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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
"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.
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.
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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