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The Cantillon Effect and Stock Market Crashes
There's a mismatch between financial returns and underlying economic activity. This mismatch deforms our society, and there's only one way out.
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Today I’m going to write about the decline in stocks, and what it means.
The Big Ouch
Anyone who has paid attention to stocks has noticed a pretty vicious downturn over the last six months. Since its high late last year, the NASDAQ is off by over a quarter, with big tech leading the way down. It’s not just stocks, we’re experiencing a broad-based decline across different sectors, from tech to NFT’s to streaming giants like Netflix, with commodities like oil or diesel that are in short supply holding up or going higher. The bond market is having its worst performance since 1842. Along with the downturn comes pain, from layoffs in Silicon Valley to crypto message boards on Reddit with suicide hotlines affixed to Walmart indicating that broader job cuts are going to come soon. It’s an ugly situation.
And yet, while it’s painful and sad, this collapse, in many ways, can’t come soon enough. The drop in the markets is necessary.
To understand why, it helps to start with the purpose of finance. Financial markets are critical in any free society, because they enable flexibility in production and distribution. Without the ability to borrow money, speculate, and go bankrupt, it is very difficult if not impossible to systemize innovation, kill off old and inefficient firms, or cater to consumer tastes. Yet, finance should be a small part of the economy, because speculation isn’t intrinsically valuable. Banks should serve production, providing capital to ventures that will eventually generate income.
Sometimes, however, financiers are able to take control of production, and that leads to wild inefficiencies, speculation purely on asset price inflation, and eventually authoritarian politics. As economist John Maynard Keynes wryly put it, “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” That’s where we are now. Compensation for financial intermediaries has historically cost about 2% of GDP; today it’s at 9%. To put it differently, a small number of people are collecting hundreds of billions of dollars in fees running private equity funds, but private equity is no better (and probably worse) in terms of returns than public equity indexes.
This is no way to run a country. In a society with a coherent social vision, people would get rich investing in baby formula production, or medical dye, or generic pharmaceuticals, all of which are in shortage. But instead, money has been flooding into cryptocurrencies, weird obvious scams like SPACs, and a manic art market. Christie’s, for instance, just sold a famous Andy Warhol painting, a 1964 silk-screen of Marylin Monroe. The work went for $195 million to an anonymous bidder, which is the size of the annual budget for a small city, like Norman, Oklahoma. When baby formula is in shortage and art markets are insane, the economy has clearly become the byproduct of a casino. (I suspect there’s probably some form of collusion here, of auction houses, high-end museums, and billionaires, to keep prices high, but the point stands.)
The effects of such a mania aren’t constrained to the financial class; this chart from the New York Times shows that the huge increase in asset values since the Federal Reserve started pumping money into the financial system during Covid has showered $6 trillion on homeowners, while denying homeownership to an entire generation.
Essentially, if you own assets or intangible capital assets, you’re doing great. If you rely on your income making or moving something, you’re not. Hence the shortage in stuff that needs to be made or moved like baby formula, and the surplus in bullshit like cryptocurrency.
The Kill Zone Economy
There are a few important reasons why we are living in a giant casino. The first is monopolization. An economy full of corporate monopolies simply does not allow for enough new investment in productive ventures that can fulfill consumer needs. Monopolies either choke off new entrants to the market, or they buy them out.
Venture capitalists call the industry segments dominated by big tech firms like Google or Amazon ‘kill zones,’ indicating that’s where they won’t invest. But kill zones apply more broadly. Google blocks new entrants into search, just as Abbott Labs, Nestle, and Mead Johnson control baby formula, and group purchasing monopolies stop firms from making generic pharmaceuticals in shortage.
Indeed, in 2017, economist Simcha Barkai found that consolidation across the economy was costing significant amounts of investment. He wasn’t initially looking at investment, but at why workers weren’t benefitting from productivity gains. What he found is that the problem wasn’t just with workers, capital investment itself was going down faster than labor share. Firms were spending less on workers, while also spending less on robots. What was up, was profits. The reason, Barkai found, was consolidation across the U.S. economy since 1985, with the trend more pronounced in more concentrated sectors and less pronounced in ones that were less consolidated.
