Most people are aware that historically there have been speculative bubbles. Some of them can even name a few – the South Sea bubble, tulips, and more recently dot-coms. Some historians can go even further, quoting the famous account by Charles Mackay of the South Sea bubble, the tulip mania and the Mississippi bubble, published in the mid-nineteenth century.
The most valuable bubble empirically for the purpose of our elucidation has to be the Mississippi bubble, whose central figure was John Law. Law, a Scotsman whose father’s profession was as a goldsmith and banker in Edinburgh, set up an inflation scheme in 1716 to rescue France’s finances. He proposed to the Regent for the infant Louis XIV a scheme that would be based on a new paper currency.
Law was a somewhat louche character, who in his Continental travels had spent his mornings studying finance and the principles of trade, and the evenings in the gaming-houses of Europe. He was a successful gambler, because of his ability to calculate odds.
Some similarities with the personality of Keynes two hundred years later are striking. Keynes was a mathematician first, and an economist second. Their approach was also similar: see a problem and try to find a solution, instead of seeing a problem and trying to understand why it existed before solving it. Both Law and Keynes felt that sound money was too restrictive for the enhancement of an economy.
Consequently, much of what Law proposed and then enacted in France rhymes with our neo-Keynesian world today. The difference, perhaps, is that when given the opportunity Law seized it, and had ultimate financial and monetary power. He harnessed the roles of a central bank, monopolist in international trade, stock promoter and finance minister. The downfall of his schemes occurred in less than five years after he set up his inflation machine. Keynes, by contrast, never directly drove his schemes, acting as an advisor to governments rather than as an executive. Even though he wrote of the gold standard as a barbaric relic in his Tract on Monetary Reform in 1923, gold convertibility for the reserve currency was only completely abandoned long after his death.
This article looks at John Law’s actions in the years following Louis XIV’s death in 1715, and how he brought a brief period of prosperity to France on a mixture of monetary and asset price inflation. The reason for examining the monetary history of this period in France is to see what lessons we can draw from it, given the similarity between Law’s monetary policies and those of governments today.
The establishment of Banque Generale
The death of Louis XIV in 1715 left France’s state finances (which were the royal finances) in a state of bankruptcy. The royal debts were three billion livres, annual income 145 million, and expenditure 142 million. That meant only three million livres were available to pay the 220 million interest on the debt, and consequently the debt, mostly billets d’etat (the equivalent of modern treasury bills) and billets de monaie (floating and war debt) traded at a discount of as much as 80% of face value.
The Duke of Orleans had been appointed Regent to the seven-year old Louis XV, and so had to find a solution to the nation’s financial difficulties. The first attempt in 1713 was the often tried and repeatedly failed expedient of recoining the currency, depreciating it by one-fifth. The result was as one might expect: the short-term gain in state revenue screwed up the French economy by taxing it 20%. Furthermore, the Controller General of Finances announced the intention of further devaluations of the coinage with a view to adjusting the economy from a war footing to peacetime. This crazy plan was announced as an attempt to somehow stimulate the economy, but the effect was to increase hoarding of the existing coinage instead, as predicted by Gresham’s law.
Following this one-off debasement tax, many tax collectors, who subsisted on a percentage of taxes extracted, were taken to court suspected of swindling the state. For the unpopular tax collectors, it was the ordinary person’s opportunity to get his own back by informing on this hated class, and the courts rapidly filled with those accused. Revenue was raised through fines, but this must have severely compromised further tax collection, leaving the state still insolvent. By now it was early-1716.
At about this time, Law presented himself at court and offered his considered solution to the Regent. He diagnosed France’s problem as there being insufficient money in circulation, restricted by it being only gold and silver. He recommended the addition of a paper currency, such as that in Britain and Holland, and its use to extend credit.
Banknotes did not previously exist in France, all payments being made in specie, and Law persuaded the Regent of the circulatory benefits of paper money. He requested the Regent’s permission to establish a bank which would manage the royal revenues and issue banknotes backed by them as well as notes secured on property. These notes could be used as a loan from the bank to the king at 3% interest instead of the 7½% currently being paid.
