Preface to all three parts: I’ve written dozens of books, but the only history book I’ve ever written was Panic Prosperity and Progress. This weekend, I’m sharing one of the chapters from the book in three parts, since it offers interesting lessons about what can happen when governments decide to experiment with finance and economics. You can read Part One here and Part Two here.
Unlike many modern legislative bodies, the French Parliament did not accept the financial machinations happening around them lightly. Parliament had, by and large, protested the introduction of paper money, and even as apparent prosperity pulsated through Paris, the Parliament viewed it with great skepticism.
A few of the more astute traders, however, sensed that the party would soon come to an end. Quietly, and in small quantities, savvy traders began making trips to the Royal Bank and exchanging handfuls of paper notes for gold coins. Some went even farther, not only exchanging notes for gold, but placing that gold within the safety of neighboring countries, just in case their own country’s disposition toward the metal and its confiscatory value might one day change. England and Holland became favorite storehouses for the coinage.
One astute trader is said to have exchanged a million dollars of bank notes for the equivalent amount of gold and, after dumping the metallic fortune into a cart, covered it with cow manure and escorted it far out of the city, unnoticed. He even went so far as to dress himself in the filthy clothes of a peasant so that his departure with such a vast fortune would attract no attention.
At the beginning of 1720, shares of the Mississippi Company started to succumb to gravity which, given the highly-leveraged ownership of many of the traders involved, caused alarm and concern.
Law proclaimed that the company would, in fact, guarantee the purchase of shares at a fixed price of $10,000, which pegged the price at that level for several months. The stock price stopped falling, but the fact it wasn’t rising anymore didn’t go unnoticed. The only reason the share price was holding firm at $10,000 was because Law’s company had pinned its pledge at that price.
All of the paper money circulating through the economy began to have the same effect that any overabundance of money has in an economy: it created inflation. Prices for houses, consumer goods, food, and everything else that could be bought with bank notes was on the ascent, and in early 1720 inflation was raging at a pace of 23% per month. As the paper notes could pay for less and less, confidence in the paper notes declined as well, while the value of gold began a swift ascent.
Law began to view the situation with alarm, and wanting to suppress the public’s newfound affection for gold, he had the crown issue an edict stating that payments in gold or silver for anything over $100 in value were prohibited, and that ownership of over $500 in gold was illegal. This is somewhat akin to if all the financial institutions in the United States decreed that credit cards could not be used for any charges greater than $20 and no card would be permitted a credit line greater than $250. The effect on the economy was stifling and immediate.
Because so much gold had already fled the country, spirited away by those prudent enough to ditch their paper money for something more tangible before the masses got wise to the situation, there was little bullion left in the country. The scarce quantity of gold and silver coins that were still around were hoarded, and the merchants in the economy, increasingly disinterested in accepting paper notes for transactions, brought business to a near standstill.
The crown began issuing edicts to take its economic dictatorship to a greater extreme. In February of 1720, it was decreed that coins were banned as legal tender altogether, and only the notes from the Royal Bank could be used to transact business. The purchase of small and valuable hard assets, such as jewelry and precious stones, was likewise forbidden, and the citizenry was encouraged to police itself, offering handsome rewards to anyone who turned in a friend, neighbor, or family member from violating any of the economic decrees.
Thus, neighbor turned against neighbor. No evidence was required for a police investigation; mere suspicion was adequate to search a person’s home and belongings for anything in excess of the tiny amounts of precious metals that were allowed.
The Royal Bank also took measures to try to slow down the extraction of real money from its vaults. For example, if a person came to withdraw gold in exchange for notes, the teller would count out the change at a comically slow pace, thus frustrating the others in line and reducing the amount that could be physical taken out in the business day.
Another trick was to put clerks in line who were instructed to withdraw some gold and then simply return the coinage to the vault immediately afterward, thus slowing down legitimate customers even further merely by making the lines longer.
As another desperate measure, Law ordered that a pile of banknotes be set ablaze in a bonfire, to try to convince the public of the growing scarcity of the notes. One can be excused for puzzling over why Law would think this a convincing display, since ink and paper are usually in abundant supply, bonfires be damned, but considering the pressures on the man, perhaps he wasn’t thinking altogether clearly.
Shares of The Mississippi Company entered a free-fall, plunging from $10,000 to $4,000 in just a couple of weeks.
Another especially comic effort was made to try to convince the public that the Louisiana Territory was about to offer up untold bounty: Law arranged for 6,000 prisoners to be put into work clothes, provided shovels and pick-axes, and paraded around the streets of Paris prior to their purported departure to Louisiana. Day after day, the thousands of ostensible Louisiana-bound workers made a show of it, but once their duties were done, they headed out to the countryside, sold the tools for whatever they could, and dispersed themselves, never to be heard from again.
