The South Sea Bubble and Law's Mississippi Scheme
"...History reveals a financial system based on paper money depends almost entirely on the confidence of the public in the currency that is issued by the monetary authorities, and that once confidence in a currency is badly shaken, painful consequences are inevitable. The reader should ask himself the question: for how much longer will foreign investors, which are financing the US trade and current account deficit, be willing buyers and holders of American stocks, bonds, and the dollar? Surely, there will be a time when, as was the case at the time of the Mississippi Scheme and the South Sea Bubble, the present 'chain letter' type of fiat money operation practised by the US Federal Reserve Board will no longer work and lead to a sharp depreciation of the US dollar..."
Dr. Marc Faber
[Editor's note: Admittedly, the following article is a bit long... and rather dense. But considering the apparent "success" of the Federal Reserve's reflation attempt - reflected in an 8-month bear market rally on Wall Street - no better lessons from history can be had than those of the South Sea Bubble and Law's Mississippi Scheme. And, of course, writers with the keen insight of Dr. Marc Faber are few and far between. So, if you're inclined, sit back with a hot beverage... and enjoy.
It's may also be worth noting, the bubble analysis you find below figures strongly in both Dr. Faber's best-seller Tommorrow's Gold, and our own, Financial Reckoning Day. Both books are available wherever books are sold.]
Hong Kong-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. Two of the most well known examples of this phenomenon are John Law's Mississippi Scheme and the South Sea Bubble, which occurred almost simultaneously in the early 18th century.
In 1711, the Earl of Oxford, better known as Robert Harley, established the South Sea Company in order to take over £10 million of government debt, which was converted into shares of the South Sea Company. In exchange, it received annual interest payments from the government and the monopoly to trade with the King of Spain's subjects in South America. In addition, a year later the company obtained the exclusive rights to sell slaves in South America. Right from the start the company enjoyed great prestige, but profits were elusive, because the Spanish King Philip V had refused to let the company send more than one cargo of merchandise per year to South America, and even from this slim venture, insisted on a share of the profits. Moreover, the "Assiento", the permission to transport Negro slaves to the South American plantations, was fraught with high risks, since many slaves died on the way, and the unarmed ships were frequently attacked by buccaneers or were driven away by the Spanish coast guards who participated in the slave trade by siding with privateers and pirates, and therefore didn't tolerate any competition.
On top of these difficulties, in 1715 the South Sea Company lost two of its founders, Lord Bolingbroke and Lord Oxford, both of whom were accused of treason. At this point, the company's directors thought it wise to interest King George in their affairs in the hope that he might secure them more advantageous terms with the King of Spain. Since the King had no wish to embroil himself in English business matters, the directors enrolled the services of the King's two Hanoverian mistresses, Madam Schulenburg and Madam Kielmansegge, both of whom were extremely greedy (as well as ugly), but had considerable influence over the King. As a result, the company eventually managed -- through political manoeuvring, bribes (paid in the form of shares in the South Sea Company to the two mistresses), and intrigue -- to get King George to accept the South Sea Company's invitation to serve as governor.
In the meantime, in France, a Scottish adventurer, John Law, who, having understood the laws of probability, had made a fortune as a professional gambler, opened in 1716, under the patronage of the French regent, a bank (Banque Générale) which issued paper money backed by gold and silver. (Since Louis XV was only five years old when Louis XIV died, the Duc d'Orleans was installed as regent.) John Law had been exiled from Britain for having killed a man in a duel and was later also banished from France for holding the view that paper money was superior to gold and silver. ("When blood does not circulate through the body, the body languishes; the same when money does not circulate.")
But in 1713, after the War of the Spanish Succession, he returned to France where, following the death of Louis XIV in 1715, he was successful in convincing the regent of the advantages of paper money and credit. In turn, the regent gave him permission to open a bank, which would issue paper money and guarantee that the issued paper money would always be redeemable into gold coins of a fixed weight (in principle, a private gold standard). The bank's capital was comprised of one-quarter in coin and three-quarters in government billets.
With the help of the regent, the bank became an immediate success. Its banknotes were very convenient, since the government accepted them for tax payments. (In 1718, the government even guaranteed the bank's obligations.) In 1717, based on this first success, Law managed to convince the regent to grant his new venture, the Mississippi Company, the monopoly on all commerce between France and its French territories in North America, which included the present states of Louisiana, Mississippi, Arkansas, Missouri, Illinois, Iowa, Wisconsin, and Minnesota, in return for accepting outstanding notes of the French government as payment for the Mississippi shares. This arrangement amounted basically to a partial conversion of France's government debt into shares of the Mississippi Company.
