Rationality VS Irrationality

In the last two posts, we’ve talked about how irrationality and rationality lead to a bubble. Who is responsible for Mississippi Bubble? Perhaps no one in France at that time is innocent. From my point of view, rationality interacts with irrationality, resulting in the bubble. If everyone is rational, the bubble can be avoided before it burst. If everyone is irrational, then the bubble would keep inflating. Unfortunately, behaviours of human beings are changeable and unpredictable, which makes the economic or financial theories inconsistent with the real world. In other words, people’s behaviours are uncertain, or unstable, contributing to the financial instability.

Hyman Minsky introduces a model which emphasizes the pro-cyclical changes in the supply of credit to interpret financial crises. If a positive “displacement”, exogenous shock, occurs to the macroeconomic system, investors will become more optimistic about the future. Thus, they are eager to borrow in order to invest. At the same time, lenders are willing to make loans regardless of risk. As a result, optimistic expectations of investors encourage credit expansion and in turn credit expansion further boosts the optimistic expectations and asset prices as well. The danger comes when the economic conditions slow, resulting in less optimistic and more cautious attitude of investors and lenders. Therefore, it is the increases in the supply of credit in good times and decreases in the supply of credit in less optimistic economic times that lead to “fragility in financial arrangements and increased the likelihood of financial crises”.

In Mississippi Bubble, the creation of paper money and the establishment of central bank can be regarded as a positive shock to the macroeconomic. Such financial innovations conceal the inflation and create a “money illusion”. After that, the many advantages of Law’s company increase the demand for investment. To meet such demand and further stimulate economy, Law prints more money, resulting in credit over-expansion. Unfortunately, the negative shocks (caused by the news that no gold in Mississippi and the huge demand of species) destroy the irrational exuberance. Investors believe the share price is far away from its true value and rush to sell it, resulting in the rapid decrease in stock price. Meanwhile, such decrease increases the investors’ pessimism, accelerating the collapse of credit system of paper currency. At last, the bubble burst and followed by the crisis, which make the French curse the word “Banque” for a century.

Law’s intention is good. Schumpter speaks highly of John Law, "he worded out the economies of his projects with a brilliance and, yes, profundity which places him in the front ranks of monetary theorists of all times." Law devotes himself to help France out of depression. His idea (printing money in depression) can be found in Keynesian economics, supply side economics and monetarism. But just as Mackey Charles says, “He did not calculate upon the avaricious frenzy of a whole nation; he did not see that confidence, like mistrust, could be increased almost ad infinitum, and that hope was as extravagant as fear”. Although he fails finally, he is lucky because he is the first one and the only one to put his theories into practice entirely and massively.

Mississippi Bubble is one of the earliest bubbles in the history. The boom and burst of it proves Minsky’s crisis theory. Law’s story is extremely pure. Only then can it reveal the nature of bubble typically and directly: under the stimulus caused by optimistic expectation, credit expanding interacts with increase in share price. In modern economy, such essential relationship is always covered by various kinds of advanced financial instruments, complicated trading patterns and financial arrangements. In this sense, this story is worth retelling and remembering.

What cause a bubble?

Allen and Gale (Bubbles and Crises, 1998) develop an asset-pricing model to explain how the agency problem results in asset bubbles. Before obtaining fund by issuing debt, borrowers may claim that they will invest the fund in relatively safe projects. However, they may break their promise after getting the money since risky assets are more likely to bring them excess return above debt payment. Thus, they bid the risky asset at the price above the fundamentals and such price departure leads to bubbles. Unfortunately, lenders are unable to observe such moral hazard caused by ex post asymmetric information. Therefore, even if the investors are rational, bubbles also exist.

Although this model is not perfect to explain the Mississippi Bubble, we can also find the agency problem in it. Law prints money in order to stimulate the economy. If we regard the money as lending (because Law can print money if he wants, the money creation can be considered as credit expansion), then we can observe the agency problem. The public spend all the paper money to buy the shares. They believe the share price would keep increasing. Thus, they are willing to buy shares at a high price level, resulting in the sharp rise in stock price and large departure between the market price and fundamental price. For example, the share price increased from 8000 livers to 10000 livers in a single day (the story is shown in the last post).

