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Bubble, Toil, and Trouble

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Bubble, Toil, and Trouble 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.
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