In 1715, France was essentially insolvent as a nation. Even though taxes were raised to extremely high levels, the hole that warfare had left in the French treasury was too deep. France began to default on its outstanding debt and the value of its gold and silver currency whipsawed as people feared for the future of the nation. France turned to John Law to solve its problems. Law was a Scottish exile – he killed a man in a sword duel – whose talents in both gambling and finance gave him great weight with the government.
Law thought it was the unpredictable supply of gold and silver that was slowing the economy rather than a true economic problem. By switching to paper, he reasoned, more currency could be issued and trade would speed up. He created a bank that took deposits in coin, but issued loans and withdrawals in paper. Law's bank built up its reserves through a stock issue and also made a good profit by handling the government's finance needs.
Law decided to expand by acquiring the Mississippi Company. The company held a government-backed monopoly over trading with French Louisiana. Under Law's influence, the company's charters grew to include tax collection and all trade outside of Europe. The stock price shot up and the amount of cash needed to buy Mississippi shares meant that more money had to be printed.
Unfortunately, people wanted gold and silver when they took profits. Law capped redemption in gold and silver to avoid depleting his reserves. This removed France's paper currency from the gold and silver standard and put it on the Mississippi Company share price standard. The amount of paper currency afloat was now many times the actual reserves of gold and silver and hyperinflation set in.
Realizing the share price was vastly overestimating the wealth of beaver hides and gold in the French colonies, Law attempted a controlled slowdown. He depreciated the currency and the shares by half, but the decision triggered a selling frenzy that drove the share price down sharply. The paper currency became worthless and Law found himself in exile all over again. Since it occurred in the same year as the South Seas bubble, the Mississippi bubble is often confused with its British counterpart. The Mississippi bubble is actually more of a currency blunder than a true speculative bubble. (To learn more, read our feature Market Crashes: What are Crashes and Bubbles?)
This question was answered by Andrew Beattie.