While 2020 has seen its fair share of market turbulence, it has some way to go to match the volatility of 1720.
This month marks the 300th anniversary of the peak of the South Sea Bubble — one of the first financial bubbles, and still one of history’s greatest.
The bubble began when the South Sea Company came up with an arcane plan to reduce the national debt by exchanging its shares for government bonds, then receiving a reduced rate of interest on those bonds. In an effort to convince bondholders to agree to this trade, the Company engineered a bubble in its own shares, hoping that would-be investors could be lured by the promise of quick capital gains.
How did they engineer this bubble? The key ingredients were money, debt, marketability, and speculation.
So first, they lent large sums of money to gentlemen who agreed to use the money to buy shares. They then allowed the shares to be bought on credit for a downpayment of only five per cent. They also created an active secondary market in the shares, so it was always easy to find a buyer or seller. And finally, they used market manipulation to boost their share price, attracting speculative investors.
It might seem surprising that the bubbles of 1720 were engineered in this way. Financial bubbles are often thought of as sudden outbreaks of collective madness, natural disasters that strike markets at random. But the most significant bubbles in history have been created deliberately, or at the very least stemmed directly from government policy.
The playbook for creating a bubble has remained remarkably unchanged over the past 300 years. The housing bubble of the 2000s was driven by low interest rates, extended mortgage credit, the issuance of liquid mortgage-backed securities, and houses becoming an instrument of speculation. When the Chinese government decided to create a stock market boom in 2015, it lowered interest rates, deregulated margin lending, eased trading restrictions, and stimulated an initial spike in prices.
It’s always money, debt, marketability, and speculation.
Often, these efforts to create a bubble work too well. In 1720, the South Sea Company’s share price rose by 770 per cent — much more than its directors had intended. The subsequent crash was so dramatic that ruined investors successfully pushed for a government inquest. The director deemed most responsible was sent to the Tower of London, and the others had their estates seized.
Likewise, the Chinese bubble spiralled out of control in the summer of 2015. The following year, the chairman of the China Securities Regulatory Commission resigned in disgrace after failing to halt a spectacular crash.
Other bubbles arise from major new technologies, such as modern bicycles in the 1890s, mass production and electrification in the 1920s, or the internet in the 1990s. These eras are notable for the very wide range of valuations placed on technology companies: some investors think they’re worth nothing, others think they’re worth everything.
With the benefit of hindsight, overly optimistic investors can become famous for their naivety — the Yale economist Irving Fisher famously stated that stocks had reached “a permanently high plateau” in September 1929.
Curiously, however, pessimistic investors tend to get away with their bad predictions. The Netscape IPO of 1995 was dismissed by the New York Times as “juvenile”, with investors throwing their money away on “the belief that these stocks only go up”. Those who invested at its supposedly inflated first-day price received a 35 per cent annualised return until the company was acquired by AOL in 1999.
Not every new technology has resulted in a bubble, and in some eras, bubbles do not seem to be present at all. The next major bubble after 1720 did not occur until over a century later in 1825. Bubbles were also notable by their absence in the period following the Wall Street Crash. By the time the next major one arrived, the Japanese Bubble of the 1980s, many academic financial economists had come to believe that bubbles were an urban legend dreamed up by financially illiterate historians. In fact, they simply lived in an era when markets did not have enough money, debt, marketability, or speculation for a bubble to form.
What can 300 years of history tell us about bubbles today? Bubbles are notoriously hard to predict, and even if we can recognise when we’re in one, it’s impossible to tell when it’s going to burst.
We can, however, recognise the common factors: low interest rates, loose lending standards, assets becoming more liquid, and speculative investors entering the market. When these are in place, bubbles then arise as a result of political initiatives or new technology.
Since all four elements will be in place for the foreseeable future, our ability to predict bubbles depends on our ability to spot these political and technological sparks.
Boom and Bust: A Global History of Financial Bubbles by William Quinn and John D. Turner is available from today, published by Cambridge University Press.
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