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Wednesday, June 30, 2010

Common Cause, Part IX: The South Sea Bubble

Not long after the Bank of England managed to weather its first storm, it was faced with a far more serious problem. The nation became embroiled in what became known as "the South Sea Bubble." The illusion that a bank can create money out of nothing for the State is a powerful inducement to the private sector to try the same thing. The end result, of course, is similar, as the world has discovered to its great cost during the recent global financial crisis.

Misunderstanding Money, Credit, and Banking

Just as John Law's "Mississippi Scheme" in early 18th century France gave a bad name to money creation for productive purposes, the South Sea Bubble subverted popular understanding of corporate finance and investment. This was a blow that crippled economic development in a way that virtually ensured that only those people with existing accumulations of savings — the already wealthy — would be able to participate in economic growth in any meaningful fashion.

There may have been some excuse for this. Commercial banking was, all things considered, still in its infancy, and was not well understood. As today, of course, the obsession with existing accumulations of savings had (and still has) the potential to ruin otherwise sound financial techniques and force concentration of ownership of the means of production on an economy. This "slavery of past savings" also inevitably requires ever-increasing State control of money and credit in an effort to maintain some kind of equilibrium, even if it is completely artificial and always undertaken for political motives instead of economic. As Conant described the situation,
It is not surprising that the bank was unable to cope with its difficulties and that many impracticable and speculative schemes were set on foot, for the time was essentially a period of transition. The industrial and commercial world had barely set foot upon the threshold of the wonderful development of the eighteenth and nineteenth centuries. Great Britain until the time of Elizabeth had been only a second or, third rate power in Europe, overshadowed by the great Kingdoms of France and Spain, by the ancient prestige of the German Emperor, and by the power of the Pope. Her influence was raised by the defeat of the Spanish Armada, but the population of England and Wales at the Revolution of 1688 was only five and a half millions, and the supremacy in the money markets and trade of the world still belonged to the bankers and merchants of Holland and Italy. The use of bank-notes, except as mere certificates against which coin and bullion was held to the full amount, had begun only thirty years before the Revolution, and the proper management of a banking currency was almost purely a problem of abstract theory rather than of practical experience. If merchant princes and the kings of finance stood upon the threshold of an unknown world, the mass of the community but dimly viewed it from afar. They were easily deluded by extravagant hopes and easily misled by the fairy tales of the splendid riches and possibilities of the Western Continent. (Conant, op. cit., 86-87.)
It does not take too long an examination of the current wild fluctuations in the stock market and the antics of the world's central banks to conclude that the situation has not changed for the better in the past three hundred years.

A Reasonable Proposal

It started innocently enough, or at least with no discernible evil intent. In 1711 the earl of Oxford came up with a plan to retire the national debt, at the time amounting to almost £10 million in 6% government bonds. A company of merchants was organized and assumed the debt. At first nameless, this association became the "South Sea Company." So that the State could meet the interest payments, duties on a large number of imported products, at first supposed to be temporary, were made permanent. To provide for payment of principal, an act of parliament gave the merchants a monopoly on trade with the Spanish colonies in South America.

This was a trifle optimistic. Spain had no intention of allowing England, with its growing manufacturing power, to cut the Spanish government out of its primary source of income. Spain may not have invested its vast influx of wealth from the mines of the New World wisely, but that didn't mean that the Spanish were stupid. The only trading concession that Spain made was to grant permission to English merchants to import African slaves for thirty years, and to send a single ship once a year to trade with New Spain (Mexico), Chile, or (not and) Peru. Further, the vessel was to be strictly regulated as to tonnage and value of the cargo.

Nevertheless, the earl of Oxford declared that Spain had granted permission for two additional ships the first year, and gave the impression that this was just the beginning of massive expansion in trade. Spain, of course, had no such intention. The best interpretation that can be put on Oxford's statement is that he believed he could persuade the Spanish to expand the scope of the agreement, and was just being a little premature in his announcement.

Or, possibly, more than a little premature. The first voyage — of a single ship — was made in 1717. The year after, war broke out with Spain, and the agreement was canceled.

