that initiates monetary inflation and reverse changes in other countries. In other words, the exchange rate introduces another dimension to the analysis of credit expansion – an increase in the money supply can lead to both vertical and horizontal changes. New money can be introduced into the global economy both through the domestic credit market and foreign credit market, as well as through the foreign exchange market. It is also worth remembering that both in the system of fixed exchange rates as well as floating exchange rates, there may be reserve currencies, the issuers of which will benefit by increasing the money supply to a greater extent (without significant fluctuations in exchange rates).3 For countries issuing the reserve currency, the balance of payments ceases to be a significant limitation of economic policy (Bordo, 1993). Thus, citizens of such a state can buy more goods from abroad, which in other words is international inflationary redistribution. Moreover, because the country issuing the reserve currency may increase the money supply at their discretion (not fearing any outflow of money), monetary inflation will be greater. As one can see, monetary inflation always leads to changes in the structure of relative prices – both on the domestic and international market.4

International effects of credit expansion What are the international effects of credit expansion (shown synthetically in Figure 9.1)? First, the initial increase in the money supply in one country may increase the money supply in other countries, even without fixed exchange rates and currency interventions. This is due to the fact that import expenses result in an increase in bank reserves abroad, on the basis of which foreign banks can expand granting loans. Thus, the trading channel in the system of fractional reserves may transform monetary inflation into a business cycle in countries that

116 The international Cantillon effect

Channels of international credit expansion and Cantillon effect

Trade channel (global production structure)

Interest rate channel

Risk premium channel

Bank loans channel (including loans between commercial and central banks)

Exchange rate channel

Figure 9.1 Channels of international credit expansion and Cantillon effect Source: Author’s compilation

do not initiate credit expansion and conduct a relatively restrictive monetary policy. As Ciccarelli and Mojon (2005, p. 28) put it, “no country, not even Switzerland, can claim to have been completely immune from Global Inflation shocks.” Hayek (1937, p. 175) even thought that: The truth of the whole matter is that for a country which is sharing in the advantages of the international division of labor it is not possible to escape from the effects of disturbances in these international trade relations by means short of severing all the trade ties which connect it with the rest of the world. It is of course true that the fewer the points of contact with the rest of the world the less will be the extent to which disturbances originating outside the country will affect its internal conditions. But it is an illusion that it would be possible, while remaining a member of the international commercial community, to prevent disturbances from the outside world from reaching the country by following a national monetary policy such as would be indicated if the country were a closed community. In other words, there is actually one global production structure in the modern global economy. Thus, credit expansion will necessarily have a different impact on different countries, for example due to trade ties.5 At present, the production processes of virtually all products are of international nature, which entails significant consequences, as various countries specialize in manufacturing various goods at different stages of production, which are more or less sensitive to changes in interest rates.6 Therefore, the international business cycle will affect different countries unevenly. As Engelhardt (2004) notes, a country specializing

The international Cantillon effect 117 in the production of higher order goods will experience a more intense boom and a deeper recession later. What is extremely important, as long as there is one global capital market, these types of economies may experience the business cycle also as a result of loose monetary policy conducted by other central banks and the credit expansion undertaken by commercial banks in other countries. This fact may explain why so many developing countries were experiencing an economic boom early in the 21st century (The World Bank, 2010; The World Bank, 2015a). Many of them specialize in the production of raw materials, which are higher order goods. Because their production is relatively sensitive to changes in interest rates (Frankel, 2006), as a result of which the prices of these goods kept rising, these countries experienced a boom (The World Bank, 2015b).7 The increase in commodity prices was additionally amplified by the depreciation of the US dollar, in which they are quoted. It is also worth noting that participation in the global economy may increase the duration of the boom, especially in the case of small, open economies, because the possibility of importing production factors as well as raw materials and halfproducts reduces the problem of bottlenecks, postponing the end of the boom (Cachanosky, 2012). Second, credit expansion (especially in an economy that is an important economic and financial center of the world, such as the United States) leads to a reduction in the interest rate, which then leads to the business cycle in the country and abroad – through trade links and capital flows.8 Interest rate arbitrage between countries causes the outflow of capital from the country with a lower interest rate to other countries with a higher interest rate (after taking into account the expected changes in the exchange rate), in accordance with the carry trade investment strategy.9 It seems that such a phenomenon occurred in the last few years (2010–14), when the Western economies maintained very low interest rates, which led to the outflow of capital to developing countries and the increase in prices of their assets. Considering that the increase in money supply and credit is justified by positive effects for the domestic economy, such international effects may be perceived as unintended consequences of domestic monetary policy. It is also worth noting that a reduction in interest rates in major financial centers may also cause an interest rate cut in other economies that wish to avoid the inflow of capital and the appreciation of the currency (Hofmann and Takáts, 2015). As an example, a reduction of interest rates in the United States in response to the 2008 economic crisis caused interest rates to fall in many other countries (Hofmann and Takáts, 2015) and, consequently, triggered an increase in loans to developing nations and an overall increase in global credit supply (BIS, 2015).10 Another clear example of the international effects of monetary inflation may be the effects of monetary policy conducted by the Fed in the first half of the first decade of the 21st century. During this period, the US central bank maintained relatively low interest rates, which according to Schnabl and Hoffmann (2007) led to the outflow of capital from this country to developing markets and contributed to an overly rapid pace of credit expansion and,

118 The international Cantillon effect consequently, an artificial boom. Borio and Disyatat (2011) also point out that the bursting of the dot-com bubble and the subsequent lowering of interest rates by the Fed in response to it increased the supply of credit and encouraged the outflow of capital to developing countries. Some of them reduced interest rates in response, while others accumulated foreign currency reserves, mainly in US bonds, which put pressure on reducing their profitability and reduced risk premium, deepening the global credit boom. In the same way, reducing and maintaining interest rates at a relatively low level by the ECB in the same period led, according to Hoffmann (2009), to the outflow of capital to Central and Eastern Europe, which contributed to the artificial boom and emergence of price bubbles in many countries of the region. Third, credit expansion lowers not only the time preference component of the interest rate but also the risk premium, prompting investors to seek higher risk opportunities in other countries, and thus a receive a higher rate of return (Gambacorta, 2009; Subramanian, 2014). This would especially be true in the case of a drop in the profitability of long-term US Treasury bonds, which are perceived as risk-free, thus their interest rate is a benchmark used to price risky financial instruments (Mohanty, 2014).11 In addition, the reduction of interest rates due to the increase in money supply through the credit channel increases the value of collateral, which reduces the likelihood of commercial banks suffering losses and, consequently, increases their propensity for taking risk. It should not be forgotten that rising asset prices are tied to their lower volatility, which may also distort the perception of risk and encourage banks and investors to increase their exposure (Gambacorta, 2009).12 It is worth noting that in the first decade of the 21st century this aspect could also have triggered or at least intensified the boom in many developing countries, which were considered to be unstable and risky. What is more, investments in sectors producing higher-order goods (such as mining or agricultural and raw materials) that dominate in these countries seem to be particularly risky. According to Becker (2013), many African countries experienced an intense boom in the first years of the 21st century (The World Bank, 2015b), because they produced mainly higher-order goods and were characterized by a relatively high risk premium, which attracted the inflow of capital seeking the highest (expected) rates of return. Fourth, commercial banks in the country that initiates credit expansion may grant loans to foreign commercial banks or even directly to non-banking foreign entities (or buy foreign assets),13 especially if interest rates are higher abroad.14 An example may be the 1920s, when American commercial banks purchased foreign bonds offering higher yields compared to domestic ones (Eichengreen, 1989). Loans to banks and foreign enterprises also played a significant role in triggering the Asian crisis (Heffernan, 2005). After relaxing the restrictions on the free movement of capital to Asian countries and by 1996 lifting them altogether, huge amounts of foreign loans flowed there. Between 1995 and 1996, Korea, Indonesia, Malaysia, the Philippines and Thailand received

