Anyone can create money; the problem lies in getting it accepted.

—Hyman Minsky

From 1853 through 1933, the United States experienced a recession or depression once every 3.9 years. The average contraction in GDP during this time was a ghastly 23%. Each of those 22 economic downturns, save for one, saw GDP fall by double digits (and the remaining instance saw GDP fall 9.7%.)

Contrast these numbers with the period from 1934 through 2018. The last time there was a double-digit contraction in GDP was in the short recession of 1945 following World War II. Before that it was the 1937–1938 downturn. The Great Recession of 2007–2009 saw GDP fall a little over 5%, a blip on the radar screen compared to the late-nineteenth and early-twentieth century economic experience. Since 1933, the average recession in the US has seen economic growth fall by an average of just 4.3%. The two longest economic expansions in US history have both come since 1990.

There are several explanations you could offer as to why recessions have gotten shallower over time while expansions have lasted longer. The US was basically an emerging market back then. We have a far more mature, diverse, and dynamic economy now. But the reason I chose 1933 as the cut-off point, aside from the fact it was towards the end of the Great Depression, is that was the year Franklin D. Roosevelt took the US off the gold standard. An act of Congress severed the tie between gold and the dollar, effectively allowing the price of gold to float more freely and giving the Federal Reserve more ammunition to fight the forces of inflation and deflation without being hamstrung by having our currency backed by a yellow rock.

Central banks and paper currencies are by no means perfect, and they don’t prevent developed nations such as the US from experiencing recessions. But it would be foolish to think they haven’t played a role in making our economy more stable over time. The Fed acts as something of a lender of last resort for the banking system, which is one of the reasons we didn’t have a run on the banks in 2008 and fall into a deep depression. Central banks also set short-term interest rates and manage the flow of credit when necessary, which acts as a shock absorber to the system.

Not everyone agrees with the modern monetary system we have in place, but it’s much better than the alternative of massive inflationary booms and deflationary busts every few years in the old system. In fact, the US didn’t have a true central bank until 1913. There were attempts to create such a structure on numerous occasions, but the banking system remained disorganized, inefficient, and antiquated until the panic of 1907 forced government officials to make a change. That was the year John Pierpont Morgan single-handedly saved the banking system from complete collapse by lending his own money and basically forcing other banks to do the same to keep the system afloat. A banker sent Morgan a note at the time that read, “the safety and welfare of the financial structure of this country depends almost entirely upon you.” The Federal Reserve Act of 1913 was created in the aftermath of this panic which set in place the current monetary system used today.^[1]

The seeds for today’s paper money system predate the creation of the Fed. In the early-eighteenth century, a Scotsman named John Law was basically the Christopher Columbus of the modern monetary system. Law was just so far ahead of his time that his ideas created a mania that morphed into a scheme that defrauded people out of their life savings in the Mississippi bubble.

John Law and the Mississippi Company

It’s easy to spend money in the modern world through the swipe of a card, the click of a button on your phone or computer, or even, God forbid, paying with cold hard cash. But back in the early-eighteenth century, all forms of currency were hard to carry, store, use, or save because there wasn’t a single currency in circulation. There was no paper money in most countries either. Gold and other precious metals acted as the currency of the day.

John Law spent a number of years studying the monetary system as a young man, always in search of ways to make the financial system efficient. People were sick of carrying around sacks of gold or silver coins everywhere to buy stuff. Not only did Law want to create a paper monetary system, a novel concept at the time, but he also wanted more money in circulation to give governments more control over the supply of money that wasn’t tied to a set amount of gold or silver stored in a vault somewhere. Law wanted to create more inflation to increase prosperity. Banks could always increase the money supply by making loans to citizens and businesses, but Law’s breakthrough idea was that credit should reflect the strength or weakness of a country’s economy, not how much gold it possessed. The only problem was finding a country willing to give these ideas a shot in the real world.^[2]

Enter France, where King Louis XIV had an insatiable need to spend money. The country was on the verge of financial ruin through a combination of excessive debt levels from multiple wars and a corrupt monarch who spent far too lavishly. The nation was willing to get creative to pay off its debts, as many in the government were worried about a revolution from its citizens.^[3] Government debt was still a relatively new phenomenon in the late-seventeenth and early-eighteenth centuries, and as with most new shiny new toys they didn’t know how to use it responsibly.