Redefining Interest and Investment

We can only understand the earl of Oxford's optimism by examining the predominant economic philosophy of the day: mercantilism. For more than a century the idea had grown that true wealth did not consist of marketable goods and services and the means of producing them, but of accumulations of the medium of exchange, notably gold and silver. This was the logical outcome of the great usury debate of the late 16th and early 17th centuries.

The classic — and correct — understanding of usury is taking a profit from something that, in and of itself, does not generate a profit. This comes from Aristotle, who examined the nature of money and credit in the Politics (I.x). Perhaps oversimplified, usury is not simply high interest, or all interest, but any interest above and beyond what is due to an owner of savings as a just share of profits from a productive project.

"Interest" comes from ownership interest. Someone who supplies a store of accumulated savings to finance a project that results in the production of marketable goods and services is due a share of the profits that result. The amount is based on some reasonable calculation as to the value of having contributed the financing. There are many ways to determine what constitutes a fair share. It would be a needless digression to go into the ins and outs of the matter in this discussion. The bottom line is that not to give a just share of profits to those who supply the savings required for capital investment (whether the savings are past or future) is a violation of the rights of private property.

Judaism, Christianity, and Islam maintained this Aristotelian understanding of usury until the 16th century. By and large, Judaism and Islam retain the classic understanding, but, just as Christianity fragmented on theological issues with the Reformation, it divided on the issue of usury. The Catholic Church retained the ancient understanding, although enforcing it with indifferent success as the social and political influence of organized religion waned. The Protestant churches (this is a generalization) abandoned the classic understanding, and redefined usury to mean high interest.

The redefinition of usury meant that it was now considered legitimate to charge for the use of money as money — whether or not the money was used for anything that generated a profit, and as long as the charge wasn't too high. With money as money now considered valuable in and of itself, even as a commodity, there now occurred a sea change in national policy in every country that adopted this new — and very profitable — understanding of money and credit.

The goal of national monetary and fiscal policy was not to see that the country had sufficient supplies of the medium of exchange to facilitate trade and finance economic growth and new capital formation. Instead, accumulations of gold and silver were seen as valuable in and of themselves. In order to accumulate as much of this sterile wealth as possible, a country had to export as much as possible in the form of marketable goods and services, and import as much gold and silver as it could. National wealth was not measured in terms of how well the country was able to provide for its citizens by giving them the opportunity to provide adequately for their domestic needs. Instead, wealth became measured in terms of how much gold and silver could be accumulated. This has been replaced in our day by all forms of the media of exchange, preferably claims issued by other countries with a more or less sound credit rating.

Within this paradigm, production of marketable goods and services became secondary to the manipulation of the media of exchange. Just as "interest" became redefined in order to permit owners of existing accumulations of savings to take a profit without sharing in a profitable enterprise, "investment" became redefined as speculating and gambling in equity and debt without producing any marketable good or service.

The Frenzy Begins

When George I opened parliament in 1717 he expressed concern over the state of the national credit. He recommended that steps be taken to reduce the national debt. Good Queen Anne had died three years previously, leaving the country heavily in debt. The South Sea Company and the Bank of England almost immediately put forward proposals intended to deal with the situation — in ways, naturally enough, calculated to be to the financial advantage of the respective projectors. Even a brief account of the bargaining makes for fascinating reading:
The South Sea Company was essentially a Tory institution and they proposed as early as 1717 to increase their capital from £10,000,000 to £12,000,000 for the purpose of wiping out the debt due the Bank of England and several minor obligations. The bank made counter propositions, but the real contest occurred in 1719 and 1720 over the proposition of the South Sea directors to assume the entire national debt. It was estimated at £30,981,712 and was to be consolidated into one fund, to be added to the capital of the company at five per cent. interest annually. The company proposed to pay a bonus of £3,500,000 to the government in four installments, beginning in 1721. The bank met this remarkable proposition by an offer of its own to assume the entire debt on terms which were calculated to be about £2,000,000 more advantageous than those of their rivals. The South Sea Company obtained three days to amend their offer and increased the bonus to £7,567,500. The bank rejoined with another offer of £1,700 in bank stock for every annuity of £100 for ninety-six and ninety-nine years and the reduction of the interest on the consolidated debt after June 24, 1727, to four per cent. (Conant, op. cit., 90.)
After lengthy debate, parliament passed the South Sea Act, the Bank Act, and the General Fund Act. Robert Walpole was almost the only member of the House to speak against the measures. Although he put the force of his considerable eloquence behind his efforts, they were in vain. Presciently, the "fat old Squire of Norfolk" declared that speculation in stocks would divert the country from genuinely productive activity, to gambling in the hope of getting something for nothing. The directors of the Company would become the real rulers, exercising absolute power over the country without any accountability.

