South Sea Bubble

South Sea Bubble

BIBLIOGRAPHY

The South Sea Bubble was one of the first famous financial bubbles of modern times. The shares of the South Sea Company rose rapidly to ten times their par value within a few months in 1720, and even more swiftly fell back. These rapid fluctuations arose in the process of creating the first modern fiscal state. It was difficult to manage higher taxes and borrowing, and a bubble was the result.

The Glorious Revolution of 1688 brought King William (1650–1702) from the Low Countries to the English throne, together with his military ambitions and Dutch financial bureaucrats to help finance the resulting wars. The English government dramatically increased its taxes, creating a tax basis that assured investors that the government’s bonds could and would be paid.

The English government then tried to figure out how to extend its borrowing. It issued a variety of securities that were not easily transferable; some were irredeemable. While the government’s cost of servicing the national debt was substantial, most annuities traded at large discounts. Imitating the French model of John Law (1671–1729), the South Sea Company (which never traded in the South Seas) offered to exchange existing government debt for equity in the company that could be traded easily. The South Sea Company would buy and hold government debt, paying dividends on its stock from the interest it received on the bonds, and profiting by providing liquidity to holders of government debt. The company’s first major venture was the debt conversion of 1719 in which it exchanged £1 million for newly issued stock. The government’s debt payments fell, former debt holders saw the value of their securities rise, and the company earned a considerable profit.

The South Sea Company then proposed to exchange about £30 million of the national debt for its own shares, paying the English Treasury for the privilege. Parliament and the king approved the conversion by early April 1720, by which time the stock had more than doubled from January. The company obtained the right to issue new shares to finance the conversion, but the conversion ratio was not fixed, and the company could obtain government debt more cheaply as its share price rose. Public interest and company activities drove the price ever higher. Many investors bought South Sea shares knowing that they were overpriced; they hoped to sell the shares for even higher prices before the shares returned to a more reasonable level. The company issued fresh equity in four subscriptions, at higher and higher prices. It also lent generously against its own shares, reducing their supply and increasing demand for them.

The price of South Sea stock rose from around £140 in January 1720 to £300 at the start of April and £800 at the start of June. The price was near £1,000 in the summer, but it fell precipitously in September, back to £200 by October. The rapid fall of share prices in September 1720 probably was brought about by some small event that made it clear to many traders that buying opportunities based on expected price rises were coming to an end. The bubble collapsed, taking the prices of other stocks in London and Amsterdam down with the South Sea Company. The problem of providing liquid government debt was not solved until the introduction of consols (consolidated English government debt with no due date) a generation later.

SEE ALSO Bubbles; Manias; Panics; Speculation

BIBLIOGRAPHY

Dale, Richard. 2004. The First Crash: Lessons from the South Sea Bubble. Princeton, NJ: Princeton University Press.

Temin, Peter, and Hans-Joachim Voth. 2004. Riding the South Sea Bubble. American Economic Review 94 (5): 1654–1668.

Peter Temin