Chapter 8--Increases in the Supply of Money, Speculative Bubbles, and the Austrian Malinvestment Theory

Increases in the Supply of Money, Speculative Bubbles, and the Austrian Malinvestment Theory 8

As we seek explanations for the causes of speculative bubbles, the forthcoming responses from the different strains of modern mainstream economic thought are far from satisfying. The Rational Expectations School, after much muddling of figures and formulas, comes to the conclusion that bubbles are not possible since all market participants act rationally and can foretell the future. As this volume has shown, speculative bubbles do occur, and market participants—people—cannot foretell the future, and do not necessarily act rationally. Econometrics has again struck out in its attempts to explain, let alone predict, the behavior of humans. But, of course, rather than admit that their tools are inadequate, the rational expectations group concludes that, empirically, it cannot be shown that speculative bubbles exist. Thus, they do not. This otiose view flies in the face of historical fact.

John Maynard Keynes, whose school of thought when followed as policy is the modern catalyst for speculative bubbles, wrote at length concerning speculation. Keynes recognized full well the damage that speculation and malinvestment could inflict on people. What Keynes did not recognize was the root cause of these episodes. Instead, he focused on the results which he thought were the causes. The following paragraph from Keynes sums up his view of speculation:

there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, ...can only be taken as a result of animal spirits.¹

Keynes held the view, as reflected in the above quote, that these “animal spirits” lead to damaging speculation, and he, of course, prescribed government restrictions on investment to solve the problem.

So, on one end of the spectrum, we have the rational expectation camp, which says that all people—market participants—are rational, and, being in possession of all available data, can foretell the future. One hundred eighty degrees opposite the rational expectations group is Keynes, who saw all people as being possessed by “animal spirits,” i.e., being irrational, which will thus cause frequent instability and speculation in an economy, with the obvious cure being intervention by the State, which is assumed to be rational.

By reflecting back on what has been written in here, it is obvious that speculative bubbles can and do occur. And if Keynes’s “animal spirits” were the cause of speculative bubbles, these bubbles would have happened continually, ad infinitum, throughout history. Given the fact that this “animal spirit” is an inherent human trait that is not turned off and on, these speculative episodes would be constantly engendered through no other impetus but human nature. This is clearly not the case.

The three speculative bubble episodes just explored, besides having the obvious similarity that they all occurred, share the common trait that a government sanctioned bank, along with government policy, created large increases in the supply of money in each economy, prior to and during these episodes. Each episode was in its own way different, especially the Tulipmania. However, the results were the same: boom, speculation, crash, and then financial pain.

Another common element to all three experiences was a man named John Law. Law was born in 1671, after the Tulipmania bubble, but he studied the workings of the Bank of Amsterdam, which played a part in the Tulipmania, greatly admiring its operation and its positive effect on the Dutch economy. The Bank of Amsterdam was the linchpin of the strongest economy in the world because of the soundness of its operation and therefore the Dutch currency. The Bank accepted coin and bullion and issued bank money against these deposits. All bank money was backed 100 percent (in the Bank’s beginning) by specie and thus great confidence in this money was engendered.

Because of the soundness of this money and the Dutch free coinage policy, immense amounts of coin and bullion flowed to Amsterdam from other parts of Europe, America, and Japan. This torrent of coin and bullion is reflected in the deposits of the Bank of Amsterdam, which increased an estimated 60 percent in the five year period (1633–1638) which encompasses the Tulipmania episode. Total mint output of the South Netherlands for the 1636–38 period was two and a half times greater than the amount minted from 1630–32. This huge influx of money, albeit sound money, led, as Del Mar writes, to “the curious mania of buying tulips at prices often exceeding that of the ground on which they were grown.”² The culmination of Tulipmania came in January 1637 when, for example, the price of the Witte Croonen tulip bulb rose approximately 26 times in the space of that month, only to crash to a price of one-twentieth of its peak price the first week in February of that same year.

After studying the operations of the Bank of Amsterdam during the course of his travels throughout Europe, Law began to formulate monetary theories and banking proposals, which in turn he advanced to States throughout Europe. Law believed that silver and gold were ill-suited to serve as money, that their values were subject to fluctuation depending upon supply. Initially, Law’s plan called for paper money that was backed by land, thinking that this paper money would better satisfy the qualities necessary in money.

Law was initially unsuccessful in selling his proposal to any European governments, even that of his native Scotland. His views also began to change, as he studied other banks including the Bank of England, which was formed in 1694. Law was impressed with the Bank of England’s ability to pay for England’s war against France with paper money. He began to view stocks as money and that they were superior to silver, thinking that they were inflation proof.