On 5 May 1716 he gained permission to establish Banque Generale as a private bank and to issue banknotes. But when it came to the royal finances, this permission was withheld until the following year.
Law succeeded in finding other means to persuade the public to swap specie for his banknotes. He was so successful that after only eleven months, in April 1717 it was decreed that taxes and revenues of the state could be paid in banknotes, of which Law was the only issuer.
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Law now had his foot in the door and could capitalise his bank.
This was done by partially capitalising it with billets d’etat, at their face value but obtained at a discount of 70% or so, to minimise the money cost of funding the bank’s capital. He used public anticipation of future currency debasement to encourage the public to swap metallic money for his notes, which he guaranteed were repayable in coins that had the silver content at the time of the note issue. Law’s banknotes were therefore an escape route for the general public from further debasement of silver coins.
The banknotes rose to a fifteen per cent nominal premium over coins within a year. The bank was exempt from taxes, and by decree foreigners were guaranteed their deposits in the case of war. The bank could open deposit accounts, loan money, arrange for transfers between accounts, discount bills and write letters of credit. Law’s banknotes could be used to settle taxes. There was no limitation placed on the total number of banknotes issued.
Money that had been hoarded for fear of further debasement was liberated by the premium on Law’s banknotes, and the improved circulation of money rapidly benefited the economy. He was able to open branches outside Paris; these were in Lyons, Rochelle, Tours, Amiens and Orleans. Other private banks and money-lenders used Law’s banknotes as the basis of extending credit. This success meant his credibility with the Regent, the French establishment and the commercial community was secured.
The use of his banknotes to settle taxes gave the bank the status of a note-issuing central bank. The expansion of circulating money stimulated trade, particularly given the banknotes’ convenience compared with using coin. It is worth noting that the earliest stages of monetary inflation usually produce the most beneficial effects, and this combined with Law’s apparent financial and economic expertise, particularly measured against the ineptitude of the Controller-General of Finances, gave the economy a much-needed confidence boost.
It is worth noting that at this stage, there was no material inflation of the currency, banknotes being issued only against coins. However (and this it appears is not emphasised by historians) it was clear that a loan business was facilitated on the back of Law’s paper money, which almost certainly inflated the quantity of bank credit in the economy.
Law could now turn his attention to raising asset prices to pay down the royal debts, to enhance the public’s riches, and thereby his own and that of his bank.
The Mississippi connection
The Regent was understandably impressed by Banque Generale’s apparent success at issuing paper currency and rejuvenating the economy. The bank was being run on prudent lines, with banknotes being exchanged only for specie, and the quantity of what today would be called narrow money had not expanded materially. But Law had a problem: the note issue and the fact the bank had been capitalised on a mixture of partial subscriptions and over-valued billets d’etats meant the bank had insufficient capital and profits to achieve its ultimate objective, which was to reduce the royal debts and the interest rates that applied to them.
Consequently, Law developed a plan to increase the bank’s assets as well as those under its indirect control. In August 1717, Law requested and was granted a trading and tax-raising monopoly over the French territory of Louisiana and the other French dependencies accessed by the Mississippi River, the existing trading lease having been surrendered by the previous owner in lieu of taxes. A major attraction was supposed to be the precious metals that could be obtained from the natives and mined in the region, as well as the tobacco trade.
For nearly two years, Law kept the Mississippi project on hold while he established his bank, with the company’s shares trading at a discount to their nominal price of 500 livres. What was needed was a scheme of arrangement to beef up the company.
Accordingly, in the summer of 1719, he acquired three other companies to merge with the Mississippi company (whose full title was Compaigne de la Louisiane ou d’Occident). These other ventures had exclusive trading rights to China, the East Indies and Africa respectively, which effectively gave Law’s Mississippi company a monopoly on all France’s foreign trade. To pay off these companies’ debts and to build the ships required for transport, Law proposed a share issue of 50,000 shares at 500 livres per share, 10% payable on application. By the time legal permissions were granted, the shares stood at 650 livres, undoubtedly fuelled by purchases with banknotes issued by Law for the purpose, making for good gains for the new shares in their partly paid form.
