Alternative Academic Thinking...

Kindleberger (1978) argues the Mississippi bubble was “fuelled by monetary expansion in France that supported a high head of speculative steam”.He claims that the Mississippi Bubble follows his own thesis that “most price bubbles are international disturbances transmitted among two or more centres that lead to irrational and overzealous trading in each” (Kindleberger, 1978).  You can read more about kindleberger here.

 His theory is backed up by the exchange rate evidence presented by Neal and Schubert (1985). They find the existence of speculative bubbles in the prices of Mississippi stock. This is concluded from the “relative stability of dividends actually paid out compared to the volatility of the stock prices”. However Flood and Garber (1982) argue that the price movements could also be explained through changes in the market fundamentals.

 Neal and Schubert (1985) believe that portions of the Mississippi Bubble could actually be described as a rational bubble. However they agree that it is just as likely that is the result of manipulation of market fundamentals. Neal and Schubert (1985) note that rational bubbles seem to appear when there is two distinct sets of investors who co-exist for a brief period of time. These investors may be differentiated by many things including the quality of the information they hold, their attitude toward risk, or maybe even by their time horizons. The two sets of investors work in the same way but, importantly, at different points in time, leaving their unique mark on the stock prices, but only in certain time periods.
 
The theoretical literature of bubbles states that a bubble occurs “when the expected rate of change in the price of an asset is an important factor in determining the current market price” (Neal and Schubert, 1985). It is clear that in France during 1719 and 1970 the asset prices changed enough to alter the expectations of investors. Neal and Schubert (1985) believe the real question is whether the Mississippi Bubble can be considered to be rational or not.

 Neal and Schubert (1985) present an equation to calculate the returns. You can see the full article here. They describe how investors see a capital gain above the market fundamental if the bubble continues or a return to zero gain if the bubble bursts. Therefore longer the bubble lasts the higher the capital gain must be to compensate for the increasing chances of a crash.

 According to Tirole (1982), a rational bubble must meet two further terms. Firstly, expectations must be myopic i.e. successive traders must only use the expected trading options in this period and the next to make their decisions. Secondly, there must be several ‘generations’ of traders entering the market. Both of these terms were present in the Mississippi Bubble so was it a rational bubble or not?

 Neal and Schubert (1985) conclude that although the bubble may have had significant periods of rationality, these did not coincide or even overlap.

 
Bibliography:

Flood, R. P., & P.M. Garber (1982) Bubbles, Runs and Gold Monetization, in Paul Wachtel, ed., Crises in the Economic and Financial Structure, Lexington books, Lexington, Massachusetts.

 Kindleberger, C. P., (1978) Manias, Panics, and Crashes, New York: Basic Books.

 Neal L. & E. Schubert (1985) “The First Rational Bubbles: A New Look at the Mississippi and South Sea Schemes”.Working Paper No. 1188.

 Tirole, J., (1982) "On the Possibiblity of Speculation Under Rational Expectations", Econometrica, 50, pp. 1163-1181.

 

Garber's Research

Many economists have different view on the Mississippi Bubble. There are different opinions surrounding the Mississippi Bubble, especially about whether you could actually classify the Mississippi Bubble as a ‘bubble’. 

One of the most important academics in the area was Peter Garber. He conducted significant research on the Mississippi Bubble, as well as others, and presented his paper “First Famous Bubbles” in 1990. You can read the full paper here.

Garber (1990) gives an explanation of how the Mississippi Bubble simply started from a company that “sought rapid expansion of its balance sheet through the acquisition of government debt and was financed by successive issues of shares”. He explains that each new issue of shares were offered at continuously higher prices. This means that the purchasers who bought shares in the last issue incurred the greatest losses when stock prices fell, while the initial buyers generally gained as they had sold their share off again to make a quick profit.

Adam Anderson (1787) presents a great description of the ‘speculative dynamics’ which occur when a “sequence of investors buys equal shares in a venture”. He explains how the price of the shares increase with each round of shares issued, until the ‘crash’ when the share price drops. When this occurs, it’s the investors who bought shares last that will lose the most, with the first shareholders loosing very litter, or even making a profit from selling quickly.

