Author: Self-Control
Reviewers: Guanfu · Juntian

  Correction: In the previous installment, we said that John Law solved the government’s long-standing debt problem once he had replaced metallic money with paper currency. That was not in fact the case. His measures only eased the pressure of government debt to some extent, and we have corrected this point in the article below.

  In the previous installment, we described how John Law replaced metallic money with paper currency and strictly controlled the bank’s reserves to preserve confidence in it. He promoted paper currency through tax measures, successfully revitalizing the French economy. Paper money’s portability and low transaction costs also helped the economy grow rapidly. As his second step, Law established the Mississippi Company. To develop the rich mineral resources of the Mississippi River basin in North America, the French government issued a trade charter in 1717 authorizing him to establish a commercial company with a monopoly over trade throughout the river’s vast watershed; hence the name Mississippi Company. Its initial capital was 100 million livres, divided into 200,000 shares at 500 livres each. Shares could be purchased at face value with treasury notes. Soon after its establishment, the company received further privileges, including the right to collect taxes and mint money. State backing, together with continual reports that the Mississippi basin was filled with precious-metal deposits, made its shares enormously popular. Because shares could be exchanged for an equal face value of treasury notes, government debt also continued to fall. As demand for the shares grew, the government instructed the General Bank—which had by then been renamed the Royal Bank—to issue another one billion livres in banknotes. The sudden increase in market liquidity began to inflate a stock-market bubble. At this stage, money primarily drove share prices: as vast quantities of money entered the market, prices rose with them. The Mississippi Company, whose prospects then appeared highly favorable, could also use its shares to absorb surplus funds from the market, preventing the government’s large-scale money issuance from immediately producing severe inflation. This became one of the pillars supporting the financial bubble’s later expansion.

Background to the Mississippi Bubble

  In 1917, two large new share issues by the Mississippi Company sent the financial bubble into a phase of rapid expansion. Early in 1917, the French government issued a proclamation granting the company additional monopolies over trade with the East Indies, China, the islands of the South Pacific, and the territories administered by the French East India Company. The company then decided to issue 50,000 new shares to expand its capital and promised a very high dividend rate. These shares, too, could be purchased at face value with treasury notes whose market price was steadily declining; by this calculation, the return on each share was reportedly as high as 120%. The shares’ high returns, coupled with the government-controlled General Bank’s continuing expansion of banknote issuance, further inflamed enthusiasm for stock-market investment. The prices of both old and new shares rose rapidly, and the bubble grew with them. In the same year, with the aim of eliminating the government’s debt burden altogether, the Mississippi Company decided in 1719 to issue another 300,000 shares at 5,000 livres each, totaling 1.5 billion livres. All could be purchased at face value with treasury notes. To support this bold plan, the General Bank, with government authorization, issued another 1.5 billion livres in banknotes, driving the company’s share price still higher. The entire market was now gripped by a frenzied investment boom. Mississippi Company shares soared, sometimes rising by 10 to 20 percentage points within just a few hours. The excessive influx of money also produced severe inflation and sharply rising prices. Throughout this process, money served mainly to sustain expensive shares and keep driving their prices upward. As the company issued ever more shares, a continual flood of funds into the stock market was required to prevent prices from falling. Yet that enormous volume of money itself became the “fuel” propelling prices still higher. At the same time, the vast sums continually issued by the bank were not fully absorbed by the stock market. The remaining money far exceeded the economy’s actual monetary needs, resulting in severe inflation and rising prices.

  This ultimately prompted frequent attempts to redeem banknotes. Because the bank had repeatedly issued money in excess, the notes in circulation far outstripped its reserves. After several redemptions failed, panic gradually spread. News also arrived from the Americas that the Mississippi River basin did not, in fact, contain the abundant precious-metal deposits that had been claimed. Mississippi Company shares, already at extremely high prices, began to fall, deepening the panic. People rushed to exchange their banknotes for metallic money, and as redemptions intensified, the notes depreciated. To restore confidence in them, the French government issued three successive decrees around February 1720. It first devalued metallic coinage and then prohibited people from holding more than 500 livres in coins. Perplexingly, even as it issued these decrees, the government continued to expand the volume of banknotes. Public distrust grew, and attempts to cash out through every available channel became increasingly common. Faced with a situation it could no longer reverse, the French government was forced in October 1720 to abolish the circulation of banknotes and strip the Mississippi Company of all its privileges. The stock-market bubble soon burst, inflicting enormous losses on French society and the economy. At this stage, money mainly served to deepen the crisis, just as it had helped create the bubble, but the positions of banknotes and metallic money had reversed. Oversupply of notes and the stock-market collapse destroyed confidence in their value, causing them to depreciate rapidly. The bank’s money supply had also far exceeded the limit imposed by its reserves, making redemption difficult and accelerating the depreciation. As the value of banknotes collapsed, so did the wider economy. Many businesses and commercial ventures built on support from the enormous money supply faced collapse and bankruptcy; because there was nowhere near enough metallic money to redeem all the notes, the wealth of many ordinary people also shrank.

After the crisis, people produced images satirizing John Law's paper money

After this frenzy, France entered a century-long period of distrust toward finance and credit. This greatly delayed the development of its capitalist economy and gradually placed it at a disadvantage in overseas colonization, creating an opportunity for Britain to build the empire on which the sun never set. Later economists still counted John Law among the important economists of his age, but a close look at his economic thought reveals many incomplete ideas and an extremely limited understanding of money’s value and functions. This was one of the roots of the disaster he eventually orchestrated. A gambler opened a bank, rose to high office in a country, and toyed with untold wealth—a spectacle that could only leave people astonished. Law spent his later years in Venice. It is said that many valuable works of art were found in his home when he died, suggesting that he still lived quite comfortably in old age; compared with his former glory, however, they were probably only a tiny fraction. After his death, the French supplied him with a rather curious epitaph: “A famous Scotsman lies here,
His gift for arithmetic had no peer,
With simple rules of algebra,
He left all France gravely ill.”

References

  • “Misleading Monetary Policy: The French Mississippi Bubble,” Jiang Lichang, Urban Finance; “Echoes of History: The Mississippi Bubble,” Amy Farber, Financial Market Research; “John Law: Child of the Storm, Born of Crisis,” Zhang Pingping, New Industrial Economy
  • Images sourced from the internet