The man who invented the stock market bubble
We have had an endless diet of financial scandals in recent years but there is nothing new under the sun as the case of the Scottish economist John Law demonstrates. Law was born into a family of bankers and goldsmiths from Fife in 1871. At the age of fourteen Law joined the family business, where he worked and learned the ropes, until the death of his father in 1688. This led Law to abandon the firm and go off to London where he lost a fortune gambling. Things were about to get worse for the young Law. On 9 April 1694, he fought a duel with Edward Wilson over the affections of one Elizabeth Villiers. Wilson was killed, and Law was found guilty of murder and sentenced to death. This sentence was commuted to a fine for manslaughter but when Wilson’s brother appealed the sentence, Law was imprisoned. However, he managed to escape to Amsterdam. At this time the city was the world capital of financial innovation – with the world’s first central bank and the invention of the company. This was the perfect place for Law and he was able to amass a huge fortune through financial speculation. It also gave his some ideas about financial engineering – he now needed a country where he could apply them.
In 1705, he returned to Scotland, and wrote a book – Money and Trade considered, with a Proposal for Supplying the Nation with Money. The same year, he made a proposal to the Scottish Parliament for the establishment of a national bank, but his suggestion was turned down. He would have to take his schemes back to the continent.
In 1715, he settled in France, and soon came to the attention of the rakish Philippe Duc d’Orleans, Regent for the young king of France. Both Law and the Duke enjoyed frequenting gambling dens. In 1715 Philippe succeeded his uncle and would be Regent to the new king five-year old Louis XV, until 1723. Law now had his foot in the door. In 1716 he persuaded the Duke to allow him to set up the Banque Generale with the power to issue banknotes. Although it was a private bank, three quarters of the capital consisted of government bills and government accepted notes. The economic difficulties faced by the French government gave Law just the opportunity he had been waiting for to put his revolutionary ideas into practice.
We need to look at the historical context of these events. Under Louis XIV France had been at war with England for many years and this left the French economy with its rampant inflation shortage of coins and unstable prices, in a parlous state. It was on the verge of bankruptcy. Law’s plan was to convert government debt from fixed-rate annuities to shares paying a lower rate. He was going to create the Dutch model but on steroids combining a trading company and a public bank.
In 1817 the Banque Generale became the Banque Royale. Not content with having the French money supply under his tutelage, he then sought the trading concessions of the Compagnie d’Occident and he also had the Royal Mint. This was not a good idea because it gave Law and the Regent the incentive to print money. Law floated the Compagnie d’Occident as the Mississippi Company, which owned a quarter of what is now the United States in the Companie were originally issued at 500 livres, but rose to 10,000 livres in the course of 1719. When the Companie issued a 40% dividend in 1720, the share price rocketed to 18,000 livres, far-outstripping the capital base of the Companie. This was the biggest financial bubble in history, surpassing what happened in the United States in the 1920s before the onset of the great Depression. The atmosphere is captured by these observations from the time:
It is inconceivable what wealth there is in France now. Everybody speaks in millions. I don’t understand it at all. But I see clearly that the God Mammon reigns an absolute monarch in Paris.
The problem was that the Mississippi Company was based on marketing and had little fundamental value it was basically a Ponzi scheme. In 1720 after those spectacular gains, speculators resolved to take their profits and run. The share price dropped as dramatically as it had risen. As panic set in investors sought to redeem their bank notes and promissory notes, but the Companie did not have the funds it and went bankrupt. In 1720 with a false passport in his hand, Law fled France returned to his nomadic existence, and died, penniless, in Venice in 1729.
What about the consequences for France? It set back French finances and Louis XV and Louis XVI were permanently hamstrung by a lack of resources, surely one of the most important factors behind the revolution of 1789. Interestingly Britain suffered a similar crisis, The South Sea Bubble, but it did not have the same disastrous effect. The British government took a too-big-to-fail stance, nationalising the company and a resolution was proposed in parliament that bankers be tied up in sacks filled with snakes and tipped into the murky Thames. The lesson I would draw is that is that venality is a constant theme in society but it is also important not to renounce financial innovation completely. Financial innovation has also created a lot of wealth and it would be a grave mistake to throw out the baby with the bath water.