The international Cantillon effect 119 foreign loans worth 75 billion dollars, 58% of which came from interbank financing, 20% from bank loans, and 22% from the issue of bonds. At the beginning of 1997, foreign loans accounted for 40% of Asia’s total debt. Asian banks took lowinterest loans in Japanese yen and US dollars, and then provided loans to local companies in local currencies. From 1990 to 1997, the value of bank loans in the case of Thailand and Indonesia grew at a rate of 18% annually, and in Korea by 12% (while in G-10 countries that growth was only by an average of 4% per year). What’s more, because Asian currencies were bound by a fixed exchange rate with the US dollar, central banks increased the money supply in response to higher demand for local currencies, generated either directly by foreign investors or by domestic banks borrowing in foreign currencies. Monetary inflation in developed countries has, therefore, led to an increase in money supply in Asian countries (both directly through foreign loans and indirectly through pressure to strengthen the currency under a fixed exchange rate regime), which was associated with a significant Cantillon effect. Other examples are the US financial crisis of 2008, which was caused by earlier credit expansion largely financed by European commercial banks through the American shadow banking system (Shin, 2011)15 or the crisis in the euro zone. Sinn (2011) claims that the outflow of capital from Germany contributed to the boom (and subsequent crisis) in the peripheries of the euro zone.16 Fifth, central banks can lend money to other central banks, which in turn increases their ability to provide financing to commercial banks. An example of this is the swap line opened by the Fed to other central banks in December 2007 and expanded after the outbreak of the 2008 financial crisis, thanks to which central banks could provide financial institutions under their jurisdiction with the American dollars they badly needed (Fleming and Klagge, 2010). Another interesting example is the settlement between central banks belonging to the TARGET2 system. According to Sinn and Wollmershaeuser (2011), loans under this system in 2008–11 enabled the peripheral countries of the euro zone to finance their trade deficits and neutralize the outflow of private capital. Sixth, the flow of capital leads to fluctuations in exchange rates. The currency of the country that initiates the credit expansion will be depreciated, while the value of the currencies of the countries to which the capital flows will increase. Fluctuations in exchange rates will then lead to changes in the structure of production, the structure of international trade and to redistribution of income between exporters and importers, producers of exchangeable and non-exchangeable goods, etc. Moreover, appreciation of currencies issued by countries to which capital flows in will lead to a decline the value of debt incurred in foreign currency, which will encourage increasing indebtedness and credit expansion. In addition, the central banks of countries whose currencies are under appreciation pressure may decide to lower interest rates or accumulate foreign currency reserves in order to counteract the fluctuations in the exchange rate they perceive as negative. Such activities intensify the global business cycle (Mohanty, 2014).

120 The international Cantillon effect

Summary Increasing the money supply in world’s major economies, primarily in the United States – due to the widespread use of the US dollar as a reserve currency – causes the Cantillon effect on international scale. The exact mechanism of its manifestation depends on the prevailing monetary system. With one global currency or fixed exchange rates in the case of national currencies, the greatest beneficiaries are net importers, as with increased cash balances they may import goods and services at unchanged global prices. Because in the modern monetary system with floating exchange rates new money relatively quickly gets to the foreign exchange market, there is a depreciation of the national currency, on which net exporters gain.17 This does not mean, however, that the first recipients do not benefit from monetary inflation (relative to later recipients in the global economy), but their benefits are reduced due to the depreciation of the national currency.18 In the fractional reserve system, increasing the money supply in one country will thus affect other countries through the exchange rate channel and four other channels: the trade channel, the interest rate channel, the risk channel, and the credit channel. The international first-round effect may explain the global nature of business phenomena (or the observed synchronization of business cycles in different countries). The introduction of new money into the economy that initiates monetary inflation through the credit channel reduces the interest rate and – in line with interest rate arbitrage – leads to the outflow of capital to other economies, also causing inflationary phenomena. The drop in the interest rate in a significant global economy may also be accompanied by the search for higher yields and accepting more risky ventures by investors. Considering that today all countries (perhaps not counting North Korea) are more or less tied to each other economically, creating one global production structure, credit expansion, and the resulting reduction of the interest rate in an important financial center will lead to disturbances in the global production structure (e.g. a relative boom in countries specializing in the production of higher-order goods). The modern monetary system consists of national fiat currencies, so the credit expansion will not only lead to changes in the level of interest rates, but also in the level of exchange rates. Because newly created money reaches the currency market relatively fast (investors from a country that initiates monetary inflation must sell domestic currency to buy foreign currencies and invest in foreign financial instruments offering higher profitability), monetary inflation relatively quickly affects exchange rates, changing the structure of domestic and foreign prices and affecting the profitability of exports and imports. As one can see, credit expansion in the contemporary monetary system leads not only to excessive lengthening of the production structure, but also to horizontal disturbances, more specifically to changes in the structure of expenditures between imported and local goods and disturbances in the allocation of capital between the production of export and domestic goods, and between the production of exchangeable and non-exchangeable goods in foreign trade.

The international Cantillon effect 121 Analysis of the Cantillon effect on international scale leads to conclusions that are extremely important for the theory of economics and monetary policy. Contrary to many opinions, national fiat currencies do not provide isolation from global inflation processes and international cycles (Hayek, 1937). In a modern global economy, a given country – especially if it is a small and open economy – can experience inflationary processes and the business cycle, even when it conducts a relatively restrictive monetary policy. Adalid and Detken (2007) even believe that the increase in global credit supply is a better predictor of financial crises than the domestic credit supply and price inflation rate. Therefore, failure to take global inflationary factors into account may result in the central bank’s policy being too expansionary. The international Cantillon effect can also be treated as the unintentional consequence of monetary expansion in significant global economies (especially in the United States due to the dominant position of the US dollar as a reserve currency), which is another argument against (too) loose monetary policy (determined primarily on the basis of only national variables, such as the price index of consumer goods and services). Thus, international capital flows – being the manifestation of sequential propagation of money through the global economy – undermine the effectiveness of national monetary policies, because central banks do not have direct impact on the supply of credit that is provided by foreign entities or on international capital markets (besides capital control, which is a radical tool). On the other hand, due to the global spread of new money in world economy, monetary inflation in a given country does not have to cause (relatively fast) price increases if the newly created money first goes to foreign markets.19 Thus, a specific way of implementing monetary inflation – such as when new money largely goes abroad – may explain why the increase in money supply does not have to lead to significant domestic price inflation (Borio and Filardo, 2007). Likewise, credit expansion in a given country does not have to cause a significant business cycle if the newly created money is invested abroad. In other words, capital flows soften the business cycle in the country exporting capital and cause or intensify it in the country receiving capital. This confirms the legitimacy of studying how new money reaches the economy. Taking into account international capital flows – as well as trade ties in the global production structure – floating exchange rates do not allow for conducting independent monetary policy. What’s more, the modern monetary system based on national fiat currencies, floating exchange rates, and fractional reserves banking causes international capital flows – in and of themselves beneficial to the economy as a tool for effective capital allocation across the world – to deepen the global economic cycle and destabilize national economies.20 However, this is not an argument for capital controls, but rather against loose monetary policy and credit expansion and national fiat currencies with floating exchange rates.

122 The international Cantillon effect

Notes 1 The works expanding the Austrian theory of the business cycle with an international context include: Hayek (1937), Engelhardt (2004), Hoffmann (2009), Cachanosky (2012), Bilo (2018), Hoffmann and Schnabl (2013), and Doroba˘¸t (2015). 2 The only difference may be less mobility of goods and factors of production on the international scale due to, among others, governmental regulations, and therefore slower adjustments to changes in the structure of relative prices. 3 Gordon et al. (1977) distinguish three channels related to increasing the supply of the reserve currency (more specifically: the American dollar in the Bretton Woods system). First, the trade surpluses of other countries resulting from the faster growth of income in the United States and the loss of price competitiveness. Second, the monetization in the Bretton Woods system allowed the United States to finance the deficit in the balance of payments by increasing the money supply, which increased the monetary base of other countries and led to inflation in them. Thirdly, the acceleration of inflation in the United States may have caused expectations of inflation in other countries, leading to a rise in prices. 4 In the above analysis, to simplify, I omitted banking activities and credit expansion. It is worth noting, however, that international payments change the volume of bank loans and deposits in countries trading with each other. In the country where the money supply increases, there is an increase in imports and a trade deficit. As a consequence, the supply of deposits held by local residents and bank reserves are reduced, which leads to further changes. The decrease in domestic deposits prompts banks either to sell local assets or to directly increase the interest rate in order to attract depositors (Paish, 1936). 5 Doroba˘¸t (2015) argues that credit expansion in important economic centers will cause an increase in international trade (and related capital flows). One of the reasons is that the increased demand for higher-order goods (as a result of credit expansion) will lead – with the existence of an international division of labor in the higher-order goods sector – to intensification of international trade. 6 The internationalized production chain has become known as the global value chain (Gereffi and Fernandez-Stark, 2011). 7 McKinney (2014) conventionally divides countries into raw material producers (most developing countries), producers of consumer goods (e.g. China), and producers of capital goods (developed countries). Taking into account the fact that according to Austrian business cycle theory (in the Mises’ approach) the boom phase is characterized by the simultaneous occurrence of erroneous investments and overconsumption (Salerno, 2012), the boom in China in the first decade of the 21st century should not be a surprise. 8 Jordà et al. (2010) showed that global crises are preceded by an increase in the supply of money and loans. A detailed discussion of periods of significant capital inflow to developed and developing countries can be found in Reinhart and Reinhart (2008). 9 The carry trade investment strategy uses interest rate differences between countries by borrowing (taking a short position) in the currency of a low-rate country and investing these funds (taking a long position) into the currency of a high-interest rate country (Frankel, 2008). 10 Between 2002 and 2007, the supply of international bank loans increased approximately twice as fast as the nominal world GDP and more than twice as fast as in the previous decade. In turn, between 2003 and 2007 there was a 70% increase in the inflow of capital to developing countries, which caused a drop in borrowing costs (The World Bank, 2010). 11 In addition, the appreciation of currency in the countries to which capital flows improves the balance sheets of local companies, which reduces the credit risk and encourages banks to expand their loans to local entities (Bruno and Shin, 2014).