When he died after 72 years on the throne, Louis XIV left the heir to his throne, his five-year-old son Louis XV, not a huge pile of money but a huge pile of debt. The boy’s uncle Philippe became Regent to oversee the country’s finances until the young King came of age. The debt was so severe there was talk of national bankruptcy.^[4] Law buddied up to the Regent, informing him that France’s debt woes could be solved using a new monetary system. What did they have to lose? How many politicians in their right mind would turn down such a proposition?

Law’s proposed monetary system had a number of moving parts. Step one was to create a paper currency that people would receive by turning in their gold and silver. Step two was to run a central bank that controlled the supply of that paper currency to increase or decrease the supply of credit used in the economy. So far this sounds eerily similar to the current system, established after we did away with the gold standard. Step three is where Law’s plan would go off the rails. People weren’t quite ready to put their full faith behind a paper currency that wasn’t backed by anything beyond trust in the system, so Law’s regrettable decision at the time was to back paper money with government debt that could then be converted into shares of the Mississippi Company.

France controlled a large part of the United States at that point, so the Mississippi Company was established to take advantage of its resources. It was a development company that received a 25-year lease on France’s Louisiana Territory, which gave them a monopoly on discoveries and trade routes.^[5] The company hoped to strike it rich by finding gold. Shares were offered to the public but there was a twist. Not only would investors receive shares in the company, much like someone today would buy stock in Apple, Amazon, or Google, but they would do so by exchanging their holdings in government debt or annuities for shares in the company. In effect, this was a debt-for-equity swap.

Imagine loaning money to a friend to be paid back with interest to help them buy a house. But then that friend offers you shares in their newly formed treasure expedition company in exchange for the loan you gave them. Your friend’s debts to you would be cleared and you would get any upside if treasure was discovered. But if you were given a faulty map and no treasure was ever discovered…

France assumed it would find more than enough precious metals in the Louisiana Territory to make up for Law’s newly issued paper currency. The government basically signed on for this plan immediately because it would relieve their enormous war debts. And investors signed on because the company was paying generous dividends and they had Law, a growing celebrity presence due to his perceived intelligence on economic matters. All classes of French people ate up this idea, as investors were regaled with tales of gold, boundless opportunities, and fabulous riches. This opened the floodgates for the transfer of government debt into shares of the Mississippi Company, which was a huge departure from the sound monetary banking principles Law had learned and preached to others.^[6]

With a new financial system in place, liquidity for investors, and the desire to get rich quickly, the value of the company skyrocketed. No one bothered to look into the Mississippi Company’s business plan or the risk involved in swapping government debt for shares in this newly formed, unproven venture. Rising prices attract buyers just as falling prices attract sellers so as the price doubled in short order, more investors flocked to trade in their government debt for shares. Stocks are sexy when they’re rising while boring old bonds are never going to feel sexy to own.

Law became an instant celebrity. Although he was not Catholic at the time, people assumed the man had divine powers. In 1720, John Dalrymple wrote, “There can be no doubt of John Law’s catholicity since he has proved transubstantiation by changing paper into money.”^[7] Law may have understood monetary policy but he vastly underestimated the toxic mix his policies could create when combined with human nature.

Berkshire Hathaway vice chairman Charlie Munger once asked, “How could economics not be behavioral? If it isn’t behavioral, what the hell is it?” Law failed to account for the emotions – greed, envy, overconfidence, hope, and fear – money can bring out in people.

Speculation Is a Hell of a Drug

Rick James famously said on The Chappelle Show, “Cocaine is a hell of a drug,” when trying to explain his more outlandish behavior during the height of his popularity as a pop singer in the 1980s. For Law, you could substitute the word success for cocaine and the same would be true of many of his decisions once the Mississippi mania got out of hand. Success can intoxicate and corrupt even the brightest of minds.

