JOHN LAW THE FINANCIAL INNOVATOR

# This is a chapter for a book on The History of Corporate Finance edited by G. Poitras – to be published shortly #

JOHN LAW THE FINANCIAL INNOVATOR,
by Antoin E. Murphy, Department of Economics, Trinity College, Dublin.

"When John Law converted to Catholicism, a necessary change for him to become the effective Prime Minister of France (Contrôlleur Général des Finances) in January 1720, one wag commented that he would have no difficulty with the doctrine of transubstantiation as he had already achieved a similar feat in transubstantiating the French monetary system from specie to paper money. John Law, the counter alchemist, was a man of change, of metamorphosis, of transformation. He changed his profile from that of a rake to a serious monetary projector, he converted from Protestantism to Catholicism, and he altered his nationality to become a Frenchman.

Central to Law’s desire for change was his belief that the financial architecture of his time needed to be dramatically re-structured. This re-structuring involved a financial revolution. The very foundations of the French financial system were embedded on metallic money, foundations which he believed blocked the development of the economy. From an early stage – he had started writing on economic issues by 1704 - he identified the possibility of substituting paper money and bank credit for metallic money. By 1720 he had achieved this dream in that France had become specie-less. This was a dramatic financial revolution causing Nicolas Du Tot, the under treasurer of the Royal Bank, to later remark that posterity would scarcely believe that this had happened. Changing one’s religion and one’s nationality was not atypical of eighteenth century life. The ‘Glorious Revolution’ in England and the Revocation of the Edict of Nantes in France by Louis XIV were major factors in causing the interchange of religions and nationalities. However, the transformation of the financial architecture of a major economy away from gold and silver to paper money was a change of a very different order of magnitude. The achievement of this, albeit for a brief period in 1719-20, presaged the future global monetary system that would not be reached until the U.S. broke the last formal links with the gold standard in 1971. In this paper the question will be asked as to how someone with such a chequered background as that of John Law could have produced this financial revolution in Europe’s most powerful economic nation, France. How could a Scotsman2with the reputation of a rake and a gambler who had been convicted for murdering a man in a duel come to such prominence and have his ideas accepted in France?

Financial revolutions are a product of ideas and circumstances. The ideas emerge during periods when the existing orthodoxy is under pressure because of historical circumstances that cause people to have doubts about the efficiency and/or relevance of the current system. At these two levels of ideas and circumstances it may be seen how Law was able to initiate his programme for change in France. To do so he needed to challenge the existing theoretical orthodoxy through his economic writings. But he also needed to find the historical circumstances propitious to the acceptance of these ideas. In this paper it will be argued that circumstances in the form of Law’s Scottish banking background were an important initiating catalyst for sparking his interest in monetary theory. It will then be showed how he was able to produce a range of cogently argued ideas in 1704 and 1705 through John Law’s Essay on a Land Bank (1994) and Money and Trade (1705). In these works he contended that it was not necessary to base the monetary system on an intrinsically valuable metallic money and that a bank based system could be used to increase economic activity. These ideas constituted the template for his views on monetary policy. But then, after his ideas were rejected by the English authorities and the Scottish Parliament, it seemed that he was just a prophet speaking in an arid desert. No one appeared to want his ideas to be implemented as policy. It took another ten year for circumstances to intervene and when they did Law was ready. It will be argued that the circumstances took the form of Louis XIV’s legacy of a bankrupted French economy. The need to re-structure the financial system and to punish the perceived profiteers provided Law with the opportunity to present his ideas. The monetary and financial crises that the French Crown faced led to Law implementing his System. The Chamber of Justice, introduced to punish the profiteers, led to the silencing of Law’s potential critics for a critical two year period allowing him to the put the System in place. In the final section the inherent tensions created by the System are analysed.