The international Cantillon effect 123 12 In 2002–7, spreads between more risky debt instruments and those considered more secure fell significantly. For example, the risk premium for US corporate bonds with AAA rating decreased in this period from 490 to 65 basis points (The World Bank, 2010). 13 Borio and Disyatat (2011) point out that the value of commercial bank claims denominated in US dollars against non-US residents amounted to one-third of US domestic bank credit in 2010 (excluding internal transfers). 14 Monetary inflation in one country can cause significant economic effects in other countries also through internal loans between banks and their foreign branches (Cetorelli and Goldberg, 2009; Haas and Lelyveld, 2011). 15 Borio et al. (2014) believe, however, that European banks acted as intermediaries in capital flows from and to the United States. McCauley et al. (2015) also analyze the transmission of credit expansion in the United States and draw attention to the fact that since the outbreak of the financial crisis in 2008 to June 2014, the supply of credit (including bank loans and bond purchases) for non-bank foreign entities increased from 6 to 9 trillion US dollars. Its supply grew much faster than in the case of loans to non-bank domestic entities due to quantitative easing, which reduced the interest on long-term bonds and prompted investors to buy foreign bonds with higher yields and also increased the role of the international bond market in credit expansion at the expense of traditional bank loans (Shin, 2013). 16 Other examples of the significant role international loans played in total credit expansion include Ireland, Hungary, and Lithuania in the period preceding the 2008 financial crisis (Avdjiev et al., 2012). 17 The specific manifestation of the Cantillon effect – beneficial for net exporters – may explain why some countries decide to increase the money supply, even though it does not raise the real prosperity of the general public. 18 To illustrate this, let’s imagine that in country A, the money supply doubled, and all of the new money reached person X, who intended to spend it on purchasing 100 units of some imported good. Even if the exchange rate fell by half, person X can still import 50 units of the foreign good, and therefore reduce the amount of goods available to others. 19 The rate of the outflow of money depends largely on the population’s preferences as to the level of cash balances they want to maintain. Like in a closed economy, increasing the money supply will lead to changes in the level of cash balances. If individuals want to restore the original size of their cash balance, they will spend money, which will eventually bump up the prices, considering that society as a whole cannot reduce its cash balance to the previous level. However, this is possible in the case of the global economy (of course for an individual country, not for the global society as a whole). The newly created money will then flow to countries where individuals are more willing to increase (less reluctant to reduce) their cash balances (Mises, 1998 [1949]). 20 Goldfajn and Valdés (1997) showed that currency crises were preceded by increased banking activity and inflows of capital. Even earlier, Hayek (1937, pp. 393–4) noted that: “Every suspicion that exchange rates were likely to change in the near future would create an additional powerful motive for shifting funds from the country whose currency was likely to fall or to the country whose currency was likely to rise. Where the possible fluctuations of exchange rates are confined to narrow limits above and below a fixed point, as between the two gold points, the effect of shortterm capital movements will be on the whole to reduce the amplitude of the actual fluctuations, since every movement away from the fixed point will, as a rule, create the expectation that it will soon be reversed. That is, short-term capital movements will, on the whole, tend to relieve the strain set up by the original cause of a temporarily adverse balance of payments. If exchanges, however, are variable, the capital

124 The international Cantillon effect movements will tend to work in the same direction as the original cause and thereby to intensify it. This means that if this original cause is already a short-term capital movement, the variability of exchanges will tend to multiply its magnitude and may turn what originally might have been a minor inconvenience into a major disturbance.” Therefore, the “variability of exchange rates introduces a new and powerful reason for short-term capital movements, and a reason which is fundamentally different from the reasons which exist under a well-secured international standard” (Hayek, 1937, p. 387).

Synopsis and final conclusions1

The contents of the book that I have presented to the readers can be summarized as follows:   







Neutrality of money generally means that there is no impact of monetary phenomena on real variables, and non-neutrality of money indicates the existence of monetary phenomena’s impact on real variables. There are many concepts of monetary neutrality and, therefore, also monetary non-neutrality, depending on the adopted definitions of monetary phenomena and real variables. The Cantillon effect – also known as the first-round effect – means a distribution effect resulting from uneven changes in money supply, in other words from such changes that do not affect the cash balance of all economic entities at the same time and in the same proportion. Although monetary deflation will also have this effect, it is most often identified with uneven distribution of increases in money supply. The Cantillon effect is one of the causes of the non-neutral nature of money. In practice, it is a sufficient condition, though not necessary for non-neutrality, as we can also observe this characteristic in a situation in which the distribution of new money takes place evenly among all members of society. For money to be neutral, several other conditions must also be met. Although, due to the “monetarist counterrevolution”, there has been a shift towards the study of monetary phenomena, and mainstream economists have generally begun to associate business cycles with monetary impulses, they nevertheless regard the Cantillon effect as a relatively insignificant and temporary consequence of changes in money supply. Instead, they focus on other causes of money non-neutrality, such as price rigidities (new Keynesians) or imperfect information (new classicists). There are still very few studies on the Cantillon effect in the literature – our work fills this gap by undertaking a deep and broad study of the first-round effect. The Cantillon effect plays an extraordinarily important role in the economy, leading to changes in the structure of relative prices and distribution of income between members of the society. Monetary inflation taking

126 Synopsis and final conclusions place through credit expansion leads to the business cycle and – with the existence of appropriate psychological and institutional factors – to the price bubbles.  The way in which new money is introduced into the economy is of fundamental importance. A market increase in money supply results in a different effect than non-market. Differences also occur depending on whether the increase in money supply in a given national economy increases the global money supply or if it results from a transfer from another economy, as well as within these basic categories. The most relevant is whether the money supply increases through the credit channel or not. The most important differences between various channels of money supply growth are presented in Table 4.3, at the end of Chapter 4.  Differences in how commercial (and central) banks create money do not affect the basic mechanism of the business cycle (characterized by erroneous investments, as a result of the artificially lowered interest rate), but are responsible for differences in the so-called secondary features of business cycles, which causes business cycles to not be identical, despite obvious similarities. Differences in their course are caused by many factors, one of which is certainly the non-uniform nature of the channels of distribution of new money in the economy, resulting in different manifestations of the Cantillon effect. For example, granting a significant amount of mortgage loans may lead to a real estate boom and relative growth of the construction sector, wealth effect, reduced employee mobility, greater private debt, lower bank liquidity, and lower financial stability – these phenomena do not have to occur (or may occur to a smaller extent) when banks grant other loans or purchase securities. The analysis of the differences between individual cases of credit expansion made it possible to create the initial typology of business cycles, which enriches the theory of the business cycle and in the future may become – as I hope – a useful analytical tool used by economic historians.  Institutions other than commercial banks can also create money and credit. This can be done by other depository institutions (such as savings banks or credit unions), as well as institutions offering deposit-masking instruments (e.g. money market funds) and shadow banks. The creation of money through a shadow banking system seems particularly important in the modern economy. Securitization allows traditional commercial banks to increase lending, and the intermediation of liabilities allows banks to create loans for themselves by themselves. An increase in credit supply occurring in a shadow banking system results in a different manifestation of the Cantillon effect.  The financial sector is one of the first recipients of new money. Therefore, the increase in money supply spurs the growth of the financial sector, which leads to redistribution of income and wealth from other sectors to the financial sector. The increase in money supply causes redistribution of income from relatively late recipients of new money to those that receive it relatively early, because the latter group will have a larger cash balance at



Synopsis and final conclusions 127 their disposal while prices are yet relatively unchanged. As a result of sequential propagation of new money through the economy and gradual price increases, subsequent recipients will be confronted with increasingly higher prices. Monetary inflation also redistributes income from net creditors to net debtors, as well as from people with fewer assets, whose price increases (more) as a result of inflation, and who spend more on consumer goods that are more expensive, to people who have more assets protecting them against inflation, and who spend less on the more expensive consumer goods. It turns out that poorer people are worse off during monetary inflation, relative to richer people. This is because they do not have access to newly created money, and the changes in the structure of relative prices are comparatively unfavorable for them (e.g. they have fewer assets whose prices rise during inflation). The Cantillon effect may therefore contribute to an increase in income and wealth inequalities. The first-round effect also occurs on the international scale, especially in the case of an increase in the money supply of a major global economy that is the issuer of reserve currency (such as the American economy). In the current monetary system, the increase in money supply in one country will affect other countries through the trade channel, the interest rate channel, the risk channel, the credit channel, and the exchange rate channel.

