Paper and Trust: The First Bubbles

A bulb worth a house

It is told that in the winter between 1636 and 1637, in the cities of Holland, a single tulip bulb of a prized variety could be exchanged for a sum equal to the price of a house on the canals of Amsterdam, or for years upon years of an artisan’s wages. There are tales of sailors ending in prison for mistaking for an onion, and eating for breakfast, a bulb worth a fortune; of entire estates built and destroyed in a few months; of a whole nation seized by a collective fever for flowers, which ended in ruinous collapse when, suddenly, no one wished to buy any more and prices plunged to nothing. “Tulip mania” has entered the collective imagination as the first and most spectacular example of speculative folly in history, the very symbol of the irrationality of crowds when they let themselves be swept away by greed.

It is a magnificent story, and for that very reason it must be handled with great caution, because much of it is legend. Many of the most colourful details — the imprisoned sailor, the stratospheric figures, the idea of a whole nation ruined — come not from documents of the time, but from moralistic accounts written much later, in particular from a famous nineteenth-century book on popular delusions that fixed the dramatised version destined to become common sense. Historians who have examined the contemporary sources closely have greatly scaled back the picture: the speculation on tulips was real and the prices of some rare varieties did reach extravagant levels, but it concerned a relatively narrow circle, largely of merchants and enthusiasts, and its collapse, however ruinous for the individuals involved, by no means had the effect of devastating the Dutch economy, which indeed continued to prosper. Tulip mania was not the national cataclysm the legend paints; it was a circumscribed speculative episode, later inflated by literature until it became a myth [Goetzmann 2016].

It is worth understanding why, of all goods, it was tulips that set off the speculation, because the answer shows how even the most absurd manias almost always start from a kernel of real value. The tulip was, in seventeenth-century Holland, an exotic and sought-after novelty, recently arrived from the East, and it rapidly became a status symbol among the well-to-do classes: to own rare tulips was a sign of taste and of wealth. The most prized varieties were those with petals streaked in vivid colours in fantastic and unrepeatable patterns — streaks that, it was discovered only much later, were the effect of a virus that infected the bulb, and that precisely for this reason were unpredictable and hard to reproduce. A bulb capable of generating a flower with spectacular streaks was therefore genuinely rare and coveted, and a certain high price had its justification. Onto this kernel of real value the speculative dynamic then grafted itself: prices began to rise, the increase attracted those who bought not for love of flowers but to resell at a profit, and the spiral set in, detaching itself ever more from any reasonable foundation. It is a pattern we shall meet in every bubble: at the origin there is almost always something real — a true innovation, a true discovery, a true reason for value — that speculation then inflates beyond all measure, until it turns a justified rise into a senseless mania. Bubbles are not born from nothing, but from the exaggeration of something real.

Why begin a chapter with a story half false? Because the distance between the myth and the reality is itself instructive, and because — beyond the exaggerations — the kernel of the phenomenon is authentic and deeply revealing. In the tulips one sees, for the first time with such clarity, a mechanism that would mark the whole history of modern finance: the speculative bubble, the surge of a price dragged not by the real value of what one buys, but by the conviction of being able to resell it at a price still higher. And the tulips are only the appetiser: this chapter tells how, in those very decades and those very places, the instruments were born that would make bubbles no longer an eccentricity tied to flowers, but a permanent feature of financial capitalism — the joint-stock company, the stock exchange, paper money — and how those instruments, barely born, generated two of the most gigantic bubbles in history, capable this time of truly shaking whole nations.

The anatomy of a bubble

It is worth pausing at once to understand what a speculative bubble is, in general, because the pattern we shall meet in the tulips, in Law’s system and in the South Sea Company is always the same, and will repeat itself identically down to the crises of our own time. A bubble arises when the price of a good — a flower, a share, a house — begins to rise, for whatever initial reason, and that rise attracts buyers not because they desire the good in itself, but because they expect the price to keep rising and count on reselling to someone else, gaining on the difference. It is the logic of the “greater fool”: I buy at an already high price, knowing perhaps that it is excessive, but convinced of finding someone even more willing to pay, on whom to offload the good before the collapse. So long as other buyers enter the game, the price rises, and every rise seems to vindicate whoever has bought, attracting new enthusiasts in a self-feeding spiral. It is the phase of mania, in which euphoria infects ever wider strata of the population, and in which it seems the price can only rise and that whoever does not take part is a fool.

