Financial Panics: 1600 - 2000

1. Financial Panics: 1600 - 2000 Peter Fortune Ph.D. Harvard University www.econseminars.com Email: pf@econseminars.com

2. Legendary Crises in the 17th and 18th Centuries

3. The Dutch Tulip Mania Of 1636-37: A Famous Non-Event References Garber, Peter. Famous First Bubbles: The Fundamentals of Early Manias, MIT Press, Cambridge MA, 2000 (esp. pages 20-86)

4. The Context ¶The Netherlands in the 1630s Bubonic Plague in the Netherlands (1634-1637)\  17% of Amsterdam died  The National Psyche Turned To The Short Term ¶The Botony of Tulips Bulbs Were Planted in September, Bloomed in May One Bulb Could Produce Several Bulbs via Buds Exotic Bulbs Always Rare: A Known Commodity Common Bulbs Could Become Rare if Infected by a Specific Virus, Making Them A Perfect Speculative Commodity

5. The Tulip Bulb Market ¶The Exotic Bulb Market Exotic Bulbs Traded in a Sophisticated Dealer Market Exotic Bulbs Were Traded by the Bulb  Exotic Bulbs Were Very Expensive Both Before and After the Tulip Mania ¶The Common Bulb Market Common Bulbs Were Traded in Bulk Common Bulbs Traded in Taverns (“Colleges”) Common Bulbs Traded in a Forward Market: Bulbs Were Bought in the Fall for Delivery in May

6.  Characteristics Of Forward Contract ¶No Margin Required from Buyer ¶No Bulb Required of Seller (Naked Contracts) ¶All Contracts Were for Forward Delivery ¶Most Contracts Cash Settled: Delivery of Actual Bulb Was Rare ¶Contracts Were Not Marked to Market (Limited Lender Protection) ¶Contracts Traded in Taverns (“Drinking Game”) ¶Contract Trading And Prices Peaked at Height Of The Plague (1636)

7. Tulip Bulb Prices During The Bubble ¶Exotic Bulb Prices Prices Rose Steadily Throughout 1634-1636 Prices Remained High After 1636 ¶Common Bulb Prices Prices Remained Steady Until Sharp Spike in November 1636 Prices Fell Sharply After January 1637

8.  Effects on Dutch Economy ¶Government Suspended Tulip Contracts in April 1637 ¶No Evidence That Any Contracts Were Enforced By Courts ¶No Indications of Bank Failures ¶The Tulip Mania Was A Non-Event

9. The French “Mississippi Bubble” And John Law The First Financial Engineer 1716-1722 References Garber, Peter. Famous First Bubbles: The Fundamentals of Early Manias, MIT Press, Cambridge MA, 2000. (esp. pages 87-102) Velde, Francis. 2004. Government Equity And Money: John Law’s System In 1720 France. Federal Reserve Bank of Chicago, mimeo.

11. John Law ¶ A Brilliant Scottish Monetary Theorist ¶ An IveterateGambler, Probable Murderer, And An International Black Sheep ¶ Peripatetic, Chased Out of Many Cities, Settled in Paris in 1715 ¶ Became Financial Advisor to the Duke of Orleans, Regent for Louis XV After Convincing Him That A State Bank Would Improve The Public Credit

12. The Historical Context ¶Louis XIV, The Sun King, Died in 1715 ¶After Versailles, Profligate Spending, and Numerous Wars, the French Government Was Near Bankruptcy ¶The Economic Policies of Louis’s Finance Minister, Jean Claude Colbert, Left the French Economy Bound by Rigid Regulations and Restrictive Trade Policies (“Mercantilism”)

13. The French Government’s Budget Deficit Under Louis XIV

14.  Key Elements of Law’s Monetary Theory ¶Substitution of Fiat Money for Specie Will Allow Increased Credit Resulting in Increased Trade and Higher Tax Revenues ¶Privatizing the French National Debt Will Strengthen the Public Credit and Prevent “Crowding Out” of Private Investment ¶These Goals Can Be Achieved By Creating A State Bank To Sell Shares to the Public, Use the Proceeds to Buy French Government Bonds (A Debt for Equity Swap), And Increase the Money Supply by Lending and Issuing Bank Notes

15. Formation of the Banque Generale (1716) ¶Functions of the Banque Deposit And Note Issue  Took Specie Deposits Convertible Into Bank Notes Made Private Loans Issuing Bank Notes In Exchange Investments And Asset Management  Purchased French Government Debt at Par, Paying In New Bank Notes  Held Tax Farming Rights And Foreign Trading Rights ¶Protection Of Deposits And Notes Initially Held High (50%) Reserves in Specie Value of Notes Protected Against Devaluation of Coinage By 1720 the Government Prohibited Large Payments in Specie And Made Bank Notes the Sole Legal

