Chapter 5--John Law's Monetary Theories

John Law’s Monetary Theories 5

John Law’s Money and Trade Considered With A Proposal For Supplying The Nation With Money was published in 1705, and submitted to the Parliament of Scotland as a solution to lift that country from the depths of a depression. Law’s solution, of course, was to create more money.

Law felt that the use of banks was the best method to increase the quantity of money. He was especially impressed with the Bank of Amsterdam and noted its contribution to the prowess of the Dutch in their trade and commercial endeavors, despite having no more natural advantages than his native Scotland. Law noted that the Bank of Amsterdam was a “secure place,” and describes its original intent:

Banks where the Money is pledg’d equal to the Credit given, are sure; For, tho Demands are made of the whole, the Bank does not fail in payment.¹

Law goes on to say that unbacked credit was issued despite the constitution of this bank requiring 100 percent backing.

Yet a Sum is lent by the Managers for a stock to the Lumbar, and ‘tis thought they lend great sums on other occasions. So far as they lend they add to the money, which brings a Profit to the Country, by imploying more People, and extending Trade; They add to the Money to be lent, whereby it is easier borrowed, and at less use, and tho none suffer by it, or are apprehensive of Danger, its Credit being good; Yet if the whole Demands were made, or Demands greater than the remaining Money, they could not all be satisfied, till the Bank had called in what Sums were lent.²

Law then proposes that the conveniences to be gained from unreserved or unbacked money were more than equal to the risks involved.³ Those conveniences being: less interest, more money, and ease of payments.

In Money and Trade, Law, although advocating a system of fractional-reserve banking, was not ignorant of its harmful effects:

Raising [debasing] the Money in France is laying a Tax on the People, which is sooner pay’d, and thought to be less felt than a Tax laid on any other way. ...This Tax falls heavy on the poorer sort of the People.⁴

In the last half of Money and Trade, Law espouses his proposal for paper money backed by land, his view being that silver was unsuitable to be money because more and more of it was being produced. Thus, it became less valuable over time. Law believed that land would increase in value over time, for the following reasons: demand for it increases, improvements are made making it more productive, it does not lose any of its uses, and the amount stays the same. The following capsulizes Law’s proposal:

The Paper-money propos’d will be equal in value to Silver, for it will have a value of Land pledg’d, equal to the same Sum of Silver-money, that it is given out for. If any Losses should happen, one 4th of the Revenue of the Commission, will in all appearance be more than sufficient to make them good.

This Paper-money will not fall in value as Silver-money has fallen, or may fall: Goods or Money fall in value, if they increase in Quantity, or if the Demand lessens. But the Commission giving out what Sums are demanded, and taking back what Sums are offer’d to be return’d; This Paper-money will keep its value, and there will always be as much Money as there is occasion, or imployment for, and no more.⁵

Law lists the qualities necessary in money as being:

1. Ease of delivery
2. Same value everywhere
3. Kept without loss or expense
4. Divisible without loss
5. Capable of a stamp
6. Stable quantity⁶

Law insists that paper money has more of these qualities than silver. But should Law have been comparing the merits of silver vs. paper or of silver vs. land? If the paper money was to be backed by land, could one redeem their paper for land? If so, land itself must pass the above tests. If not, fiat paper must pass muster.

The following is Professor Murray Rothbard’s necessary qualities for money:

1. Generally marketable (non-monetary value)
2. Divisible
3. High value per unit weight (portable)
4. Fairly stable supply
5. Durable
6. Recognizable
7. Homogeneous⁷

The two lists are similar, however, Rothbard’s being somewhat more rigorous, it will be used for the comparison between silver, paper and land for use as money.

TABLE 3

As table 3 reflects, silver passes the test with flying colors. Paper and land do not do as well. When looking at the paper and land columns, what stands out is that by merging these two columns, the three “no” qualities of land could be changed to “yeses” by paper, and the four paper “noes” can be changed to “yeses” by land. It’s doubtful that Law went through this exercise, but his thought process must have been similar. However, the two cannot be merged. Paper backed by land would have to be redeemable in land. That forces land into the qualities of money test, with a predictable outcome.

Although Law spends 120 pages touting land-backed money in Money and Trade, this author believes that Law never intended that paper money would be redeemable in land. He was only attempting to build a case for paper money that would eventually have little or no backing. Law began to move toward this direction in later writings. He moved away from land and toward paper assets as backing for money, or to serve as money.

Antoin Murphy has written that Law, between 1707 and 1711, moved away from land bank proposals toward financial institutions patterned after the Bank of England and the East India Company. Instead of land backing financial claims, Law began to see the support being provided by:

government securities and loans to the private sector, in the case of the Bank of England, to fixed and working capital (ships, trading forts, harbours, stock in hand) and government securities in the case of the East India Company.⁸

In the late seventeenth and early eighteenth centuries, England was waging numerous wars, which it financed with continuous borrowing. This debt took the form of the government securities shown on the balance sheets of the Bank of England and the East India Company. The Bank, the East India Company, and later the South Sea Company, all were granted increased monopoly privileges in either banking or trading for their parts in buying up government debt at lower interest rates.

