The subtle Cantillon effects of inflation

The biggest problem with increases in the money supply is not that it causes a rises in prices – that monetary inflation can cause price inflation – for this is what we would expect to happen in most cases.

Rather, the biggest problem is that monetary inflation changes different prices differently, and hence changes relative prices.  This is of course the whole point of monetary injection, for if new money increased all prices by the same amount there would be little point.

These are the so called “Cantillon effects” after the 18th century Irish-French economist Richard Cantillon.

When a king depreciated the currency by clipping the coins he received in taxes, he inflated the money supply. This allowed the king to spend this new money on goods at current prices. Only later after he had spent large sums of this new money would prices rise, forcing his subjects to pay more for the goods they needed. Which prises rises will depend on what the king buys – it is quite possible that most prices might remain unchanged. But for those things which the king demanded, prices would be higher.

In such a scenario, it is clear that the inflation benefits the king and hurts his subjects – no new wealth has been created, rather, wealth has been redistributed towards the money producer. It has allowed the king to lay claim to more goods and services than he would have been able to had there not been the monetary inflation. Though the modern economy and banking system is more complex, this key truth of the effects of money creation should be noted when economists claim that monetary inflation can actually help create economic growth.

What happens in the modern economy? The recipients of the inflation are more varied – they include the government, the commercial banks, and those closest to the new money, perhaps mortgage borrowers taking advantage of lower interest rates. When central banks buy government bonds (or do so via a commercial bank), this allows the government to draw away resources from the private sector, at the later cost of higher prices in some area of the economy. This process is much more insidious than the king above, as it fairly simple to notice the coin has been clipped – just weigh it. For us today, we may notice rising prices, but the cause is usually hidden or masked behind other market based reason for the price rise.

If you had a printing press, the effects of inflation would be quite obvious. You would be able to purchase goods and services at effectively no cost, while your neighbours would eventually notice the rising prices, as more money chases the same number of goods. The resulting price inflation is therefore nothing more than an application of the usual rules of supply and demand. Creating new money always makes prices higher than they otherwise would be.

During the 1920s, Austrian school economists have argued there was significant inflation by the Fed, and this helped cause a bubble, and subsequent 1929 stock market crash. Economists of other schools have stated this cannot be the case, as prices did not rise during the 1920s. The misses two key points -firstly, that stable or even falling prices are consistent with the above statement. Without the monetary inflation, prices would have fallen at a faster rate. Secondly, while consumer prices may have fallen, asset prices such as stocks and farmland rose considerably. This is the danger of relying on indices such as CPI. We have to look at all prices to see the effects of inflation. Even in hyper inflationary situations, not all prices rise at the same rate – it depends on what people are buying.

Economic growth requires the creation of more foods and services. All creating money does is redistribute the existing wealth towards the money producer and those closest to it. In today’s society, that means the government and the banks. All those on fixed incomes suffer. If we really believe in helping the poor, we need to recognise the impact of continuous money creation. And if we want to hurt the banks, as many do, perhaps we should stop the Fed from buying $85bn of mortgage securities a month. Let the banks stand on their own two feet.

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