Lessons of History, Part I

In part one of this classique essay, which ran last October in The Daily Reckoning, Marc Faber looks to answer the ultimate question: "How much longer will foreign investors, who are financing the U.S. trade and current account deficit, be willing buyers and holders of American stocks, bonds and the dollar?"

I recently read and reviewed The Great Swindle – The Story of the South Sea Bubble by Virginia Cowles. 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 United States, 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 toward 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’]

South Sea Bubble: The Script Remains the Same

"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, overborrowings, 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 fuel the flames of irrational speculation and public participation, which involve a larger and larger group of people seeking to become rich without any understanding of the object of speculation.

The sagas of the Mississippi Scheme and the South Sea Company are historically relevant, for example, because they contain 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.

South Sea Bubble: Increase the Money Supply

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, 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 Royale) 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 Royale, 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 Royale 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, who are financing the U.S. trade and current account deficits, be willing buyers and holders of American stocks, bonds and the dollar?


Marc Faber
For The Daily Reckoning
October 15, 2004

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.

Ooh la la…dear reader, things may begin to happen.

First, the industrial metals are dropping – sharply. Copper – often called Dr. Copper – took its biggest tumble in 14 years yesterday. Copper is called "Dr." because it is the metal with a Ph.D. in economics. Why? Because modern industrial economies use copper in everything – motors, wiring, telephones and computers…everything. So when demand for copper suddenly drops, it generally means the world economy is slowing down. Manufacturers aren’t ordering as much copper; they must not expect to make so many things. Which must mean they have too much in inventory already…or consumers aren’t borrowing so much.

While the industrial metals went down, gold rose to $419.
Gold is not used in industry. It is used in jewelry and as money. It is what people buy when they’re not too sure the world’s paper money will hold up. It is what people store when they’re not sure their bonds, stocks and real estate will maintain their value. It is what people buy when they worry that today’s "just in time" economy may suddenly become an economy in which they’d like to have some real wealth stockpiled…just in case.

The Dow is not doing President Bush any favors, either. If what we read is correct, a president has never been re-elected when the Dow fell in October. So far, the Dow is down. But October is not over; anything could happen.

A collapse of the Dow either before or after the election would be something. So would a Kerry victory. Kerry and Bush do not differ on the essentials – both are perfectly happy to lead the parade down America’s road to ruin. But Kerry says he would take a different route. Instead of cutting taxes and increasing spending, he would raise taxes and raise spending even more.

Would this be a "good thing" for the economy? Well, it is hard to say. Raising taxes would probably be disastrous in the short run. Consumers are already running out of spending power. And savings are already almost nonexistent. Tax increases would only make a bad situation worse.

But spending more money would offset it somewhat. If consumers are stretched so far they cannot continue, theoretically the government could take up the slack. Of course, in the long run, the results would be even more catastrophic than had the government done nothing at all – but that seems to be what both parties are aiming for. Americans have dug a hole of debt for themselves.

Both Republicans and Democrats now offer programs to help them dig down a little deeper.

Finally, yesterday brought more signs of stress. The August trade deficit – at $54 billion – was the second largest ever. Mortgage applications and refinancings are slipping. So are homebuilding stocks. And now financial stocks are also taking a beating. Is the great consumer credit binge coming to an end? Is stuff beginning to happen?

We don’t know…but we’ll stay tuned.

More news, from Eric Fry in New York:


"Whatever one’s political leanings – whether one imagines the U.S. invasion of Iraq to be a brilliant pre-emptive strike or an ill-conceived geopolitical blunder – one thing is certain: The business of policing the world is incredibly expensive. Invading Iraq may be astute political policy, but it is awful fiscal policy."


Bill Bonner, back in London:

*** Brian Boru, one of the ancient kings of Ireland, wore a crown of gold. Charles Stewart Parnell, one of the founding fathers of Irish Nationalism, is said to once have panned for gold in the Avoca River. He got enough of it, according to legend, to make a ring for his lover, Kitty O’Shea.

And now The Daily Telegraph reports that a "massive deposit" of gold has been discovered nearby, in the Sperrin Mountains near the town of Gortin. This is likely to be "the largest deposit of gold to be found in the British Isles," says the report.

*** Meanwhile, Britain is reeling from a new report in which it is estimated that "longer life expectancy and lower birth rates will create pauper pensioners," reports the Times.

We don’t know why it took the British so long to do the math. Birth rates have been down for a long time. And it has been no secret that people throughout the Anglo-Saxon world are notoriously bad about saving money. But perhaps the English were counting on their National Health Service to wipe out the oldsters before they become a burden.

But now the word is out: "Harsh truth is that we must save more or risk retiring in penury."

Penury, for those who went to public schools, is not a forlorn town in Yorkshire, but a condition of not having enough money to buy things you really don’t need.

*** Don’t worry about it, says Anatole Kaletsky in the same paper a day later. "Pensioner poverty," he says, "is a myth."

"Ignore overheated tales of freezing grannies: The standard of living of old people will carry on improving."

How he knows that, we can’t say. And we doubt the tails of freezing grannies are overheated; we’d feel very sorry for them if they were.