“People will often overestimate the value of their opinions or even if anyone wants to hear them.” - Mark McCormack
TLDR
France had a national debt and was virtually bankrupt. A Scottish financier named John Law convinced them that the country could be saved if they let him form a company to exploit the wealth of the Louisiana territory in North America. To do this, he would re-structure the French economy by replacing a lot of the stable, solid money that was sitting in people's bank accounts with shares in his company (which were also to be traded on the stock market).
Because of the modern-day hysteria about the dot-com crash, many people have forgotten what happened a few centuries before. Previous to that bubble, there was an even Bigger Bubble in France.
What is a bubble?
A promising new company is going to change the world. It has great technology, a great management team, stellar financing, so on…
As with any economic phenomenon, the mysterious and misunderstood nature of bubbles has generated years of investigation by academics. The general belief is that three necessary conditions for a bubble – are marketability, monetary liquidity and speculation. Add a little technological or political spark and voila! You have a Great Bubble.
Bubbles are at times very deceptive and unpredictable phenomena. But, their lifecycle is made up of five basic steps, as identified by the economist Hyman P. Minsky-displacement, boom, euphoria, profit-taking and panic.
While, he wrote all this in the early 1990s, in the Financial Histroy we have some amazing examples of Crowd Madness and Irrationality- like the South Sea Bubble, the Mississippi Bubble, and the Dutch Tulipmania.
In this post, we will talk about John Law's life, career, and collapse. He was a financial genius, who conceived the Banque Royale in France-their first national bank. He was also an early proponent of economic theories that justify paper money. But before that little more history.
Confusion of Confusions
The book, 'Confusion of Confusions,' is a chronicle of the rise and fall of the Amsterdam Stock Exchange (the oldest "modern" securities market in the world, that operated as a roofless courtyard). The title reflected de la Vega’s belief that the business remained inherently irrational and uncontrollable: “one moved in a world of darkness which nobody wholly understood.”
Book also lay the foundations for modern fields of technical analysis and behavioural finance. The author is a member of a prominent Jewish merchant family, Joseph de la Vega. He was writing in the 1600s, but his observations hold true even today. He also set down new grounds in finance that is being followed even today.
One of de la Vega’s observations about the Amsterdam traders was that they were “very clever in inventing reasons” for a sudden rise or fall in stock prices. Under this context here is the story of ‘Decorative Financial Architecture’.
Mississippi a French Bubble
The growth of the Mississippi Bubble is associated with the Scottish economist, John Law. His vision of paper money was not well received in Scotland; however, he was able to sell the idea in France.
John Law (1671—1729) was a gambler, confidence trickster and swindler who at one point owned most of France. However, he entered France as a Fugitive, who had killed an influential person over a duel.
No less astute as a statesman, he manoeuvred himself into control of France's finances in 1715 and began the work of transforming that country into a major economic power.
Gambler to Mr Banker
In 1716 John Law established his own bank in France, known as the Banque Générale, with the privilege of issuing paper money. His bank, however, was only a part of the comprehensive plan, that he had developed for his larger game.
In the early 1720s, Law became the private banker for the Duke of Orleans, regent to the young king of France. The duke was soon busy on a two-front war; one against other European powers fighting over territory in Europe and one against the Jansenists, strict Catholics who embraced poverty as a virtue. Both wars needed money and so did Law. Law managed to convince the Regent Philippe, Duc d’Orleans, of the benefits of using a bank as an instrument of monetary policy.
It soon received deposits from the Regent and a number of highly placed members of the nobility. It issued banknotes against these deposits. He then created another company, patterned on the South Sea model (the original Bubble from England, where even Newton lost his life saving) but imagined in much grander terms.
Debt swap
This is the same equity for debt swap that launched the South Sea Company, and it served the same purpose: to reduce government debt service and to exploit the future riches of the New World (French colony in Louisiana). Let’s expand this further:
Payments for buying Mississippi share was ONLY in the form of government bonds. The average yield on these bonds was around 4.5%. The Company then lent money to the government, which used the loan to buy out its debt. Since the interest rate on the loan was only 3%, this substantially reduced the government’s debt burden. But the public needed to be convinced to exchange government debt for shares in a company whose main asset was government debt with a much lower yield.
For that, the price of the shares should move in a manner that despite knowing that Financial Maths is not in their favour, the Future of the company’s operations should entice them.
Displacement: Liquidity
The Mississippi Company had a monopoly on trade and mineral wealth. Given that most of the French Goverment’’s debt had been highly illiquid, Mississippi shares traded freely on a vibrant secondary market. So, the pitch was: This is a high liquid Investment
Remember the first stage of Bubble: displacement.
