Learning from past investment manias - AME Info FN

From time to time a wave of optimism spreads around the world like a bush fire. People believe that they are seeing the dawn of a new era, which will bring unimaginable riches and prosperity to all.

Waves of new era thinking are usually associated with discoveries (the Americas, gold deposits in California), the opening up of new territories (the Western territories of the US, the opening of China in recent years), the application of new inventions (canals, railroads, the automobile, radio, PCs, the Internet, wireless communication), the rise in the price of an important commodity (rubber at the beginning of the 20th century, oil in the 1970s), peace treaties (the breakdown of communism), or strong economic performances.

A typical feature of new era thinking is that it usually engulfs a country or the world not at the beginning of an era of prosperity, but towards the end of such a period and is associated with some sort of a 'rush' or investment mania. One of the most well known examples of this phenomenon is John Law's Mississippi Scheme.

In 1716, Scottish adventurer and professional gambler John Law opened the Banque Generale in Paris under the patronage of the French Regent, which issued paper money backed by gold and silver. With the Regent's backing the bank became an immediate success. And in 1717, John Law launched a new venture, the Mississippi Company, which obtained from France the monopoly of all commerce between France and French territories in North America in return for accepting the outstanding notes of the French Government for the payment for the Mississippi shares.

This arrangement was designed to induce a conversion of France's government debt into the shares of the Mississippi Company. Initially, the Mississippi Company was not profitable, because only very few French people wanted to immigrate to America and by 1719 the shares of the Mississippi Company had declined to 300 livres, down from the issue price of 500 livres. It is at this point that John Law had a great idea.

First he announced that he would pay in six months' time 500 livres for a certain number of shares in the Company. The public immediately realized that if the promoter of the Company was willing to pay almost twice the prevailing price for the stock six months later, it must be because he knew of some favorable developments.

Therefore, investors began to buy the shares of the Mississippi Company and pushed up its price. Thereafter, John Law, took over other businesses including the tobacco and coinage monopoly in return for assuming the entire French national debt, which amounted then to 1.5 billion livres. The scheme was brilliant.

The Mississippi Company would pay the French government 1.5 billion livres, in return the government would repay its creditors who would then invest the money they received in the shares of the Company, which were offered to them at less than their value, as John Law argued. The scheme worked perfectly well for a while, as each time the Company announced some new venture additional shares were issued at higher and higher prices, which attracted a larger and larger number of speculators to participate in the mania.

In particular, the public's enthusiasm was fueled by the government, which had begun to run its money printing press round the clock in the belief that the public had gained sufficient confidence in paper money. As a result, the government increased the money supply in 1719 dramatically and pushed down interest rates by lending money for as little as 1% or 2%. In addition, the Mississippi Company extended credit to the buyers of its shares.

The aim of these measures was clearly to manipulate the shares of the Mississippi Company to higher to higher prices. Indeed speculation spread and people from all over Europe traveled to Paris to speculate in the shares of the Mississippi Company. John Law was by then enjoying enormous prestige, because even poor people had made fortunes by speculating in the shares of the Mississippi Company and the increased money supply had led to an improvement in business conditions. According to John Law, the gates of wealth were now open to the entire world and this was what distinguished the fortune of his new financial administration.

Alas, the vast increase in the supply of paper money combined with the ability to purchase shares in the Mississippi Company on credit led not only to the shares rocketing towards the end of 1719 to over 20,000 livres, from 300 at the beginning of the year, but also to rapid price increases across France. Bread, milk and meat had rose within a short period of time by six times while cloth shot up by 300%. The result of this horrendous inflation made the holders of Mississippi shares and of paper money nervous and in January 1720, just two weeks after John Law had become finance minister, a number of large speculators decided to cash out and switch their funds into 'real assets' such as property, commodities and gold.

This drove down the price of the Mississippi shares and pushed up the price of land and gold, as confidence in paper money was waning. This unfortunate turn of events forced John Law to take some extraordinary measures. In order to prevent people from turning back to gold - since by then the Banque General had only 2% of its assets in gold he announced that hence only banknotes were legal tender and that the ownership of gold exceeding 500 livres in value was illegal.

Furthermore, he announced the merger of the Bank Generale and the Mississippi Company and opened a bureau of conversion where the shares of the Mississippi stock could be bought and sold at 9,000 livres. By this measure Law hoped that speculators would hold on to their shares. But by then the speculators had completely lost faith in the Company's shares and selling pressure continued, which prompted the bank to increase once again the money supply by an enormous quantity.

The result was another round of sharply escalating prices (in four years the supply of circulating medium had been trebled). John Law now suddenly realized that his main problem was no longer his battle against gold, which he had sought to debase (as today's central bankers are trying), but that inflation was the real enemy.

He, therefore, issued an edict by which bank notes and the shares of the Mississippi stock would gradually be devalued by 50%. As one can imagine the public reacted to this edict with fury and after a short period John Law was asked to leave the country. Subsequently gold was again accepted, as the basis of the currency, and individuals could own as much of it as they desired. Alas, as a contemporary noted, the permission came as nobody had any gold left.

The saga of the Mississippi Company is historically relevant because it contains all the major features of subsequent manias including the latest one in the US. It starts with a displacement, which promises extraordinary profit opportunities and is then followed by overtrading, over-borrowings, the extension of risky loans, dubious accounting practices, speculative excesses, shady characters, swindles and catchpenny schemes.

Then follows the crisis during which fraud comes to light and finally, in the closing act, the outraged public calls for the culprits to be taken to account. In each case, excessive monetary stimulus and the use of credit fuels the flames of irrational speculation and public participation, which involves a larger and larger group of people seeking to become rich without any understanding of the object of speculation.

In particular, John Law's scheme reminds us of current central banks' policies who believe, as he did, that they can solve any problem by simply increasing the money supply. That such monetary policies will lead to the same price increases and currency depreciation, which at the time of John Law's Mississippi scheme destroyed people's faith in paper money and drove them to buy gold and real assets, ought to be clear.

Whether in future, when the gold price will soar and the dollar does collapse, our central bankers and government officials will conspire to expropriate investors' gold possessions, as John law did, remains to be seen. But we should not forget that in 1933, in the midst of the Depression, the US government declared the possession of gold by individuals to be illegal.