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US economy, market bubbles and Adventures in Paradise
Gerard Jackson
No, this article is not about the late 1950s television series Adventures in Paradise starring the telegenic Gardner McKay, but it does involve the South Seas as well as the US economy.
Regardless of what many people think, history does not repeat itself: it’s just that people keep forgetting it. No matter how many stock market bubbles there have been, or will be, investors and their advisers always treat the current one as permanent, sometimes even calling it a “new era”. In the meantime, others, myself included, have abandoned all hope of people permanently remembering the lessons of history.
Casting my mind back to the Dow Jones index and thinking about the crop of explanations that were used to justify its rise caused me to reflect on what is probably the world’s most infamous stock market bubble. In fact, it was this particular explosion in share prices that gave us the word bubble to describe the phenomenon. No, I am not referring to the 1920s, I am referring to the market collapse of 1720.
In 1711 the foundations for the South Sea Bubble were laid. It was in that year that the South Sea Company was set up to take over £10,000,000 of the England’s debt for a limited period at 6 per cent interest. The company was also granted a monopoly on trading in the South Seas. Innocent enough, to begin with. The company’s directors, however, quickly developed a vision of massive wealth.
Mesmerised by the alleged riches of the east coast of South America, they persuaded investors that these Spanish colonies were waiting to exhaust their gold and silver mines in exchange for English manufactures. Rumours were spread that Spain would open up these colonies to English merchants. As the company held a government monopoly on trading in the area, profits were bound to be enormous. Receiving royal support and the imprimatur of Parliament, the Bank of England only added credibility to its claims.
As its reputation flourished and its claims became more extravagant its shares rose in value, even though, like so many internet companies, it never made a profit. Fuelled by growing public support the directors deluded themselves into thinking that the value of the company’s shares could rise indefinitely, regardless of the profit situation, and that there would always be sufficient credit to underwrite them. (Does any of this sound vaguely familiar?)
But it was in 1720 that lift-off really occurred. In that year Parliament passed a bill in which the company assumed the national debt at an initial interest rate of 5 per cent. Virtually overnight the company’s stock rose from 130 to 300. All were not happy with the arrangements and the market’s immediate response. Walpole publicly warned that it “was an evil of the first magnitude”. Lords North and Grey opposed the bill and argued it would render many destitute. Their warnings were ignored.
A speculative frenzy swept throughout London and the counties. After all, it was argued, Parliament supported the company and 83 peers voted in favour of the bill. But the aristocracy, losing all sense of proportion, had also joined the frenzy along with the parson, the baker, the shoemaker and the candlestick maker. Few seemed immune to the contagion: houses and businesses were mortgaged, jewels sold, unsustainable loans were made, inheritances and legacies sacrificed, all to buy stock in the South Sea Company. A popular ballad caught the spirit of the time:
BrookesNews.Com
Monday 10 October 2005
Among the meaner rabble;
To buy and sell, to see and hear
The Jews and Gentiles squabble
The greatest ladies thither came,
And plied in chariots daily,
Or pawned their jewels for a sum
To venture in the Alley.
So intense was the frenzy that Exchange Alley was literally blocked with the gullible struggling to part with their savings. The mania was not just confined to the South Sea Company, other schemes were floated and their stocks quickly bought up. People were trading in coffee houses, pubs, shops, street corners and even brothels.
Mob hysteria reached such a scale that one fellow floated a scheme he described as “A company for carrying on an undertaking of great advantage, but nobody to know what it is”. Incredibly enough, people queued to subscribe to what was obviously a confidence trick. He disappeared with the money and was never seen again. Otherwise intelligent people had completely lost their senses. As one banker observed in 1928 about the stock market boom: “…the more intense the craze, the higher the type of intellect that succumbs to it”.
By May 1720 the company’s stock had risen to 550; five days later it was 890 but within hours it dropped to 640. Some people were getting nervous. The company primed demand by buying its own shares, raising them to 750 by the evening. This helped to restore confidence, which the company reinforced with rumours of imminent prosperity for shareholders. Come August, the stock stood at 1000, despite more stock having been issued.
But it was becoming obvious to a growing number of people that their shares were grossly overvalued. This emerging awareness saw the stock fall to 400 by the middle of September and to 121 by December. It was now over and so were a lot of lives. Its excesses were only exceeded by the railway mania of 1845-46. (The world’s first hi-tech market boom.)
At the peak of the boom the total value of British shares were estimated at £500 million, about five times greater than Europe's cash base. What happened?
The same thing happened in 17th century Holland. In his recent book Tulipomania Mike Dash reveals that the volume of trading around promises to buy and sell during the mania “was not less than 40 million guilders” while the Dutch banking system only contained deposits of 3.5 billion guilders. Credit and paper had fuelled the frenzy and carried it to unforgettable heights of human folly and greed.
This folly was followed by John Laws Mississippi Boom that had a similar devastating effect on the already weak French economy in the early 18th century. Another lesson that was not learned by British investors and was even forgotten by the French revolutionary regime, with disastrous social, political and economic results.
The characteristics these booms shared were no coincidence. Just as the money supply rapidly expanded under Greenspan in the 1990s, it exploded under the Bank of England in the 1840s. The Bank lowered its discount rate from 4 per cent to 2.5 per cent. The result was predictable. From the end of 1844 to about February 1846 its discounts rose from about £2 million to over £13 million pounds while bank credit jumped from $22 million to nearly £36 million.
What we had here is a massive credit expansion in which discounts rocketed by about 464 per cent and bank credits by 64 per cent, even though there was only a modest increase in the note issue thanks to Peel’s 1844 Bank Act.
(Unfortunately, by accepting the currency school error of denying that checking accounts are money Peel inadvertently allowed the Bank of England to circumvent the Act).
So where did a most of this money go? Into hi-tech speculation, i.e., railway investment. More than £180 million were poured into railway schemes in 1845 and 1846, about twice the investment of the previous 10 years. By September 1847 it was all over. Almost as if it were describing the 1990s The Economist painted a grim picture of the boom, contemptuously referring to
the folly, the avarice, the insufferable arrogance, the headlong, desperate, and unprincipled gambling and jobbing, which disgraced nobility and aristocracy, polluted senators and senate houses, contaminated merchants, manufacturers, and traders of all kinds, and threw a chilling blight for a time over honest plod and fair industry.
As Schiller once said: “Anyone taken as an individual, is tolerably reasonable and sensible — as a member of a crowd, he only becomes a blockhead”. Nevertheless, that depressing fact cannot explain the extent of the boom. Once the boom was finished a large number of goldsmiths and banks collapsed while others suffered severe runs. This is an important clue. It was these businesses that supplied the credit that triggered the boom and then fuelled it.
Once again, we are back to credit expansion. The Fed’s monetary policy plus the herd instinct is what drove hi-tech shares, not any mythical “new era”.
Gerard Jackson is Brookes’ economics editor