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The Cantillon Effect

John Maynard Keynes, pioneer of Keynesian economics advocated that the increased government expenditure and lower taxes stimulate demand and pull the global economy out of the great depression. To overcome the cyclical booms and busts in an economy he proposed simulations from Governments and Central Banks will help.

A fall in demand will cause a decline in production, jobs, and wages. Concessions in tax payments and other benefits encourage employers to make capital investments and employ more people, stimulating employment and restoring economic growth.

So, in order to revive the economy, the governments and central banks try to inject money and improve cash flow into the economy byways like aggressive quantitative easing, debt moratoriums, tax exemptions, etc.

If you observe the basic mechanics of each process, the places of money injection into the economy leave you in wonder. The below write-up is to make you understand the asymmetry it creates in the economy.

In Quantitative Easing, the Country's central bank purchases long-term government bonds, as well as other types of assets and securities to induce money into the economy. For example, the Bank of Japan bought private debt and stocks during the 1997 crisis. US govt. performed a similar approach during the 2008 crisis. Recently, in March 2020, the U.S. Federal Reserve announced a quantitative easing program that summed to over $700 billion. US Federal Reserve cut interest rates to near zero.

The consequences of this can be well explained with Cantillon Effect.

French banker and philosopher named Richard Cantillon in the 18th century stated that,

“Who benefits when the state prints a bunch of money is based on the institutional setup of that state. The closer you were to the king and the wealthy, the more you benefited, and the further away you were, the more you were harmed.”

Nations used to print new money when they see increased production and when they get access to new natural reserves to back the newly created money. Obviously, we don’t just print the money as it used to be back in days, but still, his statement holds up in current scenarios. The financial institutions, hedge fund houses, huge corporations are the ones who get access to the newly formed monetary value in the economy.

Even though the central bank or government just don’t give away money to them, they are the top and first receivers of newly created or injected money into the economy. And they have the say in how they invest it. An early bird will always have an advantage, in our case a huge advantage. Considering the time frame, it takes the money to trickle down to the individual citizen, the banks get high purchasing power on their side, an increased period for wealth compounding effect to play on their side and zero effect of current inflation(because its newly created, inflation deflates the existing money, not the new one).

To put it in simple words, institutions will have the following advantages to be the first receivers,

  1. The positive effect of compounding (because the amount of time is in favor)

  2. Zero effect of current inflation (because you are first to spend it)

  3. Higher potential to dictate terms of trade (especially in case of uncertain future)

Big institutions can use this money to buy assets or instruments before the inflation effect works on it. So, they get higher values at cheaper prices. This can also cause a situation called Biflation, wherein short run you can see a spike in equity and debt-backed assets but in long run, the debt-backed assets fall in value and commodity-backed assets, instruments witness a huge spike.

The demonetization in India is also one of the events which shows a partial consequence of the Cantillon Effect. New currency notes are presently entering the economy through the formal banking system under Reserve Bank of India regulations. In the meantime, currency-dependent sellers of goods and services have lost their customers. Those who receive the new currency notes first can buy goods and resources at depressed prices.

One may say that the government not only induces money through quantitative easing but also provides tax exemptions, loan waivers, easing interest rates. But, when you compare the proportions among them you can see an astronomical difference in amounts. Any central bank will be ready to give multi-billion dollars to banks for new trades but when it comes to welfare, it is majorly dependent on only seigniorage and tax amounts collected.

So, is changing the places of money injection a solution? Should the government give away free money through welfare funds rather than routing it through investment instruments? No,

Unless our public institutions correct the skewness and asymmetry in the prevalent system, the wealth disparity is going to exist. Not only in the form of the amount of money you own but also variation in purchasing power that few institutions and high net individuals are getting when compared to others. They must come up with policies that move the value of money neutrally.

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