Cantillon effect

To those who have, more shall be given

Jakub Rehor


December 7, 2020

In the second half of 2020, growing inflation expectations have driven financial markets to new heights around the world. This is true not just for equities, but also for real estate, metals, grains, and crypto assets. The exceptions were bonds where central banks purchased trillions of dollars worth of government and corporate debt, thus preventing market prices from adjusting to new inflation expectations, and oil, where OPEC’s decision to drive US shale oil producers out of business flooded the market with cheap Saudi oil. (Thank you, our dear Saudi friends and allies.)

The study of inflation, once a flourishing subfield of macroeconomics, went through lean years during the disinflationary period of the 2000s and 2010s. Concepts that were once well-known have now fallen into neglect and oblivion. Worry not, though; the mills of God grind slow but exceedingly fine. We will be given plentiful opportunity to learn again what inflation means and how it works.

A useful tool for understanding the mechanics of inflation is the concept of the Cantillon effect. Richard Cantillon, a French-Irish economist, noticed it as early as in 1730. We can illustrate it with a simple story. The government, being short of gold and with a large payroll to meet, decides to pay its bureaucrats in newly printed money created out of thin air. There is now more money chasing the same amount of real goods. The rational expectations school of economics claims that the market would immediately realize what was up and prices would instantly rise to reflect the new money supply. In reality, the process works in steps. The bureaucrats take their freshly manufactured shekels, as good as the old ones, and spend them in the farmers’ market on eggs and bacon. The farmers, noticing that their inventory of breakfast foods is getting depleted, raise prices. Later in the day, a widow living on a fixed pension comes to the market and sees the higher prices. She will have only one egg for tomorrow’s breakfast, and no bacon. Next year, her pension may get a cost of living adjustment but in the meantime she will have to tighten her belt.

Richard Cantillon

At the end of the price adjustment process, we have the same result: eggs and bacon are more expensive for everyone. But the impact of the price increase has not been uniform. Those who got their hands on the newly created money ahead of others benefitted from inflation: they got to buy real goods at old, low prices. Those who were last in line now carry the full burden of inflation. So, among its other effects, inflation redistributes wealth from those far from the source of new money to those close to the source. Or in other words, from the poor and the powerless to the rich and well connected.

If you’re rich or well connected, that’s all very well and good, but what can the rest of us do? The most important thing is not to sit on too much cash or fixed income instruments. We don’t want to end up like the poor widow unable to afford eggs or bacon. We want to cut in line ahead of her and scoop up all the groceries at pre-inflationary prices. Thankfully, the miracle of modern financial markets has given us the opportunity to do so by investing in commodity futures. No need to store large quantities of perishables in the garden shed.

The story of 2020 is the slow awakening of investors around the world to the dynamic of Cantillon effect. Most are still unaware of it but a small and growing number of them are accumulating real assets. When the inflation really gets going the Cantillon effect will become a household word.