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May 31, 2008

Economist's View - 5 new articles

"Embedded vs. Non-Embedded Inflation"

Paul Krugman explains why the Fed focuses on core rather than headline inflation. I've made this argument a different way, but it's basically the same argument. Boiled down, the argument is that the problem prices are the sticky prices, not the prices like those on food and energy that are flexible, and you want an index (core inflation) that best highlights the problem, i.e. that includes only the problem prices and throws out the ones that can be left to adjust on their own (I prefer measures that trim out the most volatile prices or use other mechanisms to extract the slowly adjusting prices rather than simply tossing out food and energy, but that's a technical point).

Here's how Krugman explains the intuition (the exact story is model dependent, but the intuition almost always comes down to indexing the problem prices so that they stand out, and leaving the other prices to take care of themselves, and expectations of inflation are a key part of the story). But more important than the explanation for why the Fed focuses on core inflation is the conclusion Krugman comes to, that the Fed shouldn't let worries about inflation interfere with stabilization of the financial sector and the broader economy:

Embedded vs. non-embedded inflation, by Paul Krugman: The big economic debate of the moment is whether the Fed and its peers have made a terrible mistake by focusing on staving off financial crisis while more or less ignoring the rise of inflation. "Inflation is rising and it seems the world's central banks have critically misjudged the situation," says Wolfgang Munchau in the FT. I've heard even more apocalyptic views from some serious people in the last couple of weeks. As it happens, I don't agree. And I thought it's worth spelling out why — especially because many if not most of the participants in this debate don't explain their premises very clearly. So: when is it appropriate to get very concerned about inflation, and when is it OK to assume that a rise in prices is a temporary shock that will pass? The answer is that inflation becomes a big problem if it becomes "embedded" in the economy, which makes it hard to restore more or less stable prices. But how does inflation get embedded? [Here's how...]

So now you've read Krugman and you are confused. I've talked about core measures of price inflation, yet Krugman is worried about wages adjusting sluggishly. How can the two views be reconciled? There is a larger theory that says to include any price that adjusts slowly, whether it's an input price or an output price, in Fed's monetary policy rule. Here's Michael Woodford:

The theory also provides important insights into the question of which price index or indexes it is more important to stabilize. Again, the answer depends on the nature of the nominal rigidities. If prices are adjusted more frequently in some sectors of the economy than in others, then the welfare-theoretic loss function puts more weight on variations in prices in the sectors where prices are stickier... This provides a theoretical basis for seeking to stabilize an appropriately defined measure of "core" inflation rather than an equally weighted price index. .... Similarly, if wages are sticky as are goods prices, as implied by many empirical ... models, then instability in the rate of growth of a broad index of nominal wages results in distortions similar to those created by variations in goods price inflation. If [adjustments in] wages are staggered ..., then the welfare-theoretic loss function includes a term proportional to the squared rate of goods price inflation and another term proportional to the squared rate of wage inflation each period. In this case, optimal policy involves a tradeoff between inflation stabilization, nominal wage growth stabilization, and output-gap stabilization...

I should also add that, under some theoretical formulations, asset prices should also be part of the Fed's monetary policy decision rule. However, for the most part, asset prices exhibit a high degree of flexibility so little is lost from leaving those prices out. However, as I've argued before, an exception is housing prices - they can exhibit downward rigidity - and this is a reason to consider including housing prices in decisions about the direction of monetary policy, something that would cause the Fed to lean against housing price bubbles as they are inflating.

One final note. Some people will disagree that the Fed should worry about wage inflation, i.e. they will say that the Fed moves to suppress wages whenever workers begin to realize gains and hence works against their interests. But I think that wage inflation that exceeds productivity growth hurts workers in the long-run. Thus, it's something to avoided.

Greg Mankiw: The Problem With the Corporate Tax

Greg Mankiw wants a cut in the corporate income tax:

The Problem With the Corporate Tax, by N. Gregory Mankiw, Economic Scene, NY Times: At this point in the presidential campaign, Senator John McCain is the candidate of ideas on issues of tax policy. Too many ideas, in fact. While some of his ideas are great, others are almost laughable. The one that has received the most attention recently — a gas-tax holiday — falls in the second category. ...

Lost in this hubbub, however, is a bigger idea that Mr. McCain and his economic team have put forward: a cut in the corporate tax rate, to 25 percent from 35 percent. It is perhaps the best simple recipe for promoting long-run growth in American living standards. ...

A cut in the corporate tax as Mr. McCain proposes would initially give a boost to after-tax profits and stock prices, but the results would not end there. A stronger stock market would lead to more capital investment. More investment would lead to greater productivity. Greater productivity would lead to higher wages for workers and lower prices for customers. Populist critics deride this train of logic as "trickle-down economics." But it is more accurate to call it textbook economics. ...

Compared with other ways of funding the government, the corporate tax is particularly hard on economic growth. A C.B.O. report in 2005 concluded that the "distortions that the corporate income tax induces are large compared with the revenues that the tax generates." Reducing these distortions would lead to better-paying jobs.

Of course, a corporate tax cut would affect the federal budget. ... Cutting the rate to 25 percent would seem to cost the Treasury about $100 billion a year.

Part of that revenue loss, however, would be recouped through other taxes. To the extent that shareholders would benefit, they would pay higher taxes on dividends, capital gains and withdrawals from their retirement accounts. To the extent that workers would benefit, they would pay higher payroll and income taxes. Increased economic growth would tend to raise tax revenue from all sources.

Some economists think that these effects are strong enough to make a corporate rate cut self-financing. A recent study by Alex Brill and Kevin A. Hassett of the American Enterprise Institute, looking at countries in the Organization for Economic Cooperation and Development, supports exactly that conclusion. But even if that turns out to be too optimistic, both theory and evidence make it reasonable to expect a significant discount from the sticker price. In the end, the net budgetary cost of the tax cut might be, say, $50 billion a year.

Senator McCain wants to fill that hole in the budget by restraining spending. If he can stop bloated legislation like the recent $300 billion farm bill from becoming law, more power to him.

But in case that quest proves quixotic, I have a back-up plan for him: increase the gasoline tax..., a gas-tax increase of about 40 cents a gallon could fund a corporate rate cut, fostering economic growth and reducing a variety of driving-related problems.

Indeed, if we increased the tax on gasoline to the level that many experts consider optimal, we could raise enough revenue to eliminate the corporate income tax. And the price at the pump would still be far lower in the United States than in much of Europe.

Don't laugh. I'm serious.

I think a 50% recovery rate on tax revenues is far too optimistic, and I'm disappointed that Greg would even hint that the tax cut would be self-financing.

[He also discusses the distribution of the tax burden, but the 70% figure he cites as the amount of corporate taxes paid by labor relies upon an assumption of perfect capital mobility (and other assumptions), and he doesn't include how the burden of paying for the corporate tax cut would be distributed, i.e. how the gas tax or any other means of paying for the tax cut would be distributed across households. So the analysis of the tax burden is a bit incomplete and relies upon some fairly optimistic assumptions. I'm not opposed to either change, but the distributional consequences need more consideration. Predictions about the distributional consequences of policies that rely upon trickle down arguments have not been accurate in the past, and we should be wary when they are used to justify further cuts in taxes.]

From comments:

Corporate Tax Declines and U.S. Inequality, By John Irons, April 9, 2008: Over the last 60 years, the U.S. tax code has dramatically shifted away from corporate taxes and toward taxes on individuals, especially through the payroll tax, the financing backbone of Social Security and Medicare. In the 1950s, the corporate income tax brought in, on average, one of every four dollars in federal tax revenues. By the 2000s, however, it raised just one of every 10 tax dollars. The shrinking share of corporate taxes was made up by an increase in payroll taxes to fund social insurance and retirement programs. Excise and other taxes—such as fuel taxes, phone taxes, etc.—shrank as well over the last 60 years, while the individual federal income tax rose slightly, from an average of 43% of total federal revenue in the 1950s to 46% in the 2000s. This shift is important because of who pays these different taxes. The corporate income tax is significantly more progressive than other taxes. Those with incomes in the top 20% of the income distribution (those making more than about $86,000 a year in 2007) pay four times the average tax rate on corporate income than the middle 20% (those making between $27,000 and $48,000); while, for the payroll tax, those in the top 20% actually pay less than those in the middle as a share of their income. This shift has been one of the factors leading to the drop in average federal tax rates for the very highest earners. Between 1960 and 2004, the average tax rate has fallen by about 14 percentage points (from 44.4% to 30.4%) for the top 1% of earners (those making more than $435,000 in 2007), while it has increased slightly (from 15.9% to 16.1%) for those in the middle 20%. Without offsets, further erosion of corporate tax revenues—either through lower statutory tax rates or through special preferences—would expand the already wide and growing income inequality in the United States.

Stephen Gordon makes the point that the countries with larger social insurance programs generally have lower corporate taxes than the U.S., but they also do much more redistribution after taxes are collected so that the net tax burden is fairly progressive even when they rely on fairly flat tax collection mechanisms such as a value-added tax. These redistribution programs are an important part of those systems.

Obama Should Agree to Go to Iraq with McCain

McCain keeps asking Obama to go to Iraq with him. Even though the people responsible for security have said they would not allow them to go to Iraq together, and Obama has declined, I think it's a good idea. It would be a great opportunity for Obama to straighten out McCain on all the things he has wrong about Iraq. In the past, McCain has had Joe Lieberman around to whisper in his ear when he makes great big mistakes. But Lieberman has his own problems and his own misperceptions, and he can't always be there, and Barack is a much better choice if the goal is to gain a clearer understanding of the political, economic, social, military, and other issues that make Iraq and the greater area such a complicated and difficult problem to solve.

Let's start with an easy one. If the two of them were there today, Obama could point to troops and say see those people in uniform? There's 155,000 of them - more than the pre surge levels. I know you have trouble with technical stuff, economics, that sort of thing, but this is easy John - 155,000 is a bigger number than 130,000 so we are not back down to pre surge levels like you have claimed. And if the numbers have changed by the time they get there, it will still be worthwhile for Obama to explain why it's important for someone wanting to be the Commander in Chief to keep track of how many soldiers we have deployed.

He could point to Mosul and say, I know you said that things are quiet there, but on a day when there were three suicide bombings, it's probably best to describe it some other way.

He could, and this is important for McCain to learn because he's made this mistake more than once, set up meetings with Sunnis and Shi'as. Then, - very slowly because as, as just noted, McCain has trouble on this one - explain how they differ and why it's important to understand the difference.

And as a follow up to the previous point, once McCain does finally get this distinction, Obama could point out that understanding this will help him to avoid saying it's common knowledge that Iran is training Al Qaida when it's not true (though this is one case where, when he said this, the ear whispering Lieberman did cause him to correct his obvious lack of knowledge).

Speaking of Iran, though they wouldn't actually be in Iran, it's bound to come up, and when it does it would be a great opportunity to explain to McCain how Iran's government is structured. McCain has been confused about who leads Iran, so once again, Barack could help McCain with this. And he could, yet again, also explain why it's important to get this right.

If they are walking through a market under very heavy military guard, if there's no other way to enter the area other than with armed escorts, Barack could explain how it's probably not quite correct to say the market is safe.

And, while they are strolling through the streets of Iraq protected by hordes of military personnel who could be doing more important things than setting up TV shots for campaigns, maybe Obama can talk about other things too, educate McCain on the economy, explain that tax cuts don't increase revenue, that sort of thing. It's a bit unrelated, but not completely given how poorly the Bush administration has handled economic development issues in Iraq.

So I can see why John McCain wants Barack Obama to come along to Iraq with him, he needs somebody with him who actually understands how the politics, economics, relations with nearby countries, military presence, and so on affects Iraq, he needs to hear from someone who had Iraq policy right from day one.

Why should Barack help McCain? Aren't they political opponents? Yes, but McCain, along with the noise machine that supports whatever he says no matter how daffy or gaffey, has been confusing the public about these issues. There are considerable misperceptions as a result of McCain's confusion and lack of knowledge. When Obama does win the presidency this fall, that confusion will make it much, much harder to do what needs to be done to get things back on the right track, so whatever he can do now to help to overcome those misperceptions will help to pave a smoother road to the future.

So go ahead, agree to accompany McCain to Iraq, he really needs you there. McCain has been there several times already, and his lack of knowledge shows he really needed to take those trips, but it hasn't been enough, he still gets key things wrong. You'd think he'd have figured it all out by now, if he could, that he would have had someone explain it again and again until he gets it, but maybe you can help him, and yourself, and all of us, by going along.

links for 2008-05-31

"Who Gentrifies Low-Income Neighborhoods?"

This examines the distributional impacts of gentrification. The results may not be what you expect:

Who Gentrifies Low-Income Neighborhoods?, by Terra McKinnish, Randall Walsh, and Kirk White NBER Working Paper No. 14036 May 2008 JEL No. J15,J60,R23 [Open Link]: Abstract This paper uses confidential Census data, specifically the 1990 and 2000 Census Long Form data, to study the demographic processes underlying the gentrification of low-income urban neighborhoods during the 1990's. In contrast to previous studies, the analysis is conducted at the more refined census-tract level with a narrower definition of gentrification and more closely matched comparison neighborhoods. The analysis is also richly disaggregated by demographic characteristic, uncovering differential patterns by race, education, age and family structure that would not have emerged in the more aggregate analysis in previous studies. The results provide no evidence of displacement of low-income non-white households in gentrifying neighborhoods. The bulk of the increase in average family income in gentrifying neighborhoods is attributed to black high school graduates and white college graduates. The disproportionate retention and income gains of the former and the disproportionate in-migration of the latter are distinguishing characteristics of gentrifying U.S. urban neighborhoods in the 1990's.

I. Introduction

"Concern, and anger, over gentrification has grown in communities across the country as housing rental and sales prices have soared .… there are numerous reports of resident displacement from neighborhoods long ignored that now attract higher-income households."1 -2006 Urban Institute Report

Over the past several decades, there has been substantial gentrification of low-income neighborhoods in many U.S. urban areas. These neighborhoods typically experience large increases in household income and housing prices. Some laud the revitalization of decayed neighborhoods and others criticize the displacement of low-income, often minority, households.

The distribution of benefits from neighborhood change is a crucial policy issue. Since 1974 the U.S. Department of Housing and Urban Development (HUD) has allocated nearly $120 Billion in Community Development Block Grants.2 These grants, that are intended to benefit low and moderate-income individuals by eliminating slums or blight and addressing urgent community development needs, have been allocated to more than 1000 U.S. cities. While public investment in neighborhood revitalization is ubiquitous, the consequences of neighborhood gentrification for low-income and minority individuals remain an open question.