The operations of the company didn't prove to be profitable. In part, this was because when it issued shares, instead of cash it received only debts of the French government, which had been converted into shares in the company. Its lack of profitability was also due partly to the fact that very few French citizens wanted to emigrate to the territories in America. (In desperation, Law devised a scheme whereby imprisoned women and men were released on condition that they marry and emigrate to the New World. Such couples were paraded through Paris in chains, but it's unclear whether the chains were a symbol of marriage or were designed to prevent the newlyweds from escaping.)
By 1719, owing to the difficulties the Mississippi Company had encountered, its shares had declined to 300 livres, down significantly from the issue price of 500 livres. At this point, Law had a great idea: he announced that, in six months' time, he would pay 500 livres for a certain number of shares in the company. The public immediately realised that if the promoter of the company was willing in six months to pay almost twice the prevailing price for the stock, it must be because he knew of some favourable developments. Investors began to assume that future capital gains were almost a certainty and so gradually pushed up the price of the company's shares.
Law's Initial Public Offering (IPO)...
Following the announcement about the company's share price, Law, who was as great a talker and promoter as some of today's high-tech executives as well as being highly regarded, announced that the company had engaged in a series of new ventures and acquisitions with the support of the regent. In 1718, he had bought the monopoly on the tobacco trade, and in 1719 he purchased the French East India and China companies and acquired the coinage monopoly, the tax farms, and the national bank (Banque Royal) -- all in return for taking over the entire French national debt, which then amounted to 1.5 billion livres. The scheme was brilliant. The Mississippi Company would pay the government 1.5 billion livres; in turn, the government would repay its creditors who would then invest the money they received in the shares of the company, which Law offered to them at less than their value. The advantage for the government was that it paid only 3% interest on its debt to the Mississippi Company, whereas it had paid its public creditors 4%.
In turn, the advantage for the company was, as Law wrote, "that the creditors shall invest the money they receive in the shares which are now offered to them at less than their value. Thus they will be enriched while the State is relieved."
The scheme worked perfectly well for a while, as each time the company announced some new venture, additional shares would be 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 fuelled by the government, which had begun to run its money printing press around the clock. By then, the regent had taken over Law's bank (presumably given to him by Law in exchange for the latter having obtained so many privileges). But, whereas Law had always maintained a small balance of gold reserves to back the paper money the bank had been issuing, he now advised the regent that the public had gained sufficient confidence in paper money and that, therefore, gold reserves in the bank's vault were no longer necessary. (This rings a bell when one considers the recent gold sales by central banks.) As a result, in 1719, the government increased the money supply dramatically and lowered interest rates by lending money for as little as 1% or 2%. In addition, it became common practice that a buyer of the shares in the company could buy the shares on an instalment plan spread over 12 monthly payments (margin account).
The aim of these measures was clearly to manipulate the shares of the Mississippi Company to higher and higher prices. Indeed, a wave of unprecedented speculation spread through France, and people travelled to Paris from all over Europe to speculate in the shares of the Mississippi Company in the rue Quincampoix, where even common people made fortunes. (The word "millionaire" was coined at this time.) When aristocrats complained that their cooks had become "millionaires" by speculating and left their employment, Law wrote: "The gates of wealth are now open to all the world. It is that which distinguishes the fortune of the old administration from those of the present" (new era).
In fact, John Law was very generous to the aristocracy, on whose goodwill his scheme depended to some extent. He always reserved some shares for important people, which was similar to making large gifts of money or granting options on the shares of the Mississippi Company. Alas, the vast increase in the supply of paper money, combined with the ability to purchase shares in the Mississippi Company on an instalment plan (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. The cost of bread, milk, and meat had risen sixfold, while cloth was 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 been appointed comptroller general of finance (minister of finance), a number of large speculators decided to cash out and switch their funds into "real assets" such as properties, commodities, and gold. This drove down the price of the Mississippi shares, and since the speculators could only pay for real assets with banknotes, the price of land and gold soared, as confidence in paper money was waning. This forced Law, who at the time still enjoyed the backing of the regent, to take extraordinary measures. Two things had to be done: people had to be prevented from turning back to gold (since by then the Banque Générale had only 2% of its assets in gold); and the price of the shares of the Mississippi Company had to be stabilised. Thus, he proclaimed that, henceforth, only banknotes were legal tender. Payments in gold and silver above 100 francs were prohibited; in addition, the ownership of gold exceeding 500 livres in value was declared illegal.
