Burst of the Bubble

 

 

Law was confident with his solution to handle the depression: issuing paper money- converting it to company equity- offsetting national debt. However, he did two things wrong in this framework.

  



figure1: The System of Law (drawn by myself)

 

Firstly, the public bought shares because of their optimistic expectations. But Law expanded the Compagnie without any exact investment projects. In other words, the company value was based on the rumour that Mississippi was crowded with gold and silver. Unfortunately, people found gradually that the rumour was not true. Mississippi was a backwater rather than a paradise. Without actual profit, Compagnie was faced with the financial distress. Law had to issue more equity to roll over existing debts with new borrowing. He began to spread the news that Compagnie succeeded in finding gold mine and impose restrictions on the number of new shares bought by original shareholders (aiming to create a façade that the ability to buy stocks is a privilege). Furthermore, he longed Compagnie stock future at the price which was higher than a third of the market price at that time to build expectation that the share price would continue to grow.
 

Secondly, the overexpansion of money credit would inevitably cause inflation. The inflation rate in France in 1719 was only 4% while it was 23% in January 1720. The public started to worry about the purchasing power. As a result, some of them sold the shares to buy gold which resulted in the decrease in share price. Ironically, in the first half of 1720, one prince required to exchange huge notes, seriously depleting the bank reserve. Although finally he returned most of the precious metal with the invention of the Regent, but the faith in market was poisoned. More people required to get the specie and sent gold (silver) abroad. Law and Regent spared no effort to restrict the use of metallic money. For example, they ruled that paper money could serve as legal tender to pay depositors. Worse still, Law had to print more money to absorb shares sold by some investors which led to further inflation. In the end, rising trend of stock price finished. He failed to maintain the high price level and had to plan to decrease the price. Meanwhile, he devalued the money. Certainly, these operations generated the widespread panic, making the price collapse. In September 1720, share price cut to 2000 livers per share. It continued to decrease to 1000 livers in December 1720 and 500 livers September 1721 respectively (In May 1719, the share price was 500 livers!).



figure2:Mississippi Bubble money and price data( Garber,1990)




figure3: share price of Mississippi Company (Garber,1990)
                           

On October 10, 1720, the government announced an end to “The System” created by Law.  He was made ousted from his position and his property was confiscated. What’s worse, his life was in danger. Again, he fled in panic and finally died in a strange place in March 1729.

 

Here is the end of the Mississippi Bubble. I am amazed by Law’s bold attempt. His theory is reasonable and even popular nowadays. But there is no doubt that he did make mistake which destroyed the economy in France. However, is he the only one that needs to be responsible for the Bubble? In the next post, we will look at the “story” again from some prospective.