Home Economic Trends Cantillon Effects, Business Cycles and Market Bubbles – Leonel Regalado

Cantillon Effects, Business Cycles and Market Bubbles – Leonel Regalado

Richard Cantillon was probably one of the first people to actually write about economic theory, and his findings are still relevant today. We’ll focus on one specific topic: the non-neutrality of money, “Cantillon Effect”. What is this? Mark Thornton brilliantly explains it in a recent article:

“The general form of a Cantillon effect is that there is increased money coming into an economy from somewhere. The first recipients benefit. They spend it according to their preferences, and this causes certain prices to go up. The sellers of those goods benefit from the new money, while others who only face higher prices are hurt.”

So basically, when prices go up in an economy, they don’t go up at the same time, or in the same proportion. Several cases have been made to indicate how CPI is problematic because of this, but that’s not our main point. In our modern society, this expansion of money comes from Central Banks, which expand the money supply either by printing money or by adding zeros to the accounts that commercial banks and entities have with them. This new money must enter the economy somewhere: the banking system. For years and years central banks have been expanding the money supply excessively, injecting money not only into the banking system, but the financial system as a whole.

This monetary expansion that goes right into the financial system tends to make the price of whatever asset most firms are investing in go up. A clear example are real estate prices right before the Great Recession: most financial firms were investing in mortgage-backed securities, which made getting a mortgage attractive, ultimately making prices go up. Cantillon effects may take months, or years to have their full effect: money can be poured into one market, without inflationary consequences in the rest of the economy for years.

Now, let’s talk about market bubbles and how they can delay these Cantillon Effects: let’s suppose the newly created money starts going into a stock market, making prices of certain stocks go up. This makes the prospect of investing in these stocks better, so as prices start going up, more people will be investing in these stocks. This delays the change of prices in the rest of the economy because more people are spending their money on these assets than buying any other goods.

It’s not a surprise that most of the recessions in the last hundred years have come from these so-called bubbles. For Austrian Economists this is not a surprise, as credit expansion makes certain projects look profitable (which weren’t profitable before the credit expansion), people invest in these projects, leading to a boom, and then a bust when credit expansion halts. The main difference is that as time has passed, our financial markets have become deeper, and Cantillon Effects are delayed further and further as the new money very slowly exits the financial system into the consumer goods markets. But they can’t be delayed forever, which is why now, after a gigantic monetary expansion in the previous years, we’re seeing 21st century record-levels of inflation.