2020 marks the 300-year anniversary of England’s most notorious speculative mania, and the first of many economic and financial crisis.
During the first half of 1720, the price of South Sea Company stock rose eight-fold reaching a peak in early July. Restrictions on the supply of shares, coupled with surging credit availability fueled the share buying bonanza. The fear of missing out on riches drove the share price even higher.
At its peak, the Company’s market worth was around twice the total value of all the land in England. Those charged with running the Company and connected to it in government knew they had a problem: they had to keep fueling the boom or fear that it would fall around their ears and potentially crash the economy.
But that confidence act could only last so long. Eventually it began to crumble, and with it the share price. As the bubble collapsed during late summer and into September 1720 financial distress rippled out through the financial centres of Europe — from England through Holland and onto northern Italy.
The South Sea bubble follows the same distinct patterns shown in the bubble profile illustrated below. As the subsequent 300 years demonstrated: markets may change, but people do not. They forget the lessons of the past and shout “This time is different”. It never is.
The South Sea Bubble of 1720 had the same essential ingredients that make investing so challenging today: geopolitical turmoil, rapid globalisation, novel financial products, innovative business models, new communication technologies, misinformation and an abundance of tricksters ready to prey on the unwary and gullible.
As so often happens with notorious stories of financial ruin there is much more to the story. This article outlines the history of the South Sea Bubble, much of which you might know already but there will also be some of the hidden stories that will be much less familiar. But first, in order to understand the crisis that was to unfold you first need to picture the preceding decade.
The Stealth Phase
The South Sea Company exploits the shift in global trade
The South Sea Company was a British joint-stock company founded in 1711. Daniel Defoe, the author of Robinson Crusoe was a director of the Company and had persuaded the British government to setup a company to trade with the South Seas (now referred to as the islands of the south Pacific Ocean) and South America.
In return for taking on a proportion of the British national debt (effectively converting debt to equity in the Company), the government granted the South Sea Company the monopoly on all trade with the South Seas. Unknown at the time it was the beginning of the path that was to lead to a major crisis less than a decade later.
At the time the Company was created, most of South America was controlled by the Spanish and the Portuguese, and so there was little prospect of the British capturing much of that trade. However, after the end of the War of the Spanish Succession, as part of the provisions of the Treaty of Utrecht (1713), the Spanish granted the monopoly contract (the Asiento) to the South Sea Company.
The slave trade
Under the terms of the agreement the South Sea Company was contracted to import 4,800 piezas de Indias annually. A pieza was the value of a healthy male or female slave between 15 and 25 years of age. Slaves between 25 and 35, and between 8 and 15 years were valued at 2/3 peça. Slaves outside this age range and those infirm attracted a lower value. However, the terms and conditions offered an exclusion to account for the risk that shipwrecks and mortality during the crossing would affect the supply of slaves.
As well as the South Sea Company the French Mississippi Company was also set up to exploit trade with the Americas. The Mississippi Company owned the rights to develop the Louisiana territory. As with the French, the British also sought to challenge the dominant, but weakening control that Spain wielded over the Atlantic trade.
The slave trade was seen as a key route by which the British could capture some of that burgeoning trade. Often overlooked amid the mania that was to follow, the actual business of the Company involved transporting African slaves to work. The incumbent Spanish and Portuguese colonialists were suffering from a shortage of labour to mine gold, silver and other commodities— slaves were a must have.
The South Sea Company is estimated to have transported around 34,000 African slaves during the period when it was in existence. Tragically, many of the slaves transported either died during the crossing or after they were put to work. Around 15% of slaves are estimated to have died during the voyage across the Atlantic ocean — some 5,000 men, women and children. This was comparable to the mortality losses incurred by other slave operators and shows that, at least in the gruesome business metrics of the day, the Company did have some expertise in the area.
The smart money
Starting in the late 1670’s bookseller Thomas Guy began purchasing sea-man pay tickets at a large discount (when sailors returned from abroad they couldn’t always get hold of their salary and so many sailors sold that right onto others in return for some quick cash). In 1711 these tickets became part of the short-term floating national debt and were converted into shares of the South Sea Company. Guy had effectively been picking up lottery tickets for decades, and so through luck he had effectively become a major shareholder in the Company.
The Awareness Phase
A risky business
The maritime trade involved substantial risks: the voyage could be intercepted by pirates eager to capture the precious metals, ships could be shipwrecked in storms and traders faced the prospect of losing hundreds of their slaves to disease.
