An economic bubble refers to “trade in high volumes at prices that are considerably at variance from intrinsic values” (King et al, 1993). In other words, individuals often invest based on what they think a thing will be worth in the future, rather than its actual, present-day value. When this happens on a very large scale, an economic bubble is said to occur. When it becomes clear that the investment will never reach its projected value, the amount that people are willing to pay plunges and those who already have money invested lose their fortunes.
The South Sea Bubble was an economic bubble that burst in 1720. However, it began nine years earlier with the formation of the South Sea Company by an act of the English Parliament.
At this time, the English government was deeply in debt. Harley, the Earl of Oxford, came up with a scheme to free England of this debt while capitalizing on what was perceived as a largely untapped gold and silver market in South America. Harley proposed that Parliament could create an independent company that would assume all of England’s debt and, in exchange, would be able to charge the government yearly interest until the original sum was repaid. The company would be able to afford to assume this debt because England would grant it a monopoly on trade from South America. The company would prosper, English influence would be extended further into the New World, and the English government would become free of debt. This plan was so popular that it was called “the earl of Oxford’s masterpiece” (Carswell, 1969).
It took several years to form the company and work out the details of the agreement. By 1720, the South Seas Company was formed and received £30,981,712 in debt from the English government in exchange for a promise that the English government would pay £600,000 per year interest. However, the plan had already begun to show major weaknesses, even before taking on this huge debt. The success of the plan rested on the assumption that a monopoly on English trade with Latin America was worth almost limitless profit. Certainly, Spain was enjoying great profit in extracting gold and silver from this area. Yet a major problem was that Spain owned the rights to South American trade and would allow England only one ship’s worth of trade per year for the entire continent and only on the condition England pay 25% of the profits to Spain in addition to a 5% tax. Even this small concession ceased entirely in 1718 when England declared war on Spain (Carswell, 1969).
Regardless of the fact that the South Seas company was an unproven company already sunk deeply in debt, with no realistic prospects of profit, it was perceived as an almost infallible opportunity. As with all economic bubbles, the public’s perception of its potential was far greater than its actual value. For this reason, stock prices soared. Modern economists have argued that some investors may have been fully aware that this was an artificial market that was bound to fail. However, realizing that stock prices would continue to climb until the bubble burst, it would still have been profitable to buy stock with the intention of selling before prices inevitably plummeted (Temmin and Voth, 2003).
It should be noted that several members of Parliament were passionately against the plan, accurately predicting the financial ruin that would result. However, they were ignored or mocked. The majority of Parliament not only supported the South Seas Company, they purchased stock in it. In fact, so many people rushed to buy stock that roads around the stock market were jammed with people, preventing carriages from passing. Ultimately, two million shares were sold by the South Seas Company at £300; much more than the company was worth (Carswell, 1969). These shares continued to increase in price as they were traded until they reached a peak of roughly £1000 in August, 1720. At this point, many investors believed prices could go no higher and began to sell. Once shareholders began to perceive that prices had maxed and shares were being sold faster than they were being purchased, everyone rushed to sell. Prices plummeted. Stock lost its value and thousands of English citizens lost their savings.
Unfortunately, investors in the South Seas Company were not the only individuals to lose money during this time. Many businessmen, realizing the potential for profit in such an artificial market, began similar schemes to create companies with inflated stock prices. Hundreds of companies were formed within only a few months, with thousands of individuals rushing to buy stock. Ultimately, these companies went the way of the South Sea Company. Countless investors lost fortunes while many dishonest market speculators became rich (Carswell, 1969).
Interestingly, Isaac Newton was one of the many who lost their entire fortunes in the South Sea bubble. He invested early, sold high, and made a great return on his money. But he lost his patience as he watched his friends continue to invest and make even more money. So, decided to buy back all the stock he had sold plus much more. He borrowed a great deal of money to do this. He still owned this stock when prices crashed and the stock became worthless. Newton supposedly said:
“I can calculate the motions of heavenly bodies, but not the madness of people”.
Carswell, J. (1969). The south sea bubble. Stanford, CA: StanfordUniversity Press.
Iacono, T. (2011). Isaac Newton and the law of gravity. The mess that Greenspan made – blog. Retrieved from: http://timiacono.com/index.php/2011/01/27/isaac-newton-and-the-law-of-gravity/
King, R., Smith, V., Williams, A., and van Boening, M. (1993). “The robustness of bubbles and crashes in experimental stock markets”. In R. H. Day and P. Chen. Nonlinear dynamics and evolutionary economics. New York: OxfordUniversity Press.
Temin, P., & Voth, H. (2003). Riding the south sea bubble. American economic review, 94(5), Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=485482