John Law and the Système of 1720
John Law (1671-1729) as French minister of finance (19th c. copy of a family portrait).
John Law (1671-1729): a quick biographical sketchJohn Law was a Scotsman, son of a goldsmith. Little is known of his early life: he shows up a young man in London living the life of a dandy, he kills a man in a duel in 1694, is sentenced to death for it, and escapes from a London prison under mysterious circumstances.
From 1701 to 1715 he is known to have travelled around Europe, engaging in two main activities: earning a living as a professional gambler (holding gambling tables), and writing on economics and particularly on various schemes to replace metallic money with bank-issued currency.
Ultimately, he won the trust of the French government in 1715-16, and was allowed to establish a conventional note-issuing bank in 1716. The following year he founded a trading company ultimately known as the Indies Company. The Company grew by a series of mergers and acquisitions into a gigantic conglomerate that controlled most of tax collection, all of overseas trade, whose shares had replaced the public debt, and whose notes were sole legal tender; the Company, merged with the bank, was controlled by Law, who also became finance minister. In 1720, the "Système" (as the conglomerate and its underlying principles were known) collapsed as the share price fell, notes were demonetized, and an effective repudiation of the debt took place. It took several years to clean up the mess, while Law, ruined, ended his life a gambler in Venice.
The 1720 episode, which coincides with the South Sea Bubble in London and similar speculative phenomena in the Amsterdam market, is not just an early instance of stockmarket bubble, but is also a remarkable experiment in monetary and debt management policy.
A recent English-language source is a biography:
John Law's life divides neatly into two parts: from 1702 to 1716, he wrote a number of texts advancing economic ideas and various proposals to create banks. From 1716 to 1720 he had the opportunity to implement his schemes in France. Accordingly, we briefly look first at Law as economist and then turn to Law as policy-maker.
John Law as Economic TheoristLaw's writings were mainly produced in the period from 1702 to 1716. The most important is a book published in 1705 in Edinburgh: Money and Trade Considered, whose full text is available online. A "Memorandum to prove that a new form of currency can be better than gold and silver" written in French in 1707, is also available online.
It is important to recognize that John Law's writings, however theoretical they became, were always directed toward one purpose: justifying the establishment of a bank. Whether he advocated this out of devotion for the public good (as may be the case of his plan for his native Scotland) or out of ambition is unclear. At any rate, his main purpose was not to understand economics, but to find economic arguments to bolster his case.
The object of his bank proposals was to create a new form of money and replace metallic money. He expressed dissatisfaction with silver and gold as money, based implicitly or explicitly on a variety of arguments.
In a small open economy, where the currency is the same as abroad (metallic) or convertible into foreign currencies easily, then the price level is fixed by the international price level, by the law of one price (which Law recognized and described). In that case, there can be no "shortage of money": if, for some reason, there is too little money, prices would start falling, which would prompt an inflow of money as foreigners take advantage of the low prices to buy domestic goods. In a closed economy, or one where the currency is not convertible, variations in money supply may translate into variations in price level, with no particular output or welfare consequences. Indeed, it is theoretically not a trivial task to get permanent real effects from variations in the quantity of money that are not defeated by concomittant variations in the price level.
Curiously, although Law's arguments for the benefits of a bank did not change over time, the type of bank that he proposed varied:
John Law as Policy-Maker
Some Background: the situation of France in 1715In 1715, Louis XIV dies after a reign of 72 years. From 1701 to 1713, France was engaged in a European war (the War of Spanish Succession, in which England and Austria fought to prevent a French prince from inheriting the Spanish throne). The war ended with a draw, but it had proven very costly for France.
At his death, Louis XIV left debts of 2.8bn livres of which 1bn were in perpetual annuities (bonds with coupon payments that go on forever), 0.8bn in sold offices (the "wages" paid to the officer being the interest on the price of the office), and 0.8bn in floating debt (various notes and bills whose final payment had not been settled, some of which bore interest in the meantime). The interest payments amounted to 45m for the annuities and 41.5m for the offices. With revenues at 166m and spending at 146m, the primary surplus was only 20m, to service at least 86.5m in debt service, without even taking care of the floating debt.
To put these numbers in perspective, the public debt in 1715 represented about 80% of GDP. Currently, the US national debt is about 61% of GDP. Furthermore, the size of government in 1715 France was about 5% of GDP (measured as the share of tax revenues) compared to 20% for the Federal government.
