John Law, the father of inflatable paper money and modern Central Banking......Part I

The vagaries of paper money

A dying man gathered his lawyer, doctor and clergyman at his bed side and handed each of them an envelope containing $25,000 in cash. He made them each promise that after his death and during his repose, they would place the three envelopes in his coffin. He told them that he wanted to have enough money to enjoy the next life. A week later the man died. At the Wake, the Lawyer and Doctor and Clergyman, each concealed an envelope in the coffin and bid their old client and friend farewell. By chance, these three met several months later. Soon the Clergyman, feeling guilty, blurted out a confession saying that there was only $10,000 in the envelope he placed in the coffin. He felt, rather than waste all the money, he would send it to a Mission in some remote part of Africa. He asked for their forgiveness. The Doctor, moved by the gentle Clergyman's sincerity, confessed that he too had kept some of the money for a worthy medical charity. The envelope, he admitted, had only $8000 in it. He said, he too could not bring himself to waste the money so frivolously when it could be used to benefit others. By this time the Lawyer was seething with self-righteous outrage. He expressed his deep disappointment in the felonious behaviour of two of his oldest and most trusted friends. "I am the only one who kept his promise to our dying friend. I want you both to know that the envelope I placed in the coffin contained the full amount. Indeed, my envelope contained my personal check for the entire $25,000."

Inflatable paper money

There is something eerily familiar about how the pastor, the doctor and the clergyman go about dealing with what is supposed to be a provision for the dead man. It is the fact that we in the Pension and insurance industry make similar promises to young people and promise them that they will get back their money when they retire. We genuinely mean it when we say so, but very often we also do not understand how our money system works and the problem with the monetary promises that we are making. To understand the interaction between the Insurance and Pensions Sector and the banking industry, it is instructive to go back to the story of John Law, a Scottish financier who rose to become the richest man in the world, before being forced to abandon his considerable fortune and dying in poverty. Actuaries will find John Law a fascinating character because he was a master mathematician, expert in probability, a financial engineer and he used his knowledge of probability to gamble with some measure success. And to top it all, John Law used this knowledge to become the richest man in the World.

The son of a goldsmith

John Law was born in 1671 in Scotland. Perhaps the most striking thing about him was that his father was a goldsmith who had taught his son the practical aspects of the banking trade. Further education came courtesy of a decade or so exile in Holland, which John Law had to endure after killing a man in a duel over a woman. It was while in Holland that he acquired his deeper knowledge of Mathematics, probability and Finance following which he published two essays: Essay on a land bank and Money and Trade Considered . A critical revolutionary idea which ran through Law's writings was that inflatable paper money was more suited to the process of stimulating economic activity than gold or silver. The problem with gold and sliver was that from time to time, the underlying value of the metals exceed their value as money, a situation which encouraged people to then hoard them as wealth thus taking them out of circulation and reducing economic activity. This led to regular economic slumps and recession. Law's genius was to notice that in a recession, inflatable paper money could be used to stimulate the economy since it was highly fungible and portable and could be produced in unlimited quantities, unlike gold and silver whose supply is limited . As Adam Smith was to write 70 years later in The wealth of nations, the wealth of a nation should be measured by the amount of economic activity, not by the amount of gold and silver hoarded in people's vaults. John Law tried without success to sell his new found knowledge to the Scottish government. The quintessential adventurer, Law was not discouraged when they refused to implement his innovation.

Quantitative easing as opportunity meets preparation

The opportunity to try his new theories came, courtesy of a broke French government following the depredations of Louis XIV, the Sun King and builder of the Palace of Versailles who when he died left France on the verge of bankruptcy. As often happens new inventions appeal to those at the extremes of society who are least suited to their application. So heavily indebted was France that the new regent of France who succeeded Louis XIV was willing to try anything in order to save the day. Enter John Law, mathematician, probability ace, financial wizard and master gambler. And the answer that he provided was at once revolutionary and ingenious. He proposed the establishment of a bank that would issue inflatable paper money, which could then be used to buy off government bonds. Law then issued stock in the new bank and use the proceeds to buy off the French government's loans. He also took deposits in gold and silver notes, but issue loans and withdrawals in inflatable paper money. Law built trust in the new paper money by proclaiming that it was redeemable in gold and silver money. But since more people were depositing than withdrawing, this promise was never initially tested. By this mechanism John law had established conditions for slowly inflating away the French government's loan, slowly grow the French economy and restore the economy to financial soundness.

Money for nothing

As often happens in such situations, the initial success of Law's scheme encouraged more daring and reckless adventures. French government indiscipline which had bred the conditions that John Law was trying to solve had not changed, and it would be naive to assume that a tradition of waste and plunder would go away in the face of a miracle money solution which does nothing to reign in the culprits. And so law was encouraged onto a more daring scheme that would raise even more money in a shorter period of time, The Mississippi Scheme. The genius of the Mississippi scheme was that Law acquired a monopoly of trading rights over Louisiana, the French colony in modern day America which he aggregated with several other trading rights. He then proceeded to sell shares in this monopoly at increasingly exorbitant prices. Investors were allowed to buy shares using their French government debt as collateral or to borrow from Law's bank at a very low rate using their government bonds as collateral.

The Frog Jumps out

A legacy of the Mississippi scheme is that it made more millionaires than any other scheme , albeit temporarily, before it capsized. The use of the term millionaire itself is coined at the time of the Mississippi Scheme. As more and more investors came in, and the potential of Louisiana remained untapped, it became clear that the days of the scheme were numbered. The French economy and Louisiana had not grown fast enough to service the investment that was being rapidly thrown at it. Things came to a head when John Law failed to meet the gold and silver coin withdrawals as the panic spread. Ultimately, the water was brought to boil too quickly and the frog jumped out.

Some lessons for insurance and pensions actuaries

Perhaps the biggest of all is to learn how to model economic crisis and the depredations that follow. As can be seen from the graph, following the Mississippi scheme and the related South Sea crisis in England, the stock market stayed stagnant for 70 years. Very often, economist are quick to model so called equilibrium conditions where inflation is always lower than wage increases and interest rates.They proudly declare that the relationships between the assumptions matter more than their absolute values.There is a need for caution and careful reflection. Quantitative easing which John Law pioneered has created a world economy in which these relationships are no longer what they used to be. The activities of the central bank like Law's schemes can have a devastating impact on investors ( of which insurance and pension funds are the biggest ), and it is important that to understand the implications of these activities and model them correctly. John Law's brilliance in introducing inflatable paper money has some of the most far reaching consequences in world finance today ....

Conclusion

John Law was the first man to implement inflatable paper money into the economy and therefore create a whole subject of Finance around it. The concept of inflatable paper money is very important because it allows countries to grow their economies by ensuring that there is adequate money to facilitate growth. The whole concept of economic growth has its origins in the pioneering work of Adam Smith who wrote his classic "The Wealth of Nations" about eighty years later.

Tapiwa Maswera uses the risk management control cycle and the actuarial control cycle to train Financial Leaders. He can be contacted on Tapiwa@acumenacuaries.com