What Is The Cantillon Effect?

By

Jake Morr

on

July 2, 2024

The Cantillon Effect refers to the uneven impact of inflation on different economic sectors and individuals due to how and where new money is introduced. Initially, as new fiat money enters an economy, it is typically given to specific entities like banks. These initial recipients, being closer to the source of the new money (e.g., central banks), benefit as they can spend it before the general rise in prices. As this money circulates further, prices adjust, leading to later recipients facing higher prices. This process redistributes wealth and purchasing power, often benefiting those closer to financial institutions at the expense of ordinary citizens. The effect implies that inflation can act as a hidden tax, disproportionately affecting different parts of the population. Richard Cantillon, an 18th-century Irish-French economist, first observed this phenomenon, highlighting the importance of money's velocity and distribution in influencing market prices.

What Is The Cantillon Effect?

The Cantillon Effect, named after 18th-century economist Richard Cantillon, describes the uneven impact of monetary expansion (like printing money) on price inflation. When new money enters an economy, it creates "winners" and "losers". Those who receive the new money first benefit the most. They can buy goods, services, and assets before prices increase. This pushes prices up, harming those further from the money flow, like everyday citizens.

Here's why:

  • Early recipients buy at lower prices: The first recipients get to spend the new money in an economy where prices haven't adjusted to the increased money supply.
  • Later recipients face higher prices: As the new money circulates, the increased demand leads to price inflation. Those who receive the money later face these inflated prices.

This means those closest to the source of money creation, such as governments and financial institutions, benefit the most. They can acquire assets at lower prices and benefit from the subsequent inflation. In contrast, those with fixed incomes or limited access to credit are hurt the most by the decrease in their purchasing power. The Cantillon Effect exacerbates wealth inequality. This effect plays out on a global scale as well:

  • Cantillon-winning countries: Often those with reserve currencies, benefit from cheaper imports and a flow of talent.
  • Cantillon-losing countries: Experience a brain drain, rising import costs, and often fall into debt traps from taking on loans to offset these disadvantages.

Who Benefits Most From the Cantillon Effect in a Fiat Currency System?

Those with the best access to government credit, such as private banks and owners of wealth in the stock market, benefit the most from the Cantillon effect in a fiat currency system. Those who hold wealth in fiat currency or are less connected to the financial system are harmed because their savings lose value and prices rise. This is because the Cantillon effect, first described by Richard Cantillon, says that those who receive newly created money first benefit the most. They can purchase goods and services at lower prices than those who get the money later after the prices have increased due to the increased money supply.

In a fiat currency system, the Cantillon effect is heightened due to actions like selective bailouts and government-subsidized credit which primarily benefit large, well-connected entities like large corporations. These entities benefit because they can easily secure cheap debt, allowing them to acquire more scarce assets. The closer someone is to the source of money creation, the more they benefit. Bitcoin eliminates the unfair advantage of the Cantillon effect in fiat currencies by requiring miners to expend large amounts of time and energy to create new bitcoin, which are then sold in a more open market. For more insights, read about the importance of Bitcoin.

What Are the Social Implications of the Cantillon Effect?

The Cantillon effect describes the uneven effects of new money supply on price inflation. When governments increase the supply of money, those who receive the money first gain the most benefit from it at the expense of those to whom it flows last. For example, when a gold miner sells newly mined gold, they can buy goods and services at current prices, but as the gold supply increases throughout the economy, prices rise. The people who receive the gold last, like common workers, are in the worst position because prices have risen and they are unlikely to get a wage increase. The Cantillon effect is exacerbated in a fiat currency system because big entities, like banks and corporations, benefit from selective bailouts and subsidized credit during liquidity crises.

The Cantillon effect has several social implications:

  • Wealth inequality: The Cantillon effect increases wealth inequality because the people closest to the money printer, like governments, financial institutions, and wealthy individuals, benefit most from monetary expansion, while everyday citizens on the periphery are worse off. For more on wealth disparity, see What is a Pleb?.
  • Interpersonal conflict: Rising time preference, a result of the Cantillon effect, leads to the degradation of manners and mores that make human society possible. Individuals become less likely to cooperate, crime rates soar, and social unrest increases.
  • Short-term thinking: When money is devalued, people are disincentivized from long-term thinking. This can lead to a decrease in saving, an increase in indebtedness, and a reduction in capital accumulation.
  • Socialism: When a fiat system creates unnatural inequality and social unrest, it can lead to a rise in the merits of socialism as people lose faith in the existing system.

The Cantillon effect can also impact international relations. For example, the International Monetary Fund (IMF) and the World Bank, the two most important international institutions, have had a vast impact on developing nations. These organizations provide loans to countries in crisis in exchange for structural adjustments, which require the borrowers to change their economies according to the IMF and World Bank's demands. These requirements often stipulate that clients maximize exports at the expense of domestic consumption. This can lead to a situation where developing nations are reliant on the outside world to feed their people. For further details, explore What is the Cantillon Effect?.

