A 400 year old economic theory that the world has forgotten about - The Daily Reckoning
The Daily Reckoning by Vivek Kaul
On This Day - 19 December 2014
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A 400 year old economic theory that the world has forgotten about A  A  A

- By Vivek Kaul

Vivek Kaul
The Federal Open Market Committee (FOMC), which decides on the monetary policy of the United States, had its last meeting for this year scheduled on December 16-17th, 2014. After this meeting, Janet Yellen, the Chairperson of the Federal Reserve spoke to the media.

Everything Yellen spoke about during the course of the press conference was closely analysed by the financial media all over the world. The gist of what Yellen said at the press conference was that she expects that the Federal Reserve will start raising the federal funds rate sometime next year.

The federal funds rate or the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank, on an overnight basis, acts as a benchmark for the short-term interest rates in the United States. The last time the Federal Reserve increased the federal funds rate was in 2006.

In the aftermath of the financial crisis, the Federal Reserve decided to print money and pump it into the financial system by buying government bonds and mortgage backed securities. The Federal Reserve referred to this as the asset purchase programme. The economists called it quantitative easing. And for those who did not want to bother with jargons, this was plain and simple money printing.

This was done to ensure that there was enough money going around in the financial system and interest rates remained low. At low interest rates the hope was that people would buy homes, cars and consumer durables. This would drive business growth, which in turn would drive economic growth, which would create both jobs and some inflation.

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While this has happened to some extent, what has also happened is that a lot of money has been borrowed by financial institutions at very low interest rates and has found its way into stock markets and other financial markets all over the world. This has led to bubbles.

The economic theory explaining this phenomenon was put forward by Richard Cantillon, an Irish-French economist who lived during the early eighteenth century. He basically stated that money wasn't really neutral and that it mattered where it was injected into the economy.

Cantillon made this observation on the basis of all the gold and silver coming into Spain from what was then called the New World (now South America). When money supply increased in the form of gold and silver, it would first benefit the people associated with the mining industry, that is, the owners of the mines, the adventurers who went looking for gold and silver, the smelters, the refiners and the workers at the gold and silver mines. These individuals would end up with a greater amount of gold and silver, that is, money. They would spend this money and thus, drive up the prices of meat, wine, wool, wheat, etc.

This rise in prices would impact even people not associated with the mining industry, even though they hadn't seen a rise in their incomes, like the people associated with the mining industry had. This was referred to as the Cantillon effect.

Interestingly, Cantillon was also an associate of John Law. In 1705, John Law published a text titled Money and Trade Considered, with a Proposal for Supplying the Nation with Money. Law was of the opinion that money was only a means of exchange and that a nation could achieve prosperity by increasing the amount of money in circulation.

The problem of course was that when it came to gold and silver coins, only so much currency could be produced. But this disadvantage was not there with paper money. Law firmly believed that by circulating a greater amount of paper currency in the economy, commerce and wealth of a nation could be increased.

His theory was in place. But, like a physicist or a chemist, it could not be tested in a laboratory. Law needed a nation that was willing to let him test his theory. And France proved to be that nation. In 1715, France was the richest and the most powerful country in the world. But at the same time it was also almost bankrupt.

This was primarily because the country did not have a central bank of its own like the Dutch and the British had. Law's idea was to create a central bank which would have the right to issue paper money which would be a legal tender. He also wanted to create a company which would have a monopoly of trade. This would create a monopoly of both finance as well as trade for France and the profits thus generated would help pay off the French debt.

Law went around establishing a bank called the Banque Royale and formed a company called the Mississippi Company, which was given a 25-year-long lease to develop the French territory along the Mississippi River and its tributaries in the United States. The Banque Royalewas allowed to issue paper notes guaranteed by the French Crown.