In the work presented, I analyzed various types of non-neutrality of money, showing that the conditions necessary for money to be neutral are impossible to achieve. I also showed the relationship between the first-round effect, the non-neutrality of money, and monetary inflation, showing that – mainly due to the Cantillon effect – money is not neutral even in the long term. I also stated that due to the effect of the first round, the distributional effects of inflation occur regardless of whether it was planned or not. I also showed that the effect of the first round is the foundation of the Austrian theory of money and the business cycle. However, I greatly enriched the achievements of the Austrian school by:  



systematic classification of the Cantillon effect, according to the method of increasing money supply in the economy; a more disaggregated analysis of the credit expansion process, thanks to which I could explain the differences in the so-called secondary features of the business cycle and propose an initial classification of business cycles according to the dominant channel of credit expansion; indicating that entities other than conventional commercial banks (especially entities operating within the shadow banking system) may also create money and credit, which affects the course of the business cycle and the particular manifestation of the Cantillon effect, and thus augment the Austrian theory of the business cycle with the changes that have taken place in modern banking;

128 Synopsis and final conclusions 

analyzing the international dimension of the first-round effect, thanks to which I was able to broaden the application of the Austrian theory of the business cycle, which in its traditional approach assumes the existence of an economy that is closed to the contemporary monetary system. The conducted analysis leads to three basic conclusions:

1 2

3

The Cantillon effect is one of the causes of the non-neutrality of money. Various monetary inflation channels result in different manifestations of the Cantillon effect, affecting real economic phenomena in an uneven way, including the course of the business cycle. The Cantillon effect resulting from credit expansion contributes to the occurrence of the business cycle, the emergence of price bubbles, the growth of the financial sector, and the increase in income and wealth inequalities.

The above points do not constitute the entirety of conclusions for the theory of economics. The book clearly shows that the first-round effect is an extremely important economic phenomenon, the analysis of which considerably furthers the development of economic theories – both those presented by mainstream economists and by those following the Austrian school. The latter, although it does take the Cantillon effect into account, would certainly gain from more accurate and systematic analysis of the phenomena. The study of money supply growth carried out in Cantillon’s spirit is an important analytical framework that allows the development of a number of sub-disciplines in economics and a better understanding of many economic processes. The firstround effect significantly furthers the theory of economics, mainly the theory of money and inflation, and the theory of the business cycle and price bubbles, but also the theory of banking and central banking, the theory of income distribution, income and wealth inequalities, and the theory of public choice. My analysis of the Cantillon effect is an important voice in the debate on the nature of inflation and the role of monetary factors in the economy, showing deficits in the quantity theory of money (in its simplest, mechanistic approach) and showing that money is not neutral even in the long run. The effect of the first round, therefore, undermines the view that price levels change in the same proportion as the money supply, showing that the increase in money supply affects prices and production, even when the overall price level remains stable, which entails huge implications for monetary policy. The Cantillon effect shows that the impact which increasing the money supply has on prices depends on the character of such increase – therefore, not only the quantitative increase in the money supply, but also the manner in which it occurs are both important for the economy. The effect of the first round, according to which the increase in the money supply does not lead to uniform changes of all prices, but rather to significant changes in the structure of relative prices and the resulting disturbances in the

Synopsis and final conclusions 129 production structure, also develops the theory of the business cycle and the theory of price bubbles – their creation is the best proof of the fact that prices of various goods and services in the economy do not increase evenly, according to Friedman’s helicopter model, but rather unevenly, as Cantillon described it. The classification of business cycles and the observation that the increase in money supply does not lead to uniform changes in all prices, but may cause bubbles in the asset markets, may be helpful in the process of making investment decisions. The Cantillon effect highlights the redistributive nature of monetary inflation. Analysis of the first-round effect shows that the increase in money supply leads to redistribution of income and wealth, which may further increase inequalities in this realm. Therefore, the deepening of income and wealth inequalities observed in OECD countries since the 1970s may be partly due to monetary inflation. This is an important implication, which expands our understanding of the effects of monetary policy and business cycles, the theory of inflation, as well as the theory of income distribution and income and wealth inequalities. As we can see, the first-round effect entails not only purely economic but also social consequences. A more disaggregated study of the creation of new money and credit in the spirit of Cantillon’s analysis also expands the theory of banking and central banking, showing that not only the increase in money supply is important for the economy, but also the way it happens. More detailed analysis of changes in the balance sheet structure of commercial and central banks could increase our understanding of the so-called secondary features of business cycles and contribute to the creation of a systematic classification of business cycles according to the dominant credit expansion channel. The Cantillon effect also advances the theory of economic growth, because it shows that the impact which increasing the amount of money has on economic growth depends on whom the new money goes to first and what it is allocated for: consumption or savings. Moreover, the analysis of the first-round effect is an important contribution to the theory of investment expenditures, because it points out that what matters for the course of the business cycle and the particular manifestation of the Cantillon effect is not only the volume of investments, but also their structure and changes occurring in it. For example, investments in machinery and software have a different impact on economic growth and economic phenomena than investments in buildings and structures. This shows that how borrowers spend the money that was first created by commercial banks (or other financial institutions) and then loaned to them is an important factor for the economy. In addition, the first-round effect can enhance the comparative analysis of economic systems by drawing attention to the differences between the money supply growth (or the monetary transmission mechanism) in systems where the basis for financing is formed by banks, and in systems where that basis is the capital market.

130 Synopsis and final conclusions The Cantillon effect also expands the theory of public debt and points to the extremely important links between monetary and fiscal policy, which are often overlooked by economists. The analysis of public debt issues and the growth of money supply in Cantillon’s spirit shows that – contrary to Ricardian equivalence – it does matter whether the government finances its expenses by means of debt or taxes. In the current monetary system, the issuance of public debt is inflationary, i.e. it leads to an increase in the money supply and all the related economic consequences. It obviously helps the government sector, while the increase in taxes is only a transfer of purchasing power from taxpayers to the government. The Cantillon effect, therefore, causes the government sector benefits to go beyond seigniorage. Governments are, in fact, one of the first recipients of new money, and therefore they can acquire goods and services at unchanged (not yet entirely adapted) prices. Therefore, focusing on the general price level in the analysis of the inflation tax does not take into account the redistribution from the private sector to the government sector resulting from the Cantillon effect. As one can see, the study of the first-round effect also expands the theory of public choice, helping to understand many aspects of monetary policy, including public support for increasing the money supply, despite all the negative effects associated with it. First of all, it should be noted that monetary policy is founded on distribution effects, because neutral monetary policy would not make much sense, neither economically nor politically. In addition, due to the Cantillon effect, monetary inflation may be seen as a more attractive way of generating income for the governments than taxation. This is because it is a more discriminatory policy, thanks to which individual entities can be supported, initially without direct, negative effects on other entities. Thanks to monetary inflation, governments are therefore able to transfer money to specific individuals and increase their nominal income without taking money from others and lowering their nominal income. Moreover, monetary inflation may be easier to carry out from a political point of view, because it does not require passing any new legislation. It also creates an impression of general prosperity, postponing the negative effects, which often are not even properly recognized by the society. In contrast to taxation, monetary inflation is also able to lower the interest rate, and thus the cost of servicing debt. The presented publication not only expands the theory of economics, but also the history of economic thought and economic policy. As part of the former, I showed that mainstream economists do not sufficiently explore issues related to the Cantillon effect. Instead, they focus on other causes of non-neutrality of money, such as price rigidities (new Keynesians) or imperfect information (new classicists). I also came to the conclusion that Hume’s interpretation of the first-round effect is not identical to the version originally presented by Cantillon, and that Cairnes’ work seems to be forgotten in this regard.

Synopsis and final conclusions

131

When it comes to conclusions for economic policy, this book indicates many negative effects of (non-market) monetary inflation – especially credit expansion – such as business cycles, detachment of asset prices from their fundamental values, the international effect of increases in money supply and credit, redistribution of income (deepening income and wealth inequalities). The fact that central banks and regulators of the financial system do not take the Cantillon effect into account leads to monetary policy that is too loose and to excessive credit expansion. The widespread belief in the benefits of greater money supply seems to be another variation of the broken window fallacy (Bastiat, 2007 [1850]). It is relatively easy to identify the benefits of the first recipients of new money, as they take the form of higher expenditures or higher prices of goods and services sold by them. It is much harder to notice that, due to the Cantillon effect, monetary inflation causes losses for the late recipients of newly created money: it is impossible to observe unrealized demand of people whose income had not increased in the same way as prices of goods and services purchased by them. The analysis conducted in this work, therefore, enriches the literature on the limits of monetary and credit policy implemented by central and commercial banks, especially loose monetary policy and excessively expansive lending. The book I present to the readers does not exhaust all issues related to the subject matter discussed in it – partly due to the extent and importance of the issues examined, and partly because of the difficulties associated with the empirical analysis of how new money “spreads” through the economy. I believe that for a better understanding of the Cantillon effect, an empirical study showing the exact distribution of new money in the economy, preferably using input-output analysis, would be particularly fruitful. It would also be worth investigating in more detail how entrepreneurs spend the funds obtained through credit expansion and how this affects the course of the business cycle. Another promising field of research seems to be further disaggregation of types of loans granted (assets purchased) by commercial banks and other entities initiating credit expansion, which could result in an improved classification of business cycles due to the credit expansion channel – a systematic analysis of past cycles would be indispensable for this purpose.

Note 1 Some fragments of this chapter come from the article (based on doctoral thesis) titled: “The significance of the Cantillon effect in economic theory”, published in Polish in the journal Ekonomia. Wroclaw Economic Review, vol. 22, no. 3, 2015, pp. 9–25.

