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Lessons from history: The original bubble

Method or madness? As its 300th anniversary approaches, analysis of the South Sea Bubble discovers a bit of both
Lessons from history: The original bubble

Let’s go back 300 years, almost to the day. It’s 1720, an evening in June – possibly Wednesday, the 12th – and Sir Isaac Newton has returned to his Westminster town house in fashionable St Martin’s Street. There, he made the following entry in his diary: “At the Mint did speak with Mr Hall and Mr Haynes on the vexing subject of the South Sea Company. Those good gentlemen did most earnestly speak of the merits of the Company since the fortunes of the Atlantic trade are greater than is generally supposed and the risks somewhat less. Thus shall request of Dr Fauquier that he both subscribe my Redeemables for the new Company stock and pursue his best endeavours to purchase stock in Exchange Alley.”

As a result, the greatest mind of his generation made what would be the greatest mistake of his life. Newton had added to his substantial wealth by trading successfully in what would become the South Sea Bubble. He had sold out in May 1720 with a profit of £20,000, a sum that in today’s money might be worth £40m. Then, for reasons that remain unclear, Newton was persuaded to go back into the market for South Sea stock. As the frenzy was reaching its high point, he put almost all his investible capital into the stock.

Just weeks later in early August the price for South Sea stock, traded in London’s coffee houses, peaked at £1,000. But already the illusion was looking stretched. During the autumn the price fell as fast as it had risen in the spring. By the end of the year the stock was trading at £185, an 80 per cent decline from its top. In the process, Newton lost all the profit he had earlier made. 

Legend has it the event prompted Newton to protest: “I can calculate the motions of heavenly bodies but not the minds of men”. Most likely, that is apocryphal; certainly the diary entry is. It was included for the purposes of dramatic reconstruction. That said, the people mentioned – Francis Hall, Hopton Haynes and Dr John Fauquier – were all real enough, there were meetings and somehow Hall and Haynes persuaded the great man to go back into the stock. 

Andrew Odlyzko, of the University of Minnesota, who focuses on financial history and technology bubbles, reckons Newton eventually yielded to the group-think that prevailed in the high and low places of early Georgian London. Obviously, therefore, he was not alone. But only hindsight tells us Newton was foolish to believe that South Sea stock could defy the laws of gravity. Indeed, in early 1720 it seemed that the company was not so much defying gravity as being pulled by its inexorable force. In which case, investing in its stock was entirely reasonable. 

To explain, let’s start with the basic narrative. The South Sea Company was founded in 1711 by an act of Parliament – as were many companies in those days – with a monopoly to conduct England’s trade with Spanish colonies in the West Indies and South America. In the event, there was little such trade and it produced even less profit. 

No matter, a more lucrative opportunity soon presented itself. In France, a Scottish charlatan-turned-economist, John Law, thought up a brilliant scheme; in effect, the first instance of quantitative easing. He persuaded holders of French government debt to swap their paper for stock in the Mississippi Company, whose prospects for making money from the swamps of Louisiana were apparently limitless. 

Fearing that the dastardly French were about to grab a big fiscal advantage, England’s Hanoverian crown felt obliged to respond in kind. It had already done something similar in 1719 when it sold a chunk of illiquid debt to the South Sea Company, which found that holders of the debt were happy to swap their bonds for more tradeable South Sea stock. 

Encouraged by that success and by vested interests in Parliament and the City, in 1720 the government embarked on a far more ambitious scheme – essentially to privatise all £32m of the remaining government debt owned by the public. With the help of massive bribery in Parliament, the South Sea Company, led by the appropriately named John Blunt, also landed that deal. As a result, the government got a £7.5m lump sum from the company and an agreement to cut the interest on its debt. Meanwhile, the South Sea Company had the obligation to pay the interest on the debt, but not if it could persuade holders of government debt to swap it for new South Sea Company stock.

Thus began what was essentially a Ponzi scheme. Before it could pay the government the £7.5m it owed, the company needed to find the money and it did that by ramping up the price of new stock it could issue. In particular, it said its cash position was so strong it could lend to stock holders against the security of their holdings; a proposition that, naturally enough, encouraged them to buy more, pushing the market price higher. 

Meanwhile, it bribed friends to buy stock and provided them with the loans to do so. Then it added the wonder of leverage by issuing four tranches of part-paid stock. These carried the additional enticement that the timing of future instalments was vague; more about those in a moment. An authoritative historian of the South Sea Bubble, John Carswell, likened the process to a financial pump – “each spurt of stock being accompanied by a draught of cash to suck it up again, leaving the level higher than before”. 

