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.