Second, technological revolutions also contribute to bubbles. Pastor and Veronesi (Technological Revolutions and Stock Prices, 2009) indicate that “academics studying bubbles know that a technological revolution took place, but investors living through the revolution were uncertain as to the eventual impact of the new technologies”.

The “issuing of paper money” can be regarded as a technology revolution in Mississippi Bubble. What is the value of paper money? Why is some money equal 20 pound while others are worth 50 pound? How can we know we are sure to get the same amount of money through this piece of paper? We are willing to hold money since it is guaranteed by governments. Meanwhile, governments will not print money without any restriction in case a hyperinflation occurs. In the Mississippi Bubble, the public also believe that the value of banknotes equals to equivalent metallic currency at first. They trust the government. However, they have not though about why they obtain so much paper money. They fail to realize the money they hold is not worth the number on the paper. Thus, the public think they become rich and the wealth is brought by Law’s company. In fact, it is only a “Money illusion”.

Irrationality

The three mini-fictions in the last post are true stories during the Mississippi Bubble, revealing the madness of the public. There is no denying that the public should take responsibility for the bubble. Charles Mackay is the first one to show the whole story of Mississippi Bubble. He shows that psychological failings of investors may contribute to the bubbles, in his famous book, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. The book is worth reading, as Ross Emmett says, “Mackay’s tale reaches further than the facts, but that should not stop us from enjoying it.” To read this book online you can click here. But I sincerely recommend buying it if you are interested in the book.

Kindleberger and Aliber (1996) suggest in their book, Manias, Panics, and Crashes: a History of Financial Crises, that it is the rationality assumption which is inconsistent with the reality (especially during the manias) that form the basis of economic theory. “Rationality is thus an a priori assumption about the way the world should work rather than a description of the way the world has actually worked”, they write. 

Robert Shiller (2005) indicates in his book, Irrational Exuberance, that psychological factor play a key role in irrational exuberance. They introduce two kinds of psychological anchors for the market, quantitative anchors and moral anchors. Quantitative anchors are used by some investors as indications of whether the share price is over-valued or under-valued and whether it is a good time to buy. Moral anchors are more complicated in my opinion. It is associated with measuring investors’ intuition and emotion.

What cause such irrationality?

Shiller argues the overconfidence and intuitive judgment of investors may be one reason. Investors think they know more than they do. Perhaps this is because of their self-esteem from my point of view. For some investors, it is more unbearable to admit their wrong predictions than to accept their loss, such as John Maynard Keynes (the story is told by Barton Biggs in Hedge Hogging). Shiller writes, “We have all observed at one time or another that there are a lot of know-it-alls out there”. However, in fact, if people say they are certain they are right, they are right only about eighty percent of the time shown by Baruch Fischhof, Paul Slovic, and Sarah Lichtenstein (Calibration of probabilities: The state of the art to 1980, 1982). Shiller presents three reasons which give rise to overconfidence, hinder-sight bias, magic thinking and representativeness heuristic. Investors with such ideas believe the world is predictable; it is time to take certain action which will bring their wealth; history is about to repeat. Thus, their overconfidence “plays a fundamental role” in speculative bubbles.
 

Herding is another reason to cause the irrationality. Shiller mentions, “The behaviour, although individually rational, produces group behaviour that is, in a well-defined sense, irrational”. This phenomenon may be generated by an information cascade. For example, suppose you want to have dinner in a restaurant, you find two restaurants in the street, one being full of customers while another empty. Which one will you chose, assuming you are full of patience and not hungry? Intuitively, you are more likely to choose the crowded restaurant because you obtain the signal that this one is more popular. However, the truth may be the first customer chose it randomly while others just followed the first customer’s choice. Another example is the bank run from Mary Poppins, shown as the following video.
 

