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"In 1719-20, a financial whirlwind even more dramatic than anything witnessed today swept through France," author James Macdonald (A Free Nation Deep in Debt: The Financial Roots of Democracy) wrote in Thursday's Financial Times of London.[1] -- " Shares in the Compagnie des Indes, or the Mississippi Company, rose 1,000 per cent and then fell by 90 per cent in less than two years. The story illuminates current events." -- Macdonald identifies six elements that the Mississippi Bubble shares with the contemporary subprime crisis: Risky debts, a financial wizard, the power of securitization, the role of easy money, boom, and, finally, bust. -- Like James Macdonald in his article, Forrest McDonald in his review of James Macdonald's volume emphasized the long-term consequences of France's miserable experience: "In France, John Law's Mississippi Bubble led to a speculative mania and a spectacular collapse that bankrupted thousands and drove the monarchy, once and for all, away from efforts to establish public credit."[2] -- In his review, Robert Wright of NYU's Stern School of Business noted that Macdonald is "a British investment banker and independent scholar," and emphasized that Macdonald's A Free Nation Deep in Debt has "a Big Thesis: Democracies eventually defeat autocracies because "countries with representative institutions are able to borrow more cheaply than those with autocratic governments."[3] ...

Imagine the following: a collection of debts owed by a highly leveraged borrower with a bad credit record is magically transformed into marketable securities with triple-A yields. How is this miracle performed? It is through the power of financial innovation and free capital markets.

It could be the story of subprime mortgages in the U.S.; but it is not. It is, in fact, the story of government debt in France in the early 18th century. In 1719-20, a financial whirlwind even more dramatic than anything witnessed today swept through France. Shares in the Compagnie des Indes, or the Mississippi Company, rose 1,000 per cent and then fell by 90 per cent in less than two years. The story illuminates current events.

1. The dodgy debts. The French monarchy had a history of recurrent default. By the end of the War of Spanish Succession in 1714 public debt had risen to over 100 per cent of national income and was subjected to forced reductions of interest and principal. Confidence collapsed and government paper sold for discounts of up to 75 per cent and the economy was in recession.

2. The financial wizard. Along came one of the most remarkable people in the history of finance: John Law, a Scottish economic theorist who had never held any post related to public finance and who lived by his wits at the gambling table. This charismatic figure seduced the Regent with his blueprint for France: to exchange existing government debt for shares in the Mississippi Company, which held monopoly trading rights to the French colonies. The government would issue a new series of bonds to the company paying only 3 per cent in exchange for its old debts, which paid 4-5 per cent.

For the government, the cost of servicing the debt would fall sharply and the budget would look rosier. The trading rights to the French colonies were largely worthless, for there were no profits at the time and the Mississippi Company had existed for a while without exciting public interest. By the same token there was little or no reason for the debtholders to accept this exchange. Law needed extra incentives.

3. The power of securitization. The market for government debts was moribund. Law’s aim was to make Mississippi shares as actively traded as possible. This provided an incentive to swap -- to get a more liquid security and the prospect of speculative gains. In other words, Law repackaged a collection of “subprime” debts as marketable securities under a different name and thereby increased their investor appeal.

4. The role of easy money. Law proposed that Mississippi shares would be so actively traded that they would constitute “a new form of money.” This striking idea tied into the second part of his scheme: a massive monetary stimulus provided by a newly founded central bank (do I hear Federal Reserve policy 2001-04?). This monetary boost would put some pizzazz into Mississippi shares, and their rise would encourage the public creditors to convert.

5. Boom. Law’s plan worked beautifully. The debt was exchanged and became worth many times its previous value as Mississippi shares continued their dizzying ascent. The economy recovered and everyone was happy -- even though the underlying reality was an unsustainable credit-driven boom.

6. Bust. For all Law’s wizardry, the underlying assets of the Mississippi Company were still questionable royal debts that did not provide enough income to pay its promised dividends. Moreover, like many holders of collateraliseds debt obligations nowadays, speculators in Paris relied heavily on borrowed money. The rise in Mississippi shares in 1719 was reversed in 1720 and the bewildered French found themselves holding subprime paper, merely relabelled.

The lessons seem obvious. Financial innovation can achieve much, but cannot transform sows’ ears into silk purses. Moreover, there are risks that innovators do not fully understand their inventions and get carried away. The correct regulatory response to this risk is not to fuel it with easy monetary and credit conditions. The collapse of the Mississippi bubble had ruinous consequences in France. The government concluded that paper money, banks, and stock markets were inherently dangerous (“financial weapons of mass destruction”). It took until the 19th century for France to recover its nerve and its rival, Great Britain, leapt ahead in the race for financial supremacy. In the rush to reregulate markets, let us hope Western governments do not repeat the French mistake.

--The writer is the author of A Free Nation Deep in Debt: The Financial Roots of Democracy (Princeton University Press, 2006).

