UNLV Retrospective Theses & Dissertations 1-1-1991 Early speculative bubbles and increases in the supply of money Douglas Edward French University of Nevada, Las Vegas Follow this and additional works at: https://digitalscholarship.unlv.edu/rtds Repository Citation French, Douglas Edward, "Early speculative bubbles and increases in the supply of money" (1991). UNLV Retrospective Theses & Dissertations. 167. http://dx.doi.org/10.25669/h29l-bf64 This Thesis is protected by copyright and/or related rights. It has been brought to you by Digital Scholarship@UNLV with permission from the rights-holder(s). You are free to use this Thesis in any way that is permitted by the copyright and related rights legislation that applies to your use. For other uses you need to obtain permission from the rights-holder(s) directly, unless additional rights are indicated by a Creative Commons license in the record and/ or on the work itself. 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Ann Arbor, MI 48106 EARLY SPECULATIVE BUBBLES AND INCREASES IN THE SUPPLY OF MONEY by Douglas Edward French A thesis submitted in partial fulfillment of the requirements for the degree of Master of Arts in Economics Department of Business and Economics University of Nevada, Las Vegas May, 1992 The Thesis of Douglas Edward French for the degree of Master of Arts in Economics is approved. Chairperson, Murrjay N. Rothbard, Ph.D. ' / L ' t Examining Committee Member, H^n^-Herman Hoppe, Ph.D Examining Committee Member, Tclrry R. Ridgway, Ph.D. i d , / ______________________ Graduate Faculty Representative, Jay A. Coughtry, Ph.D . > id Graduate Dean, Ronald W. Smith, Ph.D. University of Nevada, Las Vegas May 1992 EARLY SPECULATIVE BUBBLES AMD INCREASES IN THE SUPPLY OP MONEY This paper examines three episodes in economic history that are commonly referred to as "speculative bubbles." The three bubbles analyzed are: Tulipmania, the Mississippi Bubble and the South Sea Bubble. The paper views these three events in a historical context emphasizing the monetary interventions particular to each episode. The Rational Expectations and Keynesian school's treatments of speculative bubbles are considered and rejected. The life and monetary theories of John Law are examined extensively, given his influence over the Mississippi and South Sea bubbles. Law is also indirectly connected to the Tulipmania, having been influenced by the operation of the Bank of Amsterdam. The conclusion of the thesis is that speculative bubbles are engendered by increases in the supply of money, with future bubbles being inevitable given fractional reserve banking and Keynesian monetary policies. The reason for the malinvestments caused by monetary interventions is illuminated by the Austrian trade cycle theory. TABLE OF CONTENTS CHAPTER ONE INTRODUCTION PAGE CHAPTER TWO TULIPMANIA PAGE 11 CHAPTER THREE FREE COINAGE, THE BANK OF AMSTERDAM, AND TULIPMANIA PAGE 19 CHAPTER FOUR JOHN LAW, BACKGROUND PAGE 36 CHAPTER FIVE JOHN LAW'S MONETARY THEORIES PAGE 44 CHAPTER SIX THE MISSISSIPPI BUBBLE PAGE 56 CHAPTER SEVEN THE SOUTH SEA BUBBLE PAGE 85 CHAPTER EIGHT CONCLUSION: INCREASES IN THE SUPPLY OF MONEY, SPECULATIVE BUBBLES, AND THE AUSTRIAN MALINVESTMENT THEORY PAGE 122 BIBLIOGRAPHY PAGE 140 iv ACKNOWLEDGMENTS I would like to thank the members of my examining committee: Hans-Herman Hoppe, Terry Ridgway and Jay Coughtry for their contributions to this paper. I am especially grateful to my committee chairman, Murray Rothbard, for his support, direction, suggestions and inspiration. I am also indebted to my wife, Barbara Ballentine, for her love, support and editing. v 1 CHAPTER ONE INTRODUCTION Speculative bubbles have occurred throughout history. These episodes are characterized by a continuous sharp rise in the price of a particular asset or group of related assets, leading to further price increases driven by new speculators, seeking profits through even higher prices. These higher prices are driven by the potential profits to be made through trading, rather than the earning capacity or economic value of the asset. These speculative manias then come to abrupt and dramatic endings, as expectations change and buyers quickly become sellers, in mass. The consequences are often disastrous, with the ensuing crash inflicting financial pain on the region or country involved. Euphoria turns to despair as the mandatory readjustment that takes place in the economy creates massive worker dislocation, and great numbers of bankruptcies. Contemporary economist's views concerning speculative bubbles vary. The rational expectations school questions whether speculative bubbles can happen at all, given rational markets. Kindleberger (1987, 281) concisely gives the rational expectations viewpoint. 2 Rational expectations theory holds that prices are formed within the limits of available information by market participants using standard economic models appropriate to the circumstances. As such, it is claimed, market prices cannot diverge from fundamental values unless the information proves to have been widely wrong. The theoretical literature uses the assumption of the market having one mind and one purpose,.... History tells a different story, of course. Market speculators at various times in history have bid up prices to extraordinary levels, not based upon fundamental values, but with the expectation of selling the asset in question at an even higher price and thus making a profit. This is sometimes referred to as the "greater fool theory." John Maynard Keynes spends an entire chapter (chapter 12) of The General Theory of Employment, Interest, and Money discussing speculation and bubbles, pointing to five factors which foster these episodes: 1) neophyte investors owning an increased proportion of capital investment; 2) the day-to- day price fluctuations having an excessive influence over the market; 3) violent changes in the mass psychology of ignorant individuals changing asset valuations; 4) professional investors devoting their skills to "anticipating what average opinion expects the average opinion to be;" and 5) confidence, or lack of, in the credit markets (1964, 153-58). Keynes (1964, 155-56) metaphorically describes speculative markets: Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine longterm validity. For it is, so to speak, a game of Snap, of Old Maid, of 3 Musical Chairs-a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbor before the game is over, who secures a chair for himself when the music stops. Keynes (1964, 159) also touches upon the consequences of speculative bubbles and manias. Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. Ironically, it is due to a Keynesian economic policy and its monetary apparatus, i.e., that of expanding the supply of money to increase economic activity, that speculative price bubbles and manias are engendered. This was exemplified by John Law, whose System (driven by a huge increase in the supply of money) created the Mississippi Bubble in France. Law, who preceded Keynes by two hundred years, held many of the same views as Keynes. As Charles Rist (quoted in Salerno 1991, 1-2) explains: It is said that history repeats itself. One can say the same thing about economists. At the present time there is a writer whose ideas have been repeated since Keynes, without ever being cited by name. He is called John Law. I would be curious to know how many, among the Anglo-Saxon authors who have found again, all by themselves, his principal arguments, have taken the trouble to read him. However, there are economists who do not feel the episode in early eighteenth century France was a bubble. As Peter Garber (1990, 46-47) writes: That Law's promised expansion never materialized does not imply that a bubble occurred in the modern sense of the word. After all, this was not the last time that a convincing economic idea would fracture in practice.