Law was finally able to find a taker for his scheme in 1716, when he began the General Bank in Paris. France at that time was devastated economically, after fighting the War of the Spanish Succession and piling up huge debts. Law was intent on refinancing this government debt so as to lower interest rates and stimulate the languid French economy. To accomplish this, Law began the Company of the West, whose only asset to speak of was the trading privilege with Louisiana. After selling shares to capitalize the company, Law refinanced the government’s depreciated debt.

Law then set out to put his system in motion. He was finally able to convince the Regent to make the General Bank part of the State, with it becoming the Royal Bank in late 1718. Law then merged three companies together to form what has been commonly known as the Mississippi Company. With the Royal Bank issuing 159.9 million livres in fresh banknotes, the price of the Mississippi Company shares began to take off in early 1719. In the second half of that same year, with Royal Bank issuing another 220.6 million livres worth of banknotes, combined with Law’s low down payment, and the extended terms method of marketing the stock, the price continued to climb, allowing Law to issue more shares. He then used the capital to refinance more of the government’s debt.

The share price peaked at 10,100 livres in January 1720, aided by increases in the supply of money that was to total 2.1 billion livres by May of 1720. In the spring of 1720, the system was beginning to unravel, leading Law to issue a series of decrees attempting first to devalue silver, then to devalue shares and banknotes. With investors attempting to sell shares and convert the proceeds to specie, Law frantically tried to keep the system afloat, and in fact was able to do so, given the lack of specie due to hoarding and Law’s policies. But by the end of the year, the bubble had been deflated. In September, shares were 43 percent of the high. Indeed, in pound sterling terms, Mississippi shares were only 14 percent of their highs, which more truly reflects the consequences of the massive increase in the supply of money engineered by Law.

While speculation was running rampant, commodity prices were exploding over the course of four years, not only in Paris, but in other cities in France. Some cities experienced worse inflation, and for some it was not as severe. The big loser was, of course, the laboring class, whose wages never caught up with prices.

Law’s “success” with the Mississippi System was viewed with envy and fear from across the Channel in England. Britain, like France, had heavily encumbered itself, with the help of the Bank of England and Lottery loans, to fight the War of the Spanish Succession. The Bank of England was an innovator in the creation of paper money and checking accounts. Its entire capital base was made up of government debt, with its charter allowing it to issue notes up to the amount of its capital.

The Bank of England was constantly hounded by competitors who wanted a share of the Bank’s lucrative business. One of these competitors was the Sword Blade Company, which was headed by Sir John Blunt. This Sword Blade Company was to serve as the credit creating arm of Blunt’s South Sea Company. In 1711, this company was given the monopoly rights to trade with South America. Unfortunately, the Spanish were to greatly hinder the exploitation of this monopoly. In exchange for this monopoly, the company refinanced £9 million in government debt.

But this was just the beginning. In 1719, with total government debt well over £40 million, the South Sea Company proposed a massive refinancing of the government’s debt, à la John Law. The Company was forced to bid against the Bank of England for this operation, and finally won out by offering extraordinary terms and extensive bribery. Once the bid had been won, the price of South Sea stock took off, which was necessary for Blunt’s plan to work. The Company would make its money on the conversion, by exploiting the exchange difference between the government debt and inflated share prices.

The South Sea shares moved quickly to £1,000, with the aid of Company loans totaling £11 million, the government loaning £1 million, the Bank of England loaning money on its own stock and the Royal African company lending in £102,000. With plenty of money in Exchange Alley, there were plenty of promoters hawking what came to be known as “bubble companies.” Eighty-eight of these companies were promoted just in the month of June, 1720.

The British government, at the urging of the South Sea Company, passed the Bubble Act which effectively shut down these upstart bubble companies. Ironically, the enforcement of this Act against four companies served to burst the bubble, and speculators rushed to sell. By December of 1720, South Sea stock was trading at £120.

The Company was bankrupt, and had no real quality assets to begin with, but speculators were not cognizant of this as the market began to feed on itself. This episode was, in relation to the Mississippi Bubble, short-lived. The difference being that the Bank of England, in an effort to raise needed liquidity, began calling in loans, not to mention not making new ones, and also offering interestbearing notes to depositors, the equivalent of selling certificates of deposit in modern banking. John Law, with his Royal Bank, had taken the opposite strategy, by creating money to support the shares, which only prolonged the Mississippi Bubble crisis.

The explanation for the cause of speculative bubbles comes to us by examining the Austrian School’s theory of the trade cycle. This theory, formulated by second generation Austrian economists, Ludwig von Mises and Friedrich A. Hayek, in fact has its roots, according to Mises, with the English “Currency School.”³ Unfortunately, the Currency School did not realize that unbacked bank accounts were equivalent to unbacked banknotes in terms of expanding excessive credit. Thus, as the Bank of England was forced to suspend payment on numerous occasions, it appeared that the Currency School’s explanation of the trade cycle was erroneous, and the view that the trade cycle had nothing to do with money or credit, but instead Keynes’s “animal spirits” came to the fore.

