Analyst Insight: Cautionary Tales - The Bubble of 1720
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When you think about investing, you’re probably not thinking about the 18th century. You’re thinking about Wall St., the wealth of America, expensive suits, yelling, and Michael Douglas.
Well, what if I told you one of the most important periods of investing actually happened before the creation of the United States, during a time when Wall St. was merely a reference to a street near a wall. (Hopefully, that fact is correct, because I took it from the ‘National Treasure’ movie)
Let’s go back to 1700 and the death of King Charles II of Spain.
Charles was the last Hapsburg ruler of the Spanish Empire. His rise to the throne followed centuries of his family quietly marrying into every royal family in Europe to consolidate wealth and power. Since the 13th century, the house of Hapsburg has produced kings of Bohemia, Croatia, Spain, Portugal, and the Low Countries of Italy, several Austro-Hungarian Emperors, some Holy Roman Emperors, and an emperor of Mexico. They are the crème de la crème of European royal families.
As time went on and the house’s reach grew, the family was split into several parallel branches, each controlling different possessions. This complicated the matter of marriage. Ideally, a royal will marry another royal, but that can produce some interesting results when every other royal is your cousin or aunt. In the case of the Hapsburgs, intermarrying led to a few health problems, some of them quite pronounced — like the infamous Hapsburg jaw.
Charles II of Spain was the culmination of decades of Hapsburg intermarriage. Historians Will and Ariel Durant described him as "short, lame, epileptic, senile and completely bald before 35, always on the verge of death but repeatedly baffling Christendom by continuing to live." His autopsy from 1700 recorded that his “heart was the size of a peppercorn; his lungs corroded; his intestines rotten, and his head was full of water.”
Unsurprisingly, Charles could not produce an heir and that left the Spanish throne and all its many dominions up for grabs. This caught England and France’s attention.
War of the Spanish Succession
In 1698, King Louis XIV of France and King William III of England drew up partition agreements to parcel off Spain’s many territories in the hopes of preserving peace on the continent. Unfortunately, this plan was resoundingly rejected by the ailing Charles. Instead, he opted to name his nephew Philip of Anjou, a grandson of Louis XIV, as his heir. This led to an immediate proclamation of war by the English and the Grand Alliance, which feared the consolidation of the French and Spanish thrones.
Over the next decade, the great powers of Europe clashed on land and at sea. England gained naval supremacy and quickly captured the Spanish Netherlands and territories in Northern Italy, while establishing permanent bases in Gibraltar and Menorca. However, it saw little success on land and was unable to make significant inroads into France or Spain. Locked in an eternal struggle, both sides agreed to begin peace talks in 1711, culminating in the Treaty of Utrecht in 1713.
All agreed to recognize Philip as the King of Spain so long as he renounced his right and the rights of his descendants to inherit the French throne. France gained a friendly next-door neighbor, while England was allowed to keep some of its captured territories, gained a few trading privileges in the Spanish Americas, and overtook the Dutch as the leading naval force in Europe. With the balance of power restored and an understanding of collective security established, it was an all around good day.
Except, every major participant left these talks with the same problem: a tremendous amount of government debt.
The Law of the Land
First to tackle the debt problem was John Law.
Law is somewhat of an economics legend and all-around bad boy of the Age of Enlightenment. Raised in Scotland, he was convicted of murder in London at the age of 23 for killing a man in a duel over a woman’s heart. Despite being sentenced to death, he escaped to Amsterdam and eventually made his way to Paris. Along the way, he made a name for himself as a casino manager, setting up games for Europe’s rich and powerful.
However, even though he was known as a great gambler and speculator, Law had some pretty significant ideas about the need for national finance reform. He envisioned a world where countries would use paper money administered through a centralized bank which wasn’t backed by gold and silver. This was largely due to his belief that the modern world would need more credit and cash to foster innovation.
Law had seen this reality happen on a micro level. His father was a goldsmith and, as such, had a safe — an uncommon possession for the period. Sometimes customers would ask goldsmiths to hold their gold for them in the safe in exchange for a receipt. These receipts went on to become like proto paper money: people would exchange them for goods and services as they were backed by gold.
Eventually, goldsmiths began handing out receipts not backed by gold as a form of loan but it was ok so long as not everyone came to cash in their receipts at the same time. This is how modern banks work today — if everyone shows up at the same time to withdraw their money it’s called a bank run.
For this reason, Law saw incredible potential in loaned money and investment, particularly within the context of mercantilism and colonization. He could see an abundant future on the horizon that would pay dividends for centuries but would need a pretty significant initial investment to get off the ground. To this end, he suggested that governments abolish small, private monopolies and instead create large, nationalized ones tied to economic ventures that could be sold to investors as dividend paying stocks. This would mean a regular citizen could buy stock in the fur business of French-Canada or the sugar business of Louisiana. As these companies would be state-owned, it would ensure the continued expansion and success of the empire without the accumulation of debt.
