Published by EH.NET (March 2005)
Richard Dale, The First Crash: Lessons from the South Sea Bubble. Princeton: Princeton University Press, 2004. ix + 198 pp. $29.95 (cloth), ISBN: 0-691-11971-6.
Reviewed for EH.NET by Larry Neal, Department of Economics, University of Illinois at Urbana-Champaign.
Many of us are still licking our wounds from the collapse of the “dot.com bubble” in March 2000. The NASDAQ index, weighted by the market capitalization of all the stocks it lists, soared from a low of 333 in October 1990 to 5,048 on March 10, 2000. The electronic trading system added hundreds of new technology companies purporting to reap network economies from “new new” applications of information technology on the world-wide web and all of them tried to expand their public equity at the behest of their venture capital backers. By the end of 2000, however, the NASDAQ had lost half its value and continued to lose another half before reaching bottom in October 2002. This was the latest financial crash, but it was just one of many other that have occurred since the existence of organized secondary markets in financial assets. After each crash, one can be sure that references will crop up to the South Sea Bubble of 1720, the granddaddy of them all. The explicit sub-text of these works is always, “People often act like damn fools;” or, more soberly, we are all subject to occasional bouts of irrational exuberance. The implicit sub-text, often made explicit, is that stock markets should be regulated closely and access to them limited, mainly to protect people from the consequences of these recurrent bouts of mass madness.
It is not surprising then that Richard Dale, Professor Emeritus of Finance at Southampton University, should take advantage of the opportunity to repeat this oft-repeated lesson of history and make explicit comparisons between the original stock market crash and the most recent one. What he contributes is an effort to validate the approach of behavioral finance as applied to the events of 1720, as well as to the more recent crash. Moreover, he argues that sound financial analysis of fundamentals was available and widely disseminated even in 1720, but that it was ignored by the masses who flocked to their fleecing at the behest of the charlatans in control of the South Sea Company. Throughout, he draws analogies with the analysis of the dot.com companies and the frauds perpetrated by the directors of Enron and WorldCom in the recent NASDAQ crash. As icing on the cake, he takes to task previous historians of the South Sea Bubble (including this reviewer) for overlooking the work of a sound financial analyst who disseminated his results publicly at the time, but to no avail against the forces of irrational herd-like behavior. Finally, he uses quantitative evidence also overlooked by previous historians on the erratic pricing of subscriptions to the new issues of South Sea stock issued at various times and various prices during the course of the South Sea Bubble, which he takes as direct evidence of market irrationality.
Dale builds his argument first by setting the scene for irrational exuberance in the coffee houses of London (chapter 1). There, subject to the intoxicating fumes of the exotic bean, people regularly lost their senses and fell prey to constant streams of misinformation produced by an untrammeled and unregulated press. In these coffee houses and the narrow confines of Exchange Alley abutting the Royal Exchange, where legitimate and regulated trade was carried on, a free-wheeling, unregulated stock market arose (chapter 2). It quickly was dominated by a few manipulative entrepreneurs, as aptly described by Daniel Defoe in his Anatomy of Exchange-Alley. Among them were the projectors of the South Sea Company, created in 1711 to help the government refinance much of the huge debt it had incurred over the course of the War of the Spanish Succession (1702-1713) (chapter 3). No recapitulation of the South Sea Bubble is complete without reference to the comparable scheme begun earlier in France by the expatriate Scot, John Law. Chapter 4 briefly describes the innovations in marketing expanded issues of capital stock that, according to Dale, imitated earlier South Sea innovations — installment payments on new shares, options, and interventions by Law to first run up the price of Mississippi stock and then to stabilize it. The crowd spirit incited by Law’s machinations then spilled back across the Channel to whip Londoners into comparable frenzies. Chapter 5 takes us back to the South Sea Bubble proper and lays out the mechanics of the scheme, while introducing us to Archibald Hutcheson, the one voice of reason who explained, again and again, in the clearest terms possible, why the scheme was fated to fail. Dale notes explicitly that many of the flaws in the scheme were repeated once again in the dot.com bubble of the 1990s.
