The Cantillon Effect: Why Wall Street Gets a Bailout and You Don't
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Today I’m going to try and explain why the Fed and Congress, while attempting to throw money at everyone, disproportionately tends to aid certain narrow financial actors.
The Cantillon Effect
Three weeks ago, the government passed a giant multi-trillion dollar bailout. Supposedly, it was money for a host of stakeholders, including hospitals, states, Wall Street banks, big business, the unemployed, and small businesses. Today the Federal Reserve built on top of Congress’s framework, announcing yet another multi-trillion dollar set of facilities, on top of what it already put out, to help cities, states, small businesses, main street businesses, and so on and so forth.
So what has happened so far? This is today’s change in stock price of a real estate venture run by one of largest private equity funds in the world.
A thirty five percent jump in a day is… a lot. The reason the stock skyrocketed is because investors believe the new measures from the Federal Reserve will bailout the debt of this private equity fund. There’s a ‘monetary bazooka’ aimed at the economy. And yet there’s a puzzle. If there’s money for the entire economy, why is that normal people and small businesses can’t access unemployment insurance and lending programs? To put it another way, why is the money meant for everyone only showing up in the stock market?
The reason is because money has to travel through institutions, and right now, the institutions for the powerful function well, and those for the rest of us are rickety and broken. So money gets to the rich first. Eventually, some money will get to the rest of us, but in the interim period before that money fully circulates, the wealthy can use their access to money to buy up physical or financial assets.
An 18th century French banker and philosopher named Richard Cantillon noticed an early version of this phenomenon in a book he wrote called ‘An Essay on Economic Theory.’ His basic theory was that who benefits when the state prints a bunch of money is based on the institutional setup of that state. In the 18th century, this meant that the closer you were to the king and the wealthy, the more you benefitted, and the further away you were, the more you were harmed. Money, in other words, is not neutral. This general observation, that money printing has distributional consequences that operate through the price system, is known as the “Cantillon Effect.”
In Cantillon’s day, the basis of money was gold, so he wrote about what happened when a nation-state discovered a gold mine in its territory. Increasing the amount of gold in the realm would not just increase price levels, he observed, but would change who had wealth and he didn’t. As he put it, “doubling the quantity of money in a state, the prices of products and merchandise are not always doubled. The river, which runs and winds about in its bed, will not flow with double the speed when the amount of water is doubled.”
Cantillon went on to discuss how money would flow, basically noting that rich people near the mine would spend it on 18th century luxuries like servants and meat pies, prompting a general rise in prices. Eventually the money would get out to the populace, but until it did, working people would have to pay higher prices without access to the new money that mine owners had. So there would be inflation, with uneven distribution of purchasing power.
There’s also a China angle. Cantillon noted that a kingdom discovering gold would in the long-run erode its own manufacturing base, that the non-neutrality of money also had geopolitical consequences.
Here’s how he put it:
When the overabundance of money from the mines has diminished the number of inhabitants in a state, accustomed those who remain to excessive expenditures, raised the prices of farm products and the wages for labor to high levels, and ruined the manufactures of the state by the purchase of foreign products by property owners and mine workers, the money produced by the mines will necessarily go abroad to pay for the imports. This will gradually impoverish the state and make it, in a way, dependent on foreigners to whom it is obliged to send money every year as it is extracted from the mines. The great circulation of money, which was widespread in the beginning, ceases; poverty and misery follow and the exploitation of the mines appears to be only advantageous to those employed in them and to the foreigners who profit thereby
This is approximately what has happened to Spain since the discovery of the Indies. As for the Portuguese, since the discovery of gold mines in Brazil, they have nearly always used foreign articles and manufactured goods; and it seems that they worked the mines only for the account and advantage of foreigners. All the gold and silver that these two states extract from the mines does not supply them with more precious metal in circulation than others. England and France usually have even more.
This dynamic is exactly what happened with the United States since the 1960s, if you replace the idea of gold mines with the ability to print dollars. In 1971, Keynesian economist Nicholas Kaldor said that dollar hegemony would turn "a nation of creative producers into a community of rentiers increasingly living on others, seeking gratification in ever more useless consumption, with all the debilitating effects of the bread and circuses of imperial Rome."
Today what Cantillon observed is far more extreme than it was in the 1960s; it is hedge funds, private equity, and bankers who have benefitted from the money printing, and the foreigners who benefit from our money printing are increasingly Chinese and foreign manufacturers.
This theory doesn’t imply that money creation is always biased towards the powerful, only that how money travels matter. There is no inherent money neutrality, such neutrality must be constructed by institutional arrangements. Much of the New Deal in the 1930s and 1940s was designed to build alternative channels for lending so that small business, industry and individuals could have access to money as quickly as big banks.
