South Sea Bubble

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.