Let me tell you about an investigation. It was a probe into what transpired when executives of a company turned out to have made claims about their business that were found to be lies. The company's colossal stock valuation, which was based on those lies, collapsed. Investors lost enormous amounts of money. The famous, respected, accomplished people who had believed the lies and invested their own (and others') money were embarrassed, if not shamed. It turned out they weren't as clever, well informed, or skillful as their public images had suggested. The investigation, conducted by a committee empaneled by the government, delivered its report on January 6.
I'm not talking about today, although it really sounds like I could be, doesn't it? I'm not referring to any recent January 6, either. The report I'm talking about was published on January 6, 1721, and the organization was the South Sea Company of England. And it may very well be where the term “bubble,” as applied to economics, came from.
It all started with a lottery (jeez, what are the chances). The British government was short of money, partly because they were paying for two wars at the same time. The Bank of England, acting for the government, had operated lotteries before with mixed results. The one launched in March of 1711, though, sold out within just a few days. The tickets cost £100, and the top prize was £20,000. But if you won, you didn't just get a lump sum — prizes were paid in installments over several years. This is the same system state lotteries use today, although now winners can typically choose a lump-sum payment of a smaller total amount. The situation was that the government still had the prize money, or most of it, in its accounts.
The government had already spent the money.
The basic problem was that the government had already spent the money paying their troops, buying munitions and provisions, and all the other sundry expenses you run up when you're financing a war. Thanks to several lotteries, the government discovered it was obligated to pay out about £9 million, but it didn't have any concrete ideas about where the money was going to come from. The answer, ginned up by the finance blokes of the time, is going to sound familiar. They didn't think of cool names like "Enron" or "credit default swaps," the way their more-recent counterparts have. But pay close attention to what they did; it’s the same kind of fast-talking “sure to confuse the mark” complexity people like that still rely on. They put into place a scheme devised by William Paterson. This was a man who had a major financial scandal in his past: the "Darien Scheme," which bankrupted a significant portion of Scotland around 1700. Nevertheless, a few years later, the erstwhile "smartest guys in the room" listened to him again.
Paterson's idea was this: the people in on the plan would form a joint private-public company to be called the "South Sea Company." By the way, in Great Britain in those days, "south seas" only meant South America and the surrounding ocean. The company would “purchase” — that is, take over ownership — of the government's £9 million debt, and everyone who was owed money would receive South Sea Company shares that had a value close to what they were owed. They didn't have any choice in this, by the way. Then the government would make interest payments — at about 6% — to the South Sea Company every year. That money was to be distributed to stockholders as an annual dividend. Sounds legit, right? But there was one other stipulation in the formation of the company: it received a monopoly from the government over all trade involving South America.
At the time, of course, South America was Spanish territory. And remember those two wars the British government was going broke paying for? One guess who they were fighting in one of those wars: Spain. Anyone peeking behind the curtains at the details of this scheme might have noticed that South America was controlled by Spain, and Great Britain was at war with Spain, so the chances of making a lot of money out of South American trading were slim. Or possibly none.
Another thing the curtain-peekers might have noticed was that the South Sea Company was receiving money annually from the government, but paying that same money out as a dividend. Setting up a trading operation takes money; you need ships, crews, provisions, as well as something to trade. But the South Sea Company didn't have any spare money, and didn't have any way to get it, either. It was the Eighteenth Century version of a shell company.
Most people, though, don't look behind the scenes. They listen, particularly when famous, respected, and accomplished people say they’re all-in on the venture, and talk it up every chance they get. So people started buying in. One more thing the general public didn't know, though, was that before the South Sea Company started showing up in the news as a fantastic opportunity, it had been in "stealth mode." That is, it became a legal entity, and the original in-crowd knew about it and the scheme, but they didn't share any other information.
Caricature of a “stock promoter” from 1720
People in the 1710 financial markets knew the government didn't have the money to pay the lottery winners. So the loan paperwork -- the credit defaults, so to speak -- had to be sold at a discount of nearly 50%. That is, if you were a lottery winner, you suspected you weren't going to get your winnings. So when somebody came along and offered to buy the debt at about £55 for each £100 you were owed, you'd be pretty likely to jump at the chance. The in-crowd, though, knew about the South Sea Company, and they bought up as many of the debts -- the "mortgages," so to speak -- as they could.
