February 13, 2019 / 10:52 AM / 7 days ago

Breakingviews - Chancellor: A 300-year lesson in bubble inflation

LONDON (Reuters Breakingviews) - Just over 300 years ago, in early December 1718, a Parisian bank was nationalised by the French state. This marked the beginning of the Mississippi Bubble, which captivated France over the following couple of years. The aristocratic world of the “ancien regime” may seem impossibly distant to modern minds. Yet there are parallels between this saga and the modern age of quantitative easing, ultra-low interest rates and highly valued asset prices. As central bankers struggle to reverse their post-crisis monetary measures, the lessons imparted by the Mississippi Bubble are more relevant than ever.

Facade of the Bank of France "Banque de France" headquarters in Paris, France, March 12, 2018. REUTERS/Charles Platiau - RC15B370DC90

The Banque Royale became France’s first central bank. It was modelled on the Bank of England, founded in 1694, but with a crucial difference. While the Bank redeemed its notes with a fixed quantity of gold, the Banque Royale’s notes were issued in a unit of account, whose value could be changed at royal whim. This paved the way for France to adopt a purely fiat currency. 

The bank was founded and managed by a Scottish-born economic visionary named John Law. His great plan was to replace gold with paper money. Law arrived in France at the end of the reign of Louis XIV, at a time when the country was suffering from high unemployment, deflation, and the king’s credit had run out. France’s situation was not dissimilar to the one that afflicted parts of the Eurozone during its recent sovereign debt crisis.

Law petitioned the Regent Philippe II, Duke of Orleans, who ruled in the name of the infant Louis XV, to establish a new bank. He promised this new institution could lower interest rates by making money more abundant, and that this would reduce the cost of public debts, raise prices and bring about more general prosperity. In his wig and frock coat, Law’s appeal sounded much like a contemporary central banker talking up quantitative easing, without the academic verbiage.

The bank was only part of Law’s scheme. He also took over a trading company, known popularly as the Mississippi Company, which laid claim to much of the current United States. He proposed that the company should take over the entire national debt, roughly equivalent to France’s national output. The idea was that the king’s creditors, known as “rentiers”, would swap their securities for Mississippi Company shares. The success of this scheme depended on pushing down the rate of interest and inflating the price of the shares.

That’s where the Banque Royale came in. In the year after nationalisation, the bank increased its note issue from 40 million livres to over a billion. Interest rates in France fell from 6 percent to under 2 percent. The Mississippi shares soared from a price of 500 livres to nearly 10,000. Given that at the peak the dividend yield was 2 percent, Law argued the shares weren’t overvalued. Likewise, it has been claimed in the post-Lehman Brothers age that U.S. stocks were not expensive relative to the yield on U.S. Treasuries, notwithstanding the fact that American rates were artificially suppressed by the Federal Reserve’s actions.

France had never witnessed a bubble before. Thousands of provincials and foreigners flocked to the open-air stock market in the rue Quincampoix. A new word was needed to describe the lucky Mississippians, they were called “millionaires”, the equivalent of today’s less-felicitously named “ultra-high net worth individuals”. They spent their newfound fortunes on renovating properties, acquiring gilded coaches and other fineries, just as today’s “nouveaux riches” throw their money away on jewel-encrusted handbags, vintage motors and dubious works of contemporary art.

France boomed, unemployment disappeared and the sovereign debt crisis was forgotten. Such was the magical effect of paper money. Or was this prosperity, as some contemporaries suspected, merely a chimera? In the early stages, the Banque Royale’s notes weren’t used for normal commercial activities. Instead, they were supplied to speculators as loans to buy shares. The company supported its own share price, by borrowing and buying back a vast amount of its own stock, in much the same manner as corporations in recent years have used cheap credit to repurchase trillions of dollars’ worth of shares.

Once the bank money seeped out of the financial world and into the real economy, however, asset price inflation was replaced by the consumer variety. By the end of 1719, food prices had doubled. This left Law in a tricky position. He could either tighten monetary policy, or he could stand pat and let inflation rip. In the summer of 1720, Law chose the deflation option. The bubble burst and the Scotsman was forced to leave the country in disgrace, his scheme in ruins.

The parallels between the Mississippi saga and the monetary experiments following the 2008 crisis are ubiquitous. Both episodes start with a financial and economic crisis and the threat of deflation. Both are followed by a miracle monetary cure, which inflated bubbles across various asset classes. At points in 2018, the U.S. stock market was trading at a higher valuation level than at any time apart from the dotcom bubble. On a dividend-yield basis, the S&P 500 Index remains somewhat more expensive than the Mississippi Company at its peak.

The trouble is that modern central bankers have failed to heed the lessons of the Mississippi bubble. As one of Law’s biographers, Antoin Murphy, writes: “What central bankers are doing now is exactly what Law recommended ... From this perspective, it may be argued that, notwithstanding the failure of the Mississippi System, Law’s banking successors have been Ben Bernanke, Janet Yellen and Mario Draghi.”

Yet Law’s failure is crucial to the story. It shows that it’s all very well for central bankers to lower interest rates, inflate asset prices and dispel unemployment by conjuring up limitless quantities of money, but it’s no easy matter to return to normalcy. As the Fed has gingerly hiked rates and run down its balance sheet, France’s unhappy experience three centuries ago suggests there’s an accident waiting to happen.

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