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The Cantillon Effect (#GotBitcoin?)

Today I’m going to try and explain why the Fed and Congress, while attempting to throw money at everyone, disproportionately tends to aid certain narrow financial actors. The Cantillon Effect (#GotBitcoin?)

Three weeks ago, the government passed a giant multi-trillion dollar bailout. Supposedly, it was money for a host of stakeholders, including hospitals, states, Wall Street banks, big business, the unemployed, and small businesses. Today the Federal Reserve built on top of Congress’s framework, announcing yet another multi-trillion dollar set of facilities, on top of what it already put out, to help cities, states, small businesses, main street businesses, and so on and so forth.

So what has happened so far? This is today’s change in stock price of a real estate venture run by one of largest private equity funds in the world.

The Cantillon Effect (#GotBitcoin?)

A thirty five percent jump in a day is… a lot. The reason the stock skyrocketed is because investors believe the new measures from the Federal Reserve will bailout the debt of this private equity fund. There’s a ‘monetary bazooka’ aimed at the economy. And yet there’s a puzzle. If there’s money for the entire economy, why is that normal people and small businesses can’t access unemployment insurance and lending programs? To put it another way, why is the money meant for everyone only showing up in the stock market?

The reason is because money has to travel through institutions, and right now, the institutions for the powerful function well, and those for the rest of us are rickety and broken. So money gets to the rich first. Eventually, some money will get to the rest of us, but in the interim period before that money fully circulates, the wealthy can use their access to money to buy up physical or financial assets.

An 18th century French banker and philosopher named Richard Cantillon noticed an early version of this phenomenon in a book he wrote called ‘An Essay on Economic Theory.’ His basic theory was that who benefits when the state prints a bunch of money is based on the institutional setup of that state. In the 18th century, this meant that the closer you were to the king and the wealthy, the more you benefitted, and the further away you were, the more you were harmed. Money, in other words, is not neutral. This general observation, that money printing has distributional consequences that operate through the price system, is known as the “Cantillon Effect.”

In Cantillon’s day, the basis of money was gold, so he wrote about what happened when a nation-state discovered a gold mine in its territory. Increasing the amount of gold in the realm would not just increase price levels, he observed, but would change who had wealth and he didn’t. As he put it, “doubling the quantity of money in a state, the prices of products and merchandise are not always doubled. The river, which runs and winds about in its bed, will not flow with double the speed when the amount of water is doubled.”

Cantillon went on to discuss how money would flow, basically noting that rich people near the mine would spend it on 18th century luxuries like servants and meat pies, prompting a general rise in prices. Eventually the money would get out to the populace, but until it did, working people would have to pay higher prices without access to the new money that mine owners had. So there would be inflation, with uneven distribution of purchasing power.

There’s also a China angle. Cantillon noted that a kingdom discovering gold would in the long-run erode its own manufacturing base, that the non-neutrality of money also had geopolitical consequences.

Here’s How He Put It:

When the overabundance of money from the mines has diminished the number of inhabitants in a state, accustomed those who remain to excessive expenditures, raised the prices of farm products and the wages for labor to high levels, and ruined the manufactures of the state by the purchase of foreign products by property owners and mine workers, the money produced by the mines will necessarily go abroad to pay for the imports. This will gradually impoverish the state and make it, in a way, dependent on foreigners to whom it is obliged to send money every year as it is extracted from the mines. The great circulation of money, which was widespread in the beginning, ceases; poverty and misery follow and the exploitation of the mines appears to be only advantageous to those employed in them and to the foreigners who profit thereby

This is approximately what has happened to Spain since the discovery of the Indies. As for the Portuguese, since the discovery of gold mines in Brazil, they have nearly always used foreign articles and manufactured goods; and it seems that they worked the mines only for the account and advantage of foreigners. All the gold and silver that these two states extract from the mines does not supply them with more precious metal in circulation than others. England and France usually have even more.

This dynamic is exactly what happened with the United States since the 1960s, if you replace the idea of gold mines with the ability to print dollars. In 1971, Keynesian economist Nicholas Kaldor said that dollar hegemony would turn “a nation of creative producers into a community of rentiers increasingly living on others, seeking gratification in ever more useless consumption, with all the debilitating effects of the bread and circuses of imperial Rome.”

Today what Cantillon observed is far more extreme than it was in the 1960s; it is hedge funds, private equity, and bankers who have benefitted from the money printing, and the foreigners who benefit from our money printing are increasingly Chinese and foreign manufacturers.

This theory doesn’t imply that money creation is always biased towards the powerful, only that how money travels matter. There is no inherent money neutrality, such neutrality must be constructed by institutional arrangements. Much of the New Deal in the 1930s and 1940s was designed to build alternative channels for lending so that small business, industry and individuals could have access to money as quickly as big banks.

