Rationality VS Irrationality

In the last two posts, we’ve talked about how irrationality and rationality lead to a bubble. Who is responsible for Mississippi Bubble? Perhaps no one in France at that time is innocent. From my point of view, rationality interacts with irrationality, resulting in the bubble. If everyone is rational, the bubble can be avoided before it burst. If everyone is irrational, then the bubble would keep inflating. Unfortunately, behaviours of human beings are changeable and unpredictable, which makes the economic or financial theories inconsistent with the real world. In other words, people’s behaviours are uncertain, or unstable, contributing to the financial instability.

Hyman Minsky introduces a model which emphasizes the pro-cyclical changes in the supply of credit to interpret financial crises. If a positive “displacement”, exogenous shock, occurs to the macroeconomic system, investors will become more optimistic about the future. Thus, they are eager to borrow in order to invest. At the same time, lenders are willing to make loans regardless of risk. As a result, optimistic expectations of investors encourage credit expansion and in turn credit expansion further boosts the optimistic expectations and asset prices as well. The danger comes when the economic conditions slow, resulting in less optimistic and more cautious attitude of investors and lenders. Therefore, it is the increases in the supply of credit in good times and decreases in the supply of credit in less optimistic economic times that lead to “fragility in financial arrangements and increased the likelihood of financial crises”.

In Mississippi Bubble, the creation of paper money and the establishment of central bank can be regarded as a positive shock to the macroeconomic. Such financial innovations conceal the inflation and create a “money illusion”. After that, the many advantages of Law’s company increase the demand for investment. To meet such demand and further stimulate economy, Law prints more money, resulting in credit over-expansion. Unfortunately, the negative shocks (caused by the news that no gold in Mississippi and the huge demand of species) destroy the irrational exuberance. Investors believe the share price is far away from its true value and rush to sell it, resulting in the rapid decrease in stock price. Meanwhile, such decrease increases the investors’ pessimism, accelerating the collapse of credit system of paper currency. At last, the bubble burst and followed by the crisis, which make the French curse the word “Banque” for a century.

Law’s intention is good. Schumpter speaks highly of John Law, "he worded out the economies of his projects with a brilliance and, yes, profundity which places him in the front ranks of monetary theorists of all times." Law devotes himself to help France out of depression. His idea (printing money in depression) can be found in Keynesian economics, supply side economics and monetarism. But just as Mackey Charles says, “He did not calculate upon the avaricious frenzy of a whole nation; he did not see that confidence, like mistrust, could be increased almost ad infinitum, and that hope was as extravagant as fear”. Although he fails finally, he is lucky because he is the first one and the only one to put his theories into practice entirely and massively.

Mississippi Bubble is one of the earliest bubbles in the history. The boom and burst of it proves Minsky’s crisis theory. Law’s story is extremely pure. Only then can it reveal the nature of bubble typically and directly: under the stimulus caused by optimistic expectation, credit expanding interacts with increase in share price. In modern economy, such essential relationship is always covered by various kinds of advanced financial instruments, complicated trading patterns and financial arrangements. In this sense, this story is worth retelling and remembering.