File - The History of Money and Financial Markets
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The History of Money and Financial Market By Ken and Brett Nelson Market Bubbles and Crashes The Tulip Bulb Bubble The Bubble of 1696 The Mississippi Company Bubble The South Sea Bubble Tulip Bulb Bubble In 1554, the Sultan of Turkey gives Tulip bulbs to Ogier de Busbecq, the ambassador of Ferdinand I, Holy Roman Emperor. He brings the bulbs and seeds to Vienna. From Vienna, the bulbs spread to Antwerp, Augsburg, and Amsterdam. In 1593, Flemish botanist Carolus Clusius propogates large amounts of tulips at the University of Leiden. Tulip bulbs grow in popularity and become a status symbol. Tulip Bulb Bubble Tulip seeds take 7 to 12 years to flower. Tulip buds take 1 to 3 years to flower. The tulip bulbs were broken down into 3 groups. The common single colored bulbs called “Couleren’. The less common white streaked bulbs on a purple background called “Violetten”. The rare yellow or white streaked on a red, purple or brown background called ‘Bizarden”. The rarer streaked bulbs were caused my a virus. This virus only affected the bulb, not the seeds, so only the bulb offshoots would have the rare streaked pattern. The virus also weakened the mother bulb, and it would only last 2 or 3 years after flowering. Tulip Bulb Mania Tulips bloom in April and May. The plant is dormant from June through September and can be dug up and moved during this time. Florists (Tulip traders) entered into futures contracts for delivery during these months. In 1610, short selling was banned. Tougher short selling rules emerged in 1621, 1630, and 1636. Tulips bulbs exchanges sprung up in several cities. Tulip bulb prices rose roughly tenfold from November 12th 1636 to February 3rd 1637. Some tulip contracts changed hands ten times a day. One explanation is the change of terms of the tulip bulb contract. Tulip Bulb Mania In late November 1636, the self-regulating group of Dutch florists started debating a change in the tulip bulb contract effective for all contracts entered into as of November 30th, 1636. (The Dutch Parliament passed this law on February 24th, 1637). The old contract was a legal obligation to buy the bulbs. The new contract allowed the buyer to walk away from the contract and pay a 3.5% penalty. This greatly reduced the risk to the buyer. Prices skyrocketed! Tulip Bulbs In March 1637, single tulip bulbs sold for what the average skilled craftsman would earn in 10 years. 12 acres of land were offered for 1 tulip bulb. The collapse in prices started in Haarlem in February 1637. Many buyers refused to show up at a routine auction because Haarlem was at the height of a bubonic plague outbreak. Prices fell. The decline turned into a rout. By May 1st prices declined 90% from their high of February 3rd. The Bubble of 1696 (We covered this in the last lecture) The Mississippi Bubble – John Law John Law – born in Edinburgh in 1671, trained as a goldsmith. He was a gambler and womanizer. He had strong mathematical skills that helped him calculate probabilities, and at various times in his life supported himself with his gambling winnings. He missed out on the English Financial Revolution of the 1690’s because he was in jail. John Law was in prison for killing a young man from a prominent family in a sword duel. Law was allowed to “escape” and fled England for Amsterdam. In Amsterdam he noticed how the Dutch central bank facilitated trade by issuing banknotes as legal tender. He realized that if government backed banks could issue large quantities of bank notes, trade would expand. Law tried to bring this idea back to England but was refused entry. He brought his idea to France. The Mississippi Bubble – Banque General John Law became friends with the Duc d’Orleans, the regent for the underage French King. Law created the Banque General with a large investment from the Duc d’Orleans. The Banque General was sold to the French government at a large profit. The bank intended to circulate a large quantity of bank notes to stimulate a weak economy. The Company of the West (known as the Mississippi Company) created in 1717 by John Law in France. Exclusive right to trade with the French colony of Louisiana. Investors could swap their French government bonds at par for shares in the Mississippi Company. Mississippi Company allowed the French Treasury to pay a lower interest rate on the government bonds in exchange for the exclusive rights to trade with the Louisiana colony. The Mississippi Company The Company of the West (known as the Mississippi Company) created in 1717 by John Law in France. Exclusive right to trade with the French colony of Louisiana. Investors could swap their French government bonds at par for shares in the Mississippi Company. Mississippi Company allowed the French Treasury to pay a lower interest rate on the government bonds in exchange for the exclusive rights to trade with the Louisiana colony. Mississippi Company Expansion Initially few bondholders exchanged their French government bonds for shares in the Mississippi Company. Joint stock companies were new in France and John Law was a foreigner. John Law won additional rights for