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wars float financial
bubbles
"When
new money is printed,
its effect is not felt instantaneously across all market sectors. The effect
moves from one individual to another individual and thus from one market to
another market. Monetary pumping generates bubble activities across all markets
as time goes by. Once, however,
the bank tightens its monetary
stance, i.e. reduces monetary pumping, this undermines various bubble
activities. The bubble bursts. Since monetary pumping generates bubble
activities across all markets, obviously the eventual bursting of the bubbles
will permeate all markets." - Frank Shostak
the Mississippi bubble
"Imagine the following: a collection of debts owed
by a highly leveraged borrower with a bad credit record is magically
transformed into marketable securities
with triple-A yields.
How is this miracle performed?
It is
through the power of financial innovation and free capital markets!
It
could be the story of subprime mortgages in the US; but it is not.
It
is the story of government debt in France in the early 18th century.
In
1719-20, a financial
whirlwind swept through France.
Shares in the Compagnie d'Occident,
or the Mississippi Company, rose 1,000 per cent and then fell by 90 per cent in
less than two years.
The story illuminates current events." - James
Macdonald, Financial Times (London) March 6, 2008 HOW THE FRENCH INVENTED
SUBPRIME IN 1719
By the end of the War of
Spanish Succession in 1714 public debt had risen to over 100 per cent of
national income and was subjected to forced reductions of interest and
principal.
Confidence collapsed.
Government bonds sold for
discounts of up to 75 per cent.
Louis XIV, the "Sun King," had
consolidated French power in Europe but the Nine Year War and the War of
Spanish Succession had effectively bankrupt France by 1715 the year of Louis
XIV's death.
France defaulted on its debt, high taxes burdened the
country and the value of gold and silver currency fluctuated wildly.
Louis XV turned to the Duke of Orleans who hired John Law, a Scottish
adventurer, economic theorist, and financial wizard/engineer.
The
charismatic John Law
lived by his wits at the gambling table
and had never held any post related to public finance.
The government
would issue a new series of bonds, paying only 3 per cent in exchange for its
old debts which paid 4-5 per cent, in exchange for shares in the Mississippi
Trading Company, which held monopoly trading rights to the French colonies.
For the government, the cost of servicing the debt would fall sharply
and the budget would look rosier.
The trading rights to the French
colonies were largely worthless, for there were no profits at the time and the
Mississippi Company had existed for a while without exciting public
interest.
The market for government debts was
moribund.
John Law's aim was to make Mississippi shares as actively
traded as possible.
This provided an incentive to swap - to get a more
liquid security and the prospect of speculative gains.
John Law
repackaged a collection of "subprime" debts as marketable securities under a
different name and thereby increased their investor appeal.
Law claimed
that Mississippi shares would be so actively traded that they would constitute
"a new form of money."
For this governmnet debt reduction plan to
succeed a new bank must be founded to provide a massive monetary stimulus of
easy money to get bond holding creditors to convert government bonds into
Mississippi trading company shares.
1716 John Law established the Banque Générale, a
bank with the authority to issue fiat bank notes.
In 1717 John Law
established the Compagnie d'Occident ("Company of the West") and obtained a
25-year monopoly to develop the vast French territories in the Mississippi
River valley of North America.
Compagnie d'Occident soon monopolized
the French tobacco and African slave trades, and by 1719 the Compagnie des
Indes ("Company of the Indies"), as it had been renamed, held a complete
monopoly of France's colonial trade.
John Law took over the collection
of French taxes and the minting of money.
In effect, John Law controlled
both the country's foreign trade and its finances.
An effective
marketing scheme was developed describing the Compagnie des Indes as a future
profit generator due to its monopolistic controls of the exaggerated wealth of
Louisiana.
This marketing scheme sent the price for a share from 500 to
10,000 livres , completely out of all proportion to earnings.
The debt
was exchanged and became worth many times its previous value as Mississippi
shares continued their dizzying
ascent.
The economy recovered and everyone was happy -- even though
the underlying reality was an unsustainable credit-driven boom.
1719 John Law had issued approximately 625,000 stock shares,
and he soon afterward merged the Banque Générale with the
Compagnie des Indes.
The Compagnie bought the right to collect all
French indirect taxes, took over the collection of direct taxes, purchased the
right to mint new coinage.
The center piece of this financial plan was
the retirement of Louis XIV's debt.
Shares of the Compagnie des Indes
were exchanged for state-issued public securities, or billets d'état,
which consequently also rose sharply in value.
The French government
debt, 1,000% of the annual budget, became property of the Compagnie des Indes.
A frenzy of wild
speculation ensued that led to a general stock-market boom across Europe.
The French government took advantage of this situation by printing
increased amounts of paper money, which was readily accepted by the state's
creditors because it could be used to buy more shares of the Compagnie.
The underlying assets of the Mississippi Company were still
questionable royal debts that did not provide enough income to pay its promised
dividends.
