------------ EH.NET BOOK REVIEW -------------- 
Published by EH.NET (March 2005) 
 
Richard Dale, _The First Crash: Lessons from the South Sea Bubble_.  
Princeton: Princeton University Press, 2004. ix + 198 pp. $29.95  
(cloth), ISBN: 0-691-11971-6. 
 
Reviewed for EH.NET by Larry Neal, Department of Economics,  
University of Illinois at Urbana-Champaign. 
 
 
Many of us are still licking our wounds from the collapse of the  
"dot.com bubble" in March 2000. The NASDAQ index, weighted by the  
market capitalization of all the stocks it lists, soared from a low  
of 333 in October 1990 to 5,048 on March 10, 2000. The electronic  
trading system added hundreds of new technology companies purporting  
to reap network economies from "new new" applications of information  
technology on the world-wide web and all of them tried to expand  
their public equity at the behest of their venture capital backers.  
By the end of 2000, however, the NASDAQ had lost half its value and  
continued to lose another half before reaching bottom in October  
2002.[1] This was the latest financial crash, but it was just one of  
many other that have occurred since the existence of organized  
secondary markets in financial assets. After each crash, one can be  
sure that references will crop up to the South Sea Bubble of 1720,  
the granddaddy of them all. The explicit sub-text of these works is  
always, "People often act like damn fools;" or, more soberly, we are  
all subject to occasional bouts of irrational exuberance. The  
implicit sub-text, often made explicit, is that stock markets should  
be regulated closely and access to them limited, mainly to protect  
people from the consequences of these recurrent bouts of mass madness. 
 
It is not surprising then that Richard Dale, Professor Emeritus of  
Finance at Southampton University, should take advantage of the  
opportunity to repeat this oft-repeated lesson of history and make  
explicit comparisons between the original stock market crash and the  
most recent one. What he contributes is an effort to validate the  
approach of behavioral finance as applied to the events of 1720, as  
well as to the more recent crash. Moreover, he argues that sound  
financial analysis of fundamentals was available and widely  
disseminated even in 1720, but that it was ignored by the masses who  
flocked to their fleecing at the behest of the charlatans in control  
of the South Sea Company. Throughout, he draws analogies with the  
analysis of the dot.com companies and the frauds perpetrated by the  
directors of Enron and WorldCom in the recent NASDAQ crash. As icing  
on the cake, he takes to task previous historians of the South Sea  
Bubble (including this reviewer) for overlooking the work of a sound  
financial analyst who disseminated his results publicly at the time,  
but to no avail against the forces of irrational herd-like behavior.  
Finally, he uses quantitative evidence also overlooked by previous  
historians on the erratic pricing of subscriptions to the new issues  
of South Sea stock issued at various times and various prices during  
the course of the South Sea Bubble, which he takes as direct evidence  
of market irrationality. 
 
Dale builds his argument first by setting the scene for irrational  
exuberance in the coffee houses of London (chapter 1). There, subject  
to the intoxicating fumes of the exotic bean, people regularly lost  
their senses and fell prey to constant streams of misinformation  
produced by an untrammeled and unregulated press. In these coffee  
houses and the narrow confines of Exchange Alley abutting the Royal  
Exchange, where legitimate and regulated trade was carried on, a  
free-wheeling, unregulated stock market arose (chapter 2). It quickly  
was dominated by a few manipulative entrepreneurs, as aptly described  
by Daniel Defoe in his _Anatomy of Exchange-Alley_. Among them were  
the projectors of the South Sea Company, created in 1711 to help the  
government refinance much of the huge debt it had incurred over the  
course of the War of the Spanish Succession (1702-1713) (chapter 3).  
No recapitulation of the South Sea Bubble is complete without  
reference to the comparable scheme begun earlier in France by the  
expatriate Scot, John Law. Chapter 4 briefly describes the  
innovations in marketing expanded issues of capital stock that,  
according to Dale, imitated earlier South Sea innovations --  
installment payments on new shares, options, and interventions by Law  
to first run up the price of Mississippi stock and then to stabilize  
it. The crowd spirit incited by Law's machinations then spilled back  
across the Channel to whip Londoners into comparable frenzies.  
Chapter 5 takes us back to the South Sea Bubble proper and lays out  
the mechanics of the scheme, while introducing us to Archibald  
Hutcheson, the one voice of reason who explained, again and again, in  
the clearest terms possible, why the scheme was fated to fail. Dale  
notes explicitly that many of the flaws in the scheme were repeated  
once again in the dot.com bubble of the 1990s. 
 
