Money does not rain down, it comes in through a door

When new money is discussed, the question that takes the whole stage is how much of it is created. There is a second one, heard far less: where it comes in. Yet that is where it gets decided who gains and who pays. The mechanism has a name, the Cantillon effect, and a description three centuries old.

The image that carries the rest, from here on, is a bathtub of cold water with the hot tap running. The hot water does not spread at once: whoever sits near the tap feels it right away, and by the time it reaches the far end of the tub it is lukewarm. No rule favours one spot in the tub over another: position is all that counts. The observation is not new. Hayek, making the same point, spoke of a thick liquid like honey poured into a bowl, which piles up where it lands and spreads out slowly from there.

There is also a famous thought experiment that says the same thing the other way round. Milton Friedman imagined a helicopter dropping banknotes over a whole town, in equal proportion for everyone and all at the same moment. If money really came in like that, the effect this post is about would not exist. That is exactly what the helicopter is for, by contrast: money never comes in like that. It comes in through one particular door, and spreads from there.

Who Cantillon was

Richard Cantillon was an Irish banker doing business in Paris in the early eighteenth century. He was not a professor and did not write for a career: his only book, the Essai sur la nature du commerce en général, circulated for years in handwritten copies and was printed only in 1755, some twenty years after his death. A century and a half later the economist William Stanley Jevons, rediscovering it, called it "the cradle of political economy": the first treatise that holds the pieces together instead of looking at them one at a time.

The interesting part is where that book comes from. In the years when Cantillon operated in Paris, France ran the most reckless monetary experiment of its age: John Law's system. The state, loaded with debt, entrusted Law with a bank that issued paper notes and a company that promised the riches of the Mississippi; the notes multiplied, the shares grew tenfold in a few months, and for a couple of years Paris lived inside the first great paper-money inflation of the modern West. Cantillon saw it from the inside, as a banker: he soon understood where the new money was coming in and what it did along the way, made money on it, and got out before the crash.

The Essai is the distillate of that experience. In it there is an observation his contemporaries missed, and which is still largely missed today: new money does not change prices all at once, it changes them in sequence, starting from whoever spends it first. And it does not change them in proportion: some things get dearer than others, depending on who receives the money and how they spend it. From this observation the Cantillon effect takes its name, and it is the mechanism the rest of this post looks at up close.

The mechanism: old prices for the first, new prices for the last

A small island, a hundred or so inhabitants, a gold coinage that has circulated in the same quantity since anyone can remember. Prices have been still for years and everyone knows them by heart: one coin for bread, two for fish. Nothing more is needed to begin.

One day a farmer, digging a ditch in his field, finds a vein of gold at the surface. Extracting it costs almost nothing, he only has to bend down. Within a few weeks he has more coins at home than the island has ever seen in one pair of hands. It is worth pausing a moment on what has not changed: the island has the same bread, the same fish, the same boats and the same houses as the month before. It has grown richer only in coins.

The farmer begins to spend, and here is the first point: he spends at old prices. Bread still costs one coin, because the baker knows nothing about the vein of gold. All he knows is that for some days now the bread has been running out before noon. After a while he raises his price, and from his point of view the coins have nothing to do with it: there is more demand, that is all.

With his takings grown, the baker buys more fish, and the fisherman, who knows nothing about the vein of gold either, after a while raises his price in turn. The new money passes from hand to hand and prices rise where it passes, in the order in which it passes. There is no announcement, no moment at which "inflation kicks in": every price goes up for a local reason that its seller can explain perfectly well.

At the end of the chain stand the schoolteacher, paid a fixed sum agreed years ago, and the widow who lives on the coins she has put aside. The new money has not reached them yet, but the new prices find them all. The coins in the mattress are the same as last year's, identical one by one; they buy less bread. Nobody came into the house to take them.

The tally, in the end, fits in one line: whoever spends first buys at old prices; whoever receives last pays new prices. Between the farmer and the widow, what decided was not how much each of them owned: it was the order in which the new money reached them.