Appendix How Richard Cantillon made his fortune, created the theory of economy and died in mysterious circumstances

As the literature on Richard Cantillon and his intellectual achievements is scant,1 the aim of this appendix is to present in a condensed fashion the most important facts about the life and achievements of this special man.

Biography We cannot say much about Richard Cantillon’s life with absolute certainty. However, the information we do have at our disposal clearly shows that his story was truly extraordinary – contemporary filmmakers could make a fascinating movie based on his life. He came to the world in an Irish noble family, most likely in Ireland, in the 1880s. His appearance remains a mystery, though according to Thornton (2013), Nicolas de Largillierre’s painting “Family Portrait” (see Figure A.1) presents the very Richard Cantillon with his family. We do know, however, that in the second decade of the 18th century Cantillon came to France, received French citizenship, and began his career as a banker. He had to have earned a good reputation in this profession, because John Law hired him to help with his financial experiment involving the issuance of fiat money to finance the French public debt and the activities of the Mississippi Company. Seeing the inevitable demise of the Scot’s monetary system, the Irishman withdrew from the investment in time to save his fortune and left the country to calmly wait out the bursting of the bubble. He returned to Paris after a few years as a millionaire, but the bad image of a soulless banker, who owed his wealth to dishonest manipulations, stuck with him for the rest of his life – he was even tried in courts, though nothing was ever proved. Fact of the matter is that Cantillon got rich by loaning money and by (short) selling the overvalued shares of the Mississippi Company at the right moment. In any case, negative opinions did not prevent him from marrying (in 1722) Mary Mahony, daughter of Count Daniel O’Mahony, a high-ranking Irish military officer, whose family advocated the Stuarts. The marriage produced two children: a son who died early and a daughter named Henrietta. In the 1920s and 1930s, Cantillon traveled extensively around Europe with his family (he had several houses in different countries), but his main place of residence at the end of his life was London.

Appendix

133

Figure A.1 “Family Portrait” by Nicolas de Largillierre, allegedly depicting Richard Cantillon with his wife and daughter

It was there that he died – in unexplained circumstances – in May 1734, in a fire that consumed his home, including valuable documents. At first it was thought that Cantillon had fallen asleep with a candle in his hand, accidentally starting a fire. However, according to a widely accepted version of the events, the Irish financier and economist was murdered by the former cook, Joseph Denier, who robbed and then set fire to the house to hide his crime. Thus, Cantillon remains probably the only outstanding economist who was murdered by a former servant after being robbed. But there is also an alternative theory, according to which Cantillon faked his death – to free himself once and for all from court trials and harassment by his debtors – and fled to Suriname (Murphy, 1986).

Publication of the Essay on the Nature of Trade in General Not unlike Cantillon’s entire life, the publication of his magnum opus, Essay on the Nature of Trade in General, is veiled in mystery. The book was probably written around 1730, but it wasn’t published until 1755, more than 20 years after the author’s death (Thornton and Saucier, 2010). It is not known why Cantillon’s book appeared in print with such a delay. Controversial is also the issue of language, in which Cantillon wrote his book – it was printed in French, probably as a translation from English (so it would seem from the title

134 Appendix page of the original issue, shown in Figure A.2). It is also not clear whether the Essay was his only work. After all, the fire at his London house consumed all his papers, probably including the famous annex to the book containing numerical data, to which the author repeatedly refers in his work, and which is

Figure A.2 Cover page of the original issue of the Essay on the Nature of Trade in General

Appendix 135 missing in the published version of the treatise. What is certain is that the Essay is the only known work of Richard Cantillon. The Essay circulated in the form of a manuscript among the elite of French and English society. For a long time, it was in possession of Mirabeau; it seems that Hume, too, was acquainted with it. It is also known that the work of the Irishman initially had a significant impact on other economists, primarily on the Physiocrats and French liberals, including Condillac and Turgot. Cantillon is one of the few authors quoted by Adam Smith. Unfortunately, the Essay was later overshadowed by the achievements of the Scotsman and other classical economists. Cantillon’s work was rediscovered in the late 19th century by Jevons, who recognized it as the first systematic economic treatise (and not just a collection of essays or pamphlets). Cantillon was also regarded by Schumpeter, Hayek, and Rothbard (Hayek, 1991, Thornton, 1998) as the true father of economics. Indeed, the Irishman’s book covers practically all the components of economic theory at the time – it consists of three parts, which according to Hayek can be characterized as follows: about wealth and production, about exchange, and about international trade.

Richard Cantillon as an economist Richard Cantillon’s contribution to the theory of economics is significant, yet for many years it has been underappreciated – and unfortunately many economists are still unaware of it. What exactly are the Irishman’s accomplishments? First of all, Cantillon emancipated economics from ethics, religion, or politics, for the first time using scientific methods and a systematic approach to the analyzed economic issues. Unlike previous authors writing on economic topics, the author of the Essay abstains from value judgments, staying away from ethical, religious, or political considerations. He is interested only in positive economics and describing the natural (hence the name of his book) cause-and-effect relationships in the economy. For example, Cantillon refrains from deciding whether it is better for the population to be large but poor or smaller and rich. It is worth noting the methodological finesse of Cantillon, who used deductive reasoning, abstraction methods, gradual approximations, and thought experiments, extensively employing the ceteris paribus clause. The Irish economist adopted methodological individualism, emphasizing the individual as the central point of analyzing the economic process. Second, Cantillon created the first modern analysis of market prices, showing in detail how the demand (which is subjective) and the supply interact in creating prices. Although Cantillon wrote that goods have “intrinsic value” (which he understood as a measure of the amount of land and labor going into the production of goods), he maintained that it is rather the subjective consumer valuation that determines the price. There is controversy as to what extent was Cantillon the precursor of subjective and to what extent the

136 Appendix objective theory of value; however, he was primarily interested in the process of creating prices in the real world, that is current market prices, and not the “normal” price level in the long run. Moreover, even if we admit that he was in favor of a cost-of-production theory of value, his value depended on both land and labor – while the physiocrats and classical economists adopted simpler theories focusing on individual production factors. Cantillon also appreciated the great importance of the price mechanism, recognizing that changes in relative prices are an important signal for entrepreneurs. On this basis, the Irish economist believed that all elements of the market economy create a natural, self-regulating, and self-balancing mechanism. In other words, he perceived the market system as a system of interrelationships and saw the roles of self-interest, private ownership, and the free market in economic activity. Indeed, he created a model of a selfsufficient farm, in which landowners decide everything. He then assumed that they lease land to farmers, which gives grounds for the development of prices and monetary economy. Interestingly, according to Cantillon the free market, through a price mechanism (gains and losses) that would lead the economy into balance, would bring the same (or even better) results as direct management (and making all decisions) by landowners. His considerations, therefore, anticipate Smith’s invisible hand, according to which the selfish actions of individuals lead to harmonious results beneficial to the whole society. Third, Cantillon not only created the concept of an “entrepreneur” but was also the first to notice the key role of entrepreneurship in the market process. His approach anticipates the theory of entrepreneurship linking this phenomenon with risk and uncertainty. For Cantillon, acting with uncertainty is the most important feature (function) of entrepreneurs. In this approach, what is important is not whether the entrepreneurs have any capital, but whether they face uncertain incomes. Therefore, Cantillon (unlike Smith) clearly distinguished capitalists from entrepreneurs. Cantillon wrote that an entrepreneur is a risk taker, someone receiving uncertain profits. Hence, he divided individuals into hired employees receiving a fixed salary and entrepreneurs whose revenues are uncertain. It is, importantly, a functional separation that does not refer to personality traits (as in Schumpeter’s work) or social strata. Therefore, according to Cantillon, entrepreneurs include farmers, who pay a fixed rent to landowners while their potential profits are uncertain, and even bandits or beggars. According to Cantillon, the activity of entrepreneurs leads to market equilibrium. They buy goods where they are cheap and sell them where they are expensive and in this way lead to a single price on the market (factoring in the transport costs), and they make profits themselves. Thus, they act as arbiters. Cantillon also aptly describes the competition process, which inevitably leads to equilibrium. If there are too many hat makers in the city (relative to the demand for hats), some (having the least customers) have to go bankrupt.

