The Cantillon Effect (And The Inevitable Demise of Financials)

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In a pertinent observation, Ludwig von Mises, a philosopher, Austrian School economist, sociologist, and liberal says: ‘Inflation and credit expansion, the preferred methods of present day government open-handedness, do not add anything to the amount of resources available. They make some people more prosperous, but only to the extent that they make others poorer.’

In fact, indiscriminate additions to money supply have a negative fallout – the Cantillon Effect. Newly created money takes its time to percolate through the economy, and worse, its reach is unequal. Since new money inevitably raises prices through an inflationary effect, those that are the earliest (or closest) near its source are the first beneficiaries because they can purchase assets with money’s higher purchasing power then prevailing, compared to recipients at the periphery. This perpetuates inequality of resources in the economy.

The Cantillon Effect and financials

Charles Gave, in his Ideas newsletter of August 19, 2014, published under the GavekalDragonomics banner, goes a step ahead and draws a somewhat disturbing inference from the Cantillon Effect – its role in market crashes.

Because the sectors closest to the fount of money supply are able to stock up on assets cheaply before the masses can, in a situation of sustained stimulus or new and easy money, they eventually hold a disproportionately large inventory of assets procured at higher and higher prices. In the context of wealth distribution, they are the chosen few and ‘more equal than others,’ but here’s the crunch – they are also the most vulnerable.

Financial institutions are usually the intermediaries chosen by governments to implement their injection of new money and are generally the prime beneficiaries of the Cantillon Effect.

“The net result is a massive change in the relative level of most prices in the economic system compared to the price of assets bought by financial institutions and also the main expense of governments in the shape of the civil servant payroll,” says Gave, in the context of near-zero interest regimes perpetrated by governments.

These low interest rates keep overheating asset prices to the advantage of the holders, but the savers in the economy are faced with negative real interest rates on their savings.

Also, the investors usurp financial resources to the detriment of the entrepreneurs, which are unable therefore to contribute real output to the economy.

Example: Real estate

Before 2008, the Fed’s emphasis on providing super cheap money percolated through the banks to the real estate sector – which soaked up available funds at the expense of other sectors – causing a major capital imbalance, or say, misallocation. When this corrected, as it eventually must, the sector collapsed.

It is also pertinent that the Chinese government’s GDP chase led to the creation of massive real estate pools that are alleged to include whole ‘ghost towns’ – falling real estate prices will cause another backlash on the financial sector which funded these construction booms.

“Whenever money is printed or there is growth in credit, there is the Cantillon Effect. Print money in the 1970s and it flows into energy and commodities. Print money at the end of the 1990s and it flows into a technology stock bubble. Print money in 2009-2010 in China and it flows into real estate. Where the money flows depends upon on demographics, tastes and preferences of those first receiving the money, or existing investment trends,” – Macro Business, giving other examples of the Cantillon Effect and economic imbalances (bubbles?).

Deflation around the corner

The inevitable outcome is deflationary, says Gave, citing the destruction of value in the housing collapse in the US.

Perhaps the most serious and debilitating impact of indiscriminate money printing is on the economy’s productive potential. “Most asset values have soared but the stock of capital available for entrepreneurs to use in productive activities has not,” observes Gave. “Hence, productivity is declining along with the median income while the Gini coefficient is going through the roof.”

(Gini coefficient: A measurement of the income distribution of a country’s residents. This number, which ranges between 0 and 1 and is based on residents’ net income, helps define the gap between the rich and the poor, with 0 representing perfect equality and 1 representing perfect inequality – Investopedia)

Gave recommends avoiding financials everywhere, given that “there has been a clear capture of the central banks,” ensuring “a different distribution of wealth that increases leverage and favors not legitimate risk takers, but groups which are politically well connected such as the too-big-to-fail banks.” This cannot go on, he says.

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