Then there is a second point, which nearly always gets lost: prices do not all rise the same. The things that rise first, and most, are the things that whoever spends first happens to like. If the farmer has a weakness for fish, fish gets dearer before bread; if he sets his mind on building a big house, stone and masons' wages go up, and whoever only needed to mend a roof finds out at their own expense. At the end of the round the island's price list is not the old one multiplied by a number: it is a different list, shaped by the tastes of whoever spent first.

Months later, once the waters are still, a passing accountant could measure everything and announce that "prices on the island have risen twenty per cent". It would be true, and it would say very little: the number photographs the arrival, not the journey. And wealth changed hands during the journey.

Inflation as a process, not a level

The island's accountant, with his figures taken once the waters are still, has a precise name today: the price index. A single number, the average of a basket, measured at regular intervals. For many purposes it is a useful number. The point is another: an average, by construction, erases differences; and here the differences are the whole story.

That is why the picture of inflation as a uniform tax, the same for everyone, tells the wrong part of the story. A uniform tax would almost be good news: annoying, but fair. Inflation seen up close is not a level that rises: it is a process that moves through the economy in a precise order, and while it runs there are those who spend new money at old prices and those who pay new prices with old incomes. The single number arrives when the game is over; the order is recorded by nobody, and it is the order that did the redistributing.

There is an objection worth taking seriously: sooner or later all prices adjust, incomes catch up, and the picture comes back into proportion. Perhaps. But even when that happens, the journey has already taken place: whoever bought at old prices has bought, whoever waited has paid, and those exchanges are not undone by the settling. Economists call it the non-neutrality of money in the short run. Said without the vocabulary: money may be neutral once everything has come to rest, but life takes place in the transient.

None of this is a recent discovery; it is, literally, the starting point. Already in Cantillon's day it was known, and Locke had written it, that an abundance of money makes everything dear. Cantillon's remark on Locke was exactly this: he saw it clearly, "but he has not considered how it does so". The great difficulty, he wrote, lies in knowing "in what way and in what proportion" the increase of money raises prices. The way and the proportion: the process, not the level. Three centuries on, the difficulty is still the same, and it is the reason to look at which doors the money comes in through today.

The mechanism today: the channels of modern money creation

Today no farmer finds veins of gold in his field, and new money does not come in through a royal treasurer's strongbox. It comes in through the financial channel. The circuit, simplified but not wrong, is this: the central bank creates money by buying securities, the sellers are banks and large investors, and the journey begins there, in the balance sheets of those who operate in the markets. The first link in the chain is no longer whoever digs: it is whoever has securities to sell.

The textbook case is the quantitative easing of the years after 2008, when central banks bought securities in quantities never seen before. The prices that moved first were not the price of bread: they were the prices of the things that get bought with money arriving in those balance sheets, that is, shares, bonds, property. Consumer prices came much later, and not everywhere. Translated onto the island: whoever owned assets was sitting near the tap, often without knowing it; whoever saved in cash was at the far end of the tub.

The financial channel has another half, though, closer to everyday life. Most of the money in use is not born at the central bank: it is born in private banks, at the moment they grant a loan. When a bank lends, it does not hand over coins it kept in a vault: it writes a new deposit on the borrower's account, and that deposit is new money. This is not a fringe thesis: the Bank of England explains it in these terms, in a 2014 paper that has become the reference on the subject. For our thread the consequence is direct: this money comes in where credit is granted, and credit goes to whoever offers collateral, that is, as a rule, to whoever already owns something. A large share of lending finances property, a share that doubled over the course of the twentieth century, and indeed that door often opens onto the housing market. Here too without design: every bank does its job, weighs the risk, asks for collateral; but the sum of those jobs decides which doors the new money comes in through, and they are doors that open more easily to those who already own.

At this point the objection is natural: what if money were given directly to people, to everyone, at once? That is Friedman's helicopter, and every so often politics actually tries to build it. The nearest attempt is from the spring of 2020, when the United States sent a cheque to the great majority of households. That helicopter, too, landed on a runway. Those whose bank details were on file with the tax authority received the money in mid-April; for the rest a queue of paper cheques set off, a few million a week, months long; at the back of the queue were those who had no bank account, or did not appear in the tax records at all. The twin programme for businesses went through the banks, and whoever already had a credit relationship was served first; the funds ran fastest where the damage was least. No malice is needed to explain it: any distribution needs a channel, and a channel has an order. The stated intentions counted for little: the order of arrival was decided by the runway, not by the intent.

