A highlight of Cantillon's theory of money is his treatment of the value of money as a special case of the value of market commodities in general. As in the case of any product, the alleged ‘intrinsic value’ of gold is the cost of its production. The value of gold and silver, like other commodities, is set by the values and hence the demands of users in the market – by the ‘consent of mankind’. As in the case of other commodities, too, Cantillon has no cost of production theory of the value of gold and silver; he simply holds, as elsewhere, that these products can only be produced if costs can be covered by the value of the product.
The process of aligning costs and values in gold, however, takes a relatively long time since its annual output is a small proportion of the total stock in existence. If the nominal value of gold falls below its cost of production, it will cease being mined; and if costs fall sharply, production of gold will be stepped up, thus tending to align costs and normal values. Cantillon recognized that government paper and bank money virtually have no costs of production, and therefore no ‘intrinsic value’ in his terminology, but he pointed out that market forces keep the value of such fiduciary money at par with the value of the gold or silver in which that paper can be redeemed. As a consequence, an increase in the supply ‘of fictitious or imaginary money has the same effect as increase in the circulation of real money’. But, Cantillon noted, let confidence in the money be damaged, and monetary disorder ensues and the fictitious money collapses. He pointed out, too, that government is particularly subject to the temptation to print fictitious money – a lesson he had undoubtedly learned from or at least seen embodied in, the John Law experiment. Cantillon also provided a sound analysis of how the market determines the ratio of the values of gold and silver.
One of the superb features of Cantillon's Essai is that he was the first, in a pre-Austrian analysis, to understand that money enters the economy as a step-by-step process and hence does not simply increase or raise prices in a homogeneous aggregate.8 Hence he criticized John Locke's naive quantity theory of money – a theory still basically followed by monetarist and neoclassical economists alike – which holds that a change in the total supply of money causes only a uniform proportionate change in all prices. In short, an increased money supply is not supposed to cause changes in the relative prices of the various goods.
Thus Cantillon, asking ‘in what way and in what proportion the increase of money raises prices?’, answers in an excellent process analysis:
in general an increase of actual money causes in a State a corresponding increase of consumption which gradually brings about increased prices. If the increase of actual money comes from Mines of gold and silver in the State the Owner of these Mines, the Adventurers, the Smelters, the Refiners, and all the other workers will increase their expenses in proportion to their gains. They will consume... more... commodities. They will consequently give employment to several Mechanicks who had not so much to do before and who for the same reason will increase their expenses. All this increase of expense in Meat, Wine, Wool, etc. diminishes the share of the other inhabitants of the State who do not participate at first in the wealth of the Mines in question. The alteration of the Market, or the demand for Meat, Wine, Wool, etc., being more intense than usual, will not fail to raise their prices. These high prices will determine the Farmers to employ more land to produce them in another year; these same Farmers will profit by this rise of prices and will increase the expenditure of their Families like the others. Those then who will suffer from this dearness and increased consumption will be first of all the Landowners, during the term of their Leases, then their Domestic Servants and all the Workmen or fixed Wage-earners who support the families on their wages. All these must diminish their expenditure in proportion to the new consumption... it is thus, approximately, that a considerable increase of Money from the Mines increases consumption....
