Money is Not Neutral: Cantillon Effects

The insight that money is a good in its own right and not just a placeholder for other goods led Mises to place special emphasis on the impact of money on the real economy. It was customary to highlight the impact of inflation and deflation on deferred payments. Inflation would entail higher money prices—that is, a lower purchasing power of money—in the future, which in turn benefited debtors at the expense of creditors. Inversely, deflation would benefit creditors at the expense of debtors. So far, so good. Following classical economists such as David Ricardo, Mises stressed that inflation and deflation of the money supply could not possibly enhance the productive potential of the nation as a whole. But such changes did have other social consequences, in particular, for the composition of society and the allocation of resources.

Although inflation and deflation could not make society as a whole better off, they modified the distribution of resources among the individual members of society, and this necessarily affected the marginal value of the various uses of these resources. For example, inflation put more money in the hands of individual A (a debtor) and less money in the hands of individual B (a creditor); since these two individuals have different subjective values and different entrepreneurial visions and talents, they will use the money differently, investing it at different times and places, paying different wages to different persons at different rates, etc.

These simple considerations illustrate the pervasive impact of changes in the money supply on the real world—a fact that did not sit well with many of Mises's contemporaries, imbued as they were with the veil-of-money doctrine. Böhm-Bawerk for instance was reluctant to admit the real impact of money, because he was used to thinking of money in aggregate terms—not on the basis of the intra-social distribution and allocation. He tried to minimize the significance of Mises's findings. He thought that the income effect creates some occasional “frictions” but did not alter the long-term state of the economy and the society.⁵⁷

Mises's analysis of the social consequences of inflation and deflation was not limited to the consideration of deferred payments. He also analyzed the redistributive impact of inflation and deflation on spot exchanges. In the case of inflation, for example, he observed that if it affected all members of society at the same time and to the same proportional extent, no redistributive effects would result. But in the real world this condition never holds true. Inflation first affects only some members of society, and through their interaction with others, it eventually affects the rest of society.

Let us, for instance, suppose that a new gold mine is opened in an isolated state. The supplementary quantity of gold that streams from it into commerce goes at first to the owners of the mine and then by turns to those who have dealings with them. If we schematically divide the whole community into four groups, the mine owners, the producers of luxury goods, the remaining producers, and the agriculturalists, the first two groups will be able to enjoy the benefits resulting from the reduction in the value of money, the former of them to a greater extent than the latter. But even as soon as we reach the third group, the situation is altered. The profit obtained by this group as a result of the increased demands of the first two will already be offset to some extent by the rise in the prices of luxury goods which will have experienced the full effect of the depreciation by the time it begins to affect other goods. Finally for the fourth group, the whole process will result in nothing but loss. The farmers will have to pay dearer for all industrial products before they are compensated by the increased prices of agricultural products. It is true that when at last the prices of agricultural products do rise, the period of economic hardship for the farmers is over; but it will no longer be possible for them to secure profits that will compensate them for the losses they have suffered. That is to say, they will not be able to use their increased receipts to purchase commodities at prices corresponding to the old level of the value of money; for the increase of prices will already have gone through the whole community. Thus the losses suffered by the farmers at the time when they still sold their products at the old low prices but had to pay for the products of others at the new and higher prices remain uncompensated. It is these losses of the groups that are the last to be reached by the variation in the value of money which ultimately constitute the source of the profits made by the mine owners and the groups most closely connected with them.⁵⁸

Thus inflation and—by implication—deflation are essentially redistributive phenomena. They cannot enrich society as a whole, but do affect distribution, allocation, and incomes within society.

Mises's analysis of effects of money on the real economy was based on his study of the great inflations of the past⁵⁹ and on his study of classical economics.⁶⁰ Today these effects are sometimes called the “Cantillon effects”⁶¹—named for the early eighteenth-century Irish-French banker and economist, Richard Cantillon, who in his Essay on the Nature of Commerce in General had first described the redistribution and reallocation effects of inflation.⁶² The Theory of Money and Credit was one of the last treatises of the subject to highlight their importance. At the time of Mises's writing, Irving Fisher, Gustav Cassel and other economists began to neglect them and concentrate only on the aggregate consequences of changes in the money supply.⁶³ Their approach won the day and thus one of inflation's most pernicious effects came to fall beneath the purview of the new “macroeconomic” radar.⁶⁴