Sunday, 9 November 2008

That Sinking Feeling

Around the Club, there has been little talk of The Crunch. Because of the Club ethos, no-one will admit to personal loss from market speculation. But last week, HM the Queen, until the previous week the wealthiest woman in Europe, set tongues a-wagging by asking, How could this happen? She herself had lost around £25 million - money she was going to use to fix up the Palace bedrooms one day. Why did no-one say anything, asked the dear lady - warn the others of the fact the Crunch had been predicted? The answer she was given is that each was relying on the others to provide such warnings. It’s part of a system of delegated and distributed responsibility that was set up in the wake of the South Sea Bubble scandal, when government set up the so-called Sinking Fund to ensure future stability and manage the national debt.
... It was indeed for that very reason, the management of national debt, that the government of the day were drawn into the Bubble. The South Sea Company was really a bank masquerading as a stock company, set up in 1711 by Harley, the Earl of Oxford, who was the Lord Treasurer and prime minister in the new Tory government, to underwrite a national debt which had grown to £30 million since the Act of Union, when Scotland’s debts had been added. An Act of Parliament awarded the South Sea Company a trade monopoly with South America, in exchange for a £7 million loan.

The official prospect presented to investors, of lucrative trading rights to Spanish slave colonies in South America (over which in reality England had no control), was a shell game talked up by insiders to lure the greedy. It was so successful that even servants began investing, borrowing money to finance the share purchase, and as the share price rose, acquiring luxury goods such as fine carriages and livery. Others sunk their entire family fortunes into the scheme. Nearly a hundred other “joint stock” companies started up, some with even less realistic aims – to buy up the Irish Bogs, manufacture square cannon balls, and so on. Speculators included the Royal family, and King George I outlawed brokers selling shares in rival offerings.
Inevitably, what goes up on the market must come down, but even the discoverer of the Law Of Gravity, Sir Isaac Newton, didn’t see that coming, and reportedly lost £20,000. He later explained 'that he could not calculate the madness of people'. “The Madness of Crowds” would become a popular phrase to explain such collective delusions. MP Robert Walpole decried "the dangerous practice of stockjobbing’ which would decoy the unwary to their ruin, ‘for a prospect of imaginary wealth.’

The dangers of jobbing stock salesman manipulating the market had already been demonstrated across the Channel the previous century, when Holland had been caught up in buying and selling shares in tulip growing enterprises. The facts that it took 7 years to grow a prize tulip from seed, and that supply soon outstripped demand, did not halt the tulip bulb futures trading mania until the price of a tulip had reached 5,000 guilders. But the Dutch economy survived the bursting of the Tulip Bulb bubble because the Amsterdam Stock Exchange had declined to trade in tulip futures. Walpole also warned the Company directors would become masters of the government, controlling the legislative process.
His warning was in vain, for over 460 MPs and 112 Peers invested. The main private backer, Blunt, Chairman of the Sword Blade Company (which had diversified into official managing forfeited estates), also publicly spoke out against greed and corruption. But behind the scenes he set up a £1 million fund to convert government debt into company stock and drive up share prices, plus a slush fund of £500,000 to bribe government officials. (He was elevated to the Lords within the month.)
European and American interests were also involved, with a Scotsman pulling the strings. Scotland had been forced to subjugate itself to England under the Act Of Union 1707 due to its facing bankruptcy over the Darien Scheme. Promoted by the Scots co-founder of the Bank Of England, the scheme had been backed by the new Bank Of Scotland, which invested a fifth of the nation’s fortune. It was meant to open up trade with China and Japan by setting up a colony on the isthmus of Panama, where a canal would be dug.