 

 

In addition, Shiller points out that new media as a cultural factor may cause the irrationality. “The stock market also has star quality. The public considers it the big Casino, the market for major players, and believes that on any given day it serves as a barometer of the status of the nation—all impressions that the media can foster and benefit from”. News media is able to provide guidance in terms of cultivating a debate or reporting on the market outlook to investors, even though the guidance is inaccurate. Moreover, investors may be confused by the record overload which create obstacle for them to make correct decisions. Victor Niederhoffer (1971) who aims to find whether big stock price movements are related to news, in his paper, the analysis of world events and stock prices, defines a crisis as a time when more than five large headlines in the New York Times occurred within a week and find eleven such crises accompanied by big stock price changes from 1950 to 1966.

Recalling the stories during the Mississippi Bubble, it is apparent that the public is irrational. Can we conclude that John Law is innocent? The bubble is largely of the investors’ own making?  To find the answer, perhaps the better way is to ask the question: What causes bubbles? In the next post, we may find it.


 

Mini Fictions

• The humpback
   

The humpback is angry, looking at the stall crowded with people. “I only have one pair of shoes” he thought, “I’ve been walking for almost two hours to have my shoes repaired by the shoemaker who requires the lowest cost in the city. How can he do this”!



The shoemaker stands behind the stall, smiling and counting money with virtually no attention paid to the humpback. His stall is near John Law’s exchange. Everyday hundreds of folks scrambled to buy Law’s shares. Over 300 thousand people have applied for the 50 thousand new shares. It is said that the yearly rental of houses near the exchange has increased tenfold. The shoemaker seizes the opportunity to make fortune, earning 200 livers per day by selling pen and paper to those who rush to buy the shares.

“They are all crazy”, the humpback muttered. Suddenly, he feels that someone is looking at him. “Hey, I will give you generous salary if you are willing to lend me your back! I need a desk! Your back is just right!” a gorgeously apparelled man shouted to him. “What?” the humpback cannot believe on his ears, frowning his brows. “Come here! I want to write on your back. I will give you huge salary!”

Well, it seems that I can also cash in today. Writing on my back? WHO CARES? From birth to now, this is the first time that I can take advantage of my hunchback. Perhaps I don’t need to have my shoes repaired. At the end of the day, I will have enough money to buy a pair of shoes, or lots of shoes if I want.

figure1:Investors outside the Offices of the Mississippi Company in
Quincampoix Street(source:http://www.mapforum.com/05/law.htm)

 

• The servant

“It’s like a dream.” The servant said to himself, breathing the fresh air and admiring the wonderful sunrise. Yesterday he was still a poor servant. But now he is rich although the money he owned is not legal. “It was master who told me to sell the share at 8000 livers.” He comforts himself. “I did no harm to his interest.”

The master was a shareholder in John Law’s company. One day, he unfortunately fell ill. Reluctantly, he had to tell the servant to sell his shares. When the servant arrived at the exchange, he found the price increased by 2000 livers (increasing 25% compared with the opening price). He struggled inwardly, “Master gave the shares to me because he trusted me. I must take back money.” Unknowingly he arrived and was summoned before his master. “Have you sold the shares?” the old man asked. “Yes, master. 250 shares and 8000 livers per share!” “Well done. You can leave now.” Instinctively the servant concealed the price increase.

“Master will know the truth sooner or later. What should I do!” he tossed and turned in bed and finally decided to flee. With his hopes and dreams for the future, he ran almost all the way. What would the next town look like? What business should I do?  I am not a servant anymore! I want to make more money. Perhaps one day I can return to Paris with the money earned by myself and repay the old man.

No matter how ambitious he could be, he might just be unable to carry out his grand plan. When he settles down in a new country, his paper money is devalued…He was a rich only on the run.

