Velde F. (2009) Eighteenth-century France’s one-man-bubble

Velde, François R. (2009) “Was John Law’s System a bubble? The Mississipi Bubble revisited” in The Origin and Development of Financial Markets and Institutions. From the Seventeenth Century to the Present, eds. Jeremy Atack and Larry Neal, Cambridge: Cambridge University Press, 99-120.

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A slightly different version of this paper is available online.

The shares of the Compagnie des Indes created by John Law to manage the colonization of Louisiana, public finances and monopolies went from 250 Livres in July 1718 when the initial offering closed to just under 10,000 L days before Christmas 1719 and finally to 50 L in March 1721 (p.108). Can this jump followed by an even more impressive collapse in under 3 years be described as a bubble? (p.109)

What the prices priced

Picture 31The importance of John Law as a individual in the French economy of the time should not be underrated. He had made the market visible and had become its focal point. His interventions affected directly share prices (p.110). His control of the government’s policies (as Finance Minister) allowed him to repeatedly support falling prices. Purchases made by the Banque Générale Privée he managed (which owed up to 28% of the shares) were also designed to energized a bearish market. These actions put a de facto floor on  the price of shares and fueled speculation with easy money (p.112).

“The market was managed, if not manipulated”

The whole of John Law’s scheme was based on a high share price, which allowed to exchange fewer shares in exchange for the subscriptions initially purchased by bondholders. But as the purchase of shares by the bank and later the company was done through the printing of notes, it led to “a pure monetization of the debt, with predictable consequences for the exchange rates and inflation” (p.113). In turn this led to the demonetization of the notes and expectedly to the collapse of Law’s Système.

Was the company overvalued?

The scheme and John Law’s actions were designed to increase the company’s P/E ratio (i.e. the price of shares compared to earnings). By the end of 1719, this ratio was close to 45 (compared with 11 for government bonds; p.117). The aim of Law was to lower interest rate on public loans while boosting the French economy’s growth rate (both of which would bring interest rates down and thus explain why he accounted for such a high P/E ratio; p.118). But even the most optimistic hypotheses imply that the share price John Law was seeking (i.e. ≈ 9,000 L) would have overvalued the company several times over.

Conclusion

The bubble was not caused by the investor’s irrationality but by the incentives provided by a single individual; Law forcefully managed the market to reach a share price that overvalued his company two or three times over. Hence the term of bubble is not appropriate since prices were driven by the best understanding of the fundamentals investors could enjoy at the time (p.119).

See also the page of David Smant (Erasmus University, Rotterdam) devoted to early bubbles.

Disclaimer: this summary is written by the contributors of the blog and not by the author of the article. Any mistake is Manuel’s fault (and he shall be punished).

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