After the War of the Spanish Succession, France was utterly crippled by debt. It had even run out of metals with which to mint new coins. Farmers couldn't borrow money to plant seeds. At one point, King Louis had to melt down his silver and gold plates to pay his soldiers. Most of the debt was held in government bonds and France was getting dangerously close to missing its interest payments and falling into default. At one point, bonds were worth just 25% of their face value.
Things were looking pretty grim.
In this dire hour, Law saw a chance to try out some of his ideas. Thanks to his years spent socializing with the royal family of France, he had a certain amount of influence.
Let Them Buy Stocks
In 1716, Law set up the Banque Générale Privée (General Private Bank) which created its own paper bills backed by gold and silver. The following year, Law struck a deal with the Duke of Orléans, regent to the French throne, that all French taxes should be paid using notes from the General Private Bank. Overnight, Law’s bank was legitimized in the eyes of the French public.
But, Law wanted more. He had seen huge trading companies like the Dutch East India Company achieve success in the New World and he wanted France to get in on the action. To this end, he bought the Mississippi Company, which controlled France’s territory in the Gulf of Mexico. Up to that point, it hadn’t done much in the way of colonization — it had only ever sent one failed expedition.
Law wanted the company to become a titan of trade so he went back to his old friend the Duke of Orléans and asked for a favor. In 1717, the Mississippi Company was granted a monopoly on all of France’s trade from North America. In exchange, Law promised to name a city in the New World after the Duke. I’m sure he would be very upset with the modern American pronunciation of New Orleans.
Over the course of the following year, the Mississippi Company acquired the Company of the East Indies and the Company of China, meaning it controlled all of France’s international commerce. It also picked up a few royal charters for tax collection just for good measure. At the same time, Law asked that the General Private Bank be nationalized and renamed the Royal Bank, allowing it to take over the royal mint.
In 1719, Law issued 50,000 shares in the Mississippi Company. But rather than asking for money, he asked investors to give him government bonds. To many investors, it seemed like a good deal — they got to offload government debt that may or may not get paid back in exchange for a piece of the wonder and riches far beyond the horizon. Law was happy too, he was about to become the middleman of the entire French economy and get incredibly rich along the way. This was made official when he was named the Controller General of Finances in 1720.
For a brief moment of time, things looked good. Money flowed more freely through France, allowing everyday people access to capital. Farmers grew more crops and people were getting rich holding Mississippi shares. Initially, they sold for 500 livres each but within a few months they were worth more than 10,000. Some investors did so well they had to make up a new word for them: “millionaires”.
Interestingly, in many cases, it was regular people buying shares. In the past, investment was only for the rich and powerful, but the Mississippi Company opened its shares up to anyone. It offered several more rounds of investment and interested parties waited eagerly outside its offices. If there was no new stock issued, investors would just frantically trade shares back and forth on the street for more than 12 hours a day.
Just Across the Channel
In England, things had taken a similar turn. Becoming the predominant naval power in Europe was incredibly expensive. Luckily, unlike the French, the English already had the Bank of England (BoE) which had practically become the financing arm of the British Treasury despite being a private institution. The BoE provided funds to military suppliers, troops, and domestic infrastructure projects in exchange for hefty interest payments. By 1707, the BoE was underwriting most government bond sales.
But 10 years of war had put significant strain on England’s finances and it too was teetering towards default. Most concerning of all, private naval contractors, who were necessary for the continued upkeep and expansion of England’s most important military arm, had stopped providing goods and services as they weren’t being paid on time.
In 1711, it was determined that the English government had more than £9 million of naval debt with no specifically allocated income to pay it off. To consolidate it, the South Sea Company (SSC) was created and debt holders were granted shares in the company in a debt-to-equity swap. But this new company needed a source of income to give its shares value so its founders took a page from John Law’s book.
In 1713, the SSC was granted a monopoly on the slave trade to the Spanish Americas, a right England obtained under the Treaty of Utrecht. This pleased initial investors and caught the attention of the public, who like their French counterparts, believed in the limitless profits to be found in the New World.
In 1719, the English Parliament was so pleased with the success of the debt-to-equity swap they allowed the SSC to do it again, this time converting government annuities from 1710. While the scheme was voluntary, more than two-thirds of annuities were exchanged and the South Sea’s stock price rose 10%.
But that wasn’t enough for the SSC. It approached parliament and asked to acquire the remaining £30 million of government debt and annuities. Despite objections from the Bank of England, the plan was accepted and SSC shares were now readily available to the vast majority of the public.
To drive prices, the SSC fueled extravagant rumors of the value of trade in the colonies and began bribing politicians with shares to ensure their interests were aligned with the company’s. A speculation frenzy quickly ensued and share prices soared. In January of 1720 shares were £128, by May they were worth £550.
Buying and selling became so frantic that the Royal Exchange, the home of commodity trading, expelled stock brokers for being too rowdy. Instead, equity trading found a home in nearby Exchange Alley, where people of all classes swapped shares in the streets and coffee shops.