The Reconstruction Finance Corporation, government procurement, the Federal Housing Administration, the Federal Reserve, agricultural credit supports, Federal Home Loan Banks, credit unions, and regulations like Regulation Q were all mechanisms to insure the flow of money would be neutral. The International Monetary Fund was originally created to ensure money neutrality on a global basis.
So we can now see that the hollowing out or subversion of these institutions since the 1980s is designed to ensure they would be non-neutral, and tilted towards the powerful. Since 1981, increasingly the only channels that work to move money creation are the Federal Reserve to Wall Street, as well as the backstop to mortgages, who could get money to new homebuyers through mortgage lenders. Housing has been a key driver in both recessions and recoveries for a lot of reasons, but also for a simple one. It’s one of the few ways to get money into the hands of normal people in America at scale.
The Federal Reserve has usually seen its role as printing money and distributing it to the economy, largely by moving money to big banks and assuming they will in turn increase the amount of money available to everyone else equally. The 2008 crisis jarred this vision of neutral and frictionless money movement, because it became obvious that institutions matter.
In 2016, Federal Reserve Chair Janet Yellen gave an important speech on this topic. It turns out, she said, that who the Fed deals with matters. To paraphrase her speech, the bigger and powerful get money first, and the small and weak get money last. That’s the dynamic we’re seeing in this bailout, with small businesses and the unemployed having trouble accessing funds and the big guys getting what they need when they need it. If you want the boring version of the speech, here’s a paragraph of Yellen explaining that the Fed economists were stupid and intellectually corrupt, but doing it so that anyone listening would fall asleep rather than get outraged.
Economists' understanding of how changes in fiscal and monetary policy affect the economy might also benefit from the recognition that households and firms are heterogeneous. For example, in simple textbook models of the monetary transmission mechanism, central banks operate largely through the effect of real interest rates on consumption and investment. Once heterogeneity is taken into account, other important channels emerge. For example, spending by many households and firms appears to be quite sensitive to changes in labor income, business sales, or the value of collateral that in turn affects their access to credit--conditions that monetary policy affects only indirectly. Studying monetary models with heterogeneous agents more closely could help us shed new light on these aspects of the monetary transmission mechanism.
Saying ‘heterogeneous’ just means that the powerful and the powerless get and use money differently. In other words, Yellen was observing, in part, the Cantillon Effect.
And this brings us to today’s bailout and the meaning of institutions. Large banks, private equity corporations, and foreign central banks get dollars through the capital markets, by trading bonds and stocks. It turns out that the Federal Reserve is very good at working in these markets, and can move trillions of dollars relatively quickly. So that’s why the real estate arms of the largest private equity funds in the world are skyrocketing today. They know that the Fed turned the spigot on, and that spigot is instant and functional.
However, the Small Business Administration, unlike institutions in the 1930s and 1940s, does not have the workforce or ability to make direct loans to businesses. They have to guarantee loans made by banks, who in turn are supposed to make loans. Or that’s the theory, but in America, commercial lending institutions have hollowed out dramatically. Neither the banks nor SBA nor anyone else have the people to originate loans. We can’t do it. And our unemployment offices aren’t much better. The only functional bureaucracy that touches business and people is the IRS.
There are a bunch of aspects of the Cantillon effect that I don’t know how to translate. This is not an inflationary moment, the money printing is happening in a moment of severe deflation. So the issue is not that prices will rise, though of course they could. And we do see shortages in certain products, which is a form of inflation. I suspect purchasing power will matter more in who can afford to hold financial assets, not who can afford meat pies and servants. But the basic outline of the Cantillon Effect, that some people have more purchasing power and others have less in the same economy, if the channels of money creation make it so, is still operative.
And that’s the lesson we’re learning in this bailout. If we want to be able to expand and reduce the money supply in a way that doesn’t benefit the already powerful and hurt everyone else, we have to have institutions to do so. There are many policies designed to fix this, including getting every American a debit card as Rep. Rashida Tlaib suggests, or using the IRS as a mechanism to extend payroll support to businesses, as Senator Josh Hawley seeks. With the technology we have today, moving money neutrally in an industrialized economy like ours should be a pretty simple undertaking. Our policymakers just have to decide to do it.
Thanks for reading. And if you liked this essay, you can sign up here for more issues of BIG, a newsletter on how to restore fair commerce, innovation and democracy. If you want to a book to hunker down with while sheltering in place, read my book, Goliath: The 100-Year War Between Monopoly Power and Democracy.
Hi Matt. I have been following you for many years and enjoy what you write. I think you really knocked it out of the ballpark with this essay.
