Bubble formation

The financial system in France was reformed by Law. He urged the use of paper money.  But how can he handle the huge amount of notes? He implemented “debt-to-equity swaps”.

In August 1717, Law set up Compagnie d’Occident which was also called Mississippi Company engaged in mining and trading in Louisiana (the French colony at that time). The company was backed by the French royal family and monopolized trade at West Indies and North America.

This was the first step to carry on his experiment. At first, he paid back debt for the government to get the right of issuing bank notes to the public; then, using the public debt as collateral, Law issued shares; the government made its payment in terms of Law’s notes while the public used these notes to buy Law’s shares. Thus, Law transformed the government debt to the company equity. Consequently, the economy had completed the first round of an upward spiral.

Law’s idea was based on the establishment of a solid “fund of credit”, which brought him relatively stable cash flow with which he promoted his grandiose business plan. The intuition behind his plan is as following. First of all, he raised money for his company. Business activities and expansion was facilitated as soon as funding for the projects was in place. In fact, Law’s company did unceasing expand its commercial activity. In September 1718, he obtained the tobacco monopoly. In November 1718, he acquired the Senegalese Company which traded with Africa. In May 1719, he merged the East India Company and the China Company. He reorganized the huge conglomerate as Compagnie des Indes. Since the company owned high monopoly of trade outside Europe and it was said that Mississippi contained lots of gold, silver and jewel, the share price kept increasing.

 

 

By this time, as Law expected, the issue of banknotes stimulated the public demand; meanwhile, the public were offered a wonderful investment opportunity: buying shares of Law’s company. Thus, the excess paper money flowed back to Law; Law again paid the government with these banknotes; the government made its payment with the paper money; the public again bought shares using notes. It really did work! All French thought that the depression passed. They became rich and owed the prosperity to Law's company! They had no doubt about the value of money!

What’s the true value of banknotes? Without the promise by government that notes can be exchanged with gold, it is just a piece of paper. It has no intrinsic value. But the public believed the paper money issued by Law. Why? Law helped them come out of the depression? He was Regent’s friends? Or he would find huge amounts of gold soon? From my point of view, the reasons mentioned above all contributed to the belief of the public and revealed the true value of paper money: credit.

In the next post, we will talk about how the credit stimulates the economy and leads to bubble inflating.