Weathering the South Sea Bubble

The South Sea Bubble describes a series of events surrounding the plan to convert a significant amount of British national debt into equity shares of the South Sea Company (SSC) in 1720. The rise and fall of the stock market during the South Sea Bubble is still one of the most heavily discussed events in history.

In 1711, the SSC was founded with a capital stock of more than £9M. It was established to purchase existing short-term government debt and help manage the national debt in a similar way to the Bank of England. The Company also intended to conduct business with the Spanish Empire.* Spanish America gained popularity as a more promising trading region than India and the Far East because the market was more accessible and traditional English exports like textile and iron items were more likely to be purchased. Following the conclusion of the Treaty of Utrecht (1712), the SSC was awarded exclusive rights to trade with Spanish America—the so-called South Seas—on behalf of the British government. The SSC also secured a 30-year contract as the sole supplier of slaves to the South Seas, known as the Asiento de Negros. Britain already had colonies in the Caribbean—and consequently, a significant share of the market for slave trading in the Western Hemisphere. The firm appeared to be well positioned in this lucrative new market.

In the autumn of 1719, however, a new war with Spain halted the SSC’s trade with the South Sea. Unlike the EIC with its robust Asian trade, the SSC had little room for maneuver. The company’s proposed solution to this dilemma was to again attempt to convert government debt into new equity shares. The scale of the proposed scheme was unprecedented, except insofar as it was inspired by the French legal system. By the end of 1719, John Law had successfully converted all French national debt into shares of the newly founded Compagnie des Indes, which monopolistically merged international trade, national banking, and tax collection. Some of Law’s system was evident in the SSC’s initial proposals, where the conversion of British national debt into South Sea shares was explored with the government, the EIC, and the Bank of England (BoE).* The EIC and the BoE, like the SSC, were both “big money” companies, meaning that both had made substantial loans to the government to justify their chartered existences. Exchanging all British national debt for South Sea shares would have posed an existential threat to these companies, so the plan evolved to excluding the debt already held by the EIC and the BoE and converting the remaining national debt into South Sea shares.

The EIC traded slaves between Madagascar and the Western Hemisphere, while the South Sea Company supplied the Royal African Company with slaves from West Africa.* The EIC directors were occupied with the outfitting of trading ships and the collection of multi-cargo loads, including bullion that would have to be transported to the Far East by these ships.

As a result of the share-price crash in the United Kingdom, a large number of investors were ruined, and the national economy shrank substantially. The scheme’s founders engaged in insider trading by purchasing debt in advance in order to profit from their prior knowledge of the timing of national debt consolidations. Huge bribes were offered to politicians in exchange for their support of the necessary Acts of Parliament for the scheme. Money from the SSC was used to trade in its own shares, and certain individuals who purchased shares were given loans backed by those shares to use for the purchase of additional shares. The public was led to believe that the company would make excessive profits from trade with South America, but the inflated share prices ended up being more than the company’s real earnings from slave trading.

According to Chaudhuri (1978), in attempts to reduce the effects of the burst bubble on foreign exchanges, the directors of the BoE and the EIC met in the middle of September 1720 to discuss the shortage of capital in London. By the end of the month, “an international crisis was developing with full force,” and in 1721, “the February description of the winter events written by the EIC’s Committee of Correspondence contains all the ingredients of a classic liquidity crisis.”* After the bubble burst, a parliamentary investigation was held to determine the causes, the SSC was eventually restructured and continued to operate for over a century.

The EIC was in a position to weather the storms experienced in 1720 as a result of prior profit maximization and a conservative dividend policy in previous years. Undistributed portions of strong profits earned between 1710 and 1716 were used to fund a reserve. The business continued to operate throughout and after the bubble. After 1722, the company was able to finance its voyages despite encountering greater than usual financial difficulties. Two years of trade losses in 1721 and 1722 led to a decline in cash reserves, but it was not until 1723 that the dividend rate was reduced to coincide with falling interest rates. The years 1717–1727 were turbulent for the EIC, but in the six years following 1727, the company’s profits increased by an average of 14.5% annually.

The EIC endured the storm created by the South Sea Bubble. Its shares continued to be actively traded securities. In 1719–1720, £3.2M of stock was owned by around 1,700 investors, by 1723 there were about 1,900 owners of the EIC’s stock.*