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The Bubble That Almost Destroyed a Stock Market

Alex Planes
June 9, 2013

On this day in economic and business history ...

The Bubble Act became law in Great Britain on June 9, 1720, near the height of one of the greatest and most outlandish speculative stock bubbles of all time. It was a watershed moment in English financial-market history, as joint-stock companies were thereafter required to obtain a royal charter to trade on public markets. Early financial scholars thought that this act was designed to discourage stock speculation, but we know better -- the act passed with the backing of the South Sea Company, which was the driving force behind the 1720 bubble and which sought a legislative monopoly on stock speculation. Once passed, the act lit a fire under the South Sea Company's shares, which was to burn white-hot for less than a month before one of the greatest bubbles in financial history exploded.

The South Sea Company was founded in 1711 to capitalize on interest surrounding frenetic colonization and resource-exploitation efforts under way in the New World. The company was ostensibly created to assume a trading monopoly with Spanish colonies, but its real business was funding the debts of the British government through share issues. Bubbleologist Jesse Columbo writes on the South Sea Company's growth from a relatively modest enterprise into one that nearly consumed the British economy:

The South Sea Company's founders and the government were able to convince shareholders to assume a total of 10 million [pounds] in short-term government debt in exchange for South Sea Company shares. In return, the government gave shareholders a continual annuity, paying a total of 576,534 [pounds] each year, or a perpetual loan of 10 million [pounds] at a 6% yield. ...

In 1719, a proposal was made by the South Sea Company in which it would purchase over half of the British national debt with new shares alongside a promise to the government that the interest rate on the debt would be reduced to 5% until the year 1727 and 4% for every year after that. This refinancing scheme allowed illiquid high-interest debt to be converted into highly liquid low-interest debt -- a win-win for all parties involved.

As of 1719, the government was in debt by 50 million [pounds], 18.3 million [pounds] of which was held by three of England's largest corporations. The Bank of England was one of the three corporations and owned 3.4 million [pounds] of that total debt, while the British East India Company owned 3.2 million [pounds] and the South Sea Company owned 11.7 million [pounds].

Though the company's trading rights with Spanish colonies were quite modest, its executives whet investors' appetites with incredible tales and rumors of South American gold and silver just waiting to imported back to Europe. The company successfully sparked a speculative frenzy for its shares in 1720, with stock prices soaring from 128 [pounds] in January, 175 [pounds] in February, 330 [pounds] in March and 550 [pounds] in May. The company was able to support unusually high valuations thanks to a 70 million [pound] fund of credit that was granted by the King and Parliament for the purpose of commercial expansion.

The South Sea Company's skyrocketing valuation led to the public offerings of many other speculative -- and often fraudulent -- enterprises, which promised all sorts of zany schemes (hair-trading and perpetual-motion wheels among them) in exchange for investor funds.

It was into this environment that the Bubble Act arrived. Following its passage and the outlawing of less-reputable schemes, desperate investors flung themselves after the South Sea Company's "legitimate" shares, bidding them up near to 1,000 pounds per share in August before the bubble tore itself apart. Around this time, it became apparent that the South Sea Company was a perpetual-motion machine of the financial sort, its assets composed almost entirely of the revenues from repeated stock sales. By the end of October, shares had collapsed to about 175 pounds, bankrupting a nation of speculators, including Isaac Newton, who has been quoted as saying "I can calculate the movement of the stars, but not the madness of men" after losing a staggering 20,000 pounds.

To put this sort of craziness in perspective, consider the South Sea Company somewhat like the Dow Jones Industrial Average (INDEX: ^DJI), since it was the focal point of all British stock trading at that time and occupied a place of even greater market prestige. Imagine the Dow starting at 10,000 points, peaking at 78,000 points, and ending up back at 14,000 points -- all in the span of a single year. By comparison, the Roaring '20s and the subsequent bust were the equivalent to starting at 10,000 points, rising to 59,700 points, and then falling back to 6,600 points, but this took place over the span of 11 years. Let's not forget that the mechanisms for stock trading were a lot less developed in the 18th century, which meant that many shareholders had no easy means to get out once the bubble popped.

At its peak, the South Sea Company was one of the most valuable companies in history. Its violent disintegration spread across the English Channel to France, which was experiencing a simultaneous -- and ultimately larger -- bubble of its own in shares of the Mississippi Company, which was a similar New World "trading monopoly" functioning in truth more as a currency-debasing bank. This bubble, too, disintegrated by the end of 1720. The two bubbles swelled to an astronomical comb