March 27, 2016

An Abundance Of Fictitious And Imaginary Money

A Sunday topic on this Reuters column by Edward Chancellor. “This year marks the 300th anniversary of the start of an economic project in France which posterity knows as the Mississippi Bubble. The brainchild of an expatriate Scot, John Law, this scheme has been hailed as the most ambitious economic experiment prior to the establishment of the Soviet Union in 1917. Like Lenin’s creation, the short-lived Mississippi Bubble burst in spectacular fashion. Central bankers around the world are currently embarked on a mission not altogether different from Law’s, making lessons revealed by his failure particularly relevant today.”

“At the height of what he called his ‘System,’ Law was the richest and most powerful man in Europe. His Mississippi Company incorporated all of France’s overseas trading companies – one of which claimed title to half the landmass of what is now the United States, along with monopolies for tax collection, tobacco, and coinage.”

“To understand the origins of the bubble it’s critical to grasp the Scotsman’s original purpose. As an economist, Law was a monetarist, an early forerunner of the late Milton Friedman. He believed that France suffered from a dearth of money and that an increase in its supply would boost economic activity. At the time of Louis XIV’s death in 1715, Law saw that France had two pressing problems. First, the state had too much debt – many of the royal debts were trading well below par. Secondly, interest rates were too high – in his last years, Louis XIV paid above 8 percent for his loans.”

“Law, according to his biographer Antoin Murphy, was a ‘low-interest rate advocate.’ He recommended setting up a national bank, which could issue notes to buy up the government’s debt, and thus bring about a decline in the interest rate.”

“Law was effectively suggesting that the central bank should expand its balance sheet to lower interest rates, which in turn would help over-leveraged borrowers, boost economic growth and employment and stimulate inflation, while simultaneously reducing the cost of servicing government debt.”

“The scheme commenced in May 1716 with the foundation of the Banque Générale, the forerunner of France’s first central bank. Over the next four years, Law enjoyed remarkable success – the Mississippi stock soared, the entire French national debt was absorbed by the company and interest rates fell to 2 percent. Paris bustled with newly coined (or rather, printed) millionaires. Within four years, however, Law’s System had exploded – the stock-market bubble burst, confidence in bank notes evaporated and the French currency collapsed. In late 1720, Law was forced into exile. He died nine years later and was buried in a pauper’s tomb in Venice’s San Moise.”

“The best contemporary critique of the System is provided by the banker and economist Richard Cantillon, who was based in Paris during the bubble. First, Cantillon questioned Law’s basic economic premise. Money printing brought no lasting benefits, in his view: ‘An abundance of fictitious and imaginary money causes the same disadvantage as an increase of real money in circulation, by raising the price of land and labour, or by making works and manufactures more expensive at the risk of subsequent loss. But this furtive abundance vanishes at the first sign of discredit and precipitates disorder.’”

“Devaluations of money promoted inefficiency: ‘Undertakers and merchants find it easy to borrow money, which decides the least able and least accredited to increase their enterprise,’ wrote Cantillon. Operations to reduce rates with freshly printed money also provided an opportunity for corruption, as large fortunes could easily be made. Cantillon argued that Law’s monetary experiment might temporarily reduce interest rates and incite speculation but the newly printed notes didn’t actually enter into the real economy. Similar criticisms have been made about central banks’ recent attempts to boost economic activity with quantitative easing.”

“As the effectiveness of monetary policies has come into question, central bankers in Japan and Europe have acted with a Law-like vehemence. Above all, the collapse of the Mississippi scheme shows that when central banks inflate bubbles there is no painless ‘exit’ – Law’s Banque Royale had to continue printing money to sustain the bubble.”