In 1720, Europe experienced its first truly international financial crash. In Paris and London, two schemes promised to solve their governments' huge debts by turning them into shares of glamorous trading companies. For a few months, it seemed to work. Then it all collapsed. In Part 2 of Great Financial Crises, we look at the Mississippi and South Sea bubbles.
The problem: crushing war debts
By the early 1700s, both France and Britain had fought long, expensive wars and carried large debts. Interest payments ate up much of their tax revenue. Governments were looking for creative ways to lower the burden. Two very different men offered answers.
France: John Law's system
A bank and paper money
John Law was a Scottish economist and gambler with bold ideas about money and credit. After the death of Louis XIV in 1715, he persuaded the French regent to let him found a bank. The Banque Générale was approved in May 1716 and issued paper banknotes. In December 1718 it was nationalised and became the Banque Royale.
The Mississippi Company
In 1717 Law set up the Compagnie d'Occident, with exclusive rights to develop French territory in the Mississippi River valley in North America. It merged with other trading companies to form the Compagnie des Indes, which by 1719 held a monopoly on much of France's overseas trade. Law also took over tax collection and the minting of coins.
Law's plan was to retire the state's debt by allowing holders of government securities to exchange them for company shares. Demand soared, helped by abundant new paper money from Law's bank.
The boom
Speculators crowded into the narrow rue Quincampoix in Paris to trade shares. According to Encyclopaedia Britannica, the price of a share rose from 500 to 18,000 livres, far beyond what the company could ever earn. The word "millionaire" is often said to have become popular in this period as fortunes were made overnight.
From early 1719, banknotes were increasingly issued without precious metal backing, and the amount of paper money in circulation grew sharply.
The bust
In 1720, confidence cracked. Investors tried to turn shares and notes into gold and silver. Law took measures to support prices and limit the use of coins, but they failed. The value of paper money was cut, triggering a run, and share prices collapsed. Law fled France in December 1720. The state took over the company's debts and raised taxes to pay them, and French suspicion of paper money and banking lasted for generations.
Britain: the South Sea Company
A trading company built on debt
The South Sea Company was formed in 1711. In exchange for taking on about £11 million of government debt, it received a monopoly on British trade with Spain's colonies in South America, including the slave trade under the asiento granted by the Treaty of Utrecht. Actual trade was limited, but the company's real business was government finance.
The 1720 scheme
In 1720 the company proposed to take over most of the national debt by converting it into company shares. The more its share price rose, the fewer shares it needed to give each debt holder, leaving the rest to sell at a profit. This gave insiders a powerful reason to push the price up, through generous loans to buy shares, payment in instalments and favours to politicians.
The price path
According to research summarised by the University of Oxford:
- Shares rose to about £600 by the end of May 1720.
- They reached about £950 by the end of June, peaking at around £1,050.
- By late summer the price had fallen to around £190.
- By December 1720 it was about £124.
The boom also produced a wave of other share offerings, some for absurd ventures. Parliament passed the Bubble Act in 1720, restricting new joint-stock companies, partly to protect the South Sea Company from competition for investors' money.
Isaac Newton's losses
Isaac Newton, then Master of the Royal Mint, held South Sea stock. He is said to have sold early at a profit, then bought back in near the top and lost heavily. A loss of about £20,000 is often quoted, though historians at Oxford note the evidence is not conclusive. He is often credited with the line that he could calculate the motions of the heavenly bodies, but not the madness of the people, although this quote is also uncertain.
The aftermath
A parliamentary inquiry found evidence of bribery and insider dealing. Chancellor of the Exchequer John Aislabie was expelled from Parliament and sent to the Tower of London, and several directors were punished. Robert Walpole, who became First Lord of the Treasury, worked to restore confidence and limit the damage to the government and City of London. The South Sea Company itself survived, in reduced form, until 1853.
Two bubbles compared
- Common idea: both converted government debt into shares of companies with grand but uncertain trading prospects.
- Money creation: France's bubble was fuelled heavily by new paper money; Britain's by credit and instalment buying.
- Political links: both involved close ties between company insiders and government.
- Long-term effects: France turned away from paper money and central banking for decades; Britain's financial system recovered more quickly.
Lessons for investors today
- Look at the real business. Neither company generated profits remotely close to its valuation.
- Beware of easy money. Abundant credit and newly created money can inflate asset prices far beyond fundamentals.
- Watch incentives. When insiders benefit from a rising share price, they may push it higher regardless of value.
- Even geniuses get caught. Newton's story shows that intelligence does not protect against crowd psychology.
In Part 3, we jump to New York in 1907, when a failed attempt to corner a copper stock triggered a panic that led to the creation of the Federal Reserve.
Sources
- University of Oxford – Newton and the South Sea Bubble
- Encyclopaedia Britannica – Mississippi Bubble
- Wikipedia – Banque Royale
Great Financial Crises: the full series
- Part 1: Tulip Mania (1637)
- Part 2: The Mississippi and South Sea Bubbles (1720) (you are here)
- Part 3: The Panic of 1907
- Part 4: The Wall Street Crash and Great Depression
- Part 5: Weimar Hyperinflation (1923)
- Part 6: The 1970s Oil Shocks and Stagflation
- Part 7: The Latin American Debt Crisis (1982)
- Part 8: Black Monday (1987)
- Part 9: Japan's Bubble and Lost Decades
- Part 10: The Savings and Loan Crisis
- Part 11: The Mexican Peso Crisis (1994)
- Part 12: The Asian Financial Crisis (1997)
- Part 13: Russia's Default and LTCM (1998)
- Part 14: The Dot-Com Bubble (2000)
- Part 15: Argentina's Collapse (2001)
- Part 16: The Global Financial Crisis (2008)
- Part 17: Iceland's Banking Collapse (2008)
- Part 18: The Eurozone Debt Crisis
- Part 19: The Covid Crash (2020)
- Part 20: The 2023 Banking Turmoil
This series is for education only and is not investment advice. Figures are taken from the sources listed and other commonly cited historical records, and may vary slightly between sources.