The South Sea bubble, nevertheless, unfolded quickly after Parliament approved it in February 1720 and the sheer momentum of the crowd’s frenzy kept it going well into July 1720. On the timing of the bubble, Dale takes sharp issue with previous analysts of the bubble who claimed that the peak occurred just before the Company closed its books in early June to prepare the summer dividends. He dismisses explicitly my argument that a severe payments crisis had hit the European economy at this time, even though he describes the currency manipulations of John Law that caused the payments crisis in his chapter on Law. Apparently, he believes that only animal spirits flowed across the Channel then, not actual means of payment.
Dale’s focus on frenzy rather than finance at this time is consistent with that of Archibald Hutcheson as well. Hutcheson was the very archetype of the mercantilist “little Englander” later derided by the Scotsman, Adam Smith. Hutcheson’s main policy recommendation was to create perpetual annuities that were obligations of the state that could be held permanently by the British citizens. One great advantage would be that foreigners would have no claims against the state, which was proving increasingly to be the case with Dutch investors and even Scottish investors who came into London in the train of William III after the Glorious Revolution of 1689. Naturally, Hutcheson’s overall goals were anathema to the Scottish supporters of the Hanoverians, and not welcome to the directors of the Bank of England and the East India Company with their strong ties to the Dutch. As early as March 1720, Hutcheson sounded the alarm against the scheme of the South Sea directors with fiery rhetoric that they threatened the very bases of English liberties and urged his fellow Parliamentarians to take preventive action against the Company so that “our Weekly Bills of Mortality may not be filled with large Articles of unhappy People, who have hang’d, drown’d or shot themselves”! (Hutcheson, p. 8, from his March 1720 pamphlet.) It may be that Hutcheson’s analysis of the frailty of the scheme was ignored not so much due to the frenzy of his audience but more because of the excesses of his rhetoric. From the beginning of his many pamphlets on the public debt, Hutcheson made it clear that he desired nothing else than a complete repayment of the national debt, including that held by the Bank of England, the East India Company, and the South Sea Company. This implied, of course, ending those companies when their current charters expired. No wonder his counsel held little charm for the thousands of shareholders in said companies!
In his “Bubble” chapter, Dale also gives the main quantitative evidence for irrational behavior lasting through the summer of 1720. These are the highest weekly prices of the three South Sea subscriptions that had been issued by mid-June. These peak at various times but well into July, implying according to Dale that the frenzy had not yet abated. He dismisses my argument that the bubble had already been pierced with a contraction of liquidity in the mercantile payments system in early June by asserting that interest rates remained remarkably stable throughout 1720, basically close to 5 percent annually. (Usury limits of 5 percent set the maximum interest rate legally offered by any company at this time.) Dale offers proof in the East India Company’s 5 percent bonds, whose prices remained fairly stable until the last quarter of 1720 (after the Sword Blade Company, which provided banking services for the South Sea Company, had failed). These India bonds were short-term bills with expiry dates of less than a year, with rollovers occurring quarterly. As they would be redeemed at par within a year, their price could not rise above par unless they were especially useful as means of payment; and if they did fall below par it could only be because the company issuing them was suspected of not being capable of redeeming all the bills as they expired. Thomas Mortimer in his classic guide to the eighteenth century stock market, Every Man His Own Broker, tells us that sellers made out the terms of sale for the India bonds, asking the par value plus the accumulated interest and then adding the market premium or discount on the basis of a ?100 bond. This premium averaged around 2 pounds through August, when increasing concerns that the troubles of the South Sea Company might spread to the East India Company drove their bonds to ever larger discounts, reaching 6 pounds at the depths of the crash. South Sea short-term bonds were even more deeply discounted by then. As Dale notes, there was no fiat money in England, unlike the situation then being attempted in France. Neither the Bank of England, the East India Company, nor the South Sea Company could create means of payment. The best they could do was to recycle idle balances more rapidly, which they had all begun to do in May 1720. This meant that the supply of India bonds could not be expanded at will to meet scrambles for liquidity. Their prices were tightly constrained by the short term of their existence and therefore the implied interest rates also tightly confined.
