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15 May 2006 Bubbles on the South SeasRichard Dale The First Crash: Lessons from the South Sea Bubble, Princeton and Oxford, Princeton University Press, 2004 (192 pp). ISBN 0-69111-981-6 (hardcover) RRP $75.00. Stock markets in Australia and around the world are in record territory. Major city real estate prices are bouncing around their historic highs, and even commodity prices have soared in the last few years. While this is all very exciting, some people are asking questions about whether these prices are sustainable or whether we are witnessing another speculative bubble that could burst at any moment. Opinion is divided. Some point to a lack of real ‘fundamentals’ underpinning these prices; others are suggesting that new forces such as the industrialisation of China and India will sustain the boom.
The issue of the stability or instability of stock markets has been important in finance for at least two decades. Meanwhile, wider share ownership by the public is now generating greater general interest in how the stock market operates. In Australia, news of movements in the stock market is now almost as common as weather reports. So a book charting the history of the first great stock market crash in England in 1720, now known as the South Sea Bubble, promises to help inform both academic debate and popular interest in stock markets. Richard Dale’s The First Crash: Lessons from the South Sea Bubble (hereafter TFC) is the latest in a series of books on the South Sea Bubble. This 18th century corporate collapse has been subject to searching scrutiny by generations of economic and business historians. The distinctive claim of TFC is that it is a financial history, focusing on the relation between the company’s changing share price and its future profit making potential. In this task, Dale has used some new archival material, from which he draws conclusions about the causes of the eventual crash. Also, as the title suggests, the book attempts to use the insights from that event to look at into the wider debate about the causes of stock market bubbles. In the former, it is reasonably successful, in the latter it is less so. Emerging Stock Markets—Funding War, Luxury and Government DebtIn the late 16th and early 17th centuries, financial markets underwent rapid change and modernisation. But in the early 1700s, the stock market was still quite small, and capital markets that did exist were developed largely to deal with needs of government finance, to fund military conquest and monarchical luxuries. The South Sea Company, which began in 1710, emerged directly out of this environment of financial innovation and government finance as the dominant factor in an emerging capital market. Government borrowing was then quite varied. In terms of its longer-term borrowing for instance, Dale gives two interesting examples. One type of loan paid the lender interest on the debt while they remained alive, and these were known as ‘single life’ annuities. Another was known as a lottery loan, which offered a small minimum return, plus the chance to win a large prize in a lottery draw.
John Blunt, one of the founders of the South Sea Company, and Dales’ main protagonist in the South Sea story, cut his teeth in promoting lottery loans. At some point, Blunt saw that there might be money to be made by promoting a company that offered to consolidate much of this government debt. In France at about this time, a canny Scotsman, John Law, also began running a company, the Mississippi Company, to consolidate government debts for the French royal family, in return for concessions in the French colony in Louisiana (and, in his case, to issue private bank notes as a sort of legal tender). It was against this backdrop that the South Sea Company was promoted by a group of stock market-types to transform the various existing government debt obligations into a standard form. In this way, the company was a sort of loans-for-shares scheme. The arrangement effectively converted government debt into shares in the South Sea Company, and the Company in turn earned its money from interest payments from the government. A company whose main assets were essentially a steady stream of government interest payments was then, as now, an unlikely company to have formed the basis for such an extreme case of speculative excess. But the story is also one of how what is now euphemistically termed ‘financial engineering’ can be used as a sort of financial smoke and mirrors trick, at least for a time. To get to the historical and contemporary issues discussed by Dale in TFC, it is useful to give a basic outline of the South Sea Company. The South Sea Company—Reputation, Financial Innovation and SpeculationThe South Sea Company began in mid-1710, when John Blunt received agreement from the British Prime Minister to convert about 9.5 million pounds of government debt into South Sea Stock. In return, the government agreed to pay 6 per cent to the company on that debt. Along with the government debt obligations, the government also granted to the Company a charter or trading monopoly for the South Seas (South America), including rights in the slave trade for that area. But the South Seas were already an area controlled by the Spanish, and consequently the trading side of the Company remained secondary to the debt conversion business. Indeed, the Company’s directors were mainly financiers, and had little shipping or trading experience. Dale reports that the early trading ventures of the Company seem to have actually been loss-making, so the name South Sea Company, although exotic, was something of a misnomer. The early history of the Company was unremarkable. A series of debt conversions between 1711 and 1719 increased the capital base of the company, but did little to alter its basic financial structure as a company holding government fixed interest rate debt. Even at the beginning of 1719, there was little or no indication of what was to follow in the ensuing eighteen months.