Excessive
issue of paper money stimulated galloping inflation, and both the paper money
and the billets d'état began to lose their value.
Moreover,
like many holders of collateralized debt
obligations, speculators in Paris relied heavily on borrowed money.
The rise in Mississippi shares in 1719 was reversed in 1720 and the
bewildered French find themselves holding subprime paper, merely relabelled
toxic debt.
1720 The value of the shares of the Compagnie plummeted,
causing a general stock market crash in France and other countries.
The
financial engineer John Law was made the
scapegoat and was forced
to flee France.
The enormous debts of his company and bank were soon
afterward consolidated and taken over by the state, which raised taxes in order
to retire it.
the South Sea bubble
1711 South Sea Company, a joint stock
incorporation is granted a monopoly to trade in the South American colonial
possessions of Spain as part of a treaty during the War of Spanish Succession.
The South Sea Company assumes the bonded debt England incurred during
the war in return for the monoploy.
Speculation in corporate
stock led to a great economic bubble known as the South Sea Bubble in 1720.
The primary trading business of the South Sea Company was transporting
slaves from Africa to America.
1719 South Sea
Company proposed a scheme by which it would assume half the bonded debt of
Britain (£30,981,712) with new shares and contractually promises to the
government that the debt will be converted to a lower interest rate, 5% until
1727 and 4% per year thereafter.
The purpose of this is to allow a
conversion of high-interest bonded debt into low-interest marketable debt as
shares of the South Sea Company.
The South Sea Company then set to
marketing the stock with "the most extravagant rumours" of the value of its
potential trade in the New World which was followed by a wave of "speculating
frenzy."
1720
The share price rises from £128 in January to £890 in early June
even though trade with Spanish colonies is limited to one ship carrying not
more than 500 tons of cargo and the slave trade.
When the speculative
adventure collapsed the estates of the directors of the incorporation are
confiscated and used to repay some creditors, and the stock of the South Sea
Company is divided between the major creditors - the
Bank of England and
British East India
Company.
"A Satire of Tulip Mania" by Jan Brueghel the
Younger (ca. 1640)
depicts speculators as brainless monkeys in contemporary
upper-class dress.
tulip mania bubble Tulip mania or tulipomania (Dutch names include tulpenmanie,
tulpomanie, tulpenwoede, tulpengekte, and bollengekte) was a period in the
Dutch Golden Age during which contract prices for bulbs of the recently
introduced tulip reached extraordinarily high levels and then suddenly
collapsed.
At the peak of tulip mania in February 1637, tulip contracts
sold for more than 10 times the annual income of a skilled
craftsman.
The mosaic virus spreads only through buds, not seeds, and so
cultivating the most appealing varieties takes years.
Propagation is
greatly slowed down by the virus.
Tulips bloom in April and May for
only about a week, and the secondary buds appear shortly thereafter.
Bulbs can be uprooted and moved about from June to September, and thus
actual purchases (in the spot market) occurred during these
months.
During the rest of the year, traders signed
futures contracts before a notary to
purchase tulips at the end of the season.
The futures contract promises
to guarantee delivery of specificied assets, in this case tulip bulbs, on a
specific date for an agreed upon at this point in time fixed price.
Short
selling is banned by an edict of 1610, which is reiterated or strengthened
in 1621 and 1630, and again in 1636.
Short
sellers were not prosecuted under these edicts, but their contracts were
deemed unenforceable.
1636 Dutch create a type
of formal futures markets where contracts to buy bulbs at the end of the season
are bought and sold.
Traders met in "colleges" at taverns and buyers
were required to pay a 2.5% "wine money" fee, up to a maximum of three florins,
per trade.
Neither party paid an initial
margin nor a mark-to-market
margin, and all contracts were with the individual counterparties rather than
with the exchange.
No deliveries were ever made to fulfill these contracts
because of the market collapse in February 1637.
On February 24, 1637, the
self-regulating guild of
Dutch florists, in a decision that
was later ratified by the Dutch Parliament, announced that all
futures contracts written
after November 30, 1636 and before the re-opening of the cash market in the
early Spring, were to be interpreted as
call option
contracts, or options to purchase in the
future.
This change of law was done at the behest of major Dutch
tulip investors who were trying to recoup lost money because of a German
setback in the Thirty Years' War.
They simply relieved the futures
purchaser of the requirment to purchase if they paid a small fixed percentage
of the contract price as a default on the failure to purchase.
An option
contract purchases the right to buy an asset at a date in the future at an
agreed upon price.
This trade was centered in Haarlem during the height
of a bubonic plague epidemic, which
may have contributed to a culture of fatalistic risk
taking.
In summation all three of
these speculative run-ups in the value of tulip bulbs or 'stock' was caused
directly by war.
Tulip investors were trying to recoup loses from
betting on Germany winning the Thirty Years War while both the South Sea and
Mississippi bubbles were designed to retire onerous government debt due
primarily to the expenses involved in the War of Spanish Succession.
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