Cantillon’s Analysis of the Monetary Economy
Following his estimation of the demand for money, Cantillon proceeded to demonstrate the different ways in which the money supply could be expanded and to outline the changes that would happen when the money supply moved out of line with the demand for money.
This led to his conceptualization of what is now referred to as the “black box transmission mechanism”. The black box is meant to describe the different ways in which increases in the money supply permeate through the economy influencing prices, output and the balance of payments. Cantillon’s concern was (1) to show the way in which the monetary economy could be meshed in with the real economy to produce an overall equilibrium and then (2) to outline the consequences of an over-expansion of the money supply out of line with the needs of the real economy in terms of inflation, output and the balance of payments. He was not prepared to accept a crude monetarist type that suggested a proportionate relationship between increases in the money supply and an increase in prices. For him there was a need to examine the channels through which monetary expansion could influence expenditure and he was critical of John Locke for not detailing the monetary transmission mechanisms.Cantillon took up this challenge and provided a detailed taxonomy of these mechanisms outlining four potential sources of monetary expansion: (1) the mining of gold and silver; (2) a balance of trade surplus; (3) capital inflows; (4) invisible earnings.
He then proceeded to show that, depending on the sources of the monetary expansion, the money might be spent, saved or hoarded.
Arising from these decisions, the money could flow either into the commodity market or the financial market. There were two further elements in the chain linking changes in the money supply to changes in expenditure. First it was necessary to consider the openness of the economy and, secondly, the degree of spare capacity in it.
Depending on these factors the increased money supply might affect employment and output, or inflation or the balance of payments. Blaug termed the differential effect on prices of an increase in the money supply, arising from different monetary injections, as the “Cantillon Effect” (1962: 21).Cantillon had witnessed the volatility of financial capital flows across Europe in 1720 and understood how this superstructure of finance could very quickly collapse as investors lost confidence in a particular country.
Cantillon’s overall analysis showed the way the real and monetary economies can be meshed together. Consistent with this he recognized the need to keep the rate of monetary expansion, emanating from the financial sector, in line with the size and growth of the real economy. In the case of an over-expansion of the money supply, his analysis of the black box provided a variety of transmission mechanisms so as to identify the pressures that the excessive money supply would generate for output, prices, employment and the balance of payments.
Cantillon realized that this meshing together of the real and monetary economies was a difficult exercise. This arose because there was a further element that needed to be incorporated into the analysis, namely, financial innovation. So far Cantillon had confined his analysis to a specie-based economy. He was a metallist at heart and believed that silver represented the “true sinew of circulation” (Cantillon 1755: 423). He was also a banker and he realized that there were other substitutes for silver money, namely, paper banknotes and bank credit. In his monetary taxonomy Cantillon did not wish to include such types of money in his definition of the money supply. For him they were financial instruments - he referred to them as “fictive money” - that influenced the velocity of circulation of money but not the stock of money. However, in influencing V rather than M he still understood that these financial instruments could have a considerable impact on the economy.
As a practising banker Cantillon had witnessed the enormous benefits that the incipient financial revolution had created in Great Britain. Paper money and bank credit had come to Exchange Alley in London, and the Bank of England, which had just managed to escape from the trauma of the South Sea Bubble, was becoming an anchor institution in what would later be called the City. While reluctant to classify paper money and partially backed bank deposits as money, he was prepared to accept the benefits of these new banking innovations in facilitating an increase in the velocity of circulation of money. He was sufficient of a realist to accept a certain amount of financial innovation. In normal times banknotes and bank accounts facilitated the purchase and sale of government stocks and shares. At the same time he fully understood the tension that existed between financial innovation and financial prudence. The scales could tip to the former causing financial prudence to be neglected.Cantillon fully understood that the financial innovation that had created banknotes and bank credit had greatly increased the potential of financial leverage. It resulted in an environment in which monetary policy was too loose. An excessive amount of money creation, in Cantillon’s opinion, pushed equity and property prices too high and generated a bubble. The bubble in turn impacted on the real economy when asset holders attempted to use some of their gains, made in the financial economy, to increase expenditure in the real economy leading inevitably to the destruction of the bubble or “system”.
Cantillon identified the dangers created by a financial system, excessively leveraged through financial innovation, for the real economy of “ordinary expenditure”: “This example clearly shows that the paper and credit of public and private banks may produce surprising results in everything unconnected with the ordinary expenditure involved in drinking, eating, clothing and other family necessities” (Cantillon 1755: 423).
Antoin E. Murphy
See also:
Balance of payments and exchange rates (III); British classical political economy (II); French Enlightenment (II); David Hume (I); John Law (I); Mercantilism and the science of trade (II); Money and banking (III); Adam Smith (I).