the British Treasury and the merchant class. England had been in a battle with Spain since the early 1700s in what is referred to as the “War of Spanish Succession.” The war had been very costly; the Crown need to finance its debt, and the Lord Treasurer Robert Harley came up with a good idea: Sell a franchise!
He granted exclusive trading rights to a group of merchants in the “South Seas.” It is a common misconception that the “South Seas” were in the Pacific, but in eighteenth-century Europe, the term referred to South America and the Caribbean Sea, not the Pacific.
The first round of financing granted the company “exclusive” trading rights for the sum of £10 million (approximately £500,000 million in 2014 £). In effect, the merchants convinced investors to take stock in the company and replace the bonds issued by the English Treasury. In exchange, the government granted the company a permanent annuity paying a little more than 5 percent. The merchants quickly resold the notes and guaranteed a profit to investors from the Treasury “in perpetuity.” Today, we would call this arbitrage, and it is the way many investment banks generate billions in profit: Buy debt for one price, sell it for a discounted amount to investors, and take the difference and put it in their pocket.
The British government viewed the transaction as a layup. It would charge tariffs on trade from the “South Seas” to fund the interest and pocket the difference.
When the war with Spain was finally settled in 1713 by the treaty of Utrecht, the terms were not as favorable as the Crown or the merchants had hoped. Although there is no evidence the company had ever made dollar one, the Treasury was able to float another round of financing in 1717 for £2 million. The original notes were converted to the new debt and the government continued to pay the interest. Nowadays, financiers call this type of sovereign debt replacement Brady bonds in honor of the US Secretary of the Treasury whose ingenuity bailed out US banks and Latin America in the 1990s.
The new debt funded the original loans from 1711. Nevertheless, as time passed and the company still did not flourish, the Crown needed to raise more capital. In 1719, the company conceived of a new idea.
Exchange the existing debt for equity in the Crown!
The company proposed to buy the majority of the Treasuries debt for £30 million. In exchange, the government guaranteed to pay interest on the shares at a preferred rate of 5 percent for a period of eight years, and then 4 percent “in perpetuity.” To sweeten the deal, the shares were allowed to be traded, and any “appreciation” could be used to buy more shares.
Needless to say, this arrangement benefited the company and the Crown. Rumors circulated that the trading rights granted the South Sea Company in the “New World” were far in excess of what was being revealed (can you say “new economy stocks”?), which caused frenzied speculation. Trading in the winter and spring of 1720 drove the price of the stock up almost 400 percent. Greed pulled in even more investors anxious to be in on the big payoff. Insiders and the Crown were rumored to have made a killing.
In June 1720, after scores of joint-stock companies joined in the feast, Parliament – fearing a revolt by the general population – passed the “Bubble Act,” which forbad joint-stock companies from participating in unregistered issuance of stock. Unfortunately, this did not curb the bubble, but triggered even more aggressive buying of the South Sea Company stock. In a perverted way, the South Sea Company was viewed as a flight to quality!
Shares prices exploded, peaking at 1,000 percent of their issuance price from the final conversion of debt to stock in 1719. Finally, in August 1720, “No greater fool could be found,” and the prices started to tumble. In six weeks, it was all over. The price was back to £150.
What became of the South Sea Company?
It continued to exist until 1763, when it was disbanded. In between wars, it continued to serve as a front for the Crown's debt. In times of war, it virtually disappeared.
The hangover lasted for decades. Scores of ordinary citizens were broken. Bitterness was unbridled and knew no class. One of the biggest losers in the scam was Sir Isaac Newton, one of the most brilliant minds of all time. He never recovered financially and died in virtual poverty March 31, 1727, in an apartment with his niece and her husband.
The Cotton Panic of 1837: Land, Commodities, and Government
The first bubble addressed took place in Europe. Let's turn our attention to the original panic in the United States. This bubble is not nearly as celebrated as its European counterpart, but it was equally as deadly. It occurred during the presidency of Andrew Jackson, 1829–1837. When the bubble burst on May 10, 1837, Martin Van Buren was the president, but make no mistake – the stage was set in the prior 10 years.
The war of 1812 was really America's second Revolutionary War. The British invasion was almost successful, and the United States came very close to being “the colonies” again. As with most wars, there is a positive effect on the economy, as manufacturing and commerce in general have a tendency to grow. Capital goods must be replaced at a far greater rate than during times of peace. Usually, the prosperity lasts a few years; however, once the “war effect” ends, a general slowdown is almost sure to occur. In the United States, it manifested itself with the downturn of 1819–1821.
By the middle of 1821, the country was on its way to a recovery. The United States was expanding it western borders; new agriculture opportunities and trade brought in an era of exceptional wealth. The population went up by almost 60 percent, primarily shifting to the West, where commerce flourished North and South along the Mississippi River valley.
When the Jacksonian Era began in 1829, the United States had expanded its borders, and had also built an infrastructure of roads and canals that allowed for a flow of goods not only North and South on the Mississippi but also from the East Coast ports to the western colonies as far as Ohio.
Jackson was a very tough and vengeful man. He had been a war hero, a US senator, a landowner – and his nickname “Old Hickory” said it all. It was the merciless streak that helped to set the wheels in motion for the disaster that was to follow.
As with any time of prosperity, the demand for commodities and the land to produce them continued to increase. By law, public land in the West and Mississippi Valley could be purchased for $1.25 per acre. Sales of land increased steadily in the 1830s, and landowners started to feel the first wealth effect. Land in some prime growing areas of the Mississippi more than quadrupled in value in five years (Iowa farmland in 2014?).
In government, a nasty personal feud between President Jackson and Nicholas Biddle, the owner of the Second Bank of the United States, resulted in the revocation of its charter. Jackson replaced the Second Bank of the United States (lender of last resort) with “Specie Circular” (gold and silver coins bimetal standard) and began to deposit money in state-chartered banks.
Unfortunately, the move to gold and silver coins did not allow for any expansion of the banking system. Consequently, when individual banks needed credit to cover land transactions, there was no institution to loan them the funds. This put banks in a huge dilemma. To counter the problem, the state banks actually exacerbated the situation by lending in “paper,” or “kiting” their own notes to cover the land speculation. The thirst for “King Cotton” in Europe was thought to be unquenchable. Conversely, with inflation on the rise, signs of darkness started to emerge in late 1835. Cotton prices doubled and it fetched nearly 20 cents a pound, and inflation was headed toward double digits.
In 1836, Britain forced new and punitive trade agreements on the United States, and greatly reduced exporting and importing with America. For any trade that did take place, the British demanded payment in hard currency, not cotton. As it turned out, the demand for cotton was not infinite. By
