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The First Stock Market Bubble

France - 1715

John Law and his Mississippi Company and Banque Royale

Introduction:-

During 1708, France’s fiscal problems were desperate. The public debt as a result of wars of Louis XIV was enormous and the government was on the verge of bankruptcy. The country was in recession. The French invited John Law, who himself had proposed to the French government that he had a solution to France’s problems. His proposal was to establish private bank which would have authorization from the government to issue currency notes (payable in gold or silver) for a period of 25 years. His proposal was accepted and he was granted the license to start the bank named “Banque Generale”.

The capital of the bank was set at 60,00,000 livres (1200 shares of 5,000 livres each) Through continuous lobbying with the government, he procured the rights that all payment of taxes in France should be done by using the notes issued by his bank – Banque Generale. Law’s ambition was to revive economic confidence in France. He wanted to achieve this by establishing a public bank which would issue paper money. As money was invested in the bank, the government’s huge debt would be consolidated. At the same time, paper money would revive French trade – and with it French economic power.

Law’s idea was based on ‘absolutist theory of finance’, based on the assertion that ‘in credit as in military and legislative authorities, supreme power must reside in only one person. In Law’s scheme, the monarch of France would effectively delegate his credit to a trading company, into which all the materials of trade in the kingdom fall successfully, and are amassed into one. The trading company or the royal bank would be a single authority for dealing with cash, upon which the entire trade and commerce on the country should depend. He also wanted to expand the French colonies. Expansion of kingdom or empire played a great role in development of Europe during the 18th century. His persuasion with the monarch procured him the license to make his bank – Banque Generale – a sort of central bank for France. He also procured the license to oversee the trade with Louisiana Territory (US), a vast but wholly underdeveloped tract of land stretching from the Mississippi Delta across the Midwest – equivalent to a quarter of what is now United States.

So now, John Law has two companies – one a bank and the other a trading company. The trading company was named ‘Company of the West’ (Compagnie d’ Occident). This company was given the monopoly of the commerce of Louisiana for a period of 25 years. The company’s capital was fixed at 100 million livres, an unprecedented sum in France. Shares in the company were priced at 500 livres each.

In December 1718, the Banque Generale was given the approval to act as a central bank for the empire. It was renamed Banque Royale. What Law was essentially doing was converting the government deficit into equity of his trading company. If the trading company were successful, the financial difficulties of the French monarch would end. John Law as the majority shareholder of both the bank and the trading company, knew that the only way to profit excessively is by way of making both the bank and the trading company as big as possible. This could be possible by allowing monetary expansion, which his own bank could generate, to fuel an asset bubble from which he more than anyone else would profit. His position was as if one man was running all five hundred of the top US corporations, the US Treasury and the Federal Reserve System all at the same time.

Law increased monetary supply and encouraged citizens to buy additional shares of his trading company. Subsequent new issues were priced at 1000 livres rather than 500 livres, which was the face value of the shares at the time of first issue. Most of the money went to the royal mint. Since the trading company was supposed to do its business not in France but in Louisiana (US), citizens did not know the prevailing conditions or the state of the business. As a start, a new city by the name ‘New Orleans’ was established at the mouth of the Mississippi Delta. The company even sent the first colonist to this new land. However, when the colonists arrived, they found not a bustling city but a sweltering, insect-infected swamp. Within a year, 80% of them had died of starvation or tropical diseases like yellow fever. Attractive advertisements were made to entice investors to buy more shares of the trading company. To help investors to purchase the new shares of the trading company, the bank – Banque Royale – even offered to lend money if investors put existing shares as collateral. The trading company even declared a 40% dividend in the first year of operation to make the company attractive for investment. All these efforts, made the share price of the trading company to soar higher and higher.

In just 2 years from the inception of his business, the share price rose from its issue price of 500 livres to 10,025 livres. A return of close to 2000% in 2 years. To add to the existing enthusiasm, John Law was appointed as the ‘Controller General of Finances’. His dream was now complete. He was now in charge of the following.
  1. The collection of all French indirect taxes;
  2. The entire French national debt;
  3. The twenty six French mints that produced the country’s gold and silver coins;
  4. The colony of Louisiana, US;
  5. The Mississippi Company, which had the monopoly on the import and sale of Tobacco.
  6. The French fur trade with Canada; and
  7. All France’s trade with Africa, Asia and the East Indies
If Louis XIV being the monarch was ‘The State of France’, then John Law was ‘The Economy of France’. However, the situation was changing rapidly. The trading company’s shares began to fall. They fell from a high of 10,250 livres to 7,930 livres in just 3 months. John Law resorted to guarantee by offering buying or selling at a floor price of 9000 livres. He also issued options costing 1000 livres which entitled the owner to buy a share for 10,000 livres over the following six months. These measures sufficed to keep the share price temporarily steady. However, inflation was accelerating alarmingly outside the stock exchange due to the monetary expansion that John Law had created through this Banque Royale.

In a space of more than a year, the bank has more than doubled the currency note circulation. Some people resorted to converting bank notes into silver and gold. In response, John Law made the notes legal tender. The export of gold and silver was banned as was the production and sale of gold and silver objects. By 1720, it was illegal for a private citizen to possess more than 500 livres of metal coin. During the same time, Law tinkered with the exchange rate of bank notes in terms of gold and silver, altering the official price of silver no fewer than thirty-five times in a span of just ONE year. All these efforts were made by him just to make bank notes more attractive than coins.

Over the next few months, the share price fell to 5000 livres. However, since the company had guaranteed to buy the shares at 9000 livres, most investors resorted to selling it back to the company. This meant that more and more notes were printed by the bank to fund the repurchase by the company. This in turn, increased the inflation. In a desperate bid to avoid meltdown, Law issued deflationary decree, reducing the official price of the company’s shares from 9000 livres to 5000 livres and at the same time halving the number of bank notes in circulation. He also devalued the bank notes. Violent public outcry forced the government to revoke these measures just six days after their announcement, but the damage done to the confidence and the system was irrevocable. After an initial lull, the share prices further slid to 4,200 livres. The government removed him from the post of ‘Controller of Finance’ and kept him under house arrest. The government was also forced to reintroduce the use of gold and silver coins in domestic transactions. The share price of the trading company further fell to 1,000 livres in a span of few months. And ultimately they became worthless. John Law had to fled the country.

The losses to France were more than just Financial. Law’s bubble and bust fatally set back France’s financial development, putting Frenchmen off paper money and stock markets for generations. The French monarchy’s fiscal crisis went unresolved and for the remainder of the reigns of Louis XV and his successor Louis XVI the crown essentially lived from hand to mouth.

John Law’s Trading Company, his bank (Banque Royale) and his financial system cased the first stock market bubble.