Unlearned history

Last updated 10:42 15/04/2009
Scottish economist John Law.

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Historians have long shaken their heads at the giddy excesses of early 18th century French financial speculation. Most of us aren't historians. But, suggests BILL VERRALL, we are living in an age of familiar folly.

It is as if there is now a new international race, not in arms or in space, but printing money.

The only way government after government can prop up its failing banks and mortgage institutes is to print money (electronically these days) to make good the guarantees they have lately been rushing to give.

We are assured this is what governments can and must do. New solutions for new problems, or so we are told.

Well hardly. See if any of this seems at all familiar ...

Louis XIV (1638-1715) left France grander, more modern and centralised, and bankrupt. The man left behind a lot of debt bonds. Tidying up this mess was left to the regent Philippe, who in desperation looked for a skilled financier to help.

Enter John Law, one of the earliest exponents of paper money. His schemes had found no success in England or Scotland, so he was living abroad as a gentleman gambler across the wealthy circuits of Europe.

Law convinced the flailing Philippe that issuing paper money would solve the problems of France.

He founded the Banque Generale in 1716 and, to gain the acceptance of the wealthy aristocracy and middle class of France (and later Europe), Law and Philippe guaranteed the paper money could be presented at the bank at any time and exchanged for coin (gold).

Any banker found printing more money was declared to be deserving of death.

Law also established the Compagnie des Indies, a company that was given a monopoly to trade in the and this word is important future wealth to be generated by France's American colony Louisiana. This became known as the Mississippi Scheme.

Shares in the new company could be bought only with the same debt bonds that Louis XIV had issued, thus effectively wiping out France's debt.

Among the bank, the new money and the Mississippi Scheme, a failproof investment was offered with an astonishing rate of return, estimated at 200 per cent per year.

The offer was 600 per cent over-subscribed, so the fight was on. The street where Law had set up his bank became virtually an open-air stock exchange where nobility, artisans and the middle classes met, bought, sold, fought and socialised.

So enchanted was Philippe that he renamed the bank the Banque Royale.

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This was better than a government guarantee; it was a royal guarantee.

Speculation was rife, prices kept increasing and huge profits were made.

All of this was simply speculation in the name of a company that was set up to trade in the profits that people either fully expected, or ardently hoped, would be made in Louisiana.

To keep up with this demand, Law now moved away from the basis of his earlier ideas and sought to ride the speculation wave. He printed more money.

Paris boomed as speculative profits spun off into art work, luxury goods, wages and decreasing unemployment. Law had established the archetypical economy which, today, nations seek desperately to emulate low unemployment, high returns, capital inflow, profit reinvestment and growth.

The price of the Mississippi shares skyrocketed. What goes up, however, must come down.

The end of the speculation mania seems to have been triggered by Law making the political mistake of denying the Prince de Conti's application for more shares. The spiteful prince invoked that initial guarantee and turned up to the Banque Royale to demand coin for all of his already considerable quantity of paper money.

Law's bank was able to meet this demand but the seeds of doubt had been sown and the fragility of the scheme stood exposed to those who were paying attention. Shrewd investors took evasive action. Many tried to redeem their paper money in smaller parcels so as to avoid notice and give themselves time to exit the scheme. The big players began to protect themselves at the expense of the smaller investors to whom they tried to sell their shares. Inevitably word got out and panic selling set in. The Middle Class investors clamoured for coin and the paper money became worthless.

Philippe decided to restore the public's confidence in the money by declaring all paper money to be valued at 5 per cent more than its face value, then 10 per cent.

In desperation he then returned to punitive actions and forbade French citizens to trade in gold, declaring any gold holdings of more than L500 to be liable for confiscation.

In the meantime he continued to print more and more money which, inevitably, became worthless. The investment boom collapsed. All investors still in the scheme lost their money and the French economy collapsed.

Law became bankrupt and was eventually exiled from France with a debt of 6.7 million livres. (In an interestingly modern twist, upon his death in 1729 it was found that his estate contained a fortune in art treasures and artifacts.)