Left to themselves, even the best pumps run out of energy. What did for the South Sea Bubble remains unclear. A liquidity crisis on the continent – exacerbated by the earlier collapse of John Law’s Mississippi scheme – did not help. Nor did corruption on an industrial scale. That fostered enemies, of which the company had plenty. In particular, there was Archibald Hutcheson. He published several pamphlets in 1720 whose rich histrionics urged Parliament to take action against the company so that “our weekly bills of mortality may not be filled with large articles of unhappy people who have hang’d, drown’d or shot themselves”. That was over the top. More sensibly, Hutcheson pointed out the illogicality of buying South Sea stock when it was cheaper to buy government bonds that stood to be converted into company stock. Perhaps that message filtered through. Or perhaps it is best to leave the explanation to the great monetary economist, Milton Friedman, who once noted that “the start and the end of a bubble just can’t be explained rationally”. 

Yet, according to some academics, the South Sea Bubble contained more rationality than it is often given credit for. The underlying point is that western Europe in the early 18th century buzzed with innovation and nowhere more so than London. This spirit, which helped inflate the South Sea Bubble, can be filed under two headings: business innovation and financial innovation. 

 

Business innovation  

Three academics at the Yale International Centre for Finance – Rik Frehen, William Goetzmann and Geert Rouwenhorst – suggest that four strands of business development came together around 1720. 

First – as mentioned – there was change in government finance in both Britain and France. Second, there was a shift in global trade towards the Americas. This captured the popular imagination with the prospect of wonderful rewards, especially for Britain and France whose governments hoped to challenge the control of the Atlantic trade by Spain, which had been weakened by the long-running War of the Spanish Succession. 

Third – and linked to the expansion of maritime trade – was the rising ability and willingness of joint-stock insurance companies to shoulder the risks of such trade. Companies such as the Royal Exchange Assurance Company and the London Assurance Company, both founded in 1720, could raise much more capital than private insurance syndicates and so provide more effective risk sharing.

Fourth, in the heady atmosphere of 1720, companies were keen to break out of the restraints imposed by their charters. This helped launch a procession of companies seeking to raise capital from England’s new class of investors. With hindsight, many of their schemes were easy to lampoon – as Charles MacKay did in his account of the bubble – and none more so than the infamous plan “for carrying on an undertaking of great advantage; but nobody to know what it is”. 

Yet many companies’ aims seemed feasible, sensible or ingenious. All, however, were killed off by a combination of the Bubble Act – passed at the instigation of the South Sea Company, which wanted to eliminate potential competition – and the fall-out from the bubble’s bursting. So much so that, according to the historian John Carswell, innovation in Britain was anaesthetised for 50 years. But for the Bubble Act, Carswell imagines Samuel Johnson heading off for his famous tour of Scotland’s highlands in 1775 by steam train rather than by coach and horses. 

 

Financial innovation 

It is not just that the South Sea Bubble offered the world’s second privatisation of government debt (assuming the Mississippi Company was the first). The South Sea scheme also offered an early form of derivative and – like almost all derivatives – the South Sea Company’s brought the potential to lever up investors’ returns. 

As soon as the company’s directors had bribed their way to securing the deal to run the government’s debt, they raised new capital by issuing part-paid stock that effectively worked like call options. In all, four tranches of part-paid stock were issued between April and August 1720, as shown in the table from a paper by Giovanni Giusti, Charles Noussair and Hans-Joachim Voth of the University of Zurich. 

 

Inflating a bubble

Subscription round

1

2

3

4

Issued (during 1720)

14-Apr

29-Apr

16-Jun

24-Aug

Issue price 

£300

£400

£1,000

£1,000

Amount down

£60

£40

£100

£200

Final payment due (i)

14-Aug-21

24-Apr-23

02-Jan-25

24-Aug-22

Premium (ii)

-1%

10%

21%

28%

Gain within one week (iii)

10%

10%

150%

54%

Notes i) according to original schedule; ii) compared with mkt price at issue; iii) change in part-paid stock after one week. Source: Giusti, Noussair & Voth, University of Zurich

 

Let’s run through what’s happening. Take the first subscription round, issued on 14 April 1720. The company issued new stock at £300 in part-paid form with £60 down. Thereafter, a further eight payments of £30 each were scheduled, with the final payment due on 14 August 1721. At the date of issue, the directors, perhaps still being a bit cautious, issued the new stock at 1 per cent below the prevailing market price after adjusting for the time value of future payments. The punters’ response was positive. One week on, the part-paid price had risen 10 per cent. 

And so it went on. Tranches of new stock were issued at progressively more ambitious prices. For example, with the third tranche, the directors asked for a 21 per cent premium. That wasn’t a problem – after a week the part-paid stock was showing a gain of 150 per cent.

Yet one puzzle was why the public was so keen to buy new South Sea stock. After all, they could acquire the right to the same future interest payments more cheaply through buying government stock in the market (the very stock that the company would buy in with the capital it was raising). 

Nor was this price gap a secret. Early 18th century London had its prototype investment analysts who pointed this out; in particular, the aforementioned Archibald Hutcheson. At the time of the third tranche of stock in June 1720, he showed that in total the company had issued stock with the nominal value of £42m for eventual receipts of £234m. On average, this worked out at £557 per 100 shares (the equivalent of one stock unit) and, at the time, stock traded in the market at £600. That might sound like a bargain, but not for those who had just committed to pay £1,000 in the latest round. So why do it?

