John Law – 300 years on
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.[i] 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[ii]
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.[iii]
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.[iv]
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.
Comment
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.[v]
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.[vi] 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.