The South Sea bubble, nevertheless, unfolded quickly after Parliament  
approved it in February 1720 and the sheer momentum of the crowd's  
frenzy kept it going well into July 1720. On the timing of the  
bubble, Dale takes sharp issue with previous analysts of the bubble  
who claimed that the peak occurred just before the Company closed its  
books in early June to prepare the summer dividends. He dismisses  
explicitly my argument that a severe payments crisis had hit the  
European economy at this time, even though he describes the currency  
manipulations of John Law that caused the payments crisis in his  
chapter on Law. Apparently, he believes that only animal spirits  
flowed across the Channel then, not actual means of payment. 
 
Dale's focus on frenzy rather than finance at this time is consistent  
with that of Archibald Hutcheson as well. Hutcheson was the very  
archetype of the mercantilist "little Englander" later derided by the  
Scotsman, Adam Smith. Hutcheson's main policy recommendation was to  
create perpetual annuities that were obligations of the state that  
could be held permanently by the British citizens. One great  
advantage would be that foreigners would have no claims against the  
state, which was proving increasingly to be the case with Dutch  
investors and even Scottish investors who came into London in the  
train of William III after the Glorious Revolution of 1689.  
Naturally, Hutcheson's overall goals were anathema to the Scottish  
supporters of the Hanoverians, and not welcome to the directors of  
the Bank of England and the East India Company with their strong ties  
to the Dutch. As early as March 1720, Hutcheson sounded the alarm  
against the scheme of the South Sea directors with fiery rhetoric  
that they threatened the very bases of English liberties and urged  
his fellow Parliamentarians to take preventive action against the  
Company so that "our Weekly Bills of Mortality may not be filled with  
large Articles of unhappy People, who have hang'd, drown'd or shot  
themselves"! (Hutcheson, p. 8, from his March 1720 pamphlet.) It may  
be that Hutcheson's analysis of the frailty of the scheme was ignored  
not so much due to the frenzy of his audience but more because of the  
excesses of his rhetoric. From the beginning of his many pamphlets on  
the public debt, Hutcheson made it clear that he desired nothing else  
than a complete repayment of the national debt, including that held  
by the Bank of England, the East India Company, and the South Sea  
Company. This implied, of course, ending those companies when their  
current charters expired. No wonder his counsel held little charm for  
the thousands of shareholders in said companies! 
 
In his "Bubble" chapter, Dale also gives the main quantitative  
evidence for irrational behavior lasting through the summer of 1720.  
These are the highest weekly prices of the three South Sea  
subscriptions that had been issued by mid-June. These peak at various  
times but well into July, implying according to Dale that the frenzy  
had not yet abated. He dismisses my argument that the bubble had  
already been pierced with a contraction of liquidity in the  
mercantile payments system in early June by asserting that interest  
rates remained remarkably stable throughout 1720, basically close to  
5 percent annually. (Usury limits of 5 percent set the maximum  
interest rate legally offered by any company at this time.) Dale  
offers proof in the East India Company's 5 percent bonds, whose  
prices remained fairly stable until the last quarter of 1720 (after  
the Sword Blade Company, which provided banking services for the  
South Sea Company, had failed). These India bonds were short-term  
bills with expiry dates of less than a year, with rollovers occurring  
quarterly. As they would be redeemed at par within a year, their  
price could not rise above par unless they were especially useful as  
means of payment; and if they did fall below par it could only be  
because the company issuing them was suspected of not being capable  
of redeeming all the bills as they expired. Thomas Mortimer in his  
classic guide to the eighteenth century stock market, _Every Man His  
Own Broker_, tells us that sellers made out the terms of sale for the  
India bonds, asking the par value plus the accumulated interest and  
then adding the market premium or discount on the basis of a =A3100  
bond. This premium averaged around 2 pounds through August, when  
increasing concerns that the troubles of the South Sea Company might  
spread to the East India Company drove their bonds to ever larger  
discounts, reaching 6 pounds at the depths of the crash. South Sea  
short-term bonds were even more deeply discounted by then. As Dale  
notes, there was no fiat money in England, unlike the situation then  
being attempted in France. Neither the Bank of England, the East  
India Company, nor the South Sea Company could create means of  
payment. The best they could do was to recycle idle balances more  
rapidly, which they had all begun to do in May 1720. This meant that  
the supply of India bonds could not be expanded at will to meet  
scrambles for liquidity. Their prices were tightly constrained by the  
short term of their existence and therefore the implied interest  
rates also tightly confined. 
 