Law’s earlier success with his banknote issue, and the contribution made to improving the French economy, coupled with his ability to enhance the share price by issuing bank notes, was a guarantee that his scheme would be spectacularly profitable for anyone lucky enough to have a subscription accepted.
The bank had been re-authorised as a public institution and renamed Banque Royale, in December 1718. At the same time, the Regent authorised the further issue of up to a billion livres of banknotes, which was achieved by the end of 1719. While it was the Banque Generale, banknotes had only been issued in return for specie to the extent of 60 million livres, but this new inflationary issue was entirely different. While it is impossible at this distance to forensically track the course of this money, we can be certain that it was used to manipulate the share price of the Mississippi venture, and it fuelled much of the public’s panic buying of shares that year.
But it was not only the printing of money to push the share price that fuelled the bubble. Law’s skills as a promoter took their elevation to a new level, with further issues of 50,000 shares approved in the summer of 1719 and executed as rights issues that autumn. Existing shareholders were offered the opportunity to subscribe for one share for every four old shares held, to be partly paid with an initial payment of 50 livres, the next payment deferred for over a month. These could be sold for an immediate profit, while providing a low price entry point for new investors.
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The expansion of the banknote issue without an offsetting acquisition of specie was used by Law to assemble and finance a total monopoly of France’s foreign trade. As well as this monetary expansion, we can be sure that private banks and money-lenders used it as a base to expand credit. We know this to be the case from court documents in London where Richard Cantillon in 1720 successfully sued English clients in the Court of Exchequer for £50,000 owed to him, despite having sold the Mississippi shares held by him as soon as they were deposited as collateral.
It seems obvious to us that to give to one man both the monopoly of the note issue and monopolies on trade, and then for him to fraudulently use the notes to create wealth out of thin air is extraordinarily dangerous. It seems equally obvious that such an arrangement was certain to collapse when the excitement died down and investors on balance sought to encash their profits.
It seems less obvious to us today that the principal elements of Law’s monopolies exist in modern government finances, which use paper money to inflate assets providing their electorates with the illusion of wealth. The difference is not in the methods employed, but the gradualness of today’s asset inflation, and the claim by the state that it is acting in the public interest, rather than one individual making the same claim.
In this context, it is interesting to note that the S&P 500 Index has risen nearly 300% since 2009, fuelled entirely by monetary policy.
Peak hubris
By August 1718, Parliament, motivated by an understandable dislike of a foreigner controlling the country’s finances, was increasingly driven by envy of Law’s success and dark mutterings over where it might all end. Opposition to Law’s plans began to mount with some councillors proposing he be brought to trial and if found guilty hanged at the gates of the Palais de Justice.
The Regent arrested the president of the parliament and two of its senior counsellors, who were sent to distant prisons, and opposition faded. Law was then able to concentrate on promoting his Mississippi venture, which he did with the rights issues in four separate tranches in the autumn of 1719, referred to above. The purpose of these issues was to raise over a billion livres to lend to the royal estate at 3% interest to permit the repayment of the higher yielding billets d’etats, along with other long-term state debts.
Meanwhile, the share price had continued rising, and by the end of 1719 it stood at 10,000 livres. Increasing pressure from share sales by people who sought to take profits had to be discouraged. The announcement of a 200 livres dividend per share was undoubtedly with that in mind, to be paid, like in any Ponzi scheme, not out of earnings but out of capital subscriptions. The price finally peaked at 1,100 livres on 8th January 1720.
By late-1719, Law found it increasingly difficult to sustain the bubble. The best part of a billion livres had been created and spent in ramping the shares. However, Law was appointed Controller-General in January 1720, and one of his first acts was to decree that his banknotes were the only permitted currency, except for small transactions, and all old coins were to be handed in or seized, effectively reneging on the convertibility clause in his notes. In March he even banned the wearing of all precious stones, presumably in case their owners were tempted to use them as barter-money. The banknote issues continued.
On 22nd February 1720, the Mississippi Company and the Banque Royale merged. The King sold to the company 100,000 shares at 9,000 livres, about 5% under the market price, to be paid to him in instalments. Afterwards, the shares began their precipitous fall, and by May, Law lost his position as Controller-General and was demoted. By the end of October, the shares had fallen to 3,200 livres, and a large portion of them had faced further unpaid calls throughout that year.
