The First Crash: Lessons from the South Sea Bubble (review)

In The First Crash: Lessons from the South Sea Bubble Richard Dale offers an easy-to-read history of the South Sea Bubble of 1720. Though many others have written on the subject, Dale pens this contribution to argue that the South Sea Bubble was driven by irrational investors. Because the South Sea Bubble was the first modern financial bubble, Dale seeks to establish that irrational behavior began forming bubbles three centuries ago.

Dale's first two chapters consider the London stock market and the flow of financial information through coffeehouses, newspapers, brokers, jobbers, and investors. While this background information is not new, Dale infuses it with his argument that the investing populace of 1720 London had a gambling culture.

In the next five chapters Dale tells the tale of the South Sea Company, the bubble, and the similar events occurring in France that came to be called the Mississippi Bubble. Again, Dale mostly provides a readable retelling. However, he does go out of his way in chapter 5 to show that there did exist contemporary analysis showing that the valuation of South Sea stock in 1720 was completely detached from any reasonable estimate of the company's potential worth. In this sense, the South Sea Bubble was irrational.

In his penultimate chapter Dale attacks the more nuanced definition of a rational bubble. In a "greater fool" type story, it is rational to buy into a bubble market if you expect to sell at a gain before the bubble bursts. Peter Temin and Hans-Joachim Voth in "Riding the South Sea Bubble" (American Economic Review 94 [2004]: 1654–68) have recently argued that this was exactly what was going on in 1720. Dale, however, disagrees because he believes that many buyers did not expect the bubble to end. In this sense, investors were irrational in a very strong sense. How could investors not expect the bubble to pop? To quote from Dale's concluding chapter, "The implication is that investors 'trusted' the Company to set the terms of each new issue and to manage subsequent issues, in a way that would guarantee profits to subscribers" (p. 181). In having no sense of risk and no expectation of a potential decline, investors were irrational.

To support this strong irrationality argument, Dale contrasts the prices of South Sea Company stock with the prices of subscription receipts. Subscription receipts were commitments to buy new stock in the future. They existed because the South Sea Company encouraged stock sales by allowing the investors to pay for the stock in installments. Because these installments eventually created a full share of South Sea Company stock, the discounted value of a subscription receipt should equal the current price of stock. Dale, however, finds that the subscription receipts from the last new stock subscriptions were, in fact, much higher in value than stock or earlier subscription receipts.

What was going on? To quote Dale, "It seems that investors were convinced that each new money subscription would yield substantial 'stagging' profits irrespective of the pricing of each issue relative to stock price" (p. 170). By "stagging profits" the author means that investors intended to sell the receipt before additional calls for installment payments came due. In other words, speculative investors greatly favored receipts over stock because receipts limited their exposure to having to actually pay cash. Dale claims that this anomaly is irrational.

A difficulty in arguing irrationality, however, is resisting rational explanations. As soon as Dale introduces the pricing gap between stock and subscriptions, he goes about explaining them: (1) by characterizing subscriptions as options to buy; (2) by arguing that most of the equity value of South Sea stock was already committed as collateral for loans; and (3) by asserting that investors had strong liquidity preferences by mid-1720. These points revive the liquidity hypothesis of Larry Neal (The Rise of Financial Capitalism [New York, 1990]), although that is not Dale's intent...