Printing an unbacked currency to avoid asset price declines. What could go wrong?

Finance & Fury Podcast

Welcome to Finance and Fury. This week we will be looking at the Mississippi bubble. I find it a very interesting story of speculation and devaluation – creating a situation of loss of confidence in an early form of fiat currencies –– Lessons to learn from this – I get asked the question a fair bit – what happens to the value of every asset when denominated in fiat currency if fiat currency fails – and it is a good question -

1. But in this instance the Mississippi Company bubble can help to provide some direction for an answer when it comes to what happens when people are no longer willing to sell assets in exchange for a fiat currency –
2. This story is similar to the south sea bubble episode I did – the Mississippi bubble can actually be confused as the South Sea bubble as the collapse occurred in the same year - during this period many millionaires would be created – and the French actually came up with the term millionaire a result of his most famous scheme – but these millionaires didn’t last long
3. But the Mississippi bubble is actually more of a currency blunder than a true speculative bubble like the SS bubble – this is where the MB has an additional element to it – that it collapsed the confidence in the very currency used to finance the purchase of shares in this venture through the bubble prices of the assets
   1. The term bubble in the world of finance is normally applied to a situation when unusually rapid increase in prices of some financial commodity occurs – can occur in shares, real estate, orange juice, crypt, tulips – anything that has a price and people are willing to speculate on can enter a bubble – but a bubble isn’t technically a bubble until the initial rapid increase in price is then followed by an equally rapid collapse in prices
   2. Is something in a bubble if the prices go up 1,000% - it may be, but if the price never comes back down then it moves from being in bubble territory to the new status quo
   3. The price movements depend mostly on people’s perceptions – the money flow – if people think something is worth a lot or think the price will go up further – they will buy
   4. The perception is what fuels a bubble – the reality or a breaking in the perception is what causes it to come back to earth – if that reality never sets back in – or the perception meets or creates the new reality – a bubble never has to pop – but sometimes some exogenous force can piece the reality that perception has created – this is the same element with most famous price bubbles
4. Has a lot to do with the modern monetary and financial system

Let’s start with looking at the history to the lead up to the MSB –

1. We start in 1715 France – where the French monarchy was essentially insolvent – therefore the nation was insolvent (i.e. bankrupt)
   1. The French government had spent a lot of money in the many anglo-french wars – most recently on the war of the Spanish succession
   2. This is before fiat currency could finance budget deficits – gold and silver were money – if you ran out of these commodities or other nations to lend these to you, then you were in trouble
   3. taxes were raised to extremely high levels on the french population but the hole that warfare left in the French treasury was too deep
   4. So – what happens to nations when they can’t pay back their debts? France began to default on its outstanding debt and people feared for the future of the nation – if you have no money you have army, i.e. no protection from the English or Hapsburgs if they decide to march an army into your nation
2. This was also the time of colonisation - the French controlled the colony of Louisiana which was a vast settlement in the interior of North America – think of the US today – this area was most of Montana, North and South Dakota, Nebraska, Iowa, Wyoming, Kansas, Missouri, Arkansas, Oklahoma, some of Texas and Colorado and Louisiana - France was the first European country to settle this area of North America (1699-1763) – so they ended up with almost 1/3rd of the current US geographic boarders
   1. This land mass was much larger than France – but on top of this the French knew little about it – let alone where it was – this was before the days of google earth
   2. But many had heard the rumour that this land was rich in silver and gold – which was the currency
3. Enter John Law – was a Scottish financier born in Edinburgh and had talents in both gambling and finance
   1. Law was a Scottish exile he killed a man in a duel and fled to France in 1714 – at this time he renewed his acquaintance with the nephew of King Louis XIV, the Duke of Orleans
   2. The duke became Regent of France after the king's death in 1715 – under old monarchy rule – a regency was when the rightful ruler (i.e. the male child of the king) was below the rightful age to commence rule – normally at the age of 15-16 – so the regent - served as ruler while the rightful heir to the throne matured – which at this time was five-year-old Louis XV
4. So John Law and the Duke of Orleans got talking – the Duke was looking for some solution to their solvency problems – whilst John Law was a bit of a gambler and was well versed in finance – match made in heaven
   1. Law thought it was the unpredictable and limited supply of gold and silver that was slowing the economy rather than France having a true economic problem of spending more than it could afford
   2. Law thought that by switching to a paper backed currency - more currency could be issued and trade would speed up – similar to a multiplier effect theory financed through fiat debt – i.e. the more money that you print and introduce into the economy, the more that people will spend and based around velocity, the greater the GDP output
   3. May 1716 – Law – who was the Controller General of Finances of France created the Banque Générale Privée = "General Private Bank"
      1. It was the first financial institution in France to develop the use of paper money
      2. It was a private bank, but three-quarters of the capital consisted of government bills and government-accepted notes – issued by the French Government

