Mississippi Bubble 1720

Warning: Many popular storytellers of bubbles and manias refer back to historical books like Mackay's Extraordinary Popoular Delusions and the Madness of Crowds. These historical sources can hardly be referred to as in any way scientific. They are primarily (religious) moral tales and warnings against perceived errors of human nature. It has been established that many of the claims made and stories told are simply false, not supported by evidence or at least exaggerated.

In May 1716 John Law, by royal edict, was allowed to establish the Banque Generale, modelled after the successful Wisselbank of Amsterdam. (Some suggest it was the Bank of England.) The business of the bank would be to take deposits and issue banknotes. Equity for the bank came from the sale of stock for both cash and conversion of government debt, the same debt-equity conversion scheme as used in England for the Bank of England, East India Company and South Sea Company. Capital of the Banque Generale was 1,200 shares of 5,000 Livre each, totalling 6 mln Livre, to be paid in one-quarter currency (1.5 mln Livre) and three-quarters billets d'Etats (4.5 mln Livre). Billets d'Etats were returned to the State, extinguishing a small part of the national debt. Although the banknotes issued by the Banque Generale were not legal tender (a status acquired later), acceptability was high and the bank's business thrived. Law made his bank notes payable at sight and, most importantly, in the coin current at the time they were issued, therefore effectively an inflation indexed note. This made the notes especially valuable in the face of repeated depreciations of the currency by the government.

In August 1717 John Law acquired a controlling interest in the derelict Mississippi Company (founded 1664) and renamed it the Compagnie d’Occident. This company had a monopoly on trade with French Lousiana in North America (at the time thought to abound in precious metals and other riches) and Canadian beaver skins. To finance the company, shares were issued and paid for in government debt. In December 1718 the Banque Generale was re-chartered as the Banque Royale and ownership was transferred from Law to the Regent (although Law remained in control) and its capital stock and note issuing authority expanded. By mid-1719 the Compagnie d’Occident was re-organized (merged with other acquired companies) as the Compagnie des Indes and had expanded to effectively monopolize all French trade outside Europe. In July 1719 the Compagnie purchased the right to mint new coinage. In August 1719 the Compagnie bought the right to collect all French indirect taxes and in October 1719 the Compagnie took over the collection of direct taxes. Finally, a plan was launched to restructure most of the national debt, whereby the remainder of existing government debt would be exchanged for Compagnie shares.

The Compagnie share price was around 500 Livre in May 1719, rose to nearly 10,000 Livre in February 1720. In May and June 1720 the share price collapsed amidst major public turmoil and declined to 500 Livre in September 1721. Is it an obvious example of a bubble?

Fundamentals

The economic fundamentals behind the Mississippi bubble story are more complicated than usual, because it is at the same time a failed macroeconomic policy experiment and a failed business project.

Monetary policy aspects

In 1705 John Law had sketched a financial system and monetary theory in which an emission of paper currency would expand real commerce permanently (Money and Trade Considered With a Proposal for Supplying the Nation with Money). He argued that metallic money was unreliable in quality and quantity. Bank notes issued and managed by a public bank would remove the brakes on the economy. Demand for the new currency was thought to increase sufficiently to preclude pressure on prices. (For a review of Law's theories, see Murphy, 1991, 1999.) Although the theory clearly did not work in practice, Law’s theory was considered plausible at the time and even has many modern manifestations today (he is frequently considered to have been the world's first "Keynesian").

The Mississippi Bubble is partly a story about monetary expansion, inflation and subsequent deflation (i.e. misguided monetary policy). Starting with the July 1719 stock issue, each stock issue of the Compagnie was accompanied by an issue of notes of the Banque Royale. In July 1719 a note issue of 240 mln Livre was authorized to more than double the 159 mln Livre of notes previously in circulation. Note issue expanded further with share issues in September/October 1719 (240mln), December 1719 (360mln) and February 1720 (200mln) to a total of 1,199 mln Livre. From February 1720 Banque Royale’s notes were made legal tender for payments above 100 Livre. Furthermore, from February 1720, any person was forbidden to have possession of more than 500 Livre in coins. From March 1720 share prices were effectively pegged at 9,000 Livre and the Banque Royale intervened to exchange its notes for Compagnie stock. Pegging continued until May 1720 but caused an expansion of notes of an enormous 1,490 mln Livre between March and May.

