Matt Stoller explains Stock Market Crashes: the Cantillion Effect
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 those under such a veil of ignorance would try and build a society not as predatory towards those without power, because of the risk being they might end up as one.
How to understand the 2022 downturn? A mismatch exists 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.
While it’s painful and sad, this collapse, in many ways, can’t come soon enough. The drop in the markets is sorely necessary.
To understand why, it helps to start with the purpose of finance in a nation’s economy. Financial markets are critical in any free society; 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 new consumer tastes.
Yet, finance should be only a small part of the economy, because speculation isn’t intrinsically valuable. Banks serve us best when they serve real production, providing capital to ventures which eventually generate jobs and income.
Sometimes, financiers are able to take control of production. This leads to wild inefficiencies, speculation purely on asset price inflation. Eventually it leads to 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 casino gambling, 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 make money investing in baby formula production, or medical dye, or generic pharmaceuticals — all of which are in shortage. 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 dominated by casino-like gambling. (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 the huge increase in asset values since the Federal Reserve started pumping money into the financial system during Covid has showered $6 trillion of asset increases on homeowners. At the same time, home prices are so high, homeownership is denied to an entire generation.
Essentially, if you own assets or intangible capital assets, you’re doing great (on paper). If you use your income to make or move something tangible, you’re not. Hence the shortage in stuff which needs to be made or moved like baby formula — and — the surplus in non-productive bullshit like cryptocurrency.
The Kill Zone Economy
Why are we living in a giant casino? There are a few reasons. The first is monopolization. An economy full of corporate monopolies simply does not allow for enough new investment in productive ventures to fulfill consumer needs. Monopolies either choke off new entrants to the market, or they buy them up to stop them competing and to increase market share.
Venture capitalists call the industry segments dominated by big tech firms like Google or Amazon ‘kill zones;’ 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 consolidation across the economy was costing significant amounts of investment. He wasn’t initially looking at investment; he was looking at why workers weren’t benefitting from productivity gains. What he found is the problem wasn’t just with workers. Capital investment itself was going down faster than labor share. Firms were spending less on workers and robot labor. What was up, was profits. The reason, Barkai found, was consolidation. It’s happening across the U.S. economy since 1985. The trend is more pronounced in more concentrated sectors and less pronounced in ones less consolidated.
What he was implying is 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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… 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. He noted from 1948 until 1980, the Dow Jones Industrial Average — 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 monopolies create. They have done so by turning to the tool of pushing up asset values. This makes it easy for financiers to borrow money and speculate with it (gambling).
During the pandemic, this sorry 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 terrible consequences for non-investors of these choices.
The place where most people experience this deformation is in the housing market. Most people cannot afford to buy a first home of any kind. Its impact in other sectors is just as profound in terms of rearranging political power.
Corporate 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 this, 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 is named after French 18th century economist and philosopher Richard Cantillon. It’s a theory of monetary policy and political power.
Cantillon described what happens to a 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. As the gold moved into the rest of society, inflation in normal goods was the result. (Cantillon also noted imports increase dramatically after a gold discovery, articulating a version of what is today known as ‘Dutch disease’ in economics.) [This also happened around Sacramento, CA after the CA Gold Rush there].
Money, in other words, does not flow in a neutral manner when it is coined or printed. Today, we don’t use gold; yet, 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 billions 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. Put simply, there were so few places to invest in production of real goods — because of consolidated markets — the only things to put money into were private equity-style takeovers, speculating 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 GameStop, it’s everywhere. I collect basketball cards, and there’s a bubble in these collectibles.” 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.
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. Where there’s speculation, there’s corruption, with ‘grading companies’ playing the same role as the rating agencies during the financial crisis.
[Tulipmania is the story of a speculative bubble, which took place in the 17th century when Dutch investors purchased tulips, pushing their prices to unprecedented highs. During Tulipmania, the average price of a single flower exceeded the annual income of a skilled worker and cost more than some houses at the time. Full text HERE.]
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 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 people’s minds wake up to seemingly impossible: assets which appeared solid, melt 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 those under such a veil of ignorance [class blindness] would build a society not as predatory towards those without power, because of the risk being they might end up as one.
When the asset values underpinning the elite American social order go wobbly, then even the powerful start to imagine the greater good has some merit. Frankly, it is about time. While the bailout in 2020 was toxic, it is only the most recent example of prioritizing finance [(speculation, gambling) over producing real goods (jobs and wages follow)]. For decades, union and public pension funds have been over-estimating returns to avoid raising taxes or contributions. This means we have a large shortfall that has been stop gapped with financial games. 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 prioritizing monopolization, speculation and cheating — over using money, [capital, to make the world better for the 99%].
I can ask an even more basic question of economic statecraft: lifespan. Are we keeping our people alive and healthy? 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 thew away the opportunity he got during the great financial crisis to restructure America into a fairer 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. To get there we have to return to a world where the person who does the work is rewarded for their work.
It’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. After that, we should restore the basic primacy of commerce over speculation and monopolization. This 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 we need to reform the Federal Reserve. Why? So when recessions happen Congress and elected leaders get a say in how to come back from them [Now it’s only elite financiers who determine how we come back from a fall. They arrange things so they come out great].
We also need to do basic things like stockpiling agricultural commodities, like we used to do, prioritize small, localfarms, as well as domestic manufacturing. These will help insulate us from supply shocks. These ideas are a start. The big Aha! is a 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 which benefits the 99%. We can do that. Or, we can choose the other much darker road. As long as the Federal Reserve keeps pumping up asset bubbles, we can’t make a choice, and the damage gets worse. So even though it will painful, the toxic bubble can’t pop soon enough.
Thanks for reading!
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The history and politics of monopoly power.
14 hr agoLiked by Matt Stoller
Great post. To kill the casino, just phase out the tax deduction for interest expense. Would reorient the economy toward greater percentage share of equity financing, reducing speculation and adding resilience.
14 hr agoLiked by Matt Stoller
Excellent and highly understandable by non-econ expert!
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