and then allow the government to pay this company a lower rate of interest . The problem was that this trade was clearly not in the interest of debt holders . Why would they swap a bond yielding 8 % interest for a share in a company whose main asset was a bond yielding 5 % interest ?
But what if those debt holders could be convinced that after they made the trade , the price of Mississippi Company shares would rise ? Investors might be aware that the long-term yield of the shares would not match that of the debt , but a few percentage points of annual interest would pale in comparison to the prospect of immediate , large capital gains . As long as the company ’ s shares were thought to be rising , completing the conversion would not be a problem .
So Law engineered a bubble in his own company ’ s shares . First , he made sure that the shares were much more liquid and marketable than the ( largely untradeable ) debt used to purchase them . This would allow investors to believe that they could easily realise any capital gains . Second , he instructed the French Banque Royale , a forerunner to the modern central bank , to rapidly expand the money supply . This ensured that plenty of money was available to buy the shares on secondary markets . Third , he allowed the shares to be purchased for an initial down payment of 10 %, effectively extending an enormous amount of credit to the market .
The final part of the plan was to use “ market management ” tricks to engineer a series of rapid increases in the company ’ s share price , thereby attracting speculative investors . Each successive share issue required the subscriber to hold existing shares , which increased the demand for these shares on secondary markets . The rising price of existing shares then made the current issue look like a much more attractive investment . He also used the news media , which was heavily controlled by the French government , to exaggerate the company ’ s profitability .
As the graph shows , Law ’ s scheme was an enormous success — but only for a while . When investors began to cash out , the price of the company ’ s shares began to fall . Law responded by pegging the price of shares at 9,000 livres , paying out investors by having the Banque Royale print bank notes . But this led to considerable
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Mississippi Company Share Price ( livres ), 1718 – 1720
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6-2-1719 8-1-1719 inflation , undermining confidence in both Law and the Mississippi Company . His entire economic project fell apart , and at the end of 1720 he was quietly sent into exile to protect him from angry investors .
To say that Law invented the financial bubble might not be exactly true , but nor is it entirely false . As the first person to make one happen , he bequeathed a recipe for bubbles to future generations . Every major bubble since 1720 has stemmed from the same key elements Law focused on : asset marketability , abundant money and / or credit and speculation . Once these elements are in place , all it takes is a spark to provide an initial increase in prices , attracting momentum traders and speculative investors . In the case of the Mississippi Bubble , Law provided this spark himself .
These conditions can be illustrated using a model analogous to the “ fire triangle ” in chemistry . In the fire triangle , when oxygen , fuel and heat are all in place , a fire can be started by a spark ; the fire can then be extinguished by the removal of one of these elements . In the bubble triangle , marketability , money / credit and speculation must all be in place , at which point a spark can be provided by politics or technology . Bubbles then come to an end when one side of the triangle is removed or runs out .
The first side of the bubble triangle , the oxygen for the boom , is marketability : the ease with which an asset can be
9-30-1719
11-29-1719 1-28-1720
3-28-1720 freely bought and sold . Marketability has many dimensions . The legality of an asset fundamentally affects its marketability . Banning the trading of an asset does not always make it wholly unmarketable , as demonstrated by the abundance of black markets around the world . But it does usually make buying and selling it more difficult , and bubbles often arise soon after the legalization of certain types of financial assets .
Another factor is divisibility : if it is possible to buy only a small proportion of the asset , that makes it more marketable . Public companies , for example , are more marketable than houses , because it is possible to trade tiny portions of the public company by buying and selling its shares .
Historically , bubbles have often been preceded by sudden increases in marketability . A precursor to the bubble of 1720 was the emergence of joint stock
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SPECULATION
5-27-1720 7-26-1720
MARKETABILITY
MONEY / CREDIT The Bubble Triangle
9-24-1720 11-23-1720
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