But no spiral of this kind can last forever, because it rests on a paradox: the price rises only so long as there are new buyers, and new buyers sooner or later run out. At a certain point the more shrewd, or the more fortunate, begin to sell to realise the gain; the sales slow the rise; the slowdown insinuates doubt; doubt pushes others to sell. It is the phase scholars call distress, the uncertain moment in which the mood of the market cracks and euphoria begins to turn into unease. And then, suddenly, trust reverses into panic: everyone runs to sell together, each trying to rid himself of the good before it is worth still less, and the price, deprived of buyers, plunges with the same rapidity with which it had risen, often to a level lower than the starting one. Whoever is left holding the good at the end — the final “greater fool”, who has found no one to resell to — pays for all, ruined. This three-stage pattern — mania, distress, panic — is the recurring anatomy of every bubble, described in a classic study of financial crises that has traced its model across the centuries [Kindleberger & Aliber 2005].

There is an ingredient that almost always feeds great bubbles and multiplies their reach, and that we must introduce because it will recur throughout the book: credit. A bubble that swells with only the money people already possess has a natural limit; but when buyers can go into debt to buy — borrow to acquire shares or goods they hope to resell at a profit — then the spiral takes on a new and dangerous power. Credit allows one to buy with money one does not have, betting on the rise: if the price climbs, one resells, repays the loan and pockets the difference multiplied; but if the price falls, one is left with the debt to pay and the good worth less, and the ruin is complete. It is the leverage we spoke of in the previous chapter, applied to speculation: it amplifies gains in the rise and losses in the fall, and for this reason it makes credit-fed bubbles enormously more violent, both in swelling and in bursting. We shall see, in Law’s system, the extreme case in which it is money itself that is created to feed the bubble, in a short-circuit between the issue of paper and speculation that is perhaps the purest historical example of this mechanism. And we shall find it again, identical in substance, in every great financial crisis down to that of 2008: behind every truly destructive bubble there is almost always a mountain of debt.

What makes bubbles so interesting, and so dangerous, is that in them money reveals in the purest way its nature as pure collective conviction. A good is worth, in a bubble, exactly what others believe it is worth, and so long as everyone believes it is worth much, it is worth much indeed — until the instant in which someone stops believing it and the whole castle collapses. The bubble is the extreme demonstration of a truth that runs through the whole book: that value is not an objective property of things, but a fact of shared trust, and that trust, when it swells beyond all foundation, can create apparent wealth from nothing — only then to make it vanish equally into nothing. It is the “value from nothing” in its most feverish and most unstable form.

The laboratory of Amsterdam

While tulip mania kindled and extinguished its ephemeral flame, the Holland of the seventeenth century was building something far more lasting and important: the foundations of modern finance. The small republic of the United Provinces, become in the seventeenth century the greatest commercial and maritime power in Europe, was the laboratory in which some of the institutions that still uphold capitalism today were born, and first of all the joint-stock company and the market in which its shares are traded.

The starting point was a practical problem: how to finance trade with Asia, the most lucrative and at the same time the riskiest activity of the age. An expedition to the East Indies required enormous capital — ships, crews, goods for exchange — and could last years, with the constant risk that the ship would sink or be captured, sending the whole investment up in smoke. No single merchant could bear such a risk alone. The solution, ingenious, was to pool the capital of very many investors in a single great permanent enterprise, dividing its ownership into shares and so spreading the risk over many shoulders. At the beginning of the seventeenth century the great Dutch East India Company was founded, the VOC, and with it was born, in its mature form, the joint-stock company: an enterprise whose ownership is fractioned into securities, each of which represents a share of the capital and gives a right to a part of the profits.

The decisive innovation was that those shares could be sold. An investor who had put his money into the company did not have to wait for the dissolution of the enterprise to recover the capital: he could cede his share to another, at any moment, at the price the two parties agreed. And since many wished to buy and sell shares, there arose a place to do it: the Amsterdam Stock Exchange, the first modern stock market, where the company’s shares were traded continuously, and where their price rose and fell according to news, expectations, moods. It was something revolutionary, and once again it touches the nature of money and of value. The share is a new form of wealth: it is neither land nor goods nor money, but a security, a piece of paper that represents a share of an enterprise and a promise to take part in its future gains. Its value lies not in what it is materially, but in what it promises and in what others are willing to pay to have it. With the share, and with the market that trades it, value dematerialises still further, becoming an expectation about the future that is bought and sold like a commodity [Goetzmann 2016].