Maritime insurance was an essential institution for risk sharing. Prior to 1720 maritime trade was insured by matching voyages with individual insurers or syndicates. In 1720 England allowed the first joint-stock insurance companies to raise capital by issuing shares. In turn this enabled a much larger capital base to be made available for underwriting.
Financial innovation became the roots of the mania
The early 18th Century was a period of dramatic innovation in government finance. One of the most innovative financial thinkers of his time, Scottish economist, John Law wanted to boost economic growth by introducing a national paper currency not backed by gold.
Trudging around the capitals of Europe he was initially unsuccessful in persuading heads of crown to see the merits of his plan. Eventually, in the spring of 1717 he finally persuaded the French Regent, Philippe Duke of Orleans to allow him to start implementing his plans in France.
Law built up a huge conglomerate fully backed by the state. It was known as the Compagnie des Indes, but known to posterity as the Mississippi Company. As well as holding the royal patent to colonise the territory of Louisiana it also controlled most of the French currency via the Banque Royale. A succession of funding rounds accompanied by a surge in paper currency resulted in an explosive boom surging into life across the French economy.
By 1719 the directors of the South Sea Company looked eagerly across the Channel and wished to imitate the system that John Law had established in France with the Mississippi Company. Not because they were eager to help the British economy. No, they were rubbing their hands at the potential for massive wealth.
Whereas John Law was trying to create an open credit pump that would energise the French economy, John Blunt of the South Sea Company was deliberately trying to create a closed circuit that would only support the price of South Sea stock.
In 1719 the Company directors made a proposal to the British government for it to take on the entire national debt. On 12th April, 1720 the offer was accepted. As so often happens in the world of financial engineering, an innovative idea was taken to the extreme.
But why would the French and British governments be so eager to adopt such new fanged financial engineering anyway? The roots of the financial innovation was a direct result of the massive debts incurred by wars between France and England culminating in the War of the Spanish Succession (1701–14). Both countries economies were spluttering under the weight of all of that debt.
The institutional investor
Richard Cantillon was an Irish-French economist who was an early investor in the Mississippi Company. As we’ll see later he spotted the flaws in the model and cashed out too early, albeit with a massive fortune. Cantillon sold his investment in the Mississippi Company at 2500 even though it would quadruple before finally peaking four months later.
Banished from France by John Law he spotted the opportunity to make even more money by investing in the South Sea Company. Again, he profited handsomely from it but as with his earlier adventures in France sold out too early. One can only imagine the pain he would have felt from his clients as he urged them to sell out, only to see the price of South Sea stock triple a few weeks later.
The Mania Phase
The directors immediately tried to inflate the price of Company stock by any means possible, but more often through the circulation of stories about the fantastical wealth that awaited investors.
The book Robinson Crusoe tells the tale of a young and impulsive Englishman who leaves his hometown, defying his parents wishes in order to seek excitement and adventure on the high seas. Written by Daniel Defoe it was published on 25th April 1719 and helped feed the mania as people speculated on the potential for riches from the South Seas. Daniel Defoe was a director of the South Sea Company and had helped persuade the British government to setup a company to trade with the region in 1711.
But in early 1720 England was again at war with Spain and so the Company’s trading monopoly was basically worthless. The Company’s entire income derived from the fixed interest payments it was receiving from holding government debt.
When the British government agreed the terms of the monopoly agreement with the South Sea Company directors they failed to see how it could be a vehicle for fraud. First, the agreement failed to place any statutory limit on the level to which the share price would be allowed to rise, while also making no provision for profit share withe state. Second, it failed to define the precise terms to be offered to annuitants for the conversion of their holdings into South Sea stock. These two fundamental oversights — whether intentional or not — provided the ideal cover for the directors to boost the share price for their own ends.
The directors fueled the share buying boom by deliberately whetting investors appetite (tales of vast riches in the South Sea’s) but also through restricting the supply of shares. They did this by issuing further rounds of share issues but then re-channeling this money back to shareholders in the form of loans. in order to buy even more shares. The loans restricted the supply of shares and increased the velocity at which they changed hands, in turn driving the share price higher and higher.
The share price of South Sea Company stock stood at £128.50 in January 1720, proceeding to climb to £350 in March. It then went into overdrive. The stock price quickly rose to £550 in May and then to £890 in June.
A number of other British companies also saw their share prices explode higher during the early part of 1720. The Royal African Company (RAC) which, like the South Sea Company, was engaged in the Atlantic slave trade rose by a similar multiple.