Advocacy groups for low-income neighborhoods in cities across the U.S. have raised concerns about a potential link between gentrification and the displacement of existing low income and/or minority residents. In contrast, potential displacement from gentrifying neighborhoods does not appear to be a major concern for HUD.3 Given the high levels of public investment in improving neighborhood quality, it is important to understand which of these two policy perspectives accurately reflects the impacts of neighborhood gentrification vis-à-vis displacement of low-income households. Further, missing from this debate on displacement is consideration of both the role of in-migrants and the impacts of gentrification on households that remain in gentrifying neighborhoods.

Surprisingly, many questions regarding the distributional impacts of gentrification remain unanswered. Some recent studies have examined the issue of displacement, and have found little to suggest that low-income households exit gentrifying neighborhoods any faster than they exit other neighborhoods. These studies, however, have been severely constrained by data limitations. As a result they either define neighborhoods as rather large geographic areas (regions on the order of 100,000+ in population), use overly broad definitions of gentrification, and/or focus on a single location – raising issues about what broader inferences can be drawn from their results.4 Even less is known about the role of in-migration in gentrification and the impact of gentrification on residents who remain in neighborhoods that experience gentrification.

In this paper we take advantage of confidential Census data, specifically the 1990 and 2000 Census Long Form Data, to provide the richest study of gentrification to date. Overall, we find that rather than dislocating non-white households, gentrification creates neighborhoods that are attractive to middle-class minority households, particularly those with children or with elderly householders. Furthermore, there is evidence that gentrification may even increases incomes for these same households.

Our specific findings are: 1) In-migration of college graduates, particularly white college graduates under 40 without children, is a key characteristic of a gentrifying neighborhood; 2) The presence of children, an elderly householder or a householder with low educational attainment dampens the likelihood that a white household moves into a gentrifying neighborhood, but these same effects are not present, or even reversed, for black and Hispanic households; 3) We finds no evidence of disproportionate exit of low-education or minority householders, but do find evidence that gentrifying neighborhoods disproportionately retain black householders with a high school degree; 4) Decomposition of the total income gains in gentrifying neighborhoods attributes the bulk of the gains to two key groups: black high school graduates (due to disproportionate retention and income gains) and white college graduates (due to disproportionate in-migration and high incomes).


VI. Conclusions

... The findings suggest that rather than dislocating non-white households, gentrification creates neighborhoods that are attractive to middle-class minority households, particularly those with children or with elderly householders. One reasonable interpretation is that because these neighborhoods are experiencing income gains, but also more diverse with regards to race/ethnicity and income than established middle-class neighborhoods, they are desirable locations for non-white middle-class households.

May 30, 2008

Economist's View - 4 new articles

Ending the Soft Ride for Mendacious Politicians

Paul Krugman, "a self-described pussycat":

Maverick loads gun for new round of shots, by Ben Naparstek, Business Day: Today, Paul Krugman doesn't seem like a maverick. A CNN poll in April found George Bush to be the least popular American president in modern history... But in the run-up to the Iraq invasion, Krugman was one of the few pundits in the mainstream media to unflinchingly attack Bush. Since beginning his twice-weekly column in The New York Times in January 2000, Krugman has relentlessly accused Bush of lying — about the motives behind cutting taxes for the rich and attempting to roll back social security, for example, and about weapons of mass destruction in Iraq.

After the September 11, 2001, attacks, newspapers and magazines of the liberal centre ricocheted to the right. As the Times, The Washington Post, New Yorker and New Republic fell obediently in line with the Bush Administration, Krugman's heretical columns made him a poster boy for the anti-war left and a hate figure to neocons. "I was largely alone on the major op-ed pages," says the mild-mannered 55-year-old Princeton economics professor. "We look back now at 2002 and say, 'Nothing really bad happened to people. We did not have a new era of McCarthyism'. But that was very far from clear at the time. It was pretty frightening." ...

In the fevered climate of post-9/11 America, his outspokenness attracted death threats. But Krugman, a self-described pussycat, ... never set out to fight political battles. "It has been a much less easy life than I expected to be leading at this point. I should be sitting around in well-stuffed armchairs reflecting upon my life's research work."

When The New York Times approached Krugman to write a column in 1999, he wrongly presumed it wouldn't be too time-consuming. The main burden would be financial — the newspaper's conflict of interest rules prohibited him from giving corporate talks, for which he commanded up to $50,000. With the American political scene calm and the economy booming, Krugman expected to write about business deals, the internet, and developing world financial crises. But the 2000 presidential election politicised him. "A funny thing was happening. The candidate of one major party was being blatantly dishonest in what he said — at that point about economics — and no one was calling him on it." Krugman argues that the media give a soft ride to mendacious politicians because journalists are trained to consider two sides of any issue.

"If Bush said that the world was flat, the headline on the news analysis would read 'Shape of Earth: Views Differ'," he said in 2000. In "The Great Unravelling..., Krugman explains why many people failed to grasp the radicalism of the Bush agenda: "People who have been accustomed to stability can't bring themselves to believe what is happening when faced with a revolutionary power, and are therefore ineffective in opposing it."

He understands why journalists feared speaking up. "There really has been, for the most part, no reward for having gotten in front of the story and reporting what was going on. On the contrary, people who got it right have been fired and there's no cost to having gotten it wrong. Most news outlets are owned by large corporations. The journalists may be mostly highly educated people from the north-east who tend to be liberal, but the ultimate decisions on the coverage are made by people who are, on the whole, Republicans."

Whereas most Times columnists are career reporters, Krugman's academic background means he was never socialised to follow the dominant media line. ... Krugman maintains his independence by leading the relatively secluded life of a university professor in New Jersey. ...

Even Krugman's admirers sometimes flinch at his savagery. "He steps over the top," says Stiglitz, a Nobel Prize-winning economist and close acquaintance of Krugman. [ more...]

If the Democrats win this presidency this fall, it will be interesting to see how people react when he is writing about Democrats rather than Republicans (it already has been interesting). My view is that Krugman has been right when most everyone else was wrong, and, agree or disagree, he's earned the right to be heard.

Update: Free Exchange seems to have stumbled across the same article (it's from an Australian business publication) and comments here.

Update: Stephen Moore of the WSJ says:

A few weeks ago, I gave a talk about tax policy to a group of elderly people ... I reminded the audience that the estate tax is scheduled to fall from 45% today to zero in 2010, but then rise all the way up to 55% in 2011. I joked that what we have here is the "Throw Mama From the Train Tax."


Democrats are starting to wake up to the death-tax calamity

I'm afraid he has this wrong, he seems to just be waking up to this, but Krugman was all over this years ago - in 2001 - even using the same joke:

Reckonings; Bad Heir Day, by Paul Krugman, Commentary, NY Times, May 30, 2001: ...The Bush tax plan was always peculiar: in order to hide the true budget impact, its authors delayed many of the biggest tax cuts until late into the 10-year planning period; repeal of the estate tax, in particular, was put off to 2010. But even that left the books insufficiently cooked, so last week the conferees added a "sunset" clause, officially causing the whole bill to expire, and tax rates to bounce back to 2000 levels, at the beginning of 2011.

So in the law as now written, heirs to great wealth face the following situation: If your ailing mother passes away on Dec. 30, 2010, you inherit her estate tax-free. But if she makes it to Jan. 1, 2011, half the estate will be taxed away. That creates some interesting incentives. Maybe they should have called it the Throw Momma From the Train Act of 2001.

That's by no means the only weird element in the tax bill. ...

Moore tries to blame it on Democrats, then says:

the obvious solution to a death-tax nightmare scenario in 2010 is to make the estate-tax repeal permanent.

Krugman predicted this:

In short, the tax bill is a joke. But if the administration has its way, the joke is on us. For the bill is absurd by design. The administration, knowing that its tax cut wouldn't fit into any responsible budget, pushed through a bill that contains the things it wanted most -- big tax cuts for the very, very rich -- and used whatever accounting gimmicks it could find to make the overall budget impact seem smaller than it is. The idea is that when the absurdities become apparent -- when mobs of angry junior vice presidents from New Jersey start demonstrating against the A.M.T., or when elderly multimillionaires develop a suspiciously high rate of fatal accidents -- Congress will always respond with further tax cuts. ...

Someday, responsible politicians — or is that an oxymoron? — will have to untangle this mess. ... But for now, it's a defensive game. The administration, having successfully rammed through a ridiculous tax bill, will try to bamboozle us on other matters. ...

Aid to Poor Countries: "Cruel Joke" Week

Is the opening paragraph serious?:

Bread and Bush-bashing, by Chris Patten, Project Syndicate: I feel a little sorry for President Bush. Whatever his other many failings, he has a pretty good record on aid to poor countries, particularly in healthcare. True to form, he recently announced a big increase in US food aid -- good for the hungry poor and good for American farmers. ...

What made me feel a little sorry for Bush was the reaction to his announcement. Bush referred to the reasons for shortages and price hikes. He did not dwell on the diversion of American corn from food to heavily subsidized bio-fuels. Nor did climate change feature prominently in his argument, although many experts suggest that this may be the cause of the droughts and floods that have ruined wheat harvests in Australia and vegetable oil production in Indonesia and Malaysia.

Bush pointed his finger primarily elsewhere. Food prices had responded to growing demand. In Asia, economic growth had stimulated food consumption. The Chinese and Indians were eating more and eating better. ...

What Bush said is of course true. ...

But many Indians are still wretchedly poor. Too many. They have a miserable diet -- not least when compared with Bush's Texan neighbors. Grain consumption per head in India has remained static, and is less than one-fifth the figure for the US, where it has been rising. I do not imagine you will find too many vegetarians in Crawford, Texas, and the meat consumed by the average American is way ahead of the figure for any other country. Think of all those T-bone steaks.

Bush's partial explanation of the world food crisis, accurate as far as it went, brought the anger of India's media and of many politicians... According to India's Defense Minister, A.K. Anthony, presumably an expert on butter as well as guns, Bush's statement was "a cruel joke."...

Later in the "cruel joke" week, Bush's White House compounded the sin. According to Bush's press spokesman, the growth in world demand for oil -- in Asia, for example -- was one of the causes of the high price of filling the tanks of gas-guzzling sports utility vehicles ... at America's pumps.

Meanwhile, the US government papered over the fact that Americans, who make up less than 4 percent of the world's population, own and drive 250 million of the world's 520 million cars. More outrage around the world at American double standards.

Now, all this is more than the knock-about of international politics. One day soon, Bush and Cheney will be out of office. But we will still be left with the most difficult global issue we have ever faced: as more of us prosper, how do we deal fairly with some of the economic and environmental consequences?

What do we do about the bottom billion in the world who remain in grinding poverty while the rest of us live better and longer lives? How do we deal with equity on a global scale when we cannot even deal with it country by country?

This conundrum will lie at the heart of the diplomacy next year to find a successor to the Kyoto agreement. Can we prevent a calamitous increase in global warming in a way that is fair,... and that does not thwart legitimate hopes for a better life everywhere? We have never faced a more difficult political task.

Meanwhile, there is a food crisis to solve. We have already seen many examples of how not to deal with it. Stopping food exports is stupid. If we restrict market forces, there will be less food and higher prices. We should also avoid the cheap political trick of holding down what we pay to poor farmers in order to benefit poor city dwellers.

Why do governments do this? The answer is obvious: city dwellers riot; in the countryside, people just starve. The best way to deal with the problem is to subsidize food for the poor; we should not cut the price we pay farmers for growing it. ...

Here's the reason I asked. This is Africa, not India, but I don't suppose the story is any different:

Food Relief For Africa 'Insufficient,' GAO Says, by Anthony Faiola, Washington Post: Efforts by the United States and multilateral agencies including the World Bank to reduce hunger in sub-Saharan Africa have been "insufficient," with foreign aid to the region failing to flow into agricultural development projects vital to the ability of poor countries to feed themselves, according to a report to be released this morning by the U.S. Government Accountability Office. ...

The report, a draft copy of which was obtained by The Washington Post, additionally describes U.S. aid efforts in sub-Saharan Africa as fragmented and misdirected. It says, for instance, that a Bush administration initiative to "end hunger in Africa" launched in 2002 effectively amounted to a repackaging of existing programs and came with no new funding. ...

The report comes on the heels of another released by the GAO last year sharply criticizing U.S. food aid programs. That report called them "inherently inefficient" because they rely on the sale of American-grown food that is costly to transport overseas, as opposed to food purchased closer to the troubled regions themselves. ...

links for 2008-05-30

Universal Health Care and Military Retention

Worries that universal health care will hurt military recruiting:

Health's Gain May Be Army's Loss, by Floyd Norris, Commentary, NY Times: Call it the law of unintended consequences. When you fix one thing, it messes up other things.

If the Democrats win the election this year, and are able to enact a health care plan that extends adequate coverage to all Americans, the loser could be the Army. Getting enough people to enlist could become a major problem for the next president. ...

Government polls show that the proportion of young people who think they might enlist is roughly half what it was in the late 1980s. The military has responded with more recruiters and higher cash enlistment bonuses, and has met its goals. A significant factor for many recruits, it turns out, is the military's generous health benefits for dependants.

Michael Massing, writing in the April 3 issue of The New York Review of Books, tells the story of one part-time college student from Brooklyn, who was holding down two jobs but still going into debt. "Meanwhile, he got married, his wife got pregnant, and he had no health care. From a brother in the military, he had learned of the Army's many benefits, and, visiting a recruiter, he heard about Tricare, the military's generous health plan." He enlisted. ... All that could change if the push for some kind of national health insurance program were to be successful. ...

[I]f such a program were adopted, it seems likely that the military, and particularly the Army, would feel the immediate effect. To expand the Army, as all the candidates say they want to do, would require some other incentive for enlistment... In the near term, it is possible that a recession will improve the military's recruiting success. ...

One partial solution to the negative effect on enlistment of a health care plan for all could be a new G.I. education benefit. Both the House and Senate have approved such a plan... President Bush is opposed to the legislation, which its sponsors say would cost $50 billion over 10 years, and it is far from clear it will be enacted. ...

Senator Jim Webb, a freshman Democrat and Vietnam veteran, is the principal Senate sponsor of the legislation. He argued — with something less than precise data — that passage of the bill would increase enlistment by 16 percent...

Senator McCain has proposed a less costly alternative that would provide better benefits to those who stay in the military longer. He may have a point. Last year about three-quarters of Army volunteers who completed their first term of enlistment, and nearly as many marines, chose not to re-enlist. ...

If we get a real health care plan for all Americans, it might require something like the Webb bill — or a very unpopular revival of the draft — just to keep fighting in Iraq and Afghanistan. The backers of health care legislation do not want to hurt the Army, but that is what could happen.

