Government Equity and Money: John Law's System in 1720 France

The paper treats Law’s System as an unusually clear illustration of the government budget constraint and the choice of liability structure across time and states, framing the System as an early, deliberate attempt to move government debt closer to equity (Introduction, p. 1). Velde invokes Sims (2001), who argues “government debt is like private debt in a fixed exchange rate regime, but like private equity in a flexible rate regime,” and notes that France was “notionally on a fixed exchange rate regime (with frequent departures),” so that Law’s System can be read as “an attempt to move government debt closer to equity without sacrificing price stability” (pp. 1-2).

At Louis XIV’s death in 1715, France carried debts of 2800 million livres (mL) – 1068mL in perpetual annuities, 830mL in sold offices, and 920mL in floating short-term debt – against interest payments of about 86.5mL and a primary surplus of only 48mL, a debt burden the paper notes was larger relative to output than contemporary Britain’s (Section 2.5, pp. 7-9). The Regent’s government under the duke of Noailles responded with partial defaults on the annuities, offices, and floating debt, two currency devaluations that captured 20-33 percent seigniorage, and conversion of most of the floating debt into “billets d’État” bonds trading at a 37 percent discount, bringing the primary surplus to 93.5mL by 1718 – measures the author summarizes as “the most traditional methods of French public finances… monetary manipulations, disguised or overt defaults, arbitrary fines,” which “put an end to the emergency, but left the State militarily diminished” (p. 9).

The Bank’s notes became attractive largely because they were made legal tender for taxes and because, unlike coins, note-holders were insulated from the losses that recurrent devaluations of the silver coinage imposed on coin-holders (Section 3.2, pp. 11-12). A 1716 decree had tax collectors redeem the notes on demand, and an April 1717 decree made them explicit legal tender for individual tax payments; because the notes promised payment “of the weight and fineness of this day,” when new, lighter silver coins were issued in 1718 with a higher face value, a decree clarified that existing 100-écu notes would still be accepted at the new, higher 600-livre value, so that “the holder of a 100 écus note… was thus clearly better off than the holder of coins” – in effect a subsidy that waived part of the seigniorage tax for note-holders (p. 12).

Beginning August 27, 1719, the Company offered the government a perpetual loan (eventually raised to 1600mL) at 3 percent, and the government used the proceeds to compulsorily buy out most of the existing perpetual annuities and other listed debts, with bondholders receiving Treasury drafts payable by the Company in specie or notes at the bondholder’s choice (Section 5.1, pp. 19-21). Although initially authorized to raise the funds by selling 3 percent bonds, the Company instead financed the buy-out entirely through new share issues – the share price rose from 3600 livres on August 26 to 5350 by September 9, and further share sales of 1500mL followed at 5000 livres – so that, in Velde’s words, “the operation was simply a gigantic swap of government bonds, bearing on average 4.5%, for Company equity” (p. 21).

Velde estimates that the Company’s shares were overvalued at their January 1720 peak of 9000-10,000 livres by a factor of roughly two to five relative to a defensible valuation based on the Company’s own disclosed earnings prospects (Sections 8.2.1-8.2.3, pp. 45-48). Reworking the Company’s December 1719 revenue projections (used to justify a 200-livre dividend) down to a “revised” estimate of about 75.5mL in sustainable annual revenue, and applying a price-dividend ratio of about 15 – drawn from how the Company’s shares and comparable French government debt were later priced on the market – yields an implied valuation of about 1875 livres per share, “one fifth of the peak share price of 9000L,” with even generous assumptions about interest-rate reductions Law’s System might have produced narrowing this only to a factor of about two.

The System collapsed because sustaining an overvalued share price required continuously escalating note issue, and once Law tried to slow that issue in early 1720 the share price fell, forcing a series of contradictory reversals that made an orderly retreat impossible (Sections 6.1-6.2, pp. 28-31; 8.4, pp. 49-50). On February 22, 1720, Law merged the Bank into the Company, capped further note issue, and halted price support, and the share price immediately fell from 9925 to 8500 livres; days later he reversed course, pegged shares at 9000 livres, and launched a plan to eliminate metallic money entirely, before a further devaluation of shares and notes on May 21 provoked public outrage severe enough that it was rescinded within a week. As Velde puts it, “once Law started backtracking, in May 1720, no orderly retreat was possible.”

From his recall to office in June 1720, Law pursued three channels to withdraw notes from circulation – converting them into new government or Company annuities, into new “bank account” balances, and into new Company shares – but all three proved slow, retiring only a fraction of the outstanding note stock before the System was abandoned (Section 6.3, pp. 31-34). By mid-July 1720 only 159mL of the newly offered government annuities had been subscribed against an intended 1000mL, and the bank accounts, intended to soak up 600mL, ultimately absorbed only 239mL; the bank note was formally slated for demonetization from August 1720, and “the bank note continued to depreciate” even as the demonetization timetable was repeatedly moved forward.

The Visa (1721-1722) required holders of every System-era instrument to submit their claims and explain how they had acquired them, then reduced the roughly 2211mL in claims actually submitted to about 1700mL in new perpetual and life annuities via a matrix of reduction coefficients that spared claims of 500 livres or less entirely but cut larger claims by 39 percent on average (Section 7.1, pp. 36-37). Velde’s overall accounting concludes that of about 2800mL in notes ever issued, roughly 2200mL ended up converted into government bonds through the Visa, with the rest redeemed in coin or converted into shares, and that the resulting French public debt level in the mid-1720s “was roughly the same… as it was in 1717 after the operations of the Noailles administration” (Section 8.5, p. 50).

Velde concludes the System involved genuine overvaluation sustained by market manipulation, only a modest net default on the order of 5 to 10 percent, and no evidence that Law was a swindler (Sections 8.2.4 and 8.5, pp. 49-50). He argues that from late 1719 onward “one cannot consider the ‘market’ price to represent anything but Law’s policies,” so the share-price rise reflected sustained price support rather than an unmanipulated bubble; he characterizes the debt reduction achieved through the Visa as “modest by the standards of the Old Regime,” disputing Marion’s characterization of it as “yet another default”; and he notes that Law’s Company was “not an empty shell” but immediately engaged in real trade and colonization, and that Law himself invested his own fortune in French real estate rather than fleeing with the proceeds – “not a good move for someone planning a quick getaway.”

Velde judges the System’s underlying logic – backing government liabilities with an explicitly stochastic revenue stream, managed by a single entity – as not conceptually absurd and, under sufficiently optimistic but not unreasonable assumptions, potentially workable at a lower share price, but finds Law’s insistence on pegging shares far above that level harder to justify (Section 8.3-8.4, pp. 48-50). He calculates that a 125-livre dividend combined with a Dutch-style 3 percent interest rate could support a valuation of about 5000 livres, “the price at which Law launched his debt conversion in September 1719,” concluding “it is possible to accept that the System could have worked” at that level; but for the far higher prices Law defended into 1720, Velde considers and partly discounts an insider-profit-taking explanation from Lüthy, concluding instead “it seems more likely that he miscalculated the price of shares… at which he thought the System was sustainable.”