The South Sea Bubble: An Introduction
The South Sea Bubble was formed by a more multifaceted set of situations than the Dutch Tulip mania, but has nonetheless gone down in history as an additional classic instance of a financial bubble. The South Sea Company was formed in 1711, and was promised a monopoly by the British government on all trade with the Spanish colonies of South America. Expectant a repeat of the achievement of the East India Company, which had a flourishing business with India, investors snapped up shares of the South Sea Company. As its directors circulated tall tales of unconceivable riches in the South Seas (present-day South America), stocks of the company gushed more than eight-fold in 1720, from £128 in January to £1050 in June, before crumpling in the succeeding months and instigating a severe financial crisis.
The South Sea Company’s foundation in 1711 followed the normal joint-stock company model. A joint-stock company held a royal charter which allowable it certain privileges which other companies did not have. Joint-stock company shareholders were protected by limited liability. This meant that they could not be pursued for debts owed by the company. Secondly, joint-stock company shares were readily assignable, i.e. they could be passed easily to another holder by sale or gift. This was an important feature not shared by many other early financial instruments. For instance, government annuities were not readily assignable and could not be sold quickly if the holder required cash urgently. Joint-stock companies such as the South Sea Company sometimes performed debt-for-equity swaps for the government. They would offer their shares in exchange for government debt such as annuities. A debt for equity swap was supposed to benefit all parties. The government would reduce its costs and the complexity of managing its debts. The company would gain the right to increase its capital and gain bargaining power. The former government debt holders would have a more liquid asset with the possibility of higher returns.
The government had issued a large number of annuities as part of its war-financing programme. Annuities were supposed to pay a fixed sum each year, but the government’s payments often fell into arrears. Holders of annuities might prefer to swap their claims on the government for some other sort of investment. A debt-for-equity swap allowed them to exchange their annuities for joint-stock company shares. They would still be paid an annual fee which would now be administered by a company. Their new shares would also give them the possibility of dividend payments or capital gains (by selling the shares on). The shares were easy to sell or bequeath, which was a valuable feature in itself. It was difficult for a large number of small creditors to pressurise a government. By joining together under the aegis of a joint-stock company, small creditors could have a stronger voice. This might make it more difficult for the government to fall behind with payments.
The government could also benefit from a debt-for-equity swap. The bureaucratic costs were reduced as it could now deal with one company, rather than a myriad of small creditors. It had to pay a single fee to the company, rather than different fees to different people. Government debts had often been arranged on a short-term and ad hoc basis and were highly complex to manage. One type of debt contract which was particularly onerous was the so-called ‘irredeemable debt’. Irredeemable were annuities which the government had no right to redeem, i.e. the government could not compel the holders of this type of debt to sell it back, so creditors often did not receive all the payments they were entitled to. This has to be taken in deliberation when likening annuities with South Sea shares.
Ideally, the government would have the option to redeem its debts. If market interest rates fell, then the government should borrow money cheaply in the market and use it to pay off its more expensive debts. For example, suppose that the government borrows £100 at an interest rate of 5 per cent. If the market interest rate drops to 2 per cent, then the government should borrow enough money to pay back the principal of £100 plus any interest owed and any bureaucratic fees. It now must pay 2 per cent rather than 5 per cent on its debt, but this should still constitute a saving. The government could not automatically take advantage of a fall in the interest rate when dealing with irredeemable debt. Therefore, it was important to persuade the holders of irredeemable annuities to relinquish their claims in exchange for joint-stock company shares.
