Financial Bubbles and Behavioural Bias: South Sea Bubble 1720

South Sea Bubble 1720
Image credits: brittanica

The details of the speculation, corruption, and gullibility surrounding the South Sea bubble of 1720–21 are rather complex. Let us begin from the beginning.

The newly appointed Chancellor of the Exchequer, Edward Harley was burdened with the responsibility of paying off the government debt of £9 million in 1710.

Initially, a series of schemes were adopted to help the government. Like the state lottery. But it was not of much success. Harley appointed John Blunt of the Hollow Sword Blades Company to help sell the tickets and surprisingly, he sold out all the tickets in just four days. He did so by guaranteeing a win of £10 on a £100 ticket, in other words, at least a 10% return on every ticket. But here’s the catch: the payment will be made over the next decade. This gave them the initial influx of money needed to write off some debt. Pretty clever right!?

The idea of the South Sea Company was conceived in 1711 by Edward and John with the sole purpose of helping the government clear off its debt. All the creditors were then required to surrender the amount of debt they held in exchange for shares of the company of the same nominal value. The company received an interest rate of 6% from the government which was used to pay off dividends to the shareholders.

South Seas actually refer to Central and South America and all their ports. But these ports were under Spanish rule and Britain was at war with Spain. Blunt and Harley decided to put an end to the war and the company was given the right to trade African slaves to the Spanish colonies of the Americas and the right to send only one ship a year for general trade to each of the Spanish ports. One ship a year. Let that sink in.

They created so much hype around the company and its shares that everybody was talking about it, from the government to some very famous people, like Daniel Defoe the man who wrote Robinson Crusoe. Even Newton, yes you read that right, Sir Isacc Newton, too, bought the company’s shares. And let’s just say Newton should have stuck with Science. More on that a little later.

Fast forward to 1714, Queen Anne died and George I became the King.

To win over the newly formed government Blunt made George II, the King’s son his partner and governor of the Company. Through this, he got the king himself to invest in the company. Taking things a step further, John also forgave 2 years’ worth of interest owed by the government, and in return, the South Sea Company was allowed to issue more stocks. In absence of a real business, these stocks greatly helped the company pay dividends to the first set of shareholders. £10 million worth of stock was then issued. To put things in perspective, that’s about half the value of stock issued by all other companies in England.

Eventually, the stock prices rose to £114. This is important because initially the value of shares was fixed at the amount of the debt at £100. Now it was £14 higher than what was required to cover the debt. The rise in prices means that the company wouldn’t have to trade as much stock for the debt and will be able to sell additional shares. This additional money was happily pocketed by John Blunt.

Now you probably would have sensed by now that a bubble is in the making. And sooner or later it’ll bursts.

South Sea’s only source of revenue was an increasing share price. To ensure an upward trend in the price of stocks, Blunt continually came up with ideas and incentives. This time the company allowed payment for stocks in installments, allowing people to buy stocks more and more. Even those who couldn’t even afford those stocks. The very enthusiastic public, at this prospect, bought stocks valued as high as 5 times the amount of stock they can pay for. More and more people started investing in the company. This crowd further attracted a bigger crowd.

This herd behavior is one of the key components of bubble creation. We are biologically wired to copy a larger group of people. The tendency to imitate the actions of others is often not backed by rational thinking or reasoning.

It was so important to not only keep the stocks up but also ensure an upward trend in the prices. After all, increasing stock prices was South Sea’s chief (and only) source of income. John was so desperate that he started to loan money to people to be able to buy stocks, basically paying people to buy shares.

The South Sea eventually owed close to £60 million by the government, more than the total amount of money in the whole goddamn economy of Britain. Not a penny of this money was made selling goods in the South Seas.

The hype was very, very strong.

The public displayed ‘irrational exuberance’, a term coined by the economist Robert Shiller which is a state of mania. When people become so confident that the asset prices will go up, they lose sight of its underlying value.

In this case, there was no value, to begin with. It was the illusion of value created by enticing influential, powerful people, even the King himself, into buying the company’s stocks. And the public happily followed suit.

At this point, there were new and promising businesses coming up in the country but this meant diversification of investment and thus less investment in South Sea. So the government officials who had personal stakes in the company began cracking down on these new businesses. By an unfathomable irony, they closed businesses on the grounds of unwarrantable practices. This led to something Blunt hadn’t thought of, people who invested in these companies suffered losses and to cover their debts, began to sell their stocks of the South Sea. And their prices started falling.

In another desperate bid to keep up the prices Blunt offered the stocks to the now suspicious public at a dividend of 30% moving up to 50% in the next 10 years. To cover the dividend the company would have to make roughly £15 million a year which is a quarter of the GDP of Britain. But the trust was already broken and stock prices fell to £150.

This was the moment the bubble popped and caused oh-so-much misery for the public. It had a huge impact on the economy, leading to recession because of the widespread financial losses. Suicide became a welcome exit.

The greater fool theory holds that we can invest in a soaring asset because there’s always going to be a person more foolish than us to whom we can sell at a higher price. But there’s always a greatest fool who ends up paying the top price when the bubble bursts.

Now about Newton, he was one of the many unfortunates who lost all their fortunes in the bubble. Initially, he made a great return on his investment. But seeing his friends buy more and more stocks, Newton decided to not only buy all his shares back but also many more. The crash at this point was near and boy was it mighty!

Newton apparently said, “I can calculate the movement of the stars, but not the madness of men.”

Financial Bubbles and Behavioural Bias: South Sea Bubble 1720

Hindsight bias says we put greater trust in ourselves when predicting the future based on the recent past. Recent performance is over-emphasized in our thinking.

This, combined with the desire to follow the crowd, thinking his wealth will increase manifolds, left Newton broke at the end.

Ironically, in every potential bubble, individuals are fooled by their cognitive biases, saying, “This time it’s different.”

Liked this piece? Also read, Loss Aversion Explained!

Leave a Reply