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State Debt Conversion In An Equity Bubble - The Tried And Tested Trick

Politics / US Debt Mar 11, 2014 - 02:20 PM GMT

By: Andrew_McKillop


John Law's Trick Which Failed

According to the Federal Reserve Bank of Chicago's economist Francois R. Velde in a 64-page memorandum published by the Reserve Bank in November 2003, written with seven other US Federal Reserve Bank economists, John Law succeeded in the period 1716-1720 to convert the government or state debt – at the time Royal debt - of France, into state-backed equity holdings. At the same time, in a coordinated move, Law also replaced silver- and gold-backed money with paper “fiat” money.

He created a card castle of fake prosperity that could only implode. The only subject of discussion concerns when and how it collapsed. The same is true today.

The main conclusion by Velde and his colleagues was that Law acted for both political and economic-monetary strategic reasons, and supported the equity issues at too high a level, aided by and resulting in further uncontrolled money creation. Law's System, or monetary-and-equity Ponzi scheme “ended with the recreation of a (French national) public debt at, surprisingly, the same level as before”. Velde and his colleagues minimize the role of the approximate 33% reduction of real GNP in France in the 10-15 years following the collapse of Law's equity bubble. Deflation had been intense, production declined radically in some sectors of the economy.

At its simplest, what was called “Law's System” inside France, and later outside, set out to float equity shares at an enticing rate of return published in “forward looking financial statements”, and at the same time issue “fiat” paper money but with no guaranteed conversion value in precious metals such as gold or silver, for purchasing shares. Government debt or its equivalent in 1716 – debt of the Royal family of France and its Court favorites – was exchanged for the newly-issued paper money by Law's bank the Banque Royale, and the newly-issued shares in John Law's Mississippi Company.  The System inevitably and rapidly unravelled with a coincident, dramatic fall in the market value of both the paper money and the paper equities. John Law rapidly became a hunted man, and fled.

Joseph Schumpeter, we can note, described John Law as among “the front ranks of monetary
theorists of all time.” By Dec. 1720 he had a price on his head, in France.  His French-born wife was imprisoned and not allowed to quit the country – which Law fled from.

Sounds Familiar

The Law System was and is astonishingly “modern” in many ways, as developed western governments rack up national debt and seek a way to justify “robust” monetary easing. By consequence, they need the prop of fake confidence provided by a “permanent” equity bubble.  Strictly speaking Law's publicly traded, privately held company (the Mississippi Company) became so powerful it took over the collection of all taxes in France, ran the mints, monopolized overseas trade in a string of French colonies, and ran French colonies in the south of the future USA. The Company offered creditors of the Royal family (the State or government) the possibility of swapping their existing debt notes or bonds, for Company equity, making this entity the State or government’s main creditor. Since it was already collecting taxes, the State's annual payments to creditors were simply deducted from tax revenues by the Company. Loan repayments on lending to the Royal family and government were replaced by debtholders becoming Company equity holders, their claims against the Royal family and government were replaced by claims on revenues from the stochastic or market-random stream of revenues, generated by stock exchange trading of Company shares. Obviously, for as long as the equity price rose at a radical double-digit annual rate, the scam could keep going.

Significantly reinforcing the rapidity of the scam's growth, and therefore collapse, the initial voluntary swap of Royal debt for either paper money, or shares in the Company, or both, was rapidly replaced by forced conversion. Savings of any kind were effectively devalued – as today. Essentially, Law sought the total conversion of State debt, to tradable paper equity in the fastest-possible time, at the same time as “old fashioned” metallic money was replaced by the paper banknotes issued by his Bank. Velde and his colleagues see this as another probable or potential reason for the scam's collapse.

Drivers of the Law System were highly comparable with recent and present “fiscal incontinence” and the recourse to uncontrolled State debt growth in countries such as the US, the EU28 and Japan. In particular, in the period of approximately 1675-1720 France engaged in a large number of European and colonial wars – each of them financed by borrowing against the expected or hoped-for “peace dividend”. This is highly comparable with hoped-for “recovery and return of economic growth” in developed countries, today. The huge debts run up by Louis XIV (reigned from 1661 to 1715) were surely and certainly a major reason why the Regent for underage Louis XV, Philippe II the Duke of Orleans, so readily accepted and welcomed Law's proposals. Showing the dire straits that Royal and government finance had fallen into, from at latest 1690 debt service payments had outstripped total government tax receipts, every year.