SCOTTISH CIRCUMSTANCES

Law’s Scottish milieu was an initiating catalyst in encouraging this change mentality that imbued his career. Born in Edinburgh, in 1671, he was the son of an Edinburgh3goldsmith. Whilst first appearances could have created the impression that the goldsmiths were the custodians of gold and silver a more detailed analysis of their operations shows that they were actually moving away from such a role to becoming embryonic bankers by lending out part of the money deposited with them to borrowers. Furthermore banking ideas were very much in the air in Scotland. A Scottish projector, William Paterson, had been instrumental in establishing the Bank of England in 1694. A year later Scotland’s first joint-stock bank, the Bank of Scotland, was established. This was followed by the establishment of two further joint-stock banks, the Royal Bank of Scotland in 1727 and the British Linen Company in 1746. Thus, by the middle of the eighteenth century Scotland had produced three publicly quoted joint-stock banks as against one, the Bank of England, south of the border.As the son of a Scottish goldsmith Law was able to activate his incipient banking gene once he had sown his ‘wild oats’ in London in the 1690s and escaped from jail while awaiting the death sentence for having killed Edmund Wilson in a duel in Bloomsbury Square in London. London at this time was a centre of change, both at the political and financial levels. The change in monarchical dynasties that had led to the replacement of the Catholic James II by the Protestant William of Orange also produced a far stronger Parliamentary system built on the Lockean principles of government by consent of the people. New ideas were in the air. Banking and financial ideas were imported from the King’s old country, Holland. The ‘Glorious Revolution’ saw the quick introduction of the Bank of England – a far more daring innovation than the Bank of Amsterdam. There was a spurt of small company flotations and contemporary pamphlets abounded in new ideas on how to change the financial system. Chief amongst the latter was the idea to launch land banks. The inspiration for this had earlier been developed in the 1650s by William Potter. In the 1690s the establishment of the Bank of England prompted a wide range of projectors to propose that land banks, with land constituting the collateral for the banknotes they issued, would be far more suitable financial institutions than the Bank of England – see Horsefield (1960). So from this perspective Law was not offering an original proposal when he successively suggested to the English (1704), Scottish (1705) and French (1706) governments his recommendations to establish a land based bank. The revolutionary element in his proposals was his method of formulating the economic 4theory behind his proposals. Law rose like a new fish in the pool of land bank projectors using a language and terminology that was so modern that it distanced him from his competitors.

LAW’S ECONOMIC THEORIES

In the ‘Essay on a Land Bank’, published recently as John Law’s Essay on a Land Bank (1994), that he sent to Lord Godolphin in 1704, Law first introduced the term ‘demand’ into the economics lexicon.i More importantly he was able to show how the interaction of supply [quantity] and demand influence price. Then, building on the concept of demand he coined the term the demand for money. This enabled him to discuss the determination of the overall price level in a supply and demand for money framework. Law showed how, if the money supply was increased out of line with the demand for money, prices would rise. His analysis of inflation in this supply and demand for money framework may be regarded as very modern some two hundred and fifty years before Friedman (1956) re-interpreted the quantity theory of money in such a way.There were many other major monetary features in this work particularly Law’s definition of money. He defined money as follows:

Money is used as the measure by which goods are valued, as the value by
which goods are exchanged and in which contracts are made payable (1994:
55)

Law’s insistence that money was the value by which goods were exchanged represented a massive break with the existing orthodoxy that defined money as the value for which goods were exchanged. Law’s replacement of the preposition ‘for’ with ‘by’ showed that he believed that money did not need to be intrinsically valuable. By decoupling money from intrinsic value he produced an alternative conceptualization to the metallist view of money. This decoupling involved a significant liberation in that instead of waiting for the supply of money to be changed by the vagaries of metallic discoveries it was possible to have a flexible money supply through the development of its banking system. If money was in short supply the policy maker could arrange for the issue of more banknotes/bank credit to meet the shortage. Here Law believed that it was vital for the policymaker to have this type of power because he believed that money drove economic activity. If there5was unemployment and underutilization of resources money could and should be used to expand economic activity.While Law emphasised the inflation problem in the Essay and discussed it in Money and Trade the main focus of the latter work was the link between money and output. The title of the work Money and Trade showed Law’s concern for the interrelationship between money and trade. Trade may be interpreted as a synonym for output. Law wished to show that there was a direct relationship between money and trade (output) with the causality running from money to trade. Scotland, and later France, he believed, were suffering from significant unemployment and under-utilization of resources. He identified the cause for this arising from a shortage of money in both economies. To show the beneficial effects of increasing the supply of money Law elaborated the basic elements of the circular flow of income, a theory which his rival Richard Cantillon would later develop in the Essai sur la nature du commerce en general (1755), and, which would be put, still later, into diagrammatic format by François Quesnay in the Tableau Economique.

..." (본문 중에서. 6쪽 중반까지)