south-sea-bubble

What Is The South Sea Bubble? The South Sea Bubble And The Rise Of Financial Bubbles

The South Sea Bubble describes the financial collapse of the South Sea Company in 1720, which was formed to supply slaves to Spanish America and reduce Britain’s national debt. The story behind the South Sea Bubble is somewhat complicated. However, it begins with the formation of the South Sea Company in 1711 by Robert Harvey.

Understanding the South Sea Bubble

Harvey created the company with the intention to partner with the government and reduce the English national debt.

He also wanted to make money for investors by underwriting the national debt in exchange for interest in return.

When the War of the Spanish Succession ended in 1713, the Treaty of Utrecht was signed.

As part of the negotiations, Britain secured the rights to supply slaves to Spanish America.

The deal was deemed a coup for the country because there were huge profits to be made by trading South American nations that were rich in silver and gold. 

Investor excitement

To reduce its national debt, the government sold a contract to the South Sea Company worth £9,500,000.

In return for taking on a substantial percentage of Britain’s national debt, the company gained monopoly access to the lucrative west coast of the Americas in 1720.

Once the deal was signed, excitement grew dramatically.

Investors saw the potential for the South Sea Company to collect interest on the loan in addition to profiting from its gold, silver, and slave interests. 

To some extent, positive market sentiment was also reinforced by the actions of the government.

South Sea Company ships received convoy protection from the Royal Navy and even the King himself made a sizeable investment in the company.

With backing from the seemingly robust British state, shareholder confidence was high. 

The bursting of the South Sea Bubble

By the summer of 1720, South Sea Company shares became dangerously overvalued.

Nevertheless, some investors continued to purchase shares hoping to sell out in time as waves of more naïve investors entered the market.

In the short term, this pushed the share price from a mere £100 in 1719 to £1,050 by August 1720. 

Unfortunately, the lucrative trade profits spruiked by management never materialized. Instead, the South Sea Company operated more like a bank and less like a shipping business.

It lent money to investors which maintained demand for company stock and artificially inflated its price.

In what some suggest was an early Ponzi scheme, money from the issuance of new shares was used to award dividends to more substantial investors.

By December 1720, the share price had fallen back to £124.

Aftermath

Once the South Sea Bubble burst, many investors suffered financial ruin.

The disaster was particularly damaging for wealthy investors who had invested large sums of money.

One of these was Sir Isaac Newton, who claimed to have said that he could “calculate the motions of the heavenly bodies, but not the madness of people.

Several directors of the South Sea Company were impeached and had their estates confiscated.

Later, it was found the company had gifted political figures company stock in exchange for their support.

Chancellor of the Exchequer John Aislabe was famously imprisoned in the Tower of London for his involvement.

While the South Sea Bubble did prompt calls for tighter controls of unregulated markets, Georgian society carried on as usual. The South Sea Company continued operating for another 133 years until it was disestablished in 1853.

Key takeaways:

  • The South Sea Bubble describes the financial collapse of the South Sea Company in 1720, which was formed to supply slaves to Spanish America and reduce Britain’s national debt.
  • Investors saw the potential for the South Sea Company to collect interest on the loan in addition to collecting profits from its gold, silver, and slave interests. Positive sentiment was also driven by the actions of the government. 
  • Lucrative trade profits never materialized, which caused the share price to become dangerously overvalued. Instead, the South Sea Company operated more like a bank and less like a shipping business. Capital invested from waves of new investors was redistributed to older investors in an early Ponzi scheme. The share price crashed in December 1720, with many South Sea Company directors impeached or imprisoned.

Related Financial Bubbles

Tulip Mania

tulip-mania
Tulip mania was a period during the 17th century where contract prices for tulip bulbs reached extremely high levels before crashing in 1637. The causes of tulip mania have perhaps been distorted over the centuries, with many assuming it was one of the first examples of a market bubble bursting. However, the proliferation of once rare tulip bulbs probably lead to them becoming less desirable. Tulip mania remains a popular term to describe markets where high prices are associated with low value or low utility items, including baseball cards, Beanie Babies, and NFTs.