The idea was ships from China and Japan would arrive on the Pacific side to trade, offering finest Cathay silks, etc. in exchange for Scots staples. In the event, there were no ships from Cathay and the colonists couldn’t even interest the local Indians in their baubles and bibles. Though guided by a former castaway (a surgeon on one of Dampier’s vessels who had been marooned for 4 years among the local Indians on the isthmus), the colonists were largely young aristocrats with unrealistic expectations. All their ships but one sank, and over 2,000 colonists perished on land. Scotland had to petition England to pay off its national debt to stabilise their paper currency.
The Isthmus of Panama at the time of the Darien SchemeA Scots economist, the so-called “father of finance,” John Law, set up a similar French operation, the Mississippi Scheme. Law was a Scots banker who helped broker the 1707 Act Of Union bail-out, but had fled to France after escaping prison following a duel over a woman. He was the exponent of two economic theories, 'The Scarcity Theory Of Value', and the 'Real Bills Doctrine'. He is credited with the notion each country should have a national bank which could issue its own paper money.
He proposed what he termed a Land bank (which wits of the time called a Sand Bank, suggesting it would sink the ship of state), whereby currency was issued according to crown land-holdings, rather than gold and silver hoards. This appealed to a nearly-bankrupt France, which had exhausted most of its coinage in a series of wars, and Law was appointed Controller-General of Finance by the French regent. Law and his brother set up Law & Co, a bank in all but name, which was awarded exclusive trading rights to the French colonies in the Indies.
To expand this empire, Law set up the Mississippi Scheme to exploit a trading monopoly with the French interests in the Mississippi basin lands. Inspired by the tales of Conquistador gold, the Mississippi stock offer was at first a runaway success. Law and associates talked up the colonies’s potential wealth, leading to massive speculation. Shares rose to over 10,000 livres apiece, and became almost a negotiable currency in themselves. To maintain public confidence, an army of over five thousand beggars was conscripted, equipped with miners’ picks and shovels and marched through the Paris streets towards the ports, supposedly bound for the gold mines of Louisiana – though it was observed most just sold their gear in taverns and returned to begging.
In 1720 Law’s scheme, like all pyramid schemes, became over-inflated. The company was re-organised as the Banque Royale, a mechanism to ease the French exchequer by issuing its own currency. But the Regent could not grasp why he should not keep on issuing paper notes far beyond any tangible assets. To prevent a run on the bank, he had to pass laws to stop people trying to cash in their paper notes for coins. It became illegal to own more than a modest amount of coin, jewellery, precious stones, or even plate, and bounties were paid for servants to turn in their masters for hoarding. Anyone suspected had their homes raided and their assets seized, even for being seen with a single louis d'or coin. Everyday trade collapsed as there was no coin for small purchases. Those with assets remaining who tried to flee were arrested at the border, stripped of any coin or plate, and imprisoned as speculators. Anyone who did escape abroad was sentenced to death in absentia.
Law’s carriage was stoned by the mob, and he fled to England while his brother was put in the Bastille for malversation. (Law would end his life in exile in Venice, where he squandered his personal fortune on his lifelong addiction, gambling, dying impoverished.) The Regent’s attempt to blame Law for his own recklessness did not solve the matter, and many others were charged by a commission of enquiry with malversation. The inflated paper currency was publicly burned, and the Paris treasury issued a new paper currency of modest denomination which was redeemable against gold, silver, or copper coin, leading to a crush in which 15 people died trapped in the bank doors.
The initial success of Law’s scheme had helped inspire England’s Bubble, but the French collapse did not prompt English official action at home. In mid-1720, South Sea Company stocks began to slide from their peak price of £1000 a share. The Sword Blade Company, who acted as chief cashiers of the Company, stopped paying out, and it became known that Sir John Blunt and others had sold out. Other bankers also closed up shop. The ruin of thousands of people followed, beginning with the working class speculators who had bought on credit. Middle-class investors were next, their life savings gone in a week.

Finally even the wealthy suffered, from bankers to bishops. Angry crowds gathered at Westminster, till the Riot Act was proclaimed. The King, George I, lost over £50,000, and his German mistresses, a Countess and a Duchess who had promoted the scheme, were booed in public. There were suicides almost daily as financial ruin spread throughout the country. The Bank of England was called upon to help by subscribing to company bonds, but declined. The South Sea Bubble had burst.
Company directors were spat at in the street and threatened. The treasurer fled in disguise to Calais, and an extradition warrant was issued for his person, but he escaped Belgian custody. A parliamentary ‘Committee of Secrecy’ was formed to investigate, and informed the House they had “discovered a train of the deepest villany and fraud that Hell had ever contrived to ruin a nation.” The Commons ordered the doors locked, and 5 MPs were placed in the custody of Black Rod, including Sir John Blunt. Blunt testified that he couldn’t remember details.

An Act was passed to prevent directors fleeing or sending assets abroad, and to seize the papers of what Tatler co-founder Sir Richard Steele called these "cyphering cits", whose arrogance led to their downfall. The Committee of Secrecy reported the company books, where they were not entirely missing, had pages torn out, contained many fictitious entries, blanks and erasures.
All the directors were arrested and their estates seized to finance a compensatory fund. Blunt alone had £178,000 seized. The Chancellor of the Exchequer was impeached for corruption and put in the Tower for a time. The Secretary of State died after bursting a blood vessel in the Lords defending himself against corruption charges. The Postmaster General died suddenly, poison being suspected. The official Parliamentary History concluded that the Company had amazed 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."
Walpole, the new Chancellor, divided assignment of the debt between the Bank of England, the Treasury, and the South Sea Company (now effectively nationalised), along with something aptly known as the Sinking Fund. This was a reserve of savings out of the annual Budget to stabilize the currency. Legislation then had to be passed (by Pitt) to stop successive Ministers raiding the fund, and it was decades before The South Sea Company and the Sinking Fund could be safely abandoned, for other economic crises continued to appear, as part of the natural boom-and-bust cycle of capital investment.
... Today of course, things are quite different. Money can be moved electronically, added or subtracted in an instant, with no need for coins or even paper. Plastic is the new gold standard. Collateral such as real estate can be re-mortgaged, the debts repackaged, sold and re-sold abroad. To maintain confidence in the stock market, the Chancellor will quickly intervene to save any bank that gets itself into a mess through mismanagement, no matter how huge the public cost and scandal. The Prevention Of Terrorism Act can be used to seize foreign assets, where there is a perceived danger to British interests.

As to the lessons of the past, many would conclude there is nothing to be learned – or rather, nothing that will be learned.

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