The South Sea Bubble

Transcript from Extra Credits' segment, Extra History.

The South Sea Bubble is perhaps some of the wildest financial chicanery of the 18th century, and has a lot of parallels with some of the events of the last few years. It gloriously highlights the importance and value of financial institutions, while also serving as a warning about the incredible danger of invented wealth.

The Sharp Mind of John Blunt

          Before we can talk about the South Sea Bubble, we have to talk about the South Sea Company. And before we can talk about the South Sea Company, we have to talk about Great Britain in the early 1700s. First off, there was no Great Britain in the very early 1700s, because until the act of union in 1707, England and Scotland were two different countries. But since that's right in the middle of the story we're about to tell, I'm just gonna refer to England as Great Britain throughout, if that's okay. And the first thing to know about our Great Britain is the fact that in the late 17th and early 18th century, it pretty much could not get enough of being at war. Not only did the English go through a major civil war in the 17th century, but then they just continued to fight pretty much everybody in Europe for the next 100 years.
          So with that in mind, I'm just gonna start us off in 1710, with a guy named Robert Harley.
          August of 1710 looks like it's gonna be a great month for Mr. Harley. Through a bunch of political wrangling, he's just gotten himself appointed Chancellor of the Exchequer, a position that's basically the same as the Secretary of the Treasury in the United States. He's been out of power for a while, but by gum, he's gotten himself back in it now; he's thinking everything is gonna be great.
          Then he looks at Britain's balance sheet. In one column is the 5,000£ still remaining in the government treasury. And in the other column is a hastily-scrawled note saying somewhere roughly probably around 9,000,000£ in big red ink. To give you an idea of just how big this debt is, the current Chancellor of the Exchequer, George Osborne, announced that a payment toward this consolidated debt will be made on February 1 of 2015. That red ink is still being paid down today, 300 years later. So with that in mind, you can pretty much imagine the freak-out that Harley had when he realized just how impossible his job was.
          His first task was just to keep the government afloat through the end of the year. Unfortunately, there were a few hurdles between him and doing that. First there was the problem of government accounting; at the time, Britain had no unified budget, so while everybody knew they were in debt, until Harley did a thorough investigation, no one quite knew exactly how in debt they were. This meant that no real preparation had been done, and since every government department had its own budget, and carried its own debt, even after doing a deep dive on the books, even Harley could only give a ballpark estimate of how much debt they really had to tackle.
          Second problem: The House of Commons was a deeply partisan, two-party body. For the last few years, the Parliament had been controlled by the liberal Whigs, with the conservative Tory minority routinely blocking any legislation from the opposite side of the house. Well, now the Tories had come into power, and you better believe the Whig minority was gonna do the same thing to them. Of course in response, the Tories were busy calling for impeachment of members of the previous Whig government, and all of this just made raising taxes a near-impossibility.
          With taxation as a revenue stream cut off, Harley turned to the next viable option to keep the government running: the Bank of England. The Bank of England, though, was created by the Whigs, and was a Whig-controlled institution. In fact, this is the beginning of the age of central banking. The Bank of England was really the first institution of its kind: a bank specifically designed to lend money to the government, and make sure the government remained solvent. But since most of the board members of the Bank of England were Whigs, and Harley was a Tory, the bank was none too quick to help the government out. This left only four increditors as a possible source of revenue for the government, but given how deep in debt the government already was, and how many people it was still fighting, outside credit wasn't really available.