16.  The Banque’s Equity Structure ¶Issued Shares to the Well Connected The King Was the Largest Investor  “Society” Subscribed Heavily ¶Shares Viewed As A Slam-Dunk—A Free Call Option Shares were sold via Call Option with 5,000L Strike Price—20% Up Front, Remainder in 5 Months, with Right to Cancel Payment for Shares was 25% Specie and 75% Government Bonds at Par (Market Price was 60% of Par) Investors could borrow from the Banque to Pay for Shares (“Margin Debt”)

17.  The Market For Banque Shares ¶ A High Share Price Was Essential To Banque Viability Shareholders Received Value Increase If Price-Earnings Ratio on Stock Exceeded The Price-Dividend Ratio On Government Debt That Was Tendered For Shares •  Three Sources Of High Stock Price •  Strong And Increasing Revenues From Government • Bonds Held, Tax Farming Rights, Foreign Trading • Rights, And Return On Loan Portfolio •  High Confidence In Convertibility Of Notes Into • Specie—A Run On Specie Would Deplete Reserves, • Force Sale Of Assets, And Reduce Capital •  The Banque’s Stock Repurchase Program

18.  Law’s Share Price Support Plan ¶ If Share Prices Fell Below A Threshold, The Banque Would Engage In Stock Repurchases Print Notes And Buy Shares To Maintain Required Price ¶ The Inherent Contradiction  Effect Of Share Support Would Be Increased Note Issue  As Notes Outstanding Grew Relative To Specie, Noteholders Would Convert Notes To Specie  A Run On The Banque Might Result  The Note Issuance Would Create Inflation  Foreign Noteholders Would Convert Notes To Specie And Repatriate The Specie  Credit Would Tighten In France And A Credit Crunch Would Emerge

19.  The Banque’s Middle Stage (1717 – 1718) ¶ In 1716 to 1717 The Banks Was Wildly Successful  Shareholders Received A 64% Annual Dividend  The Business Model Was Confirmed ¶In 1717 Law Formed the Compagnie d’Occident Purchased the Louisiana Company and the Canada Company with All Development Rights in Canada and “Mississippi” IPO Was at 500L Per Share, Payable Entirely in Government Bonds IPO Was Executed Via Call Option Sale, As In General Bank ¶In 1718 The Government Nationalized The Banque  The King Bought All Existing Shares  Provided the King With a Printing Press

20.  The Compagnie d’Occidente Buys The Government ¶In 1718 The Company of the West Undertook a Series of Major Acquisitions Bought the Rights to All “Tax Farming” in France Acquired Other Trading Companies (Senegal, West Indies, Africa) Was Granted the Right to Run the Royal Mint and Receive All Seignorage (10-20% Premium) ¶The Company Was Renamed the Compagnie des Indes Shares Sold For 500L At IPO Subscribers Coud Delay Payment And Had Right To Cancel ¶The Company Acquired the “Royal Bank” in Feb 1720

21. The Status Of Law’s System By Early 1720 ¶Law Had Completed an LBO of the Government Taken Over All Aspects of France’s Finances Taken over All Government Foreign Trading Rights Become the Sole Issuer of Bank Notes--Which Had Become France’s Sole Legal Tender Except for Company Use of Specie in Foreign Transactions ¶Use Of Banque Notes To Finance LBO Created Excessive Note Issuance And Major Economic Problems Significant Inflation Began As Money Supply Exploded The French Livre Began To Decline Relative To Specie, Reducing Confidence In Note Convertibility Into Specie The French Currency Depreciated Relative To Foreign Currencies, Creating More Inflation And Specie Outflows

22.  The Late Stage (1720-1721) ¶In May 1720 The Baque Experienced Runs As Noteholders Converted To Specie  Surge In Notes Outstanding Relative To Specie Reserves Created Loss Of Confidence In Paper Money  The Banque Lost Specie Reserves  The Loss In Reserves Led To Further Conversions  The Banque Was Forced To Sell Assets  Asset Prices Declined, Reducing Bank Capital Government Delared Notes To Be The Sole Legal Tender Goal Was To Prevent Conversion Of Notes To Specie

23.  In May 1720 The Company’s Stock Price Collapsed Initial Causes  Profit-Taking: Share Price Had Risen To 10,000L  Banque’s Capital Was Eroding  Paltry Revenues From Foreign Trading Rights Law Implemented Stock Repurchases The Company Set A Repurchase Price Of 9,000L Stock Repurchases Added To Note Issue And Additional Banque Problems