• The paper notes would be supported by the bank's assets of gold and silver and would circulate as a medium of exchange

1. Paper money was a new concept for the French; money to them was silver and gold. Law believed that paper notes would increase the money in circulation, which, in turn, would increase commerce.
2. However, the catch was that you could only deposit gold or silver, and withdraw in paper

5. Now – Enter the Mississippi Company - founded 1684 – it was actually named the Company of the West from 1717, and the Company of the Indies from 1719 – but I will be referring to it as the Mississippi company
   1. This was a corporation holding a business monopolyin French colonies in North America and the West Indies – which the French held a large territory of – Under the monopoly agreements this company was the sole provider for any trade in their regions
   2. August 1717 - Law decided to expand his banking empire by acquiring the Mississippi Company
6. How would this help the Government finance?
   1. The scheme to finance the initial operations of the Mississippi Company was simple. Law would raise the money by selling shares in the company for cash as well as for state bonds – the more state bonds that could be sold – the more France could get their way out of debt issues in the short term (debtors come knocking at the door – well they can now convert their debts for shares in this new promising company)
   2. Law accepted a low interest rate on the bonds which helped French finances while promising the company a more secure cash flow
   3. Also - the lure of the promised trade goods out of the monopoly company – i.e. gold and silver and furs brought out many eager investors in the Mississippi Company.
7. It turns out that the Mississippi Company was a small part of a much grander empire Law was trying to create
   1. The next year in September 1718 - the company acquired the monopoly in tobacco trading with Africa. He also expanded the taxation rights over the colonies under the monopoly charter. He also obtained control of the companies trading with China and the East Indies
8. January 1719 - Law's Bank Generale was taken over by the French government and renamed the Bank Royale - but Law remained in charge
   1. But this had a massive shift in confidence for those looking to invest - the crown was now the guarantor of all bank's note issue
   2. In effect – with this move - Law now controlled all trade with France and the rest of the world outside of Europe as well as having the guarantee of the French Government from defaults
9. Under the French Governments ownership, but Laws control - The company next purchased the right to mint new coins for France and by October the same year it had purchased the right to collect most French taxes
   1. In effect - Law now controlled all of France's finance, taxation collection and money creation - He controlled the company that handled all of France's foreign trade and colonial development – this was Europe's most successful conglomerate – as confidence was high
   2. But all of these acquisitions over the years and to receive these privileges weren’t free – to buy the rights to collect taxes, rights to mint coins, rights of trade – these had to be paid for - these activities and privileges were paid by issuing additional shares in the company
10. What is going on with the Mississippi Company share piece? – well it rose dramatically as Law's empire expanded
    1. Shares in the Mississippi Company started at around 500 livres per share in January 1719 (the livres was the French unit of account at the time).
    2. By December 1719, share prices had reached 10,000 livres, an increase of 1,900% in just under a year. The market became so seductive that people from the working class began investing whatever small sums they could scrape together. New millionaires were commonplace and wealth was booming – times seemed good – at the surface level
11. As the stock price shot up - the amount of cash needed to buy Mississippi shares meant more money had to be printed to meet new demands – as shares were purchased using government debts or paper money
    1. This was the weak spot in Law's scheme – as he had a never-ending willingness to issue more bank notes to fund purchases of shares in the company
    2. Markets reached their peak in early 1720 – but prices began falling in January 1720 as some investors sold shares to turn capital gains into gold coin – normal profit taking behaviours – making almost 2,000% from a gain – but any sell off spelt disaster for Law – as if people wanted to convert the funds for gold or silver, there wasn’t enough to cover a large sell down
    3. To stop the sell-off - Law restricted any payment in gold that was more than 100 livres
       1. In Response to this the paper notes of the Bank Royale were made legal tender, which meant that they could be used to pay taxes and settle most debts – essentially the form of money that would emerge under Brenton woods era of monetary policy
       2. Law and the Bank Royale needed people to accept paper notes rather than gold – so the bank subsequently promised to exchange its notes for shares in the company at the going market price of 10,000 livres – to todays POV – this doesn’t seem like much – but what it effectively did when money was in somewhat of a limited supply was double the money supply overnight – you had the paper currency in circulation – but now you also had to account for the market cap of the Mississippi company shares

