Financial bubbles are a perennially fascinating phenomenon. Some modern economists, notably of the Chicago variety, deny their very existence, arguing that investors are rational and markets are efficient in the sense that prices accurately reflect all known, relevant information. Others offer refined versions of the irrationality thesis advanced by Charles Mackay in 1841 in his celebrated book Extraordinary Popular Delusions and the Madness of Crowds.
Either way, bubbles provide exciting material for historians, not least because they are so often accompanied by financial skulduggery, along with economically debilitating banking crises. The great financial debacle of 2007-08 was just the latest case in point.
It is 300 years since the Mississippi and South Sea bubbles, the first of the genre. In Money for Nothing, Thomas Levenson covers both, though his chief focus is on the notorious South Sea boom-and-bust in which the directors of the company bribed much of the British establishment and inflicted losses on such brilliant intellectuals as Isaac Newton. Ostensibly, the company was set up to conduct trade with Spain’s South American colonies at the end of the War of the Spanish Succession. But at the heart of the bubble was a piece of financial engineering designed to reduce the huge debt incurred by Britain during the war.
The South Sea Company proposed to parliament that holders of the government’s IOUs should pass them to the company in exchange for shares. To win parliamentary approval it accepted a cut in the coupon on the debt, so helping reduce the government’s borrowing costs. The former debt holders received dividends instead of interest, while the directors hoped to buttress the payout with profits from slave trading. The result was that British government debt became tradeable for the first time, ensuring a long-lasting competitive advantage in war finance over France.
What differentiates Levenson’s account from the many earlier ones is his background as a science writer and academic at MIT. His broad thesis is that by the turn of the 18th century the power of mathematics and habits of observation associated with the scientific revolution created new ways to think about the future. In effect, the likes of Newton and Edmond Halley, the astronomer, developed a formal framework for thinking about money, risk and uncertainty, which came to full fruition in the financial engineering that characterised the bubble year of 1720.
From this novel perspective Levenson provides a vivid account of the development of share trading in the coffee shops of Exchange Alley in the City, with fascinating asides such as Newton’s extraordinarily modern management techniques when running the Royal Mint. As for the notion that the bubble might have been rational, he rightly says that it contradicts how people who lived through it described their experience.
On the nature of the scam itself he leans heavily on the narrative of Adam Anderson, a South Sea Company clerk, who said that directors could have lined their pockets from the proceeds of sales of “surplus” stock — shares in excess of what was needed to clear the public debt — so they stood to profit from creating the bubble. Levenson does not explore recent scholarship claiming that this makes no sense because the purchasers of “surplus” stock would have expected to receive the same dividend rate as the other shareholders. The book is nonetheless a compelling read.
William Quinn and John D Turner also reject the rational and irrational categorisation of investors, arguing that it does not do justice to the complexity of the bubble phenomenon. Bubble prices, they write in Boom and Bust, are set by a wide range of investors with different information, different world views and investment philosophies and different personalities. The authors, academics at Queen’s University Belfast, provide a taxonomy of bubbles, along with an analytical framework that describes their causes while explaining what determines their consequences and how they can be predicted.
They describe most of the well-known bubbles in history, with notable exceptions such as the Dutch tulip mania of 1636-37. The popular narrative on this, they argue, is largely fictional: Charles Mackay’s account is unreliable and based on second-hand evidence. And the mania was financially and economically trivial. Among the less well-known bubbles covered are the first emerging market bubble of 1824-26, the British bicycle mania of the 1890s and the Chinese bubbles in 2007 and 2015.
The book’s analytical framework is based on a triangle that describes the necessary conditions for a bubble, the three sides being marketability of the assets, expansionary money and credit, and intense speculation. These become sufficient conditions where there is a technological or political spark.
The accounts of the various bubbles are judicious, backed by painstaking primary-source research into the lesser bubbles. And the authors note that the most damaging ones are those where the inflated asset class is deeply integrated with the rest of the economy and the banking system. Also that policy-induced bubbles tend to be more economically and socially damaging than technology-based ones, which often foster innovation in a variety of ways.
For anyone interested in financial history, Boom and Bust is essential
reading. It helps explain why the aberrant behaviour that characterised the South Sea Bubble can still occur in the 21st century.
Money for Nothing: The South Sea Bubble and the Invention of Modern Capitalism, by Thomas Levenson, Head of Zeus, RRP£20, 480 pages
Boom and Bust: A Global History of Financial Bubbles, by William Quinn and John D Turner, Cambridge University Press, RRP£18.99, 296 pages
John Plender is an FT columnist
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