The Cantillon Effect

Expansionary monetary policy constitutes a transfer of purchasing power away from those who hold old money to whoever gets new money. This is known as the Cantillon Effect, after 18th Century economist Richard Cantillon who first proposed it. In the immediate term, as more dollars are created, each one translates to a smaller slice of all goods and services produced.

How we measure this phenomenon and its size depends how we define money. This is illustrated below.

Here’s GDP expressed in terms of the monetary base:

Here’s GDP expressed in terms of M2:

And here’s GDP expressed in terms of total debt:

What is clear is that the dramatic expansion of the monetary base that we saw after 2008 is merely catching up with the more gradual growth of debt that took place in the 90s and 00s.

While it is my hunch that overblown credit bubbles are better liquidated than reflated (not least because the reflation of a corrupt and dysfunctional financial sector entails huge moral hazard), it is true the Fed’s efforts to inflate the money supply have so far prevented a default cascade. We should expect that such initiatives will continue, not least because Bernanke has a deep intellectual investment in reflationism.

This focus on reflationary money supply expansion was fully expected by those familiar with Ben Bernanke’s academic record. What I find more surprising, though, is the Fed’s focus on banks and financial institutions rather than the wider population.

It’s not just the banks that are struggling to deleverage. The overwhelming majority of nongovernment debt is held by households and nonfinancials:

The nonfinancial sectors need debt relief much, much more than the financial sector. Yet the Fed shoots off new money solely into the financial system, to Wall Street and the TBTF banks. It is the financial institutions that have gained the most from these transfers of purchasing power, building up huge hoards of excess reserves:

There is a way to counteract the Cantillon Effect, and expand the money supply without transferring purchasing power to the financial sector (or any other sector). This is to directly distribute the new money uniformly to individuals for the purpose of debt relief; those with debt have to use the new money to pay it down (thus reducing the debt load), those without debt are free to invest it or spend it as they like.

Steve Keen notes:

While we delever, investment by American corporations will be timid, and economic growth will be faltering at best. The stimulus imparted by government deficits will attenuate the downturn — and the much larger scale of government spending now than in the 1930s explains why this far greater deleveraging process has not led to as severe a Depression — but deficits alone will not be enough. If America is to avoid two “lost decades”, the level of private debt has to be reduced by deliberate cancellation, as well as by the slow processes of deleveraging and bankruptcy.

In ancient times, this was done by a Jubilee, but the securitization of debt since the 1980s has complicated this enormously. Whereas only the moneylenders lost under an ancient Jubilee, debt cancellation today would bankrupt many pension funds, municipalities and the like who purchased securitized debt instruments from banks. I have therefore proposed that a “Modern Debt Jubilee” should take the form of “Quantitative Easing for the Public”: monetary injections by the Federal Reserve not into the reserve accounts of banks, but into the bank accounts of the public — but on condition that its first function must be to pay debts down. This would reduce debt directly, but not advantage debtors over savers, and would reduce the profitability of the financial sector while not affecting its solvency.

Without a policy of this nature, America is destined to spend up to two decades learning the truth of Michael Hudson’s simple aphorism that “Debts that can’t be repaid, won’t be repaid”.

The Fed’s singular focus on the financial sector is perplexing and frustrating, not least because growth remains stagnant, unemployment remains elevated, industrial production remains weak and America’s financial sector remains a seething cesspit of corruption and moral hazard, where segregated accounts are routinely raided by corrupt CEOs, and where government-backstopped TBTF banks still routinely speculate with the taxpayers’ money.

The corrupt and overblown financial sector is the last sector that deserves a boost in purchasing power. It’s time this ended.

83 thoughts on “The Cantillon Effect

  1. I agree with you about not giving the banks any more money, however just giving it to the people is also problematic. How do we ensure that debts will be paid off and what will stop more debts from being taken on. We have to remember that many of these people purchased real estate at the top or kept on refinancing real estate until the top. The money from refinancing was spent on worthless items. Many people have a bad precedent with money and will pay off debt only to acquire more.

    • How do we ensure that debts will be paid off and what will stop more debts from being taken on.

      If money is owed, new money would go directly to creditors. But yes, I take the point that Keen’s idea would be quite expensive to administer.