Garber (1990) asks why we, as outsiders, do not interpret this sequence of transactions as a bubble. He believes that the most important reason for this is the “intrinsic value of the venture from the point of view of the new investor”. He presents five situations for investments and explains that it is only the final situation that can be classified as a ‘bubble’. The five situations are as follows:

1) The new investor bases their decision on their perception of market fundamentals. This is a situation of asymmetric information which allows one player to have an incentive to mislead.

 

2) The original investor can use initial proceeds to pay dividends, providing great evidence of the abundant prospects of the venture to new investors. Garber (1990) calls this the ‘Ponzi Scheme’ but argues the new investors are still acting on their own perception of market fundamentals and so is not a bubble.

3) There may be a situation where the future earnings actually materialise and satisfy all investors. In this case the sequence of stock issues at increasing prices would be perfectly acceptable.

4) The future earning may be based upon the best evidence but may still fail to materialise. Garber (1990) states that if the investment seemed sound in the beginning and only seemed foolish in hindsight then it should be classified as being driven by market fundamentals.

5) The final situations is one in which the investors understand that there will be no large dividends, but that there will be a sequence of share buyers at ever increasing prices. The investors simply ‘take a gamble’ hoping they will not be the last investor in the sequence. This is what modern economists call a ‘bubble’.

So now that we know the situation in which a bubble occurs, can we say the Mississippi Bubble was actually a bubble?

Garber (1990) believes that we need to look at the reasons behind the John Law’s actions. He believes that Law merely proposed a monetary theory in a situation with unexploited resources. Behind the crisis John Law actually had good intentions i.e. he wanted to revitalise the French economy through financial revolution and fiscal transformation. We have to agree, even today, that his theory was actually quite good. Garber (1990) explains how the French investors could see Law rise to power and with each step his ‘economic experiment’ looked even more likely to become a reality. He believes the investors simply had to factor in the possibility of success into the share price, and personally I have to agree with him. I think I would have most likely invested in Compagnie des Indes if I had been there at the time… how could you not?

Garber (1990) argues that just because Law’s promised profits did not materialise does not imply that a bubble occurred. It was only after Law experiment was carried out that the investors could have known that there was problems. According to the modern day definition of a bubble, the events of the Mississippi Bubble are easily explainable on the basis of market fundamentals.

For a finance operation to be successful a degree of confidence from investors is essential. Garber (1990) explains that in any leveraged buyout or acquisition, high security prices must come first and growing revenues will follow. A profitable shake-up could turn to disaster if the investors were to lose confidence. Garber (1990) describes how Law’s principle was also that the finance should come first, i.e. “the financial operation and the expansion of circulating credit was the driving force for economic expansion”. This idea is still well established in recent literature.

In conclusion Garber (1990) believes that the Mississippi Bubble was much more than a simple bubble. In my next post I will look at other academic ideas on the Mississippi Bubble.

 
Bibliography:

Anderson, A., (1787) An Historical and Chronological Deduction of the Origin of Commerce, vol. 3. London: J. Walter.

Garber, P.M., (1990) "Famous first bubbles," Journal of Economic Perspectives, vol.4, 2.

The Crash

When we left of the story in January 1720 the price of Compagnie shares were falling in price. A slight ‘scandal’ occurred in May and Law decided to devalue the shares. He did this in several stages as well as devaluing the bank notes by 50%. By this stage the French realised that their supposed metal rich colonies in the Mississippi Valley actually lacked any worthwhile deposits. As you can imagine this did not go down well with the investors. Law then suspended payment in the precious metals but he promised the value of the bank notes would be upheld. This also was not well received by the French public and investors started selling their shares. By December 1720 shares had fallen to only 1000 livres, 10% of what they were only 12 months previous.

John law was now loathed by the French people, who believed they had been ‘scammed’ out of their hard earned money (remember a lot of those who became rich quickly had been very poor just a few months previously). The decrease in share price allowed Law’s rivals to swoop in and take almost two-thirds of the investor shares. By September 1721 the price of a Compagnie share was only 500 livres, not far off where they began almost two years before.

Not too long after John Law escaped France. It is said that he did so dressed as a woman for his own safety! He spent the rest of his days travelling Europe, gambling to get food where he could.