In 1719, the South Sea Company began a series of very ambitious debt conversion schemes. In January of 1720, the company even launched a scheme to convert about half of the existing government debt into South Sea shares. In order to attract the large numbers of government debt holders required for the scheme to succeed, the returns on the interest rate paid through the Company was not going to be enough. Instead, the schemes depended on luring people to invest on the basis of potential price appreciation in South Sea Company shares. Indeed, the Company began to undertake conversions that effectively required it to pay out more than it received. As Dale notes, by then, ‘the return on the Company’s main asset (interest payments from the state) was less than its cost of capital (what it was paying to convert the debt into shares)’ (p. 79). The company even began to have to issue new shares just to pay out dividends to existing shareholders. From then on, there was a fatal financial flaw at the heart of the company. The Company’s immediate future turned not on the money it earned from government interest payments; they were lower than what it was paying to convert new debt into company shares. Instead, it had to continually boost its share price so that the debt conversion would be less expensive. Quite simply, it needed to engineer a bubble in its share price to stay afloat. The Company began engaging in misleading rumors to the press, bribery of politicians (with cash and offers of options on South Sea stock) for positive statements, permitting investors to invest in shares for a small deposit, and so on. These activities were being orchestrated by an inner cabal around John Blunt, apparently without the supervision of the rest of the directors. Here, Dale makes comparisons between this activity and what companies like Enron and World Com were doing during the technology bubble of the late 1990s. I wonder whether these comparisons were needed, but more on that in a moment. For a while this ‘financial engineering’ worked very well. The price of South Sea shares rose rapidly. From 1719 to the middle of 1720, South Sea shares climbed from less than 100 pounds and reached more than 900 pounds in July. In June 1720 alone, the share price doubled (from 350 to around 700 pounds). But like a pyramid scheme, once it could no longer be expanded at this frantic pace, the whole scheme started to work backwards. In mid-1720 the financial arm of the South Sea company was in deep trouble. There is some debate about when the bubble peaked, but little debate that once the price started falling (sometime between August and September) there was no force holding it up. By December of 1720, it had crashed back to 100 pounds, considered by most financial economists to be its fair value. The Bank of England, then also a private company, took over what was left of the company, and the South Sea bubble was for all intents and purposes effectively over. Should Investors Have Seen The Crash Coming?Of course, corporate reporting and analysis was then embryonic, and certainly not as sophisticated as it is today. So this raises the question of whether it was possible to have uncovered the deteriorating condition of the Company? Was it possible to see the impending crash coming? Here, Dale relies on the largely neglected writings of the political economist Archibald Hutcheson, who wrote and published several critical accounts on the state of the Company’s finances. Dale argues that Hutcheson shows that it was in fact possible to have obtained information that exposed the true state of South Sea finances. Clearly, to have stayed invested in the company from early 1720 was a folly, despite the spectacular price increases that were occurring.
An important historical point Dale makes is that the Bubble Act of 1720, which attempted to slow the rate of new company flotation, was actually passed before the final crash of the South Sea Company. It is often thought that the Bubble Act was passed in the wake of the collapse of the South Sea Bubble. Dale makes the point that the initial intent of the Bubble Act was as a form of protection against new entrants to actually prop up the South Sea Company. Later, the Bubble Act became associated with the reaction to the subsequent crash of the company. CritiqueDespite these contributions, there are some unresolved contradictions and omissions in the book. For instance, Dale makes the case that financial market investors had the information and could have calculated the fundamentals of stock prices to see a bubble was happening. So all that is left is a temporary bout of irrationality as an explanatory device. It was a moment of popular delusion, to use a then famous term. Yet TFC and other histories of the South Sea Company provide evidence of the close links between the company, the ruling political party, other players in the stock market, the Crown, and the media. This suggests that there was another possible reason for the bubble. There was a powerful group of people inside and outside the firm who used their reputations to deceive the average investor. It bears noting here that until quite recently, the reputation of people in a venture was considered almost more important than the results published in corporate accounts as signalling corporate performance. If the English royal family and senior cabinet ministers were seen to be backing the firm, this was enough. Indeed many new investors drawn in to the stock market at this time probably could not read newspapers let alone understand double entry book keeping. As it turns out, by 1720 many of the reputable ‘gentlemen’ involved were simply interested in plundering the other (outside) investors, and to do so they had to promise increasingly fictitious returns. The South Sea Company had become a great pyramid scheme. Dale makes much throughout the book of the comparison between the South Sea Bubble and the Tech Crash of 2001. In a way, this later crash was a rather strange point of comparison. The Tech Crash was the product of a longer run-up in prices, was based around many new firms each with high tech ‘stories’, and occurred in a sector in which many were arguing for new types of capital valuation. While there were some useful parallels (as there are in all ‘bubbles’), the comparisons sometimes seemed contrived. Just because the Tech Crash was the most recent, does not necessarily make it the most appropriate. The publishers may have asked for such a comparison to give it ‘relevance’, but if Dale was going to make that concession, he might have better assembled this material in a separate chapter. There is indeed a chapter called ‘Lessons…’ but it is poor and re-runs the financial orthodoxy that the South Sea bubble was basically irrational animal spirits. Instead of the Tech Crash in the United States, for recent comparisons Dale could have just as easily looked eastward to Russia and some of the post-soviet states, where he would have found closer points of comparison. There, not only was there a loans for shares scheme, but there was also a similarly potent mix of financial innovation, an emerging market, a class of aspiring capitalists, and state fiscal crisis.