In Amsterdam there was born also, alongside the exchange, a public bank of great solidity, the bank of the city, which we have already mentioned in the chapter on the bankers: an institution where merchants could deposit their money and settle their payments by transferring credits in the bank’s registers, with an unequalled security and efficiency. It is worth dwelling on this bank, because it represents the prudent reverse of the speculative coin, and shows that Dutch finance was not only fever of bubbles but also construction of solidity. The money deposited at the bank of Amsterdam gave rise to a recorded credit — a kind of bank money, the “bank guilder” — which enjoyed a reputation of absolute reliability, to the point of being worth, in international commerce, more than the current metal coin, often worn or of uncertain weight. Merchants from all over Europe kept funds at the bank of Amsterdam and settled among themselves payments even large without moving a single coin, simply by transferring credits from one name to another in the institution’s registers. It was a ledger money of high quality, guaranteed by the city, anticipating in miniature what the central banks would later do on a national scale: to furnish a reliable and stable money, a fixed point of trust amid the confusion of the thousand metal coins. The contrast between this solidity of the bank and the fever of speculative bubbles says much about the dual soul of finance, capable at once of building the most solid institutions and of generating the most ruinous manias.

The set of these institutions — the joint-stock company, the exchange, the public bank, and a dense network of merchants, insurers, money-changers — made of Amsterdam the financial centre of the world, the place where much of the apparatus finance still uses today was invented or perfected. But those instruments, which gave finance a new power, carried within themselves also a new, gigantic potential for instability: because a market where expectations about the future are bought and sold is, by its nature, the ideal ground on which bubbles can grow to proportions never seen. And it was precisely what happened, at the beginning of the following century, in two neighbouring countries and almost at the same moment.

The man who reinvented paper money

The first of the two great disasters has a protagonist who seems to have stepped out of a novel: John Law, a Scotsman ingenious and unscrupulous, a gambler, a fugitive for a fatal duel, and at the same time — this is the point not to be forgotten — one of the most lucid and forward-looking monetary thinkers of his time. Law was not a mere adventurer or swindler, as a certain tradition has painted him: he had precise and in many ways prophetic ideas about the nature of money, and it was the possibility of putting them into practice on a national scale that dragged him, and with him a whole kingdom, into catastrophe.

Before following Law, it is worth recalling that paper money was not, strictly speaking, a European invention. It had been preceded by centuries by China, which already around the year one thousand, under the Song dynasty, had begun to issue banknotes — at first as receipts for deposits of metal with trusted merchants, then as true paper money guaranteed by the state. When the Venetian traveller Marco Polo, in the thirteenth century, described to Europe the fact that in the empire of the Great Khan people used as money sheets of paper with a seal, his readers struggled to believe him: it seemed a sorcery that a piece of paper could be worth as much as gold. And yet the Chinese had grasped, with centuries of anticipation, both its power and its danger: because the history of Chinese paper money knew in its turn episodes of excessive issue and ruinous inflation, when governments, to finance their expenses, printed more paper than the economy could absorb, until it was discredited. Europe, in short, was about to rediscover — and to learn at its own expense — a lesson another civilisation had already learned: that paper money is an instrument at once extraordinary and treacherous, and that the line between its wise use and its ruinous abuse is thin. John Law perhaps knew nothing of the Chinese experience, but he was about to repeat, on a European scale, both its ingenious intuition and its fatal error.

The underlying idea of Law was bold and, seen with today’s eyes, surprisingly modern. He held that the wealth of a nation was held back by the scarcity of metal money: if gold and silver are few, exchanges stagnate, enterprises lack capital, the economy does not grow as much as it could. The solution, Law maintained, was to free money from metal, issuing paper money in quantity adequate to the needs of commerce. A bank could print banknotes, guaranteed no longer only by a reserve of gold, but by the overall wealth of the nation, by its lands, by its activities; and that paper, putting more means of payment into circulation, would stimulate commerce and make the economy flourish. In this intuition there is the germ of ideas that would become orthodoxy only much later: the idea that the quantity of money can be managed to stimulate the economy, that money need not be a prisoner of metal, that paper can do what gold does not suffice to do. Law anticipated, by three centuries, the world of fiat money in which we live. His error was not the idea in itself, but the measure, the greed and the haste with which he put it into practice.

