The South Sea Bubble
The South Sea Bubble is one of the largest asset bubbles that the world has ever seen. In fact, this bubble bankrupted the newly prosperous British economy during the 17th Century. At one point in time, all the money is Britain was not enough to pay down the debts that accrued as a result of the South Sea Bubble.
Although this bubble happened 300 years ago, generations of British population have been paying down this debt. Even today, a portion of the tax collected from the general population is used to pay off this debt. The complete history of the South Sea company is well beyond the scope of this article. However, we will try to cover the important financial aspects.
Government of England Goes Bankrupt
The government of England had been at war with almost all of its neighbors during the 17th Century. These wars had proved to be very expensive for the exchequer. As a result of these wars, Britain had amassed a massive debt of $31 million pounds while at the same time it had a meager 50,000 pounds in reserves to service this obligation. The government of England was basically bankrupt as it had no way to pay the next interest installments that would be due on the loans.
The South Sea Scheme
A man named John Blunt came to the fore during this crisis situation. He basically offered the chancellor of English treasury an option to get rid of all the debt at once and overnight! This could be done by creating a new company called the South Sea company. This company would be given monopoly rights to trade with the South Seas i.e. Central and South America.
The money generated through such trade would have greatly increased the value of the shares. But Central and South America were under Spanish rule and Britain was at war with Spain. However, the British somehow convinced the Spaniards to allow them to load one ship of goods per year for every South American port as well as the right to trade slaves!
Not mentioning this meager trade agreement clearly, John Blunt declared that they had struck an agreement with the Spaniards and the South Sea Company was ready for business.
In fact, he even gave the king and other honorary members of parliament, shares in the business. This convinced the common man of the authenticity of the shares and the price of shares started skyrocketing.
Creating Excess Shares
As the value of each share rose, fewer shares had to be issued to knock off the 31 million pound of England’s debt. Thus John Blunt had authorization to create more shares and simply sell them at the market rate and pocket the profit. That is exactly what the South Seas company management did. By this time, John Blunt and anybody connected with him had become wealthy beyond imagination. The South Sea Company had a market capitalization which was close to 25% of the British GDP and could be considered to be valued at half the valuation of all companies listed on the New York Stock Exchange today! The South Sea Company did not earn a dime in operations and yet it was the most valuable company on the planet!
Keeping The Share Price Up
Since the South Sea Company did not make any money through operations, there was only one way to keep the company in existence i.e. ensuring that the share price went higher and higher. Only the sale of new stock could pay the dividend due to old stockholders and maintain the façade of a successful corporation.
However, John Blunt had to come with a lot of ludicrous schemes to keep the stock price up:
First he declared that the people only needed to put 20% of the money down to take ownership of the stock and the balance could be paid 2 months later. This created an obscene amount of demand since people were buying 5 times as many shares as they earlier could therefore raising the prices higher in the process. Price of a share with a 100 pound face value went up to 500 pounds in a matter of weeks
To further prop up demand, John Blunt was loaning out money from the coffers of the South Sea Company to investors who wanted to buy the stock! Once again artificially demand was created and prices were now in the 800 pound range.
Lastly, John Blunt undertook an audacious scheme and started selling shares for just 10% down with the balance to be paid out a year later. This time the stock hit the roof and the price was over 1000 pounds per share
However, the public soon realized the illusion that they had been living and started to sell off their holdings. As the prices began to collapse, John Blunt offered investors an insane 30% dividend on their stock every year for the next 10 years. This desperation by John Blunt confirmed the public fears that the South Sea Company was a gigantic bubble. A massive sale of the stock began to take place and within 3 weeks, the 1000 pound share was basically worthless.
Many people had lost their lives savings in the South Sea bubble. Bankruptcies were rampant as many common people had extrapolated the trend of South Sea’s past success and had borrowed money to invest in the company hoping to make a windfall gain in the process. Of course, the windfall gain did not happen instead the British middle class was simply wiped out and burdened with debt which is still being paid out from tax revenues 300 years later.
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