The two marine insurance companies, Royal Exchange Assurance and London Assurance rose to much higher multiples. By contrast, the two banks, Bank of England and Million Bank appreciated by much less.
Nearly 200 “bubble companies” were launched at the time, hoping to cash in on the speculative mania that was gripping the South Sea Company. Some of these ventures actually involved tapping investors for money for apparently worthy business ideas — improving the Greenland fishery or importing walnut trees from Virginia.
Most however were shady ventures looking to extract as much money from gullible investors in the shortest time possible. The most famous of which had this remarkable line in its prospectus, “a company for carrying out an undertaking of great advantage, but nobody to know what it is.” Another was formed with the purpose of building a “wheel of perpetual motion”.
These scams were bad for business. The directors of the South Sea Company were wary that these dodgy schemes would detract from the speculative mania that was fueling the price of South Sea stock. They also didn’t want money going anywhere else than into the Company.
The public are drawn in by the media revolution
The media was undergoing a revolution. Hundreds of publications appeared serving every possible niche. It was in the coffee houses of London where the merits of the stories were debated and financial deals were done.
Many of the famous literary figures from that period, such as Daniel Defoe, Jonathan Swift, Richard Steele and Alexander Pope, were involved in the South Sea Bubble, either as investors or as we saw earlier with Defoe, as propagandists writing for the slew of publications that caught coffee house drinkers attention.
Defoe was a prolific writer and an able propagandist. From the beginning of 1720 he ran a newspaper called The Commentator. He is reported to have compared the South Sea Company to John Law’s Mississippi Company as like “a real Beauty and a panted Whore”, while also condemning the unworthy imitators.
A passion for gambling meant the public quickly got taken in by the potential for huge gains. The desire to invest in any project, no matter how extreme, or even whether it was genuine or bogus reached manic proportions. The Commentator newspaper (run by Daniel Defoe) described it as:
“Tis plain, the Novelty of things at this time has its beginnings in the new fashioned frenzy of men’s minds, I mean in their hunting after money which is done with such rage in their avarice that suffers no restraint and that knows no bounds.”
The Blow off Phase
The bubble’s final act
Over on the other side of The Channel, the price of Mississippi Company shares rose by a factor of 10 in 1719 and into early 1720 before eventually bursting later in the spring. In contrast to England where there had been countless copycat schemes, the monolithic Mississippi Company left little in the way of space for other schemes. For investors exposed to South Sea Company stock the collapse of the Mississippi stock should have been a warning sign of things to come.
Under pressure from the directors, the British government passed the so-called “Bubble Act” on the 11th June 1720. This required all joint-stock companies to hold a royal charter — in one strike eliminating much of the competition. The price of South Sea stock surged higher — reaching a peak of £1,050 in early July.
As prices spiraled higher this drew in even more speculators, including some that missed out on earlier increases. There was a real fear of missing out as one banker commented:
“Though I believe you had been in town you would scarce have had the courage to have ventured, but when the rest of the world are mad we must imitate them in some measure.”
While the price of RAC stock peaked around the same date as South Sea, the stock price of the banks and maritime insurance companies marched on higher through the summer reaching a peak in late August. For the canny investor who managed to cash out at the top of the market, an investment in London Assurance at the start of 1720 would have delivered a 13 X return.
After a period of relative calm for South Sea stock during the summer, things began to unwind, slowly at first and then quicker and quicker. The final death nail for the South Sea bubble was the writ, issued by John Blunt on the 18th August in which he accused four companies of misusing their charters. Rather than restoring faith in the upward trajectory of South Sea shares it undermined confidence in all shares trading in London. South Sea shares fell by 60% to £400 by mid-September and then to £124 by December, the same price they had been at the start of that fateful year.
The Dutch Windhandel (literally wind trade)
Amsterdam was a burgeoning financial centre in the early 18th Century. With attention focused on the South Sea and Mississippi bubble people forget that the Netherlands also had its own bubble.
The Netherlands also incurred significant debts as a result of the War of the Spanish Succession. Unlike France or England it didn’t import and introduce the same degree of financial innovation. The price of West Indies Company shares rose dramatically in 1720 before slumping to a fraction of their peak value by the end of October.
In addition to multiple share offerings of West Indies Company shares there was also an attempt to launch an insurance firm (Stad Rotterdam) to compete with the British maritime insurance companies.