The opportunity presented itself to him in France, a kingdom oppressed by a colossal public debt, the legacy of the ruinous wars of the Sun King. Law persuaded the French government to entrust him with a grandiose project: he founded a bank that issued banknotes, and alongside it a great trading company to which were granted the monopoly of trade with the vast French territories of North America, along the Mississippi river, and other privileges. The company — the famous “Mississippi system” — sold shares to the public, promising fabulous gains from the exploitation of those distant lands, painted as immensely rich. And here the two mechanisms joined in an explosive combination: Law’s bank printed banknotes, and those banknotes were used to buy the company’s shares, making their price rise; the rising price attracted new buyers, who demanded more banknotes, which the bank printed, further feeding the race. It was a machine for simultaneously inflating the quantity of money and the price of shares, the one feeding the other in a vertiginous spiral.

The collapse of the system

For a time the machine worked beyond all imagination, and produced one of the most spectacular speculative manias in history. The shares of the Mississippi company rose to stratospheric levels, multiplying their value many times in a few months; crowds of people of every rank thronged the Paris street where the securities were traded, making and unmaking fortunes in a day. It is told — and here, as with the tulips, caution is needed with the anecdotes — that the word “millionaire” was born in those months, to denote the new rich created by the speculation. Law himself, the architect of it all, became one of the most powerful men in France, controller general of the kingdom’s finances, idolised as a genius who had found the secret of inexhaustible wealth. For a moment, it truly seemed that wealth could be created from nothing, by printing paper and selling colonial dreams.

But the system rested on the void, and the void, sooner or later, makes itself felt. The lands of the Mississippi, painted as an Eldorado, were in reality swamps and forests that produced nothing remotely comparable to the promised gains: the real value behind the shares was a minimal fraction of their inflated price. And the quantity of banknotes printed to feed the bubble was enormously greater than the reserve of metal that should have guaranteed them. It was enough for someone to begin to doubt, to wish to convert his shares and his banknotes into ringing gold, for the whole edifice to reveal its hollowness. When the first ran to sell and to demand metal, panic spread: everyone wished to rid themselves of the shares and convert the paper into gold, but the gold was not there — it was a minuscule fraction of the paper issued — and the price of the shares plunged, the banknotes lost all value, and the system collapsed in ruin. Thousands of people were ruined; Law, from idol, became the most hated man in France, and had to flee the kingdom, dying later poor in exile. The collapse of the system left in France a distrust so deep toward banks and paper money that the country, for generations, remained behind others in the development of modern financial institutions: a long-term wound inflicted by the excess of an idea not in itself mistaken [Davies 2002].

It is important, it is worth repeating, not to reduce Law to a swindler. His underlying intuition — that money could be freed from metal and managed to stimulate the economy — was right, and would become, centuries later, the foundation of the monetary system in which we live. What Law got wrong was all the rest: prudence, measure, respect for the limit beyond which the issue of paper no longer stimulates the economy but generates only inflation and bubbles. He discovered, despite himself and at others’ expense, the truth behind the title of this book: that one can indeed create value from nothing, by printing paper and selling promises, but only up to a certain point, beyond which the nothing takes its revenge and the value created from air returns to air. The thin line between the fiduciary money that stimulates prosperity and the worthless paper that destroys it is the central problem of all modern monetary history, and Law was the first to cross it on a national scale, in a manner so spectacular as to mark forever the memory of what happens when it is overstepped.

The bubble of the South Seas

Almost exactly in the same months in which Law’s system rose and collapsed in France, on the other side of the Channel England was living its own, parallel speculative folly: the bubble of the South Sea Company, the South Sea Bubble, which swelled and burst in 1720, the same year as the French disaster. The mechanism was different in detail but identical in substance, and it too intertwined public debt, a trading company and mass speculation in an explosive mixture.

England too was burdened by a great public debt, and the South Sea Company proposed a scheme to manage it: in exchange for commercial privileges — a monopoly on trade with Spanish America, largely illusory — the company would absorb a part of the state’s debt, converting the debt securities into its own shares. To make the scheme work, the company’s shares had to rise in price, and its promoters did everything to inflate their value, with promises of marvellous gains, cleverly spread rumours, and every sort of manoeuvre. The price of the shares rose vertiginously, and again the mania broke out: all England, from nobles to shopkeepers, threw itself into buying the company’s shares, and together a host of other improvised companies that sprang up to take advantage of the euphoria, some of which were openly fraudulent or absurd — one has remained famous, though perhaps legendary, of a company that promised great profits “for an undertaking of great advantage, but no one is to know what it is”.