The Banque Générale was closed for a few months but reopened and believe it or still exists to this day, although it’s now called Banque de France. However it around 80 years before the French reintroduced paper notes.

The collapse of Banque Générale and the Compagnie des Indes concludes the story of the Mississippi Bubble. Adolphe Thiers wrote a book on the events of the Mississippi Bubble in 1859, entitled ‘The Mississippi Bubble: A memoir of John Law’. To read the full story in more detail you can download a copy here.

In a turn of rather bad luck Britain’s South Sea Bubble popped at around the same time. You may be interested to know that even Isaac Newton tried to ride the South Sea Bubble. Kindleberger (1978) notes that he managed to get out of the market with a profit of £3,500 but decided to re-enter and lost £20,000. "He concluded, 'I can calculate the motions of the heavenly bodies, but not the madness of people'" Kindleberger (1978).

The combination of the two sent a number of European countries, including France, into a severe depression.

Quite naturally the French did not exactly appreciate John Law, and even today the name isn’t well received in France. However were his actions really that immoral?

Below is a great video telling the story of the Mississippi Bubble if you don't have the time to read the full story!

Or if cartoons aren't your thing MacKay has written a great account of the Mississippi Bubble, you can get it here. It is quite long but definitely worth the read. However, take note, as some writters claim he is too interested in story telling and makes no real attempt to understand or analyze the true events.

In my next post I will have a look at some of the academic thinking surrounding the Mississippi Bubble.


Bibliography:

Kindleberger, C. P., (1978) Manias, Panics, and Crashes, New York: Basic Books.

Thiers, A. (1859) The Mississippi Bubble: A Memoir of John Law, New York: W.A. Townsend & Company.



Was Everything as Rosy as it Seemed?

As I previously explained John Law paid for his ‘empire’ by issuing shares in the Compagnie des Indes. These shares could be paid for with bank notes (from his own bank) or with government debt. In January 1719, the shares were selling for 500 livres each, livres being the French currency at the time. The subsequent 12 months saw extraordinary growth, with the shares reaching an unbelievable 10,000 livres per share by December 1719, a 2000% increase! You can read more about the financials in a great article by Dave Smant. He estimates that the Compagnie would have had annual net revenues of 80,500,000 livres! You can read his article here.

Investors were getting slightly over excited by the potential value of trade. This was because of the promise of gold and silver from the French colonies due to the monopoly of trade they had acquired. Investors were not just from France, but from all corners of Europe. It got to the stage that soldiers were needed to maintain order in the financial district of Paris

John Law’s life had been transformed. He went from a broke gambler to one of the wealthiest men in Europe with significant power within the French government. It was not just the well-off that could invest in Compagnie des Indes, but people across all social classes. This caused many off the poorer people in France to become quite rich in a very short space of time. This is where the French word "millionaire" is said to have originated as so many people were becoming rich so quickly.

Source: Garber (1990)

You can access the full article here.

The huge demand for Compagnie des Indes shares resulted in the amount of bank notes increasing by 186% in just one year. This was because the Banque Générale issued as many notes as was demanded by the public. This resulted in serious inflation during which the price of goods doubles in just 18 months from July 1719 and December 1720. This inflation also affected the share price of Compagnie des Indes.

The problems really started by Law’s eagerness to print more paper notes to fund purchases of shares. In no time the Banque Générale far too many notes, well above the equivalent amount of gold and silver-based legal tender they kept in reserve for one who wanted to redeem their notes. Law probably thought he could fill this gold and silver deficit by importing it from the metal rich colonies in North America.

By January 1720, the price of shares began to fall as some investors ‘making a quick buck’ sold off to take profit in the form of gold coins. Law tried to prevent this by limiting payments in gold to more than 100 livres. However this was only the start of John Law’s problems. I will conclude the story in my next post.


Bibliography:

Garber, P.M., (1990) "Famous first bubbles," Journal of Economic Perspectives, vol.4,2.

The building of John Law’s Empire

Our story continues from the Banque Generale, which John Law established in May 1716. As already explained this bank took deposits of gold and silver and issued paper money in return. These banknotes were then redeemable in the metallic currency. The Banque Generale was able to build equity through the selling of shares as well as through managing the finances of the French government. To give John Law some credit, the French economy actually started to stabilize. This in turn helped to increase Law’s influence within the French government.