So incensed was the President of the French parliament that he told the king to his face that he would rather have $100,000 in gold coin that $5 million in bank notes. Given that such an outburst to a crown would normally put one’s life in jeopardy, it only goes to show how livid the French were becoming with the rapidly-declining state of affairs.
A Rush and a Crush
The public became increasingly panicked about the dwindling value of their shares and the bumbling state of the economy. The rush to convert paper money into actual coinage became literally a life-or-death task, as the crush of humans at the bank’s doors became fatal on a regular basis.
On one particular day, a full fifteen individuals were crushed to death under the feet of desperate fellow countrymen. The enraged mob put three of the corpses onto stretches, paraded en masse to the gardens of the royal palace, and screamed in fury for the king to see what misfortune his economic innovations had brought to the land.
As runaway inflation continued to maul the economy, the increasingly-haphazard Law urged the crown to devalue the currency in order to put a stop to inflation. Thus, yet another edict was issued, this one decreeing that, over the course of several months, step by step, the value of the currency would be trimmed by half.
Of course, when it is decreed that a given means of exchange is going to be cut 50%, it doesn’t matter whether the trimming is instantaneous or scheduled for years ahead of time; the effect will be the same: an immediate drop of 50% in the value of a given currency. Shortly after this edict was issued, the Parliament overturned it, surely leading to maddening confusion among the increasingly frustrated citizenry.
The share price of Law’s firm continued to drop, first to $2,000 in September 1720 and, by December, to $1,000, a 90% plunge since the peak at the beginning of the year. Opposition to Law became so intense that the man began to fear for his own safety.
A group of wealthy men decided to convert all their notes to coin en masse in order to exhaust the Royal Bank of its remaining supply of bullion. As a next step, they sought out all shareholders with questionable title to shares (mainly due to the fact they were purchased on credit) and confiscated the shares, thus reducing the public holdings of the stock by two-thirds. This greatly-diminished ownership of the stock allowed Law’s enemies to take control of the company altogether.
Clever corporate schemes were not the only tool used by the public to vent their fury against Law. As Charles MacKay tells it, in his early 19th century book Extraordinary Popular Delusions and the Madness of Crowds:
When John Law, by the utter failure of his best laid plans, rendered himself obnoxious, satire of course seized upon the French and the streets presented with songs in which neither he nor the king were spared. Many of these songs were far from decent, and one of them in particular counseled the application of all his [bank] notes to the most ignoble use to which paper can be applied.
The royal court itself began to strip the Royal Bank of its privileges: in November 1720 its right to manage tax revenue was removed, and before the year was out, it also lost all the privileges with respect to trade with other nations. Indeed, just about every privilege granted to the company was gutted, including its royal backing, leaving it an empty shell with no meaningful value.
Law was dismissed from his post as chief director of the bank at the end of 1720 and ultimately fled the country disguised as a woman for his own safety. (One can only imagine what he was thinking as he scurried across the French countryside in women’s clothing). He moved back to Brussels as a pauper and spent the next few years gambling in Rome, Copenhagen and Venice, never regaining his former prosperity.
When he learned of the death of the Duke of Orleans in 1723, Law realized he could never return to France, but fortunately for him he had been granted permission to return to London after receiving a pardon. He lived in London for four years and then, finally, moved to Venice where he contracted pneumonia and died a poor man in 1729.
The formation, inflation, and bursting of the bubble in the form of the Mississippi Company follows a template common to similar financial catastrophes throughout human history, running along these lines:
- Some kind of shift happens (political, technological, or otherwise) that opens up extraordinary profit opportunities that did not exist before. Early participants thrive;
- As word of the profits spread, a larger and more diverse array of individuals participate, and as opportunities become more scarce, leverage, excessive trading, and outright fraud begin to creep in;
- Once the original model can no longer support the participants, or once a fatal flaw is unveiled in the scheme, there is a rush to the exits, and after most participants are badly damaged financially, there is a outcry from the public for justice to be rendered against as many culpable parties as possible. Upon reflection, most of the participants recognize they really didn’t know what they were doing in the first place.
Once fear replaces greed, the bubble bursts with great speed, and the speculative orgy comes to an abrupt halt. And, in spite of solemn pronouncements that no such foolishness will ever take place again, it always does: it might take a generation or two, but financial manias, like wars, are an unfortunate aspect of human nature that occurs with disturbing frequency.
Markets tend to be efficient, and anything that appears to be “free money” is, at best, an extremely temporary displacement of market mechanics that will soon be rectified by those seeking to exploit the opportunity.
The French, feeling badly burned by their experiment with paper money, refused to touch the stuff again for the next eight decades. And although it held on to its massive Louisiana land holding for a while, it finally lost control of the area in 1763 after losing the Seven Years War to England.