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Cantillon Effect

Cantillon Effect

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Published by: Pablo Paniagua Prieto on Sep 06, 2012
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The Cantillon Effect on Relative Prices:
the redistribution of wealth through monetary policy
Pablo Paniagua June, 2012
“Mr. Locke lays it down as a fundamental maxim that the quantity of produceand merchandise in proportion to the quantity of money serves asthe regulator of market price. I have tried to elucidate his idea in the precedingchapters: he has clearly seen that the abundance of money makeseverything dear, but he has not considered how it does so. The great difficulty of this question consists in knowing in what way and in what proportionthe increase of money raises prices.” 
Richard CantillonRichard Cantillon, the Mississippi Bubble and the Non-neutrality of Money:
Richard Cantillon (1680’s – 1734) was an Irish-born economist and banker who livedmost of his life in Paris as a bank owner. He was the author of “
Essai sur la Nature duCommerce en General 
”(Essay on the Nature of Trade in General), but other essays thatCantillon may have published remain unknown. It was during his life as a banker andspeculator in Paris when Cantillon fully understood the real effect monetary policy hason real life economics. At the same time he applied this knowledge, helping him tobuild his fortune profiting from the Mississippi bubble during 1717-1720. His treatise isthe only printed contribution of Cantillon that remains today; it was written around1730 then circulated as a manuscript until it was finally published posthumously in1755.When his manuscript circulated all around Central Europe and England, it is believedthat his essay was widely read among Classic Economists at the time. It was definitelyread by and influenced most of David Hume’s insights on Monetary Policy. RichardCantillon has the honor of being amongst the few fully cited by Adam Smith in the“Wealth of Nations”. Unfortunately right after Smith’s publication, Cantillon’s
Essai 
fellinto oblivion. The neglect of all the pre-Smithian Economics helped to establishedSmith’s work as the only reliable source, influencing more than 100 years of economicthinking.Only after the Austrian Marginal Revolution of the 1870’s led by Carl Menger and thenfollowed by Austrian generations, they returned some influence and value to the pre-Smithian thoughts. This is particularly true in the field of Individualistic-SubjectivistTheory of Value, much in line with the individualistic and methodological approachfirst used by Cantillon himself. Menger later revived the individualistic approach. TheAustrian Revolution of individual-subjective methodology towards economicphenomena finally brought some attention to other theories outside the BritishParadigm and contributed to a whole new spectrum of economic analysis andmethodology in Social Sciences.Professor Hayek defined Cantillon as “this gifted independent observer, enjoying anunsurpassed vantage point in the midst of the action, coordinated what he saw withthe eyes of the born theoretician and was the first person who succeeded in
 