Continuing a discussion of this topic from not too long ago, the right way to do this is to state the the goals we are trying to reach, then build incentives into the polices that direct people toward those goals with as few negative consequences as possible.

One possible goal is retention. If you want people to stay longer, deferred compensation schemes are a way to accomplish that goal. We need to decide how many people we want to stay for additional terms, and then set the compensation incentives accordingly (these can be tweaked as needed, e.g. you can have incentives for reenlistment at each decision point, or you can discourage reenlistment after some number of terms if there is some reason to do so). Yes, it may require that the government pay people serving in the military more, at least those who stay longer, but that is simply what it will cost to reach the goal, that's the price to command these resources. People who applaud the ability of markets to value resources should understand that. If it costs too much to induce sufficient reenlistment, i.e. if the costs of producing higher retention rates are greater than the benefits, then it's not a very good policy anyway.

But if the goals are different, e.g. if the goal is to provide educational benefits to make up for lost opportunities in the private sector due to service in the military, the the policy will, of course, be different as well. When evaluating a proposed policy to, for example, increase educational benefits all of the consequences, including the effects on retention, should be examined. But this is part of a cost benefit calculation. If the educational benefit - the goal of the policy - exceeds the retention cost, then it's still worthwhile.

And it may not be necessary to give up on the retention goal just because you offer educational benefits, one does not have to be traded against the other. It's possible - if you are willing to pay the cost - to offer both higher education benefits and higher deferred compensation so that both goals are attained. More help for education is available for those who choose to leave when their term ends, but since deferred compensation is higher for those who reenlist, just as many stay as before. Whether it's worth it to do this is matter of comparing the costs and benefits, but increasing education benefits does not have to lower retention rates.

If national health care is enacted and that lowers the incentive to enlist, or to reenlist, then the compensation levels will have to be adjusted to compensate, but it doesn't have to change retention rates or the ability to provide education benefits after people leave the military if we are willing to pay what's needed to induce the desired behavior.

May 29, 2008

Economist's View - 7 new articles

"Crude Awakening: Behind the Surge in Oil Prices"

Stephen P. A. Brown, Raghav Virmani, and Richard Alm of the Dallas Fed look at why oil prices are so high, and whether the high prices are likely to continue. It's a more optimistic view than many. Their bottom line is "Absent supply disruptions, it will be difficult to sustain oil prices above $100 (in 2008 dollars) over the next 10 years" (comments at Real Time Economics and The Big Picture):

Crude Awakening: Behind the Surge in Oil Prices, by Stephen P. A. Brown, Raghav Virmani and Richard Alm, Economic Letter, Vol. 3, No. 5, May 2008, Federal Reserve Bank of Dallas: The first few months of 2008 saw crude oil prices breach one barrier after another. They topped $100 a barrel for the first time on Feb. 19, then rose past $103.76 about two weeks later, surpassing the previous inflation-adjusted peak, established in 1980. In April and early May, oil prices pushed past $110 and then $120 a barrel and beyond.[1]

These milestones reflect a new era in oil markets. After the tumult of the early 1980s, prices remained relatively tame for two decadesâ€"in both real and nominal terms (Chart 1). This long stretch of stability ended in 2004, when oil topped $40 a barrel for the first time, then embarked on a steep climb that continued into this year.

Chart 1: Oil prices hit record highs

Modern economies run on oil, so it’s important to understand how recent yearsâ€"with their surging pricesâ€"differ from the preceding two decades. A good starting point is strong demand, which has pushed world oil markets close to capacity. New supplies haven’t kept up with this demand, fueling expectations that oil markets will remain tight for the foreseeable future. A weakening dollar has put upward pressure on the price of a commodity that trades in the U.S. currency. And because a large share of oil production takes place in politically unstable regions, fears of supply disruptions loom over markets.

These factors have fed the steady, sometimes swift rise of oil prices in recent years. Their persistence suggests the days of relatively cheap oil are over and the global economy faces a future of high energy prices. How they play out will shape oil marketsâ€"and determine pricesâ€"for years to come.

Supply and Demand As incomes rise, economies use more energy for transport, heating and cooling and producing goods and services. A broad cross section of nearly 180 countries shows that doubling per capita income more than doubles per capita oil consumption (Chart 2). How much each country contributes to increases in global energy demand depends on its population and rate of income growth. Big nations moving quickly up the income ladder have huge implications for oil markets.

Chart 2: Oil consumption rises with Income

China and India, two giants with a combined population of nearly 2.4 billion, shook themselves out of a long economic slumber and began growing rapidly in the 1990s. Adjusted for inflation and purchasing power parity, China’s per capita GDP rose from $1,103 in 1990 to $4,088 in 2005; India’s went from $1,202 to $2,222. In this decade, new energy demand from China, India and other emerging countries has added to continued growth from the U.S., Europe and other parts of the world.

As economic activity in the U.S., the world’s largest oil consumer, began accelerating in 2003, markets began feeling the full force of the world’s increased appetite for oil. Global consumption rose from 82.6 million barrels a day in 2004 to 85.6 million in 2007. Since the beginning of the oil era, prices had ebbed and flowed around the U.S. economy’s ups and downs. Now, markets view demand increases as a fact of life that won’t be blunted much by a slowing U.S. economy.

With consumption on the rise, oil markets grew tighter as suppliers neared productive capacity. The Organization of Petroleum Exporting Countries (OPEC), a 13-member group that produces more than a third of the world’s oil, has maintained excess capacity of only 1 million to 2 million barrels a day since 2004, down from 4 million in 2001 and 5.6 million in 2002 (Chart 3).

Chart 3: OPEC's excess capacity dwindles

Although OPEC’s excess capacity has rebounded from its 2005 low, the gains are largely in heavy crude oils that can only be processed in specialized refineries. Those facilities are running full bore, so the added supplies aren’t relieving a tight market. The latest evidence also suggests OPEC is now restraining its output.

While some warn that oil production has peakedâ€"or will soonâ€"most industry experts contend that oil resources are plentiful; it just takes time and money to get them out of the ground and into the market.

Higher prices have done what economics would predictâ€"stimulated efforts to increase supply. Companies have expanded their exploration budgets. Oil-producing nations have announced new projects. Drilling activity is at a high level, both offshore and on land. Wages and oilfield services costs are being bid up, while shortages persist for some key skills and equipment.

So far, new supplies haven’t materialized quickly enough to keep up with growth in world demand, largely because various hurdles have slowed their development. Oil resources, for example, are concentrated in countries with state-run oil companies or little economic freedom. Where market signals aren’t allowed to work, incentives to boost production may be muted.[2]

Oil demand is inelastic in the short runâ€"that is, it doesn’t react quickly to changing prices. Consumers adjust their spending to maintain consumption as prices rise, even if they have to pay more for it.[3] Most likely, this reflects businesses’ commitment to keep up production and individuals’ need to drive to work, run errands and heat homes.

When demand is inelastic, even modest tightening in markets translates into strong price movements. In recent years, this inelasticity has magnified tight markets’ impact on prices.

The Role of Expectations The fundamentals of supply and demand not only led to higher crude oil prices but also fed expectations that world demand will continue to grow faster than supply. The result is escalated price expectations, which show up in futures markets. The anticipated price for 2011 crude oil has moved steadily upwardâ€"from around $60 in January 2007 to more than $120 in the first week of May 2008 (Chart 4).

Chart 4: Markets' rising expectations

Futures prices reveal oil traders’ expectations, but they also feed back into current prices. As a market efficiency condition, spot prices have to increase with futures prices to keep investors equally willing to hold or sell the marginal barrel of oil. If current and futures prices get out of sync, traders taking advantage of arbitrage opportunities bring prices back in line.

Forecasters offer another window on expectations. Their outlooks can provide additional information about possible price scenarios because they incorporate data beyond traders’ sentiments. Each year, the Energy Information Administration (EIA) presents a mainstream forecast, which incorporates projections on the supply and demand forces expected to shape the marketplace.

As the realities of higher oil prices have sunk in, EIA forecasts have marched steadily upward (Chart 5). The 2004 projection, for example, saw prices relatively flat in the $30 range through 2025. The latest forecast, issued in 2007, anticipates a price decline in upcoming years, with oil settling above $60 for the long haul out to 2030.

Chart 5: Forecasters look for higher prices

While $60 oil looks good in today’s markets, it’s worth noting that the EIA’s best guess for long-term prices doubled in just four years. It did so because the EIA decided its earlier demand projections were too low and supply projections were too high.

Consider the projected market for 2025 (Chart 6). It can be inferred that the EIA’s projected demand curve moved significantly to the right between 2003 and 2007, signaling the expectation that consumers will want more oil at all prices. It can also be inferred that the projected supply curve moved significantly to the left, reflecting a more pessimistic view about future production. The market-clearing price ends up considerably higher.

Chart 6: Views change on 2025 supply, demand picture

Dollar’s Weakening Oil has long traded in U.S. dollars. Having a single-currency system lowers transaction costs for a commodity that trades globally. In recent yearsâ€"while oil prices were rising on supply and demand fundamentalsâ€"the dollar has weakened against the currencies of the nation’s trading partners, particularly the European Union’s. The dollar has fallen 46 percent from its mid-2001 peak against the euro and 21 percent since 2004.

A declining dollar makes oil cheaper for Europeans and other foreign consumers, propping up their demand. A weakening U.S. currency also reduces the dollar-denominated supply from foreign producers. Together, these two factors exert additional upward pressure on prices. Daniel Yergin, chairman of Cambridge Energy Research Associates, adds a third element in arguing that some investors have used oil as a hedge against the dollar’s decline.

How much has the weakening dollar added to oil prices? If the U.S. currency had held its 2001 value against the euro, oil would have traded at about $80 a barrel in early 2008, about $21 below its actual price (Chart 7). Put another way, exchange rate movements accounted for roughly a third of the $60 increase in oil prices from 2003 to 2007.

Chart 7: Weaker dollar drives oil prices higher

Most of the dollar’s price impact occurred toward the end of the period. When it comes to adjustments in oil consumption and production, a declining dollar takes time to reshape crude oil prices because expectations don’t shift quickly. Factors that push up expectations of future prices, however, also put upward pressure on spot prices because markets will adjust until investors are indifferent between holding and selling the marginal barrel of crude oil on the spot market.

Would it matter if oil were priced in euros or a basket of consuming countries’ currencies? The headlines might be somewhat less alarming, but little would change in real terms. As the dollar’s value declined, U.S. consumers would still be paying more for oil. It would take more dollars to acquire the euros needed to buy oil. In a world where the dollar is weakening, the burden of higher oil prices would still fall more heavily on the U.S. than Europe.

Geopolitical Risks The geopolitics of oil is a brew for sleepless nights. The Middle East sits atop two-thirds of the world’s reserves. The region pumps oil amid a war in Iraq, potential conflicts elsewhere and terrorists prowling for targets. Russia, a major non-OPEC producer, has expanded state control over the oil sector, pulling more of it into the realm of dicey internal politics tinged with nationalism. In recent years, violence has cut production by a quarter in Nigeria, Africa’s top oil producer. Venezuela, South America’s largest producer, is under the sway of the quixotic Hugo Chavez, who has threatened to cut off sales to the U.S.

Tight oil markets don’t have the luxury of spare capacity to offset supply interruptions resulting from trouble in important oil-producing countries or regions. Because oil demand is inelastic, even the temporary or partial loss of significant production capacity can strongly impact prices. Wars, political intervention or unexpected breakdowns send shock waves through oil markets. Just the fear of a supply disruption is itself enough to prompt price spikes.

Fears of disruptions are reflected more in short-term price movements than in longer-term ones. The increases can prove temporary, particularly when rumored troubles fail to materialize. However, the persistent threat from some disputesâ€"for example, Iran’s long-simmering conflict with the U.S.â€"are likely to keep upward pressure on oil prices for longer periods.

Fear is hard to measure, but the futures market offers some help. We usually expect futures prices to slope upward from the spot price, a pattern the financial markets call “contango.” However, prices for future delivery sometimes dip below the spot prices, creating a phenomenon called “backwardation.” This can occur because of sudden shortages or a jolt of uncertainty.

It’s in this phenomenon that we find indirect evidence of fears of oil supply disruptions. When fear spreads, refiners bid aggressively for short-term oil supplies because they face extremely high costs for shutting down operations. Not enough oil can be brought to market quickly, and spot prices rise above futures prices, putting the market into backwardation.

Oil markets have been in the grip of backwardation lately, with futures prices declining. As spot prices climbed toward $120 a barrel in early 2008, for example, futures prices stood at $102 a year out and $100 two years outâ€"a clear backwardation (Chart 8).

Chart 8: Backwardation suggests fear of supply disruptions

Oil Price Prospects What happens with oil prices will be determined by the same four factors that have shaped the market in recent yearsâ€"global demand, expectations about future market tightness, the value of the dollar and fear of supply interruptions. If these factors stay on their present course, prices are likely to be pushed higher. If one or more factors change, markets could see some easing of price pressures.

At first blush, crude oil demand doesn’t offer much hope for lower prices. It is likely to grow with an expanding world economy. Higher oil prices will prompt some conservation and take some of the edge off pricesâ€"but not much.

The past response of U.S. oil consumption to rising prices suggests the quadrupling of oil prices since 2003 might reduce U.S. consumption by 10 to 20 percent over the next decade. Europe might see similar declines. However, these reductions won’t be sufficient to relieve pressures on prices, given the projected demand growth from China, the Middle East, India and other rapidly expanding economies. Only a dramatic, worldwide move toward energy conservation or a much stronger U.S. and European response to higher oil prices could substantially alter the outlook.

Geopolitical factors affecting supply disruptions aren’t likely to change much, either. The Middle East’s heavy concentration of conventional oil resources suggests the region will become an even more important source of world oil production. Given the region’s historical instability, episodic fears of supply disruptions could remain part of oil pricing well into the future.

The dollar might offer some relief. Forecasting exchange rate movements is fraught with difficulty, but the currency is likely to strengthen with the U.S. economy. An appreciating dollar would lower oil prices for U.S. consumers. Further dollar weakening, however, would lead to higher prices.

Geopolitics and exchange rates aside, long-term oil prices will largely be set by supply and demand, which will affect prices directly and influence the expectations that shape futures markets. The key lies in how much new oil reaches markets. Four scenarios for conventional oil resources show a range of outcomes and impacts for the trajectory of prices:

  • Oil production reaches a plateau or peakâ€"prices likely to rise further.
  • Oil nationalism continues to slow the development of new resourcesâ€"prices likely to remain relatively high.
  • In a shift of strategy, OPEC increases its output sharplyâ€"prices likely to fall.
  • Aggressive exploration activities pay off with the quick development of significant new resourcesâ€"prices likely to fall.