• Regent

“How beautiful the jewel is!” Regent appreciated, touching the glimmering diamond on the crown. “It is worthy of one of the most famous diamonds in the world!”

In fact, he once doubted whether spending 32 million livers on this unique jewel was right. However, the stock price was keeping increasing, which made him believe that the economic conditions could only grow better and better and buying such a luxury jewel is innocuous.

“Law is a genius!” Regent said cheerfully. After Law carried out his System, fewer and fewer people bothered him. “Paper money is really useful! It is magic, fuelling the economy. ” Suddenly came a knock on the door. “Your Majesty, the Duchesses are not at home. It is said that all Duchesses are in Law’s house.” A servant said respectively, “Perhaps no duchess can go to visit the princess.” “Well, it seems that I have to visit my daughter by myself” Regent said with a sign. “Law also bring me a problem. Everyone queue up to buy his shares. Perhaps I have to do everything myself soon after.”

Burst of the Bubble

 

 

Law was confident with his solution to handle the depression: issuing paper money- converting it to company equity- offsetting national debt. However, he did two things wrong in this framework.

  



figure1: The System of Law (drawn by myself)

 

Firstly, the public bought shares because of their optimistic expectations. But Law expanded the Compagnie without any exact investment projects. In other words, the company value was based on the rumour that Mississippi was crowded with gold and silver. Unfortunately, people found gradually that the rumour was not true. Mississippi was a backwater rather than a paradise. Without actual profit, Compagnie was faced with the financial distress. Law had to issue more equity to roll over existing debts with new borrowing. He began to spread the news that Compagnie succeeded in finding gold mine and impose restrictions on the number of new shares bought by original shareholders (aiming to create a façade that the ability to buy stocks is a privilege). Furthermore, he longed Compagnie stock future at the price which was higher than a third of the market price at that time to build expectation that the share price would continue to grow.
 

Secondly, the overexpansion of money credit would inevitably cause inflation. The inflation rate in France in 1719 was only 4% while it was 23% in January 1720. The public started to worry about the purchasing power. As a result, some of them sold the shares to buy gold which resulted in the decrease in share price. Ironically, in the first half of 1720, one prince required to exchange huge notes, seriously depleting the bank reserve. Although finally he returned most of the precious metal with the invention of the Regent, but the faith in market was poisoned. More people required to get the specie and sent gold (silver) abroad. Law and Regent spared no effort to restrict the use of metallic money. For example, they ruled that paper money could serve as legal tender to pay depositors. Worse still, Law had to print more money to absorb shares sold by some investors which led to further inflation. In the end, rising trend of stock price finished. He failed to maintain the high price level and had to plan to decrease the price. Meanwhile, he devalued the money. Certainly, these operations generated the widespread panic, making the price collapse. In September 1720, share price cut to 2000 livers per share. It continued to decrease to 1000 livers in December 1720 and 500 livers September 1721 respectively (In May 1719, the share price was 500 livers!).



figure2:Mississippi Bubble money and price data( Garber,1990)




figure3: share price of Mississippi Company (Garber,1990)
                           

On October 10, 1720, the government announced an end to “The System” created by Law.  He was made ousted from his position and his property was confiscated. What’s worse, his life was in danger. Again, he fled in panic and finally died in a strange place in March 1729.

 

Here is the end of the Mississippi Bubble. I am amazed by Law’s bold attempt. His theory is reasonable and even popular nowadays. But there is no doubt that he did make mistake which destroyed the economy in France. However, is he the only one that needs to be responsible for the Bubble? In the next post, we will look at the “story” again from some prospective.


 

development of the Mississippi Bubble

In January1719, Banque Generale was renamed to the Banque Royale and taken over by the Regent, with a note issue guaranteed by the crown. Law was named chairman. He issued huge amounts of paper while expanding business. He converted the massive government debt into company equity, promising high dividend. Therefore, business promoted the credit and the credit in turn boosted the business, which led to sharp increase in the share price.

