What John Law Taught Us About the Perils of Printing Money
In the same year that the Bank of England was created – 1694 – John Law became a fugitive. He killed a man in a duel, was thrown in prison awaiting execution, and escaped to Europe. After some years of gambling his way through the European courts and writing surprisingly prescient texts on monetary economics he landed in France. One of history’s first grand experiments with unbacked paper money was about to begin.
Law’s monetary extravagance between 1715 and 1720 was not simply a Ponzi scheme by a monetary quack, but — at least initially — a real value-add. He set up the General Bank (“Banque Générale”) and received a charter in 1716. The bank’s notes were not legal tender, were redeemable on demand in gold, and looked to the world as another private joint-stock company. As the paid-up capital was only partly subscribed and three-quarters of that was paid with billets d’état (government debt that traded at 40% of par value), his effective capital was only around 825,000 livres – a fairly small company. His charter permitted him only to accept deposits and discount creditworthy bills.
Richard Dale explains in his classic account of the South Sea Company (whose conversation strategy was based on Law’s then-seemingly successfully scheme) that “customers [of Law’s bank] would receive back the same amount of coins that they had deposited, regardless of any revaluation/devaluation of the livre that might occur”. In times where kings and queens altered and changed the specie content of the currency almost at a whim, such an insurance service provided by Law’s bank was very useful. Dale continues:
the Bank in effect united the unit of account with the medium of exchange, thereby removing uncertainty, and providing depositors with a convenient asset (bank notes) that were equivalent to specie in value and transferability.
In addition to that, Law also offered his customers free remittance and foreign exchange services, all in order to attract more business. When in April 1717 the Regent declared that the General Bank’s notes would be accepted in payment of taxes, Law’s bank seemed primed for triumph.
Picking up Money Printing Speed
In the second stage of Law’s experiment, he took over another joint-stock company that contained the monopoly trading rights to then-French Louisiana. To that business, he swiftly added the state’s tobacco monopoly and the trading activities of the Senegal Company before consolidating the Company of the Indies, China Company and Company of Africa into what became known as the Mississippi Company. Every step of the way, Law made good use of his financial printing press, his bank being converted into a state-owned Royal Bank with him in charge towards the end of 1718. In doing so, the government paid the full nominal price on the bank’s shares, ensuring that shareholders pocketed a hefty capital gain. As in all financial bubbles, early adopters stood to profit enormously.
At the end of 1718, notes of 40 million livres were outstanding, based on roughly 825,000 livres worth of equity and a specie ratio of perhaps 25% (the fact that Law kept his accounts hidden suggests that it might have been much lower; records have unfortunately not survived). Generating over a million livres a year in interest income from the government debt the Company had acquired, the return on equity on even fully-subscribed shares would have been something like 16% (great even by today’s standards), but as the shares were only partially subscribed, investors saw returns on their equity in the neighborhood of 100% per year.
To finance his aggressive acquisitions, Law raised even more capital through issuing more Mississippi Company stock. Curiously, in June 1719 he managed to place shares at 10% above par when shares in Rue Quincampoix were trading at a 10% discount. To achieve this Law made increasingly grandiose claims about a thriving New Orleans with its plentiful, rich and fertile soil, in a manner that would be painfully familiar to a twenty-first century reader in light of unicorn start-ups and fanciful promises of extreme future profitability.
To square his financial circle, Law had to induce investors to “the prospect of an expected capital gain,” otherwise the state’s creditors would rather hold on to their high-yielding annuities. Bailed out by the French monarch at least once , and staking his personal fortune by fully underwriting share issues, it was far from a smooth ride for Law who used the Royal Bank to keep the monetary conditions as easy as possible.
On September 4, 300 years ago this month, the shares of Law’s Mississippi Company were trading at 5000 livres,10 times their par value, after an increase of 3200% in less than two years. During the following winter, the share prices increased even further and peaked at 10,100 livres on 8 Jan 1720, for a market value of over 6 billion livres.
During the same time the Royal Bank had increased its note issue from 160 million to over a billion livres in less than six months. The newly-issued notes were used by investors to push up the share prices of the Mississippi Company in times of frenzy, and by Law and his companions in times of doubt.
Like all booms in their early stages, explains Antoin Murphy, “The Mississippi System, in all its unifying beauty appeared to be working”: the state’s previously crushing debt overhang was under control, interest rates had dropped to remarkably low 2%, and the Mississippi share prices had stabilized by issuing options and ensure guaranteed share-for-note swaps at the Royal Bank.
Like all booms, they also end. While the newly-printed money initially stayed in the financial system, pumping up prices of shares and options on the Mississippi Company, eventually this “new wealth” spilled into the real economy, doubling prices between 1718 and 1720. In the early months of 1720, Law “pegged” the price of the company’s shares by freely exchanging shares for notes at that price and ended up buying almost a third of its outstanding stock.
When Law tried to control the resulting inflation by devaluing the face value of notes – engaging in the very practice his bank initially insured against – the game was over, as was the trust in his system. Beginning in August 1720, the notes were demonetized and by November that year the company was bankrupt and Law, once again, in exile — condemned to writing outlandishly on money until his death in Venice in 1729.
You can bubble a rudimentary financial market without access to the printing press, as the South Sea Company's projectors showed the year after Law's scheme unraveled. Mere promises and extravagant expectations will suffice. But to truly boom and bust a financial system with far-fetching real consequences, you need to control the money supply. Through his Royal Bank and the legal backing of the state, John Law did precisely that — and three centuries later the story of the Mississippi Company's collapse carries great warnings for our times.