The Reconstruction Finance Corporation, government procurement, the Federal Housing Administration, the Federal Reserve, agricultural credit supports, Federal Home Loan Banks, credit unions, and regulations like Regulation Q were all mechanisms to insure the flow of money would be neutral. The International Monetary Fund was originally created to ensure money neutrality on a global basis.

So we can now see that the hollowing out or subversion of these institutions since the 1980s is designed to ensure they would be non-neutral, and tilted towards the powerful. Since 1981, increasingly the only channels that work to move money creation are the Federal Reserve to Wall Street, as well as the backstop to mortgages, who could get money to new homebuyers through mortgage lenders. Housing has been a key driver in both recessions and recoveries for a lot of reasons, but also for a simple one. It’s one of the few ways to get money into the hands of normal people in America at scale.

The Federal Reserve has usually seen its role as printing money and distributing it to the economy, largely by moving money to big banks and assuming they will in turn increase the amount of money available to everyone else equally. The 2008 crisis jarred this vision of neutral and frictionless money movement, because it became obvious that institutions matter.

In 2016, Federal Reserve Chair Janet Yellen gave an important speech on this topic. It turns out, she said, that who the Fed deals with matters. To paraphrase her speech, the bigger and powerful get money first, and the small and weak get money last. That’s the dynamic we’re seeing in this bailout, with small businesses and the unemployed having trouble accessing funds and the big guys getting what they need when they need it. If you want the boring version of the speech, here’s a paragraph of Yellen explaining that the Fed economists were stupid and intellectually corrupt, but doing it so that anyone listening would fall asleep rather than get outraged.

Economists’ understanding of how changes in fiscal and monetary policy affect the economy might also benefit from the recognition that households and firms are heterogeneous. For example, in simple textbook models of the monetary transmission mechanism, central banks operate largely through the effect of real interest rates on consumption and investment. Once heterogeneity is taken into account, other important channels emerge. For example, spending by many households and firms appears to be quite sensitive to changes in labor income, business sales, or the value of collateral that in turn affects their access to credit–conditions that monetary policy affects only indirectly. Studying monetary models with heterogeneous agents more closely could help us shed new light on these aspects of the monetary transmission mechanism.

Saying ‘heterogeneous’ just means that the powerful and the powerless get and use money differently. In other words, Yellen was observing, in part, the Cantillon Effect.

And this brings us to today’s bailout and the meaning of institutions. Large banks, private equity corporations, and foreign central banks get dollars through the capital markets, by trading bonds and stocks. It turns out that the Federal Reserve is very good at working in these markets, and can move trillions of dollars relatively quickly. So that’s why the real estate arms of the largest private equity funds in the world are skyrocketing today. They know that the Fed turned the spigot on, and that spigot is instant and functional.

However, the Small Business Administration, unlike institutions in the 1930s and 1940s, does not have the workforce or ability to make direct loans to businesses. They have to guarantee loans made by banks, who in turn are supposed to make loans. Or that’s the theory, but in America, commercial lending institutions have hollowed out dramatically. Neither the banks nor SBA nor anyone else have the people to originate loans. We can’t do it. And our unemployment offices aren’t much better. The only functional bureaucracy that touches business and people is the IRS.

There are a bunch of aspects of the Cantillon effect that I don’t know how to translate. This is not an inflationary moment, the money printing is happening in a moment of severe deflation. So the issue is not that prices will rise, though of course they could. And we do see shortages in certain products, which is a form of inflation. I suspect purchasing power will matter more in who can afford to hold financial assets, not who can afford meat pies and servants. But the basic outline of the Cantillon Effect, that some people have more purchasing power and others have less in the same economy, if the channels of money creation make it so, is still operative.

And that’s the lesson we’re learning in this bailout. If we want to be able to expand and reduce the money supply in a way that doesn’t benefit the already powerful and hurt everyone else, we have to have institutions to do so. There are many policies designed to fix this, including getting every American a debit card as Rep. Rashida Tlaib suggests, or using the IRS as a mechanism to extend payroll support to businesses, as Senator Josh Hawley seeks. With the technology we have today, moving money neutrally in an industrialized economy like ours should be a pretty simple undertaking. Our policymakers just have to decide to do it.

Updated: 7-23-2021

Banks Are Giving the Ultra-Rich Cheap Loans To Fund Their Lifestyle

Billionaire hedge fund manager Alan Howard paid $59 million for a Manhattan townhouse in March. Just two months later he obtained a $30 million mortgage from Citigroup Inc.

Denis Sverdlov, worth $6.1 billion thanks to his shares in electric-vehicle maker Arrival, recently pledged part of that stake for a line of credit from the same bank. For Edgar and Clarissa Bronfman the loan collateral is paintings by Damien Hirst and Diego Rivera, among others. Philippe Laffont, meanwhile, pledged stakes in a dozen funds at his Coatue Management for a credit line at JPMorgan Chase & Co.