At first blush, it would seem that a monograph on private indebtedness during the early years of the American republic could have little in common with a tome on the history of public finance from ancient times to the present. In curious ways, however, these two interesting and informative books are interrelated and contribute more taken together than either does separately.

To appreciate the interconnectedness, it is useful to begin with the work on private debts in America. During most of the seventeenth century in the English colonies, and indeed in most of Europe for a much longer time, owing money was generally regarded as immoral if not downright sinful. But as the colonies and the world became progressively more commercial through the 18th century, the moral stigma attached to being in debt tended to disappear, for complex patterns of trade could not be conducted on a cash basis. Debt was still regarded as dangerous, but it was necessary and was particularly necessary, as well as particularly dangerous, in the mercantile community.

The American Revolution arrested this wholesome and commonsensical development and insured that, for a considerable period, American attitudes about debt, both public and private, would be ambiguous. To declare and win independence from George III was, willynilly, to commit the United States to republicanism, and though most Americans had little understanding of what republicanism implied, they were aware that, as Montesquieu had taught, the actuating principle of a republic was virtue in the citizenry. Virtue meant manhood and independence and a disinterested devotion to the welfare of the public -- "virtue," like "public," deriving from the Latin roots for manliness. To go into debt was to forfeit one's independence by becoming beholden to one's creditors; and republican theorists from Plato to Montesquieu had taught that commerce was inimical to republican virtue, precisely for that reason and also because it bred a love of luxury, the very antithesis of manliness.

Strong as the commitment to republicanism was, the Revolution and its aftermath produced material developments that jeopardized and threatened to undermine it. In the first place, paying for the war entailed the creation of an enormous public debt, to which we shall return in a moment. In the second place, the appetite for imported foreign manufactures, whetted shortly before Independence then stifled for eight years during the war, exploded at war's end. The result was an enormous wave of importation on credit, then a severe contraction and economic recession in the mid-1780s.

Now let us turn to the area of public finance. Throughout the ages and until comparatively recently, the main reason governments or states needed funds was to bear the costs of waging war. In ancient times the method was simple: the winner defrayed the costs by looting and/or enslaving the vanquished. For the loser, the cost was not a consideration, for as a practical matter that side ceased to exist. Later, upon the emergence of absolute or nearly absolute monarchies, the economics of statecraft changed somewhat. Kings rarely had credit, for they were apt to renege on their obligations, and the moneyed classes went into hiding or hid their assets whenever agents of the crown came around. Normally, therefore, kings saved their revenues between wars, until they amassed enough to launch hostilities anew. When the funds, unless replenished by looting, ran out, they had to stop fighting. They repeated the cycle again and again.

The solution was the invention of public debt, which was possible only in states that were relatively free, for the essence of a public debt is that it is owed by the citizens of a state to one another. The central thesis of A Free Nation Deep in Debt is encapsulated in its subtitle, The Financial Roots of Democracy, and if allowance is made for the fact that James Macdonald really means free government and not "democracy," the argument is convincing and insightful.

Between the 13th and the 16th centuries, the city-states of Italy created a genuine system of public debt. Next came Holland, which was able to win its long war of independence from Spain even though the "parent" country was far richer and more populous -- because Holland had an endless source of revenue in the form of public debt owned by its citizens.

A danger inherent in public debt was its tendency to generate speculative bubbles, wherein hard money chased after paper in the hope of making profits simply by virtue of everyone's expectation (mistaken, of course) that the value of the paper would increase indefinitely. In France, John Law's Mississippi Bubble led to a speculative mania and a spectacular collapse that bankrupted thousands and drove the monarchy, once and for all, away from efforts to establish public credit. In Britain, the contemporaneous South Sea Bubble bred an even greater speculative mania (including the famous prospectus for a "Company for carrying on an Undertaking of great Advantage, but Nobody to know what it is" -- which Macdonald thinks probably never actually existed), and an equally spectacular collapse. Fortunately for Britain, however, Sir Robert Walpole and the Bank of England managed to restore order and to place English public finance on a permanently solid footing.

The result was momentous. During the century of almost perpetual war for domination between France and England, England's coffers were always full and France's were always on the brink of exhaustion, and accordingly England triumphed. Even Napoleon, who financed his wars mainly on the ancient principle of conquer and loot, was outspent and bested by Britain. As an aside, it should be noted that Britain's per capita public debt ran as high as 300 percent of the estimated gross national product, a figure that dwarfs the American public debt as of 2003.

