Learning from past investment manias (page 1 of 2)

From time to time a wave of optimism spreads around the world like a bush fire. People believe that they are seeing the dawn of a new era, which will bring unimaginable riches and prosperity to all.

Waves of new era thinking are usually associated with discoveries (the Americas, gold deposits in California), the opening up of new territories (the Western territories of the US, the opening of China in recent years), the application of new inventions (canals, railroads, the automobile, radio, PCs, the Internet, wireless communication), the rise in the price of an important commodity (rubber at the beginning of the 20th century, oil in the 1970s), peace treaties (the breakdown of communism), or strong economic performances.

A typical feature of new era thinking is that it usually engulfs a country or the world not at the beginning of an era of prosperity, but towards the end of such a period and is associated with some sort of a 'rush' or investment mania. One of the most well known examples of this phenomenon is John Law's Mississippi Scheme.

In 1716, Scottish adventurer and professional gambler John Law opened the Banque Generale in Paris under the patronage of the French Regent, which issued paper money backed by gold and silver. With the Regent's backing the bank became an immediate success. And in 1717, John Law launched a new venture, the Mississippi Company, which obtained from France the monopoly of all commerce between France and French territories in North America in return for accepting the outstanding notes of the French Government for the payment for the Mississippi shares.

This arrangement was designed to induce a conversion of France's government debt into the shares of the Mississippi Company. Initially, the Mississippi Company was not profitable, because only very few French people wanted to immigrate to America and by 1719 the shares of the Mississippi Company had declined to 300 livres, down from the issue price of 500 livres. It is at this point that John Law had a great idea.

First he announced that he would pay in six months' time 500 livres for a certain number of shares in the Company. The public immediately realized that if the promoter of the Company was willing to pay almost twice the prevailing price for the stock six months later, it must be because he knew of some favorable developments.

Therefore, investors began to buy the shares of the Mississippi Company and pushed up its price. Thereafter, John Law, took over other businesses including the tobacco and coinage monopoly in return for assuming the entire French national debt, which amounted then to 1.5 billion livres. The scheme was brilliant.

The Mississippi Company would pay the French government 1.5 billion livres, in return the government would repay its creditors who would then invest the money they received in the shares of the Company, which were offered to them at less than their value, as John Law argued. The scheme worked perfectly well for a while, as each time the Company announced some new venture additional shares were issued at higher and higher prices, which attracted a larger and larger number of speculators to participate in the mania.

In particular, the public's enthusiasm was fueled by the government, which had begun to run its money printing press round the clock in the belief that the public had gained sufficient confidence in paper money. As a result, the government increased the money supply in 1719 dramatically and pushed down interest rates by lending money for as little as 1% or 2%.