The Cantillon Effect and Home Prices

When interest rates are low, people are more likely to borrow money to buy assets like real estate. This increases demand for these assets, causing their prices to rise faster than the prices of goods and services. This is because the supply of assets like real estate is more limited than the supply of money. As a result, people who are able to borrow money at low interest rates, such as those closest to the sources of money creation (e.g., banks, corporations, wealthy individuals), benefit from asset price inflation, while those who are not able to borrow at low rates are hurt by it. For example, a first-time home buyer will face a higher inflation rate than someone who already owns a home because the price of homes is rising faster than the Consumer Price Index (CPI). The CPI is a measure of inflation that does not include home prices. In addition, people who own assets can use those assets as collateral to borrow even more money at low interest rates, which they can then use to buy even more assets. This further increases demand for assets and drives up their prices, benefiting those who already own assets at the expense of those who do not. To understand more about asset inflation, see What is CoinJoin?.

How Does the Cantillon Effect Contribute to Wealth Disparity?

The Cantillon Effect describes the uneven impact of monetary expansion on price inflation, exacerbating wealth disparity by benefiting those closest to the newly created money. Imagine a scenario where a substantial new gold mine is discovered in a gold-based economy. The initial seller of the newly mined gold benefits from acquiring goods and services at current prices. Subsequent recipients, such as merchants, also experience an advantage as the new gold circulates. However, the influx of gold eventually leads to price inflation, disadvantaging those who receive the new money last and experience the price increase. For example, ordinary workers might struggle to secure wage increases that keep pace with rising prices.

The Cantillon Effect is even more pronounced in fiat currency systems where central banks have the power to print money. When selective bailouts and subsidized credit are provided with newly created money during crises, large, well-connected entities such as corporations and banks disproportionately benefit. Their access to cheap debt allows them to acquire scarce assets at lower prices. Conversely, individuals and small businesses with limited access to credit face higher borrowing costs, exacerbating existing inequalities.

The Cantillon Effect is not limited to domestic economies. It plays a significant role in global wealth disparity as well. When the United States, as the holder of the global reserve currency, prints dollars, the impact is felt worldwide. The money primarily gets spent in the U.S. first, benefiting its residents. This system incentivizes manufacturing to move to countries with cheaper labor markets, leading to job losses in the U.S. Furthermore, ambitious individuals from developing countries often relocate to the U.S. for greater opportunities, creating a brain drain from their home countries.

To fully understand the social and political implications of wealth disparity, further research and analysis are recommended. For more information on wealth disparity and its impact on society, visit Why Offline Storage is Crucial for Safeguarding Your Bitcoin Seed Words.

The Mechanics of the Cantillon Effect

The Cantillon Effect operates through the process of currency debasement and money printing. When a central bank decides to inject new money into the economy, it usually does so through financial institutions. These institutions, being the first recipients of the new money, have the advantage of spending it before the general price level in the economy has adjusted. They can purchase assets, goods, and services at prices that have not yet increased.

As this new money filters down through the economy, it causes an increase in demand, which subsequently leads to higher prices. By the time the new money reaches ordinary citizens and smaller businesses, prices have already risen, diminishing their purchasing power. This delayed effect is what creates winners and losers in the economic system, as those further down the line face higher costs without having received the initial benefits of the new money. For an in-depth look at how this affects individuals, explore How Can You Recover Your Bitcoin if Your Hardware Wallet is Lost or Stolen?.

Broad Societal Issues Arising from the Cantillon Effect

The Cantillon Effect has several broad societal implications that contribute to economic and social challenges:

  • Increased wealth inequality: By disproportionately benefiting those closest to the source of new money, the Cantillon Effect widens the gap between the wealthy and the poor. This can lead to greater social stratification and reduced social mobility.
  • Economic instability: The distortion of relative prices and resource allocation can lead to economic bubbles and financial crises. Misallocations of capital, driven by artificially low interest rates and excessive borrowing, can result in market corrections and economic downturns.
  • Social unrest: As the wealth gap widens and economic conditions for the average citizen deteriorate, social tensions can rise. Protests, strikes, and political instability can become more common as people demand changes to address economic injustices.
  • Short-termism: The devaluation of money encourages short-term thinking, leading to lower savings rates and higher levels of debt. This can hinder long-term investments and economic growth, as individuals and businesses prioritize immediate consumption over future stability.

The Cantillon Effect highlights the inherent challenges and inequalities in systems of money creation and distribution. Understanding these dynamics is crucial for addressing the root causes of economic disparity and working towards more equitable financial systems. For more insights into the broader impacts of financial policies, read about What is Layer 2 in Bitcoin?.

The Bitcoin Rabbit Hole 🕳️ 🐇

Money is technology that allows for the exchange of value through time & space.

Don't understand Bitcoin? I wrote this article to cover the basics.

Back To Top