The Mississipi Bubble

John Law (1671-1729) was a famous Scottish economist who originated economic ideas such as the real bills doctrine. Outside of the academic world, he was an equally impressive man. He was a brilliant gambler with a great calculating ability, which allowed him to win cards games across Europe for a living. In addition to that, he also killed a man in a duel, and enjoyed what one biographer called “extraordinary success with the opposite sex”. However, his most well-known achievement was his effect on the French economy when he was effectively the central banker of the country (Murphy, 1997).

In the early eighteenth century, the economy of France was depressed. The government was deeply in debt and taxes were high. When Law came to France in 1714, he renewed his acquaintance with the nephew of King Louis XIV, the Duke of Orleans, who was the acting ruler of France as the heir to the throne, five-year-old Louis XV, was still a minor after the king's death in 1715. The Duke sought the advice of Law and assistance in straightening out France's financial mess left over from years of reckless spending under Louis XIV. 

Law proposed the French government to let him open a bank so that he could issue paper money to the country. The paper notes would be supported by the bank's assets of gold and silver and would circulate as a medium of exchange. Although paper money is very common today, it was a novel concept in France at that time. His idea was that to increase economic activity, one should increase the circulation of money, and paper notes would increase the money in circulation faster than metal coins. These conditions would help revitalise the finances of the French government. 

In 1716, with the blessings of the Duke, Law opened the Banque Générale with three-quarters of its funding consisting of government bills and notes, making it the de facto Central Bank of France. The bank started printing money and let it circulate in people’s hands, and just as expected, it business opportunities. However, it was not enough to Law. He wanted to create something which would increase the public’s appetite for spending, hence stimulating the economy further. The result was his most famous financial brainchild: the Mississippi Company. 

During that time, the French controlled the colony of Louisiana, a huge settlement in the interior of North America. The land stretched for 3,000 miles from the mouth of the Mississippi River to parts of Canada. It included the present-day states that hug the river: Louisiana, Mississippi, Arkansas, Missouri, Illinois, Iowa, Wisconsin, and Minnesota. Most French people knew nothing about it except the fact that it was much larger than France itself, and they believed the rumour there was plenty of gold and silver buried under the ground.

In August 1717, Law organised the Compagnie d'Occident, to which the French government gave the right to control the trade between France and Mississippi. The company had exclusive trading privileges in the territory for twenty-five years, and it could even appoint its governor and officers in the colony, and grant lands to potential developers. In turn, the company accepted the responsibility of transporting 6,000 settlers and 3,000 slaves to the colony before the expiration of its charter. 

Law raised money by selling shares in the company for cash and especially state bonds because the latter would promise the company a secure cash flow. Simply put, Law came up with a way to create cash flow from new economic activity. The lure of gold and silver brought out many eager investors in the Mississippi Company, and the capital flooded in. The company was a success at the beginning, and it had steadily spurred a lot of trading activities in Paris.

However, it turned out that the Mississippi Company was a small part of a much grander empire he was about to create. In September 1718 the company acquired the monopoly in tobacco trading with Africa. In May Law obtained control of the companies trading with China and the East Indies. He renamed his entire business interest the Compagnie des Indes, and now he controlled all trade with France and the rest of the world outside of Europe. Law had created Europe's most successful conglomerate. 

The value of shares in the Mississippi Company rose dramatically as Law’s enterprise expanded. Investors from across France and Europe eagerly played in this new market. Shares in the Mississippi Company started at around 500 livre tournois of gold per share in January 1719. By December 1719, the price had reached 10,000 livres, an increase of 1900 percent 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. The financial district in Paris became so agitated at times with investors that soldiers would be sent in at night to maintain order.

Regrettably, behind the facade of prosperity, there was a fatal weakness in the system. Law made this economic miracle possible by increasing the circulation of money and encouraging public investing. However, he went too far that he printed far more money than the amount of gold which was supposed to back the currency, which purportedly exceeded the number of gold by five times at the higher of the mania. If all the people were to exchange the banknotes for gold, the bank would be bankrupt.

To make the matter worse, the share price of Law’s company had gone up so much that it no longer pertained to its fundamental value. In 1720, some investors feared the Mississipi bubble is going to burst so that they started to take profit and turned their shares into money. The amount was so large that it resulted in a sudden doubling of the money supply in France. Not surprisingly, inflation began to take off, and it reached a monthly rate of 23 percent in January 1720. 

One morning, when a wealthy investor suddenly stomped into the bank and requested to cash in all of his shares into gold, it took him three full waggons to carry the load away. People suddenly started to question the validity of the money which they were holding and began to exchange their money back into gold. Since there was not enough gold, Law devalued shares in the company in several stages during 1720, and the value of bank notes to half of their face value. By September 1720, the price of shares in the company had fallen to 2,000 livres, and then to 1,000 by December. One year later, the share price had dropped to 500 livres, where they had been at the beginning. 

Suddenly, the economic miracle created by Law had burst. Thousands of people lost their shirts as their stock holdings lost ninety percent of their value. John Law had become a public enemy, and he had to flee the country secretly. Finance had become a dirty word in France for a long time, and it would be eighty years before France would introduce paper money into its economy again.

REFERENCE: Murphy, A. E. (1997). John Law. Oxford, UK: Oxford Press.