Isaac Newton

Notes for Economics www.saseassociates.com Next, we will look at the British crisis known as the South Seas Bubble, a crisis that stands as the first major manipulation of financial markets. Until the Crash of 1929, this bubble endured as the classic example of opportunistic self-enhancement. The South Seas Company was formed by Parliament as a British trade concession in 1711. This was a monopoly for areas of the Pacific that were under British rule. The company was a startup firm with no sales and no earnings, only with great prospects. The real prospects centered on market manipulation and insider trading. In the early eighteenth century, Britain had entered its period of imperial prosperity. However, stock ownership remained a matter of privilege that was limited mostly to the aristocracy. Furthermore, women could not inherit land, although females could own stock at that time. A pent-up demand for stock developed because of wide accessibility along with the added benefit that dividends that were paid out of profits went untaxed. Parliament granted the enterprise a monopoly concession along with loaned capitalization of ₤10 million pounds sterling. Publicly unknown at the time, members of Parliament had bought capitalization bonds for South Seas at ₤55. Once the company went public, these investors exchanged each unit for ₤100 of stock in the South Seas Company. However, its inexperienced directors quickly entered into the slave trade, a venture at which they failed. South Seas maintained its stock price in the market despite this misfortune as well as a war with Spain, shipments of goods that were misrouted and lost, and bonuses paid to the directors in a form that diluted the value of shares. Nevertheless, the situation improved in 1719. Britain signed the Peace of Utrecht, a treaty with Spain that enabled British trade with Mexico. Given this newfound prosperity, the directors of South Seas offered to fund the entire British national debt of ₤31 million. Stock prices doubled. Five days after the bill became law, South Seas offered a new issue of stock at ₤300 per share. The company offered a second issue at ₤400. This one rose to ₤550 per share within a month. The directors offered yet another at 10% down, with no payments for one year. Share price continued to rise to ₤1,000. The feasibility of the scheme became secondary as the Greater-Fool Theory took over—speculators would purchase shares, prices would rise, secondary buyers would appear, and the speculators would profit in the after-market. In the summer of 1720, the directors liquidated their own shares. The news of their divestiture leaked out quickly. Share price collapsed and a market panic ensued. The British government narrowly averted the complete erosion of public credit. In response to this threat, Parliament passed the Bubble Act that forbade issuance of stock certificates in any company. In addition, Britain implemented other measures in order to restore confidence. The government confiscated the estates of company directors in an attempt to remunerate South Seas Company investors. Other propositions put forth in Parliament included placing bankers in sacks filled with snakes and throwing them into the Thames River! In summarizing this bubble, let us analyze the events. First, there was a pent-up demand for investment opportunities. Second, the government sponsored a trade-concession monopoly. Third, inexperienced management failed to create any real value for the company. Fourth, war and the entry of new competition exerted external pressures on the firm. Fifth, graft occurred, which involved members of Parliament in an effort to pass legislation that was advantageous to a private company. Sixth, dilutive stock dividends and new (dilutive) stock issues were sold on generous terms and margins while insiders manipulated trading that included the dumping of shares.