Later, Law even abolished the use of gold and silver as specie (from May 1720, gold and silver would no longer be coined), and proclaimed that they would no longer be used to pay any form of debts, including foreign ones.
Severe penalties were imposed on people who hoarded gold. To enforce this most blatant expropriation, Law encouraged the public to turn informer by handing out large rewards to those who assisted in the discovery of gold, which was then confiscated. Moreover, Law implemented another even more desperate measure. Altogether, the Mississippi Company had issued 624,000 shares. Given a share price of about 10,000 livres, the market capitalisation was therefore around 6 billion livres (or about £300 million), a colossal amount at that time. Thus, the only way such a large market capitalisation could have been maintained would have been to pay a dividend. However, the company didn't even have sufficient income to pay a 1% dividend and was therefore in a precarious position.
Law then merged the Bank Générale and the Mississippi Company and announced that the price of the Mississippi stock would be fixed at 9,000 livres. In order to implement this measure, he opened a bureau of conversion where the shares of the Mississippi Company could be bought and sold in exchange for banknotes. With this measure, Law hoped that speculators would hold on to their shares and that, in future, the development of the American continent would prove to be so profitable as to make a large profit for the company's shareholders. However, by then the speculators had completely lost faith in the company's shares and selling pressure continued (in fact, instead of putting a stop to the selling, the fixed price acted as an inducement to sell), which led the bank once again to increase 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.
Law suddenly realised that his main problem was no longer his battle against gold, which he had sought to debase (as today's central bankers are trying to do); his real enemy was inflation. He issued an edict by which banknotes 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 Law was soon after asked to leave the country. In the meantime, 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 when no one had any gold left.
Meanwhile Across The English Channel
The initial success of John Law's financial dealings hadn't gone unnoticed in England. Inspired by Law's scheme, John Blunt, a shady character who was the dominant figure on the board of directors of the South Sea Company, obtained the right from the government to convert a large portion of the government debt into shares of the South Sea Company in return for the promise to pay the government £7.5 million. Blunt had beaten the Bank of England's proposal, which was similar in nature, because of the South Sea Company's excellent connections to influential politicians.
The King and his entourage were all richly rewarded (bribed) for their support. (Unlike the Mississippi Company, the South Sea Company was a fraud right from the start.) Blunt had spotted an opportunity to make a lot of money by having permission to issue £100 of South Sea stock for every £100 of debt it converted. At the time when a Parliamentary Act granted permission for the conversion, the price of the South Sea stock stood at £128. But assuming the price of the stock could be driven to £300, then, if an individual owning £1,200 of government debt wanted to convert, the company would have the right to issue 12 shares, but to give the creditor only four shares. The company could then sell the remaining eight shares in the open market and book the proceeds as profit. In fact, when the House of Commons passed the South Sea Bill, only the conversion price of the government's redeemable debt was fixed; the conversion of irredeemable debts or annuities was left open.
The success of this scheme obviously depended entirely on the shares of the South Sea Company rising in value. Fortunately for Blunt, everyone stood to gain from an appreciating share price. For the company, it meant that the higher the share rose, the fewer shares it had to exchange for annuities. As mentioned, the surplus shares could then be sold into the market and the proceeds booked as profit. In addition, the government and key politicians had an interest in a rising share price because, without a rise in the shares, the South Sea Company wouldn't have been able to pay the £7.5 million it agreed to pay the government for the right to this debt conversion scheme. Moreover, the company had secretly allocated shares to the Chancellor of the Exchequer, John Aislabie, the Postmaster James Craggs, the Secretary to the Treasury Charles Stanhope, and the King's two German mistresses. These shares were issued at a small premium to the prevailing market price, but the recipients didn't have to put up any funds and were therefore as interested in the company's share price going up as are today's executives, whose options incentive plans give them a vested interest in seeing their shares increase in value.
