Ben Bernanke might as well consider himself a performer. Tomorrow, after nearly a century of silence, the Federal Reserve Chair will hold the central bank’s first press conference.
At the Economic Prism, we are eagerly awaiting this event with both curiosity and excitement. We’re hoping for the kind of laugh-out-loud moments that you’d experience at a comedy show. However, what truly piques our interest is not just the answers Bernanke provides, but the questions he faces.
While it’s likely that most inquiries will revolve around predictable topics such as the federal funds rate, inflation expectations, and the conclusion of quantitative easing, we still hold out hope that someone will pose a completely unexpected question. Perhaps something like, “What are your thoughts on John Law?”
Among the myriad of professions, being a central banker in a paper money system is arguably one of the more cunning roles. In today’s world, where technology is continually advancing and waistlines are ever-expanding, the concept of central banking seems just as absurd as when it was first conceived.
Despite the prevalent notions surrounding inflation targeting, liquidity traps, and the scientific management of economies, central banking ultimately still resembles the work of illusionists. To illustrate this point, we need to revisit the origins of central banking. This will be the focus of today’s discussion.
John Law’s Marvelous Theory
In 1716, a gambler from Scotland named John Law convinced Philippe d’Orléans, the Regent of France, to appoint him as Controller of the General Finances of France. Right from the start, Law and the Regent were an ill-fated duo. Law had an extravagant theory about how to generate national wealth using paper money, and the Regent’s lofty political ambitions, paired with France’s dire financial state, made this gamble appealing.
Law argued that precious metals like gold and silver were simply too limited in supply. Paper money, he contended, would enhance trade because it was more widely available. But the pressing question remained: What would give paper money its value?
Law’s answer—echoing the views that Bernanke would likely share today—was that paper money is ultimately backed by the government’s assurance to pay based on future tax revenues.
On May 5, 1716, the Banque Général was established with a capital of 6 million livres, and the Regent mandated that all taxes moving forward be paid in paper currency issued by Law’s bank. Soon, the initial scarcity issue of precious metals seemed resolved. France’s economy began to thrive, confidence soared, and within just a year, the value of Law’s notes surged to a 15 percent premium while the nation’s debts dwindled.
Yet, as the saying goes, no success is without its pitfalls. Following the early success of Law’s paper money initiative, he and the Regent devised another scheme: issuing paper currency in the guise of shares in the Mississippi Company. This tale is detailed in Charles Mackay’s renowned work, Extraordinary Popular Delusions and the Madness of Crowds.
The Origins of Central Banking
According to Mackay, “Law commenced the famous project which has handed his name down to posterity. He proposed to the Regent, who could refuse him nothing, to establish a company that would have the exclusive privilege to trade the great river Mississippi and the province of Louisiana, located on its western bank. This region was believed to be rich in precious metals, and the company, buoyed by the profits from its exclusive commerce, would serve as the sole tax farmers and coiners of money. Letters patent were issued in August 1717, incorporating the company, with capital divided into two hundred thousand shares of five hundred livres each…”
“It was now that the frenzy of speculation began to seize upon the nation.”
Much like the speculations surrounding dot-com stocks in the late 20th century, the public became obsessed with something that was merely a fantasy. The tale of Louisiana was just smoke and mirrors. Profit was nonexistent, but that did not deter an overwhelming mania.
From 500 livres in 1719, shares skyrocketed to 15,000 livres in the first half of 1720—a staggering 3,000 percent increase. Naturally, everyone thought they were on the path to riches. However, by summer 1720, the truth of the shares’ worthlessness was revealed. This unexpected turn of events led to an instant collapse, with shares plummeting 97 percent overnight as investors rushed en masse to convert them into physical specie.
The abrupt crash devastated countless individuals and triggered an economic crisis throughout France and much of Europe. Nevertheless, despite the catastrophic fallout, Law’s paper money experiment laid the groundwork for what’s now known as modern central banking.
In essence, today’s financial system is built on a notion that seems utterly bizarre: that paper money, bolstered by the government’s promise to leverage future tax revenues, can maintain its value—even when these future revenues will also be delivered in the same type of paper money. Furthermore, the enduring challenge remains unaddressed: central bankers can print unlimited amounts of paper currency, and often succumb to political pressures to overissue it.
Sincerely,
MN Gordon
for Economic Prism
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