Wednesday, September 30, 2009

MacKay, Extraordinary Popular Delusions and the Madness of Crowds

Charles MacKay’s Extraordinary Popular Delusions and the Madness of Crowds, originally published in 1841 and reprinted by Traders Press in 1994 along with Le Bon’s The Crowd, recounts three “moral epidemics”: the Mississippi scheme, the South Sea bubble, and “tulipomania.” I assume everyone’s familiar with stories of tulipmania, although in a 2007 University of Chicago Press book by the same name Anne Goldgar argues that not one of these stories is true. I haven’t read her book, so I can’t pass judgment on her debunking.

The South Sea bubble resonates, among other reasons, because Sir Isaac Newton apparently lost a fortune in the venture. And he’s famously quoted as saying, in respect to the unrelenting rise in South Sea stock, that “I can calculate the movement of the stars, but not the madness of men.” By the way, for those who think that the South Sea Company bubble had anything to do with the South Seas, wrong! Although its original charter granted the company a monopoly on the trade to the South Seas, the company’s sights were set on the gold and silver mines of Peru and Mexico.

The Mississippi scheme, engineered in France by the Scotsman John Law just prior to the South Sea bubble, also revolved around precious metals, ostensibly to be found in great abundance in and around Louisiana. Law, an adventurer and gambler who for a time accumulated considerable sums by “pursuing a plan, based upon some abstruse calculation of chances” (p. 185), grew up in a banking family. After shooting his opponent dead in a duel in England and escaping from the authorities, he traveled from country to country in Europe, studying finance and the principles of trade by day and gambling by night. When he arrived in France, its financial system was in shambles. He convinced the court that he should be allowed to establish a bank that would manage the royal revenues and would issue notes both on those revenues and on landed security. “He made all his notes payable at sight, and in the coin current at the time they were issued. This last was a masterstroke of policy, and immediately rendered his notes more valuable than the precious metals. The latter were constantly liable to depreciation by the unwise tampering of the government.” Law also declared that “a banker deserved death if he made issues without having sufficient security to answer all demands.” (p. 193) Law’s notes appreciated 15% in one year, his bank opened branches across France, and Law became a cause célèbre. Law also proposed the establishment of the Mississippi Company.

Law’s successes only seemed to grow. The French regent kept conferring new privileges on the bank—monopoly of the sale of tobacco, the sole right to refine gold and silver—and finally proclaimed it the Royal Bank of France. Once the bank became a public institution its formerly sound business practices were eroded. And since Law’s name was virtually synonymous with outsized returns, investment in the Mississippi Company was frenzied and its stock kept rising. In 1719 the Mississippi Company was granted the exclusive privilege of trading to the East Indies, China, and the South Seas as well as all of the possessions of the French East India Company. The company changed its name to the Company of the Indies and created 50,000 new shares. And Law “promised a yearly dividend of two hundred livres upon each share of five hundred, which, as the shares were paid for in billets d’état, at their nominal value, but worth only 100 livres, was at the rate of about 120 percent profit.” (p. 196)

The French public went wild trying to buy into this “too good to be true” guaranteed path to wealth, and the price of shares sometimes rose 10 or 20% in a few hours. The problem was that it was a paper system. Law seemingly forgot his earlier declaration that “a banker deserved death if he made issues without having sufficient security to answer all demands.” The investors who started cashing out early had no problem getting specie for their shares, and shrewd operators quietly and methodically converted their notes into specie and, sensing looming troubles, sent wagonloads of coins to foreign countries. Soon enough there was a shortage of gold and silver in France, so not only was there no way to repay investors but the entire French banking system was at risk. In response the government handed down edict after edict that eventually rendered shares in Law’s company worthless. Miraculously, Law escaped with his life, settled for awhile in England, and died in Venice.

I would like to close this post with “the moral of the tale,” but as we know only too well, no one ever seems to learn from the bubbles of the past. This time is always different.

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