Then they announced the South Sea Company, along with its monopoly on trade to South America. And they hit the financial talk shows -- or whatever the equivalent was at the time -- and talked it up every chance they got. It worked; the company's stock skyrocketed.
Nobody wants to wear wool in 86° weather.
Suddenly the South Sea Company did have some cash. And they really did set about a trading operation. By 1713, relations with Spain had calmed down and they even managed to get Spanish permission to set up offices in some South American cities. One part of the venture was to export woolen goods made in British Isles to South America. They bought a ship and sailed the stuff to Caragena, Colombia. Where the average temperature is 86°F. Nobody wants to wear wool in that kind of heat, and more to the point, nobody wants to buy it, either.
Nevertheless, the South Sea Company had more ideas up its sleeve, and you'll never guess what they wanted to get involved in. The slave trade. They started capturing people in Africa and shipping them across the Atlantic. It was an unspeakably dirty business, but the South Sea Company seemed to be about as successful as other competitors. But not for long; by 1718 the war with Spain was back on, and the company's South American offices and assets were seized, along with any of its ships on that side of the ocean at the time.
The finance guys were undeterred. Sure, the company had just lost nearly all its physical assets along with any chance of continuing its trading operations. But come on, what about that sweet credit swapping shell game? They convinced Parliament to do the same deal as before, with more government lottery debt converted to South Sea Company stock. Of course, the way they did this was because to a large extent the South Sea Company in-crowd and members of Parliament WERE THE SAME PEOPLE. One of the original founders, after all, was John Aislabie. He was the representative of the "October Club;" a group of about 200 members of Parliament who voted as a block. And the rest of the in-crowd were government officials and the management of the Bank of England. In 1719 they managed a repeat of their original debt purchase system. It again worked, or at least seemed to.
You could easily sell stock whenever you wanted to.
Based on that apparent success, a plan appeared for the South Sea Company to purchase not just the government's lottery debt, but the entire debt of the British Government, about £50 million. This time it wasn't just lottery winners, but anybody owed money by England -- the deal was the same; you might not get 100%, but you were more likely to get paid something, and in the meantime you owned some shares of stock. And you could easily sell stock whenever you wanted. It looked like a good enough deal that the South Sea Company managed to convince Parliament (at least the part of Parliament that wasn’t, you know, running the company) to go along with it.
There were a lot of details in the contract, from the payment schedule to interest rates to the "conversion rate" of how much the Company paid per £1 of government debt. The net result was that South Sea Company stock started to fall. By the end of 1719 the Company announced that the Christmas dividend due to be paid was going to be deferred for a year. But they also made the rounds of government officials and high-profile stockholders and delivered all sorts of bribes — er, I meant to say, junkets, in-kind compensation, invitations to events, and a special deal based on "derivatives" — that is, for every £1 the stock rose, people in the right place received up to £600 cash. These were people like Lord Sunderland, the Treasurer to the Navy, the mistress and children of King George I, and so on. Surprisingly enough, some of the original founders of the company were in that group. Or maybe not so surprising?
The in-crowd once again started to talk up the stock, falling back on the same old story: potential trade. They added a new wrinkle as well: if you wanted South Sea Company stock but didn't have the cash, the South Sea Company itself would led you the money (think about that for a moment). Anyway it worked again; stock in the South Sea Company shot up from £100 at the beginning of 1720 to £1000 by August. Except that by the end of the year the price was back to £100. So many people were financially ruined that an official inquiry was launched — and that's why we know about this episode. All of the Company Directors (the only ones to consistently get rich from all the shenanigans) were fined an average of 82% of their assets. The Royal Family, of course, was immune from any recriminations, but the entirety of Parliament was recalled, quite a few officials were impeached, and those in the aristocracy found to be corrupt and knowing participants in the fraud were shamed (evidently a reaction that no longer exists).
These were the days of Sir Isaac Newton, too, and he had a comment on the sorry spectacle: "I can calculate the movement of the stars, but not the madness of men." of course, Newton himself may have lost up to £20,000. That would be somewhere around £4 nowadays.
In the final analysis, don't think for a moment that any businessman or politician in the US has had an original idea in the past couple of centuries. Messages from prominent people sometimes carry more weight than your own thinking or even personal experience. Ever seen anything like that happening? Yeah, me too.