In the year 1717, John Law used his growing connections to acquire a struggling trading company, the Mississippi Company, which he then renamed “the Compagnie d’Occident” (the Company of the West). Law was granted a trading monopoly for the trade between France and its Louisiana and Canadian colonies. This colony stretched for almost 3,000 miles from the mouth of the Mississippi River reaching parts of Canada. It included the present-day states that hug the river: Louisiana, Mississippi, Arkansas, Missouri, Illinois, Iowa, Wisconsin, and Minnesota. These colonies were considered to be valuable for their abundance of resources such as beaver skins in Canada and precious metals in Louisiana.

 Source:Wikipedia:New France

 

The scheme to finance the initial operations of the Compagnie d’Occident’s was simple. Law would raise the money by selling shares in the company for cash and, more importantly, for state bonds. Law accepted a low interest rate on the bonds which helped French finances while promising the company a more secure cash flow. In September 1718 the company acquired the monopoly in tobacco trading with Africa. In May 1719 Law obtained control of the companies trading with China and the East Indies. He then renamed the entire business interest the “Compagnie des Indes (“Company of the Indies”). This meant that Law now controlled all of the trade with France and the rest of the world outside of Europe.

The next step was to purchase the right to mint new coinage, in July 1719. Law then turned his attention to taxes and by August 1719 the Compagnie had the right to collect all French indirect taxes and by October 1719 the Compagnie took over the collection of direct taxes. Law’s last move was to restructure most of the national debt. He developed a master plan whereby the remainder of existing government debt would be exchanged for shares in Compagnie.

In January 1720, Law became the Controller General and Superintendent General of Finance.  His empire was taking shape as he now controlled all of France's finance and the creation of money as well as the company that handled all of France's foreign trade and colonial development. He was able to create a stable source of income for future business ventures by holding much of the government's debt. It can certainly be said that he had developed a huge amount of power.

By this stage everything was going so well for John Law. so much so he wrote a book entitled 'A full and impartial account of the company of Mississipi, otherwise call'd the french East-India company, projected and settled by Mr. Law'. You can read it here, and don't worry, it's in French and English!

Law paid for his ‘empire’ by issuing additional shares in the company. These shares could be paid for with bank notes (from his own bank) or with government debt.  It is these shares that will be significant factor in the fall of John Law and it is from this point that I will continue from in my next post.

Setting the Scene: The French Economy in 1715 and an Introduction to John Law

The story of the Mississippi Bubble begins in 1715. At this time the French economy was a complete shambles. It was suffering from the actions of Louis XIV, who apparently didn’t have any control when it came to spending. The country’s economy was also crippled by the huge debts incurred during the War of Spanish Succession. It was never going to work out and soon after the government started defaulting on a portion of its debts. They tried a number of solutions including lowering interest payments and raising taxes to extremely high levels. However these rash actions lead to a depressed French economy and as a result the value of its currency, which was backed by gold and silver, started to fluctuate violently.

Another slight problem the French were experiencing at the time was the fact that their King Louis XV was only five-years old. In a sensible move they appointed a group of regents to act on his behalf. These regents desperately tried to find a solution to the nation’s fiscal and economic misery. The leader of the group of regents was the Duke of Orléans, and it was he who introduced the significant man in this tale, John Law. Law was a close friend of the duke, who decided to seek his advice on France’s problems. John Law was a Scottish financier and an early theorist of monetary economics and the duke though this financial expertise could help straighten out France's financial mess.

Our key man John Law was born in Fife, Scotland to a wealthy family of bankers. He showed mathematical genius from an early age and when he turned fourteen he became his father’s apprentice and studied banking. Law travelled to London where he used his mathematical abilities to earn a living as a gambler. He was quite the ‘womaniser’ and got himself into a duel over a certain lady and decided they best way to win was just to kill his opponent. He was charged with murder and sent to prison, but managed to escape to mainland Europe, where he studied finance in a number of cities. In 1705, Law published an academic paper in which he argued against the use of precious-metal backed currency. He claimed that instead we should be using "paper" or fiat currency as this would stimulate commerce.