          So with no other options left to him, Harley turned to less orthodox sources, namely John Blunt of the Hollow Sword Blade Company. Despite Blunt being an odd name for one of the fellows in charge of the company which held the monopoly on making fine swords, our Mr. Blunt possessed a sharp financial mind, and very few (if any) scruples. He saw the government's critical financial state not as some great national crisis, but rather an opportunity to make money. Lots and lots of money. But he couldn't just sell the government rapiers; no, Blunt needed cold hard cash. So he dreamed up a scheme so convoluted it's kinda hard to even describe, but I'm gonna give it my best shot.
          The real estate market in Ireland was currently up for grabs, as the British government had just confiscated large amounts of Catholic land. Blunt wanted the Hollow Sword Blade Company to buy as much as it could as cheaply as possible; unfortunately, the Hollow Sword Blade Company didn't quite have the capital to do that, so they needed to raise some money in a hurry. Normally you would do this just by selling stock in the company, but Blunt had a much more intricate plan: he offered to trade stock in the Hollow Sword Blade Company for Army debentures at under market value to anyone who was willing to make the swap. Now Army debentures were a form of government debt; basically, they were a promissory note that the Army issued when it couldn't afford to, y'know, actually pay for things. The problem was, you can't exactly repossess the Army's car, so those promissory notes aren't actually backed by anything, making them very hard for people to collect on, which in turn made them nearly worthless.
          Okay, so at this point you're probably confused. How is the Hollow Sword Blade Company gonna make money by swapping shares in their company at under market value for Army debt that most people are just looking to get rid of anyway? Well, Blunt realized that an offer this good was going to entice a lot of people into taking him up on it, thereby massibely inflating the demand for, and thus the price of, Army debentures, so he very quietly went out ahead of time and had the company quietly buy up as many Army debentures as it possibly could, before announcing their offer to swap debentures for company shares. That way, when they announced their offer, the value of the debentures they picked up would go through the roof. On top of that, because the land he was aiming to buy was government-held, he could trade the government debt for the land directly at whatever value he'd driven the debt to. This tangly web of financial magic ended up getting him not only the 200,000£ he needed to buy land in Ireland, but also another 20,000£ which he politely loaned to the government at a very low rate. Now what Blunt and the Hollow Sword Blade Company did here is certainly illegal today, and probably was illegal back then, too. In fact, there was even a court ruling against the company, but since they were now busy lending the government money, no action was ever taken against them. After all, when you're busy lending money to the government, who exactly is gonna punish you for bending the law?
          Which is of course what got Blunt and Harley together in the first place; Blunt was helping the government find funds, and Harley badly needed funds to be found, so it was high time that they take tea. The Bank of England had been running a rather mediocre lottery for the government the last few years, and Harley decided that Blunt was just the man he needed to kick it up a notch. So he got the rights to administer the government lottery turned over to Blunt and his crew, and man, did Blunt do a bang-up job. In four days, he sold out all of the tickets, pocketing a tidy profit for himself in the process. He then followed it up with an unbelievably exorbitant lottery with tickets that cost thousands of U.S. Dollars a piece by today's standards, and he sold out all of those too. The only problem was that by part of the way he did this was by making sure that every ticket won something; at minimum you were guaranteed to get at least 10% off the price of your ticket back in winnings, which is great for the gambler, but not so great for the government. The key, though, was that the government would pay out the winnings over the next decade, rather than right away, bringing a much-needed influx of cash to the Exchequer. So while, yes, this added still more long-term debt the government owed, it gave Harley the 300,000£ he needed to see the government through the next few months.
          But it would take way more than just lotteries to solve the larger looming debt crisis...