In April 1720, at about the time the Mississippi Scheme was already in deep trouble, the company placed two very successful issues of shares -- first at £300 and then at £400. However, the South Sea Company, unlike John Law, didn't have the ability to print money; in other words, it didn't have the power to increase the money supply in order to push up its share price. The unscrupulous Blunt soon found another way to ensure that the stock would rise: he announced that the company would grant loans to holders of the South Sea shares, and that for the purchase of a third issue of shares, in June 1720, at £1,000 only a 10% down-payment was required. Since the shares had risen from around £100 at the beginning of the year to close to £1,000, the public went wild. In the process, they bid up the prices of other rather suspect companies, such as companies "for insuring marriages against divorce", "for a wheel of perpetual motion", "for planting of mulberry trees and breeding silk-worms in Chelsea Park", and "for carrying on an undertaking of Great Advantage but no one to know what it is". Aside from these highly dubious undertakings, some companies, such as a "Company of London Adventures for the carrying on a trade to settling colonies in Terra Australis" and "Puckle's Machine Gun", were floated which had a vision but were ahead of their times, since Australia was only discovered by Captain James Cook about half a century later and the machine gun only made its appearance in the 19th century.
The Trouble With Bubble Companies
The problem with this flood of new "bubble companies", most of which were fraudulent, was that it endangered the South Sea Company, which depended entirely on a steady flow of new money to boost its share price in order to keep the party going. Therefore, in an attempt to reduce the number of competitors for the speculators' money, John Blunt issued writs against a number of companies, which he claimed were operating illegally. The Lord Justices ruled that, indeed, a few companies had been operating illegally, and subsequently the shares of "out-lawed" companies collapsed. However, as these companies' share prices collapsed, they triggered margin calls, since everyone had been investing on credit, and consequently also dragged down the shares of other companies, including the South Sea Company. Once the mood among the speculators had changed, nothing could stop the South Sea shares from experiencing a vicious collapse. Having sold for around £1,000 in July, they tumbled to £190 by the end of September.
Blunt, who had already cashed out of the shares, had in the meantime tried to arrange for an emergency loan from the Bank of England to stabilise the price of the South Sea shares at £400, but the bank backed out at the last minute, because of a further fall in the price of the South Sea Company. Following the collapse in the company's shares, an inquiry was launched, as the public and the landed gentry, which had suffered colossal losses, had become vindictive and were looking for a scapegoat. In the end, all the company's directors had to pay back most of the profits they had gained from the highly questionable practices the company had engaged in. Blunt was also called upon to testify, but at a first hearing he simply replied, to whatever question was asked, that he didn't remember. In the meantime, the treasurer of the company skipped town. After Blunt had been promised leniency, he finally testified, and at that point it became evident that the company had engaged in all sorts of schemes to defraud its shareholders to the benefit of close associates and the directors. The company was eventually wound up, with each shareholder receiving £33 for each share.
The Great Swindle
The Great Swindle, Virginia Cowell's excellent account of the events that surrounded the South Sea Bubble and the Mississippi Scheme was published in 1960, but her analysis is as sharp today as it was forty years ago. Although over the following 300 or so years the stage of investment manias repeatedly changed, the script, the accessories, and the nature of the actors participating in the bubble have largely remained the same.
The "bubble" model always involves a "displacement", which leads to extraordinary profit opportunities, overtrading, over-borrowings, speculative excesses, and swindles and catchpenny schemes, followed by a crisis during which fraud on a massive scale comes to light, then by the closing act during which 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.
The saga of the Mississippi Scheme and the South Sea Company is historically relevant because it contains all the major features of subsequent manias: shady characters, corruption, fraud, dubious practices, the creation of money and the extension of risky loans in order to keep the speculative orgy going, the catalyst, which leads to the initial collapse -- usually the revelation of fraud, the inability of a large speculator to come up with the money to meet a margin call, the revelation that insiders cashed out, or some adverse economic or political news -- and then the panic during which greed and euphoria are replaced by fear and the speculators' desire to get out at any price.
What is also important to understand is that both the promoters of the South Sea Company and John Law attempted to support the market at any cost, but at some point the market forces proved to be far more powerful than any price-supporting measures that could have been taken. In particular, John Law's policies remind us of current central banks' policies, the aim of which is to solve any problem the same way Law tried to solve the Mississippi Company's problem -- simply by increasing the money supply. That such monetary policies will lead to the same price increases, which, at the time of Law's Mississippi Scheme, destroyed people's faith in paper money, ought to be clear. Whether, at that point, current central bankers and government officials will conspire to expropriate investors' gold possessions, as Law did, remains to be seen, but we shouldn't forget that in 1933, in the midst of the Depression, the US government declared the possession of gold by individuals to be illegal.
