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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The Myth of Democracy

This week, the US congress voted on an amendment to stop the NSA’s PRISM program which has been making headlines for the past few weeks. Unfortunately, the vote was defeated in the House of Representatives by 217-205, and so the NSA will continue to spy on the emails, phone calls and other communications of innocent people – in direct violation of the 4th amendment of the US constitution.

The debate both before and after the vote centres on the age old question of national security vs civil liberties. We are often told that without this unconstitutionally gathered data, Americans would be more vulnerable to terrorist attack, and we must sacrifice our liberty in order to be safe. (Benjamin Franklin might have something to say about that). This is a rather bitter pill to swallow, since the information the government is using as evidence of the program’s necessity is top secret. How can we judge the merits of the program?

Nonetheless, the above narrative at least shows these elected representatives in a good light. They are wrestling with difficult decisions, at a time when terror threats are known to be a serious risk. The truth, however, is rather more disturbing:

On average, House members who voted to uphold the domestic spy program received an average of $41,635 whereas those who voted to revoke authority for the program averaged $18,765. By the way, the leaders of the two “opposing” parties in the House, Boehner and Pelosi received $131,000 and $47,000, respectively, from the defense-intelligence establishment.

From Wired, where the above article was sourced:

The amendment was proposed by Rep. Justin Amash (R-Michigan), who received a fraction of the money from the defense industry compared to top earners. For example, Amash got $1,400 — ranking him in the bottom 50 for the two-year period.

As always, follow the money. Or as the Romans said, cui bono.


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The new man at the helm

At the start of July, Mark Carney became the new Governor of the Bank of England. He appears to have taken his job at a time when there is greater optimism regarding the state of the UK economy, which has in turn changed the expectations on how he should guide UK monetary policy. Only time will tell if the optimism is warranted.

What would my recommendation be to Mr Carney? In many respects, the job is an impossible one. If the economy does indeed improve as forecasted, he will be under pressure to raise interest rates and end QE, both of which could burst any nascent bubbles the money spigot caused. If the economy falters, he might just as easily get the blame for not extending QE or lowering rates even further.

Naturally, I don’t expect Carney to fall on his sword and end the 300 year old institution that is paying him a rather handsome salary. What I do find interesting, however, is the advice from Ben Southwood at the Adam Smith Institute, who recommends Carney implements a programme of “NGDP targeting”, instead of the inflation target that is the current focus. He summarises by saying:

In general the road ahead must be one of rules and discipline, not the translucent discretion of nine unelected barons.They must keep demand steady so we can focus on improving the supply capacity of the economy, and so there is no excuse for fiscal stimulus, with all its flaws.

In many respects, this is spot on – the MPC are never going to have all the knowledge on the economy to make the right decisions, and they are not accountable in the slightest. Yet, the solution proposed is still assuming that we can centrally plan the money supply – the key tenet of monetarism. Replacing the supposedly arbitrary plans of Keynesianism and its fiscal stimulus with the apparently more disciplined monetary stimulus of the Monetarists is no solution at all. (Of course, NGDP targeting is perfectly arbitrary – who decides the NGDP rate to target? Shall we choose 3% or 4%? And there’s nothing to stop the target being changed whenever it suits.)

I have never understood why so many believers in the free market abandon these principles when it comes to money. I recognise that the ASI does not have a strict policy position in this area, and the views of the Austrian school are promoted also. But what is so different about money to any other good or service that it becomes a major exception to the workings of the market? For all the radical ideas about legalising trade in human organs, where are the radical ideas about money? The ASI needs to step out of the shadow of Milton Friedman – a great economist and libertarian – but totally flawed in his views on money.

As I explained previously, we don’t need to create new money:

In an economy with a fixed money supply, but increasing goods and services, the purchasing power of money increases – prices fall. No new money is needed to purchase the new goods. What if the population increases? No problem, the new people just trade what they produce in order to earn money, and as there are now more goods being produced, again the purchasing power of money increases – prices fall. Rather than the money supply changing, the value of money changes instead.

From my perspective, arguing about the merits of targeting inflation, employment rates, NGDP, QE and any other system for the central bank to create money is like asking how many angels can dance on the head of a pin. They all fall down in that they share the belief that inflating the money supply is necessary and beneficial to the economy. As the Austrian school tells us, any form of monetary inflation is harmful and will ultimately damage the economy in the long run.

For those who believe in small government and the free market, please question the assumptions surrounding central banking. Do we really need a central bank? If we don’t trust the state with so many things, why do we trust it with money?

Does this sound like an institution that belongs in the free market?

  • it funds the government whilst punishing savers and workers
  • it bailouts failing private enterprises
  • it rests on monopoly privilege
  • it centrally plans prices

Read Mises. Read Hayek. Bin the Bank.

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Quote of the Day

That we are witnessing strange and dangerous deformations of the capitalist system, if we can still even call it capitalist, and that new bubbles are being blown everywhere, is not only evident by the increasingly grotesque dichotomy between a woefully underperforming real economy perennially teetering on the brink of renewed recession and a financial system, in which almost every sector is trading at record levels, but also by the fact that the high correlation among asset classes on the way up to new records is beginning to strain the minds of the economists to come up with at least marginally plausible fundamental justifications for such uniform asset inflation. ‘Safe haven’ government bonds that would usually prosper at times of economic pain are equally ‘bid only’ as are risky equities and the grottiest of high yield bonds. The common denominator is, of course, cheap money. And if cheap money for the foreseeable future is not enough, then how about cheaper money – forever?

Detlev Schlichter

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The Monarchs of Money

An interesting look at the role of central bankers from the CBC, Canada’s public broadcaster:

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George Osborne warning us about the Bank of England?

In 1997, the Bank supposedly went independent. Of course, a central bank by its very nature is anything but independent. Ask Goldman Sachs.

However the Chancellor of the Exchequer is still required by law to give advice to the Bank – so what is it? Give  “due weight to the impact of its actions on the near-term economic recovery”, and “sustain growth”. Not really the warning I was hoping for.

The implications are simple enough: stop asking banks to shore up capital (and by proxy, lend less he says) and get on with building the economy. By saying this Osborne flies in the face of Basel III, public opinion, and common sense. It is time for politicians to grow some spine and stop thinking of the near-term, as Osborne calls it (most would call it short term), and focus on the real problems that banks face – in particular one on Threadneedle Street.

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Quote of the Day

The Fed is the elephant in the living room that everyone pretends not to notice. Even many of those who blame government for the current mess leave the Fed out of the picture altogether. The free market, meanwhile, takes the blame for the destructive consequences of what it does. This charade has gone on long enough. It’s time to consider the possibility that maybe the elephant, and not little Johnny, is the one breaking all the furniture.

Thomas Woods, Meltdown

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