Both the futures markets and EIA forecasts currently anticipate some softening of oil prices over the next few years, suggesting markets expect supplies to gain ground on demand. International Strategy and Investment, an energy consulting business, has documented a substantial number of projects under way that would boost world oil supplies. The development of these resources could undermine the expectations underlying the higher oil price scenariosâ€"even those of oil nationalism.

Supplies could be bolstered by nonconventional oil sourcesâ€"tar sands, oil shale, coal-to-liquids. Industry experts regard these resources as plentiful, with development and production costs well below current oil prices. Tar sands and oil shale are already in production. Biofuels are too limited in scale and currently too costly to make much difference to crude oil pricing.

The substantial development of these nonconventional oil resources could mean downward pressure on crude oil prices in future years. Actual and expected costs of nonconventional resources suggest it might be difficult to sustain oil prices above $70 a barrel. However, the relatively high costs of these nonconventional oil sources could inhibit development because producers fear losses during a price collapse. The production and use of nonconventional resources would also generate more pollution, which could mean conventional oil could command a premium.

What’s the bottom line? Absent supply disruptions, it will be difficult to sustain oil prices above $100 (in 2008 dollars) over the next 10 years.

How High Are Oil Prices, Really?

As oil prices rose to $50, $70 and $90 a barrel, analysts often pointed out that these prices hadn't yet breached the all-time high in real, or inflation-adjusted, terms. That barrier finally fell in early March, when prices topped the real 1980 peak.

Looking beyond postâ€"World War II or even 20th century oil prices presents a somewhat different picture. Real oil prices were nearly as high as they are today when North American oil production began before the Civil War in 1860.

Oil prices can also be measured relative to changes in productivity and the level of technology, factors captured by manufacturing wages.[1] In the first quarter of this year, a typical factory worker needed slightly less than four hours to “earn” one barrel of oil. In 1980, it was just above five hours. Going further back in time, the number risesâ€"to 6.4 hours in 1920, 7.9 in 1910 and an average of 15.4 in the 1870s.

Technological advances have bolstered productivity, raised wages and made the work-time price of oil lower today than it was in the late 19th and early 20th centuries.

Finally, it is important to note thatâ€"despite rising real prices and importsâ€"oil siphons relatively less money out of the American economy than it did in the past. Expenditures on petroleum products today account for about 5 percent of all after-tax income earned in the United States, less than half of the 11.6 percent spent in 1980.[2]


  1. “Natural Resource Scarcity and Technological Change,” PDF by Stephen P. A. Brown and Daniel Wolk, Federal Reserve Bank of Dallas Economic and Financial Review, First Quarter 2000.
  2. Also see “What's Driving Gasoline Prices?” by Stephen P. A. Brown and Raghav Virmani, Federal Reserve Bank of Dallas Economic Letter, October 2007.
Real oil prices: a long view


  1. This article looks at oil prices through the first week of May and uses West Texas Intermediate as the reference price. Throughout the article, we've used a combination of daily, weekly, monthly, quarterly and annual data, which may alter the apparent timing of peaks and troughs in prices.
  2. “Running on Empty? How Economic Freedom Affects Oil Supplies,” by Stephen P. A. Brown and Richard Alm, Federal Reserve Bank of Dallas Economic Letter, April 2006.
  3. In some countries, government policies that maintain low prices interfere with the link between world oil prices and energy consumption. China, for example, hasn't fully passed price increases on to its consumers.

Two from Jeff Frankel: Whether We are Currently in a Recession and the Impact of Monetary Policy on Commodity Prices

There are two different topics to choose from, so let's start with the latest news on GDP. Today, GDP growth for the first quarter was revised upward from .6% to .9%. How does this affect the odds that we are currently in a recession? Jeff Frankel is a member of the NBER's Business Cycle Dating Committee:

Despite Positive First Quarter, Odds of 2008 Recession Are Still Above 50%, by Jeff Frankel: The Commerce Department this morning revised upward its estimate of first quarter growth in real GDP to 0.9% (precisely in line with the expectations of economic forecasters).

As a member of the Business Cycle Dating Committee of the NBER, I am asked frequently if the country is entering a recession, or if we have already done so. I cannot speak for the Committee, and I am not a professional forecaster. But I can give my views, for what they are worth.

It is hard to say that we entered a recession in the first quarter, without a single negative growth quarter, let alone two of them. Even so, three minor qualifications to that 0.9% remain: 1) The number will be revised again, and could move in either direction. 2) A bit of the measured growth consisted of an increased rate of inventory investment, which was almost certainly not desired by firms and is likely to reverse in the 2nd quarter 3) As Martin Feldstein has pointed out, the QI growth number is defined as the change for the quarter as a whole relative to QIV of 2007; within QI, the information currently available suggests that GDP fell from January to February to March.

The reason why many suspected a QI turning point in the first place is employment, which is virtually as important an indicator to the NBER BCDC as is GDP. Jobs have been lost each month since January. Total hours worked is my personal favorite, because in addition to employment it captures the length of the workweek, which firms tend to cut before they lay off workers. This indicator too has been falling.

And of course there are the longer run indicators that have been very worrisome for almost a year: depressed household balance sheets, mortgage defaults, high oil prices, low consumer confidence, etc.

The economy is a four-engine airplane flying at stall speed, skimming along the top of the waves without yet going down. ... The big question mark is the consumption engine. Is the long-spending American household taking a hard look at its diminished net worth and taking steps to raise its saving rate above the very low levels of recent years?

We are already clearly in a "growth recession." All in all, I put the odds of an outright recession sometime this year at greater than 50%. That number is meant to add together: (1) the odds that it will turn out that we have already entered reached the turning point and (2) the odds that the sharp recent expansions in monetary and fiscal policy will succeed in postponing the recession, but only until later in the year. Come the fall, if demand starts to slow, I can't see either the Fed delivering a second big dose of interest rate cuts (as they were able to in the 2001 recession, when the dollar was strong and inflation under control), nor the government delivering a second big dose of tax cuts (as they could in the 2001 recession, when the budget outlook was strong and debt under control).

Next, a different topic. Jeff Frankel defends his argument that high commodity prices are the result of easy monetary policy:

Monetary policy and commodity prices, by Jeffrey Frankel, Vox EU: In a speech delivered last week, Federal Reserve Vice Chairman Donald L. Kohn addressed a theory to which I am partial: the theory that low real interest rates have contributed to the continued rise in prices of agricultural and mineral commodities, including oil, over the last year. He said:

"Some observers have questioned whether the news on fundamentals affecting supply and demand in commodities markets has been sufficient to justify the sharp price increases in recent months. Some of these commentators have cited the actions of the Federal Reserve in reducing interest rates as an important consideration boosting commodity prices. To be sure, commodity prices did rise as interest rates fell. However, for many commodities, inventories have fallen to all-time lows, a development that casts doubt on the premise that speculative demand boosted by low interest rates has pushed prices above levels that would be consistent with the fundamentals of supply and demand. As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies, hence raising the amount demanded by people using those currencies. But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one." (Speech at the National Conference on Public Employee Retirement Systems, New Orleans, Louisiana, May 20, 2008).

As real interest rates have come down over the last year, real commodity prices have accelerated upward despite declining economic growth, as shown in Figure 1, where the commodity price has been inverted so that one can see the correlation visually.

Figure 1. The real interest rate and commodity prices, January 2007 – April 2008 Voxgraph5292008

The effect of interest rates can be demonstrated both theoretically and empirically. I have argued that the effect can come through any of three channels: inventories, production, and financial speculation.

Historically, real interest rates have had an inverse effect on oil inventories (when controlling econometrically for three other relevant factors). Nevertheless, I have to admit that inventory levels have not over the last year risen in a way that would support the theory. I thus have to rely more on the other channels of transmission to explain recent developments.


Stocks of oil held in deposits underground dwarf those held in inventories aboveground, and the decision how much to produce is subject to the same calculations trading off interest rates against expected future appreciation that apply to inventories. (The classic reference is Hotelling's Rule.)

Apparently the Saudis have decided to leave theirs in the ground. "King Abdullah, the country's ruler, put it more bluntly: 'I keep no secret from you that, when there were some new finds, I told them, 'No, leave it in the ground, with grace from God, our children need it'.''' (Financial Times 19 May). I see the interest rate as part of the Saudis' decision. Because the current rate of return on financial assets is abnormally low, they can do better by saving the oil for the future than by selling it today and investing the proceeds. Holding back production raises today's oil price, to a point where the expected future return on oil has fallen to the same level as the interest rate. Hence the inverse effect of real interest rates on real oil prices. The same logic governs others' decisions regarding how much copper to mine, how much forest to log, etc.

Cross-country evidence

In addition to the link from world real interest rates to world real commodity prices, there is a further link from individual countries' real interest rates to commodity prices expressed in their own currencies. This link primarily passes through their exchange rates: A country that eases monetary policy relative to the United States will experience a depreciation of its currency, and a proportionate further increase in commodity prices expressed in its own currency. For small countries with commodity markets perfectly integrated into world markets, the link comes entirely through their exchange rate. But some mineral markets and particularly agricultural markets are not in fact perfectly integrated, so that some of the effect of local monetary policy may come through local inventory or underground channels rather than the exchange rate.

The equation governing real commodity prices in a non-dollar country is (Frankel 2006):


  • is the real price of commodities in terms of currency j
  • is the real-fundamentals price of commodities in terms of currency j
  • is the US interest rate
  • is the interest rate in country j
  • is convenience yield of holding the commodity (net of storage costs and risk premium)

Table 1 reports results on data from the last 56 years.

Table 1 Real commodity prices in local currency and real interest rates

Voxtable52908 Note: * indicates coefficient significant at the 5% level of significance. Robust standard errors are reported.

I tested the equation on eight countries, chosen to have floating exchange rates (with a preference for countries with a commodity sector. One could equally well interpret the theory as referring to short-term interest rates or long-term interest rates. I tried both. The results show a significant negative coefficient on the real US interest rate, representing global monetary policy, as well as on the real interest differential between the national economy and the United States, representing local variations in monetary stance. This is true regardless whether one looks at the results for short-term or long-term interest rates.

The commodity price index that was used in this table comes from the Commodity Research Bureau. But I also tried the test on five other prominent commodity price indices compiled by others, with similar results. In general, the evidence appears to support the hypothesis regarding the determination the real local-currency index of commodity prices. As many observers have recently noted, the effect is equally applicable to the United States: When the Fed eases and the dollar depreciates, the price of oil in dollars goes up quickly even if it does not change in euros. In the past, many thought that there would be little effect because oil is invoiced in dollars.


Frankel, Jeffrey (2006). "The Effect of Monetary Policy on Real Commodity Prices" in John Campbell (editor) Asset Prices and Monetary Policy, University of Chicago Press.

Coming Up Short

People in other countries used to look up to Americans, but that is changing:

Economist traces height trends, by Tom Hundley, Chicago Tribune: When John Komlos wants to take the measure of a nation's economic well-being, he doesn't check its gross domestic product or consumer price index. He ignores ... unemployment figures. Instead, Komlos takes a look at how tall its people have grown.

"Height is a very good overall indicator of how well the human organism thrives in its socioeconomic environment," he explained.

Komlos, a professor in the economics department at the University of Munich, Germany, has dedicated his professional life to the study of anthropometric history—his own coinage for the academic field that studies the links between a population's height and general well-being.

What Komlos has learned is that Americans, despite their nation's prosperity, abundance of food and cutting-edge medical technology, stopped getting taller in the 1950s and have now been passed by their European cousins.

"Americans were head and shoulders above Europeans in the 18th Century, and it stayed that way for two centuries," he said. "Now it's the other way around."

This, according to Komlos, suggests that Europeans eat better, have better access to health care and enjoy a more equitable distribution of national wealth. They will almost certainly live longer than their American counterparts. ...

Genetics determines an individual's height—whether a person is shorter or taller than the national norm—but external factors determine a population's height.

While the media quickly latched onto the height rankings, Komlos and other economists were more interested in the external factors that were causing the startling disparity between American and European growth rates.

In the 2004 paper, Komlos fingered two likely suspects: the growing gap between rich and poor in the U.S., and its lack of universal health care.

Although the U.S. has been the dominant economic power since the end of World War II, its wealth has not been very evenly distributed. According to standard measures, countries such as the Netherlands and the Scandinavian nations are at the top of the list; the U.S. ranks near the bottom, tied with Ghana and Turkmenistan, according to UN figures.

When income is distributed more evenly, it follows that access to health care also is evenly and equitably distributed, Komlos said.

He noted that a high number of Americans are without health insurance (a U.S. Census Bureau report put the figure at 47 million for 2006), meaning that millions of American children do not get top-notch medical care during the critical growth years. Meanwhile, the "tall" countries of the world have been providing their citizens with cradle-to-grave health care for generations.

Komlos does not claim that his research has established a causal link between a nation's height and its health care delivery system, only that "height is a pretty good indicator of how well a society treats its children and young people."

Komlos is struck by two things when he visits the U.S.: the alarming proportion of the population that is overweight, and the shortfall in height—especially among females.

Could America's diminished stature have something to do with its expanding girth?

Very likely, Komlos said. "The tremendous amount of fast food consumed by Americans ... has to have an impact," he said. ...

The latest national height data contains some good news and some bad, Komlos said.

The good news is that there are indications that Americans may have started to grow again. The bad news is that this growth trend appears to be bypassing black females. "This is an uncomfortable finding, especially at a time when Europeans and other developed countries are not only catching up but exceeding us," Komlos said.

Here's Paul Krugman on the same topic. He says:

We seem to be left with two main possible explanations... One is that America really has turned into 'Fast Food Nation.'

A broader explanation would be that contemporary America ... doesn't take very good care of its children. ... Whatever the full explanation..., our relative shortness, like our low life expectancy, suggests that something is amiss with our way of life. A critical European might say that America is a land of harried parents and neglected children, of expensive health care that misses those who need it most, a society that for all its wealth somehow manages to be nasty, brutish — and short.

Update: Eric at Edge of the American West has a brief follow-up on whether this is due to immigration (it's not). Free Exchange weighs in here.

Taylor: Fed Partly to Blame for Global Inflation

John Taylor thinks the Fed needs to tighten policy to reduce the pressure on global inflation:

Easy policy behind global inflation: Taylor, Reuters: Inflation is rising globally because of an easy monetary policy, ... John Taylor said... To tackle rising inflation, Taylor urged the world's policy-makers to talk about adopting a global inflation target.

The creator of the so-called "Taylor rule" of monetary policy, which stipulates that interest rates should rise by more than the increase in inflation..., said U.S. interest rates are now below appropriate levels indicated by the rule.