In May 1720 total specie stock of France was estimated at 1.2 bln Livre. Therefore, money circulation of specie and notes had increased by 186% within one year (3889/1359-1). As a result of the increase in money, prices (measured as the price level in Paris) also doubled between July 1719 and December 1720. This was mirrored in a simultaneous collapse of the French currency's exchange rate against the English pound, and Dutch and German currency with a low around August 1720 (data used in Neal, 1990). Therefore, a substantial part of the increase in the nominal share price of the Compagnie must be attributed to inflation. The remaining increase in the real share price must be explained by other fundamentals.

Company profits and dividends

Investors observed Law’s expanding commercial enterprise and must have factored in the possibility of success. Apart from the profits from the commercial enterprise (trade, mint, tax collection) and the government debt conversion program (providing interest income), the de facto expansionary monetary policy could also have been perceived as stimulating economic activity and substantially increasing the profits from tax collection as well.

One estimate of the possible annual net revenues of the Compagnie looked as follows

Source: Dutot (Vol.I, p.162) from Steuart (1767) An Inquiry into the Principles of Political Economy.

[Note: Francois Velde (2004) evaluates some alternative estimates. Law's December 1719 estimate was 91 mln Livres and his 1723 estimate was 80 mln. Velde suggests a lower estimate of 75.5 mln, but this includes a view of future, ex post data on the various revenues. Generally speaking, it does not appear that Law actually provided grossly misleading information to his shareholders.]

Net present value calculations depend on the discount rate. At that time, the Banque Royale was lending money to shareholders at 2% interest, which suggests a NPV of 80.5 / 0.02 = 4,025 mln Livre, on the assumption that profits continued in perpetuity but with no growth. With between 312,000 - 600,000 shares actually in circulation (see note below) this implies a share value of 6,700 - 12,900 Livre.

Another calculation takes the announcement by the Compagnie in August 1719 of a dividend per share of at least 200 Livre. Again assuming perpetual payment and no growth, share value would then be 200 / 0.02 = 10,000 Livre.

[Note: Historical research shows that financial investors at the time were fully aware of these types of present value calculations for stock and bond prices (see for example, Harrison, 2001).]

It is not clear how many of the authorized shares were actually sold to and/or repurchased from the public. The Company had an active share repurchase program to support the share price at various levels (initially 5,000 L, later 9,600 L and then 9,000 L). Although share sales were also intended, the net result was an extensive share repurchase operation. The effect of the share repurchases would have been that the Co. created a (zero interest?) debt with the Bank for the bank notes used in the share repurchase. Alternatively, the bank formally owned the shares but should in practice be consolidated with the company, as in fact happened after February 1720. The effective number of shares, amount of share capital and market value were much lower than the frequently suggested numbers.

On the other hand, although the numbers above suggest that quantity and price of the shares do match reasonably well, they also imply that something peculiar is going on. In a normal case, the number of shares of a company is fixed and the market will determine the appropriate price. In this case, John Law fixed the price of the shares and the market adjusted the quantity of shares. This is not necessarily a problem, but in this case the share repurchases were financed with an explosive expansion of the supply of bank notes and a corresponding decrease in their value.

Of course, these calculations cannot establish the true fundamental value; such a concept does not exist in reality. Financial market prices on the upside are determined by the so-called marginal optimistic investors, ready to buy at high prices. These calculations can only show that their expectations were not without consideration of fundamental value. Without doubt, some or even many investors disagreed and decided not to participate in Compagnie shares. They were proven right, but with proof available only after the share price collapse.

Price collapse

Expansion of the volume of bank notes in circulation and the difficulties of converting bank notes into specie on demand (despite all the efforts to prop up the demand for notes by legislation and depreciation of the currency) signalled a major problem. By 21 May 1720 it was concluded that the Compagnie share price had been fixed at a too high level and a proposal was launched to reduce towards 1 December 1720 the share price from 9,000 to 5,000 Livre in a number of monthly steps. Furthermore, the bank notes would also be reduced in value to 50% of their face value.

As every financial economist today would know, announcing a future value for a durable asset such as shares, exchange rates, etc., and therefore changing expectations of future value, must have an immediate effect on its current value. Except for the value of time (discount rate), the current price will immediately adjust to the expected future value; there can be no gradual adjustment in asset prices. This is exactly what happened at the end of May 1720. Within a few days the share price dropped from 9,000 to 5,000 Livre.

Following violent public protests, these plans were revoked on 27 May and the bank notes restored to their original value. However, on the same day the Banque Royale stopped payment in specie. Confidence in the value of Compagnie shares and particularly paper money was now completely destroyed.

[Note: The literature mentions that by early summer 1720 two influential shareholders, the Prince de Conti and the Prince de Conde, asked to have their shares converted into gold, causing major problems due to the lack of specie reserves in the Banque Royale. It is unclear whether this action was the cause or the result of the cut in the share price and bank note value.]

