October 15, 2003

Federal Reserve Bank of Cleveland

Bubble, Toil, and Trouble

by Ben Craig

“I can calculate the motions of the Alternatively, the second school believes heavenly bodies but not the madness that, at times, a few uninformed market Not everyone believes bubbles occur in of people.” participants will induce behavior in the stock markets. Many economists do, —Sir Isaac Newton, upon losing informed participants that actually drives £20,000 in the South Sea Bubble the price away from its long-run value, but others think something else is hap- causing a short-run bubble, which then pening during periods of rapidly ris- During the run-up in prices of Inter- bursts and causes the price to return to its ing and plummeting stock prices. This net stocks, financial commentators of sustainable value. Commentary explains the two schools the time argued about whether the of thought and shows how both can higher prices were justified. Once prices The difference between the two schools describe a famous historical episode fell, the answer seemed all too obvious. of thought lies not in whether a temporary known as the Mississippi bubble. Investors had gotten carried away, had shock causes a market price to differ from not paid attention to the fundamental its long-run value (both schools acknowl- determinants of value, had overesti- edge this probability) or whether the mated the future return of the assets they market price eventually returns to this ■ were buying. They had succumbed to value (both schools believe this occurs). John Law and the one of the most mortifying of all The difference depends on the assumed Mississippi Company investor pitfalls: a speculative “bubble.” behavior of the informed traders: One The history of the Mississippi bubble They should have known better! theory asserts that informed traders centers around the rise and fall of John quickly push the price back to its long-run Law, a gentleman who could be But could they have? When it comes to value, the other says these same traders described as one of the very first macro- explaining episodes like the dot-com will drive the price temporarily higher economists. In 1705, he published his bust, most economists fall into two than its long-run value. (Strictly speaking, remarkable Treatise on Money, in which schools. One school rejects bubbles as if a bubble is defined as a situation in he argued that issuing paper currency an explanation and believes the price of which the price of an asset is based on should expand commerce, which, in an asset always reflects the market’s something other than the market’s assess- turn, would expand the demand for the estimate of the asset’s value (except for ment of its real value, the first school currency, so that prices would not rise. In short-lived deviations); thus the prices of would say bubbles are unlikely. We’ll 1710, Law came to France, after learn- Internet stocks truly reflected the mar- continue to refer to periods of rapid or ing that his good friend, the Duc d’Or- ket’s estimate of the value of a new tech- significant rise and subsequent fall in the leans, had been made regent of France. nology and the belief that it had opened price of some asset as bubbles if they are The French government was in financial up new possibilities for profits. Other well-known as such.) chaos. By the time Law arrived, the economists would say that prices can be crown had already had a partial default driven higher when some market partici- Which school is correct? This Commen- on its bonds and was quite susceptible to pants buy an asset in the hopes that the tary explores both explanations in light his suggestion that his ideas be put into price will continue to rise and they can of an alleged archetypal bubble, the so- practice. sell it before the price drops; they call called Mississippi bubble. This is the this scenario a bubble and say such was first bubble for which we have reliable In June of 1716, Law set up the Banque the case with Internet stocks. price data, and it has been studied for Générale, a company whose sharehold- several centuries. (The tulip bubble may ers included the crown, private investors, The first school believes that the market be better known, but we have almost no and Law himself. It was like many banks price may be temporarily displaced from reliable price data for it.) Like the dot- with an important exception. The paper its long-run value, but arbitrageurs push com bubble of recent time, it was the notes it issued on deposits of coins acted the price back to the level that can be result of a technical innovation, but in as currency. The regent, influenced by sustained. (Arbitrageurs make money by this case, the innovation was one of a Law’s views on paper notes, made them buying or selling a stock that is not new macroeconomic theory. legal tender for taxes, required tax collec- priced at its long-run value and then tors to exchange the notes for coins on closing out their position for a profit demand (thus giving the bank what when the price returns to this value. amounted to free branch offices), and