"During the past year, as global inflation has risen, global short term interest rate targets set by central banks have not increased on average by as much as inflation," Taylor said in a conference on monetary policy hosted by the Bank of Japan.

The average targets have in fact declined since the credit market crisis started in the middle of last year, largely due to sharp rate cuts by the Federal Reserve, said Taylor, now an economics professor at Stanford University.

When interest rates are declining ... in the United States, other central banks have tended to be reluctant to raise rates because that could lead to a sharp appreciation of their own currency, he said.

"Because of concerns about exchange rates and the impact on the exports sector, on the economy in general, central banks are not following the principles that they come to think of as important," Taylor said.

That leads to higher commodity prices, driving inflation all around the globe, he said.

"There is strong evidence that at least part of the increase in energy and commodity prices is related to the global inflationary pressures and thereby, in part, to the policy response to the financial crisis in the United States," he said.

The global dimension of current inflation means a global response is necessary.

"A good place to start is with discussions about some kind of global inflation target," he said, adding that such a target does not need to be a strict numerical target.

I'd like to hear more about what he has in mind for the mechanics of global inflation targeting, i.e. how it would be coordinated across central banks. Credibility of the promises of other members of the coalition in such an arrangement would seem to be one difficult hurdle to overcome (though not the only one), so there would have to be strong penalties for deviating from the global inflation targeting rule. But that would discourage nations from joining in the first place unless they were convinced that the extra restrictions they'd have to follow as part of the coalition would bring them benefits (such as reducing exchange rate changes brought about by a trading partner pursuing a high inflation policy) they couldn't get on their own by strict adherence to a domestic inflation target. [One minor technical point. The article says that the "'Taylor rule' of monetary policy ... stipulates that interest rates should rise by more than the increase in inflation...," but this is usually called the Taylor principle, not the Taylor rule.]

Drinking and Driving

When I was in high school, most of my budget went to two items, gas and beer. At that time, the price of gas was 25 cents a gallon, and beer was $1.25 a six-pack if I remember correctly (and I may not). So the relative price was 5 to 1, i.e. to get five gallons of gas, you had to give up a six pack of beer.

Today, the tradeoff is a bit different. A gallon of gas is around $4.00 and beer is over $5.00 a six-pack. I'm not sure on the price today, but say let's say it's $5.50. So now, roughly, the relative price is 5.5 to 4, or 5 to 3.63 rather than 5 to 1 as before. Gas costs a lot more beer these days, to get five gallons today you have to give up 3.63 six packs, where before it was only one.

If someone had an allowance of $5 per week back then and purchased two six-packs and 10 gallons of gas, then they would need $51 to purchase the same basket of goods (or bads) today. Since this was 36 years ago, that works out to inflation of 6.7% per year. Not quite as bad as I imagined, but still pretty high, certainly higher than the increases in the minimum wage over that time period. Kids who didn't drink at all, say they put all of their allowance into gas, would need $80 today to buy the 20 gallons of gas they could get for $5 at a quarter per gallon. That's an inflation rate of 8.0%. But an all beer kid, one who spent all $5 on beer and didn't drive at all, would only need $22 today to get the same amount of beer. That's an inflation rate of 4.1%.

Given the shift in relative prices, kids today should be tempted to drink more, and drive less.

links for 2008-05-29

"A Time of Unexampled Prosperity"

Dallas Fed president Richard Fisher reminds us that bubbles are nothing new (suggested by email):

Listening to Washington Irving, by Richard Fisher, Dallas Fed: There is nothing "unprecedented" about the situation we find ourselves in. To illustrate the point, I want to read a passage from Washington Irving's 1819 essay on the Mississippi Bubble. For those of you who think the recent housing bubble and the ensuing financial imbroglio are "unprecedented," listen to these words penned almost 200 years ago:

Every now and then the world is visited by one of these delusive seasons, when the 'credit system'…expands to full luxuriance: everybody trusts everybody; a bad debt is a thing unheard of; the broad way to certain and sudden wealth lies plain and open…. Banks…become so many mints to coin words into cash; and as the supply of words is inexhaustible, it may readily be supposed what a vast amount of promissory capital is soon in circulation…. Nothing is heard but gigantic operations in trade; great purchases and sales of real property, and immense sums made at every transfer. All, to be sure, as yet exists in promise; but the believer in promises calculates the aggregate as solid capital….

Now is the time for speculative and dreaming or designing men. They relate their dreams and projects to the ignorant and credulous, [and] dazzle them with golden visions…. The example of one stimulates another; speculation rises on speculation; bubble rises on bubble…. No 'operation' is thought worthy of attention, that does not double or treble the investment…. Could this delusion always last, the life of a merchant would indeed be a golden dream; but it is as short as it is brilliant.

And to think, Washington Irving had never met a subprime mortgage, or a CDO, a CLO, an SIV or a credit default swap...

Here's the entire essay, "The Great Mississippi Bubble" from The Crayon Papers (it's a bit longer than usual):

The Crayon Papers, The Great Mississippi Bubble, by Washington Irving:


In the course of a voyage from England, I once fell in with a convoy of merchant ships bound for the West Indies. The weather was uncommonly bland; and the ships vied with each other in spreading sail to catch a light, favoring breeze, until their hulls were almost hidden beneath a cloud of canvas. The breeze went down with the sun, and his last yellow rays shone upon a thousand sails, idly flapping against the masts.

I exulted in the beauty of the scene, and augured a prosperous voyage; but the veteran master of the ship shook his head, and pronounced this halcyon calm a "weather-breeder." And so it proved. A storm burst forth in the night; the sea roared and raged; and when the day broke, I beheld the late gallant convoy scattered in every direction; some dismasted, others scudding under bare poles, and many firing signals of distress.

I have since been occasionally reminded of this scene, by those calm, sunny seasons in the commercial world, which are known by the name of "times of unexampled prosperity." They are the sure weather-breeders of traffic. Every now and then the world is visited by one of these delusive seasons, when "the credit system," as it is called, expands to full luxuriance, everybody trusts everybody; a bad debt is a thing unheard of; the broad way to certain and sudden wealth lies plain and open; and men are tempted to dash forward boldly, from the facility of borrowing.

Promissory notes, interchanged between scheming individuals, are liberally discounted at the banks, which become so many mints to coin words into cash; and as the supply of words is inexhaustible, it may readily be supposed what a vast amount of promissory capital is soon in circulation. Every one now talks in thousands; nothing is heard but gigantic operations in trade; great purchases and sales of real property, and immense sums made at every transfer. All, to be sure, as yet exists in promise; but the believer in promises calculates the aggregate as solid capital, and falls back in amazement at the amount of public wealth, the "unexampled state of public prosperity."

Now is the time for speculative and dreaming or designing men. They relate their dreams and projects to the ignorant and credulous, dazzle them with golden visions, and set them madding after shadows. The example of one stimulates another; speculation rises on speculation; bubble rises on bubble; every one helps with his breath to swell the windy superstructure, and admires and wonders at the magnitude of the inflation he has contributed to produce.

Speculation is the romance of trade, and casts contempt upon all its sober realities. It renders the stock-jobber a magician, and the exchange a region of enchantment. It elevates the merchant into a kind of knight-errant, or rather a commercial Quixote. The slow but sure gains of snug percentage become despicable in his eyes; no "operation" is thought worthy of attention that does not double or treble the investment. No business is worth following that does not promise an immediate fortune. As he sits musing over his ledger, with pen behind his ear, he is like La Mancha's hero in his study, dreaming over his books of chivalry. His dusty counting-house fades before his eyes, or changes into a Spanish mine; he gropes after diamonds, or dives after pearls. The subterranean garden of Aladdin is nothing to the realms of wealth that break upon his imagination. Could this delusion always last, the life of a merchant would indeed be a golden dream; but it is as short as it is brilliant. Let but a doubt enter, and the "season of unexampled prosperity" is at end. The coinage of words is suddenly curtailed; the promissory capital begins to vanish into smoke; a panic succeeds, and the whole superstructure, built upon credit and reared by speculation, crumbles to the ground, leaving scarce a wreck behind:

"It is such stuff as dreams are made of."

When a man of business, therefore, hears on every side rumors of fortunes suddenly acquired; when he finds banks liberal, and brokers busy; when he sees adventurers flush of paper capital, and full of scheme and enterprise; when he perceives a greater disposition to buy than to sell; when trade overflows its accustomed channels and deluges the country; when he hears of new regions of commercial adventure; of distant marts and distant mines, swallowing merchandise and disgorging gold; when he finds joint-stock companies of all kinds forming; railroads, canals, and locomotive engines, springing up on every side; when idlers suddenly become men of business, and dash into the game of commerce as they would into the hazards of the faro table; when he beholds the streets glittering with new equipages, palaces conjured up by the magic of speculation; tradesmen flushed with sudden success, and vying with each other in ostentatious expense; in a word, when he hears the whole community joining in the theme of "unexampled prosperity," let him look upon the whole as a "weather-breeder," and prepare for the impending storm.

The foregoing remarks are intended merely as a prelude to a narrative I am about to lay before the public, of one of the most memorable instances of the infatuation of gain to be found in the whole history of commerce. I allude to the famous Mississippi Bubble. It is a matter that has passed into a proverb, and become a phrase in every one's mouth, yet of which not one merchant in ten has probably a distinct idea. I have therefore thought that an authentic account of it would be interesting and salutary, at the present moment, when we are suffering under the effects of a severe access of the credit system, and just recovering from one of its ruinous delusions.

Before entering into the story of this famous chimera, it is proper to give a few particulars concerning the individual who engendered it. John Law was born in Edinburgh in 1671. His father, William Law, was a rich goldsmith, and left his son an estate of considerable value, called Lauriston, situated about four miles from Edinburgh. Goldsmiths, in those days, acted occasionally as bankers, and his father's operations, under this character, may have originally turned the thoughts of the youth to the science of calculation, in which he became an adept; so that at an early age he excelled in playing at all games of combination.

In 1694 he appeared in London, where a handsome person, and an easy and insinuating address, gained him currency in the first circles and the nickname of "Beau Law." The same personal advantages gave him success in the world of gallantry, until he became involved in a quarrel with Beau Wilson, his rival in fashion, whom he killed in a duel, and then fled to France, to avoid prosecution.

He returned to Edinburgh in 1700, and remained there several years; during which time he first broached his great credit system, offering to supply the deficiency of coin by the establishment of a bank, which, according to his views, might emit a paper currency equivalent to the whole landed estate of the kingdom.

His scheme excited great astonishment in Edinburgh; but, though the government was not sufficiently advanced in financial knowledge to detect the fallacies upon which it was founded, Scottish caution and suspicion served in the place of wisdom, and the project was rejected. Law met with no better success with the English Parliament; and the fatal affair of the death of Wilson still hanging over him, for which he had never been able to procure a pardon, he again went to France.

The financial affairs of France were at this time in a deplorable condition. The wars, the pomp and profusion, of Louis XIV., and his religious persecutions of whole classes of the most industrious of his subjects, had exhausted his treasury, and overwhelmed the nation with debt. The old monarch clung to his selfish magnificence, and could not be induced to diminish his enormous expenditure; and his minister of finance was driven to his wits' end to devise all kinds of disastrous expedients to keep up the royal state, and to extricate the nation from its embarrassments.

In this state of things, Law ventured to bring forward his financial project. It was founded on the plan of the Bank of England, which had already been in successful operation several years. He met with immediate patronage, and a congenial spirit, in the Duke of Orleans, who had married a natural daughter of the king. The duke had been astonished at the facility with which England had supported the burden of a public debt, created by the wars of Anne and William, and which exceeded in amount that under which France was groaning. The whole matter was soon explained by Law to his satisfaction. The latter maintained that England had stopped at the mere threshold of an art capable of creating unlimited sources of national wealth. The duke was dazzled with his splendid views and specious reasonings, and thought he clearly comprehended his system. Demarets, the Comptroller-General of Finance, was not so easily deceived. He pronounced the plan of Law more pernicious than any of the disastrous expedients that the government had yet been driven to. The old king also, Louis XIV., detested all innovations, especially those which came from a rival nation; the project of a bank, therefore, was utterly rejected.

Law remained for a while in Paris, leading a gay and affluent existence, owing to his handsome person, easy manners, flexible temper, and a faro-bank which he had set up. His agreeable career was interrupted by a message from D'Argenson, Lieutenant-General of Police, ordering him to quit Paris, alleging that he was "rather too skillful at the game which he had introduced."

For several succeeding years he shifted his residence from state to state of Italy and Germany; offering his scheme of finance to every court that he visited, but without success. The Duke of Savoy, Victor Amadeus, afterward king of Sardinia, was much struck with his project; but after considering it for a time, replied, "I am not sufficiently powerful to ruin myself."

The shifting, adventurous life of Law, and the equivocal means by which he appeared to live, playing high, and always with great success, threw a cloud of suspicion over him wherever he went, and caused him to be expelled by the magistracy from the semi-commercial, semi-aristocratical cities of Venice and Genoa.

The events of 1715 brought Law back again to Paris. Louis XIV. was dead. Louis XV. was a mere child, and during his minority the Duke of Orleans held the reins of government as Regent. Law had at length found his man.

The Duke of Orleans has been differently represented by different contemporaries. He appears to have had excellent natural qualities, perverted by a bad education. He was of the middle size, easy and graceful, with an agreeable countenance, and open, affable demeanor. His mind was quick and sagacious, rather than profound; and his quickness of intellect, and excellence of memory, supplied the lack of studious application. His wit was prompt and pungent; he expressed himself with vivacity and precision; his imagination was vivid, his temperament sanguine and joyous; his courage daring. His mother, the Duchess of Orleans, expressed his character in a jeu d'esprit. "The fairies," said she, "were invited to be present at his birth, and each one conferring a talent on my son, he possesses them all. Unfortunately, we had forgotten to invite an old fairy, who, arriving after all the others, exclaimed, 'He shall have all the talents, excepting that to make a good use of them.'"

Under proper tuition, the duke might have risen to real greatness; but in his early years he was put under the tutelage of the Abbe Dubois, one of the subtlest and basest spirits that ever intrigued its way into eminent place and power. The abbe was of low origin and despicable exterior, totally destitute of morals, and perfidious in the extreme; but with a supple, insinuating address, and an accommodating spirit, tolerant of all kinds of profligacy in others. Conscious of his own inherent baseness, he sought to secure an influence over his pupil, by corrupting his principles and fostering his vices; he debased him, to keep himself from being despised. Unfortunately he succeeded. To the early precepts of this infamous pander have been attributed those excesses that disgraced the manhood of the regent, and gave a licentious character to his whole course of government. His love of pleasure, quickened and indulged by those who should have restrained it, led him into all kinds of sensual indulgence. He had been taught to think lightly of the most serious duties and sacred ties; to turn virtue into a jest, and consider religion mere hypocrisy. He was a gay misanthrope, that had a sovereign but sportive contempt for mankind; believed that his most devoted servant would be his enemy, if interest prompted; and maintained that an honest man was he who had the art to conceal that he was the contrary.

