South Sea QE
An early attempt to buy government bonds by creating money
Nov 11th 2010
DANIEL DEFOE, the author of “Robinson Crusoe”, would have felt at home in these debt-laden times. A string of failed business ventures frequently left him in hock to his creditors. 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.
The author also 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 QE.
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. Europe was then agog at the apparent success of John Law’s schemes in France, where the sale of shares in a project to develop the Mississippi delta had relieved the monarchy of much of its debt. Blunt proposed that government-debt holders exchange their paper for new stock in the company.
Unlike Law’s scheme, 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.
True, this was not a central-bank plan to buy bonds. But it could have been. The British government, which had borrowed heavily to fund a war against France, enjoyed the luxury of two bidders for its debt. The South Sea Company simply offered more than the Bank of England, promising to pay the government £7.5m for the right to assume its debt, and to reduce its interest cost from 5% to 4%.
At first the scheme seemed to work. New issues of South Sea shares, which had a par value of £100, were sold for £300, £400 and finally £1,000. Speculators were allowed to buy shares on margin and could even borrow from the company to do so. Since investors did not have to hand over cash, but ended up with an asset they could use to buy goods, this was, in effect, a case of money creation.
As the shares soared London indulged in a bout of speculative enthusiasm. The nouveaux riches paraded their wealth in the form of luxurious coaches and jewellery. Confidence in the company was high since it was regarded as virtually an arm of the administration: King George I was its governor (yes, he was Governor King).
At the time nobody described the scheme as a monetary stimulus. But the general euphoria that followed the rise in the company’s share price induced what might be called a “wealth effect” among the British. They seized the chance to invest in other companies that ingenious promoters brought to their attention.
Some of the money was attracted by the opportunities in the emerging markets of the day—companies that traded with Africa and Russia, or proposals to establish a “Grand American” fishery or to drain the bogs of Ireland. Investors also liked commodity plays, including a firm that planned to extract silver from lead.
This attempt to boost asset prices by money creation was ultimately doomed. The company’s net worth consisted entirely of the premium obtained from selling shares at more than face value. To keep the price rising the company simply lent more to prospective buyers. In short each successive round of “QE” was needed to support the last. Modern QE schemes will face no such problem since central banks will offload the hundreds of billions of bonds they have bought without affecting the price. Or so it is hoped.
History has characterised the South Sea bubble as obvious folly, even though the scheme was complex enough to deceive Sir Isaac Newton, who lost money when it collapsed. He lamented: “I can calculate the motions of heavenly bodies, but not the madness of people.” It took John Stuart Mill, writing in 1848, more than a century after the episode, to find the method in the madness. Mill declared that debt issuers “may have, and in the case of a government paper always have, a direct interest in lowering the value of the currency, because it is the medium in which their own debts are computed.”
* “The Great Swindle: The Story of the South Sea Bubble”, by Virginia Cowles, Collins, 1960
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