The highest of nobility in France sought the company of Law and his family. With his newfound wealth, he purchased lavish estates in different parts of the country. Writers and poets were constantly showering him with adulation in their scribes. Law required troops on horseback to escort him wherever he went for a time to clear the streets from onlookers who wanted to meet the man of the hour. Law could do no wrong in the eyes of the public or the government.^[8]

For investors in the Mississippi Company, speculation was also a hell of a drug. This mania didn’t discriminate by class or wealth. Both the upper and lower classes were overcome with greed as visions of dollar signs danced in their heads. These are just some of the many crazy stats and stories courtesy of this bubble:

• The share price quadrupled between August and December of 1719 as the country assumed it had figured out the path to easy riches.^[9]
• In August 1719, the Mississippi Company took over the entire national debt of France.^[10]
• At its height, the market capitalization of the Mississippi Company exceeded the entire GDP of France.^[11]
• Cobblers figured out they could make more money renting out their benches for people waiting to buy shares than making shoes.^[12]
• It’s estimated more than 300,000 people from all over the world came into the country looking to get rich. Living space became such a problem with so many people flocking to the area that houses renting for $200/year skyrocketed to $4,000/month.^[13] Speculation ran so rampant this was one of the first times in history the word “millionaire” entered the vernacular to describe the new fortunes being created.^[14]
• Houses that would typically lease for an annual rent of 1,000 livres were going for 12 to 16 times that amount.
• There’s a famous tale that a hunchbacked man earned a decent chunk of change simply by acting as a writing surface to speculators filling out paperwork on the busy streets.^[15]

Then there’s the story of a doctor who was feeling a patient’s pulse. He shrieked, “It falls! It falls! Good God! It falls, it continually falls!” So the woman cried out, “I’m dying! It falls! It falls!” The doctor became puzzled, asking, “What falls?” To which the woman replied, “My pulse! I must be dying!” The doctor then explained he was simply yelling about the price of his shares owned in the Mississippi Company, which were dropping like a brick.^[16]

The bubble may have come from intellectual monetary underpinnings, but it was a bubble nonetheless and it was beginning to take on a life of its own. Like most economists, Law created policies based on theories that would work well in a vacuum, minus the element of human nature. Unfortunately, the human element is often the overriding variable in economic outcomes. The use of borrowed money to buy shares in the Mississippi Company was simultaneously propping up the share price and making the system more vulnerable as stock was being purchased on margin.

The share price of the company increased seemingly every day for a time, which only led Law to create more shares in the company, a virtuous cycle. This probably seemed like a great idea at the time, kind of like how a fourth beer always seems like a good idea after you’ve already had three. At this stage in the game, the government could have offered the drunks (speculators) a million beers (shares) and they would’ve accepted them. The Regent who initially backed Law knew next to nothing about finance but assumed the fact that things were going well in the present meant things would continue to go well into the future. Keeping with our drinking analogy, these people wanted to spend all night getting wasted without ever having to deal with the hangover in the morning. The other problem is Law was spiking people’s cocktails by giving the drunks borrowed money to buy more shares.

The financial markets are a cruel mistress who always follows up a raging night out with a wicked hangover in the morning. The problem is no one knows how late those parties will last. Sometimes they end at midnight. Other times, to quote Calvin Broadus (aka Snoop Dogg), “they ain’t leavin’ till six in the mornin.” The Mississippi bubble went the distance in its frenzy of speculation. Law convinced the Regent if some paper currency exchanged for government debt was good, then more had to be better. The higher the share price, the more shares of Mississippi Company stock he issued to take advantage.^[17]

Pop Goes the Bubble

The supply of shares eventually overwhelmed the demand, and prices finally took a breather. This is when Law panicked. As prices fell, he instructed the central bank to buy shares, but that could only last for so long as they eventually reached a breaking point. He also tried guaranteeing investors that the new shares offered would trade at par value within six months, which would be a doubling of their money. This was a gamble that didn’t work.^[18]

The currency initially traded at a premium to its intrinsic stated value which caused something Law did not anticipate – people began selling their shares to buy more tangible assets. Using his sway with government officials, Law tried to enact rules and regulations which would stem the tide and make the precious metals like gold and silver harder to utilize as currencies, but the damage had already been done.^[19]

Prices fell 90% as shares eventually became worthless because the remaining value was well under the amount people borrowed to purchase them. Law had to be protected by guards. He fled to Holland as his life was in danger from the angry mob. Citizens went from being millionaires to being broke within a week’s time. Law himself stated, “Last year I was the richest individual who ever lived. Today I have nothing, not even enough to keep alive.”^[20] It’s important to remember that an economy that utilizes paper currency is based on faith more than anything. The people of France not only invested their money in Law’s system, but also their trust. Once that faith was broken and investor confidence was shattered it was lights out.