      The money from refinancing was spent on worthless items. Many people have a bad precedent with money and will pay off debt only to acquire more.

      Many real sustainable organic booms have included lots and lots of people buying useless junk. With free market economics, we don’t judge how people invest and spend. We leave it up to them to make that decision. The point is that there is excessive debt relative to income. Debt cancellation seems like the least bad option.

      • I do not want this problem to re occur within a few years so we may have to put some controls on the banking systems. Maybe we will need a want/need squad in the same vein as the death squad for healthcare. That would be funny, I could see corporate payoffs, no Samsung only Apple!!!

        I think it would be grand if someone gave me twenty thousand dollars, which is 5T/250M. Might not get quite 20 grand but it would be a goodly sum.

    • I agree with you Joe. People will blow it on all manner of consumer goods. I have seen this in Australia where people blew lump sum parenting payments on consumer gadgets. It will be inflationary and will blow out net exports.

      I have written on Steve Keen’s debt deflation blog about the use of a debit card system where consumption and therefore investment is boosted by a “topping up” of the public’s personal debit card from general consolidated revenue. I.e the tax base. It prevents a consolidation of cash on the balance sheets of companies and wealthy individuals as the tax rate for the companies and welathy individuals would increase in times of inflation and this would result in budget surpluses. At the same time during the period of inflation and low unemployment the card is not topped up as much or often. It is a paternalistic method of controlling consumers but we have to admit, statism and bureaucracy and keynesian methods are ingrained in the psyche of politicians and the public. In the past it was assumed by economists that people were rational. They are not and it solves this problem.

      The best solution is to let the property market pop with the inventory auctioned off to find the market price, and people who lose their homes just have to rent. The Financial system will just have to reset. Loan contracts must be honoured . Moral hazard must be limited.

      • Buddy the Australian example was explicitly aimed at pumping consumer spending, not debt reduction. This was nothing like Professor Keen’s suggestion, really.

        • I know it is different, but when I have been proposing my idea to Politicians and economists like Keen for years and they promote a bastardised version of my idea it is frustrating.

      • You may as well create a ‘community payment’. A sum of money gifted in the form of ‘negative taxation’ on a monthly basis so that people can participate in their community. This values humans for more than simply their ability to exchange labour for a wage of salary and creates demand. Don’t think it would work in societies that have heavily promoted selfishness and individualism.

        All irrelevant as the current system will collapse irrespective of what ideas are put up. The system is not capable of self reform.

  2. Yep, on one hand our problems are insurmountable, on the other they’re as easy to fix as you describe, Aziz. Of course, well-conceived reforms must be part of the equation too and there’s still going to be a whole lot of pain. And as you point out, printing money and distributing it to the people who caused the problems, only serves to transfer the consequences to those who didn’t.

    So why hasn’t this option been tried? Because this is really, truly class warfare. “I’m more important than you!” “If we give poor people money, they’ll just blow it!” etc. etc.

    As correct as everything you say here is, it will simply never happen and I know you know why.

  3. I think the ‘Modern Debt Jubilee’ is a great suggestion, but unlikely to occur in the immediate future. Bankers from the privileged cabal that profit from commissions on newly created money are as likely to agree to that proposal as turkeys would vote for Xmas. As a matter of principle however, it is the correct way to do things. If money printing dilutes the value of the currency, then holders of the currency should be regarded as shareholders in that currency. If a two -for -one share split occurred in any commercial company, the shareholders would cerainly object if the newly created shares all went to the executive board! Yet we all passively go along with this in respect of money printing. Dilution of the currency undoubtedly contributes to rising prices, which affect the weaker and more vulnerable in society, and those on fixed incomes. It is grossly immoral that a privileged few are sucking hyper profits out of the economy at the expense of everyone else.

    • An excellent analogy Martin. What we need to do is put this in a catchy one liner and a cartoon or poster image and start to pass this around to the mainstream.

      Money printing and lending to key borrowers is legal conterfeiting.