Appendix 137 However, if there are too few of them, other entrepreneurs, tempted with the vision of profit, will open their own stores. Fourth and perhaps most important, Cantillon carried out pioneering analyses of the effects of monetary inflation. According to many historians of economic thought, Cantillon’s monetary theory is essentially his greatest achievement, one that has not been surpassed (or even matched) by many economists that followed (even contemporaries). Cantillon rejected the simple, mechanistic version of the quantity theory of money. He was the first to trace the actual cause-and-effect chain between the amount of money and prices, showing how the growth of the money supply actually leads to price increases. He strongly rejected the view that prices change in proportion to the increase in money supply, noting that such increase has different effects on different prices, thus affecting relative prices. Cantillon also noticed that money entered the economy sequentially and unevenly, while the effect of increasing money supply depends on the channel through which new money is introduced into the economy. The distribution and price effects that occur as a result of the increase in money supply will be later called the “Cantillon effect” by Mark Blaug – in honor of the Irish economist. Fifth, Cantillon laid the foundations for the theory of interest rate and the business cycle. On the basis of his analysis of the effects of monetary inflation, Cantillon rejected the view that an increase in money supply always causes a drop in interest rates, arguing that the impact of changes in money supply on the interest rate depends on the channel through which new money is introduced into the economy, or more accurately whether they first go to borrowers or lenders. Noting that increasing money supply through the credit channel leads to a reduction in the interest rates, Cantillon anticipated the Austrian theory of the business cycle. Sixth, Cantillon described the price–specie flow mechanism (before Hume’s analysis!). He noted that an increase in money supply leads to an increase in prices and the outflow of money abroad (increase in imports). What is important, he distinguished both the effect of relative prices (import to export), as well as the effect of increased cash balances and increased imports. Seventh, the Irish economist laid the foundations for spatial economy, stressing the role of transport costs in the choice of location for certain businesses or urban centers and markets (markets generally develop in the center, because that significantly reduces transport costs). For example, perishable products are produced closer to cities, and factories are located closer to raw materials. Cantillon also saw the role of transport costs in regional price differences (prices of goods in large cities tend to be higher than near the place of production by the amount of transport costs). In other words, he was a precursor to the analysis of economic activity in connection with geographical location. Eight, Cantillon’s population analysis was definitely subtler and more advanced than Malthus’s subsequent work. Cantillon researched factors of population growth, such as culture, technology, and natural resources. He did not, unlike Malthus, take a pessimistic view, noting that a population adapts to

138 Appendix technology and resources – in other words: to possibilities (e.g. through migration or postponing marriage) – in the quest to maintain a certain standard of living. With unlimited resources, there is a tendency to reproduce, though the population growth is not an inexorable necessity, but an opportunity that depends on economic conditions. Of course, the above review is not a complete inventory of Cantillon’s contributions to the theory of economics. Other important achievements of the Irish economist include the foundations for the theory of income distribution – Cantillon developed a circular-flow model of the economy that anticipated Quesney’s Economic Tables – and the theory of bank loans, fiat money, and fractional reserves: Cantillon saw that bank loans based on fractional reserves contribute to an increase in the velocity of money in circulation and to raising the prices of securities listed on the stock exchange.

Note 1 See Murphy (1986), Hayek (1991), Rothbard (2006 [1995]), Thornton (1998), Brown and Thornton (2016).

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Index

Adalid, R. 121 Adam, K. 105 Africa 118 aggregates 2–3, 10, 12, 38–9, 43, 47–8, 50, 78, 82, 87, 90, 127, 129 Alchian, A.A. 20 Aliber, R. 95, 100 arbitrage 117, 120 aristocracy 64 Asia 118–19 assets 9, 21, 40–1, 127, 129, 131; asset market segmentation 48–9; asset price effect 50; and business cycle characteristics 78–90, 92; and classification of Cantillon effect 55, 58–9, 65, 67; and credit expansion 74–5; and income/wealth inequalities 105–11; and inflation 99–100; and international Cantillon effect 117–18; and money supply 96–9; and price bubbles 95, 101; transfer of cashed assets 57 Attwood, T. 35 Austrian business cycle theory (ABCT) 47, 79, 108, 114, 127–8, 137 Austrian school 2, 9, 11, 23–6, 33, 39, 43–6, 54, 66, 72–3, 75, 95, 98, 127–8 Balac, Z. 106 Bank of England 73, 105 Bank for International Settlements (BIS) 95 Bank of Japan 105 bankruptcies 100, 136 banks 2, 9, 20, 23–5, 78–9, 138; banknotes 1, 21, 55, 60, 62, 64; and business cycle characteristics 80–1, 83–92; and classification of Cantillon effect 53, 62, 65; and credit expansion

72–6; and history of economic thought 31, 37, 40, 47–8; and inequalities in income/wealth 106, 108; and international Cantillon effect 114–19; and investment 82–90; and price bubbles 97–100; shadow banks 91–2, 119, 126–7, see also central banks Banque Royale 65 barter economy 4, 6, 20, 39, 50 Beck, T. 90 Becker, J.G. 86, 118 Bentham, J. 36 Bernholz, P. 64 Bilo, S. 34 Blaug, M. 6, 15, 38, 137 bonds 40, 48, 59, 61–2, 79, 81–2, 85–7, 90–1, 96, 105, 118–19 booms 23–5, 41, 60, 64–6, 73, 80–1, 85–6, 89–90, 97, 99, 110, 117–20, 126 Boone, P. 61 Bordo, M.D. 95 Borio, C. 118 borrowers 19–20, 26, 35, 59, 73–4, 76, 78–9, 81–4, 92, 129, 137 brokerage 83, 85–6, 97 Brunner, K. 48 Brunnermeier, M. 106 Buhr, C.-C. 60 bullion 6, 8, 55–6, 62–4 business cycle 2–3, 15, 23–6, 126, 128–9, 131; and Austrian school 45–6; and classification of Cantillon effect 53–4, 59, 62; and credit expansion 65–6, 68, 75; and history of economic thought 33, 36; and inequalities in income/ wealth 104, 111; and international Cantillon effect 114–17, 119–21; and price bubbles 97; and printing of

Index 157 money 63; and real business cycle theory 47, 49; and secondary characteristics of 72, 78–94, 127, 129; theory of 137 Cachanosky, N. 115 Cairnes, J. 30, 34–5, 49, 130 Cambridge school 37 Cantillon effect 1–3, 7, 20–1, 36, 60–1, 81; and asset market segmentation 49; and Austrian school 43, 46; in business cycle 23–6, 78–94; and chaos theory 49; classification of 53–71; and credit expansion 65, 67, 72–8; and debasement 63; definition of 15; and deposits 78–82; and directions of economic thought 46–9; Essay on the Nature of Trade in General 2, 15, 65, 133–5; essence of 18–23; and final conclusions on 125–31; in history of economic thought 30–52; and inequalities in income and wealth 104–13; and inflation 99–100; international Cantillon effect 76, 114–24; and loans 82–4; and monetary disequilibrium theory 47; and monetary transmission mechanism 48; and neutrality of money 3–14; and new classical economics 42; and New Keynesianism 37–8; and price bubbles 95–103; and printing of money 63–4; and process of credit expansion 74–6; schematic of 19; and secondary characteristics of 78–94; special case of 36; synopsis of 125–31; theory of 15–29 Cantillon, R. 2–3, 9, 12, 15, 90, 129–30; biography of 132–5; and classification 53, 55; and classification of distribution effects 65; and commodity money 55; and credit expansion 72; and debt 61; as economist 135–8; Essay on the Nature of Trade in General 2, 15, 65, 133–5; and Friedman 40; and history of economic thought 30–52; and investment 58; and Mises 44–5; and price bubbles 95, 101; and secondary features 79 capital flow 97, 117, 119, 121 capital goods 22, 25, 41, 65, 75, 99 capitalization 97, 107 cash balances 1, 15, 18–20, 58–9, 125–6, 137; and history of economic thought 34, 37, 39–41, 44, 46; and international Cantillon effect 114, 120;

and neutrality of money 7–8; and price bubbles 96, 101 Castaldo, A. 58 catallactics 5 central banks 56, 62, 64–5, 126, 128–9, 131; and business cycle characteristics 80–2, 85, 87, 91–2; and credit expansion 73–4, 76; and history of economic thought 37–8, 48; and international Cantillon effect 115–17, 119, 121; and price bubbles 95, 98, 100–1, 105–7; and theory 17, 20 Central and Eastern Europe 118 chaos theory 49 Ciccarelli, M. 116 20-City Composite Home Price Index 98 Claeys, G. 105 class 109–11 classical economics 5, 35–6, 39, 136 clergy 63–4 coercion 55, 59 Coibion, O. 106 coins 1, 53, 55, 60, 62–4, 68 collateral 80–1, 87, 97, 100, 108, 118 commercial banks see banks commodities 32, 44–6, 95, 99 commodity money 18, 53, 55–6, 62, 64, 67 comparative advantage 56 comparative statics 6 construction sector 62, 75, 83, 89–90, 126 consumer price index 95, 100 consumption 8, 23, 25, 31–3, 40, 57–8, 61, 75, 83–4, 89, 99, 127, 129 Copernicus, N. 63–4 corruption 61 credit expansion 3, 11, 23, 72–7, 126–9, 131; and business cycle characteristics 78–81, 84–7, 89–91; and classification of Cantillon effect 53, 55, 60, 64–6, 68; credit channel 2, 24–6, 46–8, 65, 73–5, 78, 97, 101, 118, 120, 126–7, 137; credit crunch 100; definition 72–4; and history of economic thought 31, 46; and inequalities in income/wealth 107–8; and international Cantillon effect 115–21; international effects of 115–19; and price bubbles 95, 97, 99–101; process of 74–6 credit unions 92, 126 creditors 19–20, 30, 53, 63–4, 66–7, 75, 105, 107, 109, 111, 127