Then there is one more level underneath. Those cheques were public spending, financed with government bonds that the central bank, in those months, was buying in large quantities. The fiscal side imitated the helicopter; the monetary side remained the same channel as ever.

Why it is not an accident: proximity as a structural advantage

There remains the slipperiest word, the one that always turns up in these discussions: "intended". If it means a room where someone draws up the redistribution at a desk, the answer is no, and this post has no need to believe it. But there is a colder sense, and a sounder one. Any system in which money is created at discretion has to answer two questions: how much, and through which door. The second cannot be dodged: not choosing is also a choice, because yesterday's doors stay open where they were. The Cantillon effect is not a manufacturing defect that more careful management could remove: it is the consequence of the fact that a door, somewhere, has to be.

Intended, then, in the sense in which the shape of a building is intended: nobody "wants" the entrance to be closer to some offices than to others, but the entrance is where it is, and whoever works next to it walks less every day. The order of arrival, as we have seen, is decided by the runway; here it is enough to add that the runway does not change when the pilots change. Governments pass, mandates get rewritten, stated intentions get updated; the geometry stays. That is what "structural" means: every occupant could be replaced with a better person, and the advantage would stay attached to the seats, not to whoever sits in them.

From here a corollary that deserves a line of its own. The public debate on money is almost entirely about the first question: how much inflation is tolerable, whether two per cent is too much or too little, whether enough is being done. The second question, where the money comes in, almost never appears. Not because it is hidden: the Bank of England paper cited above is public, and the channels of money creation are described in every textbook. It is a question that simply does not get asked. Yet the first says how much prices rise; the second says at whose expense.

That is why the right tone, here, is a cold one. Whoever sits near a door often did not choose to, any more than the island's baker did; and blaming the occupants of a structure is the surest way of not talking about the structure. The useful step is another: once the geometry is seen, the questions one asks change. That is the step that is missing.

What changes once you know

Having come this far, the honest question is: so what? Knowing about the Cantillon effect does not change prices, and it hands out no place at the front of the queue: that, by definition, belongs to whoever stands at the door, not to whoever reads. It does change the eyes, though, and with the eyes the questions. A few examples of what looks different.

Monetary news, to begin with. Faced with a purchase programme of hundreds of billions, or a new support instrument, the question is no longer only "how much money is it?", but: which door does it come in through, who touches it first, which prices will move before the journey reaches the basket. These are questions the news reports rarely answer; the documents with which the programmes are announced, more often than one would think. It is enough to know that they need asking.

Then there is a small everyday puzzle that comes undone. "Inflation is at two per cent" and "I am finding it harder than last year" can both be true at once, without anyone lying: the first is an average over the whole basket, the second is a position in the chain. It works the other way round too: in the years when the index stayed flat and houses got dearer, inflation was not absent; it was passing along another road, through prices that weigh little in the basket.

Third: keeping everything in cash is a position in the chain, not a non-choice. Whoever leaves their savings sitting in an account stands where the island's widow stood: at the far end of the tub, with the new prices on their way and the old coins in hand. No advice on what to do instead follows from this, and it is not the job of this post, which hands out glasses, not wallets. But between not choosing and not knowing one has chosen, the whole difference lies right there.

Finally, a one-question test for the explanations of inflation one meets around: if an explanation never says where the money came in, it is telling the arrival without the journey. That goes for the ones that treat rising prices as bad weather, something that just happens; and for the ones that only look for a culprit downstream, in the last link that touched up the price list. The island's baker raised his prices for a local reason he could explain perfectly well: stopping there is stopping too soon.

One last question, and it is the one the post closes on: do the doors have to be where they are? Where they are is not a law of nature: it is a choice of architecture. And a choice, once seen, can be discussed.

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