In July 1719, Law’s company bought the right to produce the country’s legal tender for fifty million livers. To cover this expanditure, Law issued fifty thousand new shares (1000 livers per share). Share price rose to 1800 livers. In August 1719, Compagnie purchased the right to collect all French indirect taxes. Two month later, Law got the right to collect direct taxes which made the share price increase to 3000 livers. He pulled off three enormous share offerings in September and October 1719 (ten thousand shares in each offering and five thousand livers per share) to repay the national debt for the government. The share price rose to 10,000 livers. Suppose you were a French at that time, according to the following picture what would you forecast the stock price in March?

figure1: the share price of Law's company from April 1719 to October 1720
note: this picture is from Garber (1990).But the prices after February 1720
 were cut by me to show the sharp rise in price.                               

Law reached the apex of the power in January 1720: he was appointed as finance minister; he managed the Mississippi Company which controlled France’s overseas trade and the development of its colonies; he owned the right to collect France’s taxes; he possessed the right to mint coins; he held huge amount of the national debt. To the public, it was obvious that the future of Compagnie would be promising. In other words, its share price would keep increasing. As a result, the share price temporarily maintained at a high level. The rapid rise in the stock price was partly due to the cash flow from the rest of the Europe. But more importantly, it was attributed to the currency issuing. Every time shares were issued along with the currency. In turn, it was a flood of currency (or credit expansion) that supported the further increase in stock price.

It seemed that France stepped into a flourish time. If Compagnie did discover the gold mine, perhaps everything would be different. However, the French were so optimistic that a negative shock destroyed the whole economy.

In next post, we will talk about the burst of the bubble. What cause the collapse of France economy? What is the weakness of Law’s plan? Please stay tuned!

Bubble formation

The financial system in France was reformed by Law. He urged the use of paper money.  But how can he handle the huge amount of notes? He implemented “debt-to-equity swaps”.

In August 1717, Law set up Compagnie d’Occident which was also called Mississippi Company engaged in mining and trading in Louisiana (the French colony at that time). The company was backed by the French royal family and monopolized trade at West Indies and North America.

This was the first step to carry on his experiment. At first, he paid back debt for the government to get the right of issuing bank notes to the public; then, using the public debt as collateral, Law issued shares; the government made its payment in terms of Law’s notes while the public used these notes to buy Law’s shares. Thus, Law transformed the government debt to the company equity. Consequently, the economy had completed the first round of an upward spiral.

Law’s idea was based on the establishment of a solid “fund of credit”, which brought him relatively stable cash flow with which he promoted his grandiose business plan. The intuition behind his plan is as following. First of all, he raised money for his company. Business activities and expansion was facilitated as soon as funding for the projects was in place. In fact, Law’s company did unceasing expand its commercial activity. In September 1718, he obtained the tobacco monopoly. In November 1718, he acquired the Senegalese Company which traded with Africa. In May 1719, he merged the East India Company and the China Company. He reorganized the huge conglomerate as Compagnie des Indes. Since the company owned high monopoly of trade outside Europe and it was said that Mississippi contained lots of gold, silver and jewel, the share price kept increasing.

 

 

By this time, as Law expected, the issue of banknotes stimulated the public demand; meanwhile, the public were offered a wonderful investment opportunity: buying shares of Law’s company. Thus, the excess paper money flowed back to Law; Law again paid the government with these banknotes; the government made its payment with the paper money; the public again bought shares using notes. It really did work! All French thought that the depression passed. They became rich and owed the prosperity to Law's company! They had no doubt about the value of money!

What’s the true value of banknotes? Without the promise by government that notes can be exchanged with gold, it is just a piece of paper. It has no intrinsic value. But the public believed the paper money issued by Law. Why? Law helped them come out of the depression? He was Regent’s friends? Or he would find huge amounts of gold soon? From my point of view, the reasons mentioned above all contributed to the belief of the public and revealed the true value of paper money: credit.

In the next post, we will talk about how the credit stimulates the economy and leads to bubble inflating.