Despite the fact that virtually everything that Walpole predicted came to pass and has persisted, in one form or another, down to the present day, he was ignored. As described by Charles Mackay, author of Extraordinary Popular Delusions and the Madness of Crowds,
The proposals of the South Sea Company were accepted, and that body held itself ready to advance the sum of two millions towards discharging the principal and interest of the debt due by the state for the four lottery funds of the ninth and tenth years of Queen Anne. By the second act, the Bank received a lower rate of interest for the sum of 1,775,027 pounds 15 shillings due to it by the state, and agreed to deliver up to be cancelled as many Exchequer bills as amounted to two millions sterling, and to accept of an annuity of one hundred thousand pounds, being after the rate of five per cent, the whole redeemable at one year's notice. They were further required to be ready to advance, in case of need, a sum not exceeding 2,500,000 pounds upon the same terms of five per cent interest, redeemable by Parliament. The General Fund Act recited the various deficiencies, which were to be made good by the aids derived from the foregoing sources. (Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds. New York: Farrar, Straus and Giroux, 1932, 48.)
The South Sea Company had been transformed from a trading company into a financial institution — and, apparently, a very profitable one. Like today's bailed out gigantic financial consortia, the South Sea Company didn't actually have to produce anything. It just had to make a profit out of speculation, manipulation of the national debt, and mismanagement of the currency.

The bill took two months to work its way through parliament. As predicted, the directors of the Company took every opportunity to puff up the value of the shares. In January of 1720, the value per share was £128. After some fluctuations, the value per share stood at £330 when the House of Commons passed the bill. The bill was then rushed through the House of Lords at high speed. Several peers spoke against it, but to no avail. The bill had its first reading on April 4, 1720. On the fifth it had its second reading, on the sixth it was committed, and on the seventh it was read a third time and passed. George I signed the bill the same day, and it became law.

The country went into a speculative frenzy. "Exchange Alley" was wall-to-wall people every day, while the financial district as a whole was virtually impassable due to the carriages filling the streets. Nor was the insanity any respecter of rank. Rich and poor, low and high, all were caught up in the desire to speculate in shares of the South Sea Company and make enormous gains with no labor and without producing anything in the way of marketable goods and services. Many of the deals involved what would later be termed "derivatives." Politicians, for example, were bribed by "purchasing" shares on credit, with payment due only after the shares were sold.

The Frenzy Spreads

The gambling fever was not restricted to shares in the South Sea Company. Multitudes of new corporations sprang up seemingly from out of nowhere. As Mackay related,
There were nearly a hundred different projects, each more extravagant and deceptive than the other. To use the words of the "Political State," they were "set on foot and promoted by crafty knaves, then pursued by multitudes of covetous fools, and at last appeared to be, in effect, what their vulgar appellation denoted them to be — bubbles and mere cheats." It was computed that near one million and a half sterling was won and lost by these unwarrantable practices, to the impoverishment of many a fool, and the enriching of many a rogue.

Some of these schemes were plausible enough, and, had they been undertaken at a time when the public mind was unexcited, might have been pursued with advantage to all concerned. But they were established merely with the view of raising the shares in the market. The projectors took the first opportunity of a rise to sell out, and next morning the scheme was at an end. (Mackay, op. cit., 54-55)
As for the South Sea Company itself, the shares rose to £890 by June 3, 1720. Many people then decided it was time to sell, and the shares fell to £640. The Directors and the government began to panic, and immediate steps were taken to bolster the value per share. By the beginning of August the shares had recovered and even gained to the extent of £1,000. This triggered a massive sell off.