The biggest problem with the Mississippi Company was that it never actually made any money in the trade business. In fact, the company never really even tried. Unfortunately, no one bothered to even look into the matter because everyone was so worried about making money. That included John Law. Not a single ship from the Mississippi Company ever even departed for the shores of Louisiana. The business itself was basically an afterthought in this mania. Law died broke, nine years after the height of the bubble, in Venice.

The public lost faith in the French banking system, and the country found it challenging to borrow money for years to come. Law’s ideas were so ahead of their time, and his response to the bubble was so badly played, his scheme likely set the French economy back decades because its citizens and government officials basically revolted against the stock market from this experience. It was a disaster of epic proportions. Voltaire observed, “Paper money has now been restored to its intrinsic value.” It took decades for France’s monetary system to recover. Law’s debacle inadvertently led to the start of the French Revolution in 1789 as this was the first chink in the armor of the French monarchy. France didn’t go back to the use of paper currency until 1793, and people were so scared of what it could do they were forced to use it through the threat of the guillotine.^[21]

Type I and Type II Charlatans

When testing a hypothesis using statistics, there are two types of errors a statistician can make. A type I error is when you reject a null hypothesis that is actually true. A type II error is when you accept a null hypothesis that is actually false. These terms are a bit technical, so allow me to explain using a meme. The best example floating around the Internet is a picture of a man on the left and a picture of a pregnant woman on the right. The picture of the man on the left shows a doctor telling him he is pregnant. This is a type I error or a false positive. The picture of the pregnant woman on the right shows the doctor telling her she is not pregnant. This is a type II error, or a false negative.

You can think about charlatans who take people for all they’re worth much in the same way. There are two types of charlatans in the world. Type I charlatans are the visionaries who are more or less sincere but wind up ruining their investors anyways because they take their ideas to the extreme or fail to account for the unintended consequences. These false positive charlatans are so passionate that it becomes difficult for the victims of fraud to see any downside. When you combine intellect, passion, and people who would like to make a boatload of money, it’s easy to develop blind spots to potential risks involved in these schemes. And once a Type I charlatan gets a taste of success, it’s tough to pull in the reins when things go wrong. No one wants to admit their life’s work turned out to be a fraud.

Type II charlatans are the out-and-out fraudsters who blatantly set out to take people for all they’re worth. These hucksters are only interested in making as much money as possible and they don’t care who gets hurt to achieve that goal. These are the false-negative charlatans because their marks assume these hucksters are acting in their best interest but in reality they’re nothing but frauds. It’s difficult for victims of fraud to see through this type of charlatan because they know exactly how to sell you. They understand the patterns of human behavior and tell you exactly what you want to hear. They move the goalposts and shift the blame when it appears they’re wrong and understand how to massage your ego to keep you in line. Schemes from Type II charlatans are difficult to avoid because there are always those who can be charmed by a good sales pitch from an intelligent-sounding fraud.

Both Type I and Type II charlatans allow their ambitions to take over, especially during a financial mania. It appears as if they can do no wrong so they start to believe the hype. John Law is a classic case of a Type I charlatan. The man was far ahead of his time when it came to ideas about the monetary system, but he was a charlatan nonetheless. Law never had a doubt his project would work. He assumed France would come out of this affair as the richest, most powerful nation in the world. Law invested his money back into the country, a truly believer it was going to work. It’s not like he was pocketing money and investing it in other countries. He kept it all in France with the understanding that his ideas were gold.^[22]

There is still debate today whether Law was brilliant or a complete fraud. I think there’s room for both sides to be true. Law was an intelligent fraud, a genius who didn’t understand the downside of his own theories and completely underestimated the toxic mix leverage and quick riches can have on the herd mentality. You can be both a genius and a charlatan. The two are not mutually exclusive.

When Law met with the nobility of France in something of an exit interview after his failed experiment, he is reported to have said, “I confess that I have committed many faults. I committed them because I am a man, and all men are liable to error; but I declare to you most solemnly that none of them proceeded from wicked or dishonest motives, and that nothing of the kind will be found in the whole course of my conduct.”^[23]

In the next chapter, we’ll introduce his counterpart, Type II charlatan extraordinaire John Blunt, who took the ball from John Law and ran with it, creating perhaps the biggest bubble in recorded history.