Goldsmith bankers and merchant bankers operating in the City of London at the time found that short term credit was very tight in the summer of 1720, which proved to be the case throughout mercantile Europe. George Middleton, John Law’s banker in London, reported that money could only be had for 50 percent per month in June 1720, which coincidentally was when the effects of Law’s fiat devaluations and revaluations at the end of May were disrupting the mercantile payments throughout Europe (Neal, 1994). Also coincidentally, that was the forward premium I calculated from the forward prices of the South Sea stock when the transfer books were closed in June (Neal, 1990). Dale regards that figure as unrealistically high, but one of the most knowledgeable and active goldsmith bankers operating in London at the time reported that it was the case. Even earlier in 1720, Archibald Hutcheson noted that borrowers had to pay very high interest rates at the outset of the bubble. (Hutcheson, April 1720, p. 25, refers to “the borrowing of Money, at the rate of 10l. per Cent. Per Mensem; and even at 20 s. per Cent. Per Diem?”)
The issue of the appropriate interest rate comes into play again in Dale’s final chapter, “Lessons from the South Sea Bubble.” There, Dale argues that each subscription issued by the South Sea Company on an installment basis should, rationally, have been priced at the current price of a fully paid up share. To calculate this, one should take the amount already paid in and then add the discounted present value of the future calls on the subscription. Dale does this with a discount rate of 5 percent (which I argue is far too low for the customers buying the subscriptions) and finds what he regards as two anomalies. First, the calculated values of the subscriptions are consistently higher than the current price of the fully paid up shares of South Sea stock; and second, the various subscriptions, especially the third subscription, vary erratically relative to each other. The two findings together lead him to conclude that the market for South Sea stock was increasingly irrational from June 1720 to the end of 1720, by which time the entire scheme had collapsed, the King was recalled from Hanover, and Parliament, with the ever-helpful Archibald Hutcheson playing a leading role, was investigating the entire affair. The affair was wound up, as Dale describes in chapter 7, with a complete re-organization of the Company, the Directors removed and penalized with loss of the bulk of their estates judged to be ill-gotten, part of the Company’s stock was engrafted onto the capital of the Bank of England, and the remaining stock divided into half.
It was clear to investors at the time, however, as it would be for investors in the London capital market for centuries after, that the subscriptions had a greater value than the current full shares for two reasons. One reason, elaborated in chapter 4 of Thomas Mortimer’s handbook was that they enabled speculators in the stock to leverage their investments, gaining the rise in the price of the full share on a partially paid up subscription for a new share. A second reason, certainly understood by the infamous stockjobbers crowding the coffee houses of Exchange Alley, was the option value of defaulting on future installments in case the stock began to lose value in the market. Share warrants, as they were later named formally, always priced higher than the regular shares. Finally, if the option value varied among the three subscriptions, and they certainly did as the value of defaulting on future installments rose sharply with the Third Subscription, we should expect differences in the prices of the subscription shares to emerge, and more so as the regular stock began its precipitous decline in August 1720.
So, what are the lessons to be learned? A previous writer has suggested that the entire affair “appears to be a tale less about the perpetual folly of mankind and more about the continual difficulties of the adjustments of financial markets to an array of innovations.” After reading Dale’s efforts to revivify the tenets of behavioral finance to comprehend the significance of the South Sea bubble, I confess that statement seemed so reasonable an assessment that I wish I had made it. Checking Dale’s footnote, I was gratified to find that I had (Neal, 1990, p. 90)!
Note: 1. Later financial historians will wonder, as did most financial journalists and academic observers in the late 1990s, why it didn’t collapse earlier, and in October 1997, 1998, or 1999 rather than March 2000. Possible answers might be in the extraordinary steps taken by the U.S. monetary authority to expand liquidity after the Asian crises in 1997, the Russian bankruptcy in 1998, and the “Y2000” fear in late 1999.
Daniel Defoe (1719), Anatomy of Exchange Alley, London: E. Smith.
Archibald Hutcheson (1721), A Collection of Treatises Relating to the National Debts & Funds, London.
Thomas Mortimer (1765), Everyman His Own Broker, sixth edition, London.
Larry Neal (1990), The Rise of Financial Capitalism: International Capital Markets in the Age of Reason, Cambridge: Cambridge University Press.
Larry Neal (1994) “‘For God’s Sake, Remitt Me’: The Adventures of John Law’s Goldsmith-Banker in London, 1712-1729,” Business and Economic History, 23:2, pp. 27-60.
Larry Neal is past president of the Economic History Association and the Business History Conference and former editor of Explorations in Economic History.