300 years ago in 1720, one of the largest stock market bubbles in history came to an end. What historians now refer to as the Mississippi Bubble was the result of an economic experiment designed to revive the French economy following the death of King Louis IV. The project was the vision of John Law, a Scottish expatriate living in France. Law believed the French economy could grow if the country increased trade and adopted a new monetary policy. In 1716, the regent of France, Duc d’Orleans, granted Law the power to implement his vision.
Law created the Banque Royale, France’s first central bank, and the first financial institution to issue paper money.He also created the Mississippi Trading Company, which incorporated all of France’s foreign trading operations in America. Law was granted extraordinary power, gaining control over coinage, interest rates, tobacco, taxation, and half of the land mass that is now the United States. Law also issued shares in the Mississippi Trading Company to the public and used the proceeds to pay down the nation’s debt. The shares were wildly successful on reports of the potential riches in America, trading as much as 20 times over their initial value. So many French citizens became instantly wealthy that a new term was coined to describe them: millionaires.
The scheme began to collapse when pioneers returned to France from America and reported that there were no riches or economic prospects to be found, which caused the shares to decline. The bubble ultimately burst when draconian quarantine measures were implemented after a bout of bubonic plague hit France. Law was ultimately banished from the country, the economy declined, currency value plummeted, and a long economic malaise ensued, leaving investors to blame Law for creating nothing but contagion in unsound speculation.
Drawing parallels between the Mississippi Bubble and today’s volatility
300 years later, memories of the Mississippi Bubble appear to have faded as global policymakers repeat many of Law’s mistakes. Like France after Louis IV’s death, we entered 2020 overindebted in a system that encourages similar speculation and artificially high asset prices over sound economic activity. Government debt has reached unprecedented levels, and the lack of economic growth raises questions about how to deal with its negative effects.
Targeting interest rate levels as well as the stock price of the Mississippi Trading Company put Law far ahead of his time, and modern day central bankers are engaging in the same tactics. One of Law’s most vocal contemporary critics, economist Richard Cantillon, warned Law that artificially low interest rates would not provide any real durable or economic improvement. Cantillon argued that artificially low rates would result in lending to low-quality borrowers and merely incentivize most economic actors to speculate in financial instruments. Present-day critics of central bank policies echo this sentiment as they point out that central banks are caught in a liquidity trap whereby they are unable to escape their own policies.
The result is a low-growth global economy with an ever-increasing degree of wealth disparity. In fact, the number of billionaires is on the rise due to the flood of central bank liquidity. According to the number of billionaires increased 8.5% in 2019 to a new record high. Moreover, in 2019 there were more billionaires in Europe — 847 total — than any other region in the world, followed closely by North America, which had 834.
Just like France in 1720, a more globalized, financially engineered economy was made crash-prone and highly vulnerable to a pandemic. The COVID-19 virus was just the first-order effect that roiled markets in 2020. An oil supply shock engaged by Saudi Arabia was a second-order impact that accelerated the deflationary spiral brought on by the virus. This led investors to a flight to safety, but as panic ensued, the overleveraged global economy required liquidity at any cost, leading to indiscriminate selling across both risk and safe-haven assets.
Central banks were quick to act as the liquidation selling required an extraordinary response. Trillions of dollars and euros worth of fiscal and monetary policy were created in March to stabilize markets. The US monetary policy response involved interest rate cuts, loans, and asset purchases. To date, the scale of the response already far exceeds the stimulus enacted during the 2008 financial crisis. In fact, the Federal Reserve (Fed) announced it would engage in unlimited quantitative easing with a procedure that would include “amounts needed to support the smooth functioning of markets.” US fiscal policy was similarly extraordinary with the budget deficit expected to exceed $4 trillion in 2020.
The European Central Bank had little room to reduce interest rates so its focus was on asset purchases, including the Pandemic Emergency Purchase Program (PEPP) that will purchase roughly $800 billion in bonds and commercial paper throughout 2020. (One notable feature is that Greek government bonds will be eligible for purchase as part of this program. Greek debt is normally excluded from bond-buying due to the country’s credit rating.) In May, the European Union (EU) unveiled its first fiscal stimulus proposal, funded by bonds issued by the EU itself, rather than by individual governments of its member states. This $860 billion package is called “Next Generation EU.” It will give $550 billion in grants to member states, along with $275 billion in loans. The package must be approved by member states before it is put into effect, however. One significant change for the Fed is they are now engaging in the purchase of corporate debt, including high yield, just as the ECB has done for many years.
For asset markets, the first half of 2020 saw global bonds advance as investors sought haven protection, while commodities declined the most with double-digit losses. Global stocks limited their declines to just single digits due to stimulus led recovery that began in late March.
“Real recovery” or just a “bear market bounce?”
We enter the second half of 2020 in an economic contraction, leading us to wonder if we have entered a real recovery or just a bear market bounce. Fiscal and monetary efforts to revive the economy and markets could more accurately be described as stabilization versus stimulus.
One key question for the second half of 2020 is whether the enormous amount of liquidity can maintain solvency. Will efforts to stabilize the economy bridge the gap to a time when businesses can produce required revenues and cash flows to avoid bankruptcies, defaults, and higher levels of unemployment?
The spotlight remains on the central banks, but their role shifts from stimulating financial markets to concurrently having to finance higher budget deficits. This raises another question, as well: Who will pay for all this stimulus? One option is to raise taxes. However, there is likely to be considerable voter resistance to such a large tax increase. Although there is appetite for tax increases on the rich and companies that have benefitted from the crisis, this is unlikely to make a dent in the deficit and debt burden.
The most politically viable solution to pay for spending has historically been through inflation. The case for inflation stems from the pernicious effects of deflation on the economy. A deflationary debt collapse is the worst-case scenario for policymakers because it risks triggering a long and deep depression characterized by chronic high unemployment, increased corporate bankruptcies, and poor stock market returns. Therefore, inflationary policies are favored by both fiscal and monetary authorities to both reflate the economy and devalue the debt burden via currency debasement. This involves lending from banks and central banks, both of which create new currency to buy the newly issued government debt. Central banks will also maintain artificially lower interest rates to ease the existing debt burden, which may weaken a nation’s currency. The size, scale, and scope of these efforts to reinvigorate the global economy increase the probability of higher inflation, especially now that fiscal policy is being married with monetary policy.
In the second part of our blog series, we’ll explore the impact of this market environment on various asset classes, including stocks, bonds, and commodities, as well as our outlook for the second half of 2020. In the meantime, we’re well-served to remember the lesson of John Law, whose accommodative policy raised asset prices but failed to produce sufficient economic growth. Time will tell whether current monetary and fiscal policy can prevent the same outcome today.
Blog header image: Nathan French / Stocksy