South Sea Bubble
South Sea Bubble
South Sea Bubble
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
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.
South Sea Bubble
South Sea Bubble, popular name in England for the speculation in the South Sea Company, which failed disastrously in 1720. The company was formed in 1711 by Robert Harley, who needed allies to carry through the peace negotiations to end the War of the Spanish Succession. Holders of £9 million worth of government bonds were allowed to exchange their bonds for stock (with 6% interest) in the new company, which was given a monopoly of British trade with the islands of the South Seas and South America.
The monopoly was based on the expectation of securing extensive trading concessions from Spain in the peace treaty. These concessions barely materialized, however, so that the company had a very shaky commercial basis. Nonetheless, it was active financially, and in 1720 it proposed that it should assume responsibility for the entire national debt, again offering its own stock in exchange for government bonds, a transaction on which it expected to make a considerable profit. The government accepted this proposal, and the result was an incredible wave of speculation, which drove the price of the company's stock from £1281/2 in Jan., 1720, to £1,000 in August. Many dishonest and imprudent speculative ventures sprang up in imitation.
In Sept., 1720, the bubble burst. Banks failed when they could not collect loans on inflated stock, prices of stock fell, thousands were ruined (including many members of the government), and fraud in the South Sea Company was exposed. Robert Walpole became first lord of the treasury and chancellor of the exchequer and started a series of measures to restore the credit of the company and to reorganize it. The bursting of the bubble, which coincided with the similar collapse of the Mississippi Scheme in France, ended the prevalent belief that prosperity could be achieved through unlimited expansion of credit. Legislation was enacted that forbade unincorporated joint stock enterprise.
See studies by L. S. Benjamin (1921, repr. 1968), J. Carswell (1960), and V. S. Cowles (1960).
South Sea bubble