This week's newsletter was inspired by the recent story dominating financial news of "reddit vs hedge funds" that saw the share price of a video games retailer briefly rise twentyfold before crashing down back to earth (Link). However, rather than diving into the details of this still unfolding story, we will have a look at one of history's biggest stock market crashes that ultimately came close to bringing down the English crown. It is a tale of crushing government debt, financial buccaneering, and public folly that even saw Sir Isaac Newton lose his bearing (along with a pretty penny - Link).
And how much exactly do we owe? - As many financial crises throughout history, this one too starts with war. And lots of it. You see, in the early 18th century, the British Empire had been at war continuously for the better part of 100 years and in the process had raked up a monumental amount of debt*. However, nobody quite knew how much as each ministry spent money with little financial oversight. To make management and oversight of the debt easier, the Chancellor of the Exchequer (Robert Harley) proposed in 1711 to consolidate all public debt within the Bank of England. However, being run by the Whig faction and not in a mood to help out Harley's Tory government, the Bank of England declined and a new solution had to be found. This came in the form of the "Hollow Sword Blade Company"* - a company originally founded to manufacture rapiers that was promptly converted to run a state-sanctioned lottery system to provide cash for the government.
A new bank - The lottery system was so successful that the government promptly turned this non-sword-producing gambling venture into the de-facto new Bank of England by offloading all public debt into it. To do so, the company offered private government debt holders to swap their bonds for shares in the company which would then manage the interest income and pay it out as dividends. To make this more enticing to the new shareholders, the company was also given a monopoly for trading to the "South Seas" (Central and South America) and rebranded as the "South Sea Company"**. This trading monopoly was of course practically worthless, as the "South Seas" were mostly controlled by the Spanish Empire which had a rather hostile attitude to any ship flying the Union Jack (on account of being at war with them). While this was apparent to the governing elite, the South Sea Company was still too good an instrument for offloading debt to the gullible public (and becoming very rich through insider trading and bribes).
1754 engraving of Old South Sea House, the headquarters of the South Sea Company, which burned down in 1826
Too big to fail - By simply promising riches from the South Sea trade, the company pulled in more and more money by selling shares to the public at ever higher prices. Credibility for the company was further boosted by government officials buying into the stock (though at favourable rates to secure their continuing support for the scheme in parliament). With the meteoric rise of the share price, even the crown started to invest in South Sea shares and king George I made himself Governor of the company (which pushed the share price up even further). When even that was no longer sufficient to keep the price rising, people were offered loans by the company to purchase its shares; loans secured by the shares themselves (a move that would have even made the sub-prime lenders of the early 2000s blush). Between 1719-20, South Sea Company stock rose from around £100 per share to £1,000 per share making it the biggest financial institution in the world valued at £300M (far more than the country's GDP at that point). Stock market exuberance reached such a fever pitch that even the ominously named “Company for carrying on an undertaking of great advantage, but nobody to know what it is.” managed to raise £2,000 in an afternoon before its director duly vanished (Link). However, the fact that South Sea had essentially no trading income*** and was instead sitting on a mountain of shaky debt started to dawn on people and everything came crashing down.
Bailout - Under pressure from mounting public anger, the government resorted to a since familiar recipe: bail out the company (using the Bank of England and the East India Company) and find somebody else to blame (while preventing an investigation that would bring down the entire political establishment). So it was convenient when the Cashier of the company (i.e., the main book keeper) fled to the Austrian-controlled Netherlands. While publicly demanding his extradition back to England, a second diplomatic note was sent offering the Austrian government money to make sure he would never return home (Link). This cleared the path for a harmless parliamentary inquiry which made sure to not prosecute anybody of actual influence implicated in the whole scheme. Now, 300 years later, the UK is still paying off some of the debt incurred because of the South Sea fiasco (Link).
Tweet in 2014 by former Chancellor of the Exchequer, George Osborne
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*Ironically run by a man called "Blunt"
**Or in full: "The Governor and Company of the merchants of Great Britain, trading to the South Seas and other parts of America, and for the encouragement of the Fishery"
***The South Sea company did actually participate and profit from the slave trade across the Atlantic even after the speculation bubble had burst
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