The following post is provided by Edward Chancellor, financial historian, journalist and investment strategist.
This year marks the 300th anniversary of the start of an economic project in France which posterity knows as the Mississippi Bubble. The brainchild of an expatriate Scot, John Law, this scheme was hailed as the most ambitious economic experiment prior to the establishment of the Soviet Union in 1917. Like Lenin’s creation, the short-lived Mississippi Bubble burst in spectacular fashion. Central bankers around the world are currently embarked on a mission not altogether different from Law’s, making lessons revealed by his failure particularly relevant today.
Law was born in 1671, the son of an Edinburgh goldsmith. In adulthood, he became by turns a dandy, gambler, murderer, entrepreneur (“projector” in the parlance of his day), economist, central banker and finance minister. At the height of what he called his “System,” Law was the richest and most powerful man in Europe. His Mississippi Company incorporated all of France’s overseas trading companies – one of which claimed title to half the landmass of what is now the United States, along with monopolies for tax collection, tobacco, and coinage.
In early 1720, this company was merged with Law’s other creation, the Banque Royale, in effect France’s central bank. During its heyday, the Mississippi Company’s stock surged some 20-fold in value in the open-air stock market of Paris’s Rue Quincampoix. This early case of “irrational exuberance” didn’t come out of nowhere, however. Rather it was the consequence of Law’s monetary policy.
To understand the origins of the bubble it’s critical to grasp the Scotsman’s original purpose. As an economist, Law was a monetarist, an early forerunner of the late Milton Friedman. He believed that France suffered from a dearth of money and that an increase in its supply would boost economic activity. At the time of Louis XIV’s death in 1715, Law saw that France had two pressing problems. First, the state had too much debt – many of the royal debts (“rentes”) were trading well below par. Secondly, interest rates were too high – in his last years, Louis XIV paid above 8 percent for his loans.
Law, according to his biographer Antoin Murphy, was a “low-interest rate advocate.” He recommended setting up a national bank, which could issue notes to buy up the government’s debt, and thus bring about a decline in the interest rate. In 1715, Law expressed his views in a proposal to the Regent of France, Philippe d’Orléans:
Law was effectively suggesting that the central bank should expand its balance sheet to lower interest rates, which in turn would help over-leveraged borrowers, boost economic growth and employment and stimulate inflation, while simultaneously reducing the cost of servicing government debt. He sounds much like a modern central banker. Law’s belief that too little money constrained economic activity, while too much stimulated inflation, reflected “the (same) essential principle underlying the decisions by the U.S. Federal Reserve today”, writes economist William Goetzmann in his forthcoming history of finance, “Money Changes Everything”.
The scheme commenced in May 1716 with the foundation of the Banque Générale, the forerunner of France’s first central bank. Over the next four years, Law enjoyed remarkable success – the Mississippi stock soared, the entire French national debt was absorbed by the company and interest rates fell to 2 percent. Paris bustled with newly coined (or rather, printed) millionaires. Within four years, however, Law’s System had exploded – the stock-market bubble burst, confidence in bank notes evaporated and the French currency collapsed. In late 1720, Law was forced into exile. He died nine years later and was buried in a pauper’s tomb in Venice’s San Moise.
Why did Law fail? For a start, he was over-ambitious and over-hasty. Law’s aim was to replace gold and silver with a paper currency. This plan was forced upon the French public – Law decreed that all large financial transactions were to be conducted in bank notes. The holding of bullion was declared illegal – even jewelry was confiscated. As one 19th-century commentator observed, Law showed a “incapacity to recognize the difference between confidence and obedience. He overestimated the power of despotic authority, and underrated the influence … of public opinion in money matters”.
There was a conceptual flaw at the heart of Law’s scheme. He believed that money and financial assets were freely interchangeable – and that he could set the price of stocks and bonds in terms of money. In early 1720, the Mississippi stock was fixed at 9,000 livres with the support of the central bank. In attempting to set the price of the shares (what would now be called a “price-keeping operation”), Law lost control of the money supply. By the spring of 1720, more than 2 billion livres of bank notes had been issued, a near doubling of the money supply in less than a year.
The best contemporary critique of the System is provided by the banker and economist Richard Cantillon, who was based in Paris during the bubble. First, Cantillon questioned Law’s basic economic premise. Money printing brought no lasting benefits, in his view.
Devaluations of money promoted inefficiency: “Undertakers and merchants find it easy to borrow money, which decides the least able and least accredited to increase their enterprise,” wrote Cantillon. Operations to reduce rates with freshly printed money also provided an opportunity for corruption, as large fortunes could easily be made. Cantillon argued that Law’s monetary experiment might temporarily reduce interest rates and incite speculation but the newly printed notes didn’t actually enter into the real economy: “The excess bank notes, made and used on these occasions, do not upset the circulation, because they are used for the buying and selling of stock they do not serve for household expenses and are not changed for silver.”
Similar criticisms have been made about central banks’ recent attempts to boost economic activity with quantitative easing. Cantillon, however, observed that the real danger arises when an excess issuance of bank notes led to a loss of confidence in money. “If some panic or unforeseen crisis drove the holders to demand silver from the Bank the bomb would burst and it would be seen that these are dangerous operations,” he wrote.
The Mississippi Bubble provides many insights into where the monetary policies of central banks in Europe, Japan and the United States are heading. Central banks have lately used their digital printing presses to bring down interest rates. Like Law, they have excited speculation but provided few benefits to the real economy. The spoils of speculation have boosted inequality, as was the case in the Mississippi years.
As the effectiveness of monetary policies has come into question, central bankers in Japan and Europe have acted with a Law-like vehemence. Above all, the collapse of the Mississippi scheme shows that when central banks inflate bubbles there is no painless “exit” – Law’s Banque Royale had to continue printing money to sustain the bubble.
The Mississippi’s lessons are especially relevant to contemporary China. The People’s Republic today, like the French monarchy in the early 18th century, is attempting to mix modern financial practices with old-fashioned despotism. Confidence is coerced rather than earned. Over the past twelve months, the People’s Bank of China has inflated a stock market bubble, and then attempted a price-keeping operation when the market sagged. In emulation of Law, the People’s Bank is now proposing that banks’ non-performing loans be converted into equity. Just as Law attacked skeptics by forcing down the value of the coinage and attempting to prevent capital flight, Beijing is bolstering capital controls and manipulating the offshore currency market to deter capital outflows.
Cantillon foresaw that Law’s simultaneous attempt to keep interest rates low, control the money supply and peg the currency was doomed. The canny banker observed that the French money supply under Law had grown excessively and that this money would inevitably flow abroad. In 1720, Cantillon wagered against the French currency, which later fell by 60 percent in sterling terms.
As in France during the Mississippi years, China’s money supply has grown rapidly in recent years relative to other countries. Several well-known investors are making a similar bet to Cantillon against the Chinese currency. Capital flight may yet bring down China’s fragile financial system, just as it toppled Law’s over-ambitious scheme three centuries ago.