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The intense (heated?) debate around the Cantillon Effects after an injection of money has produced a new post by Scott Sumner. Scott Sumner argues that it doesn’t matter where money in injected first because all possible injection points produce the same initial result; buying T-Bonds. I don’t think that Sumner is wrong on this, I do think, however, that this is just a first step of analysis and that Cantillon Effects depend on what happens after the money gets into the market through the exchange of T Bonds.

First things first. Sumner is not saying that there are no effects at all. When discussing the first myth, he acknowledges that the bond seller earns a commission when selling T Bonds. He thinks, however, that the amount of this benefit is trivial at a macroeconomic level. As I said on my previous post, it is different to say that there are no Cantillon Effects than to to say that the empirical relevance is considered to be trivial. Are all these trivial effects summed together still trivial? Could there be a mechanism such that this benefit is not trivial anymore? Is it the decision to bail-out or to not bail-out Lehman Brothers trivial? Even if the Lehman Brothers example falls outside Sumner’s scenario, it does exemplify a non-trivial effect on the first steps of a policy that buys assets from a financial institution.

I think his treatment of the myth 4 helps to square what Sumner is trying to say. Sumner suggests that given the news of a monetary injection the prices of (financial) assets should rise instantaneously, so there’s no benefit in receiving the money first. This means, however, that there is a drawback if money is received later on (this is not mentioned by Sumner). Sumner says that a person that hears the news about the expansive monetary policy thinks the price of gold is going to raise and so he uses his cash or takes a loan to buy more units of gold. He, therefore, is not constrained to buy gold. Therefore, it doesn’t matter how the money gets into the economy. The bank can always lend to him the money he needs to buy more gold.

I don’t see, however, how this goes against Cantillon Effects. There are two ways I can buy more gold. With money already in my balance or by taking a credit. To argue that someone uses his savings to buy more gold means that his money demand is decreasing. We have two, rather than one, effect. Injection of money and a change in money demand. We start to move away from the ceteris paribus analysis. But this also implies that the price of savings is going to change. Therefore, the relative prices of savings with respect to other goods is going to change. That is what Cantillon Effects are about, changes in relative prices.

The second option is to get a loan a to buy the units of gold. If this person gets $100 in loan, means that those $100 cannot be given to someone else. Some buyers, and not others, can make use of the $100. What should happen for this to be immaterial with respect to Cantillon Effects? We need to distribute the $100 equivalently among all consumers. Namely, we need the helicopter.

Now, regardless of this, I think is inaccurate to stop the analysis where Sumner does. The Cantillon Effect is the result of n-steps, not 1-step. Let’s say that step-1 is the same for any potential way to inject money in the economy as Sumner describes. What happens in steps 2 to n is as important as step 1. Cantillon Effects are not just about asset prices, but about all prices in the economy. Person 1 may use the $100 to buy gold. But person 2 to buy a new house and person 3 to buy a new car… etc. Financial asset prices can react immediately because the new money is already in the financial system, but goods and services outside the financial cannot raise if the purchasing power of their clients have not increased yet. The focus on the financial market risks to do away with the problems involved in the rest of the economy.

Finally, Sumner says that “In aggregate, the total level of nominal purchases is constrained by the amount of currency in circulation. But not at the individual level. Hence being the first to get the new money doesn’t confer any advantage at all–as the new money has no more purchasing power than the existing money.  A dollar is a dollar—and a $100 bill is a $100 bill.”

It is true that the new money has no more purchasing power than the existing money. But is also true that there is more money in the economy and therefore the total purchasing power increases. How is the new purchasing power going to be distributed in the economy is what gives the initial kick of the Cantillon Effects. The final result depends on the complete sequences of kicks, not only in the first one.

It is also true that the Fed buys bonds at market prices, and that therefore the operation is a swap of assets and the size of the balance sheet may remain the same. But it also true that the composition of the asset (how much cash versus how much T Bonds) can affect how much can be bought today by however receives the swapped cash first (that is, after the bank). Eventually the banks need to decide who to lend the new amount of money, or if they are going to invest it themselves. Wouldn’t, for instance, a policy favoring the housing market potentially result in a housing bubble and a financial crisis? The institutional framework can have a bearing on the empirical extent of the Cantillon Effects.

Still, there are $100 extra that will land somewhere. Even if that somewhere immediately results on the same effect on the T Bonds, they will get into the economy afterwards with potential different paths. It may well be the case that it doesn’t matter who gets the money first, but it may well be the case that it matters who gets it second. The story in the broken window fallacy can help to illustrate the point. There are two ways the $100 value of the window can be spent in the economy. Give it to the window maker to repair the broken window or use it to buy a new suit by the shop owner (forget about the lost value of the window). In both cases the money flows differently through the economy even if the $100 were initially in the bank and got there through an exchange of T Bonds.

Still. I’m not sure of what Sumner is trying to say. I think his second post would been much more clear if it  had followed something like this: “Yes, there are Cantillon Effects. No, they do not depend on how money is initially introduced in the economy. No, I don’t think the empirical extent of the Cantillon Effect is important.” This is the best interpretation I can make of Sumner’s argument.

PS: Note that Sumner is not saying (as far as I can tell) that there are no effects by the Fed buying  Bonds. He’s saying that the effect is the same regardless of who he buys them from and that the difference between buying T Bonds through channel A or B is not economically relevant.