Partly for reasons of leverage. A £1 rise in the value of the fully-paid stock in the market would have a disproportionately beneficial effect on the price of part-paid stock. Second, the timing of instalment payments was vague. There was a schedule, but it could be varied according to how the stock was performing in the market. This was likely to encourage punting since there was always the likelihood that future instalments would be shoved into the future (as, indeed, they were). 

Related to this – and especially important – the terms of the new stock issues almost persuaded punters to walk away from their commitments. As Gary Shea, of the University of St Andrews, has pointed out, South Sea Company subscriptions essentially worked in much the same way as compound call options and, at any point in the instalments schedule, a stock holder could default on his next payment knowing he would not lose any of the profits that had accrued to him. That is because the terms of each subscription round meant that a defaulting holder forfeited his stock, but the company was only allowed to claim the amount due in the instalment. Any surplus – the ‘overplus’, as it was called – would be returned to the defaulting ex-stock holder. 

Did this mean that the South Sea Bubble was actually quite rational, or did it add to the madness? A bit of both, probably. Mr Shea reckons that, by using options pricing theory, “the relative pricing of the South Sea original shares and the subscriptions shares throughout 1720 was just about right”. Meanwhile, Messrs Giusti, Noussair and Voth of the University of Zurich label it “a classic Ponzi scheme. The secret of success is to join early (and to get out before things fall apart). As long as there is a good chance that another wave of investors will enter, it is a good idea to participate”. 

In other words, the bubble was an early example of that business school favourite, the theory of the greater fool. Somewhere there is a greater fool than you who will take whatever dross you have off your hands for a profit. The problem with that notion is that eventually the supply of greater fools runs out. There are only so many of them, as many discovered during the autumn of 1720.

Perhaps by that time Newton was not so much a greater fool as just an old fool – the glories of calculus and gravity were deep in the past. Then again, perhaps he had foreseen that the South Sea Company would follow his second law of motion. Sure, its attempts to make money from the slave trade came to little. Ditto its venture into whaling off Greenland. However, it found a purpose whose inertial force just carried it on and on. Until the mid-19th century, the company’s solid but dull purpose was to manage the government’s debt. In the process, it became steady and reliable, throwing out regular dividends that Newton’s beneficiaries may well have enjoyed. 

Sir Isaac Newton (1642-1726)

The greatest mind of his generation (or possibly much longer) was also a man of business, most notably when, at the comparatively advanced age of 54, he swapped academia in Cambridge for the hurly-burly of the City of London. There, he became Master of the Mint, effectively running England’s monetary policy. He mixed with City figures and was introduced to the fashion for dealing in company stocks. Despite his losses in South Sea stock, Newton died wealthy. His estate was valued at £30,000, perhaps £60m in today’s purchasing power. 

 

George Handel (1685-1759)

An impresario as much as a composer, Handel was a smart money maker. He had invested in South Sea stock as early as 1715 and still had a holding when – after the bubble burst – shareholders had their holdings split 50/50 between shares and South Sea annuities. Musicologist Ellen Harris says that “overall, Handel timed his market moves fairly well and did not lose money from his holding in South Sea stock”. Hallelujah. 

 

Daniel Defoe (1660-1731)

The man who gave us Moll Flanders and Robinson Crusoe was the 18th century’s Jeffrey Archer – ever on the make, with a knack for making money then losing it. Like Lord Archer, Defoe spent time in prison and had close connections with England’s leading politicians. So much so that he was charged with defending the South Sea scheme. Despite his own misgivings about it, he compared it favourably with John Law’s Mississippi scheme as “a real beauty and a painted whore”. When, however, the bubble burst, he was sure where the blame lay: “Avarice is the ruin of many people besides trades-men; and I may give the late South-Sea calamity for an example.”

 

Alexander Pope (1688-1744)

The poet and satirist of early Georgian England was unmatched for his skill with a verbal stiletto. Whether he dabbled in South Sea stock isn’t known; that he dispatched the most damning rebuke of the public’s infatuation with it isn’t in doubt:

How goes the stock becomes the gen’ral cry

Rather than fail, we’ll at nine hundred buy.

Instead of scandal, how goes the stock’s the tone,

Even wit and beauty are quite useless grown;

No ships unload, no looms at work we see,

But all are swallow’d by the damn’d South Sea

 

Thomas Guy (1644-1724)

Granted, not the only winner from the bubble, but the best known, whose legacy lives on. Guy was the Jeff Bezos of his day – a bookseller (in the late 17th century that was high-tech stuff) with a reputation for being mean to his staff. According to Andrew Odlyzko of the University of Minnesota, Guy started selling his South Sea holding in late April 1720 when the stock price was £340. By the end of June he was out, although later he needed to buy more stock to cover short positions. Professor Odlyzko estimates Guy’s profits from his South Sea holding at £175,000. Four years later he died, leaving £300,000, whose value today would be around £600m in purchasing power. Of that, £400m in today’s money went to founding Guy’s Hospital.