Goldsmith bankers and merchant bankers operating in the City of  
London at the time found that short term credit was very tight in the  
summer of 1720, which proved to be the case throughout mercantile  
Europe. George Middleton, John Law's banker in London, reported that  
money could only be had for 50 percent per month in June 1720, which  
coincidentally was when the effects of Law's fiat devaluations and  
revaluations at the end of May were disrupting the mercantile  
payments throughout Europe (Neal, 1994). Also coincidentally, that  
was the forward premium I calculated from the forward prices of the  
South Sea stock when the transfer books were closed in June (Neal,  
1990). Dale regards that figure as unrealistically high, but one of  
the most knowledgeable and active goldsmith bankers operating in  
London at the time reported that it was the case. Even earlier in  
1720, Archibald Hutcheson noted that borrowers had to pay very high  
interest rates at the outset of the bubble. (Hutcheson, April 1720,  
p. 25, refers to "the borrowing of Money, at the rate of 10l. per  
Cent. Per Mensem; and even at 20 s. per Cent. Per Diem=8A") 
 
The issue of the appropriate interest rate comes into play again in  
Dale's final chapter, "Lessons from the South Sea Bubble." There,  
Dale argues that each subscription issued by the South Sea Company on  
an installment basis should, rationally, have been priced at the  
current price of a fully paid up share. To calculate this, one should  
take the amount already paid in and then add the discounted present  
value of the future calls on the subscription. Dale does this with a  
discount rate of 5 percent (which I argue is far too low for the  
customers buying the subscriptions) and finds what he regards as two  
anomalies. First, the calculated values of the subscriptions are  
consistently higher than the current price of the fully paid up  
shares of South Sea stock; and second, the various subscriptions,  
especially the third subscription, vary erratically relative to each  
other. The two findings together lead him to conclude that the market  
for South Sea stock was increasingly irrational from June 1720 to the  
end of 1720, by which time the entire scheme had collapsed, the King  
was recalled from Hanover, and Parliament, with the ever-helpful  
Archibald Hutcheson playing a leading role, was investigating the  
entire affair. The affair was wound up, as Dale describes in chapter  
7, with a complete re-organization of the Company, the Directors  
removed and penalized with loss of the bulk of their estates judged  
to be ill-gotten, part of the Company's stock was engrafted onto the  
capital of the Bank of England, and the remaining stock divided into  
half. 
 
It was clear to investors at the time, however, as it would be for  
investors in the London capital market for centuries after, that the  
subscriptions had a greater value than the current full shares for  
two reasons. One reason, elaborated in chapter 4 of Thomas Mortimer's  
handbook was that they enabled speculators in the stock to leverage  
their investments, gaining the rise in the price of the full share on  
a partially paid up subscription for a new share. A second reason,  
certainly understood by the infamous stockjobbers crowding the coffee  
houses of Exchange Alley, was the option value of defaulting on  
future installments in case the stock began to lose value in the  
market. Share warrants, as they were later named formally, always  
priced higher than the regular shares. Finally, if the option value  
varied among the three subscriptions, and they certainly did as the  
value of defaulting on future installments rose sharply with the  
Third Subscription, we should expect differences in the prices of the  
subscription shares to emerge, and more so as the regular stock began  
its precipitous decline in August 1720. 
 
So, what are the lessons to be learned? A previous writer has  
suggested that the entire affair "appears to be a tale less about the  
perpetual folly of mankind and more about the continual difficulties  
of the adjustments of financial markets to an array of innovations."  
After reading Dale's efforts to revivify the tenets of behavioral  
finance to comprehend the significance of the South Sea bubble, I  
confess that statement seemed so reasonable an assessment that I wish  
I had made it. Checking Dale's footnote, I was gratified to find that  
I had (Neal, 1990, p. 90)! 
 
Note: 
1. Later financial historians will wonder, as did most financial  
journalists and academic observers in the late 1990s, why it didn't  
collapse earlier, and in October 1997, 1998, or 1999 rather than  
March 2000. Possible answers might be in the extraordinary steps  
taken by the U.S. monetary authority to expand liquidity after the  
Asian crises in 1997, the Russian bankruptcy in 1998, and the "Y2000"  
fear in late 1999. 
 
References: 
 
Daniel Defoe (1719), _Anatomy of Exchange Alley_, London: E. Smith. 
 
Archibald Hutcheson (1721), _A Collection of Treatises Relating to  
the National Debts & Funds_, London. 
 
Thomas Mortimer (1765), _Everyman His Own Broker_, sixth edition, London. 
 
Larry Neal (1990), _The Rise of Financial Capitalism: International  
Capital Markets in the Age of Reason_, Cambridge: Cambridge  
University Press. 
 
Larry Neal (1994) "'For God's Sake, Remitt Me': The Adventures of  
John Law's Goldsmith-Banker in London, 1712-1729," _Business and  
Economic History_, 23:2, pp. 27-60. 
 
 
Larry Neal is past president of the Economic History Association and  
the Business History Conference and former editor of _Explorations in  
Economic History_. 
 
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