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  6. I think you are pretty spot on with the whole article. Direct stimulus to the citizens is the only thing that will work. Here is one way to do it:

    Have the Fed buy every primary residence mortgage outright from the banks and current investors. pay off the current principal 100%. Turn around and refinance every mortgage at current low rates, forgiving principal based on the life of the refinanced loan. If you go 30 years you get 30% off. if you only have 21 years left, and you want to keep those terms you get a 21% reduction. During the life of the program repayments will cover all the original costs and give the Fed an additional 30%-35% to cover the cost of running the program. This should give most American homeowners at least a few hundred extra dollars per month to spend in to the economy. It will also put most of the mortgage mess behind us and to rid the system of all the fraudulent/unenforcable paper floating around.

    Arguments against, is that it will be inflationary. I say that over 30 years all the money will have been paid back so it won’t be. There is also the pension funds, etc. that will be forced to reinvest the money they get paid off, and by including financial system reforms we can improve the chances that this money will be invested in endeavors that will help bring back jobs and economic health.

    • Your program would piss me off because my house is paid off and I would get nothing but a huge tax bill. There is no difference with your system and giving the banks money. The banks should be paying for the mortgage crisis as they are the ones who irresponsibly lent the money. Just look at what DeMarco is saying at FHFA, no to mortgage write downs. Do you agree with Krugman???

  7. Aziz,
    Didn’t Australia doing something along these lines – issuing all tax-payers a stimulus check? Too bad we can’t go back in time. Everyone who paid taxes in the last 5 years getting a fat check – but forced to pay down debt with it somehow. The banks would have been whole and those who did not buy into the housing bubble would have been rewarded.

    • The thing about the Australian stimulus is that it was mainly aimed at increasing consumer demand, which I’d say is a mistake, as consumer demand is transitory and debt is fundamental.

    • I am an Australian and yes you are correct. Tax payers recieved a 900 dollar cheque via their bank account direct from the Australian Tax Office. They just gave our taxes back to stimulate demand during the height of the Global Financial Crises. Old pensioners got a top up too around 1000 i think. All that it did was pull forward consumer spending and most of it was blown at casinos or on consumer goods or alcohol. many articles in the paper discussed this. it was a lump sum and people blew it. Including me.

      BTW I bought a second hand Australian made surf board from a regional surf shop, so I felt i kept my tax dollars in my country and gave the surf shop owner a much needed boost during winter.

      Now our retail is suffering mainly due to online shopping and a slowing economy. The Government deficit is now blown out and we cant execute a similar strategy if the world economy goes backwards again.

      See my solution above.

      • Buddy, your posts are great to lighten up all this horse—- and gun smoke! Are you real, or a composite — Russian, CPA, political party founder, former-Marxist, Austrian economist, etc. — and now a surf bum!

        • Ha ha . Thanks for the flattery. I surf badly and I am a 3rd generation Australian from Ukrainian Grandparents. I can also rebuild an engine gearbox, ride a horse. Grow my own food, hunt fish. Crocodile Dundee was a Pussy.

          I am a jack of all trades master of nothing that would qualifiy for a Government job.

          I am good at getting a full refund on Australian Tax Returns. I love nothing better than limiting the taxation paid to a corrupt governmebt based on a correct interpretation of the law.

        • Don, I don,t know about US law but inAustralia a petition can result in a law being passed and I am currently organising a petition to mandate a full 5 year retrospective tax audit of all standing politicians and senior bureaucrats. I have nothing to hide so what do they have to fear if the are innocent right.

          This should be very interesting. Especially when a Politician can not be convicted of a crime.

          maybe the good people will run the show once more.

        • See Buddy’s two posts of Jul 08 below:

          Buddy, would you consider coming to the US and running for Congress? You can’t be President since you’re foreign born, unless you are a Democrat.

      • I thought that the idea of the Australian government was promoting at the time of spending the $900 and not paying down any debt they had as crazy. So what I did with the money was put it into my super fund, which the government then topped up for me nearly another $1500. What I end up with from this money in probably 35+ years when I retire is an unknown though.

  8. Aziz: Again I speak for macroeconomics laymen and concerned Americans, e.g., grandparents. Thanks for explaining your aforementioned and recommended “debt jubilee”. Please (along with Australian Buddy Rojek) tell us if Richard Haydn’s memory is correct and, if so, how did it work. For now, I’ll overlook Mark McHugh’s and Martin Edwards’ pessimism as I campaign to elect more politicians with grass-roots values.

