First, a government that engages in deficit spending covered by bond issues to the domestic private sector is not increasing the money supply, so presumably the Austrian objection is to deficits covered by direct central bank money creation (the issue of fractional reserve banking is a separate one, because private fractional reserve banks could exist without any government even existing). Secondly, the assumption underlying both the quantity theory of money and the idea of Cantillon effects is that money supply increases are merely exogenous, which ignores the fact that in the modern world money supply is mostly endogenous (this does not deny of course that you can sometimes get exogenous increases). But let us put aside these latter concerns for the moment.
The Cantillon effect is an idea derived from the work of Richard Cantillon (c. 1687–1734; for his life and work, see Pressman 2006: 17–20), in his Essai sur la Nature du Commerce en Général (Essay on the Nature of Trade in General), which was composed between 1730–1734 but published in 1755 (although the expression “Cantillon effect” appears to have been coined by Blaug 1978: 159). The Cantillon effect is the idea that price level changes caused by increases in the quantity of money depend on the way new money is injected into the economy and actually where it affects prices first. New money will then spread out altering the level of prices and structure of prices or relative prices (Blaug 1996: 21). Another way of saying this is that, although prices rise as the quantity of money increases, contrary to the naive quantity theory of money, prices do not rise proportionally, but in a complex manner that depends on who received the money and how they spent it.
But, since the Cantillon effect applies equally to privately induced changes in the quantity of money, as well as to government-induced ones, it cannot be a serious objection on its own against government intervention raising the quantity of money unless it also invalidates all private causes of the expansion of the money supply. Austrians favour complete free trade and complete freedom of capital movement. They would demand what would be called absolute liberalization of the capital account. But, since foreigners (from investors in financial markets or foreign direct investment to mere tourists) can cause significant changes in the money supply, it is clear that the actions of private agents also cause Cantillon effects, and in fact with large flows through a country’s capital account even very significant Cantillon effects. If any process that caused Cantillion effects was ruled out because of alleged impairments to economic calculation, then all injection of money via a capital account would be unacceptable under any such Austrian/libertarian argument.
Moreover, there is a further difficulty: Cantillon’s monetary theory holds that increases in the velocity of circulation (V) are equivalent to increases in the quantity of money (M), and that is not implausible. Therefore increases in the velocity of circulation would also cause Cantillon effects, and you would then have the bizarre situation where Austrians would logically have to object to any changes in the velocity of circulation as well, to prevent Cantillon effects.
This issue is related directly to Hayek’s attempt to make money neutral as a way of preventing an Austrian trade cycle from happening. Piero Sraffa had already attacked Hayek for this unrealistic idea in 1932 when reviewing Prices and Production (1931):
“The starting-point and the object of Dr. Hayek’s inquiry is what he calls ‘neutral money’; that is to say, a kind of money which leaves production and the relative prices of goods, including the rate of interest, ‘undisturbed,’ exactly as they would be if there were no money at all. This method of approach might have something to recommend it, provided it were constantly kept in mind that a state of things in which money is ‘neutral’ is identical with a state in which there is no money at all: as Dr. Hayek once says, if we ‘eliminate all monetary influences on production ... we may treat money as non-existent’” [Prices and Production, p. 109]. .... (Sraffa 1932: 42).By the time of Denationalisation of Money: The Argument Refined. An Analysis of the Theory and Practice of Concurrent Currencies (1990; 1st edn 1976), even Hayek is quite clear that any attempt to create neutral money in the real world is pointless:
“Although I have myself given currency to the expression ‘neutral money’ (which, as I discovered later, I had unconsciously borrowed from Wicksell), it was intended to describe this almost universally made assumption of theoretical analysis and to raise the question whether any real money could ever possess this property, and not as a model to be aimed at by monetary policy. I have long since come to the conclusion that no real money can ever be neutral in this sense, and that we must be content with a system that rapidly corrects the inevitable errors.” (Hayek 1990: 87–88).The search for a monetary policy that has no Cantillon effects is a bizarre quest for fools, as it requires making money neutral. As Hayek himself found out this is impossible:
“Hayek’s first approach to monetary problems was to search for a way to neutralize the effects of supply of and demand for money which were independent of at odds with the supply and demand for real goods: a concept of ‘neutral’ money. As it works out, this becomes a strict interpretation of a quantity theory of money, virtually paradoxical in that no change in the supply or demand for money could take place without affecting relative prices; that is, it could not be neutralized.” (Kresge 1999: 7).Even in a Rothbardian world of 100% reserve banking and commodity money, Cantillon effects would still happen if money entered via an anarcho-capitalist country’s capital account, and if increases in the velocity of circulation occurred.
Cantillon Effects on their own constitute no argument against government spending that increases the money supply (i.e., such as monetising a deficit as in New Zealand from 1937-1938). If it did, all private sector activity that causes Cantillon Effects would also be unacceptable (if the libertarian objection is economic) or immoral (if the objection is an ethical one).
I was going to write a post about this video below, but quickly realised there are doubts about whether this guy was even a financial expert at all. What was the BBC thinking!
Blaug, M. 1978. Economic Theory in Retrospect (3rd edn), Cambridge University Press, Cambridge.
Blaug, M. 1996. Economic Theory in Retrospect (5th edn), Cambridge University Press, Cambridge.
Hayek, F. A. von, 1990. Denationalisation of Money: The Argument Refined. An Analysis of the Theory and Practice of Concurrent Currencies (3rd edn; 1st edn 1976), The Institute of Economic Affairs, Westminster, London.
Kresge, S. 1999. “Introduction,” in S. Kresge (ed.), The Collected Works of F. A. Hayek. Volume 6. Good Money, Part II. The Standard, Routledge, London. 1–36.
Pressman, S. 2006. Fifty Major Economists (2nd edn), Routledge, London and New York.
Sraffa, P. 1932. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.