It is the start of the phase leading to the formation of a bubble when the crowd moves more money into an asset class than it would otherwise.
Boom: Mergers and Takeover
Law exaggerated the wealth of Louisiana (by giving very strong commentaries!! and with an effective marketing scheme), which led to good demand for his company’s shares. He saw the potential to absorb all overseas trading rights of France into one firm through mergers and acquisitions. Law had a virtual monopoly on all long-distance French commerce.
Euphoria: Tailgating
Coffeehouses were like today’s Twitter- where news was spread, books were written, poetry recited, and opposition plotted. They were also known as “penny universities” as hiring a table for an hour cost only a penny, and you can learn a lot by hearing the other discussions in the house. Across Europe, both Mississippi and the South Sea became the Best Financial Bet, here they will get to know about these schemes, and they thought of this exploitation of information that is not yet public. The term "millionaire" was first coined in Paris to describe the early beneficiaries of Law's dazzling scheme.
It is not so much greed and irrationality that drive bubbles, but rather, overconfidence, positive contagion, and herding are the main culprits.
The Company boomed on paper. Mr Law was soon given the title Duc d'Arkansas.
Profit Taking: Leveraged finance
He then involved a lot of speculators for the ‘market management’ tricks.
“Investing” is choosing what to do with your money in the future. “Speculation” is making that choice by guessing what will happen, rather than by examining the facts of present and past.
The Banque Royale (which was controlled by Law) was used to loan money against company shares, thus serving as what today would be called a “repo” facility, which ensured liquidity to investors. So, Mississippi Company stock continued to rise in price, as purchases were financed by inflated notes issued by the Bank.
Bubbles do not grow of their own volition. They're fed by excessive amounts of cheap credit.
Meanwhile, many speculators started to take their profits from the Mississippi Bubble, so the land prices started rising by 1719 (kinda new Displacement play).
A great speculator is not a gambler. A gambler stakes his entire capital on a single cast of the dice. A speculator risks less than his stake.
Around the same time (1720) he became the finance minister of France. Now in order to limit such exits from the leading Market Players. Law thought of putting some checks.
Panic:
The common play by the Profit-Takers of the Mississippi Company was to convert their gains back into gold and silver coins and then store/trade/export. Law passed the Laws that banned the export of gold or silver. However French government had no means to enforce such measures.
So, many ignored the new laws; others converted their Mississippi holdings into diamonds and lands. As the prices were declining, Law asked the Banks to start buying these at higher prices. And, for that, they had to JUST mint the money. But this created enormous inflation, undermining two goals that were crucial to the system: replacing metallic currency with banknotes as France’s main currency, and keeping interest rates low.
Damage was done, he was removed as Minister of Finance. His Banks were closed, and it was announced that the banknotes would no longer be accepted for the payment of taxes. The Mississippi Company’s tax collection and minting rights were removed.
It was Mayhem all over France. Law's great adventure—the Mississippi Company—had rocked the French establishment to its foundations.
Law’s reputation was ruined; he fled the country dressed as a woman and then began a peripatetic existence that saw him making station in Brussels, Rome, Copenhagen, Venice, and, finally, London where he died.
We haven't seen a character like his since Charles Ponzi or Bernard Madoff. He almost “privatized” France. It is said that if his plan was fully realized, it would have been an alternative form of democracy—a shareholder democracy!
When bubbles are getting bigger and bigger, investors become euphoric and forget the risk of losing everything. But when stock prices started declining sharply, investors panicked and sold quickly to avoid further losses.
Actionable Insights
“The purpose of knowledge is action, not knowledge.” - Aristotle
Bubbles - They captivate... they fascinate... and, boy, do they confuse! To the uninitiated and ignorant, bubbles seem so unpredictable. And yet, once you gain experience in spotting the stages of a bubble's lifecycle, they become just as predictable as other financial phenomena like inflation or stocks.
Investors at times know that stocks are overvalued, but they're still participating in markets because they think prices will keep going up. But then one of the key reasons why bubbles burst -- when investors take profits, we see mass selling that reinforces that idea that stocks are overpriced.
Any asset can be in bubble territory: stocks, bonds, houses, currencies, works of art, even commodities like gold and oil. Fortunes have been made–and lost–by a sudden shift in perception about the future value of a widely held asset.
BTW, NFT can also mean, Not Forget Tulip!
How is it different from a Bull Market?
In a Bull market, you have more people creating wealth for themselves or for their company. While in a bubble, you see asset prices increase based on expectation/speculation.