    If I may digress, November election prospects are better for a “reform” Senate majority (and of course House) than for replacing Obama — (the majority of State governments already have Republican majorities and Governors). This is another example of the founders’ genius in creating a graduated dispersed — 435 House Districts, 2 Senators per State, and 1 President — sensitivity to populist mood (in this case, awareness). However, 2008 was a one-time (hopefully) outburst of racial bloc (96.2%) voting which made Obama’s win a certainty. He is campaigning desperately for a repeat.

    • Richard Haydn is correct.
      A lot more white people than black people voted for Obama, and they’ll do so again. I personally am not taking a stand on the election. In my travels round the net I encounter a whole lot of Obama supporters who give me reasons X, Y and Z why they think Obama is better, and a few Romney supporters who think Romney is better. I don’t support either.

      • There are tons of reasons why Obama is WORSE — I’ll send you a few. Please keep in mind that it’s not Romney vs. Paul, it’s Romney vs. Obama.

      • This article is a fair representation of the situation in Australia. Fuel prices have cone down, interest rates are lower, but the mood is cautious. I have been doing Tax returns for the past few weeks and the mood is split. Some people are finding their company busy, others slowing. Those that are unemployed cant find work. Too much competition. I think the general kood is negative and people realise house prices are not rising. Many who are negatively geared are realising property prices do not always go up, and those that have to sell are losing capital i.e. Selling for less than they bought for. The final fools so to speak.

        It will depend on China buying up commodities now. if that slows, watch out. No more bragging miners buying up houses, new cars and rounds at the bar.

        Of course the bureaucrats at the top will keep spending.Their bloated wage and pension will keep their local economy propped up. Also look for businesses connected to Government contracts. i.e. The largest service providers get the contarcts because the bureaucrats don’t want to take a cha ce wioth smaller player whe. Awarding government contracts. When the Keynesians at the Treasury decide to pump prime the economy, these largest providers will be at the trough.

      • My memory (weak???) is that 88% of the 2008 voters were non-black, of which 54 to 46% voted for McCain. Unless economists, like politicians, favor malleable statistics, let’s not say that more non-blacks (of 88%) than blacks (of 12%) voted for Obama, but that Obama’s margin was 11% from a 12% bloc, whereas McCain’s margin from the other 88%, which included Obama’s mini-blocs of gays and single (pro-abortion) women, was 7%. Agree?

        • Re Aziz’s response to this: Hell’s fire, John — I understand the math! I was just trying to tactfully point out that a small bloc vote (racial in this case) can overwhelm the majority. One of the many ways* in which many African-Americans have been conned into voting against their best interests is that, if the Obama politicians succeed in prolonging this race warfare, there could be a backlash, in which the minority would come out second best.

          * The worst effect of race war on minorities is that young people are doomed to be wards of the government. The short-term worst case is that government default/bankruptcy will hit the poor the hardest!

          BTW — I failed to mention other Obama single-issue blocs: radical environmentalists and victims of scare tactics such as grandma being thrown off a cliff. So far, the Romney campaign has done a miserable job of countering disinformation and slander!

  9. Aziz re the Rockwell/Buchanan piece: Iran has pledged to eradicate Israel, has continually made proxy war on Israel and Iraq, and has refused to allow inspection.

    What is Buchanan’s (and your) “line in the sand”? None? After nuclear attack? After demonstration of nuclear weapons delivery capability? After intel reveals they have nuclear warheads?

    At their most aggressive moments, why have the USSR, China, and Pakistan not launched nukes? Does Buchanan (and do you) believe in deterrence — “Peace through Strength and the Will to Use It”? We can hope that the Ayatollahs are likewise not crazy, but should hope be the only defense?

    We don’t worry that US, UK, France, India or Israel — free, democratic and open societies — would ever launch a nuclear first strike? But absent fear of reprisal, would Iran?

    • My line in the sand?

      Stay out of the middle east. Stay strong at home. Hold nuclear weapons as a deterrent.

      If attacked, fight back with lethal force.

