Tuesday, April 3, 2012

The South Sea Bubble

I recently finished reading a book on the South Sea Bubble. I was surprised at how fascinating it was. I have heard of the South Sea Bubble before, but I couldn’t really tell you much about it. I knew that it happened in the early 1700s and there was also something called a Mississippi Bubble. However, I couldn’t make a distinction between the two, until now.

The book is The South Sea Bubble: An economic history of its origins and consequences by Helen J. Paul (2011). She is an economic historian interested in Cliometric analysis (the application of statistical techniques to history). Using statistical analysis to analyze history is, from the Austrian point of view, entirely appropriate. In fact, it is really the only legitimate use of statistics.

Anyway, to the story…

Imagine a country that has been in and out of wars year after year. As a consequence, an enormous debt has accumulated and is difficult to pay off. (Stretches the imagination doesn’t it?) This was the situation that both England and France found themselves in the early 1700s. In England, some of the debt could be paid-off early, but not all of it and not without the permission of the creditor. Furthermore, this debt was between the King and the individual and could not be traded. In other words, if the King borrowed £1000 from you, he owed you. You could not sell that debt to another, and if the King died then the debt was cancelled. With all this debt hanging overhead, how does a King borrow more money to fight more wars? The solution came in three forms: the conversion of the King’s debt into the nation’s debt, the creation of paper money and with it the establishment of the Bank of England (as a central bank), and the chartering of a monopoly company.

The monopoly company was the South Sea Company. It offered equity shares in exchange for the previously untradeable debt. A creditor could exchange £1000 in government debt for shares in the company. These shares were tradable and the value would fluctuate on the open market. This allowed creditors to reduce their risk exposure to a government default or other inability to pay.

The company would collect the government debt from the creditors in exchange for shares. The company would then be the recipient of the government’s debt payments. As a result, the company was “guaranteed” a minimum amount of income each period. Furthermore, the South Sea Company was granted the exclusive right to trade in virtually all of South America. (Of course, other nations traded in South America so the grant of monopoly only stopped other English firms from competing with the company.) Additionally, the Spanish Asiento was granted to the company. The Asiento was a grant of monopoly to import African slaves into the Spanish colonies. (The agreement also allowed a limited number of “permission” ships to also trade in other goods.) So the South Sea Company would get the slaves from the Royal African Company, ship the slaves across the Atlantic under the full protection of the Royal Navy, and sell them in the Spanish Americas.

To try to put this into today’s terms, imagine if the US government sets up a company to buy up all the national debt. The company will have a positive cash flow as the US government pays the debt, and the company has a grant of monopoly to ship oil out of the Middle East, which is backed by the full power of the US Navy. The owners of the shares will collect the profits either through dividends or increased valuations of the stock. Many people thought that this arrangement was a good deal and sold their debt for shares.

But wait there’s more! The South Sea Company allowed owners of the stock to borrow money and use the stock as collateral. So, if I have £1000 in government debt, I could convert it into company stock and then borrow £1000 and use the stock as collateral. If the stock price falls, I could just walk away and let the company keep its stock while I pocket the cash.

But wait there’s even more! If you decide to purchase the stock, you could pay in installments. So if the price of the stock falls low enough, you could just stop paying the installments and forfeit the lower valued stock. Now combine this with the fact that you could borrow against the stock! You could purchase the stock and decide to pay in installments, borrow against it, and if the price falls, you could just walk away from it. What a deal!

No wonder there was a tremendous run up in the price of the South Sea Company! The result was a bubble that popped in September 1720. The French, under the direction of John Law, had a similar scheme. It was called the Mississippi Company. It, too, had a tremendous run up in price and also popped in the Spring of 1720.

For those history of economic thought buffs, you might recalled that John Law had a right-hand man that was able to get out of the Mississippi Company right before the collapse and walk away a rich man. He wrote a book about the experience and made other insights on the financial world and the economy in general. He was later murdered in London and his house set afire to cover up the treachery. His name was Richard Cantillon. Rothbard called him, “The Founding Father of Modern Economics.” Alas, that discussion is for another post.


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