ISSN 0428-1276 encouraged the wealthy of France to company’s holding of government debt). Law chose to concentrate his business make large deposits of coins in the bank. What we do know is that initially, at operations on those functions that are The Banque Générale followed the con- least, the public had enough confidence presently performed by government servative policy of backing 50 percent of in Law’s system to have faith in the institutions: taxation and the issuing of the notes with government debt (so that future payments on this debt. currency, rather than, say, developing the fractional reserve was half the value colonial infrastructure. Perhaps of the notes kept as coins), and the notes At the height of Law’s career, in January investors hoped that Law’s economic circulated as currency at face value. The 1720, he was made France’s comptroller system could generate such fabulous operation was very profitable and earned general and the superintendent general profits in the short run that they would its investors a return of 64 percent per of finance, in addition to being a large allow the development of vast territories year by the time the crown took it over in shareholder in the Mississippi Company. in the long run. However, in May 1720, December 1718. Within a month, the company also prices of goods in terms of the com- owned the Banque Générale, whose cur- pany’s currency started rising rapidly. In August of 1717 Law established the rency was encouraged by a series of This called into question Law’s theory Mississippi Company (officially regis- edicts limiting the use of metallic money. that currency would create the economic tered as Compagnie d’Occident) in At the peak of share value, when shares conditions that would sustain its pur- which shares were purchased with a were heavily traded, the company was chasing power. combination of paper currency and worth about one-fifth of all the wealth crown debt. The Mississippi Company of France. Law tried to force a reduction in the had monopoly rights to the fur trade of official price of shares from 9000 to the Louisiana and Canadian territories Several things are important to note 5000 livres. (The secondary market indi- and could essentially manage French about the Mississippi Company and its cated an even more precipitous fall in North America as its private fiefdom. shares at this point. First, the company’s the price of shares). There were riots, (New Orleans was named after the assets, organizational structure, and and Law was fired. When it was clear regent, a large shareholder of the com- functions were poorly understood by that no one else understood how his pany.) The company exchanged shares perhaps everyone at the time except Law. company worked, he was brought back. for long-term government debt, intending Indeed, historians who have been study- His attempts to maintain the value of the to develop its North American holdings ing the company in light of modern currency by reducing the amount in cir- with the long-term stream of cash pro- financial science have a difficult time culation unraveled, and the share price vided by the interest payments on the sorting out the structure of the company. fell rapidly. By December of the same debt. Once the commercial possibilities For example, it is still unclear whether year, the share price was less than one- in North America provided a profit, the Mississippi Company used the tenth of its high value. The company’s according to Law’s plan, the demand for Banque Générale’s assets for its own currency was no longer used in regular the currency issued by the Banque purposes before the two companies were transactions, and the crown confiscated Générale would be sustained. The acqui- formally merged in 1720. (Most histori- all shares that were held in the Banque sitions of both rights and property that ans now think that both companies were Générale. There was little value left in were made by the Mississippi Company both almost completely under Law’s the company, and Law fled the country. soon included all of France’s properties control). Second, in spite of the impres- in Africa, East India, and China, and sive list of territorial holdings acquired ■ The Mississippi Company monopoly rights to their markets. by the Mississippi Company, these were Might Have Been a not the assets that generated the most “Bubble”… By October of 1719, Law’s company excitement from investors. For example, Researchers who belong to the second had privatized most of the financial similar rights to the North American ter- school described above (bubbles happen) functions of the crown: His company ritories had been given to other investors think that the rise and fall of the Missis- had the sole right to coin money and the with little or no profit to show for them. sippi Company was indeed a good exam- right to collect all direct and indirect What generated the excitement were ple of a bubble. They argue that bubbles taxes, and it held all of the government’s Law’s new ideas about money along begin with a shock that causes the market debt. Holdings of government debt were with the endorsement of these ideas by price of an asset to deviate from its sus- financed with successive share issues, the crown, which owned a share of the tainable value. Such shocks are caused by although the price of the later shares company. And excitement there was. a few uninformed investors who trade was higher. These shares were entitled based upon poor models of market Paris was swollen with investors from all to the same dividend as shares pur- behavior or on a short history of market over Europe eager to buy shares in the chased earlier at lower prices. However, performance. The bubble then forms as a new company. The price of a share