Within weeks of Stad Rotterdam’s flotation at least 30 other Dutch companies floated fearing that if they delayed they would miss the wave of speculative fervor. Like their counterparts in England these businesses had multiple lines of business activities, as well as maritime insurance. Accounts from the time described the sudden burst of speculation as “Windhandel” — trade in wind.
What goes up
Sir Isaac Newton is the name most famously associated with the South Sea crisis. When asked about South Sea stock in the spring of 1720, Newton famously declared that he “could calculate the motions of the heavenly stars, but not the madness of people”. Newton of course is known as the physicist responsible for discovering gravity.
Less well known is that Newton was also the warden of the Royal Mint. Newton should have been in a privileged position to preempt movements in the market. Unfortunately for him he lost a great deal of money in the bubble — possibly as much as $20 million in current terms — having sold his South Sea stock in the spring of 1720, later re-entering the market and investing his entire fortune in the Company just before the bubble peaked.
Thomas Guy eventually sold his entire South Sea holding (thought to be about 5 times larger than Newton’s) around the time the acclaimed physicist was buying back into the market. Unfortunately, Guy also sold some call options betting that the market would now fall. He was a month too early. The price of South Sea Company stock more than doubled during June resulting in significant losses, but still dwarfed by the profits from his long side bet. Guy later used his enormous profits to establish the London hospital that still bears his name.
The Cantillon effect
Richard Cantillon the Irish-French economist who invested in the Mississippi, the South Sea Company and the Windhandel. He was also the biggest critic of the System John Law introduced in France and later copied in England, closing his positions too early but still amassing a fortune. But what were his concerns? First, Cantillon questioned Law’s basic economic premise. Money printing brought no lasting benefits, in his view:
“An abundance of fictitious and imaginary money causes the same disadvantage as an increase of real money in circulation, by raising the price of land and labour, or by making works and manufactures more expensive at the risk of subsequent loss. But this furtive abundance vanishes at the first sign of discredit and precipitates disorder.”
Secondly, Cantillon argued that although Law’s monetary experiment might temporarily reduce interest rates and incite speculation, the newly printed notes didn’t actually enter into the real economy but instead would just encourage corruption and inefficiency:
“The excess banknotes, made and used on these occasions, do not upset the circulation, because they are used for the buying and selling of stock they do not serve for household expenses and are not changed for silver.”
Finally, Cantillon observed that the real danger arises when an excess issuance of bank notes led to a loss of confidence in money:
“If some panic or unforeseen crisis drove the holders to demand silver from the Bank the bomb would burst and it would be seen that these are dangerous operations,”
Above all, the financial crisis resulting from the collapse of the Mississippi and South Sea Company shows that when central banks inflate bubbles there is no painless “exit” — Law’s Banque Royale had to continue printing money to sustain the bubble.
Cantillon’s general observation, that money printing has distributional consequences that operate through the price system, is known as the “Cantillon Effect”. In the 18th century the closer you were to the King and the wealthy, the more you benefited — from being able to purchase financial assets at low prices and then see those prices inflate. Only later would the effects appear elsewhere, and the further away you were, the more you were harmed — perhaps through higher food prices or lower relative wages. Money, in other words, is not neutral.
The collapse of the South Sea bubble is widely believed to have produced a severe economic downturn in England. Yet records show only a small increase in bankruptcies and a slight decline in overseas trade. France was to suffer a much graver economic fallout. The deep seated distrust of banks after the crisis meant it would be impossible to formalise French governement borrowing for the rest of the 18th Century.
Despite the bust the South Sea Company continued to trade in slaves after the collapse. Indeed, some of the largest slave cargoes actually occurred after the bubble burst. Apart from a stoppage due to renewed fighting between England and Spain in 1726 the company continued to operate unaffected until 1731. After that the trade continued on a minor scale until the Asiento expired in 1750.
By the end of 1720 stock prices in three major European countries (England, France and the Netherlands) had risen seven-fold and then collapsed almost as rapidly. The widespread use of new equity issues to fund enterprise disappeared from Western Europe for several decades and didn’t return until the same levels until the 19th Century. The fact that London Assurance, Royal Exchange Assurance and Stad Rotterdam survived until the modern era proved the long-term viability of incorporated insurance companies.
Ultimately the South Sea bubble offers remains a valuable history lesson for investors 300 years later: the power of credit to pump prime a speculative bubble, the fear of missing out on riches and looking stupid by not dancing while the music is still playing, the swindlers eager to lure the unsuspecting and the emergence of fraud as the bubble cracks.
The signs were there for anyone that cared to look.