Through his interest in the Bank of England and the East India Company, Law expanded his view of what forms money could take. As early as 1707, only two years after Money and Trade was published, Law began to view exchequer bills, bills of exchange and tallies as money. In addition, new money was being created in the form of shares of stock in the Bank of England and East India Company. Murphy relates the following quote from Law in “Mémoire pour prouver qu’une nouvelle espèce de monnaie peut être meilleure que l’or et 1 argent”:

What approximates most to a new type of money is the East India Company. The stock of this Company is divided into shares like that of the bank. They are traded each day on the exchange and the current price is published for the public’s information in the gazettes. As the transfer of these shares is easy they are given and received in payment at the price at which they are traded, so that the merchant or trader with payments to make does not need to hold money as a reserve. As part of his capital is held in the Indies Company he can use these shares for payment and if difficulties in exchanging them at that day’s market rate all he has to do is send them to the Exchange and convert them into specie, but as they are convertible they will not be refused.⁹

Law believed that this “new” money would rise in value along with inflation, as opposed to silver specie that would decline in value as more was discovered or produced. Law felt that the exchequer bills and bills of exchange, like silver, were subject to this decline in value, because ultimately these instruments would be liquidated for specie. But Law was beginning to view shares of stock the way he had viewed land, as being superior to silver, believing that these shares could never decrease in value.

In “Mémoire,” Law continued to propose a banking system based upon his land-bank proposal. However, on a theoretical level, he was beginning to place more emphasis on liquidity. Murphy writes:

He was defining as money any financial instrument that could be used as a medium of exchange. Tallies, exchequer bills and bills of exchange were used for facilitating exchange and so came to be regarded as money by Law.¹⁰

These “les credits,” however, still lacked an attribute that Law was looking for in money: being inflation proof. Thus, in Law’s mind, the shares fit the bill, providing the superior store of value function that he was looking for. The capital of the East India Company was employed in productive activities, not just money, which provided this inflation protection. Law wanted his monetary system to be tied to productive assets. That was the case with his land-bank proposal—currency being backed by the productivity of the land— but now he was extending this idea to the capital of companies.

The shares of these companies were interpreted as media of exchange because of their ready marketability and, in Law’s view, a view that tended to dismiss the downside risk associated with shares, were superior stores of value than money because they were linked to a productive capital base.¹¹

In 1711, Law was in Italy advising the Duke of Savoy and preparing a proposal for a bank to be established in that country. The proposal was heavily influenced by the structure of the Bank of England. Law, by that time, had dropped the land-bank plan, and was concentrating on a proposal that would incorporate the shares of the Bank of England and the East India Company into the supply of money. The Bank of England impressed Law for two reasons: its ability to finance the long and costly wars England was engaged in, and the way it had expanded the supply of money so that trade continued to expand in the face of the outflow of specie to finance the War of Spanish Succession. Murphy quotes Law from an unpublished manuscript in the Archivio di Stato in Turin, which Law wrote and sent to Amadeus, Duke of Savoy:

The stock of the Indies Company is also divided up in shares, like that of the Bank. They are negotiated and received in payment. A merchant with payments to make does not keep large sums in cash. He invests a part of his capital in the Indies Company or in the Bank and gives this shareholding in payment when he has insufficient cash. If there are difficulties with respect to acceptance he sends them to the stock exchange to convert them into specie, but as they are negotiable they are not refused at the current market price. Most people prefer them to specie because no return is derived from specie until the occasion arises to use it. Shares constitute a value already in use which is productive.¹²

Law viewed France’s problem in 1715 as twofold, a monetary crisis (too little money), similar to that of Scotland in 1705, and also a financial crisis, which stemmed from excessive war debts. Law sought to solve this problem by establishing a sinking fund to pay off a portion of the government debt and establish a bank to increase the supply of money. The bank was to be a joint venture between Law and the King, who would receive 75 percent of the profits. Law, in turn, would receive 25 percent. However, Law’s plan called for the King’s profits to be consigned to repaying France’s debt. Thus, both problems would be served: the bank to meet the shortage of money and the king’s profits to pay off the national debt. Law was linking monetary policy with financial policy.

Law continued to develop this linkage in the “Mémoire sur les Banques,” which was presented to the French authorities in July 1715. Law recommended a credit creating bank that issued banknotes, like the Bank of England. Law also reminded the authorities of the benefits of including bank shares as part of the media of exchange. Bank of England shares at that time were trading at a 30 premium over their par value. Law’s proposal also included using bank profits to purchase the Hotel de Soissons, later to be used as the site for a stock exchange, the bank and a center for foreign-exchange transactions.¹³

Although he was repeatedly rejected by the French authorities, Law continued to write letters to the Regent espousing his grandiose plans. These plans began to include more than just his bank. Murphy quotes Law in a letter to the Regent as saying:

But the bank is not the only nor the biggest of my ideas—I will produce a work which will surprise Europe by the changes that it will generate in France’s favour, changes which will be greater than those produced by the discovery of the Indies or by the introduction of credit.¹⁴

From all appearances, this “work” Law was referring to was the inclusion of shares in the supply of money. Law wrote,

I will lighten the burden of the King and the State in lowering the rate of interest on money, not by legal methods, but by an abundance of specie.¹⁵ The specie which France mints from bullion taken from the Indies falls and loses its value in accordance with the quantities brought into Europe—the credit which I propose to introduce will have a more assured value and will gain 20 and 30 percent on specie.¹⁶

It is clear through Murphy’s findings that Law had formulated much of what was to be the Mississippi System prior to his being granted the charter for the General Bank in May 1716. Murphy, as shown in table 4, helps to outline how Law used the framework of the Bank of England, the East India Company, and the South Sea Company to formulate the Mississippi System.¹⁷

TABLE 4

This combined company served to realize three of Law’s aims: the expansion of the supply of money, with shares serving as money as well as banknotes and deposits; management of France’s debt; and the development of the real economy. Law’s “success” with his Mississippi System led not only to the Mississippi Bubble, but influenced the South Sea Company in England, and thus aided in the creation of the South Sea Bubble.¹⁸