At Louis XIV's death his great-grandson and successor Louis XV was only 5 years old, and a regency was installed, with the late king's nephew the duke of Orléans as regent. Immediately, a series of measures were taken. Partial defaults in October 1715 (on perpetual bonds), January 1716 (on wages of offices), April 1716 (on the floating debt), and in June 1717 (on the perpetual bonds) cut 7m from the debt service and brought the debt down to 2bn. The floating debt was converted into 322m in bearer notes called billets d'Etat, most bearing 4%, and with no definite redemption date. The debt service was now at 92m, revenues had increased slightly at 170m, and the government was looking for various ways to cut spending. By devaluing the livre by a third (rating the gold coin at 60 livres instead of 40 livres) it reduced some of its expenses, although it also reduced some of its revenues.
In the midst of this dire situation, John Law successfully approached
the Regent with a plan to set up a bank that would help the government
manage its debt, on the model of the Bank of England. Law's beginnings
were modest, but progressively the various companies he created merged
into a gigantic conglomerate that had taken over most of the fiscal activities
of the French state.
John Law's Système (1): the Bank
The General Bank, May 1716The first step was the creation of the General Bank in May 1716. John Law had initially proposed a 100%-reserve public bank that would handle the government's financial transactions, but the plan was rejected in October 1715. The Regent, sympathetic to Law, allowed him to set up a purely private bank, at Law's own risks.
The Bank's capital was raised by an IPO: 900 shares were offered at 5,000F each, payable with 75% in billets d'Etat at face value (which stood at a 60% market discount to their face value at the time) and 25% in cash (John Law himself bought 300 shares). Moreover, only 1/4 of the purchase price was required immediately, the rest payable at some future date. Thus, it took only 690F in cash to initially buy a share. The Bank's assets consisted initially of 375,000F in cash and 1.125mF in billets d'Etat, the interest on which was used by the Bank as working capital (which only amounted to 45,000F per year). It is not clear if the remainder of the subscription price was ever paid by shareholders (I think it was).
The Bank was structured similarly to a modern limited liability company. A general assembly was to be held twice a year with dividend distribution. Shareholders voted in proportion to their shareholdings, management was responsible to them, etc.
The Bank's main activities were to discount bills, sell foreign exchange, take deposits and manage current accounts (charging a fee of 0.025% on transfers between accounts and on cash payment orders), and issue notes payable in specific silver coins (écus) on demand to the bearer. It was not allowed to engage in trade or to borrow.
The Bank notesThe bank notes it issued were in denominations of 10 écus, 100 écus and 1,000 écus. The écu was the standard silver coin. In 1716, it was minted at 16 to a pound of silver, and its face value was 5F. So a 100 écus note was a claim to 100/16 pounds of silver, and had a legal tender value of 500F.
The bank notes had the following promise written on it: "the Bank promises to pay on sight to the bearer 100 écus of the weight and fineness of date X" where X was the date of issue of the note. In other words, the bank notes were claims to a specific quantity of a specific coin of a specific weight. When new silver écus were issued in June 1718 of lighter weight (20 to a pound of silver) and higher face value (6F), the old écus were given a new value of 6F until August 1 and were demonetized afterward (and hence worth their silver weight, 5.45F at the prevailing mint price). A decree made clear that, since the old écus were circulating at 6F like the new ones, an old 100 écus note would be paid taken to be worth 600F ("les billets de la Banque seront pris en paiement et acquittés [...] sur le pied de 6 livres l'écu"). The notes issued after June 1718 were claims to 100 new écus, or 100/20 pounds of silver, and were also legal tender for 600F. But since the old notes and the new notes were claims to different quantities of metal, they were considered different.
Getting the notes to circulate, and not return constantly to the Bank for redemption, was critical to the Bank's profitability. The Regent and several influential and wealthy backers seemed to have played a role in this, by depositing large sums at the very early stages; so the first note issues were made against deposits, not discounting, and the depositors were willing to hold the notes they received and not redeem them. More importantly, various measures were taken by the government to enhance the attractiveness of the notes. A decree of 7 Oct 1716 ordered that the various tax collectors redeem the bank notes into cash on demand. This enrolled the vast network of hundreds of tax collectors and tax accountants throughout France into unpaid branches of the General Bank. Then, on April 10, 1717, a decree made the bank notes legal tender in payment of taxes at face value.
