Are Cantillon Effects an Argument Against Government Spending?

The answer is: not even close. You can frequently find Austrians or free market libertarians arguing against government intervention – particularly Keynesian policies – by appealing to “Cantillon effects.” The question is: do Cantillon effects provide a convincing, sufficient argument on their own against government intervention by spending programs that increase the quantity of money? Not on their own they don’t.

For the purposes of this post, let us assume that prices are in fact highly flexible in response to demand, as some libertarians and Austrians imagine, even though that is grossly untrue, since the real world contains a high degree of relative price stickiness.

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 or 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).

BIBLIOGRAPHY
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.

Is GDP Meaningless?

The truly strange idea that GDP is “meaningless” seems quite prevalent. The idea is seen frequently on the Cynicus Economicus blog.

Are we really to believe that GDP literally has no “meaning”? To think so, one would seriously have to argue that GDP

(1) lacks any significance;
(2) is without use or value, and
(3) contains nothing of substance which can be agreed or disagreed with.

Unfortunately for those who believe this, the idea that GDP is “meaningless” is utterly ludicrous.

First, what is GDP? GDP equals private consumption + gross investment + government spending + (exports − imports).

GDP is a measure of the value of a country’s overall economic output or national income in terms of output. It can also be defined as “the market value of all final goods and services made within the borders of a country in a year.”

One objection that people have is that GDP is “fake” because it supposedly measures “consumption on imported products as national income.” But these people are actually clueless about what GDP actually is. In fact, by definition, the value of imported goods in the trade deficit is subtracted from GDP whether they were bought in consumption, investment or by government spending, and the resulting measure of GDP leaves us with the value of all domestic goods and services. Thus GDP is national income minus imports in the trade deficit. The value of the remaining imports is paid for by earnings on exports, so one can hardly complain that this is based on debt.

Now to the idea that GDP is “meaningless.” If this were really the case, then an immediate consequence is the components of GDP are also meaningless.

We can start with exports minus imports. Does the total value of UK exports “lack any significance” or have “no use”? The earnings from exports are a fundamental source of income through foreign exchange for a country. The total value of money spent on imports also shows how much a country is consuming from overseas. And are we to say that establishing whether or not a country has a trade deficit or surplus (i.e., exports – imports) “lacks any significance”? Clearly it does not. It is a fundamental measure of trade balance. People who regard current account deficits as a form of “living beyond one’s means” are clearly directly dependent on a major component of GDP to establish whether a country has a trade deficit or not. Such people cannot claim that a country is “living beyond its means” and then claim that the trade balance component of GPD is a meaningless measure because they are dependent on it themselves. Without it, they would have no justification whatsoever for their view, as they would have no knowledge at all of whether the country is in trade balance or not.

Next, let’s look at gross investment. Although gross investment includes spending on housing, it excludes spending on financial assets or financial instruments. Thus by definition it excludes the second major type of economic activity that causes debt-fuelled bubble growth. Although much housing is funded with debt, it at least provides a real asset that is of use to the community that can be resold as a benefit to other people. That overinvestment in housing through debt was a major factor in distorting economies over the last 20 years is undeniable. But, with orderly deleveraging and a proper correction in prices, the houses themselves are real assets that will make the community wealthier, not poorer. There is no sense in which the housing construction component of GDP “lacks any significance.” It might have been funded by excessive private debt, but this is saying something quite different from the former statement about GDP. Moreover, gross investment also includes replacement purchases, net additions to capital assets and investments in inventories. Thus gross investment includes new spending in capital goods, production facilities and factories. These are fundamental parts of the productive sector of the economy allowing it to engage in production. The belief that a measure of this “lacks any meaning” is utterly absurd. It can tell you a great deal about how much investment there is in real productive capacity in an economy (one criticism of gross investment is that it does not take account of the cost of depreciation. But this limitation is well known, and hardly makes the measure “without significance or value”).

Private consumption is the total value of private household final consumption expenditure, including durable goods, non-durable goods, and services. But it also excludes home purchases. It is here that critics complain that GDP is meaningless, because over the past two decades an increasing part of it has been financed by private debt. On the contrary, a measure of the value of private consumption allows us to calculate the extent to which consumption is being increased by private debt. Far from being meaningless or without significance, this is a crucial indicator of the health of the economy. Excessive private debt is a serious problem, but you can only know how serious by calculating GDP and looking at the annual increase in private debt. One can complain that consumption is excessive because of too much private debt, but this does not make the total value of private consumption “meaningless.” It obviously has a great deal of significance.