Now back to post-revolutionary America, where ambiguity over private indebtedness was compounded by ambiguity over the public debt. A handful of American political leaders had studied the British fiscal system and perceived that to manage the public funds of the United States in a similar way would enormously strengthen the Union. Most, however, had learned to distrust and fear the British system. A host of commentators, from Trenchard and Gordon (in Cato's Letters) to Viscount Bolingbroke and his circle had denounced Walpole and the financial revolution in terms that bordered on the hysterical. Investors in Britain's public debt, "money-men," were castigated as blood-suckers who lived by dealing in paper at the expense of the yeomanry and gentry, undermining the traditional agrarian order and destroying the balance of the English constitution. Unless a "patriot king" came along to cast the money-changers out of the temple, English liberty would be lost forever. Most Americans had concluded by 1776 that liberty in the mother country was a thing of the past, and that any attempts to install a Walpolean fiscal order in America would result in the loss of liberty here.

Installing a Walpole-style fiscal order was precisely what Treasury Secretary Alexander Hamilton had in mind, and when his scheme for funding the national debt, assuming the state debts, and instituting the Bank of the United States was in place, public credit was almost instantly restored -- or, more properly, established for the first time. To those, such as President Washington, who had experienced first-hand the idiocy of financing a war without credit, the achievement seemed miraculous.

Others, however, led by Secretary of State Thomas Jefferson, slowly perceived the implications of Hamilton's program and sought to destroy it. They attempted, following Bolingbroke's advice, to appeal to a patriot king, Washington, to overthrow the system, and when that failed they used Bolingbroke's back-up plan, to organize a "country party" of the whole people to gain control of the national government and bring about the same end. And, in 1800, the Jeffersonian Republicans won the ascendancy.

Things did not work out the way they planned. Indeed, after they killed the Bank on the eve of the War of 1812 and brought disgrace to the nation, Jefferson's former followers re-enacted most of Hamilton's program. Hostility and fear regarding public finance survived in the form of Jacksonian Democracy, and the destructive measures of the Jacksonians wreaked havoc upon the country's economy. Not until World War I was a stable system of public finance finally established in the United States.

In the meantime, private indebtedness came close to undermining the Hamiltonian order in quite the way that John Law's plan was wrecked, namely, through speculative bubbles. The first bubble, in 1792, took place due to the machinations of William Duer, a perfidious sometime friend of Hamilton's who temporarily worked as a Treasury Department agent until he had to be eased out for improprieties. Duer and his associates gambled in public paper as well as stock in the Bank of the United States and private banks. His plans were so complex that not even his closest associates knew what he was about, if indeed he knew himself; in any event, prices temporarily collapsed and Duer and hundreds of associates went broke and were sent to debtors' prisons. The second bubble came five years later. At the center of it was Robert Morris, erstwhile financier of the Revolution. It involved land operations more than public paper, and when it collapsed it brought down thousands of investors, most of whom likewise were confined to debtors' prisons. (Bruce Mann follows his narratives of these bubbles with several chapters on conditions in the prisons -- surprisingly civilized -- and one on the ill-fated Bankruptcy Act of 1800. This makes for fascinating, if disjointed reading.)

The two books are valuable contributions, and though most historians' eyes glaze over at the mention of financial matters, all could profit from reading them. I would close, however, with a pair of demurrers, for each book is marked by a large oversight. In Macdonald's case, he never tells us that the British public debt, in addition to working wonders for the nation commercially as well as financing wars, provided the basis for England's currency. The country's money supply consisted largely of notes of the Bank of England, issued against public debt certificates held in the Bank's vaults. Thus deficit financing not only kept England solvent; every issue of new government paper increased the circulating medium. The oversight in Mann's book is that he fails to understand that the biggest speculators operated in public lands, for which they contracted to pay in public securities at their face value, even though -- prior to the establishment of Hamilton's system -- the securities could be bought for ten to fifteen cents on the dollar. The Hamiltonian program sent public paper soaring to and even beyond its par value, with the result that speculators, in order to meet their obligations, had to pay several times as much as they had bargained for. It was small wonder that so many of them went broke, and a large wonder that the Hamiltonian system survived anyway.

JAMES MACDONALD, A FREE NATION DEEP IN DEBT: THE FINANCIAL ROOTS OF DEMOCRACY
Reviewed by Robert E. Wright, Stern School of Business, New York University

[James Macdonald, A Free Nation Deep in Debt: The Financial Roots of Democracy. Princeton: Princeton University Press, 2006. ix + 564 pp. $20 (paperback), ISBN: 0-691-12632-1.

Storied trade publishing house Farrar, Straus and Giroux (FSG) published A Free Nation Deep in Debt in cloth in 2003 but did not see fit to send a copy to EH.Net for review. Princeton University Press, the publisher of the new paperback edition technically reviewed here, is taking closer aim at the scholarly market. That is likely a good call. Though ably written, this book is closer in tone, density, and substance to a scholarly tome than a bookstore blockbuster. Likely, FSG was attracted to the book's Niall Ferguson-esque Big Thesis: Democracies eventually defeat autocracies because "countries with representative institutions are able to borrow more cheaply than those with autocratic governments" (p. 4). Bond markets also strengthen democracies internally by giving citizens some of the proverbial power of the purse and by aligning their interests with those of their governments. Heady, important stuff.