The key point of the Austrian trade cycle theory is that an increase in the supply of money engenders an economic “boom” followed subsequently by the correction of that malinvestment, or “bust,” which is characterized by less money or credit. The business cycle is initially generated by some sort of monetary intervention in the market, typically in the modern world by bank credit expansion to business. However, this monetary intervention could be in the form of the following, listed by Gottfried Haberler:

1. (a) An increase of gold and legal tender money.
2. (b) An increase of banknotes.
3. (c) An increase of bank deposits and bank credits.
4. (d) An increase in the circulation of checks, bills, and other means of payment which are regularly or occasionally substituted for ordinary money.
5. (e) An increase of the velocity of circulation of one or all these means of payments.⁴

People, as they earn money, spend some on consumption, keep some in cash balances, while the rest is saved or invested in capital or production. For most people, this means setting aside a portion of their income by buying stocks, bonds, or bank certificates of deposits or savings accounts. People determine the amount they wish to put in savings by their time preferences, i.e., the measure of their preference for present, as opposed to future, consumption. The less they prefer consumption in the present, the lower their time preference. The collective time preferences for all savers determines the pure interest rate. Thus, the lower the time preference, the lower the pure rate of interest. This lower time-preference rate leads to greater proportions of investment to consumption, and therefore an extension of the production structure, serving to increase total capital. Conversely, higher time preferences do the opposite, with high interest rates, truncation of the production structure, and an abatement of capital. The final array of various market interest rates are composed of the pure interest rate plus purchasing power components and the range of entrepreneurial risk factors. But the key component of this equation is the pure interest rate.

When a monetary intervention, as discussed above, occurs, the effect is the same as if the collective time preferences of the public had fallen. The amount of money available for investment increases, and with this greater supply, interest rates fall. In turn, entrepreneurs respond to what they believe is an increase in savings, or a decrease in time preferences. These entrepreneurs then invest this capital in “higher orders” in the structure of production, which are further from the final consumer. Investment then shifts from consumer goods to capital goods industries. Prices and wages are bid up in these capital goods industries. But the money does not immediately go into production, as Mises writes:

The moderated interest rate is intended to stimulate production and not to cause a stock market boom. However, stock prices increase first of all. At the outset, commodity prices are not caught up in the boom. There are stock exchange booms and stock exchange profits. Yet, the “producer” is dissatisfied. He envies the “speculator” his “easy profit.” Those in power are not willing to accept this situation. They believe that production is being deprived of money which is flowing into the stock market. Besides, it is precisely in the stock market boom that the serious threat of a crisis lies hidden.⁵

This shift to capital goods industries would be fine if people’s time preferences had actually lessened. But this is not the case. As the newly created money quickly permeates from business borrowers to wages, rents, and interest, the recipients of these higher incomes will spend the money in the same proportions of consumption-investment as they did before. Thus, demand quickly turns from capital goods back to consumer goods. Unfortunately, capital goods producers now have an increased amount of goods for sale and no corresponding increase in demand from their entrepreneurial customers. This wasteful malinvestment is then liquidated, typically termed a crash, bust or crisis, which is the market’s way of purging itself, the first step back to health. The ensuing recession or depression is the market’s adjustment period from the malinvestments back to the normal efficient service of customer demands.

This process or cycle can occur in a relatively short period of time. However, the booms are sometimes prolonged by more doses of monetary intervention. The greater the monetary expansion, both in magnitude and length of time, the longer the boom will be sustained (as was the case with the Mississippi Bubble).

The recovery phase, or recession, will weed out inefficient and unprofitable businesses that were possibly engendered by, or propped up by the money-induced boom. The recovery is also characterized by an increase in the “natural” or pure rate of interest. In other words, time preferences increase, which leads to a fall in the prices of higher-order goods in relation to those of consumer goods. As Rothbard writes:

Not only prices of particular machines must fall, but also the prices of whole aggregates of capital, e.g., stock market and real estate values. In fact, these values must fall more than the earnings from the assets, through reflecting the general rise in the rate of interest return.⁶

In the final analysis, monetary intervention cannot increase the supply of real goods, it merely diverts capital from avenues the market would dictate toward wasteful malinvestment. The boom created has no solid base, and thus, “it is illusory prosperity.”⁷

