The History of Financial Crises — Lecture 2 Study Guide
Instructor: Dr. Charles Calomiris
Lecture 2: John Law, the Mississippi Bubble, and the South Sea Bubble
1) John Law’s Early Ideas in Scotland (1705)
- Context: Scotland in 1705 was poor, underdeveloped, and financially weak compared to England.
- Law’s proposal: Creation of a land bank.
- Assets: loans secured by land.
- Liabilities: paper money.
- Rationale:
- Scotland had land but little capital.
- Paper money backed by land could expand credit, fuel growth, and attract immigrants.
- Paper could substitute for costly imports of silver/gold.
- Comparison: Similar proposals later in colonial America (e.g., Benjamin Franklin in Pennsylvania).
- Outcome: Rejected in Scotland, but idea was credible, not crazy — rooted in the logic of bootstrapping poor economies.
2) Law’s Broader Insight
- Government–bank partnerships:
- Sovereigns often destroyed banks by defaulting.
- Aligning the bank with sovereign interests (e.g., lending to crown, collecting taxes) made default less likely.
- If bank liabilities were partly backed by sovereign tax revenues, confidence increased.
- Principle: A mutualistic partnership could stabilize both sovereign finance and the banking institution.
3) Law in France: The Mississippi Scheme
- Law creates a grand system:
- Monopoly joint-stock company controlling Louisiana land rights, Canada fur trade, French tax collection, and colonial trade.
- A bank issuing legal-tender paper money.
- Consolidation of France’s sovereign debt into the company.
- Innovations:
- Installment plans for investors → allowed broad participation with limited upfront cash.
- Taxes payable only in paper → boosted demand for notes.
- Government ownership & backing of the bank.
Strengths
- Complementarities among debt holding, tax collection, banking, and trade monopolies.
- Potential for sustainable valuations (share prices of ~5,000 plausible with reasonable assumptions).
Weaknesses
- Overcentralization: eliminated dissent and market discipline.
- Removed specie convertibility of notes (1719).
- Overissuance of money to sustain inflated share prices → inflation doubled price levels.
- Reliance on installment plan forced Law to peg share prices to keep investors contributing.
- Collapse followed when confidence in paper money broke.
Result: Law fled France; the Mississippi Bubble collapsed.
Historians’ verdict: Could have survived at more moderate valuations, but excessive ambition + money printing doomed it.
4) The South Sea Bubble (Britain, 1711–1720)
- Background:
- Britain in near-continuous war with France (1688–1815) → heavy public debt.
- South Sea Company (1711, Tory-backed) created to swap sovereign debt for equity, similar to the Whig-backed Bank of England (1694).
- Nominal monopoly on Spanish-American trade, but rights were mostly worthless.
- Core function: Consolidation of fragmented sovereign debt into homogeneous, more liquid, longer-term debt.
Why it Worked
- Increased liquidity (homogenized debt easier to trade).
- Reduced default risk (powerful insiders, sovereign partnership, and legalized bribes created strong commitment not to default).
- Government profited: swapped £1m in heterogeneous debt for ~£900k in consolidated debt.
The Bubble
- Shares paid for using government debt.
- Demand stoked by:
- Bribes to politicians.
- Influx of capital after Mississippi collapse.
- Speculation by uninformed outsiders.
- Insiders (e.g., Hoare’s Bank): bought early, sold near the top.
- Outsiders: extrapolated rising prices, bought late, suffered losses.
- Prices soared, then collapsed back toward ~200.
Consequences:
- Unlike France, Britain’s broader financial system remained resilient.
- The South Sea bubble was a speculative mania with limited systemic damage.
- Highlighted divergence of informed vs. uninformed investors.
5) England vs. Scotland Banking Systems
- England/Wales:
- Bank of England monopoly (1694–1820s).
- Small, fragmented private banks.
- Restricted credit, frequent instability.
- Scotland:
- Multiple chartered and free-entry banks.
- Innovations: note clearing, interest-bearing deposits, lines of credit, collateral registration.
- Greater stability: bank failure rate 4x lower than England’s (1809–1830).
- Interpretation:
- Sovereign prioritized its own financing in England (Bank of England monopoly).
- In Scotland, allowed broader banking freedom as part of political bargain (loss of Scottish Parliament in 1707).
6) Key Concept: Calomiris’ Law of Banking
A sovereign will only allow banks to serve private credit needs after resolving its own fiscal survival risks.
- If sovereign is desperate → banks are chartered primarily to serve the state’s funding needs.
- Only after stability is achieved → banks allowed to serve private credit markets.
7) Modern Parallels
- Emerging markets (1980s–2000s): Similar state–elite partnerships (e.g., Mexico’s “six families,” Korean chaebols).
- Investors recognize equilibrium: banks serve sovereign interests first, private credit second.
- Lesson: Political equilibrium shapes banking design more than abstract economics.
8) Key Takeaways
- John Law’s schemes showed creativity and vision but collapsed from overreach and lack of discipline.
- The South Sea Bubble was sustained by politics and speculation, but did not cripple Britain’s financial rise.
- Scotland’s freer, innovative banking system outperformed England’s monopoly-bound system.
- War and sovereign survival explain divergent financial policies.
- Crises often arise from adaptive strategies, not just mistakes.
9) Review Questions
- What was John Law’s original land bank proposal, and why was it attractive for poor economies?
- How did Law’s system in France integrate tax collection, debt restructuring, trade monopolies, and banking?
- Why did the Mississippi Bubble collapse, and could it have been sustainable at lower valuations?
- What explains the political creation of the South Sea Company and its role in debt consolidation?
- How did insider vs. outsider behavior differ during the South Sea Bubble?
- Why was Scotland’s banking system more innovative and stable than England’s?
- What does “Calomiris’ Law of Banking” imply about financial development in risky sovereign contexts?
- How do modern emerging markets echo the dynamics of early modern sovereign–bank partnerships?