ONLY one question remains Is any thing new?

The collapse of the Banque Royale and the subsequent collapse of the French financial system in 1720 have some surprising similarities to the financial situation we find ourselves in today.

The initial paper currency issued by John Law was limited in its production it represented the real value of gold or gold coin held in reserve and could be exchanged for this coin at any time. Similarly the price of shares in the modern world was initially loosely tied to the value of production of companies; and the value of a country's currency was linked to the general wealth of that country based on its production.

However, just as John Law very quickly lost sight of the safeguards and simple relationship that were fundamental to the success of his initial scheme, so to have global investors lost sight of the fundamentals of production, value and wealth over the last two decades.

We might expect few, if any, investors to have a detailed knowledge of the Mississippi Scheme and we might therefore excuse them for not seeing the end of the good times. However, there have been many examples since 1720 of similar speculative bubbles and it would seem that both individuals and governments have had a policy of determined self-inflicted blindness to the clear lessons that history has to offer.

One is very close to home, and occurred in the same year as the Banque Royale collapse. The South Sea Bubble of 1720 was fed by land speculation in the mystical islands of the South Pacific.

1792 saw the United States suffer from the Treasury Bond Bubble.

1815-16 saw a speculative bubble based on the commodities trade between England and the US.

1837 had the "wildcat bank bubble" in the US.

1847 to 1857 there was English, European and American speculation in railway building.

1893 saw the "Precious Metals Mania."

1929 saw the great depression.

1987 saw the stock market collapse of Black Monday.

One would be entitled to think that with all of these examples to be guided by, everyone would realise that there are certain parameters outside of which it is unwise to invest.

It is not as if these parameters are secret or confined to the mighty brains of only economists, financial advisers or share market analysts. The fundamentals of such investing are fairly simple. Firstly there is always a relationship between "production" in its widest possible sense and value. Profits can rise and should rise where production increases or where production becomes more efficient. This is as true in a national or global sense as it is for a single business.

Nationally, production is usually measured in terms of gross domestic production. If GDP increases by 50 per cent over 20 years then it would not be unreasonable for investments, on average, to show similar returns. This keeps a stable relationship between the amount of money in circulation and the value of that money. Wealth that increases along with production cannot lose its value overnight as it represents a real asset; a real form of wealth. Money, however, that is simply artificially generated has no intrinsic value.

Unfortunately, money can be artificially increased very easily.

The most obvious way is through market speculation. As people invest in a number of companies these companies' shares increase in their worth (I hesitate to use the normal term value in this situation).

At a certain stage, the money paid for a share is such that it begins to exceed the actual fundamental value of that share (the share presenting "a share" of the actual company).

In theory this should lead to a falling-off of demand and a levelling out of the share price.

However, for many years this has not been the case.

Once a share price has begun to increase it has become a market favourite and more and more people have sought to get on to the band wagon and make money as the shares rose regardless of the actually value of the company.

People were able to create an artificial self-reinforcing spiral of price increases.

This could be called "making money in a Bull market" or it could be called "speculation."

The terminology does not matter. The facts are that the market become entirely sentiment-based. So long as people (speculators?) were prepared to continue with this form of "investing" the market would continue to rise. During the past 20 years the average real increase in the GDP of the US has been between 3 to 4 per cent per annum. However, during this same period of time share prices have risen exponentially.

The Dow Jones Industrial Average went from less than 1000 in January 1982 to over 10,000 in January 2000. The share market was in effect creating artificial wealth as share prices increased out of all proportion to their fundamental value.

That's amazingly similar to the 1720 Mississippi bubble.

However, the similarity with the Mississippi Scheme does not end there, for just as Philippe and John Law compounded the problem in 1720 by printing more and more money to try and stave off disaster, so too in the US, and much of the western world, governments and banks have simply printed more and more money in order to keep the artificial growth cycle spiralling upwards.