The three episodes discussed are examples of malinvestment at, in retrospect, its most ludicrous. All were created by different examples of monetary intervention. The Tulipmania was engendered and fueled by a massive influx of specie into Amsterdam; see Haberler’s “a” above. The Mississippi Bubble was driven by a blizzard of John Law’s paper; see “b” and “d” above. The South Sea Bubble was formed by the modern banking tools of deposits and credits, along with increasing, as Murphy relates: “the velocity of circulation of money by lending money to potential purchasers of its stock;” see “c” and “e” above.⁸

All three objects of speculation were equally dubious in terms of their investment value. With all due respect to Mr. Garber, in no way can a cogent argument be made to support how the value of a tulip bulb could be greater than the land it is grown in. John Law’s Mississippi Company had the appearance of a powerful company, but the majority of its assets were the debts of a bankrupt country. As Wagner aptly puts it, “Counterfeiting becomes a profitable activity, one that the state customarily tries to reserve for its own use.”⁹ This counterfeiting was Law’s only asset, but as we learned from Mises, it cannot create real prosperity. The South Sea Company, similar to the Mississippi Company, was capitalized with government debt and was technically bankrupt.

The busts, in all three cases, served to liquidate the malinvestments, the break being sharper in the Tulipmania and South Sea cases. In both these cases, a sound money alternative was available for capital to flee to. In the Mississippi Bubble case, the only alternative to Law’s worthless stock was his worthless currency. The ensuing recessions were painful, although short, and in the case of France, engendered a healthy distrust of paper money which served that country well. In the case of England’s handling of the South Sea episode, a mistake was made in not allowing the full brunt of the crisis to be played out. This is a mistake that has been and continues to be repeated constantly throughout history. In times of financial panic a “lifeboat operation” is employed. As Mises explains:

If the crisis were ruthlessly permitted to run its course, bringing about the destruction of enterprises which were unable to meet their obligations, then all entrepreneurs— not only banks but also other businessmen—would exhibit more caution in granting and using credit in the future. Instead, public opinion approves of giving assistance in the crisis. Then, no sooner is the worst over, than the banks are spurred on to a new expansion of circulation credit.¹⁰

Robert Walpole was possibly the originator of the “lifeboat operation” in 1721, and his legacy continues to live on in a modern world where we have unbacked fiat currency and central banking expanding and contracting—mostly expanding—the supply of money at every political whim. Thus, we live from one speculative bubble, or economic boom, to the next resounding crash, only to reinflate the supply of money, serving to maintain a shaky scaffolding under inefficient enterprise and bloated governments, forestalling the inevitable, complete bust.

Modern history is riddled with the occurrence of speculative bubbles and their inevitable crashes: Britain’s railroad mania, the 1929 and 1987 stock market booms and subsequent crashes in the United States, Japan’s stock market and property booms in the late 1980s. The common factor to all has been a monetary intervention or tremendous increase in the supply of money, ultimately leading to these malinvestments. These bubbles also share the common trait that the object or manifestation of the monetary intervention was a familiar investment instrument, i.e., stocks and/or real estate— nothing as obscure as tulips, until recently that is, when the boom in China’s stamp market was recently revealed.¹¹ The genesis for this bubble? Money, of course: it is estimated that savings deposits in China have grown to one trillion yuan. This vast increase in the supply of money has forced interest rates on bank savings accounts down to less than 2 percent! Thus, speculators and others have turned to stamps, pushing the price of some stamps up 500 percent in a two-year period.

With no contraction of China’s monetary policy, the only thing that has stopped China’s only free market is government coercion. The Chinese authorities began a crackdown to attempt to close down the market on November 9, 1991. Now Beijing’s Yuetan Park is quiet, after being a site of trading activity as frenzied as that of the taverns of seventeenth-century Amsterdam, of Paris’s Rue Quincampoix, or of London’s Exchange Alley. But too much money must go somewhere, and China’s stamp speculators are now trying to guess what the object of China’s next bubble will be: stocks¹² or antiques.

As long as we live in a world in which the supply of money is being manipulated by governments, rather than set by the free and unfettered market, monetary interventions will continue to be the norm. Although much time has passed since the occurrence of the three episodes discussed in this paper, the laws of economics do not change with time. The consequences of monetary interventions have always been and will continue to be booms and subsequent busts. Speculative bubbles are the ultimate manifestation of these monetary induced booms. It is impossible to know what the object of the next speculative bubble will be, or exactly when it will occur. What has been shown here is that these bubbles, or malinvestments, are engendered by increases in the supply of money, with the ensuing busts inevitably to follow, leading once again to bankruptcies and financial pain, as these wasteful investments are converted to more productive assets. What can be predicted with absolute accuracy is that fiat money, fractional-reserve banking, central banks, Keynesian monetary policies, and self-serving politicians will combine to ensure that there will be many more booms and speculative bubbles for future economists and historians to chronicle.