Among the illustrious victims of that mania, tradition counts none other than Isaac Newton, the greatest scientist of the time, who is said to have invested in the company, to have first drawn a good gain by selling in time, and then, seeing the price keep rising, to have re-entered by buying again at a high price, only to lose at last a considerable sum in the collapse. To him is attributed a phrase become famous: that he could calculate the motions of the heavenly bodies, but not the folly of men. As with the tulips and with Law’s “millionaires”, this anecdote too must be taken with the caution due to stories too perfect — the details and the phrase itself are of doubtful authenticity — but it captures a truth that bubbles demonstrate relentlessly: that intelligence, even the most sublime, does not immunise against collective euphoria, and that in the speculative fever the genius and the fool can ruin themselves alike. Bubbles are not phenomena of individual stupidity, but of collective dynamics: they overwhelm even the lucid, because the mechanism that drives them — the conviction of being able to resell at a higher price — can seduce anyone, until the instant in which there is no one left to resell to.

Then, as always, the bubble burst. When prices reached unsustainable heights and the first began to sell, trust reversed into panic, and the price of the company’s shares plunged, ruining a multitude of investors, among them many illustrious figures — even, it is said, great scientists and statesmen who had believed they could ride the wave. The scandal was enormous, also because it emerged that politicians and administrators had profited and favoured the fraud: there followed inquiries, trials, political ruins. And there followed, above all, a legislative reaction that had long-term consequences: to prevent the recurrence of such manias, England passed laws that made it much harder to form joint-stock companies, holding back for more than a century the development of this form of enterprise in the country. As in France with Law, in England too the trauma of a great bubble generated a reaction that long held back the evolution of financial instruments: an example of how crises, besides destroying wealth, shape the institutions and the laws that come after [Ferguson 2008].

What paper multiplies

Let us draw together these affairs, because they illuminate the crucial passage that gives the chapter its title: the entry of paper into the history of money, and with it of a new, vertiginous power and a new fragility. Up to this point in the book, money had been essentially coined metal, or the bookkeeping record of credits. With Law’s banknotes, with the shares of Amsterdam and of the South Sea Company, paper enters the scene on a vast scale: the piece of paper that is worth not for what it is — it is worth, materially, nothing — but for what it promises, a share of gold, a share of an enterprise, a participation in future gains. Paper carries to the extreme consequences the nature of money as promise that we have followed from the beginning: it is pure promise, value in the state of trust, wealth that exists only so long as someone believes in it.

And precisely here lies the twofold lesson of this chapter. On one side, paper multiplies the power of money: it allows means of payment to be created and capital to be gathered in a measure that metal would never permit, financing enterprises, commerce, development. The joint-stock company and the Amsterdam exchange, born in those years, are among the most fruitful inventions in economic history, and without them the modern world, with its great enterprises and its capital markets, would be inconceivable. On the other side, paper multiplies in exactly the same way the fragility: because what is worth only for the trust that sustains it can lose all value in the instant in which trust vanishes. A bubble is the moment in which this fragility manifests itself in its most extreme form: the value created by collective trust swells until it loses all contact with reality, and then, when trust reverses, vanishes in an instant, leaving ruins behind it. Paper is the “value from nothing” in its most powerful and most dangerous version: it can create true wealth, but it can also create illusory wealth, and to distinguish the one from the other is the permanent problem of every economy founded on credit and on markets.

The bubbles of 1720 deeply marked the collective memory, and for a time cooled the enthusiasm for paper and for speculation. But the power of the instruments born in those years was too great to be renounced: the joint-stock company, the exchange, the banknote were destined to return, perfected and disciplined, to the centre of the modern economy. What was still lacking was an institution capable of governing paper money with prudence, of issuing it in the right measure, of serving as an anchor of stability amid the breakers of trust: an institution that would prevent both the scarcity of money that held back the economy, and the excess that generated the bubbles. That institution was being born precisely in those decades, and to it — to the central bank, to its origin and to the delicate power entrusted to it — the next chapter is devoted. The history of money, having discovered the power and the danger of paper, had now to learn to tame them.