On 1 June the law against possession of coins of more than 500 livres was abolished. The 2,600 mln Livre of bank notes of the Banque Royale were to be withdrawn and exchanged for 250 mln Livre of new notes secured by revenues of the city of Paris with 2 1/2 percent interest. On 10 June the Banque Royale re-opened for business, ready to redeem notes. Frantic scenes in front of the bank continued well into July as many converted their notes into coin.

An edict of 15 August 1720 declared that all large denomination bank notes (1,000-10,000 Livre) were no longer eligible for payments, except for the purchase of annuities and bank accounts or for the payment of installments still due on the shares of the Compagnie. An October 1720 edict declared all bank notes to be deprived of value after November. All activities and privileges of the Compagnie were taken from it, reducing it to a mere private company. At the end of 1720 Law’s enemies confiscated two-thirds of the Compagnie shares outstanding. His experiment had reached its end.

The usual political blame-game ensued, with victims of the collapse seeking scapegoats and compensation for their losses. John Law fled from France to Rome and his estates and properties were confiscated. The Council of Finance and the General Council of the Regency investigated the affair and, not surprisingly, found sufficient arguments to cancel a major portion of the national debt obligations and associated interest rate payments.

Conclusion

Events surrounding the rise and fall of the share price of Compagnie des Indes are not too difficult to explain on the basis of economic fundamentals. There is no reason why the financial (government debt conversion) and commercial (tax collection) enterprises of John Law should have failed ex ante. The only major problem was the failed monetary experiment (issuing paper money and fixing the price of his shares) which generated a short period of unsustainable monetary expansion and inflation. At the time, John Law's monetary theory suggested that additional money would stimulate the economy. Even in modern times, this argument is sometimes used by some, arguably misguided economists to propose expansionary monetary policies.

Even today, some governments and policymakers remain tempted to fix certain asset prices such as nominal exchange rates, frequently with disastrous consequences in terms of a financial crisis (remember the 1997-98 Asian crisis?). We do not normally view such policy disasters in the same way as we see bubbles in financial markets linked to irrational investor behavior. Consequently, we should not refer to John Law's failed monetary experiment as simply the Mississippi "bubble".

The options feature of the subscriptions

As was the case with the English South Sea Company subscription and the various Dutch insurance company subscriptions, the Mississippi share price evaluation is complicated by the fact that the subscription installments created de facto call options on the company. In the case of the Co. des Indes subscriptions and shares were even more intimately related due to the meres, filles, petit filles system of the issue (i.e. a rights issue).

Recent literature

• Garber, P.M., "Famous first bubbles," Journal of Economic Perspectives, vol.4 (2) Spring 1990
• Garber, P.M., Famous First Bubbles: The Fundamentals of Early Manias. MIT Press, 2000.
• Murphy, A.E., John Law: Economic Theorist and Policy-Maker. Clarendon Press, 1997.
• Murphy, A.E., "The evolution of John Law's theories and policies 1707-1715," European Economic Review, vol.34 ( ) : 1109-25.
• Neil, L., "How it all began: The monetary and financial architecture of Europe during the first global capital markets: 1648-1815," Financial History Review, vol.7 (2) October 2000.
• Neil, L., The Rise of Financial Capitalism: International Capital Markets in the Age of Reason. Cambridge Univ Press, 1990.
• Velde, F. "Government equity and money: John Law's system in 1720 France," working paper and book chapter (2004) http://www.velde.org/econ/

Internet

Warning: Many of the websites, weblogs, etc. continue to repeate the popular Mackay version of the bubble stories. It has been clearly demonstrated that Mackay is simply an unreliable source with an over-emphasis on silly stories and with no real attempt to understand or analyze the true events. Any site quoting Mackay as a main source is simply of no value at all.

• John Law and the Mississippi scheme, MapForum.com Specialist Antique Map Magazine, volume 1, issue 5 http://www.mapforum.com/05/may.htm
• John Law and the Systeme of 1720, Francois Velde personal homepage http://www.velde.org/econ/
• John Law 1671-1729, History of Economic Thought website http://cepa.newschool.edu/het/profiles/law.htm
• John Law and his bank, Steuart (1767) An Inquiry into the Principles of Political Economy, Book IV Chapter 23-35 http://www.marxists.org/reference/subject/economics/steuart/index.htm
• Mackay, C. Extraordinary Popular Delusions and the Madness of Crowds, Chapter 1 Money Mania - The Mississippi Scheme. http://www.econlib.org/library/Mackay/macEx.html