Lastly, we come to government spending. This is the component of GDP that anti-government advocates of free markets object to. Their objections are usually justified with the a priori belief that government spending is never productive or beneficial. However, if you reject their a priori premise that government is bad, then there is no reason why government spending should not be included in GDP. Government provides fundamental things like basic R&D for science, education, health care, and public infrastructure – all things of use to the community. For example, our public infrastructure and transportation systems are the foundation of economic life.

The second argument against counting government spending in GDP is that sometimes it is based on public debt. This commits the fallacy of equating public debt with private debt. But public debt is wholly different from private sector debt, for these reasons:

(1) the government is the monopoly issuer of its own currency; no private individual can print money;

(2) if necessary, the government can monetise its deficit;

(3) the government has the power to rollover much of its debt, unlike private individuals;

(4) the government’s central bank has the power to buy back bonds with new money and to control interest rates and bond yields if necessary, and

(5) the government has access to tax receipts which grow over time and with economic growth.

Clearly, the belief that government debt is like household debt is utterly false. It may be a “common sense” and “intuitive” idea for many people, but this is no convincing argument in its favour. For many people over the centuries, the idea that the sun revolves around the earth was a “common sense” and “intuitive” belief. But that “belief” couldn’t be more wrong. The same thing applies to the belief that governments are like private households.

Consequently, the government spending component of GDP is meaningful.

On the other hand, there are legitimate criticisms of GDP that can be made. For example, that GDP takes no account of inequality of wealth and does not measure unpaid work. In developing countries where monetary exchanges are much less significant (e.g., where barter still has a place), GDP underestimates economic activity. In cases where economic activity involves repairing damage or rebuilding after some destructive event like a natural disaster or war, GDP is boosted in a way that can be misleading. Yet another problem is that GDP neglects negative externalities, or the harmful effects of economic transactions that are not reflected in the price.

All these criticisms of GDP, however, tend to recognise that it does convey useful information, although there may be limits to how much can be learned from the measure. This is a far cry from the absurd claim that GDP has no meaning.

Appendix 1: Other Confusions about GDP

Reviewing some of the comments on the Cynicus Economicus blog, one finds other confusions about GDP. I list these comments below with responses.

as Cynicus has previously stated GDP is no longer a measure of productivity, but it is a measure of consumption, most of which is via debt spending in shops and by companies.

GDP does not measure productivity. GDP measures the value of output, or national income in terms of output, as some prefer to say. You measure productivity by productivity indices.
Moreover, GDP includes a measure of gross investment (e.g., fixed capital investment), takes account of earnings from exports, and a good deal of government spending in R&D and education can be considered as investment as well. It is not possible to say that GDP is just “a measure of consumption.” Although consumption is clearly part of it, much of this consumption is also national income, spent on domestically-produced goods and services.

and you fail to acknowledge that consumer debt spending on imported goods is also measured in GDP of national income when clearly it is not.

This is false. As I have noted above, GDP is national income in terms of domestic goods and services, and by definition all imported goods in the trade deficit are subtracted from GDP whether they were bought in consumption, investment or by government spending.

Appendix 2: Total US Domestic Spending and Investment Minus Total Imports

As noted above, GDP subtracts the value of the trade deficit. The means to pay for imports not part of the trade deficit come from earnings from exports.

But one can also calculate the value of total US domestic public and private spending and investment minus total imports (= TDSI). To do this we would remove the value of exports from the calculation of GDP as below:

private consumption + gross investment + government spending – imports = TDSI.

Some basic figures (in 2009 US dollars):

US GDP: $14.26 trillion (2009 est.)
US Exports: $1.571 trillion (2009 est.)
US Imports – $1.946 trillion (2009 est.)
US trade deficit = 0. 3749 trillion (2009 est.).

http://www.census.gov/foreign-trade/Press-Release/2009pr/final_revisions/exh1.txt

The formula we need to work from is here:

GDP = private consumption + gross investment + government spending + (exports − imports).

So in 2009 US private consumption + gross investment + government spending = $14.6349 trillion (which is GDP + the trade deficit).

US imports were $1.946 trillion (2009 est.).

Therefore total US domestic public and private spending and investment minus total imports is as follows:

14.6349 – 1.946 = $12.6889.

Therefore the total value of all US domestic spending and investment minus total imports was $12.6889 trillion.

This means that 88.98% of US GDP was actually private or public spending or investment on US domestic goods and services. That means that the vast majority of GDP was not due to imports at all.

If you seriously believe that GDP is a “worthless” measure because it includes consumption of foreign imports, then it is not difficult to calculate that the actual size of the US economy once imports are subtracted is $12.6889 trillion.