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Extraordinary Popular Delusions

Summary

A Revolutionary Financial Instrument

Convertibility and Currency

Extraordinary Popular Delusions

Extraordinary Popular Delusions by Charles Mackay provides a tremendous glimpse into the very beginning of capital markets and speculative bubbles. The book, written in 1841, surveyed the French Mississippi Company, the South Sea Company in England as well as the Tulip Mania which so gripped Holland in the 17th century. 

In the late 17th and early 18th century paper currency was something of a novelty. Most trade was exchanged through physical gold or silver. And even if people exchanged in paper currency, it was backed in some way by gold or silver. The vast majority of people, including the merchant class, were highly skeptical of the currency system and preferred to keep their wealth in physical gold or goods in the event of a change of royal regime or currency devaluation. As the century wore on, however, southern European nations, particularly Italy, began to transition their economies almost entirely to paper currency. As such, the southern economies grew more rapidly after the adoption of the system. Trade was more efficient and commodity markets more stable. And one of Italy's inhabitants, John Law, a banished Scotsman, saw global applications of the system. After observing the wide spread successful adoption of paper currency in Italy, John Law traveled to the economically desperate France to sell King Louis XV on the idea. 

Law successfully persuaded Louis on the concept and was promptly placed in charge of the newly formed Mississippi Joint Stock Company, which was to issue stock and trade with French colonies in the West Indies. This government sanctioned and majority owned monopoly became the talk of Paris and people from all ranks of society desired to have some stock in the business. Subscription lists for shares were seemingly endless. But in order to buy shares the government stipulated that people had to exchange their gold for French denominated paper currency or government bonds.

The effects of this were twofold. One, the French government was able to drive down its own interest rates and refinance their burdensome existing debt load. Secondly, the price of gold around the world plateaued as people, particularly French merchants, began to prefer Mississippi Company shares or government debt to gold. 

Due to tremendous demand and rumors of vast riches in the West, Mississippi Company shares soared from 500 livres in May of 1719 to nearly 10,000 livres at its peak in January of 1720, nearly a +1,900% increase.

Meanwhile, the French government was slowly unwinding its ownership in the Mississippi, locking in huge profits on the backs of speculators. As news began to leak that the government was selling its shares, traders also began to exit their positions in March of 1720. Spectacular volatility ensued. In the wake of the news that the government was selling, news also surfaced that nearly all the ships that had been sent to the West Indies had been destroyed in a storm and that the remaining crews of the ships had marooned to the Americas. As such, the government stepped in and halted trading from March to May. But when trading resumed in June 1720, the shares dropped precipitously and did not stop until the Mississippi Company ceased to be a business in march of 1721.  

In 1721 John Law was chased out of France. Nevertheless, the French government had executed his plans exceptionally well. The French were able to refinance their debt, lock in huge profits, create a culture of government debt investing and preference for French denominated currency. The French profited very much by this scheme but were forced to bail out some of its nobles in the coming years to appease the people and prevent an uprising. 

Although the Mississippi Company helped popularize the very favorable currency and debt market system we know today in a very short period of time, the negative effects are a reminder of the danger of speculative bubbles. It is also a lesson in the power of perception and the value of due diligence. In our day and age, we have more resources available to do due diligence. In the 1720's, the average investor in the Mississippi (mostly nobility), could not have known that the ships were hastily built, the crew were mostly prisoners, and that the supposed trading ports in the West Indies were hostile. But today we can dive into financial reports, global trends, earnings, cash flows, dividends, default rates, sales etc. Therefore, why then is that bubbles like Bitcoin still occur? Perhaps, I argue, it is because human nature is and always will be the same. You don't have to be a historian to know that but it might help.