How the rich get richer, what it means for you, and why cryptocurrency could be the answer




The Cantillon Effect is arguably the most important economic concept you’ve probably never heard of. In this article, I’d like to change that.


Here’s a simple breakdown of the Cantillon Effect which effectively explains how the rich get richer, but although this is might be a little depressing I'll explain why crypto could be the answer.


Background


Richard Cantillon was an Irish-French economist and philosopher who was born in the 1680s.


Although he is somewhat of an enigma as not a lot is known about his life, what is known is that he was a successful banker and merchant. According to historians this success can be attributed to the political and business connections that he made through his family and an early employer.


Although Cantillon was able to acquire great wealth by speculating in, and later helping to fund, John Law's Mississippi Company he learned of the impact and importance of the proximity of power.


He recognised that money has to travel through institutions, which means that money gets to the rich first. Eventually, some money will get to the rest of society, but in the interim period before that money fully circulates, the wealthy are able to use their access to money to buy up physical or financial assets.


Through his life experiences Cantillon wrote about this in a French economics paper titled Essay on the Nature of Commerce in General (Essai Sur La Nature Du Commerce En Général) and it formed the basis of what is known as The Cantillon Effect.



The Cantillon Effect


The basis of his theory was that when large amounts of money is printed by a state it is based on the institutional setup of that state.


In the 18th century, this meant that the closer you were to the king and the wealthy, the more you benefitted, and the further away you were, the more you were harmed. Money, in other words, is not neutral. This general observation, that money printing has distributional consequences that operate through the price system, is known as the “Cantillon Effect.”


At that time the basis of money was gold, so his writings centered around what happened when a nation-state discovered a gold mine in its territory. By increasing the amount of gold in the kingdom not only had the effect of increasing price levels, but he observed that it would change who had wealth and he noted that he didn’t. As he put it:


“doubling the quantity of money in a state, the prices of products and merchandise are not always doubled. The river, which runs and winds about in its bed, will not flow with double the speed when the amount of water is doubled.”

Broadly speaking, new money creates disproportionate effects based on where it enters the system.


A Simple Illustration


To put this theory in the context of what has been going on in the world recently, let's look at a simplistic scenario that illustrates Cantillon's primary point.


Imagine you live on a small island that has a society that is generally closed from the outside world.


You wake up one fine morning and to your surprise you notice an small package addressed you to on the doorstep. When you open the package you are amazed as it is stuffed full of money, in fact when you count the crisp, new bank notes there is $1 million in it.


You are now rich! But what do you do now?


As the package appeared mysteriously and you haven't told anyone about your new found wealth you have secretly become a millionaire over night. As the package was clearly not mistakenly delivered you start spending it.


The prices on the island remain low, because no one knows that these new dollars exist yet!


Naturally your standard of living rapidly improves. You are able to buy yourself a lovely new house, the best clothes, and a number of plots of land.


After a while the other islanders start to feel and see this new money flowing through the local economy. Prices start to rise as demand increases, but the supply of these good is yet to "catch up" with the new levels of consumption. It takes a period of time for supply to step up.


So while you were able to vastly improve the quality of your life, it didn’t improve others in the same way:

  • The merchants who received your money and then sold their goods are now experiencing rising prices when they consume.

  • The workers who earned wages as a result of the sale of goods that they produced are also beginning to endure an increase in prices, at the same time as wages remaining the same.

You were extremely fortunate in being able to add nice material possessions to your life with the new money, but the majority of the islanders didn't. As such the manner in which this new money flowed into the economy and the wider effects of its distribution matter significantly.


Of course this is a simplified scenario but I hope that you can grasp the principles of the problem that was highlighted by Cantillon hundreds of years ago, in so much that how close someone is to the source of new money is extremely relevant and that the point of entry and subsequent path the money flows along has consequences in terms of the effect on its ultimate distribution.


But should you really care about this today?


Well, with the rampant "money printing" that central banks around the world have embarked on over the last year or so this has created an ever widening wealth gap between the haves and have nots (see the chart below). In essence the Cantillon Effect has accelerated.





This is an interesting chart to gauge what the effects of the U.S. government's monetary response has been following COVID.


Looking at this in simplistic terms, the result of the wholesale asset purchases by the Federal Reserve have created an injection point at the top.


Whereas the stimulus checks that were sent out as a consequence of the lock downs caused an injection point at the bottom.


The disparity between these however is significant—$4.5 trillion vs $400 billion.


Now take a look at the chart below that shows the Federal Reserve balance sheet since 2004. You can see quite clearly the spike since COVID effectively brought the US economy to a stand still in March of last year.



As a result of the asset purchases, combined with interest rates at almost zero it has been the wealthy who have benefited due to them effectively being the asset owners. For those who have held large parts of their overall wealth in things like stocks, real estate or similar assets have seen their net worth increase significantly over the past year and a half.


Those members of society who are wage earners who received some assistance as a consequence of a direct stimulus cheque, but did not see any benefit in the same way from the asset appreciation—are quite clearly getting short changed.


As inflation starts to bite across a variety of areas of the economy this will result in a disproportionate impact on their standard of living.



Conclusion


I am sure that you have started to feel the effects of inflation on your pocket and although it has been suggested that this is 'transitory' I have to strongly disagree. Supply chain bottlenecks may well be temporary but there’s a deeper structural reason for inflation, one that appears to be growing worse: the direct result of the Cantillon effect itself - economic concentration of the American economy in the hands of a relative few corporate giants and elite with the power to raise prices. Not only is inflation being felt, it is also showing signs of it being disproportionately distributed across the U.S.


So what could one do to lessen the burgeoning impact of inflation and how can the average person position themselves for the future?


It goes without saying I'm a big crypto fan, I realise that this isn't for everyone however there are ways in which inflation beating returns can be achieved without the volatility that so many people fear which is really overlooked and misunderstood by people outside of the crypto space.


Furthermore, with an asset like Bitcoin having proven to return an average of over 200% for the past 10 years I don't think anyone should be betting against this as a worthy contender for somewhere to park any spare cash with such global economic uncertainties and inflationary pressures facing the average person.


Although we are going through troubling times I would like to close on a positive note. We are in the midst of a technological revolution that will change many lives for the better. Whereas the elite may control masses of wealth right now, new found wealth will be created and transferred as a consequence of the rise of cryptocurrency and the technology that surrounds it. This is because there are no barriers to entry and for the first time in history there is an asset class where the average person can actually front run the institutions. This in itself should be inspirational and give you hope for a brighter future.....if you choose to participate in it that is.



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Hi,
I'm Paul

I am on a mission to help people start a journey to financial freedom. The key to long term success is education and understanding the incredible opportunity that exists right now.

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