Understanding the Cantillon Effect: Increasing Incomes Versus Rising Costs

Hal works day in and day out, year in and year out, at his diner. Over the course of several years, he has improved the diner’s quality and efficiency, thanks to his growing pool of knowledge and access to improving technology. And yet, the breakeven price for Hal to maintain profitability slowly marches upward. If Hal’s customers want to continue purchasing from him, they need increasingly more money in order to afford it. While Hal is working to make things better for his customers, something is preventing his customers from being able to realize Hal’s efficiency gains resulting from years of hard work. 

From a customer’s perspective, Hal seems to be struggling since he must continually charge more to stay in business. From Hal’s perspective, he is increasing productivity, but the rising input costs squeeze him to the point where he has to raise prices. Logically, we would expect an increase in productivity to lead to reduced prices, as each unit of output becomes easier to create. And yet, we actually observe the exact opposite: productivity increases are captured by constant inflationary pressure. 

In Hal’s diner scenario, we have two parties: the diner and the customer. If the diner is becoming more productive, we would expect Hal and / or the customer to benefit. Unfortunately, the benefits for both Hal and his customer get diluted through inflationary policies. Rather than Hal increasing profits or the customer receiving a more affordable meal, the productivity gains are siphoned off via the increased input costs charged by Hal’s suppliers. We can’t blame the supplier for raising the input costs though, because Hal’s suppliers face the exact same dilemma. Hal’s supplier’s input costs have also increased, causing them to charge higher prices to Hal. And of course, we can’t blame Hal’s supplier’s supplier either, because they too face higher input costs. 

So where do all the productivity gains from Hal, his meat supplier, and his supplier’s suppliers go? We know inflationary policies are the driver of price increases. The stated mission of central banks across the world is to stimulate the economy via inflation. Thus, if we trace the chain of rising input costs to its source (i.e. inflationary policies), we will find that the parties closest to the inflationary policy capture productivity gains of society. In other words, the party who first receives newly created money increases its purchasing power, causing a relative decrease in the purchasing power of everyone else. This is called the Cantillon Effect. Basically, those closest to the new money win while those furthest away from the new money lose.

While Hal’s diner was on the losing end, we can view the winning side of the Cantillon Effect with another simple example. If Haley’s car dealership creates a fresh $1 million out of thin air, she can instantly afford to buy more goods and services than her peers. If she spends the $1 million on new inventory, her suppliers gain an advantage over their competitors. As the second recipient of this $1 million, the suppliers have an advantage over everyone except for Haley, the original recipient. The suppliers can now increase their resources thanks to the freshly created $1 million, but their competitors cannot. As this $1 million continues to be cycled throughout the economy, each recipient receives a lesser advantage than the person before them.

The first people to receive the newly created money are actually wealthier, since this new money has yet to be priced in. They will see income go up before their costs rise to reflect the increased amount of money in the system. Down the chain, however, people only feel wealthier. In reality, it’s just a mirage: they have more money than before, but so does everyone else. This is Hal’s exact scenario: he receives more revenue, but so do his suppliers and competitors. In other words, those receiving the new money last will be forced to chase higher incomes in order to keep up with rising costs.

The winners of the Cantillon Effect are those lucky enough to participate in the rising incomes cascading down throughout the economy, starting with the recipient of the new money. The losers are those unlucky enough to be hit with increased costs perpetuated by the rising incomes of the winners.

Where does Bitcoin fit in? In the current system, new money is created by the wealthy and powerful, giving them (and anyone closely interacting with them) an advantage over everyone else. These people can create as much money as they see fit. With Bitcoin, new units can only be created by miners that provably contribute hash rate to secure the protocol. Bitcoin’s monetary policy is set in stone and verifiable by network participants. Thus, the miners cannot create as many new bitcoins as they see fit; they are subject to the rules of the Bitcoin protocol, just like everyone else. In short, the existing system allows for those in power to use the Cantillon Effect to a nearly limitless extent, while Bitcoin strictly limits the impacts of the Cantillon Effect.