24. Banque Notes in Circulation Peaked in May 1720

25. The Specie-Value of Banque Notes Began Rapid Depreciation in May 1720

26. The Company’s Stock Price Collapsed After May 1720

27. What Went Wrong? ¶Key Weaknesses  Law’s Business Model Flawed  Subscribers To Company Shares Could Pay Modest Amount Down, Remainder Later, With Right To Cancel Viability Required a High Share Price But Stock Repurchase Program Exacerbated The Economic Problems After Initial Success, Company Revenues Failed To Meet Expectaions Banque Had Seriously Overpaid For Government Bonds Law’s Monetary Theory Was Wrong Substitution Of Fiat Money For Specie Resulted In Inflation, Not Greater Trade

28. The Aftermath ¶Several Attempts to Save the Company by Converting Banque Notes to Banque Bonds Failed ¶Law Fled France in 1720, Died in 1729 ¶The Government Reversed the System, Converting Banque Notes and Bonds to Government Bonds ¶The Indies Company Was Given Additional Monopolies and It Survived ¶ The Clean-Up Was Completed in April 1722 ¶France Prohibited the Creation of Organizations Named “Banque,” Substituting the words “Credit” or “Societe,” as in “Credit Agricole” or “Societe Generale”

29. Did Law’s System Create Additional Trade? No, Its Primary Effect was on Inflation

30. Answer An Emphatic “NO” To All Of The Following: ¶Did Law’s System Strengthen the Government’s Credit? ¶Did The System Create Financial Stability? ¶Did The System Create More Production And Trade? ¶Did The System Develop the “Mississippi” Area? No Significant Investments Were Made in Louisiana The Spanish Were Unwilling to Let France Take Away Its Trade Routes in the Americas

31. Lessons From The Mississippi Bubble ¶Monetary Expansion Affects Prices More Than Trade ¶The Risk of Low Bank Cash Reserves – The Banque’s High Ratio of Notes Outstanding to Reserves Exposed It To Runs ¶The Risk of “Reputational Put Options” – The Company’s Efforts to Set a Floor on Its Stock Price via Buy-Backs Contributed to Its Weakness ¶The Risk of High Leverage – The Company Had High Indebtedness And Its Capital Was Easily Threatened By Declines In Asset Prices All Of These Have Re-Emerged In Later Financial Crises!

32. The English South Seas Bubble Laws’s System Redux Reference Garber, Peter. Famous First Bubbles: The Fundamentals of Early Manias, MIT Press, Cambridge MA, 2000.

33.  The Background ¶1711 - The South Seas Company Is Formed to Develop Trade With The East Coast of South America Gold and Silver in Spanish Americas: Mexico, Peru, Chile Spain was Expected to Allow English Trade Presence In The “South Seas” Spain Allowed Only One Vessel Per Year, Demanding 25% of Profits and a Tax of 5% On Remainder of Profits First Vessel Not Sent Until 1717 But Spain Allowed No More Even So, The Company’s Shares Remained Strong

34. The Government Captures The South Seas Company ¶In 1717 the King, Impressed by The Apparent Success Of Law’s Scheme, Proposed Refunding the Public Debt South Seas Company and Bank of England Both Invited to Propose Plans to Sell Shares and Buy Government Debt, Then Renegotiate Debt With Government The Company Embarked on Extensive Bribery of Parliament to Obtain Favorable Terms After Lengthy Debates, the South Sea Company Won the Contract The First Act Allowing Refunding Passed Parliament in March 1720 Investors Could Covert Government Bonds to South Seas Shares, Bonds, and Cash at Par—About Twice The Market Value Of Government Bonds

35. A Surge in Speculation on South Seas Shares Began

36.  The End ¶The Speculation Resulted in Formation of Numerous “Bubble Companies,” Many of Them Scams Parliament Passed “Bubble Act” In June 1720 to Prevent Competition With The Company  Shares of Bubble Companies Fell, Forcing Margin Calls and Sales of Shares in “Good” Companies  A Liquidity Crisis Emerged In Which The South Seas Company’s Shares Were Dragged Down

37. The U.S. Monetary System 1870 – 1936 Essential Background Information Reference Friedman Milton. Money Mischief: Episodes in Monetary History, Harcourt Brace & Co., New York, 1994. (esp. pages 51-79)