In short, the early receivers of the new money will increase spending according to their preferences, raising prices in these goods, at the expense of a lower standard of living among the late receivers of the new money, or among those on fixed incomes who don't receive the new money at all. Furthermore, relative prices will be changed in the course of the general price rise, since the increased spending is ‘directed more or less to certain kinds of products or merchandise according to the idea of those who acquire the money, [and] market prices will rise more for certain things than for others...’. Moreover, the overall price rise will not necessarily be proportionate to the increase in the supply of money. Specifically, since those who receive new money will scarcely do so in the same proportion as their previous cash balances, their demands, and hence prices, will not all rise to the same degree. Thus, ‘in England the price of Meat might be tripled while the price of Corn rises no more than a fourth’. Cantillon summed up his insight splendidly, while hinting at the important truth that economic laws are qualitative but not quantitative:
An increase of money circulating in a State always causes there an increase of consumption and a higher standard of expenses. But the dearness caused by this money does not affect equally all the kinds of products and merchandise proportionably to the quantity of money, unless what is added continues in the same circulation as the money before, that is to say unless those who offered in the Market one ounce of silver be the same and only ones who now offer two ounces when the amount of money in circulation is doubled in quantity, and that is hardly ever the case. I conceive that when a large surplus of money is brought into a State the new money gives a new turn to consumption and even a new speed to circulation. But it is not possible to say exactly to what extent.9
Not only that, but as Professor Hebert has pointed out, Cantillon also provided a remarkable proto-Austrian analysis of the different effects of the money going into consumption or investment. If the new funds are spent on consumer goods, then goods will be purchased ‘according to the inclination of those who acquire the money’, so that the prices of those goods will be driven up and relative prices necessarily changed. If, in contrast, the increased money comes first into the hands of lenders, they will increase the supply of credit and temporarily lower the rate of interest, thereby increasing investment. Repudiating the common superficial view, brought back to economics in the twentieth century by John Maynard Keynes, that interest is purely a monetary phenomenon, Cantillon held that the rate of interest is determined by the number and interactions of lenders and borrowers, just as the prices of particular goods are determined by the interaction of buyers and sellers. Thus, Cantillon pointed out that
If the abundance of money in a State comes into the hands of money-lenders it will doubtless bring down the current rate of interest by increasing the number of money-lenders: but if it comes into the hands of those who spend it will have quite the opposite effect and will raise the rate of interest by increasing the number of entrepreneurs who will find activity by this increased spending and who will need to borrow in order to extend their enterprise to every class of customers.
An increased supply of money, therefore, can either lower or raise interest rates temporarily, depending on who receives the new money – lenders, or people who will be inspired by their new-found wealth to borrow for new enterprises. In his analysis of expanding credit lowering the rate of interest, furthermore, Cantillon provides the first hints of the later Austrian theory of the business cycle.
In addition, Cantillon presented the first sophisticated analysis of how the demand for money, or rather its inverse, the speed or velocity of circulation, affects the impact of money and hence the movement of prices. As he put it, ‘an acceleration or greater rapidity in circulation of money in exchange, is equivalent to an increase of actual money up to a point’. One of the reasons why prices do not change in exact proportion to a change in the quantity of money is alterations in velocity: ‘A river which runs and winds about in its bed will not flow with double the speed when the amount of water is doubled’. Cantillon also saw that the demand for cash balances will depend on the frequency of payments made in the society. As Monroe sums up Cantillon's position: ‘the longer the interval between payments, the larger are the sums which have to accumulate in the payers’ hands, and the more money is required in the country’.10 If people save large sums, furthermore, they may have to ‘keep money locked up for considerable periods’. On the other hand, the development of more efficient clearing systems for debts, as well as of paper money, will economize on cash: ‘The rapidity of circulation is increased by the practice of offsetting accounts between merchants, and by the use of bankers’ and goldsmiths’ notes, for these men do not keep an equivalent amount of money on hand’. Cantillon summed up his analysis of the interaction of quantity and velocity: ‘According to the principles we have established the quantity of money circulating in exchange fixes and determines the price of everything in a State taking into account the rapidity or sluggishness of circulation’.
Cantillon also provided a masterful discussion of the relations between gold and silver, and advocated freely fluctuating exchange rates between gold and silver, attacking any attempts, certainly any long-lived attempts, to fix the exchange rate between them. For such a rate is soon bound to vary from the market rate. Thus Cantillon saw the problem in trying to maintain a bimetallic standard with fixed parities between two precious metals.
All in all we can understand Hayek's enthusiasm when he concludes that Cantillon's monetary theory ‘constitutes, without doubt, the supreme achievement of a man who was the greatest pre-classical figure in at least this field and whom the classical writers themselves in many instances not only failed to surpass but even failed to equal’.