He surrounded himself with a set of dissolute men like himself; who, let loose from the restraint under which they had been held, during the latter hypocritical days of Louis XIV., now gave way to every kind of debauchery. With these men the regent used to shut himself up, after the hours of business, and excluding all graver persons and graver concerns, celebrate the most drunken and disgusting orgies; where obscenity and blasphemy formed the seasoning of conversation. For the profligate companions of these revels, he invented the appellation of his roués, the literal meaning of which is men broken on the wheel; intended, no doubt, to express their broken-down characters and dislocated fortunes; although a contemporary asserts that it designated the punishment that most of them merited. Madame de Labran, who was present at one of the regent's suppers, was disgusted by the conduct and conversation of the host and his guests, and observed, at table, that God, after he had created man, took the refuse clay that was left, and made of it the souls of lackeys and princes.

Such was the man that now ruled the destinies of France. Law found him full of perplexities, from the disastrous state of the finances. He had already tampered with the coinage, calling in the coin of the nation, restamping it, and issuing it at a nominal increase of one-fifth; thus defrauding the nation out of twenty per cent of its capital. He was not likely, therefore, to be scrupulous about any means likely to relieve him from financial difficulties; he had even been led to listen to the cruel alternative of a national bankruptcy.

Under these circumstances, Law confidently brought forward his scheme of a bank, that was to pay off the national debt, increase the revenue, and at the same time diminish the taxes. The following is stated as the theory by which he recommended his system to the regent. The credit enjoyed by a banker or a merchant, he observed, increases his capital tenfold; that is to say, he who has a capital of one thousand livres, may, if he possess sufficient credit, extend his operations to a million, and reap profits to that amount. In like manner, a state that can collect into a bank all the current coin of the kingdom, would be as powerful as if its capital were increased tenfold. The specie must be drawn into the bank, not by way of loan, or by taxations, but in the way of deposit. This might be effected in different modes, either by inspiring confidence or by exerting authority. One mode, he observed, had already been in use. Each time that a state makes a recoinage, it becomes momentarily the depositary of all the money called in, belonging to the subjects of that state. His bank was to effect the same purpose; that is to say, to receive in deposit all the coin of the kingdom, but to give in exchange its bills, which, being of an invariable value, bearing an interest, and being payable on demand, would not only supply the place of coin, but prove a better and more profitable currency.

The regent caught with avidity at the scheme. It suited his bold, reckless spirit, and his grasping extravagance. Not that he was altogether the dupe of Law's specious projects; still he was apt, like many other men, unskilled in the arcana of finance, to mistake the multiplication of money for the multiplication of wealth; not understanding that it was a mere agent or instrument in the interchange of traffic, to represent the value of the various productions of industry; and that an increased circulation of coin or bank bills, in the shape of currency, only adds a proportionably increased and fictitious value to such productions. Law enlisted the vanity of the regent in his cause. He persuaded him that he saw more clearly than others into sublime theories of finance, which were quite above the ordinary apprehension. He used to declare that, excepting the regent and the Duke of Savoy, no one had thoroughly comprehended his system.

It is certain that it met with strong opposition from the regent's ministers, the Duke de Noailles and the Chancellor d'Anguesseau; and it was no less strenuously opposed by the Parliament of Paris. Law, however, had a potent though secret coadjutor in the Abbe Dubois, now rising, during the regency, into great political power, and who retained a baneful influence over the mind of the regent. This wily priest, as avaricious as he was ambitious, drew large sums from Law as subsidies, and aided him greatly in many of his most pernicious operations. He aided him, in the present instance, to fortify the mind of the regent against all the remonstrances of his ministers and the parliament.

Accordingly, on the 2d of May, 1716, letters patent were granted to Law, to establish a bank of deposit, discount, and circulation, under the firm of "Law & Company," to continue for twenty years. The capital was fixed at six millions of livres, divided into shares of five hundred livres each, which were to be sold for twenty-five per cent of the regent's debased coin, and seventy-five per cent of the public securities; which were then at a great reduction from their nominal value, and which then amounted to nineteen hundred millions. The ostensible object of the bank, as set forth in the patent, was to encourage the commerce and manufactures of France. The louis d'ors and crowns of the bank were always to retain the same standard of value, and its bills to be payable in them on demand.

At the outset, while the bank was limited in its operations, and while its paper really represented the specie in its vaults, it seemed to realize all that had been promised from it. It rapidly acquired public confidence, and an extended circulation, and produced an activity in commerce unknown under the baneful government of Louis XIV. As the bills of the bank bore an interest, and as it was stipulated they would be of invariable value, and as hints had been artfully circulated that the coin would experience successive diminution, everybody hastened to the bank to exchange gold and silver for paper. So great became the throng of depositors, and so intense their eagerness, that there was quite a press and struggle at the bank door, and a ludicrous panic was awakened, as if there was danger of their not being admitted. An anecdote of the time relates that one of the clerks, with an ominous smile, called out to the struggling multitude, "Have a little patience, my friends; we mean to take all your money;" an assertion disastrously verified in the sequel.

Thus, by the simple establishment of a bank, Law and the regent obtained pledges of confidence for the consummation of further and more complicated schemes, as yet hidden from the public. In a little while, the bank shares rose enormously, and the amount of its notes in circulation exceeded one hundred and ten millions of livres. A subtle stroke of policy had rendered it popular with the aristocracy. Louis XIV. had several years previously imposed an income tax of a tenth, giving his royal word that it should cease in 1717. This tax had been exceedingly irksome to the privileged orders; and in the present disastrous times they had dreaded an augmentation of it. In consequence of the successful operation of Law's scheme, however, the tax was abolished, and now nothing was to be heard among the nobility and clergy but praises of the regent and the bank.

Hitherto all had gone well, and all might have continued to go well, had not the paper system been further expanded. But Law had yet the grandest part of his scheme to develop. He had to open his ideal world of speculation, his El Dorado of unbounded wealth. The English had brought the vast imaginary commerce of the South Seas in aid of their banking operations. Law sought to bring, as an immense auxiliary of his bank, the whole trade of the Mississippi. Under this name was included not merely the river so called, but the vast region known as Louisiana, extending from north latitude 29∞ up to Canada in north latitude 40∞. This country had been granted by Louis XIV. to the Sieur Crozat, but he had been induced to resign his patent. In conformity to the plea of Mr. Law, letters patent were granted in August, 1717, for the creation of a commercial company, which was to have the colonizing of this country, and the monopoly of its trade and resources, and of the beaver or fur trade with Canada. It was called the Western, but became better known as the Mississippi Company. The capital was fixed at one hundred millions of livres, divided into shares, bearing an Interest of four per cent, which were subscribed for in the public securities. As the bank was to co-operate with the company, the regent ordered that its bills should be received the same as coin, in all payments of the public revenue. Law was appointed chief director of this company, which was an exact copy of the Earl of Oxford's South Sea Company, set on foot in 1711, and which distracted all England with the frenzy of speculation. In like manner with the delusive picturings given in that memorable scheme of the sources of rich trade to be opened in the South Sea countries, Law held forth magnificent prospects of the fortunes to be made in colonizing Louisiana, which was represented as a veritable land of promise, capable of yielding every variety of the most precious produce. Reports, too, were artfully circulated, with great mystery, as if to the "chosen few," of mines of gold and silver recently discovered in Louisiana, and which would insure instant wealth to the early purchasers. These confidential whispers of course soon became public; and were confirmed by travelers fresh from the Mississippi, and doubtless bribed, who had seen the mines in question, and declared them superior in richness to those of Mexico and Peru. Nay, more, ocular proof was furnished to public credulity, in ingots of gold conveyed to the mint, as if just brought from the mines of Louisiana.

Extraordinary measures were adopted to force a colonization. An edict was issued to collect and transport settlers to the Mississippi. The police lent its aid. The streets and prisons of Paris, and of the provincial cities, were swept of mendicants and vagabonds of all kinds, who were conveyed to Havre de Grace. About six thousand were crowded into ships, where no precautions had been taken for their health or accommodation. Instruments of all kinds proper for the working of mines were ostentatiously paraded in public, and put on board the vessels; and the whole set sail for this fabled El Dorado, which was to prove the grave of the greater part of its wretched colonists.

D'Anguesseau, the chancellor, a man of probity and integrity, still lifted his voice against the paper system of Law, and his project of colonization, and was eloquent and prophetic in picturing the evils they were calculated to produce; the private distress and public degradation; the corruption of morals and manners; the triumph of knaves and schemers; the ruin of fortunes, and downfall of families. He was incited more and more to this opposition by the Duke de Noailles, the Minister of Finance, who was jealous of the growing ascendency of Law over the mind of the regent, but was less honest than the chancellor in his opposition. The regent was excessively annoyed by the difficulties they conjured up in the way of his darling schemes of finance, and the countenance they gave to the opposition of parliament; which body, disgusted more and more with the abuses of the regency, and the system of Law, had gone so far as to carry its remonstrances to the very foot of the throne.

He determined to relieve himself from these two ministers, who, either through honesty or policy, interfered with all his plans. Accordingly, on the 28th of January, 1718, he dismissed the chancellor from office, and exiled him to his estate in the country; and shortly afterward removed the Duke de Noailles from the administration of the finances.

The opposition of parliament to the regent and his measures was carried on with increasing violence. That body aspired to an equal authority with the regent in the administration of affairs, and pretended, by its decree, to suspend an edict of the regency, ordering a new coinage and altering the value of the currency. But its chief hostility was leveled against Law, a foreigner and a heretic, and one who was considered by a majority of the members in the light of a malefactor. In fact, so far was this hostility carried, that secret measures were taken to investigate his malversations, and to collect evidence against him; and it was resolved in parliament that, should the testimony collected justify their suspicions, they would have him seized and brought before them; would give him a brief trial, and, if convicted, would hang him in the courtyard of the palace, and throw open the gates after the execution, that the public might behold his corpse!

Law received intimation of the danger hanging over him, and was in terrible trepidation. He took refuge in the Palais Royal, the residence of the regent, and implored his protection. The regent himself was embarrassed by the sturdy opposition of parliament, which contemplated nothing less than a decree reversing most of his public measures, especially those of finance. His indecision kept Law for a time in an agony of terror and suspense. Finally, by assembling a board of justice, and bringing to his aid the absolute authority of the king, he triumphed over parliament and relieved Law from his dread of being hanged.

The system now went on with flowing sail. The Western or Mississippi Company, being identified with the bank, rapidly increased in power and privileges. One monopoly after another was granted to it; the trade of the Indian seas; the slave trade with Senegal and Guinea; the farming of tobacco; the national coinage, etc. Each new privilege was made a pretext for issuing more bills, and caused an immense advance in the price of stock. At length, on the 4th of December, 1718, the regent gave the establishment the imposing title of "The Royal Bank," and proclaimed that he had effected the purchase of all the shares, the proceeds of which he had added to its capital This measure seemed to shock the public feeling more than any other connected with the system, and roused the indignation of parliament. The French nation had been so accustomed to attach an idea of everything noble, lofty, and magnificent to the royal name and person, especially during the stately and sumptuous reign of Louis XIV., that they could not at first tolerate the idea of royalty being in any degree mingled with matters of traffic and finance, and the king being in a manner a banker. It was one of the downward steps, however, by which royalty lost its illusive splendor in France, and became gradually cheapened in the public mind.

Arbitrary measures now began to be taken to force the bills of the bank into artificial currency. On the 27th of December appeared an order in council, forbidding, under severe penalties, the payment of any sum above six hundred livres in gold or silver. This decree rendered bank bills necessary in all transactions of purchase and sale, and called for a new emission. The prohibition was occasionally evaded or opposed; confiscations were the consequence; informers were rewarded, and spies and traitors began to spring up in all the domestic walks of life.

The worst effect of this illusive system was the mania for gain, or rather for gambling in stocks, that now seized upon the whole nation. Under the exciting effects of lying reports, and the forcing effects of government decrees, the shares of the company went on rising in value until they reached thirteen hundred per cent. Nothing was now spoken of but the price of shares, and the immense fortunes suddenly made by lucky speculators. Those whom Law had deluded used every means to delude others. The most extravagant dreams were indulged, concerning the wealth to flow in upon the company from its colonies, its trade, and its various monopolies. It is true nothing as yet had been realized, nor could in some time be realized, from these distant sources, even if productive; but the imaginations of speculators are ever in the advance, and their conjectures are immediately converted into facts. Lying reports now flew from mouth to month, of sure avenues to fortune suddenly thrown open. The more extravagant the fable, the more readily was it believed. To doubt was to awaken anger, or incur ridicule. In a time of public infatuation, it requires no small exercise of courage to doubt a popular fallacy.

Paris now became the center of attraction for the adventurous and the avaricious, who flocked to it, not merely from the provinces, but from neighboring countries. A stock exchange was established in a house in the Rue Quincampoix, and became immediately the gathering place of stock-jobbers. The exchange opened at seven o'clock, with the beat of drum and sound of bell, and closed at night with the same signals. Guards were stationed at each end of the street, to maintain order and exclude carriages and horses. The whole street swarmed throughout the day like a bee-hive. Bargains of all kinds were seized upon with avidity. Shares of stock passed from hand to hand, mounting in value, one knew not why. Fortunes were made in a moment, as if by magic; and every lucky bargain prompted those around to a more desperate throw of the die. The fever went on, increasing in intensity as the day declined; and when the drum beat, and the bell rang, at night, to close the exchange, there were exclamations of impatience and despair, as if the wheel of fortune had suddenly been stopped when about to make its luckiest evolution.

To engulf all classes in this ruinous vortex, Law now split the shares of fifty millions of stock each into one hundred shares; thus, as in the splitting of lottery tickets, accommodating the venture to the humblest purse. Society was thus stirred up to its very dregs, and adventurers of the lowest order hurried to the stock market. All honest, industrious pursuits, and modest gains, were now despised. Wealth was to be obtained instantly, without labor and without stint. The upper classes were as base in their venality as the lower. The highest and most powerful nobles, abandoning all generous pursuits and lofty aims, engaged in the vile scuffle for gam. They were even baser than the lower classes; for some of them, who were members of the council of the regency, abused their station and their influence, and promoted measures by which shares rose while in their hands, and they made immense profits.

