Roll on almost 100 years and another interesting case
is that of the British “South Sea Company”.
In 1711, the company signed a contract with the British government which
gave them a trading monopoly with South American colonies in return for
financing government debt. The lure of
the potential ‘South Sea treasure chest’ and the success of the John Law’s “Mississippi
Company” in France (another speculative venture) ignited a speculative mania for
the company’s stock, facilitated by a grandiose image and management corruption. (Other fraudulent companies also emerged to capitalize
on the benefits of investor exuberance).
However, as share prices soared, management realized the
gross-overvaluation which had occurred, and sold their stock leading to
investor panic and rapid downward price pressure. Shares became almost worthless, and eventually
the Bank of England intervened as a lender of last resort to avoid a
wider financial crisis.
South Sea Bubble (1720) |
Dale et al. (2005) empirically examine the bubble and
argue that it closely conforms to the Neal’s (1990) definition of an irrational
bubble: “the relationship of an asset to its market fundamentals simply breaks
down because of overzealous trading or an unrealistic appraisal of the value of
the stock.” Notably Dale et al. point
out that many investors were new to capital markets, suggesting that there
existed an irrational optimism for financial instruments which they did not
fully understand, which sounds similar to the actions of investors on the
derivative markets in the 2008 crisis.
Additionally, Neal and Weidenmier (2003) suggest that
the Bank of England under political pressure became a reluctant lender of last
resort in 1723 to the South Sea Company.
Furthermore, they describe 1723 as the “big-bang for financial
capitalism” as it provided a “complementary set of private commercial and
merchant banks all enjoying continuous access to an active, liquid secondary
market for financial assets, especially government debt”. However, it also suggests that this safety
net may have catalyzed the boom-bust pattern we observe in modern capitalism. Interestingly, Wilson (1940) suggests that
the modern business cycle can be traced to the 1760’s, soon after the South Sea
debacle.
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