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The year 1719 saw monetary inflation take off, directly fuelling asset prices. The decline of the Mississippi share price the following year was not as sharp as might otherwise have been expected, but against that must be put the fall in the paper livre’s purchasing power, particularly in the later months. The exchange rate against English sterling fell from nine old pence to 2 ½ pence in September, most of that fall occurring after April as the price effect of the previous year’s inflation worked its way through into the exchange rates. The prices of goods had risen sharply in Paris, where fortunes were being made, and those price rises spread outwards, initially to the other centres where a bank branch existed, and then increasingly into the regions.
In the last three months of 1720 there was no sterling price quoted for paper livres, indicating they had become worthless, as the public lost all confidence in them.
The lesson for today
Scientists often set up a laboratory simulation to assess the likely outcome of a real situation. A laboratory simulation was, in effect, done for today’s economists by John Law exactly three hundred years ago.
In many senses, the Law episode was a perfect replication of the current situation. Law convinced himself that France’s economic problems could be resolved by the expansion of unbacked paper money, just as mainstream economists do today. At the heart of Law’s experiment was a belief that the state should control the money, and it was not to be left to the choice of the markets. Law defied the established monetary wisdom of the day, just as Keynes did when he set Say’s law to one side so as to create a role for the state.
The time-scale of Law’s simulation was considerably shorter than the paper money experiment of today, which we can assume started proper when President Nixon abandoned all dollar convertibility into gold in 1971. Law took the French economy from one based on sound money, through the inflation of unsound money and to monetary collapse from 5th May 1716 to November 1720, when there was no sterling exchange price for the collapsed livre. The credit cycle had lasted just four and a half years. That compares with forty-seven years for today’s experiment with unsound money, and still counting.
So, what did the John Law experiment tell us? It confirmed that monetary inflation, in the form of both narrow money and bank credit, becomes a treadmill from which escape is difficult, or even impossible. Once the Regent authorised the further issue of a billion livres when the private Banque Generale became the official state bank, the dice were cast. As Banque Generale, the Regent could have disassociated himself from the bank; but as Banque Royale, his own future was tied in irrevocably with Law’s scheme.
The Regent had been convinced by an apparent expert that there was a solution to the insolvency of the state. The financial position of France at that time is similar to many countries today, where government expenditures are within a few per cent of tax revenues, apart that is, from the interest cost of the government’s debt. John Law sought to reduce the annual interest cost of the government’s debt from over 7% to 3%. The ECB has done somewhat better for the spendthrifts in the Eurozone, using similar if less spectacular means.
Another common feature is the deliberate use of monetary expansion to create a feeling of well-being through asset inflation. There was an initial asset inflation, more deliberately executed in John Law’s case than is the case today. But the introduction and continuation of quantitative easing in the last ten years has the same intention. Asset inflation in Paris was accompanied, if only a step behind, by price inflation. It then extended to the other cities where Banque Royale had branches. We have seen this today, with prices of ordinary goods and services significantly higher in financial centres, such as New York and London, these higher prices then spreading to other financial and commercial centres as well.
Today, the cycle of asset inflation, morphing into price inflation has so far always led to a credit crisis, but each of these crises can be regarded as a minor version of Law’s French experiment. They start with the expansion of unbacked paper currency, leading to asset price inflation, which feeds into price inflation, then a credit crisis. These cycles have so far not developed into bubbles as destructive as that of John Law’s, but the distortions have been allowed to accumulate successively over each credit cycle. Consequently, the collapse following the inflationary puff seen in France during 1720 has not yet been seen today.
That time appears to be approaching with the post-war inflationary bubble becoming increasingly difficult to sustain through successive credit crises. Both the expansions of base money and of bank credit in the last credit cycle were unprecedented, and the situation has become more unstable since. The message from Law’s experience is the collapse of the entire fiat money system is unavoidable and probably close. And when it happens it will destroy exposed paper currencies more rapidly perhaps than anyone expects.