What he was implying is that large profits weren’t going into productive investment or to wages, but instead to government bonds. There was just nothing to invest in, because monopolies had hindered entrants into markets. The kill zone, Barkai found, was everywhere.
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Julius Krein, in a brilliant essay last fall, wrote about this same dynamic, noting that there has been a stark disconnect between productivity and profits.
The U.S. economy is, to a unique extent, organized around maximizing asset values and returns on capital independently of growth—in terms of corporate behavior, financial market incentives, and government and central bank policy. This may seem obvious or even tautological: what is capitalism if not a system aimed at maximizing returns on capital?
But the disconnect that has emerged between returns on U.S. financial assets and underlying economic performance—and even corporate profits—over the last few decades should raise deeper questions about basic economic policy assumptions and their theoretical foundations. Insofar as rising asset values are not linked with growth or productivity—and at the very least it is clear that they can diverge for meaningful lengths of time—then not only are different policy approaches required to achieve these distinct objectives, but the larger relationship between capitalism and development will need to be rethought.
Economist Jan Eeckhout, who wrote The Profit Paradox: How Thriving Firms Threaten the Future of Work in 2021, had a similar observation. At a recent conference, Eeckhout presented his work, and noted that from 1948 until 1980, the Dow Jones Industrial Average - which is basically the top thirty companies - stayed at roughly the same inflation-adjusted value. It did not move at all. In 1980, we hit an inflection point, and it started rising dramatically. Large firm profits started increasing, which is something you can see in lots of other areas, like mark-ups or profit rates. Because of the dominance of these firms, overall production, Eeckhout argues, is lower than where it should be, by a substantial amount.
So when demand spikes for real stuff, inflation is one result.
The Cantillon Effect
Policymakers have, for decades, avoided dealing with the drag on growth that monopolies are, and they have done so by turning to the tool of pushing up asset values by making it easy for financiers to borrow money and speculate with it. During the pandemic, this policy framework turned comical. In March of 2020, Congress passed the CARES Act, the second finance-heavy bailout in the last twenty years. Chris Leonard’s Lords of Easy Money covered this framework well, tracing the choices of the Fed to boost asset valuations and the consequences of those choices.
The place where most people experience this deformation is in the housing market, which is basically nonviable at this point for most people trying to buy their first home. But its impact in other sectors was just as profound in terms of rearranging political power. The bailouts saved private equity shops from their Minsky Moment, consolidated corporate assets, amped up tech valuations, boosted speculative fervor in GameStop and helped Wall Street-adjacent crypto barons.
At the time I called this bailout a ‘corporate coup,’ and it was. Shortly after that, as the stock market boomed, I started harping on something called the Cantillon Effect, or why Wall Street got a bailout and ordinary people didn’t. The Cantillon Effect, which is named after French 18th century economist and philosopher Richard Cantillon, is a theory of monetary policy and political power.
Cantillon described what happens to class of people in the economy when a gold mine opened. Those near the mine, or with connections to the king, were the first to get access to the increased money supply. They bid up assets, and gain political power. Then as the gold moved into the rest of society, inflation in normal goods is the result. (Cantillon also noted that imports increase dramatically after a gold discovery, articulating a version of what is today known as ‘Dutch disease’ in economics.)
Money, in other words, does not flow in a neutral manner when it is coined or printed. Today, we don’t use gold, but the institutional closeness of the Federal Reserve to Wall Street mimics this situation. Small businesses and ordinary people did get some money from the CARES Act, but it flowed months after private equity firms and monopolies got their cash with which to bid up financial assets. Imports also skyrocketed, consistent with Cantillon’s theory. Money printing at the Fed and monopolization interacted in a toxic way, with cheap capital causing a massive merger boom that is further consolidating the economy.
During the height of the GameStop craze, the Cantillon Effect was again relevant. The gist was, there are so few places to invest in real production because of consolidated markets, that the only things to put money into are private equity-style takeovers, or speculation in financial markets. Here’s what I wrote last January.