Too Big to Fail

          Harley, stymied at every turn and frustrated with the Whig-controlled Bank of England's refusal to help, finally thought, "What if we just built a Tory-controlled company to do the Bank of England's job?", at which point Blunt probably started seeing Pound signs and hyperventilating. Together they came up with a plan for a trading company that would assume all of the government's debt: The South Sea Company.
          Here's how it would work: anybody who held British government debt would get to exchange that debt for shares in the new company. The government would pay the newly-formed company roughly 6% interest on that debt, or about 500,000£, a far lower interest rate than the government had been paying when all the debt was in the hands of private individuals. The company would then turn around and use that money as a dividend for its investors. But in order to make this offer enticing, there had to be something more. And that's where the South Seas part comes in.
          Y'see, fundamentally, to convince anybody holding government debt to give up the principal of their debt, the amount of money they first lent to the government, for stock in an unknown company, and a dividend payment that was probably lower than the interest they were supposed to be getting anyway, you'd have to convince them that the stock they were getting was gonna be worth far more than the debt they already held. So on top of that half-a-million pounds the government was gonna give the company annually, it also gave them a monopoly on trading in the South Seas. And man, did they turn on the hype machine for this. Everybody from the government to the directors of the Hollow Sword Blade Company to Daniel Defoe, the guy who wrote Robinson Crusoe, started talking about the unimaginable riches that would flow from the South Seas into Britain once this company was established. And everybody in Britain knew how well the Honourable East India Company had done for its shareholders; here was a chance to get in on the ground floor of something similar.
          There was only one small problem with this scheme: the South Seas mentioned in the deal referred to Central and South America. And by Central and South America, they meant all the major seaports in Central and South America. And by all the major ports, they meant a bunch of ports that happened to be exclusively owned by Spain. And, well, Britain was currently at war with Spain. Like I said before, Britain was at war with, like, everybody.
          This didn't phase Harley or Blunt, though. To them, the answer was simple: they would simply end a decades-long multi-national war. This time, they got the guy who wrote Gulliver's Travels to do their propaganda work. They laid it on so thick, they even got the famous Whig Sir Robert Warpole, and John Churchill the Duke of Malborough (a hero of the War of Spanish Succession), locked in the Tower of London as part of their efforts to smear the opposition. But for all this, they still didn't have the votes they needed to get past the House of Lords. Funny thing about the House of Lords, though: all you had to do to be a part of it was be a lord. You didn't need to be elected to the House of Lords; until recently, if you were a peer of the realm, you just got a seat. So with a little prodding from Harley, the Queen created twelve new peers, and presto!, a majority of the House of Lords now wanted peace.
          But oh, the irony! By locking themselves into peace, they locked themselves out of the peace they wanted. Britain's push for peace meant that they made peace independently, and earlier than their war allies, which left them with little to bargain with when it came time to actually work out the terms of the peace. In the end, the Spanish gave the South Sea company the questionably lucrative right to trade slaves in the South Seas, and the right to send one ship a year to each of the Spanish ports. One ship a year. The Honourable East India Company was sending fleets of ships every month to maintain the kind of profits that Blunt and Harley had advertised. So while the public would continue to be told about the riches of the South Seas, it was now clear to everybody close to the venture that the South Sea Company was really just a financial institution whose sole business was managing the government debt.
          Then in 1714, Queen Anne, the monarch of England, died without an heir. After much debate, George I, the elector of Hanover, was chosen by Parliament to succeed Anne, and with the new King came a new government. Harley fell out of favor, and the Whigs regained dominance. So what did our good Mr. Blunt do in response? He did what any upstanding citizen would do, and promptly booted his erstwhile ally Harley to the curb, replaced most of the Tory board members in the South Sea Company with Whigs, and in a stroke of genius, got the King's son George II to replace Harley as the largely ceremonial governor of the company. He even got the King, who was desperate for funds for the Royal Household, to invest in the company himself.
          To further smooth things over in the transition, and to avoid some of the wrath of the now-resurgent Warpole and Churchill, the very men the South Sea Company got locked up a few years before, the South Sea Company agreed to forgive the two years of interest the previous government had owed it, which helped the new administration to keep things afloat. In return, the government allowed the Company to issue more stock of an equivalent value to offset the loss, which meant the Company had roughly 10,000,000£ of stock issued. To put that in perspective, that's about half the total value of stock issued by all companies in England; this, for a trading company that's only ever managed to lose money on trading.
          This wild success led members of the government to decide that it was time to offload more of the government's debt onto the South Sea Company, because why wouldn't you, right? After all, if one company accounted for more than half of, say, the New York Stock Exchange with no discernible source of income, clearly the correct play would be to make it bigger instead of, y'know, investigating its activities. So the new plan was to allow the South Sea Company to issue even more stock, and in exchange, the Company — wait for it — would handle the government's debt from running the 1710 lottery, the lottery Blunt himself had created. Genius. That is a Montgomery Burnsian kind of genius.
          But make no mistake: the government's strange confidence in the South Sea Company wasn't just due to starry-eyed politicians' desire for somebody else to deal with their mess; there was something else to it. In 1717, the King and his son George II had gotten into a fight. In an act of spite, the King had removed his son as governor of the South Sea Company, and replaced him with himself. John Blunt now had the King himself as the company's royal figurehead. Whoa, right? Not only did this mean that they received a level of trust and prestige that they had never even come close to earning, but it also meant that the Company was now, in some ways, too big to fail. If the South Sea Company collapsed, so might faith in the monarch, and they couldn't let that happen.
          But in 1719, as the lottery debt was being exchanged, another strange occurrence happened: there was a brief abortive attempt to overthrow the King by the Jacobites, the branch of the English monarchy that had itself been overthrown during the Civil War seventy years before. It wasn't successful, but when that whole affair was put to rest, the South Sea Company did everything they could to fuel the sense of jubilation spreading around England, going so far as to peddle fabrications, like the fact that the pretender to the throne had been captured, ending the Jacobite threat forever. In doing so, they managed to crank up the stock of the South Sea Company from 100£ a share to 114£ a share. Doesn't this make you just want to hit one of these people?
          And that stock value increase is important, because when the Company had agreed with the government on how much stock they were going to issue, they agreed to an amount that would let them cover all the debt they were picking up at 100£ a share. But now, as the stock price rose, they found themselves paying for that same debt at 114£ a share, and at that rate, they didn't even need all those shares to cover the debt anymore. What did they do with all those extra shares that they'd issued but that they no longer needed to cover the debt they were obligated to pick up? Why, they sold them, and pocketed the profit (because of course they did). This gave Blunt ideas. Very, very big ideas...