38. Bimetallism Before 1870 ¶Until 1873 Most Of The World Was On A Bimetallic Monetary Standard  Both Gold and Silver Were Legal Tender  The Mint Would Buy or Sell Silver at a Silver-Gold Ratio of 16 Ounces of Silver to 1 Ounce of Gold  The U.S. was Effectively on a Silver Standard Before the 1870s Because the Silver-Gold Market Price Ratio Exceeded the Mint Parity of 16:1 ¶The Problem Of Bimetallism  When Gold-Silver Market Price Deviated From 16:1, One Metal Would Be Hoarded, The Other Used For Payments  Gresham’s Law”: Bad Money Drives Out Good Money

39. The Rise Of The Gold Standard ¶Prior To 1870 Bimetallism Prevailed Every Country Set A Mint Ratio (Usually 16:1) Mint Would Exchange 1 oz. of Gold For 16 oz. of Silver  1 oz. Gold = $20.64 => 1 oz. Silver = $ ¶ The Start of The Gold Standard Germany Won The Franco-Prussian in 1871 Germany Levied Reparations on France Payable in Gold  Germany Then Went on a Gold Standard In 1873 The U.S. Went On The Gold Standard By 1900 All Western Countries Had Demonetized Silver And Adopted a Gold Standard China and Other Asian Countries Adhered to a Silver Standard

40. The U.S. Goes To Gold ¶Fourth Coinage Act of 1873 (The Crime Of ’73)  Ended Purchases of Silver by U.S. Mint Created A Gold-Based Currency and U.S. Adherence to an International Gold Standard at 1 oz. = $20.64 Resulted in a Decline in Silver Prices and Economic Difficulties in the Western U.S. Called “The Crime of ’73” by Western “Silverites” Shaped the Political Debate for 30 Years, for example, Bryan’s “Cross of Gold” Speech in 1896 Had U.S. Stayed on a Silver Standard, the Depression of the 1890s Might Have Been Mitigated Dollar Would Have Depreciated Relative To Gold Area  Periodic Gold Outflows That Troubled The Economy Would Not Have Occurred

41. The Gold Standard after 1873

42. The Pros And Cons Of The Gold Standard ¶ Positive Aspects Of Fixed Exchange Rates No Exchange Rate Risk Easy to Compute Prices of Foreign Goods International Lending Less Risky Encourages “Globalization” of Trade and Finance  Reduces Possibility of Prolonged Inflation ¶Cons Limits Control Over Domestic Money Supply Links International Economies Together—Booms and Busts Quickly Transmitted Abroad Can Promote Economic Instability When Policies in Different Countries Aren’t Synchronized

43. The U.S. Monetary Framework Under the Gold Standard

45. 19th and Early 20th Century Monetary Crises The Panic of 1893 The Panic of 1907

46. The Panic of 1893References

47. The Ecnonomic Context ¶Railroad and Steel Consolidations  Declining Rail Tariffs led to Increased Competition, Especially For Short Haul Routes JP Morgan Led a Railroad Consolidation Movement  Morgan Formed U.S. Steel, A Consolidation of Carnegie- Related Steel Companies ¶Declining Commodity Prices Western Farmers Under Pressure As Ag Prices Fell Silver Prices Declined in Utah and Nevada  Coalition of Western Senators Pushed for Increased Credit From Eastern Banks and Return to Bimetallism

48.  The Monetary Context ¶Supply of Bank Notes Was Linked to Gold Reserves at Banks And The U.S. Treasury (High-Powered Money) ¶Predictable Credit Cycle Associated with Crop Harvests  Bank Notes And Gold Moved Westward as Farmers Borrowed In The Fall Planting Season Gold Imports Rose as Eastern Banks Borrowed Abroad in The Fall To Finance Farm Credit  A Regular Credit Crunch in Fall—Interest Rates Would Rise As Credit Demands Rose

49. The Triggers ¶Sherman Silver Purchase Act of 1890 Required U.S. Treasury to Buy 4.5M Ounces of Silver Monthly Using Silver Certificates(Bank Notes Convertible Into Silver) Created Foreign Fears That U.S. Would Abandon the Gold Standard—Lending to U.S. Fell Sharply and Gold Flowed Out of Country Reduction in Treasury’s Gold Reserves Created Incentives to Convert Gold Certificates into Gold for Non-Monetary Uses  Treasury Suspended Convertibility of Gold Certificates  Result Was A Severe Credit Crunch as Bank Lending Fell  The Sherman Act Was Suspended in 1893

50.  The Economy In The Early 1890s ¶Continued Decline of Agricultural Prices Bumper Crops in U.S.  Farm Loans Defaulted in Midst of Prosperity  Farmers Reduced Purchases ¶Important Industrial Company Failures Philadelphia and Reading Railroad National Cordage Company Many Banks (Mostly Western) ¶Labor Strikes