To prove his thesis, James Macdonald, a British investment banker and independent scholar, has written a wide-ranging survey of the co-evolution of representative governments and public debt markets. He starts with the Old Testament, which he uses as a primary source to explicate the transition of societies from a Lockean state of nature to autocracy. Small family groups that highly valued leisure were subsumed or slaughtered by larger and more powerfully organized autocracies that forced their subjects through taxation to create economic surpluses. Autocracies soon came to control much of the ancient world but found it impossible to control the vast expanses of Asia, the forests and fjords of Northern Europe, or the jungles of Africa. A few small city states, often strengthened by alliances with other nearby cities, also managed to hold off the imperial advance for a time.

The ancient autocracies financed wars from savings, their legendary "treasure troves," and equity contracts that divided the spoils of war. The democratic city states, by contrast, borrowed to fund resistance to imperial encroachments. "The picture that emerges," however, was "not of a regular system of public finance, but of a series of improvised reactions to fiscal emergencies" (p. 36). The ancient Greeks, for example, moved toward modern public credit but never explicitly connected "the principle of voluntary contribution to the public funds and the principle of distribution of surplus assets" (p. 36). The result was a dizzying array of debt instruments, some forced and some voluntary, some paying interest and others not, most short-term but some in the form of life annuities. The Greeks sometimes found it difficult to honor their obligations but the extant documentation is too sparse to say anything more definitive about their creditworthiness.

Modern public finance had to await the emergence of a different group of city states some 1,500 years later in the northern Italian peninsula. There emerged, for the first time since the fall of Carthage, a group of states run by merchants instead of soldiers. Desperate to maintain their freedom from regional despots, the representative governments of Venice, Florence, and Genoa hit upon the notion of repayable taxes, levies upon which interest would be paid if the government's finances allowed. To evade the Church's then stringent usury prohibition, repayment of the principal sum was left at the pleasure of the government. The Venetians circumvented that inconvenience by making the right to receive the tax repayments transferable to third parties, which quickly led to the creation of a secondary market. "They had invented the bond market" (p. 77) as Macdonald writes, but the Italian city states did not regularly pay interest on their repayable taxes, the market prices of which spiraled downward. City states in northern Europe eventually improved upon the Italian model by avoiding forced loans and repayable taxes and religiously servicing their debts. The Dutch Republic was the major innovator here.

Medieval and Early Modern European autocrats also borrowed but almost invariably eventually defaulted. Unsurprisingly, they could not borrow as much or as cheaply as the Dutch, who won their independence by wearing down the once mighty Hapsburg Empire. By the end of the 80-year struggle, a majority of Dutch households were creditors to their government. Default, rebellion, or large scale tax evasion became unthinkable because the interests of the government and the citizenry were thoroughly intertwined.

After revolutions of their own in 1688 and 1776, the British and the Americans adopted Dutch-style finance, funding their wars in large measure by selling bonds to citizen creditors rather than resorting to punitive levels of taxation, ruinous inflation, or physical coercion. The democracies thrived, while autocracies in France, Germany, Russia, and elsewhere lost wars and rebellions. By World War II, however, government wartime financial techniques, including financial repression, rationing, and payroll deduction, had become so powerful that the great patriotic bond drives of earlier wars lost much of their importance. The wartime financial system of that greatest of autocrats, Adolf Hitler, looked eerily similar to that of the United States.

If Macdonald is right -- and there is more than a little truth in this book -- then adherents of the English "Country" and American Jeffersonian Republican traditions exaggerated the negative aspects of national debts. Far from endangering democracies, national debts bolstered them by enabling them to defeat powerful external and internal foes. Eternal interest was as much the price of liberty as eternal vigilance.

Authors who dare proffer such a Big Thesis confront numerous tradeoffs, the most important of which is that between depth and breadth. A twenty-page bibliography is always impressive, but less so for a book that covers several millennia of finance, government, and politics. Specialists will likely be disappointed with the treatment of their areas of expertise. (I cringed at several points in his discussion of the early U.S. monetary and financial systems.) But readers should concentrate on the forest rather than the trees and judge this ambitious and important book on its panoramic vision.

--Robert E. Wright teaches business, economic, and financial history at the Stern School of Business, New York University. His most recent books include The First Wall Street: Chestnut Street, Philadelphia, and the Birth of American Finance (Chicago, 2005) and Financial Founding Fathers: The Men Who Made America Rich (Chicago, 2006, with David J. Cowen). He is currently working on a book tentatively titled Financing Freedom that will describe how the entire financial system, not just the government securities market, enabled America to vanquish its most dangerous enemies at home and abroad.