What the South Sea Company can teach us

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Financial bubbles are always a fascinating phenomenon. Some modern economists, especially from Chicago, deny their very existence, arguing that investors are rational and that markets are efficient in the sense that prices accurately reflect all known and relevant information. Others offer refined versions of the irrationality thesis advanced by Charles Mackay in 1841 in his famous book Extraordinary popular delusions and madness of the crowds.

Either way, bubbles provide fascinating material for historians, not least because they are so often accompanied by financial shenanigans, as well as economically debilitating banking crises. The great financial meltdown of 2007-08 was just the latest example.

300 years ago the Mississippi and South Sea bubbles, the first of their kind. In money for nothing, Thomas Levenson covers both, although his main focus is on the famous South Sea boom and bust in which company directors bribed much of the British establishment and inflicted losses on intellectuals. as brilliant as Isaac Newton. Apparently, the company was created to trade with the Spanish colonies in South America at the end of the War of the Spanish Succession. But at the heart of the bubble was a piece of financial engineering designed to reduce Britain’s huge wartime debt.

The South Sea Company has proposed to parliament that the holders of government IOUs pass them on to the company in return for shares. To gain parliamentary approval, he agreed to a reduction in the debt coupon, thus helping to reduce the government’s borrowing costs. Former creditors received dividends instead of interest, while trustees hoped to back payment with profits from the slave trade. The result was that British public debt became negotiable for the first time, ensuring a lasting competitive advantage in war financing over France.

What sets Levenson’s account apart from many previous ones is his training as a science writer and as an academic at MIT. His general thesis is that at the turn of the 18th century, the power of mathematics and the habits of observation associated with the Scientific Revolution created new ways of thinking about the future. Indeed, personalities like Newton and Edmond Halley, the astronomer, developed a formal framework for thinking about money, risk and uncertainty, which was fully realized in the financial engineering that characterized the bubble year of 1720.

From this new perspective, Levenson provides a vivid account of the development of stock trading in the cafés of Exchange Alley in the City, with fascinating asides such as Newton’s extraordinarily modern management techniques when running the Royal Mint. As for the idea that the bubble might have been rational, he rightly says that it contradicts the way people who lived through it described their experience.

On the nature of the scam itself, he relies heavily on the account of Adam Anderson, an employee of the South Sea Company, who said that the administrators could have lined their pockets with the proceeds of the sale of ‘excess’ actions – actions in excess of what was needed. to erase the public debt – so they took advantage of the creation of the bubble. Levenson doesn’t explore recent scholarship saying it doesn’t make sense because buyers of “excess” stock would have expected to receive the same dividend rate as other shareholders. The book is nonetheless a fascinating read.

William Quinn and John D Turner also reject the rational and irrational categorization of investors, arguing that it does not do justice to the complexity of the bubble phenomenon. Bubble prices, they write Boom and Bust, are defined by a wide range of investors with different information, different worldviews and investment philosophies, and different personalities. The authors, academics from Queen’s University Belfast, provide a taxonomy of bubbles, as well as an analytical framework that outlines their causes while explaining what determines their consequences and how they can be predicted.

They describe most of history’s well-known bubbles, with notable exceptions such as the Dutch Tulip Mania of 1636-37. According to them, the popular account of this is largely fictional: Charles Mackay’s account is unreliable and based on second-hand evidence. And the mania was financially and economically insignificant. Among the lesser-known bubbles covered are the first emerging market bubble of 1824-26, the British bicycle mania of the 1890s and the Chinese bubbles of 2007 and 2015.

The book’s analytical framework is based on a triangle that describes the conditions necessary for a bubble, the three sides being asset tradability, expansionary money and credit, and intense speculation. These become sufficient conditions where there is a technological or political spark.

The accounts of the various bubbles are sound, supported by careful research of primary sources on the small bubbles. And the authors note that the most damaging are those where the inflated asset class is deeply integrated into the rest of the economy and the banking system. Moreover, policy-induced bubbles tend to be more economically and socially damaging than technology-based ones, which often promote innovation in various ways.

For anyone interested in financial history, Boom and Bust is essential
reading. This helps explain why the aberrant behavior that characterized the South Seas Bubble may still be occurring in the 21st century.

money for nothing: The South Seas bubble and the invention of modern capitalismby Thomas Levenson Head of Zeus, RRP£20, 480 pages

Boom and Bust: A global history of financial bubblesby William Quinn and John D. Turner, Cambridge University Press, RRP£18.99, 296 pages

John Plender is an FT columnist

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