  10. So — no line in the sand beyond our coasts or your English Channel? We can make it on western hemisphere oil, but where are your and Europe’s secure sources? Are you ready for massacre in and around Israel? Israelis won’t surrender to be executed, and Muslim royalty and theocrats don’t care about their peasants. Who would stop Jihad and where? I still have nightmares from a report of young Muslims marching through my beloved England chanting “Death to the Infidels”, protected by British police on both sides of the streets. Was it true?

    If you should ever consider helping Obama to four more years, keep in mind that he hates Britain as well as Israel, America, democracy, Christian values, and economic and personal freedom.

    Still, my “line in the sand” is a lot like yours. I think attempting “nation-building” in Iraq and especially Afghanistan was foolish and should stop, but I think defending Saudi-Arabia, punishing the Afghan terrorists for 9/11, and cutting off Iraqi support for terrorism was justified. I’m glad we agree on Peace Through Strength and the Will to Use It.

    • Personally, when it comes to energy, we need to generate more in the UK. I am very optimistic about solar power, about wind, about North Sea (or even Russian) gas; anything to get us out of the middle east.

      Yes there are some radical Islamic groups in the UK. Personally, I think they have rights to say things I disagree with under freedom of speech. They are mostly talkers, although a few are militants and obviously these must be stopped.

      Israel is a very strong country. In my view Iran — even with a nuclear weapon is no threat to Israel. Israel knows the middle east very well, they understand the rules of engagement in that region and they have a serious debate in that country about just what they should do about Iran. The ex-head of Mossad (Meir Dagan) agrees with me; they think attacking Iran is a very bad idea. Iran is a very defensive country. They have not invaded any other country in the last 60 years. They are not in the business of starting wars, mostly because they would lose. I think they are developing weapons for defensive purposes. It is the USA that encircles Iran, not vice verse — the USA has 10-15 bases next to the Iranian border. Iran do support some radical militant groups like Hizbollah and Hamas, but this is limited support, and Israel is much stronger than these groups.

      I do not and will never support Obama. I think he is a very poor President on so many levels, especially civil liberties, the constitution, foreign policy, health care, banking and finance, fiscal policy, etc. If Romney wins I wish him the best of luck, and I hope he is better than Obama, but I am worried about many of his policies, especially his foreign policy. If he chose Ron Paul as his VP pick or reversed his position on Iran, or the NDAA, or banking bailouts, I might reconsider.

    • Don my line in the sand is the USA should withdraw all armies from around the world, and concentrate on rebuilding its Manufacturing base. There is ample energy outside of the Middle East. Australia is full of it. We can supply the USA.

      Let the world implode, then allow the smartest refugees to get to USA and Australia. The economies of the other tyranical countries will collapse. It is messy but the only solution to a polarised world. Israel will have to fight it out on its own. It is up to them how they defend. Not my business. Australia comes first.

      If Australia and the USA withdraw, we wont be seen as infidels and imperialists. We wont be targets but beacons of stability and affluence.

      The influx of money and global trade rebalancing will restore the US’s strength. This will save the US dollar collapse and rebalance the power of the USA from China.

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  12. Aziz: Unless there are substantial new gas finds (as some think is the case offshore Israel), or Atlantic winds make windmills surprisingly competitive, don’t hold your breath for independence from imported oil. Maybe new West African production will reduce dependence on the middle east. Eventually, Canadian and US LNG may help. As you say, Buddy, Australia is energy OK.

    Except for a minority of “non-Shariah-compliant” Muslims, there ain’t no such thing as a non-radical Muslim. Some observers in the UK and a few European nations predict that increasing numbers of Muslim immigrants will eventually take power, unless Shariah “law” is firmly subordinated to existing law. Buddy, what of Australia?

    Attack: I believe that no leaders among middle east powers, China, Russia or even Korea really want to start a war, and least of all the US. I agree that we can keep the peace — deter war — with far less costly (and you say unpopular) standing deployments, especially in Germany and Japan. But I’m not sure that Israel, Saudi Arabia, Taiwan, South Korea, Poland, etc. agree. What about your end ot the world, Buddy?

    Would you guys tolerate repeated foreign-supported Hezbollah and Hamas murderous attacks on your citizens?

    Why do you think Romney would continue “banking bailouts” and other disastrous Wall Street-Pennsylvania Avenue conspiracies?