In the early 1990s, for example, some former socialist states, like the Czech and Slovak republics, had pyramid schemes even more dramatic in some ways than the South Sea company. There too, privatisation often occurred by giving all citizens shares in the enterprises. But the assets of many of these firms were then plundered by insiders, often with government connivance and support. In Russia, the Yeltsin government also had a loans-for-shares scheme in 1996, in which a small group of politically connected businessmen were granted rights to valuable mining projects on the basis of often very small loans to the state, and support for Yeltsin in the 1996 election. Here, all Russian citizens (not just investors) were deceived when President Yeltsin effectively handed over billions of dollars of mining and gas assets to these oligarchs for few million dollars. Russia now has several of the wealthiest billionaires on the planet. The main difference there of course is that in the South Sea case investors thought for a while they were sharing in the wealth, while in Russia wealth was transferred more or less privately, and the average Russian punter never got a look in. These comparisons remind us that markets are often rough and tumble places, always vulnerable to sharp practice. There is, then, something paradoxical in financial historians not facing up to many of the seedier sides of stock market history, in the same way that international economics often glosses over the importance of the slave trade in the 18th and 19th centuries trading system. It’s as if admitting to such events casts a permanent stain—after admitting to original sin there can be no return to Eden. And while dwelling on the uniqueness of the South Sea bubble, Dale too often neglects the links with the crash of Law’s Mississippi Company in France that occurred just before the demise of the South Sea Company (and thus renders the title the first crash somewhat misleading). Indeed, the crash in Paris contributed to changing popular sentiment in London, and thus in part to the end of the South Sea bubble. Dale makes the case that the crash of the South Sea bubble did not have a significant or lasting effect on the British economy. It was, according to him, a spectacular but relatively harmless bubble on the surface of the economy (there are even some financial economists who don’t see it as much of a bubble). There is respectable opinion in this direction, and amongst financial economists it is almost the orthodoxy these days.
But Dale does not canvass the other view at all. That the crash was an important historical moment is also a view with respectable adherents. John Carswell, in his classic history of the collapse of the South Sea bubble, for instance, argues that the crash was very important. For him, it marked the end of an era:
Such was the long memory of the South Sea bubble that even 50 years later Adam Smith wrote that the joint stock company was a very inefficient and unreliable way of managing ‘other people's money’. It would have been interesting to see what Dale makes of these arguments. These specific criticisms point perhaps to a wider problem with many such financial histories. It is all too easy for historians to look back on such episodes, their views coloured by the particular period in which they are writing. And, at the risk of labouring the point, Dale’s book also shows the difficulty financial historians often have in situating a financial event in the wider social and economic conditions of the time. The spectacular rise and fall of the South Sea Company was, after all, not just a financial event. It was mixed up with the changing economic, political, and cultural conditions and attitudes of the time. Its rise and fall attracted wide popular attention. While Dale begins the book reminding readers of some of these features as background to the Company, he doesn’t consider how the bubble’s collapse affected these ongoing changes. His attempt to use the 2001 ‘Tech Wreck’ as the main point of comparison is, in this respect, symptomatic of that problem. There is much interesting material in this book, but it is surely not the last word on the South Sea Bubble. If however, it can stimulate others, especially non-financial historians, to consider financial crises in particular and finance more generally as worthy of wider analysis, Dale’s book will have proven itself an important contribution. REFERENCESCarswell, J. 2001 (1960) The South Sea Bubble, Revised edition, Sutton Publishing, Stroud. Mike Rafferty teaches at the Graduate School of Business, University of Wollongong. He is researching the development of financial markets in Central and Eastern Europe in the post-soviet era. He is co-author (with Dick Bryan) of Capitalism With Derivatives: A Political Economy of Financial Derivatives Capitalism and Class, published by Palgrave MacMillan in March 2006. |
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