the Mississippi Company. He won the exclusive right to raise tobacco, and the right to trade in slaves and other products from the French colony of Senegal. The Mississippi Company bought out the French East India and China trading companies in a bid for all French foreign trade. The Mississippi Company bought the royal mint for 50 million livres, proposed to buy tax-farming rights for 52 million livres, and assumed the entire national debt of 1.2 billion livres for additional trade concessions. Mississippi Company Shares Soar John Law arranged aggressively hyped the new company with a big public relations campaign. Through the Banque General he allowed investors to buy shares in the Mississippi Company on favorable terms with easy credit. Investors from all walks of life could buy shares with just 10% down (like in 1929). (Laws coachman retired from the profits he made trading Mississippi Company shares.) Before one secondary offering, Law announced that he and his friends intended to buy all the new shares. Law publicly stated that he wanted to fix the trading price at 10,000 livres. Law calculated that 10,000 livres was the proper price because it assumed a 2% interest rate on the French government debt his company had assumed when they took over the national debt. Law viewed 2% as the appropriate rate on French government debt to achieve a rapidly growing economy. In May 1719, the Mississippi Company shares were trading at 490 livres. By October 1719, the shares traded at 6,500 livres! Mississippi Company The surge in Mississippi Company shares made many people rich. The new term “millionaire” was used to describe the investors in the Mississippi Company stock. The regents mother said, “It is inconceivable the immense wealth there is in France right now. Everybody speaks in millions.” Luxury good demand soared: Gold Jewelry, tapestries, lace, carpets, and porcelain “It is certain that the number of people here inreases every day and that all manners of luxury does too; the Hollanders have drawn several millions hence for jewels, lace and linen; I was told yesterday that one shop had sold in less than three weeks lace and linen for 800,000 livres and this chiefly to people who never wore lace before.” The South Sea Bubble The British government was concerned about the French Mississippi Company Money left England to France to invest in the Mississippi Company. Law antagonized England. According to British ambassador John Dalyrmple, Law said “there was but one great kingdom in Europe… and that he would bring down our East India stock” Law short sold 100,000 pounds of East India shares betting on their decline. South Sea Company Founded in 1711, the South Sea Company assumes all the British Government debt in exchange for exclusive rights to trade with Spanish America. Bondholders can exchange their depreciated British government bonds at full value (par) for shares in the South Sea Company The Company agrees to accept a lower interest rate on all the government bonds it receives in exchange for the exclusive trading rights with Spanish America. South Sea Company Initially, the Spaniards only allow foreigners to engage in the slave trade with their colonies. Nearly all the income comes from interested (at reduced rate) on the companies government bonds. Stock drifts lower and doesn’t recover to par until May 1715. when new deal with the government is announced allowing South Sea to increase its capital. (In reality, this was not a significant news story, but generated more press for the company) Late 1719, King Philip V of Spain announces his intention for peace with Britain. South Sea stock shoots up on expected increase in trade with Spanish colonies. South Sea secretly sells shares on very favorable terms to high ranking government officials. South Sea rising, Mississippi down the river Early 1720, South Sea stock continues rising as Mississippi Company shares begin to fall. High inflation in France leads John Law to try to restrict credit and reduce the money supply in December 1719. Mississippi stock drops from 10,000 livres to 7,500 livres in a month. John Law reverses course and rescinds efforts to restrict easy credit. Mississippi stock rebounds to 9,400. (a crack in the dam) January 1720, John Law appointed French Controller General of France. John Law attempts to prop up Mississippi Company stock price. He passes laws banning the export of coins and precious metals out of France. When investors try to use jewelry and other valuables, he outlaws their export. How do investors react to John Law’s restrictions? They get their money out! After the new rules on capital flight are imposed, the Mississippi Company shares quickly fall to 7,800 livres. To combat the share price decline, Law more than DOUBLES the money supply. 