A number of shareholders and would-be investors complained that they were being discriminated against in the allocation of shares. The value per share began to drop. By September, it had fallen to £700. The Directors called a special shareholders' meeting, but it had the opposite effect of what was intended. By the middle of September the shares had fallen to £400. Messages were sent to the king in Germany (George I was also the Elector of Hanover) and to Walpole at his country estate to come to London immediately. The hope was that Walpole and the king would persuade the Directors of the Bank of England to float a new bond issue of the South Sea Company in order to keep up the price — an early version of a toxic asset purchase.

Being somewhat wiser than today's Federal Reserve authorities and still preserving some measure of independence (besides wanting to eliminate a rival), the Bank was reluctant to get involved any further than it already was. The Bank finally agreed to circulate the bonds, but refused to commit itself to purchase any set amount. The bonds would be offered for sale to the public, but the Bank itself would not guarantee to purchase any.

At first it seemed as if the ploy might succeed. On the morning that the subscription list opened, throngs of people descended and put their names down. The flood soon abated, however. A run began on the Bank, the goldsmiths, and other financial institutions that had gone heavily into the shares of the South Sea Company. The Bank of England was only able to stave off the worst of the run by hiring people to withdraw low denomination coins and be seen redepositing the money.

The Bank was closed on September 29, a traditional "Bank Holiday," and the panic subsided somewhat. The shares of the South Sea Company continued to drop, however, and soon reached £135. The Bank of England refused to continue trying to float the Company's bonds. The agreement, after all, was still only in draft form, with a number of important particulars left blank — including any penalties for non-performance. As Mackay related the end of the affair,
"And thus," to use the words of the Parliamentary History, "were seen, in the space of eight months, the rise, progress, and fall of that mighty fabric, which, being wound up by mysterious springs to a wonderful height, had fixed the eyes and expectations of all Europe, but whose foundation, being fraud, illusion, credulity, and infatuation, fell to the ground as soon as the artful management of its directors was discovered."

In the hey-day of its blood, during the progress of this dangerous delusion, the manners of the nation became sensibly corrupted. The Parliamentary inquiry, set on foot to discover the delinquents, disclosed scenes of infamy, disgraceful alike to the morals of the offenders and the intellects of the people among whom they had arisen. It is a deeply interesting study to investigate all the evils that were the result. Nations, like individuals, cannot become desperate gamblers with impunity. Punishment is sure to overtake them sooner or later. (Mackay, op. cit., 70.)
The Growth of Banking

Torn between its contradictory character as a commercial bank issuing asset-backed promissory notes to facilitate trade, and the creator of debt-backed promissory notes to finance State expenditures, the Bank of England weathered a number of other storms throughout the 18th century. Banking theory continued to develop, however, as the mercantile classes learned to use the new financial instruments to advantage. They had to proceed cautiously, however, for the failure of the Mississippi Scheme in France and the South Sea Bubble caused the public to look on money, credit, and banking as something mysterious and beyond the ken of mere mortals.

In 1759, however, Adam Smith published The Theory of Moral Sentiments, a production setting out what Smith believed were the principles of human interaction. In 1776 Smith published The Wealth of Nations, which was an application of the principles he had worked out in The Theory of Moral Sentiments to the field of political economy. The Wealth of Nations contains two very important sections for the understanding of money, credit and banking. Volume II dissects mercantilism, disabusing people of the notion that accumulating gold and silver or other media of exchange means that real wealth of the country is increasing.

In Volume I, however, is the explanation of "the Nature, accumulation, and Employment of Stock," that is, approximately a hundred-page treatise on the formation of capital. While not perfect, Smith presented the essence of the real bills doctrine and what would become known as Say's Law of Markets, both of which we have previously discussed.

The fact that Adam Smith worked out the basic principles is of great importance for, while he made a few errors (corrected by later authorities such as Henry Thornton, Harold Moulton, and Louis Kelso), Smith's enormous prestige is critical today in the effort to restore some sanity to the theory and practice of money, credit, and banking. People these days have, by and large, forgotten how to think for themselves. Consequently, the imprimatur of someone like Adam Smith is essential to convince people of the validity of binary economics and the soundness of widespread ownership through a program such as Capital Homesteading.