158 Index creditworthiness 106–8 crowding-out effect 62, 68 Davenport, H.D. 72 debasement 53, 55, 60, 62–4, 68 debt 20, 55, 61–2, 64–5, 67, 74–5, 83, 89–92, 119, 126, 130 debtors 20, 30, 53, 63–7, 74–5, 105, 107, 109, 111, 127, 133 deflation 11, 15, 37, 54, 62, 64–5, 67, 109, 125 demand 15, 21, 25, 119, 131, 135–6; and business cycle characteristics 80, 82, 86, 90; and classification of Cantillon effect 57, 59, 65, 67–8; and history of economic thought 32–5, 37, 40–2, 45, 47; and neutrality of money 4, 9, 11–12; and price bubbles 97, 101 Denier, J. 133 deposit creation 78–82, 85–6, 90–1 depreciation 115, 117, 119–20 deregulation 95, 98 Detken, C. 121 developed countries 73, 107–8 developing countries 61, 67, 117–18; and international Cantillon effect 118 discoordination 47 distribution effects 2, 7, 15–16, 21, 26, 33, 39–40, 42, 44–5, 50, 65, 125, 130 Disyatat, P. 118 Dobbs, R. 105 dot-com bubble 98, 110, 118 Dutch disease 56, 67 dynamic neutrality 5–11 Easterley, W. 104 economic growth 57–9, 61, 67–8, 83–4, 90, 104, 106, 108, 129 economic history/economic thought 2–3, 30–52, 130 empirical data 84–90, 109–11, 131 employment 32–3, 37–8, 107 Engelhardt, L.M. 116 entrepreneurs 21, 23–6, 35–7, 41, 43, 74–5, 79, 83–6, 108, 131, 136–7 equilibrium 1, 5, 11, 21, 25, 136; and credit expansion 73; general equilibrium model 8, 49–50; and history of economic thought 34, 36, 38–42, 45–6, 49–50; monetary disequilibrium theory 47

Essay on the Nature of Trade in General 2, 15, 65, 133–5 euro zone 105, 119 Europe 119, 132 European Central Bank (ECB) 118 exchange rates 20, 48, 115–16, 119–21 exchange rate channel 127 export of goods 54–5, 58, 67, 114–15, 120, 137 Federal Reserve 82, 85, 87–9, 98, 117–19 fiat money 8, 53, 55, 66–7, 72, 121, 132, 138 fiduciary media 53, 66 financial crises 59, 73, 83, 85–6, 90, 95, 100, 105–6, 109–11, 117–19, 121 financial sector 41, 59, 62, 74, 76, 79–80, 82, 95–7, 100, 106–8, 117, 126, 128 first-round effect (see also Cantillon effect) 1, 3, 49, 91, 125, 127–30; and classification 53, 58–9, 61, 63–7; and credit expansion 72, 74; and history of economic thought 30–1, 33–4, 47; and inequalities in income/wealth 104, 106, 111; and international Cantillon effect 114, 120, 128; and neutrality of money 4; and theory 15, 18, 24 fiscal policy 92, 111, 130 Fischer, S. 37, 104 Fisher effect 25 Fisher, I. 30, 35–7, 40 forced savings 24–5, 36–7, 68, 74, 79–80, 84 foreign aid 54–5, 60–1, 67–8 foreign currency 20, 83, 118–20 fractional-reserve banking system 9, 23, 72–4, 79, 92, 115, 120, 138 France 60, 132 free market 54–5, 59, 108, 136 Friedman, M. 1, 6, 8–9, 16, 30, 39–42, 49, 100, 129 Frost, J. 105 Fuerst, T.S. 50 Galli, R. 104 Germany 60, 119 global economy 54, 58, 76, 114–17, 120–1, 127 gold 8, 31, 33, 53–6, 63–4, 67–8, 98, 106, 110 gold standard 54, 98, 106, 110 goldsmiths 63

Index 159 government 20, 25, 57–8, 60, 64, 66–7; and business cycle characteristics 81, 92; and credit expansion 74–6; government bonds 61–2, 79, 82, 85–7, 96; and inequalities in income/wealth 109 Great Britain 9 Great Depression 85, 90, 95, 109 Gresham, T. 63–4, 68 gross domestic product (GDP) 60, 74, 97, 105, 107 Hagemann, H. 108 Harkness, J. 50 Hayek, F. 25, 30–1, 36, 43, 72, 74–5, 79, 89, 99, 116, 135 Heer, B. 104 helicopter model 1, 8, 16, 39–40, 100, 129 Hoeven, R. 104 Hoffmann, A. 117–18 Horwitz, S. 22 housing bubbles 83 Huerta de Soto, J. 2 Hülsmann, J.G. 79, 106 Hume, D. 9, 30, 33–5, 49, 130, 135, 137 Humphrey, T.M. 35 hyperinflation 20, 64–5, 68 immigration 53–7, 67 import of goods 9, 32–3, 56, 58, 114–15, 120, 137 income 2–3, 16, 25, 30, 40–1, 128–9; and business cycle characteristics 83–5; and classification of Cantillon effect 53, 57–60, 66–8; and credit expansion 74–6; and history of economic thought 45–6, 50; income effect 19; income tax 105; inequalities in 104–13; and international Cantillon effect 111, 114, 119 income distribution/redistribution 7, 16, 18–20, 125–7, 129, 131; and business cycle characteristics 79–80, 82–5, 89; and classification of Cantillon effect 53, 57, 59–62, 68; and credit expansion 74; and history of economic thought 33, 36–7, 45–6; and inequalities 104–13; and price bubbles 100–1; and theory 22, 25–6 individualism 43, 46, 135 Indonesia 118–19 inequalities 2–3, 72, 74, 79, 104–13, 127–9, 131

inflation 2–3, 9, 15–18, 125, 127–31, 137; and business cycle characteristics 82–7, 89–90, 92; and classification of Cantillon effect 53–4, 56, 58, 60–8; and credit expansion 74–6; and history of economic thought 30, 33, 35, 37, 40–1, 45; and inequalities in income/ wealth 104, 106, 108–11; and international Cantillon effect 114–17, 120–1; and price bubbles 96–9, 101; and theory 20–3, 26 injection effect 15; see also Cantillon effect interest rates 20, 23–6, 31, 36–8, 127, 130; and business cycle characteristics 80–1, 86, 91; and classification of Cantillon effect 58–9, 61–2, 64–8; and credit expansion 73–6; and deposit creation 79; and history of economic thought 45–6, 48, 50; and international Cantillon effect 110, 115–20; and price bubbles 97–8; theory of 137 international Cantillon effect 114–24 investment 21, 23–5, 31, 36–7, 126, 129; and banks 82–90; and business cycle characteristics 81, 83, 85–92; and classification of Cantillon effect 53–5, 57–9, 61–2, 66–8; and credit expansion 75; and history of economic thought 47–8; and international Cantillon effect 117–19, 121; and policy differences 84–90; and price bubbles 95–6, 100; and secondary characteristics 78 invisible hand 136 Ireland 132 IS/LM model 48 islands model 42 Italy 62 Japan 98, 119 Jordà, O. 73, 75 Kessel, R.A. 20 Keynes, J.M. 11, 30, 34, 37–9, 48 Kindleburger, C. 95, 100 King, R.G. 47 Kumhof, M. 110 Kwas´nicki, W. 1 Landon-Lane, J. 95 landowners 32–3, 63, 136 Largillierre, N. de 132–3 Law, J. 65, 132 leasing 40, 83, 87, 136

160 Index Ledoit, O. 106 Lin, K.H. 107 liquidity 11, 40, 80–1, 83–4, 86, 90, 108, 126 loans 23–5, 31, 126, 129, 131, 138; and business cycle characteristics 78–92; and classification of Cantillon effect 60, 62, 66; and credit expansion 72–3, 75; and history of economic thought 35, 40; and income/wealth inequalities 106, 108; and international Cantillon effect 115–19; and price bubbles 95, 97–100; types of 82–4 Locke, J. 6, 30 long-term contracts 8–9, 16, 35–6, 38–9, 109 Lucas, R.E. Jr. 30 McCulloch, J.R. 35 Machaj, M. 1 McLeay, M. 73 macroeconomics 35, 48, 50 Maestri, V. 104 Mahony, M. 132 mainstream economics 10–11, 23, 30, 38, 48–50, 73, 125, 128, 130 Malaysia 118 Malthus, T. 21, 137 Mankiw, G. 30 market channels 54–9, 66–7 Marshall, A. 42 Maussner, A. 104 Meltzer, A.H. 48 menu costs 9, 37 mercantilism 6, 33 Mersch, Y. 105 microeconomics 34, 41, 50 Middle Ages 63 military 60, 62–3, 68, 85, 132 Mill, J.S. 35 mining 33, 54–6, 118 minters 62–3 Mises, L. 5–6, 10, 40, 43–6, 99 Mishkin, F. 48 Mississippi Bubble 95, 132 mobility 83–4, 89–90, 109, 126 Mojon, B. 116 monarchy 63 monetarism 2, 8, 11, 48–9, 125 monetary policy 2–3, 6, 9, 22–3, 41–2, 128–31; and business cycle characteristics 78, 80, 82, 85, 91; and credit expansion 74, 76; and history of economic thought 48–9; and income/wealth inequalities