2.6 billion livres of new banknotes are issued. Inflation becomes rampant. In May 1720, the French livre trades at 39 livres to the pound. By September, the livre fell to 92 livres to the pound. By October, there is no market for French livres at any price. French depositors riot. On July 17th, 15,000 people gather outside the Banque Royale on rumors that the bank will allow exchanges of paper notes for metal coins. Over a dozen die in the riot, and the mob descends on John Law’s mansion. Large metal gates save his home, but his carriage is destroyed by the mob. Money flows out of France and into… South Sea shares?! Despite the similarities, South Sea stock and Mississippi Company were seen as competitors for investors attention. The collapse of the Mississippi company led to a surge in South Sea shares. (Other shares also surged) When rumors circulated that John Law was having a nervous breakdown South Sea stock jumped almost 50% in 3 days (from 218 pounds to $320 pounds – March 19th to 21st , 1720). Dutch East India stock rose 50% in early 1720. Dutch west india shares doubled. German mining stocks rose dramatically. The value of the British stock market rose from less than 5 million pounds in 1695 to 500 million pounds by 1720. Many new issues came to market. Average people bought shares in new companies. Many new companies were very speculative. One company imported broomsticks from Germany, another traded human hair, a third dealt in disputed land titles, a 4th extracted silver from lead. These new stock issues were referred to as “bubbles”. The Bubble Act The South Sea directors saw all these new issues as competition for investors attention. The directors lobbied the government officials (who had large holdings in South Sea shares) to restrict the competition. They passed the Bubble Act on June 9th 1720 The Bubble Act: 1. Banned the creation of new joint stock companies not specifically chartered by the government 2. Restricted existing companies to only engage in activities granted under their charter 3. Punished unauthorized joint stock promoters under the new crime called “Praemunire”. Punishment included an infinite fine and perpetual prison. It worked! South Sea shares soared to 950 pounds! South Sea profits grew rapidly, but how? Ponzi scheme South Sea earnings were meager, nearly all of it’s profits came form the below market rate interest on the government debt it held. But, accounting rules at the time allowed the company to record a profit any time they sold new shares above the original par value. As the South Sea stock rose, so did their “profits”. The Bubble bursts As the financial panic progressed in France, French investors began selling their shares in South Sea and bringing their capital back to France. The rush of money out of France reversed. By August, South Sea shares had fallen from 950 pounds to 700 pounds. The company tried to stem the decline. They announced a 30% dividend (on the original par value) for 1720, and a 50% dividend for each year thereafter (on the original par value) But there’s a problem. Troubles with the South Sea Without the stock price remaining high, the company wasn’t earning enough money to pay these dividends. Relations with Spain declined when Spain insisted on a return of Gibraltar, and the British refused. The company called a shareholder meeting on September 8th at 12:00 noon, but filled the meeting room with company supporters at 9:00AM. Disgruntled investors sold. The stock fell from 575 to 380 in a week. The South Sea Company was forced to receive a rescue package from the Bank of England to stay in business. The Economy enters a severe Recession/Depression The Bank of England called in loans making the credit crisis worse. Half finished homes and ships dotted the landscape as funding dried up. Unemployment soared. Tailors, goldsmiths, watchmakers saw their businesses collapse. Land prices fell sharply. Stocks in Amsterdam and all throughout Europe fell dramatically. Investors in Amsterdam blamed the English and burned down an English coffee house (Moses Haasverberg’s English Coffee House). English Response Members of Parliament who were South Sea directors were expelled from Parliament (including the chancellor of the Exchequer) and forced to pay restitution to shareholders. One director was shot in the streets by a disgruntled investor. New regulations passed. In 1734, Sir John Bernard’s Act banned the trading in options, futures, and short selling. But proposed new regulations in 1735, 1756, 1771, and 1773 all failed. Britain did not impose capital controls, currency market controls, money supply controls, or impose heavy taxes. Britain allowed a relatively free market. Foreign investors returned to England in the 1740’s and 1750’s. By 1776, 40% of British Government Securities were held by foreigners. French response John Law fled the country in December 1720. He died broke 9 years later. The Banque Royale was closed. The new stock exchange (Bourse) that had just been completed was closed. An official investigation (witch hunt) punished speculators who had not “acted in good faith” and forced them to pay penalties totaling 200 million livres. 500,000 people came forward and claimed losses. Through confiscations the number of shares of the Mississippi Company were reduced by over half from 135,000 to 56,000. The Mississippi Company lost the right to administer the Royal Tax system and the Royal Mint. In October 1722, all the financial journals, ledgers, and meeting minutes were publicly burned. French investors lost faith in financial markets and banks for generations.
