John Taylor's Midsummer Night’s Dream

Midsummer Night’s Dream

July 22, 2010

By John R. Taylor, Jr., Chief Investment Officer, FX Concepts

Here in Paris, the stores on avenue Matignon and rue du Faubourg Saint-Honoré are packed and long lines snake into the Louvre and other museums – the summer is wonderful. And in London and New York, as well as the Côte d'Azur and the Hamptons, it is just the same, as those with money and credit leave their worries behind. It’s hard to believe that the world isn’t in great shape. As a bear, sometimes I even feel guilty for harboring negative thoughts and raining on the triumphal parade of the ruling classes. The wealthy centers of the European and American capital cities do look better and better every year, but the business and editorial pages of the leading papers tell another story. The financial picture is deteriorating at an accelerating pace, and now even the major governments, bulwarks of the free market system, are threatening to slide into trouble. The latest phase of this has been the creation of large amounts of high powered money, issued to benefit and support crucial financial actors within the system. Finding a home for this excess liquidity has resulted in a continuing series of bubbles, large and small (one of which is the beautifully renovated monumental buildings in central Paris).

Although we have not done a word content analysis for ‘bubble’, it is our opinion that in 2010 this word has appeared more often in the financial and general press than at any time since 1720, when the Mississippi Bubble and the South Sea Bubble topped the charts in Paris and London. Does today really have parallels with 1720? That’s what vacations are for: thinking of things like this, reading murder mysteries, romance novels and financial histories, and fantasizing. After reading This Time Is Different by Carmen Reinhart and Kenneth Rogoff, which we all should memorize, I wished that their analysis had gone back to the period before 1800 as it seemed to me that the most interesting financial conflagration of the last 500 years occurred in 1720. Central banks were just beginning and the big powers were struggling with monumental debts. The British had just gone through a long revolutionary period that ended in 1688, and the “Glorious Revolution” seemed to bring a new mercantilistic twist to finance, leading to the creation of the Bank of England. The large government debt was absorbed through the Bank’s expanded liquidity and the economy grew rapidly, spawning many other joint stock companies. The most famous of these was the South Sea Company, founded in 1711, which, by promising to finance the government dramatically expanded liquidity, but it was never profitable, and eventually collapsed. The Bank of England and the British Treasury managed to avoid default, retiring the debt over many years but the economy suffered for decades. In France, the death of Louis XIV, a singularly expansionary and profligate monarch, caused the government to default in 1715. John Law arrived and introduced a bank, the Banque Royale, with the guarantee of the king to issue paper currency backed by the revenues of the Mississippi Company. The success of his venture led to the circulation of far too many banknotes, and the bubble collapsed in 1720. The French economy went into a long chaotic decline, never really recovering and ended in revolution by 1789.

The Bank of England was the first central bank and John Law’s bank was the first to act like a modern central bank. These independent banks were there to finance the government. Although both governments needed liquidity to satisfy their debts, the banks expanded so much that the economies were stronger too. However, despite the multitude of investors attracted by the  bubbles, eventually the commercial operations could not support the debts and a collapse followed. The British took a deflationary path, while the French one seemed erratic but generally inflationary. Neither brought economic relief in the next decades, but the British tactics eventually built a sounder economy.

h/t Teddy KGB