I have been struggling to understand the post-Volcker economy - with divergence of the regular main street economy and financial economy - for many years. The transition to ‘debt as money’ with debt expansion and falling interest rates has inculcated in me a concept of ‘the primacy of debt.’ With the US’s massive debt creation, I anticipated inflation – only to be perennially wrong. Expected inflation has failed to manifest generally through a sterilization of the funds at the money center bank level. It does not bleed into the real economy, apart from real and financial asset prices, higher education, and healthcare, probably since the latter two are essentially stealth jobs programs for the educated middle class. I think it’s because of banks’ refusal to lend to all except the largest entities; witness the mREITs which keep mortgages off the bank’s books.
Recently panic selling tanked issued debt 15% (g.o. bonds) -60%+ (mREITS). With an infusion of 2T, lowering of interest rates to zero, QE infinity and debt asset purchases by the Federal Reserve, we have decided, for now, to maintain the primacy of debt. This suggests that in short order, rents, costs of medical care, pharmaceutical prices, and education prices will continue to rise. But main street couldn’t afford them before. With medical care tied to employment and 20 million out of work from coronavirus, only the lucky few with secure corporate jobs and seniors with Medicare have old-style insurance which drives this price model. College students are rebelling at paying full price tuition for online schooling. We’ll see how the housing market shakes out, particularly in high cost of living states.
Kaldor’s quote terrifyingly resembles our own economy: An Instagram-led echo chamber where any disposable income is spent on frenetic airline or cruise travel, hotels, and restaurants; travelling to conferences trying to be selected to participate in the patronage economy or taking the same picture in front of the reflecting sphere at the Chicago Museum of Art as everyone else. How does our economic activity legacy of digital photos differ from the Chinese building ghost cities? It does not. And now, this entire throwaway economy predicated upon waste (wasted fuel, wasted food, wrappers, etc.) grinds to an abrupt halt, and we feel poor.
As we make our global competitors wealthier, the eventual specter of geopolitical rearrangement is raised. Unless billionaires think they will have an equivalent degree of control relocating to another nation, I don’t understand their actions. Perhaps that is a billionaire’s function – to sterilize wealth beyond the ability to spend it. How many yachts can you own? – Paul Allen had three. Being subjugated by another country in a war or losing reserve currency status tends to destroy great wealth–Barton Biggs wrote about that, with formerly wealthy families still fighting for their assets 75 years after the end of World War II.
With WTI at $20/bbl, it primes the pump for a major inflationary input into the global economy. But coronavirus is overwhelmingly deflationary. At some point, perhaps it be realized that the only way to create persistent inflation is through wage-price spirals (hard to realize when nobody works anymore due to AI but could be done through UBI). Then we can repeat the 70’s, get long term rates at double digits, and start the whole process over again for the next American century (inflating away the debt in the process). Rinse and repeat, as they say.
Finally, an observation. Cantillon was a successful 18th century banker, and funded John Law’s Mississippi company - the equivalent of today’s private equity barons. But he was dogged by lawsuits and even murder plots to his death in 1734. His writings were published formally in 1750. One would also be reminded of another 18th century event – the French Revolution, who’s economic origins resided in the expenses of foreign wars, rampant borrowing, and refusal to tax the wealthy on political grounds.
“plus ça change, plus c’est pariel”
Production couldn't be expanded as rapidly in the 17th or 18th century like it can today. Inflation is seldom the result of 'too much money' (chasing too little goods, as the flawed theory goes), but almost always a supply shock: OPEC oil price hike crisis, Zimbabwean nationalisation of productive farms, US sanctions on almost all Venezuelan imports, ... Weimar Germany devalued its currency purposefully to get out under the Versailles reparations., etc.
So the monetarist theory that more money (money supply) leads to inflation, is a lie. Usually more production will result from additional government spending, with firms competing for market share. Of course with monopolies this becomes a problem, but then it's again a supply shock with the price artificially boosted because of lack of competition.
We should have no fear for inflation when government uses its power to issue currency (which it always has with a sovereign currency but usually has ceded to technocrats because the theory goes politicians aren't to be trusted). As if technocrats don't look after their buddies.
And democracy has the best chance of giving most people a voice, even in the US with all its autocratic structures and nepotism.
People should be informed about the power of currency issuance and demand it to be under the control of Congress by default. The FED should just manage daily monetary operations but not decide who gets any money. The current situation with the FED trying to grow the economy through QE only came to pass precisely because ordinary people have so little income and domestic demand has been decimated for most. Give the QE money to regular folk and you won't have much trouble growing the economy with all the unemployed looking for something to do, mostly in the poorer pockets of the US.