Secrets of Success: Look to history for how the bubble will burst
Saturday 17 July 2004
For serious students of the stock market, there is plenty of new and timely detail to be found in a fresh account of the South Sea Bubble, to be published shortly by Princeton University Press.
For serious students of the stock market, there is plenty of new and timely detail to be found in a fresh account of the South Sea Bubble, to be published shortly by Princeton University Press. Professor Richard Dale, the author of The First Crash, is an emeritus professor of banking at Southampton University. He picks a scholarly but readable path through the events that led to the collapse of shares in the infamous South Sea Company in1720. Only the purblind could fail to draw some important parallels between the events of that year and the bubbles of the more recent past, not least the dot.com mania of five years ago.
Although most people have some recollection of what the South Sea Bubble was about, I suspect that few know exactly what it involved. At a time when the stock exchange was still rudimentary, and the Government remained in debt after years of warfare, the venture was, in essence, an early form of private finance initiative that played on the public's appetite for risk-taking. (In addition to public lotteries, it was possible in the early 18th-century to buy life insurance policies that paid out on the death of well-known public figures).
In return for a charter giving it monopoly rights over trade in South America, the South Sea Company agreed to take over and, in effect, re-finance a big chunk of the Government's debt, passing on the Government's interest payments as dividends to the investors who subscribed for shares in the company. The trigger for the great bubble of 1720 was a series of offers by the company to take on yet more Government debt, with debtholders being offered the chance to convert their holdings into shares in the South Sea Company on seemingly attractive terms.
Throughout the early part of 1720 the price of shares in the South Sea Company and the associated rights to subscribe for shares started to rise rapidly. This process was greatly helped (so it later turned out) by a combination of heavy promotional activity and massive amounts of insider dealing by the directors of the company and key members of the Government, including the Chancellor.
The faster the price of the shares rose, the more new shares the company issued, with the South Sea Company eventually raising in principle a sum far larger than any possible use the company could have had for it. The underlying weakness of the venture was that the company never made enough money from its trading activities to earn a sufficient return above the cost of the vast amounts of capital it was raising.
Two things stand out from Professor Dale's account of the South Sea drama, which ended, after a flurry of speculative mania, in the shares collapsing. First is how sophisticated many of the investment techniques and markets of the time already were. If you thought that derivatives were a modern-day problem, think again: options, contracts for differences and short selling were all part of the South Sea story.
Second, and more interesting, is that a self-taught MP, Archibald Hutcheson, had calculated the growing divergence between the quoted price of the shares and options in the South Sea Company and their intrinsic value. Just as warnings about the folly of the valuations of internet stocks were ignored in 1999-2000, so Hutcheson's warnings about the inevitable collapse of South Sea's shares were overlooked.
Even those well-informed enough to be aware that the scheme must end in disaster convinced themselves that they should take the apparently easy profits as the share price continued to escalate. Figures such as Robert Walpole and Isaac Newton bought shares in the later rounds at prices that in retrospect clearly had no prospect of ever being justified.
By the time of the final round of share subscriptions, the share price, according to Hutcheson, was more than twice the value of all the land in Britain, and at least three times any conceivably rational assessment of its true value. It is a common characteristic of all bubbles that even sensible people start acting on the greater fool theory, assuring themselves that they will get out before the bubble bursts.
The regulatory environment at the time of the South Sea Bubble was loose to non-existent, and it is tempting to use this - and other contingent factors (such as people's shorter life expectancy) - to argue that no lessons can be drawn from such remote historical examples. Professor Dale deals firmly but sensibly with such arguments. In his view, the parallels between the South Sea Bubble and modern-day examples of investor irrationality are exact, though he concedes that the pricking of the bubble in 1720 had surprisingly few wider consequences. Reputations were made and lost, wealth was redistributed (from the gullible to the smart) and after-the-horse-has-bolted reforms were introduced, with little enduring effect. The company limped on, thanks to a debt write-off from the Government and a voluntary reconstruction.
The economy did not suffer unduly, thanks in part to the Government's success in restoring public confidence after the event. The directors of the company were heavily fined and some (though not all) of the politicians who had accepted bribes of cheap shares were publicly humiliated.
The irrationality of the affair, however, which Professor Dale demonstrates by a forensic examination of the difference between the prices of different types of share through the fevered summer of 1720, is something that no legislation can outlaw, because it resides in human nature. We must hope that the property market, which is showing signs of becoming an incipient bubble, can be deflated as successfully.
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