Public interest in investing and mercantilism became so frenzied it drove other companies to IPO. This often meant small ventures with royal charters for one industry veered off into fields related to the new global economy. The London Assurance company, which was founded to provide water infrastructure to London, began providing insurance to ships bound for the English and Spanish colonies.
Together, these companies inflated throughout the fall of 1720.
All for One and One for All
Cracks began to appear in the French market sometime after John Law purchased his 12th country estate. Like in England, Law had been bribing officials to ensure support for his bank, paper bills, and the Mississippi Company. However, somewhere along the way he skipped two aristocrats who didn’t take kindly to being ignored. One day in the spring of 1720, they turned up at the Royal Bank and requested a large volume of paper currency be converted into gold. The Royal Bank had long stopped backing its currency with gold and instead was using Mississippi Company shares. This news sent shivers down the spines of investors.
At the same time, the Mississippi Company was trying to work out how to cover its upcoming dividend payout. Its high hopes for the New World hadn’t quite worked out. Most settlers had died of disease, exposure, or starvation, and New Orleans — the crown jewel of French-America — only had four houses.
To cover these shortcomings, Law attempted to issue more shares, but this only scared the public more. He tried to block the usage of livres and gold in favor of his paper currency, but these proposals were rejected by the government due to public outcry. Investors began demanding to exchange their holdings, triggering a bank run.
Worse still, it was unveiled that Law had been printing more currency in secret. Unable to finance his ventures via interest payments from government debt and bonds, he simply made more money, and then passed it into circulation to fuel the purchase of Mississippi shares — maybe there’s a reason why corporations aren’t allowed to own government mints. In 1720, French inflation climbed to more than 12%, while the Mississippi Company’s stock began to fall sharply.
Furious investors demanded Law’s head, and after failing to refinance his personal or corporate debt, he fled France at the end of 1720. His many estate and possessions were repossessed by the government, but it was not enough to cover the losses he had caused. France was forced to absorb the Royal Bank and Mississippi Company. Without any other choice, the country raised taxes to compensate for the massive amount of debt it once again possessed. Law traveled the continent for the rest of his days gambling and died impoverished.
How the Mighty Have Fallen
Just as the bubble popped in France, it accelerated in England. French investors lucky enough to escape the Mississippi Company began purchasing shares in any and all English companies. However, the South Sea Company was upset at having to compete for investor attention and appealed to the government for help. After all, it was the original and most important public entity.
To this end, parliament passed the Bubble Act of 1720 that forbade the formation of any joint-stock company unless approved by royal charter. This pinched the newly formed insurance companies that did not have a royal charter and also desperately needed to issue new stock to cover losses abroad. The first fleet insured by the London Assurance company lost all of its ships to bad weather and pirates.
The threat of legal actions caused an immediate and dramatic collapse of many bubble company’s share prices. Unfortunately for the SSC, many investors had pledged their inflated shares in these companies as collateral for loans causing a scramble for liquidity. As the fire sale spread across the market, the SSC lost 90% of its value.
Public outcry led to an investigation of the company by parliament, in which widespread instances of misleading investors and bribery were laid bare. In truth, the SSC had not generated any money in trade after 1718 as England and Spain were once again at war and it lost access to the Spanish colonies. The chancellor of the exchequer, who received a number of bribes, was used as a scapegoat to quell the people’s anger and was jailed in the Tower of London.
Beyond the Sea
Our modern banking system and that of France and England in 1720 are incredibly different, but you can see the seeds of our modern economy. After the collapse of the Mississippi Company, France went back on the gold standard and grew to resent paper money and stock markets. This stunted the French economy and slowed growth. The English, on the other hand, reformed its system, controlled IPOs via royal charter, and allowed investment to continue. Over the 70 years that followed, France’s GDP growth was half that of England’s. Investment and equity are necessary for innovation, exploration, and modernization. In this case, John Law was right.
Modern investors can also see themselves in their 18th century counterparts. Every few decades, a new investment frontier emerges, something so significant the entire world is sure it’ll change everything. NFTs, Web 3, the Metaverse — there’s a sense that these things will have endless potential and are just out of our reach, just beyond the horizon. In the Age of Enlightenment, this is what the New World represented. It was a literal blue ocean opportunity.
To be fair to these investors, they weren’t wrong, they were just early. Exactly like all those investors who jumped in a little too eagerly during the Dotcom Bubble.
In these moments of excitement, it’s more important than ever to diversify your portfolio. Make sure your imaginative future is balanced with the practicality of today and understand the risks if it’s not. Maybe someone will make money going to Mars, but in the meantime, it’s ok to make money right here on Earth.
That being said, one good thing to come out of highly speculative markets: it brings more people to investing.
They recognize the power of equity, even if they skipped a few fundamentals along the way. I guess the Mississippi Company was the Robinhood of 1700’s France. Exchange Alley in London allowed everyone to trade, including women and members of the lower classes. It was a real benchmark in financial equality and accessibility.
Hopefully, today’s new investors won’t be too scared to try again when and if the bubble bursts.