In the realm of personal finance, debt is largely viewed as a necessary evil, one that should be kept to a minimum. But with interest rates at record lows and many assets appreciating in value, it’s one of the most important pieces of the billionaire toolkit — and one of the hottest parts of private banking.

Thanks to the Bronfmans, Howards and Sverdlovs of the world, the biggest U.S. investment banks reported a sizable jump in the value of loans they’ve extended to their richest clients, driven mainly by demand for asset-backed debt.

Morgan Stanley’s tailored and securities-based lending portfolio approached $76 billion last quarter, a 43% increase from a year earlier. Bank of America Corp. reported a $67 billion balance of such loans, up more than 20% year-over-year, while loans at Citigroup’s private bank — including but not limited to securities-backed loans — rose 17%.

Appetite for such credit was the primary driver of the 21% bump in average loans at JPMorgan’s asset- and wealth-management division. And at UBS Group AG, U.S. securities-based lending rose by $4 billion.

Borrowing Binge

“It’s a real business winner for the banks,” said Robert Weeber, chief executive officer of wealth-management firm Tiedemann Constantia, adding his clients have recently been offered the opportunity to borrow against real estate, security portfolios and even single-stock holdings.

Spokespeople for Howard, Arrival and Laffont declined to comment, while the Bronfmans didn’t respond to a request for comment.

Rock-bottom interest rates have fueled the biggest borrowing binge on record and even billionaires with enough cash to fill a swimming pool are loathe to sit it out.

And for good reason. With assets both public and private at historically lofty valuations, shareholders are hesitant to cash out and miss higher heights. Appian Corp. co-founder Matthew Calkins has pledged a chunk of his roughly $3.5 billion stake in the software company — whose shares have risen about 145% in the past year — for a loan.

“Families with wealth of $100 million or more can borrow at less than 1%,” said Dan Gimbel, principal at NEPC Private Wealth. “For their lifestyle, there may be things they want to purchase — a car or a boat or even a small business — and they may turn to that line of credit for those types of things rather than take money from the portfolio as they want that to be fully invested.”

Yachts and private jets have been especially popular buys in the past year, according to wealth managers, one of whom described it as borrowing to buy social distance.

‘Significant Benefit’

Loans also allow the ultra-wealthy to avoid the hit of capital gains taxes at a time when valuations are high and rates are poised to increase, perhaps even almost double. Postponing tax is a “significant benefit” for portfolios concentrated and diversified alike, according to Michael Farrell, managing director for SEI Private Wealth Management.

Critics say such loans are just one more wedge in America’s ever-widening wealth gap. “Asset-backed loans are one of the principal tools that the ultra-wealthy are using to game their tax obligations down to zero,” said Chuck Collins, director of the Program on Inequality and the Common Good at the Institute for Policy Studies.

While using public equities as collateral is the most common tactic for banks loaning to the merely affluent, clients further up the wealth scale usually have a bevy of possessions they can feasibly pledge against, such as mansions, planes and even more esoteric collectibles, like watches and classic cars.

One big advantage for the wealthy borrowing now is the possibility that rates will ultimately rise and they can lock in low borrowing costs for decades. Some private banks offer mortgages on homes for as long as 20 years with fixed interest rates as low as 1% for the period.

The wealthy can also hedge against higher borrowing costs for a fraction of their pledged assets’ value, according to Ali Jamal, the founder of multifamily office Azura.

“With ultra-high-net worth clients, you’re often thinking about the next generation,” said Jamal, a former Julius Baer Group Ltd. managing director. “If you have a son or a daughter and you know they want to live one day in Milan, St. Moritz or Paris, you can now secure a future home for them and the bank is fixing your interest rate for as long as two decades.”

Risks Involved

Securities-based lending does comes with risks for the bank and the borrower. If asset values plunge, borrowers may have to cough up cash to meet margin calls. Banks prize their relationships with their richest clients, but foundered loans are both costly and humiliating.

Ask JPMorgan. The bank helped arrange a $500 million credit facility for WeWork founder Adam Neumann, pledged against the value of his stock, according to the Wall Street Journal. As the value of the co-working startup imploded, Softbank Group Corp. had to swoop in to help Neumann repay the loans and avert a significant loss for the bank.

A spokesperson for JPMorgan declined to comment.

Still, for the banks it’s a risk worth taking. Asked about securities-backed loans on last week’s earnings call, Morgan Stanley Chief Financial Officer Sharon Yeshaya said they’d “historically seen minimal losses.” Among the bank’s past clients is Elon Musk, who turned to them for $61 million in mortgages on five California properties in 2019, and who also has Tesla Inc. shares worth billions pledged to secure loans.

“As James [Gorman] has always said, it’s a product in which you lend wealthy clients their money back,” Yeshaya said, referring to Morgan Stanley’s chief executive officer. “And this is something that is resonating.”

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