Cantillon was an associate of John Law and observed the entire thing very closely. As Bill Bonner writes in Hormegeddon-How Too Much of a Good Thing Leads to Disaster: "Cantillon noticed that Law's new paper money backed by the shares of the Mississippi Company-didn't reach everyone at the same rate. The insiders-the rich and the well connected-got the paper first. They competed for goods and services with it as though it were as good as the old money. But by the time it reached the labouring classes, this new money had been greatly discounted-to the point, eventually, where it was worthless."

This was the Cantillon effect. As analyst Dylan Grice told me during the course of an interview: "Cantillon, writing before the days of Adam Smith, was the first to articulate it. I find it very puzzling that this insight has been ignored by the economics profession. Economists generally assume that money is neutral. And Milton Friedman's allegory about the helicopter drop of money raising the general price level completely ignores the question of who is standing under the helicopter."

The money printed by the Federal Reserve in the aftermath of the financial crisis has been unable to meet its goal of trying to create consumer-price inflation and getting consumer spending up and running again. But it has benefited those who are closest to the money creation. This basically means the financial sector and anyone who has access to cheap credit. They were the ones standing under the helicopter when the money was printed and dropped.

Institutional investors have been able to raise money at close to zero percent interest rates and invest it in financial assets all over the world, driving up the prices of those assets and made money in the process.

It has also left these investors wondering what will happen once the Federal Reserve decides to end the era of "easy money" and start raising interest rates. In October 2014, the Federal Reserve brought its asset purchase programme to an end. This did not lead to a panic in the financial markets simply because the Fed made it clear that even though it would stop printing money, it would not start immediately withdrawing the money it had already printed and pumped into the financial system over the years.

But that is going to happen one day. Yellen is trying to get the financial markets ready for interest rate hikes starting next year. At least, that is the impression I got yesterday after watching her press conference.

Once the Fed decides to start withdrawing the money that it has printed and pumped into the financial system, and which in turn has found its way into financial markets all over the world, interest rates will start to go up. That will happen sooner rather than later. Maybe 2015. Maybe 2016. Who knows.

And once interest rates start to rise, the arbitrage of borrowing at low interest rates and investing money in financial markets all over the world, won't be viable any more. It is difficult to predict precisely how exactly the situation will play out.

Nevertheless, Bonner summarizes the situation well when he says: "What exactly will happen, and when it will happen, we will have wait and find out. But it will be bad, that much is certain. We will hit rock bottom."

All I can say to conclude is-Watch this space.

References:

M. Thornton, "Cantillon on the Cause of the Business Cycle," The Quarterly Journal of Austrian Economics9, 3(Fall 2006): 45-60

J.E. Sandrock, "John Law's Banque Royale and the Mississippi Bubble." Avail-able online at http://www.thecurrencycollector.com/pdfs/John_Laws_Banque_Royale.pdf

C. Mackay, Extraordinary Popular Delusions and the Madness of Crowds(Project Gutenberg, 1841). Available online under Project Gutenberg.

When do you think the Federal Reserve will start raising interest rates? Post your comments or share your views in the Equitymaster Club.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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4 Responses to "A 400 year old economic theory that the world has forgotten about"

Om Prakash Sharma

Dec 19, 2014

The US has been successful in fooling the world and its economy has started growing to the detriment of entire world and it will continue to do it where as Japan has failed with the same trick

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satish dabholkar

Dec 19, 2014

We have not heard the analysis of USA economy fro world rating agencies as "Stadard & poor" or Moody"etc.Wewish to hear their independent views on Federal Bank's economic -money easing program me.

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Rajiv

Dec 19, 2014

Fed may start raising rate around February or March

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Ramavtar Gaggar

Dec 19, 2014

Dear Vivek,

If US currency was to falter in say next 3-5 years (doubtful but possibility) or lose its world's reserve currency status, then in such scenario how will other currencies behave maybe INR or maybe Yen / Yuan / Euro or some other major world currency? Also, how it may impact prices of Gold which is currently quoted in USD it being reserve currency?

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