    • Muslims here seem fairly peaceful. The younger generation is becoming less observant. Australian culture does that to people from foreign cultures here. Life is too easy going. The biggest rise in religion amongst the youth is actually Christianity. see Hillsong. Mixing rock music with youth fellowship us attracting a cult like following. But generally religion is not a big thing in Australia.

      I wish people worshipped Bastiat. Life would improve for many!

      • Buddy, if you get a chance ask A Muslim about Shariah, Jihad, and “non-Shariah-compliant” Muslims. But be sure he’s not carrying a knife.

  13. OOPS! My post of Jul 08 @ 05:37:58 should read “See Buddy’s posts of Jul 08 @ 03:10:59 and @03:19:06 above:”

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  24. nice piece, purely logical…

    I like Keen’s proposal, though i suspect I would do it differently than him, maybe even more ambitiously.

    In my opinion, the central bank should give everyone a monetary dividend, directly given by cash transfers into people’s bank account, and for an announced period (should be at least a few years). Let’s say 300$ a month during 3 years.

    The advantage here is that it this not a one-shot hand-out. Because it would be given on the long run, i think this would encourage people to make plans with this money: finance personal projects, investment, education, debt repayments or just daily spendings. In other words, it does not squeeze those who are not in debt, and actually enables people to produce more because they can use that money to invest in themselves. Additionally, since the cash transfers would be unconditional (not means-tested), it would also strengthen bargaining power in favor of employees.

    The advantage of a periodical income is also that the central bank can monitor better inflation pressure (for instance adjusting the amount of money distributed month per month – but should still ensure a certain level though).

    What do you think?

  25. We’re in October now, and back on the subject of printing money. Whether Cantillon, Jubilee, more Helicopter Ben, or etc. — how would this reduce, not worsen, the deadliest cancer (in the US, at least)? It’s more money, more socialism, less work ethic. Who envies Greece over Germany?

    • Such a populist and confused argument!

      Do you see “more money” in the real US, UK or Greek economy? Quite the contrary! The problem with QE is not necessarily quantitive, but qualitative: where does the money go?

      The cancer of the global economy is not ‘less work ethic’ (a lot of people would like to work more – or just work), rather the cancer is that we have a huge pile of private and public debts out there that cannot be repaid.

      As we say, “Debt that cannot be repaid won’t be repaid”

  26. I should have reminded you that it is PUBLIC debt (from whence come all your forms of giveaways) that is bringing down the EU and threatens US solvency. Isn’t this is the “debt that cannot/will not be repaid”?

    • Disagree. Look at non performing private loans data in US, Spain, Ireland or Greece. These countries are facing a private debt bubble before all.

      Don’t forget we had a banking crisis first. Private debt became public with bailouts.

      And I don’t think welfare is the main reason for recurrent deficits. Look at your US army budget, or payement interest for instance. You might find much larger squandering spendings than redistributional transfers.

      But i’m not sure what you mean here: our ‘giveways’ will create more debt, you say?

      Absolutely not: it would be debt-free money, or base money, so to speak. On the contrary, this injection of money would enable people to repay their debts, or taxes, thus deleveraging the whole financial system ie. decrease overall debt.

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  35. Congratulations on predicting “helicopter money” whereby monetary authorities directly monetize debt spent by government on “publics works” projects (yeah, right!) or even give such directly to consumers.

    Perhaps only slightly better than passing it through Wall Street, who obviously takes the benefit at the expense of everyone else (Cantillon Effect) but is this also 1) not a huge moral hazard for all debtors in society and 2) is a huge disincentive and slap-in-the-face to those Americans who have not financed their lifestyle through debt.?

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  40. The so-called “Cantillion effect” is actually partly explained by the distributed lag effect of monetary flows, volume times transaction’s velocity. Money flows may be robust, net neutral, or harmful, depending upon the lag. The lags in money flows are mathematical constants, and have been for greater than 100 years.

    The other part is how the Fed’s offset, Reserve Bank credit, is ultimately useless as compared to the release and activation of monetary savings. All savings originate within the confines of the payment’s system. Unless savings are activated, put back to work, a dampening economic impact is exerted and metastasizes (it’s called secular strangulation).

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