In a highly modern manner, the State had firstly privatized and sold its monopolies and State-dominant entities and companies for what it could get, starting with salt and tobacco. As the Velde et al study recounts, by 1701-02, the Royal or State financial controllers were even obliged to privatize the former State monopoly of supplying and selling ice and snow in Paris! Further extremes of inventing taxes - the right of levying of which was sold by auction – was extended to taxes on “the sale of pig's tongues and the rolling of barrels of wine” in Paris streets. The Paris focus was in no way accidental, because provincial tax collection had become a major political issue, directly leading to what French coined the term “jacquerie” for, the politicized regional refusal to pay taxes to a centralized entity – in this case, the Royal family. To be sure, this was by the 1780s another and major contributing factor for the French Revolution of 1789.

You Want Money

By 1715, also very comparable to today, French State debt had reached about 100% of GDP (meaning it was equivalent to one year's total GDP). By that year, “rolling devaluations and defaults”, on government specie and debt repayments, were common and regular. Everything was in place for John Law's scam to succeed – with eager Royal support!

The speed with which Law introduced and honed his System, which then collapsed, can be gauged by for example the exchange value of Law's 100-livre paper notes issued by his Banque Royale against silver livres. Through Aug 1720-Feb 1721 his fiat money bank notes lost about 90% of their previous exchange value against silver coins. Previous to this, in the “ramp up phase”, shares in the Mississippi Company moved up even higher and faster than Apple or Facebook issues of fake wealth promises. The major problem or weakness in Law's scam, as the Velde et al study suggests, was surely the direct linkage with government debt. Its growth, despite the constant attempts at “economic reform”, was literally uncontrollable. Aggravating factors bringing forward the date at which Law's scam collapsed, similar to today, included the greed of brokers and traders always seeking in-and-out daily and weekly quick gains of the maximum amount.

After Law fled the country in Dec 1720, the clean-up phase was to take several years, firstly through a liquidating company, owned by the State, called The Visa. Given total powers, The Visa was able to instantly demonetize and render valueless any holding, credit, money instrument or other negotiable instrument dating from before Dec 1720. It converted accepted instruments at various conversion ratios (previous nominal value versus that decreed by The Visa), into certificates of liquidation, convertible as government bonds or lifetime annuities at a low scrip, typically needing at least 30 years for full repayment. The fiat money bank notes issued by John Law were in many cases simply burned, or at best redeemed at a minimum 25% discount against metal specie or converted at a large discount, into shares in remaining and successful French colonial companies, such as the Indies Company. At least a half-billion livres, in nominal or paper value, of these notes was never accounted for.

No discussion of the John Law System is possible without asking what Law thought he was doing, the same way we need to know what persons such as Mario Draghi or Janet Yellen think they are doing, today. Law published several books in his lifetime, including his pitch for developing The System in Scotland, in 1705 (“Money and Trade Consider'd with a Proposal for Supplying the Nation with Money”). This proposal for revitalising Scottish government finances after the Darien colonial disaster was however rejected by Scottish lawmakers and helped decide Law to try his luck in France

His principal argument was that money must be stable and be liquid. At the time (end of the 17th century), Law could argue that world trade expansion and European colonial expansion had vastly changed the outlook for silver, if not immediately for gold supply, affecting the stability of any silver money. He also argued, but with no real credibilty - then as now - that share trading “can create stable value” for monetary instruments based on share values, not metal specie. His rationale, here, was that certain types or classes of equities “could only rise”. He also believed, like Draghi or Yellen today, that low or almost-zero interest rates were both feasible and long-term sustainable through massive and constant equities-backed currency emissions. Also very like today, Law claimed, in writing, that government (or Royal) debt was not a problem, due to governments and the state being able to “enjoy the benefit” of very low or zero interest rates as well as “constantly rising” equities.

Although claimed to be anathema by neoliberal rhetoric and propaganda, Law recommended what we have today - the leading role of de facto or realworld Government and State monopolies – starting with the State monopoly on issue of money and the effective total State control of financial markets. Law also prefigured “the permanent equity bubble”, which as we know in the very recent past of 2008-09 has no problems imploding, but ran up against serious problems of the same type Law claimed he could resolve – but spectacularly failed.

In modern parlance, Law recommended “banks not tanks”. With the Crimea crisis, perhaps, we can have both these certain-loser solutions to our real economic problems. 

By Andrew McKillop


Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2014 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisor.

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