The Daily Reckoning PRESENTS: Marc Faber, on his way to the ultimate question: '...How much longer will foreign investors, which are financing the U.S. trade and current account deficit, be willing buyers and holders of American stocks, bonds, and the dollar?' The 'answer'? Tommorrow...
LESSONS OF HISTORY, Part I
by Marc Faber
I recently read and reviewed 'The Great Swindle - The Story of the South Sea Bubble' by Virginia Cowles (Collins, 1960). The book deals with the rise and fall of the South Sea Company and John Law's Mississippi Company in the early part of the 18th century.
As I read this entertaining book I became more and more fascinated by the many parallels between this early period of speculation in our capitalistic age and today's financial environment. In particular, I was astounded by the similar role that paper money, excessive credit creation, and highly questionable practices - by governments as well as businesses - played in fuelling the financial excesses in both periods.
From time to time, a wave of optimism spreads around the world like a bushfire. People believe they are seeing the dawn of a new era, which will bring unimaginable riches and prosperity to all. Waves of new era thinking are usually associated with discoveries (the Americas, gold deposits in California), the opening up of new territories (the Western territories of the U.S., the opening of China in recent years), the application of new inventions (canals, railroads, the automobile, radio, PCs, the Internet, wireless communication, etc), the rise in the price of an important commodity (rubber at the beginning of the 20th century, oil in the 1970s), peace treaties (the breakdown of communism), or strong economic performances.
A typical feature of 'new era' thinking is that it usually engulfs a country or the world not at the beginning of an era of prosperity, but towards the end of such a period, and is associated with some sort of a 'rush' or investment mania. Two of the most well known examples of this phenomenon are John Law's Mississippi Scheme and the South Sea Bubble, which occurred almost simultaneously in the early 18th century. [Ed note: If you'd like to read Faber's full account of these fascinating case studies in monetary mayhem, grab a cup of coffee and a cozy chair and sit down for an exciting read:
'The South Sea Bubble and Law's Mississippi Scheme' ]
'The Great Swindle' is an excellent account of the events that surrounded the South Sea Bubble and the Mississippi Scheme. Although over the following 300 or so years the stage of investment manias repeatedly changed, the script, the accessories, and the nature of the actors participating in the bubble have largely remained the same.
The 'bubble' model always involves a 'displacement,' which leads to extraordinary profit opportunities, overtrading, over-borrowings, speculative excesses, swindles and catchpenny schemes, followed by a crisis during which fraud on a massive scale comes to light, then by the closing act during which the outraged public calls for the culprits to be taken to account. In each case, excessive monetary stimulus and the use of credit fuels the flames of irrational speculation and public participation, which involves a larger and larger group of people seeking to become rich without any understanding of the object of speculation.
The saga of the Mississippi Scheme and the South Sea Company is historically relevant, for example, because it contains all the major features of subsequent manias: shady characters, corruption, fraud, dubious practices, the creation of money and the extension of risky loans in order to keep the speculative orgy going, the catalyst, which leads to the initial collapse - usually the revelation of fraud, the inability of a large speculator to come up with the money to meet a margin call, the revelation that insiders cashed out, or some adverse economic or political news - and then the panic during which greed and euphoria are replaced by fear and the speculators' desire to get out at any price.
What is also important to understand is that both the promoters of the South Sea Company and John Law attempted to support the market at any cost. At some point, however, market forces proved to be far more powerful than any price-supporting measures they could ever have taken.
The Mississippi scheme in particular provides a relevant example of the ineffectiveness of printing money to stimulate the economy and lighten its debt load. John Law's policies of the day are reminiscent of those of the current U.S. central bank, the aim of which is to solve any problem the same way Law tried to solve the Mississippi Company's problem - simply by increasing the money supply.
That such monetary policies will lead to the same price increases, which, at the time of Law's Mississippi Scheme, destroyed people's faith in paper money, ought to be clear. Whether, at that point, current central bankers and government officials will conspire to expropriate investors' gold possessions, as Law did, remains to be seen. But we shouldn't forget that in 1933, in the midst of the Depression, the U.S. government declared the possession of gold by individuals to be illegal.
But despite its eventual failure, John Law's Mississippi Scheme is an important event in economic history since it represented an attempt to introduce paper money on a large scale. The Banque Générale was primarily a deposit bank and not a lending bank, and it proved to be a great success for a while. With a limited note issue (backed by gold) and branches in the provinces, it spread means of payment away from the financial centers of Paris and Lyons and therefore had a beneficial effect on trade and industry.
The problem occurred when the regent took over the bank (it became the Banque Royal) and began to issue notes with no limit to their quantity. That having been said, we must realize that there is, of course, always a limit to the quantity of money that is being issued, and this limit comes from the market mechanism. At some point, the French public began to distrust the notes that had been issued by the Banque Royal, and then - despite all the efforts of John Law, who was by then finance minister, and the regent of France - no one wanted to hold paper money anymore. The result was that the banknotes issued by the Banque Royal began rapidly to depreciate against gold, commodities, and real assets.
We see, therefore, that a financial system based on paper money depends almost entirely on the confidence of the public in the currency that is issued by the monetary authorities, and that once confidence in a currency is badly shaken, painful consequences are inevitable.
Therefore, the reader should ask himself the question: for how much longer will foreign investors, which are financing the U.S. trade and current account deficit, be willing buyers and holders of American stocks, bonds, and the dollar?
Regards,
Marc Faber
For The Daily Reckoning
P.S. Surely, there will be a time when, as was the case at the time of the Mississippi Scheme and the South Sea Bubble, the present 'chain letter' type of fiat money operation practiced by the U.S. Federal Reserve Board will no longer work and lead to a sharp depreciation of the U.S. dollar.
The other possibility, of course, is that the dollar begins to depreciate, not compared to foreign currencies, but - as was also the case at the time of John Law - against commodities and real assets.
Editor's note: Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report. Headquartered in Hong Kong for the past 20 years, Dr. Faber has specialized in Asian markets and advised major clients seeking down-and-out bargains with deep hidden value, unknown to the average investing public.