Minahil Khalid is a student of M.Phil International Relations at Kinnaird College for Women University, Lahore. Her research interests revolve around global political issues and security studies.
Introduction
One of the most infamous financial issues in history is the South Sea Bubble of 1720 which gave an insight into the fragile interplay between the government and corporate sector. Even though this event lasted for a short period, it had a significant impact on the British economy, causing a blow to the financial market and the stakeholders that were involved in the course of this event. The South Sea Bubble was a tale of speculative trade that revolved around the shares of the South Sea Company. The company was granted permission for trade in the South Seas in exchange for undertaking the British war debt.
At first, the company’s stock prices significantly increased, which attracted many investors to contribute their shares in the South Sea Company; however, the bursting of the bubble caused chaos and a severe economic crisis, leaving the financial system ruined. A historical analysis of the case of the South Sea Bubble provides insights into many things. For instance, it provides an understanding of how modern financial systems and markets came into being and how they got caught up in speculative trading practices.
Moreover, it also gives a perspective on the involvement of governmental policies in the corporate sector and financial markets, further highlighting public-private financial dealings and interactions. Looking at this case study from a banking and management perspective provides access to lessons on managing risks and the impact of psychological factors on decisions regarding investments. It gives an in-depth analysis of the stability of the international financial system.
Background of the South Sea Bubble
After the successful ending of Britain’s involvement in the Spanish Succession War in 1713 after the Treaty of Utrecht, the nation emerged as a powerful economy. Britain became a strong imperial power and its strength could be seen from its ability to provide financial support during wars. At this time, the agricultural sector was the backbone of the nation; however, there was an upsurge in the trade and industrial sector which led to a high rate of employment. The drawback was that the income was not fairly distributed. A large portion of the income was given to a small fraction of people. There was an upsurge in the population as well which was supported by the agricultural sector.
In 1711, the South Sea Company was established with the aim of creating a public-private partnership to decrease the cost of the national debt. The proposal of the South Sea Company seemed attractive to the government at first as it aimed at enhancing trade and paying off the government’s debt. Yet, the company soon got involved in speculative trading which caused the notorious bubble. The company had secured the rights to supply slaves to Spanish America and the Portuguese empire. This was all due to the involvement of the government. Allowing the company to assume a large portion of the national debt, and allowing trade with the South Seas laid down the groundwork for this speculative trade to take place.
The South Sea Bubble of 1720
The government’s consent to continue trade in the South Seas was seen as an opportunity for the South Sea Company to enter speculative trading practices. The company’s stock was rising and the projections from the profits of trade were not based on any financial fundamentals. There was an increase in demand for shares because the trade routes’ increase in wealth excited the American investors.
The company soon began to exaggerate the trading opportunities and it was successful in attracting a wide range of investors. It was believed that since the slave trade had proven profitable in the last two centuries, it would continue to do so even after the war. Promises for easy profits were made, which led to speculation and caused the rise in the shares. In 1718, King George took over the governorship of the company and this led to an inflation of the stocks. The stocks began to return 100% interest, which caused the bubble to form.
The company itself wasn’t making any sort of profits and was carrying out trade in the increasing amounts of its stocks. When the parliament allowed the South Sea Company to take over the national debt in 1720, the company made a purchase of 32 million pounds of debt for 7.5 million pounds. The stocks did sell well and thus created a demand for stocks, pushing the price. The stock price reached 1000 pounds which showed the start of the speculative trading system.
In late 1720, the stocks began to fall, losing around eighty percent of their value. This devastated the investors and caused widespread condemnation of the company and anger everywhere on the streets of London. People began to demand answers from the company. The bubble burst, and the unveiled corruption forced the House of Commons to call for an investigation. This ruined the image of the company, and the crisis was declared a parliamentary and financial scandal.
Role of Banking and Financial Management Practices
Banks played a major role in the bubble by extending credit towards the investors and allowing more people to take part in the stock market which could help increase the prices. This was beyond the limits of a bank but was still made possible. The expansion and extension of the credit led to the speculative bubble.
Moreover, the banks also invested directly in the shares of the company and they were guaranteed the success of the company accompanied by high returns. This encouraged the investors to buy more shares and it also showed the trust of the bank in the South Sea Company. The bubble caused the investors to be more aware of this speculative investing and this increased the awareness for risk management while investing as well. Those who faced huge losses due to this bubble burst, asked for re-evaluation strategies for investments so that the risk of similar future losses could be mitigated.
The government also played a crucial role as its policies related to finance, including allowing the company to assume the national debt, exacerbated the bubble. In the aftermath, the government did try to take steps in order to stabilize the economic conditions and focus on the restoration of the financial system. Nevertheless, the South Sea bubble did expose the mismanagement and the flawed system of the banking and financial management sector. This whole bubble served as a precedent for the government to follow while making investment and financial policies. Speculative trading was curbed through the introduction of regulatory practices as well as financial management.
Why Did the Bubble Burst?
There are several factors that must be noted in order to understand why this South Sea bubble burst. This speculative trading factor was one of the obvious ones; however, there are many other factors and reasons behind this. The bubble relied upon the existing investors to keep on investing instead of finding new investors. So when the influx slowed down, this caused the bubble to deflate.
Moreover, the government had started to take action against the speculation which further exacerbated the bursting of the bubble. Another underlying factor was that the investors started to understand that the South Sea Company and its stock price were not the same as its actual value. The trade profits that were promised to the investors failed to be fulfilled by the company and this is where the speculation began. The value of the company was lost in the eyes of the investors.
The consequences of the South Sea bubble helped in the development of the financial markets as well as the regulatory reforms. This set a precedent for future companies to take heed of the lessons learned from this whole speculative frenzy as it had caused thousands of people to lose their money. There were widespread riots in Britain after this whole bubble burst. The government was somehow successful in building proactive measures in order to mitigate the effects of this whole financial crisis.
Lessons Learnt
Several lessons can be learned after delving into the events of this whole financial frenzy. The downfall of the South Sea bubble called upon an urgent need for financial institutions and organizations to introduce regulatory measures for managing any sort of risk in their companies. There was a need for regulatory frameworks to keep regulatory checks on the stability of the financial stock markets.
This whole bubble was a lesson on how unchecked markets and stocks can cause huge disasters and devastating impacts on the people who invested a lot of money in the company to earn benefits. Another element to be seen here was the lack of investors in the company and the dependence on the ones who had already invested so much in the company. This whole scenario can cause significant damage to the economy of a nation.
The South Sea bubble can be compared to the global financial crisis of 2008. In the global financial crisis, the housing market was going through speculative trading in the same way as the South Sea bubble. Both of these crises were caused by zero regulatory frameworks. The South Sea bubble was due to the novel stock allowance, whereas the global financial crisis was due to the securitization schemes.
Conclusion
It can be deduced that the South Sea Bubble not only sheds light on the financial landscape of Britain in the 18th century during colonial expansion, but it also points out the threats looming around speculative trading practices while emphasizing the significance of fair and just financial management practices. The creation of the South Sea Company to assume charge of the nation’s debt along with government support eventually led to one of the most significant financial failures in history.
The bursting of the bubble had profound impacts on the economy of Britain which led to the reconsideration and upgrading of financial policies and practices in order to prevent certain financial collapses from arising in the future. Lastly, the South Sea bubble remains an important history lesson, emphasizing the need for transparency and regulatory measures to be present within the financial systems to stabilize the economy and safeguarding the protectors from speculative trading and investment practices.
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