On Friday, a Wall Street contact told me, “Matt, this speculation isn’t just about GameStock, it’s everywhere. I collect basketball cards, and there’s a bubble in these collectibles.” And sure enough, I poked around, and there is. There are endless sites and message boards talking about ‘investing' in cards, with titles like “7 Rookie Cards That Could Double Your Money In 2021”. And the price hikes aren’t happening in old rare vintage cards, but new ones printed relatively recently, like $1.8 million going for a Lebron James or Giannis Antetokounmpo rookie card.
And the pricing pattern tracks the overall speculative fervor we’ve been seeing in the post-financial crisis era. Prices of these cards started going up in 2016, but really started spiking when the pandemic hit and the CARES Act passed. And where there’s speculation, there’s corruption, with ‘grading companies’ playing the same role as the rating agencies during the financial crisis.
It’s been a frenzy, and an obvious one.
After the Crash
Because of wage demands from labor, the Federal Reserve is now pulling support from financial markets, both increasing the cost of borrowing money, and withdrawing cash directly by reducing its large balance sheet. An extremely fragile market, with all asset classes except certain commodities, is the result. The Cantillon effect is going into reverse, and the first people to get hit are those closest to the gold mine. Aka, the billionaires.
So far, the decline is not that bad, the stock market is still substantially up above its pre-pandemic level. But if the Fed continues on its path, and a big crash really does happen, then the most important consequence is that minds open up to what had previously seemed impossible, because solidity melts away, at least temporarily.
Financial crashes remind me of the American philosopher John Rawls, and his theory of fairness known as the veil of ignorance. Rawls thought that we should try and choose our principles of governance using a thought experiment. What laws would we choose if we did not know our place in the social order? His view was that those under such a veil of ignorance would try and build a society that is not as predatory towards those without power, because of the risk being they might end up as one.
When the asset values that underpin the American social order go wobbly, then even the powerful start to imagine that the greater good has some merit. And frankly, it is about time. While the bailout in 2020 was toxic, it is only the most recent example of prioritizing finance. For decades, union and public pension funds have been overestimating returns to avoid raising taxes or contributions, which means that we have a large shortfall that has been stop gapped with financial games. And underpinning this mismatch between finance and real production is imports from China.
In other words, the very essence of how we run our society is deformed by a policy framework that prioritizes monopolization, speculation and cheating over the ability to, well, do anything else. Here’s the most basic question of statecraft, lifespan. Are we keeping our people alive? Increasingly, the answer is no.
The 2020 financial crunch during Covid was the second big crisis of this century, and Donald Trump wasted it. In 2009, Barack Obama threw away the opportunity he got during the great financial crisis to restructure America into a fair society. Americans were willing to endure pain in return for justice. Instead, Obama and Trump rewarded them with Oxycontin.
We do not have to go down this road again. We can restore our communities, our markets, and our businesses. There are many policy choices to get us there, but the basic idea is that we have to return to a world where the person who does the work gets the reward for that work. That’s starting to happen. Here’s a headline yesterday on Jonathan Kanter, the new chief of the Antitrust Division.
Obviously, we’ll have to help people injured in this downturn. But after that, we should restore the basic primacy of commerce over speculation and monopolization. That means taking apart conglomerates like Abbott Labs and Google, restoring bright line antitrust rules, raising tariffs, re-regulating airlines, shipping, trucking, and railroads, and shrinking the financial sector, as well as reforming the Federal Reserve so that Congress and elected leaders get a say in when recessions happen. Doing basic things like stockpiling agricultural commodities, like we used to do, and prioritizing small farms, as well as domestic manufacturing, can help insulate us from supply shocks. These ideas are a start, the point is return to seeing wealth as making things we need, not numbers on a spreadsheet.
In the end, we have to decide whether we want to even have a society. We can do that. Of course, we can choose the other much darker road. But as long as the Federal Reserve keeps the bubble going, we can’t make that choice, and the damage gets worse. So even though it will painful, that bubble can’t pop soon enough.
Thanks for reading!
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