History of Bubbles: The South Sea Bubble

As a student of history one cannot but marvel about the nature of human mentality and human emotions. Nowhere is this more visible than when it comes to investor behaviour in the financial markets. The history of bubbles goes back hundreds of years (at least). The remarkable similarities of bubbles starts with each generation of people believing that they are living in an era of great technological change that generations before them had never witnessed. These "revolutions" probably first started with the ability of humans to use fire, then the ability to harness the wheel, maps, industrial revolution, the invention of the steam engine, telephone, electricity, railways, (may not be in that order though). In recent years the ostensible reason for elation has been technological change that invariably leaves us spellbound. The list is exhaustive.

These 'revolutions' invariably leave in their legacy of euphoria amongst the investment community and every few years we have a new fad that becomes the rage. There are a number of interesting manifestations of these manias or in investment terminology - bubbles - are the eerie similarity and their amazing simplicity. Often, in retrospect one may be forgiven to wonder how normally rational, intelligent investors could fall for such a simple illogical investment theme.

A common trait of most of the bubbles is the fact that nearly all of them characteristics that are remarkably similar in the way that they have operated through the ages.

I thought there would be no better way than to go back and research about the past bubbles from what contemporary observers (who kept their sanity) had to say. There is no better book to back to than Charles Mackay’s Extraordinary Popular Delusions & the Madness of Crowds, first published in 1841. However, writing about each of the bubbles will be my priority but due to time constraints, I thought it would be best for me to reproduce parts and pieces from different bubbles that he has documented and try to dig up similarities with bubbles that I have been observing since 1993.

Over a period of time, I have found that the best way to observe the formation of bubbles is when people in a different line of activity start taking notice of returns in a particular asset class. We opine that the greater the attention from non-professional investors, the greater the validation that a bubble has started to expand. A classic instance of a bubble was in 2000: It was reported by Marketwatch website (then http://www.cbs.marketwatch.com/ in a story titled “Buffett defends his tech aversion on 29 April 2000) that a ten year California girl demanded an explanation from Warren Buffett (considered to be one of the most successful investors of the present) during their Annual Shareholder meeting as to why he avoids technology sector.

In this post, I will highlight some important quotations about bubbles and Mackay’s observations. The South-Sea Bubble is one such classic bubble.

The South Sea Company was established in the year 1711 by Harley, the Earl of Oxford. The company was formed to restore public credit which had suffered due to the dismissal of the Whig Ministry. A company of merchants decided that they would assume the debt themselves and in return the government agreed to provide them with certain duties in lieu for a certain period of time at an interest rate of six percent per annum. A monopoly of trade was granted by the British Parliament. The amount of debt that this company of unnamed merchants would assume amounted to nearly ten million sterling, a considerable sum in those days. The interest rate was reduced to five percent from six percent in 1717 on the request by the company.

Reports then surfaced that the company was to be granted four ports in South America by Spain so that it could trade in gold, silver and slaves. These rumours held ground despite the Philip V of Spain having no intention to grant free trade concessions to the British. The Company was granted permission to increase its capital. To cut a long story short, during the course of the debate in parliament about extension of benefits to the company, the stock price exploded due to speculation.

A speaker (Walpole, the only one who spoke against the company) had the prescience to warn in parliament that, ‘the dangerous practice of stockjobbing would divert the genius of the nation from trade and industry. It would hold out a dangerous lure to decoy the unwary to their ruin, by making them part with the earnings of their labour for the prospect of imaginary wealth….’

The parliamentary debate over the bill took two months and in the meantime the stock was the magnet of speculation. The stock rose from about 100 to about 400 and then settled near 330 by the time the bill was passed by the House of Commons. At its height the stock reached a high of 890. A large part of the speculation was driven by rumours that claimed that the company would grow exponentially. Among others, an interesting rumour was that the Earl had received overtures in France from the Spanish government that they exchange the company Gibraltar and another port for some places on the coast of Peru.

On April 12, five days after the bill was passed the company decided to issue fresh shares to the public. The bids received were nearly two million more than the existing capital. Even the Prince of Wales decided to invest about 40,000 of his own money. This boom led to more companies being formed to trade.

Mackay points out that there were nearly a hundred different projects were formed. This is eerily similar to our present day bubbles. Hundreds of companies decide to raise capital from the public: all to monetise the prevailing investment fad. During that era, it was estimated that nearly three hundred million sterling was raised from the public for dubious ventures (p.68). Among the ventures for which money was raised included:
Establishment of a company to make deal board out of saw-dust
Establishment of a company for encouraging the breed horses in England, and improving glebe and church lands, and repairing and rebuilding parsonage and vicarage houses.
A company for carrying on and undertaking of great advantage, but nobody knows what it is.

Once the bubble burst, the following is the list of some of the companies that were declared to be illegal. Mackay lists nearly 85 different companies that were declared illegal and abolished. Amongst them the interesting ventures were:

1. For the importation of Swedish Iron

2. For supplying London with Sea-coal

3. For building and rebuilding houses throughout all England

4. For effectually settling the island of Blanco and Sal Tartagus.

5. For improvement of lands in Great Britain

6. For Purchasing lands to build on.

7. For Trading in Hair
8. For erecting salt works in Holy Island
9. For carrying on an undertaking of great advantage; but nobody knows what it is.
10. For paving the streets of London
11. For furnishing funerals at any part of Great Britain
12. For insuring of horses
13. For a grand dispensary
14. For improving the art of making soup
15. For a settlement on the island of Santa Cruz
16. For improving of Gardens
17. For drying malt by hot air

Once the stock collapsed, it was pointed out that the wealthy of yesterday became the beggars of today.

Source: Charles Mackay (1841), Extraordinary Popular Delusions & the Madness of Crowds, Three Rivers Press, New York, Reprint 1980.