Financial leaders in the US, in particular, seem to have invented a new world for themselves in which all past experiences that did not fit their current world view or their wished for world view were shunted out of existence.

In a vision built on almost Biblical mysticism, a new world order was proclaimed in which a new "consumer led" and "credit led" economy was pronounced as the new world order.

The truth is the market in 2000 was long overdue for a correction and such a correction was on the cards. However, this did not suit the new world order as ordained by those heavily involved in making money out of the markets. Nor did it suit President George Bush. He could not afford a correction and a return to normalcy. He had to rule during a period of growth.

Why this was so is open to speculation. Perhaps so that he could pursue his new world order foreign policy, perhaps so that his colleagues and supporters could continue to amass their private fortunes, perhaps he thought it would be good for all Americans, perhaps he genuinely thought that if he believed in something strongly enough it would just happen. perhaps as a fundamentalist Christian he genuinely thought that with God on his side it would all work out in the end.

Who knows? The point is, however, that under President Bush the Federal Reserve reversed its earlier conservative fiscal policy and began to encourage the huge debt-based economy of the US.

The debt economy came to underpin all aspects of American society. Without this "successful" economy at home Bush could not have waged war in Afghanistan and Iraq.

Once the wars were undertaken they then became an integral part of the new false economy fuelling its growth with the billions upon billions of congressional appropriations being given to fight the wars. Wars which were in fact being fought on credit.

At the end of all of this one must ask "why has the current financial crisis come as a surprise?" I cannot answer that. I cannot see how it could have been a surprise.

There have been some economists and financial gurus who have said that the speculation of the past 10 years could not last and the whole edifice would come crashing down.

However, these were in a minority and, more importantly, no-one wanted their prophesies to be true.

Perhaps it is as simple as that. We all have a huge preference for receiving only good news. Those who chose to cast doubt on the sustainability of the new order were derided and sidelined. No one wanted to see the bad times ahead. Perhaps there were personal reasons of greed or manipulation that led some to try and pretend it could go on for ever. However, it does seem very strange that this should have come as a surprise to anyone.

We should also ask "what next?" Perhaps it's time for some sobering information. When markets are significantly out of kilter with reality there must be a period of adjustment. Sometimes this adjustment is very sudden as in the `bubble' burst of 1720.

At other time it is gradual. Gradual readjustment is usually referred to as a bear market (`Bear,' because a bear claws things downward). The interesting fact is that over the last two centuries there have been eight major bear markets. Their dates are from 1802 to 1829, from 1835 to 1842, from 1847 to 1859, from 1872 to 1877, from 1881 to 1896, from 1902 to 1921, from 1929 to 1942, and from 1966 to 1982. On average these bear markets have each lasted 14 years. (That would mean 2008 to 2022). The advisers who were prepared to stick their necks out and go against the flow over the last 10 years and say that the markets were unsustainably high and that there had to be a readjustment still seem to be saying that there is some way to go before the markets are back in balance.

It does not yet appear that despite the considerable drop in share prices and the current credit crunch that the fundamental relationship between production and price has yet been achieved.

From this then comes a final question. "How wise is it for my institution, global, national or private to stand in the way of the market as it tries to get itself into a balanced situation?"

If a government, for example, chose to say that it would guarantee a bank or a business or a financial institution, can that government actually force the international markets to accept that what is obviously false value, is in fact true value.

Are all such attempts doomed to failure (remember Philippe's desperate attempts to order his paper money to be worth 5 per cent and then 10 per cent more than its face value).

Perhaps the curliest question of all is this "if governments put in say $700 billion dollars to shore up failing banks and businesses then doesn't that mean that they have simply printed, or electronically created that money and wasn't that the problem in the first place?" Won't this then simply put off the readjustment and make it much, much worse when it finally comes. I cannot help but wonder, what John Law and Philippe would have to say. I do know, however, what one of my favourite American aphorists, Yogi Berra, would say, "It's deja vu all over again."wBill Verrall recently retired as the long-standing principal of Fiordland College.

- The Southland Times

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