South Sea Bubble

south-sea-bubble
The South Sea Bubble describes the financial collapse of the South Sea Company in 1720, which was formed to supply slaves to Spanish America and reduce Britain’s national debt. Investors saw the potential for the South Sea Company to collect interest on the loan in addition to collecting profits from its gold, silver, and slave interests. Positive sentiment was also driven by the actions of the government. Lucrative trade profits never materialized, which caused the share price to become dangerously overvalued. Instead, the South Sea Company operated more like a bank and less like a shipping business. Capital invested from waves of new investors was redistributed to older investors in an early Ponzi scheme. The share price crashed in December 1720, with many South Sea Company directors impeached or imprisoned.

Mississippi Bubble

mississippi-bubble
The Mississippi bubble occurred when a fraudulent fiat banking system was unleashed in a French economy on the verge of bankruptcy. Scottish banker John Law proposed that the French transition from gold and silver-based currency to paper currency. Law theorized that he could sell shares in the Mississippi Company to pay off French national debt. When the company secured total control of European trade and tax collection, investor speculation increased to unsustainable levels. The company share price reached its peak in January 1720 as more and more speculative investors entered the fray. Law continued to issue banknotes to fund share purchases, which inevitably caused hyperinflation. Less than twelve months later, shares in the Mississippi Company declined by 1900% and Law had to flee France in disgrace.

Stock Market Crash of 1929

stock-market-crash-of-1929
The Stock Market Crash of 1929 was a major American stock market crash in October 1929 that precipitated the beginning of the Great Depression. Black Friday, Black Monday, and Black Tuesday are terms used to describe the calamitous fall of the Dow Jones Industrial Average over three days. The index would slide further in the following years and would not recapture its pre-crash value until November 1954. The Stock Market Crash of 1929 was caused by complacency during the economic prosperity of the 1920s with many new investors buying stocks on margin. Government mismanagement and company share prices that did not reflect their true value were also contributing factors.

Japanese Lost Decade

japan-lost-decade
The Japanese asset price bubble resulted in greatly inflated real estate and stock market prices between 1986 and 1991. During the late 1980s, the Japanese economy was booming as a result of exuberance in equity markets and skyrocketing real estate prices. The Nikkei stock market index reached a peak of 38,916 on December 29, 1989. The bubble burst soon after as the Bank of Japan raised bank lending rates to try to keep inflation and speculation in check. The economy lost over $2 trillion in value over the next twelve months. The Japanese asset price bubble was primarily caused by bank deregulation and expansionary monetary policy. Japanese banks who had lost their corporate clients instead lent to riskier small and medium enterprises. The 1985 Plaza Accord trade agreement also caused a sharp appreciation in the yen, which caused massive speculation that the Bank of Japan was happy to ride for years.

Dot-com Bubble

dot-com-bubble
The dot-com bubble describes a rapid rise in technology stock equity valuations during the bull market of the late 1990s. The stock market bubble was caused by rampant speculation of internet-related companies. At the height of the dot-com bubble, instances of private investors quitting their day jobs to trade on the financial market were common. Thousands of companies held profitable IPOs despite earning no profit or even revenue in some cases. The dot-com bubble began to burst after interest rates were raised five times between 1999 and 2000. Wall Street analysts, perhaps seeing the writing on the wall, advised investors to lower their exposure to dot-com stocks. The NASDAQ peaked in March 2000 and had lost 80% of its value by October 2002.

Global Financial Crisis

global-financial-crisis
The global financial crisis (GFC) refers to a period of extreme stress in global financial markets and banking systems between 2007 and 2009. The global financial crisis was precipitated by changes to legislation in the 1970s. The changes created the subprime mortgage industry and forced banks to loosen their lending criteria for lower-income borrowers. When the subprime market collapsed in 2008, one-fifth of homes in the United States had been purchased with subprime loans. Bear Stearns and Lehman Brothers collapsed because of their excessive exposure to toxic debt, while consumers were left with mortgages far exceeding the value of their homes. In the aftermath of the GFC, interest rates were reduced to near zero and there was sweeping financial reform.

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