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A history lesson for modern central bankers

Three hundred years ago, France embarked on a scheme to boost economic growth and lower interest rates with printed money. Sound familiar?

Three hundred years ago, France embarked on a scheme to boost economic growth and lower interest rates with printed money. Sound familiar?

This year marks the 300th anniversary of the start of an economic project in France, which posterity knows as the Mississippi Bubble. The brainchild of expatriate Scot John Law, the scheme had been hailed as the most ambitious economic experiment prior to the establishment of the Soviet Union in 1917. Like Lenin's creation, the short-lived Mississippi Bubble eventually collapsed in a spectacular fashion. Central bankers around the world are currently on a mission not altogether different from Law's, making lessons revealed by his failure particularly relevant today.

The rise and fall of John Law

Law was born in 1671, the son of an Edinburgh goldsmith. He became by turns a gambler, murderer, entrepreneur, economist, central banker and finance minister. At the height of the success of what he called his "System", Law was Europe's richest, most powerful man. His Mississippi Company incorporated all of France's overseas trading firms one of which claimed title to half the landmass of what is now the US. In early 1720, this firm merged with Law's other creation, the Banque Royale, in effect France's central bank. During its heyday, the Mississippi Company's stock surged 20-fold in value in the open air stockmarket in Paris. This early case of "irrational exuberance" didn't come out of nowhere. It was due to Law's monetary policy.

As an economist, Law was a monetarist, an early forerunner of the late Milton Friedman. He believed France suffered a dearth of money and that increasing the money supply would boost economic activity. At the time of Louis XIV's death in 1715, Law saw that France had two pressing problems. First, the state had too much debt many royal debts traded below par. Secondly, interest rates were too high in his last years, Louis XIV paid above 8% for his loans. Law, notes his biographer Antoin Murphy, was a "low-interest-rate advocate". He recommended setting up a national bank, which could issue notes to buy the government's debt, bringing down the interest rate (yields fall as prices rise). In 1715, Law expressed his views to the Regent of France, Philippe d'Orlans: "An abundance of money which would lower the interest rate to 2% would, in reducing the financing costs of the debts and public offices, etc, relieve the King. It would lighten the burden of the indebted noble landowners. This latter group would be enriched because agricultural goods would be sold at higher prices. It would enrich traders who would then be able to borrow at a lower interest rate and give employment to the people."

In modern terms, Law wanted the central bank to expand its balance sheet to reduce rates, which would help overleveraged borrowers, boost growth and employment and stimulate inflation, while also cutting the cost of servicing government debt. Law's belief that too little money constrained economic activity, while too much stimulated inflation, reflected "the [same] essential principle underlying the decisions by the US Federal Reserve today", writes William Goetzmann in his forthcoming history of finance (Money Changes Everything).

Law's scheme began in May 1716 with the founding of the Banque Gnrale, the forerunner of France's first central bank (renamed the Banque Royale in 1718). The Mississippi stock soared, the entire French national debt was absorbed by the company, and interest rates fell to 2%. Paris bustled with newly coined (or rather, printed) millionaires. Within four years, however, Law's System had exploded the stockmarket bubble burst, confidence in bank notes evaporated, and the French currency collapsed. In late 1720, Law was forced into exile.

Law's two big mistakes

Why did Law fail? He was overambitious and overhasty. His aim was to replace gold and silver with a paper currency, which was forced upon the French public Law decreed that all large financial transactions were to be conducted in bank notes. The holding of bullion was declared illegal. As one 19th-century commentator observed, Law failed "to recognise the difference between confidence and obedience. He overestimated the power of despotic authority, and underrated the influence of public opinion in money matters." There was also a conceptual flaw at the heart of Law's scheme. He believed that money and financial assets were freely interchangeable and that he could set the price of stocks and bonds in terms of money. In early 1720, the Mississippi stock was fixed at 9,000 livres with the support of the central bank. In attempting to set the price of the shares (what would now be called a "price-keeping operation"), Law lost control of the money supply. By the spring of 1720, more than two billion livres of bank notes had been issued, a near doubling of the money supply in less than a year.

The best contemporary critique is provided by the banker and economist Richard Cantillon, based in Paris during the bubble years. Cantillon questioned Law's basic economic premise. Money printing brought no lasting benefits, in his view: "An abundance of fictitious and imaginary money causes the same disadvantage as an increase of real money in circulation, by raising the price of land and labour, or by making works and manufactures more expensive at the risk of subsequent loss. But this furtive abundance vanishes at the first sign of discredit and precipitates disorder."

Devaluations of money promoted inefficiency: "undertakers and merchants find it easy to borrow money, which decides the least able and least accredited to increase their enterprise", wrote Cantillon. Operations to reduce rates with freshly printed money also provided an opportunity for corruption, as large fortunes could easily be made. Cantillon argued that Law's monetary experiment might temporarily reduce rates and incite speculation, but the new notes didn't actually enter the real economy: "The excess banknotes, made and used on these occasions, do not upset the circulation because they are used for the buying and selling of stock; they do not serve for household expenses and are not changed for silver."

Similar criticisms have been made of central banks' attempts to boost activity with quantitative easing. Cantillon, however, observed that the real danger arises when an excess issuance of bank notes leads to a loss of confidence in money. "If some panic or unforeseen crisis drove the holders to demand silver from the Bank, the bomb would burst and it would be seen that these are dangerous operations."

History repeats itself

The Mississippi Bubble provides many insights into where monetary policies of central banks in Europe, Japan and America are heading. Central banks have used their digital printing presses to reduce interest rates. They have excited speculation, but provided few benefits to the real economy. The spoils of speculation have boosted inequality, as in the Mississippi years. As the effectiveness of monetary policies has come into question, central bankers in Japan and Europe have acted with a vehemence and grandiosity reminiscent of Law. Above all, thecollapse of the Mississippi scheme shows that when central banks inflate bubbles there is no painless "exit" Law's Banque Royale had to continue printing money to sustain the bubble.

The Mississippi's lessons are especially relevant to China. The People's Republic today, like the French monarchy in the early 18th century, is attempting to mix modern financial practices with old-fashioned despotism. Confidence is coerced rather than earned. Over the past 12 months, the People's Bank of China has inflated a stockmarket bubble, and then attempted a price-keeping operation when the market sagged. In emulation of Law, the People's Bank is now proposing that banks' non-performing loans be converted into equity. Just as Law attacked sceptics by forcing down the value of the coinage and trying to prevent capital flight, Beijing is bolstering capital controls and manipulating the off-shore currency market to deter capital outflows.

Cantillon foresaw that Law's simultaneous attempt to keep interest rates low, control the money supply and peg the currency was doomed. The canny banker observed that the French money supply under Law had grown excessively and that this money would inevitably flow abroad. In 1720, Cantillon bet against the French currency, which later fell by 60% in sterling terms. As in France during the Mississippi years, China's money supply has grown rapidly in recent years relative to other countries. Several well-known investors are making a similar bet against the Chinese currency. Capital flight may yet bring down China's fragile financial system, as it toppled Law's overambitious scheme three centuries ago.

This piece first appeared on BreakingViews.com.

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