I should also like to mention that during the booms in the shares of the Mississippi Company and the South Sea Company, there were critics, but no one wanted to pay attention to the party spoilers. The British ambassador to France, the Earl of Stair, resisted the temptation to invest in the shares of the Mississippi Company and in a heated argument with John Law contended that his crazy scheme would more likely ruin France than enhance its power. But the cold relationship between Stair and Law, which was well known in London, brought him down. All over Europe, Law enjoyed an enormous prestige as the most successful minister of finance, and he was also greatly admired in England.
Therefore, the rift between Stair and Law became an embarrassment to the British government, which decided to call him back. In the case of the South Sea Company, the prominent member of Parliament, Archebald Hutcheson, began to publish a series of pamphlets in which he maintained that people who bought shares in the company at an elevated price must be "deprived of all common sense and understanding", since in the absence of the company having any real business, they would be giving money to the original shareholders and the annuitants.
Similarly, the Irish-born French economist Richard Cantillon (known as the first true monetarist) thought that the shares of the South Sea Company could be held up for a number of years, but that there was "a melancholy prospect for those who shall stay last". But, as is usually the case during an investment mania, the speculators didn't pay any attention to these rare voices of scepticism. It's worth noting that Cantillon had a full understanding of how a rise in money supply could, on occasion, produce short-term increases in output and employment, but would in due course also drive up the prices for commodities.
Cantillon had made a huge fortune in the shares of Law's Mississippi Company, because he had sold out near the peak of the market in early 1720 and had the foresight to leave France that year for Holland. (Upon his return to Paris ten years later, several counter-parties who had incurred significant losses took him to court. The suits, however, had no merit and were all dismissed.) But in the case of the South Sea Company, even Cantillon -- one of the most brilliant financiers and economists of his time -- clearly underestimated the forces of gravity, since the share price collapsed soon after his comment that "those who would stay last" would incur losses. (Cantillon was murdered in London in 1734 and his house, with all his writings, was set on fire. The crime was presumably committed by his cook, whom he had dismissed a week earlier. The only surviving work by this brilliant economist is "The Essay on the Nature of Trade in General", which contains an analysis of banks, bank credit, coinage, and the automatic mechanism that distributes the monetary metals internationally. Schumpeter, in his History of Economic Analysis, regarded the "Essay" to be almost "faultless", saying that it stood "in most respects unsurpassed for about a century".)
What - If Anything - Can Be Learned?
John Law's Mississippi Scheme, despite its eventual failure, is an important event in economic history since it represented an attempt to introduce paper money on a large scale. The Banque Générale was primarily a deposit bank and not a lending bank, and it proved to be a great success for a while. With a limited note issue (backed by gold) and branches in the provinces, it spread means of payment away from the financial centres of Paris and Lyons and therefore had a beneficial effect on trade and industry. The problem occurred when the regent took over the bank (it became the Banque Royal) and began to issue notes with no limit to their quantity.
That having been said, we must realise that there is, of course, always a limit to the quantity of money that is being issued, and this limit comes from the market mechanism. At some point, as we heard, the French public began to distrust the notes that had been issued by the Banque Royal, and then -- despite all the efforts of John Law, who was by then finance minister, and the regent of France -- no one wanted to hold paper money anymore. The result was that the banknotes issued by the Banque Royal began rapidly to depreciate against gold, commodities, and real assets.
We see, therefore, that a financial system based on paper money depends almost entirely on the confidence of the public in the currency that is issued by the monetary authorities, and that once confidence in a currency is badly shaken, painful consequences are inevitable.
Therefore, the reader should ask himself the question: for how much longer will foreign investors, which are financing the US trade and current account deficit, be willing buyers and holders of American stocks, bonds, and the dollar? Surely, there will be a time when, as was the case at the time of the Mississippi Scheme and the South Sea Bubble, the present "chain letter" type of fiat money operation practised by the US Federal Reserve Board will no longer work and lead to a sharp depreciation of the US dollar.
The other possibility, of course, is that the dollar begins to depreciate, not compared to foreign currencies, but -- as was also the case at the time of John Law -- against commodities and real assets. The excessive money supply creation by the Banque Royal led to soaring prices for commodities and real estate, as the French public realised that the banknotes were depreciating in value.
Asian Equities Sleuth and The Original Bear On Japan
Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and a major contributor to Strategic Investment . Dr. Faber has been headquartered in Hong Kong for nearly 20 years, during which time he has specialized in Asian markets and advised major clients seeking down and out bargains with deep hidden value - unknown to the average investing public - bargains with immense upside potential. Dr. Faber is the author of the current best-seller: Tomorrow's Gold.
21 October 2004
This article was originally published in The Daily Reckoning (www.dailyreckoning.com).
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