at its there was much that was confusing result of the dynamics of the behavior of height on the unofficial secondary mar- about these shares. Some of the pur- the mostly well-informed traders (the ket in December 1719 was 40 times its chases of the shares were made with the majority of the market). In this view, the initial value. It was clear (at least to Banque Générale’s currency, others informed traders realize that the asset’s some) that the revenues from the taxa- with government debt, and some seem price is above its value, but they differ tion rights could not possibly pay a to have been options on possible future from each other in terms of when they 5 percent dividend unless France grew at purchases at a set price. It also remains find out—some know early, others later. a tremendous rate, and even then, that unclear what the crown owned and what They are also unaware of whether they dividend would not come for many it owed to Law’s company. (The crown are early or late learners. Because no one years. Further, the territories had been was a large shareholder at the same time knows who’s early and who’s late, only minimally developed and so could that it was a heavy borrower through the informed traders gamble that they are not be expected to pay much soon. early learners and will be able to ride the Further, experimental studies of bubbles three centuries? The company owned bubble up and get out earlier than the late match the Mississippi bubble in several the economic potential of the entire learners. Their problem has shifted from aspects. These studies suggest that bub- Louisiana Territory and Canada, as well one of making sure the price of an asset bles are very likely to occur when more as the French possessions in Africa, equals its long-run value to one of opti- of the market participants are new to India, and China, although these hold- mal timing: When should one buy to ride trading (as was true in the Mississippi ings do not seem to have been the a price rise up, and when is the best time bubble), and match the spectacular price major driver of the price increase of the to get out of an overvalued asset? The rise and precipitous fall that were shares. In addition to its world hold- implication of this mechanism is that the observed in share prices of the Missis- ings, the company had all of the debt price of an asset rises above its long-run sippi Company. and the ability to issue currency and value until enough “early leavers” sell collect taxes for the largest economy in the asset so that its price drops by a cer- ■ On the Other Hand… Europe. What was the true value of all tain value. At this point, all the specula- However, the value placed on an under- of these privileges? Even with the bene- tors realize that it is time to get out and lying physical asset by well-informed fit of modern economic science it is the price falls precipitously to its long- market participants can rise and fall difficult to decide on a clear value for run value. quite rapidly. What some describe as a the potential profits of these rights in bubble may be nothing more than a 1720. In addition, a purchaser of a The theory has much to recommend it as period in which an asset’s estimated share in the company had to evaluate an explanation for the Mississippi bub- value rises and falls precipitously. For the potential of Law’s economic theory, ble. It suggests that only a few unin- example, oil might increase in price which seemed promising even to hard- formed traders are needed for the valua- because of an expected war. Buyers of ened financial experts in London in tion to be much less than the market price oil desire to buy more in order to store 1719. Garber argues that the contempo- at some time, and it even allows for many in anticipation of possible shortages rary market for the shares of Law’s of the informed traders getting burned by during the war, and the price of the oil company could very well have been the price fall when the bubble bursts. rises. A peace is negotiated, and oil buy- evaluating this “new economy” with ers now realize that they are holding on the best means available, and the prices Indeed, the proposed timing of the to an asset that is less valuable than it could have reflected that value in a theory matches well with what we would have been had a war stopped the rational price. However, the price was know about the Mississippi bubble. By wells from flowing. People quickly volatile: It went up and it went down May of 1719, 30,000 foreigners were in expect the price of oil to be lower, and as the market’s assessment of the Paris for the express purpose of trying the price falls rapidly. Notice in this sce- underlying asset’s profitability changed. to subscribe to a share in the Compag- nario that speculation has been a benefi- nie d’Occident. In the same month, the cial function of the market. In no sense ■ Bubble? Hard to Tell British ambassador reported many let- is the rapid increase in price caused by Even though the Mississippi bubble has ters from relatives and friends in Scot- uninformed behavior, for the market’s been studied for nearly two centuries, land, begging him to buy stock in the expectations are based on the real possi- economists still debate whether it was company for them. There were reports bility of future oil shortages. Uniformed even a bubble. Some say that the inexpe- of people selling their homes in order to traders