Financial Bubbles (Part II)

In Part I of this three part series, I discussed one of the first documented examples of bubbles and a dramatization of a bubble with a local sports flavor. In Part II we discuss another bubble, not involving flowers, the South Sea Bubble of 1711-1720. 

The English government had a debt of £10 million and convinced the holders of this debt to exchange it for stock in the South Sea Company (SSC).  The government granted this company exclusive trading rights in Spanish South America. The plan was for government to give the company a perpetual annuity of some £576 thousand. The holders of the government debt (now holders of South Sea Company stock) were assured of a steady stream of income in their new company. The government would apply a tariff on goods brought from South America in order to pay the annuity.   On the surface, it seemed like a fine arrangement.

During this time of English affluence, investors sought new avenues for their funds. The SSC was such a viable avenue. The cozy arrangement between the government and the SSC seemed like a sure thing. The English would trade wool and fleece for jewels and gold. Additionally, the SSC was heavily in the slave trade, resettling people from West Africa into the Americas. It was reasoned that the trade monopoly the SSC had in South America was a “can’t miss” proposition. 

The operators of the company projected affluence and thus investors sought more company ownership. The company engaged in a great deal of self-promotion by creating rumors inclined to increase the price of their stock. The market also understood there to be a deal in place between government and the SSC that included a multi-million pound line of credit for potential expansion. In an early, quasi-example of company-issued stock options, lucky recipients received stock, for which they paid nothing, and later sold the stock back to the company at a profit when the price increased. This arrangement created a moral hazard for stock owners (government officials included in this group) whose interest it was to increase the stock price. Eventually, SSC’s stock price climbed 10-fold. 

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