The Duke de Bourbon, the prince of Conti, the Dukes de la Force and D'Antin were among the foremost of these illustrious stock-jobbers. They were nicknamed the Mississippi Lords, and they smiled at the sneering title. In fact, the usual distinctions of society had lost their consequence, under the reign of this new passion. Bank, talent, military fame, no longer inspired deference. All respect for others, all self-respect, were forgotten in the mercenary struggle of the stock-market. Even prelates and ecclesiastical corporations, forgetting their true objects of devotion, mingled among the votaries of Mammon. They were not behind those who wielded the civil power in fabricating ordinances suited to their avaricious purposes. Theological decisions forthwith appeared, in which the anathema launched by the Church against usury was conveniently construed as not extending to the traffic in bank shares!

The Abbe Dubois entered into the mysteries of stockjobbing with all the zeal of an apostle, and enriched himself by the spoils of the credulous; and he continually drew large sums from Law, as considerations for his political influence. Faithless to his country, in the course of his gambling speculations he transferred to England a great amount of specie, which had been paid into the royal treasury; thus contributing to the subsequent dearth of the precious metals.

The female sex participated in this sordid frenzy. Princesses of the blood, and ladies of the highest nobility, were among the most rapacious of stock-jobbers. The regent seemed to have the riches of Croesus at his command, and lavished money by hundreds of thousands upon his female relatives and favorites, as well as upon his roués, the dissolute companions of his debauches. "My son," writes the regent's mother, in her correspondence, "gave me shares to the amount of two millions, which I distributed among my household. The king also took several millions for his own household. All the royal family have had them; all the children and grandchildren of France, and the princes of the blood."

Luxury and extravagance kept pace with this sudden inflation of fancied wealth. The hereditary palaces of nobles were pulled down, and rebuilt on a scale of augmented splendor. Entertainments were given of incredible cost and magnificence. Never before had been such display in houses, furniture, equipages, and amusements. This was particularly the case among persons of the lower ranks, who had suddenly become possessed of millions. Ludicrous anecdotes are related of some of these upstarts. One, who had just launched a splendid carriage, when about to use it for the first time, instead of getting in at the door, mounted, through habitude, to his accustomed place behind. Some ladies of quality, seeing a well-dressed woman covered with diamonds, but whom nobody knew, alight from a very handsome carriage, inquired who she was of the footman. He replied, with a sneer: "It is a lady who has recently tumbled from a garret into this carriage." Mr. Law's domestics were said to become in like manner suddenly enriched by the crumbs that fell from his table. His coachman, having made his fortune, retired from his service. Mr. Law requested him to procure a coachman in his place. He appeared the next day with two, whom he pronounced equally good, and told Mr. Law: "Take which of them you choose, and I will take the other!"

Nor were these novi homini treated with the distance and disdain they would formerly have experienced from the haughty aristocracy of France. The pride of the old noblesse had been stifled by the stronger instinct of avarice. They rather sought the intimacy and confidence of these lucky upstarts; and it has been observed that a nobleman would gladly take his seat at the table of the fortunate lackey of yesterday, in hopes of learning from him the secret of growing rich!

Law now went about with a countenance radiant with success and apparently dispensing wealth on every side. "He is admirably skilled in all that relates to finance," writes the Duchess of Orleans, the regent's mother, "and has put the affairs of the state in such good order that all the king's debts have been paid. He is so much run after that he has no repose night or day. A duchess even kissed his hand publicly. If a duchess can do this, what will other ladies do?"

Wherever he went, his path, we are told, was beset by a sordid throng, who waited to see him pass, and sought to obtain the favor of a word, a nod, or smile, as if a mere glance from him would bestow fortune. When at home, his house was absolutely besieged by furious candidates for fortune. "They forced the doors," says the Duke de St. Simon; "they scaled his windows from the garden; they made their way into his cabinet down the chimney!"

The same venal court was paid by all classes to his family. The highest ladies of the court vied with each other in meannesses to purchase the lucrative friendship of Mrs. Law and her daughter. They waited upon them with as much assiduity and adulation as if they had been princesses of the blood. The regent one day expressed a desire that some duchess should accompany his daughter to Genoa. "My lord," said some one present, "if you would have a choice from among the duchesses, you need but send to Mrs. Law's, you will find them all assembled there."

The wealth of Law rapidly increased with the expansion of the bubble. In the course of a few months he purchased fourteen titled estates, paying for them in paper; and the public hailed these sudden and vast acquisitions of landed property as so many proofs of the soundness of his system. In one instance he met with a shrewd bargainer, who had not the general faith in his paper money. The President de Novion insisted on being paid for an estate in hard coin. Law accordingly brought the amount, four hundred thousand livres, in specie, saying, with a sarcastic smile, that he preferred paying in money as its weight rendered it a mere encumbrance. As it happened, the president could give no clear title to the land, and the money had to be refunded. He paid it back in paper, which Law dared not refuse, lest he should depreciate it in the market.

The course of illusory credit went on triumphantly for eighteen months. Law had nearly fulfilled one of his promises, for the greater part of the public debt had been paid off; but how paid? In bank shares, which had been trumped up several hundred per cent above their value, and which were to vanish like smoke in the hands of the holders.

One of the most striking attributes of Law was the imperturbable assurance and self-possession with which he replied to every objection, and found a solution for every problem. He had the dexterity of a juggler in evading difficulties; and what was peculiar, made figures themselves, which are the very elements of exact demonstration, the means to dazzle and bewilder.

Toward the latter end of 1719 the Mississippi scheme had reached its highest point of glory. Half a million of strangers had crowded into Paris in quest of fortune. The hotels and lodging-houses were overflowing; lodgings were procured with excessive difficulty; granaries were turned into bedrooms; provisions had risen enormously in price; splendid houses were multiplying on every side; the streets were crowded with carriages; above a thousand new equipages had been launched.

On the eleventh of December, Law obtained another prohibitory decree, for the purpose of sweeping all the remaining specie in circulation into the bank. By this it was forbidden to make any payment in silver above ten livres, or in gold above three hundred.

The repeated decrees of this nature, the object of which was to depreciate the value of gold, and increase the illusive credit of paper, began to awaken doubts of a system which required such bolstering. Capitalists gradually awoke from their bewilderment. Sound and able financiers consulted together, and agreed to make common cause against this continual expansion of a paper system. The shares of the bank and of the company began to decline in value. Wary men took the alarm, and began to realize, a word now first brought into use, to express the conversion of ideal property into something real.

The prince of Conti, one of the most prominent and grasping of the Mississippi lords, was the first to give a blow to the credit of the bank. There was a mixture of ingratitude in his conduct that characterized the venal baseness of the times. He had received from time to time enormous sums from Law, as the price of his influence and patronage. His avarice had increased with every acquisition, until Law was compelled to refuse one of his exactions. In revenge the prince immediately sent such an amount of paper to the bank to be cashed that it required four wagons to bring away the silver, and he had the meanness to loll out of the window of his hotel and jest and exult as it was trundled into his portecochère.

This was the signal for other drains of like nature. The English and Dutch merchants, who had purchased a great amount of bank paper at low prices, cashed them at the bank, and carried the money out of the country. Other strangers did the like, thus draining the kingdom of its specie, and leaving paper in its place.

The regent, perceiving these symptoms of decay in the system, sought to restore it to public confidence by conferring marks of confidence upon its author.

He accordingly resolved to make Law Comptroller General of the Finances of France. There was a material obstacle in his way. Law was a Protestant, and the regent, unscrupulous as he was himself, did not dare publicly to outrage the severe edicts which Louis XIV., in his bigot days, had fulminated against all heretics. Law soon let him know that there would be no difficulty on that head. He was ready at any moment to abjure his religion in the way of business. For decency's sake, however, it was judged proper he should previously be convinced and converted. A ghostly instructor was soon found, ready to accomplish his conversion in the shortest possible time. This was the Abbe Tencin, a profligate creature of the profligate Dubois, and like him working his way to ecclesiastical promotion and temporal wealth, by the basest means.

Under the instructions of the Abbe Tencin, Law soon mastered the mysteries and dogmas of the Catholic doctrine; and, after a brief course of ghostly training, declared himself thoroughly convinced and converted. To avoid the sneers and jests of the Parisian public the ceremony of abjuration took place at Melun. Law made a pious present of one hundred thousand livres to the Church of St. Roque, and the Abbe Tencin was rewarded for his edifying labors by sundry shares and bank bills; which he shrewdly took care to convert into cash, having as little faith in the system as in the piety of his new convert. A more grave and moral community might have been outraged by this scandalous farce; but the Parisians laughed at it with their usual levity, and contented themselves with making it the subject of a number of songs and epigrams.

Law now being orthodox in his faith, took out letters of naturalization, and having thus surmounted the intervening obstacles, was elevated by the regent to the post of comptroller-general. So accustomed had the community become to all juggles and transmutations in this hero of finance, that no one seemed shocked or astonished at his sudden elevation. On the contrary, being now considered perfectly established in place and power, he became more than ever the object of venal adoration. Men of rank and dignity thronged his antechamber, waiting patiently their turn for an audience; and titled dames demeaned themselves to take the front seats of the carriages of his wife and daughter, as if they had been riding with princesses of the blood royal. Law's head grew giddy with his elevation, and he began to aspire after aristocratical distinction. There was to be a court ball, at which several of the young noblemen were to dance in a ballet with the youthful king. Law requested that his son might be admitted into the ballet, and the regent consented. The young scions of nobility, however, were indignant and scouted the "intruding upstart." Their more worldly parents, fearful of displeasing the modern Midas, reprimanded them in vain. The striplings had not yet imbibed the passion for gain, and still held to their high blood. The son of the banker received slights and annoyances on all sides, and the public applauded them for their spirit. A fit of illness came opportunely to relieve the youth from an honor which would have cost him a world of vexations and affronts.

In February, 1720, shortly after Law's installment in office, a decree came out uniting the bank to the India Company, by which last name the whole establishment was now known. The decree stated that as the bank was royal, the king was bound to make good the value of its bills; that he committed to the company the government of the bank for fifty years, and sold to it fifty millions of stock belonging to him, for nine hundred millions; a simple advance of eighteen hundred per cent. The decree further declared, in the king's name, that he would never draw on the bank until the value of his drafts had first been lodged in it by his receivers-general.

The bank, it was said, had by this time issued notes to the amount of one thousand millions; being more paper than all the banks of Europe were able to circulate. To aid its credit, the receivers of the revenue were directed to take bank notes of the sub-receivers. All payments, also, of one hundred livres and upward were ordered to be made in banknotes. These compulsory measures for a short time gave a false credit to the bank, which proceeded to discount merchants' notes, to lend money on jewels, plate, and other valuables, as well as on mortgages.

Still further to force on the system an edict next appeared, forbidding any individual, or any corporate body, civil or religious, to hold in possession more than five hundred livres in current coin; that is to say, about seven louis d'ors: the value of the louis-d'or in paper being, at the time, seventy-two livres. All the gold and silver they might have above this pittance was to be brought to the royal bank and exchanged either for shares or bills.

As confiscation was the penalty of disobedience to this decree, and informers were assured a share of the forfeitures, a bounty was in a manner held out to domestic spies and traitors; and the most odious scrutiny was awakened into the pecuniary affairs of families and individuals. The very confidence between friends and relatives was unpaired, and all the domestic ties and virtues of society were threatened, until a general sentiment of indignation broke forth, that compelled the regent to rescind the odious decree. Lord Stairs, the British embassador, speaking of the system of espionage encouraged by this edict, observed that it was impossible to doubt that Law was a thorough Catholic, since he had thus established the inquisition, after having already proved transubstantiation, by changing specie into paper.

Equal abuses had taken place under the colonizing project. In his thousand expedients to amass capital, Law had sold parcels of land in Mississippi, at the rate of three thousand livres for a league square. Many capitalists had purchased estates large enough to constitute almost a principality; the only evil was, Law had sold a property which he could not deliver. The agents of police, who aided in recruiting the ranks of the colonists, had been guilty of scandalous impositions. Under pretense of taking up mendicants and vagabonds, they had scoured the streets at night, seizing upon honest mechanics, or their sons, and hurrying them to their crimping-houses, for the sole purpose of extorting money from them as a ransom. The populace was roused to indignation by these abuses. The officers of police were mobbed in the exercise of their odious functions, and several of them were killed; which put an end to this flagrant abuse of power.

In March, a most extraordinary decree of the council fixed the price of shares of the India Company at nine thousand livres each. All ecclesiastical communities and hospitals were now prohibited from investing money at interest, in anything but India stock. With all these props and stays, the system continued to totter. How could it be otherwise, under a despotic government that could alter the value of property at every moment? The very compulsory measures that were adopted to establish the credit of the bank hastened its fall; plainly showing there was a want of solid security.

Law caused pamphlets to be published, setting forth, in eloquent language, the vast profits that must accrue to holders of the stock, and the impossibility of the king's ever doing it any harm. On the very back of these assertions came forth an edict of the king, dated the 22d of May, wherein, under pretense of having reduced the value of his coin, it was declared necessary to reduce the value of his bank-notes one-half, and of the India shares from nine thousand to five thousand livres.

This decree came like a clap of thunder upon shareholders. They found one-half of the pretended value of the paper in their hands annihilated in an instant; and what certainty had they with respect to the other half? The rich considered themselves ruined; those in humbler circumstances looked forward to abject beggary.

The parliament seized the occasion to stand forth as the protector of the public, and refused to register the decree. It gained the credit of compelling the regent to retrace his step, though it is more probable he yielded to the universal burst of public astonishment and reprobation. On the 27th of May the edict was revoked, and bank bills were restored to their previous value. But the fatal blow had been struck; the delusion was at an end. Government itself had lost all public confidence, equally with the bank it had engendered, and which its own arbitrary acts had brought into discredit. "All Paris," says the regent's mother, in her letters, "has been mourning at the cursed decree which Law has persuaded my son to make. I have received anonymous letters stating that I have nothing to fear on my own account, but that my son shall be pursued with fire and sword."

The regent now endeavored to avert the odium of his ruinous schemes from himself. He affected to have suddenly lost confidence in Law, and, on the 29th of May, discharged bin from his employ as comptroller-general, and stationed a Swiss guard of sixteen men in his house. He even refused to see him, when, on the following day, he applied at the portal of the Palais Royal for admission; but having played off this farce before the public, he admitted him secretly the same night, by a private door, and continued as before to co-operate with him in his financial schemes.

On the first of June the regent issued a decree, permitting persons to have as much money as they pleased in their possession. Few, however, were in a state to benefit by this permission. There was a run upon the bank, but a royal ordinance immediately suspended payment, until further orders. To relieve the public mind, a city stock was created, of twenty-five millions, bearing an interest of two and a half per cent, for which bank notes were taken in exchange. The bank notes thus withdrawn from circulation were publicly burned before the Hotel de Ville. The public, however, had lost confidence in everything and everybody, and suspected fraud and collusion in those who pretended to burn the bills.

