The Cantillon Effect

The history of economic thought gives individuals the understanding that the economic theories of today were built upon the foundations laid by past theorists. When it comes to understanding the effects of an inflation of the money supply on the economy, there are only a handfulful of theorists that truly shaped what is now called the Mises-Hayek theory of the business cycle. Probably the most important figure in the development of economic thought in this field was a failed moneylender by the name of Richard Cantillon.

Richard Cantillon is regarded by many economists, such as Murray N. Rothbard and William Stanley Jevons, as having written the first modern concise treatise on economics. Jevons stated that Cantillon had developed a "systematic and connected treatise, going over in a concise manner, nearly the whole field of economics...it is thus...the first treatise on economics." Cantillon focused on a wide array of economic phenomena in his treatise Essai Sur la Nature du Commerce and drew conclusions from observations he was making at the time with respect to monetary and price phenomena. Cantillon understood that an increase in the supply of money would ultimately raise the general price level yet what was not immediately evident was in what manner these prices were rising. Cantillon wrote that "everybody agrees that the abundance of money or ites increase in exchange, raises the price of everything" yet these individuals "have not considered how it does so."

To Cantillon, finding a connection between an increase in the supply of money and the general price level lay "in knowing in what way and in what proportion the increase of money raises prices." Essai Sur la Nature du Commerce offers an answer to this fundamental economic problem by analysing the "injection points" at which money enters or leaves the economy; that is, those industries that receive the newly created money first. Cantillon uses the example of gold and silver mines as being able to essentially extract new money from the earth. With the new gold and silver ore found at the mines, the mine owners melt the metal into coins or bars in order to use it in daily transactions. These new coins are thus given to workers as compensation for their labor and these individuals eventually spend this new money on the market. As they spend their new money on specific goods, the prices of those goods rise due to the increased monetary demand for them.

Therefore, as long as new money is being pumped into the market via mines, the prices of those goods that first come in contact with the recently extracted ore rise and will continue rising until the increase monetary demand has ceased. The rising prices of these specific goods then spread throughout the economy effecting the costs of certain production processes the use these goods and the prices of other related goods. By using the newly extracted money, the miners are able to enjoy an overall higher purchasing power and directly effect the price of those specific goods they come in contact with. In essence, the individual who receives the new money last has less purchasing power than the individual who received the new money first. Professor de Soto correctly states that Cantillon "produced a highly significant study of the influence and increase in the quantity of money in circulation exerts on prices" and that "variations in the quantity of money mainly affect the relative price structure, rather than the general price level." This is called the "Cantillon effect" or the "new money effect."

The discussion of Cantillon and the analysis of prices changes due to an increase in the quantity of money present in Essai Sur la Nature du Commerce offers Austrian business cycle theory an important foundation. It gives Austrian economists a theoretical starting point for understanding the effects of changes in the quantity of fiat money by the Federal Reserve System on the macroeconomy. Though Cantillon's explanation of price changes due to increases in the quantity of gold are correct, such occurrences are quite insignificant and the rate of increase in the supply of gold tends to be of such a nature that it would have little to no effect on the prices of specific goods or the general price level in our modern economy. Instead, Cantillon's theory must be applied to the drastic changes in the money supply found under the existence of an inflationary central banking system. Next week we will see how Austrian business cycle theory uses Cantillon's observations in order to find a solution to the seemingly endless boom and busts present in the modern economy.