Five centuries of bubbles and panics
In 1711, Britain was deep in debt following its debilitating war with Spain. It owed £9 million and had no means of paying it off. The prospects of government bonds being paid back were so low that they were trading at 50% discount. It made the financial elite of Britain to form a private organisation to take over and manage the government debt. In return, they demanded a monopoly to trade with the Spanish colonies of South America which, at that time, was referred to as the South Seas.
A new company, called The South Sea Company, was born to take over the debt. The holders of debt would get shares in the new company but the government would continue to make interest payments to the company. In essence, their cash flows were secured by interest payments and their profits by the monopoly trading rights, even though Britain was still at war with Spain till 1713.
The reality was different. There was hardly anything to trade with South America. For seven years after the formation of South Sea Company, not a single ship left Britain to trade. When it did, it was to trade not in products or materials, but in slaves. The agreement with Spain was too restrictive: supply the Spanish colonies with 4,800 slaves per year for 30 years and just one ship of up to 500 tonnes of other cargo. If that trade were profitable, the Spanish king would take away 25% of the profit.
Meanwhile, there were no interest payments by the government. Unpaid interest had accumulated to over a £1 million. Shareholders were expecting dividends from that interest. To make up, fresh shares were issued. The shares of South Sea Company got listed and started to move up gradually until late 1719 because of the expected profits from trading with distant mysterious lands. But soon war broke out again between Britain and Spain and the South Sea Company got reduced to just a building in London holding a bunch of bonds of dubious value. This did not deter massive speculative frenzy in South Sea shares.
There was heady excitement about bold new frontiers in finance being conquered, with private enterprise running public finance. South Sea stock took off and, with it, stocks of newly listed companies committed to outrageously harebrained schemes such as trading in hair, horse insurance, creating a wheel of perpetual motion and “carrying on an undertaking of great advantage but nobody to know what it is.” South Sea Company promoters were unhappy with this bubble. They even got a Bubble Act passed by bribing the lawmakers requiring all traded companies to receive a royal charter. Most of them did not get the charter and were suspended. The South Sea, of course, got one and its shares shot up tenfold in six months!
This caught the attention of Britain’s most distinguished scientist at that time—Sir Isaac Newton. In early 1720, he bought some shares at £150 and sold them at £350 for a princely profit of £7,000. The stock continued to climb. Newton jumped back in and put in much more money to make up for lost time (and profits), even borrowing money for it. The stock almost hit £1,000 and then crashed like a waterfall inflicting a loss of £20,000 (which, in 1720, amounted to almost all his life savings). This prompted him to say: “I can calculate the movement of heavenly bodies, but not the madness of men.”
The South Sea Company is one of the great bubble and crash stories. Many books have referred to it. One of the finest is Devil Take the Hindmost by Edward Chancellor. Panic, Prosperity and Progress, by Timothy Knight, is of the same genre. It documents five centuries of such episodes starting with the Tulip Mania in Netherlands and moving on to California Gold Rush, hyperinflation of Germany, the Internet bubble and the financial meltdown of 2008. An interesting read but should be available in paperback.