The result was that the Bank was able to issue a fairly large amount of notes, 40-50m per year on average, while maintaining a reasonable specie reserve (about 50%). When the Bank was converted to a Royal Bank in December 1718, it had 39.5mF in circulation. If it held 50% of the corresponding assets in specie and the rest in bills yielding 4 to 6% (the discount rate it charged), the income should have been about 1,000F per share annually.
The Bank's "nationalization" in December 1718The Bank appeared successful in getting its notes to circulate. Its total dividend payments (3 half-yearly payments from 1716 to 1718) amounted to 615F, a respectable 15% rate of return on the cash price of the initial shares (assuming they were paid in full; the profit becomes 68% if they were not!), although not as high as one would expect given the note circulation. It succeeded in lowering the commercial paper rate in Paris, because the Bank successfully discounted at rates from 4 to 6%. By late 1718, the Regent was convinced that the Bank was a profitable enterprise, and accepted Law's suggestion to nationalize it.
The Regent, on behalf of the king, bought out all the existing shareholders in cash at the face value of the shares (5,000F). Having taken control of the Bank, it took the paid-up 6mF that formed the Bank's capital base and invested it in shares of the Company of the West (see below). Finally, the operation was made public by a declaration of 4 Dec 1718. The Bank would henceforth be managed for the king, and all profits turned over to the Royal Treasury.
For a shareholder who was bought out in December 1718 by the King, the rate of return on his investment over 18 months was an annualized 64%, a very good deal.
The Royal BankIt is likely that the Bank ceased to be a classic private bank at this point, and just became a tool in the hands of the Regent, or more precisely Law (who ran the Bank for the Regent). An important innovation takes place on Jan 5, 1719: new types of bank notes are issued, which are not denominated in specific coins, but rather in units of account, the livre tournois, or franc, of 10F, 100F and 1,000F. The note said: "The Bank promises to pay on demand to the bearer 100 livres tournois in silver coins" without saying how many coins. (See a picture of such a bank note).
Then, in April 1719, a decree explained that the new issue of écu-denominated notes had not been met by any demand, and that older écu-denominated notes were increasingly turned in to be converted into the new livre-denominated notes. It was therefore decided to cancel the former types of notes altogether and order the conversion of the remaining ones. The Bank's liabilities were therefore only denominated in units of account.
Further measures were taken to favor the notes against specie. Branches of the Bank were established in several cities of France. On 27 Dec. 1718, transactions larger than 600F were to be made only in gold or bank notes: the legal tender of silver coins was thus limited to 600F. Furthermore, on 22 April 1719, it was decided that, in towns where the Bank had branch offices, creditors could refuse gold and silver payments, and demand payment in notes instead. Also, the king's tax collectors were advised that, in case of currency alteration, they would be responsible for the capital loss on their specie holdings. On the other hand, the notes were immune from any alteration: that is, changes in the face value of coins had no legal consequence for the face value of notes (which was not the case for écu-denominated notes, of course). Of course, the quantity of silver that one would receive for a note would change in case of a currency alteration.
Notes of 10,000F were authorized on 13 Sept. 1719.
John Law's Système (2): The CompanyMeanwhile, John Law also secured the Regent's approval for the creation of a trading company, the Company of the West (Compagnie d'Occident), in August 1717.
The Company's initial business was trade. It initially purchased from the government the exclusive right to develop and trade with the Louisiana colony. (Incidentally, the city of New Orleans was named after the Regent). This was a common arrangement by which European rulers had developped their colonies in the Americas and elsewhere: the rights to develop the colony are granted to a private entrepreneur or a company, who is given monopoly rights to ensure profitability. The ruler generally profits by receiving a payment from the entrepreneur, and eventually by increasing his tax base as the colony prospers. Also, since the early 17th century, it was thought that long-distance trade such as trade with India and the Far-East could only be carried out by large companies with monopoly rights, such as the Indies Companies of England and the Netherlands. The French Company was following the same model. Louisiana was ceded to the Company as a fief in perpetuity; moroever, the Company had a 25-year monopoly on trading with the colony, as well as a monopoly on the profitable beaver fur trade in Canada. The Company was granted the Louisiana territory as a fief, was allowed to raise a private army, to enter into treaties with the Native Americans, and to call on the government for military assistance against other European powers.
