Richard Cantillon on Cantillon Effects

There's a dustup between market monetarists and Austrians over Cantillon effects. See Nick Rowe, Scott Sumner, Bill Woolsey, and Bob Murphy. What are Cantillon effects? One definition is the effect that a change in the money supply has on the real economy due to where money is injected. Rereading Cantillon, I think its better to define the effect he is writing about as the influence that a change in the money supply has given that people are incapable of anticipating that change.

Cantillon wrote in a world in which huge discoveries of gold in the Americas had steadily increased the price level. We know that if people perfectly anticipate the arrival of new gold, all prices will immediately rise. Cantillon thought somewhat differently. According to him, the initial discovery of gold would go unnoticed by people:

It is also usually the case that the increase or decrease of money in a state is not perceived because it comes into a state from foreign countries by such imperceptible means and proportions that it is impossible to know exactly the quantity which enters or leaves the state.

Il arrive aussi d'ordinaire qu'on ne s'apperçoit pas de l'augmentation ou de la diminution de l'argent effectif dans un Etat, parcequ'il s'écoule chez l'Etranger, ou qu'il est introduit dans l'Etat, par des voies & des proportions si insensibles, qu'il est impossible de savoir au juste la quantité qui entre dans l'Etat, ni celle qui en sort.

In his paper on Richard Cantillon, Michael Bordo echoes this:

In Cantillon’s work, the dynamic path of adjustment of relative prices, output, the interest rate, and specie flows depends on the expectations of agents in the various markets. This emphasis on expectations presages much of modern monetary theory. It is unclear exactly how expectations are formed in his scheme but the frequent examples of agents catching on slowly suggests that they are formed adaptively. Moreover, the repeated examples of people being fooled suggests that the availability and cost of information is an important aspect of Cantillon’s scheme. Such an emphasis antecedes modern macro theories of disequilibrium.

Cantillon then goes on to describe how unanticipated gold inflows would first be spent on food, forcing up food prices and the earnings of farmers. Farmers in turn employ more land, forcing up land prices. While all prices have now adjusted to the change in the money supply, during the adjustment period landowners are relatively disadvantaged since the price of their product is the last to increase.

While we don't have to agree with Cantillon's ordering of effects, it seems uncontroversial to assume that if expectations only adapt slowly, then there will be some sort of distributional effect during the adjustment period to an unanticipated change in the money supply. There can certainly be debate over the size and consistency of this effect. Austrians, for instance, build a business cycle theory out of it. Others consider the effect to be ephemeral.

On the other hand, if rational expectations are assumed from the start, then the location of gold's injection point is moot since everyone perfectly anticipates the repercussions and adjusts. In talking about injection points under rational expectations, it seems to me that market monetarists are having a totally different conversation than Austrians, who are interested in injection points under imperfect expectations. Is this just a debate over the nature of expectations? I see that Bryan Caplan has made the same point.

Questions for Bob Murphy and other Austrians on the inevitability of the bust

David Glasner had some recent posts (here and here) on Ludwig von Mises and Austrian Business Cycle Theory (ABCT). Bob Murphy pushed back here with a good rebuttal. But David's general point still stands: what necessarily forces a central bank that has adopted the practice of lending at a rate below the natural rate to ever cease this practice? Why does there have to be an inevitable bust?

I consider myself an Austrian in that one of my favorite economists is Carl Menger. I've also written a thing or two for the Mises Institute, my most recent being on Menger and Leon Walras and how the two would have differed on the phenomenon of high frequency trading. On the other hand, when it comes to macroeconomics, I remain a business cycle agnostic. I'm willing to be converted though. All you've got to do is answer a few questions of mine.

Say a central bank decides to reduce the rate at which it lends below the natural rate. Businesses can come to it for cheap loans -- and they do. Mises points out that as long as this differential exists it'll eventually lead to a "crack-up boom". The currency enters hyperinflation stage and, at its peak, people either turn to barter or dollarization occurs. Alarmed at this prospect, the central bank will probably increase rates in order to stave off the crack up.

But say the central bank and the currency users exists on a small island far from everywhere so dollarization can't happen. Say also that the police force is vigilant about preventing people from bartering. As a result, the currency issued by the central bank continues to be used, even during hyperinflation. The inevitable flight from money — the crack-up boom — can't occur. The currency perpetually falls.

So having assumed the crack-up boom away, why should the setting of market rates below the natural rate inevitably end in a bust? Sure, in the interim there might be a redirection of capital towards projects that are only profitable at low rates. In this context, a sudden increase in rates by the central bank back up to the natural rate might show some of these projects to be unprofitable. You've got a bust of sorts. But our central bank, released from the disciplining threat of a crack-up boom, steadfastly refuses to raise rates.

So if rates can be kept perpetually too low, and a crack-up boom can be averted, what causes the bust?

To start off, one explanation for a bust occurring is that when rates are kept too low, excess resources are allocated to interest-sensitive distant projects and not enough to less interest-sensitive near-term projects. At some point there's a realization that not enough capital has been allocated to present needs and all those future projects suddenly collapse in value. Thus a bust. What causes this sudden epiphany? As David Glasner asks, are workers dying of starvation?  It can't be higher interest rates that render these projects unprofitable since, as I've already pointed out, the central bank keeps rates permanently low.

Even if capital begins to flow into projects that are only profitable at low rates, wouldn't the prices of materials required by those projects be bid up relative to other prices, thereby putting a quick end to the profitability of these distant projects? Wouldn't the relative prices of material required for near term projects fall, thereby increasing the profitability of near term projects? How can any significant capital misallocation proceed given these rapid relative price adjustments?

If you can answer all my questions, then you'll have successfully converted me.