• It is not surprising then that inflation started to take off – where inflation reached a monthly rate of 23% in January 1720 – in the same month

12. This effectively devalued the shares in the company – but this practice would continue in several stages during 1720 – as the value of bank notes was reduced to 50 percent of their face value with inflation
    1. By September 1720 the price of shares in the company had fallen to 2,000 livres and to 1,000 by December
    2. In the end – the fall in the price of the MC shares allowed others to take control of the company by confiscating the shares of investors who could not prove they had actually paid for their shares with real assets rather than credit – remember credit is seen as paying for the shares with government bonds (i.e. debt) or paper money
    3. By September 1721 share prices had dropped to 500 livres, where they had been at the beginning – a loss of 95% of the value

So, what went wrong – and what can we learn from this

1. Obviously, the financial world between now and 300 years ago are different – but people and their behaviours are relatively similar
2. Back in 1720 - people wanted gold and silver when they took profits from the sale of the MC - But Law capped redemption in gold and silver to avoid depleting his reserves - This removed France's paper currency from the gold and silver standard and put it on the Mississippi Company share price standard – while at the same time increasing the money supply by the market cap of the MC – then because the amount of paper currency afloat was now many times the actual reserves of gold and silver and hyperinflation set in
3. People want a medium of exchange that they see as valuable – at some point in 1720 – people started to view the paper currency of the Royal bank as worthless when compared to gold or silver
   1. Because it technically was – this paper currency was meant to be backed by gold and silver – but it wasn’t to the extent it should have been
   2. The solution from the Royal Bank was the continue to print unbacked livres to inflate and support the collapsing Mississippi bubble
4. Between then and now - It isn’t an exact comparison – but CBs today are providing a service that John Law with the MV company were doing
   1. Printing additional unbacked currency to help maintain the value of financial assets – mostly in the debt markets – but also in the share and property markets by keeping interest rates low to zero
5. Our whole financial system is confidence based – confidence backs everything and it is the thing that holds the whole modern system together – if people no longer have any confidence that the value of something will maintain its current price – then they sell – the prices go down, then more people lose confidence, then these people sell, then more people lose confidence, then they sell – and so on – and in the modern economy – this happens quickly
6. Think about Government bonds and the debt markets – if every holder of government debt were to sell in an instant – this would create a massive market decline
   1. Many central banks are expanding their balance sheets by buying government debts, companies – both equity and debt – which essentially have a monopoly on a lot of the market in their ownership
   2. For investors beyond this - Why don’t they sell? Because they have the confidence that Governments/Central banks will continue to provide QE – printing additional funds – increasing the money on unbacked dollars to help maintain the prices of government debt
7. But this story of John Law and the Mississippi Company is as intriguing as it shows the issues that the monopoly powers have over the control of currency
   1. Especially when that currency is what is used to pay taxes, debts and buy goods and services

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/