"Emerging market speculation tends to appear at a juncture in the economic cycle when
declining yields on domestic bonds combine with an excess of capital to make
foreign investments particularly attractive."
-Edward Chancellor
Chapter 4, Fool's Gold: The Emerging Markets of the 1820's
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The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
This year marks the 300th anniversary of the start of an economic project in France which posterity knows as the Mississippi Bubble. The brainchild of an expatriate Scot, John Law, this scheme has been hailed as the most ambitious economic experiment prior to the establishment of the Soviet Union in 1917. Like Lenin’s creation, the short-lived Mississippi Bubble burst in spectacular fashion. Central bankers around the world are currently embarked on a mission not altogether different from Law’s, making lessons revealed by his failure particularly relevant today.
Law was born in 1671, the son of an Edinburgh goldsmith. In adulthood, he became by turns a dandy, gambler, murderer, entrepreneur (“projector” in the parlance of his day), economist, central banker and finance minister. At the height of what he called his “System,” Law was the richest and most powerful man in Europe. His Mississippi Company incorporated all of France’s overseas trading companies – one of which claimed title to half the landmass of what is now the United States, along with monopolies for tax collection, tobacco, and coinage.
In early 1720, this company was merged with Law’s other creation, the Banque Royale, in effect France’s central bank. During its heyday, the Mississippi Company’s stock surged some 20-fold in value in the open-air stock market of Paris’s Rue Quincampoix. This early case of “irrational exuberance” didn’t come out of nowhere, however. Rather it was the consequence of Law’s monetary policy.
To understand the origins of the bubble it’s critical to grasp the Scotsman’s original purpose. As an economist, Law was a monetarist, an early forerunner of the late Milton Friedman. He believed that France suffered from a dearth of money and that an increase in its supply would boost economic activity. At the time of Louis XIV’s death in 1715, Law saw that France had two pressing problems. First, the state had too much debt – many of the royal debts (“rentes”) were trading well below par. Secondly, interest rates were too high – in his last years, Louis XIV paid above 8 percent for his loans.
Law, according to his biographer Antoin Murphy, was a “low-interest rate advocate.” He recommended setting up a national bank, which could issue notes to buy up the government’s debt, and thus bring about a decline in the interest rate. In 1715, Law expressed his views in a proposal to the Regent of France, Philippe d’Orléans:
“An abundance of money which would lower the interest rate to 2 percent would, in reducing the financing costs of the debts and public offices, etc., relieve the King. It would lighten the burden of the indebted noble landowners. This latter group would be enriched because agricultural goods would be sold at higher prices. It would enrich traders who would then be able to borrow at a lower interest rate and give employment to the people.”Law was effectively suggesting that the central bank should expand its balance sheet to lower interest rates, which in turn would help over-leveraged borrowers, boost economic growth and employment and stimulate inflation, while simultaneously reducing the cost of servicing government debt. He sounds much like a modern central banker. Law’s belief that too little money constrained economic activity, while too much stimulated inflation, reflected “the (same) essential principle underlying the decisions by the U.S. Federal Reserve today”, writes economist William Goetzmann in his forthcoming history of finance, “Money Changes Everything”....MORE