who might panic and send the rience of a few investors in the market buy a share. As the price rose, there is price of oil skyrocketing are not part of led to speculative behavior that drove the evidence that many of the traders real- this story. The dominating influence on price much higher than most informed ized that the price was not sustainable. the market of well-informed traders is investors would have valued it. Others The French banker Martin wrote about enough to push the current price back to say the price of the shares rose and fell the trading, “When the rest of the world a point that reflects the future shortage as new information was evaluated about are [sic] mad, we must imitate them in of oil. the worth of Law’s theory. Both expla- some measure.” The question became nations can be applied to other, more when to sell to avoid being caught. The Peter Garber, an economic historian, recent episodes called bubbles, such as hope was, as Carswell, writing about believes that this is all that happened in the Internet bubble. Settling the debate is the South Sea bubble, an international the Mississippi bubble. He asserts that made most difficult by the fact that we echo of the Mississippi bubble, in this and other so-called stock market know very little now about what reason- observed, “[to] sell out betimes and so bubbles rapid price ascents and descents able expectations of the “true valuation” let the Devil take the hindmost.” Expe- occur because of corresponding reason- should have been, given only the infor- rienced financial traders could do very able expectations about the true profit mation available to the market traders well: The Langedoc bankers got out prospects for the underlying property when they were trading. Just because the early enough, as did the canton of right represented by the asset. It is the price ultimately fell when more informa- Berne, which made a profit of 10 times rapid reaction to new information about tion arrived does not mean that shares its original outlay. The Dutch financial this underlying value that causes the had been valued unreasonably high. community also did extremely well, steep decline of prices. Some researchers of the recent dot- and Law might have ended very com episode point out that the price-to- There is also something attractive about wealthy had he not diversified his earnings ratios for stocks rose far above this “nonbubble” explanation of the shares into French land, which was con- their historic levels and then fell back to Mississippi bubble. Indeed, how does fiscated after the bubble burst. Thus, the these levels after the price fall, suggest- one value the potential profits of the actors required for a bubble seemed to ing traders had not been attending to the assets of the Mississippi Company even be present, and the rapid rise and fall of right determinants of value. However, with the benefit of hindsight of almost the price of shares also are consistent other researchers suggest that this with the bubble story. temporary deviation may have reflected a ■ Recommended Reading new valuation paradigm that depended Peter M. Garber, 2000, Famous First Ben Craig is an economic advisor at the less upon price-to-earnings ratios and Bubbles: The Fundamentals of Early Federal Reserve Bank of Cleveland. more on other factors. Manias. Cambridge, Mass.: MIT Press. The views expressed here are those of the author and not necessarily those of the Federal The debate continues to be unresolved François Velde, 2002, “Government Reserve Bank of Cleveland, the Board of because it depends on a concept that is Equity and Money: John Law’s System Governors of the Federal Reserve System, or unmeasured, given the present state of of 1720,” presented at the Economic its staff. economic science: the market’s assess- History Association’s 62nd Annual ment of long-run value. The argument Meeting, “Private versus Public Institu- Economic Commentary is published by the centers around whether this assessment tions,” October 11–13, 2002. Research Department of the Federal Reserve is reflected in the price. A nonbeliever in Bank of Cleveland. To receive copies or to be bubbles asserts that the price is the Dilip Abreu and Markus Brunnermeier, placed on the mailing list, e-mail your request assessment and delivers anecdotes to 2003. “Bubbles and Crashes,” Econo- to [email protected] or fax it to suggest that the high price is not prepos- metrica, vol. 71, no. 1, pp. 173–204. 216-579-3050. Economic Commentary is also terous. Either a new invention or a new available at the Cleveland Fed’s site on the William C. Hunter, George G. Kauf- paradigm has made the notion of extra- World Wide Web: www.clev.frb.org/research, man, and Michael Pomerleano (eds.), ordinary profits quite reasonable, justi- where glossaries of terms are provided. 2002, Asset Price Bubbles: The Impli- fying a high price. A believer in bubbles, cations for Monetary, Regulatory, and We invite comments, questions, and sugges- on the other hand, uses anecdotes or International Policies, Cambridge, tions. E-mail us at [email protected]. historical measures of reasonable prices Mass.: MIT Press. to argue that most participants in the market know that the high prices are not sustainable. Until there is an ability to measure the sustainable price that is acceptable to both sides, the argument is likely to remain unresolved.

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