A Tale of Recession: 18th Century Mississippi Bubble and the 2022 Economy

To talk about the past, we should look at the recent. As you know, to combat the effects of the pandemic and to promote growth, countries across the world launched massive stimulus programs. Northern Trust points out, “Since the COVID crisis, the money supply has grown by 40% in the U.S., 22% in the U.K. and 20% in the eurozone.”

This sudden influx of money into the system coupled with supply chain disruptions caused goods to become more expensive i.e., inflation to spike.

To control inflation and remove the excess liquidity from the monetary system, the Federal Reserve raised interest rates five times this year, up to the time these lines are written, and is expected to make further moves to tame inflation. Given the dollar dominance in export related trade, what happens in the U.S. affects every country.

The high returns of the S&P 500 of 2020 and 2021 have petered out and now markets are flashing warning signs that the global economy is teetering on a cliff’s edge!

To understand why boom times, inflation and recession seem to follow each other we should look to the past.

To a bubble that involves increasing money supply, hyperinflation, leading to recession and currency devaluation.

The year was 1715, France had a problem, it was massively in debt. It had fought a costly war; the War of Spanish Succession, lasting 13 years against Britain, Netherlands, and Austria. France along with Spain fought together to protect the power of the next Spanish King.

To finance the war, France issued war bonds, borrowing money from people by issuing debt securities, leading to unprecedented levels of debt. All to be repaid from government coffers.

John Law, a financial theorist, proposed a solution: permit a “General Bank” whose main purpose is to collect taxes and issue bank notes which would be exchangeable for coins. Thereby the bank took deposits of coins but issued loans and withdrawals in paper.

Once notes were commonplace, the bank could increase the notes supply while only holding coins worth a fraction of the value of all outstanding bank notes. Printing money without the backing of gold/silver coins. Aka fractional- reserve banking.

The bank could then increase the money supply to encourage economic growth, thus increasing tax revenues and helping the government to pay off its debt. By the end of 1719, the total notes issued expanded from 200 million livres (the French currency of the period) to 1 billion livres, a 5x jump in just 4 years.

Seeing the success of General Bank, Law was granted a charter to establish the Mississippi Company. The company took over large portions of French overseas trade and obtained a monopoly on tobacco production.

Eventually in 1720, the Mississippi Company took over General Bank, thus taking over the rights to print money and collect taxes.

Speculation was rampant and encouraged in the company shares.

The increased money supply, combined with the fact that shares could be purchased with only 10% of the total share price needed for down payment and a vibrant secondary market, provided all the necessary ingredients needed for a bubble to form.

The share price surged ahead. Law seemed to have engineered a self-fulfilling belief that the price of the shares could only go up!

Soon after, the Company’s largest operation, became a scheme for the reduction of the government’s debt.

The essence of this scheme; an equity-debt swap. People must surrender government bonds to buy Mississippi shares. People surrendered debt which was yielding 4.5% for the hope of making a windfall capital gain on the shares.

The company lent the money raised from the share proceeds to the government, which used the loan to buy out its (government) debt from the company. The interest rate on the loan taken by the government was only 3%, thus in effect the burden of interest on the government had been substantially reduced from 4.5% to 3%.

But Law could only propagate a belief for a brief period and after poor financial decisions made by the company, the momentum on the share price started to flag. After a 25% decline in price, Law committed to making the General Bank buy back shares at a price significantly above the prevailing market price, and the shareholders overwhelmingly chose to take him up on the offer.

The company did not have enough liquid funds to buy back all the surrendered shares, Law once again increased the supply of bank notes, from 1.2 to 2.7 billion livres over the course of the next 3 months, creating hyperinflation.

At that point it was game over for the Law game - The French government’s ambitious efforts to reform its debt had comprehensively failed.

Because of failed policies, France experienced a severe recession. The currency had to be devalued. But the trust in the system had vanished resulting in the paper currency becoming worthless. Creditors doubted France’s ability to repay the loans and penalised the country with a high interest rate. The Mississippi bubble resulted in a serious handicap in future conflicts as the repayment of the debt looked dubious and the once burnt creditors became averse to purchasing government debt again.

A dramatic increase in money supply and then attempts to manipulate debt using various methods. Sound familiar? It seems that the echoes of history can be heard even today.

Fast Forward to Where the US Stands Today?

An excerpt from the analysis done by the Committee for a Responsible Federal Budget

“Under current law, debt will rise from an already massive 98 percent of GDP at the end of FY 2022 to 185 percent by 2052. The deficit, meanwhile, will total 11.1 percent of GDP in 2052 – higher than the 3.5 percent of GDP average seen over the past 50 years and higher than at any point in modern history outside of World War II and the COVID-19 pandemic. And interest costs will reach 7.2 percent of GDP by 2052, more than twice the prior record.”

…

“Ultimately, high debt levels will slow income and wage growth, increase interest payments on the national debt, place upward pressure on interest rates, reduce the fiscal space available to respond to an economic recession or other emergency, put an undue burden on future generations, and heighten the risk of a fiscal crisis. Policymakers should work today to get our long-term fiscal house in order.”

Basically, we have reached a breaking point, we used debt liberally in the past to fuel growth. But now the debt is becoming unsustainable, revenue is being used to service the debt and inflation is at an all-time high.

The circumstances which fueled the Mississippi bubble are present today. There is more money sloshing in the system than ever before, assets are being bought for the sole purpose of generating a profit meaning they possess little/no fundamental value and there exists the infrastructure to easily buy and sell assets limiting friction and reducing costs associated with the process.  

What does this uncertainty mean for investors?

During times of crisis or when one seems to be rapidly approaching it, it is best to refer to what the experts have to say.

Martin W. Hennecke, Head of Asia Investment Advisory, St. James's Place – Asia Wealth Management advises diversification across markets, sectors and asset types is essential to protect capital against adverse conditions.

“These may include different types of assets such as property, commodities, equities, inflation linked bonds etc. Furthermore, equities can protect from inflation in so far as they can pass on rising input costs to customers in the form of higher prices if they have got an edge in the market, the economy remains stable and inflation is broad based including wages as well”, says Martin.

“Given the uncertainties we are seeing globally with regards to interest rates, inflation, potential recession, geopolitics etc. I would caution investors to be free of debt, or at least to limit debt exposure, as much as possible, as volatility may persist, and the worst scenario is for investors to receive margin calls and potentially get stopped out of positions during crises at the worst possible times”, says Martin.

For risk seeking individuals, Martin suggests, “assets/markets which have sold off particularly deeply in recent times trading at low valuations from an equity (and/or currency perspective) should be considered to be included in portfolios, such as for example China and Japanese equities, although we would still highly recommend being diversified globally.

Investors nowadays also need to be conscious of the risk of ‘not investing’ given that we are in an environment of significantly negative real interest rates which implies an erosion of purchasing power of cash holdings over time.”

During uncertain times, steady hands guide the ship best. That is something we at Asia SGE specialize in.

Operating since 2013, we have provided services to corporations and HNWI’s which have helped them navigate market volatility. Our “Assets under oversight” services provide you with support in the form of jurisdiction, operational, tax efficiency to enhance return on your assets.