A general confusion now took place hi the financial world. Families who had lived in opulence found themselves suddenly reduced to indigence. Schemers who had been reveling in the delusion of princely fortune found their estates vanishing into thin air. Those who had any property remaining sought to secure it against reverses. Cautious persons found there was no safety for property in a country where the coin was continually shifting in value, and where a despotism was exercised over public securities, and even over the private purses of individuals. They began to send their effects into other countries; when lo! on the 20th of June a royal edict commanded them to bring back their effects, under penalty of forfeiting twice their value; and forbade them, under like penalty, from investing their money in foreign stocks. This was soon followed by another decree, forbidding any one to retain precious stones in his possession, or to sell them to foreigners; all must be deposited in the bank, in exchange for depreciating paper!

Execrations were now poured out on all sides against Law, and menaces of vengeance. What a contrast, in a short time, to the venal incense that was offered up to him! "This person," writes the regent's mother, "who was formerly worshiped as a god, is now not sure of his life. It is astonishing how greatly terrified he is. He is as a dead man; he is pale as a sheet, and it is said he can never get over it. My son is not dismayed, though he is threatened on all sides; and is very much amused with Law's terrors."

About the middle of July the last grand attempt was made by Law and the regent to keep up the system and provide for the immense emission of paper. A decree was fabricated, giving the India Company the entire monopoly of commerce, on condition that it would, in the course of a year, reimburse six hundred millions of livres of its bills, at the rate of fifty millions per month.

On the 17th this decree was sent to parliament to be registered. It at once raised a storm of opposition in that assembly, and a vehement discussion took place. While that was going on a disastrous scene was passing out of doors.

The calamitous effects of the system had reached the humblest concerns of human life. Provisions had risen to an enormous price; paper money was refused at all the shops; the people had not wherewithal to buy bread. It had been found absolutely indispensable to relax a little from the suspension of specie payments, and to allow small sums to be scantily exchanged for paper. The doors of the bank and the neighboring streets were immediately thronged with a famishing multitude, seeking cash for bank notes of ten livres. So great was the press and struggle that several persons were stifled and crushed to death. The mob carried three of the bodies to the courtyard of the Palais Royal. Some cried for the regent to come forth and behold the effect of his system; others demanded the death of Law, the impostor, who had brought this misery and rum upon the nation.

The moment was critical, the popular fury was rising to a tempest, when Le Blanc, the Secretary of State, stepped forth. He had previously sent for the military, and now only sought to gain tune. Singling out six or seven stout fellows, who seemed to be the ringleaders of the mob: "My good fellows," said he, calmly, "carry away these bodies and place them in some church, and then come back quickly to me for your pay." They immediately obeyed; a kind of funeral procession was formed; the arrival of troops dispersed those who lingered behind; and Paris was probably saved from an insurrection.

About ten o'clock in the morning, all being quiet, Law ventured to go in his carriage to the Palais Royal. He was saluted with cries and curses, as he passed along the streets; and he reached the Palais Royal in a terrible fright. The regent amused himself with his fears, but retained him with him, and sent off his carriage, which was assailed by the mob, pelted with stones, and the glasses shivered. The news of this outrage was communicated to parliament in the midst of a furious discussion of the decree for the commercial monopoly. The first president, who had been absent for a short time, re-entered, and communicated the tidings in a whimsical couplet:

"Messieurs, Messieurs! bonne nouvelle! Le carrosse de Law est reduite en carrelle!"

"Gentlemen, Gentlemen! good news! The carriage of Law is shivered to atoms!"

The members sprang up with joy; "And Law!" exclaimed they, "has he been torn to pieces?" The president was ignorant of the result of the tumult; whereupon the debate was cut short, the decree rejected, and the house adjourned; the members hurrying to learn the particulars. Such was the levity with which public affairs were treated at that dissolute and disastrous period.

On the following day there was an ordinance from the king, prohibiting all popular assemblages; and troops were stationed at various points, and in all public places. The regiment of guards was ordered to hold itself in readiness; and the musketeers to be at their hotels, with their horses ready saddled. A number of small offices were opened, where people might cash small notes, though with great delay and difficulty. An edict was also issued declaring that whoever should refuse to take bank notes in the course of trade should forfeit double the amount!

The continued and vehement opposition of parliament to the whole delusive system of finance had been a constant source of annoyance to the regent; but this obstinate rejection of his last grand expedient of a commercial monopoly was not to be tolerated. He determined to punish that intractable body. The Abbe Dubois and Law suggested a simple mode; it was to suppress the parliament altogether, being, as they observed, so far from useful that it was a constant impediment to the march of public affairs. The regent was half inclined to listen to their advice; but upon calmer consideration, and the advice of friends, he adopted a more moderate course. On the 20th of July, early in the morning, all the doors of the parliament-house were taken possession of by troops. Others were sent to surround the house of the first president, and others to the houses of the various members; who were all at first in great alarm, until an order from the king was put into their hands, to render themselves at Pontoise, in the course of two days, to which place the parliament was thus suddenly and arbitrarily transferred.

This despotic act, says Voltaire, would at any other time have caused an insurrection; but one half of the Parisians were occupied by their ruin, and the other half by their fancied riches, which were soon to vanish. The president and members of parliament acquiesced in the mandate without a murmur; they even went as if on a party of pleasure, and made every preparation to lead a joyous life in their exile. The musketeers, who held possession of the vacated parliament-house, a gay corps of fashionable young fellows, amused themselves with making songs and pasquinades, at the expense of the exiled legislators; and at length, to pass away time, formed themselves into a mock parliament; elected their presidents, kings, ministers, and advocates; took their seats in due form, arraigned a cat at their bar, in place of the Sieur Law, and, after giving it a "fair trial," condemned it to be hanged. In this manner public affairs and public institutions were lightly turned to jest.

As to the exiled parliament, it lived gayly and luxuriously at Pontoise, at the public expense; for the regent had furnished funds, as usual, with a lavish hand. The first president had the mansion of the Duke de Bouillon put at his disposal, already furnished, with a vast and delightful garden on the borders of a river. There he kept open house to all the members of parliament. Several tables were spread every day, all furnished luxuriously and splendidly; the most exquisite wines and liqueurs, the choicest fruits and refreshments, of all kinds, abounded. A number of small chariots for one and two horses were always at hand, for such ladies and old gentlemen as wished to take an airing after dinner, and card and billiard tables for such as chose to amuse themselves in that way until supper. The sister and the daughter of the first president did the honors of the house, and he himself presided there with an air of great ease, hospitality, and magnificence. It became a party of pleasure to drive from Paris to Pontoise, which was six leagues distant, and partake of the amusements and festivities of the place. Business was openly slighted; nothing was thought of but amusement. The regent and his government were laughed at, and made the subjects of continual pleasantries; while the enormous expenses incurred by this idle and lavish course of life more than doubled the liberal sums provided. This was the way in which the parliament resented their exile.

During all this time the system was getting more and more involved. The stock exchange had some time previously been removed to the Place Vendome; but the tumult and noise becoming intolerable to the residents of that polite quarter, and especially to the chancellor, whose hotel was there, the Prince and Princess Carignan, both deep gamblers in Mississippi stock, offered the extensive garden of the Hotel de Soissons as a rallying-place for the worshipers of Mammon. The offer was accepted. A number of barracks were immediately erected in the garden, as offices for the stock-brokers, and an order was obtained from the regent, under pretext of police regulations, that no bargain should be valid unless concluded in these barracks. The rent of them immediately mounted to a hundred livres a month for each, and the whole yielded these noble proprietors an ignoble revenue of half a million of livres.

The mania for gain, however, was now at an end. A universal panic succeeded. "Sauve qui peut!" was the watchword. Every one was anxious to exchange falling paper for something of intrinsic and permanent value. Since money was not to be had, jewels, precious stones, plate, porcelain, trinkets of gold and silver, all commanded any price in paper. Land was bought at fifty years' purchase, and he esteemed himself happy who could get it even at this price. Monopolies now became the rage among the noble holders of paper. The Duke de la Force bought up nearly all the tallow, grease, and soap; others the coffee and spices; others hay and oats. Foreign exchanges were almost impracticable. The debts of Dutch and English merchants were paid in this fictitious money, all the coin of the realm having disappeared. All the relations of debtor and creditor were confounded. With one thousand crowns one might pay a debt of eighteen thousand livres!

The regent's mother, who once exulted in the affluence of bank paper, now wrote in a very different tone: "I have often wished," said she in her letters, "that these bank-notes were in the depths of the infernal regions. They have given my son more trouble than relief. Nobody in France has a penny.... My son was once popular, but since the arrival of this cursed Law, he is hated more and more. Not a week passes, without my receiving letters filled with frightful threats, and speaking of him as a tyrant. I have just received one threatening him with poison. When I showed it to him, he did nothing but laugh."

In the meantime, Law was dismayed by the increasing troubles, and terrified at the tempest he had raised. He was not a man of real courage; and fearing for his personal safety, from popular tumult, or the despair of ruined individuals, he again took refuge in the palace of the regent. The latter, as usual, amused himself with his terrors, and turned every new disaster into a jest; but he too began to think of his own security.

In pursuing the schemes of Law, he had no doubt calculated to carry through his term of government with ease and splendor; and to enrich himself, his connections, and his favorites; and had hoped that the catastrophe of the system would not take place until after the expiration of the regency.

He now saw his mistake; that it was impossible much longer to prevent an explosion; and he determined at once to get Law out of the way, and then to charge him with the whole tissue of delusions of this paper alchemy. He accordingly took occasion of the recall of parliament in December, 1720, to suggest to Law the policy of his avoiding an encounter with that hostile and exasperated body. Law needed no urging to the measure. His only desire was to escape from Paris and its tempestuous populace. Two days before the return of parliament he took his sudden and secret departure. He traveled in a chaise bearing the arms of the regent, and was escorted by a kind of safeguard of servants in the duke's livery. His first place of refuge was an estate of the regent's, about six leagues from Paris, from whence he pushed forward to Bruxelles.

As soon as Law was fairly out of the way, the Duke of Orleans summoned a council of the regency, and informed them that they were assembled to deliberate on the state of the finances, and the affairs of the India Company. Accordingly La Houssaye, comptroller-general, rendered a perfectly clear statement, by which it appeared that there were bank bills in circulation to the amount of two milliards, seven hundred millions of livres, without any evidence that this enormous sum had been emitted in virtue of any ordinance from the general assembly of the India Company, which alone had the right to authorize such emissions.

The council was astonished at this disclosure, and looked to the regent for explanation. Pushed to the extreme, the regent avowed that Law had emitted bills to the amount of twelve hundred millions beyond what had been fixed by ordinances, and in contradiction to express prohibitions; that the thing being done, he, the regent, had legalized or rather covered the transaction, by decrees ordering such emissions, which decrees he had antedated.

A stormy scene ensued between the regent and the Duke de Bourbon, little to the credit of either, both having been deeply implicated in the cabalistic operations of the system. In fact, the several members of the council had been among the most venal "beneficiaries" of the scheme, and had interests at stake which they were anxious to secure. From all the circumstances of the case, I am inclined to think that others were more to blame than Law, for the disastrous effects of his financial projects. His bank, had it been confined to its original limits, and left to the control of its own internal regulations, might have gone on prosperously, and been of great benefit to the nation. It was an institution fitted for a free country; but unfortunately it was subjected to the control of a despotic government, that could, at its pleasure, alter the value of the specie within its vaults, and compel the most extravagant expansions of its paper circulation. The vital principle of a bank is security in the regularity of its operations, and the immediate convertibility of its paper into coin; and what confidence could be reposed in an institution or its paper promises, when the sovereign could at any moment centuple those promises in the market, and seize upon all the money in the bank? The compulsory measures used, likewise, to force bank-notes into currency, against the judgment of the public, was fatal to the system; for credit must be free and uncontrolled as the common air. The regent was the evil spirit of the system, that forced Law on to an expansion of his paper currency far beyond what he had ever dreamed of. He it was that in a manner compelled the unlucky projector to devise all kinds of collateral companies and monopolies, by which to raise funds to meet the constantly and enormously increasing emissions of shares and notes. Law was but like a poor conjurer in the hands of a potent spirit that he has evoked, and that obliges him to go on, desperately and ruinously, with his conjurations. He only thought at the outset to raise the wind, but the regent compelled him to raise the whirlwind.

The investigation of the affairs of the company by the council resulted in nothing beneficial to the public. The princes and nobles who had enriched themselves by all kinds of juggles and extortions, escaped unpunished, and retained the greater part of their spoils. Many of the "suddenly rich," who had risen from obscurity to a giddy height of imaginary prosperity, and had indulged in all kinds of vulgar and ridiculous excesses, awoke as out of a dream, in their original poverty, now made more galling and humiliating by their transient elevation.

The weight of the evil, however, fell on more valuable classes of society; honest tradesmen and artisans, who had been seduced away from the safe pursuits of industry, to the specious chances of speculation. Thousands of meritorious families also, once opulent, had been reduced to indigence, by a too great confidence in government. There was a general derangement in the finances, that long exerted a baneful influence over the national prosperity; but the most disastrous effects of the system were upon the morals and manners of the nation. The faith of engagements, the sanctity of promises in affairs of business, were at an end. Every expedient to grasp present profit, or to evade present difficulty, was tolerated. While such deplorable laxity of principle was generated in the busy classes, the chivalry of France had soiled their pennons; and honor and glory, so long the idols of the Gallic nobility, had been tumbled to the earth, and trampled in the dirt of the stock-market.

As to Law, the originator of the system, he appears eventually to have profited but little by his schemes. "He was a quack," says Voltaire, "to whom the state was given to be cured, but who poisoned it with his drugs, and who poisoned himself." The effects which he left behind in France were sold at a low price and the proceeds dissipated. His landed estates were confiscated. He carried away with him barely enough to maintain himself, his wife, and daughter, with decency. The chief relic of his immense fortune was a great diamond, which he was often obliged to pawn. He was in England in 1721, and was presented to George the First. He returned shortly afterward to the continent; shifting about from place to place, and died in Venice, in 1729. His wife and daughter, accustomed to live with the prodigality of princesses, could not conform to their altered fortunes, but dissipated the scanty means left to them, and sank into abject poverty. "I saw his wife," says Voltaire, "at Bruxelles, as much humiliated as she had been haughty and triumphant in Paris." An elder brother of Law remained in France, and was protected by the Duchess of Bourbon. His descendants have acquitted themselves honorably, in various public employments; and one of them is the Marquis Lauriston, some time lieutenant-general and peer of France.