104–6, 108, 111; and international Cantillon effect 115–17, 121; and price bubbles 95, 100–1 monetary theory 25, 40, 43, 45–6, 137 money 1–3; base money 9; inside money 47; monetary diffusion 15; monetary disequilibrium theory 11, 47; monetary illusion 8–9, 36, 42; monetary systems 114–15; monetary transmission mechanism 48–9; monetization 62, 64–5, 92; money multiplier 73–4; money substitutes 9, 63, 73; money surprise 8; Money of Zero Maturity 98; neutrality of 3–14, 34–5, 43, 46–7, 50, 125, 135; non-neutrality of 2, 7, 11, 15–17, 22, 26, 31, 33–6, 38–9, 42–3, 46–7, 50, 125, 127–8, 130; old money 21; printing of 63–4; purchasing power of 6, 10, 18, 21–4, 35, 44, 56, 59, 65–6, 105, 130; quantity of money 5–6, 9–11, 30–1, 41, 44–5; sticky money 38; velocity of money 10–11, 36, 43, 138, see also monetary policy; money supply; new money money supply 1–3, 6, 21, 44–50, 125–31, 137; and asset prices 96–9; and business cycle characteristics 78–9, 82, 91–2; and classification of Cantillon effect 53–63, 65–8; and credit expansion 72–4; and history of economic thought 30–1, 33–42; and income/wealth inequalities 105–6, 108–11; increased money supply 55–9; and international Cantillon effect 114–15, 117–21; M1 47, 110; M2 47; and market channels 55–9; and non-market channels 55, 59–65; price bubbles 95, 100 moral hazard 101 Morgenstern, O. 12 mortgages 74–5, 83–91, 98–9, 126 Mundell-Tobin effect 11 NASDAQ 98 National Home Price Index 98 neoclassical economics 5, 25, 38, 46, 50 new classical economics 8–9, 11, 35, 42–3, 125, 130 New Keynesian economics/school/New Keynesians 8–9, 11, 33, 35, 37–9, 43, 50, 125, 130 new money 1–3, 7, 15–16, 125–7, 129–31, 137; and business cycle characteristics 78–80, 82–4, 90–1; and classification of Cantillon effect 53–7,

Index 161 59–60, 63–7; and credit expansion 72–6; and history of economic thought 30–1, 34–6, 39–40, 44–6, 48–9; and income/wealth inequalities 104–8, 111; and international Cantillon effect 114–15, 120–1; and price bubbles 96–8, 101; and theory 18–19, 23–6 New York Stock Exchange (NYSE) 98 Nikkei 225 Stock Index 99 Nobel Prize 40–1 nominal variables 1, 5–10, 20, 34–9, 41–2, 44, 47, 62–3, 105, 130 non-market channels 54–5, 59–66, 68 OECD 2, 72, 74, 95, 129 O’Mahony, D. 132 paper money 18, 63–4 pensions 35, 75, 105 perfect information 16, 22 Philippines 118 Philips, C.A. 86 Philips curve 36, 42 Physiocrats 135–6 Piachaud, D. 108 Piketty, T. 105 Plosser, C.I. 47 plucking model 41 plunder 54–5, 60, 68 portfolio rebalancing channel 96 positivism 42 post-Keynesianism 37–9 poverty 32, 63–4, 108–9, 111, 127 precious metals 54–6, 62 premiums 20, 31, 91, 116, 118 prices 10, 12, 15, 125, 130, 135; and classification of Cantillon effect 56–8, 61, 63–5, 67; and credit expansion 74; and history of economic thought 30, 33, 36, 40, 42–4, 46, 48; and income/ wealth inequalities 104, 106, 108–9; and international Cantillon effect 115, 121; price bubbles 2–3, 72, 75, 79–80, 82, 84, 89–90, 95–103, 118, 126, 128–9; price effects 19–21, 26, 39, 45, 50, 114, 137; price level 10, 12, 21–3, 25, 30, 36–8, 40–3, 48, 64, 106, 128, 130, 136; price mechanism 25, 45, 136; price rigidity 2, 8–9, 11, 16–17, 35, 37–9, 41, 50, 125; price-distribution effect 7; price-specie flow mechanism 33, 114, 137 private sector 20, 60, 66, 82, 85, 107, 130 private transfers 58

production 1–3, 7–11, 15–16, 18–26, 128–9, 135–7; and business cycle characteristics 79–81, 83–4, 89; and classification of Cantillon effect 53, 57–9, 61–2, 66–8; and credit expansion 74–5; and history of economic thought 31, 33, 35–43, 45–8, 50; and income/ wealth inequalities 104, 108; and international Cantillon effect 115–17, 119–21; and price bubbles 99; private production 55–6 productivity 47, 84, 92, 110 profit 24, 34, 56, 60, 66–8, 107–8, 136–7 profitability 8, 24, 35, 37, 56, 58; and business cycle characteristics 81, 83, 86; and classification of Cantillon effect 61–2, 66; and credit expansion 73; and international Cantillon effect 115, 118, 120 promissory notes 62 property transfers 53–5, 57, 67 Prussia 60 psychology 97, 101, 126 public choice theory 128, 130 public sector 20, 60–1, 66, 68, 74 purchasing power 6, 10, 18, 21–4, 35, 44, 56, 59, 65–6, 105, 130 quantitative easing 74, 91, 105 quantity theory of money 5–6, 9–11, 30–1, 36–7, 40, 41, 43–5, 128, 137 Quesney’s Economic Tables 138 rates of return 75, 82, 118 rational expectations 8, 11, 38, 42 raw materials 41, 56, 91, 117–18, 137 real business cycle theory 11, 47, 49 real estate 20–1, 23, 57–9, 67, 75, 81, 83–4, 86, 89–90, 95, 98–100, 107, 109, 126 real values 20, 74, 105 recessions 73, 81–3, 85, 89, 98, 100–1, 110, 117 Reichsbank 64–5 Reilly, B. 58 reparations 60 reserve currencies 76, 114–15, 121, 127 Ricardo, D. 92, 130 risk channel 120, 127 Romer, C.D. 104 Romer, D.H. 104 Rothbard, M.N. 109, 135

162 Index Roventini, A. 104 Rzon´ca, A. 90, 105 S&P/Case Schiller Index 98 Saiki, A. 105 salaries 33, 35, 63 Sannikov, Y. 106 savings 24–5, 36–7, 57, 59, 66, 68, 72, 74, 79–80, 84, 92, 108, 126, 129 Schnabl, G. 117 Schumpeter, J. 5, 135–6 securities 48, 62, 65, 75, 78–82, 85–8, 90–2, 99, 109, 126, 138 securitization 81, 126 seigniorage 130 shares 11, 20, 48, 59, 65, 79, 85–7, 100, 132 Sinn, H.-W. 119 Skousen, M. 2, 56 Smith, A. 2, 135–6 social welfare 6 software 17, 92, 129 South Korea 118–19 South Sea Bubble 95 Spain 32–3 speculation 65, 89, 95–8, 100–1, 111 state 20, 31–2, 53, 55, 60–5, 68 stock exchanges 83, 97–8, 138 stock markets 86, 90–1, 95, 97, 100, 107 stocks 79, 83, 85–6, 90–1, 95, 97–8, 100, 105, 107, 109, 138 Stuart dynasty 132 subsidies 53 super-neutrality 5, 10–11 Suriname 133 Switzerland 116 synopsis 125–31 TARGET2 system 119 tâtonnement 42, 50 taxes 9, 35, 61–2, 66–7, 92, 105–6, 130 textbooks 72–3 Thailand 118–19 Thornton, M. 98, 132 Tobin’s Q ratio 48, 81, 100

Tomaskovic-Devey, D. 107 Torrens, R. 35 tourism 53–7, 67 trade 2, 8, 15, 31, 33, 53, 76, 114–17, 119–21, 127, 133–5 transaction costs 9, 62 transfers 53–5, 58, 60–1, 65–8 treasury bonds 61, 82, 85, 90–1, 118 Tzamourani, P. 105 uncertainty 5, 8, 22, 25–6, 39–40, 136 unintended consequences 82, 111, 117, 121 United Kingdom (UK) 105 United States (US) 3, 74, 85–9, 95, 97–9, 105–7, 109–11, 117–21, 127 Urban Land Price Index 99 vertical integration 20 wages 1, 11, 20, 23, 32–5, 37–9, 45, 56–8, 105, 109–10 Walras, L. 8 war 53, 60, 63, 66–7 wealth 2–3, 16, 21, 25, 128–9, 135; and business cycle characteristics 85; and classification of Cantillon effect 53, 57, 63; and credit expansion 74, 76; and distribution/redistribution 79, 100–1, 126–7, 131; and history of economic thought 30–2, 36, 40, 44–6, 50; and international Cantillon effect 111; and neutrality of money 6; wealth effect 48, 83–4, 89–90, 126; wealth inequalities 104–13 Weimar Republic 64–5 White, L. 98 Wilson, G.W. 105–6 Wolff, E.N. 109 Wollmershaeuser, T. 119 World War I 85, 90, 109 World War II 86, 90, 110 Yaeger, L. 11, 105