In 1716 when the duke came looking for Law, he decided he would use this as an opportunity to test out this theory. He managed, almost immediately, to convince the French government to let him open a bank, the Bank Générale . This bank took in deposits of gold and silver and issued paper bank notes in return which would circulate as a medium of exchange. Law alleged that these paper notes would increase the money in circulation and increase commerce, and so would recover the state of the French government finances. Below is a scan of one of the notes from Bank Générale  that still exits. This was taken from an auction site and you can purchase one of your own for $1000-$2000.

 Source: icollector.com

I will pick up the story from this point in my next post and explain the significance of the "Compagnie d’Occident" to the Mississippi Bubble story.

Brief Overview of the Mississippi Bubble

The Mississippi Bubble was an economic bubble that occurred in France in the early 1700s. It developed around the same time as Britain’s disastrous South Sea Bubble. The ‘brains’ behind the Mississippi Bubble was a Scottish financier, John Law. He was described as a ‘gambler and playboy’ who managed to get himself into the highest levels of French public finance.  Law used his friendship with the ‘Duke of Orléans’ to achieve his dreams. 

John Law became the 'go-to guy', the French government’s number one financial advisor and he used this position to open a bank, the Banque Générale. This bank had the authority to issue ‘paper’ money i.e. bank notes. Law later formed the Mississippi Company, subsequently known as "the Compagnie des Indes", which was granted control of the development of France’s extensive territory in North America.

This American land was very new to the French people and most knew nothing about it. However they did believe the rumours that this land was rich in silver and gold,which happened to be the French currency at the time. This led investors to bid Compagnie des Indes shares up to crazy heights. Unfortunately, the company’s prediction turned out to as wrong as could be and the shares crashed. This crash led to a downturn in France’s stock market and even severely affected public finances. You can read a very good overview of the Mississippi Bubble here.

I will subsequently explore the Mississippi Bubble in more detail explaining the events leading up to the bubble, the actual bubble phase, the crash and the lasting effects on our world today.

 

Introduction

Our recent financial crisis has resulted in the collapse of large financial institutions, the bailout of a number of banks by government, and a decline in stock markets all over the world. Not only that, it has also contributed to high unemployment, failures of many key businesses and retailers as well as declining consumer wealth. Was this all caused by a simple bubble bursting? This is not the first financial crisis to affect Britain and it most likely will not be the last. Financial crises can take a form of a crash, a bubble (i.e. a mania), a banking crisis, a recession or in the worst case a depression.

 

 

Kindleberger (1987) defines a bubble as “as a sharp rise in the price of an asset or a range of assets in a continuous process, with the initial rise generating expectations of further rises and attracting new buyers – generally speculators, interested in profits from trading in the asset rather than its use or earnings capacity”. This definition implies that during a bubble the price of the asset rises above its ‘fundamental value’, which is usually followed by a reversal of expectations and a sharp decline in prices (i.e. a crash).

A bubble can be classified as either a financial asset bubble or a real asset bubble. Financial asset bubbles are those which relate to stocks whereas real asset bubbles are those which relate to anything else other than stocks i.e. commodities and real estate.

This idea of bubbles dates back many centuries with the very first bubble occurring as early as the 17^th century. This first bubble was Holland’s Tulip Mania in the 1630s. Next was the South Sea bubble and Mississippi bubble in 1720, followed by the Railway Mania in the 1840s. Garber provides a great explanation of these first few bubbles in his paper 'Famous First Bubbles'. You can read the full article here.

After, came the Stock Market bubble (Wall St. Crash) in 1929 and the Great Depression in the 1930s. More recently was the Dot-com bubble in the 90s and the very familiar Housing bubble in 2005 and ‘Credit Crunch’ (2007-08).

The Mississippi bubble led to a great stock market crash in Europe in 1720. It originated from a Scotsman in France trying to start his own company. In my blog I am going to investigate the Mississippi bubble in greater detail explaining why it happened and what effect it had on Europe.



Bibliography:

Kindleberger, C.P. (1987), "Bubbles", in The New Palgrave. A Dictionary of Economics, edited by J.Eatwell, M. Milgate and P. Newman, MacMillan, London.

Garber, P.M., "Famous first bubbles," Journal of Economic Perspectives, vol.4 (2) Spring 1990