Tuesday, November 16, 2010

THE SOUTH SEA BUBBLE

One of the largest stock scams of all time, The U.K.-based South Sea Company's shares saw a huge appreciation based on rumor, speculation and false claims before plummeting and eventually becoming worthless. Thousands of people lost their life savings.




Daniel Defoe, the author of “Robinson Crusoe”, played a role in the evolution of “Quantitative Easing” (QE), or using newly created money to buy debt. He has been credited with dreaming up the South Sea Company, the subject of an early experiment in Quantitative Easing.


It was the era of big poofy wigs . . .


Defoe was in hock up to his eyeballs due to a string of failed business ventures. As a result he was known as the “Sunday gentleman” because he ventured out into polite society only on the Sabbath, when custom forbade the arrest of debtors.

Defoe was an enthusiast for Latin America and persuaded the British government to set up a company to trade with the region in 1711. Early business opportunities were almost non-existent thanks to Spanish opposition. But an enterprising director of the company called John Blunt saw another way to make money. Blunt proposed that government-debt holders exchange their paper for new stock in the company.




The company did not print the money to buy government bonds but a degree of financial jiggery-pokery was still involved. The South Sea Company had no real business so its shares had no value, save for the cash raised by their issue. The scheme could “work” only if investors could be persuaded to drive the stock above its par value—to create wealth out of thin air.


The South Sea Bubble, explained:

The scam occurred in 1720, when South Sea's stock soared in the wake of speculation and greed surrounding the monopoly the South Sea Company was perceived to have in the shipping and trade industries, particularly in Mexico and parts of South America.



With nothing to prevent it from doing otherwise, South Sea Company's management continued to issue shares in response to seemingly insatiable demand. As a result, the stock's price soared, defying all fundamental sense. Eventually, the truth was exposed: the company was making virtually no profit, and the share price plummeted when investors fled.


That's how Quantitative Easing came out in the wash . . . it didn't work in 1720 - and it won't work now.


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