Again, shares were issued, this time payable 100% in billets d'Etat. The Company had an arrangement with the government to convert the billets (a total of 100m at face value, bearing 4% interest) into perpetual bonds, with interest accruing from Jan 1717. This served as working capital of 4m per year. The first dividend was not payable until July 1718. Thus the 4mF was available to the Company for about a year before a payment was due to the shareholders.
The IPO began on September 14, 1717 and 29mF had been subscribed within two weeks, but 13.3mF were bought by Law himself. After that, subscriptions were very slow, and dragged into 1718. In July 1718 measures were taken up to speed up payment, and the subscription was closed on Dec 31, 1718, with 100mF sold; of that, 40% was owned by the King.
M & As galoreFrom its creation, Law's Company grew by a series of mergers and acquisitions, and extended its activities from trade to tax collection:
The various companies and tax leases were bought for relatively small amounts. Law's justification was that they were inefficiently run, and therefore underpriced. He expected to run them more efficiently (for example, the tobacco lease, which cost 4m a year, was expected to generate 6 to 8m per year) and thus create enough profit to justify the high dividends he was promising.
These acquisitions were financed by successive issues of shares. Every time, the shares were payable in monthly installments. The successive offered prices were increasingly high, although each new share had equal standing with the older shares (entitled to the same dividend). Law also sold the June 1719 issue to holders of the June 1717 shares, and the September 1719 issue to holders of both earlier types of shares. This requirement helped turn the secondary market in the older shares into a frenzy. Law also demonstrated the profits to be made in a bull market by introducing Parisians to options, buying call options on shares of the Company in March-April 1719, and cashing in after the merger with the Indies Company had helped boost the price of his Company.
Here is the list of successive share issues of the Company:
The other source of financing for the Company's acquisitions was note issues by the Bank, which was managed by the same people (and eventually merged into the Company in February 1720). In December 1718, the General Bank's note issue had stood at 40m livres; by July 1719, the Royal Bank's issue stood at 400m livres, and reached 1bn in January 1720. My suspicion is that the Bank simply lent notes to the Company.
The Debt TakeoverThe final component of John Law's Système (as it came to be called) fell into place on 27 August 1719. The Company made the following offer to the government: a loan of 1.2bn (later raised to 1.6bn livres) at 3% which the government could use to buy out the whole government debt. The details were initially sketchy: bondholders were supposed to receive drafts from the Royal Treasury, payable by the Indies Company in specie or bank notes. At the same time, the Company was authorized to borrow 1.2bn in the form of perpetual bonds or shares: an public offering of 500mF worth of shares was authorized on Sept. 13. Then, on Sept. 26, it was decided that the new shares could only be purchased with the Treasury's drafts; and, on Sept. 26 and October 2, other offerings totalling 1,000mF were authorized. It seems that no perpetual bonds were issued by the Company.
In other words, since government bonds were accepted in payment of the
shares, the operation was simply a gigantic swap of government bonds for
equity of the Company.
AftermathBy 1724, spending was down to 140m and debt service to 65m.
The text on the note says: "The Bank promises to pay to the bearer on sight 100 livres tournois in silver coins, received value. Paris, January 1 1720." This is followed by the signatures of three officials in lieu of a director (Fenellon), the cashier (Bourgeois) and the government-appointed controller (Durerest).
A Share of Law's Indies Company
A government bond of 1720This document, on pre-printed parchment, is in fact a receipt for 7,000 livres in bank notes, for which the government promises to create a perpetual annuity (rente perpetuelle) at a 2.5% interest rate. The annuity issue of June 1720 was designed to absorb part of the bank notes of John Law, which by then had reached 3.9bn livres. The "face value" of the annuities created in June 1720 was 1bn livres. "Face value" means the amount that the government would have to pay to extinguish the debt. Perpetual annuities were payable forever unless the debtor chose to repay the debt at its face value. In fact, in 1789 the annuities of 1720 were still in existence, having never been repaid. They were consolidated with other long-term debt in 1793, reduced by 2/3 in 1797, and redeemed in the course of the 19th century when falling interest rates made it profitable to do so.
Notice that the portion of the receipt filled in by hand specifies not only the name and position of the creditor (Pierre Hevor, judicial officer in the Paris court), but also the origin of the bank notes he held: he stated that they came from a repayment of a debt owed to him by the canons of the abbey of Saint Victor in September 1719. Many people took advantage of the flood of bank notes to repay their debts, a pattern that repeated itself during the French Revolution.