Inside today’s Daily Journal…

You have probably never heard of Richard Cantillon. And there’s a very real, and powerful reason why not: his ideas are dangerous to bankers.

John Law’s Mississippi Scheme (1720) was the first modern, fiat-driven, paper-money financial bubble. It crashed the French economy and wiped out most of the wealth of the French nobility.

Cantillon, working out of his Paris bank, was one of the most aggressive early buyers of Mississippi Company shares as they went from a few hundred livres in 1718 to roughly 10,000 livres by late 1719. Cantillon had two structural advantages most speculators didn’t. He had privileged access to the share-issuance machinery (he got shares first), and he lent money against shares as collateral, which both generated interest income and gave him critical information about the size and the stability of the speculative leverage in the market. He sold most of his Mississippi position into the late-1719 mania.

To maintain the price of the stock, John Law had to create enormous amounts of new bank notes. More bank notes meant the livre would, eventually, collapse against the British pound sterling. So as Cantillon was liquidating his clients’ collateral shares (as the margin loans were called in), he converted the heavily inflated French currency into sterling. When the livre crashed, the same nominal pile of money was suddenly worth a fortune in hard currency.

Cantillon wrote an intricately detailed account of the entire affair and circulated his notes among a close group of friends. He then retired in London. Or he tried to. All of the investors who’d gotten wiped out using his margin loans sued him for fraud and generally made his life miserable. In May 1734, Cantillon’s London townhouse burned down and his body was found in the wreckage. The coroner ruled it an accident. But there is compelling evidence Cantillon had faked his own death – he had been locked in bitter lawsuits with former clients trying to claw back his fortune – and appears to have sailed for Suriname under an assumed name and lived out his days there in obscurity.

After his real death, the notes he shared with friends were published as a book: Essai Sur La Nature Du Commerce En Général (Essay On The Nature Of Trade In General). It is the first complete work of modern economic theory – predating Adam Smith by almost 50 years. However, it wasn’t translated into English until 1931 – 221 years after his death.

What’s so dangerous about his ideas? They explain the power bankers have over an economy.

No one thinks carefully about what happens when a central bank buys assets (usually Treasury bonds). That new money doesn’t spread through the economy uniformly, like food coloring dropped into a glass of water. Cantillon knew this firsthand. New money, he observed, enters the economy at a specific point, through the hands of a specific set of people first. And those people, because they hold the new money before prices have adjusted higher, are able to profit enormously from the inflation that follows.

In Cantillon’s time, the point of entry was the royal mint. When a king needed money for a war, he ordered the mint to call in the old coins and restrike them with more copper and less silver. The first people to receive the new, debased coins were the royal contractors – the arms merchants, the shipbuilders, the grain suppliers, the army officers. They took their shiny new coins to market and bought steel, timber, wheat, and horses at the old prices. By the time the coins had circulated for a year or two, the country boys delivering wheat to the docks were being paid in coins worth 20% less. The wheat farmers and journeymen paid the full inflation. The royal contractors profited from it.

That is the Cantillon Effect. New money benefits its first recipients at the expense of its last recipients.

This is incredibly important to understand. You’re taught that inflation is an invisible tax. And that’s true – eventually. But the timing matters. Understood more completely, inflation is a transfer. Value is taken from the people farthest from the printing press and given to the people closest to it.

Today, the Federal Reserve does not mint coins. It creates new money electronically. New dollars enter the economy through the primary-dealer system – the 18 or so large banks authorized to transact directly with the Fed’s open-market desk. Those dealers do not lend the new dollars to young families trying to buy their first house. They lend to hedge funds, private-equity firms, and corporate treasurers, who use the money to buy stocks, investment properties, whole companies in leveraged buyouts, farmland, Manhattan office buildings, and Aspen ski chalets – all at yesterday’s prices, using tomorrow’s money.

But there is a second money spigot in this country, even closer to the printing press than Wall Street. It is the federal budget itself.