penetrating and presenting to us almost the entire field which we call noweconomics”. Therefore the Austrians consider Cantillon as the “first of the moderneconomist”. He helped to emancipate economic analysis from the entanglement withethical and political concerns in order to establish it as a subject of its own.Therefore after more than 250 years of neglect and oblivion, today we can say withconfidence that Richard Cantillon, the French-Irish banker was the “Father of ModernEconomics” since he wrote
Essai 
a full 4 decades before the “Wealth of Nations”.Although little is known about Cantillon’s life, we have the certainty that most of hisrelevant work and life experience was conducted in Paris, where he experienced reallife economics in a way that completely changed his insights forever.The most important experience during his life as a banker was his association andparticipation in the Mississippi Company with the Scottish adventurer and inflationistbanker John Law (1571-1729). Law, backed by the King of France Lois XIV, secretlyembezzled a great part of the French population with his financial scheme of issuingextensive paper money to keep financial assets highly valued. In particular, he kept theMississippi Company’s stocks at unsustainable high levels while it devaluated thecurrency and decreased the French government’s debt burden. Law persuaded theKing of France to take control of issuing money in order to “promote wealth”;therefore Law established a loose monetary policy.He believed that with a massive flow of paper money to the economy, the governmentcould reduce its deficit while “promoting growth” through the Mississippi Company.This inflation scheme ended abruptly in 1720 when the speculative Mississippi bubbleburst. It was under this massive injection of liquidity and indiscriminate stateintervention that influenced much of Cantillon’s
Essai 
on Monetary Policy. Cantillonhimself became a millionaire through of the speculative bubble: he understood thescheme and rode the bubble, then sold his assets before it burst. This left him wealthyand the entire French nation impoverished. Cantillon returned to London and in 1730he wrote
Essai 
based on his earlier first-hand experience with paper money andirresponsible monetary policies conducted by Law and the French monarchy.With the collapse of Law’s paper money scheme, Cantillon understood that marketforces are the true determinant of money’s value. He also understood that moneyitself is not neutral in the real economy in terms of the production structure,consumption and income distribution. The real value of money is in its ability tofacilitate transactions within a market economy. Therefore the intrinsic value of moneyrelays on the commodity to which it is pegged but the money in the market willfluctuate around that intrinsic value. In most cases, it should be the intrinsic value of gold attached to its production and extraction cost. In a free market economy thevalue of the gold money will be set by the individual’s interaction within the system, orby the “consent of mankind”. Cantillon then realized that paper money has no cost of production therefore does not have intrinsic value. The market spontaneously sets thevalue of paper money at par with the gold money, just as long as the fiduciary papercan be redeemed in the commodity.Cantillon noted that an increase in the monetary paper base has the same effect as anincrease in the real gold commodity. He noticed that this process happens as long as
 
the market participants are confident and do not notice the paper money’s monetarydebasement. Cantillon understood that since paper money has zero production costfor governments and it is treated as gold money in the market, it puts thegovernments in an advantageous position. It is a large temptation to increase themonetary base and print more money, but this would create unforeseen distortions. Itis the paper money introduced by the state which lies outside the spontaneous accordof mankind that unsettles the market’s interactions. Therefore is not neutral, asCantillon stated:
When money circulates there in greater abundance than among its neighbors anational bank does more harm than good. An abundance of fictitious andimaginary money causes the same disadvantages as an increase of real money incirculation, by raising the price of land and labor, or by making works andmanufactures more expensive at the risk of subsequent loss. But this furtiveabundance vanishes at the first gust of discredit and precipitates disorder.
Then the real value of gold as money is set within the interaction of individuals and itsvalue will sporadically fluctuate with the market process. Therefore Cantillonunderstood that if the state introduces a centralized paper money, along with the goldcurrency, money will diverge from being neutral to creating instability in the marketprices. The Mississippi bubble was his most lively reminder of this fact.
Individualistic Approach and the Cantillon Effect:
Cantillon in many ways is considered a proto-Austrian since he carried much of theindividualistic insights of the Austrian School that enriched the development of ideasabout economic phenomena. This approach is attributed to Carl Menger, the founderof the Austrian School, but Cantillon reflects them as well. Like the Austrian School, hebelieved that economic phenomena should be analyzed on the base of individualeconomic decisions and actions of single persons.Following this approach, it becomes comprehensible that under a form of spontaneousorder in which economic actors interact and make decisions (adjusting their actions tothe contingency of others), the only way to create an efficient communication systemamong decentralized activities is through a price system. It is this sort of price systemthat can truly reflect the real spontaneous interactions of decentralizing decisionsmade by individuals. Therefore prices are the way to disseminate relevant informationwithin a market economy and are the most efficient and decentralized allocation of resources.We can see that if societies rely on any form of spontaneous order in their economicactivities,
unadulterated prices
are the way that relevant information gets transmittedto actors. Under this system, the relevance of relative prices on economic decisionsbecomes extremely evident. It is under the Austrian and Cantillon’s individualisticapproach that the flexibility of individual interactions can be reflected in relative pricesand not in macroeconomic aggregates. This is why single and relative prices are soimportant to the economy. This approach is in complete contrast with other Economicschools that rely on macroeconomic aggregates. The approach led by Cantillon and

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